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Mainstream, Vol XLVII, No 22, May 16, 2009

Recession—Diagnosis and Remedies

Monday 18 May 2009, by P R Dubhashi

I. The New Face of Financial Capitalism

Business cycles, that is, upswings and downswings in the economy, booms and busts, have been a characteristic of the capitalist economy. Many economists have analysed the phenomenon and come out with empirical findings as well as theories regarding the causes and nature of these occurrences and remedies either for moderating the impact or for preventing their occurrence. Gottfeied Haberler’s classic treatise Prosperity and Depression brought together several theories regarding business cycles—monetary, structural and even those related to psychological waves of optimistic and pessimistic expectations in the business world. In the heyday of neoclassical economics and policies of laissez-faire, it was believed that the equilibrating forces of demand and supply in the market, and the balancing of costs and prices would automatically provide the remedy. Thus during the downswings and recessions, demand and prices fall and the producer will perforce be required to reduce costs. Wages and returns to other factors of production will fall. Reduced costs will reduce prices and demand will consequently pick up. However, it was found that this only exacerbated the situation, converting recession into deep depression.

It was in the aftermath of the depression in 1929-30, the worst setback to the capitalistic economy, that it was realised that there was something wrong in assuming that there would an automatic cure through the equilibrating mechanism. It was at this time that Keynes came out with his theory of macro economics. Briefly, it stated that the level of the economy depends on the aggregate demand. Consumption and investment are the two main components of the aggregate demand. In times of depression when both fall, it is the state which should take the initiative in boosting both these components through public investment and welfare programme. The validity of this approach of public intervention to supplement the market was demonstrated by the New Deal programme of President Roosevelt. The Keynesian theory brought back the formulations of pre-classical and pre-neo classical economists regarding under-consumption and under-production.

The current recession, which is so severe in nature as to bring back the memories of the great depression of 1929-30, is, however, the aftermath of ‘over-consumption’ rather than ‘under-consumption’; hence it requires a different kind of analysis and theory. However, economists have not come out with it so far.

For the last several years, the successful working of the market (capitalistic) economy was taken for granted. This created a sense of complacency. Keynesian economics itself was thrown aside and superseded by the Chicago School under the leadership of Milton Friedman and his associates which celebrated the triumph and infallibility of the capitalist market economy.

This despite the fact that there were clear signs of new systemic defects creeping into the capitalistic economy of the affluent countries, especially the USA. First was the tendency to live beyond means—both at the individual and national levels. The families in the USA became used to living on credit for fulfilling their extravagant life-styles. The credit card revolution supported such a life-style. Every family would boast of possessing several credit cards which would be operated without discrimination. Also, the sustained policy of low interest rate, promoted by former head of the Federal Reserve Allen Greenspan, encouraged financial institutions to lend extravagantly at low interest rates. The leading example was ‘sub-prime lending’ by the mortgage banks—they lent without insisting on down payment and proof of ability to repay the loan, simply depending on the assumption that the loan was covered by an appreciating asset like a house. Securitisation of these loans provided the basis for further rounds of ‘financial products’ floated by the investment banks and hedge funds. Soon this gave rise to a tremendous facade of ‘financial capitalism’ in which financial products and their transactions themselves became the core business of investment banks and financial institutions like hedge funds without any regard to ‘real’ transactions. Finance ceased to be the support for the production in the real economy but became a product in itself.

The same tendency seeped into the world of ‘real production’. Chief Executives of companies in the production business started aiming at increasing share values in the stock market rather than attending the technological upgradation, human resource development, organisational improvement, and rationalisation of the production process to raise productivity. Soon these degenerated into corporation scams in the form of falsification of balance-sheets just to improve the image of the company in the stock market in order to attract investors. This had disastrous consequences as illustrated by the Enron scandal in the USA and the Satyam scandal in India.

The CEOs of corporations started transforming Adam Smith’s concept of ‘pursuit of self-interest’ into unscrupulous greed using their positions to appropriate for themselves disproportionate salaries, bonuses, and corporate facilities like aero-planes, helicopters and holiday resorts. Neither the accountants and auditors, nor the Board members could stop this naked pursuit of self-interest.

This philosophy of insatiable greed became characteristic of the ruling classes and the policy-makers as well. After all, it was money power which placed them in positions of political power. Their policies made America the largest debtor country in the world with internal and external deficit running into trillions of dollars. Yet the dollar could maintain its value because countries like China, with higher balance of payment surplus, chose to keep their surpluses in US Treasury bills.

