Raj Nallari's blog

The traditional micro-prudential regulations of bank-by-bank audit and supervision proved inadequate during the recent global financial crisis. There is now a new thinking on (i) how to reform the global financial system and how to reduce the vulnerability of the system to adverse changes in macroeconomic and market conditions; and (ii) which macroprudential approaches to be introduced to complement micro-prudential policies to deal with systemic and aggregate risks, such as excessive leveraging by all types of firms and households coupled with liquidity mismatches during a boom followed by excessive risk-averseness and de-leveraging during busts. There is also the issue of how best to deal with too big to fail institutions and inter-connectedness.

The objective of macroprudential policies is to ensure financial stability which means maintaining a steady stream of financial services to the whole economy, such as payment services, credit availability and insurance against risk. Other goals such as dampening unnecessary exuberance and over-leveraging, and avoiding asset price bubbles can also be added to the objectives of macroprudential policies. So there is a need for consensus on what exactly should be the goal(s) of macroprudential policies and supervision.

The labor market has the unenviable task of not only absorbing the additional workers entering the labor force each year (as a result of population growth) but also dealing with the unemployed workers as economies. The Keynesian view of unemployment is due to lack of aggregate demand while the neoclassical view is that when prices and wages adjust unemployment will come down significantly. In more and more developing countries, long-term unemployment (workers unemployed for over six months) is spilling over into structural unemployment, which the ILO in its several publications underscores as the mismatch between the skills of the unemployed and the demand for skills in the labor markets.

This structural unemployment may arise due to automation in the work place (e.g. need for higher and higher computer skills), rigidities in the labor market, such as high costs of training or in the case of US de-industrialization as manufacturing jobs are continuously lost to

Global GDP growth and as well as GDP growth in each of the regions were lower in 2009 compared to 2007. More specifically, specifically, negative growth rates were observed during 2009 in developed countries & European Union, Central and SE Europe & CIS countries and to a lesser extent in LAC, while the growth rates for East Asia, South Asia, Middle East, North Africa and Sub-Saharan Africa were positive in 2009 but lower than in 2007.

Reflecting this, all regions experienced higher unemployment rates, with the highest being in the developed economies & EU, Central and SE Europe & CIS and LAC economies, which again all had negative GDP growth rates in 2009. The ILO estimates that the global crisis has led to 34 million more unemployed and the World Bank estimates that about 60 million people may have been pushed into poverty.

Greedy speculators in housing and private bankers, financial innovation and failure of risk models, regulators and credit rating agencies were all deservedly blamed for the recent financial crisis. Behind this all is public policy that worsened the problems.

Long before the greed of speculators and bankers went wild and long before there were sub-prime housing loans, there was the US Government involvement in the form government subsidies as reflected in (i) the existing tax-deductibility of home-mortgage interest payments; (ii) Federal Housing Administration programs which provide credit to first-time home buyers and permit up to 97 percent leverage at origination and also permit cash-out refinancing that resulted in 95percent leveraging (take-out of $520 billion each year by households through re-financing); and (iii) government financial subsidies through federal home loan bank lending for owning ‘an American dream’ and directing credit to low-income communities in line with the spirit of Community Reinvestment Act of 1977 and establishment of quasi-government agencies such as Frannie Mae and Freddie Mac. In addition, there is ever increasing moral hazard in the financial sector over the past century in the form of deposit insurance, reduction in capital adequacy ratios, implicit and explicit guarantees for bank bailouts to all types of financial institutions, including the too big to fail institutions. These policies combined with Fed policy of cheap money by keeping interest rates low to help economic recovery from the dot-com bubble burst of early 2000s only fueled credit growth and exacerbated the speculative bubble in housing market. From Iceland to Ireland to other European countries and USA housing bubbles were spawned in this fashion.

Development is about welfare enhancing transformation through economic, social, political, and technological progress. Transformation is predicated on per capita income growth but development is also about progress in reduction of poverty and inequality, individual capabilities, access to social services, and quality of life. Both growth and development are also predicated on distributive politics of how a society is able to deal with vested interests and social conflicts.

During past sixty years, growth spurts have occurred in most countries but generally outcomes have fallen short of expectations. Developed economies have averaged growth rates of 2.4 percent during 1990 and 2008 while developing economies have collectively increased their GDP by an average of 4.7 percent over the same period. For low and middle income countries, physical capital is the

All over the world, countries have put in place fiscal stimulus packages as a response to the global crisis. In the US and UK, despite the large fiscal stimuli, the economies are stalling and unemployment rates are still high. Now, Paul Krugman is advocating a second $800+ billion stimulus as he is worried of a Third Depression (i.e. 1873-4, 1929-30 and now) or at best a low job creation and low GDP growth for the short to medium term. According to Krugman, low growth and high unemployment are shorter term problems that have to be resolved before fiscal austerity and debt reduction (which are longer term issues as bond financiers are still buying US securities). Others of conservative leanings, such as John Taylor and Gary Becker, are of the opinion that the Bush tax relief of 2008 did not work and that the Obama stimulus may not work because of small “fiscal spending multiplier”, and as the package is badly designed.

