…and its economic consequences
V Anantha Nageswaran
The following is an extended background to Dr Anantha Nageswaran’s essay that appears in the February 2007 issue:
Global equities begin to smell fear
American stocks began the year on a negative note. It was said to be the worst start for the Dow-Jones Industrial Average in a century. Superstition has it that if the Dow-Jones is negative in the first week of trading, it would end the year on a negative note. The tone has been set for 2008, thus.
Then, in the third week of January, the flood gates opened. More than forty equity indices around the world dropped precipitously and shed more than a fifth of their value in less than two weeks. The American Federal Reserve Board, returning to work after the Martin Luther King holiday, cut the Federal funds rate down to 3.5%. Just about six months ago, it stood at 5.25%. This was an unscheduled emergency decision, just one week before they were scheduled to meet to take decisions on interest rates. That was not enough to restore calm in the equities markets. Equities continued to go deep into oversold territory on Wednesday before a set of inexplicable reasons helped to turn sentiment around.
There was a talk that the two companies that insured bond payments would be re-capitalised. Some companies reported encouraging results in the fourth quarter and fewer than expected American workers who had lost jobs filed claims for first time unemployment benefits. These calmed nerves. The important one is the news concerning bond insurers.
They all live in glass houses
That they had come to this state was a testimony to the cancer that has spread through the body of American capitalism. The bond insurance business was meant to help municipalities issue bonds at a lower interest rate by insuring their coupon and principal payments to bondholders. It was a stable and low risk business. The companies became greedy. They got into insuring riskier bonds. That would have been fine too had they understood the dynamics and the risks of the bonds or debt instruments they were insuring. Evidently, they did not. They relied on the ratings issued by credit rating agencies that were culpable of the same folly, at the minimum or of worse crimes. That is a separate and sordid chapter of the unfolding tragedy.
Most of the instruments they insured had gone so much down in value and even defaulted that the insurers’ capital is depleted. Their guarantees far exceed the capital at their disposal. If bond insurers go bankrupt, the guarantees they have extended to bondholders become worthless. Consequently, those bonds would drop in value. Another spiral of write-downs, more losses and re-capitalisation for banks would ensue. Hence, banks are now trying to re-capitalise the bond insurance companies as that is relatively less expensive. It is not going to be easy.
In the meantime, it has turned out that the exaggerated declines in global stock markets particularly that started in Europe were due to losses on bets taken by one trader working for a French bank. He had allegedly single-handedly caused losses worth USD 7 billions for his employer. The Bank of France was aware and had not bothered to inform the Federal Reserve. The Federal Reserve thus found itself responding to a stock market decline that was not reflective of market concerns over an economic recession in the US but due to the unwinding steps taken by the bank in question.
The culpability of the US Federal Reserve
A moment of reflection would reveal that the week of January 21 captured all that was wrong with modern capitalism where the financial sector has steadily gone from being the tail that wagged the dog to becoming the dog itself. The real economy is a mere side show.
In America, the share of profits of the non-financial corporate sector in the nation’s GDP has steadily declined whereas that of the financial sector has steadily climbed. The crisis in America’s capital markets is going to reverse this. The reversal would take years if not decades and it would be painful for all those who benefited from the perverse order.
Coming back to the present, the Federal Reserve has no one but itself to blame for its predicament. It has wasted precious interest rate bullets over a flimsy cause. Now, global equity markets still expect it to cut rates on Wednesday. If they do not, equity markets would again decline precipitously nullifying the purpose for which the Federal Reserve intervened on January 22nd.
When asset prices rise, the Federal Reserve comes up with any number of arguments not to temper their ascent, even if many deem such asset price booms to be unjustified by fundamentals and hence unsustainable. Nonetheless, when asset prices drop, they find enough reasons to intervene.
In a country that swears by capitalism on paper, the existence of a central bank jars the nerves of many liberals. They liken the central bank to a Soviet-style central planning agency. Worse, such a central bank also seems to have judged that its leitmotif is to serve the interests of Wall Street.
Capitalism turned executive cartel
It used to warn of inflationary consequences of rising wages when average earnings of American workers rose. But, it has stood pat when executives, first in the banking industry and elsewhere, awarded themselves exorbitant pay increases and in a crass display of avarice and greed, backdated stock options and lowered strike prices on such options so that they could profit from them, regardless of how the company’s stock performed. Stock options were meant to align managers’ interests with shareholder interests. Instead, they have become an entitlement.
The differential between executive pay and worker pay had climbed forty-fold in the last two to three decades from a ratio of 14:1 to over 500:1. Further, executives who cause huge losses to shareholders and cut thousands of jobs consequently are rewarded with golden parachutes running into hundreds of millions of dollars when they are ejected from their companies. Recent examples are Stan O’Neill of Merrill Lynch and Charles Prince of Citigroup.
Excerpts from the published article
Given America’s pre-eminence in the global economy, it has consequences for all of us. That is the difference between the Latin American crises of the eighties and nineties and the Asian crisis of the nineties. The centre held then. This time, the centre is wobbling.
The rest of the world—after five years of high economic growth and tight resources—finds itself having to choose between allowing its currencies to appreciate against a steadily depreciating dollar or import America’s low interest rate setting with mostly adverse consequences for price stability and hence social stability.
This predicament applies to most of the developing world but none more acutely than in the case of Asia. That they have to worry about letting their currencies appreciate after five years of strong growth shows that they had done precious little to wean themselves off the diet of export growth to support economic growth. Second, it also shows that it is impossible to wish away the dragon in the room—China.
China’s economic growth is predicated on strong export growth and an undervalued currency. The country still maintains a quasi-peg to the dollar. Therefore, a weakening dollar weakens the yuan as well against other currencies, notwithstanding yuan appreciation against the US dollar. Other countries have to be mindful of this as China has steadily eaten into the export market share of many countries. India’s Economic Advisory Council in its latest report reviewing 2007-08 said as much.
It is not clear whether America is deliberately or inadvertently helping China or actually hurting it. After all, China professes to be concerned with overheating and rising inflation. It has ordered a freeze on the prices of energy and food items, similar to ordering thermometers to be rigged so that fever is never indicated. If so, then America’s dropping rates and falling dollar are making China’s economic policy choices harder and not easier.
India has done better in spite of the government
India has done well so far, largely due to the sagacity of the Reserve Bank of India and in spite of meddling, often for wrong reasons, by the government. Banks were ordered to set aside higher provisions for risky loans and Indian banks were closely watched for any investment into American mortgaged backed securities. They have almost negligible exposure. But, India cannot take this for granted. Pressure is mounting on the Reserve Bank to loosen its grip over monetary policy for the sake of maintaining short-term growth.
The government faces elections next year. It would like to engineer a false feel-good factor for the short-term for consequences of economic policy errors and good choices reveal themselves with a lag. Just as this government is enjoying the fruits of some wise moves by the previous government, the next government will bear the consequences of the economic mismanagement of the present regime. The RBI has done its best to minimise consequences. But, for the public that is interested in the long-term good of the country, eternal vigilance remains the price of liberty.