Economic change and crisis have tended to produce great economists whose work has profoundly shaped economic policy and political philosophy. The Industrial Revolution in England in the first half of the 19th century inspired Karl Marx and Friedrich Engels to produce The Communist Manifesto (1848). The Great Depression of the 1930s inspired John Maynard Keynes’ General Theory of Employment, Interest and Money (1936) and that, in turn, became the reference point for Western governments post World War II. The oil crises of the 1970s nourished Milton Friedman’s monetarism.
Therefore, it matters a lot as to which economist will define this crisis and come up with the most practical policy recommendations for Western governments. Those policy recommendations are then likely to shape our lives and our fortunes. In this column, I will highlight four economists whose work is most likely to shape the next 10-20 years of economic policy.
Coming in at third position is Nouriel Roubini, a professor at the New York University, who said as far back as 2005 that the US house prices were riding a speculative wave and their collapse would trigger a powerful economic downturn. In Crisis Economics (2010), Roubini and co-author Stephen Mihm point out that free market systems have been inherently unstable and are prone to frequent bouts of panic. The sub-prime crisis is just the latest bout of such panic. During a crisis, governments need to spend plenty of taxpayers’ money to ward off disaster. After the crisis, governments need to get back to cutting government debt and applying free-market principles.
Jogging in at second place is Raghuram Govind Rajan, a professor at the University of Chicago and former economic counselor and director of research at the International Monetary Fund. Like Roubini, in 2005, Rajan warned central bankers of the growing risks arising from overleveraged banking systems in the West. In Faultlines (2010), Rajan strings together a compelling narrative of how economic incentives provided 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 instance, widening income inequality and falling access to education for low income people in the USA and the wide trade imbalances between America and its trade partners (and the ensuing flow of capital into the US Treasuries). Until these fundamental issues are resolved, the fate of the American recovery will be in the balance.
Coming in at pole 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 – 2009 and A Decade of Debt – 2011), these two economists have highlighted that:
“…public debts in the advanced economies have surged in recent years to levels not recorded since the end of World War II, surpassing the heights reached during the World War I and the Great Depression.”
Sovereign debt crises, large scale sovereign default (and the banking crises which often precede the sovereign debt crises) have repeatedly hit economies around the world (including the Western economies). The ‘down phase’ following such crises typically spans five years and on an average, leads to 7 per cent points rise in unemployment, 9 per cent points fall in GDP/per capita, 36 per cent fall in house prices (in real terms) and 56 per cent fall in stock prices (in real terms).
History shows that once a country’s sovereign debt:GDP ratio crosses 90 per cent, economic growth is adversely impacted and, in turn, exacerbates the debt:GDP ratio. In fact, 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.
“We conjecture here that the pressing needs of governments to reduce debt rollover risks and curb rising interest expenditures in light of the substantial debt overhang, combined with an aversion to more 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 would include the savaging of pension funds.”
Investment Implications Of Reinhart & Rogoff’s Work
The low growth and high unemployment foreseen by Reinhart & Rogoff in 2009 are already the grim reality for the West. Hence, I will focus on the policy implication of Reinhart & Rogoff’s work – the potential imposition of capital controls (of the sort we are used to seeing in India) by Western countries.
Imposition of such controls on Western pension funds and banks is obviously bad news for India, given our stock market’s dependence on Western risk capital. Secondly, such controls will raise the cost of capital globally as arbitrage across markets 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.
Looking on the positive side, such banking repression in the West should take the steam out of commodity prices for a considerable period of time and thereby alleviate India’s structural inflation challenge. Secondly, once the Indian government realises that India can no longer grow by relying on Western risk capital, it might embark upon the next wave of domestic economic reforms.
On balance, it seems while an economy as robust as India’s can adjust to capital controls in the West, during the adjustment process, global and Indian equities may derate significantly as Western governments will forcibly channel risk capital into their own depleted coffers, rather than allowing it to flow into global equities.