The Hindu Business Line : Go for the shock absorber

This is 219th in the Vision 2020 series. The previous article was published on January 21.
If stock markets had shock absorbers, they would have a system to curb speculative profits and losses. When speculative profits are restricted, volatility will come down automatically, says P.V. INDIRESAN.

The past couple of weeks were dominated by the volatile stock market; the next few weeks will be dominated by speculations on the Budget. Both are interesting topics and also ephemeral. Hopes, fears and anxieties of both will soon be forgotten, however much they capture the headlines in the meantime.

Stock market oscillations have a parallel in engineering — many engineering products are deliberately designed to be oscillators. Pendulums, microwave ovens, radio gadgets, pumps are all oscillators. In other instances, engineers design artefacts not to oscillate. Shock absorbers in vehicles are a common example of devices that suppress oscillations.

A leaf out of science

The science of engineering has a highly developed understanding of what makes systems oscillate, and also what should be done to prevent unwanted oscillations.

Somehow or other, economists who have borrowed quite a few ideas from physical sciences have been slow (or reluctant) to draw lessons from physical sciences in the matter of economic cycles.

In the most elementary case, an oscillator needs three kinds of devices to be put together — a spring, a mass and some friction to keep the situation under control.

Economic systems oscillate when they combine savings from the past with credit allowed in expectation of a return in the future. Thus, business cycles are a consequence of excessive flow of credit.

The depth of economic fluctuations depends on the price of credit, the extent it is leveraged on the expectation of future flow of income. In engineering, we call that the Q factor. Q determines how long oscillations will continue. Wild fluctuations will be checked only by introducing friction in the system, by increasing the price paid for speculation.

Current wisdom states that whenever stock market falls, interest rates should be reduced. That is like throwing out a weight out of the car whenever it goes over a pothole (and putting it back again when it encounters a hump). Interest rate adjustments are useful as far as they go but that is not much. After all, how far can interest rate be reduced?

After it goes down to zero, should we make it negative, that is should we start ‘pump priming’ programmes of Keynes? With the kind of administration we have in India, such programs will leak like a sieve.

Shock absorbers are different. As their name implies, they absorb the energy in the shock produced by vibrations. In the stock market, some people make paper money and some others lose paper money. If stock markets had shock absorbers, they would have a system to curb such speculative profits and losses. When speculative profits are restricted, volatility will come down automatically.

Modified Tobin Tax

Nobel Prize winner Professor Tobin proposed a tax to curb currency speculation in international markets.

A modification of the Tobin Tax — a levy on the fluctuations in stock prices, should be equally effective in stabilising stock markets. Then, every one who sells high (or buys low) pays a tax. That tax (as low a rate as 0.1 per cent) will become a disincentive to push prices too high or too low. Tobin Tax has never been accepted possibly because powerful vested interests make a lot of unearned money by speculation. Hence, Professor Tobin is a victim of Keynes’s famous aphorism:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler a few years back.

It is possible that sometime in the future, some Finance Minister will think he has heard voices in the air and put into practice Professor Tobin’s idea. We may have to wait till that time for an equivalent of Tobin Tax to be imposed on stock market speculation too.

Recipe for explosion

It is a matter of curiosity that few people in India are drawing any lesson from the way the present crisis started, namely, sub-prime lending in the US. As in the case of stocks, financiers in the US and Europe recklessly assumed that house prices in the US will only go up, and not come down. Unfortunately, our bankers and investors too are betting on the assumption that real-estate prices will only go up, and will never come down. I will be accused of crying ‘Wolf! Wolf!’ if I were to say an equivalent of sub-prime crisis can happen in India too.

Admittedly, in terms of GDP, the risk is much lower here because mortgage finance is only 4.9 per cent of GDP whereas it is 64.5 per cent in the US. On the other hand, in India, the problem is not financial instability alone; risk of disenchantment among the people poses a greater danger. In many of our slums, people are living literally on sewage. Next door, fabulous unearned profits are made by speculation. That is a recipe for an explosion.

Housing – 4 problems

In a recent seminar, Mr Sridhar, Chairman of the National Housing Bank, succinctly identified the problems associated with housing the poor as four — availability, affordability, risk mitigation and effective legal framework. Availability is more critically one of space than of finance.

Once space availability is ensured, land will automatically become affordable, risk too will come down.

Plenty of land is available in the country but not in the cities where nearly 90 per cent of housing finance is concentrated. Hence, the ultimate problem is with our legal framework: it lets housing concentrate where it is too expensive for the needy.

Therefore, we need a tax law that penalises those who make unearned profits by speculating in real-estate at the expense of the poor — and the middleclass too. Like the Tobin tax in currency speculations, we need a similar shock absorber, a device that increases friction in speculative land transactions.

Liberalise land transactions

Real-estate prices are decided these days not by current returns (in the form of rent) but by the expectation of future increase in capital value. That expectation of inflation in land prices is based on the assumption land for housing will always be kept scarce.

If, instead, credible plans are made to increase land availability in step with demand, (that is not difficult, because at the most we have to find each year an extra 0.1 per cent per year of the country’s land area) there will be no inflation; prices will become realistic and not speculative.

Our outdated laws restrict space for housing in many ways. If only land transactions are liberalised, then, as in the telecom case, land will become freely available, prices will tumble down, everyone will start affording shelter and risk in housing finance will become nominal.

Instability caused by excessive speculation — whether in the stock exchange or in the real-estate business or in currency trading can be checked only by adding friction in the system the way shock absorbers do in vehicles.

Such friction needs taxation on the lines of the Tobin Tax. The Finance Minister can do much more to reduce financial volatility than he realises.

(The author is former Director, IIT, Madras. Response may be sent to: indiresan@gmail.com)

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