The Need Of The Hour

Economist Prabhat Patnaik is part of a four-member group appointed by theUnited Nations to debate the consequences of the financial crisis and its impacton developing countries. The committee, headed by Nobel laureate Joseph Stiglitz,will submit its report at a UN discussion in early 2009 on reforminginternational financial organisations. 

This is the full text of his presentation at TheInteractive Panel of the United Nations General Assembly on the Global FinancialCrisis: The Present Crisis And The Way Forward

Discussions of the current world economic crisis tend to focus exclusively onthe bursting of the housing bubble in the United States. This no doubt is theimmediate cause of the crisis, but underlying its operation is the fact that thestimulus for booms in contemporary capitalism has increasingly come from suchbubbles. The U.S. whose size and strength make it, in the current regime oftrade liberalization, the main determinant of the pace of expansion of the worldeconomy as a whole, has increasingly come to rely on such bubbles to initiateand sustain booms. The dot-com bubble whose bursting had caused the previouscrisis was followed by the housing bubble which started a new boom. This has nowcome to an end, precipitating a major financial crisis and initiating what lookslike a major depression reminiscent of the 1930s.

John Maynard Keynes, writing in the midst of that Depression, had located thefundamental defect of the free market system in its incapacity to distinguishbetween "enterprise" and "speculation" and hence in itstendency to get dominated by speculators, interested not in the long-term yieldon assets but only in the short-term appreciation in asset values. Their whimsand caprices, causing sharp swings in asset prices, determined the magnitude ofproductive investment and hence the level of aggregate demand, employment andoutput in the economy. The real lives of millions of people were determined bythe whims of a bunch of speculators under the free market system.

Keynes wanted this link to be severed through what he called a comprehensive"socialization" of investment, whereby the State acting on behalf ofsociety always ensured a level of investment in the economy, and hence a levelof aggregate demand, that was adequate for full employment. This prescriptionentailed not only a jettisoning of the free market system in favour of Stateintervention, but also restraints on the free global mobility of finance, sincemeaningful State intervention could not be possible if the nation-Statefaced internationally-mobile capital. "Let finance be primarilynational", he had said, if the State had to have the autonomy to intervenemeaningfully in the economy.

The process of globalization, involving above all the globalization of finance,which began during the period of Keynesian demand management itself, hasundermined Keynesian demand management in the capitalist countries, and removeda whole host of regulatory measures that characterized the Keynesian regime.Boosts to aggregate demand have of late come increasingly from the stimulationof private expenditure, associated with the creation of bubbles in asset prices,rather than from an adjustment of public expenditure within the context ofreasonably stable asset prices. The reliance on bubbles in short has acted as asubstitute for the earlier regime of Keynesian demand management; it ismanagement through the creation and sustenance of bubbles rather than throughthe pace of public spending. Not surprisingly, the frequency of financialcrises, associated with the bursting of these bubbles, has increased greatlyafter 1973, and the capitalist world is even now headed for a major crash.

Governments in advanced countries have still not recognized this onset of acrash. They have proceeded on the assumption that the injection of liquidityinto the system is all that is needed. It was thought initially that thisinjection could be achieved through the government purchase of "toxic"securities, but widespread opposition to that scheme has now made mostgovernments accept the idea of injection of liquidity in lieu of equity, i.e.through the part-nationalization of financial institutions.

But injection of liquidity, even in this manner, is not enough. Credit will notstart flowing simply because banks can access more liquidity. There has to beadequate demand for credit for viable projects by solvent and worthwhileborrowers. And this is not happening. First, the injection of liquidity does notimprove the solvency of firms saddled with "toxic" securities, so thatthe risk associated with lending to them remains prohibitively high. Andsecondly, quite apart from this, the anticipation of a Depression makesborrowers chary of borrowing and lenders chary of lending.

This anticipation in turn derives from several factors: first, the bursting ofone bubble is not necessarily succeeded by the immediate formation of another,so that some recession of a more or less prolonged duration is in any caseinevitable. Secondly, the very scale of the current financial crisis is such asto entail an anticipation of a prolonged recession. And thirdly, since therecession has already started, the prospects of crisis prevention now throughthe usual monetary instruments (including liquidity injection) appear distinctlydim. The scenario, in which tendencies towards increased liquidity preference onthe part of private individuals and institutions and a downward slide in thereal economy mutually reinforce one another, has already started unfoldingitself and will continue for a prolonged period, unless governments now actto inject demand into the economy directly, apart from injecting liquidity.Until this happens on a large enough scale the Depression will persist.

The third world countries will not escape the effects of this Depression. True,many of them whose financial systems are still not sufficiently "openedup" and hence have not been "contaminated" by ally links to"toxic" securities, will escape the direct impact of the worldfinancial crisis (though even they cannot escape some "sympathetic"movements in their financial markets as well). But they certainly will have toface the impact of the Depression of the real economy. Their export earnings,both merchandise and invisibles, will be hit, causing unemployment and outputcontraction on the one hand, and foreign exchange crisis, exchange ratedepreciation and accentuated inflation on the other. (The latter will beaggravated by the outflow of speculative capital that had come in earlier to the"newly emerging markets" under the auspices of Foreign InstitutionalInvestors).

