Reforms not outdated, Mr PM?
The UPA’s high decibel cry of ‘reforms’ echoed by the euphoric pink media has deprived the nation of the critically needed debate about what constitutes economic ‘reform’, particularly after the 2008 global meltdown. Even as the economic theories that the West trusted till the crisis in 2008 are being re-written by it, the current Indian ‘reforms’ are based on the obsolete economic ideas of the pre-crisis West. Tectonic changes have taken place in the economic thinking of West, including the United States, since the US-led global meltdown in 2008. Here are a few examples. Big banks, once seen as the cynosure, are now feared as ‘too big to fail’ and ‘too big to save’; financial instruments like derivatives, then viewed as advanced, are now seen as destructive; the consumption-driven economic model celebrated prior to 2008 is now viewed as unsustainable; in the G20 meet in April 2010, France and Germany castigated the equity-driven free market financial model of the US as ‘Anglo-Saxon’ and threatened to walk out the meet if the US did not agree to rule-changes. The Economist confessed in June 2010 that much of the macro economic theories developed in the last 30 years ‘are useless at best or positively harmful at worst’. Look at what these ‘useless’ to ‘harmful’ macro economic theories have done to the US and to the world at large.
These theories drove the US to pursue ‘market-based’ — read stock-market driven — financial model as more efficient, in place of a ‘bank-based’ financial model even though neutral studies showed that a bank-based model was not less successful. The market-based idea postulated that stock market, not banks, could efficiently allocate finance. What then would banks do? Even big banks would cease to be lenders and become brokers and intermediaries earning fees. See how the theory worked in the United States. Policies were devised to cut interest rates to move people away from banks and into stocks. In 1990, the US interest rates were 9 per cent and only a quarter of US families had held stocks; in 2001 the US interest rate was cut to one per cent, forcing more than half US households move to stocks. With their interest rated incomes crashing, pension, retirement and insurance funds shifted their huge investments from banks to stocks. According to America’s Investment Company Institute (ICI) Fact Book, in 1990, the tax-exempted retirement funds held 42 per cent of their funds in bank deposits, which came down to 7 per cent in 2007; correspondingly, the share of stocks and mutual funds rose from 22 per cent to 48 per cent. As pension and retirement funds ploughed huge sums into stocks, the US stock indices roared, which, in turn, attracted more and more pension and retirement funds into stocks. Thus pension funds and stock indices acted as escalator for each other. According to ICI, the US pension and retirement funds exploded from $3.9 trillion in 1990 to $17.8 trillion in 2007; of which almost $6 trillion flooded the mutual funds. Out of it, a tsunami of $2.7 trillion money hit the stock market. The result: the US market capitalisation in 1990 which was $3 trillion, rose up by five times to over $15 trillion in 2008.
This caused huge, unsustainable rise in stock prices generating ‘asset appreciation’ or ‘paper wealth’. The artificial asset appreciation was certified as bankable equity to extend easy credit to consumers. Americans were encouraged to buy lavishly even as the US ran huge trade deficits with China. The high stock prices, which classical economists would have dreaded as an asset bubble, was regarded as real wealth effect by modern economists. Modern economists rightly saw commodity price rise as inflation and therefore wrong, but they celebrated asset price rise as wealth and prosperity! At least twice — once in 1987 and later in 2000 — huge asset bubbles nearly exploded the US stock markets. On both occasions, interest rates were cut, more credit was infused into markets to lift market sentiments. The strategy succeeded. The US Federal Reserve head, Alan Greenspan, who turned the market on both occasions, was regarded as the ‘God of Money’! He taught that producing paper money and making credit available to all by securitising it was at the core of economic policy. For that, he said, managing investor sentiments in the market — which produces monies out of thin air, namely, asset prices rise — was critical. The world mesmerised by him woke up in the 2008 crisis that showed that the ‘God of Money’ was without clothes after all! Greenspan himself admitted to the US Congress on October 23, 2008 that “the whole intellectual edifice” (of market-based economics) “has collapsed”. However, he had already bankrupted US families. Just months before, in his book The Age of Turbulence (p385) he had brushed aside family savings as the virtue of underdeveloped and insecure people. The developed US people, he said, are a confident lot; therefore, they borrow beyond their income and spend. The Americans did it and did in the US first and later, the world itself. The US could do it for two reasons. One, their local currency, the US dollar, was also the global currency; so the United States could limitlessly borrow to fund its current deficit of $10 trillion so far and continue to borrow. Two, the US had become the unipolar power. Yet, the 2008 crisis has shown that the US (Anglo-Saxon) financial capitalism is failing in the US itself. Yet the ‘bank-based’ India still looks at the ‘market-based’ US only for its ‘reform’ agenda.
