International Development Economics Associates (IDEAs) organised a Panel Discussion on ‘New Directions in Financial Regulation’ in New Delhi on 7th February 2009. It was attended by a total of about 125 participants from the academia, government and the media. This Panel Discussion was held in the context of the unprecedented and still unfolding global financial crisis because of which the world economy, the developing countries in particular, are continuing to suffer. This is the time for a fundamental rethink on financial liberalization in order to reduce the systemic instability of global financial markets, which passes through into real economies across the world. The Panel Discussion was organized to throw light on the emerging issues in this context.

The speakers in the Panel Discussion were:

Jomo K. Sundaram (UN Assistant Secretary-General for Economic Development, UN-DESA and Member, UN High level Task Force on Regulating Finance);

Arjun Sengupta (Chairman, National Commission on Enterprises in the Unorganized and Informal Sector (NCEUS) and Former Special Representative of the IMF on International Financial Architecture);

Prabhat Patnaik (Vice-Chairman, Kerala State Planning Board and Professor, Centre for Economic Studies and Planning, Jawaharlal Nehru University); and

C.P. Chandrasekhar (Chairperson, Centre for Economic Studies and Planning, JNU).

The panel was chaired by Jayati Ghosh (Centre for Economic Studies and Planning, JNU).

Prof. Jayati Ghosh started the proceedings of the evening by placing the broad contours of the relevant issues of the topic on the table. These pertained to the impact of the ongoing global financial crisis on developing countries and the policy measures needed to be undertaken to safeguard the interests of the people.

Presentation by Prof. Jomo K. Sundaram
Professor Jomo K. Sundaram opened the session with his presentation on the topic titled “The Global Financial and Economic Crisis: Challenges for the South”. He began by pointing out that contrary to impressions created by the business media that the global financial crisis was unexpected, the current crisis had been foretold by many in various parts of the world. At the institutional level also, the crisis was anticipated and identified at least ten months before the crisis had actually begun in August 2007, by the UN and the UNCTAD. Further, it had also been predicted that the crisis in all likelihood would emanate from the sub-prime mortgage market segment.

Setting the background of the discussion, Professor Sundaram enumerated a set of interrelated issues essential for understanding the genesis of the global financial crisis, its impact, especially on the developing countries and the options available to deal with the challenges brought about by the crisis.

Listing the first among the various such issues, he said that underlying the crisis, on the real side of the economy, is the problem of the global imbalances that have emerged, particularly over the last decade. These global imbalances are not only unsustainable but also reflect certain asymmetry and injustice in the global economic system. The global imbalances that were earlier reflected in the large trade deficit that the US had accumulated vis-à-vis the developing countries, persists even today. Although the US deficit has decreased somewhat in the recent period, the European deficit has gone up, especially because of the strengthening of Euro vis-à-vis the US dollar. So the fact of global imbalances continue, even though the shape of the imbalance has changed somewhat.

The other issue of importance is that of the dominance of finance in the last two or three decades. There is a broad perception that globalisation has brought about significant trade integration. While it is true that globalisation has seen manifold increase in global merchandise trade, in reality, finance-driven globalisation has been much more important. What is significant is that the flow of finance has not been accompanied by or has not led to any significant increase in real investment or gross fixed capital formation. Because of and consequent to the ascendance of finance, the logic of business practices in what was earlier known as the real economy has been transformed by the logic of finance. This has introduced very serious problems and therefore, any understanding of the systemic character of the crisis necessitates an understanding of this issue.

The third issue that needs to be taken into account is the reform of the international financial architecture. Although Bill Clinton introduced this term in 1998, in the year following the South-East Asian crisis, there has actually been no well designed plan and very little has been done in terms of financial reform even more than a decade later.

The fourth issue of concern relates to the ideology of the ascendance of finance and the related logic of deregulation and the avowed principle and claims of self-regulation. While these claims are now rarely invoked, history is replete with instances that show that it takes very little time for ideology to change. At present, everybody seems to be Keynesians. It is, however, essential to be sceptical of such positions since the whole debate is under a broad rubric of what is to be considered as Keynesian. In the same light, it is equally necessary to be clear about the exact meaning of the ‘need for financial regulation’ which is being talked about by almost everybody across the spectrum.

The fifth area of concern relates to the vulnerability of emerging markets in this whole situation. An important part of the vulnerability of emerging markets arises from the irresponsibility of IMF policies, in particular the policy of capital account liberalisation. While the Articles of Agreement of the IMF recognise the importance of national control over the capital account, what has been encouraged by IMF staff has been in contravention to what has been provided for by these Articles of Agreement. In effect, this has meant the triumph of ideology over the agreed basis of the international monetary agreement.

Sixth, the vulnerability of developing countries to financial liberalisation has been recognised even by non-heterodox economists like Kenneth Rogoff, Chief Economist IMF in the early part of the decade and the chief economic advisor to the McCain campaign in US elections last year. The proponents of financial globalisation have made some strong claims about the benefits of the financial globalisation. Rogoff, on the other hand, prepared some papers at the end of his IMF tenure which suggest that financial globalisation has not contributed to growth instead it has adversely affected the stability of the financial system and increased volatility.

Yet another issue is regarding the notion of decoupling, a notion which is especially important for countries like India and Brazil. The decoupling concept had many proponents even till a couple of months ago. The proponents of the decoupling notion claimed that the developing countries have developed their own growth dynamics and are therefore not likely to be adversely affected by the vagaries facing the developed countries. While the proponents of the decoupling theory have become silent because of the spread of the crisis, it is the same set of people who had in the recent period been the cheerleaders of globalisation. It is the same set of people, who started forwarding the decoupling argument when it became apparent that globalisation is the cause of the current crisis.

