Critique of The New Consensus Macroeconomics and Implications For India

India Studies in Business and Economics
Dilip M. Nachane
Critique of the
New Consensus
Macroeconomics
and Implications
for India
Foreword by Kaushik Basu
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Dilip M. Nachane
Critique of the New

Consensus Macroeconomics
and Implications for India
123
Dilip M. Nachane
Indira Gandhi Institute of Development
Research
Mumbai, India
ISSN 2198-0012 ISSN 2198-0020 (electronic)

ISBN 978-81-322-3918-5 ISBN 978-81-322-3920-8 (eBook)
https://doi.org/10.1007/978-81-322-3920-8
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To the millions who lost their bread (in the
global crisis) because of a handful who
wanted more cake
Foreword: Dilip M. Nachane’s Macroeconomics
Dilip M. Nachane’s new book on macroeconomic theory and policy is the kind of
book that I would have loved to have had on hand, when I was Chief Economic
Adviser to the Government of India. It is a remarkably comprehensive book that
starts with a review of the main schools of macroeconomic thought, from Keynes’s
General Theory to contemporary models of analysis, many of them inspired by
actual policy challenges and crises, such as the global financial crisis of 2008. The
book closes with two chapters devoted exclusively to India, with a special focus on
the fiscal and monetary policy concerns that India faced over the last decade. As
such, the book should be valuable to students of economics and to policymakers in
India, with an interest in macroeconomic policy, wanting a refresher course.
Macroeconomics as a discipline emerged with the groundbreaking work of John
Maynard Keynes and his audacious effort to bring under one framework of analysis
the world of money and finance, the world of goods and services, and the world of
labor and jobs. The emergence of Keynesian macroeconomics coincided with the
last stages of the Great Depression, and subsequently became the go-to handbook
for countering recessions and crises. But the world economy is a complex organism
that has continued to spring surprises in terms of new kinds of recessions that would
not respond to standard policy packages. That led to the modifications of old ideas
and impetus to look for new macroeconomic paradigms. There were powerful
criticisms of the Keynesian model by the Chicago school and, in particular, by
Milton Friedman that led to the doctrine of monetarism as an alternative model.
This book takes the reader through these various schools of thought, all the way
to the New Consensus Macroeconomics, which is presented and dissected at some
length, showing its strengths but also casting doubt on some of its features,
including whether “consensus” is quite the right word for describing any kind of
macroeconomics.
But this is not a book on theory for the sake of theory. Having presented some
of the main theoretical schools, the book ventures to discuss real-world problems.
We learn at length how the subprime mortgage crisis emerged in the USA, became
a generalized financial crisis, and then infected other markets and economies.
vii
viii Foreword: Dilip M. Nachane’s Macroeconomics
By 2009, the crisis had spread to emerging economies, including India. Foreign
investors nervous about the global economy, began withdrawing their money from
“distant” economies. By September 2008, the Bombay Stock Exchange Sensex
Index was plummeting. From a level of 19325.7 in January 2008, it fell to 8995.5
by March 2009. Merchandise exports to advanced economies were beginning to
stall, and by the end of 2009, GDP growth in India had sharply declined.
Having been in the policy world at that time, I am acutely aware how the crisis
was part and parcel of our lives. What made the job harder was that there was no
good paradigm to fall back on. We had to use old-fashioned theory with a hand-
some dose of common sense and gut feeling, to design policy and respond to the
crisis. There will of course never be an exact textbook paradigm for most real-world
problems; intuition and common sense will always play a role. Nevertheless,
Professor Nachane’s new book tries to make some amends for the current lacuna,
by blending our theoretical knowledge of macroeconomics with the actual expe-
rience in advanced and emerging economies. Therein lies the strength of the book,
and the reason why students of economics and practitioners of economic policy can
benefit from it.
Ithaca, USA Kaushik Basu

July 2018 Carl Marks Professor
Cornell University
Preface
The New Consensus Macroeconomics (NCM) which established itself in the 1980s
as the mainstream in macroeconomics essentially represents an “uneasy truce”
between the then dominant new classical and real business cycle schools (associ-
ated with Lucas, Sargent, Wallace, Kydland, Prescott, etc.) on the one hand and on
the other the nascent neo-Keynesian view (of Akerlof, Mankiw, Gordon, Phelps,
Taylor, etc .). It combines features like Keynesian sticky prices and wages with the
new classical assumptions of rational expectations and efficient markets. It also
incorporates features from classical monetarism such as the natural rate hypothesis
and a vertical Phillips curve. Its econometric medium continued to be the dynamic
stochastic general equilibrium (DSGE) models of the real business cycle school.
NCM sets the tone for much of the macroeconomic (especially monetary) policy
followed by the advanced economies in the period of the Great Moderation (1990–
2005). Among the major policy recommendations of NCM, special mention may be
made of (i) inflation targeting, (ii) Taylor rule, (iii) non-intervention in asset markets
(Jackson Hole consensus), (iv) light-touch regulation and (v) a strong belief in the
ability of financial markets to regulate themselves (market discipline). So far as the
emerging market economies (EMEs) are concerned, NCM (and especially its twin
pillars—the rational expectations hypothesis (REH) and the efficient-market
hypothesis (EMH)) supplied the intellectual basis for the successive waves of
financial liberalization undertaken by governments in these countries beginning in
the decade of the 1980s.
The recent global crisis has posed a very serious challenge to the NCM. Firstly,
empirical models based on NCM failed to anticipate the occurrence of the crisis and
later its extent and severity. Secondly, the solutions proposed within the NCM
framework have met with limited success in the USA and actually compounded
problems in the EU. This has led to serious questioning of the NCM from four
major alternative schools, viz. the post-Keynesian, the Austrian, the Minskyan and
the Marxist.
ix
x Preface
The above considerations constitute the underpinnings of the proposed book.

The book addresses six major questions, viz.
(i) To what extent were the macropolicies based on the NCM responsible for the
developments leading up to the recent global crisis?
(ii) Has the NCM theoretical framework outlived its utility and is in need of
replacement by a suitable alternative?
(iii) Do some of the other alternative theoretical frameworks provide more con-
vincing explanations of the modern-day business cycles?
(iv) Is the current focus of regulation centred on capital requirements and market
discipline (Basel II to be succeeded by Basel III) appropriate?
(v) For the less-developed and emerging market economies, is financial liber-
alization (financial deregulation plus financial innovation) an unmixed
blessing or is there a benchmark beyond which such liberalization can prove
detrimental?
(vi) What are the political economy considerations underlying the current
ongoing process of financialization in EMEs and is it in the long-term interest
of these nations?
The first four chapters of the book outline the evolution of macroeconomics from
the publication of the General Theory of Keynes in 1936 to the establishment of a
broad consensus (the New Consensus Macroeconomics (NCM)) around the
mid-1980s. Chapters 5 and 6 deal, respectively, with the origins of the global crisis
in the USA and its transmission to the other major regions of the world. Chapters 7
to 10 analyse the four major alternative perspectives on the global crisis offered by
the Austrians, the Minskyans, the post-Keynesians and the Marxists. Chapter 11
attempts to provide a consolidated overview of the main theoretical post-crisis
critique of the NCM, while Chapter 12 is devoted to a discussion of the critique
of the policy mix followed in the period leading up to the global crisis. Chapter 13
analyses in a Lakatosian framework, the process by which the mainstream NCM
has countered this critique and largely stood its ground, making certain ad hoc
changes while keeping the main edifice intact. While the mainstream framework
remains intact, the harsh lessons of the crisis have not been lost on the policy-
makers. The comity of nations have been unanimous in advocating a coordinated
approach to deal with global instability issues—the main partners in such a coor-
dinated approach being national regulators and international bodies such as IMF,
WTO, BIS. Chapter 14 deals with the modalities of the amendments needed to the
national and global financial architecture to facilitate the dialogue necessary to
achieve a coordinated response to crises that have the potential of destabilizing the
world trade and investment order. The last two chapters deal with the Indian case in
detail. Chapter 15 outlines the main contours of the financial sector as it has evolved
in India over the past three decades, and the special challenges posed for the
financial regulators in a system that is being aggressively pushed towards dereg-
ulation and liberalization by a market-oriented domestic corporate structure together
with the imperative of participation in the global financial community. Our analysis
Preface xi
leads us to a somewhat critical assessment of the financial sector policies followed

in India since the initiation of reforms in 1991. In particular, we feel that the road
map carved out for India’s financial sector, by the two recent official reports (Percy
Mistry and Raghuram Rajan), presents several pitfalls. In the concluding chapter,
we analyse these pitfalls and suggest safeguards which need to be in place for a
proper dovetailing of the financial sector into the rest of the macroeconomy.
I must record my appreciation of the excellent library and computer facilities
provided by IGIDR, which were of great assistance to me in the writing of this
book. My particular thanks to Dr. Mahendra Dev, Director, IGIDR, for his unfailing
enthusiasm and encouragement in the writing of this book. IGIDR is an intellec-
tually vibrant place, and discussions with colleagues like Drs. Ashima Goyal,
Naveen Srinivasan, Subrata and Jayati Sarkar, and Rajendra Vaidya have always
been fruitful. My long-standing friend, Dr. Vikas Chitre, encouraged me in the
writing of this book and read the drafts of some chapters, providing incisive
comments, which have benefitted me enormously. Mahesh Mohan provided
much-needed secretarial help, and my student, Aditi Chaubal, was a great help with
the figures and references. To all of them, I extend my heartfelt thanks.
It is indeed a felicitous happening for the book that a person of Dr. Kaushik
Basu’s eminence agreed to write the Foreword. No words can adequately convey
my profound gratitude to him for sparing so much valuable time for this task.
I express similar sentiments towards Drs. C. Rangarajan, Y.V.Reddy, Kunal Sen, R.
Barman, Vikas Chitre, Errol D’Souza and Tirthankar Roy. Their good wishes
constitute a happy augury for the book’s fortunes.
The book would never have been completed without the active assistance and
encouragement of the entire Springer team led by Ms. Sagarika Ghosh. Her
countless gentle reminders, endless deadline extensions and continuous encour-
agement kept the book on the right track. Ms. Nupoor Singh was of great help with
her editorial guidance, and Ms. Krati Srivastava did a splendid job with the
supervision and execution of the printing process.
Finally, my wife, Prafulla, has always been a tower of strength for all my
endeavours. My daughters, Bhagyashree and Aparna, have energetically spurred
me on, under the (possibly mistaken) impression that I was doing something really
worthwhile. No words would suffice to thank them, as well as my sons-in-law and
grandchildren. I only hope that this book does not disillusion them.
Mumbai, India Dilip M. Nachane

What Do the Experts Say
“Prof. Nachane has written an extremely thought provoking book on Macroeco-

nomics. It is a masterly analysis of the post Keynesian developments. The coverage
is wide, almost encyclopedic. He also traces meticulously the theoretical under-
pinnings of the various policy measures introduced particularly after 2008 crisis.
The jury is still out on what the ‘optimum’ level of ‘financialization’ is. A must-read
book for every serious student of economics.”
—C. Rangarajan, Former Governor of Reserve Bank of India
and Former Chairman, Economic Advisory Council to the Prime Minister
“The book is a unique and unparalleled treatment of a complex subject by an

eminent economist, which is a must read for academicians, policy makers and
financial market participants. It reflects the author’s acknowledged command over
the theory and practice of economic policies globally, and his decades of
involvement in research and policy in India in the areas of money and finance. The
book should prove of immense contemporary value in India, where money and
finance are currently under stress.”
—Dr. Y. V. Reddy, Former Governor, Reserve Bank of India
“Following the Global Financial Crisis of 2008, the basic tenets of mainstream
macroeconomics have been increasingly questioned. Dilip Nachane’s authoritative
book provides an insightful survey of the debates in modern macroeconomics. The
sweep of the book is remarkable, from Marxian and Austrian economics to the New
Consensus Macroeconomics. The book is a must-read for all scholars and students
of economics.”
—Dr. Kunal Sen, Professor of Development Economics, University
of Manchester, UK; and Director-Designate of UNU-WIDER
xiii
xiv What Do the Experts Say
“Professor Dilip Nachane has achieved a unique feat. He elucidates the emergence
and the content of the New Consensus Macroeconomics, the post-crisis critiques of
it from a spectrum of perspectives encompassing the Austrian, the Post-Keynesian,
the Minskyan, and the Marxist, and the hard lessons learnt from the crisis by the
policy makers. Arguing the need for monetary and financial stability for economic
growth and social welfare, he critically analyses the macroeconomic policies and
the institutional and political economy aspects of financial liberalization for
achieving this purpose, in the context of India.”
—Prof. Vikas Chitre, Former Director, Gokhale Institute of Politics and
Economics, Pune, India
“In Macroeconomics history has affected the evolution of economic thought which
in turn has had a feedback on the course of history itself as this timely book reveals.
Keynes broke with the Classics but Friedman later brought Classical principles back
in. Dilip Nachane’s insightful book provides a perspective on these intellectual
developments that were associated with the Great Moderation of business cycles and
the Great Financial Crisis. It reviews this seemingly chaotic history, and critically
examines the political economy of policies around financial intermediation and
stability and the regulation of the financial sector.”
—Prof. Errol D’Souza, Director, IIM-A (Ahmedabad)
“This is a book by a leading economist which is a master piece on macroeconomics –

tracing the evolution of different schools of thought and the rationale behind them. It
is a work of great scholarship and is thought provoking, which will be very useful
even for a non-specialist.”
—Dr. R. Barman, Chairman, National Statistical Commission,
Government of India
“Written with clarity and insight, this book by a leading macroeconomist of India
explains the historical context in which a consensus emerged within modern
macroeconomic thought, and how that consensus changed history. A fascinating
read, and a work of outstanding scholarship.”
—Prof. Tirthankar Roy, Professor of Economic History,
London School of Economics
Contents
1 Keynesian Economics: Brief Overview . . . . . . . . . . . . . . . . . . . . . . 1

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 Keynesian Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.1 Main Constituents of the Keynesian Framework . . . . . . . . . . . 2
3 The IS-LM Synthesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.1 Hicks’ IS-LM Synthesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.2 Keynes and the IS-LM Analysis . . . . . . . . . . . . . . . . . . . . . . 13
4 IS-LM Keynesianism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
4.1 Real Balance Effect and Wage Flexibility . . . . . . . . . . . . . . . 15
4.2 The Phillips Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
4.3 Keynes and General Equilibrium . . . . . . . . . . . . . . . . . . . . . . 21
5 IS-LM Analysis for an Open Economy: Mundell–Fleming
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 22
5.1 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 22
5.2 Monetary and Fiscal Policy Effectiveness Under
Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . ....... 25
Flexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . ....... 29
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 36
2 The Resurgence of Neoclassicism . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2 Monetarism: Main Tenets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
2.1 Characteristics of Monetarism . . . . . . . . . . . . . . . . . . . . . . . . 40
3 Friedman’s “Modern” Quantity Theory of Money . . . . . . . . . . . . . 41
3.1 Modern Quantity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3.2 Supply of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
4 The Phillip’s Curve and the Natural Rate Hypothesis . . . . . . . . . . . 44
4.1 Expectations-Augmented Phillips Curve . . . . . . . . . . . . . . . . . 45
4.2 Accelerationist Hypothesis and NAIRU . . . . . . . . . . . . . . . . . 48
xv
xvi Contents
5 A Monetary Policy Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

6 Flexible Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
7 Monetarism: Decline and Fall . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3 New Classical Economics and Real Business Cycle Theory . . . . . . . 61
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2 Four Basic Tenets of New Classical Theory . . . . . . . . . . . . . . . . . 62
2.1 Micro-foundations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
2.2 Complete Markets, Continuous Equilibrium and Gross
Substitutability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
2.3 Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
2.4 Neutrality of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
3 Main Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
3.1 Lucas Aggregate Supply Function and Equilibrium
Business Cycle Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
3.2 Anticipated Nominal Demand Shocks Do not Matter . . . . . . . 67
3.3 Lucas Critique . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
3.4 Ineffectiveness of Feedback Policy Rules . . . . . . . . . . . . . . . . 70
3.5 Ricardian Equivalence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
4 Real Business Cycles Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.1 Basic Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.2 A Formal Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
4.3 An Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4 Towards a New Synthesis: New Consensus Macroeconomics . . . . . 83
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
2 Neo-Keynesian School: Role of Rigidities . . . . . . . . . . . . . . . . . . . 84
2.1 Nominal Rigidities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
2.2 Real Rigidities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3 Hysteresis and the Natural Rate of Unemployment . . . . . . . . . . . . . 93
3.1 NRU Influenced by Cyclical Factors . . . . . . . . . . . . . . . . . . . 93
3.2 A Role for Stabilization Policy . . . . . . . . . . . . . . . . . . . . . . . 95
4 Multiple Equilibria and Coordination Failure . . . . . . . . . . . . . . . . . 97
5 New Consensus Macroeconomics (NCM): Theoretical
Aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
5.2 Main Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
6 Monetary Policy in the NCM . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
6.1 Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
6.2 Taylor Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
6.3 Monetary Policy and Asset Prices . . . . . . . . . . . . . . . . . . . . . 103
Contents xvii
7 The Monetary Policy Framework of the NCM . . . . . . . . . . . . . . . . 103

8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
5 Inception of the Global Crisis in the USA . . . . . . . . . . . . . . . . . . . . 109
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
2 Long-Term Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
2.1 The Great Moderation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
2.2 Global Imbalances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
3 Medium-Term Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
3.1 Inappropriate Monetary Policies . . . . . . . . . . . . . . . . . . . . . . 118
3.2 Structural Flaws in the US Financial System . . . . . . . . . . . . . 120
3.3 Lax Regulation of the US Financial Sector . . . . . . . . . . . . . . 126
3.4 Bursting of the US Real Estate Bubble and the
Unfolding of the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
4 US Policy Responses to the Crisis . . . . . . . . . . . . . . . . . . . . . . . . 130
4.1 Conventional Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . 130
4.2 Unconventional Monetary Policy . . . . . . . . . . . . . . . . . . . . . . 131
4.3 Fiscal Stimulus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
6 Universalization of the US Financial Crisis . . . . . . . . . . . . . . . . . . . 141
1 Contagion to the Rest of the World . . . . . . . . . . . . . . . . . . . . . . . . 141
2 Crisis Spreads to Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
2.1 Crisis Transmission from the USA to EU . . . . . . . . . . . . . . . 142
2.2 Euro Area Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
2.3 Policies in the UK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
3 The Crisis and Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
3.1 China and the Global Crisis . . . . . . . . . . . . . . . . . . . . . . . . . 155
3.2 India in the Global Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
3.3 Crisis and ASEAN 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
4 Crisis and the African Continent . . . . . . . . . . . . . . . . . . . . . . . . . . 171
5 Crisis and Latin America and The Caribbean . . . . . . . . . . . . . . . . . 172
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
7 Austrian Business Cycle Theory and the GFC . ....... . . . . . . . . 177
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . ....... . . . . . . . . 177
2 Haberler’s “Hydraulic” Version of the Austrian Theory . . . . . . . . . 178
3 Criticisms of the “Hydraulic” Version . . . . . . . ....... . . . . . . . . 179
4 The Austrian Theory: A Restatement . . . . . . . . ....... . . . . . . . . 180
5 The Austrian View of the GFC . . . . . . . . . . . . ....... . . . . . . . . 182
xviii Contents
6 Policy Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

6.1 Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
6.2 Productive Macroprudential Regulation . . . . . . . . . . . . . . . . . 185
6.3 Real Sector Recommendations . . . . . . . . . . . . . . . . . . . . . . . . 188
7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
8 The Crisis: A Minsky Moment? . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
2 Minsky’s Theory of Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
3 Financial Instability Hypothesis (FIH) . . . . . . . . . . . . . . . . . . . . . . 195
4 Disruption by a “Not Unusual” Event . . . . . . . . . . . . . . . . . . . . . . 196
5 Debt Deflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
6 Floors and Ceilings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
7 Global Crisis: Collapse of “Money Manager” Capitalism? . . . . . . . 198
7.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
7.2 “Money Manager” Capitalism . . . . . . . . . . . . . . . . . . . . . . . . 199
7.3 Triggers for the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
9 The Global Crisis According to Post-Keynesians . . . . . . . . . . . . . . . 205
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
2 Post-Keynesian Perspective on the Crisis . . . . . . . . . . . . . . . . . . . . 206
3 FIH Applied to Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
4 Financial Fragility in the Global Context . . . . . . . . . . . . . . . . . . . . 207
5 Herd Behaviour of Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
6 Endogeneity of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
7 Income Inequality and the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . 213
8 Godley’s Seven Unsustainable Processes . . . . . . . . . . . . . . . . . . . . 215
9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
10 Marxian Perspective on the Global Crisis: “Povorot”
or “Perelom”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
1 Marxian Crisis Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
2 Stable Capitalism Phase in the USA (1890–1970) . . . . . . . . . . . . . 224
2.1 Real Wage Trends (up to the Late 1970s) . . . . . . . . . . . . . . . 224
2.2 Stabilization Strategies of Capitalism . . . . . . . . . . . . . . . . . . . 224
3 Marxism and the Current Crisis in the USA . . . . . . . . . . . . . . . . . 226
3.1 Reversal of Real Wage Trends (Post-1970s) and the Eruption
of the Current Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
3.2 Weakening of Stabilization Factors . . . . . . . . . . . . . . . . . . . . 227
4 Marxian Solutions to the Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
Contents xix
11 The Post-crisis Critique of the NCM: Theoretical Aspects . . . . . . . 233

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
2 Representative Agent Equilibrium Models and Reductionism . . . . . 234
3 Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
4 Transversality Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
5 Nature of Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
6 Complete and Efficient Markets . . . . . . . . . . . . . . . . . . . . . . . . . . 239
7 RBC and DSGE Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
12 NCM Critique: Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . 255
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
2 Rethinking Monetary Policy in the Wake of the Crisis . . . . . . . . . . 256
2.1 “Slipping Transmission Belt” Syndrome . . . . . . . . . . . . . . . . 257
2.2 Inflation Targeting, Asset Prices and Monetary Policy . . . . . . 260
2.3 Monetary Policy and Asset Prices—The Jackson Hole
Consensus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
3 Redefining the Role of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . 264
4 Regulatory and Supervisory Policy . . . . . . . . . . . . . . . . . . . . . . . . 266
5 Limitations of DSGE Models for Policy . . . . . . . . . . . . . . . . . . . . 267
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
13 Post-crisis NCM Theory Adaptations: Evolutionary,
Revolutionary or Cosmetic? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
2 Methodological Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
3 Mainstream Reactions to the Crisis . . . . . . . . . . . . . . . . . . . . . . . . 281
3.1 The Loyalist’ Stand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
3.2 The Position of the Moderates . . . . . . . . . . . . . . . . . . . . . . . . 285
3.3 The Insider Critics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
4 The NCM Controversy in a Lakatosian Framework . . . . . . . . . . . . 290
4.1 The Lakatosian Framework . . . . . . . . . . . . . . . . . . . . . . . . . . 290
4.2 The NCM and the Post-crisis Critique . . . . . . . . . . . . . . . . . . 293
5 Perpetuation of the NCM Paradigm . . . . . . . . . . . . . . . . . . . . . . . . 297
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
14 Revisiting Domestic and Global Macroeconomic Policy
in the Aftermath of the Global Crisis . . . . . . . . . . . . . . . . . . . . . . . 305
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
2 Role of National Policy-Making Bodies: Post-crisis
Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
3 Central Bank Jurisdiction: Rethinking Monetary Policy . . . . . . . . . 309
3.1 Asset Prices and Financial Fragility—the Jackson
Hole Consensus (JHC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
xx Contents
3.2 IT and Nominal Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . 312

3.3 IT and Fiscal Dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
4 Financial Regulatory & Supervisory Authority Jurisdiction . . . . . . . 313
4.1 From Micro-prudential to Macroprudential Regulation . . . . . . 313
4.2 Strengthening and Expanding the Scope of Regulation
and Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
4.3 Reinforcing Prudential Standards . . . . . . . . . . . . . . . . . . . . . . 316
4.4 Devising Market Incentives for Prudent Behaviour . . . . . . . . . 318
4.5 Early Warning and Prompt Corrective Action System
(EWPCAS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
4.6 Reducing Costs of Financial Failures . . . . . . . . . . . . . . . . . . . 323
5 Measures Under Government Jurisdiction . . . . . . . . . . . . . . . . . . . 326
5.1 Revisiting Full Capital Account Convertibility . . . . . . . . . . . . 326
6 Role of the IMF and Proposed Reforms . . . . . . . . . . . . . . . . . . . . 329
7 International Advisory Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
7.1 G20 and Its Role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
7.2 Financial Stability Forum (FSF)/Board . . . . . . . . . . . . . . . . . . 334
8 International Financial Standard-Setting Bodies . . . . . . . . . . . . . . . 335
8.1 The Bank for International Settlements (BIS) . . . . . . . . . . . . . 335
8.2 International Organization of Securities Commissions
(IOSCO) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
15 Sustaining Growth with Monetary and Financial Stability
in India: An Appraisal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
2 Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
2.1 Brief History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
2.2 Urjit Patel Committee (2014) . . . . . . . . . . . . . . . . . . . . . . . . 358
2.3 Alternatives to Inflation Targeting . . . . . . . . . . . . . . . . . . . . . 359
3 Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
4 Financial Regulatory and Supervisory Policy . . . . . . . . . . . . . . . . . 369
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
4.2 Special Regulatory Authority . . . . . . . . . . . . . . . . . . . . . . . . . 369
4.3 Coordination Among Regulators . . . . . . . . . . . . . . . . . . . . . . 370
4.4 Strengthening and Expanding the Scope of R and S
to the Shadow Banking Sector . . . . . . . . . . . . . . . . . . . . . . . 371
4.5 Reinforcing Prudential Standards for Financial
Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
4.6 Market Incentives for Prudent Behaviour/Market
Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
Contents xxi
4.7 Reducing Cost of Financial Failures . . . . . . . . . . . . . . . . . . . 381

4.8 Emphasis on Macroprudential Regulation . . . . . . . . . . . . . . . . 386
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388
16 By Way of Conclusion: Selected Issues in Designing
a New Architecture for the Indian Financial Sector . . . . . . . . . . . . 393
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
2 HPEC and CFSR Reports: A Critical Appraisal . . . . . . . . . . . . . . . 394
2.1 General Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
2.2 Principles-Based Versus Rules-Based Regulation . . . . . . . . . . 396
2.3 Integration of Financial Trading Regulation
and Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
3 Financial Sector Legislative Reforms Commission
(FSLRC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
4 Regulatory and Supervisory Independence:
A Neglected Issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401
5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
Abbreviations
AA Adjudicating Authority
ABRR Asset –based Reserve Requirements
ABS Asset-based Securities
ABSPP Asset-based Securities Purchase Programme
ACE Agent-based Computational Economics
ADB Asian Development Bank
ADR American Depository Receipts
AIF Alternative Investment Funds
AIPAC Alternative Investment Policy Advisory Committee
AMEs Advanced eCompanies
HPEC High-Powered Expert Committee (Percy Mistry Committee)
IAIS International Association of Insurance Supervisors
IBBI Insolvency and Bankruptcy Board of India
IBC Insolvency and Bankruptcy Code
ICA Inter-Creditor Agreement
ICAI Institute of Chartered Accountants of India
IEC Independent Evaluation Committee
IFRS International Financial Reporting Standards
IIFC India Infrastructure Finance Company
ILO International Labour Organization
IMF International Monetary Fund
INR Indian rupee
IOSCO International Organization of Securities Commissions
IPA Insolvency Professional Agency
IRDAI Insurance Regulatory & Development Authority of India
IRF-FC Inter-regulatory Forum for Monitoring Financial Conglomerates
IR-TG Inter-regulatory Technical Group
IRS Interest Rate Swaps
IT Inflation Targeting
IUs Information Utilities
xxiii
xxiv Abbreviations
JHC Jackson Hole Consensus

JLF Joint Lenders’ Forum
LBRR Liability Based Reserve Requirements
LCR Liquidity Coverage Ratio
LDC Less Developed Country
LR Leverage Ratio
LTV Loan to Value Ratio
MAP Mutual Assessment Process
MBS Mortgage Based Security
MEC Marginal Efficiency of Capital
MFMG Macro-Financial Monitoring Group
MIS Management Information Systems
MMMF Money Market Mutual Fund
MNREGA Mahatma Gandhi National Rural Employment Guarantee Act
MPC Monetary Policy Committee
MRO Main Refinancing Operations
MTM Mark to Market
MURI Minimum Unemployment Rate of Inflation
NABARD National Bank for Agriculture and Rural Development
NAIRU Non-Accelerating Inflation Rate of Unemployment
NASDAQ National Association of Securities Dealers’ Automated Quotation
NBFC Non-Bank Financial Company
NCEUS National Commission for Enterprises in the Unorganized Sector
NCLT National Company Law Tribunal
NCM New Consensus macroeconomics
NFE Non-financial Entities
NGO Non-Governmental Organization
NHB National Housing Bank
NINA No Income, No Assets
NIVA No Income, Verified Assets
NPA Non-Performing Asset
NRH Natural Rate Hypothesis
NRI Non-Resident Indian
NSE National Stock Exchange (India)
NSI-D-NBFC Non-Systematically Important Deposit Accepting Non-Bank
Financial Companies
OICV Organisation Internationale des Commissions de Valeurs
OLA Orderly Liquidation Authority
OLIR Optimum Long-run Inflation Rate
OTC-D Over-the-Counter Derivatives
PCA Prompt Corrective Action
PDCF Primary Dealer Credit Facility
PDMA Public Debt Management Agency
Abbreviations xxv
PFRDA Pension Fund Regulatory & Development Authority

PPM Private Placement Memorandum
PPP Purchasing Power Parity
QE Quantitative Easing
R&S Regulation & Supervision
RBI Reserve Bank of India
RBP Risk-based Premium
RD Revenue Deficit
REER Real Effective Exchange Rate
REH/RET Rational Expectations Hypothesis/Theory
RWA Risk-Weighted Assets
SARFAESI Securitisation and Reconstruction of Financial Assets and
Enforcement of Securities Interest Act
SAT Securities Appellate Tribunal
SDR Special Drawing Rights
SEBI Securities and Exchange Board of India
SEC Securities Exchange Commission
SGP Stability & Growth Pact
SIDBI Small Industries Development Bank of India
SI-D-NBFC Systematically Important Deposit Accepting Non-Bank Financial
Companies
SIFI Systematically Important Financial Institutions
SIV Special Investment Vehicles
SIVA Stated Income, Verified Assets
SLR Statutory Liquidity Ratio
SMA Special Mention Accounts
SMP Securities Market Programme
SPE Special Purpose Entity
SPV Special Purpose Vehicles
SRM Single Resolution Mechanism
SRP Scientific Research Programme
TLAC Total Loss Absorbing Capacity
TSLF Term Securities Lending Facility
TW-SB Trip Wires & Speed Bumps
ULIP U/nit Linked Insurance Plan
UNCTAD United Nations Conference on Trade and Development
UNDP United Nations Development Programme
UPC Urjit Patel Committee
URR Unremunerated Reserve Requirements
VaR Value-at-Risk
VAR Vector Auto-regression
VLTRO Very Long-term Refinancing Operations
VM Variation Margin
xxvi Abbreviations
WARP (Wald’s) Weak Axiom of Revealed Preference

WB World Bank
WMA Ways & Means Advances
WTO World Trade Organization
ZLB Zero Lower Bound
About the Author
Dilip M. Nachane is currently Chancellor, University of Manipur, Imphal, India;

Professor Emeritus, Indira Gandhi Institute of Development Research (IGIDR),
Mumbai, India; National Fellow, Indian Council of Social Science Research
(ICSSR); Honorary Fellow, Institute of South Asian Studies (ISAS), National
University of Singapore; and Honorary Fellow, Indian School of Political
Economy, Pune, India. He has earlier served as Director, Department of Economics,
University of Mumbai (1993–1999); Vice Chancellor, IGIDR (2007–2010);
Visiting Professor, University of British Columbia, Vancouver, Canada (1988–
1989); Visiting Professor, University of Ulster, UK (1991–1992); Hallsworth
Fellow, University of Manchester, UK (1987–1988); and Fulbright Fellow,
University of Texas, Austin, USA (1982–1983). He has served on several official
committees such as Technical Advisory Committee on Monetary Policy, Reserve
Bank of India (2005–2011), and Member, Vijay Kelkar Committee on Regional
Imbalances in Maharashtra (Government of Maharashtra, 2011 onwards). He was
elected President of the Indian Econometric Society (TIES) (2002–2003). He has
been continuously listed in Marquis’ International Who’s Who for the last 15 years.
For his outstanding contributions to research and teaching of economics in India, he
received the UGC Pranavananda Saraswati Award for Best Teacher in Economics,
2004. He has published the following book with the Oxford University Press,
“India Econometrics: Theoretical Foundations’ and ‘Empirical Perspectives”. He
has also edited/coedited seven volumes including the “India Development Report
2011”. He is currently Editor-in-Chief of the Journal of Quantitative Economics
(Springer), and Coeditor of Macroeconomics and Finance in Emerging Market
Economies (Taylor and Francis).
xxvii
Chapter 1
Keynesian Economics: Brief Overview
Abstract Writing against the background of the Great Depression of the 1930s,
Keynes was trying to develop a theoretical understanding of why unemployment
could be persistent in a capitalist economy. The received theory at that time (which
Keynes dubbed as classical but which today is usually termed as neoclassical)
attributed this hysteresis in unemployment to the downward rigidity of nominal
wages due to “money illusion” on the part of workers. We begin this introductory
chapter with a brief overview of the economics of Keynes’ General Theory and
discuss various attempts at its formalization and synthesis with the earlier neo-
classical economics, embodied in the IS-LM framework. We then introduce the
Phillips curve and its incorporation into Keynesian analysis. In the final section, we
introduce open economy considerations into the IS-LM framework.
1 Introduction
In his Presidential Address to the Eastern Economic Association on the occasion of

the 50th anniversary of the publication of Keynes’ General Theory of Employment,
Interest and Money (henceforth GT for short), Solow (1986) describes it as “the
most influential work of economics of the 20th century”. Many economists would
perhaps find the title of Klein’s book The Keynesian Revolution a bit overenthu-
siastic and Diebold’s statement (see Adams 1992, p. 31) that “before Keynes and
Klein there really was no macroeconomics” highly exaggerated. Yet, Keynes GT is
widely regarded by most writers as the logical starting point for any narrative on
macroeconomics. Perhaps, there is no greater compliment to an individual than one
coming from his severest critics. And in Keynes’s case, it came from Pigou, when
in the course of his Marshall Lecture (1952–53) he admitted “Nobody before him
(Keynes), so far as I know, had brought all the relevant factors, real and monetary at
once, together in a single formal scheme, through which their interplay could be
coherently investigated”.
We begin this introductory chapter with a brief overview of the economics of
Keynes’ GT and discuss various attempts at its formalization and synthesis with the
© Springer (India) Pvt. Ltd., part of Springer Nature 2018 1

D. M. Nachane, Critique of the New Consensus Macroeconomics
and Implications for India, India Studies in Business and Economics,
https://doi.org/10.1007/978-81-322-3920-8_1
2 1 Keynesian Economics: Brief …
earlier neoclassical economics, embodied in the IS-LM framework. We then

introduce the Phillips curve and its incorporation into Keynesian analysis. In the
final section, we introduce open economy considerations into the IS-LM
framework.
2 Keynesian Economics
Writing against the background of the Great Depression of the 1930s, Keynes was
trying to develop a theoretical understanding of why unemployment could be
persistent in a capitalist economy. The received theory at that time (which Keynes
dubbed as classical but which today is usually termed as neoclassical) attributed
this hysteresis in unemployment to the downward rigidity of nominal wages due to
“money illusion” on the part of workers. With nominal wages rigid downwards, the
fall in prices due to industrial recession led to a rise in real wages, and a contraction
in employment. While this view was held by a majority of economists writing on
the issue at that time, as its archetypical representative Keynes selected Pigou
(1927, 1933), in whose writings the view finds its most systematic articulation.
2.1 Main Constituents of the Keynesian Framework
This section is devoted to a discussion (somewhat brief, since most readers would
be reasonably familiar with the contents) of the basic Keynesian analysis in the
General Theory.
Aggregate Demand and Supply : The starting point of Keynesian analysis is the
concept of aggregate demand and supply. Whereas aggregate demand refers to the
total planned expenditure in an economy, aggregate supply refers to the total
planned production. The economy is in equilibrium when aggregate demand and
supply are equal.
Let us now examine the components of aggregate demand Y D . These are,
respectively, (i) domestic private consumption C, (ii) domestic private investment I,
(iii) government expenditure G (including both consumption and investment goods)
net of taxes T, (iv) exports of consumption and investment goods X and (v) imports
of consumption and investment goods M. Thus, we can write
Y D ¼ C þ I þ ðG T Þ þ ðX M Þ ð1Þ
2 Keynesian Economics 3
If Y S denotes aggregate supply, then the equilibrium condition is
Y S ¼ Y D ¼ Y ¼ C þ I þ ðG T Þ þ ðX M Þ ð2Þ
where we denote the equilibrium output as Y. (2) is the famous Keynesian national
income identity.
A traditional way of introducing the Keynesian theory of unemployment is via
the concepts of aggregate demand and supply curves. We note the very obvious fact
that as total employment in the economy increases, output also increases. This may
be denoted by the relation
Y ¼ N ðE Þ ð3Þ
where E is employment and Y is output. Let EF denote the full employment level
and YF the corresponding full employment level of output.
We can draw an aggregate demand curve (AD) showing the relationship
between the demand for real GDP and the aggregate price level P, which would
slope downwards, and an aggregate supply curve (AS) relating the total supply of
real GDP to the price level P, which would be upward sloping.
We know from (1) that the aggregate demand is made up of four components,
viz. C, I, (G − T) and (X − M). Let us see how each of these is affected by a fall in
the aggregate price level. First of all we note that the component of government
expenditure and taxes is unaffected by the price level. The fall in the aggregate price
level increases the real value of the money balances held by households. A part of
this additional purchasing power is spent on consumption, but a part is also invested
in financial assets. Thus, C increases but additionally, the rate of interest is reduced,
thereby stimulating investment. Thus, both C and I increase. Finally, the fall in the
price level makes exports cheaper so that X increases; simultaneously, because
domestic goods are now cheaper relative to imports, there is a decrease in imports
M. Thus, a lower aggregate price level P corresponds to a higher level of aggregate
demand Y. Hence, the aggregate demand curve AD is downward sloping.
Let us now turn to the supply side. The Keynesian aggregate supply
(AS) essentially consists of three stretches—a flat stretch (corresponding to a
recessionary phase), an upward sloping middle stretch and a vertical sloping final
stretch corresponding to full employment of resources. In a recession, it may be
reasonable to assume that employment of labour can be increased without raising
wage costs, since a pool of unemployed labour is available. Similarly, the use of
other resources which are lying idle can be activated without increases in rentals.
Thus, output can be increased without raising average costs. Hence, the AS curve is
horizontal over an initial stretch (up to the output level Y 1 in Fig. 1). However as
the economy recovers, and the availability of unemployed resources dries up, wages
and other rentals start rising. Further with more intensive use of resources,
diminishing returns may set in. Thus over the employment levels Y 1 to Y f in Fig. 1,
P LRAS
Aggregate Price
Level
SRAS
AD
Y1 Ye Yf Y (National Output)
Fig. 1 Aggregate demand and supply
the AS curve is upward sloping. The output level Y f corresponds to the full
employment level, beyond which no further expansion in output is possible.
The AS curve then becomes vertical. The middle upward stretch of the AS curve is
sometimes referred to as the short-run AS (SRAS) curve, while the vertical stretch
is referred to as the long-run AS (LRAS) curve.
The point of intersection of the AD and AS curves represents an equilibrium for
the economy, and the corresponding level of output (Y e in Fig. 1) is referred to as
the level of effective demand.
For a detailed discussion of these concepts, refer to (Bade and Parkin 2011;
Schiller and Gebhardt 2016; D’Souza 2008, etc.). The Appendix to the chapter
offers a related but distinct approach to the problem, which has the advantage of
offering a bridge between Keynes’ Treatise and the General Theory.
The Multiplier : The origin of the concept of the employment multiplier is widely
attributed to Kahn (1931), who argued that any investment increases “direct”
employment in the investment goods sector, and as the wages and profits generated
in this sector are spent on consumption goods, there will be secondary effects on
employment. The effects are passed on successively, but with diminishing intensity,
until they become negligible. In sum, the total employment generated will be a
multiple of the original direct employment, the multiplier depending on the
employment intensity of the investment and consumption goods sector. Keynes
took up this idea and applied it to investment outlays (rather than employment) (see
Marcuzzo 2002).
Basic to the Keynesian multiplier is the idea of a consumption function, which
relates consumption (C) to income Y. In the exposition, for the sake of simplicity,
we take the consumption function to be linear.
C ¼ f ðY Þ ¼ a þ cY ð4Þ
where a and c are constant parameters. c is termed as the marginal propensity to

consume (it is the addition to consumption due to a unit rise in income) and c 1;
since people usually consume only a portion of any increment in income.
If investment I now increases by a quantity DI, by the national income identity

(2), the direct increase in income DY is simply DI. This leads to an increase in
consumption of ðcDIÞ in the first round, c2 DI in the second round and so on ad
infinitum. The total increase in income is thus
DI
DI 1 þ c þ c2 þ cn þ ¼ ¼ mDI ð5Þ
ð 1 cÞ
where m ¼ ð1c1
Þ is defined as the Keynesian expenditure multiplier. As c 1; the
1
multiplier m is greater than or equal to 1. Thus, an increase in investment increases

income by a multiple of the original investment.
Interestingly, the idea of an expenditure multiplier seems to have been first
enunciated by Hawtrey in January 1931 in a working paper (No. 66) for the
Macmillan Committee (see Davis 1981, pp. 216–217).
Marginal Efficiency of Capital : The view about investment held by the neo-
classical school prior to the General Theory was that firms invested in machinery to
the point where the marginal productivity of capital was equal to its rental (proxied
by the rate of interest). The marginal productivity of capital was assumed to be a
stable and declining function of the level of capital. Keynes recognized that in a
modern capitalist economy, expectations (about returns) played a key role in
determining the level of investment, and these expectations were subject to mood
swings of exuberance and pessimism. Hence, investment was inherently volatile
and uncertain. Further, this uncertainty was pure uncertainty of the Knightian
variety, which cannot be captured in well-defined probability distributions over
outcomes (statisticians refer to this as non-ergodic uncertainty). To allow for the
crucial role of expectations in determining investment, Keynes introduced the
concept of the marginal efficiency of capital.
Let a machine whose supply price2 is Q, yield prospective (expected) returns to
the entrepreneur of R1 ; R2 . . .Rn over its expected lifetime of n years. Further, its
scrap value at the end of its life is supposed to be S. Then the marginal efficiency of
capital is that rate of discount q, at which the net present value (left-hand side of (6)
below) of the machine equals its supply price Q, i.e.
R2 ðRn þ SÞ
R1 þ þ ¼Q ð6Þ
ð1 þ qÞ ð1 þ qÞn1
(see Keynes 1936; Tsoulfidis 2008; Fuller 2014, etc.).
1
The left-hand side of (5) is a convergent geometric series (if c is strictly less than 1) with the sum
shown on the right-hand side.
2
To Keynes, the supply price of a piece of machinery is the amount which would just induce a
producer of that machine to engage in its production. It is to be distinguished from the market
price. Following the convention of later writers, we do not pursue this distinction here.
Keynes now considers an entrepreneur contemplating the number of machines of

a particular type to buy. If q1 ; q2 . . .qk are the marginal efficiencies of successive
units, then there is a good case for assuming that these decline with each additional
unit obtained, i.e. q1 q2 qk . This according to Keynes results from the fact
that with each fresh unit of a particular type of machine produced, its expected yield
declines and the cost of producing it (supply price) increases (see Keynes 1970
[1936], p. 136). If we draw a diagram showing the marginal efficiencies corre-
sponding to successive units of machinery, then such a curve would be downward
sloping. The entrepreneur would carry on purchasing machinery as long as he can
borrow funds in the market at a rate lower than the marginal efficiency of capital,
i.e. till the point of intersection between the marginal efficiency of capital schedule
and the horizontal line indicating the long-term interest rate (point K* in Fig. 2).
Thus in Keynes’ General Theory, the quantum of investment depends on the
interest rate as with the neoclassicals. But whereas for the latter the investment
schedule is a stable function of the interest rate, in Keynes, the schedule is highly
volatile, depending on expected returns, which could swing violently and unpre-
dictably with the moods of the market. This unpredictable volatility is at the heart of
Keynes’ theory, an insight often lost in the later attempts to formalize the Keynesian
analysis (see Sect. 3).
Liquidity Preference Theory : The third pillar of Keynesian economics is the
liquidity preference theory. Keynes view of the rate of interest differed funda-
mentally from that of the earlier neoclassicals. The rate of interest is not (according
to Keynes) the price which equilibrates the demand for investment funds with the
supply of savings (as the neoclassicals supposed). Instead, in the Keynesian liq-
uidity preference theory, the interest rate is the reward demanded by economic
agents to relinquish their control over liquidity.
Keynes distinguished between three motives for holding money, viz. the
transactions, precautionary and speculative motives (see Keynes 1970 [1936],
p. 170). The first two motives are a predictable function of income, and Keynes did
not focus much on them. The speculative motive is what Keynes concentrated on,
Marginal
efficiency of
capital/ rate
of interest
r*
(Long-term rate
of interest) MEC
K* Units of machinery
Fig. 2 Marginal efficiency of capital (MEC) schedule

as in his view, that was unpredictable and played a key role in determining market
interest rates. Assuming that people have only two choices of the medium in which
to hold their funds, viz. money (liquid but earning no return) and infinite duration
bonds (consols) (which are not fully liquid but which earn some interest given by
the coupon rate).3 The market rate of interest r in the General Theory is determined
by the demand for liquidity (money was defined in Keynes’ time, usually, as cash
plus bank current account deposits)—the so-called liquidity preference schedule—
and the fixed supply of money M injected in the economy by the central bank (see
Fig. 3). The liquidity preference schedule plots the amount of money demanded
(for speculative purposes versus the rate of interest). It is downward sloping (as the
reward for parting with money decreases, people desire to hold more of it), and it
flattens out towards the right (see Fig. 3). This latter tendency is dubbed as the
liquidity trap and occurs because of two factors: (i) at very low rates of interest,
there is always the expectation that the interest rate may rise, and (ii) a small rise in
the interest rate imposes huge losses on bondholders when the interest rate is very
low.4
Some important criticisms of the liquidity preference theory may be found in
Appelt (2016), Panico (1988), Bibow (2005), etc.
Money Wages and Unemployment : The neoclassical theory, by subscribing to
Say’s law, saw full employment as the automatic consequence of the working of
market forces in an environment characterized by fully flexible wages and prices.
Many neoclassical writers (see, e.g. Pigou 1950) were careful to emphasize that full
employment may not always exist, but tends to be established. The short-term/
disequilibrium departures from unemployment could arise because of downward
wage inflexibility in the short run, but in the long run, there are strong forces that
impel real wages to fall in the face of unemployment. This fall in real wages would
automatically restore the demand for labour by employers and increase
employment.
Keynes’ contention regarding the relationship between wages and unemploy-
ment is quite complicated. He has actually two theories about this. Firstly, in
Chap. 2 of the General Theory, he notes his point of agreement with the neoclas-
sical position “…an increase in employment can only occur to the accompaniment
of a decline in the rate of real wages” (Keynes 1970 [1936], p. 17). But he disputes
on pragmatic grounds, the neoclassical postulate that in practice workers and
3
It is a straightforward matter to generalize Keynes’ analysis to the multi-assets case with differing
degrees of liquidity and returns streams (see, e.g. Patinkin 1956; Tobin 1958).
4
Consider 2 situations. First, suppose a person holds a bond whose face value is 100 and the
coupon rate is 5%. If the current market rate of interest is also 5%, then the market price of the
bond is also 100. Suppose the market rate of interest rises by 25 basis points (0.25%) to 5.25%, the
price of the bond will fall to 95.23 (since now only this amount of investment is needed to get a
return of 5). Next, suppose on the other hand the initial market rate of interest had been 1%, the
price of the same bond would have been 500. Now if the rate of interest rate rises to 1.25%, the
price of the bond would drop to 400. Thus whereas in the first situation the loss to the bondholder
is about 4.75% of the initial price, in the second situation the loss on the initial price is 20%.
Rate of
interest
LL2
Money Supply
r*
Liquidity Preference Schedule
LL1
M* Demand for Money
Fig. 3 Liquidity preference schedule
employers can bring real wages down through a process of mutual bargaining of
money wages. He is thus attributing the long-term unemployment associated with a
long depression to money wage rigidity. The money wage rigidity could be
attributed to “money illusion” of workers in general, who are reluctant to let wages
decline in money terms, even if this leads to lesser unemployment. But there is an
additional factor in the picture—workers in any specific industry are also keen to
protect their wages relative to those of workers in other sectors. Thus, a general
wage reduction cannot be achieved via bargaining between unions and manage-
ment, sector by sector. The only possibility is a general wage reduction by gov-
ernment fiat, which in a capitalist democracy would involve a considerable
infringement of individual rights. Much of the later literature in the neo-Keynesian
tradition (discussed in the Chap. 4) is aimed at providing theoretical explanations of
why real wages may be rigid in actual economies.5
But if this were all to the Keynesian theory, it would have hardly been the basis
for an intellectual revolution. The second, more substantive theory, elaborated in
Chap. 19 of the General Theory goes on to develop the argument that even if money
wages were flexible, the required fall in real wages (to raise employment) may not
necessarily occur. In the Keynesian theory, any fall in the general level of money
wages would bring about a rise in employment, if the following three possibilities
applied in conjunction. If, however, not all of them were applicable, the outcome
would depend on the relative strengths of the possibilities which held true and those
which did not. The three possibilities considered were a fall in the money wages
leading to (i) a rise in the marginal propensity to consume, (ii) a fall in the long-term
interest rate and (iii) a rise in the marginal efficiency of capital. Keynes (1970)
[1936] in Chap. 19 considers all three possibilities in detail.
5
An early writer who attempted to provide justification for this fact is Smith (1956) whom Darity
and Young (rightly) regard as foreshadowing the neo-Keynesians.
Because a fall in money wages may not lead to an equivalent fall in prices,
income distribution shares would shift in favour of profits and away from wages.
Since the rich entrepreneurs would tend to save more than the poorer workers, the
marginal propensity to consume is most likely to fall.
Since a fall in money wages would lead to lower mass purchasing power,
business expectations of future sales from their product would contract, lowering
the marginal efficiency of capital for all items of mass consumption.
Finally, while a contraction of incomes would lower the transactions and pre-
cautionary demand for money, thereby making more money available to satisfy the
speculative motive, this would only lower the rate of interest if the economy was
not operating on the horizontal section of the liquidity preference schedule; i.e. the
economy was not already at a very low rate of interest. But even if the market rate
of interest were above the liquidity trap, the lowering of money wages would create
a situation of social unrest in which people’s desire for liquidity would rise; i.e. the
liquidity preference schedule would shift outwards (from LL1 to LL2 Fig. 3). With
a given level of money supply, this would set up a tendency to raise the rate of
interest. Of course, if the money supply were increased, then the rate of interest
could still fall. But then the following question arises—if a fall in the interest rate
could be engineered both by a fall in money wages or by an increase in money
supply, why not choose the latter method which is much easier to implement
politically and can be done almost with a stroke of the pen? A general money wage
reduction across all sectors by contrast (as we have seen above) is almost infeasible
in a modern democracy, where each sector might be dominated by a distinct union.
3 The IS-LM Synthesis
Immediately following the publication of the General Theory, a number of younger

economists tried to formalize the underlying analysis in mathematical terms (see
Darity and Young 1995 for a detailed critical appraisal of these early efforts). The
most famous of this is, of course, the IS-LM formalization of Hicks (1937), but
there were several other somewhat less famous, but equally insightful, formaliza-
tions by Champernowne (1936), Lerner (1936), Meade (1937), Harrod (1937),
Modigliani (1944), Hansen (1953), Lindahl (1954), etc. We confine our attention to
the Hicksian analysis, which we discuss in some detail. The discussion in the next
few sections is restricted to the context of a closed economy, i.e. one which does not
engage in foreign trade.
3.1 Hicks’ IS-LM Synthesis
Hicks’ (1937) paper is significant for three reasons. Firstly (as mentioned above), it
attempted to present a formalization of the largely verbal reasoning in the General
Theory; secondly, it showed that both the neoclassical and the Keynesian systems
were really particular characterizations of a more general meta-model; and finally,
this meta-analysis could be encapsulated in simple diagrammatic terms.
For his meta-analysis, Hicks considers a two-sector model—a consumer goods
sector whose physical output we denote by C þ and an investment goods sector
with physical output I þ : It is assumed that both sectors are composed of a large
number of perfectly competitive firms. Let NC and NI denote the aggregate
employment in the two sectors and because capital stock in the two sectors is
assumed by Hicks to be fixed in the short run (in keeping with the General Theory
formulation), the output in each sector depends only on the employment of labour
in that sector. If the aggregate technical production functions in the two sectors are
denoted by fC and fI , we get the following relation
C ¼ fC ðNC Þ ð7Þ
I ¼ f I ðN I Þ ð8Þ
N ¼ NC þ NI ð9Þ
where N is the total employment in the economy.

