I
wrote this in the Calcutta Telegraph on 4 November 2008 - five weeks before P
Chidambaram was moved from the finance to the home ministry.
STEERING IN A STORM
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We have entered a phase of economic history unlike anything we
have seen in 60 years. None of the living generation would remember what
India went through in the Great Depression of 1929. That was only the last
depression; there were many before it. And they were not local; they emanated
from industrial countries, and buffeted India, which then was predominantly
an agricultural exporter. A slump in industrial countries reduced India’s
export earnings and depressed its agriculture.
The many depressions gave governments experience in dealing with
them. Economists worked out theories of the trade cycle, and derived rules on
anti-cyclical policies. The oldest of them concerns liquidity. The most
devastating impact of trade cycles was that banks could not pay their
depositors on demand and a shortage of means of payment ensued. The remedy
developed was that there should be a central bank — a lender of last resort —
which would lend money to banks on demand so that they could pay off
panicking depositors. Soon the depositors would regain confidence; the banks
could then repay the money to the central bank. This rule has become a part
of central banks’ credo. It has reappeared in the present crisis. The
American government has given money to its banks in exchange for equity, and
European governments have guaranteed bank deposits.
However, this ancient rule is no longer enough. New financial
institutions have emerged besides banks. Lehman Brothers and Bear Stearns
were mortgage lenders; AIG was an insurance company; Merrill Lynch was a
hybrid financial intermediary. They could not be helped by central banks.
When they could not meet their obligations, they looked for companies that
could take them over. But rescue acts are difficult to organize because no
one would buy institutions whose value has become negative — whose
liabilities exceed their assets. For them, bankruptcy is the only option.
Bankruptcy is painful to its victims; but legally it could not
be simpler in the United States of America. All that a businessman has to do
is to download a form from the net, and file it in a bankruptcy court. A court
receiver then sells his business off or sells off the assets piece by piece,
and pays off creditors. The bankrupt businessman is freed of all obligations,
and can start a new life. Bankruptcies in the US went up from 218,909 in
July-September 2007 to 226,413, 245,695 and 276,510 in the next three
quarters.
But in India, bankruptcy is impossible. Under an antiquated law,
a defaulting firm must file for bankruptcy in a high court. High courts are
so overloaded that liquidation proceedings do not even start. Meanwhile,
defaulters can merrily default on their debts and carry on.
Debt defaults are extremely damaging to business confidence, but
would not stir our government. When the debt is owed to a bank, however, the
government gets worked up because it owns the banks. So 10 years ago it
bypassed the bankruptcy law, and passed a special law to enable banks to take
away assets mortgaged by their defaulting debtors, and special tribunals to
rule in the banks’ favour. These debt recovery tribunals too are now clogged;
but banks have recovered much of their money.
That was the last cycle; a new one is just beginning. As Western
economies sink, our exports to them are falling. Exporters cannot recover
their export proceeds. Businessmen in trouble are no longer flying. So
airlines are going empty. Those that have borrowed to buy planes cannot
service their loans. They are defaulting on their debts to airports and to
oil companies. Developers who have taken thousands of acres to build flats
for flourishing salarymen find that professionals are losing their jobs, or
are feeling so insecure that they are not prepared to buy flats. With flats
unsold, builders cannot pay their workmen and suppliers.
This is the classic start of a depression. And it evoked the
classic response. The Reserve Bank of India reduced the cash reserve ratio —
the cash it requires banks to keep idle. Every time it did so, newspapers
screamed: the RBI had released so many thousands of crores into the economy.
It had done nothing of that sort. Depositors were withdrawing cash, banks
were running short of money, and the RBI allowed them access to their own
cash which it had locked up.
So where did this idea of crores being released come from? The
idea was that with more cash in hand, banks would be able to lend more. But
banks have lent almost up to the limits allowed by the cash reserve ratio.
Enterprises are failing to pay, not because banks are not lending them money,
but because losses are draining businesses of their cash. In these
circumstance, CRR reduction is a futile and ineffectual measure. So is a
reduction in the RBI’s interest rates. As Keynes said in his General
Theory, monetary policy is ineffective against depressions.
Keynes instead proposed using fiscal balance countercyclically —
taxing more and spending less in booms, and taxing less and spending more.
Our finance minister did precisely the opposite. He ran massive deficits
during the last boom; so he cannot run bigger ones without forcing more
government bonds on banks, and in effect taking credit away from businesses.
He can do much to improve business sentiment. He only has to reverse the many
mistakes he made in his last four budgets. He can also improve incentives to
investment, and restructure government expenditure towards productive
activities. But that is not what he is up to. He has made numerous statements
instead.
In these statements, he gave copious statistics of the economy’s
past performance. Many were not relevant; in a sinking economy, past
performance is no indicator of the future. He reported on the RBI’s actions —
which the RBI was announcing anyway. He tried to cheer up the public, telling
it not to be fearful and to take informed decisions — implying that his
irrelevant statistics were relevant to decisions about a changing future. And
he reiterated his view that the “fundamentals” of the economy were strong and
that its problems were related to liquidity, which in his view, the RBI had
been pumping into the economy — an ineffectual action if there was one.
This response, from the principal economic policymaker, is
misjudged. The finance minister has the quixotic notion that he can talk the
economy out of the depression. But his talk cannot offset falling profits and
disappearing cash. For this depression we need many policy measures, mostly
other than monetary. The finance minister is ill equipped to conceive of
them, let alone take them. We need strong, central leadership, backed by
economic expertise.
The biggest uncertainty is political; it has made the government
indecisive. The first step to reducing uncertainty is to have the general
election straightaway and bring in a new government immediately. Failing
that, the next best would be for the prime minister to appoint the one
economist-politician he trusts — Montek Singh Ahluwalia — as finance
minister, to appoint the best Indian monetary economist, Raghuram Rajan, as
his adviser, and to let them appoint an advisory council of their choice. P.
Chidambaram would make an excellent home minister — that was the ministry in
which he made a distinguished debut 25 years ago.
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