The other important issue concerns the double standards in the kind of policies being pursued not only in the US but also other countries in the West. These countries have all adopted policies like fiscal stimuli, lower interest rates, bail outs etc. i.e. exactly the policies that were eschewed by the IMF during the Asian crisis. There are thus clear double standards in what policies are acceptable and desirable. If the US was to take IMF advice, including IMF advice provided during the Asian crisis, then it would not do any of the things it has been doing not only currently with the Obama administration but even during the previous Bush administration. A part of this has to do with the fact that the role of the central bank has changed in the emerging markets, where the singular focus has been on curbing inflation, whereas the US Fed has focused not only on financial stability but also on growth. Though these are allowed in the IMF Articles, ironically they rarely figure in the advice and conditionalities imposed on developing countries.

Lastly, there is the point of the failure of international cooperation. G7 has proved to be incompetent in anticipating and managing the crisis. This is the reason it has felt the necessity to revive the G20, which has otherwise been inconsequential till now. The revival of G20 has been done in order to not only have participation of the developing countries but also to ensure continuing domination of the rich countries. In fact, the G20 meet in November 2008 had 22 countries, with Spain and Holland getting themselves invited to the group. But that does not mean that the G20 has any particular legitimacy. This is precisely the reason why there is conflict between G20 efforts and the US efforts which sees itself as embodying a much more inclusive multilateralism. The lack of legitimacy of the G20 can be juxtaposed with the increasing marginalisation of the UN’s role in the recent decades, especially in economic matters, because of its not being in clear control of the dominant powers of the world.

Detailing the link between the financial crisis and the real economy, Prof. Jomo K. Sundaram brought out the interconnection between the sub-prime crisis and the full-blown recession in the US. The financial crisis emanating from the sub-prime crisis has contributed to the ensuing credit crunch and resulted in banks reducing lending and therefore firms cutting investment spending. Less investments has meant more lay offs, that in turn has led to lower consumption demand.

The immediate trigger for the financial crisis of course has been the collapse of the housing market in the US. But there is also the general problem of asset price bubbles which has been exacerbated by the kind of financial deregulation that has taken place, especially in the recent years. There is also the related role of the policies of the US Federal Reserve Bank in terms of easing monetary policies following the US slowdown in 2001. The other issue is that of the growing US household and government debt which has been largely financed by Asian debt.

The adverse impact of the negative wealth effect owing to the bursting of the asset prices bubbles and drop in stock market prices has resulted in less disposable income and reduced effective demand in the US. As a result, the global economy is on the brink of a recession, coupled with more unemployment, less government revenue and hence greater limits on government spending. Since 2008, many OECD countries have gone into recession. And there have been significant slowing down of growth in the developing world as well. While this continues to be uneven, with China and some other developing countries continuing to grow, there has been an average drop of 3 to 4 percentage points in the growth in the developing world. Given the fact that population continues to grow in much of the developing world, the modest growth that persists does not translate into a significant growth in per capita terms.

Unlike in the 1970s, the situation for the developing countries as it stands today shows that globalisation and greater integration of the world economy has led to their fate being much more intricately linked to that of the developed countries. It is true that about a dozen or so developing countries have benefited from increasing demand for manufactures from the US, which helped increase their export of manufactures. The strong US demand for manufactures in turn supported primary commodity prices and prices had risen to levels comparable to those attained during the 1970s. This had benefitted quite a number of countries, including countries in sub-Saharan Africa, which had not experienced growth upto three decades.

However, now, the rare opportunity for many developing countries – including the least developed countries (LDCs) – to generate substantial financial resources from higher primary commodity exports for investments and growth in the last 5 years are largely over. This in turn implies that there are less investible resources and slower growth is very likely, as a consequence.

In this context, the price spike of 2008 in a number of sectors, mainly in energy and food had been largely due to speculation and the flight of capital from Wall Street to the Chicago Commodity market. Although there has been some drop in food prices in the recent months, issues regarding food security continue to be of concern. According to him, the long-term reasons of rising food insecurity have been the general neglect of food production and research and development. As a result, productivity increases associated with green revolution has largely been exhausted.
There has also been a tremendous change in land use, climate and consumption pattern, which has their own implications for food security. There also has been the issue of asymmetrical agricultural trade liberalization and growing power of agri-business both in terms of production of inputs and production of food itself. It is evident that a number of factors have been responsible for the growing neglect of concerns of food security. The neglect of food security can be, in fact, linked with the end of the new international order since the 1980s and the characterisation of food security concerns as an anachronism from a bygone era. Instead of food security, the promotion of export-oriented agricultural liberalisation has been the focus in the South, while the countries in the North have continued to subsidise their agriculture. As a result of all these, many countries in the South which were earlier food exporters have become food importers.

There are both long-term and short-term factors that have led to a worsening of food security. Among the short-term factors, important are the ones related to western bio-fuel policies, speculation (especially from mid-2007) and oil price effects. All these have had implications for food security, in particular prices of edible oils.
Coming back to the recessionary impact on developing countries, there are three major channels of impact. The first impact has been felt through the decline in exports and export prices of developing countries. Second is through the turbulence affecting the financial markets that has had strong impact on the emerging markets. The terms of trade have gone down, thereby affecting trade surpluses and reserves which had been built up in some countries.

The impact on the South are varied but it can be summed up as significantly reduced exports and reduced export prices and increased flight of capital from the developing countries. Therefore, it is not incorrect to say that is in fact the emerging markets that have been especially adversely affected by the crisis. Stock market collapse in emerging markets has been far more severe than those in the West. This in turn has wealth effects and a whole lot of other adverse effects on the real economy.
There also has been significant decline in foreign direct investment. But, more importantly, there continues to be significant flight of capital, what is known as ‘flight to safety’. People have been investing in US treasury bonds despite the fact that the yields in terms of interest rates are very low and the US currency is going to depreciate in the future.

