Last week my old friend Martin Wolf delivered a lecture in Delhi on the occasion of the launch of a festschrift volume (India’s Economy: Performance and Challenges, Oxford University Press) compiled by Rakesh Mohan and myself in honour of an even older friend, Montek Ahluwalia. Martin’s lecture was titled “Globalisation and Development after the Financial Crisis”. Since he is one of the world’s best-known commentators on global economic affairs, I thought it might be useful to convey the gist of his talk to a wider audience.
Martin began by outlining six key reasons for the global financial crisis: unjustified faith in the “great moderation” in world inflation (much more due to China’s export surge than wise Western central banks); accommodative monetary policy aimed at targeting inflation; emergence of large global imbalances in external accounts of countries (and associated unprecedented accumulation of foreign exchange reserves) through most of the noughties; low real and nominal interest rates which spawned a “reach for yield” across old and new asset classes; massive (and unwise) innovation in the financial sector to create supposedly safe, high-yielding assets; and major failures of both commission and omission in financial regulation. Right up through 2007, “success bred excess and excess bred collapse”. By now, this list of factors behind the crisis is widely accepted, though the relative importance assigned to each varies substantially across analysts.
The financial meltdown led to the “Great Recession”, which, in turn, triggered unprecedented peace-time fiscal expansions in major economies along with massive expansion of liquidity by key central banks. The collapsing financial sector (especially in the US and the UK) was rescued by “socialising risk”. Martin agreed with many others that these extraordinary measures staved off a major economic depression and sparked the beginnings of a recovery by the second half of 2009. In the process, the monetary and fiscal policy “firepower” in rich countries was used up. For example, fiscal deficits in the US, the UK and Spain were close to or above 12 per cent of GDP by 2009 and over 10 per cent in Japan. What is now necessary is a strong private sector lead recovery. But given the still weak financial systems, large private sector debt overhangs and fragile housing markets in major industrial economies, Martin was sceptical about the prospects for such a recovery.
Looking ahead, he foresaw four other major risks to sustained global economic development in the coming five years: possible dollar and fiscal crises at the heart of the world economy (in the Financial Times of February 10, Harvard historian Niall Ferguson writes apocalyptically about “a fiscal crisis of the Western world” and notes that the previous week Moody’s warned that the triple A rating of the US cannot be taken for granted); a surge in commodity prices and a jump in inflation; more bad lending and another global credit crisis; and a serious outbreak of protectionism, perhaps triggered by a stubbornly undervalued Chinese renminbi, which could even end the post-World War II globalisation era.
What does the global crisis portend for capitalism, globalisation, development, the balance of power and India? Wolf believes that market capitalism will survive but the finance and macroeconomics has to learn important lessons. The financial system has to be strengthened by reforms in the current framework or a transformation of the system. The first option entails higher capital norms for financial institutions, a resolution regime for banks and a shift of trading of financial instruments and products to exchanges. The second, more systemic, option involves a new partitioning between boring commercial banks and exciting investment banks and/or a confinement of commercial banks to “narrow banking”, where they take public deposits and only lend for safe and liquid assets. Martin notes that the present thrust of reforms focuses on the first option but doubts that it will work. On macro policy, he asserts that “inflation targeting is not enough”. Central banks have to do a better job of identifying big asset bubbles and taking pre-emptive action, perhaps through the deployment of “macro-prudential tools”. He also favours a much more active fiscal policy to cope with asset bubbles.
Wolf foresees serious threats to the post-WWII trends of globalisation. First, the problem of global imbalances endures: emerging nations continue (oddly) to be net exporters of capital, though rich countries have failed manifestly to absorb such inflows wisely. For globalisation to survive, imbalances have to reduce and insurance mechanisms (perhaps IMF-based) have to be strengthened to protect nations from sudden capital flow reversals. Second, the “export-oriented mercantilist strategy” (exemplified by China) cannot go on without provoking serious protectionist backlashes from big deficit nations like the US. And that would undermine the liberal world trade order, which underpins globalisation.
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For developing countries, Wolf lists three key lessons of the crisis. First, countries with substantial foreign exchange reserves and an ability to ramp up domestic demand performed better, notably China and India. Second, although capital inflows proved volatile, foreign direct investment was the least unstable, unlike bank lending and portfolio flows. Third, despite the sharp reduction in foreign trade, high trade ratios accorded desirable flexibility to those countries that had them.
Like quite a few other analysts, Wolf assesses this global crisis as a key turning point in the evolution of the global balance of power. The financial crisis and the major recession “have undermined Western credibility and prestige”, while demonstrating the resilience of China and India. He foresees a continued rise in the relative economic and political power of these Asian giants, if not all members of BRIC.
Wolf commends India’s macroeconomic policies and suggests a number of lessons. First, although sustaining an open world economy will be difficult, India should do its bit to help. Openness to trade has helped India in many ways, including in the recent crisis (contrast the damage to India from the oil shocks of the 1970s when the economy was much more closed). Second, recognising the instability of certain types of capital inflows, India would be well-advised to be choosy; a clear endorsement of capital account management. Third, capital flow instability justifies substantial reserve holdings, though “China’s $2.5 trillion is excessive!” Fourth, there is wisdom in containing large domestic asset and credit bubbles. Fifth, India needs much more “fiscal room for manoeuvre”; hence the currently high deficits and debt ratios need to reduced soon. Sixth, India needs strong economic reforms to sustain rapid economic development. Finally, Wolf cautions, “Expect the unexpected”. So, “flexibility is essential in both the economy and policy-making”.
Great lecture, Martin. Now give us the paper!
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal