Category: India

On Financial Markets: The Problematic Assumptions

More than half of the dissertations and theses in India are on financial markets. Various aspects such as pricing of options, efficiency of markets, volatility of markets, its impact on the real sector, futures markets, effect of foreign trade, etc are analysed. Financial markets refer to the stock market, the derivatives market, the commodity markets, etc. For our purposes, we will take into account only the stock/share market as it is the one that is most well-understood in comparison to the rest. This blog post echoes a lot of my concerns with the way financial markets are analysed, and also indicates some of the broader concerns about econometric work in general. I have been greatly motivated and moved by Benoit Mandelbrot’s and Richard Hudson’s book The (Mis)Behaviour of Markets in writing this post. All quotations in this post are from their book.

On attending several pre-submission, post-submission, work-in-progress and viva-voce seminars, I have often wondered about economists fascination with the ‘normality assumption’. We assume that price changes follow a normal distribution, that is, outliers (both small and large) do not significantly affect the average/expected value. That is, standard theories of finance ‘assume the easier, mild form of randomness. Overwhelming evidence shows markets are far wilder, and scarier, than that.’ Now, in natural sciences, this is a common enough assumption. Is there any empirical evidence supporting the use of such a distribution in economics, mainly the analysis of changes in prices and quantities’ One wonders. In fact, it is this distribution which underlies the most commonly used tool in regression ‘ the method of least squares. Most studies (academic and corporate) measure volatility using variance or standard deviation of the normally distributed variables. As Mandelbrot asks, ‘is this the only way to look at the world”

Apart from the normality assumption, orthodox financial theory makes the following assumptions. This list is directly based on Mandelbrot’s book. (1) People are rational and aim only to get rich. (2) All investors are alike and they are price-takers, not makers. (3) Price change is practically continuous. (4) Price changes follow a Brownian motion, that is each price change appears independently from the last, the price changes are statistically stationary and that the price changes are normally distributed.

Assumptions (1) and (2) need no discussion, owing to their obvious falsity. Now it is assumption (3) that allows the use of continuous and differential functions; whereas, the reality is that ‘prices do jump, both trivially and significantly’ and that discontinuity is an ‘essential ingredient of the market.’ The meaning of independent price changes is that, price at t+1 is not dependent on price at t. In other words, prices have no memory. An example from tossing a fair coin will illustrate this better. Suppose a fair coin is tossed once, we get a head. The outcome of the next toss is not based on the outcome of the previous one. Again, how true this is of stock markets or of prices is questionable. How can such an assumption cope up with ‘expectations’ of investors’ The statistical stationarity of price changes implies that the process generating the price changes stays the same over time.

Very often, in research, we do not have the time to question these assumption; not only that, these assumptions function as received wisdom. However, as Mandelbrot comments, ‘They work around, rather than build from and explain, the contradictory evidence’ because ‘It gives a comforting impression of precision and competence.’ For, a high kurtosis (the measure of how closely the data fits the bell curve) has been found in the prices of commodities, stocks and currencies.

To conclude, how does one as a researcher overcome such problematic/unreal/easy assumptions’ Is this what academic ‘discipline’ means’ Or are we to learn adequate mathematics and statistics so that we can find a way around it’ Or do we cooperate and seek help from mathematicians and statisticians’ Mandelbrot has developed tools and concepts such as ‘fractal analysis’ and ‘long memory’ which can aid economics, which is inherently not a study of normally distributed variables.

Model Building and Planning in India

Ever since the First Five Year Plan, we have utilised models in order to channel resources for achieving objectives of higher growth, establishing strong capital base, strengthening import substitution, reducing poverty, increasing foreign exchange resources and so on. The early plans made use of Harrod-Domar model and the Feldman-Mahalanobis models. The models used for planning purposes were largely taken from economic theory, which were then adapted (hopefully) by the Planning Commission. Owing to changes in the structure of the Indian economy, the nature of modelling has also undergone various alterations. This post highlights certain issues in the macro-modelling that was done for the 11th Five Year Plan, chiefly based on the publication by the Planning Commission Macro-Modelling for the Eleventh Five Year Plan of India edited by Kirit S Parikh.

