Triumphant return of John M Keynes

It is imperative that we not just respond adequately to the current crisis but undertake the long-run reforms that will be necessary if we are to create a more stable, more prosperous and equitable global economy, says Joseph E Stiglitz

WE ARE all Keynesians now. Even the right in the United States has joined the Keynesian camp with unbridled enthusiasm and on a scale that at one time would have been truly unimaginable. For those of us who claimed some connection to the Keynesian tradition, this is a moment of triumph, after having been left in the wilderness, almost shunned, for more than three decades. At one level, what is happening now is a triumph of reason and evidence over ideology and interests. Economic theory had long explained why unfettered markets were not selfcorrecting, why regulation was needed, why there was an important role for government to play in the economy. But many, especially people working in the financial markets, pushed a type of ‘market fundamentalism’. The misguided policies that resulted — pushed by, among others, some members of US President-elect Barack Obama’s economic team — had earlier inflicted enormous costs on developing countries. The moment of enlightenment came only when those policies also began inflicting costs on the US and other advanced industrial countries. Keynes argued not only that markets are not self-correcting, but that in a severe downturn, monetary policy was likely to be ineffective. Fiscal policy was required. But not all fiscal policies are equivalent. In America today, with an overhang of household debt and high uncertainty, tax cuts are likely to be ineffective (as they were in Japan in the 1990s). Much, if not most, of last February’s US tax cut went into savings. With the huge debt left behind by the Bush administration, the US should be especially motivated to get the largest possible stimulation from each dollar spent. The legacy of underinvestment in technology and infrastructure, especially of the green kind, and the growing divide between the rich and the poor, require congruence between short-run spending and a long-term vision. That necessitates restructuring both tax and expenditure programmes. Lowering taxes on the poor and raising unemployment benefits while simultaneously increasing taxes on the rich can stimulate the economy, reduce the deficit, and reduce inequality. Cutting expenditures on the Iraq war and increasing expenditures on education can simultaneously increase output in the short and long run and reduce the deficit. Keynes was worried about a liquidity trap — the inability of monetary authorities to induce an increase in the supply of credit in order to raise the level of economic activity. US Federal Reserve chairman Ben Bernanke has tried hard to avoid having the blame fall on the Fed for deepening this downturn in the way that it is blamed for the Great Depression, famously associated with a contraction of the money supply and the collapse of banks. And yet one should read history and theory carefully: preserving financial institutions is not an end in itself, but a means to an end. It is the flow of credit that is important, and the reason that the failure of banks during the Great Depression was important is that they were involved in determining creditworthiness; they were the repositories of information necessary for the maintenance of the flow of credit. BUT America’s financial system has changed dramatically since the 1930s. Many of America’s big banks moved out of the ‘lending’ business and into the ‘moving business’. They focused on buying assets, repackaging them, and selling them, while establishing a record of incompetence in assessing risk and screening for creditworthiness. Hundreds of billions have been spent to preserve these dysfunctional institutions. Nothing has been done even to address their perverse incentive structures, which encourage shortsighted behaviour and excessive risk taking. With private rewards so markedly different from social returns, it is no surprise that the pursuit of self-interest (greed) led to such socially destructive consequences. Not even the interests of their own shareholders have been served well. Meanwhile, too little is being done to help banks that actually do what banks are supposed to do — lend money and assess creditworthiness. The federal government has assumed trillions of dollars of liabilities and risks. In rescuing the financial system, no less than in fiscal policy, we need to worry about the ‘bang for the buck’. Otherwise, the deficit – which has doubled in eight years – will soar even more. In September, there was talk that the government would get back its money, with interest. As the bailout has ballooned, it is increasingly clear that this was merely another example of financial markets mis-appraising risk – just as they have done consistently in recent years. The terms of the Bernanke-Paulson bailouts were disadvantageous to taxpayers, and yet remarkably, despite their size, have done little to rekindle lending. The neo-liberal push for deregulation served some interests well. Financial markets did well through capital market liberalisation. Enabling America to sell its risky financial products and engage in speculation all over the world may have served its firms well, even if they imposed large costs on others. Today, the risk is that the new Keynesian doctrines will be used and abused to serve some of the same interests. Have those who pushed deregulation ten years ago learned their lesson? Or will they simply push for cosmetic reforms — the minimum required to justify the megatrillion dollar bailouts? Has there been a change of heart, or only a change in strategy? After all, in today’s context, the pursuit of Keynesian policies looks even more profitable than the pursuit of market fundamentalism! Ten years ago, at the time of the Asian financial crisis, there was much discussion of the need to reform the global financial architecture. Little was done. It is imperative that we not just respond adequately to the current crisis, but that we undertake the long-run reforms that will be necessary if we are to create a more stable, more prosperous and equitable global economy.

