By Kadambari Shah and Purvasha Sinha
Kadambari Shah is Senior Analyst at IDFC Institute, a Mumbai-based think/do tank.
Purvasha Sinha is a Market Data Analyst at Bloomberg, Mumbai.
The bitcoin, part of an emerging class of digital currencies, is making waves across the world. Some speculate that its mysterious, volatile prices are a bubble, while others optimistically believe that the cryptocurrency is a legitimate asset. Despite their harbingers sprinkled across numbers and charts, economic bubbles appear to come out of nowhere. The problem is, these warnings only seem to become evident after the crisis hits.
Crisis in effect
There are several trends at play. When policymakers build a new road with the aim of spreading out traffic, they are often faced with increased bottlenecks. This paradox, the Law of Traffic Congestion, is reflective of ‘induced demand’, which theorises that the more an opportunity presents itself, the more it will be used. Then, was the new road a smart decision? In a similar vein of thought, when a financial/economic crisis occurs, policymakers rally efforts to mitigate its shocks and hedge against risks. However, sometimes, these attempts outrun their purposes, in turn leading to further crises. The question arises, is there a way to determine this inflection point, and pacify the preponderance of a crisis?
Crises are turning points in which a change takes place, resulting in either stimulating recovery or a further aggravation of the problem. However, if this ‘change’ elicits hasty reactions, the economy takes a muddled path, first reaching a peak of exaggerated growth and then crashing down.
The most recent prominent example is the 2008 global financial crisis. In the 2000s, after the burst of the internet bubble, the Clinton and Bush governments encouraged home ownership as a ploy to garner votes. Blurred by eco-political motives, the evaluation of creditworthiness was impaired, which led to the rise of subprime mortgage loans. Simultaneously, the Fed responded to the dot-com bubble by keeping interest rates low, which further fueled the rise of subprime loans. An unintended consequence of rising speculations in the property market happened. Investors were driven by ‘irrational exuberance’. As housing prices soared, brokers sold mortgages and lenders liberally lent money without conducting adequate due diligence, and a host of derivatives markets (like the MBS and CDS markets) gained excessive momentum. In this case, one explanation is that the interest rates were kept too low for too long. Once the policy had performed its function of boosting credit to various economic classes and providing housing loans, it overshot its very purpose. That is, low-interest rates led to asset bubble formations and consequently instigated the financial crisis.
Similarly, China’s ‘quasi-privatisation’ of communal farming in the late 1990s intended to introduce incentives to boost productivity and GDP growth. This entailed a policy that encouraged rural households to invest in local businesses and manufacturing, thereby fostering ‘town and village enterprises’. These structural reforms succeeded in increasing exports and fostering double-digit growth rates. However, excessive emphasis on infrastructure development gradually invited supply-side problems, causing overcapacity and squeezed profit margins. Ultimately, China ended up with ‘zombie enterprises’.
A third example is a financial liberalisation and deregulation in Thailand. From the 1960s to 1980s, high economic growth induced by inflows of direct foreign investment buttressed export activities. The Thai government was convinced that export-led growth was the way to go. In order to meet the requirements of large-scale investments, Thailand opened its doors, welcoming foreign funds by liberalising its financial system. Consequently, the Thai economy attracted significant foreign capital inflows. This buoyancy spawned further boosts to an already robust system. Inevitably, growth was not sustained long. With export-friendly sectors happily fed, little concern was given to the allocation of surplus funds. The money flowing in was misallocated to non-productive industries, which created obstacles for further growth. Therefore, inflating the use of capital account liberalisation and biting off more than could be chewed, with large chunks of foreign investments, only impaired economic growth in the long-term.
These well-intended policies ended up becoming myopic in nature, creating bubbles doomed to burst.
The way forward
Looking back, it is easy to chalk out timelines and pinpoint instances that led to crises. However, it is much harder to identify turning points in real-time, while the economy is churning in motion. Yet, a success story is that of minimum wage/basic income policies. These policies are revised frequently to correct for inflation, thereby controlling for shocks to the economy. This close supervision of wages has had significant impacts on growth trajectories across countries. Another lesson comes from Union/Federal Budgets all over the world. Every year, people eagerly wait to see the revised rates on subsidies, infrastructure spending, labour concessions, and so on. These are then used as planning mechanisms for the ensuing year. A more recent example is the tightening of regulations on offshore derivatives by increasing fees and banning complex products in India. This credible move by the watchdog (SEBI) manifests the very role of a regulator.
In all six examples, while policies did have a significant role to play, it is difficult to draw direct causal links to growth or setbacks. It is not just policies that cause bubbles, but also other factors, the most prominent of which is human behaviour. John Nash spoke of game theoretic approaches to this situation: People pay close attention to other people’s actions. In each case, sooner or later, people changed their strategies from investing in the bubble to take out their money because one player/group decided to change the strategy. However, it is important to note that economic growth is often not synced with the fundamentals of human behaviour.
Opportunities for India
India contains large opportunities for financial deepening, widening, and strengthening. Therefore, it is important to observe the growth of each asset class to understand the human rationales for their existence. Subsequently, policies will need to be levered and fine-tuned to cater to the market. India is still in an early growth phase so it will likely experience significant policy reforms, in addition to demonetisation and GST, to temper the fundamentals of the economy. As much as financial liberalisation looks tempting, stories like that of the United States, Chinese and Thai economies illustrate that the consequences of poor decision-making to achieve high growth targets involve several trade-offs. These trade-offs necessarily include instilling confidence in the system via long-sightedness, sometimes at the expense of short-run disruptions. It also includes preempting shortfalls and shocks via close monitoring, diversifying risks, and construing backup plans for worst-case scenarios.
Bubbles will come and go, some will burst and some will waft away. Thus, while there is no set recipe or list of ingredients to predict crises, the next-best scenario is preparing for them.
Featured Image Source: Pixabay
The views expressed here are those of the author’s and do not represent the views of IDFC Institute or Bloomberg.