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INTER-PLANETARY ECONOMICS: THE MELTDOWN AND BEYOND A Popular Exposition
C. T. Kurien
Vikas Adhyayan Kendra
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Inter-Planetary Economics: The Meltdown & Beyond
Vikas Adhyayan Kendra (VAK) established in 1981, is a secular Voluntary Organisation engaged in the study and research of contemporary social issues. Geographically, VAK’s activities are oritented towards Western India, viz, Maharashtra, Gujarat & Goa.
Inter-Planetary Economics : The Meltdown and Beyond A Popular Exposition C. T. Kurien Edition: August 2009
Cover Design: Priya Kurien
Published by Vikas Adhyan Kendra D-1, Shivdham, 62 Link Road Malad West, Mumbai 400 064 Ph: 2882 28 50/2889 86 62 Fax: 2889 89 41 Email:
[email protected] Website: www. vakindia.org Printed by Omega Publications 2 & 3, Emerald Corner, Maratha Colony Tilakwadi, Belgaum 590006 Cell: 988620 3256
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Preface
This write up was taken up at the suggestion of members of the family – my wife, daughter and brother – that I should make the complexities of the global meltdown intelligible to them. The draft that they found helpful was circulated over e-mail to other members of the family and a few close friends, none of them with special knowledge in finance or economics. To my surprise all of them found it intelligible and some offered comments also. They felt too that the material should be made available to a wider readership. Since I had virtually retired from active academic life almost a decade ago and had paid only casual attention to the plethora of writings on the topic, I deemed it necessary to get critical professional opinion on what I had written. Hence a modified and slightly polished version was circulated to about a dozen of my former professional colleagues who are still active in research, teaching and writing. Practically all of them responded immediately and enthusiastically with valuable suggestions urging me to place the material in the public domain at the earliest. The text has been further revised in the light of the comments received. I am grateful to all of them, members of the family and friends, for their comments and encouragement; but I am solely responsible for the piece as it appears now. When the piece was under circulation over e-mail, I had suggested to the recipients that they should feel free to forward it on to any one they thought would be interested in it. In that process it reached Ajit Muricken with whom I had contacts some years ago, but had not been in touch for a while. He immediately called me and asked for permission
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to have the piece brought out as a Vikas Adhyayan Kendra publication. I am grateful to him for his support. The cover was designed by my daughter, Priya and I am deeply indebted to her for it and for being my mentor on all technical matters. – C. T. Kurien
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I. The Two Planets
There is a striking passage in the early pages of Niall Ferguson’s recent book, The Ascent of Money: A Financial History of the World: “In 2006 the measured economic output of the entire world was around $47 trillion. The total market capitalization of the world’s stock markets was $51 trillion, 10 percent larger. The total value of domestic and international bonds was $68 trillion, 50 percent larger. The amount of derivatives outstanding was $473 trillion, more than ten times larger”. Stocks (or shares), of course, are claims to wealth, and bonds are widely known as debt instruments. Derivatives may be less familiar although they are widely used and discussed in financial circles. As the word itself suggests it is something derived from another word or object. To begin with, we may note that within the realm of finance a derivative is a financial instrument derived from another and underlying instrument such as a debt. Briefly, then, what Ferguson says is that we have reached a situation where finance is clearly dominating what is often referred to as the “real economy” which produces the tangible goods of everyday life and the services associated with their production. Ferguson puts it more picturesquely. “Planet Finance is beginning to dwarf Planet Earth”, he says. The figures given above will make better sense now. When Ferguson was writing his book (it was published in 2008) Planet Finance was rapidly expanding at a rate much higher than that of Planet Earth. “The volume of derivatives … has grown even faster” he says, “so that by the end of 2007 the notional value of all ‘over-the-counter’ derivatives … was just under $600 trillion. Before the 1980s such things were virtually unknown”. If international currency exchanges are
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also brought into Planet Finance, they increased from $500 billion per day in 1990 to $1500 billion in 1998 and to a whopping $3.2 trillion in 2007. Indeed, in those heady days of Planet Finance, reports about it, especially its innovation, expansion and achievements were greatly overshadowing the rather slow moving and, at any rate, the older and less fascinating Planet Earth. It was as though Planet Finance had its own and somewhat mystifying laws of motion which were far beyond the grasp of the uninitiated. Then suddenly in the last quarter of 2008 there were signs of panic in Planet Finance – some of its major parts collapsed; resuscitation attempts became visible; and there was a crash! It is part of the prevailing confusion that the crash is also referred to as “the meltdown”. But even those who do not know what has happened recognize that the glamour is gone. The mood now is one of depression. Major Issues In this context there are many things that call for explanation. The most obvious is the spectacular rise of Planet Finance in the few years immediately preceding 2008 and its sudden collapse in the last quarter of that year, as noted above. Equally important to consider is whether some kind of revival is likely, and if so when. More important is whether Planet Finance and Planet Earth are independent of each other, and if that is not the case, what is the nature of interdependence between the two. And third, since these entities are “planets” only as metaphor, how are they related to the realities that we all know and experience? In particular, how are they related to other realities that we deal with, administration and governments in our country and globally? This article deals with these issues, not necessarily in the order mentioned above, but in such a way that any interested reader will be able to follow it. No professional training in economics or finance is expected of the reader.
