GLOBAL FINANCIAL CRISIS : LESSONS FOR THE THIRD WORLD

GLOBAL FINANCIAL CRISIS : LESSONS FOR THE THIRD WORLD

1. GLOBAL FINANCIAL CRISIS : LESSONS FOR THE THIRD WORLD 1

2. GLOBAL CRISIS : MAIN STAGES 1. STARTS IN THE US AS A FINANCIAL CRISIS (AUG. 2008) 2. RAPID CONTAGION SPREAD TO EUROPE 3. CONTAINED IMPACT ON THIRD WORLD 4. WORLD CONDITIONS STILL DEPRESSED (DOUBLE-DIP, U-SHAPED, V- SHAPED, W- SHAPED, L-SHAPED?). SLOW RECOVERY IN US, AND SOME EU COUNTRIES BUT MOST OF EUROPE STILL TO RECOVER. 5. MILD RECOVERY IN ASIA BUT UNORGANISED SECTOR CONTINUES TO SUFFER BROADLY 2

3. ANATOMY OF U.S. CRISIS 3

4. ORIGINS OF THE CRISIS IN U.S.SIX DRIVING FACTORS REAL FACTORS 1. Great Moderation 2. Global Savings Glut FINANCIAL FACTORS 3. Loose Fed Policy Under Greenspan 4. Home Price Bubble 5. Sub-prime Lending Growth 6. MBS (Mortgage Based Securitization) 4

5. GREAT MODERATION 1. Low inflation 2.Low short-term interest rates 3. Steady growth in U.S. and Europe 4. High growth in EMEs (China & India in particular) 5. Rising housing prices 5

6. GLOBAL SAVINGS GLUT 1. Rise in savings in China, Japan, OPEC, East Asia 2. Decline in savings and huge current a/c deficits in US and Europe 3. Flow of investment into US treasury securities 4. Low real long-term interest rates in us 5. High demand for credit 6

7. LAX MONETARY POLICY How Wrong Can One Man be? Title of Chapter 1 in W.A.Fleckenstein & F.Sheehan (2008) “Greenspan’s Bubbles : The Age of Ignorance at the Federal Reserve” 1. Aggressive Cutting Of Short-term Interest Rates in 2000 and 2001. 2. Loose Monetary Policy Over 2001-04 Led To Home Price Bubble. 7

8. HOME PRICE BUBBLE 1. Unprecedented House Price Boom Over 1996-2005 In US And World Wide 2. Belief In US Growth Story 3. Bullish Herd Behaviour 8

9. SUB-PRIME LENDING GROWTH Four types of us mortgages 1. Prime (following standards set by Fannie Mae & Freddie Mac) 2. Jumbo- exceeding loan limits set by FM1 and FM2 3. Alt-A – not satisfying fm criteria but borrowers have good credit fico scores 4. Sub-prime-borrowers with poor credit history and scores

10. SECURITIZATION 1. Began in 1968 under Ginnie Mae based on combining FHA/VA loans 2. In 1981 Fannie Mae introduced MBS (mortgage based securities) based on prime mortgages 3. A little later private label securities started emerging including MBS with sub-prime mortgages. Separated into 3 tranches –equity, mezzanine and senior 4. Losses incurred on the 3 tranches above were recorded as successively higher proportions of mortgage loans defaulted. 5. Collateral Debt Obligations (CDOs) based on combinations of MBS with varying Tranches. More complicated products such as CDOS-Squared, CDOS-Cubed etc.