It is incorrect to argue that planning in India has become redundant after the 1991 reforms. These reforms provided freedom to the firms with respect to what to produce and how to produce them. As the recent global financial crisis has shown, unregulated finance can lead to unfavourable outcomes for the financial as well as the real sectors of the economy. Also, significant divergences in income and wealth are being reported. This is the case, especially in India which is home to some of the richest and poorest people in the world. As Parikh writes, ‘As long as disparities in income, endowments and wealth persist, access to public goods and services is uneven and infrastructure paucity is there, we need active government policy. We need planning.’ [Planning Commission 2009, 16]

The 11th Five Year Plan’s goal is to have ‘Faster and More Inclusive Growth’. The basis of this goal is that the growth of GDP is treated as a necessary and almost sufficient condition for improving livelihoods. We know that markets exclude those without adequate purchasing power. And growth in GDP mainly results in an increase in the extent/size of the market. Unless appropriate systems are in place, ‘trickle down’ does not take place. Hence, an outline of how ‘inclusive growth’ can take place needs much greater attention. And it is disappointing to see that employment generation is not considered as a central objective. For the first time, the inputs of the 11th Five Year Plan have been provided by a ‘modelling forum’. The forum consists of researchers from NCAER, IGIDR, IEG and ISI Bangalore apart from the in-house team of the Planning Commission.

A formal model is constructed for the purposes of planning because it makes the assumptions transparent, ensures consistency and provides insights into the inter-relationship between various actors and sectors in the economy. These models in turn borrow concepts, categories, functional relationships and links from the paradigms in economics. The paradigms that have influenced modellers, according to Parikh are Input-Output, Walrasian, Neoclassical, Keynesian, Structuralist, Vector Auto Regression/Error Correction, New Neoclassical and Dynamic Stochastic General Equilibrium. The most obvious drawback of this classification is the mix-up of paradigms with tools of economics. For instance, IO framework, VAR models and DSGE models are only tools. For our later exposition, it would be helpful to point out the important characteristics of each of these paradigms/tools.

Input-Output: Usage of inputs in fixed proportion

Walrasian: Optimising behaviour of economic agents

Neoclassical: Pricing through supply and demand mechanism and full employment at prevailing wage rate

Keynesian: Underemployment equilibrium

Structuralist: Imperfect markets and incomplete monetization of the economy

Vector Auto Regression: All variables depend on lagged values of all variables and data speak for themselves

New Neoclassical: Microeconomic foundation of macroeconomics- importance of information, expectations and contracts

DSGE: Forward looking and optimising economic agents

In the modelling for the 11th Five Year Plan, six different models with different analytical approaches have been used. The models are a) Perspective Planning Division’s In-house Model, b) A VAR/VEC Model from ISI, Bangalore, c) A General Equilibrium Model from IGIDR, d) An Econometric Model from IEG and e) Macro-Econometric Model of NCAER. The various model scenarios show that the direction of policy shocks are similar ‘though the structure and philosophy of the models are different’. However, this is not such a shocking or an interesting revelation. For everybody knows that oil price shocks have a negative impact on the GDP growth rate and that the global slowdown affects the GDP adversely. The only result of interest is that of an increase in NREGs by 1% of GDP. This will result in an increase of around 0.35 to 0.5 GDP percentage points. However, it must be noted that this is based on ‘a general equilibrium model in which it is assumed that the adjustments to the new equilibrium are completed in one year. Thus, the impacts may be overstated as in reality this may not be the case’.

Overall, it seems that the assumptions of the various models are far from our Indian reality. There is no attempt at including the unorganised sector. And it is very clear, from the recent evidences from neuroeconomics, experimental economics and game theory that individuals are not rational optimizing machines. Instead, we are more moved by social concerns and we exhibit a pro-social behaviour which is norm-based. There is no explicit move to analyse employment generation. Nor is there the necessary focus on agriculture. It is stated that agriculture needs to grow by 2.4 % to 4 % so as to achieve 9% GDP growth rate. One cannot help but wonder whether the objective of economic planning in India is only about the GDP growth rate! And as to the use of VAR models, the generators of the model argue that since there is ‘no real basis to say which variable is endogenous and which is exogenous’, they adopt a ‘general equilibrium approach, where everything (except rainfall, of course) depends on everything else.’ [Planning Commission 2009, 88] An easy route indeed!

This publication by the Planning Commission is a must read for all those who are interested in understanding the Indian policy making. Also, it provides the crucial link between policy and theory. Hence, making the study of economic theory very significant, especially for policy makers. It will also be of interest to students and practitioners of time series methods using the VAR framework.

Reference

Planning Commission (2009), Macro-Modelling for the Eleventh Five Year Plan of India, edited by Kirit S Parikh, Academic Foundation: New Delhi.

