How failure on multiple fronts let the crisis in
In conversation with MoS (civil aviation) Jayant Sinha, Inklude Labs chairman Narayan Ramachandran and Asian Development Bank’s former vice-president Lakshmi Venkatachalam on the 2008 financial crisis
On the 10th anniversary of the 2008 financial crisis, are we staring at another global meltdown? The storied collapse of the Lehman Brothers disrupted as much as it shaped a new world order, but what were the characteristics that led to it? What were the takeaways, especially in the Indian context?
Mint explores all aspects of how the crisis shaped the global, and the Indian economy in a panel discussion moderated by Anil Padmanabhan in Bengaluru. The panellists included minister of state for civil aviation Jayant Sinha, Inklude Labs chairman Narayan Ramachandran and Asian Development Bank’s former vice-president, private sector and co-financing operations, Lakshmi Venkatachalam:
Welcome to Mint Roundtable. What are your initial thoughts on the past 10 years?
Jayant: It was quite dramatic and extremely scary for those of us who were participants in the global economic system. Day-after-day the screens were painted red. Whichever screen you looked at, whichever instruments you looked at, whichever capital market you looked at, every one of them was on a flight path down. The global economic system, regulators, central banks, policymakers all responded quite effectively, otherwise, we would have gone through another global depression. During the depression, not only did the economic activity collapse, GDP in different countries were negative by 10-20%, employment in the US was 25%, which was startling. The Great Depression had resulted in cataclysmic political impact, including the Second World War. We avoided those consequences even though the severity of what was happening was perhaps even more, because of swift coordinated policy action. But, developing a perspective on the crisis, why we were able to deal with an arrest, the collapse, the long-term consequences, economy by economy, country by country, are still being worked through. The long-term impacts are very much still with us.
Narayan: Actually, the crisis began at least half a decade earlier in 2001, when partly in consequence to a slowdown and, partly in consequence of the terrorist acts on 9/11, there was significant policy action in 2001-02. That policy action set in place the runaway train that got derailed in 2008. Along with the culpability of the Wall Street and its actions in this difficult period, you have to go back to the 1920s, which was somewhat similar. The regulators took a very benign view of regulations, which then facilitated this runaway train as well. The seeds were sown in the dramatic reduction rates and the liquefying of the markets by Greenspan fair, famously called the Greenspan Put, at that time.
Lakshmi: I’d like to focus on the complicated structure of the credit markets, which was very clear in the run up to the crisis. The fact that you had these very complex derivatives products, where the link between the lender and the borrower was getting much more blurred with each layer of securitization. Valuations were also becoming very problematic. It was an era that was really innovating a lot of products, without really understanding the sort of impact these products would have. When you add that to what Narayan said about regulatory forbearance, or perhaps even the degree of incomprehension, then you had the perfect recipe for a disaster. But let me just tone the lenses down now to more regional perspective. While in the US it was directly linked to the sub-prime crisis, it sort of sped over to Europe, then Asia. The Asian region was in many ways much more insulated and the direct exposure to the sub-prime crisis was much less. This could perhaps be throwback to the 1996-97 crisis in the East Asian countries, after which there was a lot of restructuring that took place among the banking institutions. There was a much better diversification of banking services and products. There were exceptions. There were small exposures in countries such as Japan, South Korea and China. But if you take Asia as a larger swathe of nations in the ASEAN group, these were much more insulated. At the same time, these were also developing markets in terms of financial sector development. And I daresay, grappling with all this innovation that was coming. I think this would come to roost much more in the post-crisis period.
Just collating all three. Is the bottom of the problem cosy relationship between Wall Street and Washington? And if so, are there consequences?
Narayan: To some extent there was a cosy relationship. But to unpack the problem, as only because of the cosy relationship, will be a very simplistic view of the world. This was the relationship of adults and the consequences were to all adults in the room. Equally culpable were the rich doctors in middle America. Equally culpable were anybody. The TV, the press. On the other extreme, you have in some emerging markets, including ours, very little relationship between the ministry and the regulators. Then you have a very different problem. That’s why you can’t have a single point analysis of this, and have to think of it holistically. And the revolving door definitely needs some adjustments. We had it to some extent, and still have, in the US. The first few secretary of treasury came in and out from Wall Street.
