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Global Financial Crisis:A Long Way from Recovery

While there are optimists who expect a revival in the economic downturn in the United States, a downturn which has had a negative impact on the emerging markets, the pessimists counter that there will soon be more financial turmoil as the housing crisis, credit contraction and losses worsen. With the balance heavily tilted towards the bearish case, this article argues that most economies and financial markets around the world are likely to be flat or down over the next few years.

COMMENTARYseptember 6, 2008 EPW Economic & Political Weekly16Global Financial Crisis: A Long Way from RecoveryIgnatius ChithelenWhile there are optimists who expect a revival in the economic downturn in the United States, a downturn which has had a negative impact on the emerging markets, the pessimists counter that there will soon be more financial turmoil as the housing crisis, credit contraction and losses worsen. With the balance heavily tilted towards the bearish case, this article argues that most economies and financial markets around the world are likely to be flat or down over the next few years.The global financial crisis, the worst since the depression of the 1930s, is unlikely to end soon. Since it began in mid-2007, the United States (US) econ-omy has had tepid growth. Some econo-mists say the US is currently in a recession, together with Japan and the European Union (EU). In fact, the Japanese economy shrank at an annualised rate of 2.4 per cent in the April to June quarter, while that in theEU fell by 0.2 per cent. The downturn in the developed countries has had an impact on other countries: growth in most emerging economies has slowed considerably. On the financial side, bank credit growth in the US contracted at an annualised 5.8 per cent rate in the April to June quarter, the largest drop since such data were first collected in 1947. This credit tightening has spread from the US, dampening eco-nomic activity at all levels and around the world. At one end, even solvent, high income Americans find it difficult to qualify for loans to buy a home. At the other end, several major projects in developing coun-tries have halted due to lack of equity and debt capital, including plans in India to add 90,000 MW of power capacity by 2012. Equity indexes in the developed countries are in a bear market, with declines of over 20 per cent. The losses are far mere severe in emerging stock markets, notably in the major ones of China and India.Housing CrisisSince the crisis was triggered by collaps-ing home prices in the US, it is likely to come to an end only after prices reach a bottom. Stable home prices “will clarify the level of equity in homes, the ultimate collateral support for much of the finan-cial world’s mortgage backed securities”, says formerUS Federal Reserve Bank (Fed) chairman Alan Greenspan [Green-span 2008]. Over $ 6 trillion of such secu-rities were created by Wall Street firms, by packaging individual home loans made in the US.1 Already some $ 500 billion in losses on these securities have been recog-nised by financial and other institutions around the world. But it is the fear of the size of the unrecognised losses, and its impact, that is crippling financial markets. President George Bush initially said that his government had no responsibility to bail out home owners, especially housing speculators. But, under pressure from Republican congressmen worried about losing their seats in the upcoming Novem-ber elections, the Bush administration has taken some measures. In July the govern-ment said it is explicitly backing the debts of Fannie Mae and Freddie Mac (the largest US housing finance companies), thereby ensuring adequate and cheap funding for these institutions, which together provide financing for 80 per cent of loans being cur-rently made to home buyers; most of the other 20 per cent is financed by the Federal against the real lending rate, ie, the real prime lending rate between 1980 and 2008. It depicts a clear negative relation-ship. As the rate of inflation goes up, what-ever be the response of RBI policies and pri-vate sector strategies, eventually real lend-ing rate actually goes down! It is well known that rising inflation, ceteris paribus, is a boon to borrowers; in real terms they have to pay back less than the initially con-tracted amount. If lending was inflation indexed, the real lending rate should remain the same before and after inflation. If the nominal rate adjusts less than the inflation rate, the borrowers must gain and that has happened in all the years. Whenever the rate of inflation increased, the borrowers mainly the business groups always retained some advantage from higher inflation.The problem is that the mythical story of a rise in interest eating into incentives to invest and hence paralysing growth, rotates around economic arguments developed in the pre-historic age of the discipline of Economics. For reasons obvious to many, much wisdom is dug out of its grave by the captains of modern day finance and technology experts for pressurising the government and creating policy paranoia of some sort. This also calls for a method of corporate accounting which must look into the “real” side of the problem. ReferencesBasudeb, Guha-Khasnobis and Faisal Bari (2003): ‘Sources of Growth in South Asian Countries’ in Isher Judge Ahluwalia and John Williamson (eds), The South Asian Experience with Growth, Oxford University Press, New Delhi.Marjit, S and K P Das (2008): ‘Financial Sector Reform for Stimulating Investment and Economic Growth: The Indian Experience’,ADB Volume, Oxford University Press, New Delhi (forthcoming).Nagaraj, R (2008): ‘India’s Recent Economic Growth’, Economic & Political Weekly, 43 (15).Subramanian, A (2008):India’s Turn: Understanding the Economic Transformation, Oxford University Press, New Delhi.Ignatius Chithelen ( is with Banyan Tree Capital Management, New York.