(The author, professor of economics at Columbia University, is recipient of the 2001 Nobel Prize in Economics)

(Source: Economic Times)

Who will let the dollar go down?

Asian economies have to creatively invest their resources in productive activities instead of parking them in US treasuries. That’s the only way Asia can bring the world economy out of recession, says Neeraj Kaushal.
IN THE United States, half a million jobs evaporated last month, over 1.2 million were lost in the last three months. Businesses are closing down every day. Banks are afraid to lend, credit market continues to be tight. Consumer confidence is dwindling. Most forecasts suggest that the US gross domestic product will decline by 4% to 5% on an annualised basis in fourth quarter of 2008, and the economy will continue to experience a decline in GDP in 2009. Every expert and non-expert has declared that the US economy is in the worst recession since the 1929 Great Depression. But the US dollar is unfazed; it continues to enjoy strong confidence in a world economy shaken by financial turmoil. The greenback is getting stronger every day just as the US economy is plunging deeper into recession. Since August, the dollar has appreciated 17% against the rupee, 23% against the euro, and 34% against the British pound. Couple of weeks ago, the dollar strengthened somewhat even against the Chinese currency, renminbi. News reports suggest that the recent decline in export orders is putting pressure on the Chinese government to allow the renminbi to depreciate against the dollar — by five or even 10%. Dollar’s resurgence is a puzzle when compared with how currencies of other countries collapsed in national or regional financial crises in the past two decades. The Argentine peso depreciated 75% against the US dollar during the Argentine economic and financial crisis during 1999-2002. In the 1994 Mexican peso crisis, the Mexican currency fell 55% against the dollar. During the 1997 Southeast Asian financial turmoil, Thai bhat, Indonesian rupiah, Korean won experienced huge depreciations as did the currencies of Malaysia, the Philippines and other Southeast Asian economies. Financial crises in these countries not only caused substantial depreciations of their currencies, but also flight of foreign, and sometimes even domestic, capital. So far there is no shine off the value of the dollar, nor any major flight of foreign capital from American shores. What’s with the greenback? Against all odds, how has it regained in the past four months what it lost against most currencies in the previous three years? Clearly, the dollar has benefited from the fact that it continues to be the international currency of exchange, trade and reserve. The strengthening of the dollar is also helped by the fact that Japan and the economies of the euro zone are as deeply sunk in recession as is the American economy and growth in China and India is projected to be lower than it had been in the previous few years. Most of all, fright in world financial markets has sent investors running away from risky assets towards the US dollar and US treasury bonds. In the worst financial crisis since the Great Depression, the dollar has regained almost half of what it lost in the past six years. Consequently, American businesses are becoming less competitive as compared to foreign businesses. This will dampen demand for American exports and increase its imports. American multinational corporations will also find that returns to their investments abroad decline, when expressed in dollars. American travellers, who have suffered erosion in their purchasing power abroad during the past seven years will, however, benefit from the current strengthening of the greenback. HOW will the dollar fare once the full impact of the US government’s $700-billion bailout package becomes known is not clear. Will investors start shunning US treasury bonds once they realise the full import of US fiscal deficit? Will foreign investors’ confidence in the US economy fade with the prospects of its future economic growth? If the answer to these questions is yes, then it is clear that the ‘global’ economic recession has not yet led to the much needed correction in the global financial system. While the world economy is looking towards Asia, in particular China and India, for economic growth in the coming five years, Asian economies in turn depend heavily on US consumers. The recent depreciation of the Chinese yuan, said to be triggered by the slackening of export orders, is an indicator. A weak Chinese currency is expected to keep US demand for Chinese goods buoyant, while the recession in the US would dampen it. However, if the US economy remains in a prolonged recession, it would be foolish to expect that somehow the US would continue to increase its purchase of goods from the rest of the world to keep the world economy going, and it would be foolish and even dangerous to keep financing American imports through debt. If China continues to use its reserves to prop up the dollar, it will seriously weaken its own position and reduce its policy options. Any future dollar depreciation would only result in a decline in the value of Chinese reserves. China can keep its economy growing at double digits by using its $2 trillion reserves to bring prosperity to its people, by creating more jobs and paying workers higher salaries. China can also provide its own people consumer goods at low prices, same as it has been doing for American consumers for decades. China can redeploy its reserves to increase investment in other Asian economies. The Chinese government has announced a $600-billion initiative to boost its economy over the next two years. The boost constitutes 14% of China’s GDP, and can help China maintain its potential economic growth even with slackening of US imports. According to the most recent forecast of the world economy by the International Monetary Fund, advanced economies will experience almost a one percentage point reduction in their GDP in 2009. It is clear from these forecasts that world economic growth in the next two to three years would heavily depend on Asian economies. Asian economies have to creatively invest their resources in productive activities instead of parking them in US treasuries. That’s the only way Asia can bring the world economy out of recession.

