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It ain’t broke

Avoid the wrong lesson from the financial crisis

Written by Jaithirthrao |
October 6, 2008 12:07:52 am

In the ‘50s, the Soviet Union put a Sputnik into space and initiated humankind’s first journeys beyond the earth’s atmosphere. This event combined with the Soviet Union’s prowess in many areas like science, technology, military capabilities, athletics (they used to win dozens of Olympic medals), chess and so on dazzled the Indian elite. We got convinced that the Soviet model was the right one if we wanted to become a developed nation. We rejected markets and went in for our own imitation version of Soviet-style central planning. The now infamous “permit-licence raj” was seen as progressive. Those who championed individual initiative, entrepreneurial efforts and market-friendly economics were dubbed as reactionaries. The so-called Bombay school of economics was discarded in favour of the noises emanating from the schools of Delhi and Calcutta. Prof Shenoy was forced out of the Planning Commission for warning about the dangers of the statist planned model.

Over the next few decades as the countries of the Far East successfully eliminated poverty, we got stuck with the proverbial Hindu rate of growth and all we were able to produce was the anti-poverty “garibi hatao” slogan. It is important to remember that in the ‘50s, South Korea’s wealth and income situation was comparable to India’s. Now they are some twenty times ahead of us.

The short-lived achievements of the Soviet Union were based not only on the foundation of great human misery (millions died during the forced collectivisation embarked on by Stalin), but was destined to implode as it was characterised by the complete absence of timely information feedback. Markets are seemingly anarchic. But through price signals they communicate powerfully on a continuous basis allowing producers, consumers and investors to calibrate their decisions to achieve a level of optimality far superior to that which the self-appointed pundits of any central planning commission can device and certainly beyond anything that they can implement.

Today, we are confronted not so much with Soviet success, but the crisis caused by excesses in the Western capitalist world. It is therefore tempting to discard the market-friendly model and our quest for economic reform and go back to renewed emphasis on state control, nationalisations and so on. That would be the wrong conclusion. No one denies that booms and slowdowns are embedded into capitalist economies. They are referred to as business cycles. But the important thing to note is that they have in them an in-built self-correcting mechanism. Markets sometimes give harsh messages. This results in mid-course corrections. In the Soviet Union, no harsh messages could be conveyed to the ruling elite for years on end until the system broke.

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The recent happenings in the global economy show the pendulum’s amplitude in the business cycle getting extended. Instead of a boom, we are faced with a bubble. Bubbles are a weakness of the market system. But the system cannot be judged as bad because of this weakness. We need to see what happens over a period of time as the consequences of both the positive and negative features are wrung out. If we consider long-term secular trends, the market system comes out ahead in terms of wealth creation and poverty elimination. If stock market wealth drops by 50 per cent in six months, we get concerned. We conveniently forget that it went up by 200 per cent over the previous two years. At the end of 30 months we are still 150 per cent ahead. It has been repeatedly shown that over a person’s earning and saving lifetime, regular monthly investments in the stock market always outperform investing in so-called safe government securities even taking into account the volatility of the ups and downs of equity. The right strategy to ensure that one has a financially sound retirement is to invest regularly in the equity markets, not to get scared and stick with so-called safe returns which will lead to capital erosion in the face of inflation, not capital preservation or appreciation.

No one is happy when bubbles happen and they burst. But to turn our backs on financial sector reform would be a retrogressive move. Remember that the British were able to prevail over the French in the 1700s because a well-developed London capital market enabled the British government to raise loans efficiently at modest cost. The French who even in those days were enamoured with state control were unable to do this and they descended into fiscal paralysis. We need a modern, open, transparent financial system. Along with this come some risks. Risks associated with “irrational exuberance” and “animal spirits”. When these get out of hand, we have the occasional crisis. But without these risks, we will have no growth, no prosperity. In the pursuit of risk-reduction we may end up with an outcome of too little risk-taking. Medieval Hindu society was dead set against risk. Individuals were supposed to follow the occupations of their ancestors and not try out anything new, anything outside of tradition.

They were not even encouraged to travel abroad. We certainly had a stable low risk society. Please note: such stability is synonymous with a stagnant state of affairs. Is that what we want going forward?


It is a delicate balancing act to ensure that as a country we tread a path that makes sure that entrepreneurial risk-taking and an exuberant financial system co-exist with regulations of transparency and sobriety — but not rules that strangle and stultify. We must not repeat the mistake of the ‘50s and go in for a permit-licence raj in the financial sector. Western capitalism will live through the present crisis and ten years from now global stock markets would have recovered and climbed new heights. If we straitjacket ourselves by stopping the engine of financial sector reform, once again we will be left behind by the Koreas of tomorrow and once again we will postpone by several generations any possibility of eliminating “garibi” in our land. In these challenging times our political leadership should have the courage to reform steadily and with steadfastness.

The writer divides his time between Mumbai, Lonavla and Bangalore

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First published on: 06-10-2008 at 12:07:52 am

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