Take Japan, Germany, France and other Continental European nations. The GME Consulting study on the saving behaviour of West, citing researches on ‘market-based’ and ‘bank-based’ economies, says, ‘one of the fundamental differences’ continues to be ‘the traditional division between the Anglo-Saxon ‘market-based’ economies and the Continental ‘bank-based’ model. Germany and other southern European countries remain heavily dominated by their banking sector”. It also shows that the savings rate in bank-based economies is higher. According to Business Week (September 30, 2010), in the end of 2009, stocks constituted just 3.9 per cent of German household financial assets; life insurance 28 per cent and cash and bank deposits 38 per cent. Japan is identical. In a paper presented to the Bank of International Settlements in May 2009, Bank of Japan officials point out that ‘Japanese households prefer bank deposits over risky financial assets when all the financial instruments are so well-developed and heavily traded in Japan unlike in other Asian markets’. The ‘bank-based’ Japan and Germany are as efficient as the ‘market-based’ US, if not more.
Indian households too prefer bank deposits, insurance and similar instruments. The bank deposits to gross domestic product (GDP) ratio in India in 1991 was 34 per cent; it has almost doubled to 67 per cent in 2011, according to the Economic Survey 2012 (p94). So, like in Japan and Germany, savers in India overwhelmingly prefer banks. Only some 5 per cent of Indian savings gets into stocks (Hindu Business Line, November 9, 2011). So India, with its overwhelmingly ‘bank-based’ economic model, is closer to the ‘bank-based’ Japan and Germany, and other Continental European nations. It is nowhere near the Anglo-Saxon United States. Yet the economic reforms of ‘bank-based’ India tend to follow the ‘market-based’ US economic theories, especially when the very theories threaten to become outdated in the US itself. Look at how things have changed even in India. In his previous tenure as Union finance minister P Chidambaram dreamt of ‘reforming’ the banking sector by creating four or five large banks for India by merging all medium sized banks. Would he now repeat that idea when the West is itself afraid of big banks? Never. The prime minister told the Indian savers not to go to banks but to Dalal Street in Mumbai and buy stocks instead. The people of India, however, did not oblige him. The government can’t reform culturally defined financial habits of the people.
The West is rethinking and seriously introspecting about its economics that we tend to follow. On May 24-25, a continuing project titled ‘Responder’ initiated by the Research Institute for Managing Sustainability (RIMAS), Vienna University of Economics and Business, had organised a global meet on ‘The Role of Household Savings and Debt in a Sustainable Economy’. Its declared intent was to review the savings-drying and consumption-driven economic model of the West that was, till the 2008 meltdown, considered as the fast track growth model. Till 2008 all countries tended to adopt the United States model — not thereafter. That is why the World Bank in its newsletter for May 2008 confessed that there is no economic or financial model that fits all and each country has to choose the model that suits its specifics. No nation can copy another nation.
QED: Indian ‘reform’ process has to be endogenous. Not exogenous. Yet, Indian ‘reformers’ are habituated to search the waste paper baskets of the ‘market-based’ US for its outdated ideas to ‘reform’ the Indian economy. Are the ‘reformers’ listening?
S Gurumurthy is a well-known commentator on political and economic issues.