Raghuram Rajan’s >opening statement on taking office as governor of Reserve Bank of India left no room for doubt. He intends to open up the capital account and replicate the United States financial system in India with all its bells and whistles. Given recent global economic and financial history, this is a shockingly disastrous set of objectives to be setting. That Mr. Rajan would do so even as the Indian economy is being buffeted by the vagaries of the global financial system is noteworthy. It suggests that as governor, he will not so much be setting out policy but dogma. By clinging to the thoroughly discredited dogma that “arm’s length” financial markets always know best, Mr. Rajan risks putting the RBI on the wrong side of economic history.
To be clear, this is not an argument against markets, nor is it an argument against finance. We need finance to provide as much credit as possible to every productive nook and cranny of the Indian economy in much the same way as banks in America financed a massive increase in output after World War II and as the German banking system continues to fund its mittelstand of small and medium enterprises. What we don’t need, however, is the ‘casino banking’ which was developed first in the Anglophone countries in the early 1980s and has since spread around the world causing so much devastation in its wake and which Mr. Rajan seems hell-bent on replicating in India.
Reading our English-language press over the last few weeks, one could easily be forgiven for thinking that the last 15 years of global financial and economic history simply didn’t happen. Latin America’s assorted tequila crises apparently didn’t happen, nor did the East Asian crisis in 1997-98 which soon pulled in Russia, Brazil and Turkey, nor did Argentina in 2001. All these of course were labelled as crises of ‘crony capitalism’ as the ‘natives in their grass skirts’ didn’t know how to run a financial system. But then Lehman Bros. went bankrupt and we soon saw that the U.S. and other ‘advanced’ economy emperors whom we previously believed to be fully clothed in their pinstripe suits were actually stark naked and didn’t know how to run a financial system either.
There is simply no getting away from the fact that the Anglophone model of running a financial system is broken. As former Fed chairman Greenspan admitted in a rare moment of unguarded honesty, “the entire intellectual edifice has collapsed.” The Anglophone model is based on increased debt creation and financial intensification both of which are facilitated by ‘light touch’ regulation. Before too long the financial industry starts to run amok. It soon runs out of productive outlets for its debt and ends up creating a real estate bubble instead. Inevitably, the bubble bursts, the banking system becomes insolvent and the taxpayer is left to pick up the pieces in a shattered economy. We’ve seen this happen time and again from Japan in 1989 (from which it has still not managed to extricate itself) to all the crises mentioned above and many more which haven’t.
It’s the same movie with the same ending.
Indonesia in 1997-98 should serve as a cautionary example to India because of its similar size, ethnic diversity, etc. Indonesia had a budget surplus, a trade surplus, relatively low inflation, high GDP growth and, by virtually every measure, was in the pink of economic health before its financial crisis in mid-1997. The year after that, Indonesia’s GDP growth was -18% (yes, that’s minus!). It led to riots in the capital, Jakarta, and ultimately the overthrow of the government and a political revolution. There was also a huge upsurge in secessionist violence in Aceh (where thousands died) and ethnic cleansing and ultimately independence for East Timor.
Yet this is the road we have been glibly going down. The Indian economy has all the hallmarks of one afflicted with the Anglophone disease — a current account deficit caused by too much domestic debt issuance (the media focus on exports and imports and the exchange rate is superficially misleading), an inability to fund the current account as foreign inflows prove fickle, an economy overly dependent on real estate and construction, rising inequality amidst a growth slow-down and, most importantly, an economic governing class which has run out of ideas. At least in America there is a degree of awareness that the system is in large part broken which is why it’s presumed new central bank governor Larry Summers is being publicly hauled over the coals for his role in maintaining ‘light touch’ regulation in the run-up to the U.S. financial crisis. In India, we are bizarrely lauding Mr. Rajan for seeking to institute the very same ‘light touch’ regulation even as regulators in the U.S. and around the world are scratching their heads trying to figure out how to get back to a position India is currently in right now.
We need to stop believing two myths. Firstly, we need to stop believing the myth that central bank governors can ‘fine tune’ an economy by waving their interest rate magic wand. The reality is that our true economic prospects are determined on the supply side, by cartels operating at sabzi mandis , by infrastructure bottlenecks and most importantly by our education system. But understanding the supply side requires our policymakers and commentariat to roll up their sleeves and get their hands dirty, something which those safely ensconced in Delhi have been hitherto unwilling to do. Instead they prefer trotting out the same tired old airy prognostications about aggregate demand and macro imbalances which are invariably ex-poste rationalisations rather than accurate ex-ante analysis.
Secondly, we need to stop believing the myth that a more developed economy requires an intensification of financial industry products and gimmicks. From a banking perspective, all we need is an efficient payments system and an equally efficient credit delivery system. All the other supposed productivity or innovation is actually just smoke and mirrors which either redistributes gains and losses within finance (to no benefit to the rest of us) or is parasitic on the rest of the real economy. Finance is only the distributive agent and deserves nowhere near the outsized rewards it has been awarding itself.
Prior to the collapse of Lehman, crises in emerging markets were blamed on ‘crony capitalism’ and other such supposed cultural defects. Now that the rogue elephant that is the global financial system has devastated all the ‘advanced’ economies as well, it is time to fundamentally re-think our approach to finance. Mr. Rajan’s seeming refusal to do so does not augur well for the stability of our financial markets and economy.
(The writer has worked for Morgan Stanley and Citigroup in London and is now based in Delhi)