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Mistaking turmoil for crisis

Mistaking turmoil for crisis
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First Published: Sun, Jul 27 2008. 10 12 PM IST

Updated: Sun, Jul 27 2008. 10 12 PM IST
Here’s a tough one. Let’s banish the use of the term “crisis” from all discussion relating to unhappy economic conditions. Granted, it will be hard to do. In the first place, more cumbersome words may have to be crafted to replace a single word. And, by some standards, it seems a perfectly good reference to a set of circumstances that involve bad economic news. In all events, it has gained certain credibility by government officials and organizations such as the International Monetary Fund (IMF).
Confusion arises from using this term because it excites a sense of an impending or a recent brush with disaster, even catastrophic collapse. As such, it invites officials to make ill-advised policy moves to calm an over-wrought citizenry by “doing something”.
Upon reflection, using the term crisis is mostly a wild exaggeration. As a shorthand expression describing economic turmoil, it is applied even when conditions are not severe or even particularly widespread. Newspaper headlines scream out about financial crises, currency crises, debt crises, and economic crises.
Despite the emotionally charged nature of the term “crisis”, many academic economists familiar with how markets work use the term with little introspection. It turns out that few professional economists even used the term until the late 1990s. A survey of the academic literature yields very few references to “crises”, even when referring to the Great Depression.
Until the recent past, crisis was used almost exclusively by Marxist economists in their critique of the “inherent and fatal contradiction” of markets. Despite their analysis being discredited, we are left with a misguided malapropic legacy.
So what about all the bad new? Are these really crises? In most instances, the serious negative effects seldom occur while most citizens face few of the most dire consequences. The question then is: How did this term come into such heavy misuse? One explanation is that politicians and bureaucrats readily invoke images of doom to justify their interferences in economic matters and validate their discretionary use of public resources.
Consider the record of IMF. It claims that more than two-thirds of its member countries experienced significant financial shocks over the last 20 years. With such data, it offers “proof” of its necessity and of its army of international bureaucrats with their six-figure salaries and their quasi-diplomatic status. But these highly paid bureaucrats have been incapable of helping avoid unhappy events because they have seldom seen them coming.
Consider that within a month after heaping praise on Turkey for its macroeconomic stability under its tutelage, events unfolded that were deemed by IMF to be a “crisis”. When Russia defaulted on its international debt in 1998, it was under IMF care. Despite evidence of relentless malfeasance, no one in IMF has been punished or held accountable.
So let’s get over it. Since true crises are rare, it should not be used to describe every instance of economic or financial turmoil.
While financial turbulence is inevitable, understanding how this process works makes it easier to anticipate the future. One place to start is with a study from the Milken Institute that found that economies with bank-dominated financial sectors tend to have more volatility and lower rates of economic growth.
Among the findings were that size, composition, ownership arrangements, levels of concentration and range of activities affect the performance of the financial system. As seen in 1997-98, otherwise robust economies in East Asia collapsed due to the weak foundations in their financial systems.
Several policy recommendations from these findings include encouraging diversified financial systems. It turns out that a positive correlation exists between the size of a financial system (i.e., the total of commercial bank assets, equity market capitalization, and bonds outstanding) and economic development as measured by gross domestic product per capita.
A common thread found in most proposals offered here is to depoliticize the financial sector. An appropriate role for governments is the provision of an appropriate legal, regulatory, enforcement and accounting environment for development and efficient functioning of domestic capital markets.
Yet heavy restrictions on banks’ activity should be avoided since they often interfere with customer service and tend to thwart innovation. As capital markets develop, individual banks or other corporate interests are less able to dominate the intermediation process.
Steps should be taken to privatize state banks and limit concentration in bank ownership in private hands. This is because both arrangements introduce additional political and commercial risk into the financial sector that undermines economic development. But, privatization of state banks should occur only after there can be effective competition among private banks, including allowing the entry of foreign banks.
Many emerging market economies have underdeveloped domestic capital markets so they are dependent upon foreign capital and vulnerable to quick reversals of the flow of funds. Developed economies can suffer from similar problems. For example, Japan’s capital market is small relative to the size of its economy and represents a small fraction of its financial sector.
So, while eliminating “crises” is as simple as not using an inappropriate term, minimizing the cost of adjustments to financial turmoil is a bit more complicated. It involves the development of robust and well-supervised financial systems with well-capitalized financial institutions to reduce the vulnerability of emerging market economies to external shocks.
Christopher Lingle is research scholar at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Your comments are welcome at theirview@livemint.com
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First Published: Sun, Jul 27 2008. 10 12 PM IST