(The author teaches at Columbia University)

(Source: Economic Times)

Looking at the jungle for some succour

By R A J R I S H I S I N G H A L
THE markets have always been fascinated by animals. Time and again, innovative market players have delved into the animal kingdom for inspiration on new products. Whenever, capital market players, especially those in the bond market, have come up with new products, and were faced with the prospect of naming the newer beast, they found inspiration from animal names. The time may have come again to look to the jungle for some respite. The fascination with quadrupeds began with investment banks venturing into the government securities market. These banks would buy US government treasury bonds, put them into an escrow account and re-create instruments derived from these bonds. The interest payout on the original bond would be used to create new bonds. Typically, these instruments would be issued at a deep discount to their face value and investors would receive the face value at maturity, the difference being the implied interest rate.

These bonds were issued mostly between 1982 and 1986. Merrill Lynch — recently taken over by Bank of America — floated TIGRs, or Treasury Investors Growth Receipts. Similarly, Lehman Brothers, which went bankrupt and had to be shut down floated LIONs, or Lehman Investment Opportunity Notes. Not to be outdone, Salomon Brothers invented CATS, or Certificates of Accrual on Treasury Receipts. Predictably, the market referred to these bonds collectively as “felines”. In the past, Indian MFs also took a stab at launching new fund offers with similar names. For example, DSP Merrill Lynch had floated a new scheme called the TIGER fund, which was an acronym for The Infrastructure Growth and Economic Reforms Fund. ING Bank’s local mutual fund arm floated LION Fund, which expanded into the slightly contrived and convoluted Large-cap, Intermediate-cap Opportunities New Offerings Fund. Recently, insurance companies, stung by the colossal damage claims arising out of storms, hurricanes, typhoons, earthquakes and other similar natural calamities, came up with CAT bonds, which are different from the ones floated by Salomon Brothers. These are a short form for “catastrophe bonds”. Insurance companies float these specialised bonds to transfer their risk to the broader capital market. Typical investors include hedge funds and dedicated catastrophe-oriented funds. Given the upheaval in the world markets — called by various people a calamity, catastrophe or a cataclysm — this might be the right time to launch some more “animal” bonds to revive investor interest. Here are some of the mythical beasts.

DOG: Expanded they stand for — pardon the expression — Dump On Government. These are bonds issued by all kinds of special investment vehicles which may or may not have any underlying assets. In case the issuer stops paying interest, the government will be obliged to buy them back.

GOAT: Government Offering for Actual Trading, instruments primarily designed for Indian markets. These are paper issued by the government in lieu of all its payments — subsidy, tax refunds, bank recapitalisation, et al — which can then be traded on the market. This one feature will be the big, big difference. The current lot of bonds — issued to oil companies to make up for the shortfall between cost and market prices, and banks for sterilising dollar purchases, fertiliser companies — cannot be traded on the market and has left treasury heads of all these companies and banks in a quandary.