11. SECURITIZATION CHAIN Home owner/borrower →broker→originator (bank/mortgage company)→arranger/issuer→ Trust/SPV→asset fund/SIV→end-investor (could be any individual, bank, finance company anywhere in the world) Switch from “originate and hold” model to “originate and distribute” model. Two important facts about chain : 1. Huge information gap between each link 2. Role of credit rating agencies 11

12. WEAK LINKS IN THE SECURITIZATION CHAIN 1. Brokers driven by commission based on quantum of loans rather than their quality-evidence of manipulation of credit scores etc. 2. Originators had no incentives to ensure quality of loans under the O&D system as opposed to the older O&H system 3. Huge profits from securitization encouraged strong leveraging 4. Tranching enabled SPVs to tailor CDOs to needs of various investors (CDOs based on senior tranches with AAA ratings to pension funds, CDOs based on lower tranches with BBB ratings for SIVS and conduits etc) 5. Rating agencies made a large share of their products from rating CDOs etc. They get their fees from the issuer rather than the investor. Hence some incentives for rating agencies to compromise their standards 6. Fund managers motivated by bonuses based on competition relative to peers. CDOs offered high returns with the underlying risk carefully cached. 7. Less liquid tranches could not be “marked to market” and were hence “marked to model 12

13. ALTERNATE EXPLANTIONS OF CURRENT GLOBAL CRISIS 13

14. COMPETING THEORIES OF THE CRISIS : 1. Mainstream View (New Classical) Several competing theories of what triggered the global crisis in the U.S. All theories recognize that the Crisis is multi-causal but each theory emphasizes a different set of factors. Mainstream economists (new classicals) tend to emphasize the following three factors (i) a myopic (and over-loose) monetary policy of the FRB under the tenure of Greenspan and the growing twin deficits of the US. (ii) the weak links of “inefficient securitization” especially of mortgage based securities (which is blamed on the earlier US policy of “affordable housing for all”) and (iii) the emergence of an inadequately regulated “shadow banking” sector. See in particular Brunnermeier (2009), Gorton (2008, 2010) Giovanni & Spaventa (2008), Reddy (2009) etc. 14

15. COMPETING THEORIES OF THE CRISIS : 2. Alternate View (Post-Keynesian) The alternate view (Post-Keynesian) lists the following factors as the main culprits : Global imbalances (global savings glut) Increased income inequality both in the advanced and emerging economies “herd behaviour” and asset price bubbles the weak links of “inefficient securitization” especially of mortgage based securities (which is in this view, blamed on premature deregulation and financial liberalization) In this viewpoint the main culprit is the phenomenon of “financialization” (Heim & Truger (2010), Wade (2009), van Treeck (2009) etc. ) 15

16. NEO-LIBERALISM : A REAPPRAISAL WITH HINDSIGHT 16

17. NEO-LIBERAL RATIONALE FOR FINANCIALIZATION The intellectual basis for the wave of financial liberalization that rose in the 1980s was three-fold: 1. The efficient market hypothesis which assured us that financial markets allocated resources efficiently and that they were driven by fundamentals rather than speculation 2. the “Jackson Hole” Consensus which insisted that financial stability was a by-product of inflation stabilization 3. The McKinnon –Shaw thesis which argued that financial liberalization was a precondition for “real” economic growth All three of the above hypotheses are strongly rooted in the free market philosophy. The recent Crisis has subjected all 3 hypotheses to serious criticism. 17

18. POST-CRISIS REAPPRAISAL OF THE ROLE OF THE FINANCIAL SECTOR I : EFFICIENT MARKETS HYPOTHESIS 18

19. The efficient market hypothesis was never seriously entertained by actual financial market participants. Warren Buffet once famously remarked that “ I would be a bum in the street begging with a tin bowl in hand, if markets were efficient”. The global crisis dealt it a final blow. “Slapped by the Invisible hand” is the title of a book by Gorton (2010) on the 2007-08 financial crisis and the subsequent global recession. And this possibly captures the majority feeling of the economists’ profession today. 19