To begin with, Hicks assumes that the money wage rate is fixed at x ¼ x
If PC and PI denote the price of consumption and investment goods, respec-
tively, then because of the assumption of perfect competition in both sectors, price
will equal the marginal cost, i.e.

dNC
PC ¼ x ð10Þ
dC

dNI
PI ¼ x ð11Þ
dI
The total monetary value of the output in the two sectors is denoted by C and
I. And by definition
C ¼ PC C þ and I ¼ PI I þ ð12Þ
If we add a government sector and let G denote the value of government

expenditure and T the taxes, then total nominal income Y in the economy is defined
as
Y ¼ C þ I þ ðG T Þ ð13Þ
Hicks assumes that consumption depends on both income (Y) and rate of interest
r. If we denote the savings in the economy by S, then
3 The IS-LM Synthesis 11
S ¼ sðr; Y Þ ð14Þ
Investment is assumed to depend on the market rate of interest. Thus
I ¼ hð r Þ ð15Þ
Finally, Hicks assumes the demand for money MD as determined by the trans-
actions and speculative motive and thus depending on both Y and r, i.e.
MD ¼ LðY; r Þ ð16Þ
The money supply is assumed fixed by the monetary authority
MS ¼ M ð17Þ
The system is closed through three equations. The first is the national income
identity (13); the second is the investment-saving equilibrium condition
I ¼ S or hðr Þ ¼ sðr; Y Þ ð18Þ
Lastly, the money market will be in equilibrium if
MD ¼ MS ¼ M ð19Þ
The Hicksian meta-model (7)–(19) embeds both the Keynesian and the neo-
classical model as special cases. The neoclassical model involves replacing (14) and
(16) by
S ¼ sðr Þ ð140 Þ
MD ¼ kY ð160 Þ
(k is a constant)
In the Keynesian model, (14) is modified to
S ¼ sðY Þ ð24′′Þ
while (15) and (16) are retained but with an emphasis on their volatile nature.
Thus, in the neoclassical system, monetary equilibrium determines national
income, and the rate of interest equilibrates saving and investment. In the Keynesian
system, by contrast, the determination of both interest and income depends on the
attainment of simultaneous equilibrium in the goods and money markets.
In the neoclassical system, the investment function (15) is assumed to be a
largely stable relation, whereas in the Keynesian system, it is highly volatile and
unpredictable. Similarly, in (16), the speculative component of the demand for
money introduces a strong element of uncertainty.
The immense popularity of the Hicksian analysis owes much to the geometric
device that Hicks used in order to present his meta-model. Using a two-dimensional
graph, with income (Y) plotted on the x-axis and the rate of interest (r) on the y-axis,
he derives two curves. The first of these curves (which we call the IS curve)
represents the goods market equilibrium, obtained by solving (14), (15) and (18).
For a given level of r, say r0 , from (15) we get the corresponding investment level
I0 . For equilibrium in the goods market, (18) must hold and equating the right-hand
side of (14) to I0 we get the level of income Y0 consistent with I0 and r0 . Thus for
each level of r, we get a corresponding value of Y and the resultant plot is called the
IS curve. This curve is downward sloping and moves to the right if G is increased or
T is decreased.6 The second curve is drawn to represent the money market equi-
librium and is obtained by equating the demand for money (16) to the given money
supply M (17). It thus shows all combinations of r and Y at which the demand for
money equals a given level of money supply and is thus a curve, each point of
which represents money market equilibrium. This curve (referred to as LM) is
upward sloping and depends on the level of real money supply. As real money
supply increases, the LM curve shifts outwards.7 If a liquidity trap exists (say at rl ),
then the LM curve is almost flat for a stretch at rl (for even if the level of income is
low, and the transactions demand for money is correspondingly low too, all this
additional money will be absorbed once the rate of interest hits the lower bound rl ).
Similarly, the LM curve is likely to be vertical to the right—if incomes rise so high
(full employment level) that the transactions demand for money absorbs virtually all
the money supply, very little will be available to satisfy the speculative motive and
interest rates will shoot up sharply (in practice, no monetary authority will stand by
passively and watch this happen, but intervene and increase the money supply).
The economy is in overall equilibrium at the point (Y*, r*) where the IS-LM
curves intersect (see Fig. 4). In this diagrammatic representation, a fiscal stimulus
corresponds to an increase in G by the government through public investment, or a
decrease in T through tax cuts, and shifts the IS curve to the right. A relaxation of
monetary policy (an increase in real money supply) corresponds to an outward shift
of the LM curve.
Now consider the situation where the economy is coursing through smoothly at a
fairly high level of income. In Fig. 5a, the economy is on the near vertical stretch of
LM. On this stretch, any shift in the real money supply (i.e. LM curve) changes
income from the original equilibrium Y0 to the new equilibrium Y2 (a significant
6
The IS curve is downward sloping because as r increases, investment falls and the corresponding
level of income lowers. Any increase in G (or decrease in T) means that at a given rate of interest,
investment is increased as also the corresponding level of income.
7
That the LM curve slopes upwards can be seen as follows. As Y rises, more of the money supply
will be diverted to the transactions motive and less will be available to satisfy the speculative
motive. People will hold less money only if the rate of interest is higher. By a similar argument, a
rise in money supply means that at the same level of income, more will be available to satisfy the
speculative motive leading to a fall in the rate of interest. Thus, the LM curve will shift outwards.
Fig. 4 IS-LM framework Rate of LM

interest
r*
rl IS
Y* Income
shift). By contrast, a shift in the IS curve leaves income more or less unchanged (the
insignificant shift from Y0 to the new equilibrium Y1 in Fig. 5a) while producing a
sharp change in the rate of interest. The vertical stretch of the LM curve thus
corresponds to the classical near full employment case.
If, by contrast, the economy is on the horizontal stretch of the LM curve (see
Fig. 5b) with interest rate at its floor level, and high unemployment with output
much below capacity (i.e. a depression), an increase in money supply (an outward
shift in the LM curve) fails to affect either the output or the rate of interest.
A change in the IS curve (either because of an increase in government expenditure
G, or a change in the marginal efficiency of capital or propensity to consume) on the
other hand strongly affects income (as evidenced by the shift in income from Y0 to
Y1 in Fig. 5b. We are thus in the Keynesian world, where monetary policy is largely
ineffective, and the only alternative available to emerge from the recession is to
increase government investment in public works. Finally over the middle stretch of
the LM curve, we have a hybrid world which is neither purely neoclassical nor
purely Keynesian, in which the relative efficacy of fiscal and monetary policy would
depend on the relative slopes of the IS and LM curves.
Thus, the Hicksian IS-LM model is a meta-model of which the Keynesian and
neoclassical models are special instances. It is in this sense that the IS-LM model
marks a synthesis—we call it the Old Neo-Classical Synthesis to distinguish it from
the more recent New Synthesis which forms the subject matter of Chap. 4.
3.2 Keynes and the IS-LM Analysis
In one of his early articles, Samuelson (1947) had observed thus “until the
appearance of the mathematical models of Meade, Lange, Hicks and Harrod, there
is reason to believe that Keynes himself did not truly understand his own analysis”.
Careful research by Rymes (1987, 1989) has resulted in a compilation of notes
(a)
Neo-classical Special Case
LM LM’
Rate of
interest
IS’
IS
Y0 Y1 Y2 Income
(b)
The Keynesian Special Case
Rate of
LM LM’
interest
IS IS’
Y0 Y1 Output
Fig. 5 a Neoclassical special case. b The Keynesian special case
taken by students attending Keynes lectures during 1932–1935. From the notes of
the lecture on 4 December 1933, it appears that Keynes formalized his theoretical
system in the following equations (see Dimand 2017, p. 8). These equations are
reproduced below (notation slightly changed to conform to that used by us):
M ¼ Lðr; gÞ ð20Þ
C ¼ uðY; gÞ ð21Þ
I ¼ hðr; gÞ ð22Þ
Y ¼ C þ I ¼ uðY; gÞ þ hðr; gÞ ð23Þ
The close resemblance between Hicks’ formalization of the Keynesian system

and the above system is immediately apparent.8 (Note, in particular, Keynes’ use of
the variable η to highlight the uncertainty underlying the various relationships.)
Thus, Samuelson’s statement is quite misplaced—Keynes was fully aware of the
way his system could be formalized. The only reason for him not using this for-
malization in the General Theory was that in keeping with the preferred mode of
articulation of his times, he chose to present his analysis in verbal terms.
4 IS-LM Keynesianism
In the years following the General Theory, criticisms, amendments and extensions
followed in quick succession. It is not possible for us to consider all these later
developments, but we focus on three of the most important, viz. the real balance/
wealth effect, the Phillips curve and the attempts to extend the Keynesian analysis
to the general equilibrium context.
4.1 Real Balance Effect and Wage Flexibility
As we have seen above, Keynes in the General Theory had maintained (Chap. 19)
that even if money wages were flexible, in a depression wage cuts would be
ineffective in restoring full employment. A number of writers critically examined
this proposition, in an attempt to salvage the neoclassical view, that in theory, wage
cuts could restore employment, howsoever infeasible their applicability in practice.
Among the most notable of these attempts was Pigou (1943, 1947, 1950), who
introduced the so-called wealth effect. Keynes had postulated that the consumption
function depended primarily on current income Y. Pigou, by contrast, made con-
sumption a function not only of current income Y, but also of “real net wealth”
W. As W increased, people felt themselves richer and consumed more out of their
8
The only difference between the two formulations is that Keynes uses the consumption function
rather than the savings function, and he drops the income level Y from his demand for money
function.
current income. Thus, Keynes’ consumption function (21) (dropping the uncer-
tainty parameter η) is modified to
C ¼ uðY; W Þ ð24Þ

where W was defined to comprise (i) real money supply MP and (ii) real supply of

bonds BP (where B and M are, respectively, the amounts of bonds outstanding and
money supply, while P is the aggregate price level). Thus, real wealth W was
defined by9

M B
W¼ þ ð25Þ
P P
Patinkin (1948) works out the implications of the wealth effect (what he calls as
the real balance effect)10 for the full IS-LM system. His modified consumption
function is (24) as in Pigou, but he also made an important change to the demand
for money function by expressing the Keynesian demand for money function as a
demand for real money balances11

MD M
¼ Lðr; Y Þ ¼ ð26Þ
P P
We have seen earlier (Sect. 2.1) that Keynes had expressed scepticism about
both (i) the feasibility of wage cuts in practice as well as (ii) their utility in restoring
full employment, even granting their feasibility. Pigou and Patinkin wholeheartedly
agreed with Keynes on the first of these points. But on the second, they felt that the
real balance/wealth effect would alter Keynes’ pessimistic conclusion considerably.
Their argument ran as follows. As money wages fell, prices would fall to some
extent. This fall in prices would raise real wealth W (see 25) and lead to a rightward
shift in the consumption function (24). This has the implication of shifting the IS
curve outwards. Simultaneously, the fall in prices would raise the volume of real
money balances in the economy, shifting the LM curve also to the right. This
double effect would certainly yield a rise in employment, and the bigger the fall in
money wages, the greater the associated decline in prices and the larger the gain in
employment (see Fig. 6).
9
To this, Metzler (1951) added the physical capital K in the economy. However, its inclusion
makes little difference to the analysis.
10
Most of Patinkin’s (1956) book is concerned with an exchange economy in which there is no
production.
11
Actually since Keynes concerned himself (in the General Theory) with a fixed prices model, the
distinction between real and nominal money balances is not relevant to him.
4 IS-LM Keynesianism 17
r
LM1 LM2
Rate of
interest
IS2
1
IS
Y1 Y2 Y, Output
Fig. 6 Real balance effect (Pigou–Patinkin): effects of a fall in money wages
While the Pigou–Patinkin analysis seems quite elegant, closer analysis reveals that
its importance might be highly exaggerated and on balance, even on purely theo-
retical grounds, Keynes rather than Pigou–Patinkin, seems to have carried the day.
Dimand (2017, pp. 10–15) offers a very succinct assessment of the debate.
Firstly, Kalecki (1937) argued that the real balance effect applies only to outside
money or what we nowadays call as reserve money (cash plus bank reserves with
the central bank), not inside money (bank deposits), since the latter were backed by
the bank’s reserves and loans to other agents. But outside money is only a very
small proportion of total money supply (In India, for 2016–17, reserve money as a
proportion of broad money stood at 14.7%). Secondly, as Keynes in the General
Theory had already pointed out, and as we have discussed earlier, a fall in money
wages and prices would adversely affect investors’ expectations, depressing the
marginal efficiency of capital. Thus, whereas the consumption effect exerts a pull on
the IS curve outwards, the marginal efficiency of capital effect depresses it inwards,
and hence the net shift of the IS curve, will be the outcome of these two opposing
forces. Thirdly, as people tend to be extremely cautious in uncertain times, and
falling money wages and prices tend to arouse people’s worst fears, a rush for
liquidity is likely to be triggered, most likely overcoming any increase in the real
supply of money. The shift in the LM curve is then uncertain but more likely
inwards than outwards. Finally, Fisher (1933) writing before the General Theory’s
publication had advanced the “debt-deflation theory”. In a depression, if wages and
prices start falling, wealth is redistributed from debtors to creditors. Creditors
become further averse to lending, as they perceive a significant increase in their
lending risk. This has the effect of increasing liquidity preference. Entrepreneurs
(who are usually operating on borrowed funds) find their borrowing costs rising
steeply, while at the same time their expected future returns from investment
projects decline. Together, this will depress investment and incomes even further.
The upshot of the entire discussion above seems to be that, contrary to Patinkin’s
(1956) claim, it is far from clear that the debate of the 1940s on money wage cuts
had been decisively won (on theoretical grounds) by the neoclassicals rather than
the Keynesians.
4.2 The Phillips Curve
One important lacuna in Keynesian analysis was that there was no coherent theory
of the general level of prices. Prices were assumed to be (nearly) constant till the
attainment of full employment. After full employment was achieved, any additional
increase in money supply raised prices rather than output. This hardly fitted in with
observed reality—prices started rising much before employment was anywhere near
full employment. Phillips (1958) in a purely empirical exercise examined the
relationship between growth rate of money wages and unemployment in the UK for
nearly a century (1861–1957).12 He found the relationship to be nonlinear and
downward sloping, and the curve that he fitted 13 to the scatter plot had the form:

x_
log þ a ¼ logðbÞ þ c logðU Þ ð27Þ
x
where x and x_ represent the money wage rate and its rate of change respectively,
U is the unemployment rate, _ a and b are positive parameters whereas the parameter
c was negative. The term x x may be termed wage inflation for convenience.
The Phillips curve obtained was nonlinear and downward sloping (in the
unemployment–wage inflation plane—see Fig. 7) with a positive intercept on the x-
axis.
The importance that the Phillips curve acquired in the macroeconomic theory
and policy of the 1960s and 1970s owes a great deal to Lipsey’s (1960) derivation
of the same through neoclassical micro-economic principles. Lipsey argued that
disequilibrium in the labour market for a particular industry tended to correct itself,
by an adjustment mechanism in which wage rate changes depended on the excess
demand for labour (as a proportion of the total supply), i.e.

x_ ðLd Ls Þ
¼F with F ð0Þ ¼ 0 and F 0 [ 0 ð28Þ
x Ls
where Ld ; Ls denote the demand for and supply of labour, respectively. All variables
in (28) refer to the particular industry under consideration.
12
Closely related research to Phillips’ analysis is Brown (1955), Dicks-Mireaux and Dow (1959),
Klein and Ball (1959), etc.
13
The manner in which Phillips fitted this curve to the data is described in great detail in Wulwick
(1987).
The Phillips Curve
Money Wage
growth
Phillips curve
Unemployment
PC
Fig. 7 Phillips’ curve
Thus, the rate of change of money wages is positively related to the

h excess i
demand for labour, or negatively related to the rate of unemployment ðLdLL
s
sÞ
,
giving the Phillips curve its downward slope.14 Further, for money wages to be
constant, we require Ld ¼ Ls .
In empirical studies, Ld is difficult to measure since data on industry vacancies is
highly unreliable and often non-existent. Hence, in practice,
h analysts
i use the offi-
ðLd Ls Þ
cially published unemployment rate U as a proxy for Ls in drawing the
Phillips curve (see Fig. 7). However, we must note that the unemployment figure
U from official statistics comprises both Keynesian (involuntary) unemployment
u and frictional unemployment z, i.e. U = (u + z). If E denotes the number of
employed and v the vacancies in the particular industry under consideration, then by
definition
Demand for labour Ld ¼ E þ v ð29Þ
Supply of labour Ls ¼ E þ z þ u ð30Þ
From (29) and (30), the excess demand for labour is given by
Ld Ls ¼ ðv u zÞ ð31Þ
14
A more rigorous derivation of the negative slope is given in Dicks-Mireaux and Dow (1959).
x_
Thus for money wages to be stable, i.e. x ¼ 0, we require Ld ¼ Ls , or
alternatively
u ¼ 0; and v ¼ z. This would mean that the unemployment rate

U ¼ u þ z ¼ zðsince u ¼ 0Þ
This gives the empirical Phillips curve a positive intercept on the x-axis
(unemployment axis).15
The nonlinear shape of the Phillips curve is more difficult to justify. Lipsey’s
(1960) original explanation was later discarded as unsatisfactory, and a fully sat-
isfactory rationale was given much later by Grossman (1974) and Barro and
Grossman (1971), basing it on structural imbalances and frictional considerations
(see Santomero and Seater 1978).
While the original Phillips curve was in terms of money wage rate changes, it
was often translated into price inflation by assuming that prices (p) were a fixed
markup (l) over wages w
i.e.
p ¼ xþl
and then

x_ p_
¼ ¼p ð32Þ
x p
where p is the rate of price inflation of that industry.

The Phillips curve then becomes
p ¼ gð U Þ ð33Þ
Lipsey (1960), and others after him, have taken the above analysis as a repre-
sentative firm analysis and from these micro-foundations have generalized to a
Phillips curve for the economy as a whole, which inherits the same features
(nonlinear, downward sloping and with a positive intercept on the x-axis).
What greatly contributed to the popularity of the Phillips curve was the paper by
Samuelson and Solow (1960), which taking the representation (33) for the
macroeconomy, argued that the Phillips curve represented a stable relationship
between inflation and unemployment, which could be exploited effectively for
policy purposes. Policymakers would indicate the level of inflation that they are
prepared to tolerate to drive unemployment down to a particular level by selecting
an appropriate point on the (assumed stable) Phillips curve (see Hetzel 2013). Thus,
15
A more detailed explanation is given in Wulwick (1987).
for the USA, Samuelson and Solow (1960, p. 192) state “In order to achieve the
non-perfectionist’s goal of … no more than 3 percent unemployment, the price
index might have to rise by as much as 4–5% per year”. Of course, these kinds of
statements are caricatures of actual policymaking. But they supplied the broad
intuition behind the large-scale Keynesian econometric models that started making
their appearance in the USA from the 1960s onwards16 and which were often useful
inputs for policy at the FRB (see Brayton et al. 1997).
4.3 Keynes and General Equilibrium
Most of the mainstream macroeconomic research in the decades following the

publication of the General Theory, took the view that since wages could be
legitimately regarded as inflexible in the short run, the Keynesian theory was
essentially applicable in the short run and the neoclassical Walrasian theory applied
in the long run when wages were flexible (this view of course ignores Chap. 19 of
the General Theory, wherein Keynes had tried to show that his theory applied even
when wages were flexible downwards). This view was also regarded as a neo-
classical synthesis. We will call it the Keynes–Walras synthesis to set it apart from
the IS-LM synthesis discussed earlier. The difference between the two syntheses is
well-brought out by Woodford (1999, pp. 9–10), when he states “The neo-classical
synthesis, as developed by John R. Hicks and Paul A. Samuelson, among others,
proposed that both the Keynesian theory and the neoclassical general equilibrium
theory could be viewed as correct, though partial accounts of economic reality…
The details of how one got from the Keynesian short-run to the “classical” long-
run were not really worked out…”. Similar views have been expressed by Howitt
(1987), Mankiw (2006), De Vroey and Duarte (2012), etc.
The early attempt at showing how the Keynesian short run coalesced into the
Walrasian long run such as Samuelson (1947), Klein (1947) was somehow off the
mark. Their dynamic stability analysis managed to show that the neoclassical
system converged to a Walrasian long-run equilibrium, whereas the Keynesian
short-run system converged to a long-run disequilibrium one, which could hardly
be regarded as a Keynes–Walras synthesis. Patinkin (1956) in Chaps.13 and 14 of
his book, tries to show how in a Walrasian system markets clear instantaneously,
while in the Keynesian case because of the presence of wage and price rigidities,
the adjustment is sluggish, producing the typical Keynesian, short-run disequilib-
rium. However, in the long-run, wages and prices adjust and this induces a “real
balance effect” which restores a long-run equilibrium (see Mankiw 2006). This
long-run equilibrium is identical to the Walrasian one. Though Patinkin’s analysis
16
Prominent among these models are the Klein–Goldberger (1955) model, Brookings-SSRC
Quarterly model (Fromm and Klein 1965), FRB-MIT-PENN model (see Ando and Modigliani
1969; de Leeuw and Gramlich 1968).
is not fully rigorous from a mathematical point of view, its intuition was fairly
acceptable as evidence of a Keynes–Walras synthesis. However, as pointed out by
Donzelli (2007), De Vroey and Duarte (2012), etc., in contrast to Walras, who had
by assumption, ruled out trading at disequilibrium prices, Patinkin allows for such
trading. Hence, the long-run equilibrium reached via Patinkin’s analysis is not
identical to the Walrasian neoclassical long run. Later, Barro and Grossman (1971)
showed that a Keynes–Walras synthesis of the type envisaged above, seems
impossible.
5 IS-LM Analysis for an Open Economy:

Mundell–Fleming Model
5.1 The Basic Model
So far our concern has been exclusively with a closed economy, i.e. one which does
not engage in international trade or investment. Mundell (1963) and Fleming (1962)
have generalized the IS-LM analysis to the open economy case. We give below a
somewhat simplified overview of the Mundell–Fleming model (for more detailed
expositions, reference may be made to Cuthbertson and Taylor (1987), Kenen
(1985), Blanchard (2006) etc.).
Let us reconsider the IS-LM analysis above by introducing international trade
and capital flows. We also make the assumption of fixed prices. The national
income identity (2) is now reproduced below:
Y ¼ C þ I þ ðG T Þ þ ðX M Þ ð34Þ
where X and M denote exports and imports, G and T are government expenditure
and taxes. The balance of trade surplus B is defined as
B ¼ ðX M Þ ð35Þ
Note that B can be negative, corresponding to a balance of trade deficit. Because

of the assumption of fixed prices, there is no need to distinguish between the trade
balance in real and nominal terms.
In the closed system considered so far, full economy equilibrium is characterized
by simultaneous equilibrium in the goods market and the money market and cor-
responds to the point of intersection of the IS and LM curves. In the open economy
system, full equilibrium requires additionally a balance of payments equilibrium.
The balance of payments equilibrium is characterized by a situation in which the
balance of trade deficit (surplus) is matched by an equal amount of net capital
inflows (outflows). If F denotes the net capital inflows (a negative value corre-
sponding to net outflows), then the balance of payments equilibrium condition is
given by
5 IS-LM Analysis for an Open Economy: Mundell–Fleming Model 23
B ¼ F or B þ F ¼ 0 ð36Þ
Let e denote the exchange rate expressed as units of domestic currency (say
rupees) per one unit of foreign currency (say US$). A rise in e corresponds to a
devaluation of the domestic currency and increases exports by making them
cheaper in foreign markets, and, by making imports dearer in domestic markets,
curtails their use. Thus, the net impact of a devaluation (appreciation) of domestic
currency may be expected to lead to an improvement (deterioration) in the balance
of trade. However, this depends on the satisfaction of a certain condition called the
Marshall–Lerner condition, which we assume to be fulfilled.17
The balance of trade also depends on Y, since a rise in Y will lead to a rise in
imports as people generally increase their consumption (including of imported
goods) as incomes rise. Exports however depend on the incomes in foreign
countries and not so much on domestic income Y.
Taking into consideration the above two features, we may write
B ¼ Bðe; Y Þ
with
@B @B
0; 0 ð37Þ
@e @Y
Further, capital inflows depend on the differential between the domestic interest
rate r and the foreign interest rate r*. If r is higher than r*, then foreign portfolio
funds will flow into the country and vice versa—the extent of the inflow depending
on the restrictions imposed on capital inflows by official policy (such as Tobin
taxes, restrictions on certain types of flows etc.). We can thus write
F ¼ F ½ ð r dÞ r ð38Þ
where d is the (domestic) country risk premium, which depends on factors such as
risk of sovereign debt default, currency devaluation etc.
When full capital account convertibility prevails, we must have ðr dÞ ¼ r for
if ðr dÞ falls below r , there will be capital flight and in the reverse case, the
country would be swamped with inflows.
17
The Marshall–Lerner condition states that a devaluation improves the balance of trade if the
following condition is fulfilled:
jgEX j þ jgIM j [ 1
where jgEX jandjgIM j represent the absolute values of the elasticities of exports (X) and
imports (M) with respect to the exchange rate e.
We note that
@F @F @F
0; 0; 0 ð39Þ
@r @d @r
Mundell–Fleming now introduce a curve called the BB curve which depicts

equilibrium in the balance of payments for various combinations of r and Y.
We have already seen that the balance of payments equilibrium requires the
satisfaction of
Bðe; Y Þ þ F ½ðr dÞ r ¼ 0 ð40Þ
To calculate the slope of the BB curve in the (Y, r)-plane, we take the total
differential of (40) as r and Y vary, but so as to always satisfy (40). This yields

@B @F
dY þ dr ¼ 0 ð41Þ
@Y @r
or
" #
@B
dr @Y
¼ @F 0 ð42Þ
dY @r
The positive sign in equation (42) follows as the numerator of the right-hand side
of (42) is negative and the denominator positive.
Thus, the BB curve has a positive slope. However, if there are no restrictions
@F on
capital inflows (full capital account convertibility), the quantity @r can be

extremely large and corresponding the slope ddYr extremely small (nearly zero). In
this case then, the BB curve will be nearly horizontal (see line BB’ in Fig. 8).
Any point above the BB curve, such as A, will correspond to an interest rate r1
higher than the interest rate re required to generate the capital inflows sufficient to
meet the balance of trade deficit at the corresponding level of income say Ye . Thus
at point A, there is a balance of payments surplus. The opposite applies at points
below the BB curve.
An important fact to note about the BB curve is that its position varies with the
exchange rate e. If the exchange rate depreciates, i.e. e rises, then at each Y the
balance of trade deficit is lower, so that a lower capital inflow is sufficient to
maintain the balance of payments equilibrium (see Eq. 40). Thus each Y is now
associated with a lower rate of interest along the new BB curve. Hence, the BB
curve shifts to the right whenever there is an exchange rate depreciation.
Full equilibrium in the economy occurs when the goods market, money market
and the balance of payment are all in equilibrium and is given by the common point
of intersection E (if it exists) of the IS, LM and BB curve (see Fig. 9).
Fig. 8 BB curve (restrictions r

on capital flows) and BB’ BB
rI A
curve (no restrictions on
capital flows)
re
BB’
0 Ye Y
Fig. 9 Open economy r

BB
equilibrium (Interest rate)
LM
IS
Y (real output)
5.2 Monetary and Fiscal Policy Effectiveness Under Fixed

Exchange Rates
We first consider the case where the country follows a fixed exchange rate system,
i.e. one in which the exchange rate e is not changed except in extraordinary
circumstances.
Monetary Policy : Let us now analyse the effectiveness of monetary policy in a
fixed exchange rate system. Figure 10a shows the case where there are no
restrictions on capital flows and the curve depicting external equilibrium BB1 is
nearly horizontal. The initial equilibrium is at E 1 where all three curves, viz. the
IS; LM1 and BB1 intersect. Suppose now that the central bank desires to reduce the
rate of interest from r 1 to r 2 (and raise output from Y 1 to Y 2 ). For this purpose, it
injects additional money supply in the economy. Because of the assumption of fixed
prices, real money supply is also increased and the LM1 curve shifts outward to
LM2 . The goods market and money market are now in equilibrium at the new point
E 2 ; but at this point the balance of payments is out of equilibrium. At the new
(a)
r
LM1
(Rate of
interest) LM2
E1
r1 BB1
r2 E2
IS
Y1 Y2 Y (real output)
(b) BB2
r
(Rate of
interest) LM1
LM2
E1’
E2’
IS
Y1 Y2 Y (real output)
Fig. 10 a Monetary policy with fixed exchange rates: case of full capital account convertibility.
b Monetary policy under fixed exchange rates: case of restrictions on capital flows
equilibrium, the output level Y 2 is higher than the old output level Y 1 : This leads to
some rise in imports and an increase in the trade deficit. More importantly, because
of the lower interest rate r 2 in the new equilibrium, there are massive capital
outflows which will put pressure on the domestic economy to depreciate its cur-
rency. Because of fixed exchange rates, the exchange rate cannot be allowed to
depreciate. The central bank will be forced to intervene in the foreign exchange
market and sell foreign exchange for domestic money. But this will curtail money
supply18 and push the LM2 curve backwards until it falls back to its original
position LM1 very rapidly (shown by the double arrows in Fig. 10a). Thus, there is
a reversion to the original equilibrium position E 1 :
If capital mobility is less than perfect, the capital outflow will be on a lesser scale
than in the perfect mobility case and the output can be increased temporarily from
Y 1 to Y 2 . The increase in income will also cause a deterioration in the balance of
trade by raising imports. Both these features will put pressure on the exchange rate
(though not to the same extent as in the earlier case) and the LM2 curve will be
ultimately pulled leftwards. Thus, the process is just the same as in the full mobility
case, but stretched over a longer period. The lengthier process is indicated by a
single arrow in Fig. 10b.
In conclusion under a regime of fixed exchange rates, monetary policy is inef-
fective in influencing output irrespective of the degree of capital mobility. However,
capital mobility affects the speed at which the system reverts to the original
equilibrium.
Fiscal Policy : By contrast, fiscal policy can be quite effective under fixed
exchange rates. The situation is illustrated in Fig. 11a for the case of perfect capital
mobility with the BB1 curve drawn horizontal. The initial equilibrium is at the point
E 1 where the three curves IS1 ; LM1 and BB1 intersect. The equilibrium output is
Y 1 : Suppose now that the government gives the economy a fiscal stimulus by
raising government expenditure G (or reducing taxes T). The IS1 curve now shifts
outwards to IS2 , and the new equilibrium in the goods and money markets is now
located at point E 2 ; with interest rate r 2 and income Y 2 both higher than in the old
equilibrium at E1 . However at this new equilibrium, there are two countervailing
forces at work—the rise in income leading to a worsening of the trade balance, but
the higher interest rates resulting in massive inflows. Because of full capital account
convertibility, the latter will swamp the former and the net outcome will be a large
balance of payments surplus. This will create pressure for exchange rate appreci-
ation. To resist this appreciation, the central bank has to buy the foreign currency
and in the process release additional domestic money into the economy. The LM1
curve moves rapidly rightwards to LM2 with the new equilibrium established at the
point E 3 corresponding to a higher output level Y 3 .
In the presence of restrictions on capital mobility, the effect of fiscal policy under
fixed exchange rates depends on the degree of restrictiveness, as indicated by the
slope of the BB curve. The case is shown in Fig. 11b where the curve BB2 is quite
steep, indicating low capital mobility. Suppose there is a positive fiscal stimulus
which shifts the IS1 curve outwards to IS2 and the equilibrium shifts from E1 to E 2 .
At the new equilibrium E2 ; the income Y 2 and the rate of interest r 2 are higher than
18
In practice the central bank can counter this tendency by engaging in what are called sterilization
operations in which high powered money is increased by a corresponding purchase of government
securities in the market. But this can only be a short-term measure and there are definite limits to
this process (see, e.g. Bordo et al. 2011).
(a)
r
(Rate of
interest)
E2
r2
E1
r1 BB1
E3
LM1 IS2
IS1
LM2
Y1 Y2 Y3 Y (real output)
(b)
r BB2
(Rate of
interest) LM2
E3
r3
LM1
r2 E2
r1
E1
IS2
IS1
Fig. 11 a Fiscal Policy under fixed exchange rates: full capital account convertibility. b Fiscal
policy under fixed exchange rates: limited capital account convertibility
at the old equilibrium E 1 : Once again there will be two opposite tendencies, viz. a
worsening of the trade balance and a rise in capital inflows. But with low capital
mobility, the overall effect is likely to be dominated by the trade balance effect. The
balance of payments will deteriorate creating pressure for depreciation. Once again
the central bank (to maintain the fixed exchange parity) will have to sell foreign
exchange, which (as explained above) curtails the domestic money supply and
shifts the LM1 curve leftwards to LM2 and the final equilibrium is reached at E 3 ,
where the output Y 3 is only slightly higher than Y 1 . Note that the steeper the BB2
curve the closer the final equilibrium output is to the original output.
Thus under a regime of fixed exchange rates, fiscal policy can be effective in
stabilizing output, but this effectiveness is lower the greater the restrictions on
capital movements.

Flexible Exchange Rates
We now pass on to the case where the exchange rate is flexible and varies in
accordance with the market signals.
Monetary Policy : We first examine the effectiveness of monetary policy in a
flexible exchange rate system with full capital account convertibility. The balance
of payments equilibrium is thus represented by the horizontal BB1 curve. In
Fig. 12, the initial equilibrium is at E 1 with interest rate r 1 and income Y 1 .
A monetary expansion now shifts the LM1 rightwards to LM2 leading to a new
equilibrium point E 2 : At this new equilibrium, the balance of trade deficit worsens
because output is higher (worsening of trade deficit) and interest rate lower (capital
outflows) than in the old equilibrium. With the exchange rate free to move, it settles
to a new depreciated level (i.e. e is higher). The depreciated exchange rate stimu-
lates exports while curtailing imports thus increasing the trade balance. This shifts
r
(Rate of LM1
interest)
LM2
E1
r1 BB1
E3
r2 E2
IS2
1
IS
Fig. 12 Monetary policy under flexible exchange rates: full capital account convertibility
the old curve IS1 rightwards till it moves to IS2 where a new full equilibrium is
attained at E 3 : At the final equilibrium E3 , the output is higher than in the original
equilibrium but the interest rate has risen to its original level. Thus, monetary policy
in this case can be effective in influencing output.
The result is qualitatively similar in the case where capital mobility is less than
perfect. We may therefore summarize our result regarding monetary policy under
flexible exchange rates as follows.
Monetary policy can be effective in stabilizing output under a flexible exchange
rate regime, the degree of effectiveness varying with the extent of capital mobility.
Fiscal Policy : The impact of fiscal policy in a floating exchange rate regime
depends crucially on whether capital flows are subject to restrictions or whether free
flow of capital is allowed. In Fig. 13a, we consider the case where there are no
restrictions on capital mobility. The external equilibrium curve BB1 is then hori-
zontal. The original equilibrium is at E1 where the curves IS1 ; LM1 and BB1
intersect. The government now undertakes a fiscal stimulus which pushes the IS1
curve outwards to IS2 : The system moves to a new position E 2 where the rate of
interest is higher. However, the system can remain at the new position only tem-
porarily. Because of full capital account convertibility, the higher interest rate at E 2
generates massive capital inflows leading to exchange rate appreciation. This
appreciation increases the trade deficit and pushes the curve IS2 inwards. This
process continues till the exchange rate is back to its original position and the
capital inflows resume their earlier level; i.e. till the old IS1 curve is restored and the
economy is once again back at E 1 : Thus with full capital account convertibility and
flexible exchange rates, fiscal policy is totally impotent in affecting output.
However, the situation changes when capital restrictions are present. Consider
Fig. 13b in which the initial equilibrium is at E 1 . Note that the curve BBðe1 Þ
corresponding to the prevailing exchange rate e1 is upward sloping, reflecting the
presence of capital restrictions. Suppose that a fiscal stimulus shifts the IS1 curve to
IS2 with a new potential equilibrium at E2 , where both the output ðY 2 Þ and interest
rate ðr 2 Þ are higher than before. The higher output will lead to a trade deficit and
even though capital inflows will rise, they will not be sufficient to overcome the
deficit (in view of the capital restrictions in place). Overall, the balance of payments
is likely to go into a deficit leading to an exchange rate depreciation. This will have
two effects—firstly, the resultant stimulus to the balance of trade will shift the IS2
curve further to the right to IS3 , and secondly, the BBðe1 Þ will also shift to the right
to a new position BBðe2 Þ. The new equilibrium will now be at E3 corresponding to
a higher level of output Y 3 (as compared to the initial level Y 1 ).
Thus the effectiveness of fiscal policy under a flexible exchange rate system
depends on the degree of capital mobility. It is impotent if full capital account
convertibility prevails, but it can be quite effective if capital movements are subject
to restrictions.
(a)
r
(Rate of LM
interest)
2
E
E1
BB1
IS2
IS1
Y (real output)
(b)
r BB(e2)
(Rate of BB(e1)
interest) LM 1
r3 E3
E2
r2
r1 E1
IS2 IS3
IS1
Fig. 13 a Fiscal policy under flexible exchange rates: full capital account convertibility. b Fiscal
policy with flexible exchange rates: limited capital account convertibility
Our discussion of the Mundell–Fleming model has been exclusively concerned

with the fix-price case. The model can be extended without much difficulty to the
case of flexible prices and also to include wealth effects. However, we do not
consider these extensions here. The interested reader may refer to Argy (1994),
Obstfeld and Rogoff (1996), Feenstra and Taylor (2009), etc.
Appendix
The Keynesian theory of “effective demand” can be introduced in a number of

ways. In this appendix, we explain the concepts of aggregate supply, aggregate
demand and effective demand using an alternative approach developed by Fusfeld
(1985), Darity and Young (1995) and Gillman (1999). We feel that even though the
approach is somewhat unconventional, it has the advantage of establishing a link
between Keynes’ Treatise on Money (Keynes 1930) and his General Theory,
instead of treating the latter as completely independent of the former.
The aggregate price theory adopted by Keynes in the Treatise is essentially
founded in the Marshallian micro-economic theory of the firm (Marshall 1920), but
has a somewhat specialized interpretation of profits. This specialized interpretation
of profits is usually attributed to Levy (1943) and Kalecki (1937) and known as the
Levy–Kalecki identity. But it seems to have been known to Keynes while writing
the Treatise (though he seems to have discarded it in the General Theory).
A simple exposition of the Levy–Kalecki identity is as follows (see Levy et al.
2008; Pressman 2008, etc.):
Assuming a closed economy, and no hoarding (so in the aggregate whatever is
saved is invested), we have as an identity
I ðrealized investmentÞ ¼ Sðrealized aggregate national savingÞ

¼ Hs ðhousehold savingÞ þ CS ðcorporate savingÞ
þ GS ðgovernment savingÞ ðA1Þ
Further, corporate savings are simply retained profits which are corporate profits
minus dividends paid out to shareholders giving us the identity
CS ðcorporate savingÞ ¼ pðcorporate profitsÞ DðdividendsÞ ðA2Þ
Substituting (A2) in (A1) and rearranging, we get
pðcorporate profitsÞ ¼ I þ D ½Hs þ GS ðA3Þ
(A3) is the famous Levy–Kalecki macroeconomic equilibrium condition, which

states that corporate profits are equal to investment plus dividends minus
non-corporate savings (i.e. savings by households and government), viz. ½Hs þ GS .
It is to be noted that (A3) is a macroeconomic identity which may not hold at the
individual firm level.
According to the Treatise, the aggregate price of output (P) is the average cost of
aggregate output (AC) plus the average aggregate profit. In equation form this
becomes
Appendix 33
1
P ¼ AC þ ½I þ D ðHs þ GS Þ ðA4Þ
Y
If we denote TR as the total revenue in the economy and TC the total cost, then
(A4) yields
TR ¼ PY ¼ ðACÞY þ ½ðI þ DÞ ðHs þ GS Þ ¼ TC þ ½I ðHs þ GS Þ ðA5Þ
While in the short run, p could be nonzero and ðI þ DÞ Q ½Hs þ GS , and cor-
respondingly TR Q TC, in long-run equilibrium the Treatise imposes the condition
p ¼ 0 and D ¼ 0 ðA6Þ
From (A1)–(A6), it follows that in long-run equilibrium
I ¼ S ¼ ðH s þ G S Þ ðA7Þ
i.e. the distinction between non-corporate and aggregate saving disappears and
investment is equal to both. Correspondingly, in the long run
TR ¼ TC ðA8Þ
If average costs do not change with the level of output (as would happen with a
constant returns to scale production function such as the Cobb–Douglas), we may
take without loss of generality this constant average cost as 1, so
TC ¼ Y ðA9Þ
Further, the total value of output is given by TR which is divided between

consumption C, investment I (ignoring the government sector at the moment)
TR ¼ C þ I ðA10Þ
In the General Theory, Keynes made two fundamental assumptions: (i) con-
sumption increases as income increases but by less than income and even at zero
income levels consumption is positive and (ii) investment I moves independently of
Y. Putting (A9) and (A10) together, we get the famous Keynesian equilibrium
condition
Y ¼ CþI ðA11Þ
Plotting (A9) and (A10) in a diagram (with these assumptions), we get the
famous Keynesian cross (see Fig. A.1). The total cost curve (A9) becomes a 45°
line through the origin while the total revenue curve has a positive intercept on the
y-axis and then bends towards the x-axis. The point of intersection of the two curves
TC
Total
cost / revenue
TR
I (Investment)
C (Consumption)
45◦
Y* Y (Income)
Fig. A.1 Keynesian cross
(point K in the figure) represents the point of long-run equilibrium, with p = 0. To

the left of K, the TR curve lies above the TC curve and corporate profits p are
positive. Similarly, corporate profits are negative to the right of K. The output Y
corresponding to K is called the level of effective demand in the General Theory.
The aggregate demand price (ADP) corresponding to an employment level E is
simply the total sum of proceeds expected from the sale of the output Y producible
by E. If P is a suitably defined average price of all the goods produced in the
economy (N(E)), by employing E amount of labour,
ADP ¼ PY ¼ PN ðEÞ ðA12Þ
In the General Theory, Keynes assumed P to be constant and capital stock

characterized by excess capacity—an assumption which is not unduly restrictive as
he was mainly concerned with the short run in an economy characterized by
depression. However as E increases, diminishing returns may set in at some stage so
that the output produced by an additional unit of employment is likely to fall. This
means that the ADP curve plotted in the diagram (Fig. A.2) is upward sloping but
arches towards the x-axis as E increases beyond a point. Note that we make a
distinction between the AD curve and the ADP curve.
The aggregate supply price (ASP) corresponding to an employment level E is
simply the total costs involved in producing the output corresponding to E, so that
ASP ¼ ðACÞN ðE Þ ðA13Þ
where AC is the average cost corresponding to the level of output produced by E.

As employment increases, AC is likely to rise (mainly because of rising wages
and capital rentals), and coupled with diminishing returns this gives the ASP an
Appendix 35
Fig. A.2 Aggregate demand ASP

price, aggregate supply price
and effective demand
A* ADP
0 E* Ef
upward slope which becomes steeper to the right, until at the full employment level
EF , the ASP becomes vertical (since it is impossible to expand output beyond this
point).
The ADP curve lies above the ASP curve near the origin (i.e. profits are posi-
tive), and given the shape of the two curves, they will intersect at the point A*, and
the corresponding employment level is denoted by E*. The level of output N(E*)
implied by E* can be refered to as the level of effective demand. There is no
automatic mechanism in the General Theory that will bring E* to coincide with EF .
In situations of overall pessimism in the economy, the ADP curve will shrink
downwards and in all probability E* will lie to the left of EF . In this case, the
difference ðEF E Þ corresponds to what Keynes calls as “involuntary unem-
ployment” comprising those who are willing to work at the prevailing wage rate but
unable to find employment.
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Chapter 2
The Resurgence of Neoclassicism
Abstract The 1970s heralded the dawn of a difficult era for the global economy.
Inflation which had been fairly subdued in the 1960s suddenly started flaring
up. But this was not accompanied by any decrease in unemployment rates as the
Keynesian Phillips curve analysis, so popular at that time, would have led us to
expect. Against this background, the earlier criticisms launched by Friedman (J
Polit Econ 78(2):193–238, 1970) against the Keynesianism then prevalent, started
attracting attention, and the doctrine of monetarism that he proposed as an
alternate theoretical framework, gradually gained ascendancy, till by the end of
the 1970s, it displaced IS-LM Keynesianism as the dominant mainstream para-
digm. This chapter elaborates on the main tenets of monetarism including the
modern quantity theory, the natural rate hypothesis, monetary policy rules and
flexible exchange rates.
1 Introduction
The 1970s heralded the dawn of a difficult era for the global economy. Inflation
which had been fairly subdued in the 1960s suddenly started flaring up. In the USA,
for example, inflation shot up to 6.7% in the quinquennium 1971–75 as compared
to 3.9% in the previous 5 years. A similar pattern was evident in most of Europe,
Japan and many EMEs.1 But this was not accompanied by any decrease in
unemployment rates as the Phillips curve analysis, so popular at that time, would
have led us to expect. Instead over the two periods of comparison, unemployment
rose from 3.9 to 6.1% in the USA, from 2.1 to 3.2% in the UK, from 1.7 to 2.5% in
France, etc. (see Friedman 1977, p. 461). Hard core Keynesians tried to explain this
as a shift in the Phillips curve—a cost-push type of inflation due to the oil price
shock of 1973. However, this seemed essentially an ad hoc explanation, which
could not fit in very well with the accompanying theory.
Against this background, the earlier criticisms launched by Friedman (1970)
against the Keynesianism then prevalent, started attracting attention, and the doc-
1
In India, inflation in 1969 was 0.6% but rose to as high as 28.6% in 1974.

https://doi.org/10.1007/978-81-322-3920-8_2
40 2 The Resurgence of Neoclassicism
trine of monetarism that he proposed as an alternate theoretical framework, grad-

ually gained ascendancy, till by the end of the 1970s, it displaced IS-LM
Keynesianism as the dominant mainstream paradigm.
2 Monetarism: Main Tenets
In many respects, the intellectual basis for the reaction against Keynesianism had
deep roots in the earlier neoclassical tradition of Walras, Jevons, Marshall and Pigou,
which as we have seen in the previous chapter was largely supplanted by
Keynesianism in the 1940s and 1950s. Hence, these developments of the 1970s and
1980s in effect marked a reversion to a highly modified version of neoclassicism. The
three major schools of thought which comprised this resurgence of neoclassicism are
(i) monetarism, (ii) New Classical economics and (iii) real business cycle theory.
2.1 Characteristics of Monetarism
De Long (2000) identifies two major antecedents of Friedman’s monetarism, viz.