VIPER: These will be a genre of paper in the manner of “catastrophe” bonds, but issued for insuring disaster in the financial sector, instead of natural mishaps. Called Voucher In Place Exceptions Regretted, these bonds will help insurance companies provide cover against the next generation of banks, which issue exotic derivatives, going kaput.

COBRA: These instruments — Collateral Based on Reducing Assets — will be designed for subscription by conglomerates, especially those which need tax breaks. Imagine a holding company with investments spread across a large number of companies. This portfolio could also include minority interest joint ventures. In such cases where the minority interest company is making a loss, the holding company is unable to take the benefit of a tax write-off. This bond allows the holding company to do that.

CHEETAH: You’ve heard of NINJA — No Income No Jobs or Asset — loans provided to sub-prime borrowers. When the next spell of easy money rolls around — and you can bet your shirt that it will, given the kind of liquidity being pumped in daily by the world’s central banks — the same kind of loan can be rolled off the assembly line, albeit with a different name: Childless, Earning-Exempted, Totally Assetless Homes.

LAMB paper: As soon as Lehman went bust, the impact was felt on all those holding paper issued by the investment bank. The current credit crisis was sparked off when one money market mutual fund woke up one Monday morning and found its asset value wiped out. But, there might be a contrarian — and intrepid — vulture investor, or even a former Lehman trader, who might find some residual value in some of that paper.

Source : Economic Times

We’re all for public ownership now

THIS is a time for rescues of financial systems everywhere. Britain’s plan is considered especially bold. Under the plan, the UK government will inject up to £50 billion in capital into eight of Britain’s largest banks and building societies.

In the first step, the UK has injected £37 billion into three banks. This will give it a 60% stake in one bank and a 40% stake in two banks that are undergoing a merger. The UK government plans to have its directors on the boards of these banks — just when the Raghuram Rajan committee wants the Indian government to exit its own. There appears to be no escape from public ownership of banks in the US as well as Europe. Nothing else will restore confidence in the banking system. Most people accept this. But they also say that public ownership should be a temporary affair. Why so? Because, it is said, public ownership of banks makes them prone to failure. Governments will feel obliged to save them and the costs are borne by the exchequer. This is an astonishing statement to make — and not just because of private bank failures in the present crisis.

Economies worldwide have gone through the same thing over the past several decades. Private banks fail, the government recapitalises them, later restores them to private ownership. Banking failures are costly. They impose recapitalisation costs in the range of 5-45% of GDP. And yet there is a presumption that public ownership alone imposes fiscal costs. There is one distinguished exception to the story of banking failures in recent decades: the Indian banking system. In 1992-93, India opted to retain public sector dominance in banking. The government provided public sector banks (PSBs) with $5 billion in capital — a pittance compared to the sums being talked about now. These two decisions have contributed to stability in Indian banking. Public sector dominance is not the only factor: sound macroeconomic management and strong regulation have helped. But it is certainly a key factor. Seeing the plight today of the nation’s largest private bank, one shudders to think of what might have been, had public ownership been absent.

Critics say this may be true but we have paid a heavy price for stability. The banking system is hugely inefficient. The RBI Report on Currency and Finance(2006-08), which focuses on the Indian banking sector, squarely addresses this criticism. This is a monumental study, bringing to bear on the entire gamut of policy issues a vast body of research. Let me highlight its key findings on ownership and efficiency in Indian banking. One, efficiency in Indian banking has improved, especially since 2001-02, going by several accounting measures. Two, the Indian banking sector compares favourably with banks in both developed and emerging markets on most performance indicators. Three, using economic measures of efficiency, “ownership has no definite relationship with efficiency”.

How is it that the Indian experience defies the conventional wisdom that private ownership is superior? There are good reasons. Typically, state-owned enterprises (SOEs) run out of steam because the state’s finances are in a mess and the state is unable to provide capital. These firms are then sold to private (often foreign) owners who bring in capital. Academics compare the performance of firms in years when they were starved of capital under government ownership with performance following the infusion of capital. They find an improvement in performance. They conclude it is privatisation that made the difference. Not many economies have experimented with serious public sector reform: allowing SOEs to raise capital by going public; ushering in improvements in governance; and allowing SOEs to compete with private firms. India has done all of these. The improvements are there for all to see. India’s somewhat unique approach to the issue of public ownership has paid off richly.