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II. The Banking System and Credit
By way of background it may be useful to have an understanding of banks and related institutions in the working of a modern economy. A bank is an intermediary between those who wish to deposit their funds with it and those who are eager to borrow funds (credit). Credit is required because there is a time lag between what is needed now and the ability to repay later or over time. Hence what credit does is to link the present and the future: indeed, because what is lent now was generated earlier, credit links the past, present and future. Providing this temporal connection is crucial for the smooth functioning of a modern economy. But if there are many who have funds to lend and many who are eager to borrow why do they not establish contacts directly instead of going through an intermediary? At least for three reasons. The first is that an individual or any other unit that has funds to lend may not know the person or unit who requires credit and vice versa. An intermediary connects those who have funds and those who require credit. We may think of a bank also as an institution that pools information about lenders and borrowers and makes it available to those who need such information. Actually, the bank pools borrowings from large numbers of lenders (that’s why it is a bank) so that the borrower does not have to know anything about individual lenders and lenders won’t know who is borrowing their funds. The bank as an intermediary, thus, performs the important task of gathering and processing information and that plays a major role in the effective functioning of an economy. The bank plays a second and more important role. Lending of funds to a strange or even a well-known borrower
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is a risky thing to do: you may never get back what is yours! The bank may also lose funds that it lends, but there is a sort of safety in numbers. What you do when you lend to the bank, the intermediary, rather than to an individual borrower, is to reduce risk considerably. Of course, you are taking the risk that the bank may fail, but if you are into the business of taking risks you know that you are calculating probabilities, and you know from experience that a bank failing is less likely than an individual borrower disappearing or going bankrupt. Thus information (gathering) and processing and risk reducing are the crucial functions of a bank as an intermediary. The Bank provides these valuable services not free of cost, but for a consideration. The bank pays you (a specified rate of interest) for the deposit you make (usually a higher rate for a longer period of deposit). The bank charges a higher rate of interest to those who borrow from it. The margin between the lending rate and the deposit rate is (part of) the earnings of the bank for the services it renders. We may note also that when there are several banks they come to have additional roles and powers that individual banks may not have. The banking system as a whole can create credit; you leave your money with the bank trusting that it will be safe and sure that you will earn something by way of interest; the bank knows that you will not withdraw your money immediately and lends it for a while to those who can use it. A group of banks or the banking system as a whole can generate more credit than a single bank can do. For these and other reasons banks come under regulations from higher authorities, usually from a central bank (the Reserve Bank of India in our case) which is an independent body, but finally responsible to the government. Features of Intermediation An economic system characterised by intermediaries or the role of intermediation has some characteristics which we must note. If an important function of an intermediary is to gather and process information, it becomes an information
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specialist in selected spheres. A bank is a specialist on credit just as a real estate broker is a specialist on matters relating to that market. Where intermediation is general, therefore, one must expect information asymmetry, and not a uniform spread of information as is usually assumed by some widely touted economic theories. A second feature of intermediation is closely related. An intermediary who is a specialist in some areas tends to use it for his own advantage. After all, he too is an economic agent! And, if distorting information is to his advantage why expect him not to use it to his benefit? This common sense understanding of the behaviour of an economic agent goes under the name of Agency Problem in technical literature which states that an agent may (usually does) become more concerned with his own interest rather than the interest of the principal whom he is supposed to be representing. We shall soon see how this agency problem plays a role in an understanding of Planet Finance. Third, intermediation has a tendency to proliferate. We noted that by resorting to the intermediation of a bank the depositor reduces risk. The bank must find ways of reducing its risk of lending. One thing it can do is to turn to an insurance agency to cover the risk, of course for a payment. So another intermediary emerges. A second possibility for a bank (usually a big one) is to repackage the debt instruments it holds according to differences in the rate of interest, the date of maturity, risk profile and pass on the repackaged “products” to other agencies. Agencies twice or more removed from the original principals come to the scene handling new financial instruments – “derivatives” – thus contributing to the glamour and rapid expansion of Planet Finance. In the next section we shall trace how such changes actually happened, particularly in the USA.
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III. The American Scenario
The last two decades of the past century saw many changes in the credit and banking systems in the US, and many other parts of the world. We shall concentrate on the changes themselves, not much on the why and the how. One major factor responsible for the changes was the large surplus that petroleum producing countries came to have following the oil price rise of 1973. Although the US dollar then was not as strong as it was in the immediate post-Second World War decades, it was still the international currency, readily convertible to any other in the world. Hence those who had large surpluses preferred to park them in US banks (as also the financial instruments of the US government). US banks, therefore, became flush with funds and were willing and eager to expand credit and make it available to those who required it. The lending and borrowing spree of the early 1980s led to severe debt crisis for several poor countries, especially African countries towards the end of the decade. Credit expansion led to new credit instruments and institutions. Since they have a bearing on the meltdown we are concerned with, let us try to understand the credit growth phenomenon and related issues. When a bank makes credit available to a person or any other economic entity, it is done on the basis of a collateral. Usually the collateral is some tangible asset like land or buildings. The title of the asset concerned is passed to the bank which ensures that it is not sold till the loan is repaid. Banks assist in the purchase of assets from third parties by paying that party and recovering the payment in instalments over time. The borrower’s ability to repay is ensured by providing proof of the ability to pay by way of a salary certificate, for instance. Banks also accept non-tangible assets such as shares as collateral for credit, although since the
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value of shares fluctuates, the risk involved is likely to be greater. The point to note is that the lending bank will usually have collaterals of various kinds that considerably differ in terms of their nature, payment schedules and risks. The bank can repackage these collaterals and pass them on if there are other agencies willing to take them over. Thus, when credit expands and collaterals increase, a new secondary credit market for collaterals emerges with new purchasers who then can become sellers if there are other buyers. In other words, a new financial “product” would become available as long as there was demand, and there would be demand as long as entering into the market was considered profitable. Since “production” in this case was almost costless, it was a demand-generated phenomenon where differing perceptions about risks and profitability were the sole considerations. The generic name for these newly engineered synthetic financial instruments is collateralized debt obligations (CDO) and soon there emerged CDOs, CDO2, CDO 3, each variety being a further step removed from the original lenders and borrowers of Planet Earth. Since branding became unavoidable even for these “products” new ones started appearing such as Collateralized Loan Obligations (CLO), Collateralized Mortgage Obligations (CMO), Collateralized Mortgaged-Backed Securities (CMBS) and so on indicating proliferation and the standard productdifferentiation. The process was facilitated by breakthroughs in desktop computing and the entry of a group of highly qualified academics into the realm of finance who could rearrange asset classes depending on even slight differences in the stock prices of companies or of the rate of interest. Planet Finance appeared to be emerging as a separate entity with a law of motion of its own, moving up and up as creating paper assets was an easy task and virtual assets even easier. It was not only business concerns that were involved with these new forms of assets. As recently as the mid 1980s, 75 per cent of household savings in the US was in the form of savings accounts or fixed-interest securities; by the end of the 1990s the position changed substantially with about the same per cent chasing high profit, though risky, paper assets around the globe.
