Some finance ministers now interpret the bizarre and incongruous outcome of American finance being abruptly nationalised (as if the US were Cuba or Venezuela) as proving beyond doubt that the credit of the State alone stands behind all finance at all times. To them, arguments about the disutility and sub-optimality of state-owned banks and financial institutions (such as those in India) dominating the financial system, and retarding it in the process, are hogwash.
But such ?logic? is suspect. The reason that the credit-standing of the State is activated to bolster the underpinnings of finance, when confidence has collapsed, is not that the State is always a better, wiser, safer, more efficient, manager of financial institutions or systems. It is rooted in the sovereign State (through its central bank) being the only entity that can legitimately create money and print currency; thus redeeming its financial obligations at face value by resorting to that expedient when necessary. Thus, the State?s intervention in extremis can restore public confidence in finance when it has collapsed, in a way that no other intervention can.
Unfortunately, the conclusion that, since the State?s credit underpins all finance, there is nothing wrong with State-owned institutions dominating financial systems at all times, confuses the ?in extremis? case for the ?steady state? situation. It is like believing that permanent intensive care is the normal steady state for human existence. But the opposite is true.
In ?normal? times (that now seem so distant), evidence around the world suggests incontrovertibly that State domination of finance is sub-optimal; even if it is falsely reassuring about the security of deposits. In other words, in extreme conditions?like the ones we are now going through?all financial participants may need bolstering by the credit of the State until confidence is restored and a semblance of normalcy returns. But if all financial participants were always bolstered by the credit of the State, what would eventually result is a Zimbabwe type situation. That certainly happened in the USSR when communism collapsed and may well happen in China as well as time unfolds. If India keeps going the way it is, that might happen in India too.
When you cut through all the niceties, finance is the only legitimate con-game in town. Without the confindence, the game ends and we revert to a barter economy. That was what Messrs Paulson and Bernanke were worried about when their gamble to let Lehman Brothers go bankrupt did not pay off. So, they switched from saving institutions to saving the system. They did the only thing left that they could do to stop further unravelling. That is not the same as financial system nationalisation and state financial domination Indian-style. Nor should it be seen as such. It is not a matter of preference but of necessity. The US has done this before on a smaller scale with savings and loans institutions and with New York City municipal obligations. But it has always reverted back to privatisation as soon as that is possible.
Whether what is being attempted will succeed is unknown. People are worried whether the $700+ billion Transfer of Assets Package (Tarp) will be enough. It will not address the fundamental problem of under-capitalisation that now afflicts almost every US financial institution. Value unwinding is so rapid and so uncertain, that it is leading to provisioning and write-downs which are draining net worth too swiftly, as mark-to-market valuation rules apply even when the market is not working or emitting the right price signals. Many reasonable people are worried that this measure and the fiscal burdens it creates may put at risk the US?s own sovereign AAA credit rating, which so far has underpinned the credit and credibility of the global financial system.
To most Indian commentators and the average Indian (aam aadmi or aam aurat), what this crisis shows beyond any doubt is how wise and omniscient our regulatory authorities and policy-makers have been. They were cautious and conservative (reassuring adjectives, compared to ?ignorant?, ?timorous?, ?traditional? or ?unimaginative?) in not upgrading our quintessentially Indian financial bullock-cart, for a modern automobile, because of the dangers of car crashes, and being taken for a high-speed ride by posturing financial geniuses. Too many in India who do not understand derivatives or securitisation now condemn these instruments as inherently dangerous.
There is a large part of India that will always think in this fashion. Not much can be done to change it without brain transplants and thought-bypasses on a massive scale. There is a large part of India that is against sophistication of any sort and inherently wedded to the crudest forms of traditionalism. It sees sophistication as ?western? and ?antediluvianism? as Indian. But can one hope that at least the part of India that is amenable to thinking straight, will not learn all the wrong lessons from this crisis and gloat over the inherent ennui and ?do nothingism? that saved India from being damaged by it?
The author is an economist and corporate finance expert. He chaired the high-powered committee on making Mumbai an international financial centre