06 January 2009

Financial crisis

Today, I along with Prof. Arpita Ghosh, my colleague at the institute, spoke on the financial crisis at the ‘IIM-A Doctoral Colloquium 2009’. A member from the institute in the audience had some views, many of which I don’t agree with.

a) Markets are efficient. The crisis does not prove that herd behaviour took place.
My take: Markets are random and unpredictable, but that is not saying the same thing as the markets are efficient. There clearly is herd behaviour and the assumption of the ‘greater fool’ theory in financial bubbles throughout history. Daniel Kahneman, winner of the 2002 Nobel, and many others in that line have very interesting thoughts on the reasons for the herding and group foolishness. Starting from the tulip mania (certain tulips were $75,000 each (in today’s money) before falling to $1 each in a few months time), the south sea bubble, the florida land bubble, the internet bubble, the present worldwide land and property bubble are but a few examples of rational people going berserk all at the same time. As Charles Mackay, the expert on bubbles said in his famous book – "Men go mad in crowds, and they come back to their senses slowly and one by one." rings true.

b) The US government should not have intervened and let the markets decide its appropriate level and the economy would have find its feet.
My take: I think, the US government should have intervened – the stakes are too high and much as we may hate the suited financial guys for their greed, the world in times of acute financial distress does need help from the biggest players of them all (though growing relatively smaller and smaller) – the government. At the same time, the way it has intervened leaves much to be desired. While allowing all the financial institutions to fail would have extracted too high a cost on the real economy – the existing practice of bailing out without imposing a cost on the shareholder and managers of these firms is a sad example of ‘privatizing profits, nationalizing lossess’. Clearly, when a company has been economically bankrupted, there is no case for the government to bail out the company’s shareholders who are holding the risk capital of the company (See AIG, Fannie, Freddie, Citi). The government needed to wipe out the existing shareholders – and over a longer term get saner people in control – neither of which it has done in the US. Indications of crony bailouts are also becoming more apparent with former wall street alumni in the government directing the actions of the bailout in the teeth of the will of their parliament. See an excellent piece on “How to Repair a Broken Financial World” by Michael Lewis and David Einhorn published three days back in the New York Times.

c) The cause of the crisis is excess liquidity. How can it be the solution as well – i.e. pouring of huge amounts into the markets by the government is wrong.
My take: I just have two phrases for this – ‘Herber Hoover’ and ‘1932’. How can we repeat that mistake again?

d) Infrastructure spending will take years before it will have an impact on the economy and the crisis.

My take: The benefits of infrastructure buildup is relatively immediate for the crisis. Employment is generated, consumption is increased and services are consumed beginning immediately. To take an example of a hydro electric project - the dam may take a half decade to build, but the main point of the project is not the electricity but to create economic benefits on the demand side - this is of course infinitely better than the digging-holes-and-filling-them-up kind of employment generation.

See my main blog here.

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