20. POST-CRISIS REAPPRAISAL OF THE ROLE OF THE FINANCIAL SECTOR II : JACKSON HOLE CONSENSUS 20

21. PRE-CRISIS CONSENSUS ON FINANCIAL STABILITY Prior to the Crisis there seemed to be a loose Consensus among mainstream academics and policymakers regarding three issues viz. (i) that commodity inflation control should be the overriding (if not exclusive) objective of monetary policy (ii) that asset price bubbles are better left alone as attempts to control (or worse “prick”) such bubbles could lead the economy into dangerous territory and (iii) if, and when, asset prices burst central banks should “mop up the mess” i.e. go into the “ lender of last resort” act (see Greenspan (2002), Blinder & Reis (2005), Mishkin (2007) etc.). 21

22. JACKSON HOLE CONSENSUS (contd.) Bernanke & Gertler (1999) cryptically summarize this viewpoint (often referred to as the Jackson Hole Consensus following Issing (2009)) “ central banks should view price stability and financial stability as highly complementary and mutually consistent objectives”. Based on a conventional Friedmanian argument that financial instability is the outcome of unexpected shocks to the inflation level, mainly arising from over-enthusiastic central banks trying to stimulate the economy beyond its natural rate (see Friedman & Schwartz (1963), Schwartz (1998) etc.). The global crisis brought out the fatal flaw in this consensus. 22

23. ALTERNATE POST-CRISIS VIEWPOINT ON FIN. STABILITY Alternate viewpoint : monetary stability can co-exist with financial instability . Often there is a causal nexus from the former to the latter. Periods of monetary stability (e.g. Great Moderation (1990 - 2007) →output growth and bullish expectations of future prospects → booms especially in equity markets and real estate → High Demand for credit to invest in highly profitable rising asset markets. If concurrently, central bank (exclusively focussed on commodity market inflation) keeps interest rates low this stimulates high risk speculative investment. 23

24. ALTERNATE POST-CRISIS VIEWPOINT (contd.) This sets the stage for the kind of asset price booms which have preceded many crisis episodes including those of 1893, 1907, the Great Depression (1929-33), the Asian Crisis of 1997-98, and of course the current global crisis beginning with the Lehman collapse of 2007. Artificially low interest rates (benchmarked say, against a conventional Taylor Rule) enhance financial fragility by feeding the “ disaster myopia” psychology of investors. (see Borio and Lowe (2003), Bean (2003), Rajan (2005) etc.) 24

25. IMPLICATIONS OF ALTERNATE VIEWPOINT (contd.) Central Bank cannot afford to play the combined role of a bystander while an asset boom is in progress and a good Samaritan once the boom goes bust of its own accord. Central Bank intervention could assume either of three forms (including combinations). (i) Firstly monetary policy could be made responsive to asset price developments (ii) Secondly, by a stricter system of controls on capital requirements in banks and other financial institutions and (iii) Thirdly, by restricting certain types of trades in asset markets (see Friedman (2010)). 25

26. POST-CRISIS REAPPRAISAL OF THE ROLE OF THE FINANCIAL SECTOR III: McKINNON-SHAW THESIS 26

27. McKINNON-SHAW THESIS 1. Financial regulations widely prevalent in the developing world kept interest rates “artificially low” leading to excessive use of capital and other mal-allocations of resources. (Financial Repression). 2. Contrary to the then prevailing view among development economists that finance was incidental to economic development (Robinson (1952), Lucas (1988), Seers (1983) etc.) , M-S assigned a key role to financial intermediation and innovation in overall development reminiscent of Schumpeter (1912). 27

28. McKINNON-SHAW THESIS (CONTD.) Finance (according to M-S) performs the following roles : 1. Efficient resource allocation 2, mobilization of savings for investment 3. expanding goods & services markets 4. facilitation of pooling, hedging and diversification of risk. 4. monitoring managers and exercising corporate control 5. providing credit to informal sector (microfinance) 28

29. POST-CRISIS REAPPRAISAL 1. The post-crisis critique , recognizes of course that financial development can be conducive to growth but sees definite limits to this process. Beyond a point financial developments can be detrimental to growth. The relationship between financial development and economic growth has an inverted-U shape. 29

