Modern thought has been greatly influenced by German sociologist Max Weber’s theory that the Protestant ethic of hard work and deferred gratification was in some way responsible for the flowering of capitalism. The belief that organizations and nations must work hard, save for a rainy day and reinvest in meaningful projects has underpinned the edifice on which economics and finance has been based. This goes hand in hand with another underpinning: that if institutions and individuals don’t pay the price for their follies, we invite moral hazard. But after two giant bailouts, how much of these is still valid?
With the European Union’s (EU) decision last month to provide a $1trillion bailout, no one can be blamed for throwing away the old economic textbooks. Two years ago, when the US government came up with a similar bailout package, it was argued that the sudden and unexpected nature of Lehman’s collapse had caught many institutions on the wrong foot and that the bailout was required to save the world as we knew it. We’re hearing the same explanation from the other side of the pond, though it is clear that the same situation did not apply to Greece.
Greece, after all, is a sovereign, and sovereign countries have different ways to deal with their defaults. The problems in Greece have been known for several months and seasoned bankers would have taken necessary steps to at least partially offset the risks of a default. There ought to have been more pressure on various institutions to renegotiate the terms of that debt, as was done during the South American sovereign defaults of the past. But markets have smelt the fear in politicians after the simplistic response to the financial crisis, and see no reason to make any compromises on their own. The bureaucrats in the EU, held hostage by their fear of the markets, blinked and offered to write a cheque for $1 trillion.
This bailout is not just in contravention of the EU’s own charter, but, as the link between business mistakes and their consequences breaks down, that of basic rules of the game. A clear message is being sent out that economic rules can be twisted at the will of the political executive. One should not seek to pretend otherwise any more. This was always the case, perhaps, but it is now in the open.
In one form or another, most economic crises have their origins in faulty political action. These might sometimes be crony capitalism as was the case in Asia, or a vote-catching desire to make mortgages cheap as we saw in the US, or simply profligate government expenditure as may have been the case in Greece. With the impact of economic failures being judged almost exclusively by political consequences, and with the economic endgame not being determined by normal market forces, we are now entering a new business paradigm. We need a new theory to reflect the new normal.
British economist John Kay once said the test of economic theory is whether it is useful, rather than whether it is true. The economic theories of the past—based on rational expectations, efficient markets and an element of certainty about the future—were known to not be always correct, but, so far, they were at least a useful guide to the future. Now that their usefulness is under doubt, they may require an overhaul.
The recognition that markets will often fail has motivated the alacrity with which governments have intervened in markets. But governmental interventions in markets will likely be an inefficient economic instrument. And greater intervention will mean that the financial implications of various economic choices will fall unevenly at best and perversely at worst.
All these factors constitute the “new non-ideal normal”. Companies and financial institutions will need to factor in the higher volatility, questionable allocation of resources and moral hazard into their strategies for the future.
Govind Sankaranarayanan is chief financial officer, Tata Capital Ltd. He writes on issues related to governance.
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