Life after the global financial crisis

Y. V. Reddy

Y. V. Reddy  

The timing of the exit is critical since premature exit may derail recovery and growth while delayed exit may feed inflation

While financial institutions and markets became global, regulation remained national.

There are multiple causes for the global economic crisis. Basically they can be defined as ‘synchronised extensive excess’. The excess liquidity that permeated the global economy — in the U.S. especially but also in other countries — was caused by the action of monetary authorities concentrating on price movements and hence targeting inflation ‘passionately’. In the process they neglected increases in prices of physical assets (such as real estate) and financial assets (share prices).

Consequently there was excessive ‘financialisation’. The financial sector has grown more rapidly than other goods and services. In a way, that made growth of finance an end in itself and not a means to meet human needs such as food, fuel, health and education.

Extensive excesses

Excessive financialisation often resulted in a redistribution of wealth in favour of a few, leading to a widening of inequalities. In the U.S., for example, labour’s share in growth was far less than that of capital. The excess inequalities have led to less stable aggregate demand. Excessive financialisation was also accompanied by multiplication of transactions, excessive leverage and excessive risk taking. High leverage simply means doing business with more of others’ than one’s own money. Excess risk taking happens when individuals or institutions have a perception that they get a share of gains but need not share in the losses; particularly if their remuneration depends on short-term profits. Several factors aided these excesses. A belief that costs of regulation are high relative to benefits and excessive innovation aimed at avoiding prescribed regulatory capital thus boosting shareholder value. Innovations were also aimed at injecting complexity to undermine regulation. Another cause was excessive networking within different segments of financial markets and across the borders of countries which made regulation difficult. Excessive networking reinforced the strength of large conglomerates which in turn became too big to fail. More important, they were aware that they were too big to fail and hence could take undue risks. These excesses were accompanied by excessive globalisation of finance. While financial institutions and markets became global, regulation remained national. The crisis spread to other countries from the U.S. and the U.K. through several channels including trade, finance and sentiment. Why did these excesses occur?

(a) Ideological preference for unfettered markets.

(b) Global imbalances: countries like the U.S. having persistent large current account deficits and countries such as China having matching surpluses. Also enabled by the fact that the dollar remains the global reserve currency.

(c) Race to the bottom in regulation of finance to attract financial activity, especially among those who wanted to be global financial centres such as the U.S. and the U.K.

(d) Capture of the regulatory authorities by the powerful and increasingly wealthy lobby of the financial sector.

(e) The dominant influence of large systematically important countries such as the U.S. and Europe over the ideology and operations of multilateral watchdogs such as the IMF.

Implications for future

While the large unconventional fiscal and monetary measures have worked it is necessary to examine their implications for the future:

First, large amounts of liquidity that has been injected has the potential for fuelling inflation expectations and possibly inflation, unless the magnitudes, manner and timing of such withdrawal are appropriate.

Second, the fiscal stimulus increases the public debt which has to be serviced in future thereby imposing a burden on tax payers.

Third, the nature of stimulus is critical to the medium to long term process of correcting imbalances. For example, the stimulus in the U.S. aimed at boosting domestic demand goes against the grain of boosting savings in a country with low savings rate.

Four, if the fiscal stimulus had large elements of recurring entitlements or recurring expenditures, the withdrawal of such a stimulus would pose problems. Managing the crisis has been critical and largely successful, thus front-loading the benefits, but the costs are back-loaded and the distribution of the burden among different sections of the people contentious.

In brief, the crisis is global, actions are national; benefits could be universal, but burdens in future on their account have to be incurred at national level.

The timing of the exit is critical since premature exit may derail recovery and growth while delayed exit may feed inflation and threaten growth over the medium term. There are genuine dilemmas and the indicators generally used in the past to resolve such dilemmas may not be adequate in view of the extraordinary events. There is no ready precedents and no easy ways of assessing, ex ante, the consequences of withdrawal of stimulus.

‘New normalcy’

Normalcy could be taken to mean reverting to the legal, institutional and policy framework that existed prior to the onset of the crisis. This approach holds that boom and bust are a normal part of economic activity. Crisis will recur no matter that each of them has certain distinct features.

The fundamental reality of the benign nature of free market has to remain. This is one extreme view.

Diametrically opposite to it is the view that the crisis signifies the end of capitalism since it erupted at the epicentre of capitalism. In other words, there will have to be a new world of socialist global economy.

The middle ground, which is the mainstream path, views that the exit cannot be to the old normalcy since it is proven to generate crisis; but has to be a new normalcy.

(Excerpts from a lecture delivered by former Reserve Bank of India Governor Y. V. Reddy at the S. Ranganathan Memorial Lecture at India International Centre on November 30, 2009, in New Delhi.)


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