Coming to the question of dealing with the crisis, Prof. Jomo K. Sundaram opined that there are three types of challenges facing the South. The first challenge facing the South is to be able to limit the spread of the crisis across border as well as limit the spread from the financial sector to the real economy.

The second set of challenges is related to attempts to reflate the economy and for this fiscal space is needed. While in the recent times, IMF too has been espousing the role of fiscal stimuli, it is however, conditional on and recommended only for countries which have a fiscal surplus to begin with. The US certainly does not have a fiscal surplus but like many other countries, the US too has adopted policies of providing fiscal stimuli. On the other hand, even though monetary policies too are important for reflating the economy particularly for developing countries, they are usually less effective than fiscal policies.

The third is the broader medium-term challenge of regulatory reform at the national level, which is usually the appropriate domain for such reform. There is also the additional and perhaps more important challenge of reform at the international level, which is a major challenge because at present there is no proper authority which is an inclusive body overlooking such reform.

In this context, one particular challenge of reform priorities is to ensure that regulation is counter-cyclical rather than pro-cyclical. Another challenge is to be able to develop and reaffirm the need for capital controls in order to stem excessive and undesirable capital inflows as well as sudden, disruptive large outflows. Yet another major reform is concerning the need to ensure that both the fiscal and the monetary systems are used for more than just crisis management or crisis avoidance. Fiscal and monetary policies should be designed in a manner so that they are able to provide affordable financing for productive long-term investments, e.g. development banks, commercial banks, deeper financial markets, especially bond markets etc.

Given that financial liberalisation has led to the current crisis, reforms in the domain of finance are equally important. Financial regulation in fact, should be more than just prudential risk management, but should also be about financing growth, it should develop counter-cyclical measures and should support developmental and inclusive finance.

In today’s situation, there is an urgent need for social protection and not just providing social safety nets. Since social protection measures are largely countercyclical in nature, it is particularly welcome at this juncture so as to generate employment, which is crucial especially for poverty reduction etc.

Finally, Prof. Jomo K. Sundaram brought to the table the challenges regarding international cooperation. Most institutions like the Bretton Woods Institutions have been more or less marginalized. Even the institutions like the G7 and OECD have proved to be more or less irrelevant. There has been, however, an attempt to reassert the role of the IMF, particularly for developing countries. In this regard, it is important to understand the reasons behind the failure of the Bretton Woods Institutions, for there to be a successful reform of the Fund and for it to play an effective role. There is therefore, not only need for international cooperation, but also enough room for discussion. The process is likely to be difficult but the fact of resuscitation of the G20 suggests a need as well as some renewed space for such a reform.

Response to Questions
Responding to the comment about the impact of trade liberalisation on developing countries, Professor Jomo reiterated his position that trade liberalisation can be disastrous from the development point of view. Even World Bank’s own projections about the consequences of trade liberalisation suggest very little net gain from the Doha Round. Further, looking back one realises that the periods of the fastest growth in the US has been during the periods of maximum protectionism.

On the question raised about the problem of crony capitalism coming in the way of the proper implementation of policies in developing countries, Professor Jomo K. Sundaram’s response was that crony capitalism is not a problem of developing countries alone, but is a characteristic of developed countries as well. Even Jagdish Bhagwati and Joseph Stiglitz agree on the issue of crony capitalism in the US. While Bhagwati talks of the nexus between the Wall Street and the US Treasury, Stiglitz talks of the nexus between Treasury and the ways in which public policies are influenced by the Wall Street. Just because many of the activities are considered legitimate in the US, lobbying for example, it does not mean that it is less corrupt in a moral sense or less corrupt in terms of influencing business policies. Thus successful implementation of policies is a problem for both the developed and the developing countries.

As a response to the question regarding the logic of depending on the World Bank to promote food security, Professor Jomo K. Sundaram clarified that he had always maintained the position that World Bank has, especially since the 1980s, systemically undermined efforts to promote food security. And this has happened in two ways: one, it has not funded food agriculture in a significant way; and two, it has instead promoted agriculture for exports. In fact, it has also been belatedly recognised in the World Development Report 2009 that there has been a huge decline in funding for agriculture and the World Bank is part of the problem.

On the question of the problem of measuring human welfare on the basis of economic concepts like GDP, Professor Jomo K. Sundaram accepted that it is an important issue. Pointing to the importance of the still unresolved issues, he mentioned that a commission has been set up recently by the French President, Sarkozy, for understanding precisely these issues.

Answering the question about the reasons for the flight of capital from developing countries to the US despite the fact that the US rates of interest are lower than those prevailing in the developing countries, Prof. Jomo said that until about the third quarter of 2008, there had been a significant flight of capital from the US. However, thereafter capital has returned to the US and this is partly because of lack of avenues for locating capital which also ensure some degree of certainty. In other words, given that there is so much uncertainty, it is usually perceived that the US offers much more certainty within an uncertain world. What is interesting is that much of this return of capital has happened exactly at the time of a much more interventionist posture of the Bush administration. This also had the consequence of an appreciation of the dollar, which further drove down commodity prices. There is a general view that the correction of the global imbalances is unlikely to develop with a strong dollar policy which characterised much of the Bush period. And there is an expectation that sooner or later the dollar would depreciate once again.

Presentation by Prof. Prabhat Patnaik
In his presentation, Prof. Prabhat Patnaik said that he was not going to talk about the origins of the crisis, but rather about where we go from here. The point of concern is not about what would be acceptable policies to various governments, but whether we can put on the table a set of measures which actually appear reasonable, humane and so on. In other words, his presentation was about developing an agenda as opposed to selling an agenda to the existing governments or powers that be.

