C. Rangarajan

Financial capitalism will undergo the most radical changes. Acceptable capitalism would require more regulation.

The current financial crisis has raised several questions regarding the future of capitalism. What will be the shape of capitalism in the coming decades? Will it undergo radical changes or will the changes be only marginal?

Great Depression and after

In this context, it is worthwhile to go back to the 1930s and find out how the measures taken to address the Depression changed the contours of capitalism. It may be noted that the policymakers were mostly inactive immediately after the onset of the depression. Any action taken by them only deepened the crisis. It was nearly four years before action was taken and the measures came to be known as the “New Deal” in the United States. As a consequence, capitalism underwent changes in three important directions. First, there was a clear recognition of the role of the state in economic activities. The government’s involvement in public works programmes became a critical element. Second, a wide range of social security measures became an integral part of the system. Once again, there was a clear recognition of the need for the state to provide social security. These programmes took several forms, including unemployment relief. Third, the financial system underwent a radical restructuring. The banking system was subject to stricter regulations, including the separation of banking from non-banking and non-deposit-taking financial activities. Some of these trends were reinforced in the post-World War II period. There were fears of recession as the war came to an end. The role of the state in economic management thus continued to expand. Public expenditure as a proportion of GDP which was 18 per cent before World War II rose to 40 per cent in 1980.

The 1980s, and more especially the 1990s, saw an expanding role of the market. The process of deregulation started in many areas. But the economy during this period also expanded enormously. The exuberance of the system came to a halt only last year. The current financial crisis also is a child of this exuberance.

Features of current crisis

Three aspects of the current economic crisis deserve attention, as we look at the future. First, the crisis did not originate in the real sector of the economy. It was triggered by the excesses of the financial system. Fixing the financial system has thus become the first priority. Second, policymakers have also to address some fundamental issues such as the persistent current account deficit in the U.S. and the low and declining savings rate in the advanced countries, particularly the U.S. Unless the U.S. economy is put on a sounder footing, concerns will continue to arise regarding the strength of the dollar and this has implication for its use as a reserve currency. Third, globalisation has proceeded on a rapid pace in the recent period. While this resulted in better allocation of resources, particularly investment, among different countries, the emphasis on efficiency which is the outcome of globalisation also led to the accentuation of inequalities among and within countries. Globalisation spreads both prosperity and distress. It cuts both ways. Global institutions will have to play a more decisive role in taming globalisation. Each country will have to decide on the extent of openness with which it is comfortable.

Regulatory failure

What stands out glaringly in the current economic crisis is the regulatory failure in relation to the financial markets. Some parts of the financial system were either loosely regulated or were not regulated at all. This resulted in ‘regulatory arbitrage’ with funds moving from the more regulated to the less regulated segments. The second was the failure of the regulatory authorities to understand fully the implications of the various derivative products. The regulators did not exercise the required degree of oversight and control. Financial capitalism will be the one that will undergo the most radical changes in the coming years. The scope and nature of the regulations will receive the maximum attention. Micro prudential indicators will have to be supplemented by system-wide prudential indicators.

In a way, it is ironic that the regulatory failures should have occurred at a time when intense discussions were being held in Basel and elsewhere to put in place a sound regulatory framework. Capital adequacy provisions will have to be revisited so that the quality and quantity of overall capital in the financial system is enhanced. A counter cyclical capital adequacy regime may have to be introduced. Some understanding will also have to be reached among countries on how to control institutions which operate across countries and globally. Many agencies are currently engaged in evolving a new set of regulations to cover all segments of the financial system including “shadow banking” and credit rating agencies. One can thus expect to see a reversal of the trend towards deregulation with a move towards a tighter control over the financial system. Standards of regulations will have to be globally consistent and a need for an international authority to oversee the implementation of the regulations within countries may become imperative.

State and market

The structure of capitalism in any economy depends on the respective roles assigned to the state and the market. The boundaries between the two have been changing over time. There can be a further shift in the context of the current crisis. In any economy, the state can play three roles in relation to economic activities — as a provider of marketable goods and services; as a provider of public goods and services and; as a regulator.

The role of state as a provider of marketable goods and services has been going down. This trend may continue. Even though as part of crisis management, some of the leading industrial countries have injected capital into private banks, this may only be a temporary phase. There is no intention on the part of governments to participate in the management of these institutions. The state’s role as a provider and facilitator of public goods and services may grow further. Even here, there are many experiments going on in terms of joint participation of the public and private sectors. While the broad goals are set by the government, the delivery system is handled by the private sector. Public interest concerns are transmitted through appropriate covenants.

It is in the area of the state as a regulator that one will see significant changes in the coming years. Regulation of markets, more particularly financial markets, will assume importance. The regulatory failure seen in recent years needs to be corrected. There will be a restraint on financial innovations. Runaway financial innovations which are dysfunctional in character can do more harm than good. This is a lesson that we can draw from the current fundamental crisis.

Course of globalisation

Globalisation as a process of connecting countries and communities will continue. International trade in goods and services will continue to expand. Even in the current crisis, analysts have been warning against countries adopting protectionist policies. However, the coming years may see restrictions being put on financial flows. Developing countries may not want to see unfettered freedom in the flow of funds. This will also slow the process to capital account convertibility. Which may cease to be the cherished objective of the developing countries.

Thus, in the final analysis, the fundamental characteristics of capitalism may not undergo any big change. Markets will continue to play an important role but what will emerge as a consequence of the financial crisis will be greater control and regulation of the markets in general, and financial markets in particular. The productive sectors of the economy have not shown any basic weakness. In fact many industrially advanced countries have seen an improvement in productivity in recent years. It is the failure of the financial system that has affected the productive sectors. The excesses of the financial system are the ones that need correction. Acceptable capitalism would require more regulation.