The United States Congress approved an emergency bailout package of $700 billion during that fateful week in September 2008. This was just days after the spectacular crash of Lehman Brothers.
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That bailout package was part of what became the Troubled Asset Relief Program, or TARP, which was used to buy off mortgage-backed securities from banks, hedge funds and pension funds to avert further Lehman-type bankruptcies. These mortgages had turned into toxic assets that nobody wanted to buy, and government funds were used for purchases of last resort.
As a result, fresh money was injected into the banking system for it to resume normal credit operations and clean up balance sheets. Some people believe that the then Treasury secretary Henry Paulson practically spooked the Congress into approving a gigantic package at short notice, without adequate debate. Such was the state of panic and fear of domino failures in the financial system that the package was de facto viewed as fiscal support, even though it was a monetary tool.
Subsequent actions of the US government and Federal Reserve blurred the distinction between fiscal and monetary policy. A fancy term was coined to describe unorthodox measures like a central bank buying off mortgages and loans, and thus taking credit risk onto its balance sheet. It was called ‘quantitative easing’ and was merrily pursued by all the major central banks of the developed world, from New York and Washington to London, Frankfurt and Tokyo.
Central banks embarked upon an aggressive money-printing spree. Assets on their books ballooned. The chairman of the European Central Bank (ECB) famously said that he would do whatever it took to revive the economy. This meant buying even junk bonds to push the envelope. Nothing seemed untouchable to a central bank. While the US economy did stabilize and its unemployment rate halved, the monetary effort seemed excessive for the limited success it was achieving.
On the other side of the Atlantic, European growth did not pick up significantly, hampered as it was by sovereign debt crises in addition to the mortgage crisis. But a recession was averted and some tepid growth was achieved.
During the pandemic year more than a decade later, the West’s monetary spigots have been opened even more. A liquidity glut has ensued. The size of the Federal Reserve’s balance sheet has grown by seven times since its pre-Lehman days, which amounts to a compound annual growth rate of about 21% over a 12-year period. While the rate of monetary expansion over this period has been torrid, neither employment nor economic output grew by even a fraction of that rate.
Still, the US economy stayed afloat and stock markets rallied, while wealth inequality worsened. How does a central bank exit this chakravyuh, or maze? Any hint of reducing the rate of money expansion threatens to cause panic and burst the bubble it blew. Just a mention of the word ‘taper’, which means reducing the pace of money expansion, caused a big shock to the world economy in 2013. The shock was such that the T-word has got seared into the collective memory of global financial markets.
The Reserve Bank of India (RBI) too finds itself in a similar predicament, where the way out of its liquidity glut is hazy. By last August, RBI’s balance sheet had ballooned by more than 30% over the previous year, thanks to purchases of foreign exchange externally and of government bonds domestically. That pace has been sustained. RBI has injected liquidity through long-term repo operations, which essentially provide long-term money at low overnight rates.
The Indian central bank has also provided implicit liquidity support to mutual funds, which is like an Indian version of unorthodox monetary policy. It has not quite ventured into taking credit risk onto its books, nor has it signalled a readiness to buy toxic assets, but that day may not be far off when it is asked to defrost frozen credit markets. To enhance market liquidity through money infusion or through open market operations is nothing but money creation.
As a result of India’s liquidity glut, money is flowing in and out of the central bank to the tune of ₹7 trillion on a daily basis. This has resulted in an anomaly: market lending rates have gone below RBI’s reverse repo rate, which is supposed to be the de facto floor. Cheap money is an invitation to do foolish and risky things, which, if done widely and voluminously enough, can spell disaster for financial stability. So RBI has tentatively tried to nudge market rates higher by announcing a reverse repo auction. This is our own mild version of policy normalization (sans the dreaded T-word).
But the market reaction was one of panic all the same, and there was a spike in interest rates, causing the central bank to rethink its strategy. To calm nervous bond traders, the governor has categorically said that liquidity support will continue as long as necessary, but surely we need to plan an exit from the current glut?
Why not simply loan ₹5 trillion to the central government against shares of public sector undertakings, on a bilateral basis at a low rate of 3% for a period of five years to fund its huge deficit? That will bypass markets and not cause any disruption to interest rates. Whatever the way out of this whirlpool of liquidity, it’s not going to be easy.