Two areas are of special concern here. One is the inevitable decline in theterms of trade for primary commodities that will occur in a Depression, whichwill push cash-crop growing peasants into even greater distress and destitutionand into even larger mass suicides. (These have been already occurring for sometime on a disturbing scale in countries like India). The second is the loss offood security over much of the third world that will inevitably occur. Foodsecurity in the third world of course has been getting undermined for some timenow (see below), but matters will become even worse with the onset ofDepression. There are at least three mutually reinforcing reasons for this:first, the loss of foreign exchange earnings owing to the decline in exports andin the terms of trade will cause a decline in foodgrain availability infood-importing countries owing to a decline in their import capacity. Secondly,even if food availability is somehow maintained, the decline in the incomes ofexporting peasants and small producers and of those affected by the rise inunemployment will mean that large masses of people will simply lack thepurchasing power to buy necessary food. And thirdly, if the terms of trade ofnon-food primary commodities decline relative to food, as has been happening forsome time now, then both the above problems will be greatly aggravated.

There is a tragic irony here. The booms fed by asset price bubbles not onlydid not benefit the large mass of peasants, petty producers, agriculturallabourers, craftsmen, and industrial workers in the third world, but wereactually accompanied by an absolute deterioration in their living standards.This happened not despite the boom but because of it, in a number of ways.First, with the interlinking of global financial markets, asset price booms inthe US tended to produce stock market booms, and more generally financial sectorbooms, even in third world countries, where banks and other financialinstitutions withdrew from productive sector lending to speculative lending,firm rural lending to urban lending and from agriculture and small-scale sectorlending to consumer credit to the affluent, and loans against securities Thisdamaged the productive base of the peasant and small-scale sector. Secondly, thechanged role of the State in the new dispensation where it was more concernedwith supporting the financial sector boom and in maintaining "theconfidence of the investors" than with sustaining peasant and pettyproduction, entailed a withdrawal of State support from the latter sector: inputsubsidies, the price support system, essential public investment, and Statespending on rural infrastructure and on social sectors, were all drasticallycurtailed; and without them the entire small producer economy became submergedin crisis.

A simple statistic illustrates the point. During the quinquennium 1980-85, theper capita cereal output in the world was 335 kilogrammes. By 2000-05 it hadfallen to 310 kilogrammes. This absolute decline in per capita cereal outputmeant also an absolute decline in per capita cereal consumption for the world asa whole. But since per capita cereal consumption, taking both direct andindirect consumption into account, increased for the advanced countries, theoverall decline for the world as a whole was caused by a massive decline in thethird world countries, where even countries like China and India whichexperienced remarkably high GDP growth rates, did not escape this trend.

The fact that this decline in per capita cereal output in the world economywas not accompanied by any rise in relative cereal prices (in fact between thesetwo years the terms of trade of cereals vis a vis manufacturing in the worldeconomy declined by nearly 40 percent), even when the per capita income in theworld economy was increasing quite noticeably, suggests that the squeeze on thepurchasing power of the masses in the third world was even greater. The otherside of the speculative boom occurring in a deregulated andfinancially-interlinked capitalist world therefore was a drastic squeeze on theliving standards of the masses, especially in the third world (whichincidentally is one reason why the "locomotive" analogy often givenfor the US economy's role in the world economy is so inapposite: this locomotivewhile pulling some coaches, pushes back some others).

But even though the masses suffered from the effects of the speculative boom,they would also suffer additionally from the effects of its collapse. We do nothave a symmetry here between the effects of booms and of depressions, and hereinlies the tragic irony of the situation.

It is clear from the above that the need of the hour is not just the injectionof liquidity into the world economy but also in addition the injection ofdemand. This can occur only through direct fiscal action by governments acrossthe world. For activating governments for this, two conditions have to besatisfied. The first is control over cross-border financial flows, for otherwisegovernments will continue to remain prisoners to the caprices of globally-mobilespeculative finance capital. And the second is the setting up of aninternational financial facility, operated on principles different from theexisting multilateral institutions, which not only makes concessional financeavailable to them, but also enables them to substitute long-term loans for theircurrent short-term borrowing, so that they are not caught "borrowing shortto invest long".

The sectors where government spending will go up will of course vary fromcountry to country, but the general objective of such spending must be thereversal of the squeeze on the living standards of the ordinary peopleeverywhere in the world that has been a feature of the world economy in the lastseveral years. In the United States, government spending may have to take theform of increasing the social wage and enlarging welfare state activitiesgenerally, increasing infrastructure expenditure and making more funds availableto states through federal transfers. But in India, China and other third worldcountries, in addition to welfare state measures, larger government expenditurehas to be oriented towards a substantial increase in agricultural, especiallyfoodgrains, output.

Taking the world economy as a whole, the new growth stimulus will have to comenot from some new speculative bubble but from enlarged government expenditurethat directly improves the livelihoods of the people, both in the advanced andin the developing economies, and that is geared towards improving the foodgrainoutput of the world through a revamping of peasant agriculture (and not throughcorporate farming, since that would reduce purchasing power in the hands of thepeasantry and perpetuate its distress). In short, the new paradigm must entail afoodgrain-led growth strategy (on the basis of peasant agriculture), sustainedthrough larger government spending towards this end, which simultaneously ridsthe world of both depression and financial and food crises. The trade andfinancial arrangements of the world economy have to be oriented towardsachieving this rather than being made to conform to some a priori freemarket principles that have the effect of pushing the world economy intofinancial crises and slumps, and the peasantry and small producers of the worldinto destitution both during the booms and also, additionally, during theslumps.