Jayant: It is much deeper than just a cosy relationship. It is an elite worldview that was at odds with whatever was happening. The financial elite, the policy making elite, had got distanced, or had lost touch with the actual system. There were derivatives, put on top of derivatives, creating a superstructure completely out of touch of where the real risk factors were. That worldview is now sort of melting down and leading to populism. There was smug-ness and arrogance about that worldview that met its end in the financial crisis.
You have had a stint in the ADB, the IMF, institutions that missed this crisis completely. What happened?
Lakshmi: I really can’t speak for IMF. ADB is a regional, multilateral bank, and the spectrum is pretty much Asia. There was a lot of criticism in that period as to why were we not able to anticipate and predict what was going to happen. But I just want to draw your attention to what Raghu-ram Rajan said in his book, Fault Lines. It is very clear that there were very deep fault lines in many areas of the economy and, in an integrated global economy, the challenge was that what was good for an institution or an individual will not be good for the system. I think that realisation came much later.
Narayan: It is the elitist worldview that is the cause, and all of us appreciated it only in sort of retrospect. Condition for financial crisis had occurred many times, but it was different this time because the purpose was lost. The financial sector had become 40%, 45% of big index. And everything was done with the purpose of making money on money, most particularly without putting any money.
Jayant: It was the tail wagging the dog.
But the tail could wag the dog because the environment was in place. Isn’t it?
Jayant: That was the elitist world view—that we could create value, we could shed risks, we could structure derivatives to work ourselves out of any situation. Despite the slowdown in growth, there was this notion that we will borrow our way to prosperity. So, that compounded all of this and the notion was that we could shed all risks ultimately, forever. And that sooner or later something that has to stop will stop. And it stopped.
You mentioned in passing about populism. Could you please elaborate?
Jayant: There are many aspects to it. Certainly the financial system at some level has not yet been fully healed, many of the problems we had, are still with us right now. In India, we are still dealing with NPAs and the challenges that our banking system has. The wages, the growth in productivity are still below from where it needs to be. If you look at the opportunity cost of GDP, experts say if you continue to grow at the rates that you should have, your GDP would have been at X, but because of the slowdown you are at 0.8 or 0.9X. In some ways there has been the rise of populism, which really is because of all these other factors. When you lose faith in the elitist worldview, you lose faith in the more prosperous future. You lose faith in the system. Then what happens? That’s a lot of what we are seeing right now.
Narayan: I would like to dissect what populism is. It is a reaction to what happened over the first 15 years of the new century, and it is always the mixture of the positive and the negative. You get what might have been called a unified China, but under communism. Taliban, when they came, were reacting to what had caused hyperinflation and all kinds of crony capitalism. So the early stage of Taliban was actually positive in Afghanistan. The positive part of populism is that it is responding to an elitism that had ignored most common people and almost every thought process. Populism is the economic baggage, the pendulum swinging the other end. The unfortunate challenge is that the pendulum has swung completely to the other hand. That is the negative consequences of populism we are now seeing in many parts of the world. You know, trade wars are never won by anybody.
That’s what concerns us. It becomes very difficult to keep yourself focused in public policy when you have this pressure of populism in it. There are beginnings of warnings, the dollar is beginning to ascend very sharply, there are ripples moving through the world economy. Do you think lessons have been learned in this context? Because if they have not been learned, there will be serious consequences.
Jayant: Of course, the lessons have been learned. The response in the US was literally a classic response. Don’t forget that Ben Bernanke was a scholar of the Great Depression. As was Hank Paulson, and a whole host of other central bankers, who cut their teeth in monetary and economic policies. As policymakers, we had read books and spoken to experts. Again, history does not necessarily repeat itself, but it does rhyme. We see parallels now, but they are somewhat different and the problems are also somewhat different, which is why the solutions have to be customized to what we are seeing right now. Those exact same things will not happen, but similar types of things are happening. Do we have the right policy tools and mechanisms? I think the jury is still out on that. The fact that we are in a trade war, which stems from a political pressure obviously because of president Trump, tells us that we are not yet able to grapple with and resolve these problems as far as the US is concerned. If you look at Turkey, they are going for central challenges as well. Brexit is a manifestation of that. In India, we have learned the lessons, and are following very thoughtful policies. Yet, we are part of a global economic system and there are these pressures. Our roles have to be that we avoid the excesses of the past and are able to navigate all of this. It is, in process, still happening.