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The process also meant that a penumbra of agencies was emerging around the banking system, the most prominent and powerful among them being “hedge funds”. Hedge funds are essentially private partnerships with each partner contributing usually upward of $1 billion. They specialize in dealing with high risk financial instruments or securities as their funds enable them to take up greater risk for higher payments. The most widely known among them was Long Term Capital Management (LTCM) founded in 1993, famous then because its core members included two economists who had won the Nobel Prize in the subject for their contributions to the understanding and treatment of risk. It collapsed by 1998 because its management of risk proved to be a failure! Intervention by the government gave it a new lease of life. There are other hedge funds also that have continued, because as they are huge and influential, they can raise loans way beyond their capital base, the process referred to as leveraging. Without going into the processes involved, it may just be pointed out that at one stage LTCM controlled $125 trillion in derivatives on a capital base of just around $5 billion. New Financial Architecture(NFA) Now, if they are big risky enterprises, there will have to be insurance companies to insure them against risk, agencies that specialize in assessing risks, credit rating agencies and so on. Demand created its own supply and many agencies of this kind emerged in the 1980s and 1990s and there were frequent references to America’s new financial architecture (NFA). But note that though many of them were engaged in the banking function of creating and administering credit (enterprises that simply packaged loans into securities and made them available styled themselves as investment banks, though they were neither banks nor did any investing) they did not come under the formal regulatory regime that banks had to subject themselves to. Hence it may be appropriate to refer to them as “shadow banks”. The scene was dominated by huge and powerful private bodies, well-known corporations such as Lehman Brothers, Goldman Sachs, Merrill Lynch, not
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accountable to any external agency or to the public at large. This state of affairs was justified on the belief that “the Market” would discipline them by rewarding those who performed well with high profits and punishing those who did not. Belief in the efficacy of the market was so entrenched that many regulations that existed were withdrawn or ignored. One more feature of the NFA deserves attention. Banks that are subject to regulatory authorities have to submit their audited statements of accounts and balance sheets to those authorities and so financial auditors have a major role in informing the management of the banks, their share-holders and the regulatory authorities about the soundness of the business that each bank does. The auditors are assumed to be external agencies doing their professional job independently. Over time the auditors had evolved a procedure to assess the soundness of their clients. But the emergence of “shadow banks” introduced many grey areas where it was not easy to decide on the soundness of banking transactions and investment operations. Auditors could be persuaded to go as the bank wanted. From the point of view of the auditors, the business was large, the fee substantial and the prestige irresistible. They retained the façade of independence, but for all practical purposes became business partners with their clients. After all, auditing firms also had to show that their profits were increasing so that their share prices would go up! If this was the case with banks with some sense of public accountability, it was not surprising that enterprises not subject to regulations found it easy to persuade risk-rating companies and auditors to go along with them. A risk-rating firm, for instance, was not taking any risk by providing a favourable opinion to a hedge fund, but was retaining good business. Profit-making became the only objective for many “independent” professional service firms. All was fair when the going was good, but all would collapse when something went wrong somewhere.
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IV. The Boom and the Bust
We can now move on to the recent boom and bust of Planet Finance which originated in the United States, but quickly spread to the rest of the world. The American economy is quite used to booms and busts. Who hasn’t heard of the Great Depression of 1929-32 which caused massive unemployment and a fall of one third in the GDP of the United States? Franklyn Roosevelt’s New Deal projects and the stimulus received during the Second World War succeeded in reviving the economy and put it on a high growth path that lasted till the end of the 1960s. The 1970s turned out to be turbulent and in the 1980s and 1990s there were some ups and sharp downs. During the last few years of the century there was the much celebrated dot-com boom that led many to think that technology would provide uninterrupted upward movement of the economy; but by the turn of the century there was a crash! And the economy was caught in a recession. A standard way to fight recession is for the banking system to bring down the rate of interest hoping that it would encourage investment and thus revive the economy. Reduction of the interest rate is signalled by the Federal Reserve Board (commonly referred to as “the Fed” and in terms of its role fairly similar to our Reserve Bank) and it brought down its rate of lending to banks from 6.5 percent to 3.5 percent within a span of a few months. The events of 9/11 (2001) led to further cuts and by 2003 the rate was just 1.0 percent with inflation-adjusted short-term rate actually turning out to be negative. What more incentive must banks have to lend when there were many institutions ready to purchase debt instruments from them? All that was
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needed was to persuade someone to turn to the banks to borrow. Who would that be? The Real Estate Boom No problem. In a country where “property owning democracy” is something of a national creed, there would be many willing and, indeed, eager to take a housing loan if the terms appeared to be reasonable. With property developers ready to make land, or if needs be even buildings available, and salaried people and commercial concerns wanting land and buildings, the real estate market would be the natural sphere of activity for the banks. Banks would lend, but instead of holding the loan in their books, they would package them into CDOs and sell them to other agencies. They, in turn, would pass them on also. On the other side, as interest rates came down, the demand for housing loans increased and construction activity picked up leading to land prices going up and the real estate market booming. Thus economic activity overall received a stimulus, causing employment and incomes to go up. As on all previous boom periods known in history, there was a great deal of speculative trading (this time not much in commodities but in financial papers) that yielded huge profits. Those who had the institutional facilities to play with other people’s money (OPM) made enormous profits too. Share prices appeared to be steadily soaring and dividends were increasing. Market activities appeared to be bringing all round advantage and prosperity. Alan Greenspan, the widely known and highly respected Chairman of the Fed gave his enthusiastic encouragement to what he called “a new paradigm of active credit management”. Of 2006 Forbes magazine proudly announced: “This is the richest year ever in human history” as the number of billionaires had risen 19 per cent to 946 over the previous year’s 793 and their combined net worth climbed by $900 billions to $3.5 trillion, adding, “never before in human history has there been such a notable advance”.
