Real woes in a virtual world

Are we witnessing the end of neo-liberalism, or the beginning of the end of capitalism itself?

In 1933, the great economist John Maynard Keynes said, “I sympathise with those who would minimise, rather than with those who would maximise, economic entanglement among nations … let goods be homespun whenever it is reasonably and conveniently possible, and, above all, let finance be primarily national.” Without the type of ideas proposed by Keynes, capitalism would not have survived the Great Depression of the 1930s. However, as nation states embraced neoliberal policies over the past few decades, his proposals about the proper role of the state in the functioning of a capitalist economy were forgotten. Now, these policies are undergoing a revival in some quarters, as the severity of the current global financial crisis is forcing massive state intervention worldwide.

India’s stock-market index, the Sensex, crossed 21,000 points in January 2008. Now, it is valued below 9000, having lost almost two-thirds of its monetary value in the face of what is being called the worst global financial crisis in 80 years. It has devastated the top Indian banks and corporates, who now only have illusions of wealth to harvest from their half-decade of vainglory. All hope that the ongoing crisis will leave emerging economies (and, among them, those in Southasia) unscathed have faded from the horizon. Prime Minister Manmohan Singh recently expressed his helplessness: “We are not in complete control. There are bigger players, and we are victims of that. The crisis is not of our making” Nor was the credit-led boom “of our making”, he might have added, since global finance, led by the ‘cheap money’ policies of the US Federal Reserve, financed it. That boom is now over, as attested to by the falling growth rate. Till recently, the crisis had been mostly financial; now, it is engulfing real economies, as demonstrated by the approaching bankruptcies of the three giant carmakers in the US.

This understated and least-debated form of globalisation – financial liberalisation – has drawn the destinies of countries as disparate and far-flung as China, Venezuela and the US into the same vortex of troubles, prompted by what the former chairman of the US Federal Reserve, Alan Greenspan, has admitted is a “once-in-a-century” financial crisis. Many pundits within and outside professional economics have long debated the perils and virtues of globalisation, mostly in terms of the opening-up of economies to trade and investment. Only a few exceptions among the professionals – most notably Joseph Stiglitz – have spoken about the dangers of financial liberalisation, and that too only after being sobered by the East Asian financial crisis of 1997. Now that larger fractions of this financial liberalisation are more apparent to the public eye, it is becoming clear that markets united by intricately organised, state-promoted greed can spell economic mayhem, resulting in untold distress for those who live at the mercy of the abstractions generated by forces over which they have little control. As confidence evaporates along with credit, countries are beginning to experience growth slowdowns, large layoffs and rising unemployment.

Yet, the big players in the world of finance continue to live by their whims, even as lessons in ‘market discipline’ are distilled for the rest of the population. ‘Panic legislation’, recently pushed through at the behest of corporate czars and the US Treasury Secretary (and ex-CEO of Goldman Sachs) Hank Paulson, places them above the law, insofar as the discharge of their public duties as the guarantors of corporate debt are concerned. In effect, the tax-paying public is being asked to underwrite the lucrative gambles of financial adventurers in the top investment firms. Such action privatises gains while socialising costs, losses and risks. It generates what economists have long identified as a ‘moral hazard’, exempting the culprits from market discipline, and giving them an incentive to commit excesses again. It is argued that some firms are just ‘too big to fail, that their failure imperils the entire financial system. But this only ensures that a similar crisis will recur in a more vicious form in the future.

Restoring confidence
All capitalism is state capitalism. The massive public bailout of large investment firms, insurance and mortgage giants in the US in September 2008, amounting to more than USD 1 trillion thus far, should put an end to the debate between free markets and state regulation. In the West, there is universal applause at the fact that governments – from Washington, DC to Bonn, London and Paris – have acted in a timely manner to restore confidence in the global financial system. Even Washington has had to follow the European lead in injecting capital into failing banks, something it had been loath to do. If markets were so perfect and efficient, this should have been not only redundant, but a highly flawed move on behalf of the state. Not even the most obstinate laissez-faire loyalists are today claiming this. All too often, capitalism has to be saved from the capitalists themselves.

