Insight Episode 5: Prof. Ashok Banerjee speaks on Financial Sector and the Economy at IIM Calcutta

Post 2008 because of the Financial crisis many sectors got affected. Finance of course was at fault and press reports suggested that whenever people lost their jobs in automobile, telecom, retail and other sectors, the non-financial sectors, there was sympathy for the people who lost jobs because it not only affects the life of the employee but also their family.  However post 2008 in the financial sector when there was a salary cut or people lost their jobs, people accepted with greet. They said that something good has happened and it is a good correction. So yes financial sector is one of the major players rather culprits for this. But you need financial sector because you need it to distribute risk.

Every business is exposed to risk and the best vehicle you have to spread the risk across a large number of people is financial sector. Otherwise, risk remains concentrated with a few institutions and when a crisis like that happens the effect will be much larger. Since the financial sector distributes the risk may be a larger size will be affected but the ticket size of the effect will be small. It is true that if anything abuses an innovation it affects adversely. Financial sector has done some abuse with some instruments which were designed to meet some purpose which was good.

In light of that, what do you think are the steps the European as well as the US governments have taken and how it has impacted the global financial sector?

The European economists have always been following the welfare economic state. Which means the state or the government had a role. So we saw huge investment programs, construction programs drawn by the respective governments. So there are many government led investments happening so this they think will spur the demand. It is more a government intervention in Europe. Whether it has paid a dividend is another issue, I am not coming to that. In the US, it is not fully government driven. It is true they have given the initial funding and if there are problems with the funding we say that why should government bailout big banks whereas to those who are losing jobs government is not doing anything. So in the US it is not only the government led measures but private sector has also contributed in terms of right-sizing the structure of the organization, cutting costs aggressively.

The beauty is the US is typically theirs is an entrepreneurial culture. Labour laws in the US are very flexible; they give the freedom to the organization to cut the labour force in recession and at the same time increase during boom. So in the US it is a highly elastic labour market. While in the UK or the other European countries it is not the case. Because of less flexible labour laws during downturn there is less paying for them and in upturn there are not many jobs being created because companies are like ‘If I take somebody, I have to retain that guy’. In the US it is not so. We have found historically that US have adjusted themselves much better than the European countries. What we saw in the US is there was a ruthless cut in the jobs and people lost their homes but they took it as a challenge and found out alternative ways. For example, Energy is the main driver of all these problems we saw (a lot of speculation was going on in the energy markets). When the crude oil price reached about $140 per barrel at that time, a lot of government sponsored investments happened in finding out alternative sources of energy.

In short, the way US responded to the crisis is through the 3 Cs. The first is Control; you saw Dodd Frank Act coming trying to put control on the financial sector as a whole and mostly on the banks. This present practise of accounting ring fencing between the investment arm and the loan arm should go. So investment bankingshould be separate from the traditional banking. The second C is compassion, only control will not work. The compassion was in the form of giving more money, the stimulus – financial incentives, bail out packages; that is the compassion. And the third C is competence. So those who survived this entire turmoil or who could turn it around are those who are competent. It is not that the entire financial sector has gone down. Those companies which were competent to handle risk survived. And the US always gives signal that only those who are competent will finally win. These are the three Cs they applied to take care of the risks other than what Europe has done which is mainly state driven. Europe did not have all the other weapons to handle the crisis which is why it is still under crisis. US by and large as come out of the crisis, only problem it is facing is employment. Otherwise they are growing and their GDP is again showing up.

What do you think has been the impact of these policies globally?

We have talked about Europe and US which are like the major two continents or parts of continents covered. But if you look at the emerging markets – the other part of the Globe, India in particular. We have been saying that emerging markets are growing at a much faster pace, so it does not matter much; we are a bit de-coupled from the Global crisis so it would affect us although not as much or as painfully as it did the developed nations. However that is not the case. If you look at China, their entire model was export-led. Their growth story came from exports. Their domestic purchasing power was very low. Now when the financial crisis happened, the importing countries reduced their imports and that started affecting China. So China was very smart and improved the wages of their domestic workers so that they can create domestic demand. So today they are looking at local market. They have realized that export market will not be booming in the way it was earlier.

In India the problem is that of policy paralysis. China is a commanding economy. If you like it or not when a policy is drawn, it is executed fast and decisively. In India we keep on discussing and fail to execute. So the Indian problem was different. It is not that we were too much dependent on export. We had the population to support the domestic demand. Our problem was uncertainty in governance.

Still, a lot has been said about the resilience of the Indian Economy especially in the light of this crisis. But the recent events like the rupee devaluation or the problem with regard to inflation lead us to think otherwise. So do you think form the macro perspective, India has done well?

If you see the financial sector, the way other countries’ financial sectors were affected post crisis, India’s was less affected. That is because we did not have so many innovative products. We were late in innovating financial instruments. For that we have to give a little credit to the RBI because the Central bank did not allow us or the Indian Corporate Banking sector to offer too many exotic products. So when the CDAs and the other things failed, India was not affected that much because our exposure to those synthetic products was limited. This is on one side. Fundamentally speaking if you see Indian Economy as a whole, the data does not say that we are facing a serious crisis. Look at our GDP growth rate even at 5% or so it is not that bad. The only problem rather paradox we have is Inflation versus growth. There is no one answer here and these are two major schools of thought. I think that India has not yet found out the answer to handle these two.

Once there was a kind of demarcation that RBI will only handle inflation by changing the money supply and the rates and government will look at the growth part. But what you see now is government policy is affecting inflation and growth is not happening because of policy paralysis. So on one hand if RBI takes some steps to smoothen the inflation rate by controlling interest rate, government comes up with a dole out package like food security bill or minimum wage or NREGA. All these social welfare schemes are good but they have a bearing on the purchasing power of people and hence the inflation. So whatever RBI is trying to do it is getting negated by some policies of the government. So government rather than spurring growth is affecting inflation. So recently we have seen the RBI governor saying ‘Let the Parliament decide or the government tell us this is the psychological level of the inflation rate and leave it to us to control it’.

So, that is it for today. See you again for the next episode of Insight. Thank you.