COMMENTARYEconomic & Political Weekly EPW september 6, 200817The Centre for Budget and Policy Studies, Bangalore has completed ten years of work in the area of local finances, planning and contributing with empirical data to the efforts by civil society and government to better governance and transparency. The CBPS works at the local level and its interface with higher levels of government and its work is based on primary data from panchayats and municipalities. We also work with secondary sources where required. CBPS believes in taking the results of its work back to the local areas for informed debate, and for its use in local planning.For more information, please log on to: To strengthen its team, the CBPS is looking for at least two senior scholars who will contribute to enriching its work in these and related fields in the coming years.The ideal candidates should have around 15 years of experience, with advanced degrees in economics, statistics, political science or other disciplines relevant to this field of study. They will be familiar with quantitative techniques, and be prepared for travel to remote areas not just for data collection, but also for dissemination of the results of the research and participation in local planning exercises. They will be expected to work independently, to formulate proposals for funding, and to implement projects of the Centre.The positions are based in Bangalore. The Centre offers a salary packages that is comparable to the best in the NGO sector and will roughly equal the UGC scales. Health and accident insurance are provided. Please email your CV to, with “Research Position” in the subject line within a month of this advertisement.Housing Authority. A government guaran-tee is necessary since Fannie and Freddie are gravely undercapitalised, with the mar-ket value of their equity falling by more than 90 per cent over the past year to about $ 7 billion, while their debt exceeds over $ 5 trillion. The administration is offering tax credits of up to $ 7,500 to first time home buyers. Banks are also being encouraged to take a loss and reduce the size of loans to home owners, who have defaulted on their payments, in return for the repayment of the revised smaller loan being guaranteed by a government agency. Then, to try and boost overall consumer confidence and de-mand, in the second quarter the adminis-tration refunded $ 92 billion in income taxes to low and middle income Americans. In part due to these measures, the bulls argue that we are near the bottom of the crisis and that the global economy should pick up next year. The tax refund and other measures and the boom in exports, due to the weak dollar, helped the US economy grow by 1.9 per cent in the April to June quarter. Then the recent fall in crude oil prices, to $ 113 a barrel in mid-August from the July peak of $ 147, is a major cost sav-ing for consumers and businesses in the US and also worldwide. Rising crude oil prices are estimated to have added $ 112 billion in costs borne by American consumers in the 12 months ending June 2008. Greenspan AnalysisGreenspan and other analysts expect house prices to stabilise in the first half of 2009. But meanwhile, he says, rising stock markets are essential since “…the price of equities worldwide will determine whether the international financial system can maintain a modicum of stability as it eases out of the credit crunch or falls back into another period of angst and turmoil” [Greenspan 2008]. Estimates are that institutions exposed to mortgage securities will have to take an additional $ 500 billion to $ 1 trillion in losses. There is then the risk that a weaken-ing economy will trigger losses from defaults in other areas, especially consumer credit cards, commercial real estate and corporate debt. With losses destroying balance sheets, the affected institutions need to raise capi-tal, including from the government, to avoid bankruptcy. This then is the context for Greenspan seeking help from rising stock markets, while waiting for a housing rebound. He