Global economic crisis:

Governments too responsible

Surekha GALAGODA and Gamini WARUSHAMANA

The global economic crisis is deepening day by day and most of the economists and policymakers have taken liberal economic policies to task and are seeking more and more protectionist measures as solutions. However some of the prominent economists still believe that the solution to the crisis is within the capitalist market economic system. Professor Razeen Sally who shares this view explains his position in an exclusive interview with the Sunday Observer.

Professor Razeen Sally pic: Iresha Waduge

Q1: All predictions about the depth of the global economic crisis have proved wrong within a short period of time. What are your views? How will this end?

A: This is one of the worst global recessions since the Second World War. But it is not nearly as bad as the Great Depression of the 1930s. However, policies adopted by governments will decide whether it will get worse or better, shorter or longer. So far, government policies around the world have not helped. They threaten to deepen and prolong the crisis.

Q2: Is this a crisis of the capitalist economic system or just another down swing of the cycle?

A: Crises are not new in capitalist economies, and they occur periodically. Sometimes they are local, sometimes regional or global. The last global crisis was in the 1970s. I don't expect an imminent destruction of the capitalist system.

The market mechanism will enable global recovery. On the other hand, there is a serious crisis in the global financial system. This is the biggest financial melt down since the Great Depression. Therefore, the first priority for public policy should be to restore the normal functioning of financial markets. That means cleaning up banks and other credit-creating institutions by taking toxic assets out, recapitalising viable concerns, getting credit flowing and putting appropriate regulations in place.

Q3: Do you believe that solutions can be found within the capitalist system or is new thinking needed?

A: Yes, I think we have to find solutions within the capitalist system. That is the best prospect for minimising the costs of the present crisis and enabling a healthy recovery. Not least, recovery requires further globalisation of the world economy, which can only happen through freely-functioning markets.

The danger comes from governments moving away from market solutions. This will make the crisis worse. The present conventional wisdom is that overwhelming market failure - a result of too much liberalisation - is responsible for the global economic crisis. Yes, there has been market failure - in financial markets. But that is not the only cause of the crisis. Massive government failure has also occurred; and this is at least as responsible - indeed probably more responsible - for the current state of the world economy as market failure.

Governments have failed in four main respects:

i. Basel II capital ad frequacy ratios introduced in 1990s, which tightened bank regulation, had the unanticipated effect of shifting lending off banks' balance sheets and boosting a largely unregulated shadow banking system. Now, re-regulation of financial markets, also encompassing the shadow banking system, will be the price to pay for less volatility.

ii. The US credit crunch, which started in August 2007, is a direct result of US government failure - in the housing market. Successive US administrations, egged on by Congress, artificially boosted mortgage lending through government-backed institutions. This created the market for sub prime mortgages. Mortgages were doled out to millions of people who simply couldn't afford to pay them. This is how the global financial crisis started.

iii. The US Federal Reserve maintained an excessively loose monetary policy by keeping interest rates low after 2001, even as the US and global economies were growing strongly. This fuelled excessive credit and led to an asset-price bubble.

iv. Global macro economic imbalances have provided the overall context for the financial crisis since last year. This results from a toxic combination of highly unbalanced macroeconomic policies in the USA and China. In the USA, reckless and insane fiscal policies under the Bush administration have led to huge budget deficits and worsened a US culture of saving too little and consuming too much. US current account deficits - the product of under-saving - have had to be financed by inflows of capital from abroad. China, on the other hand, has an economy geared to saving too much and spending too little. It has accumulated huge current-account surpluses and foreign-exchange reserves. Much of this surplus saving has been invested in low-yielding US Treasury bonds, which have financed US fiscal and current-account deficits. In effect, China has been propping up irresponsible US macroeconomic policies. It has contributed to excessive liquidity and to asset-price bubbles in the US, not least in the housing market. The combination of these policy failures artificially boosted a global economy that was already growing strongly. This created the climate for excessive financial innovation, risk-taking and debt-creation. It is important to stress these government failures to correct the highly misleading impression that the present crisis is the result of out-of-control markets and too-little government regulation. Correct diagnosis is vital if we are to get policy prescriptions and responses right to get out of the present crisis.

Q4: Is there something that contemporary economists can learn from the teaching of Karl Marx in finding solutions to the present crisis?

A: Marx, more than the mainstream classical economists of the time, grasped the cyclical nature of economic activity, and the fact that market economies are prone to periodic crises. But he got practically everything else about the workings of capitalism wrong. His "iron laws" of capitalism have been proved wrong by historical record. Capitalism, and by extension market-led globalisation, has flourished despite crises, along the way. Capitalism has not been destroyed by its inner workings. So no: there is nothing to learn from Marx about the proximate causes of the present crisis; nor indeed for lessons on how to get out of it.

Q5: Do you think that nationalisation of financial institutions is a solution to the financial crisis?