Prof. Patnaik pointed out that Keynes had thought of a crisis, or in particular recovery from a crisis, as a non-zero sum game. In a crisis, there is unemployment. If you recover from it the workers benefit, because employment increases without any significant reduction in real wages. Likewise, you have unutilized capacity and therefore any recovery from the crisis implies capacity utilization improve, therefore profits improve. So, a crisis is a situation in which both workers and capitalists are worse off. If you recover from the crisis then everybody is better off and consequently it is a non-zero-sum game. It is a non-zero sun game in which capitalist economies get trapped because fundamentally there are certain inherent irrationalities in the system. Keynes’ argument was that we should avoid getting trapped in these irrationalities and that we can do so provided we have a correct understanding of how the system operates. He placed a lot of emphasis on ideas and he thought therefore that the right ideas about how the system operates are essential for getting us out of the crisis. The key to getting us out of the crisis is to overcome what he called ‘muddle’ and to develop the correct ideas.

Prof. Patnaik said that in a certain sense, of course, he was being over optimistic because of the following. It is true that immediately as we come out of a crisis, everybody may be better off. But the fact remains that over a period of time, the manner in which we come out of the crisis influences the longer-term interests of the different participants. For instance, if we have substantial state intervention, while it may get us out of the crisis immediately, over a period of time it could be used as a potential challenge to the capitalist system generally; it could be used as a potential challenge to the hegemony of the capitalists; it certainly could also be used as a potential challenge to the hegemony of financial interests. Finance has always been opposed to pro-active state intervention, except in its own interests. But in the interests of employment generation, production and investment, financiers have always been opposed to pro-active state intervention, because their long-term rationale gets jeopardized by active state intervention.

It is not surprising therefore that there is opposition of finance to pro-active state intervention for getting an economy out of a crisis, despite the fact that getting the economy out of the crisis in the immediate short-run is beneficial to all; this particular opposition is what held up the recovery in the 1930s. As a matter of fact, even Roosevelt’s New Deal is something which really did not get the capitalist economies out of the crisis. It did temporarily in 1935 when Roosevelt actually ran a big fiscal deficit. But fairly soon as the economy was beginning to look up, once more the doctrines of sound finance began to affect Roosevelt’s policy. Thus, there was a cut back on the fiscal deficit and in 1937 again there was a major crisis. As a result, the capitalist world economy came out of the Depression only with the War. So it is not surprising that finance’s opposition was responsible for keeping the world mired in an economic crisis for a very long period, even when the ideas of how to get out of that crisis were well known and had been developed by Keynes. It is also not surprising that with the decline of the Keynesianism becoming apparent in the late ‘60s and early ‘70s, instead of moving forward, there was actually a reversion back to a system of financial de-regulation, back to a system of a set of neo-liberal economic policies which again was finance-driven.

Prof. Patnaik also pointed out that today when we look at the current crisis, there are fundamentally two ways in which we can proceed. The way that international finance capital would like us to proceed essentially is to keep the financial system going. Governments bail out the financial system to keep it going and prevent it from collapsing and at the same time, wait for a new bubble to emerge. As a matter of fact, if we have a system of de-regulated finance which necessarily supports speculative booms of various kinds, the nature of growth of the real economy under capitalism itself becomes dependent on sustaining bubbles. This is because, as asset prices rise, there are further speculative increases, which are superimposed on an initial rise, and then these speculative increases in turn bring about additional production of new assets, which is what generates employment, output and income etc. So essentially, growth takes place because of bubbles in a world of deregulated finance.

Keynes’ idea however was to have a fiscal stimulus while keeping finance under control, particularly cross border movement of finance under control, because demand management is not possible without cross border control of finance. It is quite interesting that when the G-20 met in mid-November last year, everybody went there talking about fiscal stimulus. As a matter of fact, no fiscal stimulus happened. Now, the Germans are opposed to any coordinated fiscal stimulus and once more the idea of fiscal stimulus has receded to the background. Basically people are saying that we just bail out the financial system and wait for a new bubble to take place. That is the way finance would like us to come out of the crisis.

As opposed to this, according to Prof. Patnaik, one can think in terms of a coordinated fiscal stimulus among a whole set of countries, especially advanced countries or G-20 countries. The fiscal stimulus has to be coordinated for the following reasons. Suppose only the USA goes ahead with the fiscal expansion package by increasing government expenditure and thereby increases the fiscal deficit. Since a very substantial proportion of this increased expenditure would leak out in the form of higher imports outside the US economy, its impact on the US economy will be correspondingly restricted. As a result, a fiscal stimulus which is provided by the USA alone is likely to be accompanied by protectionist measures on the part of the US. So, the point is if you talk in terms of a single country (realistically speaking, the USA) undertaking a fiscal stimulus, it will be accompanied by protectionism. If US goes protectionist, there will be retaliatory protectionism on the part of other countries as well.

In this context Prof. Patnaik pointed out that if we have overall protectionism, it has the following impact. Imagine two situations; while the level of employment is the same in both of them, one of them is more protectionist than the other. The first situation with greater protectionism will necessarily entail a lower share of wages in GDP because for any given level of money wages, prices will be higher. This will result in a lower value of the multiplier. Therefore the size of the fiscal deficit has to be much larger to maintain the same level of employment in a protectionist regime than in a non-protectionist regime. So, an individual country providing a protectionist thrust is not really enough. It is important to have a coordinated fiscal stimulus. This is not a new idea. This is an old idea in the sense that in the 1930s this was the essence of the Keynes plan.

