Rules and Principles

Kunal and Gaurav are right. In this post, I was talking of the trade-off between rules and principles in policy enforcement.  Actually, when you think of it, rules vs. principles is not a simple dichotomy, but a spectrum of choices.

Imagine that these choices are spread from left to right. At the left end of the spectrum is automation. Rules are enforced automatically, without anyone having the responsibility of enforcing them. The best example  of automation in my stories was actually the turnstile – it automated the task of checking for tickets, leaving very little scope for discretion.

Another example is the jugad “automation” that the Hyderabad police enforced. Blocking off the right turn doesn’t seem like an example of automation, but for our purposes, it is, because it enforced the rules without the police having to intervene.

To the right of automation come rules – clear and transparent rules that leave no scope of discretion to the enforcers. But then, whether to follow the rule or not is still a choice – and ensuring that officials enforce the rule depends on the existence of procedural mechanisms.

As you move further to the right,  you find that the rules have more and more discretion embedded in them. For example, consider the difference between enforcing a red light and ticketing someone for rash driving. The former is easier to enforce fairly than the latter.

At the extreme right of the spectrum is the idea of “principles-based regulation”.  This distinction  between rule-based regulation and principles-based regulation is used most often in the financial sector, so let me use an example from Banking to illustrate.

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We Always Need More Regulations

As Ajay Shah points out, we don’t just regulate our financial system, we micro-manage it. When things are going well in the US, and we make the case for deregulation, we get the answer: “See, even in the US, we don’t have a completely free market system. Even they have regulations. How can you propose that we junk ours?”

When things go wrong in the US, we get the answer: “See what happened to the US because they followed a free market system? How can you propose that we junk our regulations? We need more.”

This bias ensures that we will always follow suit when the US moves left, never when it moves to the right.

Markets and the Long Term

The Economist has an article on the problems of aligning the CEO’s interests with those of the shareholders. The obvious solution to this  is to ensure that a large proportion of the manager’s compensation is in the form of shares or stock options. But it turns out that during the recent financial crisis, the more shares of a bank its CEO held, the worse the bank performed.

I believe that this is confounding two different problems. The agency problem relates to aligning an incentives of the agent (i.e. the CEO) to that of the principal (i.e. the shareholders).  The second problem is that of translating long term goals into short term actions.

Human beings are not very good at solving the second problem even when the principal and agent are the same people. We aren’t good at planning our own diet and exercise so that our long-term health is maximized. The challenge is not only the intellectual one of long-term planning, it is also one of the incentive to execute the plan. Who wants health food and rigorous exercise when fried stuff and indolence are so pleasurable?

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The Hackneyed Man From the Past

Gaurav non-Sabnis thinks that  the use of the man-from-the-past technique in my Pragati editorial ”The Case for Freedom” was hackneyed.  He is free to think so. He also thinks that my introduction was inaccurate. He is free to think so too as long as he doesn’t mind being mistaken.

Gaurav makes two errors - a misinterpretation and a factual error. The misinterpretation is this: He says that “mismatch between supply and demand must be as old as beginning of trade”. Well, duh. Obviously, a famine is a severe mismatch between the demand for food and the supply of food. If I had said that there is now a greater mismatch than before, it would have been an extremely stupid statement.

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Pragati Alert

I have written the opening editorial for the March 2009 issue of Pragati. It should be out any time now.  This is how it starts:

A visitor from the 17th century would be rather surprised to learn that the United States of America of 2009 is in distress. He would of course be no stranger to troubled times, but in his time, troubles came in the form of famines, diseases, strife and taxes. This blight called “recession” that has struck the United States would seem strange to him. Factories that were at full steam two years back are now idle, though their productive capacity is undiminished. Healthy men and women who were working in those factories now sit at home. Goods lie in warehouses even while vehicles to transport them in and roads to carry them on remain intact.  Further inquiry by our visitor would reveal that the cause of the United States’ trouble is a breakdown in the system by which it co-ordinates demand and supply, present and future consumption, and risk and reward. The visitor would not be prepared for the scale and sophistication of the system that has now suffered a setback, but he would be no stranger to the idea of markets. Markets and traders have existed for as long as humankind has, and so have attacks against them.

Read the rest when you get the issue in your mailbox

Thatz Why We Need Strong Regulations

Okay, so why are Indian companies in trouble in spite of Palaniappan Chidambaram’s ironclad assurances that Indian markets are so well-regulated that we are insulated from the crisis?

It is because our financial sector is so well-regulated that we do not have a decent corporate bond market.  So, Indian companies that wish to borrow end up borrowing in foreign currency from global markets. In other words, we have regulated our financial markets so well that we are more tightly coupled with the evil deregulated financial markets than we should have been.

The solution, of course, is more regulation. It always is.

Betrayed Trust of India

UTI Mutual Fund is running an ad campaign where it is claiming credit for the education of Indian investors. I am glad to see UTI being man enough and owning up responsibility for the abysmal financial knowledge of the average Indian investor. I suppose they think that five years is enough for investors to forget the saga of US-64 and the time when they used to get their agents to “promise” guaranteed returns on mutual funds.

Risk Management

The crisis in the US reminds me a bit of my own personal finances. Till last year, I was managing my money rather badly. I used to  to maintain large amounts of money in my savings bank account. My investments were all ad hoc and I was not doing a whole lot of long term planning.

Last year, I decided to pull up my socks. I drew up an investment plan. I answered a questionnaire to find my risk apetite, used the 100 minus age rule to decide how much I ought to invest in equity and systematically put money into index funds. When the NAV went up I congratulated myself on my choice and when it went down, I decided that I was in there for the long haul. I also forecast my cash flows and moved the funds I needed as buffer into short term debt funds.

I had three bank accounts that I needed to maintain to pay my home loan, car loan and other recurring ECS mandates. I moved most of my funds into one account and set up reminders to ensure that I would move funds to the others only when needed. This, I decided, was better than keeping too much idle money in multiple accounts, making it difficult to manage. Then one day, the home loan reminder went off, I was in a hurry and I transferred money to the wrong account. The ECS instruction bounced and I was hit with a charge of 500 bucks.