With financial capitalism dead & gone, it’s time to get real

The current global financial and economic crisis is among the most serious the world has faced since the Great Depression of the 1930s.

The International Monetary Fund (IMF), usually given to understatements, has warned of financial meltdown, underscoring the gravity of the current crisis. While the epicentre of the current turmoil is in the industrial countries, particularly the US, the UK and Europe, no part of the world (including India) is immune from its impact.

As an example, the Bombay Stock Exchange’s benchmark index has dropped by nearly two-thirds from its peak in early January 2008. The households and businesses are finding access to credit much more difficult, and are facing higher cost of credit when it is available. India also faces diminished growth prospects.

Among several factors contributing to the crisis, the following two are widely regarded as the most critical:

First, the fundamental inconsistency between globalisation of finance and disproportionate role of the financial sector in the major economies on the one hand, and limited institutional and regulatory capacities of the domestic agencies on the other has finally been demonstrated to be unsustainable.

The Federal Reserve of the United States admitted that vast proportion of the total liquidity created by “shadow banks” was outside its regulatory purview. It has since then be forced to assume liabilities (whose precise magnitude is unknown) of these banks.

The financial sector share of GDP in the US increased from around 4% of GDP in the mid-1980s to 12% in 2005. This increase was aided by excessively loose credit conditions, and almost automatic acceptance of the benefits of financial innovations in products (for example of credit default swaps, which have helped to spread the crisis globally), and of financial leveraging.

This period also witnessed the emergence of new financial institutions (for example, hedge funds, sovereign wealth funds (SWFs) and private equity firms) whose reach was global, but they largely escaped regulatory oversight, both domestically and internationally.

The second major factor has been large and unsustainable global macroeconomic imbalances. The US has persistently run excessively large budgets and trade deficits. These have been financed by correspondingly large trade surpluses of export-led economies such as China, and of resource-rich countries.

The surpluses were largely reinvested in the US and Europe, lowering the interest rates. Some argue that these led to substantially increased risk appetite of the financial institutions, contributing to the types of financial innovations and accounting practices which have now proved to be excessively risky.

The response of the policymakers to the global financial turmoil strongly suggests that the era of financial capitalism has ended. Thus, there has been an effective nationalisation of large chunks of the financial sector in the US, the UK and Europe. Recapitalisation of banks, primarily from governmental resources; and extensive guarantees for bank deposits have been the major instruments of governments around the world, including in Asia.

Such recapitalisation and guarantees involve complex technical issues. They also imply that governments will have to bear large unknown amounts of contingent liability. This could severely constrain the use of fiscal policy to stimulate demand and reallocate expenditure towards growth and social consensus-enhancing expenditure in many countries.

The financial sector will henceforth not play as dominant a role as in the recent past. However, the transition to a more sedate and scaled-down financial sector will be painful, and will not be achieved quickly.

The government ownership of large segments of the financial sector represents a sudden reversal in the prevailing intellectual climate concerning the state-market mix. It is, however, important to draw the right lessons. Historically, the role of the state (more loosely government) has increased at times of major crisis, such as wars, financial crisis, and deep recessions. But to undertake any economic activity (for example provision of infrastructure, health and education services, or financial services) in an appropriate mix of the state and the market is needed.

A regulatory and supervisory failure in major developed countries has been among the major reasons for the current crisis. Thus, increasing the role of the state without increasing regulatory capacities and willingness to regulate is unlikely to address the root causes of the crisis.

It is not yet clear how the dynamics created by the current global financial turmoil will help in addressing the global macroeconomic imbalances without serious and prolonged damage to the world economy.

The proposed meeting of major developed and developing countries in mid-November, 2008 in the US is expected to discuss the new global financial architecture and reforms of existing institutions such as the IMF and the World Bank.

As has usually been the case, there is less pressure on the surplus countries, such as China, to adjust. Traditionally, the burden of adjustments has primarily been on the deficit countries. However, the reserve currency status of the US dollar, and the fact that US consumer demand has underpinned global growth in recent years, are complicating the traditional adjustment mechanism.

The emergence of new global economic powers such as China and Russia also create challenges for addressing the global macroeconomic imbalances. Nevertheless, a more multi-polar world is likely to emerge.

The global weight of those with large surpluses, and of those countries which are economically well-managed and governed, is likely to increase. The current global financial turmoil could, however, lead to substantial reduction in the current level of foreign exchange reserves and assets of many countries.

Many resource-rich and trade-surplus economies have entrusted their reserves and assets to their SWFs. The future role of the SWFs will be determined by the appetite for political risk tolerance of the population, and institution of accountability mechanisms in each SWF originating country; and by how they are perceived in the recipient countries.

At this juncture, it is still unclear what would replace the financial capitalism which dominated the global economy for the past quarter of a century. Even as the countries cope with the current global financial turmoil, policymakers (including those in India) would do well to focus on the fundamentals of sustained economic growth, and improved quality of life.

India must look beyond the immediate measures designed to cope with the financial crisis. To sustain growth, it requires more competent and prudent economic and political management, and an environment in which India’s inherent entrepreneurial capacities have opportunities to create wealth for the society.

The writer is professor of public policy, National University of Singapore and can be reached at mukul.asher@gmail.com. Views are personal.