NAYAK: Savior of capitalism

OPINION:

OP-ED:

Long live John Maynard Keynes and Keynesianism. Known as the savior of capitalism for retrieving it out of the quicksand of the 1930s, the legendary British economist and his rule book had to be referenced once again by the policymakers to deal with the current financial imbroglio gripping the U.S. and global economy. Despite the miraculous post-war economic prosperity and sweeping institutional changes over the span of more than half a century to suit the brave new world, the Keynesian philosophy still remains in tact, undeterred by the ravages of time.

Capitalism continues to suffer from systemic cyclicality and needs government action in times of major distress that result from the swings of markets. Unorthodox government intervention alone can save capitalism from its crisis. The theory of an automatic correcting mechanism of capitalism is once again negated. It also reinforces the view that the chariot of capitalism needs an accomplished charioteer (regulator). Prudential regulation is the only panacea for ensuring that the chariot of capitalism and its financial system are running on the safe and constructive path.

The government’s $700 billion bailout — to acquire mortgaged-backed securities that have become illiquid causing this financial crisis — is one of largest in global history. This follows the earlier takeover by the government or nationalization of the failing AIG by authorizing an $85 billion line of credit from the Fed in exchange of 80 percent of its equity, and later of Freddie Mac and Fannie Mae, marking it a historical landmark in the evolution the global economy and system. The collapse of Lehman Brother and take over of Merrill Lynch by the Bank of America — two legendary investment banks, icons of the Wall Street and torch bearers of American capitalism — and other events demonstrate that, despite all the Keynesian tools and monetarist measures at its disposal, the U.S. economy still continues to be subject to recurrent damage by one of weakest spots of the capitalist system: its inherent cyclicality.

The U.S. economy continues to remain vulnerable to the vicissitudes of investment and credit cycles — from the 1987 Wall Street crash to the current housing-loan trauma. The U.S. economy has passed through the 1991 savings and loan crisis, the 1994 Mexican Tequila, the 1997 Asian Drama, the 1998 Russian Roulette, the 2000 Hedge Fund Long Term Capital Management Fiasco and the 2001 dotcom boom and bust. It took a long pause and hence the magnitude of the current burst is much larger and historically the biggest.

The economic policy responses by the Fed and the government have been a commendable and judicious mix of both monetary and fiscal measures. The loan window of the Fed has not only pumped much-needed liquidity nearing a trillion dollars into the system, following the record write offs by the banks, but also avoided a larger bank failure, which is too costly for the system. However, despite the exemplary macro-management of the environment, micro-level eruptions are threatening the stability of the financial system from time to time. These financial volcanic eruptions reflect the systemic lacunae in management at the micro-level comprising inadequate supervisory framework and the absence of an early alarm system.

The recent crisis manifests certain systemic lacunae in the financial system and economy. The economy continues to be vulnerable to the cyclicality of investment and credit where excesses finally lead to downturn and failures. Due to the earlier low-interest rate policy, the “risk” became the most undervalued asset leading to sloppy risk management. The rating agencies also seem to have undervalued risks in many securitized mortgage debt instruments. The investment banks and hedge funds that dominated the collateral mortgage debt securities also remained beyond the supervision of the Fed and the Securities and Exchange Commission. The synthetic securities and products markets have been the playground of hedge funds and speculators more than pure hedge operators who have real transactions in the securities, commodities or financial markets to be hedged. The predominance of these players, and the enormous growth in synthetic trades, amplified the volatility of the futures markets, which in turn influence the spot and delivery based markets.

Better disclosures and stricter regulation of the futures markets and their participants will go a long way toward imparting resiliency and stability to the delivery based financial and commodity markets. More efficient micro-management of the financial system is needed to complement the macro measures in ensuring the sustained financial stability of the markets.

Satyendra S. Nayak, an author, is professor of banking, finance and economics at Center for Advance Research in Banking and Finnace at ICFAI Business School.