A: I am sceptical because I fear governments attempting to run banks will mess things up even more. That is the historical record - in Sri Lanka and elsewhere around the world. But, in some developed countries, it may be part of a range of short-term policy responses to fix banking systems - but only if nationalisation is temporary, with governments exiting once financial systems are working normally. I have even less trust in bank nationalisations in developing countries with weaker institutions, weaker regulatory frameworks, and with a history of nepotism, corruption and arbitrary government intervention. Overall, in the worst-affected countries like the USA and the UK, the problem is one of insolvency with many banks. Toxic assets need to be taken out and "good banks" recapitalised. Policy tools other than temporary bank nationalisations should be used, but the latter cannot be ruled out in this-or-that extreme situation.

Q6: Why did the developed countries fail in restoring the confidence of the consumers on markets?

A: Lack of consumer confidence is due to lack of confidence in banks. They are not lending. It is vital to restore trust and confidence between lenders and borrowers. Fiscal stimulus packages are a side issue and a distraction from the main problem, which lies in banking systems.

Q7: How will the protectionist measures initiated by president Obama from his 'Buy American' Policy affect this situation?

A: Protectionism is inevitable in a global economic crisis. We saw this in the 1970s. Fiscal-stimulus packages are making it worse. A lot of protectionism around the world is now happening under cover of fiscal-stimulus packages. Subsidies are being sprayed at uncompetitive industries - the car industry being the headline example. Some of these subsidies discriminate against foreign competitors and distort international trade. Banks receiving bail-out packages are asked not to lend in foreign countries. There are increasing restrictions on FDI. Migrant workers are being laid off and sent home. Anti-dumping duties are increasing again. And governments are using various regulatory standards as protectionist non-tariff barriers. Take the US fiscal stimulus package. It heralds massive government expansion and intervention in the US economy.

It also contains specific protectionist measures, notably "Buy America" provisions that favour domestic suppliers over foreign suppliers in government procurement. This shows President Obama's trade policy is starting on the wrong foot. It is sending out dangerous signals. And it is related to misguided domestic interventionist policies - in the name of fiscal stimulus.

Q8: Do these stimulus packages comply with Keynes theories and have they helped to restore consumer demand?

A: Present policies are crudely Keynesian. Expansionary fiscal policies, especially via increased public spending, are supposed to boost aggregate demand. This is supported by many economists today. However, there are prominent macro economists who have serious reservations. They doubt that these fiscal-stimulus packages will work, especially via public spending. I share their doubts. One reason why these policies are unlikely to work, especially in countries like the USA, UK, India and even Sri Lanka, is that they are pursued by governments with a record of fiscal profligacy and debt buildup. People - producers and consumers - simply don't trust these governments.

They think that government borrowing to finance fiscal stimulus will be paid for in the future through high taxation, interest and inflation. Hence they will save as much as they can and spend cautiously - just the opposite of what governments want them to do at the moment.

Q9: How will this crisis affect developing countries such as Sri Lanka in the future specially the areas of exports donor assistance, credit etc.?

A: The global economic outlook for 2009 is very bad. Global demand for exports has shrunk. Trade, FDI, trade finance and remittances are being hit hard. This will make life more, not less, difficult for Sri Lanka and many other developing countries. Commodity prices will probably remain low for a while.

Sri Lanka's major exports such as garments and tea are of course hugely exposed. Tourism will take time to rebound.

All this means that even a military victory in the North and a safer security environment is not going to translate into better short-term economic prospects.

View of the BNP Paribas logo, seen at the headquarters of the French bank, in Paris, Monday March 9. The Belgium Government reached a fire-sale deal Saturday to sell Fortis, the largest bank in Belgium and the Netherlands to France’s BNP Paribas.                                                                                                                            AP Photo

Looking beyond the short-term, global conditions will be far less benign for Sri Lanka and other emerging markets. Sri Lanka managed to grow by an average of 6 per cent per annum for three decades - due to market-liberalisation policies and despite ethnic conflict, political instability and bad governance.

That is because global economic conditions were benign, especially from the early 1990s. This era is over.

My view is that foreign consumers, lenders and investors will be much pickier than in the past. They will pay even closer attention to the soundness or otherwise of macroeconomic policies and microeconomic policies affecting the business climate - including trade policies.

Sri Lanka has long had an unstable, stop-go policy environment. Macroeconomic policy has never been responsible or stable for long. Market opening since 1977 has been compromised by all sorts of unpredictable government interventions and a bloated state sector.

The politicisation of institutions set in long ago and has got worse over the decades. This translates into an uncertain and high-cost business climate - for domestic as well as foreign traders and investors.

In recent years, the policy environment has deteriorated markedly, on both macro and microeconomic fronts. These policies will be punished more severely than they were in the past.

I would add one final thing. The lesson from East Asian economic success is that one has to work hard and responsibly to be successful.

That applies to individuals, families and governments. It is the critical ingredient of sustained growth and development for the benefit of the broad mass of people.

There is no quick fix; no one owes any country in the world a living; and both success and failure begin and end at home.

That is a lesson that has eluded Sri Lanka since independence. If these underlying attitudes don't change, surely there is no hope for Sri Lanka as a true emerging market.