‘Slump will take both fiscal and monetary action’

Professor Nicholas Stern, former chief economist of the World Bank, was in Mumbai recently to address a CII event on the global financial crisis. He is IG Patel Professor of Economics and Government at the London School of Economics, besides director of the India Observatory, chairman of the Asia Research Centre and chairman of the Grantham Research Institute on Climate Change and the Environment.

N Sundaresha Subramanian and Joel Rebello caught up with him for a chat at the Gateway room in the now-gutted Taj Mahal Palace two weeks ago. Excerpts:

What do you think will be the new US administration’s approach to the financial crisis?
I think that there will be a recognition in the new administration of the basics, which is that the world needs a coordinated expansion in demand, partly monetary, but also fiscal. And it must keep trade avenues open. The key mistakes made after 1929 were contractionary fiscal measures by governments that saw revenue fall and close markets for trade by erecting protectionist barriers. Those were the key things that dragged the world economy down. I think G-20 economists have recognised that we must not repeat the mistakes and cause coordinated fiscal crunch and keep trade open and indeed, possibly include Doha round and WTO. That would be the right kind of measures.

Henry Paulson recently said he won’t buy any more troubled asset. Your views...
It’s a question of where the resources are going to be allocated. What they are going to do in the US is more like what they are doing in other parts of the world, especially the UK, i.e. recapitalising the banks so that the banks start lending again. Recapitalising means more control. In some places, it may even mean nationalisation. That’s been going on in the UK and Europe. We need to see banks lend to each other.

Do you see the US doing that?
Yes. It’s already happening. US Federal Reserve is starting to lend. It has started lending to a broader range of financial institutions against weaker collaterals for a longer period. There are many dimensions for monetary action, not just interest rate story. Fed is already thinking in broader terms than it would have done in normal times. Therefore, in addition to fiscal measures, strong monetary action…

China and other Asian countries have been buying into US treasuries. What role did this play in fostering the crisis?
After East Asian crisis of 1997, many countries around the world, particularly from Asia, felt they needed big reserves to protect themselves in future. They have been building up. How do you build reserves? You save; you run balance of payment surpluses. Many countries in Asia have been running BOP surplus. Many oil economies have been running major surpluses as well. Those big surplus areas, largely in the Mid-East and Asia, have been willing to hold their assets in the US, which means the big deficit in the US had a willing funder. If you ask, ‘Who is responsible for this?’ It’s not the people, who have been prudent and have been saving — they facilitated this. But the people who lend unwisely in the housing sector, they are responsible. Those mounted the complicated derivatives on their back, they are responsible. They got facilitation from savings from outside.

What role do you see for the Asian economies in the days ahead?
Asia is going to suffer slowdown by 2-3% in growth rates. If you are growing 2% and there is a slowdown of 3%, you will go into recession. That’s what is happening in the US and Europe. Chinese growth rates will come down from 10-11% to 8%. That’s a corresponding reduction in growth, though it’s less painful because you are growing. But it’s still a decrease in expectations and aspirations.

Some people who might have done well will not do so. Same will be true in India. There will be some slowdown. I believe Indian authorities will act strongly, both fiscal and monetary, to reduce that pain.

India doesn’t seem to have headroom for financing a fiscal stimulus package like China?
Different countries respond in different ways. The balance between fiscal and monetary policies will be different in different countries. In India, the balance will be more towards financial and monetary side than fiscal relative to China. China started out with fiscal surplus. In India, the balance has to be worked out in due course; the officials in Delhi and Mumbai do exactly that.

Do you see the world moving away from US dollar?
It’s already happening. Why should you hold all currency in one place? People will spread into euro, yuan, pound and other currencies.

What end do you see for this crisis?
We will come out of this in a year or two. We learn lessons on how to not get into these in future.

Capitalism has come to an end…
No. We are going to be in a world where key allocation decisions will be made in the markets. I hope we learn to manage the markets better. Market needs government policies; market needs regulations. Markets need different people operating. That will be true. I think we need to learn to forecast and manage systemic risks.

We seem to forget what we learnt when the going is good?
There is a lot of forgetfulness. All we can do is educate, remember and learn. I do think the world needs a body which will be the very senior, quite senior quite slow, quite dependant, which will be in charge of systemic risks to ensure that in future the crisis does not attain the magnitude it has reached currently.

What kind of capital flows do you see in the next few years?
People won’t give up on emerging markets. Overall investments will fall in the next year or two as the world becomes more cautious with credit. But, attraction of emerging markets will remain strong.

n_subramanian@dnaindia.net
r_joel@dnaindia.net