If we can segue into the India study of this whole crisis. India responded with a big fiscal stimulus. And many say it also sowed the seeds of what we are seeing today, the whole NPA crisis. So how do you see the Lehman crisis and the impact on India? You were not in the government at that point in time. Now you are. You have a different view altogether. When you collate these two views, what is the sense that you get?
Jayant: The analysis of what has happened with NPAs and the public sector banking system is still undergoing. As a scientist and somebody who is fact-based in my own thinking, I will have to say that the science and the research by no means is definitive at this stage. Largely, what we have is a series of opinions by various people, which is, that there are whole series of compounding factors when it comes to India’s public sector banks. Those deal with what we went through as part of a global financial crisis. There are institutional deficiencies that had to be addressed. There were policies, for example the coal allocation, that created a lot of stress in the market system. Then, of course, no bankruptcy code for a long time. It was all of these factors that have created a perfect storm our public sector banking system, or a toxic set of things that we had to work through. This type of an institutional reform, particularly in financial system or public sector banking system, is as large as it is, it does not happen very easily and overnight. It will take us a long time to work through that. I think, we are getting through it and we have taken all the necessary steps.
Lakshmi: From the Indian point of view, there are two aspects. In the way we dealt with the immediate aftermath of the Lehman crisis, we made all the right moves, including a huge dose of fiscal stimulus. Three shots, in a spate of about four-five months, which came on the heels of a budget that was fairly generous in terms of allocations to NREGA, subsidies, etc. And the results spoke. Within a year, the growth rate did rebound. But the critical issue was that when was the time to stop. And then, look at the hardcore analysis in terms of now what we do to build up resilience, improve surveillance, and also may be direct the whole pattern of growth. Look at the kind of consumption-led growth that led to those growth rates prior to the crisis, and see how this sort of connection should be thought about. When you look at this, one does think that perhaps the time to sort the asset quality of banks should have started not much later. Nevertheless, there has been a full-throttle attempt now to deal with the problem and to bring it to some sort of safe state. But then this is a continuing quest for stability and as Christine Lagarde says, ‘we come far but not far enough, we made the world safe but not safe enough, we have broadened our growth but it is not shared’.
Jayant: Let me interject. A very important point. Our government deserves tremendous amount of credit because the bankruptcy code is fundamentally the antidote for the credit culture that we have had. A lot of the challenges that we are dealing with today is because we had a credit culture, where you could keep borrowing, ever greening out transfer assets around, between different types of holding companies, and so on. Now with the bankruptcy code, we put in place timelines, have taken companies through the bankruptcy code and got recovery, promoters have been held accountable. It is the only way for us to strengthen our banking system and begin to deal with the credit culture we had in past. Until that very powerful structural reform was not in place, the financial system could not be heeled, could not be fixed. Now that we have done it, we are maturing and it takes time for all of that to settle down. That is a truly transformative structural reform that is happening.
Narayan: The bankruptcy code is a very impressive structural reform—one of those few reforms where the brain and the spine are connected. I commend the reformers for breaking this sort of psychosis of addiction to credit and evergreening of credit in whatever manner possible, including semi-fraudulent means of getting to the next stage. But two areas remain. That same credit culture remain in the agrarian sector. It is a political dynamite and is untouched. We are still into when can I have my farm waiver discussions between states and the centre all the time. The second one is the governance structure of public sector banks. We will need to get to that, somewhat on the basis of the P.J. Nayak committee report. Exact solutions can vary, but fundamentally the governance structure of public sector banks has to be insulated and accountable.
Lakshmi: We also need to add a bit about regulatory framework in public sector banks. The reserve bank has raised many issues about independent regulation.
How do you deal with this kind of criticism that you are soft on agriculture, on public sector bank governance, and the claim of not having oversight mechanism?
Jayant: Agriculture is a state subject. Policies to support farmers are decided by each state. Every election, you win a mandate from the people and that mandate has certain elements, which become a contract between elected representatives and the people. It is the people’s prerogative to set priorities and how to expend it. With respect to public sector banking, it is a very complex financial system and there are many aspects of it that have to be addressed. The NPAs, the recapitalization, the financial condition of these banks has to take priority because we have to ensure that deposits are safe and people get the banking services delivered. There is a sequencing that has to be taken into account. The process we are doing right now is fixing the credit culture, ensuring the banks are financially sound, they are appropriately capitalised and then moving on from there to the others.
