Contours of finance after the crisis

Financial Express, 30 March 2009

A return to dirigisme?

When the Great Depression came about in the 1930s, it presented an unprecedented challenge to the vision of open markets and open minds. On one hand, democracy was then challenged by communist and Nazi visions. On the other hand, the prophecy of Karl Marx, that capitalism was subject to cycles of increasing magnitude, appeared to be coming true. Many genuinely smart intellectuals swung to the left.

John Maynard Keynes, who personified all that is good and desirable about liberalism, argued in favour of a bigger role for the State in macroeconomic stabilisation. He did not do this because he liked a big State. He was acutely conscious about the venality and incompetence of governments. His policy positions were arrived at with a heavy heart, so as to salvage some elements of civilisation and freedom, given that the alternative was the barbarism of Russia or Germany. The West thought that by setting up a welfare state, the risk of workers rising up in revolt would abate.

The post-war model of the Western world was thus an uneasy combination of big states with democracy. This combination proved to be a poor one. It broke down, giving way to the double helix of free markets and democracy. The system of governments managing exchange rates broke down on 15 August 1971, after a life of roughly 25 years. By the early 1980s, the Reagan and Thatcher revolutions were rolling back the State in all walks of life. Liberal intellectuals got back to advocating a tax/GDP ratio of 10%, arguing that it is possible to run an efficient State that delivers core public goods within 10% of GDP.

From 1979 till 2007, this worked very well and gave us the `Great Moderation', a period of unprecedentedly high growth with unprecedentedly low growth volatility. Then, starting in August 2007, we got the global crisis.

How should the world be reconstructed, reflecting the lessons of the crisis? Left intellectuals like Joseph Stiglitz or Dani Rodrik are getting a fresh dose of credibility in the crisis. The stuff one normally reads in the Hindu is popping up in Business Standard. The left is enthusiastic about selling the idea that financial capitalism is a broken enterprise, that we should now roll back to a world of capital controls, banks as highly controlled payment utilities, etc.

I think such change is not going to come about. Mainstream economists simply do not see financial capitalism as irretrivably broken. Genuinely smart economists are not swinging to the left. Specific mistakes were made; these will be identified and remedied. For those who look back to the Great Depression, and seek inspiration for obtaining a massive interference in the economy by governments, there are two hurdles. First, US unemployment is still well below the 25% mark. Second, in the 1930s, liberal democracy was under challenge from Nazi and communist philosophies. Today, those challenges are absent; there is only one game in town.

So what comes next?

The path to new ideas in financial regulation is being led by the Turner Report in the UK and the Geithner Proposal in the US, both of which were released in March. Both these are outstandingly well written documents, and well worth reading by everyone who works in these issues.

Geithner proposes:

On systemic risk, Geithner proposes:

The Turner Report, which came two weeks earlier, anticipated the Geithner proposal on all these areas. In addition, it argues in favour of new work on the problems of credit rating agencies, and remuneration policies.

Direct implications for India?

Observers in India are looking curiously at the lessons, if any, from these reports for the Indian debate on financial sector reforms. India is far, far behind the rest of the world in getting to a plausible financial system; we're still running a license-permit raj and barring the equity market, there are no real financial markets in India. Hence, there is very little about either the crisis or the lessons from the crisis which applies here. Ten of the big ideas in the proposals for reforms in India are:

  1. Refocus RBI on delivering low and stable inflation while having transparency and independence from political authorities;
  2. Capital account openness;
  3. Unification of securities markets regulation (both spot and derivatives) at SEBI, which implies folding FMC into SEBI;
  4. A bias in favour of exchange-traded derivatives as opposed to the non-transparent and risky OTC derivatives;
  5. Emphasise export-orientation in financial services;
  6. Rewrite critical legislation such as the SC(R)A and the RBI Act, reflecting the new knowledge that has come about after 1956 or 1934;
  7. Provide investment banking services for the government through a new Debt Management Office;
  8. Level playing field for foreign financial firms;
  9. A banking system dominated by private and foreign banks, as opposed to PSU banks;
  10. Establishment of a proper deposit insurance mechanism.

I did not see anything in the Turner or Geithner reform proposals that contradicted any of this.

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