Internal And External Liquidity Crises
Both landed up in Delhi this Christmas. Professor Sen expressed views which he has often expressed before. While they are worth expressing over and over again for Indias record in mass education and social welfare continues to be shameful they have been well publicised. I was myself intrigued by some of the things Jagdish Bhagwati said. They seemed inconsistent with the liberal views he has always espoused; they made me think.
He said that opening up of trade was good, including opening of trade in services. He was for permitting foreign investment in financial services such as banking and insurance. But he was against uncontrolled movement of capital. An economy may be opened up to capital movements, and may grow faster with the help of capital inflows, often for decades. But suddenly foreign investors perceived risk may shoot up, capital flows may be reversed, and the economy may go into a crisis because the flows of goods and services do not reverse themselves with equal ease to permit repatriation of capital. This is what happened in India in 1990; it happened in Mexico in 1995, and in Korea, Thailand, Malaysia and Indonesia in 1997. The only way a current account surplus can be generated to permit the capital outflow required by foreign investors is by deflating the economy so much that its imports shrink enough below exports. The more import-intensive the exports, the less sensitive will the balance of payments be to changes
in the level of domestic activity, and the greater the shrinkage in domestic production and employment required to improve the current account. The only way to reduce the pain is to borrow from someone to pay off the panicky foreign investors; and International Monetary Fund and World Bank are available for such emergency lending. But they too will want to make sure they get their money back; besides, they must convince other investors and lenders that the economy will be able to sustain capital outflows within a short time. So they will impose an austerity programme on the affected economy which would enable it to repay over a somewhat longer period. Thus, if they reduce the pain, they also prolong it. With or without their help, there is no painless adjustment to sudden reversals of capital inflows.
So in these crises, who is the demon? For communists, it is the Bretton Woods twins; they impose heartless austerity programmes. But their programmes are designed to postpone pain, not to increase it. That is why even communists will turn to the Fund and the Bank when the economy gets into trouble. It was the finance ministry under Dandavate, Shukla and Deepak Nayyar, that went first to the Fund in the 1990 crisis; Manmohan Singh and his team came in much later, when the leftists had already run through the first easy tranches. The Fund and the Bank are firefighters; they get the blame because the forest fires are uncontrollable or, some may argue, because the Fund-Bank firefighting techniques are primitive.
A leftist who accepts this argument would still blame the market market is a dirty word in Marxist lexicon. Competitive markets not all markets are devices for allocation which require less direction, information and judgment than more dirigiste alternatives; for that reason they are preferable. But at times, there will be situations when markets that are structurally competitive work like monopolistic markets. If there is an irremediable excess demand for something, buyers will want to stock up, and their efforts to accumulate stocks will accentuate the shortage. This is how the market for cars or scooters has often operated in India: since imports are not allowed, demand often outruns supply, anyone who can get hold of a car can make a profit by reselling it, financiers rush to corner supplies, and the shortage is accentuated. Similarly, if a country is running a trade deficit, there is no way it can suddenly generate the trade surplus required to finance a capital outflow. Once foreign investors realise this, those who take their money out first will have the best chance of taking it out without exchange loss. So all will rush to take their investment out, and that will cause a balance of payments crisis. Here, it is not the market that is the demon; it is commodities in fixed supply, or markets in which supply and demand are interdependent and inversely correlated.
This brings me to Bhagwatis demon the Wall Street Treasury complex. In his view, the big financial firms of New York would like to see full capital convertibility everywhere, because they can then extend their business to other countries. Robert Rubin, US Treasury Secretary, comes from the Wall Street, so he promotes its interests by using his influence to make other countries go convertible.
This is not, however, in the interest of the host countries who would be exposed to instability by full convertibility. So Bhagwati is in favour of controls on capital flows, especially on short-term capital movements.
Is this enough? Can long-term capital movements not cause crises? Bhagwati himself pointed out a way in which they could. There are commodities other than exchange which are subject to fixed or inelastic supply. If capital, whether local or foreign, moves into such assets, it can lead to cumulative price spirals, or asset bubbles as they are called. There was an asset bubble in the Indian stock market in 1992, and there have been asset bubbles in property markets in South-east Asian countries in the past year. When players come to the view that the spiral cannot last, they will start selling, and their sales will lead to a downward spiral. If they have borrowed to buy the assets, they will become unable to repay their debts, and their creditors also will run short of cash. Thus a contagion of illiquidity and bankruptcy will spread through the economy.
Thus, there are two types of crisis an economy may run into: an external and an internal crisis. The mechanism of both is very similar, and both may occur together. For both, the remedy after they have occurred is bitter so bitter that there will always be leftists to say that death would have been better than the cure. But a people cannot die; it can only suffer. Hence prevention is better than cure. There is no foolproof way of preventing crises, but governments must try.