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To be a free-market capitalist or not

To be a free-market capitalist or not
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First Published: Thu, May 14 2009. 09 22 PM IST

Updated: Thu, May 14 2009. 09 22 PM IST
Adam Smith, the 18th century Scottish philosopher, widely known as the father of free-market economics, would be squirming in his grave right now, may he rest in peace.
If he had been aware of Indian regulations over the past several decades, his reaction wouldn’t have been any different, but India is better off for the gradual deregulation of its economy.
America’s economic beliefs have been fairly deep-rooted in its free markets. The American model is now increasingly being dubbed as laissez-faire capitalism, especially by those inclined away from the right. Critics of the free market or aggressively deregulated model are finding voice now, and they have plenty of ammunition.
Markets may or may not be the best clearing mechanisms, but they do tend to overshoot—both to the downside and the upside. Analogous to markets, the very ideologies that would want to curb this over-correction themselves tend to straddle the two extremes—extreme intervention or extreme under-regulation.
The Financial Services Modernization Act of 1999 repealed the Glass Steagall Act that had been standing since 1933, essentially bringing down the walls between commercial banks and investment banks. The initial thought behind this was to stimulate competition; little did regulators know that they were creating the assembly line of the future credit crisis—a bank that made mortgage loans could now package these off themselves as mortgage-backed securities.
State backing: The role of the US government in the auto industry is a flagrant example of policy response having overshot reasonable means. Paul Sancya / AP
The belief that securitization spreads and reduces systemic risk has also been proven to be false. In fact, taking a large part of the credit creation outside the traditional, regulated banking system itself was a big reason for the stumbling of the global financial system.
Far from crying over spilt milk, regulators have never been in vogue more as a response to the apparent failure of the free markets, and government intervention has gone far beyond propping up the inarguably systemically important financial system.
The role of the US government in the auto industry is a flagrant example of policy response having far overshot reasonable means. With restructuring clearly inequitably skewed away from debt holders, at a time when capital should be king, and towards labour, we are clearly leaning to the left in the US. When the government is done with, we will have arguably the most incompetent auto company in the world, General Motors Corp., cleaned off all its legacy liabilities and with the full backing of the US government, its largest shareholder. How can one expect Ford Motor Co. then, a company that’s managed to survive without government aid, or Toyota Motor Corp. for that matter, to compete with the US government? The less said the better about the recent stress tests of the 19 largest US banks, which were a farce really—an obvious effort to convince the markets that these banks are adequately healthy, even as the government vows to stand behind the banks anyway.
Now with talk of compensation of the financial industry—and not just of the banks that accepted government aid, but private equity firms and hedge funds as well—being regulated by the government, we have vehemently overreached just a reasonable winding back of the clock of the deregulation era.
On the other hand, in India, expectations are set in stone that deregulation will be gradual, and thank heavens, generally independent of political ideology in power. While that can seem frustrating at times, it has saved us in India from regular boom-bust cycles.
This conservatism is partly responsible for India’s robust banking system, and this inspite of having had the mother of all credit cycles in India and our share of irresponsible lending. When incremental credit deposit ratios for most banks in India were running at 100% plus, the Reserve Bank of India resisted calls to reduce the statutory lending ratio. This does create a captive source of funding for wasteful spending by the government, but has also meant that a large part of the banking balance sheet is risk less.
RBI’s reluctance to better the restrictive environment in which foreign banks operate in India has also been a boon in disguise as the large, global banks struggle to survive in their home markets. Although the credit cycle has seen to it that the banks have increasingly relied on wholesale funding, external borrowing isn’t a problem at all as was commonly the case with current account deficit countries such as Turkey.
Off booms and busts that the US has seemingly got used to, which are not as common in India, few people know that the origin of today’s Citigroup Inc. was the single City Bank of New York located in New York City and founded in 1912. The City Bank of New York went bankrupt in the 1930s; apparently it had made far too many risky real estate loans!
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to globalbeat@livemint.com
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First Published: Thu, May 14 2009. 09 22 PM IST