(feb 2009)

A Six Step  Solution to Global Economic Crisis

By Achyut Wagle

Disasters choose bad times to strike. When they do, situation becomes worse, and the worst comes when people supposedly responsible to steer  out the world from them, for whatever reason, fail to do so. The accelerated downward spiral of the world economy is now going through all these three tests of time. When the crisis began in the form of subprime aftereffects in the US, the election fever was at its pinnacle. The US presidential hopefuls found it easier to point finger to the opposition than working cohesively on finding the solution. The Bush Administration that was over-dragged by the issues like protracted war in Iraq and his 'crusade' against global terrorism found itself in defensive in the fray, and as the result, Republicans lost the vote.

By now the demon has spread its wings world over and life of everyone living in any monetized economy on earth has started to feel the pinch of it. More precisely, such pang is graver amongst wage-earners, and the people, and countries, at the bottom end of the so called economic ladder. But the aspired level of sensitivity, however, is not manifested among the political leaders and policy-makers of the world. It would be cynical to think that the world leaders are as clueless as generally thought about regarding the possible way out of the crisis.

But, despite that, nothing workable appears to be transpiring in immediate future. The politics of procrastination, instead of addressing the problem head on, has come to play as the consolidated outcome of three different sets of reluctance among the leaders of 'rich club' of the world. The failure, for all practical purposes, ofG-20 Summit in Washington DC last week, portrayed as the second Bretton Woods, proved nothing but, to dismay and disappointment to the world, vindication of their imperviousness to impending, potentially disastrous, hurricane of global scale.

As the epicenter of the crisis, the US leaders have the responsibility of honestly putting their efforts to resolve it sooner than later. But President Bush towards fag end of his tenure is neither prepared to take any bold corrective action to stop bleeding nor is in mood to subscribe the 'dooms day to capitalism' hypothesis. The economic elites of the country are also ashamed to declare that two decade-long Greenspan policies, which are largely blamed for the present woes, have practically failed. Bush's priority even now seems to be on killing remaining two months of his White House term and escape as unscathed as possible, rather than on finding the lasting solution to the problem. The leaders of integrated Europe have a better sense of security than US, provided by a large regional internal economy of their own. The US call to end the 'protectionism' has made them hesitant to act fast; as they understand it was their stringent regulations which have so far prevented the European financial structure from crumbling like that of US.

For the third lot of leaders from emerging economies like China, India and Brazil, it is basically not their problem. Only area they have started to feel the heat is in the export market, which constitutes barely 7 to 12 percent of their GNP.  And, they too understand that the developed countries have no option than taking 'some' action to  protect themselves which in turn would automatically benefit them as well. Besides, this third group does not have the influence adequate to initiate something on their own that can help the world economy to re-embark on the growth path, sooner. Even more dangerous is the oscillation of the debate in two extremes.

At the one end, the viewpoints of intelligentsia and, at the other, impulsive media portrayals occupied the ground that was meant for meaningful, practicable debate which could contribute to find a lasting solution. Typically cynical, mainly left-leaning theorists are quick to over-joyously conclude that it was beginning of the end of capitalism. The media, televisions and live wire services in particular, presented their analyses and predictions mainly on the basis of stock exchange trends world over, as if they were the sole yardsticks to judge the strength of a particular economy, including the real sector. This caused a situation where the countries and individuals responded frantically, whereas, ideally, stock exchanges should have been only the reflections of the economic realities; not the hoodwinkers on the actualities. As a matter of the fact, the stock exchanges and the capital markets would, and should, be on the frontline to face any change in the regulatory regime aimed at curbing at least the 'gambling' component of it in a bid to rescue the world from present meltdown.

Recently, President Bush declared that free market itself will bring solution to the present economic crisis of the world. He must have tried only to sound politically correct, but this is the truth. But, looking at his acts and plans like announcing more bailouts purely on political considerations are contrary to this philosophy of allowing the free market to function. Clearly, Bush appears to be working on the advice of different sets of advisors and ghost writers. Direct cash injections before introducing properly anchored policies is neither long nor short term solution. Instead of exploring a diagnostic solution to the very cause, it is rather like putting bandage from outside to cover a chronic wound. Most of Bush's policy advisors have regulation phobia and hold a blanket approach that any additional oversight provision is against the concept of free market. It is not the case always. There must be adequate rules to ensure healthy competition and transparent operation of the free market. Such rules have long been overdue in the areas like derivative markets.  The only key message of the G-2o Summit was also to 'boost oversight' on the financial transactions.

