It would have been inconceivable just a year ago that the US government would need to support Fannie Mae and Freddie Mac and become a de-facto majority shareholder in General Motors, AIG, Citibank and Bank of America, and the UK government would hold controlling shares in the Royal Bank of Scotland. The Financial Times was concerned enough to run a series on the “Future of Capitalism”. Maybe the underlying concern was more about the future of capitalists, particularly those engaged in asset management and investment banking activities. However, public memory is notoriously short and we again have fawning comments about Goldman Sachs and the $3.4 billion profits posted by it in the April-June, 2009 quarter. These profits were driven by trading in fixed-income securities. In recent times, the bid-ask spreads on US government bonds have been wide since competition has been less with fewer market-makers. The Fed has deliberately stayed on the sidelines allowing banks to improve their financial health. It is surprising that such profits are being ascribed to financial acumen.
Goldman has returned $10 billion of TARP funding but it had also issued medium-term bonds worth several billion dollars which were guaranteed by the US Federal Deposit Insurance Corporation (FDIC). Goldman also benefited from the US government-funded bailout of AIG since it received $12.5 billion from AIG. Further, the somewhat discredited Value-at-Risk measure for Goldman is reported to have doubled over the last quarter. Steep bonuses seem to be back and there have been no consequences for most senior personnel in financial sector firms for decisions which resulted in their too-big-to-fail institutions receiving taxpayer-funded support.
At the same time, leading economists, central bankers and policymakers in finance ministries around the world have expressed sharply contrasting and even diametrically opposed views on the fundamentals of economics and finance. The following is illustrative of the issues on which there are clashing views. Namely, whether:
- asset-price bubbles can be recognised well in time and should central banks be made accountable for monitoring and preventing systemic risk from ballooning;
- inflation targeting delivers low inflation, steady growth, low levels of unemployment and financial sector stability or whether these three objectives were achieved in the last ten years due to a combination of global factors which were inherently unsustainable;
- it is possible to prevent financial firms from becoming too big to fail;
- the financial sector, including banking should be made “boring”, that is made to focus on core lending functions by raising capital requirements for trading activities;
- there should be ceilings on compensation in financial institutions since this could reduce greedy risk-taking;
- taxpayers are adequately compensated for government-funded support for private sector firms;
- the Efficient Markets Hypothesis (EMH) holds.
Paul Krugman has suggested that “much of the past 30 years of macroeconomics was spectacularly useless at best and positively harmful at worst.” According to other commentators, many policymakers and central bankers bought into the myth that economics is more than a social science. Taking a step back in time, Alfred Nobel conceived of five prizes, one each for Physics, Chemistry, Physiology or Medicine, Literature and Peace, for work which “conferred the greatest benefit on mankind.” The first prizes were awarded in 1901. And, it is only in 1968 that the Swedish central bank decided to fund a Nobel Prize for Economics. This was probably based on a consensus that innovative thinking in economics is more relevant for social welfare than, for example, history or sociology. Robert Skidelsky has suggested that economics should go back to its roots since its predictive power is similar to that of other social sciences and it should give up its excessive reliance on mathematical models.
Bertie Wooster, the central character in P G Wodehouse novels, would have remarked that his “mind boggles” if he had encountered the current uncertainties about established tenets of economics and finance. More seriously, and in fairness to these two inter-related disciplines, all these issues have been debated often in the past and there can be no categorical answers which apply uniformly over time and across countries. Unfortunately, however, now that there are signs that the major economies are recovering it may soon be back to business as usual.
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In the late 1990s, an important insight of the then President of the World Bank was that economists needed to understand finance. To that end he insisted that all senior managers, which included many PhDs in economics, undergo basic finance training and learn how to read a balance sheet. The recent economic meltdown was triggered by a breakdown in investment banking and international capital markets. It is conceivable that central bankers and other regulators may have acted earlier if they were better informed about capital markets in general, and derivatives markets in particular. Consequently, in the Indian context, it would be useful to have a Chief Financial Adviser (CFA) in the ministry of finance in addition to a Chief Economic Adviser. The CFA could complement the work of the CEA to give the finance ministry a more in-depth picture of the health of financial markets and provide inputs on the state of accounting and corporate governance. A CFA could also highlight the need to move faster on deregulation of interest rates on small savings, making the government yield curve arbitrage free etc.
More generally, the mutually inconsistent opinions of Nobel Prize-winning economists are symptomatic of the multi-disciplinary and ever-changing confluence of factors, which drive economic outcomes even within the same country. India’s systemic shortcomings in eg providing assured irrigation, basic infrastructure, pricing of power, fertiliser and petroleum products and corporate governance (Satyam) or the problems of companies such as General Motors in the US, banks in Europe stem from a variety of factors. Clearly, purely formulaic remedies such as inflation targeting, liberalising exchange rate policies, introduction of exchange-traded forex derivatives, developing corporate bond markets, raising/lowering of interest rates and safeguarding the independence of RBI may not be sufficient or even appropriate. India-based economists and finance specialists have been relatively quiet about the applicability of recommendations based essentially on available data and static models. Further, we also need to reflect a bit more about the continuing capture of economic and financial sector policies by special interests in developed countries when thinking about solutions for comparable situations in India.
The author is India’s Ambassador to the European Union, Belgium and Luxembourg. Views expressed are personal