The Hindu Business Line : ‘Avoid anti-inflationary overkill’

In the present fragile state of the global economy, measures to tighten monetary policy would exacerbate the global slowdown. Any policy with contractionary effects will have to be applied very cautiously, warns Unctad’s Trade & Development Report.

G. Srinivasan

At a time when the focus of the world economy is on high inflation, elevated prices of food and fuel and how to ensure growth in a non-inflationary milieu, the United Nations Conference on Trade and Development (UNCTAD) finds it fitting to expatiate on these issues.

In its annual publication, the Trade & Development Report (TDR), the Geneva-based UN body, known for its analytical rigour, has advocated return to roots in terms of boosting interventionist approach by the authorities even as it has been fashionable to leave markets to determine allocation of resources for development. Without mincing words, it said the situation on the ground is fragile; “uncertainty and instability in international financial, currency and commodity markets, coupled with doubts about the direction of monetary policy in some major developed countries, are contributing to a gloomy outlook for the world economy and could present considerable risks for the development world.”

‘Fragility exposed’

Drawing on the developments in the global financial markets, it said the meltdown in the sub-prime mortgage segment of the most sophisticated financial market in the world has exposed the fragility of today’s global financial sector. A financial system that, every three or four years, is subject to a severe crisis that not only hurts actors in financial markets but also has repercussions on the real sector must be “deeply flawed.”

Till recently, the moral hazard associated with the explicit or implicit presence of a lender of last resort was a problem only for deposit-taking commercial banks. But recent actions of the US’ United States Federal Reserve have shown that investment banks and mortgage lenders too, could be deemed “too big to fail” and that their liabilities are protected by implicit insurance. The latest casualties of the sub-prime crisis are Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). With the hybrid status of government-sponsored enterprises (GSE), the twin institutions hold or guarantee $5200 billion worth of mortgages (corresponding to more than 40 per cent of all mortgage debt in the US).

Though these agencies are not allowed to extend or guarantee sub-prime loans, they have been badly hit by the fall in housing prices that followed the sub-prime crisis. Their stock prices started to wobble and wane in mid-2007 and collapsed in early July 2008 when it became obvious that they were insolvent on a mark-to-market basis. Both the US Treasury and the Federal Reserve quickly announced their support to these two agencies.

As long as the US government backs their liabilities, the two agencies would be able to keep rolling over their debt, continue their operations, and thus prevent a further deterioration of the US real-estate market. But, it said, this might generate “perverse incentives because the management of a company with negative or zero equity value but with guaranteed debt might be tempted to gamble for redemption.”

cooperative approach

Describing this as another instance of a situation where “profits are privatised and losses are socialised”, Unctad cautions that if the crisis persists, it would be better for the government to assume, temporarily, full ownership of the two agencies and decide later whether to liquidate them, fully privatise them or keep them fully and permanently in the public sector. If the US government decides that different types of financial institutions need to be bailed out because their failure could lead to a systemic crisis, these institutions ought to be subject to a tighter prudential regulation akin to that imposed on deposit-taking banks. Highlighting the risk of anti-inflationary overkill, Unctad has warned that in the present fragile state of the global economy, measures to tighten monetary policy would exacerbate the global slowdown and as such any policy with contractionary effects would have to be applied very cautiously.

Its call for a cooperative approach involving trade unions, employers, governments and central banks to prevent a wage-inflation spiral, than the use of monetary policy alone, needs to be paid due heed, particularly by Indian authorities who have announced the implementation of the Pay Commission award to legions of government employees when inflation is in full throttle.

Unctad’s suggestion to bring both commercial and development consideration to bear on credit allocation through joint financing of certain investment projects by private and public banks is a desirable proposition. This way the commercial bank would contribute its expertise in assessing the viability of a project from a private sector perspective, while the public financial institutions would make a call on the project’s overall development merits. The latter’s participation in the financing could minimise risks to the commercial bank.