Prof. Prabhat Patnaik then pointed towards the following implications of the above mentioned policy. Firstly, it should be noted that if we have a coordinated fiscal stimulus, since such a stimulus will be accompanied, in a world of liberal movement of finance across borders by all kinds of unpredictable shifts of speculative funds, any coordinated fiscal stimulus has to be accompanied by capital controls. Now, with this coordinated fiscal stimulus, there will be some countries which would be having current account surpluses and some countries would be having current account deficits. Starting from the initial situation, those countries which have current account surpluses are, as it were, getting a bonanza because if we did not have this coordinated stimulus, they would be having the surplus anyway. If so, then even if this surplus is taken away from them, then nothing happens to their overall wealth position compared to the initial state of affairs. So it follows that if the countries which are gainers by way of current account surpluses in such an expansionary world are made to hand over their entire increase in surplus as a grant to the less developed countries, they are no worse off.

The less developed countries can in fact use it for enlarging their food security. Or if their expenditure for enlarging food security is essentially something whose multiplier effects are felt domestically, and does not entail any foreign exchange outflow, then their reserves might get built up. But on the other hand, if they are made to spend those reserves, then they would be spending on various goods. Any such spending would automatically act in the direction of reducing the current account deficits of the other countries. So, it follows that we are actually talking about a recycling of surpluses into the deficit countries, but doing so in a round about way which has an advantage of being more humane.

These advantages, as pointed out by Prof. Patnaik are the following. In the world economy in such a situation, output and employment would be larger than what it was at the beginning of the crisis. Secondly, in such a situation we would also find that the least developed countries would be having more availability of goods to them and of course to the extent they spend it on food security, all the better. Thirdly, we would have in such a situation, a recycling, where the deficits of the deficit countries would be progressively eliminated through the expenditure of surplus countries which are recycled through the least developed countries. So, it is possible to think in terms of an alternative arrangement, keeping in mind the basic proposition that the recovery from a crisis can benefit everybody in which the world economy is better off, in which we have some kind of handing over of purchasing power to the poorest countries, and therefore, an improvement in the conditions of the people who live there. The opposition that would arise against such a scheme is the opposition of finance capital.
Prof. Patnaik concluded his presentation with the point that it is very important for us to come to the table with certain ideas, which no matter whether they are currently acceptable or not, but are ideas none the less which are correct and which we can actually place before the world at large.

Response to Questions
Prof. Patnaik emphasized that when he is talking about coordinated fiscal stimulus what is meant is that a large number of countries simultaneously undertake expansionary government expenditure. This Government expenditure should be in the direction of greater transfer payments to the poor, larger expenditure on rural infrastructure, etc. That kind of a fiscal expansion in each country should be coordinated.

In response to a question as to why should the surplus countries give away the surplus instead of investing them domestically, Prof. Patnaik mentioned that if they actually undertook investment then there would be no current account surplus. This surplus arises when instead of undertaking an expansion of the domestic absorption, they actually hold claims on dollars. So, what is suggested is that if there is fiscal stimulus across countries and the surplus countries recycle it through the least developed countries instead of simply holding dollars, and if this recycling takes the form of a grant to the least developed countries, then there is no increase in indebtedness in the world economy, but none the less there is a larger expansion of output and employment.

Prof. Patnaik also maintained that it is not suggested that this coordinated fiscal stimulus is going to happen any time soon. But the point is that we must have some ideas and proposals for the global economy itself. In other words, typically we always say that in India we should have fiscal stimulus under protectionism. But we should also have some ideas to put forward for the global economy also.

In response to a question regarding the requisite share of developing countries in the proposed coordinated fiscal stimulus, Prof. Patnaik pointed out that it does not really matter whether this fiscal stimulus is undertaken by 10, 15, or 100 countries, as long as major countries undertake this expansion and the surplus is given as a grant to the least developed countries.

In response to a question on why we cannot wait for another bubble, Prof. Patnaik pointed out three reasons. Firstly, unemployment will get prolonged. Secondly, unemployment, if persistent, can give rise to politically dangerous tendencies like fascism. Thirdly, if we allow the crisis to go on for very long, we may get into a situation of price deflation. If that happens, then the real rate of interest starts rising and then we will be stuck in a crisis for a very long time.

In response to the question as to whether we can look beyond GDP for assessing economic growth and development, Prof. Patnaik said that he would rather not look at GDP at all and be concerned about full employment and the basic well being of the people.

Presentation by Prof. Arjun Sengupta
Prof. Arjun Sengupta made the argument that even as it is possible to blame external factors for the current situation that India faces, it cannot be denied that India grew very fast since the early 1990s due to globalization. If we did not have globalization, it would not have been possible to have this kind of rate of growth in India. But, even now, we have incomplete globalization. Even though we are liberalised on the trade and financial accounts, there remain many restrictions on both trade and finance. We are not talking of total capital account liberalisation, although it has been liberalised progressively compared to the previous regimes. In the case of the effects of capital market liberalisation, it is a fact that we have built up substantial foreign exchange reserves. To a large extent, the economy has not been able to absorb it and that is the reason for the reserve build-up. But, if we had not allowed that, it is not clear how much it would have affected the investment growth in the country.

At the same time, it is clear that one of the reasons why this crisis hit us so hard is the capital markets. Prof. Sengupta pointed out that he uses the term de-coupling for referring to weak linkages. India is less exposed to the crisis, since we are less dependent on exports. But, on the capital markets, we are more hit because we are more integrated with global capital markets. The process unfolded in the following manner. The huge inflows of foreign institutional investments (FII) that had led to a massive increase in stock prices suddenly dried up as a result of external push factors, in the aftermath of the sub-prime crisis. This led to a sharp fall in the Indian stock prices, which in turn led to a fall in asset prices. So, we have to surely control our stock markets much more effectively.

