Lessons from a financial meltdown

The Reserve Bank of India’s lecture series held in memory of its first governor, C.D. Deshmukh, provides its distinguished speakers a platform for sharing perspectives on banking in the context of the larger world of economic thought and behaviour.

Never has this seemed more necessary than this year when the Nobel Laureate Joseph Stiglitz was invited to deliver what he titled most appositely: “Revolution in Monetary Policy: Lessons in the wake of the global financial crisis.”

Revolution, at first glance, seems an odd phrase to use for a talk before India’s central bankers and invited participants from its financial hub. But at the end of the talk it was clear that the term had to be used in a more complex way than it has been used traditionally. For what Stiglitz did was to critique the underlying assumptions of the financial collapse, assumptions that had and still do, the halo of myths. The lessons he wished to impress upon the audience were revolutionary because they buck existing and dominant discourses by asking for a return to a more cautious and regulated financial future.

The prescriptions that he drew from those lessons were ‘revolutionary’ because they emanated from the recognition that those myths, by which we thought the world could become richer, were fallacious; because more than at any other time, these myths widened the gap between what he terms private reward and social returns, created instability in both financial and economic worlds as never before and increased inequality all around. As his latest book, The Price of Inequality suggests, that gap is still being widened.

Finally, they are revolutionary because they ask us to revert to the past when some policy planners and central banks did learn from the Great Depression and put in place structures that would check and perhaps ring fence the tendency of bankers to play with other people’s money. In today’s context then, becoming conservative in financial practices is revolutionary.

These ‘myths’ (not his term) that he deconstructs and demolishes have been assiduously inculcated into India’s elite and middle class; they form some of the “truths” taught at post-graduate courses and are the articles of faith that India’s financial elites dream by.

Size matters

One key myth that influenced banks was: Size and interconnectedness matter. The bigger you are, the larger your asset base, the more interconnected your portfolio, the more infallible you became, the more difficult to fall. Attendant myths fortified the central one: since large banks are so interconnected, they, unlike, say, a large manufacturing corporation, are more strategic to the society (as are indeed banks in general central to the economy) and so governments will do everything to make sure they do not go bust. This sort of implied guarantee provides a strong and unspoken incentive to take excessive risks. So long as the gamble pays off, “they walk off with the profits. If they lose, the public picks up the losses.”

Self-regulation is best

The strongest incentive to risk-taking, when the spate of deregulation and privatisation began in the 1980s, was self-regulation. As Stiglitz remarks wryly, “The notion that financial markets are self-regulating seems slightly quaint now.” But its durability in no small part is explained by its mythic status as a self-evident truth, despite the lessons of history and theory. The Nobel Laureate terms self-regulation an ideology, but its credibility did not vanish even after the 2008 meltdown offered enough proof for its burial. Micro bubbles have erupted repeatedly; as Wall Street moves into High Speed Trading, with ineffective regulation watching helplessly, we could be entering another phase of financial speculation even as the rest of the world strives to recover from the previous one.

Universal banking

One myth feeds another: Stiglitz points an accusing finger at universal banking. When de-regulation abolished the distinction between retail and investment banking to create universal banks, it created the room for financial innovation and the production of financial services. Universal banks seemed the perfect vehicle for the expression of the underlying myths of size, self-regulation and financial innovation. The last would benefit everyone by spreading risks, and self-regulating markets would well, self-correct.

Once again, 2008 showed up the emptiness of financial innovation. Not only did it exacerbate asymmetry of information to the point where the Federal Reserve Board Governor had to admit ignorance of Collateral Debt Obligations but it eventually led to the downfall of the real economy. Financial innovation, as Stiglitz points out, “contributed more to inequality — to greater wealth for bankers — but it was hard to see societal benefits. Indeed it has been associated with more instability.” As we all should know and as he reminds us, some financial innovation was used to exploit poor Americans, at regulatory arbitrage, and “some at new forms of market deception.” The result? “…marked discrepancies between social and private returns.” And whenever such discrepancies prevail, “not only will markets not be efficient, innovation will not be directed at enhancing societal welfare.”

The radical solution

So where should the revolution in monetary policy begin? By “…ensuring a diversity of financial institutions with different ownership, incentives and objectives. This argues strongly against the universal bank model.” Stiglitz acknowledges that “more specialised financial institutions may face a greater risk of bankruptcy” but he is worried more about systemic failure the risk of which is “greater where all banks are universal banks…” The social cost of systemic failure outweighs the costs of failure of individual banks.

Stiglitz lists 14 lessons to be learnt from the crisis for a healthy regulatory system. In the context of the dominant discourse governing modern banking they are indeed radical; even for Indian policy planners in New Delhi hoping for an economic revival on large, interconnected universal banks offering a wide menu of financial products.

(blfeedback@thehindu.co.in)

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