Enterprise reform has been complemented by strong regulation. Former RBI governor Y V Reddy has received well-deserved plaudits for his management of monetary policy and exchange rates in the face of a surge in foreign inflows. His contributions towards bank regulation were as substantial. Their value is beginning to be grasped in today’s turbulent conditions. During Dr Reddy’s tenure, the RBI unveiled separate roadmaps for private ownership of banks and for foreign banks in India. These served to ensure that neither private bank nor foreign bank expansion happens in ways that undermine stability in Indian banking. Dr Reddy was roundly criticised for overprotecting the public sector. The Percy Mistry report of 2007 asked that all PSBs be privatised. The Rajan committee wants selective privatisation of PSBs. How ironical that close on the heels of these reports, we should be seeing a world-wide embrace of public ownership in banking even if under duress!
(Author T T RAM MOHAN)

(Source Economic Times)

Don’t Cry For Me, America

The US recession will be severe, but not devastating
Paul Krugman
Princeton: Mexico. Brazil. Argentina. Mexico, again. Thailand. Indonesia. Argentina, again. And now, the United States. The story has played itself out time and time again over the past 30 years. Global investors, disappointed with the returns they’re getting, search for alternatives. They think they’ve found what they’re looking for in some country or other, and money rushes in.

But eventually it becomes clear that the investment opportunity wasn’t all it seemed to be, and the money rushes out again, with nasty consequences for the former financial favourite. That’s the story of multiple financial crises in Latin America and Asia. And it’s also the story of the US combined housing and credit bubble. These days, we’re playing the role usually assigned to third-world economies.

For reasons to be explained later, it’s unlikely that America will experience a recession as severe as that in, say, Argentina. But the origins of our problem are pretty much the same. And understanding those origins also helps us understand where US economic policy went wrong.

The global origins of our current mess were actually laid out by none other than Ben Bernanke, in an influential speech he gave early in 2005, before he was named chairman of the Federal Reserve. Bernanke asked a good question: “Why is the United States, with the world’s largest economy, borrowing heavily on international capital markets — rather than lending, as would seem more natural?”

His answer was that the main explanation lay not here in America, but abroad. In particular, third-world economies, which had been investor favourites for much of the 1990s, were shaken by a series of financial crises beginning in 1997. As a result, they abruptly switched from being destinations for capital to sources of capital, as their governments began accumulating huge precautionary hoards of overseas assets.

The result, said Bernanke, was a “global saving glut”: lots of money, all dressed up with nowhere to go. In the end, most of that money went to the United States. Why? Because, said Bernanke, of the “depth and sophistication of the country’s financial markets”.

All of this was right, except for one thing: US financial markets, it turns out, were characterised less by sophistication than by sophistry, which my dictionary defines as “a deliberately invalid argument displaying ingenuity in reasoning in the hope of deceiving someone”. E.g., “Repackaging dubious loans into collateralised debt obligations creates a lot of perfectly safe, AAA assets that will never go bad.”

In other words, the United States was not, in fact, uniquely well-suited to make use of the world’s surplus funds. It was, instead, a place where large sums could be and were invested very badly. Directly or indirectly, capital flowing into America from global investors ended up financing a housing-and-credit bubble that has now burst, with painful consequences.

These consequences probably won’t be as bad as the devastating recessions that racked third-world victims of the same syndrome. The saving grace of America’s situation is that our foreign debts are in our own currency. This means that we won’t have the kind of financial death spiral Argentina experienced, in which a falling peso caused the country’s debts, which were in dollars, to balloon in value relative to domestic assets. But even without those currency effects, the next year or two could be quite unpleasant.

What should have been done differently? Some critics say that the Fed helped inflate the housing bubble with low interest rates. But those rates were low for a good reason: although the last recession officially ended in November 2001, it was another two years before the US economy began delivering convincing job growth, and the Fed was rightly concerned about the possibility of Japanese-style prolonged economic stagnation.

