Thursday, March 5, 2009

Techniques For Better Decision-Making

Thursday, March 5, 2009

Fiscal and monetary policies have been (a) extremely tardy, (b) inadequate, and (c) uncoordinated.
Concepts that may be useful for developing convergent policies for growth: Decision Analysis/Logic Trees, & Coherent Waves with 'Constructive Interference'

Shyam Ponappa / New Delhi March 5, 2009

There’s a view that with the global downturn, India’s economy has to slump. There’s another view that with a large, domestically oriented economy (65 per cent consumption) with room for expansion from its low base, eg, in energy, transportation, etc, the economy is growing well below its potential.

True, several export sectors are badly hit, such as diamond cutting-and-polishing, textiles, engineered goods, with threats to sectors like IT and IT-enabled services. However, the potential in sectors such as energy/power, communications, education, healthcare, even IT and ITES, is high.

Can we have high growth despite a global downturn? Yes, if we can capture this potential. The question is how to convert latent demand into manifest demand and growth.

India’s ‘plight’ includes robust growth despite the contraction, including some sectoral crises. A better understanding of likely outcomes of policy decisions could help formulate better solutions. And convergence in such decisions could give even better results.

‘Coherent Waves’ and ‘Interference’

An analogy from lasers could help to make decisions that reinforce each other, instead of working at cross-purposes. The concepts are ‘coherent waves’ and ‘interference’.

‘Coherent waves’ have the same frequency or wavelength, and are ‘in phase’, ie, their crests and troughs match. When two such waves intersect, there is ‘interference’. When the crests and troughs coincide as in Figure 1 B, there is

Figure 1: Reinforcing Decisions or Cancelling Out

‘constructive interference’, and the size (amplitude) of the resulting wave is the largest. When the waves diverge, they weaken each other. They are considered ‘out of phase’ when one trough coincides with the other crest, and ‘destructive interference’ results in their cancelling out (Figure 1 C). This analogy could be used in taking measures that reinforce each other for better results.

Decision Analysis

Another useful technique may be Decision or Logic Trees, which help lay out a sequence of dependent events. These events can be decisions, such as taking a fork in a road, or chance outcomes, where one has no control over events/outcomes (one fork is blocked). Logic trees can be used for (a) diagnosing problems or understanding/ demonstrating linkages; (b) developing alternatives; and (c) choosing reasonable solutions.

Consider India’s economy in the second half of 2008. Inaccessible capital — which was very expensive when available — combined with a fall in demand led to collapsing enterprise profits. Increased liquidity could have made finance more accessible. Lower repo and reverse-repo rates with limits on bank investments in government securities (at 31.41 per cent of deposits in mid-February, with the SLR at 24 per cent) could have boosted demand through cheaper loans and lower prices for higher profits, making it easier for banks to lend, and possibly retaining more foreign capital.

While these may seem obvious, rate and tax cuts have been (a) extremely tardy, (b) insufficient, and (c) uncoordinated. A logic tree as in Figure 2 could perhaps have helped in thinking through remedial decisions.

Profits are a probabilistic outcome of costs, prices and demand. Costs are affected by interest rates and taxes, and in turn affect prices, which then affect demand. Profits may be high, low or somewhere in between (as in a ‘fan’ in Figure 2, representing a range of possible outcomes between the high and low ends). Whether profits are high or low, the Price/Earnings multiple can vary, depending on the state of the markets and the psychology of investors. Markets can be more-optimistically or less-optimistically priced, ie, with higher or lower earnings multiples for the same profits. In the best case, there is easy access to capital at low cost, as at the top of Figure 2. Profitable enterprises with good prospects have desirable stocks, so investors will pay higher multiples of earnings. However, if stocks are priced too high, they become over-valued and unsustainable. Also, for the same profits, if prospects

Figure 2:
CostsPricesDemandProfitsP/E RatiosMarketsCapital Access/Cost

uncertain, eg, because of turmoil in international trade or domestic instability, investors may pay less.

As profits and prospects drop, capital is more difficult to get and costs more, going down the logic tree. At the bottom, low profits and low prospects result in low P/E ratios and bearish markets. In such circumstances, funding is the least available and most expensive, foreign capital is unavailable, and domestic investors abstain.

The logic tree shows that when profits are high (within reason), there is easier access to capital at lower rates. Similarly, we could analyse demand, and disaggregate it into its components of consumption, about two-thirds of total demand, and government demand. Each component can be considered separately to estimate the likely outcomes of policy decisions and time lags.

Government Spending

Issues of government spending with long lead times and uncertain results are often debated, but we have had little resolution in terms of (a) developing new delivery systems, eg, for food subsidies directly to users with radical changes in our Public Distribution System, or (b) using systematic project management methodologies to accelerate and improve the execution of infrastructure projects. A great deal remains to be done, which is why more spending would be inadvisable without better design and execution.

['India Today' has a searing take on the building (or the not-building) of roads in the last eight years. See 'Roads To Nowhere' by Nivedita Mukherjee, January 30, 2009. However, the picture below leaves little to the imagination.]

Perhaps these concepts can help in thinking through decisions, eg, in coordinating tax, interest rate and CRR cuts to reinforce each other, and avoiding ‘destructive interference’, like government giveaways with massive borrowing when enterprises are starved of reasonably priced credit.

A logical approach would be to combine (a) steps to increase demand — tax and interest rate cuts of sufficient magnitude for consumer loans, and effective systems and processes for government spending — with (b) steps to improve profits (reduce the CRR, decrease repo and reverse-repo rates, with limits on bank investments in government bonds).

The aim should be policies that reinforce positive effects. Instead, like a rocket with insufficient exit velocity, these initiatives have sputtered ineffectually.