II. Recession—Causes and Strategies

This is the background of the US capitalistic economy against which the present recession that had its origin in the USA can be understood. The reckless (sub-prime) lending by mortgage banks led to their inevitable bankruptcy. The banking and financial institutions like Fanny Mac and Fredie Mac, Lehman Brothers, AIG, Merill Lynch, Goldman Sachs, Stanley Morgan, Washington Bank etc., which had their financial empires built by securitarisation and leveraging of these loans, collapsed like a pack of cards. The disastrous failure of banking institutions led to the collapse of confidence in the market choking the credit system. What started as a Wall Street crisis soon became a Mainstreet crisis.

The financial crisis rapidly spread to Europe with a similar pattern of collapse of financial institutions followed by the collapse of business confidence, both leading to the outset of recession. There was not only fall in growth but also contraction of the GNP and rising unemployment.

President Bush had to face the crisis in the sunset years of his Administration. His Treasury Secretary, Henry Paulson, and Federal Reserve Chairman, Ben Bernanke, worked out a $ 700 billion bail-out plan to resurrect the financial institutions. The plan was quite out of tune with he economic philosophy of the Republican Party which for several years had forcefully advocated and pursued the policy of free market economy of the Chicago School. According to them, the state should keep away from meddling in the market economy. And now here was a huge plan to bail out big financial institutions on the Wall Street—all in the private sector—at the cost of the taxpayer. No wonder the plan was severely criticised as ‘socialism for the rich’ reserving capitalism for the poor!

However, the Bush Administration justified it by saying that the common people themselves would suffer if the credit line for consumption, education and housing would be clogged. The credit institutions had to be revived in the interest of the ordinary people. The road to Mainstreet was from the Wall Street.

Obama, who followed Bush, had, however, a different view. He severely chastised the Wall Street barons for their ‘greed and irresponsibility’ which led to the bankruptcy of the financial institutions. He instead had an alternate plan of $ 899—for surge in public expenditure on upgrading infrastructure, health and welfare measures. He, however, persisted with the bailout plan. The person whom he selected to succeed Henry Paulson for the post of Treasury Secretary, Timothy Geitmer, was himself a head of the New York Federal Reserve Bank, closely connected with the business world and has become a leading architect of the bailout plans and justifies them in the name of helping business and consumers and making credit flow again. Obama had, however, the discomfiture of seeing the bailout funds used for making hefty bonus payment to those very CEOs whose malfeasance had led the financial institutions to bankruptcy. The extravaganza of buying corporate jets and helicopters and holiday resorts did not stop. The Citi Bank at its annual meeting of shareholders did not serve coffee and doughnuts but spent high sums for hiring 50 security guards.

The USA and Britain took the initiative for convening the G-20 meeting at London on April 2. There was a clear difference of approach in tackling recession. While the US plan was to boost public expenditure to stimulate the economy, the France-German approach was to tighten regulations since it was lax regulation which led to financial mismanagement and consequent collapse of financial institutions. Britain wanted severe action against ‘tax havens’ which drew away funds from productive investment in business. The meeting agreed to provide a booster dose of $ 1.1 trillion through the IMF and other multilateral institutions particularly to the poorer countries.

While admitting that it was the financial mismanagement in the USA which led to loss of confidence in the credit system and the consequent onset of recession, the US Treasury Secretary felt that the US needs to be supported by other nations, especially the emerging economies like China, India and Brazil, in dealing with the recession and protecting the poorer economies from the impact of recession.

The reaction of Indian policy-makers to recession was in the beginning one of denial. The Indian banking system, they argued, was strong thanks to sound regulatory mechanism. The Indian economy would be insulated from the recession that has hit the USA and Europe. India would stand ‘decoupled’. However, as months passed the impact of world recession was apparent. The stock market plunged. Export sector enterprises like the Surat based gem and jewellery industry, Kanpur based leather industry and textile industry in different parts of the country felt the impact of recession as cash-rich markets of the US and Europe dried up, lakhs of skilled workers lost jobs. The flourishing IT software industry too lost business as outsourcing by banking and other companies in the US and Europe substantially went down. Consequently fresh recruitment was halted and compensations of existing staff were reduced in one way or another. The building industry too slowed down and real estate prices plunged. A further setback to the economy was withdrawal of $ 15 billion by the foreign investors.

The government had to come up with a series of monetary measures to improve liquidity such as successive reduction of the CRR by the RBI and extension of credit line to Mutual Funds. This was supplemented by reduction in Repo and reverse Repo rates to facilitate cheap credit to industry by the banks. But the banks were reluctant to reduce interest and give loans liberally. The recession atrophied the repaying capacity of business establishments and banks feared rise in the NPAs. The government supplemented monetary measures by the fiscal stimulus. There was across-the-board cuts in excise duties to reduce costs and prices and stimulate demand. All these measures had had only limited success. Prime Minister Manmohan Singh has promised fresh packages of measures were the voters to bring the Congress back to power.