says, “...lower global stock prices could impede the recapitalisation of banks and other financial institutions. Debt issuance would also be suppressed as it lev-erages off the level of equity.”Greenspan does not disclose the specific mechanisms by which central banks and finance ministries can boost stock markets. His own actions, while running the Fed, are widely criticised for blowing a series of bubbles, including the frenzied speculation in US housing in 2005 and 2006. Credit AvailabilityOver the past year, the Fed and the other financial and regulatory authorities in the US have taken numerous steps to try and revive credit availability and boost finan-cial markets. The Fed funds rate, which typically determines the cost of borrowing in theUS economy, has been cut from 5.25 per cent to 2 per cent. The Fed has pro-vided additional billions of dollars in liquidity to banks and other financial insti-tutions, while also relaxing collateral requirements and extending the duration of such lending from overnight to three months. The US treasury department assumed potential losses on some of the liabilities of Bear Stearns taken on by J P Morgan Chase, when it bought the collapsing major investment bank. This saved Bear Stearns from bankruptcy, which will havetriggered defaults by other entities in the financial chain. The central banks and financial authorities in theEU, Japan and elsewhere have simulta-neously implemented steps to enhance liquidity, expand credit and boost their own financial markets. The bears argue that as the housing cri-sis, credit contraction and losses worsen, there will soon be more financial upheaval, including possibly the US government being forced to take over Fannie Mae and Freddie Mac.Falling Demand for HomesIn past recessions, cuts in the Fed funds rate have revived the economy in large part by boosting demand for housing and auto-mobiles, the two major consumer pur-chases. This time around, even as the Fed cut rates by 3.25 per cent over the past year, the cost of borrowing to buy a home has not dropped. The interest rate on a bench-mark 30-year home loan is around 6.7 per cent, roughly the same as a year ago. Then the managements of Fannie Mae and Fred-die Mac, in trying to avoid a government bail out and stay independent, are tight-ening lending standards and shrinking operations to profitable areas, thereby reducing overall demand forhomes.2
COMMENTARYseptember 6, 2008 EPW Economic & Political Weekly18Home prices in the US have declined by about 20 per cent from their 2006 peak, and by much more in Florida, Las Vegas and other areas that saw wild speculation. This price drop though has not fuelled demand growth. House prices have to drop by at least 20 per cent more to reach levels where renters will find it attractive to switch to buying a home. It is likely though that home prices will drop much further. Typically, after speculative bub-bles burst price declines wipe out all the preceding gains and more before the market bottoms. In past economic cycles in the US, rising unemployment led to a fall in housing demand. This time around, demand began sliding in mid-2006 while the job market was still strong. Since then the unemploy-ment rate has risen, from 4.4 per cent in 2007 to 5.5 per cent in July 2008. Rising job losses can only mean further weakness in housing demand. On the supply side, the overhang of sin-gle family homes in theUS is estimated to be around 1.8 million units, nearly double the inventory during the pre-boom era of the late 1990s. This data may understate the level of excess supply on the market, since many sellers have withdrawn their homes from the market. Rather than sell at a smaller profit or a loss in the current market where prices keep falling, they expect to sell for higher prices as demand picks up in the future. In the case of automobiles, the more than doubling in the price of gasoline in a year, to around $ 4 a gallon, the reduced wealth effect from falling home prices and a weak-ening job market led to a 28 per cent con-traction in