Had I been in Davos..

Based on this news-item, I presume that bankers would have told the finance ministers, gathered in Davos, in a private meeting that they should stop bashing bankers. I presume Mr. Geither would have been there in that room as well. Had I been there in that room, this would have been my message to both the Finance Ministers and the bankers:

With every passing day, as asset prices rise and economies appear to stabilise, the sense of urgency for action is fading. But, that would be a pity. Critical issues thrown up by the 2008 global financial and economic crisis remain unaddressed. They need to be addressed if the world were to minimize the chances of another crisis and to put more time between that one and the last one.

First, it is worth reiterating that it was a global financial crisis. Explanations that focus on US-centric practices both within and outside the banking industry are incomplete. Housing bubbles happened in many countries. Many risky assets were priced to perfection. A fund manager travelled the world in January 2007 and wrote of the global nature of the bubbles that he saw.

Two main causes for the global nature of the bubble stand out. One is that interest rates were low and for long, in the US. Given the US dollar’s reserve currency status and its de facto influence on other countries via the exchange rate, monetary policy in other parts of the world was also too loose.

Asymmetric responses to economic contractions (quick to cut rates) and to economic expansions (rates normalizing too slowly) should be recognized as a principal sources of mispricing of risk.

Low short-term rates lead to mispricing of risk as it gives rise to excessive systemic leverage, boosting returns on financial assets, making them appear safer than they are. Credit ratings are at their best at the peak of the cycle. Counter-cyclical approach to ratings, to leverage ratios and to the pricing of risk is needed.

Low interest rates, mispricing of risk and the resulting excess financial returns lead to excess compensation in the sector. The problem is not that higher returns or profits generate higher personal income but that they are not risk-adjusted since risks manifest over time and not immediately.

 Excessive personal incentives in the financial sector have also contributed to the depletion of talent in other parts of the economy. The world needs to create real assets to absorb the liquidity and money creation of the financial system. That requires allocation of resources (including human resources) to real sectors of the economy. For that reason alone, compensation practices in the financial sector should not get too far out of line with the rest of the economy. Further, they need to be risk-adjusted, as both gains and losses from risk-taking have to be borne by those who engaged in risk-taking.

That brings me to another point. One of the biggest grievances that the rest of the world has with our sector (I refer to the joint letter signed by many distinguished pro-market economists from across the world, as an illustration) is not that it played an important role in precipitating the economic crisis but that the losses generated by the sector have been passed on to segments of the population that had nothing to do with those losses.

In other words, one of the crucial tenets of capitalism – that rewards and losses for risk-taking have to be borne by those who knowingly took those risk – has been neglected in most cases in the post-crisis repair work. Going forward, such mechanisms have to be put in place before the event since, post-crisis, legitimate fire-fighting takes precedence over other normative considerations.

Lastly, the developed world experienced great moderation between 1982 and 2007 or at least for most of this time. Growth was stable and inflation rates declined. This was because, for the most part during this period, commodity prices declined,  inflation rates climbed down, interest rates dropped from high levels in the early 1980s and demographic trends were favourable. These, together with regulatory attitudes, created conditions for the financial sector to assume a position of dominance in many respects.

These factors are unlikely to repeat themselves and more importantly, they are set to reverse too. For starters, the growth-inflation trade-off is unlikely to be as favourable as it was during that quarter-century due to resource constraints and given current state of technology. Therefore, it is reasonable to expect macro-economic volatility to rise rather than remain stable or decline.

In such a scenario, low cost of capital can create asset price bubbles that bear no relation to macro-economic reality. They would be sources of profound instability when they bust, as they inevitably do.

 All the players in the financial system – public and private – have to be mindful of this risk. That is, they should factor that into their policies and practices such that financial markets (i.e., asset prices) hold a mirror to the real economy, and not become the tail that wagged the dog.

