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Mon, Aug 11 2014. 01 40 AM IST

Another market crash in the offing?

RBI governor Raghuram Rajan has said excessively accommodative monetary policy in developed economies has led to asset bubbles
Reserve Bank of India governor Raghuram Rajan has added his
voice to a steadily rising chorus warning of the heightened risks of a
global market crash. Specifically, he says theres a disconnect
between the state of the economy and asset prices; that excessively
accommodative monetary policy in the developed economies has
led to asset bubbles; that competitive monetary easing is leading to
beggar-thy-neighbour policies reminiscent of the Great Depression
in the 1930s; that the recent low volatility masks many of the risks;
and that not enough is being done in terms of improved regulation.

Raghuram Rajan should know of global market crashes.

He was one of those who predicted the recent financial
crisis. Photo: Mint

Rajan should know. He was one of those who predicted the financial
crisis. At that time, he had said that among the reasons for the crisis
were the skewed incentives for fund managers that led to excessive
risk-taking. That hasnt changed. Nor has the pervasive inequality in
the US. Several economists have argued that the lack of growth in
real wages was the underlying reason for the explosion of private
sector debt that led to the financial crisis, as debt was substituted for
income. The International Monetary Fund has warned that housing
markets are once again getting overheated in several countries.

There have been half-hearted attempts at regulation, but its far from enough. The attempt has been to get back to business as usual, by
papering over the cracks with money. As the Bank for International Settlements pointed out in its annual report last year, the role of
accommodative monetary policy was to buy time to put reforms in place. Instead, it warned, The time has not been well used, as continued
low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to
finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money
makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.
But theres another side to the story. Andrew Haldane , chief economist of the Bank of England, has said hes happy that monetary policy
aided and abetted risk-taking, because thats precisely what they wanted. In fact, the entire rationale for quantitative easing was to lift asset
prices, as central banks hoped that the wealth effect would help banks and lead to more spending and a recovery in their economies. One
mans nuttiness, said Haldane, is another mans animal spirits.
But is another market crash really something new? After all, since the demise of Bretton Woods, the growth of the world economy has been
a story of serial bubbles and busts. True, there had been periodic crises before, but not at such short intervals. Its almost as if we are
seeing a series of linked crises. They started with the oil surpluses of the 1970s recycled on the one hand to the US, where they set the
stage for the Savings & Loans crisis and to Latin America on the other, where they led to a debt crisis and a lost decade of growth.
Then the US, in an effort to stem its loss of competitiveness to Japan, forced the Plaza Accord on it, forcing the yen to be revalued. In an
effort to remain competitive, Japan kept interest rates low, creating a massive bubble in stocks and property there. Japan has still not
recovered from the spectacular bursting of that bubble.
One result of the rising yen was the shift to south-east Asia of Japanese investment. International portfolio flows also found their way to
these tiger economies, attracted by the investment boom. That finally ended in 1997 with the Asian crisis. Footloose capital winged it back
to the US, setting up the scene for the dotcom boom and the inevitable bust.
After that, Alan Greenspans rate cuts led to a global boom in asset prices, a party cut short by the financial crisis of 2007. And thats not
mentioning the Mexican tequila crisis, the Russian financial crisis of 1998 and the European sovereign debt crisis. As David Harvey has
observed, capitalism never solves its crises, it moves them around geographically.
So, another market crisis would not really be anything unexpected. Such periods of creative destruction could also be the economys way

of renewing itself, of starting afresh. Perhaps this is the only way developed economies can grow in an age of financialization, when the
financial tail wags the real economy dog.
The worry is the bubbles seem to be getting larger and larger and we are still to recover from the bursting of the last one. And after using up
all available ammunition on tackling the current crisis, how will the world deal with another bust?
Will the central banks be able to engineer a soft landing? The history of serial booms and busts casts serious doubts about that. Indeed, if
history is any guide, the Chinese Communist Partys record of steering its economy to a soft landing is much better than that of Western
governments and central banks, although whether they will be able to handle their current crisis remains to be seen. The silver lining, if one
may call it that, is that there is often a gap between the first warnings and the final bursting of a bubble. For instance, some had cautioned
as early as 2004 that a bubble was in the making. And Raghuram Rajans famous warning at Jackson Hole was made in August 2005, two
years before the crisis hit.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments and feedb ack are welcome at