Economics and the Economic Crisis: Who is to blame?

At my university, a generous alumnus, Stephen Bruce, has funded an initiative on “Rethinking Capitalism.” As the fallout of the financial crash of 2008 drags on, now with the banking crisis in Spain, the topic seems inordinately relevant. Even in India, the crisis has given critics of economic reform ammunition against that direction of policy, aside from the direct impacts on India of the weakening global economy.

In April, the Bruce Initiative took its efforts from the redwoods of Santa Cruz to the closest academic precincts of the centre of capitalism, with a conference at New York University, a stone’s throw from Wall Street. And the opening remarks were delivered by NYU’s Goddard Professor of Media, Culture and Communication, who happens to be a very famous expatriate Indian, Arjun Appadurai. Professor Appadurai began as follows, “Why does there appear to be no one to blame for the ongoing destruction of the economy, society and environment? The government, banks, experts, and regulators have all claimed innocence, while taxpayers have had to speculate on their futures. It is time to point the finger: it is the discipline of economics that has brought about this state of affairs. From business to the media to academia, economists now run the world.” I have heard this sentiment in different forms from several colleagues across the other social sciences and the humanities, along with complaints that economists should now show more humility, since we got things so wrong.

Are economists to blame for where we are now? My first thoughts on reading Appadurai’s remarks were that he was tarring the whole profession with the misguided optimism of a part of it—Alan Greenspan musing on the taming of the business cycle, for example—and that he was confusing economists with business people and politicians, who indeed did much to bring about the current mess. Towards the end of his brief talk, however, Appadurai states, “We can move toward a new form of social inquiry that looks at the relationship between quantity, quality and personhood. This is a different theory of social action that moves away from rational choice.” So clearly he has a problem with the core methodology of economics.

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Navigating the Next Crisis

Is a new economic crisis coming? Is it just a playing out of the financial crisis of 2008? What should India’s policymakers do? These may seem like just a tough set of questions from a civil service exam. But they are real challenges that face India's leaders. Unlike their counterparts in the US, Europe and China, India’s leaders actually have significant room to maneuver. What should they do, and why?

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Did bank nationalization save India?

When India survived the global financial crisis relatively unscathed, several prominent public figures claimed that the country’s public sector banks had been pillars of stability and resilience, contributing to the economy’s strong performance under stress. Indeed, during the crisis, households and firms shifted money from private to public banks, and the latter outperformed the former through those tough times. But what really happened? At the recently held India Policy Forum, Viral Acharya of New York University provided a comprehensive and provocative empirical analysis. No such analysis is perfect, but there is great merit in actually digging into the data, rather than jumping to conclusions and shaping policy without adequate investigation.

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Thoughts on the G-20 and the BRICs

Reflections last year on the role of the BRIC countries

Bric-à-Brac or More?

The second Bric summit is just under way at the time of this writing. The grouping was the inspired creation of Jim O’Neill, Goldman Sachs’ chief economist, almost a decade ago. Economic size and growth potential were the main criteria for the grouping of Brazil, Russia, India and China. Other dimensions of size—area and population—correlate as well. Three of the four have nuclear weapons capabilities and the same three are also strategic powers by virtue of size and geography.

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Thoughts on the decline of Europe, prompted by Greece's mess

Greece, the G-20 and India

Greece’s fiscal problems have had ripple effects across Europe, bringing back memories of the autumn of 2008, when a global financial meltdown seemed imminent. At that time, countries such as Hungary and Latvia were the poster children for profligacy and bad risk management. Greece was hiding its fiscal woes at the time, apparently by using currency swaps sold by Goldman Sachs. Now its budget deficit is revealed to exceed 13%, and financial concerns have spread to Portugal, Spain and Italy.

Unlike the 2008 problem countries of Eastern Europe, the new fiscal bad boys are all members of the euro zone. This raises the stakes enormously, since they do not have independent currencies that can depreciate, and their pain becomes the entire euro zone’s problem. How did this come about, and what can be done?


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Two more recent pieces on the G-20 and global rebalancing

What the G-20 Should Do

The upcoming G20 summit takes place at a pivotal moment. The halo of the G20’s response to the financial crisis in 2009 has faded, and it is receiving a lot of flak for not getting things done. In my last column (November 1), I argued that the G20 has an important potential role to play as a manager of current and emerging global risks, including those of climate change as well as financial volatility. For the moment, though, the focus is on global imbalances—the large current account surpluses and deficits that major members of the G20 are running. These imbalances were less of an issue (though still a concern) when the world economy was growing rapidly, and the US, in particular, was booming. The change in US circumstances is therefore a major cause of the new frictions.

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A Guide to Global Rebalancing

The financial crisis rejuvenated the International Monetary Fund (IMF) and the G20, giving each new roles to play in managing the economic mess. New rules for financial regulation and new financial safety nets to promote stability are being developed. Presumably, when the world economy next looks like it is falling off a cliff, the response will be strong and coordinated. It is harder to get agreement on non-crisis tasks. There is some consensus that large current account imbalances (mirrored by large international capital flows) prolonged the run-up to the crisis and made it worse when it hit. In any case, large imbalances are not indefinitely sustainable, because they lead to unsustainable debt positions for borrowers and tricky portfolio decisions for lending countries.