Irving Fisher’s monetarism (old monetarism) and the Chicago monetarism
embodied in the famous oral tradition of Viner, Knight and Simons. Both these
versions were subtle variations of the quantity theory and equation of exchange, but
had difficulties in providing a properly coherent theory of business fluctuations.
Friedman’s monetarism, by contrast, was a fully developed theory of nominal
income determination, which provided the basis for a major rethinking of
macroeconomic theory and policy. Friedman’s theory also needs to be interpreted
against his ideological belief in the efficient working of markets and a corre-
sponding distaste for government intervention in their functioning.
The main characteristics of Friedman’s brand of monetarism are the following
(see Laidler 1981):
(i) The demand for money is stable and could be analysed on the basis of a
modern version of the quantity theory, and fluctuations in nominal income
are predominantly explained by variations in the quantity of money.
(ii) The Phillips curve is vertical in the long run, though a short-run trade-off could
well exist between inflation and unemployment (natural rate hypothesis).
(iii) Monetary policy is characterized by long and variable lags, and hence,
monetary policy should be conducted by a fixed rule, involving a suitable
measure of money supply. The central bank’s discretionary component in
monetary policy should be kept to a minimum.
(iv) A monetary approach to the balance of payments and exchange rate
determination.
We elaborate on each of these below.
3 Friedman’s “Modern” Quantity Theory of Money 41
3 Friedman’s “Modern” Quantity Theory of Money
It is customary among historians of economic thought to distinguish between three

variants of the traditional quantity theory—the transactions version (Fisher 1911), the
income version which is simply a refinement of the transactions version (see, e.g.,
Angell 1936) and the Cambridge cash balance version associated with the names of
Marshall, Robertson, Pigou and others. However, the three versions shared the
common assumptions that (i) the only substitute for holding money balances was
spending on commodities and services, bypassing financial markets altogether,
(ii) the demand for real money balances (and velocity) was stable and (iii) the validity
of Say’s law which ensured full employment. Hence, any increase in money supply
would increase nominal income and this increase would be spent on goods and
services. Further, because of the assumption of full employment, the brunt of the
additional expenditure would be borne by prices [output being already at its full
employment level no further increase was possible (see, e.g., Hayes 1989)].
3.1 Modern Quantity Theory
Friedman’s (1956) “modern” quantity theory is in many ways an elaboration of the

Cambridge version of the traditional quantity theory. Like the Cambridge economists,
Friedman assumed a stable demand for money function and full employment.
However, whereas they had assumed this demand to depend only on nominal income,
Friedman introduced a vector of determinants. He also realized that the demand for
money balances would depend upon different sets of factors for what he termed as
ultimate holders of wealth (consumers of final goods) and business enterprises.
Consider first the determinants for consumers. He assumed these to be (i) total
wealth W, (ii) proportion (η) of wealth W held in non-human form, (iii) rates of
return on holding money R0 and other fixed value securities Rb , (iv) rates of return
on physical assets Re and (v) the utility attached to holding liquid money balances
which may be denoted by u.
The logic for the choice of these variables is explained in detail in Friedman
(1956, 1959). However, a brief explanation may be offered along the following
lines. For consumers, the limits on spending are determined by total wealth rather
than current income (as assumed in the Cambridge version of the quantity theory).
But total wealth is difficult to measure empirically and hence may be proxied by the
concept of “permanent income” elaborated in Friedman (1957). In practice, per-
manent income is simply calculated as a long-term average of past current income
streams.2 Alternatively, we may use the relation between wealth, income and the
interest rate to express
2
A more rigorous method of estimation of permanent income is given in DeJuan and Seater
(2006).

Y
W¼ ðwhere Y is current income and r the rate of interest Þ ð1Þ
r
Further, wealth can be held in non-human form (real estate, gold, bonds, shares,
etc.) or embodied in the consumer as human capital. But while purchases of goods
and services can be easily made on the basis of non-human wealth, the conversion
of human wealth into purchasing power is much more difficult.
Inflation enters implicitly through the variables R0 ; Rb and Re acting as an
opportunity cost of holding the various assets.
The variable u is a portmanteau variable which Friedman attempts to use as a
measure of the utility of services rendered by money. It depends on a host of factors,
including political instability (in times of political uncertainty like wars, etc., the
value set on liquidity increases), inflation and its variability, the volume of trans-
actions on the capital markets, etc.
Friedman’s demand for money function is a demand for real balances and by
considerations discussed above may be expressed (for an individual consumer) as
follows:

MD
¼ F Y; g; R0 ; Rb ; Re ; u ð2Þ
P
The left-hand side of (2) represents the real demand for money expressed as the
ratio of nominal demand MD to the aggregate price-level P. Y enters as a proxy for
W from (1) but the variable r may be dropped since it will be closely aligned to the
return on bonds Rb . The asterisk (*) indicates an expected value of that variable.
The demand function (2) is for ultimate wealth holders/consumers. Friedman
also considers separately a demand function for business enterprises. This is similar
in most respects to (1) except that the variable g is of little relevance here and Y may
be a scale variable for the business enterprise (say net value added).
Aggregating over all individuals and business enterprises in the economy, we get
a function of the same form as (2), but with Y standing for total national income
(incomes of all individuals and aggregate net value added by business) and the
variable g dropped from the analysis for lack of data availability. The variable u
includes several qualitative variables, which are difficult to measure, but inflation is
an important and measurable variable affecting the value attached to liquidity of
money balances. Hence, Friedman obtains an empirically manageable form of the
aggregate demand for money function as

MD
¼ F ½Y; p; R0 ; Rb ; Re ð3Þ
P
where p denotes the inflation rate and expected values of the rate of return on assets
have been replaced by actual rates of return. The important thing to note about (3) is
that the demand for money is a demand for real balances.
3 Friedman’s “Modern” Quantity Theory of Money 43
3.2 Supply of Money
The demand for money has to be reconciled with its supply. Friedman’s theory of
money supply stressed the fact that money supply was exogenous in the sense that it
could be altered within tolerable limits of variation by the monetary authority and
was largely independent of the factors affecting the demand for money. He dis-
tinguished between the money supply M and high-powered or base money H.
H ¼ CC þ BR ð4Þ
MS ¼ CC þ DD ð5Þ
where CC denotes currency with the public, BR denotes the reserves banks are
obliged to keep with the central bank andDD denotes demand deposits.3 Further
define the currency deposit ratio as c ¼ DD CC and the reserve deposit ratio as

b ¼ DDBR . Then it is easily seen that the relations (4) and (5) can be combined into
MS ¼ mH ð6Þ
where m is called as the money multiplier and defined by

cþ1
m¼ ð7Þ
bþc
The currency deposit ratio c is determined by the public’s preference between

holding currency and deposits and would depend on the payments system of the
country (i.e. the extent to which payments can be made through credit cards, etc.,
economizing on the use of currency), the rate of interest on deposits, the extent of
political and economic uncertainty which determines the value attached to liquidity,
etc. There are reasons to suppose that these factors will remain relatively stable at
least in the short run. The reserve deposit ratio b is determined by the reserve
requirements imposed by the central banks and the excess reserves held by banks.
Thus by and large, while m is not fully determined by the central bank, it is to a
large extent influenced by its policies. H is also largely controlled by the monetary
authority in a closed economy (with no capital flows) or in an open economy if
capital flows are not very significant in relation to the quantum of H (a reasonably
valid assumption in the 1960s and 1970s). Hence, Friedman felt justified in
assuming the money supply to be exogenous and alterable by the monetary
authority at its discretion (see Friedman 1987).
3
We have worked out the analysis in terms of “narrow” money M defined as in (5). The analysis
extends in a straightforward fashion to “broad” money which is defined as “narrow money” plus
time deposits.
Money market equilibrium is attained when the demand for nominal money
balances equals the exogenously determined money supply, i.e. when
MS ¼ MD ¼ PF ½Y; p; R0 ; Rb ; Re ð8Þ
The transmission mechanism by which the equilibrium (8) is established is as

follows. Suppose that money supply rises from its level MS0 to MS1 . Prices ðP0 Þ will
not rise immediately so that the real value of money balances available is more than
what the people need. Consumers and business enterprises spend this excess money
partly on commodities, partly on financial assets and partly on physical assets.
Prices of assets rise and their yield falls till all yields are equalized to the yield on
money (by arbitrage). This process may take some time. The spending on com-
modities will change relative prices and shift the composition of output and may
lead to a temporary rise in the aggregate output Y. However in the long-run
aggregate, output is fixed by assumption (at the full employment level) and
R0 ; Rb ; Re ultimately return to the levels associated with the old equilibrium level of
money supply. The only variable in (8) which can now bring about an adjustment in
the right-hand side of (8) is the rate of inflation p. Prices thus rise till their new level
P1 is such that
0
MS1 MS
¼ ð9Þ
P1 P0
i.e. the old level of real balances is restored. Also from (9), if the money supply
rises by say 5%, then prices will also rise by the same percentage. This is the strict
version of Friedman’s quantity theory, and in several respects, it is very similar to
the old Cambridge equation.
M ¼ kPY ð10Þ
except that instead of being an invariant, k depends on a vector of variables most

importantly the yield on assets and inflation.
4 The Phillip’s Curve and the Natural Rate Hypothesis
As we have seen in the previous chapter, the Phillips curve became an integral part
of IS-LM Keynesianism in the 1960s. This came under severe criticism from
Friedman (1968, 1977) and Phelps (1967, 1968, 1969). Both of them denied a
long-run trade-off between inflation and unemployment along the Phillips’ curve,
while allowing for the possibility of a trade-off in the short run. This demonstration
had important implications for both theory and policy and became an important
pillar of Friedman’s monetarism.
4 The Phillip’s Curve and the Natural Rate Hypothesis 45
4.1 Expectations-Augmented Phillips Curve
The fundamental distinction between the Friedman–Phelps analysis and the tradi-
tional Phillip’s curve lies in the important role assigned to expectations in the
former. Suppose, for some reason, there is an unexpected rise in nominal demand.
In any specific industry, the producer will initially see a rise in the demand for his
product and he expects this to get reflected in higher future prices for his product.
The real wages that matter to him are the wages expressed in terms of the expected
price of his product, and these have declined in his perception. Suppose that the
original demand and supply schedules of labour are given by Ld and Ls , respec-
tively, with the equilibrium point E0 given by a real wage rate of wo and
employment of OL0 . Since real wages have declined in the producer’s perception
and demand for his product has increased the producer will shift his demand for
labour curve outwards to L0d (see Fig. 1). So far as labour in this industry is
concerned, the real wages of relevance to them are the nominal wages deflated by
the general price level. But workers take some time to realize that the general level
of prices has risen. They expect the old price level to continue for some time
without realizing that their real wages have declined. Thus in the interim, before
price expectations are revised, workers continue to slide along the same labour
supply curve Ls . The new equilibrium will thus shift to E1 and employment will rise
to OL1 . But as the perception slowly sinks about the overall rise in nominal
demand, producers curtail their production plans and workers demand higher real
wages, thus bringing the economy back to its old equilibrium level E0 (see
Friedman 1977, pp. 456–458). Figure 1 can be blown up from the one particular
industry considered to the economy as a whole.
Real
Wages
LS
E1
E0
0 L0 L1 Employment
Fig. 1 Unanticipated changes in nominal demand

The implications of the above analysis for the Phillips’ curve seem to be that
following an unanticipated rise in nominal demand, there might be a temporary fall
in the unemployment rate while expectations of workers and producers adjust to the
new situation. Once this adjustment is complete, unemployment reverts to its old
equilibrium. This long-run equilibrium value of unemployment to which the
economy eventually returns after expectations have fully adjusted, Friedman (1968)
terms as the natural rate of unemployment (NRU). The situation is depicted in
Fig. 2 which is adapted from Friedman (1977). Suppose the original inflation level
is at h, with the (short-run) Phillips curve SPC(h). The original equilibrium
unemployment will then be at UN . Suppose now inflation rises to h1 then before
expectations are adjusted, the old Phillips curve SPC(h) will apply and the economy
will move to the new equilibrium level of unemployment UL . However, as
expectations adjust to the new inflation level the Phillips curve will shift to a higher
position SPCðh1 Þ and unemployment will revert to its old equilibrium level UN .
This unemployment level UN to which the economy reverts when expectations have
adjusted is called as the natural rate of unemployment. Thus, there may well be a
number of short-run Phillips’ curves each corresponding to a particular expectation
of the inflation level and exhibiting trade-offs between inflation and unemployment.
But in the long run, there is no trade-off, i.e. the long-run Phillips curve (LPC) is
vertical at the NRU given by UN (see Fig. 2).
It is important to stress that the existence of the temporary fall in unemployment
is only because the rise in nominal demand is unanticipated, it disappears if the rise
is fully anticipated.
More formally, we saw in Chap. 1 (see Eq. 33), that the Keynesian Phillips
curve may be expressed as
Rate of
LPC
Inflation
E1 E2
θ1
θ E
SPC (θ1)
SPC (θ)
uL uN Unemployment
Fig. 2 Natural rate hypothesis

p ¼ gð U Þ ð11Þ
where p and U denote inflation and unemployment, respectively, while g() is a

functional notation.
The analysis of Friedman and Phelps adds a term pe to (11), viz.
p ¼ gðU Þ þ pe ð12Þ
(12) is called the “expectations-augmented Phillips’ curve” and is actually a

collection of short-run Phillips’ curves, each corresponding to a different state of
expectations.
However, the mechanism by which expectations converged to the true level was
left unspecified by Friedman but elaborated by later monetarists such as Laidler
(1977, 1981), Layard et al. (1991), Johnson (1973) etc.
The adjustment mechanism is an adaptive scheme
e
dp
¼ k½p pe ð13Þ
dt
where k [ 0 (i.e. when the actual inflation exceeds the expected inflation, expec-
tations are revised upwards and vice versa). The higher the value of k, the faster the
adjustment.
Equation (13) is a first-order differential equation, and it can be shown that as t
becomes large
pe ðtÞ ! pðtÞ ð14Þ
i.e. expectations about inflation ultimately catch up with the actual (see Santomero
and Seater 1978, pp. 516–523).
The adaptive expectations scheme can also be written in discrete format as
pe ðtÞ ¼ a1 pðt 1Þ þ a2 pðt 2Þ þ þ ap pðt pÞ ð15Þ
where expected inflation pe ðtÞ is expressed as a weighted average of p past values

of actual inflation p(t) (ða1 ; a2 ; . . .; ap Þ are positive constant weights).
The NRU is defined by Friedman as the rate of unemployment that would
prevail once short-run factors have played themselves out. It depends on real (as
opposed to monetary) factors such as the efficiency of labour markets, labour
participation rates, the bargaining strength of trade unions, the degree of compe-
tition in the industry, the barriers to entry in industry. It is not a constant and can
vary over time, but does so slowly.4
4
Friedman (1977) offers a long discussion on why the NRU had been rising in the USA in the
1960s and 1970s.
Using the NRU concept, we may rewrite the Phillips curve (12) as
p ¼ g ð U U Þ þ pe
(where U and U are the NRU and actual unemployment rates, respectively)
Or taking g() to be linear,
p pe ¼ aðU U Þ with a [ 0 ð16Þ
(see Ball and Mankiw 2002).

Very often, however, an amended version of (16) is used, viz.
p pe ¼ aðU U Þ þ v ð17Þ
where the term v is supposed to capture the supply shocks [In empirical work, one
would add a stochastic error term to (17)]. The supply shocks v are essentially
short-term temporary factors such as crop failures, industrial unrest, international
commodity price rises. These are thus to be distinguished from the factors affecting
the NRU (listed above) which are more structural and longer lasting.
4.2 Accelerationist Hypothesis and NAIRU
As we have seen above, temporary deviations from the NRU are feasible in the face
of a once-for-all unanticipated change in nominal demand. Suppose an overzealous
monetary authority tries to keep unemployment low by raising inflation perma-
nently. This will not have the expected effect of pushing unemployment below the
NRU, since the inflation will soon be anticipated. Phelps (1967), however, raises
the possibility that unemployment can be lowered permanently by continuously
accelerating inflation, since then the increase in inflation will be unexpected and
will lower unemployment. For every fresh dose of higher inflation, unemployment
will fall below the NRU and if the ever higher doses of inflation are maintained, the
sequence of temporary decreases in unemployment can become permanent. This is
termed as the accelerationist hypothesis. In a situation, where unemployment is
chronic and high, this strategy could be tried out for a short time (see Taylor 1975;
Hall 1976, etc.), but its long-term use could easily lead to a hyperinflationary
situation.
The non-accelerating inflation rate of unemployment (NAIRU) was first intro-
duced by Modigliani and Papademos5 (1975) and is defined as that rate of
unemployment at which the inflation rate is constant. But when the inflation rate is
5
It may be of interest to note that Lucas Papademos served as the Prime Minister of Greece for a
very brief period (November 2011–May 2012) in the wake of the Greek debt crisis.
constant the expected inflation pe equals the constant inflation rate p. From (17), the
unemployment rate U þ that corresponds to this situation is given by
v
U þ ¼ U þ ð18Þ
a
U þ is then the strict definition of NAIRU [Our analysis above is a simplified
version of that proposed by Estrella and Mishkin (1998)]. However, many writers
prefer to use the terms NAIRU and NRU synonymously (see Gordon 1997; Staiger
et al. 1997; Ball and Mankiw 2002, etc.). We feel that the strict distinction between
NAIRU and NRU is useful, at least for interpretative purposes. The NRU depends
on structural features of the labour market and varies, if at all, slowly over time. As
such, it may not be very useful for policymakers concerned about the outlook for
inflation over the next few quarters. The strict definition of NAIRU by contrast can
be viewed as the unemployment rate that is consistent with a steady level of
inflation over a reasonably short period, say 4–6 quarters in the future (see Estrella
and Mishkin 1998; Walsh 1998, etc.). And hence monetary policy models have
focused primarily on the NAIRU. Empirical work on the estimation of NAIRU
received an impetus with the publication of the book by Layard et al. (1991). Since
then a great deal of empirical literature has been generated on this topic (see Cross
1996; Gianella et al. 2008; Chan et al. 2015; Cusbert 2017, etc.).
5 A Monetary Policy Rule
In his extensive empirical study of the monetary history (1867–1960) of the USA
with Anna Schwartz, Friedman documented a key stylized fact of the economy, viz.
that monetary policy lags on prices are both long and variable (see Friedman and
Schwartz 1963). The methodology that was employed, was to study the timing of
the peaks and troughs in relation to the reference cycle—a consolidated entity
supposed to capture the movements in the level of economic activity. The original
conclusion was sharpened by Friedman (1972), and a distinction was introduced
between the effects of money supply changes on output and prices, with the effect
on prices considerably more protracted than on output.
Of course the term lag needs careful interpretation, since it has been variously
understood in the literature. The term can have at least three distinct connotations,
viz.
(i) Impact lag (the time elapsed between the introduction of a monetary policy
change and its initial impact on the economy),
(ii) Peak lag (the time required for a monetary policy impulse to attain its
maximum effect) and
(iii) Cumulative lag (the time elapsed before the impulse is dissipated
completely).
There is some confusion in Friedman’s use of the terminology. In Friedman

(1971), he seems to be using the term in the second of the above senses, since he
takes the lag at which the correlation between money supply and inflation is highest
as an estimate of the monetary policy lag (21 months for M1 and 23 months for
M2) (see Friedman 1972, p. 12). In his earlier paper, however, (see Friedman 1961
p. 463) he explicitly asserts that “what is relevant for our purposes …(is) the
weighted average interval between the monetary change and the effects”.
Even though Friedman’s methods of arriving at his conclusions were dismissed
as overly simplistic by econometricians (see especially Hendry and Ericsson 1985)
and ideologically biased (see Kaldor 1981; Modigliani 1988, etc.), the surprising
thing is that the conclusions have proved to be fairly robust over the years. Studies
using modern sophisticated econometric techniques also uncover a substantial and
variable lag in the effects of monetary policy on inflation (see Bernanke and Boivin
2003; Svensson and Gerlach 2001; Batini and Nelson 2001; Nachane and Lakshmi
2017, etc.), for different countries. So much so that a lag from monetary policy
changes to inflation of between 5 and 8 quarters is routinely adopted in models for
monetary policy design used by many central banks.
While Friedman’s main arguments for positing the monetary policy lags as long
and variable were empirical, he does attempt to provide some theoretical justifi-
cation for his empirical findings. As a matter of fact, his justification for the rather
long lag has already been discussed above, when we discussed his modern quantity
theory and saw how changes in money supply impacted final expenditures. The
only point that we wish to highlight here is that the process could take a consid-
erable amount of time, because (i) balance sheet adjustments are sluggish,
(ii) output changes cannot be made overnight except if there is a huge stock of
accumulated inventories and (iii) very often changes in asset and goods markets
have second-round effects on money supply, which add on to the first-round direct
effects.
So far as the variability of the lag is concerned, Friedman himself was unable to
give a very cogent or formal rationale. But it is not hard to imagine that the process
described above will hardly be identical over cycles. The lag length may thus
depend on people’s relative preferences for physical and financial assets (which
may change from cycle to cycle), the stage of the cycle at which the money supply
is injected/withdrawn, the modality of altering the money supply (whether by
changes in the bank rate, the reserve ratio or open market operations), the liquidity
position of banks, etc.6
6
The variability of the lag is more fully explained by later writers (see, e.g., Mishkin 1996;
Bernanke and Gertler 1995; Taylor 2000). These writers distinguish between six major channels of
monetary policy, viz (i) the credit channel, (ii) the interest rate channel, (iii) the bank lending
channel, (iv) the exchange rate channel, (v) the balance sheet channel and (vi) the asset prices
channel (emphasized by Friedman). These channels may operate in isolation or more likely,
together. Some of them, such as the asset prices channel, take a long time to work out, others such
as the exchange rate channel, may be faster. The actual lag in any cycle will thus be a reflection of
which transmission channels are the predominant ones in that cycle.
5 A Monetary Policy Rule 51
Thus, according to Friedman (1961, 1968, 1972) the existence of long and
variable lags necessitated a complete reorientation of the monetary policy paradigm
then prevalent, exemplified by the “fine-tuning” experiment of Arthur F. Burns,
who was Chairman of the Federal Reserve from 1970–78. The long lags mean that
any monetary policy taken in response to the current economic situation would take
several quarters to have the desired effect, by which time the economic situation
might have altered drastically. Thus, monetary policy to be effective would require
the ability to forecast accurately the state of the economy several months ahead. In
theory, a good econometric model could perhaps achieve this but only if the past
lags (though long) were constant. If lags are variable, they are also unpredictable.
In short, a discretionary “fine-tuning” monetary policy is singularly unsuitable in
practice.
Friedman then goes on to emphasize that the main task that monetary policy
should occupy itself with is “to provide a stable background for the economy”
(Friedman 1968, p. 13). He lists two major requirements for a good policy, viz. (i) it
should be guided by magnitudes it can control reasonably well and (ii) it should
avoid sharp swings in policy.
He considers several magnitudes as possible indicators, including the exchange
rate, unemployment rate, inflation etc., but ultimately settles for the money supply.
Of course, he was quite aware that money supply cannot be controlled directly by
the monetary authority, but it does exercise a fairly close control over the monetary
base H. From (6), if the money multiplier m were stable (and contemporary
empirical studies had convinced him that this was the case), then the monetary
authority could fruitfully use the money supply as an intermediate target. So far as
the choice of the particular measure of money supply was concerned (i.e. whether
M1 or M2 or some other aggregate), he was largely indifferent.
To achieve the second objective, viz. avoiding sharp swings in policy, he rec-
ommended the k% money supply rule which, by making the money supply grow at
a fixed percentage would eliminate both violent policy swings and (by removing
policy surprises) eliminate a major source of uncertainty in the minds of consumers
and producers. Friedman did not specify a rigid value of k—to him the choice of
some k mattered much more than the value itself.
Friedman’s arguments favouring a simple rule for monetary policy, received
powerful ex-post support from the “rules versus discretion” debate that took place a
decade after Friedman’s writings (see Taylor (1993) for an exhaustive discussion).
This debate concluded overwhelmingly in favour of rules but with some allowance
for discretion in exceptional circumstances (such as deep recessions, hyperinflation,
political uncertainty etc.), provided the long-run adherence to a rule is not sacrificed
—the so-called constrained discretion strategy (see Bernanke and Mishkin 1997).
The main argument that dominated the debate was the time-inconsistency problem
introduced by Kydland and Prescott (1977), and later extended by Barro and
Gordon (1983). They showed through a rather technical argument (which we do not
present here) that even when the central bank and the public are fully informed, and
the central bank is altruistic (i.e. its only concern is public welfare) discretion is
suboptimal to a rule-based policy. A monetary policy rule by providing an anchor
for public expectations and by committing the central bank to a course of action, on
which it cannot renege in the future, provides a higher level of social welfare (than a
discretionary policy). Apart from the time-inconsistency problem, there are other
considerations which favour rules over discretion, such as (i) imperfect knowledge
of the economy on the part of the monetary policy authority (see Taylor 2012;
Soderstrom 2002, etc.), (ii) political interference by governments (see Cargill and
O’Driscoll 2013; Boettke and Smith 2014, etc.), (iii) domination by financial
institutions over monetary policy decisions (see Buiter 2008; Salter 2014, etc.) and
(iv) the bureaucratic structure of decision-making at central banks (see Mankiw
2006; Pennington 2011, etc.).
The settlement of the debate in favour of rules meant that Friedman’s rule was
followed by a number of other rules in succession. The most famous of these is the
Taylor rule (1993), which has now been implicitly (not explicitly) adopted by a
number of central banks. Another rule which has considerable theoretical appeal but
has found less favour in practice is the McCallum Feedback rule (McCallum
1988)].
Salter (2014) proposes a simple framework to adjudge the various policy rules,
viz. that provided by the classical quantity theory:
MV ¼ PY ð19Þ
(M—money supply measure, V—velocity of circulation, P—aggregate price

level, Y—real output)
Further, the money supply Eq. (6) is also invoked
M ¼ mH ð20Þ
(M—money supply measure, H—high-powered money/base money, m—money

multiplier)
By dynamizing Eqs. (19) and (20), i.e. writing them in terms of growth rates, we
get
gM ¼ gP þ gY gV ð21Þ
g M ¼ gm þ gH ð22Þ
(where gM denotes growth rate of money supply and so on for the other
variables)
Friedman’s k% money supply rule is designed to ensure a stable price level, i.e.
gP ¼ 0, which from (21) implies that
gM ¼ k ¼ gY gV ð23Þ
But the monetary authority cannot choose gM directly, it can only choose gH .
From (22), this means that if gM ¼ k;
5 A Monetary Policy Rule 53
gH ¼ k gm ð24Þ
What Friedman had in mind was that if the quantities gm ; gY and gV were stable
over the time horizon of interest say about 3–5 years, then one could take their
average values over this period, in specifying the growth rate k for money supply.
While in practice gY can usually be taken as stable, and gm ; gV were reasonably
stable over the 1960s and 1970s in the USA and Europe, this situation altered
drastically in the 1980s. The demand for money function (the reciprocal of the
velocity of circulation) increasingly displayed signs of instability—the so-called
missing money problem (see Leventakis and Brissimis 1991 for a full survey).
Similarly, the money multiplier also displayed signs of volatility from the 1980s
onwards (see Fratianni and Nabli 1979; Nachane 1992; Downes et al. 2006, etc.)
under the double impact of domestic financial deregulation and globalized capital
flows. This considerably reduces the appeal of Friedman's k% rule—though not
necessarily of the other rules.
6 Flexible Exchange Rates
To put Friedman’s case for flexible exchange rates in a proper perspective, we need
to note a fundamental proposition in international finance, viz. the impossible
trinity, or the trilemma, (which is a logical consequence of the so-called Mundell–
Fleming model (see Mundell 1963; Fleming 1962) discussed in Chap. 1 Section).
The trilemma states that for any country the three objectives of monetary inde-
pendence, exchange rate stability and financial integration cannot all be attained
simultaneously. Inevitably one of them has to be sacrificed in order to satisfy the
other two (see Obstfeld et al. 2005 for an exposition and a historical evaluation of
the trilemma). In practice, policymakers attempt to resolve the trilemma not by
dropping one objective altogether, while trying to fulfil the other two objectives in
toto, but by pursuing the three objectives to varying extents depending on the
relative weight assigned to each. Thus, they really maximize a weighted combi-
nation of the objectives.7
Let us now turn to the main issue of our interest, viz. Friedman’s advocacy of
flexible exchange rates. As is well-known, the World War II completely overran the
prevalent global financial structure. The economic hegemony of Britain and Europe
came to an end and the USA emerged as the major economic superpower, holding
nearly 70% of global stock of gold. The Bretton Woods system emerged towards
the end of the War (1944) as an agreement among the victorious Allied nations. The
7
It would be interesting to observe for any country the relative weights assigned to the three
objectives. Aizenmnan et al. (2013) introduce the “trilemma indexes” that measure the extent of
achievement in each of the three dimensions of the trilemma (viz. monetary independence,
exchange rate stability and financial integration).
salient features of this agreement are summarized below (see Bordo 1993;
Giovannini 1993, etc.):
(i) Gold convertibility was reintroduced with the US Treasury committed to
exchange gold for dollars with foreign official bodies at the rate of $35 per
ounce of gold.
(ii) Other countries should try (via intervention in foreign exchange markets) to
maintain their exchange rates within a band of 1% of a predetermined parity
vis-à-vis the dollar. This was an adjustable peg in the sense that countries
were permitted to change their exchange rate parity with the dollar, in the
event of what the IMF considered as a fundamental disequilibrium.
(iii) Countries were given access to IMF credit to cover short-run balance of
payments problems subject to conditionalities.
(iv) Controls on short-term capital flows were permitted so as to allow autonomy
to individual countries in their monetary policy decisions, and in order to
pre-empt destabilizing exchange rate speculation. In terms of the trilemma,
this meant that the Bretton Woods system assigned a low weight to the
objective of free movement of capital vis-à-vis exchange rate stability and
monetary policy sovereignty.
Friedman had been a long-standing critic of the Bretton Woods system. As early
as 1953, he had expressed scepticism both about the viability of capital controls and
the desirability of an adjustable peg arrangement (see Friedman 1953). He advo-
cated a move towards a global financial system in which exchange rates were
flexible (i.e. determined daily on the foreign exchange markets without any gov-
ernment intervention in the operation of these markets) and capital moved freely
between countries. Friedman’s main arguments in support of this position were the
following (see Johnson 1969; Dellas and Tavlas 2017, etc.):
(i) As we have seen above Friedman firmly believed that the best course for
national monetary policy was a money supply rule, the enforcement of which
would be jeopardized in the absence of national monetary sovereignty. In
view of the trilemma, this would mean that either of the other two objectives
(fixed exchange rates or free capital movement) had to be sacrificed. Whereas
the Bretton Woods system had opted to retain fixed exchange rates and allow
restrictions on capital flows, Friedman felt that national interests would be
best served by moving over to flexible exchange rates and removing all
official controls on capital flows.
(ii) Friedman felt that the international comity of nations stood to gain consid-
erably by the free movement of capital, since with no hindrances to move-
ment, capital would flow to the most productive use internationally. This
efficient allocation of global capital would enhance global productivity and
each individual nation would stand to benefit in this win–win situation.
(iii) But apart from the desirability of free capital movement per se, Friedman also
was aware that capital controls were porous and recognized the
6 Flexible Exchange Rates 55
“administrative limits to the extent to which it is possible to impose and

enforce such controls” (see Friedman 1953, p. 169).
(iv) Critics of flexible exchange rates had always voiced fears about their being
unstable. Friedman tried to assuage fears of instability by reasoning that
freely floating exchange rates would not move erratically. They would do so
only if the underlying forces of demand and supply for foreign exchange
behaved erratically which would happen either if the domestic economy
policy were mismanaged or there were huge unpredictable external shocks.
But in such a situation, a fixed exchange rate system would be equally under
strain. As a matter of fact, Friedman went even further and argued that the
Bretton Woods adjustable peg system was far more prone to destabilizing
speculation, since the exchange rate was adjusted infrequently and much
after the need for change had materialized (and the general direction of
change widely anticipated)—thus creating a one-way bet for speculators (see
Friedman 1953, p. 164).
(v) Finally, an argument made by Friedman (1962) but frequently ignored in the
literature is that flexible exchange rates by granting sovereignty (indepen-
dence from international pressures) to national policymakers, make the latter
democratically accountable. They cannot screen themselves from blame for
domestic failures by retreating behind the excuse of helplessness in the
presence of international pressures to maintain an untenable exchange rate
parity (see Frankel 2015; Dellas and Tavlas 2017).
Later events vindicated Friedman’s position with a vengeance. One of the basic
flaws of the Bretton Woods system was that it was underpinned by the US dollar
and hence critically tied to the developments in the US economy. The system
worked well in the 1950s when US inflation was well under control, and the dollar
served as a global nominal anchor. But the US involvement in the Vietnam War,
together with the welfare expenditures of the Kennedy–Johnson era inflated the US
fiscal deficit, which spilled over into a balance-of-payments deficit. A US
balance-of-payments deficit meant an oversupply of dollars in international foreign
exchange markets. The dollar–gold parity became unsustainable as several coun-
tries began a scramble to convert dollar holdings into gold as the dollar was thought
to be overvalued. Simultaneously as US inflation accelerated towards the late
1960s, countries became reluctant to peg their currencies to the dollar for fear of
importing inflation. Finally in August 1971, dollar convertibility into gold was
abandoned. There were efforts to save the fixed exchange rate system—the main
one being the Smithsonian Agreement between the G-10 countries negotiated in
December 1971.8 However, the agreement failed to halt the downward slide of the
dollar (mainly because the USA was unable to control its fiscal expansionism)
which was devalued by a further 10% in February 1973. Major countries started
8
The Smithsonian Agreement pegged the values of the national currencies at a new parity with the
US dollar (now devalued by nearly 8%) with a permitted fluctuation band of 2.25% around the
new parity.
abandoning the dollar peg—the UK had already floated the sterling in June 1972,
and the Japanese yen and the German Deutsche Mark were floated in early 1973.
This set the tone for other OECD countries to follow suit and may be regarded as
signalling a moratorium on the Bretton Woods system (see Bordo and Eichengreen
1993; Steil 2014; McKinnon 2014, etc.).
The collapse of the Bretton Woods system was interpreted by many as an
intellectual triumph of Friedman’s views and contributed enormously to the pop-
ularity of monetarist doctrines in the 1970s and early 1980s, not only in the USA
but worldwide.
7 Monetarism: Decline and Fall
If the stagflation of the 1970s signalled the retreat of Keynesianism from the arena
of policy, the US recession set in train by the inflation-fighting strategy adopted by
the Fed in October 1979 under the Chairmanship of Paul Volcker, seems in ret-
rospect to have had the same effect on the Friedmanian version of monetarism. In
October 1979, in a clear message to the US public, Volcker announced the Fed’s
commitment to a monetarist inflation-busting strategy. As a result of this new
policy, the federal funds rate, which averaged 11.2% in 1979, shot up to a record
high of 20% in late 1980. The policy achieved its stated purpose of bringing
inflation under control. Inflation which had peaked at 14.8% in March 1980 was
brought down to 5% in the first quarter of 1982. However, the costs of this dis-
inflation were severe: (i) a severe recession set in beginning July 1981 and lasted
right up to November 1982, (ii) unemployment rose from about 7% to as high as
10.8% during the trough of the recession in November 1982, (iii) apart from the
recession there were other costs. While the Fed continued to maintain high real
interest rates, the Reagan administration embarked on a policy of fiscal expan-
sionism with large tax cuts. This combination of a tight monetary policy and
expansionary fiscal policy produced a large budget deficit. (iv) Further, high real
interest rates led to a dollar appreciation and balance of payments problems (see
Mishkin 2001; Goodfriend 2007, etc.).
This combination of factors led to considerable industrial unrest. There were
protests from farmers, car dealers, machine tool employees and ordinary house-
holders (who found mortgage rates to be too high). While disenchantment with the
Fed was high, there was an even greater disillusionment with monetarism. In
August 1982, the Fed abandoned monetary targeting and monetarism may be said
to have been formally expunged from the policy arena in the USA.9 Its academic
9
In India, as it often happens, ideas are imported from the West, long after they have lost their
freshness and duly discarded there. Monetary targeting was adopted in India in 1990 and retained
right up to 1998 (see Mohanty and Mitra 1999 for a detailed post-mortem of the experience).
7 Monetarism: Decline and Fall 57
reputation also went into decline with the emergence of newer theories like New
Classical economics, real business cycle theory and neo-Keynesianism—the study
of which forms the subject matter of the next two chapters.
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Chapter 3
New Classical Economics
and Real Business Cycle Theory
Abstract This chapter is devoted to two important schools of thought, viz. new
classical economics and real business cycle theory which rose to prominence in the
late 1970s. The new classical school shares with Friedman’s monetarism, three
features—a profound belief in the self-corrective properties of markets and a cor-
responding distrust of Keynesian interventionist policies (widely prevalent in the
late 1960s and 1970s), a denial of the existence of a long-run trade-off between
inflation and unemployment along a Phillips curve, and a recognition of the
important role played by agents’ expectations in macroeconomic outcomes. Real
business cycle theory usually associated with the names of Prescott, Kydland,
Plosser, Long, etc., builds on a line of earlier thinking, associated on the one hand
with the impulse and propagation mechanisms of business cycles due to Frisch and
Slutzky, and on the other with the neoclassical growth model of Solow.
1 Introduction
The new classical school which rose to prominence in the 1970s, shares with
Friedman’s monetarism, three features—a profound belief in the self-corrective
properties of markets and a corresponding distrust of Keynesian interventionist
policies (widely prevalent in the late 1960s and 1970s), a denial of the existence of
a long-run trade-off between inflation and unemployment along a Phillips curve,
and a recognition of the important role played by agents’ expectations in
macroeconomic outcomes. This similarity has led several authors to regard new
classical economics as a variety of monetarism1 (see, e.g. Hahn 1980; Tobin 1981;
Hoover 1984). However, while new classical economics does share several features
with Friedman’s theory, it differs in two essentials. Firstly, while Friedman’s
methodology was essentially Marshallian attempting to keep the analysis tractable
by isolating a specific problem to focus on, the new classical methodology is
distinctly Walrasian adopting a general equilibrium approach (see Lucas 1980;
Hoover 1984, etc.). Secondly, while Friedman did underline the role of expecta-
As a matter of fact, Tobin (1982) terms new classical economics as “Monetarism Mark II”.
1

https://doi.org/10.1007/978-81-322-3920-8_3
62 3 New Classical Economics and Real Business Cycle Theory
tions, he assumed them to be adaptive (see Chap. 2). The new classical approach,
by contrast, postulates expectations to be rational (see discussion below). Thus,
while the new classical and monetarists share several policy conclusions, they differ
fundamentally in their theoretical approach.
2 Four Basic Tenets of New Classical Theory
2.1 Micro-foundations
New classical theory lays strong claims to being scientific in the sense that its
macroeconomic models (the so-called DSGE—dynamic stochastic general equi-
librium—models) are securely rooted in micro-economic foundations. It attacks
both Keynesian and monetarist theories on the grounds that their macroeconomic
relations are ill-defined, since they do not capture the micro-economic behaviour of
economic agents (see Lucas 1976). This viewpoint, that aggregate relations are
derivable solely from individual behaviour is termed as “reductionism” by
philosophers (see Murphy 2010).2 Of itself, reductionism does not maintain that all
the individuals in the ensemble are homogenous, but typically, new classical
economists impose this condition in their theorizing and presume that the typical
behaviour of an economic agent is captured by a representative agent, who opti-
mizes an objective function (expected utility in the case of consumers or expected
profits in the case of firms).
Thus in effect, new classical models are making three distinct assumptions, viz.
(i) reductionism, (ii) representative agent and (iii) representative agents as
optimizers.
The term representative agent is used in at least two alternative senses.
A stronger sense of the term in which all consumers/firms are identical and a
weaker sense in which agents differ but their preferences are such that the aggregate
of their individual choices is mathematically equivalent to the decision of one
individual. This latter possibility holds under fairly restrictive assumptions, e.g.
when the individual expenditure shares functions differ but are linear in the
heterogeneity term (Stoker 1986) or when the expenditure shares are of the Gorman
polar form (see Gorman 1959).3 If the linearity assumption holds, we have the case
of exact aggregation.
Such representative agent reductionist models, which are at the heart of the new
classical theory, postulate that aggregate demand/supply curves can be arrived at by
2
Actually, philosophers distinguish between three types of reductionism, viz. theory reductionism,
methodological reductionism and ontological reductionism. Economists usually have the last in
mind which Murphy (op. cit) p. 82 defines as denial “that wholes are anything more than their
parts”.
3
Further details on the representative agent and the related problem of aggregation may be found in
Fisher (1992), Blundell and Stoker (2005), and Browning et al. (1999).
2 Four Basic Tenets of New Classical Theory 63
aggregating over individual demand/supply curves. But this is only valid if (i) either
the term representative agent is used in its stronger sense or (ii) the term is used in
the weaker sense but under the very restrictive case of exact aggregation.
2.2 Complete Markets, Continuous Equilibrium and Gross

Substitutability
Complete Markets: The new classical theory makes two key assumptions of market
organization, on which several of its conclusions rest. These assumptions are often
not spelt out explicitly, but assumed as a “matter of fact” or as a “sufficiently good
approximation to the real world”. The first is that markets are complete, and the
second is that markets clear continuously.
Complete markets imply that there are markets for every good to cover the space
of all possible states of nature (see Flood 1991; Anderson and Raimondo 2008,
etc.). Futures and options markets are viewed in this framework as efficient allo-
cators of risk between hedgers and speculators (see Adam and Feernando 2006;
Allen and Yago 2010, etc.) or as Flood (op. cit) p. 54 refers to it—the distribution of
fat and lean meat between Jack Sprat and his wife in the nursery rhyme.
In the complete market system, inter-temporal budget constraints are always
satisfied and real-world phenomena like illiquidity, wilful default, insolvency and
“market freezes” are ruled out a priori.
Continuous Market Clearing and Gross Substitution: The assumption of
continuous market clearing is a direct descendant of the classical Say’s law. It is
possibly the most critical and controversial assumption in new classical models. It
states that the price vector which equates demand and supply in all markets is
established instantaneously. If all markets clear continuously, then Walras’ law is
redundant and full employment prevails continuously (see Lange 1945; Sowell
1974, etc.). This of course requires perfect wage and price flexibility as pointed out
by Laidler (1997). The continuously clearing market assumption has been the
subject of a virulent attack after the global crisis.
A further point to be noted in this context is the implicit new classical
assumption of gross substitutability between producible and non-producible assets
in savers’ portfolios. As is well known from elementary micro-economics, goods
X and Y are gross substitutes if a rise in the price of either (say X) drives up the
demand for the other (Y). Keynes (1936), Chap. 17, makes two important
assumptions; viz. (i) the elasticity of production of liquid financial assets (including
money) is zero, i.e. an increase in their demand cannot be met by increasing their
production, and (ii) the elasticity of gross substitution between all liquid assets,
including money (which are not reproducible by labour in the private sector) and
producibles (in the private sector), is zero, i.e. when the price of manufactures
increases, people will not increase their demand for money.
While the assumption of gross substitution between producible and

non-producible assets is not explicitly made in the new classical theory, the
assumption of Say’s law and the denial of involuntary unemployment can be shown
to be tantamount to making this assumption (see Davidson 1984).
2.3 Rational Expectations
While the theory of rational expectations is usually attributed to Muth (1961), its
implications for macroeconomics derive from the seminal articles of Lucas (1972,
1976). Simply stated, the rational expectations theory (RET) maintains that agents
make use of all available information and their knowledge of the working of the
economy, in forming their expectations about the future (see Hoover 1988, p. 14; de
Paula and Saraiva 2016, etc.).
It is important to state the definition of rational expectations a bit formally.
A A
Let It1 denote the information set available to an agent A in period t. Thus, It1
is the collection of all information available to A at time t. The agent will have his
own subjective expectation of how a macroeconomic variable, say inflation (p), will
evolve in the future. Let EtA ðpt þ 1 Þ denote agent A’s subjective expectation formed
in period t regarding
the value that p will assume in period (t + 1). Let further
Et pt þ 1 jIt1
A
denote the true (objective) expectation of p, given the information set
available to agent A in period t. Then, the agent A is said to form rational expec-
tations about p if

EtA ðpt þ 1 Þ ¼ Et pt þ 1 jIt1
A
þ 2At ð1Þ
where 2At is the expectational error of agent A. Further, the expectational error is
zero on the average and errors in successive time periods are uncorrelated (i.e.
errors are not systematic).
Equation (1) indicates that based on the information available to him, the rational
agent makes the best possible prediction around the true value of the variable. He does
make mistakes, but these cancel out on the average, and the errors are not systematic.
While the above definition closely follows Muth (1961), as noted in Knudsen
(1993, p. 153) the revival of rational expectations by Lucas (1972) involved the
assumption that the expectations of every single agent were rational. This involves
at least two further assumptions, viz. that there is consistency among agents in their
perceptions about the economy and that there is a high degree of stability and
regularity in the phenomena under study (see Sargent 1993, p. 3; Knudsen 1993,
etc.).4 As pointed out by Ayala and Palacio-Vera (2014), the second of these
4
If the phenomenon of interest exhibits sufficient stability and regularity over time, it can allow
economic agents to infer its main features and attach (subjective) probabilities to its alternative
outcomes.
2 Four Basic Tenets of New Classical Theory 65
assumptions implies that rational expectations cannot be applied if phenomena

exhibit Knightian uncertainty (what in Chap. 4 we term as non-ergodic uncertainty).
2.4 Neutrality of Money
One immediate and important consequence of the rationality assumption is the

neutrality of money. While Friedman had asserted the long-run neutrality of money,
the new classical theory goes further and maintains that money is neutral in the
short run too. Continuous optimization and rationality imply that agents are able to
correctly anticipate the systematic component of monetary policy, and can dis-
criminate between nominal and real changes. In particular, workers do not suffer
from money illusion and the labour supply decisions depend only upon relative (not
absolute) prices. Similarly, output supply is also dependent solely upon relative
prices. Short-run non-neutralities can only emanate from monetary policy shocks,
which cannot be anticipated. However, their effects are soon dissipated after agents
realize that they have occurred and incorporate them in their expectations (see
Hoover 1984; Snowdown and Vane 2005, p. 12).
3 Main Policy Implications
3.1 Lucas Aggregate Supply Function and Equilibrium

Business Cycle Theory
One of the major challenges faced by the new classical school was to explain
business cycles within the framework of its assumptions (see Gerrard 1996). Lucas’
(1973) response to the challenge was to posit that agents face imperfect information
and this fact is sufficient to reproduce the stylized facts of real-world business
cycles, even in the presence of continuous market clearing and rational expecta-
tions. Imperfect information relates to the agents’ inability to distinguish between
relative and absolute price changes. Lucas (op. cit.) distinguishes between two types
of shocks which occur in the economy: (i) shocks which affect relative prices (such
as change in preferences or technology) to which producers will react by altering
their output and (ii) shocks which affect the aggregate price level without impacting
relative prices such as changes in money supply to which rational producers will not
react.
In any given situation, an individual producer’s total output of a good A is
assumed to fluctuate around its constant potential (natural) level YN;t
A
(in logs) in a
cyclical fashion. While the natural level of output5 depends upon secular factors
such as capital and population growth, and thus changes slowly over time, the
cyclical component YC;t A
(also expressed in logs) fluctuates rapidly over time in
response to changes in prices. Lucas postulates that the producer is unable to
observe changes in the absolute price level—he only observes the change in the
price level of his product. He is thus unaware as to whether the observed change in
his product price is a relative price change or part of a change in the general price
level. Let PAt denote the price of good A at time t, and let Pt denote the aggregate
A
price level at time t (both prices in logs). His cyclical production decision YC;t will
A
depend on how much of the observed price in that market Pt he believes to be a
relative price change, i.e. on the excess of PAt over his expectation of the absolute

price level Pt based on his information set say It ð AÞ, where It ð AÞ ¼ It1 [ PAt .6
Thus, if YtA denotes the (log of) production in market A, then

YtA ¼ YN;t
A
þ YC;t
A
¼ YN;t
A
þ c PAt E ððPt jIt ð AÞÞÞ ð2Þ
(c > 0 being a parameter indicating how output responds to changes in relative

prices.)
Now, the producer will form his expectation about the absolute price level based
on the information set available to him at time t, viz. It ð AÞ: In forming this
expectation EððPt jIt ð AÞÞ, the producer will use two sets of information—his
expectation of the absolute price level Pt based on his information set It1 and the
actual price of his product PAt .
E ððPt jIt ð AÞÞÞ ¼ hE ðPt jIt1 Þ þ ð1 hÞPAt ð3Þ
where 1 > h > 0 is the reliability attached by the producer to his expectation
E ðPt jIt1 Þ based on past experience.
Substituting (3) into (2) yields the following supply function for the producer of
good A,

