Interplanetary Economics: The Meltdown and Beyond

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INTER-PLANETARY ECONOMICS: TH E MELTDOWN AND BEYOND A Popular Exposition

C. T. Ku rie n

Vikas Adhyayan Ken dra

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In ter-Plan etary Econ om ics: The M eltdow n & Bey on d

Vikas Adhyayan Kendra (VAK) established in 198 1, is a secular Volun tary Organ isation en gaged in the study an d research of con tem porary social issues. Geograph ically, VAK’s activities a r e o r it e n t e d t o wa r d s We s t e r n I n d ia , viz, M a h a r a s h t r a , Gujarat & Goa.

In te r-Plan e tary Eco n o m ics : Th e Me ltd o w n an d Be yo n d A Po pu lar Expo s itio n C. T. Ku rie n Edition: August 20 0 9

Co ve r D e s ign : Priya Kurien

P u b li s h e d b y Vikas Adhyan Ken dra D-1, Shivdham , 62 Link Road Malad West, Mum bai 40 0 0 64 Ph: 28 8 2 28 50 / 28 8 9 8 6 62 Fax: 28 8 9 8 9 41 Em ail: vak@bom 3.vsn l.n et.in Website: www. vakin dia.org P rin te d b y Om ega Publication s 2 & 3, Em erald Corner, Maratha Colony Tilakwadi, Belgaum 590 0 0 6 Cell: 98 8 620 3256

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Pre face

Th is wr ite up was taken up at th e suggestion of m em ber s of th e fam ily – m y wife, daugh ter an d br oth er – th at I sh ould m a ke t h e com p lexit ies of t h e glob a l m elt d own in t elligib le t o t h em . Th e d r a ft t h a t t h ey fou n d h elp fu l wa s cir cu la t ed over e-m ail to oth er m em ber s of th e fam ily an d a few close fr ien d s, n on e of th em with special kn owled ge in fin an ce or econ om ics. To m y su r p r ise all of th em fou n d it in telligible a n d s om e offer ed com m en t s a ls o. Th ey felt t oo t h a t t h e m a t er ia l sh ou ld b e m a d e a va ila b le t o a wid er r ea d er sh ip . Sin ce I h ad vir tu ally r etir ed fr om active academ ic life alm ost a d e ca d e a go a n d h a d p a id o n ly ca s u a l a t t e n t io n t o t h e p leth or a of wr itin gs on th e top ic, I d eem ed it n ecessar y to ge t cr it ica l p r o fe s s io n a l o p in io n o n wh a t I h a d wr it t e n . H e n ce a m o d ifie d a n d s ligh t ly p o lis h e d ve r s io n wa s cir cu la t e d t o a b o u t a d o ze n o f m y fo r m e r p r o fe s s io n a l collea gu es wh o a r e st ill a ct ive in r esea r ch , t ea ch in g a n d wr itin g. Pr actically all of th em r espon d ed im m ed iately an d e n t h u s ia s t ica lly wit h va lu a b le s u gge s t io n s u r gin g m e t o place th e m ater ial in th e public dom ain at th e ear liest. Th e t ext h as been fu r t h er r evised in t h e ligh t of t h e com m en t s r e ce ive d . I am gr ateful to all of th em , m em ber s of th e fam ily an d fr ien d s, for t h eir com m en t s an d en cou r agem en t ; bu t I am solely r espon sible for th e piece as it appear s n ow. Wh en t h e p iece wa s u n d er cir cu la t ion over e-m a il, I h ad suggested to th e r ecipien ts th at th ey sh ould feel fr ee to for war d it on to an y on e th ey th ou gh t wou ld be in ter ested in it. In th at pr ocess it r each ed Ajit Mur icken with wh om I h ad con tacts som e year s ago, but h ad n ot been in touch for a wh ile. H e im m ediately called m e an d asked for per m ission

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to h ave th e piece br ou gh t ou t as a Vikas Ad h yayan Ken d r a publication . I am gr ateful to h im for h is suppor t. The cover was designed by m y daughter, Priya and I am deeply in debted to her for it an d for bein g m y m en tor on all tech n ical m atter s. – C. T. Ku rie n

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I. Th e Tw o Plan e ts

Th er e is a str ikin g passage in th e ear ly pages of Niall Fer gu son ’s r ecen t book, The Ascen t of M on ey : A Fin an cial History of the W orld: “In 20 0 6 the m easured econom ic output of the entire world was around $ 47 trillion. The total m arket capitalization of the world’s stock m arkets was $ 51 trillion, 10 percent larger. The total value of dom estic and international bon d s was $ 68 tr illion , 50 p er cen t lar ger . Th e am ou n t of derivatives outstanding was $ 473 trillion, m ore than ten tim es larger”. Stocks (or sh ares), of course, are claim s to wealth , and bonds are widely known as debt instrum ents. Derivatives m a y b e les s fa m ilia r a lt h ou gh t h ey a r e wid ely u s ed a n d discussed in financial circles. As the word itself suggests it is som eth in g d er ived fr om an oth er wor d or object. To begin with, we m ay note that within the realm of finance a derivative is a financial instrum ent derived from another and underlying instrum ent such as a debt. Briefly, then, what Ferguson says is th at we h ave reach ed a situation wh ere fin an ce is clearly dom in atin g wh at is often r efer r ed to as th e “r eal econ om y” wh ich pr oduces th e tan gible goods of ever yday life an d th e services associated with their production . Ferguson puts it m or e pictu r esqu ely. “Plan et Fin an ce is begin n in g to dwar f Planet Earth”, he says. The figures given above will m ake better sen se n ow. When Ferguson was writing his book (it was published in 20 0 8 ) Plan et Fin an ce was rapidly expan din g at a rate m uch higher than that of Planet Earth. “The volum e of derivatives … has grown even faster” he says, “so that by the end of 20 0 7 the n otion al value of all ‘over-the-coun ter’ derivatives … was just un der $ 60 0 trillion . Before the 198 0 s such thin gs were virtually un kn own ”. If in tern ation al curren cy exchan ges are

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also brough t in to Plan et Fin an ce, th ey in creased from $ 50 0 billion p e r d a y in 1990 t o $ 150 0 billion in 1998 an d t o a whoppin g $ 3.2 trillion in 20 0 7. In deed, in those heady days of Plan et Fin an ce, reports about it, especially its in n ovation , expan sion an d achievem en ts were greatly overshadowin g the r a t h e r s lo w m o vin g a n d , a t a n y r a t e , t h e o ld e r a n d le s s fascinating Planet Earth. It was as though Planet Finance had its own an d som ewhat m ystifyin g laws of m otion which were far beyond the grasp of the uninitiated. Th en su d d en ly in th e last qu ar ter of 20 0 8 th er e wer e sign s of p an ic in Plan et Fin an ce – som e of its m ajor p ar ts collapsed ; r esu scitation attem pts becam e visible; an d th er e was a crash! It is part of the prevailing confusion that the crash is also referred to as “the m eltdown”. But even those who do n ot kn ow wh at h as h appen ed r ecogn ize th at th e glam our is gone. The m ood now is one of depression. M a jo r Is s u e s I n t h is co n t e xt t h e r e a r e m a n y t h in gs t h a t ca ll fo r explanation. The m ost obvious is the spectacular rise of Planet Finance in the few years im m ediately preceding 20 0 8 and its sudden collapse in the last quarter of that year, as noted above. Equally im portant to consider is whether som e kind of revival is likely, an d if so wh en . More im portan t is wh eth er Plan et Finance and Planet Earth are independent of each other, and if th at is n ot th e case, wh at is th e n atu r e of in ter d ep en d en ce between the two. And third, since these entities are “planets” only as m etaphor, how are they related to the realities that we all kn ow an d experien ce? In particular, how are they related t o ot h er r ea lit ies t h a t we d ea l wit h , a d m in is t r a t ion a n d govern m en ts in our coun try an d globally? This article deals with these issues, not necessarily in the order m entioned above, but in such a way that any interested reader will be able to follow it. No profession al train in g in econ om ics or fin an ce is expected of the reader.

