I am very honoured to be invited once again to New Delhi by ICRIER, Bruegel and CEPII to join this luminary conference on “International Cooperation at Times of Global Crisis: Views from the G20 Countries”. When I was last here in February, the world was still deep in the throes of the financial crisis. Since then, the crisis has entered into the damage control and reform phase, with first signs of economic recovery and an intense debate about necessary policy and institutional reforms. My sincere thanks therefore to Isher and Montek Ahluwahlia and Rajiv Kumar for an irresistible invitation to New Delhi to express some personal views on what emerging markets should do in G20.
In the Third Lall Memorial Lecture, the causes of the current global crisis were attributed to four mega-trends of wage arbitrage, interest rate arbitrage, knowledge arbitrage and regulatory arbitrage that led to the four excesses of liquidity, leverage, risk-taking and greed.
On further reflection, our collective failure to prevent the global crisis had four blind spots – first, the failure to have a historical perspective that financial crises have become a hardy perennial, increasing with volatility and frequency. Second, we failed to have a macro-system-wide perspective that global imbalances, loose fiscal and monetary policies and lax financial regulation were unsustainable. Third, we failed to examine the micro-institutional incentive structures that drove financial leverage to generate profits for private greed at massive social costs. Fourthly, after looking in dismay at the hasty reforms and reflation packages introduced, I have realized that there is a deeper and darker cause to how we arrived at where we are today. Our academic and professional training have become so specialized and compartmentalized that we ignored the truly big political economy issues of our times: social inequities, political capture by vested interests, global warming and other complex factors that affect financial stability.
Finance is a derivative of the real economy that amplifies growth through leverage, accumulating unfortunately higher non-linear risks. In this lecture, I ask the political question of who benefited most from the mega-trend of rising leverage which has been evident in global finance since the 1980s from one time GDP to nearly four times, on the conventional measure, and 12 to 16 times if you include derivatives. What is clear is that the shareholders of the financial institutions lost, the taxpayer lost and the real sector employees of non-financial institutions have also lost through higher unemployment.
Who gained was the top management of the financial institutions, who took a larger and larger share of the profits on the pretext that they were creative financial engineers that helped society manage risks. They did this on the basis of a free market economic philosophy that allowed unfettered finance to brew the largest crisis in the last 70 years, intellectually supported by complex finance models that were blind to long-tail Black Swan risks. Openly and with tacit permission from that ideology, the agents have taken over much of the rights of the principals.
In other words, it is the political consequences of the economics profession striving to make economics a quantitative science that did not add up. Some of you may recall that I observed that the American dream, where everyone can have whatever they desire, might be true for a small group of Americans, but certainly our fragile world cannot sustain the resource demand if every Indian, Chinese, Asian, African and Latin American were to live at the same American per capita standard of consumption. We need to ask the right questions before we can come up with the right answers.
My intention today is not to take on the economics profession, because Nobel Laureate Paul Krugman has already stated much more authoritatively that “much of the past 30 years of macroeconomics “was spectacularly useless at best, and positively harmful at worst.” My intention is to look at what emerging markets should do for themselves within the remit of G20 and see whether collectively, the world can address the important issues of our times, rather than pretending that some of us can still enjoy unfettered prosperity and pass the consequences to future generations.
Why didn’t we see it coming?
In November 2008, Her Majesty Queen Elizabeth II asked the simple but obvious question: Why had nobody noticed that the credit crunch was on its way? The august British Academy replied in their letter of July 2009 as follows: “the failure to see the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”
There are three possible answers to these excuses of very bright people – first, it was truly an unknown unknown, but that ignores the obvious fact that recent history witnessed repeated financial crises and that Cassandras such as Nouriel Roubini and William White at BIS were warning in 2005/2006 about the unsustainability of the asset bubbles forming. No one in authority paid serious attention.
The second excuse was that the present methodology of analysis is faulty. But the physicists and other social science had been arguing for years that the economic profession was using outdated tools that ignored the human factor, again with little impact.
The third is the possibility that the whole regulatory system was captured by the financial industry, both in ideology and as custodians of public savings and pensions, holding society to ransom. By capture, I mean that everyone was so captivated by the heady brew of unending prosperity promised by the financial engineers that they forgot to take away the punch-bowl. It has never been easy for any individual leader to stake personal reputations on the line to stop the gravy train heading for the inevitable crash. Unfortunately, the dustbin of history contains many tarred reputations of leaders who acted conventionally with unconventional consequences.
In the last eight months of 2009, there has been a flurry of major studies on the crisis, recommendations and also national proposals for regulatory reform. These would include the G30, the Geneva, De Larosiere and the UN (Stiglitz) Reports. At the national level, the US Treasury, the European Commission and UK have also issued major consultation reports for reform that are under varying stages of legislative approval. I find that the most perceptive critique of the proposals is that of Chicago Professor Richard Posner who made his reputation on the law and economics of regulatory capture, arguing that over time, regulatory agencies come to be dominated by the industries regulated. Professor Posner thought that the US Treasury’s proposals for regulatory reform were premature, because “it advocates a specific course of treatment for a disease the cause or causes of which have not been determined”. Amongst the causes omitted include the errors of monetary policy, large annual fiscal deficits, deregulation movement in banking industry, “regulators were asleep at the switch”, and “complacency of and errors by the economics profession.”
Posner also thought that “plans for reorganizations are cheap and visible, and plans are the easy part; it is at the stage of implementation that government falls down…the reorganization usually fails, because of inertia, turf warfare, passive resistance and lack of follow through, leaving in its wake more bureaucracy.”
In other words, this is not just a financial crisis, but also a crisis of governance. As the Growth Commission led by Nobel Laureate Michael Spence has noted, global governance is challenged by the growing magnitude and scope of interdependence versus our collective capacity to coordinate regulatory and policy responses. The challenge is not just of policy, but our ability to execute and implement global solutions, when the world is fragmented into national compartments, and national implementation is further divided into silos of departmental turf wars. At the heart of the problem is Bank of England Governor Mervyn King’s lament, “global banking institutions are global in life, but national in death.”
Finally, we have brought institutions into the centre-place of the on-going policy debate. All policy debates are intellectually interesting but effectively useless if they are badly implemented by the bureaucracy or unimplementable because of institutional deficiencies, such as vested interests. The reality is that we do not have as yet global bureaucracies that are effective, because most policies are implemented at the national or local level that are often contradictory and inconsistent at the global level.
 Andrew Sheng, From Asian to Global Financial Crisis, Third Lall Memorial Lecture, ICRIER, New Delhi, February 2009.
 Total banking assets, stock market capitalization and bond market size, divided by GDP. See Appendix Table 3 of IMF Global Financial Stability Report, various issues for explanation. See Sheng (2009), Figure 13.1 on the unstable pyramid of global leverage.
 British Academy, Letter to Her Majesty the Queen, 22 July 2009, London.
Geneva Report No. 11, Fundamental Principles of Financial Regulation, March 2009, www.voxeu.org/index.php?q=node/2796;
The de Larosiere Group, Report on Financial Supervision, February, 2009, www.ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf;
The Turner Report (March 2009) www.fsa.gov.uk; UN Commission of Experts (Stiglitz Report) on Reforms in International Monetary and Finance Systems, March 2009.
US Treasury, Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation, available at www.treas.gov.