YtA ¼ YN;t
A
þ ch PAt E ððPt jIt1 ÞÞ ð4Þ
Blowing this up for all the producers in the economy yields an aggregate supply
function for the economy.
YtS ¼ YN;t þ ch½Pt E ððPt jIt1 ÞÞ ¼ YN;t þ YC;t ð5Þ
5
The natural level of output is the most efficient level of output (i.e. that level at which the average
cost of the firm is at its minimum).
6
The information set It ð AÞ denotes the information available to producer of good A in period
t. This includes information about aggregate price level in period (t − 1) (which will become
publicly available in period t) and the price PAt in market A at time t.
3 Main Policy Implications 67
P A
with YtS denoting the (log of) aggregate supply in the economy and YN;t ¼ A YN;t
(the total natural output for the economy is the sum of natural outputs of all the
producers).
The Lucas aggregate supply function (5) is presumed to apply to the cyclical
component of national income. It shows that this cyclical component can vary in
response to changes in absolute prices because of imperfect information. Thus,
monetary factors (by influencing the general price level) can produce output fluc-
tuations in the short run (i.e. at business cycle frequencies). Lucas extends this
earlier analysis (Lucas 1973) of monetary misperceptions to develop a full-fledged
equilibrium business cycle model in which monetary shocks act in combination
with lags in investment to generate business cycles in a model satisfying all the
basic assumptions of the new classical world (Lucas 1975; Gerrard 1996).
3.2 Anticipated Nominal Demand Shocks Do not Matter
The Lucas aggregate supply function can also be used to demonstrate another key
new classical proposition, viz. that shocks to nominal demand can affect output only
if they are unanticipated. Since this analysis is focused on the cyclical component
of YtS , we assume without loss of generality that YN;t ¼ 0 in (5).
We now proceed to look at the aggregate demand side of the economy. If YtD
denotes aggregate real demand and XtD the aggregate nominal demand (both in
logs), then
YtD ¼ XtD Pt ð6Þ
Lucas (1972) (see also Sargent and Wallace 1976) assumes that nominal demand
XtD follows a random walk with drift.
XtD ¼ Xt1
D
þ d þ gt ð7Þ

where d is the drift term (constant) and gt N 0; r2g is the random error with
E ðgt ; gs Þ ¼ 0; t 6¼ s
Equation (7) can be interpreted as saying that changes in nominal demand at any
time t occur under two sets of influences—a systematic component d and an
unanticipated random component gt .
Equating YtD and YtS and writing Yt ¼ YtD ¼ YtS , we get from (6) and (7)
Pt ¼ Yt þ Xt1
D
þ d þ gt ð8Þ
Taking expectations on both sides of (8),7 we get
E ðPt jIt1 Þ ¼ E ðYt jIt1 Þ þ Xt1

D
þd ð9Þ
Further taking expectations of both sides of (5) yields
E ðYt jIt1 Þ ¼ ch½E ððPt jIt1 ÞÞ EE ½ððPt jIt1 ÞÞ ¼ 0 ð10Þ
Since EE ððPt jIt1 Þ ¼ E ððPt jIt1 Þ

Using (10) in (9), we find that
EðPt jIt1 Þ ¼ Xt1

D
þd ð11Þ
We now subtract (11) from (8) to obtain
Pt E ðPt jIt1 Þ ¼ Yt þ gt ð12Þ
Thus in view of (12), from (5) we obtain the important result.
Yt ¼YtS ¼ ch½Pt EððPt jIt1 ÞÞ ¼ ch½Yt þ gt or

ch ð13Þ
Yt ¼ g
1 þ ch t
Thus, our long derivation shows that the equilibrium national output Yt is not
affected by the systematic/anticipated component of the nominal demand shock
d but only by the random/unanticipated component of the shock, viz. gt .
Since monetary policy usually acts as a nominal demand shock, a corollary of
the above result is that only the unanticipated component of monetary policy can
affect output. We will generalize this result somewhat when we discuss the policy
ineffectiveness proposition.
7
Since we are forming expectations for period t based on information available in period (t − 1),
D
E Xt1 jIt1 ¼ Xt1D
since the previous period value has already occurred and hence the
expected value equals the actual value. E ðgt jIt1 Þ ¼ 0 because successive shocks are uncorre-
lated so that having all the knowledge about previous shocks is not going to change our
expectation about gt . Thus, the conditional expectation E ðgt jIt1 Þ is equal to the unconditional
expectation of gt , which is zero.
3.3 Lucas Critique
The intuition behind the Lucas critique (Lucas 1976) is fairly straightforward.
Agents base their actions on their expectations about government policy; hence, any
change in government policy is likely to affect their behaviour. If policy does not
factor in this change of behaviour, then that policy will not achieve its intended
effect. The main thrust of the critique was directed at the large-scale econometric
models (mostly Keynesian) used for policy in the 1970s and 1980s. Such models
were estimated over a particular time period during which a certain set of policies
may have been followed. The models were then used to derive optimal policies by
comparing alternative “feedback policy rules”, under the strong assumption that the
estimated parameters and the lags involved remained invariant to alternative poli-
cies.8 Lucas, however, maintained that each feedback policy rule would affect
agents’ behaviour by altering their expectations, rendering the entire exercise
vacuous.
More formally, the model estimated over a time period ð0; T Þ may be written as
Yt þ 1 ¼ F ðYt ; U t ; w; tt Þ ð14Þ
where Yt is the vector of the economic variables of interest (such as employment,

output, inflation), U t is a vector of policy variables, w is a vector of parameters, and
tt is a random error term.
Suppose the feedback policy rule over ð0; T Þ was a certain rule A, described by
U t ¼ G Yt ; /A ; et ð15Þ
where /A is a vector of parameters characterizing policy A and et is a random error

term uncorrelated with tt .
For some reason, the government would like to consider some alternative rule
say B described by
U t ¼ G Yt ; /B ; et ð16Þ
A typical Keynesian model would use the same parameter w in (14) to evaluate
policy B. In other words, the parameter w is assumed not to depend on the policy
parameter /. However, Lucas argues that because the expectations of agents under
policy B will be different from those under policy A, the parameter w will not be the
same under the two policies. Hence, w depends on the policy parameter /, and
w /A need not be equal to w /B . Hence, evaluation of policy B assuming the
parameter vector in (14) as w /A instead of w /B will lead to misleading results
8
Feedback policy rules are rules where the policy variables depend on the state of the economy. An
example of a feedback policy rule is the Taylor rule in which the interest rate (policy variable) is
set equal to a weighted average of the output gap and inflation.
(for further details, refer Rudebusch 2002 and for an empirical verification see
Lindé (2001)).
The Lucas critique brought out the severe limitations of policy analysis based on
reduced forms of econometric models. The need was highlighted for building
models which were based on micro-economic foundations in which expectations
and optimization processes of agents were explicitly modelled. The structural for-
mat of such models would involve structural/deep parameters which would be
largely invariant to policy changes. This rationale prepared the ground for the
emergence of dynamic stochastic general equilibrium (DSGE) models, a decade or
so after the Lucas critique made its original appearance in Lucas (1976).
3.4 Ineffectiveness of Feedback Policy Rules
Sargent and Wallace (1976) offer a further critique of Keynesian-type feedback

policy rules. While their critique applies quite generally to feedback policy rules, it
can be illustrated with a fairly simple example [see Sargent and Wallace (op. cit.)].
Suppose that the central bank has estimated empirically over the period ð0; T Þ the
following relationship between inflation p and the rate of growth of money supply
m, viz.
pt ¼ a þ bpt1 þ cmt þ ut ð17Þ
(ut is a random error which is identically and independently distributed with

mean 0 and variance r2u .)
The true structure which has generated this reduced form (17) could be
pt ¼ a þ bpt1 þ cðmt Et1 mt Þ þ et ð18Þ
(where Et1 mt denote the expectations of mt formed in period (t − 1) and et is

identically and independently distributed with mean 0 and variance r2e .)
mt ¼ D0 þ D1 pt1 þ mt ð19Þ
(where mt is identically and independently distributed with mean 0 and variance

r2m . Further, mt and et are distributed independently of each other.)
Et1 mt ¼ d0 þ d1 pt1 ð20Þ
In the above structural model, (18) indicates that expectations of monetary

policy play an important role in determining inflation. Equation (19) is the mone-
tary policy rule relating the growth rate of money supply to the previous period’s
inflation, and (19) shows how agents’ expectations about policy are being formed.
At the moment, we do not assume these expectations to be rational.
Substituting (20) into (18) yields the following reduced form.
pt ¼ A þ Bpt1 þ Cmt þ gt ð21Þ
where A ¼ a cd0 ; B ¼ b cd1 ; C ¼ c; and gt ¼ et :

Thus, while (21) has the same mathematical form as (17), there is a very
important difference. The parameters A and B in (21) depend on the expectational
parameters d0 and d1 . If the policy parameters in (19) change, then so will A and B,
and if policymakers do not take this into account but proceed simply via (17), then
policy will be misdirected. Note that the Lucas critique does not depend on the
assumption of rational expectations.
Further, (21) can also serve to illustrate the policy ineffectiveness proposition. Let
us now assume that expectations are rational. Because of rational expectations, any
feedback rule will be inferred by agents from past observations and we will have
d0 ¼ D0 and d1 ¼ D1
From (19) and (20), with d0 ¼ D0 and d1 ¼ D1 ;
ðmt Et1 mt Þ ¼ mt ð22Þ
Using (22) in (18) yields
pt ¼ a þ bpt1 þ cmt þ et ð23Þ
Thus, the policy parameters D0 and D1 do not figure in the inflation-generating

mechanism, and hence there is no way in which policy can influence the
macroeconomic variable pt . Thus under rational expectations, feedback policy rules
are ineffective.
It is important to note that the policy ineffectiveness proposition does not say
that all government policies are ineffective—only policy based on feedback rules
(see Hoover 2008).
3.5 Ricardian Equivalence
The consequences of government budget deficits on the general level of economic

activity have been a matter of considerable interest to economists right from the
early classical economists such as Smith, Malthus and Ricardo. For the classicals,
an adherence to Say’s law and the consequent belief in the automatic equality of
savings and investment, meant that government overspending via public debt issue
would impede “the natural progress of a nation towards wealth and prosperity”
(Smith 1937, p. 674)—in effect, the government is only diverting productive
resources from the private sector to possibly wasteful purposes.9
Keynes’ General Theory took a radically different view of expansionary fiscal
policy. His theory, specifically written in the context of the Great Depression,
advocated the use of fiscal deficits to prop up aggregate demand in a situation of
less than full employment.10
The Keynesian position on fiscal deficits dominated the policy space of many
developed countries for the two post-World War II decades. As a matter of fact, in
many less developed countries such as India, deficit financing was regarded as a
useful device for generating financial resources for much-needed public investment
(especially during the periods of the second and third Five-Year Plans in India).
However towards the end of the 1960s and the decade of the 1970s, two new
hypotheses came to increasingly dominate academic and policy thinking on public
expenditure and fiscal deficits viz. the crowding out hypothesis and the Ricardian
equivalence proposition.11 The two hypotheses are distinct, though related. The first
states that increased public expenditure is counterbalanced by a decrease in private
expenditure (usually private investment) either of an equivalent amount (complete
crowding out) or by something less than the equivalent amount (partial crowding
out). Thus, public expenditure fails to stimulate aggregate demand.12
Whereas the “crowding out” hypothesis refers to the displacement effects of
public expenditure, Ricardian equivalence is a theory about debt financing of fiscal
deficits. Many of the earlier Keynesians believed that fiscal deficits financed by
government bonds would stimulate aggregate demand via a wealth effect, as these
bonds are viewed as net wealth by the private sector. Hence, these writers viewed
“bond-financed deficits” as more expansionary than “tax-financed deficits” (see
Metzler 1951; Modigliani 1964; Tobin 1972, etc.). In a seminal contribution, Barro
(1974) presents an alternative view. He argues that an issue of government bonds to
finance a fiscal deficit is not viewed as an increase in net wealth by the private
sector agents, as they rationally foresee an increase in future taxes to finance the
9
The classical views on public debt are discussed in Mirowski (1982), Bernheim (1989), Dome
(2004), etc. Tsoulfidis (2007) in particular provides a very detailed and insightful perspective.
10
The rise in aggregate demand and output following from the fiscal expansion, however, leads to
an increase in money demand, and the size of the fiscal multiplier is somewhat reduced—the
reduction being greater the smaller the elasticity of money demand (or the larger the elasticity of
private investment) with respect to interest rates. There is partial crowding out of private invest-
ment, but the multiplier can still be positive (see Blanchard 1985). A fuller discussion is given in
Brown-Collier and Collier (1995).
11
As these hypotheses have been discussed in some detail in Chap. 4, we only present a brief
sketch here for the sake of completeness of exposition.
12
This hypothesis is usually associated with Friedman (1972), Brunner and Meltzer (1972),
Andersen and Jordan (1968). Detailed early reviews and critiques of the entire debate are available
in Carlson and Spencer (1975) and Friedman (1978). For more recent theoretical developments
and empirical evidence, see Romer and Romer (2010), Ramey (2011), Mountford and Uhlig
(2008), etc.
amortization and interest payments on this debt (see Canto and Rapp 1982 for a
detailed exposition). Since the wealth effect does not arise with a bond-financed
deficit, the impact on aggregate demand is negligible. This effect was termed as
Ricardian equivalence by Buchanan (1976) who detected considerable similarity
between Barro’s theory and the earlier work of Ricardo (1817).
4 Real Business Cycles Theory
4.1 Basic Features
While (as we have seen) Keynesians, monetarists and new classicals had major
differences, their theories shared one feature in common, viz. that the economic
fluctuations were regarded as temporary (though occasionally severe and prolonged)
deviations from an underlying long-term trend. The sources of such temporary
deviations were in most cases assumed to be demand-side shocks. Econometrically
speaking, if this were the case, then the time series properties of GDP should exhibit
stationarity around a deterministic trend. With the emergence of unit root econo-
metrics in the late seventies (see Dickey and Fuller 1979), it became possible to test
this hypothesis. In a widely quoted paper, Nelson and Plosser (1982) showed that far
from being stationary around deterministic trends, most US macroeconomic series
followed a random walk. This statistical result is interpreted as showing that
macroeconomic series such as GDP, experience permanent shocks with no tendency
to revert to the former trend. Since nominal demand shocks can only be a source of
transitory fluctuations, they cannot account for a significant share of observed fluc-
tuations in output. One has to seek an explanation in real supply-side factors.
Real business cycle theory usually associated with the names of Prescott,
Kydland, Plosser, Long, etc., (see Kydland and Prescott 1982; Prescott 1986; Long
and Plosser 1983, etc.) builds on a line of earlier thinking, associated on the one
hand with the impulse and propagation mechanisms of business cycles due to
Frisch (1933) and Slutzky (1937), and on the other, with the neoclassical growth
model of Solow (1956).
Stadler (1994, p. 1753) most cryptically describes real business cycle theory as
“the neo-classical model of capital accumulation, augmented by shocks to pro-
ductivity …”. Unlike almost all business cycle theories except perhaps the Austrian,
this theory does not regard business cycles as welfare-reducing. Rather, business
cycles are viewed as a natural (even ideal) response to exogenous productivity
shocks perfectly consistent with economic efficiency (see Long and Plosser 1983,
p. 42).
The model retains almost all the assumptions of new classical economics, viz.
(i) micro-foundations and the assumption of representative optimizing agents (firms
and households), (ii) rational expectations, (iii) complete and continuously clearing
markets and (iv) neutrality of money.
The purpose of real business cycle theory is to show that even within the
framework of these pristine new classical assumptions, and abstaining from causal
factors considered by other theories [such as animal spirits and herd instincts
(Keynes), imperfect information (new classical theory), monetary policy and gov-
ernment intervention (Friedman)], technology shocks are perfectly capable of
generating business cycles theoretically (see e.g. Cogley and Nason (1995)). Even
more importantly, these cycles also exhibit several of the stylized features associ-
ated with real-world cycles such as (see Rotemberg and Woodford (1996), Stadler
1994, p. 1751 etc.).
(i) A high degree of coherence between output movements in different sectors.
(ii) Consumption exhibits less volatility over the cycle than output, and the
consumption–output ratio is countercyclical.
(iii) Investment is far more volatile than output, and the investment–output ratio
is pro-cyclical.
(iv) Employment is less volatile than output.
(v) Velocity of money is countercyclical .
(vi) Long-term interest rates are less volatile than short-term interest rates.
As mentioned earlier, the real business cycle literature adopts an impulse and
propagation approach to explaining business cycles. The impulse factor causes a
variable to deviate from its steady-state value, while the propagation mechanism
causes these deviations to persist for some time. The impulse mechanism consid-
ered is technological shocks to productivity (or occasionally shocks to preferences).
Four propagation mechanisms are considered (see Stadler 1994):
(i) Consumption smoothing: Consumers generally tend to smooth consumption
over time. Hence, any rise in current output will not be totally consumed but
partly invested in additions to capital stock, which will raise future output.
(ii) Lags in investment: These lags can result in a current shock affecting future
investment and output.
(iii) Inter-temporal substitution of leisure: Most technology shocks have a
long-term impact on real wages, but there could be some technology shocks
which could be transitory but persistent (e.g. a new computer language).
Altig et al. (2011), Basu et al. (2006) and others show that with temporary
shocks, agents will reduce leisure (work harder) when wages are high, and
reduce their labour supply when wages go back to their lower level. This
introduces some persistence in output over the duration of the effect of the
shock.
(iv) Inventories: Firms may use inventories to meet unexpected changes in
demand. Once these are depleted, they will be built up only gradually so that
output rises several periods ahead.
4 Real Business Cycles Theory 75
4.2 A Formal Model
A major contribution of the real business cycle literature is that it has paved the way
for building large-scale economic models, which are based on micro-foundations
and “deep parameters”, and hence immune from the Lucas critique. At the same
time, these models can be calibrated to real-world data in a meaningful way. Below,
we try to capture the essentials of this approach in terms of a simple but formal
model (adopted for purely expository purposes).
The model that we take up is the real business cycle (RBC) model (Hansen
1985; King et al. 1988; Ireland 2004, etc.) in which a representative agent (who is a
consumer, labourer, supplier of capital and producer, all rolled into one) has a linear
utility function defined over consumption Ct and hours worked Ht for each period
t = 0, 1, 2….13 He is supposed to maximize the expected utility function over his
entire lifetime (assumed infinite).
( )
X
1
Max E0 bt ln Ct cHt ð24Þ
t¼0
where Et is the expectations operator denoting expectations about future values

formed at time t, the discount factor b satisfies 0\b\1 and the disutility factor
c [ 0.
Output Yt is produced with capital Kt and labour Ht via a Cobb–Douglas
production function.
Yt ¼ At Kt gt Ht

h 1h
ð25Þ
Here, g [ 1 is a measure of the technical progress (of the Harrodian variety) and
0\h\1.The technology shock At follows the first-order AR process:
ln At ¼ ð1 qÞ lnð AÞ þ q ln At1 þ t ð26Þ
where A [ 0 and 1\q\1 while t Nð0; r2 Þ and serially uncorrelated.

In addition, we have the definitional identities which close the system, viz.
Yt ¼ Ct þ It ð27Þ
where It is investment (additions to capital stock).
13
This assumption is not as restrictive as it appears at first sight. The model can be easily extended
to introduce separately,—consumers, producers of intermediate and final goods, capitalists, etc., at
the cost of complicating the technical aspects but not changing the main narrative. Our exposition
closely follows Ireland’s (2004) model.
Ktþ 1 ¼ ð1 dÞKt þ It ð28Þ
with the depreciation rate d in (0,1).

The Euler conditions for the maximization problem (24) subject to the side
conditions (25) to (28) include the intra-temporal condition.14

1 h t Kt h
Ct ¼ At g t ; ðt ¼ 0; 1; . . .Þ ð29Þ
c g Ht
(which simply equates the marginal rate of substitution between consumption

and leisure to the marginal product of labour).
Additionally, we have an inter-temporal optimizing condition.
h i
1 1
Ct ¼ bEt Ctþ 1 h Ytþ 1 Ktþ 1 þ ð1 dÞ ðt ¼ 0; 1; . . .Þ ð30Þ
(This is a formal statement of the intuitive fact that the inter-temporal rate of
substitution between current consumption and expected future consumption equals
the marginal product of capital.)
In some versions of the model, a competitive market real interest rate is also
appended:
h1
Kt
Rt ¼ 1 þ h At d ð31Þ
gt Ht
Equations (24) to (30) or (31) constitute the dynamic stochastic general equi-
librium DSGE formulation of the RBC model. Of course, as we have already stated
earlier and which we now reiterate for emphasis, this model is highly simplified and
only being used for expository purposes. DSGE models, actually used for policy
purposes, are considerably more elaborate (see, e.g. as Smets and Wouters 2003,
2004; Harrison et al. 2005; Sborodone et al. 2010 etc.). Among the elaborations
which are most common is the introduction of a separate labour supply function,
different types of firms, staggered pricing and stick wages, a monetary policy
function and so on. Nevertheless, the basic model used here can illustrate the
essential issues which are central to DSGE-RBC modelling in an easily compre-
hensible manner.
Since we are interested in the cyclical behaviour of the system, we need to study
the deviations of the variables around their long-term/steady-state values. To do
this, we need to log-linearize the above system around its steady state. Let the
steady-state values of the variables be denoted by corresponding lower-case letters
as y ; c ; i ; k ; h ; r and a . Defining deviations of the actual values around the
14
For a detailed discussion of optimization in discrete dynamic systems, refer to Stokey and Lucas
(1989).
4 Real Business Cycles Theory 77
steady-state values by lower-case letters without asterisks, i.e. as

yt ; ct ; it ; kt ; ht ; rt and at (where yt ¼ ln yt =y and the other deviations are similarly
defined), we can log-linearize the system (25) to (31) around the steady state using a
first-order Taylor series approximation. This yields the system,
yt ¼ at þ hkt þ ð1 hÞht ð32Þ
at ¼ qat1 þ t ð33Þ

g g
1 þ d yt ¼ 1 þ d hðg 1 þ dÞct þ hðg 1 þ dÞit ð34Þ
b b
gkt þ 1 ¼ ð1 dÞkt þ ðg 1 þ dÞit ð35Þ
c t þ ht ¼ y t ð36Þ

g g
ðg=bÞEt ðct þ 1 Þ ¼ ðg=bÞðct Þ þ þ 1 d E t ð yt þ 1 Þ þ 1 d ðkt þ 1 Þ ð37Þ
b b
rt ¼ lnðhÞ þ at þ ðh 1Þkt ðh 1Þht ð38Þ
Because of the expectations operator figuring in the system (see Eq. 37), special
techniques have to be invoked in order to solve the system. These are discussed in
Blanchard and Kahn (1980), Sims (2003), Uhlig (1999), etc., where necessary
conditions for the existence and uniqueness of the solution are also presented. Thus,
using these and other specialized techniques we can under fairly general conditions
solve the above RBC system and obtain the time paths of consumption ct ;
investment it and labour (man-hours ht ). These represent the time path of business
cycles in an economy.
4.3 An Evaluation
Empirical evidence, as to whether RBC models can reproduce the stylized features
of real-world business cycles, is mixed. The basic RBC first-generation models
generally fail to generate observed stylized facts such as output persistence, labour
supply volatility (King and Rebelo 1999), or observed labour supply decreases after
a positive productivity shock (Gali 1999; Christiano and Davis 2006, etc.). The
problem seems to be that RBC models have internal propagation mechanisms that
are too weak to account for the periodicity and other observed features of real-world
cycles. They are also unable to account for real-world recessions, since in RBC
models these would require economy-wide reductions in productivity (see
Summers 1986; Stadler 1994, etc.). Later, RBC theorists have introduced several
new features in these models to make the models more congruent to the data. These
include the role of monopolistic unions (Maffezolli 2000), habit persistence

(Boldrin et al. 2001), labour hoarding (Burnside et al. 1993; Danthine and
Donaldson 1993), human capital (Comin and Gertler 2006), imperfect information
(Mankiw and Reis 2010; Levine et al. 2010, etc.), monetary shocks (Huh and
Trehan 1991), government expenditure shocks (Christiano and Eichenbaum 1992)
and portfolio flows (Kavli and Viegi 2015; McGrattan and Prescott 2014, etc.).
Such efforts will undoubtedly go on, but it is unclear how far they will ultimately
succeed in replicating—to a reasonable degree of approximation—business cycles
in the real world.
There is an important group of criticisms that is addressed to new classical and
RBC theories in common, the discussion of which we postpone till Chap. 11.
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Chapter 4
Towards a New Synthesis: New
Consensus Macroeconomics
Abstract By the beginning of the 1980s, the triumph of the new classical and real
business cycle schools was more or less complete. However led by a group of
prominent economists (Akerlof, Blanchard, Stiglitz, Greenwald, Romer, Yellen, etc.)
in the mid-1980s, Keynesianism made a strong revival under the new banner of neo-
(or new)-Keynesianism. The neo-Keynesians tried to resurrect Keynesianism by
placing it on sound micro-foundations. However, the movement seemed to lack a
unifying monolithic structure. The task of integrating these different dimensions into
a coherent whole was left to be accomplished by the so-called New Consensus
Macroeconomics (NCM) that emerged a few years later. This chapter analyses the
various aspects of neo-Keynesianism and the NCM in some detail.
1 Introduction
As we have seen in the previous chapter, by the beginning of the 1980s, the triumph
of the new classical and real business cycle schools was more or less complete.
Keynesian economics seemed to be in disarray, with few takers in both academic
and policy circles. However, led by a group of prominent economists (Akerlof,
Blanchard, Stiglitz, Greenwald, Romer, Yellen, etc.) in the mid-1980s,
Keynesianism made a strong revival under the new banner of neo- (or new)-
Keynesianism. The neo-Keynesians realized that there were several worthwhile
features of the old Keynesian system (which had been overhastily discarded by the
new classical school), but there was also the recognition that the main weakness of
the old system was its inattention to micro-foundations.
In particular, the neo-Keynesians taking cognizance of several empirical studies,
had become increasingly sceptical of the new classical equilibrium business cycle
model of Lucas (in which imperfect information alone is the source of business
fluctuations and only unanticipated monetary policy affected output—see Chap. 3)
to replicate the observed stylized facts of real-world cycles. They tried and were
largely successful, in showing that the early Keynesians were right in asserting that
nominal aggregate demand shocks (such as changes in money supply) were largely

https://doi.org/10.1007/978-81-322-3920-8_4
84 4 Towards a New Synthesis: New Consensus Macroeconomics
responsible for producing output fluctuations. As we have seen in Chap. 1, most

early Keynesians regarded nominal wage rigidity as an important propulsion
mechanism for business cycles. But because they simply postulated wage rigidity
without offering any explanation for it, they became an easy target for criticism.
The neo-Keynesians showed that many Keynesian features could be preserved,
even with the new classical assumptions of rational, optimizing representative
agents, provided the assumption of continuous market clearing is abandoned.
Hence, neo-Keynesianism tried to resurrect Keynesianism by placing it on sound
micro-foundations. Its weakness, in retrospect, seems to be that it lacked a unifying
monolithic structure. It often gave the appearance of a collection of separate efforts,
each important in itself, and emphasizing one particular dimension of market
failure. The task of integrating these different dimensions into a coherent whole was
left to be accomplished by the so-called New Consensus Macroeconomics
(NCM) that emerged a few years later.
The main sources of market failure that concerned the neo-Keynesians were the
following:
(i) Nominal wage and price rigidity
(ii) Real wage and price rigidity
(iii) Hysteresis and the natural rate
(iv) Multiple equilibria and coordination failure.
We will discuss each of these in some detail (though not extensively).
2 Neo-Keynesian School: Role of Rigidities
2.1 Nominal Rigidities
At the outset, it is necessary to distinguish between nominal and real rigidities. The
distinction is set out in formal terms in Gordon (1990, p. 1139). Nominal rigidities
arise when wages or prices change less than proportionately to changes in nominal
demand. Real rigidities refer to a situation where there are impediments to
adjustments of (i) wages in one industry relative to those in another, (ii) wages
relative to prices or (iii) prices relative to other prices.
Another important point to note is that while real rigidities might suffice to
provide an explanation of involuntary unemployment, unless accompanied by
nominal frictions, they cannot explain the non-neutrality of money or the failure of
the classical dichotomy. Suppose money supply rises by 10%, then in the absence
of nominal rigidities, all prices will also rise by 10%, leaving relative prices and
hence real output unchanged (see Ball et al. 1988; Romer 1993, etc.). Thus,
nominal rigidities are an integral part of the neo-Keynesian theory for demon-
strating the effectiveness of systematic monetary policy (not simply unanticipated
monetary policy as in the Lucas’ new classical model) on output and employment.
2 Neo-Keynesian School: Role of Rigidities 85
Nominal Wage Rigidity: Some of the earliest papers to talk about nominal wage
rigidity are Phelps (1968), Baily (1974), Gordon (1974), Azariadis (1975), Fischer
(1977) and Taylor (1980). In most countries, wages are not adjusted on a spot basis,
but usually fixed for a definite period, either through an explicit contract or through
an implicit agreement with the unions. This period could range from a year to three
years but it is certainly longer than the average period over which monetary changes
are made. Such contracts introduce an element of rigidity in nominal wages which
can make monetary policy effective (i.e. violate monetary non-neutrality) over the
duration of the contract, even if prices are flexible and agents are rational.
The consequences of nominal wage rigidity can best be illustrated by using the
Lucas aggregate supply function (5) of Chap. 3, which we now reproduce as
Eq. (1) below.
YtS ¼ YN;t þ ch½Pt EððPt jIt1 ÞÞ ð1Þ
In Fischer’s model, the contractual nominal

wage is set at the beginning of
period t = 0 so as to keep real wages Pt fixed over the contract period say t = 0,
Wt

1. Assume (for ease of illustration) that units are so chosen that W P0 ¼ 1.
0
In period 0, when the contract is made the unions do not know the price in period
1, but because rationality is assumed and the union objective is to keep real wages
constant, wages over the contract period are set at,
¼ EððP1 jI0 ÞÞ
W ð2Þ
Substituting (2) into (1) yields the aggregate supply curve for period 1 at,

Y1S ¼ YN;1 þ ch½P1 W ð3Þ
Thus, the aggregate supply curve now is given by (3), and since c and h are both
positive, the aggregate supply curve exhibits a negative relationship between output
and the real wage. Note that the aggregate supply curve plots the relationship
between the aggregate supply and the price level for any given level of nominal
wages. If the nominal wage level increases (decreases), the aggregate supply curve
moves inwards (outwards).
In Fig. 1, we plot the period 1 aggregate supply curve ASðW Þ for the fixed level

of wages W: Initially, we assume that the economy is operating at E with the
nominal level of GDP YN . Suppose now that there is a negative demand shock in
period 1, which pushes the aggregate demand curve from AD0 to AD1 . Because
the aggregate supply curve remains unaltered, and
wages are fixed by contract at W;
with fully flexible prices, the equilibrium shifts downwards along the aggregate
0
supply curve from E to E while output decreases from YN to YN . We have thus
shown that nominal demand shocks can generate real effects, i.e. that the classical
dichotomy fails. If nominal wages had been perfectly flexible, they would have
AD0
AD1
Fig. 1 Nominal demand shocks generate real effects
declined to a new level W 0 such that the new aggregate supply curve ASðW 0 Þ;
intersects at the new aggregate demand curve AD1 at the old equilibrium level of
output YN .
So far we have considered the case where wages are fixed by implicit/explicit
contracts. But in reality, there is a further complication—not all firms have a fixed
period for the contract nor a fixed calendar date in the year when contracts are
revised. This means that the contracts across firms may not be synchronized but
staggered (see Taylor 1979, 1980; Blanchard 1983, 1986, etc.). Staggered contracts
can be useful in explaining why the effects of nominal demand shocks can persist
well beyond the typical contract period (see Ball et al. 1988, pp. 10–11). In the
modern world, the production chain process can be fairly evolved, with different
stages of the chain very often being located in different countries. If wage stag-
gering occurs along these different stages, then the effect of nominal shocks are both
strengthened and prolonged (see Blanchard 1983).
Nominal Price Rigidity: While the earlier focus of the neo-Keynesian school
was on nominal wage rigidity, it was soon found that this was unsatisfactory for two
reasons. Firstly, it was unable to furnish a strong micro-economic basis for the
existence of wage contracts. Secondly, in the absence of price rigidity, it implied a
countercyclical behaviour of real wages, when in fact for most developed countries,
real wages tend to be acyclical or mildly pro-cyclical (see, e.g. Snowdown and
Vane 2005, p. 371). Partly, in response to this criticism, several neo-Keynesians
(most prominently Gordon 1981; Blanchard 1982; Mankiw 1985; Akerlof and
Yellen 1985; Parkin 1986; Rotemberg 1982, etc.) turned their attention to models of
nominal price rigidity.
The central theme in such models is that nominal price rigidity can be privately
efficient (i.e. it is rational from the viewpoint of the individual producer), but
socially inefficient. Changing the price of a product does involve some costs (re-
ferred to as menu costs) such as printing new catalogues, price tags and billboards
etc., but by any reckoning, these costs are small and insufficient to explain
real-world price stickiness. However, Mankiw (1985), Romer (1993), etc., show
that even with small menu costs, price stickiness can result if the profits foregone by
not changing the price are also of a negligible magnitude. This is shown in Fig. 2.
In Fig. 2, the initial demand curve is shown by AD0 with the corresponding
marginal revenue curve MR0 . Equilibrium occurs at the point E0 where MR0
intersects the marginal cost curve MC which is assumed horizontal for ease of
illustration. The equilibrium price and output are, respectively, P0 and Y0 . Suppose
now that a negative demand shock shifts the aggregate demand curve to the left to
the position AD1 and the corresponding new marginal revenue curve is shown by
MR1 . The new profit-maximizing equilibrium is at E1 with price reduced to P1 and
output to Y1 . Suppose the producer decides not to alter his price but to keep it at the
old equilibrium level P0 . The output, in that case, is reduced further to Y2 and
profits to ðC þ AÞ. Note that because P1 is the profit-maximizing output with the
new demand curve AD1 , we necessarily have,
ðC þ DÞ [ ðC þ AÞ or ðD AÞ [ 0 ð4Þ
E
P0
A
B
P1
C D
AD0
AD1
E1 E0 MC
MR0
MR1
Y2 Y1 Y0 Y
Fig. 2 Small menu costs and price stickiness

Thus, if the firm decides not to change its price to P1 but retain the old price P0 ,
the profits foregone are precisely,
ðC þ D nÞ ðC þ AÞ ¼ ðD A nÞ ð5Þ
where the menu costs of changing the price are given by n. Then, if these menu costs
exceed the value of the profits foregone, i.e. ðD AÞ\n, then the producer will not
have the incentive to change the price (see Snowdown and Vane 2005). Romer
(1993) shows that the firm’s incentive to lower its price is greater (i) the steeper the
marginal cost curve MC and (ii) the smaller the leftward shift of the MR curve.
What is the cost to society of the firm’s decision not to alter its price. Suppose
we measure social welfare as the sum of consumers’ surplus and producers’ surplus
(i.e. profits). Then, we have:
Social welfare ðat price P1 Þ ¼ ðE þ A þ BÞ þ ðC þ D nÞ ð6Þ
Social welfare ðat price P0 Þ ¼ ðE þ ðA þ CÞÞ ð7Þ
Note that the menu costs n are only incurred if the price is changed to P1 . Thus,
the loss in social welfare by not changing the price is,
½Social welfare ðat price P1 Þ ½Social welfare ðat price P0 Þ ¼ ðB þ D þ nÞ
Thus, if,
ðB þ DÞ [ n [ ðD AÞ ð8Þ
then it will be perfectly rational for the firm to stick to its nominal price P0 , even
though such a strategy imposes a social welfare loss.
Akerlof and Yellen (1985) introduce the concept of near rationality, whereby
even in the absence of menu costs, firms may not change prices if the consequences
of this action are of a “second order of smallness”. They show that that near
rationality is an adequate description of price stickiness, if the profit function of the
producer is differentiable in his own wages and prices. Differentiability of the profit
function obtains in models of imperfect competition or imperfect information by
buyers.
Thus, Mankiw (1985), Akerlof and Yellen (1985), Romer (1993) and others
show that the presence of even small menu costs can produce a situation where
firms have little incentive to change prices. But if this narrative is typical of most
firms in the economy, we have a situation where moderately sized nominal demand
shocks would not call forth much price change. Thus, nominal demand shocks, in
the presence of small menu costs, can generate large aggregate output responses and
additionally impose sizeable social welfare costs.
2.2 Real Rigidities
Real Wage Rigidity: Several theories have been proposed to account for the phe-
nomenon of real wage rigidity. Among the most prominent of these is the efficient
wage hypothesis due to Solow (1979) and elaborated by several others including
Yellen (1984), Shapiro and Stiglitz (1984), Akerlof and Yellen (1987) etc. The
theory is based on the appealing intuition that the productivity of labour increases
with the real wages paid (at least up to a point). Thus, the efficiency E of labour
(L) increases with the real wage rate (w), i.e.,

dE
E ¼ E ðwÞ with 0 ð9Þ
dw
In the short run, capital is fixed and therefore the production function of the firm
depends only on labour and its efficiency. Thus, if q denotes total production,
q ¼ f ðE ðwÞLÞ ð10Þ
Assume that the firm is operating in a perfectly competitive environment so that

the price for its product is fixed (say at p*). The firm’s total profits p are given by,
p ¼ p q p wL ¼ p f ðE ðwÞLÞ p wL ð11Þ
(remembering that w is the real wage rate).

The firm maximizes p by selecting an appropriate combination of w and L at
which,
@p @p
¼ ¼0 ð12Þ
@x @L
or

@p 0 dE ðwÞ
¼p f L p L ¼ 0 ð13Þ
@x dw
@p
¼ p f 0 EðwÞ p w ¼ 0 ð14Þ
@L

0 @f
where f ¼
@ ðE ðwÞLÞ
From (13) and (14), it follows that,

dE ðwÞ E ðwÞ
¼ ð15Þ
dw w
What (15) says is that from the point of view of the firm the optimum level of
real wages (say we ) is one at which the elasticity of efficiency with respect to wages
is unity.
Next, note that the marginal product of labour is given by,
@f
¼ f 0 E ðw Þ ð16Þ
@L
From (14) and (16), we obtain the result that the firm will offer employment up
to the level at which the marginal product of labour equals the optimum real wage
rate we .
Figure 3 draws some implications of this result. Firstly, the efficiency wage will
be necessarily greater than the market real wage rate (otherwise, there is no
incentive for workers to put in any extra efforts). Now, the firm’s demand curve for
labour is simply the marginal productivity curve of labour and is drawn as DL1 in
Fig. 3. The supply curve of labour is shown as SL. At the real wage rate w*, the
demand and supply of labour are equated at a level of employment L*. But if the
firm decides to offer the efficiency wage we ; the demand for labour at L1 will fall
short of the supply (at the wage rate we Þ, viz. Le and there will be “involuntary
unemployment” to the extent of L1 Le .
We can also show with the help of Fig. 3 that nominal demand shocks can
generate real output effects. Suppose there is a nominal demand contraction which
pushes the demand for labour curve leftwards to DL2 . The optimal efficiency wage
we by (15) depends only on the relationship between efficiency and wages as given
Wages SL
E2 E1
we
w* E*
DL1
DL2
L2 L1 L* Le Employment
Fig. 3 Efficiency wages and involuntary unemployment

by the curve E(w), and this curve does not change with alterations in the demand for
labour. With we unchanged, the new employment level is at L2 and thus unem-
ployment rises by the amount L2 L1 . Thus, the efficiency wage hypothesis as an
explanation of wage rigidity indicates that nominal demand shocks can have real
effects on employment (and output).
While the efficiency wage hypothesis remains the most popular explanation of
real wage rigidity, several other explanations have also been advanced such as
(i) incomplete labour contracts and shirking (Shapiro and Stiglitz 1984), (ii) adverse
selection and job market signalling (Spence 1973; Weiss 1980, etc.) and (iii) in-
sider–outsider models (Lindbeck and Snower 1986). We do not discuss these here
but refer the interested reader to the detailed reviews by Ball (1990), Sanfey (1995)
and Snowdown and Vane (2005) (Chap. 7).
Real Price Rigidity: The foregoing discussion on nominal rigidities has indicated
that even though the frictions producing nominal rigidities may be small, they can
generate sufficient nominal rigidity overall, to ensure that nominal demand shocks
have real output consequences. But of themselves, such nominal rigidities are
incapable of generating non-neutralities on the scale observed in actual economies.
However, as shown by several authors (e.g. Ball et al. 1988; Blanchard and
Kiyotaki 1987; Akerlof and Yellen 1985 etc.) real rigidities in combination with
nominal frictions, are capable of generating models of business cycles closer to the
real world.
We first try to understand some of the real frictions that can be a source of price
rigidity.
One such source is the countercyclical behaviour of the markup. Following Pindyck
et al. (1998, p. 340) and Snowdown and Vane (2005, pp. 377–378), we can write the
total revenue (TR) of a firm as the product of its price (p) and quantity sold (q).
TR ¼ pq
and
p ð17Þ
@ dp q dp
MR ¼ ðTRÞ ¼ p þ q ¼ p þ p ¼ pþ
@q dq p dq e
where e is the price elasticity of demand.

At the profit maximization output, MR ¼ MC so that from (17),

1 1
MC ¼ p 1 þ or p ¼ MC ð18Þ
e 1þ 1
e
This equation expresses the price as a markup on the marginal cost MC, where
the markup l is given by,
" #
1
l¼ ð19Þ
1þ 1
e
Note that because the elasticity of demand is negative, the markup l always
exceeds 1. Also, it can be seen that l varies inversely with the magnitude of e.
Suppose now that there is a contractionary nominal demand shock. There is a
tendency for the MC to fall as output contracts (remember the MC curve is upward
sloping), but as shown by Hall (1991), Rotemberg and Woodford (1991) and
Stiglitz (1984), the markup moves countercyclically rising in recessions and falling
in booms. This is because oligopolistic collusion strengthens in recessions (l rises)
when conditions become adverse for sellers and weakens in booms when conditions
become more competitive. Thus, [from (18)] prices could be sticky if the potential
fall in MC for a reduction in output is sufficiently counterbalanced by the rise in l:
The argument applies pari passu to a rise in aggregate nominal demand. Thus, the
countercyclical behaviour of the markup can be a real source of price rigidity,
especially in situations where the MC curve is relatively flat.
While the countercyclical movement of the markup is an important explanation
of price rigidity, it is not the only one. Several other explanations have also been
advanced. One such explanation is staggered and non-synchronized price setting
(see Taylor 1980; Blanchard 1986; Carlton 1986, etc.), which has already been
discussed in the context of wage rigidity.
Another important explanation is “thick market externalities” (Diamond 1982;
Romer 1993, etc.). These refer to the possibility that purchasing inputs and selling
final products are easier in booms and more difficult in slumps. This is likely to raise
the MC curve in slumps and lower it in booms. This means that during a slump while
there is a leftward movement along the MC curve due to output contraction, the MC
curve itself could move upwards and hence overall prices may remain nearly
unchanged. This is shown in Fig. 4 where the original demand curve is shown as
AD0 with the corresponding marginal curve being MR0 . The original marginal cost
curve is MC0 : The initial equilibrium is thus at E0 with price P0 and output Y0 .
Now, if there is a fall in aggregate demand, the average and marginal revenue
curves will shift leftwards to AD1 and MR1 , respectively. But because of the
presence of “thick market externalities”, the marginal cost curve also shifts upwards
from MC0 to MC1 . The new equilibrium (profit-maximizing) price is P1 which is
very close to the old equilibrium price P0 . Akerlof and Yellen’s near rationality
may now be invoked to show that the old price will be retained. The argument can
also be used analogously to show how price inertia arises also in booms.
Credit market imperfections can be another potential source of price rigidity.
Stiglitz and Weiss (1981) have considered imperfections in credit markets arising
from asymmetric information (between borrowers and lenders) and adverse selec-
tion. Under these twin possibilities, a possible equilibrium outcome is one char-
acterized by credit rationing—a situation where some borrowers are denied bank
funds, even though they are willing to pay the market rate of interest. They have
then either to approach informal credit markets or rely on internal funds. Internal
funds are likely to be more easily available in booms than slumps, and informal
credit markets, are likely to dry up during recessions. Hence, borrowing costs for
firms are likely to be higher in recessions than during booms, or in other words, the
marginal cost curve moves countercyclically. This can lead to price inertia in the
Price,
Cost MC1
P0 MC0
P1
AD0
E1 E0
AD1 MR0
MR1
Y1 Y0 Output
Fig. 4 Thick market externalities and near rationality
same manner as discussed above for the case of thick market externalities (see
Mankiw 1986; Bernanke and Gertler 1989; Romer 1993; Stiglitz and Greenwald
2003 etc. for further details).
3 Hysteresis and the Natural Rate of Unemployment
3.1 NRU Influenced by Cyclical Factors
We have already encountered the natural rate of unemployment (NRU) in Chap. 2 in

our discussion of monetarism. As we saw there, the NRU depends on structural
features of the labour market such as labour participation rates, the bargaining
strength of trade unions, labour militancy and other real factors such as the degree of
competition in the industry, barriers to entry and exit, pace and direction of tech-
nology etc. Hence the NRU varies, if at all, slowly over time. Most importantly, in the
Friedmanian viewpoint, the NRU evolves independently of cyclical movements in
nominal demand and cannot be influenced by monetary stabilization policy.
However, the 1980s were characterized by prolonged and severe unemployment
problems in Europe (especially France and Italy), and to a lesser extent, in Canada
and the USA. At the same time, empirical estimates of the NAIRU1 showed a
1
As we have seen in Chap. 2, the NAIRU is conceptually distinct from the NRU, but it is a good
proxy for the latter and easier to estimate empirically.
precipitous rise (see Nickell 1997; Katz and Krueger 1999; Blanchard and Wolfers
2000; Fitoussi et al. 2000, etc.), which was difficult to reconcile with the
Friedmanian view of a gradually evolving natural rate, uninfluenced by the cyclical
state of unemployment. It became increasingly evident that the natural rate was not
impervious to the cyclical movements in unemployment, and analysts began to look
for hypotheses that might explain this phenomenon.
An early hypothesis due to Hargreaves Heap (1980) is the changing proportion
of frictional unemployment. The natural rate is consistent with a certain amount of
frictional unemployment. Consider an economy in which the NRU is 3.5% of
which 0.2% is frictionally unemployed (the remaining depending on the labour
market characteristics, etc.). The frictionally unemployed workers are those
involved in moving from one job to another, or skilled workers enhancing their
skills via training or switching over to unskilled jobs, because their skills have
become redundant. All these efforts do imply some period of unemployment, but
one, which is much shorter than the duration of the business cycle. Thus, the
frictionally unemployed are also likely to be temporarily unemployed. Now sup-
pose for some reason the actual rate of unemployment rises above the NRU to 5%
and remains so for a sufficiently long period. In this situation, job search and labour
mobility decline, the unemployed suffer considerable deterioration in their skills,
training opportunities dry up, etc. In short, the proportion of the frictionally
unemployed increases, say from 0.2 to 0.5% in our hypothetical example. The NRU
then rises to 3.8% (=3.3 + 0.5%).
A second hypothesis relies on the insider–outsider theory of wage bargaining
(see Boddy and Crotty 1975; Blanchard and Summers 1986; Lindbeck and Snower
1988, etc.). This is based on the observation that trade unions and worker welfare
boards are more concerned with protecting the job security and wages of the already
employed, rather than generating jobs for the unemployed. At the same time, the
pressure of the unemployed serves to act as a disciplining device on the already
employed, by posing a potential threat of taking over the jobs of the latter. However
if this threat is to be effective, the unemployed have to be re-employable. The
re-employability of the unemployed deteriorates rapidly as the duration of unem-
ployment increases due to the erosion of their morale and human capital. Thus with
a long recession, the wage-disciplining threat of the unemployed recedes gradually
and the power of the “insiders” then keeps wages at a higher level than necessary to
reduce unemployment. Thus, a cyclical rise of the unemployment rate over the
NRU for a long period can raise the NRU itself.
A third hypothesis is sociopolitical, viewing unemployment as the outcome of a
wage bargaining process resulting from the balance of class forces. During a pro-
longed recession (such as due to strong supply shocks), the market system comes
under criticism, class relations are exacerbated, and union militancy increases. This
introduces a strong inflexibility in wages which can pull the NRU above its pre-
vailing level (see Greenhalg et al. 1983; Schmidt 1983; Weir 1987, etc.).
3 Hysteresis and the Natural Rate of Unemployment 95
3.2 A Role for Stabilization Policy
The above discussion can be formalized as follows (see Hargreaves Heap 1980;
Jaeger and Parkinson 1994, etc.). If Ut and UtN denote the actual and natural rates of
unemployment at time t, then we have,
UtN Ut1
N
¼ d Ut1 Ut1
N
ð20Þ
with 0\d\1.
Thus, (20) captures the earlier discussion by saying that when the actual rate of
unemployment exceeds (falls below) the natural rate of unemployment, then the
natural rate itself increases (decreases) in the subsequent period. The fact that the
adjustment is not completed in a single period is reflected in the value of d being
positive but less than unity.
We next show that stabilization policy can play some role in bringing the
economy close to a desired unemployment target say U*. If in the initial period
(t = 0) the actual rate of unemployment equals the natural rate, i.e. U0 ¼ U0N ; then
in the next period (t = 1), by (20).
U1N ¼ U0N ¼ U0
Suppose now the government lowers the actual unemployment rate by an

expansionary monetary or fiscal policy to some desired level U* and keeps
unemployment at this level for the next T years. Thus,
U1 ¼ U2 ¼ UT ¼ U ð21Þ
What happens to the natural rate in this process? By putting t = T in (20) and
using (21) we get,
UTN U ¼ ðUT1
N
U Þ þ d UT1 UT1
N
¼ ðUT1
N
U Þ þ d U UT1
N
ð22Þ
) UTN U ¼ ð1 dÞ ðUT1
N
U ð23Þ
Iterating successively on (23) (T − 1) times, we get
UTN U ¼ ð1 dÞT1 ðU1N U ¼ ð1 dÞT1 ðU0N U ð24Þ
(since U1N ¼ U0N ),