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In the meanwhile, rate of interest on housing loans started coming down further as the banks were competing to secure more business. Refinancing (or “refi”) schemes became popular. Lower interest rates made it possible to borrow more for the same monthly payment, pay off the old loan, and still be left with an extra sum to go on a vacation or buy a new car. Lower rates also enabled the more enterprising to go in for a second house as a form of investment. Refis shot up from around $15 billion in 1995 to nearly $250 billion a decade later. It was all achievement and affluence, America! Sub-prime Lending Soon housing loans came to be at rates below the prime mortgage rates of banks (sub-prime lending, also known as teaser loans). For long banks continued to make careful scrutiny of the economic credentials and repaying capacity but the belief that land prices would only move upwards led to light-documentation mortgages, the extreme form of it came to be known as ninja loans – no income, no job, no assets. Sub-prime lending which amounted to $145 billion in 2001 soared to $ 625 billion in 2005, accounting then for some 20 per cent of the loans. Some of the sub-prime mortgages were tricky in nature; the low rates were applicable only for the first year with interest rates gradually going up later making it difficult for some borrowers to close the mortgages. Instances of borrowers not being adequately informed about these arrangements were not rare. Soon defaults became not uncommon and by 2007 doubts were beginning to be expressed about the sustainability of the real estate and housing boom. By middle of that year it was public knowledge that two mortgage hedge funds were in trouble. The problem spread to CDOs linked to sub-prime mortgages which, in turn, had its impact on some investment banks. By the fourth quarter, well-known financial institutions like Citigroup, Merrill Lynch, Lehman Brothers, UBS, and Bank of America had to announce major write downs. The Fed and other official
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agencies had to take note and attempt remedies, mainly making available credit to institutions in need through the first half of 2008. The Crash The crash came in the second half of the year, mid September with Lehman Brothers going bankrupt. Lehman was one of the leading commercial paper makers. It was a counterparty to many CDS contracts, and a prime broker providing finance to hedge funds. But being outside the banking system it could not get the support of the Fed or the US Treasury. When Lehman became insolvent its clients also faced difficulties. George Soros, the financier called the fall of Lehman “the game changer” because it changed the complexion of the crisis by introducing serious uncertainty about how things would turn. Next to go under was AIG, the giant insurance firm with global operations. To ward off further calamity there were hectic attempts at mergers and buyouts. Merrill Lynch was taken over by Bank of America. Panic was spreading and spilled over immediately to the stock market. The credit squeeze and the lay offs affected the households also, those relying on credit cards in particular. The drastic reduction in spending led to a deflation which soon turned into a recession. Pension funds, endowed funds of universities, foundations, religious organisations and many more were also impacted losing anywhere between 20 and 40 percent of their assets within a couple of months. The government took a standoffish position in the early stages partly because of the ideological consideration that the market would correct itself, but also because there was strong opposition to spending public money to save or support private firms like Lehman. But the crisis and panic was so intense that a wait and watch position was no longer tenable. The Fed brought down its rate to close to zero. The Treasury decided to pump in $700 billion to enable banks to lend more, but on the assumption that the crisis was one of liquidity. The real issue, however, was the insolvency of many big names as
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a result of profit-chasing recklessness. The failure to grasp the distinction made public policy ineffective, if not counter productive. By the end of 2008 Planet Finance and its NFA, America’s great pride and success symbol was in shambles. Planet Finance – Planet Earth Links But it will be a mistake to think that the problems were confined to Planet Finance. Planet Earth was also in doldrums. The most widely reported was the upscale Chrysler Motor Company going bankrupt. More recently General Motors (yes, GM about which it used to be stated that what is good for GM is good for America!) followed suit. And think of the millions who lost their jobs and the thousands who had no choice except to move out of their homes as they were in no position to pay the instalments of their mortgages. There was irony too which can be appreciated only from a Planet Earth perspective. While all the merry-making was going on in Planet Finance, down below inequalities of income were sharply rising. Charles Morris points out that between 1980 and 2006 the top tenth of the population’s share of all taxable income went up from 35 to 46 percent, an increase of almost a third. What is even more striking was the disparity within the top ten. Almost all of the top tenth’s share of gains went to the top 1 percent who doubled its share from 9 to 20 percent; and the top tenth of that 1 percent tripled its share! And not surprising either. Top executives of Planet Finance firms were getting (more realistically, assigning themselves) fabulous salaries, perquisites and bonuses not only when their companies were doing well, but even at times of liquidation. Even “doing well” was a matter of perception. According to a well documented case, a private equity firm “created value” of some $100 million by laying off workers and the two partners gave themselves a bonus of $1 billion (no mistake here) for their commendable performance! We see how the problems associated with intermediation dealt with earlier, particularly information asymmetry and agency problem played a role in the rise and fall of Planet Finance.