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II. Th e Ban kin g Sys te m an d Cre d it

By wa y o f b a ck gr o u n d it m a y b e u s e fu l t o h a ve a n understanding of banks and related institutions in the working of a m odern econom y. A bank is an in te rm e d ia ry between those who wish to deposit their fun ds with it an d those who are eager to borrow funds (credit). Credit is required because there is a tim e lag between what is needed now and the ability to repay later or over tim e. Hence what credit does is to lin k th e p re s e n t a n d th e fu tu re : in deed, because what is len t n ow was gen erated earlier, cre d it lin ks th e p a s t, p re s e n t a n d fu tu r e . Pr ovidin g th is tem por al con n ection is cr ucial for the sm ooth fun ction in g of a m odern econ om y. But if there are m any who have funds to lend and m any wh o are eager to borrow wh y do th ey n ot establish con tacts directly instead of going through an interm ediary? At least for three reasons. The first is that an individual or any other unit that has fun ds to len d m ay n ot kn ow the person or un it who r equ ir es cr ed it an d vice ver sa. An in ter m ed iar y c o n n e c ts those who have funds and those who require credit. We m ay think of a bank also as an institution that pools in fo rm a tio n about len ders an d borrowers an d m akes it available to those wh o n e e d s u ch in fo r m a t io n . Act u a lly, t h e b a n k p o o ls borrowin gs from large n um bers of len ders (that’s why it is a ban k) so th at th e borrower does n ot h ave to kn ow an yth in g a b ou t in d ivid u a l len d er s a n d len d er s won ’t kn ow wh o is bor r owin g th eir fu n d s. Th e ban k as an in ter m ed iar y, th u s, p e r f o r m s t h e i m p o r t a n t t a s k o f ga t h e r in g a n d p ro ce s s in g in fo rm a tio n and that plays a m ajor role in the effective fun ction in g of an econ om y. Th e b a n k p la ys a s econ d a n d m or e im p or t a n t r ole. Lending of funds to a strange or even a well-known borrower

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is a risky thin g to do: you m ay n ever get back what is yours! The bank m ay also lose funds that it lends, but there is a sort of safety in n um bers. What you do when you len d to the ban k, the interm ediary, rather than to an individual borrower, is to reduce risk con siderably. Of course, you are takin g th e risk that the bank m ay fail, but if you are into the business of taking risks you know that you are calculating probabilities, and you know from experience that a bank failing is less likely than an in dividual borrower disappearin g or goin g ban krupt. Th u s in for m ation (gath er in g) an d p r ocessin g an d r isk reducing are the crucial functions of a bank as an interm ediary. The Bank provides these valuable services not free of cost, but for a con sider ation . Th e ban k pays you (a specified r ate of interest) for the deposit you m ake (usually a higher rate for a lon ger period of deposit). The ban k charges a higher rate of interest to those who borrow from it. The m argin between the lending rate and the deposit rate is (part of) the earnings of the ban k for the services it ren ders. We m ay note also that when there are several banks they com e t o h a ve a d d it ion a l r oles a n d p ower s t h a t in d ivid u a l banks m ay not have. The banking system as a whole can cre ate credit; you leave your m on ey with the ban k tru s tin g that it will be safe an d sure that you will earn som ethin g by way of in t er est ; t h e b a n k kn ows t h a t you will n ot wit h d r a w you r m oney im m ediately and lends it for a while to those who can use it. A group of banks or the banking system as a whole can generate m ore credit than a single bank can do. For these and ot h er r ea son s b a n ks com e u n d er r egu la t ion s fr om h igh er authorities, usually from a central bank (the Reserve Bank of In dia in our case) which is an in depen den t body, but fin ally respon sible to th e govern m en t. Fe a tu r e s o f In te r m e d i a ti o n An econ om ic system characterised by in term ediaries or the role of in term ediation has som e characteristics which we m ust n ote. If an im portan t fun ction of an in term ediary is to gath er an d pr ocess in for m ation , it becom es an in for m ation

The Banking Sy stem and Credit

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specialist in selected spheres. A bank is a specialist on credit just as a real estate broker is a specialist on m atters relating to that m arket. Where interm ediation is general, therefore, one m ust expect in fo rm a tio n a s ym m e try, an d n ot a un iform spread of in form ation as is usually assum ed by som e widely tou ted econ om ic th eor ies. A second feature of interm ediation is closely related. An interm ediary who is a specialist in som e areas tends to use it for his own advantage. After all, he too is an econom ic agent! An d, if distortin g in form ation is to his advan tage why expect h im n o t t o u s e it t o h is b e n e fit ? Th is co m m o n s e n s e u n d er stan d in g of th e beh aviou r of an econ om ic agen t goes un der the n am e of Age n c y P ro b le m in techn ical literature wh ich states th at an agen t m ay (usually does) becom e m ore concerned with his own interest rather than the interest of the prin cipal whom he is supposed to be represen tin g. We shall s o o n s e e h o w t h is a ge n cy p r o b le m p la ys a r o le in a n un derstan din g of Plan et Fin an ce. Third, interm ediation has a tendency to proliferate. We n oted th at by r esor tin g to th e in ter m ediation of a ban k th e depositor reduces risk. The bank m ust find ways of reducing its risk of lending. One thing it can do is to turn to an insurance agency to cover the risk, of course for a paym ent. So another interm ediary em erges. A second possibility for a bank (usually a b ig on e) is t o r ep a cka ge t h e d eb t in st r u m en t s it h old s accor d in g to d iffer en ces in th e r ate of in ter est, th e d ate of m aturity, risk profile an d pass on the repackaged “products” to other agen cies. Agen cies twice or m ore rem oved from the origin al prin cipals com e to the scen e han dlin g n ew fin an cial instrum ents – “derivatives” – thus contributing to the glam our and rapid expansion of Planet Finance. In the next section we shall trace how such chan ges actually happen ed, particularly in the USA.

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III. Th e Am e rican Sce n ario

Th e la st t wo d eca d es of t h e p a st cen t u r y sa w m a n y changes in the credit and banking system s in the US, and m any other parts of the world. We shall concentrate on the changes them selves, n ot m uch on the why an d the how. On e m ajor factor respon sible for the chan ges was the large surplus that petroleum producing countries cam e to have following the oil pr ice r ise of 1973. Alth ou gh th e US dollar th en was n ot as st r on g as it was in t h e im m ed iat e p ost -Secon d Wor ld War d e ca d e s , it wa s s t ill t h e in t e r n a t io n a l cu r r e n cy, r e a d ily con vertible to an y other in the world. H en ce those who had large surpluses preferred to park them in US banks (as also the fin a n cia l in st r u m en t s of t h e US gover n m en t ). US ban ks, therefore, became flush with funds and were willing and eager to expand credit and m ake it available to those who required it. The lending and borrowing spree of the early 1980s led to severe debt crisis for several poor countries, especially African countries towards the end of the decade. Credit expansion led to new credit instruments and institutions. Since they have a bearing on the m eltdown we are concerned with, let us try to understand the credit growth phenomenon and related issues. When a bank makes credit available to a person or any other economic entity, it is done on the basis of a collateral. Usually the collateral is some tangible asset like land or buildings. The title of the asset concerned is passed to the bank which ensures that it is not sold till the loan is repaid. Banks assist in the purchase of assets from third parties by paying that party and recovering the payment in instalments over time. The borrower’s ability to repay is ensured by providing proof of the ability to pay by way of a salary certificate, for instance. Banks also accept non-tangible assets such as shares as collateral for credit, although since the

The Am erican Scenario

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value of shares fluctuates, the risk involved is likely to be greater. Th e poin t to n ote is th at th e len din g ban k will usually h ave collaterals of various kinds that considerably differ in term s of t h eir n at u r e, p aym en t sch ed u les an d r isks. Th e ban k can repackage these collaterals and pass them on if there are other agencies willing to take them over. Thus, when credit expands an d collater als in cr ease, a n ew secon d ar y cr ed it m ar ket for collaterals emerges with new purchasers who then can become sellers if there are other buyers. In other words, a new financial “product” would become available as long as there was demand, and there would be demand as long as entering into the market was considered profitable. Since “production” in this case was almost costless, it was a demand-generated phenomenon where differing perceptions about risks and profitability were the sole considerations. The generic nam e for these newly engineered s yn t h et ic fin a n cia l in s t r u m en t s is c o l l a t e r a l i z e d d e b t o b li g a ti o n s ( CD O) an d soon th er e em er ged CDOs, CDO 2 , CDO 3 , each var iet y bein g a fu r t h er st ep r em oved fr om t h e original lenders and borrowers of Planet Earth. Since branding b eca m e u n a void a b le even for t h ese “p r od u ct s” n ew on es st a r t ed a p p ea r in g su ch a s Colla t er a lized Loa n Ob liga t ion s ( CLO) , Co lla t e r a lize d M o r t ga ge Ob liga t io n s ( CM O) , Collateralized Mortgaged-Backed Securities (CMBS) and so on in d ica t in g p r o life r a t io n a n d t h e s t a n d a r d p r o d u ct differentiation. The process was facilitated by breakthroughs in d eskt op com p u t in g a n d t h e en t r y of a gr ou p of h igh ly q u a lified a ca d em ics in t o t h e r ea lm of fin a n ce wh o cou ld rearran ge asset classes depen din g on even sligh t differen ces in the stock prices of com panies or of the rate of interest. Planet Fin an ce appeared to be em ergin g as a separate en tity with a law of m otion of its own, m oving up and up as creating paper assets was an easy task and virtual assets even easier. It was not only business concerns that were involved with these new form s of assets. As recently as the m id 198 0 s, 75 per cent of household savings in the US was in the form of savings accounts or fixed-interest securities; by the end of the 1990 s the position ch an ged substan tially with about th e sam e per cen t ch asin g high profit, though risky, paper assets around the globe.

