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The end of capitalism ?

Mirza Azizul Islam
MANY analysts view the current global financial crisis as a failure of market-based capitalist principles. Some have gone to the extent of speculating that the failure will lead to die re-emergence of socialist economic management
It is evident that the failure of financial markets is the principal villain in the story of the present cnsis. That the financial sector is prone to market failure and associated booms and busts is well-known. There are certain inherent characteristics of financial markets which expose them to such volatility.
The first of these relates to asymmetry of information. Lenders know far less about the intrinsic solvency of the borrowers than the borrowers themselves. The risk assessment by lenders is thus imperfect, leading to assumption of excessive risks.
Second, financial sector is often characterised by what is known as adverse selection. Borrowers who gamble on high-risk, high-yield ventures offer higher return and are serviced by the financial institutions at the cost of good borrowers who would like to engage in low-risk, low-yield ventures.
Third, financial sector institutions tend to be pro-cyclical in their behaviour. During periods of rising demand and increasing asset prices, they push more credit, adding fuel to the bubble. Once the bubble bursts, they reduce the supply of credit, accentuating the downward spiral
of consumption and investment.
Fourth, there is a moral hazard associated with the financial institutions. Many of them, particularly systemically important bigger ones, thrive under the notion that they wall not be allowed to fail In the event they run into trouble, they will be bailed out by public authorities.
In view of the above characteristics, it is not surprising that even before the present crisis many countries including the US experienced quite serious financial sector problems, requiring large sums of public money for bail-outs or other corrective measures.
These included Argentina. Chile. Spain and the US in the 1980s and Finland, Indonesia, Japan, Malaysia, Mexico, Republic of Korea, Sweden. Thailand and Venezuela in the 1990s. What distinguishes the present crisis is not its severity, but its simultaneity affecting many countries at the same time -- a consequence of globalisation of financial markets.
There is no doubt that the primary cause of the present meltdown is the abject market failure in the financial sector. But the public authorities (both governments and central banks) cannot be absolved of their failure either. This occurred in several ways.
First, there was a complete lack of appreciation of the severity of risk exposure created by complex debt securities and newer types of financial institutions which did not conform to the norms of traditional banking practices. The result
was that the vast swathes of financial markets were left outside regulatory purview.
Second, the credit and asset bubbles were fuelled by loose monetary policies pursued over long periods of time in an apparently low-inflation environment.
Third, a related failure was that the regulators did not explicitly take into account the bubble of asset prices in assessing sustainability and the likelihood ofan impending burst.
Above all. the public authorities failed to draw lessons from the past experiences of financial crisis and to initiate preemptive measures. They woke up only after the manifestations in the forms of defaults, credit crunch, reduced consumption and investment, decrease in the production of goods and services and aggravated unemployment.
Ihe late awakening has elicited a wide variety of responses which fall into one or moreof the followingcategories:
• Reduction of central bank interest rates known variously as discount rates, policy rates etc.
• Widening categories of assets to be furnished as collaterals, including mortgage-backed securities, for borrowing from central banks.
• Expansion of types of institutions eligible for access to discount windows to include investment banks.
• Provision of cash loans to troubled financial institutions under new lendingprograms.
• Provision of financial support to facilitate mergers and acquisitions of weak financial institutions..
• Lengthening maturity periods of loans from discount windows.
• Provision of guarantees against poorly performingassets.
• Swapping of government bonds for hard -to-trade mortgage backed securities..
• Extended guarantee of bank deposits, rising upto 100 per cent in some cases.
• Assumption of liabilities of financial institutionsin the national budgets.
• Injection of new capital into financial institutions by governments/central banks.
• Full-scale nationalisation of selected financial institutions or quasi-nationalisation through injection of government capital.
• Loans to selected large-scale manufacturing industries, notably in the automobilesector.
• Large fiscal stimulus by both developed and many developing countries in the forms of reduction of income and consumption taxes, deferred payment of taxes by companies, cash grants to families and issue of shopping vouchers to increase consumption, government support for technological upgradation and workers' training, and vastly increased public expenditure on transport, energy, environment, health and education.
It is evident that the above responses are primarily aimed at: (i) improving the solvency of financial institutions and thereby enhancing their credit disbursement capacity, (ii) stimulating domestic demand for both consumption and investment goods and thereby demand for credit as well, and (iii) providing succour to hard-hit families.
There have been very few instances of nationalisation or quasi-nationahsation (notable among these are Fanny Mae, Freddie Mac, AIG and Citibank in the US and Northern Rock and Hypo Real Estate in the UK). Such cases have remained confined to financial institutions. No manufacturing concern has yet been nationalised.
nor is there any discussion towards this end. In fact, most of the measures so far adopted are in the nature of market enhancing or market strengthening.
What is likely to happen in the days to ' come is that the public authorities will take a harder look at their regulatory regimes affecting the financial sectors. A wider variety of institutions and instruments will be subjected to regulatory discipline. The institutional architectures for administering and monitoring compliance with the regulatory requirements at the national level maybe revamped.
In particular, there will be reforms to bring about greater centralisation of regulatory functions, or at least improved coordination among authorities in countries where multiple regulators operate. Some mechanisms may be put in place to facilitate greater exchange of information and perhaps even heightened cooperation among national oversight authorities.
There is some loose talk about establishing a new international financial architecture to complement or supplant the Bretton Woods institutions. But no concrete ideas have yet emerged. Similar talks in the wake of Asian crisis of the 1990s have led to no result beyond some swap arrangements among some East and South-East Asian countries. The chances of the emergence of a new international architecture which would require a consensus among large number of nations appear to be no brighter this time around.
To sum up, the reforms will remain largely limited to the financial sectors. 1 am convinced that the ideological zealots who may be dreaming of the re-emergence of socialism as reaction to the stress created by the market dominated systems are destined to be disappointed.
Mirza Azizul Islam, Ph D. is former Adviser to Caretaker Government. Ministries of Finance and Planning.