For better or worse, the US remains the intellectual fountainhead for the world of finance and capital markets post-War. If the global housing bubble was precipitated by the US monetary policy, the US credit bubble (housing finance bubble) was precipitated by its regulatory forbearance and imported by others to avoid regulatory arbitrage.

Hence, the United States has to play a role in the creation of a new balance between financial markets and the rest of the economy not only in the US but in the rest of the world too.

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Redistributing from savers to bankers

Mr. Otaviano Canuto (Vice-President in World Bank for poverty reduction) sends a very important message (ht: Hemant Takalkar) for policymakers in emerging economic giants. I can think of India and Indonesia, for example. Perhaps, his message is more relevant to them than to many other nations.

The most important task is to facilitate and strengthen the creation of new assets, and there is much that developing countries can do in this regard. They can take advantage of the current bonanza in available capital to build contestability, transparency, and institutional quality around markets in which greenfield investments can be implemented. They can ensure that the rules they have in place are consistent and favorable to funding investment projects with long maturities. And they can invest in their own capacity for project selection and design. [More here]

This must be read in conjunction with Reserve Bank of India’s recent exhortation to the Government of India:

If the Government is able to commit more resources to capital expenditure, it will help deal with some of the bottlenecks that contribute to supply-side inflationary pressures. [More here]

Either the government creates assets on its own or it lets the private sector do it or in partnership with it. India is, at present, doing a poor job of all three. Mr. Canuto’s reminder is a timely one.

The second piece that is short and makes a valid point is that of Axel Leijonhufvud, Professor Emeritus at UCLA. In his short piece for VoxEU, he reminds the public and that too in  the financial industry about the 21st century shell-game whereby banks have been restored to profitability by robbing savers of their returns. Hence, when banks return the bail-out money and it is hailed as a success, it is a clever con-game. Such profits have been made at the expense of savers and hence, when bailout sums are returned, the loss of a fair return to savers remains uncompensated. The subsidy is irreversible.

He concludes with a terrific last word on the so-called central bank independence:

The independence doctrine, however, is predicated on the distributional neutrality of their policies. Once it is realised that monetary policy can have all sorts of distributional effects, the independence doctrine becomes impossible to defend in a democratic society. [Full piece here]

Sequel to capital controls

On 19th January, TGS wrote about capital controls. TGS is happy to note that Eduardo Levy-Yayati who used to be the Head of Emerging Markets Strategy for Barclays Capital (and now it appears that has turned a full-time academic) chips in with his favourable opinion on capital controls.

I am glad that he makes this important observation that economists often forget, in their observations and critiques of others’ works or that of policymakers:

Making a convincing case based on a counterfactual analysis of a single case is virtually impossible – the sceptical argument that controls in Chile failed to fend off capitals inflows and revert the real appreciation says nothing about what inflows and appreciation would have been like in the absence of controls. [More here]

CBO is too optimistic

I managed to go through five pages of the summary report of the Congressional Budget Office on the US deficit projections. They strike me as somewhat optimistic. Deficit is projected to come down rapidly and significantly in the second half of this decade before raising later, due to entitlement expenditure. I question the rapid reduction projected for this decade. The tax/GDP ratio is expected to hit a level by 2020-21 that it has not touched in the last forty years.

As for economic growth this year and next, CBO writes:

As measured by the change from the fourth quarter of the previous year, real GDP is projected to increase by 3.1 percent this year and by 2.8 percent next year (see Summary Table 2). That forecast reflects CBO’s expectation of continued strong growth in business investment, improvements in both residential investment and net exports, and modest increases in consumer spending.

All the assumptions made therein can be questioned. Latest data suggests that orders for durable capital goods (non-defense and excl. aircrafts) have started to slow down from the end of last year. That raises doubts on the assumption of ‘continued strong growth in business investment’. It is difficult to foresee improvements in residential investment when home prices are still dropping. It should continue to do so in 2011. Recent optimism on a sustainable recovery in the US appears somewhat too premature. Hence, CBO’s projections on deficit may end up getting revised higher for 2012 and possibly for 2011 too.