The main problem is that we have not done our own work for inclusive development, by addressing the question of redistribution. That means we have gone simply by the market philosophy that whoever can earn more, can extract more capital and become richer and richer. We have not done anything systematically to control this. Our reform process started in 1992-93. It should be noted that the ratio of social expenditure to GDP had fallen by 1996-97. Basic areas of domestic development, namely health and agriculture, were thoroughly neglected. These are policy decisions that could have been taken by the government if it had been really committed to inclusive development. They did not think this was necessary because they believed that economic growth will result in pulling up the poorest of the poor. But, we have to recognise that if we have to redistribute wealth, we have to do it through fiscal policies; it is not possible through the markets. We have to redistribute either through differential taxes or differential expenditures; it has to be done by the state. We cannot have inclusive development after withdrawing state and reducing state expenditures. If we had actually worked out a program which was deliberately inclusive, may be the rate of profit of some industries would have been lower. One does not know if the economic growth would have been lower, but definitely, it would have been more inclusive. Then, if we had such a more inclusive domestic economy, then the impact of a crisis could have been arrested at the roots through a stronger domestic economy.

So, Prof. Sengupta argued that if we have to get out of this crisis, we have to follow a policy which will stimulate domestic demand. Domestic demand-led growth implies discretionary state expenditure. We have to stimulate demand through expenditures that will increase the purchasing power of the people directly and immediately. We should provide the stimulus in such a way that the poorest segments of the population, the marginal and the vulnerable, get more money for consumption and investment. There are two such segments which need urgent attention.

Firstly, the National rural Employment Guarantee Scheme (NREGA) is one of the best social insurance schemes that we are providing. If we expand this scheme, we can actually build up assets, unlike the Keynesian ‘digging holes’, even if they take time. So, this is a situation when we should expand NREGA throughout the country in a very significant way, so that there will be a direct improvement in social security as well as an increase in the purchasing power of these people.

Secondly, there should be substantial support provided to the small and marginal units of production. There are 58 million units of non-farm producers in India who are producing all kinds of goods, which have a domestic market if there is a domestic demand of the poor people. But, they cannot increase their production since they do not have capital, neither access to credit, nor any kind of market support. If we give that to these units, their purchasing power will increase and they will increase the supply of goods, which will be immediately absorbed and this will lead to an increase in GDP. In fact, Prof. Arjun Sengupta pointed out that in one of the reports by the National Commission for Enterprises in the Unorganised Sector (NCEUS), the details of a number of such schemes are given.

Therefore, the problem before the government is of deciding whom to support in the current situation. If we really want to do something for the country, we can do it. We can immediately do the fiscal stimulus of Rs 40,000 crore. This is just 1 per cent of GDP. Since this expenditure will increase GDP, the fiscal deficit ratio will be less than one per cent of GDP. So, we can increase this kind of stimulus that would have an immediate impact in this crisis situation, which is affecting the employment situation in our country.

The main point made is that this particular crisis is something which is made by us. India’s crisis now is not that we are suffering from sub-prime crisis nor that our banks are going to fail. Our crisis is that we are unable to follow a policy of proper expenditure and proper stimulus, with the simple aim that we shall not allow unemployment to increase.

Response to the Questions:
Prof. Arjun Sengupta emphasised that when he talked about capital controls, he meant an increase in capital control or reduction in capital de-control. The logic is that we should not give complete freedom for the movement of capital. But, when it comes to trade liberalisation, he chose to differ from Jomo Sundaram, but not because he believes that trade liberalisation is always good. Trade liberalisation creates the potential which can be good and can lead to large increase in GDP if proper policies are followed; but he agreed that if proper policies are not followed, it can be disastrous.

On Prof. Prabhat Patnaik’s point about co-ordinated fiscal stimulus, Prof. Sengupta argued that when it came to implementation, Keynes’ notion of coordinated fiscal stimulus was to be carried out through the IMF, and the role of SDRs become important in this context. Who will coordinate the movement of surplus from capital-surplus countries to capital-deficit countries? If we accept a world economy that is not socialist by any means, who will allow you to increase the aid? This was debated in the IMF when the whole question came up and it was Keynes who came forward with the idea that we will be able to coordinate this only in terms of the financing of it. And that is how the SDRs were actually invented.

It would have been a very ideal world if the fiscal stimulus were all coordinated. But, they are not. So, what are we going to do in India? What is of concern is that here we are not willing to give a fiscal stimulus, which will increase, as Jayati Ghosh says, the multiplier effect. Even now we are mostly taking about monetary policy expansion, when alternative policies exist.

On the question of whether it is difficult to follow the policies required to get us out of the crisis, Prof. Sengupta responded that in the case of any policy, it is a question of political will. If we want to do anything, the policy solutions exist. If we did not undertake particular policies that would have helped inclusive development, the answer is a political one. It is not a technical reason why the governments did not do it. It is because the governments are guided by certain forces who consider that this is not the way to do it. For them, it is much better to do the “trickle-down” process of development than any kind of active intervention. If we look at any of the specific examples that we considered, the NREGA case is self-explanatory. But the other point is to help the micro units, which employ less than 10 people, have less than Rs 25 lakh capital and are very poor. They produce 30% of the GDP and have about 55% of the workers employed there. But, we have seen that with a little bit of money they can immediately expand their output.

Prof. Sengupta then agreed with Prof. Prabhat Patnaik’s point on fiscal stimulus giving rise to a rise in imports, if there are no trade restrictions. He pointed out that if we give money to the poor people, they will spend on goods - even on durable goods, which, unfortunately will be supplied by China. So, Prof. Patnaik is right when he says that that we have to have some kind of import controls. But, Prof. Sengupta did not want to suggest such controls since he believes that if we give time and some help, the Indian producers will adjust. But if we do not do anything, there is the risk that cheaper goods coming from China might actually take advantage. So, these are policy questions that can be considered.

