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Business News/ Opinion / Another market crash in the offing?
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Another market crash in the offing?

RBI governor Raghuram Rajan has said excessively accommodative monetary policy in developed economies has led to asset bubbles

Raghuram Rajan should know of global market crashes. He was one of those who predicted the recent financial crisis. Photo: MintPremium
Raghuram Rajan should know of global market crashes. He was one of those who predicted the recent financial crisis. Photo: Mint

Reserve Bank of India governor Raghuram Rajan has added his voice to a steadily rising chorus warning of the heightened risks of a global market crash. Specifically, he says there’s a disconnect between the state of the economy and asset prices; that excessively accommodative monetary policy in the developed economies has led to asset bubbles; that competitive monetary easing is leading to beggar-thy-neighbour policies reminiscent of the Great Depression in the 1930s; that the recent low volatility masks many of the risks; and that not enough is being done in terms of improved regulation.

Rajan should know. He was one of those who predicted the financial crisis. At that time, he had said that among the reasons for the crisis were the skewed incentives for fund managers that led to excessive risk-taking. That hasn’t changed. Nor has the pervasive inequality in the US. Several economists have argued that the lack of growth in real wages was the underlying reason for the explosion of private sector debt that led to the financial crisis, as debt was substituted for income. The International Monetary Fund has warned that housing markets are once again getting overheated in several countries.

There have been half-hearted attempts at regulation, but it’s far from enough. The attempt has been to get back to business as usual, by papering over the cracks with money. As the Bank for International Settlements pointed out in its annual report last year, the role of accommodative monetary policy was to buy time to put reforms in place. Instead, it warned, “The time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change."

But there’s another side to the story. Andrew Haldane, chief economist of the Bank of England, has said he’s happy that monetary policy aided and abetted risk-taking, because that’s precisely what they wanted. In fact, the entire rationale for quantitative easing was to lift asset prices, as central banks hoped that the wealth effect would help banks and lead to more spending and a recovery in their economies. “One man’s nuttiness," said Haldane, “is another man’s animal spirits."

But is another market crash really something new? After all, since the demise of Bretton Woods, the growth of the world economy has been a story of serial bubbles and busts. True, there had been periodic crises before, but not at such short intervals. It’s almost as if we are seeing a series of linked crises. They started with the oil surpluses of the 1970s recycled on the one hand to the US, where they set the stage for the Savings & Loans crisis and to Latin America on the other, where they led to a debt crisis and a lost decade of growth.

Then the US, in an effort to stem its loss of competitiveness to Japan, forced the Plaza Accord on it, forcing the yen to be revalued. In an effort to remain competitive, Japan kept interest rates low, creating a massive bubble in stocks and property there. Japan has still not recovered from the spectacular bursting of that bubble.

One result of the rising yen was the shift to south-east Asia of Japanese investment. International portfolio flows also found their way to these tiger economies, attracted by the investment boom. That finally ended in 1997 with the Asian crisis. Footloose capital winged it back to the US, setting up the scene for the dotcom boom and the inevitable bust.

After that, Alan Greenspan’s rate cuts led to a global boom in asset prices, a party cut short by the financial crisis of 2007. And that’s not mentioning the Mexican tequila crisis, the Russian financial crisis of 1998 and the European sovereign debt crisis. As David Harvey has observed, capitalism never solves its crises, it moves them around geographically.

So, another market crisis would not really be anything unexpected. Such periods of “creative destruction" could also be the economy’s way of renewing itself, of starting afresh. Perhaps this is the only way developed economies can grow in an age of financialization, when the financial tail wags the real economy dog.

The worry is the bubbles seem to be getting larger and larger and we are still to recover from the bursting of the last one. And after using up all available ammunition on tackling the current crisis, how will the world deal with another bust?

Will the central banks be able to engineer a soft landing? The history of serial booms and busts casts serious doubts about that. Indeed, if history is any guide, the Chinese Communist Party’s record of steering its economy to a soft landing is much better than that of Western governments and central banks, although whether they will be able to handle their current crisis remains to be seen. The silver lining, if one may call it that, is that there is often a gap between the first warnings and the final bursting of a bubble. For instance, some had cautioned as early as 2004 that a bubble was in the making. And Raghuram Rajan’s famous warning at Jackson Hole was made in August 2005, two years before the crisis hit.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments and feedback are welcome at capitalaccount@livemint.com

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Published: 11 Aug 2014, 01:32 AM IST
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