30. ADVERSE EFFECTS OF FINANCIALIZATION 30

31. FINANCIALIZATION : POSSIBLE ADVERSE EFFECTS Financialization (i.e. excessive financial development) could broadly impact the economy adversely via three channels : 1. Reducing the effectiveness of monetary policy 2. Systemic risk and financial instability (increased vulnerability to financial crises) 3. Introducing a disconnect between “profits and investment” 4. Competing away resources from other sectors of the economy 31

32. 1. MONETARY POLICY Financial Developments and the “weakening” of monetary policy. “Slipping Transmission Belt” syndrome : (i) unchecked financial innovation leading to the emergence of several new near substitutes for money (ii) a relative decline in the role of banks in credit creation (iii) the switchover from a reliance on direct monetary policy instruments such as CRR, SLR, credit ceilings etc. to indirect measures such as OMO and repo rates and (iv) unrestricted global capital flows. Details may be found in D’Arista (2002), Nachane (2009) 32

33. 2. SYSTEMIC RISK & VULNERABILITY TO CRISES Financialization can lead to (i) excessive leveraging (ii) weak links in the securitization chain (shift from “originate & hold” model to “originate and distribute” model) (iii) emergence of financial conglomerates exploiting economies of scale & scope (iv) growth of “shadow banking” institutions esp. hedge funds (v) increased reliance on “credit rating” agencies. All of the above can lead to what is called as “systemic risk” 33

34. 3 . DISCONNECT BETWEEN INVESTMENT & PROFITS Stylized fact about Western Capitalist economies : 1. Share of Profits (including interest) in Value Added of the manufacturing sector has been steadily rising since the 1980s with a corresponding fall in the wage share 2. The ratio of investment to profits has been declining. This is a paradox for almost all schools of economic thought (including Marxists who presume that all profits are re-invested). 34

35. RESOLVING THE PARADOX 1. In the post-war years, regulations were in place in various countries (e.g. The Glass-Steagall Act in the U.S.) which insulated the real sector from the financial sector. 2. This led to the critique (se e.g. Jensen & Meckling (1976)) of the conflict between management & shareholders (so-called principal-agent problem), which led to “ lack of shareholder control over management, and the pursuit of market share and growth at the expense of profitability”. 35

36. RESOLVING THE PARADOX (contd.) The onset of financial liberalization had the following effects : 1. The emergence of new financial instruments (e.g. junk bonds) which provided a convenient means for hostile takeovers, by groups of shareholders who were dissatisfied with the performance of the management 2. An increasing proportion of profits was distributed as dividends to keep shareholders satisfied, instead of being re-invested. Frequent buybacks of shares to keep share prices buoyant 3. Hostile takeovers were often preceded by substantial “downsizing” of the enterprise. 4. Hence financialization marked a shift from the earlier “retain and reinvest” philosophy of the firm to “downsize and distribute”. 36

37. 4. FINANCIALIZATION & LONG-TERM GROWTH In recent years a number of influential economists have raised serious doubts about the perceived benefits of financial liberalization (beyond a point) (see e.g. Friedman (2011), Cecchetti & Kharroubi (2012), Shiller (2012), Reddy (2012) etc.). Specifically two arguments are advanced : 1. The “profits-investment” disconnect means that the aggregate national income identity has to be satisfied by a rise in domestic consumption and imports. Additionally, as retained profits decline and shareholder payouts increase investment shifts from “real investment” in machinery etc. to investment in consumer durables or real estate. 2. The financial sector is skill-intensive and as it expands it draws talent from others sectors esp. those using high skilled personnel (R&D intensive sectors like pharma or micro-electronics). 37