The recession does not seem to have been handled with a sure touch in the USA, European Union and elsewhere. As the Economist has pointed out in a recent article, though the rate of decline is slowing, glimmers of hope cannot be interpreted as the beginning of strong and sustained recovery. The worst global slump is far from over. Central banks have pumped in trillions of dollars, policy interest rates are approaching zero and governments have provided fiscal stimulus, but the banks have not been purged of ‘toxic assets’, and European Banks face $ 1.1 trillion in losses. Budget deficits of the order of nine per cent of the GDP have created serious dangers of inflationary spiral. The World Economic Outlook expects global output to sink by 1.3 per cent this year—the first fall in 60 years. Big automobile companies like General Motors and Chrysler are facing bankruptcy. If they fold up, there would be a cumulative fall in the economy.

Though several months have elapsed after the onset of recession, there is still no clarity of understanding amongst the policy-makers and economic thinkers as to how exactly it should be tackled and how long it will last. While some are already seeing signs of recovery, others fear that there will be further waves of recession. The confidence in the self-correcting capacity of the free market has been severely shaken and the concept of minimalist state has already been abandoned in favour of the interventionist state. The brash and arrogant claims on behalf of unbridled capitalism have given way to grudging concessions in favour of mending the defects of capitalism. While the shortcomings of the capitalist system have been exposed, there is yet no clear formulation, no comprehensive theory such as that of Keynes after the 1929-30 depression, which could provide an alternative reformed model of capitalism. Economists need to do fresh thinking regarding economic theories and economic policies.

III. Alternative Models of Capitalism

A realisation has dawned that government measures are at best palliatives and efforts have to be made to remove the systemic defects which have crept in the capitalist economic system in recent years. Narayan Murthy, the founder of Infosys who has become an icon, has came out with his concept of ‘compassionate capitalism’. Obiviously he has been disturbed by the ravages of ‘rapacious capatalism’ as exemplified by Enron and Satyam. A company like Infosys, he said, will not, in the face of recession, resort to indiscriminate hiring and firing. Rather, it will use the slowdown as an opportunity to upgrade the skills of workers through an extended programme of training. Well, Narayan Murthy’s zeal to ‘reform’ capitalism is commendable, but the limits of the concept of ‘compassionate capitalism’ are quite apparent. With all its best intentions, Infosys, in the face of falling profits, has been compelled to stop fresh recruitment. Even Infosys, for all its success in boom time, will not be able to ward off the consequences of recession.

What is required is an alternative model of the economic system and a fresh set of policy measures to bring it into existence. The neo-liberal model followed since 1991 has created economic, legal and administrative systems which have favoured a few ‘billionaires’ at the cost of ordinary urban workers and millions of farmers toiling on land in the countryside. Inequalities of the order that exist in India and the world cannot lead to sustainable development. The unconscionable earnings in the luxury sectors like Bollywood and Cricket and the ostentatious style of living of a few cannot be allowed co-exist with the horrible conditions of slumdogs who have to live without minimum facilities like clean drinking water, sanitation and housing.

Inequalities in the field of education and health are also quite appalling. Private schools and colleges charging unconscionably high fees co-exist with substandard municipal schools which even the poor families do not want their children to attend. Public hospitals are in an appalling state while the luxury hospitals provide up-to-date medical treatment and facilities at a cost which only the rich can afford.

Recession is an opportunity to bring about a root-and-branch change in the economic policy and the economic system with the aim of not only eliminating the systemic defects in capitalism and the evils of unsatiable greed and bubbles of prosperity which they gave rise to, but also by deliberately building public systems of education, health, transport, housing etc. free from corruption, entirely handled by professionals and free from interference by self-serving politicians and parties and devising policies to support agriculture and promote agro-processing and village industries like handloom which provide employment to masses of people. ‘Safetynets’ attached to a basically iniquitous economic system will not do. The system itself needs to be made more equitable. Unfortunately neither the Congress nor the BJP nor the Left parties have taken the opportunity of the general elections to place before the people a comprehensive economic philosophy and policy measures and agenda of action to deal with the consequences of recession and other shortcomings of the present economic system.

Dr P.R. Dubhashi is the former Vice-Chancellor, Goa University, and an erstwhile Secretary, Government of India. He can be contacted at e-mail: dubhashi@giaspn01.vsnl.net.in

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