sales during the first half of 2008. Car and light truck sales in July 2008 were running at a 12.5 million annual rate, the lowest level in 17 years, and down from the 18 million peak rate in 2005. Till about a year ago, light trucks were more popular than cars with American consumers, despite having anywhere from a third to half the fuel efficiency of a car. Demand for light trucks in July was at a six million annual rate, half the level in 2005. Threat of Stagflation?Inflation in the EU has climbed to 4 per cent. So far the European Central Bank has not cut its benchmark interest rate, now at 4.25 per cent, for fear of fuelling further rises in inflation. In the US, inflation is run-ning at around 5 per cent and yet the Fed cut its funds rate to 2 per cent. This shows, some analysts say, that the Fed is not fight-ing inflation and so the US will soon face stagflation, as it did in the 1970s. Others argue that the US will not see stagflation, as there is little chance of a wage price spiral: employees seeking and getting higher wages to compensate for ris-ing prices and on and on. Indeed, the abil-ity of labour to demand higher wages in most parts of the US economy is weak due to the relatively high level of unemploy-ment and underemployment throughout the current economic cycle, the outsourc-ing of jobs and the continuing decline in union enrolment and bargaining clout. The risk of a wage price spiral causing stagfla-tion may be higher in Canada and some of the EU countries, like Germany and France, with their relatively rigid labour markets. But inflation could continue to rise in theUS, especially given the large external and domestic debt, fed by growing trade and budget deficits. Based on his research on the history of financial crises, Kenneth Rogoff, a former chief economist at the International Monetary Fund (IMF), points out that “…governments in every corner of the world showed themselves perfectly WORKSHOP ON ECONOMETRIC METHODS AND USE OF ECONOMETRIC SOFTWARES IN INTERNATIONAL TRADE RESEARCHMizoram University is organising workshop on “Econometric Methods and Use of Econometric Softwares in International Trade Research” under UNCTAD-DFID-GOI project on Strategies and Preparedness for Trade and Globalisation in India during 27-31 October, 2008. The objective is to train/enhance skills of university/college teachers involved in teaching international economics and other researchers undertaking empirical research in international trade. Ph.D scholars, currently doing research on trade issues, will also be allowed to participate. Interested persons may apply giving particulars such as Name, Areas of research, Name of Institution, Email Address, Postal Address, Fax Number, Phone Number and brief Profile/Bio-Data) on or before 1 October 2008 to Prof. Lianzela at TA and DA will be given to selected participants as per UGC/ university’s rule. capable of achieving very high rates of inflation long before they had the assist-ance of modern unions”.3 In addition to uncontrolled inflation in the developed countries, there are the risks of unfore-seen events, like geopolitical problems, a run on the dollar and growing protectio-nist policies, that can further hurt the global economy. ConclusionsAny further weakness in the developed economies will impact most emerging countries, especially those dependant on commodity exports.4 Already, due to the economic slowdown in the US, Europe and Japan, prices of most commodities have fallen sharply from the highs reached early this year. According to the bullish view, as the numerous corrective measures taken by theUS and other developed nations begin to take effect, global financial markets – and with it the global economy – will soon revive. The bears counter that there will soon be more financial turmoil, as the housing crisis, credit contraction and losses worsen. With the balance of these opposing trends heavily tilted towards the bearish case, most economies and finan-cial markets around the world are likely to be flat or down over the next few years.