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The process also m eant that a penum bra of agencies was em erging around the banking system , the m ost prom inent and powerful am ong them being “hedge funds”. Hedge funds are essentially private partnerships with each partner contributing usually upward of $ 1 billion . They specialize in dealin g with h igh r isk fin an cial in str u m en ts or secu r ities as th eir fu n d s enable them to take up greater risk for higher paym ents. The m ost wid ely kn own a m on g t h em wa s Lon g Ter m Ca p it a l Man agem en t (LTCM) foun ded in 1993, fam ous then because its core m em bers in cluded two econ om ists who had won the N ob el P r ize in t h e su b ject for t h eir con t r ib u t ion s t o t h e u n d er stan d in g an d tr eatm en t of r isk. It collap sed by 1998 b e ca u s e it s m a n a ge m e n t o f r is k p r o ve d t o b e a fa ilu r e ! In ter ven tion by th e gover n m en t gave it a n ew lease of life. There are other hedge funds also that have continued, because as t h ey ar e h u ge an d in flu en t ial, t h ey can r aise loan s way beyond their capital base, the process referred to as leveraging. Wit h ou t goin g in t o t h e p r ocesses in volved , it m a y ju st b e pointed out that at one stage LTCM controlled $ 125 trillion in derivatives on a capital base of just aroun d $ 5 billion . N e w Fi n a n c i a l Ar c h i te c tu r e ( N FA) Now, if they are big risky en terprises, there will have to be insurance com panies to insure them against risk, agencies that specialize in assessing risks, credit rating agencies and so on. Dem and created its own supply and m any agencies of this kind em erged in the 198 0 s and 1990 s and there were frequent r efer en ces to Am er ica’s n ew fin a n cia l a r chitectu r e ( N FA) . Bu t n ot e t h a t t h ou gh m a n y of t h em wer e en ga ged in t h e b a n k in g fu n ct io n o f cr e a t in g a n d a d m in is t e r in g cr e d it (en ter pr ises th at sim ply packaged loan s in to secu r ities an d m ade them available styled them selves as in v estm en t ban ks, th ough th ey were n eith er ban ks n or did an y in vestin g) th ey did n ot com e un der the form al regulatory regim e that ban ks had to subject them selves to. Hence it m ay be appropriate to refer to them as “shadow banks”. The scene was dom inated by huge and powerful private bodies, well-known corporations such as Lehm an Brothers, Goldm an Sachs, Merrill Lynch, not

The Am erican Scenario

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accoun table to an y extern al agen cy or to the public at large. This state of affairs was justified on the belief that “the Market” wou ld d iscip lin e th em by r ewar d in g th ose wh o p er for m ed well with high profits and punishing those who did not. Belief in th e efficacy of th e m ar ket was so en tr en ch ed th at m an y regulation s that existed were withdrawn or ign ored. One m ore feature of the NFA deserves attention. Banks that are subject to regulatory authorities have to subm it their au dited statem en ts of accou n ts an d balan ce sh eets to th ose a u t h or it ies a n d so fin a n cia l a u d it or s h a ve a m a jor r ole in in form in g the m an agem en t of the ban ks, their share-holders an d t h e r egu lat or y au t h or it ies abou t t h e sou n d n ess of t h e business that each bank does. The auditors are assum ed to be extern al agen cies doin g their profession al job in depen den tly. Over tim e the auditors had evolved a procedure to assess the sou n d n ess of t h eir clien t s. Bu t t h e em er gen ce of “sh ad ow ban ks” in troduced m an y grey areas where it was n ot easy to d e cid e o n t h e s o u n d n e s s o f b a n k in g t r a n s a ct io n s a n d investm ent operations. Auditors could be persuaded to go as the bank wanted. From the point of view of the auditors, the b u s in es s wa s la r ge, t h e fee s u b s t a n t ia l a n d t h e p r es t ige ir r esistible. Th ey r etain ed th e façad e of in d epen d en ce, bu t for all practical purposes becam e business partners with their clien ts. After all, auditin g firm s also had to show that their profits were increasing so that their share prices would go up! If t h is was t h e case wit h ban ks wit h som e sen se of p u blic a ccou n t a b ilit y, it wa s n ot su r p r isin g t h a t en t er p r ises n ot su bject to r egu lation s fou n d it easy to per su ad e r isk-r atin g com panies and auditors to go along with them . A risk-rating fir m , for in st a n ce, wa s n ot t a kin g a n y r isk b y p r ovid in g a favourable opin ion to a h edge fun d, but was retain in g good busin ess. Profit-m akin g becam e the on ly objective for m an y “in depen den t” profession al service firm s. All was fair wh en th e goin g was good, but all would collapse wh en som eth in g wen t wron g som ewh ere.

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IV. Th e Bo o m an d th e Bu s t

We can n ow m ove on to th e r ecen t boom an d bu st of Plan et Fin an ce wh ich or igin at ed in t h e Un it ed St at es, bu t q u ickly s p r ea d t o t h e r es t of t h e wor ld . Th e Am er ica n econ om y is quite used to boom s an d busts. Wh o h asn ’t h ear d of t h e Gr eat Dep r ession of 19 29 -32 wh ich cau sed m assive u n em p loym en t a n d a fa ll of on e t h ir d in t h e GDP of t h e Un ited States? Fr an klyn Roosevelt’s New Deal pr ojects an d t h e s t im u lu s r e ce ive d d u r in g t h e Se co n d W o r ld W a r su cceed ed in r evivin g t h e econ om y a n d p u t it on a h igh gr owth path th at lasted till th e en d of th e 1960 s. Th e 1970 s tur n ed out to be tur bulen t an d in th e 198 0 s an d 1990 s th er e wer e som e ups an d sh ar p down s. Dur in g th e last few year s of th e cen tur y th er e was th e m uch celebr ated dot-com boom t h a t le d m a n y t o t h in k t h a t t e ch n o lo gy wo u ld p r o vid e u n in t er r u p t ed u p wa r d m ovem en t of t h e econ om y; b u t b y th e tur n of th e cen tur y th er e was a cr ash ! An d th e econ om y was cau gh t in a r ecession . A st a n d a r d wa y t o figh t r ecession is for t h e b a n kin g syst em t o b r in g d own t h e r a t e of in t er est h op in g t h a t it wou ld en cou r age in vestm en t an d th u s r evive th e econ om y. Red u ct ion of t h e in t er est r a t e is sign a lled b y t h e Fed er a l Reser ve Boar d (com m on ly r efer r ed t o as “t h e Fed ” an d in ter m s of its r ole fair ly sim ilar to ou r Reser ve Ban k) an d it br ough t down its r ate of len din g to ban ks fr om 6.5 per cen t to 3.5 per cen t with in a span of a few m on th s. Th e even ts of 9 / 11 (2 0 0 1) led t o fu r t h er cu t s a n d b y 2 0 0 3 t h e r a t e wa s ju s t 1.0 p e r ce n t wit h in fla t io n - a d ju s t e d s h o r t - t e r m r a t e a ct u a lly t u r n in g ou t t o b e n eg a t iv e. Wh a t m or e in cen t ive m ust ban ks h ave to len d wh en th er e wer e m an y in stitution s r eady to pur ch ase debt in str um en ts fr om th em ? All th at was