In this contract between the electorate and the government, how do you manage the tension between the unelected power—the judiciary, the technocrat, the central banker and so on. How do you make them accountable as much as you are?
Jayant: That is a very constitutional question. We have separation of powers, certain responsibilities are given to each of the different aspects of our governance system. Certainly, when it comes to the central bank, ultimately the central bank governor is appointed by the political executive and the political executive is accountable in an indirect way. We really have to resolve it at the constitutional level in terms of how the separation of powers have to work, what are the relationships between the different branches of the government.
Narayan: Yes. The framework is constitutional, but within that broad framework, you could have institutional evolution and maturity.
The monetary policy committee, as a recent evolution in India, I think is a very good example of how you translate accountability to the people to a technocratic institution. Let’s call them sub-frameworks. Saving the country from the politicians, like mentioned in the recent New York Times op-ed, is a stupid idea.
Either you like democracy or you don’t like it. If you don’t like them, don’t create hedges, to use a Wall Street term against politicians. Put in these sub-frameworks that allow for methods to be technocratic, but politically accountable. But all that said, the question is, at what point is that election manifesto extreme—politically, racially, economically—and how does that get corrected? In a world-wide political system, where it appears that roughly 30% of the vote wins power, as it happens in India and the US, you can get to the top. That behooves a serious discussion in our societies, as to how you can have very extreme views and yet make it to the top. So, political accountability is not the holy grail, that itself needs a little bit of evaluation.
Talking of the great cohesion that happened, after the 2008 crisis. There is a new phenomenon, Trumpism, and this cohesion is one thing that is going to be very hard to come by. If there is another crisis, this won’t be happening. So, each of you, your thoughts.
Lakshmi: I don’t know if we can anticipate a similar financial crisis. I would rather say the new normal is a lot of uncertainty. We have to continuously deal with it. The remedy really lies within.
To begin with, countries have to establish a very sustainable pattern of growth and understand their strengths and weaknesses. And as far as the coming together, it seems to be now jeopardized by all these later developments. There will be new forms of partnerships that are continuously emerging. For instance the emphasis on regional cooperation is certainly gaining a lot of traction. But for the kind of stresses that the global economy is continuously undergoing in some way or the other, we do need global institutions. If they are not working, we’ve got to make it work.
Jayant: If we had a crisis today, we will solve that because otherwise the system will collapse. Everybody recognizes that for survival that has to be done. So, there will be enough trip wires, and that is going to happen with the kind of multilateral arrangements that we have in place. So, I am not particularly worried about that.
The next set of issues that we have to deal with is building on what Lakshmi was saying—jobs and trade and their economic activity. That is a vexed issued today and our multilateral arrangements, whether it is the WTO, currency imbalances, tariffs—none of that has been worked out. That is part of the reason why we are in the middle of a trade war, where people are disputing each other on those issues, and where jobs and economic activities are hotly contested. I worry about that.
Then, there is a third set of issues, which is really around long-term sustainable development. Do we have consensus? Do we have multilateral arrangements that can grapple with that? Absolutely not. Climate change, issues of immigration, issues of handling terrorism, cyber security, all of these long-term issues that bedevils sustainable development, are very much up for grabs right now. We have to keep on worrying about how we ultimately deal with these.
Lakshmi: Governor Subbarao put it quite well. He said: ‘Capital is global, but regulation is local or national.’ It behooves us to find multilateral platforms where these issues can be pursued. We do have history of sectors where UN conventions have been quite successful. I have worked in the shipping sector, where the international conventions have been very beautifully translated into domestic laws, of course with a lag, but quite successfully. The answer is a lot of persistence to make this happen through constant efforts. Political leadership has to rise above partisan approaches and realise what is good for the country and for the world as a whole.
Narayan: If I were to break it up as disaster response, recovery and progress, I have to agree with minister Sinha, that disaster response will be quick and effective. The ability to respond quickly is still there within the system and everybody understands their respective incentives. And luckily they are all aligned. But for recovery and progress, my view is not as sanguine as theirs. We are in a different world. These multilateral institutions that were established in the post-war period are obsolete. They need to be completely rediscovered. If we don’t do that soon enough, the forest is dry and susceptible to a match.
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