Now the world leaders and financial experts need to work on specifics of what and how such oversights would be introduced, consolidated and executed in a coordinated manner globally. It is now time for Barack Obama to take the lead in coordination with the leaders of the major economies of the world. Considering the fact that next crisis the world would be facing could be far worse than the present one, his focus has to be not only on averting the current crisis but creating safeguards from frequent reoccurrence of similar menaces in future. To begin with, a determined political will and well-devised action plans are inevitable. He needs to focus primarily on six areas of reform—namely, reviewing of risk-weighing patterns against the wealth created through stock markets, bringing the derivative market into the range of oversight radar, rationalizing the overt cost addition to (basic) services, reducing the repayment range of investment to logical limits, putting to an end to anti-free market practices like bailouts and, increasing the level of financial education and awareness. The process of plugging these six holes could be initiated in the following order:

i)      Bell the bull: The secondary market has started to pose as the mainstay of the economy. This is the first danger. Along with the over-speculated transactions of share certificates through the exchange, estimation of the real worth of any company has practically become impossible. As is the case, apart from the book value any particular company received from IPO, the added value on the price of the shares by stock trading never enters into the company. In addition rights and bonus shares are periodically issued against those shares without additional cash injection into the company in question. But the net worth of the company is computed on the basis of market price of per unit share at particular point of time.

Unlike manufacturing and other service industries, this practice makes the business of banks and financial institutions (BFI) highly vulnerable. It is because, the investment limit of any BFI is, generally, linked to its combined strength of net worth and deposits. In this scenario, BFIs are allowed to lend exceedingly larger amount than their real worth and risk-bearing capacity. If the share price drops, even without any convincing reason, the net value of the company, which in fact was never with it but the shareholder, momentarily plummets; leaving it instantly cash-starved. Also, the deals made in share transactions have proved impossible to keep under the regulatory purview as 'insider trading', manipulation by a handful of players in world's biggest floors and, lately, use of media to swing the price according to the vested interests of influential trades have become open secret. Therefore, the oversight authorities should introduce new regulations so as to calculate net worth of BFIs under new framework, revisit the system of setting investment benchmarks against the quantum of risk and real value of the investor and, to bring all transactions under legal lenses.

ii)     Woggle the boodle: There is a highly mysterious 'financial underworld' of derivative market that is well beyond comprehension of a common man. When Warren Buffet, the 'investor with Midas touch', termed derivatives as the 'financial WMD (weapons of mass destruction)' in 2003, it was then taken as mere retort to Greenspan policies. But now, his statement appears to have vindicated. It is so huge in size, any single government in the world cannot even think of regulating and streamlining them. According to an estimate by the Bank of International Settlement, the cumulative value of derivatives world over stands now at whopping US$ 345 trillion. Very nature of its products, clandestine and incomprehensible nature of operation and separate lexicons used for trade are deliberately aimed at evading any form of regulation.

Products like parallel loans, currency and interest rate swaps, forwards and option sells across any national boundary are tailor-made to suit to evade the oversight regimes of any particular nation. 'Reg. arb.'—regulatory arbitrage is pronounced mantra to make 'boodle'—the filthy lucre (money). Unquestionably, present financial crisis is largely an outcome of this irresponsible trade and, interestingly, its influence is so all-encompassing that the political leadership of the world, like in recent G-20, is simply not prepared to regulate and streamline it, in fear of reprisal. Arguments are also floating that the disturbance caused to this trade would further aggravate the crisis. May be true, but it will be one-time burn, worth bearing. Streamlining the derivative markets is indeed a very challenging task, needs unflinching political will and cooperation among the governments of at least major economies of the world. It is unwise considering to bring entire business to a halt, but there must be a woggle-a pass hole for all cash transactions, which law can monitor it through. Instead, if we fail to bring this huge market effectively under regulatory radar of universal nature, the world financial architecture will continue to suffocate under this Damocles' sword; and the crisis like the present one might become norm than exception.

iii)    Rationalize the expansion of service sector : Like the manufacturing sector, service sector is equally important to any economy. Many economists also argue, the larger the service sector proportionately, the more developed the economy is.  The link between the producers and the end users of any product is possible only by means of services-transport, communication or marketing. But for some products, like the financial products, 'service sector' of unnecessarily swollen proportion has emerged between the product and the user. The intermediary services like the aftermarket and derivative market, investment banking, hedge funds and mortgage managers are on the one hand impeding the direct communication between actual buyers and sellers of the financial services and, on the other hand, putting both sides at risks with increased cost accrued out of their services, and often from their unethical greed for money. Banks, financial institutions and insurance companies themselves are service providers. Therefore, their expansion should be allowed within their managerial capacity and new practices should be introduced to reduce the role of the secondary services providers like facilitators, mediators, intermediaries and brokers, as far as possible. The enforcement of KYC (know your customer--customer as the end user) rules by BFIs would solve a larger chunk of the problem.