The Boom and the Bust

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n eed ed wa s t o p er su a d e som eon e t o t u r n t o t h e b a n ks t o bor r ow. Wh o wou ld th at be? Th e Re a l Es ta te B o o m N o p r ob lem . I n a cou n t r y wh er e “p r op er t y own in g dem ocracy” is som ethin g of a n ation al creed, there would be m an y willin g an d, in deed, eager to take a housin g loan if the ter m s appear ed to be r eason able. With pr oper ty developer s ready to m ake lan d, or if n eeds be even buildin gs available, an d salar ied people an d com m er cial con cer n s wan tin g lan d an d bu ild in gs, th e r eal estate m ar ket wou ld be th e n atu r al sphere of activity for the banks. Banks would lend, but instead of holdin g the loan in their books, they would package them into CDOs and sell them to other agencies. They, in turn, would pass them on also. On t h e ot h er sid e, a s in t er est r a t es ca m e d own , t h e d e m a n d fo r h o u s in g lo a n s in cr e a s e d a n d co n s t r u ct io n act ivit y p icked u p lead in g t o lan d p r ices goin g u p an d t h e r eal estate m ar ket boom in g. Th u s econ om ic activity over all r eceived a st im u lu s, ca u sin g em p loym en t a n d in com es t o go u p . As on all p r eviou s boom p er iod s kn own in h ist or y, th er e was a gr eat d eal of specu lative tr ad in g (th is tim e n ot m u ch in com m od ities bu t in fin an cial p ap er s) t h at yield ed h u ge p r ofit s. Th ose wh o h a d t h e in st it u t ion a l fa cilit ies t o p la y wit h o t h e r p e o p le ’s m o n e y ( OP M ) m a d e e n o r m o u s p r ofit s t oo. Sh a r e p r ices a p p ea r ed t o b e st ea d ily soa r in g an d d ivid en d s wer e in cr easin g. Mar ket act ivit ies ap p ear ed t o b e b r in gin g a ll r ou n d a d va n t a ge a n d p r osp er it y. Ala n Gr een span , th e widely kn own an d h igh ly r espected Ch air m an of th e Fed gave h is en th u siastic en cou r agem en t to wh at h e ca lled “a n ew p a r a d igm of a ct ive cr ed it m a n a gem en t ”. Of 2 0 0 6 For b es m a ga zin e p r ou d ly a n n ou n ced : “Th is is t h e r ich e s t ye a r e ve r in h u m a n h is t o r y” a s t h e n u m b e r o f billion air es h ad r isen 19 p er cen t to 946 over th e p r eviou s year ’s 793 an d th eir com bin ed n et wor th clim bed by $ 90 0 b illion s t o $ 3 .5 t r illion , a d d in g, “n ever b efor e in h u m a n h ist or y h as t h er e been su ch a n ot able ad van ce”.

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In ter-Plan etary Econ om ics: The M eltdow n & Bey on d

In the m eanwhile, rate of interest on housing loans started com in g down further as the ban ks were com petin g to secure m o r e b u s in e s s . Re fin a n cin g ( o r “r e fi”) s ch e m e s b e ca m e popular. Lower interest rates m ade it possible to borrow m ore for the sam e m onthly paym ent, pay off the old loan, and still be left with an extra sum to go on a vacation or buy a new car. Lower rates also enabled the m ore enterprising to go in for a secon d h ou se as a for m of in vest m en t . Refis sh ot u p fr om ar ou n d $ 15 billion in 1995 to n ear ly $ 250 billion a d ecad e later. It was all achievem en t an d affluen ce, Am erica! S u b -p r i m e Le n d i n g Soon housing loans cam e to be at rates below the prim e m ortgage rates of banks (s u b-p rim e le n d in g, also known as t e a s e r l o a n s ). For lon g ban ks con t in u ed t o m ake car efu l scr u tin y of th e econ om ic cr ed en tials an d r ep ayin g cap acity but the belief that land prices would only m ove upwards led to l i g h t -d o c u m e n t a t i o n m or t gages, t h e ext r em e for m of it cam e to be kn own as n in ja lo a n s – n o in com e, n o job, n o assets. Sub-prim e len din g which am oun ted to $ 145 billion in 20 0 1 soar ed t o $ 6 25 billion in 20 0 5, accou n t in g t h en for som e 20 per cent of the loans. Som e of the sub-prim e m ortgages were tricky in nature; t h e low r a t es wer e a p p lica b le on ly for t h e fir st yea r wit h in terest rates gradually goin g up later m akin g it difficult for s o m e b o r r o we r s t o clo s e t h e m o r t ga ge s . I n s t a n ce s o f b o r r o we r s n o t b e in g a d e q u a t e ly in fo r m e d a b o u t t h e s e a r r a n ge m e n t s we r e n o t r a r e . So o n d e fa u lt s b e ca m e n o t u n co m m o n a n d b y 2 0 0 7 d o u b t s we r e b e gin n in g t o b e exp r essed a b ou t t h e su st a in a b ilit y of t h e r ea l est a t e a n d housing boom . By m iddle of that year it was public knowledge that two m ortgage hedge funds were in trouble. The problem spread to CDOs linked to sub-prim e m ortgages which, in turn, h a d it s im p a ct on som e in vest m en t b a n ks. By t h e fou r t h q u a r t er , well-kn own fin a n cia l in st it u t ion s like Cit igr ou p , Merrill Lyn ch, Lehm an Brothers, UBS, an d Ban k of Am erica had to announce m ajor write downs. The Fed and other official

The Boom and the Bust

17

agencies had to take note and attem pt rem edies, m ainly m aking available credit to institutions in need through the first half of 20 0 8 . Th e Cr a s h Th e cr a sh ca m e in t h e secon d h a lf of t h e yea r , m id Septem ber with Leh m an Broth ers goin g ban krupt. Leh m an was on e of th e lead in g com m er cial p ap er m aker s. It was a cou n t er p a r t y t o m a n y CDS con t r a ct s, a n d a p r im e b r oker providing finance to hedge funds. But being outside the banking syst em it cou ld n ot get t h e su p p or t of t h e Fed or t h e US Treasury. When Lehm an becam e insolvent its clients also faced difficulties. George Soros, the financier called the fall of Lehm an “the gam e changer” because it changed the com plexion of the cr isis by in t r od u cin g ser iou s u n cer t ain t y abou t h ow t h in gs wou ld tu r n . Next to go u n der was AIG, th e gian t in su r an ce firm with global operations. To ward off further calam ity there were h ectic attem pts at m ergers an d buyouts. Merrill Lyn ch was taken over by Bank of Am erica. Panic was spreading and sp illed over im m ed ia t ely t o t h e st ock m a r ket . Th e cr ed it squeeze an d th e lay offs affected th e h ouseh olds also, th ose relyin g on credit cards in particular. The drastic reduction in spending led to a deflation which soon turned into a recession. Pen sion fu n d s, en d owed fu n d s of u n iver sities, fou n d ation s, r eligiou s or gan isation s an d m an y m or e wer e also im pacted losin g an ywh er e between 20 an d 40 per cen t of th eir assets within a couple of m onths. The govern m en t took a stan doffish position in the early stages partly because of the ideological consideration that the m arket would correct itself, but also because there was strong op p osit ion t o sp en d in g p u b lic m on ey t o sa ve or su p p or t p r ivate fir m s like Leh m an . Bu t th e cr isis an d p an ic was so intense that a wait and watch position was no longer tenable. The Fed brought down its rate to close to zero. The Treasury decided to pum p in $ 70 0 billion to enable banks to lend m ore, but on the assum ption that the crisis was one of liquidity. The real issue, however, was the insolvency of m any big nam es as

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In ter-Plan etary Econ om ics: The M eltdow n & Bey on d

a result of profit-chasing recklessness. The failure to grasp the d ist in ct ion m a d e p u b lic p olicy in effect ive, if n ot cou n t er productive. By the en d of 20 0 8 Plan et Fin an ce an d its NFA, Am erica’s great pride an d success sym bol was in sham bles. Pla n e t Fin a n ce – Pla n e t Ea rth Lin ks But it will be a m istake to think that the problem s were confined to Planet Finance. Planet Earth was also in doldrum s. Th e m ost wid ely r ep or t ed was t h e u p scale Ch r ysler Mot or Com pany going bankrupt. More recently General Motors (yes, GM about which it used to be stated that what is good for GM is good for Am er ica!) followed su it. An d th in k of th e m illion s wh o lost t h eir job s a n d t h e t h ou sa n d s wh o h a d n o ch oice except to m ove out of their hom es as they were in no position to pay the in stalm en ts of their m ortgages. There was irony too which can be appreciated only from a Plan et Earth perspective. Wh ile all th e m erry-m akin g was going on in Planet Finance, down below inequalities of incom e were sh arply risin g. Ch arles Morris poin ts out th at between 198 0 an d 20 0 6 the top ten th of the population ’s share of all taxable incom e went up from 35 to 46 percent, an increase of alm ost a third. What is even m ore strikin g was the disparity within the top ten. Alm ost all of the top tenth’s share of gains went to the top 1 percent who doubled its share from 9 to 20 percen t; an d the top ten th of that 1 percen t tripled its share! An d n ot surprisin g either. Top executives of Plan et Fin an ce firm s were gettin g (m ore realistically, assign in g th em selves) fabulous salaries, perquisites and bonuses not only when their com pan ies were doin g well, but even at tim es of liquidation . Even “doing well” was a m atter of perception. According to a well docum en ted case, a private equity firm “created value” of som e $ 10 0 m illion b y la yin g off wor ker s a n d t h e t wo par tn er s gave th em selves a bon u s of $ 1 billion (n o m istake h er e) for th eir com m en dable per for m an ce! We see h ow th e pr oblem s associated with in ter m ed iation d ealt with ear lier , p a r t icu la r ly in for m a t ion a sym m et r y a n d a gen cy p r ob lem played a role in the rise and fall of Planet Finance.