(24) shows that the natural rate of unemployment in period T, viz. UTN will move
closer to the desired rate of unemployment U* as T increases. The rate of con-
vergence depends on how close the adjustment parameter d is to 1 and how far the
initial natural rate of unemployment U0N is from the desired rate U*.
What happens to the inflation rate in the course of the above process? In Chap. 2
, we have seen that the relation between the NRU and inflation is given by Eq. (17)
of that chapter as,
pt pet ¼ a Ut UtN ð25Þ
where pt ; pet denote the actual rate of inflation and the expected rate at time t, a is a
positive parameter, and the supply shock term v has been dropped. Further, we take
a simple version of Eq. (15) in Chap. 2 in which,
pet ¼ pt1 ð26Þ
Using (26) in (25), we get,
pt pt1 ¼ a Ut UtN ð27Þ
(27) is a version of the accelerationist hypothesis (noted in Chap. 2, Sect. 4.2)

which shows that the current actual rate of unemployment Ut can be forced below
the prevailing natural rate UtN only by raising the inflation rate.
Suppose now we have a desired rate of unemployment U* in mind and we put as
in (13) U1 ¼ U2 ¼ UT ¼ U . Then from (27) and (24),
pt pt1 ¼ a U UtN ¼ að1 dÞt1 U0N U ð28Þ
Thus, the inflation at some future date T is equal to the initial inflation p0 plus the
additions to inflation that occur over each intervening period, i.e.,
X
T X
T
pT ¼ p0 þ ðpt pt1 Þ ¼ p0 þ a ð1 dÞt1 U0N U ð29Þ
t¼1 t¼1
As T becomes large,
a
pT ! p0 þ U0N U ð30Þ
d
Thus from (30), we see that there is a long-term trade-off between the rate of
inflation pT and the chosen rate of unemployment U . This represents an important
contrast from the Friedmanian theory of the NRU, which precludes any long-term
trade-off between inflation and unemployment.
4 Multiple Equilibria and Coordination Failure 97
4 Multiple Equilibria and Coordination Failure
Another major strand to emerge from the neo-Keynesian school is the possibility of
multiple equilibria and coordination failure. As this development involves tech-
niques from advanced game theory, we can only outline the theory in brief. For
detailed results, reference may be made to Diamond (1982), Cooper and John
(1988), Bohn and Gorton (1993), etc. A coordination failure results from the
inability of agents to coordinate their actions, resulting in the prevalence of multiple
equilibria, some of which may be Pareto inefficient. If the economy finds itself at a
Pareto inefficient equilibrium, there exists the possibility that movement to another
equilibrium could make some agents better off without making anyone worse off.
Coordination failure can arise due to a number of factors such as (i) strategic
complementarity in which the cost of implementing or using certain processes
declines as more agents use it (telephone/ wireless networks). This can sometimes
have a “lock-in” effect which may block the advent of newer and better tech-
nologies. Thus, the equilibrium which results might be “path-dependent” (see
Bulow et al. 1985 for a detailed discussion) and (ii) increasing returns in which the
economies of scale depend on the market size—in such a situation any firm cutting
down its production in a recession in excess of that warranted by the fall in demand
could trigger an all-round rise in marginal costs and cutbacks in production and
employment. This could reinforce the original recessionary tendency by a further
decline in effective demand (see Romer 1993, pp. 14–15).
With coordination failures and multiple equilibria, stabilization policy can have
an important role to play in moving an economy from a Pareto inefficient equi-
librium to a Pareto efficient one. By increasing government expenditure in a
recession, nominal demand can be stimulated which can lead to an overall increase
in production by lowering costs (in the presence of strategic complementarity and/
or increasing returns) of all firms. Thus, stabilization policy acts as a coordination
device—a substitute for the coordination among private agents, which will not be
forthcoming because externalities drive a wedge between private benefits and social
welfare.
5 New Consensus Macroeconomics (NCM): Theoretical

Aspects
5.1 Introduction
The New Neo-Classical Synthesis or New Consensus Macroeconomics (NCM)2

which established itself in the 1980s as the weltanschauung of the macroeconomics
2
For uniformity of nomenclature, we have used the term New Consensus Macroeconomics
throughout the book.
profession, essentially represented an “uneasy truce” between the then dominant

new classical and real business cycle schools on the one hand, and the (then)
nascent neo-Keynesian view on the other—a truce achieved by securing the
micro-foundations of Keynesian sticky prices and wages with dynamic optimiza-
tion by agents under rational expectations. Its scope may be best described in the
words of Goodfriend and King (1997), who are usually credited with the intro-
duction of the term New Neo-Classical Synthesis into the literature.
“The New Neoclassical Synthesis is defined by two central elements. Building
on new classical macroeconomics and RBC analysis, it incorporates inter-temporal
optimization and rational expectations into dynamic macroeconomic models.
Building on New Keynesian economics, it incorporates imperfect competition and
costly price adjustment. Like the RBC program, it seeks to develop quantitative
models of economic fluctuations” (Goodfriend and King 1997, p. 255).
We may add further that the quantitative models used are often of the DSGE
genre, which were the stock-in-trade of the RBC school. But unlike the models
favoured by the RBC school which are based on efficient, complete and continu-
ously clearing markets (see Chap. 3), in the NCM framework, the DSGE models
allow for sticky wages and prices, as well as, many other market imperfections.
The NCM [and especially its twin pillars—the rational expectations hypothesis
(REH) and the efficient-market hypothesis (EMH)] also supplied the intellectual
basis for the wave of financial liberalization that rose in the 1980s in the developed
world and a decade later in EMEs and developing economies.
5.2 Main Features
As mentioned earlier, the NCM essentially incorporates most aspects of the new
classical and real business cycle schools but with the important new Keynesian
feature of limited flexibility of prices (and wages), though the latter is now solidly
grounded in micro-foundations of rational (i.e. model-consistent) expectations. It
must be noted that the NCM school is not a monolithic entirety. Rather it represents
a loose, almost amorphous consensus, spanning a wide spectrum across the middle
ground between the new classical and neo-Keynesian extremes. Nevertheless, one
could isolate the following set of core theoretical propositions to which most
modern mainstream (NCM) economists would subscribe (see Goodfriend and King
1997; Gali and Gertler 2007; Woodford 2003, 2009, etc.).
Natural Rate Hypothesis: As we have seen, the natural rate hypothesis (NRU or
NAIRU) constitutes one of the key pillars of the Friedmanian, new classical and
RBC schools. Most models in the NCM tradition subscribe to the NRH and
incorporate a Phillips curve, which is upward sloping (exhibiting a trade-off
between inflation and unemployment), at least in the short run. Since a large part of
NCM concerns itself with explaining business cycle fluctuations, whether the
long-run Phillips curve is vertical or otherwise becomes an irrelevant issue and is
not often discussed. However, most mainstream economists (except diehard new
5 New Consensus Macroeconomics (NCM): Theoretical Aspects 99
classicals) today would admit that prolonged cyclical unemployment could raise the
NAIRU and stabilization policy can play a useful role in such a situation (see the
discussion in Sect. 3.2 above).3 The actual rate of unemployment may temporarily deviate
from the natural rate in case there are unexpected exogenous shocks, but this deviation is
soon corrected as agents’ perceptions take the new developments into account.
Representative Agent and Rational Expectations: The NCM builds its
“micro-foundations” on the assumption of a representative agent basing his con-
sumption decisions on an inter-temporal utility-maximizing framework, in which
expectations about the future are formed rationally, i.e. by making best use of all
available resources. It also incorporates the important neo-Keynesian insights
flowing from the extensive discussion on state-dependent or Calvo pricing which
attempts to model temporary wage and price stickiness in terms of transaction and
menu costs, staggered price setting, etc. (see Calvo 1983; Yun 1996; McAdam and
Willman 2007, etc.).
Ergodic Uncertainty: In the NCM framework, uncertainty is assumed to be
“ergodic”; i.e. future events can be attached specific probability generating func-
tions which are reasonably stable over the typical short-run horizons that concern
macroeconomists.4 Within such a framework, a “rational” individual’s subjective
probability distributions can be used to generate “fan charts” which will converge
(with possibly some allowance for “learning”) to the true or objective probability
distributions. This is, of course, an important consequence of the rational expec-
tations hypothesis (REH).
Complete and Efficient Markets: The NCM makes two key assumptions of
market organization, on which several of its conclusions rest. These assumptions
get rarely spelt out explicitly, but are often assumed as a “matter of fact” or as a
“sufficiently good approximation to the real world”. The first is that markets are
complete, whereas the second refers to the efficiency of financial markets. Complete
markets imply that there are markets for every good to cover the space of all
possible states of nature (see Flood 1991; Anderson and Raimondo 2008, etc., and
the discussion in Chap. 3, Sect. 2.2).
The hypothesis of efficient financial markets (EMH) posits that current market
prices of financial assets embody all the known information about prospective
returns from the asset. Future uncertainty is of the “white noise” kind. It is not ruled
out that “noise traders” (speculators) may succeed in pushing the markets tem-
porarily away from equilibrium.5 But with market clearing continuously, “rational
traders” will bring the system back to equilibrium, by taking countervailing
positions and imposing heavy losses on those speculators who bet against the
3
See Mankiw (2001), Ball and Mankiw (2002), Blanchard and Katz (1997), etc., for more dis-
cussion on this point.
4
The concept of “ergodicity”, in common sense terms, is best explained by North (1999, p. 2) “If I
say the world is ergodic, I mean that it has a stable underlying structure, such that we can develop
theory that can be applied time after time, consistently”.
5
Of the vast literature on this topic for the sake of brevity I cite only three references, viz. Fama
(1970), De Long et al. (1989) and Lowenstein and Willard (2006).
fundamentals. Equilibrium asset prices will thus be altered only when there are
“shocks” to the fundamentals.
Three forms of efficiency are usually distinguished, viz. (i) weak efficiency,
where current asset prices embody the full history of past prices (viz. asset prices
have infinite memory), (ii) semi-strong form efficiency, where asset/security prices
fully reflect all available public information (assumed known to all investors), and
based on this information, no investor can earn excess returns and (iii) strong
efficiency where asset prices reflect both public and private information (such as is
available to insider traders) and excess returns cannot be generated on the basis of
this information (see Fama 1991; Borges 2010, etc.).
If the assumption of perfectly competitive markets is grafted onto the REH,
weak efficiency of markets can be easily derived (EMH). Most NCM analysts
accept the weak form of the efficiency hypothesis.
Abandonment of the LM Curve: One of the notable features of the NCM is the
absence of the LM curve from its monetary policy framework. Instead, some version
of a monetary policy rule is adopted, the most common being Taylor’s rule. Taylor’s
rule relates the policy short-term interest rate to the output gap and inflation. Thus, the
quantity of money ceases to figure in the model. This feature has been analysed
extensively by Friedman (2003) and to some extent by Gertler et al. (1999), Romer
(2000), Taylor (2000), etc. Friedman (2003) feels that this is a case of theory fol-
lowing practice—in the sense that while there is no overwhelming theoretical reason
for dropping the LM curve, the central bank practice in most countries has been to
switchover from attention to monetary aggregates to a direct focus on inflation tar-
geting. Further, according to him, this has three undesirable consequences. Firstly,
vital information regarding how much of their wealth, households and firms choose to
hold in the form of monetary assets, at various interest rates is lost. Secondly, the LM
curve brought into the analysis the liabilities side of banks (deposits) and thereby also
the asset side (credits). With no LM curve, the credit market figures nowhere in the
analysis of monetary policy. This is an important lacuna in economies (like India)
where bank credit is important for industry and agriculture. Thirdly, in the absence of
the LM curve, the mechanics by which the central bank actually maintains the target
rate (e.g. the Fed Funds rate in the USA) by influencing the liquidity in the money
market, becomes opaque rather than transparent (see Friedman 2003, pp. 4–7).
Transversality condition: The consequences for credit markets of abandoning the
LM curve are compounded by a rather innocuous looking assumption in the NCM.
This is the “transversality condition” (Blanchard and Fisher 1989, Appendix 2A),
which postulates that in the inter-temporal optimization of the representative
individual, all debts are paid in full, thus effectively leaving no space for money,
finance and liquidity to enter the model in a meaningful way (see Buiter 2008). This
renders the model particularly inappropriate to analyse the real-world problems of
credit risk and default and has shown up as a major limitation post-crisis.
Advocacy of Financialization and Capital Account Convertibility: In the context
of the EMEs, the NCM puts its weight behind the McKinnon–Shaw thesis which, as
is well known, strongly argued for financial liberalization as a precondition for
“real” economic growth. The NCM attitude to financial markets was that they posed
5 New Consensus Macroeconomics (NCM): Theoretical Aspects 101
no grave dangers of instability, being generally self-equilibrating and further that,

through several channels, financial development could play a defining role in
promoting real growth (see, e.g. Aghion et al. 2004). As a natural consequence,
financialization6 became an important ingredient of the standard IMF prescription
of neo-liberalism for the many countries that faced structural macroeconomic crises
in the 1980s and early 1990s. Advocacy of open capital accounts for EMEs was
based on the view that free global capital markets would enable them to get cheaper
access to international credit, thereby promoting growth and stability. This view,
always of dubious theoretical merit (see Arteta et al. 2003; Nachane 2007; De Long
2009, etc.), was seriously challenged, both by the currency crises of the 1990s in
Latin America and Asia (see Ocampo et al. 2008) and, of course, the recent global
crisis.
6 Monetary Policy in the NCM
The above theoretical structure supplies the foundation for the monetary policy
recommendations of the NCM.
6.1 Inflation Targeting
Goodfriend and King (1997, p. 256) have enunciated the three cardinal principles
underpinning monetary policy in the NCM framework. Firstly, monetary policy
should be guided both by aggregate demand and aggregate supply considerations. It
should be “activist” so as to manage aggregate demand to accommodate any supply
shocks. Secondly, there is little trade-off between real output and inflation at low
rates of inflation. Thus, monetary policy should stabilize inflation at a low level so
as to keep output at its potential. Thirdly, as long as price-setting behaviour of firms
depends on expectations, the issue of central bank credibility in controlling inflation
assumes importance. These three principles constitute the intellectual basis for the
policy of inflation targeting (IT), which is possibly one of the most important
recommendations following from the NCM.
Inflation targeting goes considerably beyond merely setting an inflation target
and is best described by the following quote from Bernanke et al. (1999, p. 4) “(IT
is) characterized by the public announcement of official quantitative targets (or
target ranges) for the inflation rate over one or more time horizons and by explicit
acknowledgement that low, stable inflation is monetary policy’s primary long-run
6
Financialization, (as a term usually, but not always, used pejoratively), refers to “the increasing
importance of financial markets, financial motives, financial institutions and financial elites in the
operation of the economy and its governing institutions, both at the national and international
levels” (Epstein 2001, p. 1).
goal. Among other important features of inflation targeting are vigorous efforts to
communicate with the public the plans and objectives of the monetary authorities,
…”. Given the various lags involved in the transmission mechanism, inflation
forecasts become the intermediate targets of monetary policy (Svensson 1997). IT
proponents take some pains to clarify that in practice IT is not tantamount to a fixed
mechanical rule but allows for “constrained discretion” on the part of the central
bank.7 Several advantages have been claimed for IT including most prominently
that it (i) provides a nominal anchor for monetary policy, (ii) enhances its trans-
parency, (iii) lends credibility to monetary policy by “locking in” inflationary
expectations while (iv) maintaining flexibility (ability to react to unanticipated
shocks). Several countries have adopted the IT framework,8 and there is some
empirical evidence to indicate that it has worked fairly well—though this evidence
is not conclusive.
6.2 Taylor Rule
The prototype NCM model typically includes three equations (see, e.g. Gertler et al.
1999; McCallum 2001; Arestis and Sawyer 2008), viz. the IS curve, the Phillips
curve (incorporating the accelerationist hypothesis) and a monetary policy rule.
A typical monetary policy rule is the one originally suggested by Taylor (1993)
with various later emendations (see Rudebusch 2002; Levin et al. 1999, etc.).
Essentially, the Taylor rule9 is coming in as a substitute for the LM curve (in which
the NCM has little faith because of the instability of the demand for money). Thus,
in effect the rate of interest is set exogenously by the central bank, while the money
supply adjusts endogenously to the needs of trade.10
7
As noted by Bernanke (2003, p. 2) constrained discretion allows policymakers “considerable
leeway in responding to economic shocks, financial disturbances and other unforeseen develop-
ments … however this discretion of policy makers is constrained by a strong commitment to keep
inflation low and stable”.
8
Currently, about 30 countries have formally adopted the IT framework. Interestingly, their
composition is heterogeneous including advanced economies, EMEs as well as some LDCs.
A selective list (with years of adoption in brackets) is the following: New Zealand (1989), Canada
(1991), UK (1992), Sweden (1993), Australia (1993), Korea (2001), Brazil (1999), Chile (1999),
Mexico (2001), Thailand (2000), Philippines (2002), Indonesia(2005), Ghana (2007), etc. India is
well on way to adopting IT in the near future.
9
The Taylor rule is a mechanism that sets the short-run nominal interest rate i(t) via the equation,
iðtÞ ¼ ð1 aÞ r þ Et ðpðt þ 1Þ þ bYg ðtÞ þ cðpðt 1Þ p Þ þ aiðt 1Þ
(where i(t) is the nominal interest rate at time t, r* is the “equilibrium” real rate of interest,
Yg ðtÞ; pðtÞ and p are the output gap (at time t), the inflation rate at time t and the inflation target,
respectively).
10
However, as noted by several authors (see Gnos and Rochon 2007; Setterfield 2004, etc.) the
NCM has no theory to support the endogeneity of money supply and tends to simply fall back
upon the difficulties of controlling money supply in practice as a justification for the neglect of
monetary aggregates altogether.
6 Monetary Policy in the NCM 103
6.3 Monetary Policy and Asset Prices
The issue of whether asset prices should figure in discussions of monetary policy
has always been controversial. The NCM explicitly advises monetary policy to
leave asset price bubbles alone, as attempts to control (or worse “prick”) such
bubbles could impose considerable collateral damage on the real economy.
However, if and when, asset price bubbles burst, central banks should step into
“mop up the mess”, i.e. go into the “lender of last resort” act (see Greenspan 2004;
Blinder and Reis 2005; Mishkin 2007, etc.). This view is often referred to as the
Jackson Hole Consensus (a term due to Issing 2009). The intellectual underpinnings
of this view are based on the conventional Friedmanian argument that financial
instability is the outcome of unexpected shocks to the inflation level, mainly arising
from overenthusiastic central banks trying to stimulate the economy beyond its
natural rate (see Friedman and Schwartz 1963; Schwartz 1998, etc.). The NCM thus
views price stability and financial stability as highly complementary and mutually
consistent objectives for a central bank.
7 The Monetary Policy Framework of the NCM
To understand these policy recommendations, it is helpful to briefly present a

formal model of the monetary policy framework implied by the NCM.
We present below the model as put forth by Clarida et al. (1999) and are
extension to the open economy case by Arestis and Sawyer (2007) and Angeriz and
Arestis (2007).11 The open economy version has six equations as follows:

Yg ðtÞ ¼ L1 constant; Yg ðt 1Þ; r ðtÞ; er ðtÞ þ u1 ðtÞ ð31Þ

pðtÞ ¼ L2 Yg ðtÞ; pðt 1Þ; Et ðpðt þ 1Þ; Et ðpw ðt þ 1Þ DeðtÞÞ þ u2 ðtÞ ð32Þ

iðtÞ ¼ L3 r ; Et pðt þ 1Þ; Yg ðt 1Þ; iðt 1Þ; ðpðt 1Þ p þ u3 ðtÞ ð33Þ
er ðtÞ ¼ L4 ½constant; ðr ðtÞ rw ðtÞÞ; CBðtÞ; Et r ðt þ 1Þ þ u4 ðtÞ ð34Þ

h i
CBðtÞ ¼ L5 constant; Yg ðtÞ; Ygw ðtÞ; er ðtÞ þ u5 ðtÞ ð35Þ
eðtÞ ¼ er ðtÞ þ pw ðtÞ pðtÞ ð36Þ
where Li ; i ¼ 1. . .5 are all linear functions, ui ðtÞ; i ¼ 1. . .:5 are stochastic shocks at
time t, and Et ð:Þ denotes expectations of a variable formed at time t, The variables
11
Both Arestis and Sawyer (2007) and Angeriz and Arestis (2007) present the model with a strong
critical thrust.
are defined as follows: Yg ðtÞ—domestic output gap at time t; Ygw ðtÞ—world output
gap at time t; pðtÞ—domestic inflation; pw ðtÞ—world inflation; r(t)—domestic real
interest rate, rw(t)—world real interest rate, iðtÞ—nominal interest rate; er ðtÞ—real
exchange rate, e(t)—nominal exchange rate; DeðtÞ ¼ eðtÞ eðt 1Þ; p —target
inflation rate; r*—equilibrium real rate of interest.
The first equation is the aggregate demand equation and postulates that the
output gap (actual GDP minus potential GDP) depends on (i) its own past value,
(ii) its expected future value, (iii) the real rate of interest and (iv) the real exchange
rate. This equation derives from the inter-temporal optimization of lifetime
expected utility subject to a budget constraint (see Blanchard and Fisher 1989).
Next, we have the vertical Phillips curve with inflation determined by (i) the
current output gap, (ii) past inflation, (iii) future expected inflation and (iii) expected
changes in the nominal exchange rate deflated by expected world prices.
The third equation is a monetary policy rule specifying the nominal interest rate
as a function of (i) expected inflation, (ii) deviation of past inflation from the
“inflation target”, (iii) past output gap and the equilibrium real rate of interest.
The fourth equation relates the real effective exchange rate12 to (i) the differ-
ential between the domestic and foreign real interest rates, (ii) the current account
balance and (iii) the expected future value of the real effective exchange rate.
The fifth equation posits the current account determinants as (i) the real effective
exchange rate, (ii) the domestic output gap and (iii) the world output gap.
Finally, the model is closed via a definitional identity relating the real and
nominal effective exchange rates.
While the above reduced form model does capture several predominant features
of the NCM, most practitioners in the NCM tradition would not adopt this model
for actual policy purposes, as from their point of view it lacks credible
micro-foundations. They would prefer instead to work with a full-scale DSGE
formulation. As DSGE models have been discussed in some detail in Chap. 3
Sect. 4, we do not discuss them again here.
8 Conclusion
The recent global crisis has posed a very serious challenge to the NCM, partly
because the NCM failed to anticipate the extent and severity of the crisis and partly
because solutions proposed within its framework met with limited success in the
aftermath of the crisis (see, e.g. Rakshit 2009). This has led to a serious questioning
of the NCM from four major heterodox schools, viz. the post-Keynesian, the
Austrian, the Minskyan and the Marxist. These post-crisis critiques have been quite
insightful and trenchant and often acerbic, and we review them in detail in Chaps. 6,
12
The methodology of calculating the real effective exchange rate for a country is explained in
detail in Takàts (2012).
8 Conclusion 105
7, 8, 9 and 10. However, they have not really succeeded in achieving anything like a
Kuhnian paradigm shift. The reasons as to why and how the NCM has been able to
withstand this onslaught form the subject matter of Chaps. 13 and 14.
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Chapter 5
Inception of the Global Crisis in the USA
Abstract The recent global crisis which originated in the USA in 2007, and then
rapidly spilled over to the rest of the world has had profound implications for
economic theory and policy. This chapter delves into the causes of the extent and
severity of the crisis. In particular, we try to understand the factors responsible for
triggering and perpetuating the crisis in the USA. The latter portion of the chapter is
devoted to an evaluation of the policies undertaken by the US Fed and Treasury to
control the crisis especially QE (quantitative easing) and fiscal stimuli.
1 Introduction
Financial crises have been occurring periodically in various countries throughout

history.1 However, their intensity, duration, causes and consequences have varied
widely (Kindleberger and Aliber 2005; Bordo et al. 2001; Reinhart and Rogoff
2011, etc.). Some of the major crises recorded in the last 300 years have been—the
South Sea Bubble (1720–25), Bank of the United States Speculative Crisis (1790–
92), Latin American Crisis (1820–26), Cotton Crisis (1837), Railroad Crisis (1857),
the European Crisis brought about at the conclusion of the Franco-Prussian War
(1873), the Knickerbocker Crisis (1907–13), the Great Depression (1929–34) (see
The Economist 12 April 2014) and more recently the Asian Crisis(1997–2001) and
the LTCM Crisis (1998). To this list must be added the recent Great Financial Crisis
(henceforth GFC) (which began in the Summer of 2007 and which is widely
considered to have ended in Fall 2011, though several commentators feel that the
global economy has not yet fully recovered from its consequences).
The GFC has thrown into turmoil both the theoretical perceptions about how the
macroeconomy works, as well as several of the well-entrenched notions about how
policy (especially monetary policy) should be conducted and towards what goals.
1
As a matter of fact, the first recorded banking crisis seems to have occurred in Rome during the
reign of the emperor Tiberius in AD 33 (see Frank 1935).

https://doi.org/10.1007/978-81-322-3920-8_5
110 5 Inception of the Global Crisis in the USA
For a better appreciation of these consequences, it is appropriate to delve (albeit

briefly) into the causes of the extent and severity of the crisis.2 There is general
agreement among economists that no single factor can be regarded as the causa
prima of the GFC, and that the crisis was attributable to a complex interplay of
several factors. Different schools of thought, nevertheless, single out for emphasis, a
few factors that they feel germane to their world view. For example, the Mainstream
school (NCM) (see Bernanke 2005, etc.) tends to emphasize Global Savings
Imbalances, the Austrian School (see Boettke and Coyne 2010; O’Driscoll 2009;
Templeman 2010) lays stress on credit booms and asset bubbles due to faulty
monetary policies and lax regulation of the financial sector, while the Post-
Keynesians see the global financial crisis (henceforth, GFC) in terms of Minsky’s
financial fragility thesis (see Minsky 1986, 1992; Dimsky 2010; Sinapi 2011, etc.).
Many analysts feel that in looking at a phenomenon as complex as the GFC, an
eclectic approach may serve us better, especially as the factors listed above are often
complementary and mutually reinforcing, so that the explanations of the different
Schools have inevitable overlaps.
Among the potential factors which have been held responsible for the crisis, the
following are usually regarded as the important ones:
(i) The Great Moderation
(ii) The Global Savings Imbalances
(iii) Inappropriate monetary policies and easy liquidity conditions in the USA
followed by the FRB under Greenspan.
(iv) Structural Flaws in the US Financial Structure
(v) Lax regulation of the US Financial Sector in the decade preceding the crisis
(vi) Real estate price bubble and mortgage-based securitization (MBS, for short)
in the US.
We adopt the eclectic approach here, separating the above factors into long-term
and medium-term factors.
2 Long-Term Factors
2.1 The Great Moderation
The Great Moderation is usually taken to refer to the relatively tranquil period (from
about 1983 to 2007) for the global economy (though marred by the Asian Crisis of
1997–98 and the dot.com bust of 2001) in which most of the Western economies
experienced low inflation rates accompanied by a noticeable drop in
2
Detailed accounts of the crisis are available in several writings. Of particular relevance are
Brunnermeier (2009), Gorton (2008, 2010), Giovanni and Spaventa (2008), etc. The impact of the
crisis on India is described in Reddy (2009), Nachane (2009), etc.
2 Long-Term Factors 111
macroeconomic volatility (as compared to the previous decade and a half), low
interest rates and steady (though moderate) rates of growth while the EMEs
(Emerging Market Economies) grew rapidly and asset prices generally (but resi-
dential property prices in particular) rose sharply in the developed world as well as
the EMEs.
Several analysts feel that the Great Moderation was not simply the proverbial
calm preceding the storm, but was itself, in fact, an important contributing factor to
the storm (GFC). Bean (2009) adduces three possible explanations for the Great
Moderation viz.
(i) It was a fortuitous situation for the western developed economies as they
gained access to cheap manufactured goods from China and other Asian
EMEs (as these economies rapidly opened up in the 1990s)—an advantage
which was reversed in the latter part of the period as strong global growth
pushed up oil and commodity prices.
(ii) Important structural changes were occurring in both the developed econo-
mies and EMEs in the wake of the liberalization-globalization process, ini-
tiated throughout the world beginning in the eighties—such as the
composition of the GDP changing in favour of the services vis-à-vis the
manufacturing and agricultural sectors, increased competition in products
and labour markets, improved organizational structures owing to the rapid
dissemination of information technology (henceforth IT) and management
information systems (MIS for short), etc. Many of these structural changes
provided economies greater resilience against external and domestic shocks.
(iii) The period of the Great Moderation also witnessed an improvement in
official macroeconomic policies, such as inflation anchoring via rules-based
monetary policy (including inflation targeting under various variants), greater
central bank independence, better fiscal discipline in many EMEs,3 improved
global policy frameworks for managing risks in banks (such as Basel I and
II), etc. Many of these provided an anchor for sound policy over a long
period, but (as the GFC so tellingly demonstrated) in the end they proved to
be inadequate to confront the massive shocks that affected the USA (and
subsequently the world) beginning in the summer of 2007.
There is a distinct possibility that such a long period of relative tranquillity
persuaded economic agents, including investors, regulators and policymakers, to
the belief that crises were a thing of the past, in the process leading them to
seriously underestimate the potentiality of actual events to upset the apple cart of
their sanguine expectations (see e.g. Broer and Kero 2011). The practical conse-
quence of such complacency was an increased willingness on the part of financial
3
In India, for example, a long-term fiscal policy outline was announced in December 1985,
automatic monetization of the budget deficit via the system of ad hoc Treasury Bills was aban-
doned in March 1997, monetary targeting was replaced by interest rate targeting around 1997, and
the exchange rate regime was progressively liberalized from a pegged system to a managed float
over 1992–97.
investors and institutions to assume greater risks, to seek higher yields via extended
leverage4 and often to use derivatives for speculation rather than hedging. (This
point is discussed further in Sect. 3.2 below).
This behaviour was reinforced by a strong belief in the efficacy of official policy
toward off any impending disasters via bailouts and rescue packages. Big financial
players tended to be particularly adventurous under the presumption that they were
“too big to fail” or “too interconnected to fail”. Further, capital regulation as pro-
posed under Basel I and II was an insufficient check on such behaviour. The value
at risk (VaR, for short) models,5 which formed the cornerstone of their regulatory
framework, were “backward-looking” rather than “forward-looking”, implying that
the default probabilities on which these models were based related to past data of
the “tranquil period” of the Great Moderation. Such default probabilities and the
associated regulatory capital charges were woefully inappropriate for the turbulent
period which lay ahead.
So in a sense the Great Moderation contained within itself the seeds of its own
ultimate demise (see, e.g. Bean 2009; Cooley 2008; Haldane 2009; Trichet 2008.).
2.2 Global Imbalances
Global current account imbalances have often been cited as a prominent cause of
the GFC by several academics and quite a few leading policymakers. In the decade
prior to the GFC onset (1996–2006), there was a dramatic turnaround in the current
account balances globally. Many developed economies whose current accounts
were in surplus at the start of the decade found themselves saddled with huge
deficits at the end of the decade. Conversely, the newly Emerging Asian economies
and the Middle East oil producers with current account deficits in the mid-1990s
were having huge surpluses in the years before the GFC. The US current account
deficit which was US$124.77 billion in 1996 ballooned to US$530.71 billion in
2003 and further shot up to nearly US$806.73 billion by 2006 (about 6% of US
GDP). The situation in the EU displayed a similar trend, but was less dramatic with
a marginal surplus of US$56.48 billion in 1996 changing to a modest deficit of
about US$15.94 billion in 2006. These changes were mirrored in many of the Asian
4
There are several measures used to measure the leverage of a firm. The two measures most in
common use are the debt ratio (ratio of total debts to total assets) and the debt-equity ratio (ratio of
total debts to total equity).
5
The value-at-risk for a firm’s portfolio is defined as the maximum loss that the firm can expect on
that portfolio over a given period with a given probability. Thus, if the value at risk on a portfolio
is Rs. 200 million over the next month with a probability of 1%, this would mean that there is a 1%
chance that the firm can lose Rs. 200 million on the portfolio over the next month. Usually, the
value at risk is stated in terms of confidence levels. Thus, our firm can assert with a 99%
confidence level that the maximum loss on its portfolio (over the next month) could be
Rs. 200 million.
economies swinging round from deficits to surpluses. Emerging and Developing

Asia’s (comprising 29 countries including China, India, Bangladesh, Sri Lanka,
Indonesia, Malaysia, Philippines, Thailand.) current account deficit of US$15.75
billion in 1996 was transformed to a surplus of US$272.61 billion in 2006, driven
almost entirely by China (whose small surplus of US$40.36 billion in 1997 mul-
tiplied several fold to US$231.84 billion in 2006). The Middle East and North
Africa group of countries also experienced strong growth in their current account
balances following the spurt in oil revenues since 2003 rising sharply from US
$15.59 billion in 1996 to US$289.77 billion in 2006 (see Table 1).
A great deal of the literature has been expended on why and how these global
balances arose and what was their role in the perpetration of the GFC. To get a clear
picture of the forces at work, it is best to look at four alternative identities relating
the current account balance to some important macroeconomic categories (see
Sibert 2010; Borio and Disyatat 2011).
The first identity is simply the definition of the current account balance as
Current Account Balance ¼ Net sales by home residents to the Rest of the World
ði:e: Exports ImportsÞ
þ Net current transfers from the Rest of
the World to home residents
ðincluding wages; dividends; royalty; interest on foreign debt)
þ Net transfers from Rest of the World to national
government on official account
ð1Þ
The second identity derives from the national accounting identity

GDP = Private and Public Consumption + Private and Public
Investment + Current Account Balance from which it follows that
Current Account Balance ¼ Domestic Saving ðPrivate and PublicÞ

Total Investment ðDomestic plus ForeignÞ ð2Þ
The third identity is derived from the balance of payments identity
Current Account Balance ¼ Change in resident holdings of foreign assets ðgross outflowsÞ
Change in resident liabilities to non-residents ðgross inflowsÞ
¼ Net capital outflow
ð3Þ
It is to be noted that an important component of gross outflows is official

reserves (defined as official holdings of foreign currency liquid assets). Hence, (3)
can be alternatively written as
Table 1 Global current account imbalances (US$ billion)

Year US EU ASEAN 5 MENA Emerging Emerging China
(Thailand, (Middle markets and
Singapore, East and and developing
Malaysia, North developing Asia
Indonesia and Africa) economies
the
Philippines)
1996 −124.77 +56.48 −32.43 +15.59 −60.25* +15.75 +40.36*
2006 −806.73 −15.94 +44.85 +289.78 +647.36 +272.61 +231.84
2008 −686.64 −233.95 +31.08 +349.70 +684.02 +425.75 +420.57
2010 −443.93 +14.30 +45.30 +174.29 +315.70 +234.70 +237.81
2016 −454.64 +341.02 +14.55 +14.55 +125.42 +340.90 +380.18
Source IMF World Economic Outlook April 2016
Notes
(i) (−ve) denotes deficits and (+ve) denotes surpluses
(ii) (*) figures refer to the year 1997
(iii) The list of countries constituting the EU and the group emerging markets and developing
economies may be found in IMF world economic outlook October 2016—database WEO groups
and aggregates information
(iv) Figures for 2016 are forecasts
Current Account Balance ¼ Change in official Reserves þ other gross outflows

gross inflows ð4Þ
As can be seen from Tables 1 and 2, the bulk of the current account imbalances
are accounted for by the US, China, MENA and Emerging Markets and Developing
Asia (overwhelmingly dominated by the Chinese situation). From Tables 3 and 4,
we see that over the decade prior to the GFC (1996–2008) investment had been
relatively stable in these countries but saving had displayed distinct secular trends.
In the USA, for example, investment was around 21% of GDP in 1996 as well as
2008, whereas saving decreased markedly from about 19 to 15% of GDP; in
MENA and China (as between 1997 and 2008) investment rose appreciably by
about 7% of GDP but the rise in the savings rate was much more dramatic from
26.69% in 1997 to 43.08% in 2008 for the MENA group of countries and from
39.75 to 51.18% (over the same period) for China. Thus, from (2) one may con-
clude that changes in savings rather than in investment were the prime mover in the
global imbalances.
Of course, global imbalances of themselves may not be a bad thing. Often they
can simply be a reflection of efficient allocation of capital and risk (see Milesi-Feretti
and Blanchard 2009). But in the GFC episode, they were distinctly responsible for
creating economic distortions and mispricing of risk (see Kohn 2010).
How did these skewed balances arise? One favourite hypothesis due to Bernanke
(2005) is termed the “savings glut” hypothesis. According to this hypothesis, the
Table 2 Global current account imbalances (% of GDP)

Year US EU ASEAN 5 MENA Emerging Emerging China
(%) (%) (Thailand, (Middle markets and (%)
Singapore, East and and developing
Malaysia, North developing Asia (%)
Indonesia and the Africa) economies
Philippines) (%) (%) (%)
1996 −1.54 +0.54 −4.75 +2.10 −0.99* +0.58* +3.84*
2006 −5.82 −0.09 +4.60 +17.35 +4.86 +5.62 +8.42
2008 −4.69 −1.27 +2.19 +14.13 +3.44 +5.74 +9.21
2010 −2.95 +0.01 +2.64 +6.77 +1.24 +2.41 +3.96
2016 −2.91 +2.51 +1.81 −7.50 −0.57 +1.65 +2.60
(i) (−ve) denotes deficits and (+ve) denotes surpluses
(ii) (*) figures refer to the year 1997
(iii) The list of countries constituting the EU and the group emerging markets and developing
economies may be found in IMF world economic outlook October 2016—database WEO groups
and aggregates information
(iv) Figures for 2016 are forecasts
Table 3 Domestic savings and total investment (% of GDP)

Year
Country 1996 2006 2008 2010 2016
Saving Inv. Saving Inv. Saving Inv. Saving Inv. Saving Inv.
US 19.52 21.62 19.11 23.33 15.41 20.79 15.08 18.39 17.53 20.45
EU 21.86 21.36 22.58 22.64 21.88 23.11 20.49 20.48 22.06 19.56
ASEAN 5 28.95 36.06 28.71 26.40 30.59 28.39 31.23 28.59 30.35 29.28
MENA 26.69 23.31 41.82 24.81 43.08 30.13 35.81 30.05 21.29 26.64
Emerging 23.27* 24.47 31.77 27.25 33.02 29.80 32.11 30.96 31.09 31.45
markets and
developing
economies
Emerging 32.70* 32.99 41.04 35.91 43.79 38.06 43.95 41.49 40.18 38.48
markets and
developing
Asia
China 39.75* 35.90 48.47 40.05 51.83 42.62 51.18 47.22 44.42 41.82
(i) (*) figures refer to the year 1997
(ii) The list of countries constituting the EU and the group emerging markets and developing economies may
be found in IMF world economic outlook October 2016—database WEO groups and aggregates
information
(iii) Figures for 2016 are forecasts
Table 4 Foreign exchange reserves of selected countries (US$ billion)

Year
Country 1996 2003 2006 2008 2010 2015
China 107.04 408.15 1068.00 1949.02 2866.14 3345.38
Korea 20.37 155.28 238.88 201.14 291.49 363.15
Thailand 37.73 41.08 65.29 108.86 167.53 151.27
Mexico 19.43 58.96 76.27 95.13 120.27 173.46
Brazil 58.32 48.85 85.16 192.84 287.06 354.16
Russian Federation 11.28 73.18 295.57 411.75 443.59 319.84
Saudi Arabia 16.02 24.54 228.95 451.28 459.31 626.99
India 20.17 98.93 170.73 247.15 275.27 334.31
Japan 225.59 673.55 895.32 1031.77 1096.89 1233.51
Source World Bank Database
last decade of the 1990s was marked by severe crises in several EMEs and
developing countries viz. the Mexican crisis in 1994, the East Asian crisis of 1997–
98, the crises in Russia (1998), Brazil (1999) and Argentina (2002). Many of the
affected countries (such as Korea and Thailand) had to turn to the IMF for bailout
packages and in the process face tough conditionalities such as raising interest rates,
fiscal consolidation, labour reforms which often proved unpopular at home. But
these measures did raise both household and government saving, and as investment
was slow in picking up after the crisis, current account balances started building up
[see (2) above]. Many such countries in order to insure against a repetition of
similar crises started accumulating a war-chest of foreign exchange reserves (see
Allen et al. 2009) out of these current account surpluses [see (4) above]. The
reserves were partly a response to an increasingly skewed distribution of income
and partly built up by deliberate policies such as restrictions on dividend distri-
butions and high real interest rates. Simultaneously, their governments mopped up
domestic household savings via sales of government securities and this allowed
these countries to resist appreciation of their real exchange rates, in pursuance of
their export-led growth strategies. This further built up their current account sur-
pluses by stimulating exports and reducing imports.
There was also a surge in the current account surpluses of oil exporters, mainly
the MENA group of countries due to a rise in oil revenues. Crude oil prices which
were ruling at around $35 a barrel at the beginning of 1997, climbed steadily to
about $60 per barrel by January 2005 and then accelerated to a peak of $133.86 in
July 2008.6 These countries lacked investment opportunities to utilize the oil rev-
enues and hence these revenues were parked in foreign exchange reserves.
Table 4 displays the build-up of foreign exchange reserves in a few selected
countries, some affected by the crises in the 1990s (Korea, Thailand, Brazil, Mexico
6
Oil prices since then have been on a steady decline and in July 2016 at $41 per barrel were nearly
back to their 1997 levels.
and Russia), some like Saudi Arabia and Russia being oil producers, and a few
others not belonging to either group, but still accumulating huge reserves (China,
Japan and India).
But of course, the process did not stop there. These foreign exchange reserves
had to be invested in safe assets and hence many countries started heavy invest-
ments in US (and to a lesser extent European) debt instruments, especially Treasury
Securities, and Fannie Mae and Freddie Mac mortgage-based securities which were
viewed as “safe” prior to the onset of the GFC (these securities are discussed
below). This had the effect of lowering long-term real interest rates in the USA and
other advanced economies (see Bernanke 2005). Apart from this, in view of the rise
in US productivity in the 1990s, US capital markets became an attractive avenue for
foreign investors. The flow of foreign capital raised stock prices creating a wealth
effect which fuelled a consumption boom in the US Foreign Investment also flowed
into the housing market due to the apparent profitable opportunities afforded by
mortgage-based securitization (see the discussion below). The rise in household
equity and its acceptance as collateral for bank loans encouraged households to fuel
their consumption via such loans (see Johnson and Kwak 2010; Suominen 2010,
etc.). This led to the decline in saving propensity brought out so clearly in Table 3.
A similar process but to a lesser extent was also evident in other industrialized
countries. Simultaneously, the US dollar strengthened, which helped widen the
current account deficit further. Thus, the savings glut hypothesis does attribute a
positive causal role to the excessive savings in East Asia and MENA, in the
build-up of the US current account deficits and, by implication, in the unfolding of
the GFC.
The causal role assigned to global current account imbalances by the saving glut
hypothesis is not uncritically accepted. Several economists maintain that it played a
minor role, if at all, in the GFC. DeLong (2011), Dooley et al. (2009) and others
tend to blame lax financial regulation and supervision instead (this is discussed
below), while Taylor (2009), Bibow (2008), etc., put the blame squarely at the door
of loose monetary policy in the USA under Greenspan initiated from the beginning
of 2001 in the wake of the dot.com bust and continued till the middle of 2004 (after
which it was tightened abruptly). Borio and Disyatat (2011) introduce the concept
of “elasticity” of the financial system (referring to the ease with which the financial
system can restrain the credit creation process). In their view with financial inno-
vation and lax prudential regulation in several industrial countries (most promi-
nently the USA), the domestic financial system becomes excessively elastic. This
introduced substantial distortions in the patterns of global gross (as opposed to net)
financial flows, stretching the elasticity of the international financial system and
thereby leading to global imbalances. Unless this excessive elasticity is attenuated
via an appropriate regulatory and prudential framework, global imbalances will
keep on recurring. Thus, global imbalances are only the symptoms of a
deeper-seated malady.
Obstfeld and Rogoff (2009) take a nuanced position, viewing the global
imbalances and the GFC both as the effects of inappropriate domestic fiscal and
monetary policies in the USA and other industrialized countries such as Japan and
the EU, combined with structural defects in the international financial architecture
which allowed countries like China to build up huge foreign exchange reserves and
resist exchange rate appreciation.
The anomalies of the international financial architecture and their contributory
role to the GFC have been analysed in some detail by Dunaway (2009), who
identifies three pitfalls in this architecture:
(i) The first pitfall refers to the special role played by countries (such as the
USA) whose currencies provide reserve assets to the others. Such reserve
providing countries can run huge current account deficits for long periods in
view of the special status of their currencies, and delay much-needed reforms
such as fiscal consolidation, etc.
(ii) Secondly, inadequate IMF surveillance permits current account surplus
countries (most prominently China in the years leading up to the GFC) to resist
currency appreciation for prolonged periods constitutes the second pitfall.
(iii) The third pitfall in the international system emerged in the wake of the
flexible exchange rates, which replaced the earlier Bretton Woods fixed
exchange regime. While flexible exchange rates can provide some insulation
to countries against exogenous shocks, strategic gradual depreciations have
been used by several countries to maintaining their competitive status in the
face of stagnant productivity, thereby enabling these countries to delay
unpopular structural reforms in their manufacturing and service sectors.
3 Medium-Term Factors
3.1 Inappropriate Monetary Policies
One of the important factors often held responsible for the global crisis is the
conduct of US monetary policy under Alan Greenspan (see, e.g. Taylor 2009;
Bibow 2008). Greenspan succeeded Paul Volcker to the Chairmanship of FRB in
June 1987 and systematically began a process of reversing his predecessor’s con-
servative monetary policies, following the October 1987 Wall Street Crash. He is
widely believed by many to have been responsible for the dot.com bubble disaster
(1995–2001)—by refraining from raising interest rates or imposing stock market
margins as the bubble built up, till it was too late (see Krugman 2009c; Canterbery
2011, etc.). The easy money policy continued in the wake of the bubble burst,7 as
part of the mop-up operations. Within a span of about 3 years, the Fed Funds rate
(the key FRB monetary policy target) was down from 3.5 to 1%. Not surprisingly
this provoked a boom in asset markets, including housing prices, and a
7
On 10 March 2000, NASDAQ reached its peak at 5048, but went into a continuous side thereafter
falling to 68% of its peak value on 17 September 2001.
3 Medium-Term Factors 119
corresponding fall in the US dollar. Greenspan’s policies appear to be a direct

consequence of the NCM orthodoxy, which ruled the roost then and which strongly
advocated a “hands-off” policy as far as asset price bubbles were considered (the
Jackson Hole consensus described in Chap. 4). In mid-2004, Greenspan reversed
the interest rate cycle, and in the process brought about a hard landing of housing
prices, shortly after his tenure ended in January 2006.
In the wake of the GFC, several authors have highlighted the role of easy
monetary conditions in perpetrating financial rises (see Borio and Zhu 2008; Adrian
and Shin 2009; Gambacorta 2009, etc.). Apart from low real interest rates leading to
excessive credit expansion and asset booms (the traditional credit channel), there
seems also to be a significant link between low interest rates and banks’ risk-taking,
which has now been termed as the risk-taking channel of monetary policy. This
channel operates in three distinct ways:
(i) Firstly, in a low interest rate regime, low returns on safe securities (such as
government securities and AAA-rated corporate instruments), act as a spur on
banks, asset managers and insurance companies to take on more risk in their
“search for yield” (see Rajan 2005). This happens because of the desire to
protect the nominal returns to which they have become accustomed in earlier
higher interest rate regimes. Occasionally, this desire could simply be a
reflection of money illusion but more frequently it is accounted for by regu-
latory and institutional constraints. Insurance companies, employee provident
funds and public pension funds have typically (by legal fiat or contractual
obligations) to provide guaranteed nominal returns to their clientele. In a low
interest rate regime, the interest on safe/risk-free government securities may
fall short of this guaranteed returns, prompting asset managers of insurance and
provident fund companies to look for higher yielding but riskier investments.
(ii) Secondly, low interest rates can operate via the financial accelerator
mechanism, by raising the values of borrowers’ collaterals, which enables
them to get access to more credit on favourable terms, thus reducing bor-
rowing constraints (Bernanke et al. 1996; Vermeulen 2012, etc.). This has a
twofold effect—on the one hand, it can lead to a credit boom and secondly it
can make banks take on more risk (through the impact on probabilities of
default, loss given default and volatilities). For recent empirical evidence on
this effect, reference can be made to Altunbas et al. (2009), Gambacorta
(2009), von Heideken (2009), etc.
(iii) Thirdly, low interest rates by raising the demand and supply of credit (see
(ii) above) can boost asset prices. Increasing asset prices often tend to reduce
asset price volatility, and thus risk perception. Higher stock prices increase
the value of equity relative to corporate debt, in effect reducing corporate
leverage. In an effort to revert their earlier leverage ratios, corporates may
engage in greater borrowings. In the event of the asset boom busting, this can
saddle these corporate with unmanageably huge debts (see Adrian and Shin
2009; Danielsson et al. 2004, etc.)
Many economists seem to agree in retrospect that inappropriate monetary

policies in the latter period of the Greenspan regime had a role to play in the build
up to the GFC.
3.2 Structural Flaws in the US Financial System
The financial liberalization philosophy, that came to prevail almost universally in

the decades following the 1970s, had its intellectual roots in the twin NCM
hypotheses of rational expectations and efficient markets. According to this finan-
cial intermediation paradigm, financial developments are best left to the open
markets with freedom from too much “regulatory oversight”. Further, systemic
risks should be unbundled through the instruments of derivatives and securitization
[what Volcker (2008) calls “slicing and dicing”], so that risk is allocated to those
most willing and capable of bearing it. Any market inefficiencies can be overcome
by allowing full play to arbitrage avenues. It is further argued that with financial
development, the possibility of financial crises cannot, of course, be avoided (these
being an integral part of any capitalist system) but their amplitude and frequency
can be considerably attenuated. The US financial structure in the two decades prior
to the GFC, evolved under this financial intermediation philosophy.8 But with the
wisdom of hindsight, it is now felt strongly that the financial structure which
resulted had several fault lines and was an important contributor to the GFC.
We now discuss some of the specific features of this financial architecture which
had a bearing on the crisis.
Mortgage-Based Securitization (MBS): What lent the GFC its special severity
was the development of a housing estate bubble and proliferation of
mortgage-based securitization (MBS) in the USA.
The housing price bubble had its beginning in the decision of the Clinton
Administration in the mid-1990s to promote homeownership among the econom-
ically and socially backward, who would otherwise be denied mortgages by
commercial financial companies and banks, under the CRA (Community
Reinvestment Act 1977). This had the immediate effect of driving up home demand
and home prices (see Table 5). As we have seen above, a part of the huge foreign
exchange reserves accumulating in the Middle East, China and the rest of East Asia
in the decade prior to the GFC, found its way into the US housing market via the
MBS route.
Traditionally, the US housing market has been characterized by four types of
mortgages, viz.
8
Because the GFC originated in the USA, we have focused on the developments there.
Developments elsewhere in the world, especially the OECD and EMEs (including India) were
broadly similar—any differences being of degree rather than kind.
Table 5 S&P/Case–Shiller Month and year Index