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In the light of this interaction between finance and the “real” economy, it is necessary to consider whether they are two distinct planets. If celestial finance impinges on terrestrial housing so intensely, they must be closely connected. Though “Planet Finance” and “Planet Earth” are useful metaphorical descriptions up to a point, they are not, cannot be, separate and independent entities, but only inter-related aspects of national economies and the global economy. The role of finance is to facilitate the functioning of the “real” economy (another useful expression, but quite misleading if taken literally, for finance is real too!). However, finance has the tendency to assert its independence and to dominate the real economy – a case of the facilitator becoming the boss. It is also the manifestation of an in-built feature of the kind of economic order we are dealing with that the few who control finance - the most abstract and, in a sense the most “useless” form of wealth - have power over the toil of the masses and the savings of millions to further enrich themselves.
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V. The Global Dimension
Exclusive attention paid to the USA so far is not because the problems in the financial sector – the emergence of the shadow banking system, the proliferation of CDOs, sub-prime lending etc – happened only there. America, of course led the way. But the problems surfaced in various forms in other parts of the world as well, in the UK, and many countries of Europe. This is not surprising because many of the agencies involved were already global operators and the global financial system is controlled by a consortium of financial authorities from the rich world. And not surprisingly too, the rest of the world had a tendency to “follow the leader”. For a more basic understanding of the meltdown we must link together the global performance of finance with trade of goods and services and the associated movement of trade surpluses between nations. Such a treatment is necessary for a better appreciation of global finance as well. America Lives Beyond Its Means Immediately after the Second World War, the US as the leader of the Allies and about the only country in the world whose economy had flourished because of the war efforts, took upon itself the task of reviving and rebuilding the “free world”, that is those countries that were not part of the bloc led by the Soviet Union. The Marshall Plan of transfer of capital from the US to Europe was one of the measures. The second was the acceptance of the US dollar as the universal reserve currency (the role that the British pound played during the heyday of the Empire) as the US had become the major supplier of the world and thus practically every country was in need of dollars. Thus US
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capital was moving out to the rest of the world and the dollar was effectively the global currency. Today’s world presents a different picture. The dollar still retains much of its position, though Europe’s euro is emerging as a serious contender. But the value of imports by the US is far in excess of the value of its exports which makes it a nation in debt to the rest of the world. Strange as it may appear, for several years now the US has been at the top of the list of countries in debt borrowing around $800 billion a year. And how does it manage this situation? By other countries, ironically China lending to it – the irony of a low income country lending to a rich country or as one writer has expressed it, communist China lending to capitalist America. But the mechanics is simple: China exports a wide range of goods to the US; it does not buy much from the US and thus has a trade surplus; which it holds as dollars or bonds of the US government as, for the present, the dollar is the strongest and most stable currency precisely because China and many other countries that have a trade surplus “lend” it to the US. However strange as it may appear, this is one of the realities of today’s world. There is another and perhaps more revealing way of expressing this. American people are living beyond their means and manage to do so because people from other parts of the world, with per capita incomes far below the US level are continuously lending to it. Which means also that surpluses from the rest of the world are first flowing into the US, enter into the books of American banks, then going out as capital flows to the rest of the world. To link this up with our main story, credit expansion in the US is made possible by the rest of the world and hence collapse of the credit system in the US will have a bearing on other parts of the world also, China and yes, India as well. To trace these processes will be tiresome and we shall just illustrate them. And to bring out the implications more realistically we shall bring the exposition down to the level of the people whose lives get affected. To begin with we shall examine
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the US and China who are major partners in economic relationships. Impact on China and India Once China decided to reverse its initial policy of pursuing an internally driven growth pattern and opened up to the rest of the world, exports became a significant share of its GDP, now over 50 per cent. Exports accelerated after it became a member of the World Trade Organization (WTO) in 2001 and by 2003 China was Asia’s largest exporting country replacing Japan and by 2005 the third largest in the world, next to USA and Germany. By that year it was supplying a fifth of the USA’s requirements of manufactured goods and had a trade surplus of over $100 billion with that country, held largely in the form of US Treasury bonds. Chinese exports into the US continued to grow at around 20 percent for the next couple of years as well. Let us now turn to what happens when there is a meltdown in the US, starting in the financial sector, but spreading rapidly throughout the economy. Jobs are lost and incomes come down. Goods imported from China and used in the industrial sector get reduced. People’s spendings go down and there is less demand for Chinese goods which had invaded supermarkets – let us say, electronic goods and toys. Factories producing these export goods in China are affected and workers are laid off. Millions of Chinese workers from industrial towns are forced to go back to their rural families. What started in the posh cities and financial centres in the USA soon reach the humble dwellings in far away China, and the meltdown has become a worrisome global phenomenon adversely affecting the lives of millions of people everywhere. India has been affected too, but not as much as China because our exposure to the rest of the world – whether in the form of capital flows or trade – has not been as high as in the case of China. When the early signs of trouble in the financial sector in the US started appearing, there were those who maintained that India (perhaps China too) could be