The failure to pencil in a recession any time this decade (never mind its length) is the most glaring omission of all. One wonders if the authors of the CBO report saw the work by Deutsche Bank Fixed Income Strategists published in September 2010. To make it easy for them, here it is.

For the economic growth assumptions of CBO to materialise, Free Exchange in ‘Economist’ recommends Tyler Cowen’s new book for policymakers in economically developed countries. I have not read it yet.

Malegam Committee

The Malegam Committee has released its report on the microfinance sector. More formally, it is the ‘Report of the Sub-Committee of the Central Board of Directors of Reserve Bank of India to Study Issues and Concerns in the MFI Sector’.

IFMR blog had done a good job of sumarising the Committee’s recommendations and then critiquing them. You can find them here and here.

Mr. Vijay Mahajan has made a foreful critique of the Committee’s recommendations here.

My problem with the Committee’s recommendations go beyond the specifics. The mindset of Indian regulators has to change from coming up with rules, regulations and guidelines that focus on catching 10% or 20% wrong-doers rather than faciliating the economic activity of the other 80% – 90% who are doing good work.

How, on earth, should or Microfinance Institutions can verify that the income of the household is less than Rs. 50,000 per annum and that the bulk of the loans are used for income-generating activities rather than for consumption activities?

Even if households use it for consumption smoothing, so what? Will a major medical bill be considered consumption activity? If so, should they not borrow for that purpose? Do they have health insurance coverage?

See this column by Mr. Ashok Desai reproduced in IFMR blog.

Unfortunately, the attitude among regulators still is that we tighten the regulatory screws until the machine breaks down completely.

(Disclosure: I am on the Board of Bharatiya Samruddhi Finance Limited (BSFL), a NBFC-MFI. Mr. Vijay Mahajan is the Chairman of the Board of BSFL)

Bark sharper than the bite

Reserve Bank of India’s monetary policy decision on Jan. 25th was disappointing and lame. It should have raised rates by 25 basis points. I had mentioned as much in my MINT column. Nonetheless, RBI’s third quarter review of monetary policy is well worth a read. Following paragraphs caught my attention:

The combined risks from inflation, the CAD and fiscal situation contribute to an increase in uncertainty about economic stability that consumers and investors will have to deal with. To the extent that this deters consumption and investment decisions, growth may be impacted. While slower growth may contribute to some dampening of inflation and a narrowing of the CAD, it can also have significant impact on capital inflows, asset prices and fiscal consolidation, thereby aggravating some of the risks that have already been identified. [Paragraph 41 – vi]

While energy prices are driven by global developments, the food price scenario is primarily a reflection of persistent structural constraints in the domestic agricultural sector. …Unless meaningful output enhancing measures are taken, the risks of food inflation becoming entrenched loom large and threaten both the sustainability of the current growth momentum and the realisation of its benefits by a large number of households. [Paragraph 45]

If the Government is able to commit more resources to capital expenditure, it will help deal with some of the bottlenecks that contribute to supply-side inflationary pressures. With reference to revenue expenditure, while large and diffused subsidies may contribute in the short term to keeping supply-side inflationary pressures in check, they may more than offset this benefit by adding to aggregate demand. [Paragraph 46]

The full document is here. May be, this is a dynamic link and might be replaced when the next quarter document arrives.

In a note to clients, Jahangir Aziz of J.P. Morgan concluded as follows:

RBI’s concern that in the presence of a significant fiscal deficit and high inflation, the large current account deficit could severely deter investor interest in India thereby tarnishing medium-term growth prospects is a fair warning. However, whether or not this risk materializes depends to a very large extent on monetary and fiscal policy actions taken in the near term. A stronger action today by the RBI could have significantly reduced this risk.

Amen to that last sentence.