Budget 2010: An Analysis

The budget document considers the high growth rates India has achieved as a ‘gain’, which needs to be consolidated so that there can be ‘inclusive’ growth. Economics, during its course has divorced rate of growth of output (of commodities and services) from the question of employment. Hence, we need to use terms like ‘jobless growth’, ‘inclusive growth’ and so on. Unfortunately, a weak form of trickle down theory is assumed in most cases. Therefore, having a high growth rate becomes a necessary pre-requisite.

It is comforting to see that the need for good institutions have been emphasised in the document. As one of the challenges is ‘to address the weaknesses in government systems, structures and institutions at different levels of governance. ‘

Unorganised sector has been highlighted in the document. A National Social Security Fund has been established for workers in this sector. And the National Skill Development Corporation has approved three projects worth about Rs 45 crore to create 10 lakh skilled manpower at the rate of one lakh per annum targeting the unorganised sector. I guess the question is: do we impart skill to the workers or do we provide jobs according to their skill’

On the agricultural front, 5 more mega food parks are going to be set up as an impetus to the food processing sector. Under the Debt Waiver and Debt Relief Scheme for Farmers, the period of repayment has been extended owing to the drought. In order to step up agricultural production, around 60,000 ‘pulse and oil seeds villages’ are going to be set up. And the benefits of ‘green revolution’ are going to be increased by carrying out similar activities in the eastern region of India. The ‘benefits’ indeed!

Owing to the financial crisis, an apex level Financial Stability and Development Council will be set up with a view to strengthen and institutionalise the mechanism for maintaining financial stability. Alongside this, FDI flows will be liberalised more. It is interesting how new challenges/problems are brought about. Regulation is removed in a particular sector and regulation is increased in some sector. Overall, it seems to appear that ‘less regulation’ is considered efficient- right prices, no wastage of output and so on. Thanks to Neoclassical Economics.

Several projects are being set up to meet our energy demands and also to conserve our environment. Strengthening transparency and public accountability seems to be given adequate importance (in paper at least). In this context, an Independent Evaluation Office (IEO) chaired by the Deputy Chairman, Planning Commission to be set up to evaluate the impact of flagship programmes. More and more committees and commissions coming up!

On the whole, I think it is a more government’s budget than people’s or the corporates! However, their highlighting of the unorganised sector and the crucial role of institutions need to be congratulated.

What are the Contents of India's Economic Growth’

The above question was discussed by Bhabatosh Datta in 1977 in his book The Contents of Economic Growth and Other Essays. This blog post briefly revisits Datta’s article to see whether the current growth of India is on the right track. A few details about Datta is in order. For most of his life, he taught at Presidency College, Calcutta. He is an economist who has written on diverse aspects of the Indian economy – industrialisation, planning, regional rural banks, economic growth, monetary reforms, commercial banks, financial system and on Indian economic thought. And for this reason, his work is of utmost relevance to us- who want to understand the Indian economy.

On 29th December 2009, the Deputy Governor of RBI spoke about the ‘Current Macroeconomic Developments in India’. I reproduce some of her observations below:

India had a strong recovery in the second quarter of 2009-10 at 7.9 per cent. “The sequential recovery over the first quarter of 2009-10 was driven by notable turnaround in industrial output (9.0 per cent), and services sector (9.0 per cent), while agriculture sector also came to record a positive growth (0.9 per cent), despite drought like conditions and floods in some parts of the country.”

Which India had a strong recovery, when more than 60% of Indian population work in the agricultural sector’ As Datta writes, for India, economic growth takes place when there is “growth in employment and growth in incomes of large numbers.”

“On the whole, agricultural production during 2009-10 hinges critically on the performance of the North East monsoon and rabi production.”

“The recovery in industrial growth has been broad-based with acceleration in growth of all the three sectors, viz., mining, electricity and manufacturing .”

The consumer durables sector shows an impressive growth with 22.2 per cent in the second quarter of 2009-10.

Consumer durable showing strong growth, a recovery of industrial growth alongside a critical agricultural sector seems to suggest that Indian policy makers and economists seem pre-occupied with non-problems. As Datta lucidly points out: “it is possible that over a particular year there has been only a very small increase in agricultural and essential industrial production, while there has been a substantial rise in the output of luxury goods, high-income varieties of consumer goods and outdated capital goods.”

It is easy to forget that 8% or 9% rate of growth does not have a unique meaning. For, it might express many alternative states of affairs. I often wonder, what our objective should be as an economist in India! As I had argued elsewhere, it is time that we looked at the structure or the contents of economic growth carefully.