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“decoupled” from such calamities because our economy was essentially internally driven, finance did not play a dominating role in our system unlike in the US, and our financial system was thought to be adequately insulated from global finance. But today it is openly admitted by economists, business people, administrators, politicians and many more that our economy has been adversely affected by external factors. A brief examination of what has happened is worthwhile. Though in overall terms the rate of growth of the Indian economy has continued to be a respectable close to 6 percent per annum, it still is a fall from the near 9 percent we had achieved before the troubles started and the 10 percent that we anticipated could be achieved. Our banking sector, on the whole, still remains robust because of the dominance of the public sector banks that have been forced to follow the effective supervisory role of the Reserve Bank that prevented banks from following adventurous paths. And although the Indian economy’s total external transactions (value of exports and imports plus gross capital flows) have increased from around 47 percent of GDP in 1997-98 to over 117 percent in 200708, we have not yet gone in for full convertibility of the rupee. Hence, so far there has been no banking crisis or shake up in the financial sector. Only our stock markets which are linked to their counterparts in the rest of the world have crashed and have become subject to volatility. Capital flows into the country, on the other hand, have declined especially those coming from foreign institutional investors (FII). In fact, a reverse flow of funds from FIIs had set in towards the close of 2007. (In this connection a major difference between India and China may be noted. We relied largely on financial flows from outside whereas China insisted on foreign capital going into productive activities.) External commercial borrowings have also declined. These two have lowered the level of investment in the country and the growth of the manufacturing sector has been adversely affected. Our exports have declined too as Indian exports in which services account for some 37 percent are very sensitive to levels of
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income in the Western countries. The domestic sectors affected have been metals and metal products, textiles and garments, automobiles, gems and jewellery and information technology. Many business concerns have been affected, IT, travel and tourism, hospitality and entertainment. Associated with it has been loss of jobs for which there have been no firm estimates mainly because close to 90 percent of the total workforce in the country is in the unorganised sector about which it is not easy to get clear information. But an official survey sponsored by the government has estimated that about 1.5 million workers would be thrown out of work between September 2008 and December 2009. Many consider this to be a rather optimistic estimate. Thus, the impact of the meltdown in India has been largely on the real economy and on the lives of real people from the lower sections in particular.
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VI. Quo Vadis?
Where do we go from here? We shall not go into bailout schemes and quick fixes of that kind, but deal with some basic issues that need to be addressed in the light of the contemporary global calamity. Regulation of Credit and Direction of Investment Of these one of the immediate ones is how credit and the banking system are to be regulated. Credit is the most omnipresent, though largely invisible, aspect of any modern economy. It is based on economic considerations, but is principally grounded in trust which is above and beyond the economy. If trust fails, credit fails and banks fail too. If that is the case, the regulation of credit must be vested with the most publicly accepted and most stable of social institutions, the government. This is similar to, but more important than, the control over currency, or money in general. In the early stages of the evolution of credit and currency, these were under the responsibility of agencies whom the immediate transacting parties trusted. Over time the government took over the responsibility of intermediation which accounts for the general acceptability of these instruments. Thus because of the allpervading role of credit and the need to assure and sustain trust, credit must be under the regulation of the government. To a large extent, and for the same reasons, it is best for the banking system also to be under the ultimate control of the government. This suggestion may be resisted, if not rejected, on the grounds that anything that is under the control of the government will become bureaucratic; and it is a genuine apprehension. Unlike in the case of credit which is largely unseen, banks are visible and enter intimately into the
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day to day lives of ordinary citizens. If banks become bureaucratic institutions, it will be terrible indeed. However, it is possible for banks to be functioning as banks should, but for the control over them and their regulation to be exercised by an agency of the government. That is what the nationalised banks in our country have demonstrated. Granted that banks are in an intrinsically risky business, the essence of the regulation of banks is that they are prevented from becoming too adventurous which businesses motivated largely by profitmaking cannot seem to avoid. That is what shadow banking has shown. The principle underlying the agencies that later turned out to be shadow banks is sound: the separation of the credit generation function and the investment function of banks. This was tried out and legalised in the US after the Great Depression and appeared to be working well for a while and a number of investment banks emerged. But over time they made a nonpermissible entry into the banking function of credit expansion through the “innovative” method of CDOs, CDO 2s, etc which must have had the initial approval of the banks also because both found it a new method to increase their profits. However, they also succeeded in generating a horizontal credit network, outside the regulatory system of banks. Then came the proliferation of intermediaries, all guided by the sole objective of making profits pretending that self-regulation (that is, regulation by the market) provided the necessary protection and also enabled wealth to increase. But before anyone realised it, they slipped into a crisis bringing down themselves, their base, the banking system, and further down, the rest of the economy as well. Hence, one of the first things to be done is to eliminate the “derivatives industry” and with it shadow banking because these are based on the possibility of costless production ensuring easy profits – for a while. Once this is done, it will be possible to bring credit creation and financial investment under social control. In the US, the Fed as an independent non-
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governmental agency claims that it is responsible for regulating credit through regulating money supply. There are many problems here. First, more than formal control over money supply is necessary to regulate credit because credit instruments themselves which are beyond the purview of the Fed can form the basis for credit expansion. Second, the Fed has no mandate to deal with financial investments and hence leaves it entirely to the market. And third, and most important, while the Fed claims to be independent of the government, its true nature is seen only during periods of crisis when it becomes a partner, a junior partner actually, of the government. This is not surprising either because while the Fed may supervise and regulate the banking system, only the government can deal with the economy as a whole. Thus, a designated independent authority, responsible to the government, is unavoidable for the management of credit and the regulation of the banking system. This authority must also be entrusted with the task of deciding whether and when new credit instruments are required, ensuring that “profit only” will not be allowed to become the criterion for resorting to them. The question of investment decisions also has to be considered. The reference is not to physical investment (fabricating machinery, putting up construction, oil drilling etc) but to financial investment. Those who have large amounts to spare, individuals as well as institutions such as pension funds, are always looking for opportunities to invest them. Safety and expected (in most instances, assured) returns are the main considerations and there are many potential possibilities – shares, bonds, mutual funds and the like, all segments of the general category of finance. Subject to considerations of risk, the main objective is to secure the highest returns, and naturally this is the avenue where intermediaries with their objective of maximising profits function. Naturally too, this is the area where most problems arise mainly because there is either no independent regulatory authority or because regulations