As many commentators have noted since the sub-prime mortgage crisis began to hit the US in August 2007, the problem with financial innovation is financial innovation itself. Computer-generated financial instruments (called derivatives, taking their name from the fact that their value is derived indirectly from the value of the underlying assets on which they are based) are rarely understood, even by the people who create them. Certainly no one understood the risk carried by many of the assets, which had been routinely transacted over the past decade. Thus, it comes as no surprise that government regulators – or, for that matter, credit-rating agencies – failed to apprehend any trouble before it was too late. Highly rated financial firms have raced to bankruptcies in the past few months; regulatory bodies are severely understaffed and conceptually outpaced. In such a climate, the actual implementation of free-market ideology can only hasten catastrophe. It remains to be seen how governments such as the US’s attempt to restore a semblance of sanity to the markets under circumstances in which innovations in finance, information and communication technologies are seen as too sacred to allow for any interference.

In any country, the central bank plays a pivotal role in keeping the macro-economy in balance and as close to full employment as possible. In the hope of raising the real economy’s growth rate, ‘cheap money’ policies often end up generating bubbles in asset markets such as real estate, if investments in the real economy are not forthcoming on the credit being created. This is the lesson to be learnt from the baseless optimism displayed by the US Federal Reserve under Alan Greenspan for more than a decade. When money was available at ridiculously low rates of interest, financial concerns found it opportune to borrow large sums for purely speculative purposes, and leverage investments in various areas of the global economy. Hedge funds (private investment funds open to a limited range of investors) gambled with everything from mortgages and real estate to insurance and commodities (like oil or food grains).

The surplus of funds was enormously augmented by the huge tax cuts issued to the affluent classes in the West (especially in the US and the UK) since the years when Margaret Thatcher and Ronald Reagan were in power. This had the consequence of not only transferring resources from the poor to the rich, but also of leaving the rich with much extra cash with which to play. The money typically ended up via bank deposits and fund managers in speculative investments in financial markets, in the expectation of quick and easy multiplication.

To add fuel to fire, far too much money was allowed to be created over the past decade, especially through the action (or inaction) of arguably the world’s most powerful institution, the US Federal Reserve. As the Iraq war drained spending away from the US economy (by raising the price of large oil imports), thus also contributing to large federal deficits, the task of achieving full employment was left to the Fed. This institution did so by providing interest rate cuts to ridiculously low levels such as two to three percent, and relaxing financial regulations to allow credit to expand freely. The amount of money created was thereby vastly disproportionate to the underlying income and wealth being generated in the real economy. The derivatives market worldwide is estimated to be over USD 600 trillion. This can be put in perspective if one bears in mind that the gross domestic product of the entire world is about USD 50 trillion!

Bubbles and bursts
The regime of deregulated finance has encouraged far more investment in financial speculation than in the real production of goods and services. In many ways, this is even truer of poor and emerging economies than of the richer countries. Loosening domestic controls has meant that India, in particular, has been a favourite of global financial investors in recent years, yielding some of the highest average returns on stocks – more than 40 percent per annum, significantly higher than markets anywhere else. The ensuing bubbles and bursts (in such areas as real estate) highlight the lie in claims of allocative efficiency of free markets. On the contrary, pursuing such policies distorts market signalling in systematic ways, and scarce capital resources meant for developmental goals are misused. No economy has ever industrialised without an alert state actively guiding the use of credit at crucial stages.

The banking system is too important to be left to private firms. This is true not only because scarce capital needs to be guided to priority areas of a developing economy. In addition, increasingly, the pension funds and savings of the middle classes worldwide are being used as seed capital for speculative purposes by financial firms. Notice that the rich countries, led by the European Union nations, have had few qualms in nationalising the core areas of their banking systems, thanks to the severity of the present crisis. The Economist reports that USD 2.5 trillion of taxpayer money now needs to be spent on a highly rewarded industry.