The Boom an d the Bust

19

In the light of this in teraction between fin an ce an d the “real” econ om y, it is n ecessary to con sider wh eth er th ey are two distinct planets. If celestial finance im pinges on terrestrial housing so intensely, they m ust be closely connected. Though “Plan et Fin an ce” an d “Plan et Earth” are useful m etaphorical description s up to a poin t, they are n ot, can n ot be, separate an d in d ep en d en t en t it ies, bu t on ly in t er -r elat ed asp ect s of n a t ion a l econ om ies a n d t h e glob a l econ om y. Th e r ole of fin an ce is to facilitate th e fun ction in g of th e “real” econ om y (a n ot h er u sefu l exp r ession , b u t q u it e m islea d in g if t a ken liter ally, for fin an ce is r eal too!). H owever , fin an ce h as th e tendency to assert its independence and to dom inate the real econ om y – a case of th e facilitator becom in g th e boss. It is also th e m an ifestation of an in -bu ilt featu r e of th e kin d of econom ic order we are dealing with that the few who control finance - the m ost abstract and, in a sense the m ost “useless” form of wealth - have power over the toil of the m asses and the savin gs of m illion s to further en rich them selves.

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In ter-Plan etary Econ om ics: The M eltdow n & Bey on d

V. Th e Glo bal D im e n s io n

Exclusive attention paid to the USA so far is not because th e problem s in th e fin an cial sector – th e em ergen ce of th e shadow banking system , the proliferation of CDOs, sub-prim e lending etc – happened only there. Am erica, of course led the way. But the problem s surfaced in various form s in other parts of the world as well, in the UK, and m any countries of Europe. This is n ot surprisin g because m an y of the agen cies in volved were already global operators and the global financial system is controlled by a consortium of financial authorities from the rich world. And not surprisingly too, the rest of the world had a ten den cy to “follow the leader”. For a m ore basic understanding of the m eltdown we m ust lin k together the global perform an ce of fin an ce with trade of good s a n d ser vices a n d t h e a ssocia t ed m ovem en t of t r a d e surpluses between nations. Such a treatm ent is necessary for a better appreciation of global finance as well. Am e ric a Live s B e yo n d Its Me a n s I m m ed ia t ely a ft er t h e Secon d Wor ld Wa r , t h e US a s t h e lead er of t h e Allies an d abou t t h e on ly cou n t r y in t h e wor ld wh ose econ om y h a d flou r ish ed b eca u se of t h e wa r effor ts, took u pon itself th e task of r evivin g an d r ebu ild in g th e “fr ee wor ld ”, th at is th ose cou n tr ies th at wer e n ot p ar t of th e bloc led by th e Soviet Un ion . Th e Mar sh all Plan of t r a n sfer of ca p it a l fr om t h e US t o Eu r op e wa s on e of t h e m easur es. Th e secon d was th e acceptan ce of th e US dollar as th e u n iver sal r eser ve cu r r en cy (th e r ole th at th e Br itish p ou n d p layed d u r in g t h e h eyd ay of t h e Em p ir e) as t h e US h a d b e co m e t h e m a jo r s u p p lie r o f t h e wo r ld a n d t h u s p r act ically ever y cou n t r y was in n eed of d ollar s. Th u s US

The Global Dim en sion

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capital was m ovin g out to th e r est of th e wor ld an d th e dollar wa s effect ively t h e glob a l cu r r en cy. Today’s wor ld pr esen ts a differ en t pictu r e. Th e dollar st ill r et a in s m u ch of it s p osit ion , t h ou gh Eu r op e’s eu r o is em erging as a serious contender. But the value of im ports by the US is far in excess of the value of its exports which m akes it a n ation in debt to th e rest of th e world. Stran ge as it m ay appear, for several years now the US has been at the top of the list of countries in debt borrowing around $ 8 0 0 billion a year. An d h ow does it m an age th is situation ? By oth er coun tries, ir on ically Ch in a len d in g t o it – t h e ir on y of a low in com e co u n t r y le n d in g t o a r ich co u n t r y o r a s o n e wr it e r h a s expressed it, com m un ist Chin a len din g to capitalist Am erica. But th e m ech an ics is sim ple: Ch in a exports a wide ran ge of goods to the US; it does not buy m uch from the US and thus has a trade surplus; which it holds as dollars or bonds of the US governm ent as, for the present, the dollar is the strongest an d m ost stable curren cy precisely because Chin a an d m an y other coun tries that have a trade surplus “len d” it to the US. However strange as it m ay appear, this is one of the realities of tod ay’s wor ld . Th er e is a n ot h er a n d p er h a p s m or e r evea lin g wa y of exp r essin g t h is. Am er ica n p eop le a r e livin g b eyon d t h eir m ean s an d m an age to do so because people from other parts of the world, with per capita in com es far below the US level are continuously lending to it. Which m eans also that surpluses from the rest of the world are first flowing into the US, enter in to th e books of Am erican ban ks, th en goin g out as capital flows to the rest of the world. To link this up with our m ain story, credit expansion in the US is m ade possible by the rest of the world and hence collapse of the credit system in the US will have a bearing on other parts of the world also, China and yes, India as well. To trace these processes will be tiresome and we shall just illu st r a t e t h em . An d t o b r in g ou t t h e im p lica t ion s m or e realistically we shall bring the exposition down to the level of the people whose lives get affected. To begin with we shall examine

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In ter-Plan etary Econ om ics: The M eltdow n & Bey on d

t h e US a n d Ch in a wh o a r e m a jor p a r t n er s in econ om ic relationships. Im p a c t o n Ch in a a n d In d ia Once China decided to reverse its initial policy of pursuing an internally driven growth pattern and opened up to the rest of th e world, exports becam e a sign ifican t sh are of its GDP, n ow over 50 per cen t. Exports accelerated after it becam e a m em ber of the World Trade Organization (WTO) in 20 0 1 and by 20 0 3 China was Asia’s largest exporting country replacing J apan and by 20 0 5 the third largest in the world, next to USA and Germ any. By that year it was supplying a fifth of the USA’s requirem ents of m anufactured goods and had a trade surplus of over $ 10 0 billion with that country, held largely in the form of US Treasury bonds. Chinese exports into the US continued to grow at aroun d 20 percen t for the n ext couple of years as well. Le t u s n o w t u r n t o wh a t h a p p e n s wh e n t h e r e is a m elt d own in t h e US, st a r t in g in t h e fin a n cia l sect or , b u t spreading rapidly throughout the econom y. J obs are lost and incom es com e down. Goods im ported from China and used in the industrial sector get reduced. People’s spendings go down and there is less dem and for Chinese goods which had invaded superm arkets – let us say, electronic goods and toys. Factories producing these export goods in China are affected and workers are laid off. Millions of Chinese workers from industrial towns are forced to go back to their rural fam ilies. What started in the posh cities and financial centres in the USA soon reach the h um ble dwellin gs in far away Ch in a, an d th e m eltdown h as becom e a worrisom e global ph en om en on adversely affectin g the lives of m illion s of people everywhere. In dia h as been affected too, but n ot as m uch as Ch in a because our exposure to the rest of the world – whether in the form of capital flows or trade – has not been as high as in the case of China. When the early signs of trouble in the financial sect or in t h e US st a r t ed a p p ea r in g, t h er e wer e t h ose wh o m a in t a in e d t h a t I n d ia ( p e r h a p s Ch in a t o o ) co u ld b e

The Global Dim en sion

23

“decoupled” from such calam ities because our econ om y was essentially internally driven, finance did not play a dom inating role in our system unlike in the US, and our financial system was th ough t to be adequately in sulated from global fin an ce. Bu t t od a y it is op en ly a d m it t ed b y econ om ist s, b u sin ess people, adm in istr ator s, politician s an d m an y m or e th at ou r econ om y h as been adversely affected by extern al factors. A brief exam ination of what has happened is worthwhile. Th ou gh in over a ll t er m s t h e r a t e of gr owt h of t h e I n d ia n econom y has continued to be a respectable close to 6 percent per an n u m , it still is a fall fr om th e n ear 9 per cen t we h ad achieved before the troubles started an d the 10 percen t that we anticipated could be achieved. Our banking sector, on the wh ole, still rem ain s robust because of th e dom in an ce of th e public sector banks that have been forced to follow the effective su p er visor y r ole of th e Reser ve Ban k th at p r even ted ban ks from followin g adven turous paths. An d although the In dian econ om y’s total exter n al tr an saction s (valu e of expor ts an d im ports plus gross capital flows) have increased from around 47 per cen t of GDP in 1997-98 to over 117 per cen t in 20 0 70 8 , we have not yet gone in for full convertibility of the rupee. Hence, so far there has been no banking crisis or shake up in the financial sector. Only our stock m arkets which are linked to their counterparts in the rest of the world have crashed and h ave becom e subject to volatility. Capital flows in to the coun try, on the other han d, have d eclin ed esp ecially th ose com in g fr om for eign in stitu tion al investors (FII). In fact, a reverse flow of funds from FIIs had set in towards the close of 20 0 7. (In this connection a m ajor difference between India and China m ay be noted. We relied largely on financial flows from outside whereas China insisted on foreign capital goin g in to productive activities.) Extern al com m ercial borrowin gs h ave also declin ed. Th ese two h ave lowered the level of investm ent in the country and the growth of the m anufacturing sector has been adversely affected. Our exports have declined too as Indian exports in which services accou n t for som e 37 p er cen t ar e ver y sen sit ive t o levels of