The real sin, both of the Fed and of the Bush administration, was the failure to exercise adult supervision over markets running wild. It wasn’t just Alan Greenspan’s unwillingness to admit that there was anything more than a bit of “froth” in housing markets, or his refusal to do anything about subprime abuses. The fact is that as America’s financial system has grown ever more complex, it has also outgrown the framework of banking regulations that used to protect us — yet instead of an attempt to update that framework, all we got were paeans to the wonders of free markets.

Right now, Bernanke is in crisis-management mode, trying to deal with the mess his predecessor left behind. I don’t have any problems with his testimony yesterday, although one suspects that it’s already too late to prevent a recession. But let’s hope that when the dust settles a bit, Bernanke takes the lead in talking about what needs to be done to fix a financial system gone very, very wrong. — NYTNS

(The writer has won the 2008 Nobel Prize for economics. This article was first published in January.)

(Source Economic Times)

Free Market Capitalism?

With the latest round of global market turmoil and the latest set of 'steroids' injected into the financial markets, the problem seems to be far from over. The LIBOR, one of the globally recognised benchmarks for inter bank borrowing/ lending witnessing unprecedented levels, credit markets have come to a grinding halt. All efforts by Central Banks of major developed economies, by way of co-ordinated interest rate cuts and injecting funds have come to naught. Our own RBI is not the be left behind. It has announced decrease in CRR by a massive 150 basis points, in a matter of one week after a period of 5 years of CRR hikes. But all policy action towards providing liquidity and at cheap rates doesn't seem to work on the ground. Reason being the 'skepticism', to put it mildly, among bankers to lend each other. With major institutions going bust week after week, the inter bank lending has dried out. Banks are stashing their deposits in T-bills, leaving little to lend. Be it the commercial paper market, institutional funding or the equities market, all have become non functional, literally. Leaving businesses reeling under the downward credit spiril.

Some have criticised the nationalisation and bailout packages being bundled out by the US, labeling them as socialist in nature and away from the principles of free market & democracy . To the US's defense the role of a democracy is much more then just free markets, its more about the welfare of the people. The debate is not going to die anytime soon thou. But I having turned into a staunch free market fundamentalist believe that the bail out packages being thrown around is not going to bring back confidence which is an essential prerequisite for the banking and financial systems to work. Which is exactly the reason why we find that though the interest rates have been cut, corporates find no takers for their paper and whatever financing is done is at exorbitant rates. The ban on short selling imposed to abate the slide in equities is another such misstep. It can trigger another Pandoras box. Unregulated entities like hedge funds known for shorting aggressively can be caught wrong footed with the ban. Hedge funds, hiterato unscathed can pretty easily find themselves in the midst of all action if things go awry.

May be had it not been for the bailing out of Lehman Brothers, AIG etc, we would have had spiraling systemic problems, no one can ever be for sure as to the right solution to the issue on hand. But one thing is for sure we will witness sea change in the way the financial world is managed and compensations doled out.

Terror debate

Switch on any news channel, three out of ten times, you are bound to find some breaking news on a new bomb blast or new leads into the investigation proceeding. A host of talk and debate shows are aired on television for weeks after each blast, wherein the spokesperson for various political parties turn up and and compare how successful their govt is/was (depending on which side of the table they are) compared to the other govt. The very purpose of such debates is completely zilch, serving no purpose whatsoever. Instead bringing to the forefront the very lack of nationalism, spirit of rising for a greater cause, partisan politics and n no. of such other virtues which the political leaders for any country should display.
There are others who want a ban on other fascist and radical religious groups too, their argument being that you cannot classify and differentiate between terrorism. I don't support or counter the above argument. But I just feel that there is much more which can be done at the political and administrative levels, if police, intelligence and the politicians rise above for a greater national and human cause.

But the winner in all the turmoil are the religious fanatics, the terrorists, who have managed to achieve their goal of spreading terror in the hearts and minds of people on the street and markets. But terror is just a mean to a larger goal, will they actually succeed in realizing the end.... I don't think so. Recent slew of reports suggest how the Indian Muslim's are living under the threat of terror, terror of being picked up as a suspected terror link, terror of denial by follow citizens. The very foundation of Indian Republic, is it's secularism and communal harmony. The people taking up humanity as the only religion, is a dream which looks too distant... atleast in the present scenario.