The credit-led boom of the past decade had induced amnesia among the policy elites around the world regarding the significance of Keynesian-style public expenditure in keeping a capitalist economy alive. As long as loose monetary policy could sustain the housing and credit bubbles in the US (and keep the massive demand for Chinese exports, paid for in US dollars, going in the process), it seemed to many that capitalism had overcome the business cycle itself. The current crisis is forcing everyone to acknowledge that a bust follows every boom.

At the same time, how many can recall the inescapable Keynesian insight that only state spending of a counter-cyclical nature can attenuate the fluctuations through appropriate expenditures? For instance, in India today, the employment guarantee scheme could be expanded on a war footing, funding environmental projects that could control the effects of climate change even as they generate jobs, reduce poverty and add to aggregate demand in a time of recession, thereby lifting expectations all around. Policy elites in the developing world ought to now challenge the Washington Consensus policies of the International Monetary Fund (IMF) and the World Bank, which have forced dozens of developing countries over the past few decades to privatise public assets and cut back on ‘social spending’ with deflationary fiscal policies, precipitating much harm to working people in the process. Legislation such as India’s Fiscal Responsibility and Budget Management (FRBM) Act of 2003, which commits the government to a balanced budget, ought to be ignored in the extraordinary context that has been created.

Dubious decoupling
A key feature of the era of financial deregulation has been financial liberalisation, or the removal of national controls over the movement of capital flows across international boundaries. This has meant that capital is free to move around the planet, finding the most ‘lucrative’ areas of investment. It has played havoc with the national economies of many developing countries in the past, as was brought out by the 1997 East Asian financial collapse. It is again being manifested by the present crises, whose flames continue to grow across Asian markets, putting an end to all fantasies of ‘decoupling’.

After the sub-prime crisis, it had been hoped that even if the West fell into recession, fast-growing economies such as India and China could continue to grow, relying on an independent momentum. In fact, decoupling would only have been possible with a far more selective engagement with globalisation, involving, among other things, falling out of the neoliberal embrace. Notice that China has maintained strict capital controls throughout its massive expansion. Countries in Southasia need to follow this example, and prevent capital-account convertibility at all costs. It is empirically fallacious to argue that, by imposing capital controls, poor countries are denied the possibility of access to developmental credit from the rich world. The truth is that, in the era of deregulated finance, there has been a massive net transfer of resources from the poor to the rich nations as a whole, amounting to hundreds of billions of dollars every year.

The hope of decoupling emerging markets from the movements in financial markets abroad has turned out to be a huge illusion. Decoupling would have been possible only if the basis for economic growth in this part of the world was mostly independent of the capital inflows from the rich economies. This is evidently not the case, as the recent pulverising of the Sensex (and all other major Asian stock exchanges) amply demonstrates. Global finance is far too tightly integrated now for capital outflows from developing economies to leave stock markets here unaffected. It is worth asking why capital is flying from India even when the growth rate has remained between seven and eight percent despite the meltdown.

The reason is that institutional investors from abroad urgently need the funds to bolster their own balance-sheets. They also perceive India’s economic growth as lacking in independent momentum. In other words, it is significantly dependent on the self-same flows that are now on the retreat. In recent weeks, the Reserve Bank of India has had to repeatedly intervene in the currency markets to protect the falling Indian rupee, which has already lost 20 percent of its value vis-à-vis the dollar in the past few months. This has led to significant depletion of the much-touted hard currency reserves. If oil prices had not been falling so rapidly worldwide, countries such as India would have been facing an insurmountable balance-of-payments situation due to a rapidly rising import bill – necessitating another knock on the doors of the IMF, as Pakistan is being forced to do.

In addition, the outflow of capital from poor countries is bound to lead to significant falls in overall investment and spending in the economy, making a downturn inevitable. Signs of this are already evident. Confidence and trust have evaporated from credit markets as risk-averse banks and investors have opted for liquidity. There are significant slowdowns in sectors like steel, construction, real estate, retail, automobiles and aviation. For example, Mittal-Arcelor, the world’s largest steel producer, is putting on the shelf INR 1 trillion worth of direct investment in India. Forced to restructure, some Indian companies, like Jet Airways, have gotten themselves into a fair amount of political trouble for laying off large numbers of employees. The real fear is that many large corporates may have expanded too fast in different directions (especially in finance) during the era of cheap money, and may now be faced with growing debts as the outlook darkens.