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In ter-Plan etary Econ om ics: The M eltdow n & Bey on d

in com e in t h e Wes t er n cou n t r ies . Th e d om es t ic s ect or s affected h ave been m etals an d m etal p r od u cts, textiles an d garm en ts, autom obiles, gem s an d jewellery an d in form ation techn ology. Man y busin ess con cern s have been affected, IT, travel and tourism , hospitality and entertainm ent. Associated with it has been loss of jobs for which there have been no firm est im a t es m a in ly b eca u se close t o 9 0 p er cen t of t h e t ot a l workforce in th e coun try is in th e un organ ised sector about which it is n ot easy to get clear in form ation . But an official survey sponsored by the governm ent has estim ated that about 1.5 m illion wor ker s wou ld be t h r own ou t of wor k bet ween Septem ber 20 0 8 and Decem ber 20 0 9. Many consider this to be a rather optim istic estim ate. Th u s, t h e im p a ct of t h e m elt d own in I n d ia h a s b een lar gely on th e r eal econ om y an d on th e lives of r eal people from the lower section s in particular.

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VI. Qu o Vad is ?

Where do we go from here? We shall not go into bailout schem es and quick fixes of that kind, but deal with som e basic is s u e s t h a t n e e d t o b e a d d r e s s e d in t h e ligh t o f t h e con tem p or ar y global calam ity. Re gu la tio n o f Cre d it a n d D ire c tio n o f In ve s tm e n t Of these one of the im m ediate ones is how credit and the b a n kin g s ys t em a r e t o b e r egu la t ed . Cr ed it is t h e m os t om n ipresen t, th ough largely in visible, aspect of an y m odern econ om y. I t is b a sed on econ om ic con sid er a t ion s, b u t is prin cipally groun ded in trust which is above an d beyon d the econom y. If trust fails, credit fails and banks fail too. If that is the case, the regulation of credit m ust be vested with the m ost publicly accepted an d m ost stable of social in stitution s, th e governm ent. This is sim ilar to, but m ore im portant than, the control over currency, or m oney in general. In the early stages of the evolution of credit an d curren cy, these were un der the r esp on sibility of agen cies wh om th e im m ed iate tr an sactin g p a r t ies t r u st ed . Over t im e t h e gover n m en t t ook over t h e responsibility of interm ediation which accounts for the general acceptability of th ese in strum en ts. Th us because of th e allper vadin g r ole of cr edit an d th e n eed to assur e an d sustain trust, credit m ust be under the regulation of the governm ent. To a large extent, and for the sam e reasons, it is best for th e ban kin g system also to be un der th e ultim ate con trol of t h e gover n m en t . Th is su ggest ion m a y b e r esist ed , if n ot r eject ed , on t h e gr ou n d s t h a t a n yt h in g t h a t is u n d er t h e control of the governm ent will becom e bureaucratic; and it is a genuine apprehension. Unlike in the case of credit which is largely unseen, banks are visible and enter intim ately into the

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In ter-Plan etary Econ om ics: The M eltdow n & Bey on d

d a y t o d a y live s o f o r d in a r y cit ize n s . I f b a n k s b e co m e bureaucratic institutions, it will be terrible indeed. H owever, it is possible for banks to be functioning as banks should, but for the control over them and their regulation to be exercised by an agency of the governm ent. That is what the nationalised banks in our country have dem onstrated. Granted that banks a r e in a n in t r in sica lly r isky b u sin ess, t h e essen ce of t h e regulation of banks is that they are prevented from becom ing too adventurous which businesses m otivated largely by profitm akin g can n ot seem to avoid. Th at is wh at sh adow ban kin g h as sh own . Th e pr in ciple u n d er lyin g th e agen cies th at later tu r n ed ou t to be sh ad ow b a n ks is s o u n d : t h e s e p a r a t io n o f t h e cr e d it ge n e r a t io n fu n ct ion a n d t h e in vest m en t fu n ct ion of b a n ks. Th is wa s tr ied out an d legalised in th e US after th e Gr eat Depr ession an d appear ed to be wor kin g well for a wh ile an d a n um ber of in vestm en t ban ks em er ged. But over tim e th ey m ade a n on p e r m is s ib le e n t r y in t o t h e b a n k in g fu n ct io n o f cr e d it expan sion th r ough th e “in n ovative” m eth od of CDOs, CDO 2 s, et c wh ich m u st h ave h ad t h e in it ial ap p r oval of t h e ban ks also becau se both fou n d it a n ew m eth od to in cr ease th eir p r o fit s . H o we ve r , t h e y a ls o s u cce e d e d in ge n e r a t in g a h or izon tal cr ed it n etwor k, ou tsid e th e r egu lator y system of ban ks. Th en cam e t h e p r olifer a t ion of in t er m ed iar ies, all gu id ed b y t h e sole ob ject ive of m a kin g p r ofit s p r et en d in g t h a t s e lf- r e gu la t io n ( t h a t is , r e gu la t io n b y t h e m a r k e t ) p r ovid ed th e n ecessar y p r otection an d also en abled wealth t o in cr ea se. Bu t b efor e a n yon e r ea lised it , t h ey slip p ed in t o a cr is is b r in gin g d o wn t h e m s e lve s , t h e ir b a s e , t h e ban kin g system , an d fur th er down , th e r est of th e econ om y as well. H en ce, on e of the first thin gs to be don e is to elim in ate the “derivatives industry” and with it shadow banking because t h ese a r e b a sed on t h e p ossib ilit y of cost less p r od u ct ion ensuring easy profits – for a while. Once this is done, it will be possible to bring credit creation and financial investm ent under social con tr ol. In th e US, th e Fed as an in d ep en d en t n on -

Qu o Va d is?

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go ve r n m e n t a l a ge n cy cla im s t h a t it is r e s p o n s i b le fo r regulating credit through regulating m oney supply. There are m an y pr oblem s h er e. Fir st, m or e th an for m al con tr ol over m on ey supply is n ecessar y to r egulate cr edit because cr edit in strum en ts them selves which are beyon d the purview of the Fed can form the basis for credit expansion. Second, the Fed has no m andate to deal with financial investm ents and hence le a ve s it e n t ir e ly t o t h e m a r k e t . An d t h ir d , a n d m o s t im p or t a n t , wh ile t h e Fed cla im s t o b e in d ep en d en t of t h e governm ent, its true nature is seen only during periods of crisis wh en it becom es a partn er, a jun ior partn er actually, of th e govern m en t. This is n ot surprisin g either because while the Fed m ay supervise and regulate the banking system , only the govern m en t can deal with the econ om y as a whole. Th u s, a design ated in depen den t au th or ity, r espon sible to th e gover n m en t, is u n avoid able for th e m an agem en t of cr e d it a n d t h e r e gu la t io n o f t h e b a n k in g s ys t e m . Th is au t h or it y m u st also be en t r u st ed wit h t h e t ask of d ecid in g wh et h er a n d wh en n ew cr ed it in st r u m en t s a r e r eq u ir ed , en su r in g t h a t “p r ofit on ly” will n ot b e a llowed t o b ecom e th e cr iter ion for r esor tin g to th em . Th e q u est ion of in vest m en t d ecision s a lso h a s t o b e con sid er ed . Th e r efer en ce is n ot t o p h ysica l in vest m en t (fabr icatin g m ach in er y, pu ttin g u p con str u ction , oil dr illin g et c) b u t t o fin a n cia l in ves t m en t . Th os e wh o h a ve la r ge am oun ts to spar e, in dividuals as well as in stitution s such as pen sion fun ds, ar e always lookin g for oppor tun ities to in vest t h em . Sa fet y a n d exp ect ed (in m ost in st a n ces, a ssu r ed ) r et u r n s a r e t h e m a in con sid er a t ion s a n d t h er e a r e m a n y p ot en t ia l p ossib ilit ies – sh a r es, b on d s, m u t u a l fu n d s a n d t h e like, a ll segm en t s of t h e gen er a l ca t egor y of fin a n ce. Su b ject t o con sid er a t ion s of r isk, t h e m a in ob ject ive is t o secu r e th e h igh est r etu r n s, an d n atu r ally th is is th e aven u e wh er e in t er m ed ia r ies wit h t h eir ob ject ive of m a xim isin g pr ofits fun ction . Natur ally too, th is is th e ar ea wh er e m ost p r o b le m s a r is e m a in ly b e ca u s e t h e r e is e it h e r n o in d ep en d en t r egu la t or y a u t h or it y or b eca u se r egu la t ion s