US National Home Price
Index (base: January August 1995 81.13
2000 = 100) November 1997 86.67
January 1998 87.66
January 1999 96.63
January 2003 128.46
February 2006 183.30
February 2007 184.63
March 2009 148.66
December 2011 136.64
July 2016 180.55
1. Prime mortgages [following standards set by FREDDIE MAC (Federal Home

Loan Mortgage Corporation) & FANNIE MAE (Federal National Mortgage
Association)]
2. Jumbo mortgages [exceeding loan limits set by FM1 (FANNIE MAE) & FM2
(FREDDIE MAC)]
3. Alt-A mortgages [not satisfying the criteria laid down by FM1 & FM2 but with
borrowers having good credit (FICO9) scores]
4. Subprime mortgages (covering borrowers with poor credit history and FICO
scores).
Securitization or the bundling of bank loans to create tradeable bonds may be
said to have commenced in 1968 with GINNIE MAE (Government National
Mortgage Association) issuing saleable instruments based on combining FHA/VA
loans. In 1981, FANNIE MAE introduced MBS (mortgage-based securities) based
on prime mortgages. Government-sponsored enterprises (GSEs) began to pool
conventional prime mortgages to create “mortgage-backed securities” (MBS) for
sale with guarantees against default on the underlying mortgages. Securitization is
often referred to as an O-D10 model in contrast to the traditional O-H (or
“originate-to-hold” model), wherein the bank originating the mortgage held it till
maturity and bore the risk of default.
By about 2002, a pronounced change was occurring in the MBS market. Private
financial players saw in this market, a unique opportunity to expand their business.
Instead of MBS being issued by government agencies (GSEs) based exclusively on
prime mortgages, their origination was now increasingly being undertaken by
private companies (private label securities), based on subprime mortgages. Home
lending proliferated under schemes such as SIVA, NIVA and NINA (or Ninja
9
FICO refers to Fair, Isaac & Co.
10
Acronym for “originate-to-distribute” model, as the original mortgages are now removed from
the bank’s books and the risk of default is correspondingly shifted from banks to investors in the
MBS. Banks favoured the new arrangement as it released valuable capital for them to expand their
loan base.
loans),11 while subprime mortgages grew from 5% of total originations ($35 bil-
lion) in 1994, to 20% ($600 billion) in 2006. Many financial institutions, invest-
ment banks in particular, issued large amounts of debt during 2004–2007 and
invested the proceeds in mortgage-backed securities (MBS), essentially betting that
house prices would continue to rise and that households would continue to make
their mortgage payments. This strategy was essentially bare-faced speculation,
yielding huge profits while the housing boom was on.
The credibility of these new instruments was underpinned by a network of credit
rating agencies. A thriving market for these low quality private label securities was
sustained by the global “Giant Pool of Money” (estimated at around $70 trillion)
arising from the savings glut in the rapidly growing economies of China and East
Asia, which sought higher yields than those offered by US Treasury Bonds during
the years 2002–07.
An additional dimension of riskiness was imparted to the mortgage market by
the ARM (adjustable rate mortgage) where the interest rate is not fixed, but floating
with the current market interest rate.12 Many ARMs also had “teaser” rates below
4% for the initial period, with the possibility of monthly payments rising steeply
after the initial period. In his February 2004 speech, Greenspan suggested that more
homeowners should consider taking out ARMs. The Fed own funds rate was then at
an all-time-low of 1%. Shortly after this, the interest rate cycle was moved upwards
with rates rising to 5.25% about two years later. This is widely believed to have
brought about the 2007 subprime mortgage crisis, as ARMs were adjusted to
interest rates much above those originally negotiated by borrowers.
Emergence and Proliferation of New Complex Financial Products: One
notable feature of the MBS market was that the “private label” originators used
“structured finance” to create securities. Structuring involved “slicing” the pooled
mortgages into “tranches”, each having a different priority in the stream of monthly
(or quarterly) principal and interest stream. The top buckets/tranches possessed
considerable creditworthiness, capable of attracting “triple-A” credit ratings, mak-
ing them saleable to money market and pension funds that would not otherwise deal
with subprime mortgage securities. With a view to marketing the MBS tranches
lower in payback priority, that could not earn higher ratings, investment banks
developed another security—known as the collateralized debt obligation (CDO).
These CDOs pooled the leftover BBB, A-, etc., rated tranches and produced new
tranches—70 to 80% of which were rated triple-A by rating agencies. The 20–30%
11
Under SIVA (stated income, verified assets) loans proof of income was replaced with a
“statement” on faith. NIVA(no income, verified assets) loans replaced proof of employment
requirements with a proof of money in borrowers’ bank accounts, whereas “No Income, No
Assets” (NINA) or Ninja loans were based only on credit scores, with no proof of any owned
assets.
12
Within the ARM there were further options. The interest-only ARM, allowed the homeowner to
pay only the interest (not principal) of the mortgage during an initial “teaser” period. Even looser
was the payment option ARM loan, in which the homeowner has the option to make monthly
payment that does not even cover the interest for the first two or three years of the loan.
remaining mezzanine tranches were sometimes bought up by other CDOs, to make

so-called CDO squared securities.
Another financial innovation that made its appearance around this time was the
Credit Default Swaps (CDS), proposed as a hedge for MBS investors from the risk
of default but could also be used by speculators to profit from default. The volume
of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the
debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47
trillion. CDS are lightly regulated, largely because of the Commodity Futures
Modernization Act of 2000. As of 2008, there was no central clearing house to
honour CDS in the event a party to a CDS proved unable to perform its obligations,
under the CDS contract. Required disclosure of CDS-related obligations has been
criticized as inadequate, and an important contributory factor to the crisis.
While in theory, such derivatives were supposed to unbundle risks into simpler
segments, and disperse the risks across a wide spectrum of investors globally, in
practice these instruments were based on complex mathematical models,13 too
opaque for even the smartest investors (see Crotty 2009; Das 2005; Bookstabber
2007, etc.)
Banks found it increasingly convenient to entrust the task of issuing such CDOs
to SPVs (Special Purpose Vehicles) and Trusts. A Special Purpose Vehicle
(SPV) (or a Special Purpose Entity (SPE)) is a legal entity created by the sponsor or
originator, typically a major investment bank or insurance company, to fulfil a
temporary objective of the sponsoring firm. SPVs can be viewed as a method of
disaggregating the risks of an underlying pool of exposures held by the SPV, and
reallocating them to investors willing to take on those risks. Tranching enabled
SPVs to tailor CDOs to needs of various investors (CDOs based on senior tranches
with AAA ratings for pension funds, CDOs based on lower tranches with BBB
ratings for SIVs and conduits, etc.). An SPV allows investors to invest in specific
projects or ventures without investing in the parent company directly. Such struc-
tures are frequently used to finance large infrastructure projects. The parent com-
pany typically prefers this arrangement as the resulting assets do not figure on its
(originator’s) balance sheet. Being off-balance sheet, these assets attract little capital
requirements.
Parallely, SIVs (Special Investment Vehicles) emerged to market these securities
to individual buyers. SIVs or conduits engage in sales and purchases of structured
financed products such as MBS or asset-based securities (ABS) in general. SIVs
fund themselves by issuing short-term debt such as high-rated commercial paper.
As they are often subjected to less regulation than other investment pools, they are
induced to build-up leverage to generate returns on the spread between the interest
on their short-term debt and the higher yields on the holdings of their long-term
structured assets. As they are typically off-balance sheet vehicles, they tend to be
13
On a personal note, while pursuing my post-graduate courses more than 40 years ago I used to
marvel at the high abstraction levels of mathematical concepts like rings, ideals and conformal
mappings. Little did I know that one day these very same concepts would be put to such profitable
private, and devastating public, uses!
greatly favoured by commercial banks, insurance companies, mutual funds, etc.

Further, because SIVs undertook pooling and diversification of risky assets, the
tranches issued had higher credit ratings, which also helped promote the originating
bank’s securitization business.
Thus, in the years leading up to the crisis, there emerged a fairly longish
securitization chain linking several agents. For example in the case of housing
loans, we had the following long chain.
Home Owner/Borrower ! Broker ! Originator (Bank/Mortgage Company) !
Arranger/Issuer ! Trust/SPV ! Asset Fund/SIV ! End-Investor (who could be
any Individual, Bank, Finance Company, etc., located anywhere in the World).
Shadow Banking: Excessive securitization led to the emergence of a parallel/
shadow banking system, which was not subject to the same degree of regulatory
and supervisory controls as depository banks. A precise definition of shadow
banking is difficult to come by. One definition often adopted is that due to FSB
(2012) which describes shadow banking as “credit intermediation involving entities
and activities (fully or partially) outside the regular banking system”. We feel that
the alternative—“functional”—approach serves our purpose better here. This sim-
ply views shadow banking as a collection of specific intermediation services, each
responding to a specific demand (see example Cetorelli and Peristiani 2012).
Typically these services may comprise (see Fig. 1 in Claessens and Ratnovoski
2014).
(i) Securitization, including tranching of claims (as in MBS), maturity
transformation.
(ii) Collateral services, primarily through dealer banks, in repo transactions, for
OTC (over the counter) derivatives and in securities lending.
(iii) Bank wholesale funding arrangements.
(iv) Deposit-taking and/or lending by non-banks, including that by insurance
companies (e.g., France) and bank-affiliated companies (e.g., India and
China).
Many such functions are carried out by banks and insurance companies.
Additionally, in capital markets, hedge funds, investment companies, underwriters,
market-makers, etc., routinely undertake these and allied functions.
An important characteristic of the shadow banks is that they all rely on a
backstop (A backstop is very simply a last-resort support. Very often, these entities
need to raise capital through an issuance, and they try to obtain a backstop from an
underwriter or major shareholder to buy any of the unsubscribed shares). Shadow
banks are thus designed to play two key financial intermediation roles. On the
liabilities side, they engage in enhancing the value of collaterals and in the pro-
vision of higher yielding (supposedly) safe assets via securitization and on the asset
side they provide credit to borrowers. However, the inherent systemic risks in the
largely unregulated shadow banking system, with high leverage, and asset-liability
maturity mismatch, escaped the attention of many observers and policymakers.
The ABCPs (asset-backed commercial paper) and other securities (e.g.

auction-rate preferred securities, tender option bonds and variable rate demand
notes), issued by these types of shadow banking financial companies (primarily
hedge funds, asset funds, money market mutual funds, etc.) by 2007, amounted to
over $6 trillion—about 60% of the overall US` banking assets (of around $10
trillion). These entities were especially vulnerable because they borrowed
short-term in liquid markets to purchase long-term, illiquid and risky assets. This
meant that disruptions in credit markets would make them subject to rapid
deleveraging, selling their long-term assets at depressed prices. Overlaying this
shadow banking structure was the fact that in the years leading up to the crisis, the
top four US depository banks moved an estimated $5.2 trillion in assets and lia-
bilities off-balance sheet into SPVs or other entities in the shadow banking system.
This enabled them to essentially bypass existing regulations regarding minimum
capital ratios, thereby increasing leverage and profits during the boom but
increasing losses during the crisis. Such a huge superstructure of loosely regulated
and volatile finance created a classic Minsky-type of situation of financial fragility
(Minsky 1986, 1992; Papadimitriou and Wray 1997; Sinapi 2011, etc.).
Perverse Incentives in the Financial Sector: The US financial system over the
years had evolved a system of incentives, which while ostensibly striving to get the
maximum productivity out of the system, in practice turned out to be perverse to a
high degree. Without going into all the myriad details, we briefly summarize the
salient aspects of this system.
Top executives in financial companies received huge bonuses in years charac-
terized by high revenues and profits—with no corresponding deductions in the
years under losses. As a matter of fact, Di Napoli (2009) and Crotty (2009) present
several instances where top executives have continued to receive sizable bonuses
even when the companies themselves were reeling under huge losses (this is of
course can be partly explained as a tax-saving gimmick). Operating in such an
environment, lent managers and executives strong incentives to take on excessive
risk and maximize profits in a boom, secure in the knowledge that when the chicken
did come home to roost, they would not be the ones who would have to stand up to
the consequences.
Similarly, securitization generated fee incomes for the originators (banks,
mortgage finance companies, etc.), for brokers (who marketed the loans), for
investment banks (who bundled the assorted tranches into securities), for credit
rating agencies, for financial consultants, etc. This income was related to the vol-
ume of the securitization business, not to its quality. The fees were non-refundable
even if the securities later turned out to be loss-making. Thus, originators had no
incentives to ensure quality of loans under the O-D (originate and distribute)
system in contrast to the earlier O-H (originate and hold) system. Further, bankers
were unavailable for sorting out borrower problems and minimize defaults during
the course of the loan/mortgage. Huge profits from securitization in buoyant times
encouraged strong leveraging, which proved to be a stranglehold on companies in
difficult times.
Brokers driven by commission based on quantum of loans rather than their

quality, created a situation of moral hazard, with manipulation of credit scores, etc.
A large share of the business of credit rating agencies emanated from CDOs, CDS,
etc. Typically in the earlier O-H model, originators (usually banks) carefully
monitored their borrowers. In the securitized world of the O-D model, credit rating
agencies substituted this detailed micro-studies with statistical models to provide
ratings to complex products. In order to ensure high ratings for their complex
products, issuers of such products often turned to the so-called monoline insurance
companies, that (for a fee), provided guarantees to issuers, often in the form of
credit wraps, that enhance the credit of the issuer. The ratings of debt issues that are
securitized by credit wraps often reflect the wrap provider’s credit rating (see
Paulson 2010, p. 68). Thus, the rating of a securitized product often reflected not so
much its own risk profile, but that of the monocline insurer providing the credit
wrap. Further, as rating agencies themselves, get their fees from the issuer rather
than the investor, there are strong incentives for credit rating agencies to compro-
mise their standards.
3.3 Lax Regulation of the US Financial Sector
The NCM paradigm that was uncritically accepted in US policymaking circles in the
decade prior to the GFC, favoured “light touch” regulation in the belief that dise-
quilibrium phenomena in financial markets were self-correcting, if arbitrage was
allowed full play, with minimum regulatory interference. Against this backdrop, the
regulatory system developed quite a few anomalies, some of which were critical to
the build-up of systemic risk14 in the financial sector (see Barth et al. 2004).
The first cause for concern was the treatment of assets held by an SIV, as an
off-balance sheet item for the parent bank. This had an important bearing on the
regulatory capital requirements of banks. Since off-balance sheet items under
Basel I (which prevailed for much of the decade immediately preceding the GFC)
attracted no capital charges, SIVs proved a handy vehicle for banks to camouflage
risky assets. Under Basel II (which came into force in the USA in 2004),
off-balance-sheet items were converted into credit exposure equivalents through the
use of credit conversion factors (CCF). Under this provision, commitments with an
original maturity up to one year and those with over one year will receive a CCF of
20 and 50%, respectively. Direct credit substitutes, e.g. general guarantees of
14
There are several (closely related) definitions of systemic risk and we mention here the two most
commonly used. The G-10 (2001) define systemic risk as “the risk that an event will trigger a loss
of economic value or confidence in, and attendant increases in uncertainty about, a substantial
portion of the financial system that is serious enough to quite probably have adverse effects on the
real economy”, whereas the IMF (2009) definition runs somewhat parallel as “a risk of disruption
to financial services that is (i) caused by an impairment of all or parts of the financial system and
(ii) has the potential to have serious negative consequences for the real economy”.
indebtedness (including standby letters of credit serving as financial guarantees for

loans and securities) and acceptances (including endorsements with the character of
acceptances) will receive a CCF of 100%. Thus, much of the advantages that SIVs
enjoyed under the old regime were eroded under Basel II.
Secondly, Basel II introduced the concept of IRMs (internal risk-management
models) for large banks under regulatory discretion. Under the IRM system, these
banks were allowed to calculate their own capital charges based on the concept of
VaR (value at risk).15 There are several limitations of such an approach. The
statistical limitations are discussed in Artzner et al. (1999), Krause (2003) etc. Here,
we focus more on the regulatory implications. Crotty (2009) points out that VaR
probabilities calculated on past data are often irrelevant for current risk assessment,
as the associated probability distributions may be subject to unpredictable changes.
This is especially true of asset price correlations, which increase precipitately
during times of stress and crises. Another limitation is that VaR models are based
on the assumption of normal distribution of events. Normality assigns relatively low
probabilities to extreme loss events, when in fact such events are often very likely
(see Haldane 2009; Crotty 2009; Blankfein 2009, etc.). The crux of the problem is
that VaR modelling proceeds on the assumption of ergodic uncertainty, when in
fact the uncertainty is non-ergodic and needs to be approached via robust methods.
An additional perverse incentive was generated by the practice of allowing the less
liquid tranches of packaged securities, which could not be easily “marked to
market” to be “marked to model”, i.e. their valuation was based on the internal VaR
models of financial companies, often misleading the regulators, clients about the
true net worth of the companies.
Finally, and perhaps most importantly, the regulatory system prevalent prior to
the crisis, based on Basel I and Basel II framework, with its emphasis on
micro-prudential regulation, fell considerably short of forestalling the crisis, though
it did play an important role in putting (globally active) individual financial insti-
tutions (FIs) on a sound footing. Micro-prudential regulation is essentially geared to
addressing idiosyncratic risks specific to individual FIs. It is thus centred on a
partial-equilibrium approach to regulation aimed at preventing the costly failure of
individual financial institutions (FIs). The string of successive failures of financial
institutions in the USA and Europe subsequent to the Lehman collapse highlighted
the inadequacy of a micro-prudential regulatory structure. The GFC made it
abundantly clear that financial crises tend to be typically characterised by a Domino
scenario in which the collapse of a few key FIs is followed by a general collapse of
the financial system, and that only a regulatory and supervisory (R&S) framework
designed to address systemic risk, provided a measure of insurance against a general
“Minsky moment” (Minsky 1986; Cassidy 2010). Inter-institutional linkages
accompanied by low capitalisation and an excessive reliance on short-term sources
15
A VaR gives the maximum loss that a bank may have to incur on its portfolio with a specific
probability. Thus, a VaR of Rs. 10 million at 1% significance means that the there is a chance of
1%, that the bank may sustain a loss exceeding Rs. 10 million on its portfolio or 99% of the time
its loss is guaranteed to remain below that amount.
of funding (maturity mismatch) often lead to general rollover problems thus cre-
ating a potential for financial crises. Further, such systemic episodes can be trig-
gered by relatively minor impulses
As noted by Whelan (2009), systemic risk can often arise even with individual
institutions having good risk-management systems in place. Reduction of
institution-specific risk is not always enough and sometimes can even have the
perverse effect of aggravating systemic risk, as in their attempts to diversify away
idiosyncratic risk the portfolio holdings of FIs tend to get increasingly correlated
and concentrated on a favoured class of assets (Acharya 2011, pp. 17–19). It is now
realized by central banks the world over, and strongly recommended under
Basel III, that the focus of regulation should be macroprudential rather than
micro-prudential (some of the modalities of such a shift are discussed in the Indian
context in Chap. 15, Sect. 4 of this book).
3.4 Bursting of the US Real Estate Bubble

and the Unfolding of the Crisis
The built-up fragility in the US financial system became increasingly evident as

mortgage rates started rising following the tightening of the interest rate cycle over
the period 2004–07. By mid-2005, the downturn in housing prices became pro-
nounced and subprime mortgage defaults showed a rapid rise leading to foreclo-
sures. The first visible signs of trouble were the suspension of purchases of certain
risky MBS by Freddie Mac (Federal Home Loan Mortgage Corporation) in
February 2007 and the filing for bankruptcy by a leading subprime mortgage lender
New Century Financial Corporation in April 2007. Shortly thereafter (July 2007),
Bear Sterns liquidated two of its hedge funds which had heavily invested in various
types of MBS. By October 2007, approximately 16% of subprime adjustable rate
mortgages (ARM) were delinquent, the proportion rising rapidly to 25% by May
2008. The next important event in the housing sector crisis was the transfer to
government conservatorship of the two major GSEs, viz. Freddie Mac and Fannie
Mae on 7 September 2008. By September 2009, about 14.5% of all US mortgages
were delinquent and about a million residences faced foreclosure over the period
August 2007–October 2008.
The crisis which began in the housing sector was now rapidly spilling over to the
rest of the financial sector. In domino style, beginning in 2007, financial institutions
and individual investors holding MBS also suffered significant losses from mort-
gage payment defaults and the resulting decline in the value of MBS. This spread
uncertainty across the system, as investors wondered which companies would be
required to cover their mortgage defaults. In June–July 2007, several CDOs backed
by MBS were downgraded by the three big rating agencies—Standard & Poor,
Moody’s, and Fitch.
Most SIVs had funded their purchase of CDOs by issuing short-term ABCPs,
which needed to be rolled over monthly. In view of the adverse capital market
developments,16 short-term funding to support such rollovers was rapidly drying
up, leading to a seizure of the ABCP market. Effectively, the securitization markets
supported by the shadow banking system started to close down in the spring of
2007 and nearly shutdown in the fall of 2008. More than a third of the private credit
markets thus became unavailable as a source of funds, while the traditional banking
system did not have the capital to close this gap. In March 2008, the Fed staved off
a Bear Stearns bankruptcy by assuming $30 bn in liabilities, and engineering a sale
to J. P. Morgan at a throwaway price. Then in a climactic development, on 12
September 2008, one of the major investment banks Lehman Brothers went
bankrupt after the US Treasury refused to bail it out.17 A bankruptcy of this
dimension created much uncertainty as to which financial firms would be required
to honour the CDS contracts on its $600 billion of bonds outstanding. Merrill
Lynch’s large losses in 2008 were attributed in part to the drop in value of its
unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased
offering credit default swaps (CDS) on Merrill’s CDOs. The loss of confidence of
trading partners in Merrill Lynch’s solvency and its inability to refinance its
short-term debt led to its acquisition by the Bank of America. Thus during 2008,
three of the largest US investment banks either went bankrupt (Lehman Brothers) or
were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch). These
failures augmented the instability in the global financial system. The remaining two
investment banks, Morgan Stanley and Goldman Sachs, opted to become com-
mercial banks, thereby subjecting themselves to more stringent regulation.
Insurance companies, such as American International Group (AIG), Municipal
Bond Insurance Association (MBIA) and Ambac Financial Group, faced ratings
downgrades because widespread mortgage defaults increased their potential expo-
sure to CDS losses. These firms had to obtain additional funds (capital) to offset this
exposure. AIG with a holding of CDSs against $440 billion of MBS sought and
obtained a Federal government bailout of $85 billion on 16 September 2008. The
reasons for the apparently differential treatment of AIG and Lehman are made clear
by Paulson, the then US Treasury Secretary. “…unlike with Lehman, the Fed felt it
could make a loan to help AIG, because we were dealing with a liquidity, not a
capital, problem. The Fed believed that it could secure a loan with AIG’s insurance
subsidiaries…the toxic quality of Lehman’s assets would have guaranteed the Fed a
loss, meaning the central bank could not legally make a loan”. (see Paulson 2010,
p. 30). Subsequent to this several monoline insurance companies were driven out of
business. Thus by end 2008, the GFC had firmly entrenched itself.
16
The US stock market peaked in October 2007, when the Dow Jones Industrial Average index
exceeded 14,000 points. It then entered a pronounced decline, which accelerated markedly in
October 2008.
17
This refusal came after both the Bank of America and Barclays Bank refused to buy out Lehman
Bros’ nearly $50 billion of soured real estate mortgages (including an estimated $17 billion of
MBS).
4 US Policy Responses to the Crisis
Policymakers in the USA were quick to respond to the alarming developments set
in train by the housing bubble bust and the subsequent failure of many big financial
institutions. The policy response may be characterized under three headings
(i) conventional monetary policy (ii) unconventional monetary policy (quantitative
easing) and (iii) fiscal stimulus.
4.1 Conventional Monetary Policy
Beginning 18 September 2007, the Federal Reserve Board (FRB) reduced the target
federal funds rate (main monetary instrument of conventional monetary policy in
the USA) in a series of steps from its then prevailing level of 5.25% to the range of
0 to 0.25% on 16 December 2008. Simultaneously the primary credit rate was
reduced from 5.75 to 0.50%.18
Simultaneously, the liquidity in the economy was sought to be enhanced through
several measures. The first such measure was the Term Auction Facility
(TAF) (introduced on 11 December 2007) under which term funds were to be
auctioned to depository institutions against collateral.19 Another measure (intro-
duced on 16 March 2008) was the Primary Dealer Credit Facility (PDCF) under
which primary dealers could get credit at the primary credit rate against a broad
range of investment grade debt securities. Two other similar measures were the
Term Securities Lending Facility (TSLF)20 and the Asset-Backed Commercial
Paper Money Market Mutual Fund Liquidity Facility (AMLF).21
18
The Federal Reserve Banks offer three discount window programs to depository institutions:
primary credit, secondary credit and seasonal credit, each with its own interest rate. Primary credit
refers to very short-term (usually overnight) loans extended to banks and other depository insti-
tutions in sound financial condition. This rate is slightly higher than the federal funds rate. Less
sound financial institutions are allotted secondary credit from the discount window at rates higher
than the primary credit rate. Seasonal credit is extended to relatively small depositories with
recurring seasonal fluctuations in funding needs, mainly agricultural credit banks. The discount
rate for seasonal credit is an average of selected market rates.
19
All depository institutions that were eligible to borrow under the primary credit program were
eligible to participate in TAF auctions. Each TAF auction was for a fixed amount, with the rate
determined by the auction process (subject to a minimum bid rate). The TAF was discontinued on
March 8, 2010.
20
The TSLF was addressed to provision of liquidity to primary dealers, during periods of
heightened collateral market pressure. Under this program, the FRB loaned relatively liquid
Treasury Securities for a fee to primary dealers for one month, in exchange for eligible collateral
consisting of other, less liquid securities. The TSLF programme was initiated in March 2008 and
was discontinued in February 2010.
21
The AMLF provided funding to US depository institutions to finance their purchases of
high-quality asset-backed commercial paper (ABCP) from money market mutual funds under
4 US Policy Responses to the Crisis 131
4.2 Unconventional Monetary Policy
Before we turn to a review of the unconventional monetary policy measures

deployed by the FRB during the GFC, it may be useful to understand what precisely
these measures are and what they purport to do. We have seen above that by
December 2008, the federal funds rate had attained the zero lower bound
(ZLB) being in the range 0–0.25%. But the financial crisis was in full swing with the
real sector now contracting and unemployment climbing up. With the scope for
conventional monetary policy drying up, unconventional monetary policy measures
had to be tried. In general, unconventional monetary policy measures are those
directly targeting the cost and availability of external finance to banks, households
and non-financial companies (see Bernanke 2009; Eggertsson and Woodford 2004,
etc.). This can be done by influencing real long-term interest rates (see Smaghi 2009)
and one way to do this is by operating on market expectations—the so-called for-
ward guidance under which the central bank can resort to a commitment to maintain
the policy rate at the ZLB for a sufficiently long period of time (see Fawley and
Neely 2013; Dotsey 2016 etc.). But such forward guidance cannot be credible unless
backed by a large portfolio of securities at the central bank. Thus, the central bank
needs to expand its balance sheet by purchasing government and private securities
from the market—a process commonly dubbed as quantitative easing (QE).
Apart from forward guidance, the central bank can also operate on the cost of
long-term credit by purchasing long-dated government securities, MBS, corporate
bonds, etc., and thereby driving down long-term yields on such assets.
Additionally, QE is sometimes resorted to reduce the risk premium on illiquid or
impaired markets by central bank purchases of such tainted assets.
There are important differences between quantitative easing (QE) and open
market operations (OMO). Briefly these are the following: (i) Under an expan-
sionary OMO, the central bank purchases assets (usually long-term securities) from
banks and financial institutions, but this is funded through some existing central
bank assets such as short-term securities, foreign currency holdings, gold so that
banks get hold of relatively more liquid assets while the size of the central bank
balance sheet is left unchanged. QE, on the other hand, funds the asset purchases
from banks and other financial institutions by increasing the monetary base, in the
process expanding the size of the central bank balance sheet is expanded. (ii) OMO
is typically addressed to maintain the market short-term interest rates around a
desired level, QE is directed at influencing the long-term interest rate.
(iii) While OMO purchases are confined to government securities, asset purchases
under QE can be extended to other financial instruments including corporate bonds,
MBS, etc. (iv) OMO is a general liquidity management technique, not focusing on
any asset markets in particular, but QE is often explicitly intended to repair
anomalies in specific malfunctioning markets.
certain conditions. The program was intended to foster liquidity in the ABCP market and money
markets more generally. The AMLF ran from September 2008 to February 2010.
The FRB conducted the QE operations in three phases. The first phase QE1 may
be said to have begun on 25 November 2008 when the Fed announced purchases of
$100 billion of loan obligations of the government-sponsored enterprises (GSEs)
Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks, and of $500
billion in MBS backed by GSEs. In March 2009, the Fed expanded the mortgage
buying program and said it would purchase $750 billion more in mortgage-backed
securities. The Fed also announced it would invest another $100 billion in Fannie
and Freddie debt and purchase up to $300 billion of longer-term Treasury Securities
over a period of six months.
On 14 October 2008, the US Treasury Department announced the $700 billion
Troubled Asset Relief Program (TARP). TARP’s focus was initially to be on the
purchase of MBS and non-securitized residential and commercial mortgages
(so-called whole loans), but shortly after, it was announced that $250 billion of the
TARP allotment, would be earmarked to the Capital Purchase Program. The Capital
Purchase Program (CPP) was launched to stabilize the financial system by pro-
viding capital to viable financial institutions of all sizes throughout the nation.
These funds were not given as grants. Treasury received preferred stock or debt
securities in exchange for these investments. At the end of the investment period for
the program (February 2009), Treasury had invested approximately $205 billion
under the CPP.
QE1 concluded in the first quarter of 2010, with a total of $1.25 trillion in
purchases of mortgage-backed securities, $300 billion in Treasury Bonds and $175
billion in federal agency debt.
The second phase QE2 commenced on 3 November 2010 and involved an
additional purchase of $600 billion of longer-term Treasury Securities. It was ter-
minated at the end of June 2011.
The third and final phase of quantitative easing QE3 commenced on 13
September 2012 and involved Fed purchases of an additional $40 billion of MBS
each month till the phase lasted. Unlike the earlier two phases, which were ended
abruptly, QE3 was tapered beginning 18 December 2013 to end on 29 October
2014. This was accomplished by a progressive reduction of $10 billion in the Fed’s
$85 billion monthly asset purchases schedule.
Another unconventional monetary policy programme (though not strictly a part
of quantitative easing) was the so-called Operation Twist initiated by the Fed in
September 2011. This was with the explicit purpose of increasing the average
maturity of the bank’s Treasury Portfolio. Under this initiative, the Fed purchased
$400 billion worth of Treasury Securities with maturities ranging from 6 to
30 years and sold off an equal amount of treasuries that had maturities in the 3–
36-month range. Operation Twist was intended to lower yields on long-term bonds,
mortgages and commercial loans. while keeping short-term rates little changed.
Thus, without increasing the reserve money directly, the measure could stimulate
consumer and business spending.
Further, in an attempt to stabilize expectations via forward guidance, the Fed
announced an extension of the period over which interest rates would be maintained
at the ZLB from the end of 2014 to mid-2015.
Most observers attribute a measure of success to QE in restoring the US econ-

omy from a deep recession (see Baumeister and Benati 2010; Chung et al. 2012,
etc.). However, as QE was in parallel operation to other measures such as con-
ventional monetary policy easing and fiscal stimulus, there is always a problem of
attributing success for the actual recovery to the various measures individually. The
recovery may be said to have begun in the USA from 2010 onwards, judged by the
metrics of GDP growth, gross capital formation and unemployment (Table 8).
However, empirical evidence suggests a difference in the impact that the various
rounds of QE have had on the economy, with most studies agreeing that QE1 was
quite effective, with subsequent rounds having less effect (see Joyce et al. 2012;
Chung et al. 2012, etc.). Empirical evidence also suggests that QE successfully
lowered nominal interest rates on different financial instruments (agency debt,
MBS, corporate bonds), though, of course, the impact differed by the type of
instrument and its maturity.
QE has not suffered from a dearth of critics either. One line of criticism questions
the very necessity of initiating a QE programme. This is very clearly brought out in
Alan Meltzer’s interview to Fortune magazine (see Matthews 2014) where he
(Meltzer) states “… Fed bond buying didn’t really encourage increased bank
lending. With $3.5 trillion in excess reserves sitting in the banking system, what
good can the Fed do by adding to it that the banks couldn’t do on their own? The
answer is nothing. Whatever has happened in the economy isn’t being caused by
quantitative easing”. In his view, the additional liquidity and low interest rates
prompted corporates to issue debt and buy back stock, rather than undertake fresh
investments (as the Keynesian marginal efficiency of capital had sunk to near-zero
during the crisis).
Another widely shared concern was the potentiality of the “liquidity overflow”
unleashed by QE, to spill over into inflation once the economy was on the recovery
path—an inflation which may not be easy to control as the central bank may be
reluctant to reverse the interest rates cycle in a significant way, in an environment
where the markets had become accustomed to a low interest regime for a very long
time. Besides, as highlighted by the Bank for International Settlements (BIS) in its
83rd Annual Report, the huge growth in bank reserves brought about by QE in the
USA and other advanced economies was driving overnight-lending rates to
near-zero, making it hard for central banks everywhere to resume using conven-
tional monetary policy. There was the risk of a permanent dependency on QE.
A related concern refers to the fiscal profligacy that governments might be
tempted to indulge in as QE, by keeping interest rates too low for too long, reduces
pressures on the fisc to rein in public debt (see Economist 2012).
Finally, the significance of the QE for EMEs should not be lost. Persistently, low
interest rates made possible by QE in the USA and other advanced economies
generated capital outflows from these economies to EMEs where the returns were
appreciably higher. These capital flows, however, were highly unstable, as they
were extremely sensitive to announcements about changes in QE in the major
advanced economies. The implied volatility in the exchange rates of EMEs had
adverse consequences for their exports and in some cases pushed economies
working well hitherto into a recession. We will be discussing this in greater detail in
the next section, when we discuss the impact of the crisis on EMEs and LDCs.
4.3 Fiscal Stimulus
The severity of the GFC had become rapidly evident after the Lehman crisis of
September 2008. It was evident that monetary policy of itself could not be relied
upon to pull the US economy out of the recession. Fiscal measures had also to be
called into play. To this effect, on 17 February 2009, the US Congress enacted the
American Recovery and Reinvestment Act of 2009 (ARRA) (PL 111–5), authorizing
a fiscal stimulus package of $787 billion (later raised to $831 billion). The professed
principal focus of the US fiscal stimulus was to salvage existing jobs and create new
ones for those displaced from their current jobs. But there were also various sub-
sidiary objectives, such as providing “safety nets” and temporary relief programs
for those most affected by the recession, and investing in infrastructure, education,
health, and renewable energy. While the prime rationale for the fiscal stimulus is the
Keynesian view that in recessionary times, public investment can close the gap left
by the dearth of private investment, there is hardly any agreement on issues such as
the necessity of the measure in the first place, its appropriate quantum and above all
whether it achieved any success in its professed objectives.
We do not go into these controversies here but the interested reader is referred to
the extensive discussions in Freedman et al. (2009), Becker (2009), Feldstein
(2009), Miron (2009), Hall (2009), Ilzetzki (2013), etc.
For the US, two sets of estimates for the fiscal stimulus are available [viz.
ILO-EC-IILS (2011) and OECD (2009)]. In its comparative evaluation of global
fiscal stimuli, the ILO (see ILO-EC-IILS 2011) has adopted the national discre-
tionary fiscal measures announced and/or implemented. This has some limitations,
chiefly that the operation of automatic stabilizers may not be accounted for uni-
formly across different countries. But the advantage of the ILO estimates is that the
fiscal stimulus can be decomposed into five important categories: (i) labour market
measures (ii) direct money transfers to low-income households (iii) infrastructure
spending (iv) tax cuts and (v) additional measures to boost aggregate demand
(public expenditure on R & D, defence, pay commissions, etc.).
The OECD (2009) adopts an approach more consistent with the theoretical
definition of the fiscal stimulus. The fiscal stimulus is calculated as the deviation of
the fiscal balance from a “no-crisis-related action scenario” (see Appendix 3.1 of
OECD 2009). The OECD estimates are more comparable across countries, but their
decomposition is on a different basis from that of the ILO. The fiscal stimuli are
decomposed into two main categories, viz. government expenditure and tax mea-
sures. The main categories are further decomposed into the following
subcategories:
Government expenditure: (i) government final consumption, (ii) public invest-

ment, (iii) transfers to households, (iv) transfers to business and (v) transfers to
subnational governments.
Tax measures addressed to: (i) individuals (mainly personal income tax),
(ii) business (VAT and other indirect taxes), (iii) consumption (subsidies, etc.) and
(iv) social contributions.
The other advantage of the OECD measures is that the fiscal multipliers22 which
are used to judge the effectiveness of fiscal stimuli are available for the main as well
as subcategories of the fiscal stimuli. However, it should be remembered that these
are available only for the member countries and thus exclude several EMEs and
LDCs.23
Interestingly, the total fiscal stimulus as estimated by the ILO and OECD coin-
cide. These and the various components of the stimulus (as estimated by the two
methods) are displayed in Tables 6 and 7. The US fiscal stimulus was substantial at
around 5.6% of the GDP (next only to China whose stimulus was a whopping
12.7%). By and large, the fiscal stimulus seems to have worked well (see in par-
ticular Wilson 2011). Table 7 sets out the fiscal multipliers for the various subcat-
egories of the OECD fiscal stimulus estimates.24 It appears that the fiscal measures
are higher in the case of stimuli corresponding to government expenditure (uni-
formly above 1) as compared to those based on tax measures (uniformly below 1).
What was the overall response of the US macroeconomy to the combined
armoury of monetary policy (conventional and unconventional) together with fiscal
stimuli? GDP growth which was in negative territory in 2008 and 2009, started
looking up by the third quarter of 2009 and the growth in 2010 at 2.53% had nearly
reverted to its pre-crisis level of 2006 (see Table 8). About 11% of the fiscal
stimulus was spent on labour market measures as per the ILO estimates(see
Table 6) which is estimated to have created between 2.5 million to 3.6 million jobs,
somewhat offsetting the 7 million job losses during the crisis (see IMF 2010).25
22
The fiscal multiplier is simply the ratio of the change in output DY ðtÞ in response to a fiscal
stimulus DBðtÞ: One can distinguish between the impact multiplier ðDY ðtÞ=DBðtÞÞ, the multi-
Max ðDY ðt þ k Þ=DBðtÞÞ over any
plier at horizon k ðDY ðt þ kÞ=DBðtÞÞ, the peak multiplier |{z}
0kN
PN
DY ðt þ k Þ
horizon N, and the cumulative (total) multiplier at horizon N, Pk¼0
N
(see
k¼0
DBðt þ k Þ
Spilimbergo et al. 2009).
23
Countries which acquired OECD membership after 2010 (such as Chile, Latvia.) are also
excluded.
24
The calculation of these multipliers is based on the 2002 version of the OECD-INTERLINK
Model (see Box 3.1 OECD 2009).
25
A substantial part of the US fiscal stimulus (about 13.7% as per the ILO estimates and about
8.9% as per the OECD estimates—see Table 6) was also spent on direct transfers to those
households adversely affected by the crisis, and the economically vulnerable. About $48 billion
was allotted to the Supplemental Nutrition Assistance Programme (SNAP) which provided
assistance to low-income families in the form of food vouchers. On the health front, the stimulus
provided for premium reductions for health benefits under the Consolidated Omnibus Budget
Table 6 US fiscal stimulus size and its decomposition

ILO estimates
Fiscal Labour Tax cuts Transfers to Infrastructure Additional
stimulus market (% of fiscal low-income spending measures
(% of 2008 measures stimulus) households to boost
GDP) (% of fiscal (% of fiscal aggregate
stimulus) stimulus) demand
(% of
fiscal
stimulus)
5.6 12.28 33.35 13.74 14.03% 26.0
OECD estimates
Fiscal Government expenditures Tax measures
stimulus (% of (% of fiscal stimulus) (% of fiscal stimulus)
2008 GDP) 42.85 57.15
Subcategories of government expenditures Subcategories of tax measures
(% of fiscal stimulus) (% of fiscal stimulus)
GE1 GE2 GE3 GE4 GE5 T1 T2 T3 T4
5.6 12.5 5.28 8.93 0.0 16.14 42.85 14.28 0 0
Notes The following abbreviations have been used in the above table
1. (i) GE1—Government consumption, (ii) GE2—Government investment, (iii) GE3—Transfers to households,
(iv) GE4—Transfers to business, (v) GE5—Transfers to subnational governments and
2. (ii) T1—Individual tax measures (ii) T2—Business tax measures (iii) T3—Consumption tax measures
(iv) T4—Social contributions
Source (i) ILO Estimates based on ILO (2011) p. 7 (Fig. 3)
(ii) OECD estimates based on OECD (2009) Tables 3.2 and 3.8
Table 7 US fiscal multipliers for the OECD fiscal stimulus estimates

Government expenditure Tax measures
Government Government Transfers Personal Indirect
consumption investment to income taxes
households tax
Year 1 (2008) 0.7 0.9 0.5 0.3 0.2
Year 2 (2009) 0.8 1.1 0.8 0.5 0.3
Two year 1.5 2.0 1.3 0.8 0.5
cumulative fiscal
multiplier
Source OECD (2009) Appendix 3.2, p. 138
As Table 9 shows the unemployment rate which had shot up from 5.9% in 2008 to
9.4% in 2009, before peaking at 9.7% in 2010, moderated somewhat in 2011 and
has been in steady (but slow) decline since then. The gross capital formation rate
Reconciliation Act of 1985 ( COBRA), which gave workers, who had lost their health benefits the
right to purchase group health coverage.
Table 8 Key US macroeconomic parameters pre- and post-crisis

Year GDP Gross capital Unemployment rate (% of CPI inflation
growth rate formation (%) of total labour force) rates (%)
(%) GDP
2006 2.67 23.33 4.7 3.23
2007 1.78 22.35 4.7 2.85
2008 −0.29 20.78 5.9 3.84
2009 −2.77 17.51 9.4 −0.36
2010 2.53 18.39 9.7 1.64
2011 1.60 18.54 9.0 3.16
2012 2.22 19.35 8.2 2.07
2013 1.49 19.54 7.4 1.47
2014 2.43 19.92 6.2 1.62
2015 2.43 20.23 – 0.12
declined precipitately from 20.78% in 2008 from 17.51% in 2009, but then
recovered somewhat over the next few years being nearly restored to the 2008 level
in 2015 (see Table 8).
Hence, it is generally agreed that the USA passed from a deep recession to a
tepid recovery by about 2011 (see IMF 2011, p. 73, and IMF 2012, 2015a, b).
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Chapter 6
Universalization of the US
Financial Crisis
Abstract The crisis which originated in the USA rapidly spreads to other coun-
tries. Almost no region of the world escaped from the consequences of the crisis,
though the scale of the damage varied considerably across countries, as did the time
taken for economies to recover. The transmission of a crisis from one country to
others can occur via several channels, and this chapter begins with a brief overview
of these channels. Later, we see how the crisis was transmitted to the EU, Latin
America, the African continent, China, India and the rest of Asia. For each region,
we evaluate the firefighting measures deployed to fight the crisis.
1 Contagion to the Rest of the World
In the highly integrated world of today, a crisis of the magnitude of the GFC was
bound to have strong global effects. And this fear was indeed confirmed.
Worldwide losses from the assets held in the USA and other developed countries
were estimated at around $4 trillion (IMF 2009a), while world GDP growth
plunged from a robust 4.31% in 2007 to 1.85% in 2008, before entering negative
territory in 2009. In absolute terms, world GDP contracted by $3.90 trillion as
between 2008 and 2009. Almost no region of the world escaped from the conse-
quences of the crisis, though the scale of the damage varied considerably across
countries, as did the time taken for economies to recover. The transmission of a
crisis from one country to others can occur via several channels (see Toporowski
2009; Gurtner 2010; Nissanke 2010, etc.), of which the following are specially
relevant.
(i) Financial System Contamination: Financial contamination occurs via the
write-downs on toxic assets of the affected country, held by banks and
financial institutions in other countries.
(ii) Comovements in Financial Asset Markets: Financial asset markets in
crisis-affected countries experience sharp downturns. These are very quickly
translated to financial asset markets in other countries, where the asset
depreciation can adversely influence consumption and investment plans.