The slowdown in developing economies will be exacerbated by the growing recession in the West. The real economies of Europe and North America are now officially in recession: consumer confidence is down, overall output is declining fast and workers are being laid off by the tens of thousands. The US economy has already lost over a million jobs this year. These trends will impact the demand for exports from the emerging economies, as much as from export-based economies such as Japan, whose currencies are already falling rapidly due to both declines in export orders and capital outflows. China will be more badly affected than countries that do not export much to the West. (Over 70,000 factories have shut down in China this year, according to a report in the Washington Post.) India will also lose significant markets in its information technology (IT) and business process outsourcing (BPO) sectors, which have so far enjoyed significant patronage by Western companies.

This is one more reason to have compensatory public spending by the state in areas such as employment-guarantee schemes. Countries like India will explode with political conflict if they continue to adhere to neoliberal tenets of cutbacks in social spending by the state. Money has to be found for such schemes, even if budget deficits grow. The middle classes in countries such as India, which have enjoyed the upside of the credit boom for more than half a decade, are already cutting back on consumption spending, due to the fact that loans for the purchase of housing, automobiles or other consumer durables are hard to come by (or are too expensive) in a period of receding capital. This will again aggravate the downturn. Developing economies with significant overseas short-term loans will find their debt burden considerably worsened, as their exchange rates fall vis-à-vis the hard currencies.

Governments in developing countries should realise that they have been seriously negligent in their economic responsibilities, in passing the buck to the operations of the ‘free market’. The present crisis shows that there is no such thing as a free market. The state cannot and must not be allowed to escape its enormous economic responsibilities, even if the goal is that of saving capitalism.

Bills of history
We are witnessing the end of an era. But is this transition merely the end of deregulated finance, or is it the end of the dollar-based global financial system, as crafted by the US? The mechanism of fixed exchange rates, put in place after the breakdown of the Bretton-Woods system in 1971, has continued to provide monopolistic privileges to the US, in paying for its imports in its own currency and thereby living off other countries and its own future. We do not know how policy elites and working people in the rest of the world will respond to this crisis, in particular to the ultimate insolvency of the dollar itself.

Is this the end of capitalism as the modern world has known it? That would depend on how temporary or permanent is the nationalisation of banking systems in the West, and how effective they are in regulating the dangerous effects of financial innovations. What is amply clear is that capitalism cannot survive for long without a strong state overseeing its large-scale activities. Everywhere in the world the tail of finance has been wagging the dog of the real economy for a very long time. Unless this changes, capitalism may be in terminal crisis, with chaos and open pillage to follow, unless working people respond with collective courage and uncommon imagination to the growing distress to come. The crisis in the real economy is on its way, and will reach every doorstep soon enough; but the length, depth and breadth of the ‘slowdown’ is becoming very hard for anyone to predict.

What would Keynes say if he were alive today? He would be utterly astonished at the state of the capitalist system, and mock the cures being applied. Interest-rate cuts by central banks at a time of ‘liquidity preference’, he would argue, are to mistake one of the causes of the disease for its remedy. Banks are simply absorbing the cash infusions they are receiving, and even issuing bonuses and dividends in some cases. When confidence has vanished and expectations are so gloomy, markets are helpless; the state needs to socialise the entire financial system, not just the banks. It also needs to carry out public (fiscal) spending on a large scale to counter the downturn, since private spending is fast falling. There is no shortage of projects – from infrastructure to environment – that need attention.

Then Keynes might add that it is only now that the bills of history are coming home. The future off of which the world’s rich have been sponging is finally here. In a financially integrated world, situations change every moment. But in this age of disclosures, each revelation throws new light on the recent past, presenting to us the illusions we were led to take as reality. And when reality is shown to be full of illusion, both despair and deliverance are close at hand.

~ Aseem Shrivastava has taught economics in India and the US. He is based in New Delhi.