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a r e n ot effect ive. P u b li c Re g u la ti o n Ot h er t h an elim in at in g in t er m ed iar ies wh ich h ave n o justifiable raison d’etre, there are no easy ways of dealing with th is ar ea. H owever , a pr ocedu r e th at m ay br in g down th e pr ofit-on ly oper ation s an d agen cies is wor th con sid er ation . Som e elem ents of it already exist. During the apartheid regim e in South Africa, m any individuals and institutions in different parts of the world decided that they would n ot let the fun ds they had available for investm ent go to firm s that had dealings with that regim e, or doing business with that country. It was a fo r m o f p r o t e s t ; a fo r m o f e ffe ct ive ly m a kin g a m o r a l statem ent. The sam e spirit can be m ade m ore positive by the decision of those who have funds that they are willing to forego som e earn in gs to support fin an cially soun d but n ot-for-profit o r ga n is a t io n s . E d u ca t io n a l a n d m e d ica l in s t it u t io n s , publishin g con cern s are exam ples. These should be allowed to receive fun ds as in vestm en ts assurin g a reason able return to th e in vestor s. To en cou r age th e pr actice, tax in cen tives, for instance, can be given to those who m ake such investm ents. Th e id ea is t o b u ild u p a con st it u en cy t h a t will con sid er r ea son a b le r et u r n s a s a con st r a in t , r a t h er t h a n m a xim u m r e t u r n s a s t h e s o le o b je ct ive . I n it ia lly o n ly co n vin ce d in d ivid u als an d in stitu tion s m ay take th is r ou te. H owever , on ce th is becom es an establish ed alter n ative, it will spr ead an d can brin g about a qualitative differen ce to the econ om ic system as a whole. Obviously, agencies that run not-for-profit busin esses sh ould com e un der public regulation , th e reason being that they are using funds from the public. Th e wor d “pu blic” u sed above h as a con n otation qu ite differen t from what it has com e to have in ordin ary parlan ce where “public” is alm ost synonym ous with governm ent as for instance in “public sector” undertakings. But in the paragraph above, “public” is used as the antonym for “private”. A fam ily or partnership which uses its own resources can be considered p r ivate, bu t an y con cer n wh ich u ses fu n d s fr om th e p u blic

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becom es a public concern irrespective of who owns it, whether t h e gover n m en t or a com p a n y. I n t h is sen se, a b u sin ess co r p o r a t io n t h a t r a is e s fu n d s fr o m t h e m a r k e t ( s t r ict ly sp ea kin g fr om t h e p u b lic t h r ou g h t h e m a r ket ) is a p u b lic concern, even if it does not receive any financial support from th e gover n m en t. By th e sam e token , a “pu blic” r egu lator y a u t h o r it y n e e d n o t n e ce s s a r ily b e a b o d y o f a n d b y t h e governm ent: it can be a body set up by m em bers of a particular industry, but independent of it with a m andate to protect the in terest of th e public associated with th at in dustry, an d n ot that of any particular concern within that industry or even of all con cern s that con stitute that in dustry. As a m atter of fact, in a dem ocratic set up the governm ent itself is such a public body constituted by the largest “public” with the specific task of protecting and prom oting the “com m on good”. Th e judiciary is an oth er in depen den t public body to ensure that the governm ent as a public body does not assum e arbitrary powers and does not deviate from the tasks assigned to it. And the s tate is the ensem ble of independent authorities ea ch wit h it s own sp ecific m a n d a t e, a n d a ll n ecessa r y t o articulate, prom ote and protect the com m on good. (It is very un for tun ate th at th e cr ucial distin ction “public” as opposed to “p r ivate” an d p u blic as syn on ym of “gover n m en t” is n ot p r op er ly a p p r ecia t ed . Th in k a lso of t h e u se of t h e wor d “public” in Public Schools which everybody knows are private, an d Pu blic In t er est Lit igat ion wh ich is t h e con cer n of t h e public, often again st th e govern m en t. Perh aps we n eed two different words instead of the sam e word “public”.) S ta te vs Ma rke t With that understanding we m ay briefly revisit “the state v ersus m arket” debate. Th e first th in g to n ote is th at if th e exp r ession is m ea n t t o con vey t h a t societ y h a s t o ch oose b e t we e n t h e t wo , it is e it h e r fa ls e o r is b a s e d o n m isu n d er st an d in g. For , t h er e is n o m od er n societ y wh ich fun ction s, or can fun ction , without both in som e form or the other. If authority is the essence of the state, without it there

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will be chaos. Further, it was kn own from the days of Adam Sm ith that agen cies con cern ed on ly with profits will have n o in cen tive to provide in frastructural facilities an d m erit goods s u ch a s d e fe n ce , e d u ca t io n e t c, a lt h o u gh in e d u ca t io n , h ealt h car e an d so on p r ivat e bod ies soon d iscover ways of m aking profit. Hence in m any societal aspects including what m ay be con sid er ed to be “str ictly” th e r ealm of econ om ics, t h e s t a t e ( t h r o u gh it s r e p r e s e n t a t ive m a n ife s t a t io n , t h e govern m en t) has a m ajor role to play. Th is p osit ion is ver y d iffer en t fr om a view st r on gly can vassed by a powerful body of Am erican econ om ists (an d their followers in the rest of the world) and converted into an ideology by politicians that the ideal econom ic system is where the state perform s the m in im um n ecessary fun ction s leavin g the rest to the m arket based on the prin ciple of self-in terest. Th e r ation ale of th is view is often tr aced back to a passage from the writings of Adam Sm ith in which he stated that when individuals work for their own gain they are “led by an invisible hand” to prom ote social good also. Sm ith, indeed, m ade such a statem ent. But what is often forgotten is that Sm ith’s basic position was that “justice upholds the edifice [of society, and] if it is r em oved , th e gr eat, th e im m en se fabr ic of society … m ust in a m om en t crum ble in to atom s”. Uph oldin g justice, u n d er stood at least as th e com m on good , is th e r ole of th e state in the social order. Part of the reason for m an y of the econom ic ills of recent decades has been a deliberate attem pt t o u n d e r p la y t h e go ve r n m e n t ’s u n a vo id a b le r o le in t h e econ om y. Tu r n in g n o w t o t h e m a r k e t , if e xch a n ge is t h e r u d im e n t a r y fu n ct io n o f t h e m a r k e t , wit h o u t it e ve r y individual (or fam ily or som e sm all group like that) will have to be selfsufficient. Hence the m arket certainly is a useful social institution. At tim es, as in the context of discussions on finance, it is the (self) regulatory function of the m arket that is featured. When thin gs are workin g well it m ay appear legitim ate also. But even Alan Greenspan who, as Chairm an of the US Federal Reser ve Boa r d fr om 19 8 7 t o 20 0 6 , m a in t a in ed a n d a vid ly

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p r op a ga t ed t h is view a d m it t ed wh en t h e a va la n ch e of t h e financial crisis erupted that he was wrong. One thing that is often overlooked is that except for the m ost elem en t a r y for m of b a r t er , a ll m a r ket t r a n sa ct ion s, in cludin g the tran saction s of com m odities, are don e through in ter m ed iar ies an d h en ce m ar kets in gen er al ar e su bject to the problem s of m ediation noted earlier. As we have already seen , the problem of m ediation is m ore so in tran saction s of credit an d fin an ce but is in heren t in all m arket tran saction s. H en ce as a gen eral proposition we m ay say th at all m arkets h ave to be su bjected to n on -m ar ket r egu lation s. Mon etar y tr an saction s ar e effectively syn ch r on isation s of m ar ket an d state in so far as m oney is a sym bol of authority. But in som e transactions m ore than that sym bolic authority and regulation is r eq u ir ed . Mor e im p or t a n t st ill, we h a ve seen t h a t t h e foundation of a m odern econom y is tru s t which is beyond the m ar ket an d n o t self-in t er est con sid er ed t o be t h e basis of exchan ge an d the m arket system . The state com es in to m atters of fin an ce because though finance is, up to a point, the realm of the well-to-do it im pinges on the lives of m ost m em bers of society, or the public at large. A d em ocr at ic p olit y, in p ar t icu lar , can n ot affor d t o ign or e econom ic and social problem s of sharp increase in inequalities that finance brings about when its perform ance is considered to be good, an d the loss of jobs, in com es an d shelters of the or d in a r y p eop le wh en t h in gs go wr on g. Bu t h ow a r e t h e in terests of the ordin ary citizen s to be protected? Gr o w th ? Stim ulating growth is put forward as the im m ediate and st a n d a r d r em ed y. H owever , u n sp ecified gr owt h is ju st a num ber which can m ean m any things depending on what has been growing. Hence the com position of growth itself m ust be exam in ed . For in stan ce, gr owth gen er ated su bstan tially in the finance sector will have one kind of im pact on the econom y a n d s o cie t y co m p a r e d wit h gr o wt h ge n e r a t e d in t h e