https://doi.org/10.1007/978-81-322-3920-8_6
142 6 Universalization of the US Financial Crisis
This is particularly true of stock markets. Similar comovements can also

occur in real estate markets.
(iii) Foreign Capital Flows: Foreign capital flows are extremely sensitive to
market sentiment. As the signs of a major crisis become visible, foreign
institutional investors are very prone to jitters, often leading to a massive
reversal of capital flows from the affected countries.
(iv) Trade Channel: As consumption and investment demand contracts in the
economies under stress, exports from other countries are affected. The impact
is particularly severe for primary exporters and for export-dependent
economies.
(v) Flow of Remittances: In the last two decades or so, home remittances by
migrant workers have become an important item in the current account of
many EMEs and LDCs. A sharp downturn in incomes of advanced econo-
mies can have a substantial impact on these remittances.
2 Crisis Spreads to Europe
2.1 Crisis Transmission from the USA to EU
Owing to the high degree of financial integration between the EU financial system
and that in the USA, it was inevitable that the financial crisis would spread to
Europe. The primary transmission channel was what we have called above, as the
Financial System Contamination channel. In August 2007, the German bank IKB
Deutsche Industriebank had to be bailed out. A few weeks thereafter (September
2007), the large UK mortgage bank Northern Rock failed and had to be nationalized
in February 2008. Shortly after the Lehman crisis, the UK government had to bail out
the Royal Bank of Scotland and Lloyd’s TSB. Several banks and financial com-
panies faced liquidity problems in Europe, including Banco Santander (Spain),
Fortis (Benelux), Landsbankinn (Iceland). During the GFC, the write-downs by
Euro Area banks on MBS and CDOs held in US banks was estimated at $649 billion
for the period 2007–10 (see Hodson and Quaglia 2009; ECB 2009a, b).
The developments in Europe since the GFC have been anything but sanguinary
(see von Heideken 2009). First, there was the Icelandic financial crisis (2008–11)
triggered by three interrelated events, viz. the default of three of the country’s major
privately owned commercial banks (Kaupthing, Landsbanki and Glitnir) in late
2008, sharp depreciation of the Icelandic króna in 2008 and a large external debt
estimated at about €50 billion in 2008 (about seven times the country’s GDP) (see
IMF 2012). Almost simultaneously, there were similar financial crises in Ireland and
Russia. Since 2010, we have had the European sovereign debt crisis,1 which refers to
1
Extended discussions on the European sovereign debt crisis may be found in Mody (2009),
Sgherri and Zoli (2009), Arghyrou and Kontonikas (2011) etc.
2 Crisis Spreads to Europe 143
the fact that several eurozone member states (Greece, Portugal, Ireland, Spain and
Cyprus) went bankrupt, being unable to roll over their government debt, and had to
be bailed out by the ECB, or the IMF.2
2.2 Euro Area Policies
Monetary Policy: We now turn to the post-crisis policies adopted in the Euro Area,
which currently consists of 19 member countries.3 Monetary policy in the Euro
Area is administered by the Governing Council of the European Central Bank
(ECB).4 While monetary policy is centralized, fiscal policy is largely left to national
governments. Fiscal coordination is achieved through the Stability and Growth Pact
(SGP) which lays down rules for fiscal discipline for all EU members (not only for
the Euro Area members) (see Buti et al. 1998 for details of the implementation of
this pact).
The ECB monetary policy operates via three key policy rates, viz. (i) interest rate
on the main refinancing operations (MRO),5 (ii) interest rate on the overnight
deposits with ECB by banks in the system and (iii) the interest rate on the marginal
lending facility.6 The MRO interest rate is taken as the policy reference rate with
the other rates adjusting more or less in tandem (see Micossi 2015).
On 9 August 2007 as the first signs of the global financial crisis struck, the ECB
reacted immediately, allowing banks full and unrestricted access to overnight liq-
uidity at the prevailing reference rate of 4%. The total amount of liquidity pumped
into the system during this episode was €95 billion. Additionally, to ease the
tensions in the foreign exchange market, the ECB also started supplying US$
liquidity against euro-denominated collateral (see ECB 2010). However, in view of
the build-up of inflationary pressures and the fear of an asset prices bubble, the
reference rate was raised by 25 basis points to 4.25% on 9 July 2008.
When the Lehman crisis erupted in mid-September 2008, it became clear that
decisive policy measures were needed to insulate the Euro Area to the extent
2
On the Greek crisis, reference may be made to the discussion in Schumacher and di Mauro
(2015), Gourinchas et al. (2016).
3
The Euro Area refers to the 19 countries of the 28 European Union members which have adopted
the euro as their common currency. These 19 countries comprise Austria, Belgium, Cyprus,
Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta,
The Netherlands, Portugal, Slovakia, Slovenia, and Spain.
4
The national central banks’ involvement in this process is ensured by the fact that all the
Governors of the National Central Banks of the Euro Area are members of the Governing Council,
which additionally has 6 members of the ECB Executive Board.
5
This is a regular (weekly) open market operation with banks bidding via tenders for short-term
liquidity, in the form of a reverse repo.
6
A standing facility of the Eurosystem for overnight credit from national banks against eligible
assets.
possible, from the fallouts in the US financial sector. Beginning 8 October 2008, the
reference rate (MRO refinancing rate) was reduced successively by 325 basis points
till it stood at 1% in May 2009. Correspondingly, the other two key rates were
reduced over the period July 2008 to May 2009 from 3.25 to 0.25% (overnight
deposit rate) and 5.25 to 1.75% (marginal lending facility rate).
With the functioning of the financial markets severely impaired, it was clear to
the ECB that the cut in interest rates needed to be supplemented by additional
non-conventional measures. As a consequence over the period October 2008 to July
2009, a number of far-reaching non-conventional measures were introduced.
(i) Firstly, the ECB switched over to a “fixed rate full allotment” refinancing
procedure, whereby the eligible Euro Area banks were provided unlimited
liquidity at the MRO refinancing rate against adequate collateral (October
2008).
(ii) Secondly, the list of eligible collateral for refinancing was expanded, as also
the number of counterparties eligible for refinancing (December 2008).
(iii) Thirdly, the term maturity of long-term refinancing operations (LTROs) was
extended from 3 to 6 months in November 2008, which was later (May
2009) extended to 1 year.
(iv) Fourthly, the ECB negotiated swap arrangements with other central banks,
particularly the Fed, to provide liquidity to euro banks in foreign currency
(September 2008).
(v) In July 2009, the ECB launched the covered bond7 purchase programme
(CBPP1), purchasing covered bonds issued by banks (July 2009). Between
July 2009 to June 2010, the ECB purchased €60 billion covered bonds in
both the primary and secondary markets.
The above ECB policy measures may be considered as a direct response to the
GFC, but in 2010 as the Eurozone crisis struck, additional measures had to be
introduced. A new phase of covered bond purchasing was initiated in November
2011 (CBPP2), which lasted till October 2012 and involved ECB purchases of
€16 billion covered bands. In December 2011, the ECB introduced the very
long-term refinancing operations (VLTROs) with a 3-year maturity.8 In September
2014, the ECB announced the implementation of two asset purchase programs—the
asset-backed securities purchase programme (ABSPP) and the third phase of its
covered bonds purchase programme (CBPP3) originally expected to last till
September 2016, but whose deadline has now been extended to March 2017. As of
March 16 2016, the ECB had purchased €165 billion of covered bonds, and simple
and transparent asset-backed securities, under these two programmes. The osten-
sible goals of these programmes, were (i) to address specific market imperfections
7
Covered bonds are debt securities collateralized by cash flows from mortgage payments or public
sector loans.
8
The ECB performed two VLTRO auctions; the first in December 2011 (lending €490) and
another in February of 2012 (€540).
(ii) to open some of the blocked illiquid channels of credit and (iii) more generally
to shift the risk away from the banking system to the ECB.
A more targeted response to the Eurozone crisis was the announcement of the
securities market programme (SMP) in May 2010. The programme was designed to
buy sovereign debt in order to reduce the interest rates of stressed countries’ debts,
and alleviate the problems in their banking systems.
It is worthwhile noting that the programmes considered so far were treated as credit
enhancement measures rather than QE measures. The credit enhancement measures
are almost fully sterilized (over a period of time) implying that the central bank
balance sheet is not expanded.9 However the ECB balance sheet underwent a full
cycle—rising from about €2.0 trillion in the fourth quarter of 2008 steeply to
€3.05 trillion in 2012 (especially due to the introduction of VLTROs), but was
gradually unwound to €2.31 trillion in March 2015 (see Yardeni and Quintana 2016).
On 22 January 2015, the European Central Bank (ECB) dropped its earlier
hesitation about QE and launched its Expanded Asset Purchase Programme, with
the aim of reviving the Euro Area economy. Under EAPP, the ECB will add the
purchase of ‘euro-denominated investment-grade securities issued by Euro Area
governments and European institutions, to its existing asset-backed securities
(ABSPP) and covered bonds (CBPP3) programmes. The combined monthly pur-
chases under the three programmes would amount to €60 billion (later raised to
€80 billion). The programmes were originally scheduled to run till September
2016, or until “a sustained adjustment in the path of inflation towards the ECB’s
objective of lower but close to 2% is observed” (see Delivorias 2015). However, the
programme was not discontinued in September 2016.
Speculation is now rife as to the exit strategy and exit time from the QE.
According to a Bloomberg report (dated 4 October 2016), the ECB is likely to taper
the QE in steps of €10 billion a month till March 2017 but did not rule out a
spilling over of the programme beyond that date (see Bloomberg Markets 2016).
What invites concern, however, is that the QE has expanded the ECB balance sheet
steeply ever since its inception—in June 2016 the total assets of the ECB stood at
€3.10 trillion.
Fiscal policy: Euro Area fiscal policies were an important component of the
strategy to control the fallout of the GFC. In November 2008, the EC launched the
European Economic Recovery Plan (EERP), comprising a total package of
€200 billion of which the member states were called upon to contribute
€170 billion and the remaining was to come from the EU budget10 and the
European Investment Bank (EIB). As mentioned above, fiscal policy in the EU is
9
The CBPP was something of an exception. It was not sterilized under the expectation that the
purchases would be automatically sterilized because they would substitute the LTRO facilities.
10
The European Union has a separate budget to pay for policies carried out at European level
(such as agriculture, assistance to poorer regions, overseas development aid) and for its admin-
istration. This budget is funded from sources such as customs duties on imports from outside the
EU, a percentage (around 0.3%) of each member state’s standardized VAT, and a percentage
(around 0.7%) of each member state’s gross national income.
largely left to national governments. Definitional and measurement issues related to

the fiscal stimulus have already been discussed in Chap. 5, Sect. 4.3 (while con-
sidering the US case). It was seen there that while the ILO and OECD estimates
each had its advantages, overall there were some reasons to prefer the latter. The
fiscal stimuli (as posted by the ILO-EC-IILS 2011 and OECD 2009) by a few
individual EU member countries are displayed in Tables 1 and 2, respectively.
The two tables show a great deal of variation both in the quantum of the fiscal
stimulus and its composition. The size of the fiscal stimulus is quite high for Spain,
and moderately so for Germany. For most of the other countries, the stimulus has
been quite modest and for some countries (such as France and The Netherlands)
quite low. The decomposition of the fiscal stimulus also presents interesting vari-
ations among individual countries. Tax measures seem to have been the over-
whelmingly popular method of transmitting the fiscal stimulus in most of the EU
countries (considered here). Except for France and Spain, tax measures account for
more than half of the total fiscal stimulus as per the OECD reckoning (see Table 2).
In the case of UK and the Netherlands, the proportion of the fiscal stimulus
accounted for by tax measures exceeds 90%, with the bulk of these focused on
social contributions (in the case of the Netherlands) and consumption subsidies (in
the case of UK), the remaining being distributed between tax concessions to
individuals and businesses. For France and Spain, where government expenditures
dominate tax measures, the bulk of the government spending is on investment or
direct transfers to households (France) or transfers to businesses (Spain). The ILO
Table 1 Fiscal stimulus size and its decomposition for selected EU countries (ILO estimates)
UK Spain France Germany Italy The Belgium
(%) (%) (%) (%) (%) Netherlands
(%)
Fiscal stimulus (% of 2.2 8.1 1.3 3.3 4.9 1.4 n.a.
2008 GDP)
Labour market 11.1 n.a. 13.3 8.8 14.4 n.a. n.a.
measures (% of fiscal
stimulus)
Tax cuts (% of fiscal 44.3 n.a. 4.0 44.5 15.6 n.a. n.a.
stimulus)
Transfers to 21.2 n.a. 13.1 0 0 n.a. n.a.
low-income
households (% of
fiscal stimulus)
Infrastructure 3.6 n.a. 35.1 15.5 13.3 n.a. n.a.
spending (% of fiscal
stimulus)
Additional measures 19.8 n.a. 34.4 31.1 56.6 n.a. n.a.
to boost aggregate
demand (% of fiscal
stimulus)
Source ILO-EC-IILS (2011), Fig. 3, p. 7
Table 2 Fiscal stimulus size and its decomposition for selected EU countries (OECD estimates)
(%) (%) (%) (%) (%) Netherlands (%)
(%)
Fiscal stimulus (% 1.5 3.5 0.6 3.0 0.6 1.5 1.6
of 2008 GDP)
Govt. exp. (% of 6.7 54.3 67.0 46.6 50 6.7 37.5
fiscal stimulus) of
which:
Govt. cons. 0 8.57 0 3.3 0 0 0
Govt. inv. 3.4 20.0 33.6 26.7 0 0 6.25
Transfers to 3.3 5.75 33.4 6.6 33.0 6.7 31.25/5
households
Transfers to 0 20.0 0 10.0 17.0 0 0
business
Transfers to 0 0 0 0 0 0 0
sub-national
governments
Tax measures (% 93.3 45.7 33.0 53.3 50 93.3 62.5
of fiscal stimulus)
of which:
Individual taxes 42.85 45.7 17.21 20.2 0 13.4 18.75
Business taxes 7.10 0 15.78 9.8 0 26.8 37.5
Consumption 50.05 0 0 0 50 0 6.25
subsidies
Social 0 0 0 23.3 0 53.1 0
contributions
Source OECD (2009), Table 3.2, p. 111
estimates reinforce this narrative, but via a different decomposition. Once again, tax
cuts dominate the fiscal stimulus, with France providing the exception—the bulk of
the stimulus being concentrated on infrastructure spending and labour market
measures with a negligible tax cuts component.
The effectiveness of the fiscal stimulus strategy can be assessed via the fiscal
multipliers (see footnote 22 of Chap. 5 for a definition). These are only available for
the OECD estimates and are reported in Table 3. It is evident from the table that the
multipliers for government consumption are uniformly higher than for tax measures.
The cumulative fiscal multiplier (obtained by adding the values given in Table 3 for
2008 and 2009) is highest for government investment ranging between 1.6 and 1.8,
and lowest for business tax cuts (between 0.2 and 0.4). The latter is possibly a
reflection of the openness of the EU economies, so that the traditional consumption
multiplier suffers “leakages” due to expenditure on imports. On the other hand,
government investment does seem to be playing the substantial role envisaged for it
by Keynes in the Great Depression, viz. reviving the marginal efficiency of private
investment. Miron (2009) expresses considerable scepticism about fiscal sttimuli in
the USA and the EU.
148
Table 3 Fiscal stimulus multipliers for selected EU countries (OECD estimates)

Netherlands
2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009
Fiscal multipliers for government expenditure measures
Govt. cons. 0.5 0.6 0.5 0.6 0.6 0.7 0.4 0.5 0.6 0.7 0.3 0.4 0.3 0.4
Govt. inv. 0.8 1.0 0.8 1.0 0.8 1.0 0.8 1.0 0.8 1.0 0.7 0.9 0.7 0.9
Transfers to households 0.4 0.6 0.4 0.6 0.4 0.7 0.3 0.5 0.4 0.7 0.2 0.4 0.2 0.4
Fiscal multipliers for tax measures
Individual taxes 0.2 0.4 0.2 0.4 0.2 0.4 0.2 0.3 0.2 0.4 0.1 0.2 0.1 0.2
Business taxes 0.2 0.2 0.1 0.2 0.2 0.2 0.1 0.2 0.2 0.2 0.1 0.1 0.1 0.1
Source OECD (2009), Appendix 3.2
Notes Fiscal multipliers for the other two categories of government expenditure, viz. transfers to business and transfers to sub-national governments, have not
been reported. Similarly, fiscal multipliers for the other two categories of tax measures (consumption subsidies and social contributions) have not been reported
by the OECD
6 Universalization of the US Financial Crisis
In the wake of the Eurozone crisis, it has been widely felt that for enhancing the
potency of fiscal policy, a fiscal union should complement the monetary union (see,
e.g., Marzinotto et al. 2011; Obstfeld 2013; Allard et al. 2013). Such a fiscal union
could be a mechanism for providing adequate fiscal resources at the federal level to
avert financial crises and bail out individual countries in fiscal distress. Besides, this
could instil greater fiscal discipline and insulate national governments from the
temptation to indulge in populist government expenditures for short-term political
gains.
Tables 4, 5, 6 and 7 present important macroeconomic statistics for the entire EU
and seven of its members (we have considered UK in these seven countries as the
Brexit vote came only in June 2016, and the UK is expected to formally quit the EU
only in 2018). Looking at the GDP growth rates in Table 4 in conjunction with the
Table 4 GDP growth rate (%) of selected EU countries

Year EU UK Spain France Germany Italy The Netherlands Belgium
2006 3.38 2.66 4.17 2.37 3.70 2.00 3.51 2.50
2007 3.12 2.59 3.76 2.36 3.26 1.47 3.70 3.39
2008 0.50 −0.47 1.12 0.19 1.08 −1.05 1.70 0.74
2009 −4.39 −4.19 −3.57 −2.94 −5.62 −5.48 −3.76 −2.29
2010 2.08 1.54 0.01 1.97 4.08 1.69 1.40 2.69
2011 1.76 1.97 −1.0 2.08 3.66 0.57 1.66 1.79
2012 −0.48 1.18 −2.62 0.18 0.41 −2.81 −1.06 0.16
2013 0.18 2.16 −1.67 0.58 0.30 −1.75 −0.49 0.00
2014 1.36 2.85 1.36 0.26 1.60 −0.34 1.01 1.29
2015 1.95 2.33 3.21 0.16 1.69 0.76 1.99 1.37
Source World Bank Data Tables
Table 5 Unemployment (% of total labour force) of selected EU countries

2006 8.2 5.5 8.6 8.8 10.3 6.8 3.9 8.2
2007 7.2 5.4 8.4 8.0 8.6 6.1 3.2 7.5
2008 6.9 5.4 11.5 7.4 7.5 6.7 2.8 7.0
2009 8.9 7.8 18.1 9.1 7.7 7.8 3.4 7.9
2010 9.6 7.9 20.2 9.3 7.1 8.4 4.5 8.3
2011 9.6 7.8 21.7 9.2 5.9 8.4 4.4 7.1
2012 10.5 8.0 25.2 9.9 5.4 10.7 5.3 7.5
2013 10.9 7.5 26.3 10.4 5.3 12.2 6.7 8.4
2014 10.2 6.3 24.7 9.9 5.0 12.5 6.9 8.5
2015 – – – – – – – –
Notes The unemployment rates are estimated as per the methodology developed at ILO (2010)
Table 6 Gross capital formation (% of GDP) of selected EU countries

2006 22.74 18.78 31.29 23.17 19.77 21.89 21.51 23.88
2007 23.49 19.18 31.34 24.11 20.75 22.18 22.26 24.45
2008 23.06 18.02 29.60 24.09 20.86 21.78 22.35 25.73
2009 19.81 15.29 24.57 21.31 18.07 19.39 20.94 21.66
2010 20.47 16.37 23.55 21.91 19.63 20.54 20.42 22.69
2011 20.94 16.16 21.91 23.21 21.08 20.46 20.52 23.99
2012 19.72 16.25 20.23 22.65 19.26 17.86 19.16 23.20
2013 19.31 16.89 19.14 22.31 19.38 16.96 17.99 22.13
2014 19.56 17.48 19.78 22.59 19.31 16.32 18.10 23.05
2015 19.55 17.51 20.66 22.34 18.76 16.77 19.05 22.64
Table 7 Inflation (GDP deflator—annual %) of selected EU countries

2006 2.60 2.33 3.98 1.68 1.58 1.90 2.55 2.31
2007 2.63 2.32 3.33 1.48 2.30 2.43 2.11 2.06
2008 4.21 3.61 2.14 2.81 2.63 2.48 2.48 1.96
2009 0.95 2.17 0.25 0.08 0.31 1.96 0.40 0.81
2010 1.67 3.29 0.16 1.53 1.10 0.32 0.85 1.93
2011 3.31 4.48 0.03 2.12 2.07 1.47 0.14 2.00
2012 2.71 2.82 0.05 1.96 2.01 1.38 1.42 2.04
2013 1.38 2.55 0.57 0.86 1.50 1.22 1.38 1.35
2014 0.22 1.46 −0.40 0.51 0.91 0.81 0.81 0.67
2015 −0.06 0.05 0.61 0.04 0.23 0.75 0.39 0.86
unemployment rates of Table 5, a consistent pattern is evident. All the economies

seem to have been badly hit by the crisis in the years 2008 and 2009, with the
impact being at its peak in 2009. A mild recovery seems to have been underway in
2010, which was severely interrupted by the fallout of the Eurozone crisis which
struck Greece, Portugal and Ireland early that year. GDP growth once again
retreated and unemployment mounted during 2011–13. Some evidence of a distinct
pickup in the growth rate is evident in 2014, but unemployment continues to be
disturbingly high. In the EU as a whole, unemployment has been higher in recent
years than even at the height of the global crisis in 2009. This is also true for five of
the seven EU members we have considered here—the exceptions being UK and
Germany (Tables 8, 9, 10, 11, 12 and 13).
Table 8 World commodity prices (2006–16)

Year Commodity price index Non-fuel Industrial Crude oil
(includes both fuel and commodity price inputs index prices (US$
non-fuel indices) (base: index (base: (base: per barrel)
2005 = 100) 2005 = 100) 2005 = 100)
2006 120.72 123.26 136.29 64.27
2007 134.94 140.49 154.31 71.13
2008 172.34 151.62 145.67 97.04
2009 120.52 127.43 118.66 61.78
2010 152.14 161.38 169.94 79.03
2011 192.02 190.40 197.76 104.01
2012 185.77 171.31 167.13 105.01
2013 182.87 168.99 163.32 104.07
2014 171.47 162.27 153.50 96.25
2015 110.98 133.91 123.59 50.79
2016 99.25 130.23 114.26 42.96
Source IMF World Economic Outlook Database
Notes (1) Non-fuel commodities include (i) food (cereals, vegetable oils, meat, seafood, sugar,
bananas and oranges), (ii) beverages (coffee, cocoa beans and tea) and (iii) industrial inputs
(2) Industrial raw materials include (i) agricultural raw materials (timber, cotton, wool, rubber and
hides) and (ii) metals (copper, tin, aluminium, iron ore, nickel, zinc, lead and uranium)
(3) Crude oil prices are a simple average of three spot prices, viz. Dated Brent, West Texas
Intermediate and Dubai Fateh
Table 9 Important maroeconomic indicators for sub-Saharan Africa

Year GDP Investment Unemployment Terms of Current Total
growth (%) (% of rate (% of total trade account external
(constant GDP) labour force) (annual % balance debt (% of
prices) change) (% of GDP) GDP)
2007 7.12 20.73 7.95 3.70 1.63 21.72
2008 5.93 20.52 8.14 6.41 0.32 19.72
2009 3.90 21.16 8.10 −8.65 −2.63 22.68
2010 6.95 20.38 8.10 12.31 −0.69 21.19
2011 5.03 20.12 8.12 10.77 −0.49 20.53
2012 4.33 20.61 8.09 0.61 −1.55 21.59
2013 5.24 20.94 7.91 −1.40 −2.07 22.43
2014 5.05 21.49 7.97 −3.08 −3.66 –
2015 3.35 20.61 – −14.16 −5.87 –
2016 1.43 19.85 – −2.41 −4.51 –
Source (i) IMF World Economic Outlook Database for all variables except unemployment
(ii) Unemployment data are from the World Bank Data Tables
Notes (i) The unemployment rates are estimated as per the methodology developed at ILO (2010)
(ii) Terms of trade are defined as the ratio of (merchandise exports deflator in US$) to
(merchandise imports deflator in US$) (see Spatafora and Warner 1999)
Table 10 Important maroeconomic indicators for Latin America and the Caribbean
Year GDP Investment Unemployment Terms of Current Total
growth (%) (% of rate (% of total trade account external
(constant GDP) labour force) (annual % balance (% debt (% of
prices) change) of GDP) GDP)
2007 5.87 22.11 6.90 3.22 0.08 25.81
2008 4.01 23.29 6.45 3.69 −0.96 24.96
2009 −1.82 20.42 7.52 −6.69 −0.83 22.95
2010 6.13 21.75 7.27 8.51 −1.91 26.44
2011 4.63 22.21 6.67 7.07 −1.95 25.57
2012 3.01 23.33 6.25 −1.13 −2.32 24.85
2013 2.92 22.32 6.29 −1.22 −2.77 27.83
2014 1.02 21.86 6.58 −2.67 −3.17 29.98
2015 −0.03 22.23 – −8.79 −3.56 –
2016 −0.56 20.66 – −0.95 −2.27 –
Source Same as Table 9
Notes See note to Table 9
Table 11 Important maroeconomic indicators for ASEAN 5

Year GDP growth Investment Terms of trade Current account Inflation
(%) (constant (% of (annual % balance (% of (average
prices) GDP) change) GDP) consumer
prices)
2007 6.24 26.27 3.91 4.59 4.74
2008 5.35 28.39 4.30 2.19 9.13
2009 2.42 25.67 −3.40 4.82 3.28
2010 6.91 28.60 1.51 2.64 4.49
2011 4.72 28.58 −0.20 2.55 5.79
2012 6.20 29.59 −0.92 0.32 3.82
2013 5.06 28.97 0.48 −0.18 4.61
2014 4.60 28.43 0.28 1.09 4.63
2015 4.76 24.49 2.07 1.55 3.29
2016 4.83 29.39 −0.27 1.23 2.47
Source IMF World Economic Outlook Database
Notes See note to Table 9
2.3 Policies in the UK
We now discuss some of the measures taken by the Bank of England (BoE) and the
UK Treasury to manage the crisis. Our reason for discussing the UK case separately
is that the UK is a member of the European Union but not of the Eurozone. As such
it enjoys virtual autonomy in its monetary policy measures, though as a member of
the EU, it is bound by the fiscal provisions of the Stability and Growth Pact.
Table 12 GDP growth rate (%) of selected countries in Asia and Pacific (pre and post-crisis)
Australia New Japan Korea Indonesia Malaysia Thailand Singapore Hong
Zealand Kong
(SAR)
2007 3.75 2.86 2.19 5.46 6.34 6.30 5.44 9.11 6.46
2008 3.71 −1.31 −1.04 2.83 6.01 4.83 1.73 1.78 2.12
2009 1.82 −0.54 −5.52 0.71 4.62 −1.51 −0.74 −0.60 −2.45
2010 2.01 1.37 4.71 6.49 6.22 7.43 7.51 15.24 6.76
2011 2.38 2.69 −0.45 3.68 6.17 5.29 0.83 6.20 4.81
2012 3.63 2.74 1.74 2.29 6.03 5.47 7.23 3.67 1.7
2013 2.44 1.58 1.36 2.90 5.56 4.71 2.70 4.67 3.07
2014 2.50 3.17 −0.03 3.34 5.02 5.99 0.82 3.26 2.61
2015 2.26 3.39 0.47 2.61 4.79 4.95 2.82 2.01 2.36
Source World Bank Database
Table 13 Volume of exports of goods and services (% change) and exchange rates in ASEAN 5
Exchange rates (national currency units per US$) Volume of exports of
goods and services
(annual % change)
Indonesia Malaysia Thailand Philippines Singapore ASEAN 5
(IDRs per $) (MYRs (THBs (PHPs to $) (SGDs to $)
per $) per $)
2007 9141.00 3.44 34.51 46.15 1.50 14.71
2008 9698.96 3.34 33.31 44.32 1.41 6.88
2009 10,389.94 3.53 34.29 47.68 1.46 −8.50
2010 9090.49 3.22 31.69 45.11 1.36 20.97
2011 8770.43 3.06 30.49 43.31 1.26 12.09
2012 9386.63 3.09 31.08 42.23 1.25 4.51
2013 10,461.24 3.15 30.73 42.45 1.25 6.81
2014 11,865.21 3.27 32.48 44.40 1.27 6.19
2015 13,389.41 3.91 32.25 45.50 1.38 −0.60
Source (i) World Bank Data Tables for Exchange Rates and
(ii) IMF World Economic Outlook Database for ASEAN 5 exports
IDR Indonesian rupiah; MYR Malaysian ringgit; THB Thai baht; PHP Philippine peso; SGD Singapore dollar
As the financial crisis erupted in 2007, like most central banks, the BoE was also
concerned with ensuring liquidity support to its financial system, so that industry
was not starved of credit. Like the Fed, the BoE’s initial response was also to cut
the policy interest rate (bank rate) from 5.75% in July 2007, to 5.5% in December
2007 to a low of 2.0% at the end of December 2008 and a further cut to 0.5% in
March 2009. With little scope for further reduction, the BoE resorted to quantitative
easing (QE) measures. The first step in the direction of QE was taken in January
2009, with the Chancellor of the Exchequer authorizing an Asset Purchase Facility
(APF) under which the BoE could buy high-quality assets (gilts and corporate
bonds) financed by the issue of Treasury bills. This was followed on 5 March 2009,
with the BoE announcing its intention of purchasing ₤75 billion in long- and
medium-term gilts over the next 3 months. In another three weeks (on 25 March
2009), the BoE commenced purchases of corporate bonds under its APF.
Specifically targeting credit markets, it also began purchases of commercial paper
and later corporate bonds through this specially created Asset Purchase Facility.
Between January 2009 and January 2010, under QE, the BoE purchased
£200 billion of assets (mostly medium and long-dated gilts). Further QE operations
were not undertaken till 10 October 2011, when an additional gilt purchase of
₤75 billion was announced over the next 4 months. At its meeting on 1st August
2013, the Monetary Policy Committee (MPC) resorted to forward guidance by
promising to maintain the prevailing level of the bank rate at 0.50% and the overall
stimulative monetary policy stance, at least until the unemployment rate fell to the
benchmark level of 7%, or inflation breached the 2% target (see Joyce et al. 2011;
Fawley and Neeley 2013, etc.).
As in the US, monetary policy measures were sought to be supported by fiscal
stimuli in the UK. Throughout 2008, a number of fiscal measures were introduced,
including a £145 tax cut in the basic income tax rate, a temporary cut in VAT
taxation rate from 17.5 to 15% until 2010, and various other measures intended to
support investment in the real estate sector, so as to sustain employment via job
creation in construction activities. Additionally, the government also introduced a
₤20 billion Small Enterprise Loan Guarantee Scheme. Altogether, the total size of
the fiscal stimulus was estimated at ₤31 billion (or about 2.2% of the 2008 GDP)
(see Commission of the European Communities 2008; Economist 2008).11 As is
evident from Table 6, nearly half of the fiscal stimulus was by way of tax cuts,
transfers to low-income households were slightly more than 20%, while infras-
tructure spending and direct labour market measures combined amounted to around
10%. After January 2009, the government found itself fiscally strapped (owing to
the large public burden of bank bailouts) with the fiscal deficit rising to 12.4% of
GDP in 2009–10.
The Conservative–Liberal Democratic coalition government which came to
power in May 2010 put an end to the fiscal stimulus package and embarked instead
on a fiscal consolidation program, which latter was continued by its successor
Conservative government elected in 2015.
11
While this measure of fiscal stimulus is the one officially adopted in the UK, the OECD (2009)
defines the fiscal stimulus differently (see the discussion in Chap. 5).
3 The Crisis and Asia 155
3 The Crisis and Asia
We first consider the case of the two Asian giants, viz. China and India, in some
detail and then pass on to a brief discussion of about the rest of Asia or more
specifically, the ASEAN 5.
3.1 China and the Global Crisis
Impact of the Crisis: Around the time that the global crisis erupted, China was
growing at an exceptionally high rate of 14.20% (see Table 14). With US
$1.3 trillion in exports, it was the world’s top exporter with exports accounting for
30% of its GDP. As Table 14 shows, Chinese growth slipped somewhat in 2008
and 2009 (to 9.60 and 9.20%, respectively) before recovering in 2010. While the
impact seems considerably muted as compared to some other countries in the region
(such as Japan, Singapore, Korea, Thailand and Malaysia), its presence cannot be
denied.
The impact operated through several of the channels discussed above. The asset
prices channel went into effect immediately, with the stock market crash in
mid-November 2007. The Shanghai Stock Exchange (SSE) Composite Index,
which had risen more than threefold over its level 18 months ago, reaching a peak
of 6124.04 on 16 October 2007, dropped precipitately over the next few months to
2651.61 at the end of June 2008 (see Yao and Luo 2008). Over this period, the
combined market value of Shanghai Stock Exchange (SSE) Composite Index and
Shenzhen Stock Exchange (SZSE) slumped from 32.71 trillion RMB (renminbi) to
17.8 trillion RMB. Banking stocks were the worst performers (being the most
affected by the US financial mess), leading the overall decline (see Yao et al. 2008).
Foreign capital flows were another transmission channel, though the impact here
was not very pronounced. Financial institutions across the globe started posting
huge losses, as the crisis unfolded in the USA. This triggered a general loss of
investor confidence, resulting in recalling investment from EMEs and LDCs to the
“safe havens” of US and Europe (ironically, the regions at the epicentre of the
GFC). FDI to China grew as between 2007 and 2008, by about 9.8% to US
$171.53 billion, but then fell in 2009 to US$131.06 billion (see Table 14), a fall of
about 23.6%. However by 2010, FDI had rebounded well over its pre-crisis levels
(to US$243.70 billion).
The major impact on China was not so much through the financial channels, as
through the trade channel, which though quiescent at first, started biting once the
US and EU financial crises started spreading to their real sectors. As mentioned
above, Chinese exports were a leading engine of growth accounting for more than
30% of its GDP in 2007 and 2008. But by 2009, the sector started running into
difficulties, as demand for Chinese products started contracting in the advanced
countries. Exports’ (volume of goods and services) growth declined sharply from
156
Table 14 Important maroeconomic indicators for China

Year GDP growth Investment Unemployment Inflation FDI Domestic credit Volume of exports Current
(%) (% of (% of total (average (US$ to private sector of goods and account
(constant GDP) labour force) consumer billion) (% of GDP) services (% change) balance (% of
prices) prices) GDP)
2007 14.20 41.24 3.8 4.80 156.24 105.73 20.93 9.89
2008 9.60 43.21 4.4 5.90 171.53 101.92 10.64 9.13
2009 9.20 46.33 4.4 −0.70 131.06 124.21 −11.29 4.75
2010 10.61 47.88 4.2 3.30 243.70 126.30 25.64 3.92
2011 9.50 48.01 4.3 5.40 280.07 122.75 14.59 1.81
2012 7.90 47.18 4.5 2.65 241.21 128.50 5.88 2.51
2013 7.80 47.25 4.6 2.62 290.93 133.80 8.76 1.54
2014 7.30 46.68 4.7 1.99 268.10 140.15 6.91 2.63
2015 6.90 44.96 – 1.44 249.86 153.34 −1.83 2.96
2016 6.59 43.66 – 1.94 2.38
Source (i) IMF World Economic Outlook Database for all variables except unemployment rate and domestic credit to private sector, which are from the World
Bank Data Tables. (ii) The unemployment rates are estimated as per the methodology developed at ILO (2010) and reported in World Bank Data Tables
Notes ILO estimates, for China and India, are widely regarded as too low
20.93% in 2007 to 10.64% in 2008, before decelerating further to −11.29% in 2009

(see Table 14). Merchandise exports contracted even more sharply from 25.91 and
17.21% in 2007 and 2008, to −16.08% in 2009. Similarly high-technology exports
fell by more than 15% (from 2008 to 2009). However, exports recovered strongly in
2010. Exports of goods and services grew by 25.64% in 2010, and merchandise
exports recovered to well above (about 28.69%) their pre-crisis (2007) levels by
2010. High technology exports recorded a spectacular growth of 31.17% in 2010.12
However, some China analysts have maintained that the contraction in the
macroeconomy was not so much due to the decline in world demand for Chinese
exports as due to domestic investment suppression due to the massive inventory
destocking undertaken by Chinese manufacturing firms (in response to the collapse
of the international commodity markets in August 2008—see Mingchun 2009 and
Zhang 2009). This view is, however, contested by Johnson and Kwak (2009).
Monetary Policy: Chinese monetary policy was considerably eased, once it
became clear that the global crisis would be a long drawn out affair and could have
important repercussions for the Chinese economy. The PBOC (People’s Bank of
China) lowered its interest rates from 7.47% at the end of August 2008, in a series
of steps to 5.31% at the end of that year. It was maintained at this level till 30
September 2010, after which it was raised to 6.56% by July 2011. A downward
cycle was once again initiated in May 2012 which has brought down the rate to its
current (October 2016) level of 4.35%. As a result of the easy monetary policy
stance adopted towards the end of 2008, bank credit to the private sector surged by
7.3 trillion yuan13 or US$1.07 trillion (at the then prevailing rate of 1US
$ = 6.83 yuan) in the first half of 2009—compared with 3.63 trillion yuan for the
entire year 2007 (see Yongding 2009). As a proportion of GDP, bank credit to the
private sector rose to about 125% in 2009 and 2010, as compared to slightly above
100% in 2008 (see Table 14). As is well known, the PBOC had been engaging in
sizeable foreign exchange market intervention to resist the appreciation of the yuan,
but these interventions were usually sterilized almost fully, to prevent a liquidity
overhang. As noted by Yongding (2009), the sterilization post-intervention was
virtually suspended in the last quarter of 2008, and this led to a considerable
softening of the inter-bank interest rates. Meanwhile to support the easy money
stance, the CRR (cash reserve ratio) was brought down from 17% at the beginning
of 2008, to 15% at the end of that year. However, as inflationary pressures started
becoming evident towards the end of 2009, the CRR was raised successively,
reaching a peak of 21% in 2011 (which was also a high inflation year—see
Tables 14 and 15).14
12
Growth rates for merchandise and high-technology exports have been calculated from the World
Bank Database.
13
China’s currency is officially called the renminbi. The yuan is the unit of account.
14
The CRR currently stands at around 17% with inflation being well below the comfort zone of
2%.
Table 15 Fiscal stimulus (size and decomposition) for China and India countries
Country Fiscal Fiscal stimulus decomposition
stimulus Labour Tax cuts Transfers to Infrastructure Additional
size (% market (% of low-income spending (% measures to
of 2008 measures fiscal households of fiscal boost aggregate
GDP) (% of stimulus) (% of fiscal stimulus) demand (% of
fiscal stimulus) fiscal stimulus)
stimulus)
China 12.5 2.2 11.3 0 46.6 40.0
India 4.5 17.4 0 0 77.0 5.6
Table 16 Quarterly GDP (at market prices at constant prices) estimates for India over the crisis
years (rupees billion) (new series base: 2004–5)
Year Q1 Q2 Q3 Q4
2007–08 9750.12 9891.02 11,215.28 11,653.06
(10.81%) (9.14%) (10.54%) (8.82%)
2008–09 10,538.33 10,557.23 11,387.40 11,680.55
(8.08%) (6.73%) (1.53%) (0.2%)
2009–10 11,064.60 11,291.79 12,322.37 13,229.62
(4.89%) (6.95%) (8.21%) (13.26%)
Source Handbook of Statistics on the Indian Economy, Reserve Bank of India
Notes Figures in brackets represent the (%) growth of that quarter over the corresponding quarter
of the previous year
Fiscal Policy: A major advantage that China enjoyed over many of the advanced
as well as emerging economies was that it had considerable fiscal space at its
disposal. Its fiscal deficits as a percentage of GDP were contained within 3% since
2000. As a matter of fact, it ran a small budget surplus of 0.4% of GDP in 2007.
When the crisis struck in 2008, its budget deficit was simply 0.4% (of GDP), and
hence, it could announce a sizeable fiscal stimulus of 4 trillion yuan (or US
$575 billion) in the third quarter of 2008 (5 November 2008) for 2009 and 2010
(see Li et al. 2012). This fiscal stimulus was around 12.5% of the GDP (for 2008),
and its cotransfers to households, with taxmposition (as given in Table 16 and
based on the ILO estimates) shows that slightly less than half of it was devoted to
infrastructure spending, with tax cuts being the next significant item. However, the
ILO figures are not very revealing, since it is not clear what are the items figuring
under the omnibus term “additional measures to boost aggregate demand”.
An alternate taxonomy of the fiscal stimulus is given in McKissack and Xu
(2011) in which (i) infrastructure spending accounts for 2.87 trillion yuan (or
71.8% of the fiscal stimulus) composed of general infrastructure (1.50 tril-
lion yuan), Sichuan earthquake reconstruction (1.00 trillion yuan) and rural
infrastructure (0.37 trillion yuan), (ii) expenditure on technology and environment
is 0.58 trillion (14.5% of the fiscal stimulus), (iii) social expenditure amounts to
0.55 trillion yuan (13.75% of the stimulus), the bulk of which (0.40 trillion yuan)
was earmarked for construction and renovation of houses for low-income groups,
and the remaining (0.15 trillion yuan) allotted to social security and health.
Surprisingly, McKissack and Xu (2011) do not account for the tax cuts15 estimated
at around 150 billion yuan and financial assistance to state-owned enterprises
(SOEs) estimated at 500 billion yuan.
A further complication with the Chinese fiscal stimulus is that because banks are
state-owned, new bank loans and new bonds issued by SOEs should also be log-
ically considered as part of the fiscal stimulus. Reckoned this way, the actual
stimulus works out considerably larger at around 9.7 trillion yuan (comprising
1.7 trillion yuan of fiscal deficit, 7.25 trillion yuan of new bank loans and
0.58 trillion yuan of new bond issuance by SOEs) spread over 27 months from the
third quarter of 2008 to the last quarter of 2010 (see OECD 2011).
Fiscal multipliers for China have been estimated by a number of analysts. Cova
et al. (2010) derive multipliers within a dynamic general equilibrium multi-country
framework. Chinese fiscal multipliers for the existing fixed exchange rate regime
work out to be 2.62 for 2009 and 0.64 for 2010. The corresponding figures would
have been much higher (at 3.33 for 2009 and 0.93 for 2010) under the
counter-factual of the exchange rate being pegged to the US dollar (as the loose
monetary policy stance from the USA would exert pressures for a relaxed policy in
China too).16 Another set of fiscal multipliers for China is presented by Wang and
Wen (2013) employing an Structural Vector Autoregression (SVAR) methodology.
They find an impact multiplier of 2.68 which is very near the benchmark estimate
of Cova et al. (2010), but their peak multiplier at 5.55 and long run (total multi-
plier) at 4.86 are quite high.17
The Chinese fiscal multipliers are much higher than the fiscal multipliers for the
EU (see Table 3). This could be primarily on three accounts. Firstly, the timeliness
of the fiscal stimulus—In view of its strong fiscal position, China could put in place
a large stimulus as soon as the economy showed signs of stress (viz. in the third
quarter of 2008). Secondly, most of the expenditure on infrastructure was entrusted
to local governments, which could quickly initiate activity on infrastructure projects
(see Yongding 2009). Thirdly, the composition of the fiscal stimulus made an
enormous difference. As Table 3 (for the EU) makes evident, the expansionary
impacts of government investment are the highest, those of government con-
sumption come next, followed by transfers to households, with tax cuts having the
least impact of all. Exactly, the same features are exhibited in Table 7 of Chap. 5 for
the USA. Even though these results are for the advanced countries, evidence from
15
Tax cuts included increasing VAT rebates on exports, reducing the VAT on small firms, and
replacing the existing investment-type VAT with a consumption-type VAT (see OECD 2011).
16
Cova et al. (2010) also perform a simulation for the case where China follows a flexible
exchange rate policy while adopting a Taylor rule-based monetary policy stance. The fiscal
multipliers are now much lower at 1.83 for 2009 and 0.64 for 2010.
17
The impact multiplier, peak multiplier and total multiplier are defined in footnote 24 of Chap. 5.
other EMEs (see McKissack and Xu 2011; Wang and Wen 2013 for China and
Bose and Bhanumurthy 2013 for India) is in conformity with this broad pattern. In
the Chinese case as we have seen above, a large part of the fiscal stimulus was
earmarked for public investment in infrastructure, technology and environment,
while social expenditure and direct transfers to households and firms as well as tax
cuts were relatively less significant. Hence, it is more than likely that the compo-
sition of the fiscal stimulus was largely responsible for it playing a large part in the
fiscal stimulus playing a leading role in the Chinese recovery. However, the
stimulus has not been an unmixed blessing. A large part of the credit expansion
found its way into the real estate and stock markets, and inflationary pressures built
up around 2011 (see Table 14). The property bubble peaked in 2011 but started
deflating by the end of 2013, which some analysts see as an important reason for the
downturn in Chinese growth from 2013 onwards. Another problem created by the
easy monetary policy and fiscal stimulus was the asset quality of bank lending. In
2010, the Chinese government recapitalized state-owned banks to the tune of 380
billion yuan (about US$56 billion).
It is generally recognized that in conjunction with the easy monetary policy, the
fiscal stimulus was quite effective in staving off a major recession in China. As
Table 14 indicates, GDP growth, investment as well as FDI resumed their normal
trajectory in 2010 and 2011, after their somewhat depressed levels in the previous
two years. The moderation in growth experienced since 2012 has less to do with the
global crisis than with a structural transformation in the Chinese economy aimed at
a slower but more sustainable growth, in which the composition of the GDP is
expected to shift from industries to services, and there will be a rebalancing of the
economy in favour of consumption rather than investment (see Dizioli et al. 2016;
Cashin et al. 2016 etc.). Additionally, as mentioned above, the bursting of the
property bubble in late 2013 may also have had some role to play in the deceler-
ation of Chinese growth.
3.2 India in the Global Crisis
Impact of the Crisis: The Indian economy was exhibiting robust growth around the
time the crisis erupted. GDP had grown consistently over 9% in the three years
2005–06, 2006–07 and 2007–08. Dooley and Hutchinson (2009) have indicated
that the EMEs were largely insulated from the crisis till May 2008, after which the
global nature of the crisis started becoming apparent. This position is supported by
the quarterly GDP figures reported in Table 15, which show that Indian growth
started slipping in the first quarter of 2008–09 and then decelerated very rapidly in
the remaining quarters of that year as the Lehman blow struck in September 2008.18
However, there was a smart rally in the first three months of 2009, so that growth for the
18
financial year 2008–09 as a whole stood at a more decent 6.7% (see Viswanathan 2010, p. 48).
The crisis transmission to India was, in several respects, similar to the Chinese
case. As India’s integration into the global financial community had been very
cautious and gradual, the financial contamination was much less than in several
other EMEs. The exposure of the Indian banking system to foreign toxic assets was
estimated to be around $450 million in the aggregate ($90 million by public sector
banks and $360 million by private banks—see Chandrasekhar and Ghosh 2008;
Ghosh and Chandrasekhar 2009 etc.). But this is not to say that the financial system
was totally insulated from the crisis. The Indian stock market which had been
booming at the beginning of 2008 started displaying signs of stress in March of that
year, as foreign portfolio investors in a panic reaction to the US subprime crisis,
started withdrawing from emerging markets. In September 2008 (in the wake of the
Lehman crisis), the BSE SENSEX Index plummeted from its level of 19,325.7 in
January of that year to a low of 14,722.1 and was in a free fall till March 2009
bottoming out at 8995.5. After that, there was a marked recovery in equity markets,
but it was only in September 2010 that the SENSEX reached its pre-crisis levels.
Another important source of transmission is the inward flow of foreign capital
(see Reddy 2009). In the Indian case, as seen from Table 17, FDI (foreign direct
investment) inflows did not react immediately to the crisis, actually increasing in
the year 2008–09, though they declined significantly over the next two years. By
contrast, foreign portfolio investment (FPI) was far more volatile. There was a
precipitous fall in the crisis year 2008–09 followed by a strong recovery the next
year. If one takes a closer look at the monthly FPI figures (available from successive
issues of the RBI Bulletin), one finds that the inflows turned negative in February
2008 and remained negative throughout that year implying a total drain of US
$10.72 billion over the entire year. However, investors started returning by April
2009, and FPI remained robust till 2012–13, after which they declined once again
owing to the Euro crisis related investor phobia.
Table 17 India: foreign Year FDI FPI

direct investment (FDI), (Net) (Net)
foreign portfolio investment
(FPI) (US$ billion) 2006–07 7.693 7.060
2007–08 15.893 27.430
2008–09 22.372 −14.030
2009–10 17.966 32.396
2010–11 11.834 30.293
2011–12 22.061 17.170
2012–13 19.819 26.891
2013–14 21.564 4.822
2014–15 31.251 42.205
2015–16 36.021 −4.130
Source Handbook of Statistics on the Indian Economy, Reserve
Bank of India
The global credit crunch also adversely impacted the ability of Indian corporates
to raise cheap funds abroad. Funds raised by Indian corporates through American
Depository Receipts (ADRs) and Global Depository Receipts (GDRs) declined by
63% in 2008–09 compared to the previous year (see Rangarjan 2010; Kishore et al.
2011; Viswanathan 2010; Gupta 2009, etc.).
But as in the Chinese case, most of the transmission occurred via the trade
channel. There was a substantial contraction in the demand for merchandise imports
in the advanced economies during the crisis. North American imports from the Rest
of the World increased slightly (by about 7.5%) from 2007 to 2008, but then
declined from US$2.59 trillion in 2008 to US$1.93 trillion in 2009—a fall of
25.48%. The pattern was similar for the Euro Area and the OECD group of
countries where the decline as between 2008 and 2009 was 24.26% (US
$4.70 trillion to US$3.56 trillion) and 24.68% (US$11.00 trillion to US$8.28 tril-
lion). Reflecting this contraction in global demand, India’s merchandise exports
declined by 15% between 2008 and 2009. Exports of goods and services which had
been growing rapidly at about 18.49% in 2007 decelerated to 6.86% in 2008 and
actually declined by 2.40% the next year (see Table 19).
Further, as the job market shrank in the advanced crisis-affected countries and
incomes contracted, there was a significant effect on the “invisibles” item in India’s
balance of payments. Invisible transactions are classified into three categories:
(i) the first component is services comprising travel, transportation, insurance,
government not included elsewhere (GNIE) and miscellaneous. Miscellaneous
services include apart from software (which is the major component) communi-
cation, construction, financial, news agency, royalties, management and business
services. (ii) The second component of invisibles is income, defined to include both
payments and receipts—payments on account of non-residents employed in India,
interest payments made to those who have deposited FCNR deposits and interest
charges on loans made to India, besides dividends and profit share to investors in
India with receipts defined correspondingly. (iii) Transfers (grants, gifts, remit-
tances, etc.) which do not have any quid pro quo form the third category of
invisibles. This item is usually decomposed further into private and official trans-
fers. A major part of private transfers is accounted for by NRI remittances.
Table 18 presents a break-up of “invisibles” by category. From the table, it is
immediately evident that the two dominating items are miscellaneous services and
private transfers. During the crisis years, “invisibles” did not decline with imme-
diate effect in 2008–09, but declined substantially for the next two years. Contrary
to a popular misconception, it was not NRI remittances which contributed to the
decline. The decline was almost entirely attributable to the category “Miscellaneous
services” (primarily software exports) which declined by nearly US$20 billion as
between 2008–09 and 2009–10 (a decline of 37%). As a matter of fact, private
transfers (of which, as noted above remittances form the most important con-
stituent) actually increased during the two years 2009–10 and 2010–11 and pro-
vided some cushion to the decline in “invisibles”, stemming mainly from the
miscellaneous services category.
Table 18 India: invisibles by category (US$ billion)

