Last week, I had argued that the developments in financial markets last year, and the volatility of all asset prices point to the limitations, indeed failure, of the God of Market Fundamentalism. Too many economists have fallen prey to the efficient market hypothesis, and the ability of the markets to produce the right prices. The argument that markets are always right and any intervention in their functioning is a sin, leads to the corollary that the real economy must adjust its costs and realisations to whatever price the speculation-dominated market produces. (One example: should investors in, say, alternative energy resources evaluate projects on the basis of an oil price of $150 or $40, that too within a six-month period?) The underlying assumption is that market participants are rational, taking up or unwinding positions based on their analysis of economic fundamentals and developments. This is a great myth. For one Warren Buffett, there are a thousand trend-followers, leading to overshooting of prices in either direction: you keep playing the game as long as the music continues, as Citibank’s then Chairman said last year, just before the music stopped.
Arguing that currency markets have become too “efficient”, Nobel Laureate James Tobin had proposed a tax on transactions which would help mitigate the huge gyrations. It went nowhere: there are too many powerful vested interests in the financial economy which benefit from exchange rate volatility. The fact is that the virtues of fully-floating exchange rates were being trumpeted by Wall Street interested more in earning trading profits, than in the implications for the broader, “real” economy. As the last year’s experience evidences, Wall Street itself never knew the value of what it was investing in and the whole world economy is paying the price of its arrogant foolishness and greed, through huge loss in jobs and output, including in countries least able to bear them.
Exchange rates have become one of the most important variables for the real economy in an era of globalisation. Businesses can go bankrupt when sudden and sustained real exchange rate appreciation caused by speculative capital flows, makes their costs uncompetitive. Companies and jobs are destroyed and it is difficult to see what is “creative” about such destruction. But believers in the market will never accept the need for managing exchange rates. Keynes of course had a different view: “These criticisms do not mean that I have weakened in my advocacy of a managed currency or in preferring stable prices to stable exchanges. The currency and exchange policy of a country should be entirely subservient to the aim of raising output and employment to the right level.” (from his open letter to President Roosevelt in late-1933). The last year’s gyrations have reconfirmed my belief in the virtues of managed exchange rates aimed at raising output and employment; that fully-floating exchange rates benefit only currency traders, at the cost of the real economy. To be sure, managing exchange rates can entail some costs. But these costs, in my view, are far less than these of grossly misaligned exchange rates.
Full float of a currency was justified on another ground: the famous “impossible trinity” of independent monetary policy, managed exchange rate, and full convertibility on capital account, as argued by Nobel Laureate Robert Mundell. The unstated assumption underlying this justification was that full convertibility was a highly desirable objective, notwithstanding the fact that there is little empirical evidence suggesting positive correlation between a liberal capital account and economic growth. In fact, capital account accountability (CAC) too was a Wall Street conspiracy supported by the US Treasury, with the IMF/World Bank meekly following, as argued by Dr Jagdish Bhagwati a decade back: too many of us accepted the virtues of CAC as being self-evident!
Fully floating exchange rates are not integral to globalisation of goods, services and investment capital: on the contrary, exchange rate gyrations add to the risks of cross border trade and investment, and are therefore a negative factor as far as globalisation is concerned.
One of these days, the real economy may have to face yet another pernicious impact of the financial economy: spreads over benchmark rates for loans would fluctuate with the spreads in the credit default swap market. (The CDS market, where spreads are determined by traders, is highly speculative). Such a change would be a classic example of the proverbial tail wagging the dog: in theory, CDS spreads are supposed to be determined by the credit premium for individual bonds over the risk-free rate. But what an opportunity for hedge funds! Short a company’s shares, buy CDS: done with enough financial muscle, the share price will fall and the CDS spreads rise, increasing the company’s interest costs, putting further downward pressure on the share and upward pressure on the CDS spread. The company may go bankrupt but the speculator would make good profit on his investment!
What about a free market economy and morality? I shall revert in a later article.
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