Lessons from crises

ECONOMISTS are often compared to generals who have figured out how exactly they could have won a war that is already lost. But is critical analysis of the past, including the failures of the past, not an important aspect of the learning process? Certainly the explorations of space during the past decades have had some costly mistakes, and scientists would have been foolish if they did not examine the causes of the failures and figured out how to avoid them in the future. T ruly has it been said that if you do not learn from history you will repeat it.

That, indeed, seems to be the problem in matters economic. Think of the global meltdown that has been going on since late 2008. It is often described as the worst economic crisis since the Great Depression of the late 1920s. In terms of fall in output and loss of employment, there are many things in common between them, including the fact that both started in the United States and then spread to other parts of the world. But there has been a crucial difference too. The crisis of the present is the result of the big spurt in the realm of finance since the 1980s, its rapid spread throughout the globe, the disconnect between finance and the real economy wherever it went and the consequent opportunity it provided to a minuscule minority in rich and poor countries alike to have exceptionally high profits and asset accumulation. In the picturesque language that Niall Ferguson used in his 2008 book The Ascent of Money: A Financial History of the World, Planet Finance is beginning to dwarf Planet Earth (the real economy). What the present crisis has shown is that if finance whose legitimate role is to serve the real economy becomes the master, there is bound to be a crash.

It is forgotten that just a decade prior to 2008 there was a mini rehearsal of the crisis in East Asia. In 1997, Thailand showed that currency and financial crises have a devastating effect on the real economy. It soon spread to neighbouring East Asian countries Indonesia, Malaysia, Philippines and South Korea. But because the East Asian crisis was soon contained (or so it was thought), there appeared to have been an attempt not to learn from it and so there has been a repeat on a larger scale starting in 2008.

In the present volume, rightly and boldly titled After Crisis, Jayati Ghosh and C.P. Chandrasekhar show how financial crises develop, how they manifest themselves and what trail they leave behind. The main part of the volume consists of case studies of the five affected economies as also of Russia, Turkey, China, Vietnam and selected Latin American countries. Altogether these case studies provide a rich fare for those who wish to follow the course of currency and finance in modern economies, and the authors, editors and publishers deserve to be thanked for making them available. As the editors say, This book is concerned with delineating the alternative trajectories of post-crisis development in different economies, the lessons they offer and the implications they have for alternative policies.

In a theoretical analysis Prabhat Patnaik brings out the crucial role that global financial markets play in individual economies through financial assets initially, their impact on currency values immediately and on employment and incomes thereafter. The final effect of these is bringing Third World assets into the ambit of portfolio decisions of First World wealth-holders.

Since the source of the crisis is global finance, some understanding of its magnitude will be helpful. In The Ascent of Money Niall Ferguson gives the following figures that provide the relative magnitudes of finance and the real economy. In 2006 the measured economic output of the entire world was around $47 trillion. The total capital market capitalisation of the worlds stock markets was $51 trillion, 10 per cent larger. The total value of domestic and international bonds was $68 trillion, 50 per cent larger. The amount of derivatives outstanding was $473 trillion, more than 10 times larger. In the meanwhile currency transactions globally shot up from $500 billion a day in 1990 to $1,500 billion in 1998 and to $3.7 trillion in 2007.

An inevitable consequence of this kind of proliferation in international liquidity is that it leads banks and non-bank financial institutions to search for new avenues of financial investments within countries and across boundaries. Such expansion and innovation easily slips out of regulations, marking the beginning of a reckless quest for profits, transgressing of limits, failures, panic and crisis. It is a kind of systemic imperative.

How this phenomenon manifested in East Asia and other countries in the late 1990s is expounded by a select group of scholars largely from the respective countries. It is the story of how mobile capitalism impinges on particular economies. The country studies show a variety of patterns, but the general features are worth noting. It is the fall in the return to capital in the advanced countries that leads to the flow of capital to the developing countries.

One of the earliest steps is the entry into these countries of foreign banks and the growth of private banks in collaboration with them. Simultaneously, there is a relaxation of controls on the inflow of capital and repatriation of profits and a general liberalisation of the financial system to accommodate the strategies and styles of the guests. This, in turn, leads to a movement of firms from the developed to the developing countries (now more frequently referred to as emerging markets). Soon there is a proliferation of new institutions, new instruments and new practices. There is an inevitable transformation of the domestic economy in terms of what it produces, what it trades in, who benefits and so on.