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are not effective. Public Regulation Other than eliminating intermediaries which have no justifiable raison d’etre, there are no easy ways of dealing with this area. However, a procedure that may bring down the profit-only operations and agencies is worth consideration. Some elements of it already exist. During the apartheid regime in South Africa, many individuals and institutions in different parts of the world decided that they would not let the funds they had available for investment go to firms that had dealings with that regime, or doing business with that country. It was a form of protest; a form of effectively making a moral statement. The same spirit can be made more positive by the decision of those who have funds that they are willing to forego some earnings to support financially sound but not-for-profit organisations. Educational and medical institutions, publishing concerns are examples. These should be allowed to receive funds as investments assuring a reasonable return to the investors. To encourage the practice, tax incentives, for instance, can be given to those who make such investments. The idea is to build up a constituency that will consider reasonable returns as a constraint, rather than maximum returns as the sole objective. Initially only convinced individuals and institutions may take this route. However, once this becomes an established alternative, it will spread and can bring about a qualitative difference to the economic system as a whole. Obviously, agencies that run not-for-profit businesses should come under public regulation, the reason being that they are using funds from the public. The word “public” used above has a connotation quite different from what it has come to have in ordinary parlance where “public” is almost synonymous with government as for instance in “public sector” undertakings. But in the paragraph above, “public” is used as the antonym for “private”. A family or partnership which uses its own resources can be considered private, but any concern which uses funds from the public
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becomes a public concern irrespective of who owns it, whether the government or a company. In this sense, a business corporation that raises funds from the market (strictly speaking from the public through the market) is a public concern, even if it does not receive any financial support from the government. By the same token, a “public” regulatory authority need not necessarily be a body of and by the government: it can be a body set up by members of a particular industry, but independent of it with a mandate to protect the interest of the public associated with that industry, and not that of any particular concern within that industry or even of all concerns that constitute that industry. As a matter of fact, in a democratic set up the government itself is such a public body constituted by the largest “public” with the specific task of protecting and promoting the “common good”. The judiciary is another independent public body to ensure that the government as a public body does not assume arbitrary powers and does not deviate from the tasks assigned to it. And the state is the ensemble of independent authorities each with its own specific mandate, and all necessary to articulate, promote and protect the common good. (It is very unfortunate that the crucial distinction “public” as opposed to “private” and public as synonym of “government” is not properly appreciated. Think also of the use of the word “public” in Public Schools which everybody knows are private, and Public Interest Litigation which is the concern of the public, often against the government. Perhaps we need two different words instead of the same word “public”.) State vs Market With that understanding we may briefly revisit “the state versus market” debate. The first thing to note is that if the expression is meant to convey that society has to choose between the two, it is either false or is based on misunderstanding. For, there is no modern society which functions, or can function, without both in some form or the other. If authority is the essence of the state, without it there
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will be chaos. Further, it was known from the days of Adam Smith that agencies concerned only with profits will have no incentive to provide infrastructural facilities and merit goods such as defence, education etc, although in education, healthcare and so on private bodies soon discover ways of making profit. Hence in many societal aspects including what may be considered to be “strictly” the realm of economics, the state (through its representative manifestation, the government) has a major role to play. This position is very different from a view strongly canvassed by a powerful body of American economists (and their followers in the rest of the world) and converted into an ideology by politicians that the ideal economic system is where the state performs the minimum necessary functions leaving the rest to the market based on the principle of self-interest. The rationale of this view is often traced back to a passage from the writings of Adam Smith in which he stated that when individuals work for their own gain they are “led by an invisible hand” to promote social good also. Smith, indeed, made such a statement. But what is often forgotten is that Smith’s basic position was that “justice upholds the edifice [of society, and] if it is removed, the great, the immense fabric of society … must in a moment crumble into atoms”. Upholding justice, understood at least as the common good, is the role of the state in the social order. Part of the reason for many of the economic ills of recent decades has been a deliberate attempt to underplay the government’s unavoidable role in the economy. Turning now to the market, if exchange is the rudimentary function of the market, without it every individual (or family or some small group like that) will have to be selfsufficient. Hence the market certainly is a useful social institution. At times, as in the context of discussions on finance, it is the (self) regulatory function of the market that is featured. When things are working well it may appear legitimate also. But even Alan Greenspan who, as Chairman of the US Federal Reserve Board from 1987 to 2006, maintained and avidly
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propagated this view admitted when the avalanche of the financial crisis erupted that he was wrong. One thing that is often overlooked is that except for the most elementary form of barter, all market transactions, including the transactions of commodities, are done through intermediaries and hence markets in general are subject to the problems of mediation noted earlier. As we have already seen, the problem of mediation is more so in transactions of credit and finance but is inherent in all market transactions. Hence as a general proposition we may say that all markets have to be subjected to non-market regulations. Monetary transactions are effectively synchronisations of market and state in so far as money is a symbol of authority. But in some transactions more than that symbolic authority and regulation is required. More important still, we have seen that the foundation of a modern economy is trust which is beyond the market and not self-interest considered to be the basis of exchange and the market system. The state comes into matters of finance because though finance is, up to a point, the realm of the well-to-do it impinges on the lives of most members of society, or the public at large. A democratic polity, in particular, cannot afford to ignore economic and social problems of sharp increase in inequalities that finance brings about when its performance is considered to be good, and the loss of jobs, incomes and shelters of the ordinary people when things go wrong. But how are the interests of the ordinary citizens to be protected? Growth? Stimulating growth is put forward as the immediate and standard remedy. However, unspecified growth is just a number which can mean many things depending on what has been growing. Hence the composition of growth itself must be examined. For instance, growth generated substantially in the finance sector will have one kind of impact on the economy and society compared with growth generated in the