On the question of why foreign institutional investors take out money from the Indian stock markets, Prof. Arjun Sengupta put forward that it is not the level of interest rates nor the differential interest rate that are the main determinants in stock market behaviour. It is the expectation of what will happen tomorrow. If they expect the prices to go up, then they invest. The FII money is not brought in for real investment; they are brought in with “expectations of profit”, as opposed to how Prof. Patnaik described it as speculative. If they know that they can sell later what they invest now, then they will come here. The fact that so much of FII money came into India was not because of our rate of return here was very high compared to the others. Then all this money should have gone into probably, Korea and Taiwan province of China. But, the moment they saw that here is a very rapidly growing economy with 9 per cent-a- year growth rate, according to the government, they believed they can invest now and take it out later and that is why so much money came in. And so when our growth stopped, the exact reverse of this happened. Of course, there were the push factors. Although their own sources have dried up, the fact is that they lost confidence in our ability to sustain regularly rising prices of the stocks.

At this point, Prof. Jayati Ghosh, the Panel Chair, made an intervention that among the things which the Indian government can do right now is to increase the money to the state governments. This is crucial since the states are responsible for all these things that actually affect the citizens today. Prof. Arjun Sengupta responded by saying that he has indeed forwarded a recommendation to the government supporting the same. This is because he believed that the expenditure on fiscal stimulus has to occur through the existing policies of NREGA and rural road connectivity, etc., which are actually implemented by the states.

Presentation by Prof. C. P. Chandrasekhar
Prof. C.P. Chandrasekhar began by making the argument that if we look back, we will see that this financial crisis has been around for a long time. The sub-prime trigger was recognized in mid-2007 and has been a long process of muddle through. One aspect that he focused on was whether the crisis was in some sense triggered because of the changes in the world of finance and the specific kind of links that it has set up with the real economy.

One of the things which the policymakers should have been forced to rethink is the institutional structure of the financial system. Did the liberalization of late 1970’s, 1980’s and 1990’s create an institutional structure of the financial system, which resulted in its tripping consecutively? We know it tripped in terms of the Savings and Loans crisis, we know it tripped at the time of financial frauds, it tripped in terms of the dot com bubble, and now of course there is the major stumble-and-fall that we have had. Therefore, there is a need to rethink about the institutional structure of the financial system which triggers this kind of a crisis, cumulates the problem and brings us to where we are today. Currently, we have a situation where there are 500,000 jobs or more being lost every month in the United States and as many or may be more lost across the rest of the world every month, intensifying this crisis.

Initially when the crisis happened, there were two things which everybody pointed to. First they said that the sub-prime crisis was going to be restricted only to the sub-prime markets and it was not going to go elsewhere and that it was enough to deal with only those institutions which were overexposed to this market.

The second thing they said was that even if something does happen outside, then the problem could be solved by injecting more liquidity into the system. There is an element of counter party risk. Different people are exposed to the sub-prime market in different ways including the derivatives linked to the sub-prime market. This is making them wary in terms of lending, partly because they have bad assets on their books and partly because they do not know whether those they lend to will be in a position to be able to actually meet their commitments in terms of interest payments and amortization when it is due. Therefore, what we need to do is to actually clear this credit pipe, by injecting large quantities of liquidity in the system. But this was not enough. Soon it was clear that injecting liquidity is going to neither set right the financial problem nor is it actually going to correct for the effects that financial problem is having in terms of recession in the real economy.

Next they said that since injecting liquidity was not enough, what we need to do is to provide guarantees when people lend money, such that we can ensure two things: The weakest institutions can be taken over by better institutions and we can ensure that people will lend because there is an implicit or explicit sovereign guarantee being provided by the state or the central bank. And this was not only in the United States; this was being resorted to across the world including Europe in a very big way.

This actually created a stink. The biggest stink was created when JP Morgan Chase was asked to buy Bear Stearns against huge quantities of explicit and implicit guarantees. The net result was a deal which was struck over a weekend. By the time the deal was announced and the terms of it became clear, JP Morgan Chase was forced by shareholders to actually increase the price they were paying per share of Bear Stearns from $2 a share to $8 a share because people said this was actually government taking over all the bad assets of this entity, selling it to you and you were going to get it at $2 a piece. So this was not workable. So it became clear that actually what you are doing is you are paying off sections of finance in order to pretend as if the crisis has not happened.

When this kind of a problem arose, then they said that instead of getting into this kind of thing, the systems would be allowed to close. So they said that let Lehman Brothers close without being offered this kind of guarantee. There are a number of people who write in financial media and other places and say that this crisis would not have broken if Lehman had not actually been allowed to close. It had such a major ripple effect on the rest of the system. This is because there were so much integration of the books and the assets of different segments of the financial sector that once Lehman was allowed to close, this actually triggered a process that led up to the intense crisis that we have.

When it became clear that you actually now have to save these set of entities, without making it appear that you are actually making a back door payment, the only thing that the government could do was to come upfront. It came upfront and said that it will actually pump money into the financial institutions. AIG was the first and subsequently, as we know, this is true now of a large number of major institutions, including the major banks like the Royal Bank of Scotland, Anglo Irish Bank, Citigroup, etc. It is true of almost all the major banks of the world. You have ended up with a kind of situation where government has pumped in money. So in essence what has happened is that there is an implicit nationalization which has occurred across the financial system, including one of the largest insurers of the world like AIG and including some of the largest banks in the system. But obviously, this is not liked.

However, because circumstances have pushed you into a crisis which has been triggered by finance, the best way to deal with this is to actually get rid of the situation which led up to the kind of activity that triggered this crisis- the private capital that is unregulated, which controls the core of the financial system. One has to take over the core of the financial system to protect it from failure because via failure there is going to be a major crisis. Obviously nobody likes this, whether it is explicit or implicit nationalization.