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Markets and Institutions

Here are my recent Mint columns on markets, institutions and management

Markets, morals and motives

The fall of Communism two decades ago also seemed to be the triumph of markets. Since then, we’ve seen that was not the case. If anything, the world is confronting two global market failures: The rampant greed in the financial sector that almost collapsed the entire economic system, and the largest of all tragedies of the commons—the warming of earth’s atmosphere and oceans. There are many specific causes and solutions for these massive problems, but they also highlight more fundamental issues of human behavior.

My colleague, Daniel Friedman, has written an erudite and brilliant book, Morals and Markets, which gets to the heart of the dilemmas we face.

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Managers and markets

Markets are quite good at allocating products and services to those who want them the most (and can pay to fulfil those desires). The insight of Ronald Coase, and after him, Oliver Williamson, was to view business firms as solutions to the problem of resource allocation when markets do not work well in some ways. The boundary between firms and markets changes with the times, as technologies and capabilities evolve. Some firms may swallow their suppliers, others may outsource. Firms use hierarchies to organize decision making, and hierarchies need managers. In my last column (19 October), I noted that markets are also not abstractions, and may require rules, monitors and enforcers to function well. EBay manages its vast electronic marketplace, and various managers in eBay oversee the different components of that market management. In a more traditional manufacturing firm, workers make physical products, and managers organize and oversee those production activities.

The idea of management as a science has been around for over a century, and found expression in time-and-motion studies, process certifications and more broadly in the MBA degree and management consulting profession. Recently, academics such as Nick Bloom have been quantifying management quality through indices of adherence to good practices, and measuring management quality in many firms in several countries. Management quality turns out to vary a lot within and across countries, and is positively correlated with productivity and profits (“Does management matter?” Mint, 11 August 2008). Can one do better than measuring a correlation, though?

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The Economics Nobel

This year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel went to two distinguished scholars with long careers. Elinor Ostrom became the first woman to win the prize, “for her analysis of economic governance, especially the commons”. Oliver Williamson was also recognized for his analysis of governance, but especially with respect to the “boundaries of the firm”. Both scholars have examined how non-market alternatives can work where markets run into problems.

Ostrom has contributed to our practical and conceptual knowledge of how user associations can successfully manage common property resources. Markets may fail in such cases because individual actions can have impacts on others that the market cannot properly price. Collective decision making can work through rules and enforcement that shape incentives. User associations might be characterized as primarily horizontal organizations. Williamson has looked at more vertical organizations, namely business firms. Firms exist to produce goods and services to sell in the marketplace, but many of their internal resource allocation decisions could conceivably be made through arm’s-length market-mediated transactions. Williamson explores the many reasons why this is so. An important example is of situations where relationship-specific investments would limit or distort ex post market competition.

The prize announcement spoke of economic governance and the organization of cooperation. It highlighted the fundamental contributions of Ostrom and Williamson. Subsequent comments tried to draw some lessons for our current world.

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Regulating riskiness

Here is a quote from a Reuter's story:

"Plans to improve banking regulation focus too much on bonus curbs and capital buffers, ignoring the need to divorce risky investment banking from the 'very safe and boring' business of commercial banking, an OECD official said.

"The OECD's Adrian Blundell-Wignall told Reuters that riskier banking businesses should pay the higher cost of capital for their activities, and not make inflated profits subsidised by cheaper funding from more conventional operations."

This is basically back to Glass-Steagall, it seems. But the world has changed. I don't see how you can really separate the two, unless you really place restrictions on a whole host of actions by commercial banks. In this last crisis, many of the problems were associated with securitization which moves assets off the books. Would this official ban securitization too? Essentially, modern financial instruments make the distinction between commercial and investment banking fuzzy, if not obsolete. So I think he's getting things very wrong.

He's right that focusing on capital buffers and compensation caps isn't enough to fix the problem. He's also right that the problem is contagion risk (of course it is!). But trying to control corporate structure -- which he claims is the issue here -- is not what it's about, except to the extent that corporate structure includes leverage. But leverage is where capital buffers come in. This guy is talking about restricting a firm's product line. but why do that? Why should a firm be forced to offer only certain types of financial products?

The real issue, to my mind, is making the markets for financial products more competitive and that means transparency and disclosure, as well as rules for a level playing field -- all of those have been missing from many derivative markets. My prescription is getting market institutions right, rather than putting controls that may increase inefficiency and anyway be circumvented.

YV Reddy comments on the RBI's role and the global financial reform agenda

This is a lengthy interview, also in The Mint -- good to read alongside Rakesh Mohan's comments

Rakesh Mohan on the RBI and the global crisis

Rakesh Mohan defends the RBI's policy moves and the response to the global crisis in particular in an interview with The Mint