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agricultural sector. In India, where the contribution of the services sector in the GDP is already greater than the combined value of the output of the agricultural and industrial sectors, “growth” often means merely a further bloating of service sector itself. And growth confined to selected segments of the economy and limited sections of society is often illusory. Hence it is important to consider what exactly is growing and to ensure that growth is inclusive reaching the lowest rungs. The specifics will depend on the type of economy concerned. But a democratic system must ensure that the productive activities of its economy are directed such that the basic needs of all are met. Special attention should be paid to reach out to those who have been thrown out by the financial crisis. A deliberately designed bottom-up strategy of growth will be the best to rehabilitate the economy and set it on a healthy growth path. A strong case can also be made to have a permanent safety net that will provide protection to vulnerable sections of society. This is not only a philanthropic consideration. Growth will increase and can be sustained when all become productive. Since shelter is a basic requirement, providing minimum housing at reasonable rates to all must be included as part of social policy. In fact, food, clothing, shelter, education and health care must be recognised as economic entitlements of all citizens in an enlightened democratic system. Changes at the Global Level While these are matters largely for each country to decide, some changes are required at the international and global level because no country today can ignore its economic relationships with other countries. This can be best stated with reference to the US-China relationship dealt with earlier. As noted there, the domestic situation in the US is partly the result of its currency’s dominating role globally. A vast and relatively low-income country like China should not be using its resources to provide American consumers low priced goods. However, at this stage China cannot afford to suddenly change that pattern as its productive activities are so crucially
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linked to the American market. It cannot also withdraw its piled up dollar reserves because that will weaken the dollar and make China poorer! Nor can China raise the value of its currency suddenly as that will adversely affect the export advantage it now enjoys, although in the long run it should readjust its economy to produce more for the use of its own citizens, if necessary importing more than it is now doing. What we see is that even a country that has the basic economic strength to make readjustments cannot do that because of its global tie ups. China, therefore, has put forward the legitimate demand for a genuinely global currency that will not give any one country special advantages. Towards the end of the Second World War a similar need was felt and the International Monetary Fund (IMF) which permitted member countries to draw on its reserves when required was created for that purpose. However, the role of the IMF was then perceived to be to deal with only payment problems between countries and not long term needs of development. More crucially, the special drawing rights (from the IMF) is related to each country’s contribution as decided in 1944 when the Fund was set up, and do not reflect the vastly changed international economic conditions today. Hence if the IMF is to continue to be the global currency authority, it will have to be radically restructured. If that is to be achieved the United Nations Organisation must also be reorganised in tune with the vastly changed profile of the nations of the world today. International trade regulations also require to be changed to stabilize a new global currency and to have healthy economic relations between nations. The poorer countries of the world are at an economic disadvantage because of the strong trade barriers that the richer countries maintain to provide protection to sections of their own citizens. The WTO was set up for this purpose and to bring about freer trade between countries. But after several rounds of negotiations not much progress has been made. To move forward it is necessary to have a new architecture of global governance with a global reserve currency which is not the national
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currency of any one country, something corresponding to a World Reserve Bank that will lay down fair conditions for drawing on global reserves, a just international trading system that protects the interests of the poor and vulnerable throughout the world. Thus, within countries and between them there is much to be done to remedy the problems created by the global meltdown and go beyond. The suggestions put forward may appear to be too idealistic as they call for changes in attitudes and priorities, as well as considerable institutional restructuring. But the attempt has been quite deliberate, and for two reasons. The first is that it is widely recognised that what happened to the US financial system in 2008 and has been spreading to the world since then is not merely one more of the many crises that the US economy has gone through in the past. It is qualitatively different and is sure to mark the beginning of the end of the global economic domination of the US. Hence this is the time to think anew. Secondly, that opportunity should be used to heavily underline that fairness, not greed, must be the cornerstone of economic systems within countries and in an increasingly globalising economic order. The message of the meltdown is that while institutionalised greed may sustain the system and even provide some semblance of well-being for a while, it surely paves the way for destruction from within.
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Note : In writing this piece the following have been of help: 1. Cable Vince, The Storm - The World Economic Crisis and What It Means, London, Atlantic Books, 2009. 2. Economic and Political Weekly, Special Number on Global Economic and Financial Crisis – An Agenda for the Future, Vol.XLIV, No. 13, March 28- April 3, 2009. The papers in this Number also provide extensive references. 3. Ferguson Niall, The Ascent of Money – A Financial History of the World, London, Allen Lane, 2008 4. Morris Charles R., The Trillion Dollar Meltdown – Easy Money, High Rollers And The Great Credit Crash, New York, Public Affairs, 2008. The statistics relating to income inequalities in the United States given in Section IV are taken from pages 152 &153. 5. Soros George, The Crash of 2008 and What it Means – The new Paradigm for Financial Markets, New York, Public Affairs, 2008. Comments received from a wide circle of members of the family and friends on earlier versions that led to substantial revisions are also gratefully acknowledged.