At the end of the Second World War, Thailand was one of the most backward economies of South-East Asia. But over the next half century, the economy averaged a growth of 7 per cent a year, multiplying real per capita income around eight times. By early 1990s, Thailand had become a candidate to be known as a newly industrialising country. It showed an exceptionally high rate of savings and investment of around 40 per cent of gross domestic product (GDP). Virtually all domestic investment was family business conducted by the Chinese settled in Thailand. The economy was highly geared to exporting but had no mechanism to manage the flow of commercial finance into the country.

So when the export sector suffered in 1997 resulting in an unprecedented exchange crisis, the response, mainly on the advice of the International Monetary Fund (IMF), was to close down financial firms that had suffered heavy capital loss and to allow greater freedom to foreign capital. There was a sudden spurt in the inflow of foreign capital, both as direct investment and as portfolio investment in the second half of 1997. These inflows were concentrated in export-oriented manufacturing, finance, large-scale retail, property and a range of service industries. The net effect was substantial subordination of domestic capital mainly to multinationals who concentrated largely on the export sector.

One of the main consequences of this change was a drastic fall in domestic investment from 40 per cent of the GDP before the crisis to 20 per cent in the immediate aftermath, though it recovered to 30 per cent by 2005. Also, as the essay on Thailand points out, an export-oriented, multinational-owned manufacturing sector tends to be capital-intensive, to have low labour absorption and to have relatively few linkages with the rest of the economy.

The exchange crisis that was first noticed in Thailand in 1997 soon manifested itself in Indonesia. But it took a different course there. The scholars dealing with Indonesia remark: Indonesia experienced the entire cycle of economic crisis from exchange rate collapse to a liquidity crisis to a bank crisis and finally generalised bankruptcy in the corporate sector. In 1998, the Indonesian economy contracted by 12.8 per cent, the worst economic reversal in the world outside the former Soviet Union and Eastern block.

What was responsible for this? Indonesia had a current account deficit throughout the 1980s and a huge foreign debt both of the public and private sectors. The currency crisis in the neighbourhood, therefore, led to a loss of confidence in the Indonesian economy and the Indonesian currency also fell. With the active collaboration of a domestic lobby nicknamed the Berkeley Mafia, the country turned to the IMF for advice and support. The IMF recommended its standard remedy strong deflationary policy, which broadened and deepened the crisis. The liquidation of many banks late in 1997 triggered a run on even the top banks precipitating the collapse of the national banking system and the sinking of the rupiah. Millions lost their jobs and half the population fell below the poverty line.

Indonesian recovery has been slow and tortuous at least as far as the real economy is concerned because even after the IMF withdrew from the scene efforts at recovery were concentrated on the financial sector. Because of Indonesias high interest rates there was a flow of hot money into the country that resulted in an asset boom and rise in prices, which were seen as evidence of recovery. However, investment had not picked up and Indonesia was a fertile ground for the global crisis of 2008 to enter.

Malaysias experience was different. It had an open-door policy towards foreign capital in the 1990s, which led to foreign capital inflow largely as portfolio investment. It made possible a rapid rise in imports. The resulting current account deficit led to a loss of investor confidence, and a reverse flow of capital started in 1997. As the weakening of the currency became obvious, the official response initially was to defend it. The government refused to accept the IMF route and in September 1998 introduced what was then considered to be a bold measure, a lock-in period of one year on foreign capital that had come in. But in a way it was too late because considerable outflow had already taken place. The controls regime was also abused by certain powerfully connected business interests to consolidate their corporate domination. Malaysia too demonstrated that treating a financial crisis solely as a financial crisis does not lead to full recovery and steady growth of the economy as a whole.

All case studies in the volume are informative and are studies by scholars for scholars. They bring out variations in strategies and experiences of the affected countries, but also some disturbing similarities as the editors say in the introductory chapter. In general, the return to growth has been associated with much less buoyancy in employment generation, lower investment rates and greater volatility in financial markets, rendering the economies more fragile and more externally dependent than they were before the crisis. This must come as a warning to those who think that the bigger crisis of 2008-09 is over and economies are ready to move on to a steadier process of growth.