Prof. Chandrasekhar also pointed out that today we are having talks all over the world of creating good banks and bad banks. Bad banks are the banks into which the following assets are proposed to be located. Firstly, the toxic assets, that is, assets whose values we do not know, they are not liquid, they cannot be traded in the market and nobody is willing to buy them so you do not know what they are worth. And then there are bad assets which everybody knows that they are bad because of the fact that they are mortgage defaults, there are defaults on credit card payments, then there are defaults in the loans provided to the auto industry and so on. So all these assets are taken together and located in something called the bad banks. Now how do we do that? The only way you can do it is to actually have the state buying up these assets and putting it into a bad bank, which then will wait over a period of time with the hope that it will be able to retrench these assets at some price and make them disappear from the system. The banks then would become good because of the fact that their balance sheets have been cleaned of the bad assets. It was a stupid idea because the question everybody started posing is the following. It is fine that the state is going to buy these bad assets to put them in bad banks at the expense, of course, of the tax payer, but what is the price of a bad asset? If you start pricing these bad assets, since some of them actually do not have prices, you have to have reverse auction. You tell banks to come and tell you that if you give so much I will give you so much of these assets. People actually start bidding against each other until you get a price at which there is enough money coming into the system for them to sell these assets. The moment you do that, that set of assets which exists in the balance sheet of these banks has to be written off. And once they write it off, they become insolvent. So the idea was that you cannot have a situation where the state takes over by buying into the assets even if it is the worst asset of the system, because by selling those assets at prices lower than the original price at which they were created or acquired, you actually create a balance sheet which is completely denuded. Therefore, money would have to be injected into the good banks and the state will have to inject money into the good banks. And once the state injects money into the good banks they become public.

So the situation is that you are really in a world in which everybody is in a state of denial that you do not want a system of publicly owned banks, because it is a system which is perceived as corrupt and non-competitive. While many do not want it, there does not seem to be a solution other than one where at least some of the major chunks of the core of the financial system are publicly owned.

Prof. Chandrasekhar concluded by saying that one of the ways in which you can run capitalism without having too many slippages is may be to have a publicly-owned financial core. The reason we need to make this point is because we need to separate two things: we need to separate between fraud and failure. Everybody is upset that these bank managers used to pay themselves 7 million dollars a year in salaries and bonuses and Obama has said you cannot take more than 500,000 dollars. But still you are bringing them down may be from 700,000 to 500,000 dollars. So this is a case where you are trying to identify the problem being one of fraud. That is people actually speculated in order to be able to give themselves large bonuses and the system tripped. The whole experience is suggesting that what we have is a situation of failure. That failure is that if you have the core of the financial system in private hands then you cannot regulate it too much. Because if you regulate it too much, the return which would be earned by those in the core of the financial system would be less than the return earned by those outside the core of the financial system and would be less than the returns earned by those who are outside the financial system itself.

So why should something which is so crucial to lubricating capitalism be penalized by lower returns, is what the private owners of the core would ask. So the implication is, the core cannot be owned privately or you will have to deregulate. Once you begin this process of deregulation, you begin this process through which a host of things occur. You actually have a system where risks build up and you end up with a kind of crisis like this where even though you do not like it, you are forced to nationalize the core of the financial system. If you really are a good learner, you will possibly realize that the best thing to do is to take this lesson and go back to a capitalism with a nationalized financial core.

Response to Questions:
In order to elaborate on the point that it is impossible to have a privately owned regulated financial system, Prof. Chandrasekhar said that the core of the financial system will have lower rate of return if it is regulated, because the idea of regulation is one that we do not want banks which take deposits from public at large to actually spend this in the securities market, real estate market and so on, so that you want to restrict the activities of banks to banking per se. We do not want competition among banks and so we are actually going to regulate the interest rates as well as give deposit insurance so that one bank is as good as another. The third notion is that the bank was the principal risk carrier. It created a credit asset, held the asset till maturity and got its return essentially in the form of net interest margin. And if you want to lend it to productive sectors, then net interest margin is going to be relatively low. So you end up with a situation where within that kind of frame of regulation, you get a certain rate of return, but it is a protective small rate of return. But you are allowing hedge funds, private equity funds and other kinds of productive activity to earn much higher rates of return. So there is a contradiction that you cannot have a privately owned banking system which is regulated for the good of the country, which actually is rewarded with a lower rate of return. Therefore, the pressure builds up over a period of time to say that we need to liberalize, we need to let these people move from lend whole strategy to originate-and-distribute strategy where fees and commission become important and all the risks come along. So the reason you regulate the core actually determines the rate of return.

In response to the question as to why in the US liquidity could not be infused to a particular set of institutions that did not come under the net of the central bank intervention, e.g., households, for whom perhaps liquidity infusion would have worked better, Prof .Chandrasekhar said that when liquidity is put into the system, the banks or other institutions get the right to lend if people are willing to borrow. In this situation, the Federal Reserve actually asked the banks to give all those toxic assets against which they would be given funding. So the banks could have told people who hold mortgages against which they could not pay, to give them their mortgages and they would buy it back at the price they paid. And then let them decide whether they want to take the cheaper mortgage. But normally that is not how the real liquidity would be given. Had it been given in this manner, then the liquidity would have worked.

Finally Prof. Chandrasekhar said that one cannot say that the flow of liquidity into the capital markets and the large reserves they built up in India did not lead to the liquidity and interest rate situation of the kind that we had. It is only that we are relatively more protected than many other countries since we have a public sector banking system. But he pointed out that it is not only the advanced countries that have got a sub-prime problem, India has also got a sub-prime problem.

February 11, 2009.