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agr icultur al sector . In In dia, wh er e th e con tr ibution of th e services sector in the GDP is already greater than the com bined value of the output of the agricultural an d in dustrial sectors, “gr owt h ” oft en m ean s m er ely a fu r t h er bloat in g of ser vice sector itself. And growth confined to selected segm ents of the econ om y a n d lim it ed sect ion s of societ y is oft en illu sor y. Hence it is im portant to consider what exactly is growing and to ensure that growth is in clu s ive reaching the lowest rungs. The specifics will depen d on the type of econ om y con cern ed. Bu t a d em ocr a t ic syst em m u st en su r e t h a t t h e p r od u ct ive activities of its econom y are directed such that the basic needs of a ll are m et. Special attention should be paid to reach out to th ose wh o h ave been th r own ou t by th e fin an cial cr isis. A d eliber ately d esign ed bottom -u p str ategy of gr owth will be th e best to reh abilitate th e econ om y an d set it on a h ealth y gr owt h p a t h . A st r on g ca se ca n a lso b e m a d e t o h a ve a p e r m a n e n t s a fe t y n e t t h a t will p r o vid e p r o t e ct io n t o vulnerable sections of society. This is not only a philanthropic consideration. Growth will increase and can be sustained when all becom e productive. Sin ce shelter is a basic requirem en t, providing m inim um housing at reasonable rates to all m ust be included as part of social policy. In fact, food, clothing, shelter, ed u cation an d h ealth car e m u st be r ecogn ised as econ om ic en t it lem en t s of a ll cit izen s in a n en ligh t en ed d em ocr a t ic syst em . Ch a n ge s a t th e Glo b a l Le ve l Wh ile t h ese a r e m a t t er s la r gely for ea ch cou n t r y t o d ecid e, som e ch an ges ar e r equ ir ed at th e in ter n ation al an d global level because no country today can ignore its econom ic r elation sh ips with oth er cou n tr ies. Th is can be best stated with reference to the US-China relationship dealt with earlier. As noted there, the dom estic situation in the US is partly the result of its curren cy’s dom in atin g role globally. A vast an d relatively low-in com e coun try like Chin a should n ot be usin g it s r esou r ces t o p r ovid e Am er ica n con su m er s low p r iced goods. However, at this stage China cannot afford to suddenly change that pattern as its productive activities are so crucially

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lin ked to th e Am erican m arket. It can n ot also with draw its piled up dollar reserves because th at will weaken th e dollar an d m ake Chin a poorer! Nor can Chin a raise the value of its cu r r en cy su d d en ly a s t h a t will a d ver sely a ffect t h e exp or t advan tage it n ow en joys, alth ough in th e lon g run it sh ould readjust its econ om y to produce m ore for the use of its own citizens, if necessary im porting m ore than it is now doing. Wh at we see is th at even a cou n tr y th at h as th e basic econ om ic st r en gt h t o m a ke r ea d ju st m en t s ca n n ot d o t h a t because of its global tie ups. China, therefore, has put forward th e legitim ate dem an d for a gen u in ely global cu r r en cy th at will n ot give an y on e coun try special advan tages. Towards the end of the Second World War a sim ilar need was felt and t h e I n t er n a t ion a l Mon et a r y Fu n d (I MF) wh ich p er m it t ed m em ber countries to draw on its reserves when required was created for that purpose. H owever, the role of the IMF was t h en p er ceived t o b e t o d ea l wit h on ly p a ym en t p r ob lem s between coun tries an d n ot lon g term n eeds of developm en t. More crucially, th e special drawin g righ ts (from th e IMF) is r elat ed t o each cou n t r y’s con t r ibu t ion as d ecid ed in 19 4 4 when the Fund was set up, and do not reflect the vastly changed international econom ic conditions today. Hence if the IMF is to continue to be the global currency authority, it will have to be radically restructured. If that is to be achieved the United Nation s Organ isation m ust also be reorgan ised in tun e with the vastly changed profile of the nations of the world today. International trade regulations also require to be changed t o s t a b ilize a n e w glo b a l cu r r e n cy a n d t o h a ve h e a lt h y econom ic relations between nations. The poorer countries of t h e wor ld ar e at an econ om ic d isad van t age becau se of t h e st r on g t r ad e bar r ier s t h at t h e r ich er cou n t r ies m ain t ain t o provide protection to sections of their own citizens. The WTO was set u p for t h is p u r p ose an d t o br in g abou t fr eer t r ad e between coun tries. But after several roun ds of n egotiation s n ot m u ch pr ogr ess h as been m ad e. To m ove for war d it is n ecessar y t o h ave a n ew ar ch it ect u r e of global gover n an ce wit h a glob a l r eser ve cu r r en cy wh ich is n ot t h e n a t ion a l

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cu r r en cy of an y on e cou n tr y, som eth in g cor r espon din g to a Wor ld Reser ve Ban k t h at will lay d own fair con d it ion s for drawing on global reserves, a just international trading system t h a t p r o t e ct s t h e in t e r e s t s o f t h e p o o r a n d vu ln e r a b le th rough out th e world. Thus, within countries and between them there is m uch t o b e d on e t o r em ed y t h e p r ob lem s cr ea t ed b y t h e glob a l m eltdown and go beyond. The suggestions put forward m ay appear to be too idealistic as they call for changes in attitudes a n d p r io r it ie s , a s we ll a s co n s id e r a b le in s t it u t io n a l restructuring. But the attem pt has been quite deliberate, and for two reasons. The first is that it is widely recognised that wh at h appen ed to th e US fin an cial system in 20 0 8 an d h as been spreading to the world since then is not m erely one m ore of the m an y crises that the US econ om y has gon e through in the past. It is qualitatively differen t an d is sure to m ark the beginning of the end of the global econom ic dom ination of the US. H en ce th is is th e tim e to th in k an ew. Secon d ly, th at opportunity should be used to heavily underline that fairness, not greed, m ust be the cornerstone of econom ic system s within coun tries an d in an in creasin gly globalisin g econ om ic order. Th e m essage of th e m eltdown is th at wh ile in stitution alised gr e e d m a y s u s t a in t h e s ys t e m a n d e ve n p r o vid e s o m e sem blance of well-being for a while, it surely paves the way for destruction from within .

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N o te : In writing this piece the following have been of help: 1.

Cable Vin ce , The Storm - The W orld Econom ic Crisis and W hat It Means, Lo n d o n , Atla n tic Bo o ks , 2 0 0 9 .

2 . Eco n o m ic an d Po litical W e e kly, Sp e cial N u m be r o n Global Econom ic and Financial Crisis – An Agenda for the Future, Vo l.XLIV, N o . 13 , Ma rch 2 8 - Ap ril 3 , 2 0 0 9 . Th e p a p e rs in th is N u m be r a ls o p ro vid e e xte n s ive re fe re n c e s . 3 . F e r g u s o n N i a l l , T h e Ascen t of M on ey – A Fin a n cia l History of the W orld, Lo n d o n , Alle n Lan e , 2 0 0 8 4 . Mo rris Ch arle s R., The Trillion Dollar Meltdow n – Easy M on ey , H igh R ollers An d The Great Credit Crash, N e w Yo rk, P u b lic Affa irs , 2 0 0 8 . Th e s ta tis tic s re la tin g to in c o m e in e q u a litie s in th e U n ite d S ta te s give n in Se ctio n IV are take n fro m p age s 152 &153 . 5 . So ro s Ge o rge , The Crash of 20 0 8 and W hat it Means – The n ew Paradigm for Fin an cial M ark ets, N e w Yo r k , Pu blic Affairs , 2 0 0 8 . Com m ents received from a wide circle of m em bers of the fam ily an d frien ds on earlier version s that led to substan tial revision s are also gratefully ackn owledged.