Carmen Reinhart and Rogoff document eight centuries of financial crisis and come to the conclusion that almost all the time it ends in tears with “deficits, debts and defaults.” Reflecting this view, leaders at the recent G-20 meetings pledged for fiscal austerity as the fiscal stimulus packages are quite unpopular in the western world.

Seventy percent of all trade is trade in goods. World trade volume declined by over 20% from peak levels trough April 2008 to January 2009, and this decline was observed across the board – advanced economies recorded a decline of over 23%, Asia about 25%, and so on. Several explanations were provided. One was that countries were raising tariffs and nontariff measures to protect domestic industries during the global downturn. Now, there is evidence that despite some ‘buy American’ and ‘buy British’ type of fiscal stimulus packages, and notwithstanding the rhetoric of governments, protectionism was muted and almost all countries held up their side of the WTO agreements. Others stressed that decline in economic activity was the primary cause of sharp decline in trade. But as pointed out by Chinn (2009) and others, the decline in US imports was much larger than that warranted by the decline in US GDP. The value of the dollar, as it gained strength during a period of international uncertainty, and the change in relative prices were other plausible explanations, but these too do not fully explain the decline in trade volume across all parts of the world.

After all is said and done, this crisis had its genesis in US and European countries living beyond their means. This was reflected in large current account deficit which was financed by emerging economies of China, Russia, Brazil, Korea and others. This was in contrast to economic theory which tells us that advanced economies are supposed to generate savings and hence have current account surpluses while developing countries should be borrowing to finance their deficits (as they need foreign capital to finance their infrastructure and other needs).

The world is in the midst of extreme political risk – defined as not only wars and coups but governments rushing in with quantitative easing, banking bailouts, and large fiscal stimulus packages, embarking on industrial policies, and trying to re-regulate without fully understanding the unintended consequences of their actions. These expansive domestic policies have increased sovereign debt risk and raised stock prices in a large number of countries. Governments are trying to find domestic solutions to global problems of market volatility – volatility as reflected in descent of euro vis-à-vis the dollar, large movements in stock market indices, and swings in commodity prices. Markets in turn are looking at how governments are coping with big problems, such as the sovereign debt problems in Greece, Spain and other European countries. California could default on its debt obligations – what then for the global economy?

The World Bank estimates that there are more than 1.4 billion people in the world who live below the poverty line of $1.25 per day. It will be interesting to see what happens to children born in poverty: to follow them from womb to tomb, the entire life cycle. We now have several countries with detailed information in the form of living standard measurement and other surveys. There is a lot of country-by-country variation but the trends are unmistakable.

We know from Deaton and Subramanian (1996), the poorest people—the ones in the bottom decline in terms of per capita expenditure—consume on average slightly less than 1400 calories a day, which is almost half of that recommended by poverty specialists. Women, particularly pregnant women still suffer from under-nourishment, iodine and other deficiencies, and lack of pre-natal care (despite the advances made in maternal mortality and pre-natal care in recent years).

We took advantage of the recent ABCDE conference in Stockholm during May 31-June 2, 2010 to hold side discussions with 15 high-profile academics and researchers. We were expecting that they would tell us that economic development thinking should be revisited in the light of the crisis, but surprisingly, the responses were that likely no. Views fell in two broad camps – first, that it is too early to say because the evidence has not yet been fully studied; and second, as far as the poor are concerned, the crisis is a ‘tempest in a tea-cup’ as the bottom 20% of the population living close to the poverty line of $1.25 per day are in ‘perennial’ crisis, are always at risk and vulnerable.

The finer grain of the researchers’ reflections highlighted six main aspects:

(1) Those focusing on extreme poverty alleviation underscored that even before the crisis markets were not working for the poor. The crisis unfortunately furthers highlights this and will probably impede further efforts to fight against poverty. Financial markets were singled out as particularly deficient. It was observed that globalization has widened the income inequality with haves at one end and poverty traps at the other end. Some of our interlocutors went further to say that the bottom 20 percent do not have physical capital/assets to use as a stepping stone, and a solid enough human capital base, and therefore end up being forced to eke out a living relying on natural capital (environmental assets) and social capital precluding any possible accumulation.