iv)     Reduce the repayment range: The crises like the sub-prime, among other factors, are the result of imprudent consumer financing. The indolent and unscrupulous lenders, instead of exploring new markets, concentrate in urban areas and compete for longer periods of repayment at less interest rate than other player in the market. Lending for a period of thirty to fifty years, which now has become a common practice, is absolutely amateurish proposition. During such a long time, a lot of changes in technology, social, political and economic fronts and, natural and demographic set ups are sure to take place.
For example, before two decades, nobody had thought that cyberspace and microchips would hold such a huge business potential and entrepreneurs related to this high-tech world would become billionaires.  Similarly, if a bank invests heavily now in fossil fuel project with repayment range of, say, next fifty years, in all likelihood, it is sure to be doomed once the alternative fuels replace the fossil fuels.  But it could still be wise decision to lend for a decade.

These periodic shifts in the very nature of economic activities also alter the earning of borrowers with particular skills, which in turn will have bearing on the repayment schedules of the borrowings.  The point here is: there must be rethinking on the current term-lending practices. Except in large infrastructure projects, consumer financing for unforeseeable periods are always prone to leave the lenders' future in peril.

v)      No more bailouts: The hasty decisions like that of US and several other governments to bailout mainly the troubled financial institutions is the most unfortunate development, in light of the nature of present crisis. It will only open the Pandora's Box as it would encourage more and more companies to announce bankruptcy and the government, any government for that matter, can neither remain biased to particular sector in supporting revival nor could it manage enough resources to meet all demands. The BFIs must be supported, but such support must come in the form of monetary policy instruments. In the same way, the manufacturing and other sectors might be supported by policy options like marginal subsidies, rebate or taxes holiday and product-based incentives—not the outright liquid cash to the manufacturers.
Some, even big, BFIs and other companies unable to compete may collapse. They must be allowed to fall. Then, new, may be smaller but efficient, will emerge, and grow in future. This is the rule of the game—the basic norm for competition in the capitalism. Of course, the governments must have rescue and contingency plans in place to ameliorate the hardship of common man emanated as the aftereffects of such collapses. But, it is important to note here that the ultimate right point which public coffers should be opened for the revival of the economy is  after a series of collapses of unsustainably managed corporate structures; invariably for faster profit earnings than they actually deserved.

vi)     Focus on financial education: The underlying importance of financial education had never been realized so intently before than outburst of the present crisis. It is urgent and necessary for all levels-from decision-makers, service producers and providers and, users and public at large. To simplify, a four-tier financial education and awareness programs could be appropriate, not only to help rescue the world form present downturn but also for a continuous understanding of developments in this sector.

First, such education is required at the leadership level. It is interesting paradox that political leadership in all developed countries, and international institutions like The World Bank and International Monetary Fund, except for a very few exception, is not trained to understand the minute intricacies of the financial as well as economic systems; and the people who are better versed have no access to decision making. This is the reason; the policies are formulated just as reaction to crises, whereas any good policy must precede the crisis with inherent foresight to avert them. In many cases like in derivative market, the regulations are never able to catch-up the arbitrage.

Second, the providers and users of the financial services in the developed world must be trained to stop to resort in overuse of the services. Many BFIs try to push their products to a limited clientele. Normally in a certain time period, undiversified investment bandwagon is followed by investors, posing a question on the existence of creative faculty in the brains of so exorbitantly paid executives of the financial world. Investment in residential properties was one of such investment bandwagons that caused sub-prime disaster. Similarly, one carries a dozen cash cards in wallet, as a clear sign of overuse, and trend of misusing them by family and kids is growing at alarming level.

Third, considering the fact that more than half of the world population is completely deprived of access to any form of formal financial services, a different sort of awareness schemes to sensitize them to use the simplest products like deposits, borrowings and insurance are also equally necessary—to integrate these people in the monetization processes of economies. It will help the BFIs now competing for the same piece of pie in the urban areas to diversify and expand their services to newer clients. The expanded operation networks help reduce the risk and contribute to more balanced growth of economies; with built-in better shock-absorption capabilities.

Fourth, it has become extremely important to train the mass media on financial reporting. Despite so much of combined potential of television, newswires, news portals, radio and newspapers, to steer the crisis towards resolution with informed, well investigated and analyzed, timely and correct version of the news, the world media, largely, acted more as a havoc-creator than the informer. Only basis of their reporting appeared as the stock market, not the real sector.

It grossly failed to report even the simplest factors like where the aftermarket was distorted and where the oversight authorities overlooked and failed. This clearly demonstrated either lack of properly trained manpower even in the leading corporate media or their lack of will to dig out and serve the real stories about the causes and impact of quake of this mammoth scale on world's financial architecture.

[Author is an economist, also served as Advisor to Prime Minister (2001-02) and Advisor to the Governor of Central Bank of Nepal (2004-08)]