Mains Paper: 3 | Economic Development
Prelims level: 2008 financial crisis
Mains level: 2008 financial crisis and its effect on Indian economy.
• The 10th anniversary of the collapse of Lehman Brothers, which pushed the global financial system to the brink of a breakdown.
• The fall of Lehman was a consequence of excesses built in the financial system over the years; if not Lehman, it would perhaps have been some other firm.
• After all, another large investment bank, Bear Stearns, had to be bailed out earlier in 2008.
• Ten years after the financial crisis, the biggest question is: Have those excesses been addressed well enough to guard against another crisis?
Addressing the 2008 financial crisis
• The chairman of the Federal Reserve said in 2010, the financial crisis was an extraordinarily complex event with multiple causes.
• That said, the basic causality has been firmly established since: from interest rates that were kept too low for too long in the aftermath of the dot-com crash, pushing asset prices, rising housing prices that encouraged people to borrow with very little equity, to lenders stumbling into the trap of lending even to people who had no capacity to repay.
• In fact, interest rates had been trending down at least since the early 1990s.
• It when interest rates went up, defaults rose and the contagion spread via the subprime mortgages that investment bankers had sliced and diced into complex securities and sold across the world.
• The Fed didn’t see it coming but it was focused on the general price level and not asset price inflation.
• But it did act quickly once the crisis struck. It helped that Bernanke, a scholar of the Great Depression, was leading it.
• The US central bank reduced interest rates and flooded the system with liquidity.
• It effectively became the global lender of last resort.
• Ten years after the crisis, the US economy is growing at a strong pace and the Fed is in the process of reversing the crisis-era policies in a calibrated manner.
• But beneath the headline growth numbers and higher stock prices, there are several risks.
• For instance, rising asset prices are seen to have benefited only the rich and increased inequality. Arguably, this is one of the reasons for the rise of populism, which is practically threatening the very foundation of the post-war global economic system.
• Raghuram Rajan, former governor of the Reserve Bank of India and someone who famously foresaw the 2008 crisis, recently noted leverage and asset prices have built up again.
• Years of policy accommodation in the US and other parts of the developed world have increased debt. As the International Monetary Fund showed in its April edition of “Fiscal Monitor”, global debt in 2016 reached a new high of 225% of the gross domestic product.
Impacts on other countries
• China has been the driving force, low-income countries have also seen a significant increase in debt levels.
• Policy normalization in the US and the tightening of financial conditions in the global market are affecting a number of emerging economies and could become a risk for global growth.
• The global economy looks unprepared to deal with a significant reversal in growth.
• Apart from higher leverage, central banks in Europe and Japan are still working with crisis-era policy tools.
• It has not been able to create enough policy space to fight a serious downturn.
• Therefore, it is possible that systemically important central banks may find it difficult to fight another downturn in the next few years.
• It is likely that flooding the system with cheap money will have diminishing returns.
Impacts on India
• As the financial crisis showed, the Indian economy is far more integrated with the global economy than is commonly perceived.
• Economic growth in the financial year 2008-09 slipped to 6.7%, compared to 9.3% in the previous year. Although the recovery—backed by the fiscal and monetary stimulus.
• It was quick, it could not be sustained. In fact, the stimulus led to higher inflation and a wider current account deficit, resulting in a near currency crisis in 2013.
• Though India recovered from the shock, the strengthening of India’s macro fundamentals is a work in progress.
• For instance, the government has not yet been able to reduce its fiscal deficit to the pre-crisis level.
• Also, macroeconomic management has become more difficult for developing countries like India due to the global monetary non-system.
• The ongoing turbulence in the currency market is a consequence of the way policy has been managed in India and other parts of the world over the last decade.
• The 2008 financial crisis has not, after all, been consigned to history.
• It continues to cast a long shadow on the global economy.