Lessons from global financial crisis

ET 23/6/09

The cyclical tyranny of the global markets has long been upheld as a trait of the free market economy. The current crisis in the global markets should, however, force us to introspect on the limitations of the free market economy model.

Clearly, the heady excesses of the free market model have seen their best years. The doctrine of “self-interested pursuit of wealth not being individually satisfying but leading to an aggregate increase in wealth that is in the best interests of a nation” needs to be re-examined. So, how free are free markets? How do they adjust to major economic downturns/financial crisis? Is it true they happen only "once-in-a-century"? Are there lessons for Indian policymakers?

A glance at the current global financial crisis will tell us that some fundamentals free markets take for granted just do not always work, even in the most sophisticated financial markets such as the US. In the traditional world of banking, banks accept deposits and lend monies to long-term clients and pocket the difference. In many parts of the world, particularly in countries like India, which are highly under-banked, that’s what they still do.

To some extent, in the developed markets these traditional banks have vanished, giving way to institutions like Lehman Brothers and Bear Stearns that undertake complex deals and are referred to as ‘non-depository” institutions. In fact, some believe these institutions would do a better job of spreading and reducing risks.

There is seemingly nothing wrong with this model, but when it comes to failure/bailout why should any government put the taxpayers monies at risk? Further if these institutions are, in effect, banks then they should be regulated as any other bank and hence should be entitled to bailouts.

Policymakers the world over, particularly in developed free markets, always worry as to the consequences of such relief measures as those initiated by either the US Fed or the government. The nervousness is justified as policymakers are painfully aware that such bailouts do sometimes reinforce even more risky behaviour by the markets in the future.

It would be no exaggeration if one were to state that the market did bet on Lehman Brothers and similar banks being bailed out. When the first signs of it not happening were received, Lehman stock crashed and the company had no other choice but to file for bankruptcy. The more recent bailout after Bear Stearns is that of the world’s largest insurer AIG. Here, we should again remind ourselves that whom to bail out and whom not to is not a decision driven by markets; such complex decisions are taken by policymakers.

Countries such as India will, over the next 10 to 15 years, need to move towards a far greater integrated global financial world, and policymakers in India need to rethink the framework for such integration. India to a great extent, today, is far less integrated with the global financial markets and is fortunate in its leadership at the policy level.

Our policy makers will navigate India through the present crisis. That’s the least of our worries. But what if the degree of integration is far more intense? How should our regulators/policymakers then protect our markets? Though agriculture’s contribution to GDP has almost halved in less than two decades, it employs close to 60% of the workforce in India.

In the past, we didn’t flinch when the 1970s oil crisis struck — some critics say, though unkindly, that we were too miserable to feel the pain anyway. The crisis in the 1990s that nearly made the Asian Tigers as endangered as their wildlife counterparts passed us by, without a murmur. But what of the current crisis? Will this too pass? Perhaps yes, but definitely not without a few telling scars.

In India, there is an ever-growing demand for greater deregulation, and rightly so. While this level of aggression and commitment, particularly of the Indian middle class and the media, is to be proud of, we need to exercise restraint and build a regulatory framework for the economy at a much faster rate. Further, we need to pause to ensure that we do not get carried away with blind faith in the doctrine that there is a direct relationship between economic growth and economic freedom.

Typically, in the developed world tens of thousands lose jobs. However, in the not so well to do economies there is a sudden slowdown of growth. This hurts millions and millions of people who live below the poverty line and the slowdown of growth dramatically affects their quality of life.

It is possible that Indian policymakers are already in a state of alert. They may have to undertake several measures including the setting up of simulation models (however complex) to sketch ‘what if’ scenarios relating to what would happen to our major banks or NBFCs if there was a market failure.

Some may not be even aware that the list of Lehman’s biggest unsecured creditors is dominated by several Asian financial institutions and banks. Markets by nature will always tend to speculate. Markets do adjust to a crisis but also drag down several institutions before the slide stops.

In retrospect, some of our socialistic fiscal policies and sure-footed economic practices had relevance. We need to build economic models and financial markets through a calibrated reform process that takes into account the glaring disparities in our society. A key lesson is that India needs to continue to develop its own economic model.

Definitely far away from the socialistic model, but equally distant from the “free for all market”. India needs a modified free market economy model — shepherded, however, by a body of independent regulators. A model that is prey neither to the machinations of the Left or the Right nor self-serving interests.

The current crisis does tell us not to get sucked into the whirlpool of absurd financial doctrines propagated by institutions that have had no perspectives on the past and, possibly, none on the future. There are several lessons we need to learn from the ongoing global financial crisis.

The heart of the crisis lies in the recklessness of the banking system that started giving loans to subprime borrowers in the belief that the real estate boom that had doubled home prices in the US would allow people with even dodgy credit backgrounds to repay the loans that they were taking to buy or build homes.

This, coupled with the US government’s altruism to encourage leaders to lend to subprime borrowers, compounded the damage. To my mind, it was not the lack of regulation that led to this cataclysm but sheer recklessness on the part of the key players in the financial sector.

(The author is director, Bennett, Coleman & Co Ltd Views are personal.)

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