38. POLICY IMPLICATIONS : A 7-POINT AGENDA The global crisis precipitated an extensive debate on the role of national regulatory and supervisory authorities in crisis prevention and crisis management via macro-prudential regulation Two recent reports encapsulate the general trend of thinking viz. d e Larosiere Group (Feb. 2009) in the EU and the Working Group 1 of the G20 (March 2009). 7 suggested measures : A. Making Monetary Policy Respond to Asset Prices B. Strengthening and expanding the scope of regulation and supervision (R & S) C. Controlling leverage of financial institutions D. Dampening pro-cyclicality of capital requirements E. Reducing costs of financial failures F. Devising market incentives for prudent behavior G. A Shift from Micro-Prudential to Macro-Prudential Regulation

39. Global Crisis : Need for a Co- ordinated Response Main Partners in A Co- ordinated Response : 1. NATIONAL REGULATORY & SUPERVISORY AUTHORITIES 2. IMF REFORMS 3. FINANCIAL STABILITY FORUM (FSF) & INTERNATIONAL STANDARD SETTING BODIES –BCBS( BASEL COMMITTEE ON BANKING SUPERVISION) , IOSCO (INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS) ETC 4. INFLUENTIAL GROUPS LIKE G-20 NOTE : IN THIS TALK, I FOCUS MAINLY ON THE FIRST OF THE ABOVE, MAKING A BRIEF REFERENCE TO THE OTHER 3 ASPECTS.

40. ROLE OF NATIONAL REGULATORS : A 7-POINT AGENDA The global crisis precipitated an extensive debate on the role of national regulatory and supervisory authorities in crisis prevention and crisis management via macro-prudential regulation Two recent reports encapsulate the general trend of thinking viz. d e Larosiere Group (Feb. 2009) in the EU and the Working Group 1 of the G20 (March 2009). 7 suggested measures : A. Making Monetary Policy Respond to Asset Prices B. Strengthening and expanding the scope of regulation and supervision (R & S) C. Controlling leverage of financial institutions D. Dampening pro-cyclicality of capital requirements E. Reducing costs of financial failures F. Devising market incentives for prudent behavior G. A Shift from Micro-Prudential to Macro-Prudential Regulation

41. REFORMING IMF

42. PROPOSED IMF REFORMS General dis -satisfaction among LDCs and EMEs about inadequate representation of their point of view Several successive efforts to remedy situation. 1. IMF Quota & Voice Reforms (2008) ratified on 3 March 2011 2. . IMF Quota & Voice Reforms (2010) awaiting ratification

43. VOTING SHARES (%) COUNTRY /BLOC PRIOR TO 2008 REFORMS CURRENT (AFTER 2008 REFORMS) PROPOSED (DEC. 2010 REFORMS) ADVANCED ECONOMIES : 59.5 57.9 55.2 G7 44.3 43.0 41.2 USA 16.7 16.7 16.5 CHINA 3.65 3.80 6.06 RUSSIA 2.68 2.38 2.58 INDIA 1.88 2.34 2.63 BRAZIL 1.38 1.71 2.22 BRIC 9. 59 10.23 13.49

44. IMF Governance Reform Committee (24 Mar. 09) IMF Governance Reform Committee (24 Mar. 09) . ( i ) radical changes in access, pricing & conditionality for IMF borrowers (FCL- Flexible Credit Lines) (ii) by recommending the lowering of threshold on critical decisions from 85% to 70-75%, the us veto is proposed to be annulled (as the us has 17% voting power) (iii) doubling of quotas and shifting of 6% of voting power to dynamic EMEs. (IV)A Proposed Tripling Of Basic Votes (Number Of Votes Every Country Has Qua Member) Would Increase Developing Country Votes From 32.3% To 34.4% (The Corresponding World Bank Figure Is 42.6% Proposed To Be Raised To 43.8%) (V) Double Majority Voting On Selected Issues– A Majority Of Weighted Votes (As Currently) + A Majority Of Countries. The System Prevails At The Inter-American Dev. Bank, ADB, African Dev. Bank For Election Of A New President/Head (See Birdsall-2009) (Awaiting Ratification)

45. THANK YOU 45