Back to the future

Over the past two centuries, times of rapid economic change and crisis have produced great economists whose works have shaped economic policies and political philosophies. For example, the Industrial Revolution in England, in the first half of the 19th century, inspired Karl Marx and Frederic Engels to produce The Communist Manifesto (1848), which inspired a generation of Europeans to shun capitalism. The Great Depression of the 1930s inspired John Maynard Keynes’ General Theory of Employment, Interest and Money (1936). And it went on to become a reference point for Western leaders post World War II. The 1970 oil crises and the abrupt end of the post-war economic boom nourished Milton Friedman’s monetarism, which became a cornerstone of economic policy, globally. 

So, it matters a lot as to which economist will define this crisis and make the most practical policy recommendations for Western governments. Those policy recommendations are then likely to shape our lives and our fortunes. 

In this note I will highlight four economists whose work is most likely to shape the next 10-20 years of economic policy. And I will choose a winner based on which economist has: (a) Put the crisis in appropriate historical context; (b) Understood the likely impact of the current crisis the best; and (c) Produced the most practical policy prescriptions to deal with the crisis.

Coming in at third position is Nouriel Roubini, a professor at New York University and founder of a successful economics consultancy. Roubini, arguably the poster boy economist of this crisis, said as far back as 2005 that US house prices were riding a speculative wave and their collapse would trigger a powerful economic downturn. In Crisis Economics: A Crash Course in The Future of Finance (2010), Roubini and co-author Stephen Mihm point out that free market systems are inherently unstable and prone to frequent bouts of panic. The sub-prime crisis was the latest bout of such panic. During a crisis, governments need to be “Keynesian” and spend plenty of taxpayers’ money to ward off disaster and prop up the banking system. After the crisis, governments need to get back to cutting government debt and applying free-market principles.

Coming in at second place is Raghuram Rajan, a professor at the University of Chicago and former chief economist, IMF. Like Roubini, in 2005, Rajan warned central bankers of the growing risks arising from overleveraged banking systems in the West. In Faultlines: How Hidden Fractures Still Threaten the World Economy (2010), Rajan’s compelling narrative points out how economic incentives given to American homeowners, bankers, investors and policymakers resulted in the sub-prime crisis, in spite of the fact that everybody behaved exactly as they should have. Where Rajan excels is in pointing out that the issues at the heart of the sub-prime crisis are still very much with us today. For example, widening income inequality and falling access to education for low-income people in the US, and the wide trade imbalances between America and its trade partners (and the ensuing flow of capital into US Treasuries). Until these issues resolve, fate of the American recovery will be in the balance.

At numero uno position are Carmen Reinhart of the Peterson Institute for International Economics and Kenneth Rogoff from Harvard University. In two meticulously researched and brilliantly conceived books spanning five centuries of economic data — This Time is Different: Eight Centuries of Banking Folly (2009) and A Decade of Debt (2011) — these two economists have highlighted that “...public debts in the advanced economies have surged to World War II levels, surpassing the heights reached during World War I and the Great Depression.”

Sovereign debt crises, large scale sovereign default (and banking crises that often precedes the sovereign debt crises) have repeatedly hit economies, globally. The down phase following such crises typically spans five years and, on average, leads to a 7 percentage points rise in unemployment, a 9 percentage points fall in GDP/per capita, a 36% fall in house prices (in real terms) and a 56% fall in stock prices (in real terms).

History shows that once a country’s sovereign debt:GDP ratio crosses 90%, economic growth is affected and, in turn, exacerbates the debt:GDP ratio. It is relatively rare for countries to recover from large scale banking and economic crises without going through either sovereign default or fiscal cutbacks or both. In fact, following a systemic banking crisis, the debt reduction process goes on for an average of seven years. 

“The government’s need to reduce debt rollover risks and curb rising interest expenditures in light of the substantial debt overhang, combined with an aversion to explicit restructuring, may lead to... financial repression. This includes more directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates and tighter regulations on cross-border capital movements. A less generous depiction of financial repression includes the savaging of pension funds.” 

What that means

The low growth and high unemployment foreseen by Reinhart & Rogoff in 2009 is already a reality for the West. So, I will focus on the policy implication of Reinhart & Rogoff’s work — the potential imposition of capital controls and financial repression (of the sort seen in India) by Western countries. If such capital controls are imposed on Western pension funds and banks, it is bad news for India, given our stock market’s dependence on Western risk capital. Secondly, such controls will raise the cost of capital globally since arbitrage across markets/countries will become harder with capital forcibly segregated into smaller, less efficient pools. Thirdly, and perhaps most damagingly, once Western countries move towards financial repression, it will put paid to any hopes of large scale banking liberalisation in emerging markets such as ours.

On the positive side, such banking repression in the West should ease commodity prices for some time and, thereby, alleviate India’s structural inflation challenge. And that might allow the RBI to pull repo rates down. Secondly, once the Indian government sees that India can no longer grow by relying on Western risk capital, it might embark upon the next wave of domestic economic reforms (including creating a proper pensions industry and allowing life insurers to invest a greater proportion of their corpus in equities). 

On balance, it appears to me that while an economy as robust as India’s can deal with financial repression and capital controls in the West, that adjustment process will be painful and lengthy. During which, global and Indian equities could derate to levels significantly below where we are today, as Western governments forcibly channel risk capital into their own depleted coffers rather than allowing it to flow into global equities.

These are the writer’s personal views