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Steve Ovett, the famous British middle-distance athlete, won the 800-metres gold medal at the Moscow Olympics of 1980. Just a few days later, he was about to win a 5,000-metres race at London’s Crystal Palace. Known for his burst of acceleration on the home stretch, he had supreme confidence in his ability to out-sprint rivals. With the final 100 metres remaining,
[wptelegram-join-channel link=”https://t.me/s/upsctree” text=”Join @upsctree on Telegram”]Ovett waved to the crowd and raised a hand in triumph. But he had celebrated a bit too early. At the finishing line, Ireland’s John Treacy edged past Ovett. For those few moments, Ovett had lost his sense of reality and ignored the possibility of a negative event.
This analogy works well for the India story and our policy failures , including during the ongoing covid pandemic. While we have never been as well prepared or had significant successes in terms of growth stability as Ovett did in his illustrious running career, we tend to celebrate too early. Indeed, we have done so many times before.
It is as if we’re convinced that India is destined for greater heights, come what may, and so we never run through the finish line. Do we and our policymakers suffer from a collective optimism bias, which, as the Nobel Prize winner Daniel Kahneman once wrote, “may well be the most significant of the cognitive biases”? The optimism bias arises from mistaken beliefs which form expectations that are better than the reality. It makes us underestimate chances of a negative outcome and ignore warnings repeatedly.
The Indian economy had a dream run for five years from 2003-04 to 2007-08, with an average annual growth rate of around 9%. Many believed that India was on its way to clocking consistent double-digit growth and comparisons with China were rife. It was conveniently overlooked that this output expansion had come mainly came from a few sectors: automobiles, telecom and business services.
Indians were made to believe that we could sprint without high-quality education, healthcare, infrastructure or banking sectors, which form the backbone of any stable economy. The plan was to build them as we went along, but then in the euphoria of short-term success, it got lost.
India’s exports of goods grew from $20 billion in 1990-91 to over $310 billion in 2019-20. Looking at these absolute figures it would seem as if India has arrived on the world stage. However, India’s share of global trade has moved up only marginally. Even now, the country accounts for less than 2% of the world’s goods exports.
More importantly, hidden behind this performance was the role played by one sector that should have never made it to India’s list of exports—refined petroleum. The share of refined petroleum exports in India’s goods exports increased from 1.4% in 1996-97 to over 18% in 2011-12.
An import-intensive sector with low labour intensity, exports of refined petroleum zoomed because of the then policy regime of a retail price ceiling on petroleum products in the domestic market. While we have done well in the export of services, our share is still less than 4% of world exports.
India seemed to emerge from the 2008 global financial crisis relatively unscathed. But, a temporary demand push had played a role in the revival—the incomes of many households, both rural and urban, had shot up. Fiscal stimulus to the rural economy and implementation of the Sixth Pay Commission scales had led to the salaries of around 20% of organized-sector employees jumping up. We celebrated, but once again, neither did we resolve the crisis brewing elsewhere in India’s banking sector, nor did we improve our capacity for healthcare or quality education.
Employment saw little economy-wide growth in our boom years. Manufacturing jobs, if anything, shrank. But we continued to celebrate. Youth flocked to low-productivity service-sector jobs, such as those in hotels and restaurants, security and other services. The dependence on such jobs on one hand and high-skilled services on the other was bound to make Indian society more unequal.
And then, there is agriculture, an elephant in the room. If and when farm-sector reforms get implemented, celebrations would once again be premature. The vast majority of India’s farmers have small plots of land, and though these farms are at least as productive as larger ones, net absolute incomes from small plots can only be meagre.
A further rise in farm productivity and consequent increase in supply, if not matched by a demand rise, especially with access to export markets, would result in downward pressure on market prices for farm produce and a further decline in the net incomes of small farmers.
We should learn from what John Treacy did right. He didn’t give up, and pushed for the finish line like it was his only chance at winning. Treacy had years of long-distance practice. The same goes for our economy. A long grind is required to build up its base before we can win and celebrate. And Ovett did not blame anyone for his loss. We play the blame game. Everyone else, right from China and the US to ‘greedy corporates’, seems to be responsible for our failures.
We have lowered absolute poverty levels and had technology-based successes like Aadhaar and digital access to public services. But there are no short cuts to good quality and adequate healthcare and education services. We must remain optimistic but stay firmly away from the optimism bias.
In the end, it is not about how we start, but how we finish. The disastrous second wave of covid and our inability to manage it is a ghastly reminder of this fact.