COMMENTARYEconomic & Political Weekly EPW september 6, 200819It is inconceivable that Shiv Sena and Bal Thackeray financed the Communist Party of India (Maoist), but that is part of the confession extracted through narco-analysis of Arun Ferreira, alleged to be a member of the latter party. Narco-analysis is torture, both physical and mental. No wonder that India is yet to ratify the UN Convention against Torture which came into force on June 26, 1987. In May 2007, the Indian police arrested four political activists from a public ground called Diksha Bhoomi in Nagpur. It was alleged that they were activists of the Communist Party of India (Maoist) – CPI (Maoist). The CPI (Maoist) has been banned under the Unlawful Activities (Prevention) Act.The police subjected all the four activ-ists to torture, both physical and mental. In addition, the police subjected them to certain tests – narco-analysis, polygraph and brain mapping. Narco-analysis is the most invasive of all the three. In this case, the police take the subject to a forensic science laboratory where certain drugs are administered to him/her, the names of which are not disclosed. Such practices are very common in India. It is worth remembering that the US does not con-duct such tests even in Guantanamo.The laboratories where such tests are conducted claim that the administration of such drugs puts the subject into a trance, akin to deep hypnosis. Hypnosis is a state which resembles sleep; it is induced by a hypnotiser whose suggestions are readily accepted by the subject. In the case of narco-analysis, there is no hypnotiser. The drugs hypnotise the subject. But the drugs cannot make suggestions to the subject. So there is a human agency to make the suggestions. The government claims that in such cases, the suggestions made are based on reliable information. This so-called reliable information obvi-ously comes from the police. A forensic laboratory does not have its own source of information.Narco-Analysis Is TortureLet us examine one particular case in this context. One of the four arrested was one Arun Ferreira. Narco-analysis was con-ducted on him. His mother applied for a copy of the report regarding the test under the Right to Information Act. The forensic laboratory replied that they could not comply with her request on the specious plea that the result of the analysis was only a part of the police investigation and not a part of the evidence in his trial. Then Ferreira himself wrote to the laboratory. After all, the test had been conducted on him. He had a right to know what sort of test he was subjected to. He also told the authorities that he would move the Bombay High Court to issue a writ to the government to disclose the result of the tests performed on him. Under pressure the laboratory conveyed to him the result of the tests.The person who was in charge of the tests was a doctor, one S Malini. She said that a person who is under the influence of narcotics called “truth serum” cannot think or imagine because the highest point of his brain is knocked out by the drugs. The subject can talk only of the things which he/she knows. He/she cannot con-coct or fabricate stories. That is why the combination of the drugs administered is called “truth serum”.We will proceed taking the statement of the doctor at face value. At one place Arun Ferreira says that the Shiv Sena and its leader Bal Thackeray financed the CPI (Maoist). Shiv Sena is a fascist Narco-Analysis and the Indian Criminal Justice SystemP A SebastianHowever, if inflation surges in theUS and other developed countries or if there are unforeseen shocks, financial markets are likely to decline sharply and the economic crisis will be very severe. Notes1 For an analysis of the factors behind the US housing collapse and its impact see Chithelen 2007.2 In this context, highly successful investor and philanthropist George Soros points out that FannieMaeand Freddie Mac are “public/private partnerships in which the risks are borne by the public sector while the profits accrue to the private sector: management and share holders.” See Soros 2008.3 See Rogoff (2008). Also, Rogoff and Reinhart (2008a), Rogoff and Reinhart (2008b).4 For a discussion of why the economies and finan-cial markets in most emerging countries will not de-couple from the US and other developed coun-tries, see Chithelen 2008.ReferencesChithelen, Ignatius (2007): ‘Central Banks and Speculative Froth’, Economic & Political Weekly, November 24. – (2008): ‘Emerging Markets: A Time to Cash In’, Knowledge@Wharton Website, April 2.Greenspan, Alan (2008): ‘The World Must Repel Calls to Contain Competitive Markets’,The Financial Times, August 5. Rogoff, Kenneth (2008): ‘The World Cannot Grow Its Way Out of This Slowdown’,The Financial Times, July 29.Rogoff, Kenneth and Carmen Reinhart (2008a): ‘This Time Is Different: A Panoramic View of Eight Cen-turies of Financial Crises’, manuscript, Harvard University, April 16.–(2008b): ‘The Forgotten History of Domestic Debt’, manuscript, Harvard University, April 17. Also available as National Bureau of Economic Research (NBER), working paper 13946.Soros, George (2008): ‘A Danish Fix for America’s Mortgage Debacle’,The Financial Times, August 11.P A Sebastian is a lawyer and democratic rights activist based in Mumbai.

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