Year Invisibles Non-factor services (Net) Income Private Official
(Net) (Net) transfers transfers
(Net) (Net)
Travel, GNIE Misc. Total
transport non-factor
and services
insurance (Net)
2005–06 42.002 −0.851 −0.215 24.236 23.170 −5.855 24.49 0.194
2006–07 52.217 2.898 −0.150 26.721 29.469 −7.331 29.83 0.254
2007–08 75.730 1.185 −0.045 37.712 38.853 −5.068 41.71 0.239
2008–09 91.604 0.252 −0.404 54.069 53.916 −7.110 44.57 0.232
2009–10 80.022 2.067 −0.084 34.033 36.015 −8.038 51.79 0.254
2010–11 79.269 5.679 −0.285 38.687 44.081 −17.952 53.13 0.016
2011–12 111.604 7.692 −0.302 56.707 64.098 −15.988 63.47 0.025
2012–13 107.493 9.522 −0.239 55.632 64.915 −21.455 64.34 −0.309
2013–14 115.313 9.705 −0.490 63.851 73.066 −23.028 65.48 −0.205
2014–15 118.081 7.420 −0.418 69.526 76.529 −24.140 66.26 −0.572
2015–16 107.928 6.252 −0.291 63.716 69.676 −24.375 63.14 −0.512
Source Handbook of Statistics on the Indian Economy, Reserve Bank of India
The deterioration in merchandise exports and invisibles over the years 2008–09
and 2009–10 was reflected in an increasingly adverse current account balance
beginning in 2008 and continuing right through 2012 (see Table 19). In conjunction
with the FPI inflows turning negative in 2008–09 (see Table 18), these develop-
ments put the rupee under considerable pressure, leading to a 17% depreciation in
its value as between 2007 and 2009. The decline would have been even more
pronounced if the RBI not intervened in the foreign exchange market to shore up
the sagging currency.19
The crisis also contributed to the steep fall in total investment over the three
successive years 2008, 2009 and 2010 had shown in Table 19. In absolute terms,
gross domestic capital formation declined from Rs. 16,568.92 billion in 2007–08 to
Rs. 15,703.33 billion in 2008–09 (a decline of 5.22%), while the decline in net
domestic capital formation (over the same period) was double at 10.40%.20 Total
investment (as a percentage of GDP) declined from 38.11% in 2007 to 34.31% in
2008, recovered somewhat in the next two years, but did not revert to its pre-crisis
level till 2011 (see Table 19). As a result, growth for the year 2008 plummeted to
3.89%. Other macroeconomic parameters deteriorated in 2008 too (see Table 19).
19
According to available estimates the extent of intervention was to the tune of US$60 billion.
20
This data are taken from the RBI Handbook of Statistics on the Indian Economy.
164
Table 19 Important maroeconomic indicators for India

Year GDP Total Unemployment Inflation Domestic credit Volume of exports of Current Rs-US$
growth (%) investment (% of total (average to private sector goods and services account exchange
(constant (% of labour force) consumer (% of GDP) (annual % change balance (% rate (Rs per
prices) GDP) prices) of GDP) 1 US$)
2007 9.80 38.11 3.7 5.93 46.22 18.49 −1.27 41.35
2008 3.89 34.31 4.1 9.20 50.66 6.86 −2.28 43.51
2009 8.48 36.48 3.9 10.61 48.78 −2.40 −2.81 48.41
2010 10.26 36.50 3.5 9.50 51.14 25.42 −2.81 45.73
2011 6.64 39.58 3.5 9.54 51.29 10.51 −4.29 46.67
2012 5.62 38.26 3.6 9.93 51.85 1.01 −4.80 53.44
2013 6.64 34.66 3.6 9.44 52.20 4.63 −1.73 58.60
2014 7.24 34.09 3.6 5.93 51.80 4.37 −1.31 61.03
2015 7.56 32.37 – 4.91 52.62 −3.98 −1.07 64.15
2016 7.62 31.67 – 5.49 – 5.88 −1.42 67.18
Source (i) IMF World Economic Outlook Database for all variables except unemployment rate, S & P Global Equity Index and domestic credit to private
sector, which are from the World Bank Data Tables
(ii) The unemployment rates are estimated as per the methodology developed at ILO (2010) and reported in World Bank Data Tables
Notes ILO estimates, for China and India, are widely regarded as too low
Inflation, in particular, rose to 9.20% (from the modest level of 5.93% in the
previous year) and remained elevated right through to 2012. The inflationary
pressures as well as the deterioration in the balance of payments and the exchange
rate were attributable partly to the global crisis, but also partly to the steep
appreciation in international commodity prices (including fuel as well as non-fuel
items) which remained elevated from 2008 right up to 2014.
The major social costs of a recession are those associated with job losses and
lay-offs. However, assessing the employment impacts of the crisis presents several
difficulties as estimates of job losses made by different agencies vary considerably.
According to a survey conducted by the Ministry of Labour and Employment (see
Government of India 2009), the last quarter of 2008 witnessed 500,000 (5 lakhs)
job losses. The most affected sectors were gems and jewellery, transport and
automobiles where the employment is estimated to have declined by 8.58, 4.03 and
2.42%, respectively, during the period Oct–Dec, 2008. In the textile sector, the
retrenchment was lower at 0.91%. The major impact of the slowdown showed itself
in the export-oriented units. As the sampling frame used for this survey is that of the
ASI, the job losses may be taken to refer to those in the organized sector.
Considering that about 86% of the labour force in India belongs to the unorganized
sector (see NCEUS 2009b), the total job losses are likely to be in the region of
3 million at a rough reckoning.
A more recent UNCTAD Report (2013) places the total job losses due to the
crisis at 11.66 lakhs in 2008–09 and 13.30 lakhs in 2009–10 or total job losses of
nearly 2.5 million over the two years. The Report further identifies three sectors
which were particularly affected, viz. gems and jewellery, ores and minerals and
textile products. The Report also notes a shift of a part of the displaced labour force
to agriculture (about 5.3 lakhs) and plantations (about 16.9 lakhs), which possibly
acted as a sort of cushion or shock absorber. Another valuable source of infor-
mation on the post-crisis unemployment scenario is provided by the ILO (2009).
Considering three alternative scenarios,21 the Report projects an increase in
unemployment ranging from 4 million to 17 million for South Asia over the period
year-end 2007 to year-end 2009. Unfortunately, the ILO report does not present
separate estimates for individual countries in South Asia, but considering that about
75% of the total employment in South Asia in 2010 was located in India (see World
Bank 2012; Chap. 3), we could tentatively put the range of increase in unem-
ployment in India anywhere between 3 million and 12 million. The lower figure
looks more reasonable, and it is in conformity roughly with the UNCTAD and the
Ministry of Labour and Employment (Government of India) figures mentioned
above.
21
The three alternative scenarios are (i) trend analysis (optimistic scenarios), (ii) incorporating the
special employment coefficients likely to prevail during crises (medium scenario) and (iii) addition
to the 2007 unemployment rate a flat 0.5% (largest recorded annual increase since 1991) (pes-
simistic scenario).
A major contribution of the ILO report is that it highlights the need to look
beyond unemployment rates per se, to get a more accurate assessment of the social
distress caused by the crisis. It introduces two supplementary concepts (i) working
poverty referring to people who are in jobs, but whose incomes fall below a
threshold level of US$1.25 per day22 and (ii) vulnerable employment is defined
rather loosely as “the sum of the employment status groups of own account workers
and contributing family workers. They are less likely to have formal work
arrangements and are therefore more likely to lack decent working conditions,
adequate social security and ‘voice’ through effective representation by trade unions
and similar organizations. Vulnerable employment is often characterized by inad-
equate earnings, low productivity and difficult conditions of work that undermine
workers’ fundamental rights” (UN 2015a, b).
Typically, in a crisis, the vulnerably employed workers are likely to be the first
to be retrenched. Simultaneously, workers laid-off from their regular jobs may fail
to find re-employment in other regular jobs, even if they are willing to accept wage
cuts. In countries like India, with no unemployment insurance, these laid-off
workers are forced to join the ranks of the vulnerably employed at lower wages,
pushing down the already low wages there, sometimes even below the threshold of
$1.25 per day. Thus, we have some kind of a downward employment spiral, with
the regular workers shifting to the vulnerable section, and the latter either tending to
working poverty or joining the ranks of the unemployed poor.
In the Indian context, the National Commission for Employment in the
Unorganized Sector (NCEUS) had given several pointers to the government as to
how the crisis would affect employment in the unorganized23 sector (see NCEUS
2009a). In particular, it identified four specific effects: (i) firstly, small producers
and traders dependent upon export markets were badly affected in industries such as
handlooms, apparel, leather products, gems and jewellery, carpets, oil meals,
marine products. (ii) Secondly, the steep fall in international commodity prices over
2008–09 (see Table 8) had impinged on small producers’ incomes via import
competition as well as depressed prices in sectors like cotton and oilseeds pro-
duction. (iii) Thirdly, bank credit to the commercial sector as a whole shrank
considerably immediately after the crisis (see below), and it almost froze for the
unorganized sector. Even before the crisis, the share of the unorganized sector in
formal credit was miniscule at between 5 and 7%. After the crisis, the share was a
22
The ILO also uses a higher threshold of US$2 per day, but the lower threshold is the one used by
the World Bank as its definition of the poverty line. The Indian definition of the poverty line at Rs.
27 for rural areas and Rs. 33 for urban areas is even lower than the lower threshold of US$1.25
considered by the ILO in its report.
23
The NCEUS definition of the unorganized sector as “all unincorporated private enterprises
owned by individuals or households engaged in the sale and production of goods and services with
less than 10 total workers” implies that employment in this sector would be considered “vulner-
able” according to the ILO definition.
mere 1.2% (see NCEUS 2009a). (iv) Finally, there is the domino dependence of the
unorganized sector on the organized sector, as the latter constitutes about 70% of
the market demand for the former’s output (see Nachane 2009).
The Indian policy response in the aftermath of the crisis was addressed to three
concerns, viz. (i) revival sans stagflation, (ii) erecting firewalls around the financial
sector and (iii) building safety nets for the vulnerable sections of the population.
With this end in view, the Indian government pursued a three-pronged strategy, viz.
(i) easing monetary and liquidity conditions, (ii) adequately capitalizing the banking
system and (iii) fiscal stimuli. It should be noted that funds for capitalization of
nationalized banks come from the government fisc and is properly regarded as part
of the fiscal stimulus. We therefore consider this aspect as a component of fiscal
measures.
Monetary Policy: On the monetary policy front, the repo rate was reduced in a
succession of steps from 9% in September 2008 to 4.75% in April 2009, at which
level it was maintained till March 2010, when an upward interest rate cycle was
initiated. Correspondingly, the cash reserve ratio (CRR) was reduced from a high of
9% in August 2008 to 5% in January 2009, at which level it was pegged till
February of the next year. The statutory liquidity ratio (SLR) was lowered by 1–
24% in November 2008.24 These measures in combination were estimated to have
released more than Rs. 4 lakh crores (US$80 billion at the then prevailing exchange
rate) into the system. However, this massive liquidity injection failed to revive the
sagging credit demand. Bank credit which had grown at a healthy rate of 21% in
2007–08 grew at 16.9% in 2008–09, the third quarter of 2008–09 (viz. Oct–Dec.
2008) exhibiting a particularly low off-take (see RBI Press Release dated 4 March
2009). This low credit off-take in 2008–09 was partly a reflection of low aggregate
demand in the crisis aftermath, but partly also of the credit rationing by banks,
rendered overcautious in an uncertain business environment (see Nachane 2009;
Bhattacharya 2009).
Fiscal Stimuli: Turning to the fiscal stimuli, we find considerable controversy
regarding its measurement. The ILO figure of about 4.5% of the 2008–09 GDP (see
Table 5) is considerably higher than the 3% figure that is given in Subbarao (2009).
Bajpai (2011) equates the fiscal stimulus with the difference between the actual
(gross) fiscal deficits for the years 2007–08 (Rs. 1269.12 billion) and 2008–09 (Rs.
3369.22 billion), which as a proportion of the 2008–09 GDP works out to be about
3.9% and is thus not very far from the ILO figure. There is, however, a further
complication here. In February 2008, the government had announced several
measures designed to stimulate aggregate demand including schemes to support the
rural employment guarantee scheme (MNREGA), rural infrastructure (Bharat
Nirman), farm loan waivers, fertilizer subsidies, etc. (see Kumar and Vashisht
24
In some back-tracking, the SLR was raised again in November 2009 to 25% and then restored to
24% in December 2010. Since then it has been continuously lowered and as of January 2017
stands at 20.75%.
2009). Together, the expenditure on these schemes accounted for about 3.7% of the
2008–09 GDP. Since the decision on these schemes was taken before the crisis
advent in India, these measures cannot be properly considered as a part of the fiscal
stimulus undertaken in response to the crisis,25 though it cannot be denied that they
played a part in propping up rural consumption and investment demand during the
crisis.
There were three fiscal stimuli undertaken in direct response to the crisis. The
first of this (announced on 7 December 2008) involved a 4% across the board cut in
excise duty (implying a loss of Rs. 8700 crores to the government exchequer) and
expenditure on infrastructure, housing, textiles, etc., and subsidies to exporters on
their interest costs. The total stimulus was estimated at Rs. 30,700 crores. The
second stimulus package (2 January 2009) was mainly directed at insulating the
financial sector from the adverse developments abroad. To this end, it earmarked Rs
20,000 crores for bank capitalization of the Tier-1 capital of several public sector
banks (for details see Acharya 2012). Further, with a view to support infrastructure
financing, the public sector company Indian Infrastructure Finance Company (IIFC)
was allowed to borrow Rs. 30,000 crores from the market by issuing tax-free bonds.
The third and final fiscal stimulus (24 February 2009) involved a 2% reduction in
both the central excise duty (from 10 to 8%) and service tax (from 12 to 10%).
Further, the earlier 4% cut in central excise duty announced in Dec. 2008 was
extended beyond March 31, 2009. An additional measure was the exemption of
naphtha imports for power generation from customs duty. Taken together the
measures under the third stimulus implied a loss to the exchequer of Rs. 29, 100
crores. Taken together, the three fiscal stimuli amounted to about Rs. 109, 800
crores (about 2.1% of the GDP in 2008–09).
Thus, we have a rather wide range for the estimates of the Indian fiscal stimulus.
Confining our attention only to the three officially announced fiscal stimuli between
December 2008 and February 2009, we get an estimate of 2.1% of the GDP. If to
this we add the additional pre-crisis stimuli announced in February 2008 but taking
effect in 2008–09, we get a total estimate of 5.8%. The other estimates range
between these two extremes viz. 3% (Subbarao 2009), 3.9% (Bajpai 2011) and
4.5% (ILO-EC-IILS 2011).
How effective were the fiscal stimuli in stimulating aggregate demand? Detailed
estimates of fiscal multipliers for various categories of government expenditure are
available in Bose and Bhanumurthy (2013), Jain and Kumar (2013) and Goyal and
Sharma (2015). The impact multiplier for capital expenditure ranges from a low of
0.22 obtained by Goryal and Sharma (2015) to a high of 2.45 given in Bose and
Bhanumurthy (2013). For revenue expenditure, estimates of the impact multiplier
are slightly below 1.00 for Bose and Bhanumurthy (2013), whereas the other two
25
Note that the way Bajpai (2011) has defined the stimulus incorporates this component. The ILO
definition also seems to include some part of this pre-crisis outlay.
studies place it much lower at around 0.35. Interestingly, Bose and Bhanumurthy
(2013) also present separate impact multipliers for various categories of revenue
expenditure and tax cuts.26 The cumulative capital expenditure multiplier (after
2 years) is around 2.35 in Goyal and Sharma (2015) and around 3.6 (after 2 years)
in Jain and Kumar (2013) and 4.8 (after 7 years) in Bose and Bhanumurthy (2013).
While the studies differ in their methodology and estimates, they unanimously
reinforce the role of government capital expenditure in propping up aggregate
demand.
Overall, the policy measures taken by the government must be regarded as fairly
successful in staving off the worst consequences of the crisis. As a matter of fact,
the Indian economy rebounded smartly in 2010 with a double-digit growth rate and
a sharp upturn in both exports and foreign portfolio investment (see Tables 18 and
19). Reflecting these developments, the Indian rupee also appreciated sharply.
However, inflation continued to be high, partly in response to the aggregate demand
stimulus and partly in response to the rising world commodity prices. The RBI had
to go into an inflation-fighting mode, raising the repo rate from 4.75 to 5% in March
2010 and then successively in five steps of 25 bps each to reach 6.25% at the end of
that year. The upward cycle continued, and the rate reached a maximum of 8.50%
in October 2011. Simultaneously, the gross fiscal deficit which had been at a
comfortable 2.54% of GDP in 2007–08 shot up to 5.99 and 6.46% in the next two
years as a result of the fiscal stimuli. Exports growth in goods and services which
had been at a high of 25.42% in 2009 more than halved to 10.51% in 2010 and
virtually stagnated in 2011 (see Table 19), in view of the tepid nature of the global
recovery. However, the uncertain global investment led to foreign investors rolling
back their exposures to EMEs including India. FPI declined from US$30.29 billion
in 2010–11 to US$17.17 in 2011–12, improved somewhat in 2012–13 but then
nosedived to a trickle of US$4.82 billion in 2013–14 (see Table 17). The current
account balance (as a percentage of GDP) reached its nadir of 4.8% in 2012.
Matters were compounded by the downgrading of India’s sovereign credit rating by
Standard & Poor from BBB+ (stable) to BBB− (negative) in April 2012.
This set the stage for a significant setback to the recovery process in the next few
years. A stagflationary sort of situation prevailed till 2013, with the growth impulse
subdued and inflation remaining elevated. The year 2014 marked a turnaround with
inflation showing signs of definite softening and growth set to revive. This benign
trend has been continued right up to the current year (2016).
3.3 Crisis and ASEAN 5
The impact of the crisis on the rest of Asia on the one hand showed a certain
uniformity of pattern, with the region as a whole (as well as individual countries)
26
These are respectively 0.98 for transfer payments, 1.01 for personal income tax cuts, 1.02 for
corporate taxes and 1.08 for a goods and services tax.
experiencing a sharp drop in GDP from 2007 to 2009, but a smart recovery
thereafter. GDP growth in the East Asian and Pacific country group fell from 6.71%
in 2007 to 3.58% in 2008 and bottomed out at 1.32% in 2009, before recovering to
more than its pre-crisis level to 7.27% in 2010. A similar pattern is evident for the
ASEAN 5 (see Table 11). On the other hand, the peak to trough adjustment varied
quite a bit among the countries of the region. This is brought out in Table 12, where
the GDP growth rates in selected Asian and Pacific economies (except India and
China which are discussed separately later) are displayed over the period 2007–
2015.
The post-crisis developments in Asia seriously questioned the theory that Asian
economies had “decoupled” from the USA and EU. Apart from the GDP growth
rates, several other parameters also seemed to indicate a strong effect of the crisis on
the Asian situation. Focusing on the ASEAN 5 group, as broadly representative of
the Asian emerging markets (except China, Japan and India), we find that the S & P
Global Equity Index declined substantially between 2007 and 2008 before staging a
strong recovery in 2009.27 The decline in exports of the ASEAN 5 group as a whole
and the exchange rates for the five constituent countries separately are shown in
Table 13. It is seen from that Table that ASEAN 5 exports declined by over 8%
from 2007 to 2008 and by a further 8% the next year—an overall decline of 16% in
the wake of the crisis (2007–09). For the wider group of Emerging and Developing
Asia,28 the decline was similar (over 15%).29 The behaviour of the exchange rates
needs some explanation. While the Indonesian rupiah (IDR) depreciated by about
13.5% over the crisis years 2007–09, the decline in the Malaysian and Philippines
currency was marginal (around 3%), while the Thai baht and Singapore dollar
actually appreciated. Since 2009 and right up to 2014, all the ASEAN 5 currencies
(except the Indonesian rupiah) have been continuously appreciating (see Table 13).
This rather unexpected behaviour of the ASEAN 5 currencies is attributable to the
“hot money” flows associated with near-zero interest rates in the USA, Europe and
Japan, along with the huge QE programs in these countries. Investors profited from
the “carry trades” operating on the interest rate differentials between these advanced
country financial markets and those in the Asian economies. Thailand’s real estate
markets, in particular, served as a strong attraction. FDI to Thailand increased
substantially and the stock market as measured by the SET index, nearly quadru-
pled as between August 2008 and August 2013.
27
In Indonesia, the index declined by 61% in 2008, while the decline (for the same year) was much
less (about 43%) for Malaysia, and between 50 and 55% for the other three economies, viz. the
Philippines, Singapore and Thailand.
28
This group comprises the following countries: Afghanistan, Bangladesh, Bhutan, Brunei
Darussalam, Cambodia, China, Fiji, India, Indonesia, Kiribati, Laos, Malaysia, Maldives,
Myanmar, Nepal, Pakistan, Papua New Guinea, Philippines, Samoa, Sri Lanka, Thailand, East
Timor, Tonga, Vanuatu and Vietnam.
29
As calculated from the IMF World Economic Outlook Database.
For the situation over the crisis years 2007–10 for Asian countries in general,
several informative accounts are available (see particularly Filardo 2011;
Athukorala and Chongvilaivan 2010; IMF 2009b, etc.).
4 Crisis and the African Continent
So far as the Third World was concerned, the crisis from the USA and Europe was
transmitted, not so much by financial contamination and asset price comovements
as by the other three routes. The most significant channel was the trade channel,
whereby many African countries suffered due to the fall in export demand as well as
the decline in prices of primary commodities.30 Some African countries that were
heavily dependant on remittances witnessed a sharp drop in this inflow. Remittance
flows to sub-Saharan Africa as a group declined from US$28.5 billion to
US$27.23 billion in 2009 (or by about 4.5%), but in some individual countries the
decline was much steeper (e.g., in Botswana remittances in 2009 at
US$15.21 million were nearly one-third of its 2008 level and one-sixth of the level
in 2007).
In the wake of the crisis, private capital flows to the region, mainly consisting of
foreign direct investment (FDI), have slowed to a trickle, hindering economies that
had been relying on these flows to finance much-needed infrastructure and natural
resource access projects. In sub-Saharan Africa, for example, FDI declined mod-
erately from US$38.91 billion in 2008 to US$36.58 billion in 2009 and then
steeply to US$28.328 billion in 2010. Countries like Kenya and Nigeria experi-
enced very sharp falls in FDI over the crisis years.31 This has had a serious impact
on infrastructural investment in several countries of the region. Combined with the
drying up of remittances, there were pronounced adverse effects on the current
account deficit as well as overall growth in Africa. The current account which was
showing a small surplus in 2007 and 2008 for sub-Saharan Africa turned negative
in 2009 and has continued to be in deficit thereafter, right up to 2016 (see Table 9).
The robust growth experienced by the continent in the pre-crisis quinquennium
was put into reverse gear. Sub-Saharan Africa was especially badly affected with
real GDP growth declining from a high of 7.08% in 2007 to 2.84% in 2009, before
staging a modest recovery in 2010. The experience of some individual countries
was particularly bad—GDP growth in Kenya declined sharply from 6.85% in 2007
to 0.23% in 2008 (recovering slightly to 3.30% in 2009), in Angola the decline was
even sharper (from 22.59% in 2007 to 2.41% in 2009) while in Botswana growth
30
During the second half of 2008, oil prices fell 69%, whereas non-energy commodity prices
dropped 38%.
31
In Kenya FDI contracted very sharply from US$0.73 billion in 2007 to US$0.09 billion in 2008,
while in Nigeria it fell from US$8.55 billion in 2009 to US$6.03 billion in 2010.
plunged from 8.68% in 2007 into negative territory in 2009 (at −7.65%).32 (see Ali
2009; African Development Bank Group 2009).
Most importantly, the crisis also severely affected the vulnerable sections of the
population operating through adverse shocks to the Four F’s (viz. fuel, fertilizers,
food and finance) (see Obiorah 2014). According to one estimate (Arieff et al.
2010), about 7 million people would be added to those living below the interna-
tional poverty line in Africa in 2009 and another 3 million in 2010 (see also IMF
2009c) as a consequence of the global crisis. The impact on poverty was possibly
further compounded by the effects of the 2008 food crisis, and the curtailment of
social safety nets as government revenues dropped. Additionally, it was estimated
that the crisis could be directly caused between 30,000 and 50,000 excess infant
deaths in Africa (see Baird et al 2011).
However, it must be noted that the overall development prospects in Africa were
far worse affected by the decline in oil and other commodity prices that set in
motion in 2014 and early 2015 (as well as lower demand from China—the largest
single trade partner of sub-Saharan Africa) than by the US financial crisis (see IMF
2015). This is evident from Table 9, which also shows the adverse turn in the terms
of trade for sub-Saharan African since 2013. The human costs of these setbacks
have yet to be fully evaluated.
5 Crisis and Latin America and The Caribbean
In the initial stages of the crisis, it appeared as though the Latin American and
Caribbean region would escape the worst consequences of the crisis. GDP growth
for the region slipped somewhat from 5.87% in 2007 to 4.01% in 2008. By the
second half of 2008, signs of trouble became evident. Foreign capital inflows
started declining, and foreign remittances were reduced as migrant workers were the
worst hit by the unemployment in US industry and construction activity. FDI to the
region declined sharply from US$217.86 billion in 2008 to US$153.06 billion in
2009, whereas private remittances from migrant workers abroad fell from US
$63.18 billion (in 2008) to US$55.48 billion next year. This had an adverse impact
on the current account which was in surplus in 2007 but turned into deficit after
2008. This deficit widened further over the period 2008–15 (see Table 10).
The GDP in the region which had been growing at slightly less than 4% in 2008,
actually declined in 2009, registering a negative growth rate (−1.82%) in 2009.33
Just as in sub-Saharan Africa, the consequences of the crisis were further accen-
tuated by the global commodity prices decline which set in motion in 2013 (see
32
All data is from the World Bank Database.
33
Mexico was particularly badly affected—GDP growth declining from 1.4% in 2008 to −4.7% in
2009. Brazilian growth was also badly affected (−0.12% in 2009 as compared to a little over 5%
the previous year).
5 Crisis and Latin America and The Caribbean 173
Table 8), which is also clearly reflected in the falling terms of trade for the region
since then (see Table 10) (see Guillen 2011; Jara et al. 2009, etc., for greater details
on the Latin American situation in the aftermath of the crisis).
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Chapter 7
Austrian Business Cycle Theory
and the GFC
Abstract The Austrian business cycle tradition owes its full-scale development to
the several writings of Hayek in the 1930s. It seems to have staged something of a
comeback in the wake of the Global Crisis, with many analysts believing that the
facts of the crisis seem to uncannily follow the pattern set out by the theory. The
general Austrian school philosophy is that market economies (grounded firmly in an
institutional setting of the rule of law and property rights) possess self-correcting
properties, and absent government intervention, are capable of weeding out any
inefficiencies and malfeasances in the system. In keeping with this thrust, inap-
propriate monetary and fiscal policies and over-lax regulation are seen as the key
factors in perpetrating the recent global crisis.
1 Introduction
The Austrian business cycle tradition dates back to von Mises (1934, [1912]), but
owes its full-scale development to the several writings of Hayek in the 1930s (see
Hayek 1931, 1933[1928], 1937 etc.). As an explanation of business cycles, it has
faced a remarkable vicissitude of fortunes. In the 1930s, it was widely regarded as a
major rival to Keynes’ General Theory (1936). As a matter of fact, the Keynes–
Hayek debates of that time have been characterized as “the clash that defined
modern economics” (Wapshott 2011). However, the intellectual triumph of the
Keynesian school and the large successes attributable to Keynesian policies adopted
in the Western world in the two decades succeeding World War II meant a cor-
responding eclipse of the Austrian school. As a matter of fact, we find Milton
Friedman dismissing the Austrian theory as not only an unsuccessful theory, but a
pernicious one (see his interview with Jeff Scott reproduced in Scott 1998). “I think
the Austrian business-cycle theory has done the world a great deal of harm. If you
go back to the 1930s, which is a key point, here you had the Austrians sitting in
London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop
out of the world. You’ve just got to let it cure itself. You can’t do anything about it.
You will only make it worse. You have Rothbard saying it was a great mistake not

https://doi.org/10.1007/978-81-322-3920-8_7
178 7 Austrian Business Cycle Theory and the GFC
to let the whole banking system collapse. I think by encouraging that kind of do-
nothing policy both in Britain and the United States, they did harm”. In a similar
vein, Krugman (1998), dubbed it “a hangover theory”.
However, the Austrian theory seems to have staged something of a comeback in
the wake of the GFC, with many analysts believing that the facts of the crisis seem
to uncannily follow the pattern set out by the theory (see Tempelman 2010).
2 Haberler’s “Hydraulic” Version of the Austrian Theory
We first set out the main elements of the Austrian theory as presented in the early
account of Haberler (1963) [1937]. The reasons for describing this version in detail
are that it has provided the proverbial straw man for modern-day critics of the
Austrian theory to shoot down. Central to the Austrian theory is the concept of the
natural rate of interest, as the rate at which the supply of loanable funds matches
the demand. 1 An increase in credit creation by banks leads to an increase in the
supply of loanable funds, shifting the supply curve outwards as in the figure (see
Fig. 1). This leads to a fall in the market rate of interest to r below the natural rate r
leading to a rise in investment by AB, while simultaneously desired savings con-
tract by AC. This gap between desired investment and saving (viz. CB) is bridged
via “forced savings” brought about by the credit expansion in the manner described
below.
The increase in bank credit, while making additional funds available to, also
misleads them to believe that the supply of savings has increased, i.e. that there is a
shift in consumers’ time preference for future over present goods. This induces
businesses to invest more in the production of capital goods (“higher order goods”
in the Austrian terminology), relative to consumer goods. Under conditions of full
employment, such a diversion of resources leads to greater production of capital
goods at the expense of consumer goods, resulting in a relative price shift in favour
of consumer goods. The rise in the prices of consumer goods leads to a restriction of
consumption or what Austrians refer to as “forced saving”.
Meanwhile, another process is also set in motion. The new bank credit percolates
from capital goods producers to wage earners and rentiers, who (with some lag)
direct this flow into demand for consumer goods, pushing up the prices still further.
The fundamental source of the problem, according to the Austrian theory is that the
artificial boom induced by the forced savings is unsustainable. This is because,
whereas the pattern of production has changed, nothing has happened to alter the
time preference of consumers. Thus, the actual production of capital goods exceeds
the demand for them, so that there is “overinvestment” in capital goods. The
1
It is assumed that savings respond positively to the interest rate, while decisions to borrow are
related negatively to the rate. Thus, the natural rate of interest rate is that which equates desired
savings to investment.
2 Haberler’s “Hydraulic” Version of the Austrian Theory 179
SS
SS’
Real rate
of
interest
E
re (Natural rate)
r (Market rate)
E1
E2
0 C A B Investment / Savings
Fig. 1 “Forced savings” in the Austrian theory
process is ultimately brought to an end by the central bank responding to the rising
consumer price inflation by raising interest rates. As the market rate of interest
moves closer to the natural rate, profits and prices in the capital goods industry
decline and many firms retrench labour and others are shut down. Unemployment
rises in the capital goods industry and recession sets in. During the recession, there
is an expansion of consumption, and labour and other resources temporarily dis-
placed from the capital goods industries are reabsorbed in this expanding consumer
goods industries.
3 Criticisms of the “Hydraulic” Version
Many later day Austrian school adherents such as Salerno (2012), feel that much of
the criticism directed at the school stems from a misunderstanding of its basic
principles as enunciated in the above popular exposition (or what Salerno (op. cit.)
dubs as the hydraulic version). Basically, there are four major criticisms directed at
this hydraulic version of the Austrian school—two theoretical and two empirical.
(i) The first theoretical inconsistency was pointed out by Haberler (1963)
himself and reiterated by Krugman (1998). Basically, if the national income
identity (total national spending equals total national income) is to be
maintained, then a decision to spend less on investment goods automatically
implies more is spent on consumption goods and vice versa. So why should
there be an asymmetry between the phase of capital goods expansion and

consumer goods contraction (which is associated with a boom) and the
obverse phase of capital goods contraction and consumer goods expansion
(which is identified as a recession)? As DeLong (2010) puts it. “There is
generally no period of high unemployment when resources are transferred
out of consumption-producing sectors into investment goods-producing
sectors. There is no necessity that the transfer of resources out of investment
goods-producing sectors be accompanied by high unemployment”.
(ii) The second theoretical inconsistency is pointed out by Caplan (2008) and
discussed at length in Salerno (2012). The Austrian theory predicts that
during a recession, there will be a decline in employment in capital goods
sector and an increase in the consumer goods sector. But this does not
constitute an explanation of why unemployment is high during the “bust”
and low during the “boom”.
(iii) As Krugman (1998), Cowen (2008), DeLong (2010), etc., point out the
predictions of the Austrian theory are at variance with an important stylized
fact. According to the theory, greater production of capital goods in the boom
is accompanied by a contraction in production of consumer goods, whereas
in the recession the opposite is true. This contradicts the stylized fact
observed in almost all business cycles in the developed countries that
investment and consumption are positively correlated over the business
cycle.
(iv) On the premises of the Austrian theory, in the recession when time prefer-
ences “reassert themselves”, the consumption goods industries enjoy a huge
boom. This is hardly borne out by the empirical experience. In reality, retail
sales show substantial decline during recessionary episodes. The early years
of the GFC (2007–09), for example, were marked by a number of
bankruptcies, liquidations and massive lay-offs in major retail suppliers such
as Chrysler, Circuit City, CompUSA (see Barbaro 2008; Zarrello 2009).
4 The Austrian Theory: A Restatement
As mentioned earlier, many later day Austrians feel that these criticisms are mis-
directed, based as they are on the hydraulic version of the theory, which fails to be
an adequate representation of the theory as originally propounded by von Mises
(1998) [1998], Hayek (1933) [1929] and Rothbard (2000) [1963]. Salerno (2012),
Howden (2010), Murphy (2008), Garrison (2004) and others argue against such
misplaced criticisms and present what according to them constitutes the “correct”
interpretation of the Austrian theory. This reinterpretation is not only internally
consistent, but fits the overall stylized facts of business cycles generally and, in
particular, offers a more coherent explanation of the recent GFC.
4 The Austrian Theory: A Restatement 181
The hydraulic version posits the Austrian theory as an overinvestment theory

when in fact on a correct interpretation, it is a theory of mal-investment as well as
overconsumption. The divergence between the natural rate of interest and the
market rate brought about by credit expansion and does divert investment into
projects of longer duration (in the manner described by the hydraulic version) but
(the artificially lowered interest rate) also creates an illusory “wealth” effect, mis-
leading consumers into overestimating their real income and net worth, which spills
over into greater consumption and depresses savings. This greater consumption is
financed by bank credit expansion, or in the later stages of the boom, when the
credit expansion is likely to be discontinued, people may increasingly resort to
dis-saving. As prices and profitability increase in the consumer goods sector, capital
and other factors are diverted from the capital goods sector into consumer indus-
tries. The existing stock of factors becomes difficult to replenish in the capital goods
sector—a phenomenon referred to as “capital consumption”, which is a prominent
feature of the Austrian theory but finds scant mention in the hydraulic version.
Thus, mal-investment, not overinvestment, is the distinctive feature of Austrian
business cycle theory. Once these features of mal-investment and overconsumption
are given due recognition as essential features of the Austrian theory, the criticism
(iii) above (that the theory is not in conformity with the observed comovement of
investment and) loses much of its edge.
As we have seen above, in the hydraulic version “forced savings” bring about
the increase in savings necessary to support the desired investment. However, this
phenomenon is subject to several qualifications. Firstly, as Mises (1998) (pp. 555–
556) argued, the mechanism comes into play, depending on whether wage rises lag
or precede price inflation. Further, even if wages lag prices initially and forced
saving results, as inflationary expectations become firmly entrenched, overcon-
sumption is likely to intensify and simultaneously, wage demands likely to be made
in anticipation of future inflation, thus swamping the forced savings process.
Laidler (2003) enters three additional caveats, viz. (i) the newly created bank
deposits are essentially in the form of loans to firms, (ii) the effects of nominal
money creation must be unanticipated and (iii) the process of credit creation is
initiated when the economy is in equilibrium at full employment. The only way to
maintain investment is then for bank credit to be renewed at a continuously
increasing rate. Eventually, the resultant inflation fuels inflationary expectations and
sets the stage for an “irrational exuberance” among entrepreneurs. “Paper profits”
keep on exceeding expectations, and the general climate of overconfidence
undermines sound business calculations (see Hayek 2008, p. 319; Salerno 2012).
Investment decisions become completely distanced from the underlying
fundamentals.
If the central bank keeps interest rates too low for too long, the stage is set for the
financialization of the economy, i.e. the displacement of real investment by
investment in financial assets (see Howden 2010), as entrepreneurs lose touch with
real conditions, owing to the distorted signals provided by the central bank. The
financial sector, on these distorted signals, appears far more profitable than the real
sector. The tendency is further fuelled by informational cascading2 (see

Bikhchandani and Sharma 2001), because of which investors do not inquire too
closely into the viability of the assets they invest in, but instead accept the market
price blindly as summarizing all the essential risk characteristics of the asset.
Ultimately a stage is reached, when the central bank is forced to step in. The easy
monetary conditions are reversed, and interest rates raised. Capital investors find
that their projects are unsustainable, banks recall their loans, Ponzi schemes
flounder, several firms that cannot roll over their loans go bankrupt, and if such
bankruptcies are widespread, creditor banks and financial institutions are also
dragged along with them. As industries are shut down, there are considerable job
losses and both investment and consumption are slashed.
Recessions are usually prolonged beyond their natural life, by the collapse of
entrepreneurial confidence, in the wake of huge losses and capital wipeouts. They
will then switchover from real and illiquid financial assets into highly liquid
monetary assets. In this state of overall business optimism, stimulative policies
(whether monetary or fiscal) will have little effect. But as the recession proceeds
further, the unemployment is aggravated and the prices of factors of production
(especially labour) fall steeply, even more than product prices. This is the so-called
secondary deflation (see von Mises 1998, pp. 568–569; Garrison 1997; Salerno
2012), etc. In the Austrian view, the secondary deflation is the endogenous result of
business pessimism, but is a painful but essential remedy for the macroeconomic
disequilibrium to correct itself. The decline in real wages and rentals that occurs
during this phase and restores the natural rate of interest to a level that is in
conformity with saving and investment propensities of the economy. It is this factor
which pulls up the sagging entrepreneurial confidence and persuades them to start
investing in fresh projects.
Thus according to the Austrian theory, credit-financed booms lead to waste-
ful mal-investment, which is basically unsustainable. The “recession” is a
much-needed correction mechanism, by which the economy reverts to a pattern of
production in conformity with society’s time preferences (see the essays by Hayek,
Rothbard and von Mises in Ebeling 1978).
5 The Austrian View of the GFC
The Austrian perspective on the GFC is set out in several publications including
notably Wolf (2014), Murphy (2008, 2010), Boettke and Coyne (2010) and (from a
critical perspective) DeLong (2010) and Morgan and Negru (2012). The general
Austrian school philosophy is that market economies (grounded firmly in an
2
“In an informational cascade, an individual considers it optimal to follow the behaviour of her
predecessors without regard to her private signal since her belief is so strongly held that no signal
can outweigh it” (see Çelen and Kariv 2003).
5 The Austrian View of the GFC 183
institutional setting of the rule of law and property rights) possess self-correcting
properties, and absent government intervention, are capable of weeding out any
inefficiencies and malfeasances in the system. In keeping with this thrust, inap-
propriate monetary and fiscal policies and overlax regulation are seen as the key
factors in perpetrating the GFC.
We have seen in Chap. 5, Sect. 3.1, that since the bursting of the dot.com bubble
in 2000, the Fed had been aggressively cutting interest rates and expanding liq-
uidity. Within a span of about 3 years (2001–2004), the Fed Funds rate (the key
FRB monetary policy target) was brought down from 3.5 to 1%, and the monetary
base over the corresponding period was raised by about US$200 billion (a cumu-
lative rise of about 33%). By mid-2003, this massive credit expansion began to
boost corporate profits, stock markets and real estate prices.
As interest rates were kept too low for too long, the phenomena of financial-
ization and information cascading (see the previous section) came into active play.
These tendencies found fertile ground in the financial deregulation and which had
been occurring in the previous decade and which accelerated in the first half of the
last decade (i.e. 2000–2005). In particular, mortgage-based securitization, shadow
banking and new financial instruments like CDOs and CDS coupled with lax
regulation led to enormous increases in “paper wealth” and illusory capital gains on
financial assets, but most particularly in real estate. Ordinary households could not
resist the temptation to increase their consumption of luxury goods by “cashing out”
a part of their home equity. Over the period 2001–2005, the US personal savings
rate declined from over 4% to less than 1% of the GDP. The Austrians tend to view
this as a vindication of their capital consumption thesis.3
But the key question is what motivated the FRB to maintain low rates in the face
of an evident boom in asset prices. A convincing answer to this enigma is provided
by White (2006) and O’Driscoll (2009). Policymakers were misled by the low
inflation over the decade prior to the crisis.4 Even though the USA was not formally
an inflation-targeting country, the general philosophy espoused by the Fed under
Greenspan was for the Fed to concern itself primarily with CPI inflation and not to
interfere in asset market bubbles (see Chap. 4, Sect. 6.3). The Austrians had long
opposed an exclusive concern with the overall price level.5 To them, it is relative
price movements which are important for the dynamics of the cycle and the overall
price level reveals nothing about such movements (O’Driscoll, p. 172). Both Mises
(1971) and Hayek (1935) believed that the prices of assets moved inversely in
3
Based on the Wilshire 5000 Total Market Index (which is supposed to be a good proxy for capital
accumulation in the USA) Salerno (2012) and Blackstone (2010) estimate that over the years
2007–09 the capital consumption in the USA was about US$7.5 trillion (the index declining from
US$15.5 trillion in 2007 to US$8 trillion in 2009).
4
As between 1995 and 2005, there were only two years in which CPI inflation exceeded 3% per
annum, viz. 2000 and 2005.
5
Of course, the Austrians are not alone here. Even a noted Keynesian such as Leijonhufvud (2007,
p. 5), for example, noted that “… a constant inflation rate gives you absolutely no information
about whether your monetary policy is right”.
relation to the level of interest rates, and asset bubbles could build-up even in a
low-inflation environment. White (2006) has reiterated the Austrian position, citing
several examples from economic history, where serious macroeconomic downturns
were preceded by long periods of price stability including most prominently the
Great Depression in the USA of the 1930s, the Japanese financial crisis of 1992, the
southeast Asian crisis of 1997, the Russian crisis of 1998, etc.
In the Austrian view, prolonged periods of price stability encourage an unjus-
tified optimism regarding the future among entrepreneurs, accelerating credit
growth, firm leverage and asset inflation (see White 2006; O’Driscoll 2008, etc.).
6 Policy Recommendations
In understanding the Austrian policy recommendations, it is important to remember

that the Austrians view the recession as some kind of a “bitter medicine”, which
needs to be swallowed in order to restore the imbalances which have developed
owing to a credit-financed boom. This basic principle allows us to put the Austrian
prescriptions for the GFC in perspective.
6.1 Monetary Policy
As has been discussed above, the Austrian school was pronouncedly sceptical about
the government’s role in money matters. Taking the cue from Menger (1892) on the
evolutionary approach to money, von Mises (1912), Meulen (1934), Riegel (1944),
Rothbard (1962), Hayek (1976) and others have developed the so-called “free
banking school” in which banks issue their own brand of money in competition
with each other and with the official legal tender. However, this extreme measure
finds little support from other lines of thought (see Pesek and Saving 1967; Johnson
1968 for early criticisms and Nachane (2000–2001) for a detailed review) and
hence is not seriously entertained by most modern-day adherents of the school.
Recognizing that “free banking” at best can be an utopian ideal, modern-day
Austrians have confined their policy suggestions to the typical institutional set-up
that broadly characterizes modern developed and emerging market economies.
Within such a context, they view expansionary monetary policy measures such as
lower interest rates and quantitative easing as unwarranted in a crisis, since this will
only be a short-term palliative, boosting employment temporarily and postponing
the necessary adjustment. The result will be another bout of asset bubbles and an
ultimately deeper recession. Fiscal stimuli are also disfavoured for the same reasons
(see Polleit 2011; Thornton 2011; Murphy 2008, etc.).
The influence of Hayek (1935) and von Mises (1971), however, still remains
important and is discernible, for example, in the Austrian antipathy to an
inflation-targeting policy. Specifically, as elaborated by O’Driscoll (2009, p. 177),
6 Policy Recommendations 185
such a policy interferes with the inter-temporal allocation of resources, by forcing

market rates to be lower than they otherwise would be. This raises asset prices first
and consumption prices only later. White (2004, 2006) and Borio (2003), therefore,
suggest a more symmetric application of monetary policy over the cycle. In other
words, whereas the traditional approach has been to tighten policy somewhat gently
in the upward phase of the cycle but loosen it aggressively in the recession phase,
the Austrian view is to tighten policy equally aggressively during the boom.
Similarly, a more aggressive tightening of fiscal policy in the boom is advocated to
prevent continuous growth in debt levels over time.
6.2 Productive Macroprudential Regulation
Modern-day Austrians share many of the concerns regarding systemic financial

instability with other schools of thought, most notably the post-Keynesians. While
early Austrians focused exclusively on the state’s role in distorting incentives and
mispricing risk, their more recent followers have also recognized that the role
played by private agent errors and cupidity in perpetrating a crisis also need to be
accounted for. In other words, there is considerable role for the central bank to set
up a framework for productive (as opposed to obstructive) macroprudential regu-
lation.6 The contours of such productive regulation have been set out by Goodhart
and Danielsson (2001), Goodhart (2004), White (2004, 2006), Borio (2003), etc.
Vulnerability Indicators: In developing a productive regulation framework, a
basic necessity is the development of reliable vulnerability indicators, i.e. a set of
leading indicators for predicting financial crises. Considerable work on this has
been done at the IMF, the BIS and by individual academics. The IMF list of
candidate indicators is indeed a long one and is continuously updated,7 including
most prominently (i) annual real GDP growth, (ii) annual rate of inflation, (iii) in-
vestment (as percentage of GDP), (iv) fiscal deficit (as percentage of GDP),
(v) movements in nominal exchange rates and real effective exchange rates,
(vi) domestic credit (as percentage of GDP), (vii) current account balance (as
percentage of GDP), (viii) short-term capital inflows (as percentage of GDP),
(ix) private capital net inflows (as percentage of GDP), (x) ratio of broad money
(M2 or M3) to narrow money (M1), (xi) change in stock prices.
Borio and Lowe (2002, 2004) find that, of the various leading indicators sug-
gested in the literature, three in particular seem to perform well on econometric
grounds (for both developed economies and EMEs), viz. above trend rates of
6
For definitions of macroprudential regulation and systemic stability, see Chap. 5 (p footnote 14)
of this book.
7
The rationale and analytics of the IMF indicators are provided by Navajas and Thegeya (2013),
and the latest update is IMF (2015).
growth of bank credit, asset prices and investment.8 Interestingly, these indicators
are precisely the ones that the Austrian school associates with financial excesses and
sectoral imbalances. However, unlike the post-Keynesians who attribute these
imbalances to private agent errors and animal spirits, the Austrians view them as
resulting from undue central bank interference in financial markets.
Time-Varying Capital Requirements: Since Austrians regard uncertainty and
complexity as the defining characteristics of a market economy (see Caldwell 2011;
Calabria 2009, etc.), they are sceptical about the ability of central banks and
governments to predict emerging systemic imbalances and hence do not favour any
discretionary regulatory policy. However, this does not mean that they did not
recognize the need for some regulation. Rather, they were for a system of general
rules which would provide the institutional framework for individuals to make
decisions. What could be a general system of rules in such a situation?
One system of rules has been advocated by Danielsson and Goodhart (2002)9 in
which collateral requirements, loan-to-value ratios, regulatory capital, etc., are
linked to changes in the rates of growth of credit, asset prices, output and invest-
ment. In a later paper, Goodhart (2005) slightly modified this position and rec-
ommended relating the capital requirement on bank lending to the rate of change of
asset prices in the relevant sector. Thus, the capital adequacy requirement (CAR) on
mortgage lending could be related to the rise in housing prices, while for lending to
manufacturing and services, the CAR could be related to the rise in equity prices.
Thus, what is being recommended is time-varying capital requirements, in which
financial institutions build-up capital buffers during economic expansions, which
could then be unwound in times of recession.
Dynamic Provisioning: This is another important way of operationalizing the
concept of time-varying capital requirements.10 This has already been introduced in
Spain in 2000 and the Ind AS 109 contemplated to be introduced in India in 2018 is
also very similar in content (see Mahapatra 2012; Lavi 2017, etc.). According to
current practice, most banks are required to make two types of provisions, viz.
general provisions (GP) on standard assets and specific provisions (SP) on
non-performing assets (NPAs). The former are related to credit growth and the latter
to the quantum of NPAs. Under dynamic provisioning, the total provisions are
determined by a latent risk measure, defined as a function of the level of credit. In
formula terms (see de Lis and Herrero 2009; RBI 2012), the general provisions
(GP) are now computed as follows (the specific provisions (SP) remain as before):
8
For EMEs, Borio and Lowe (2004) find that an overvalued exchange rate may also act as a crisis
triggering factor. Goldstein and Turner (2004) add a further dimension, viz. currency mismatches
(an imbalance between liabilities that need to be serviced in foreign currency and revenues that
accrue in domestic currency).
9
This paper also gives a detailed critique of the VaR methodology adopted in Basel II for its failure
to reduce pro-cyclicality in capital requirements and its inability to predict emerging systemic risk
in the banking system.
10
Loan loss provisioning is the amount set aside by a bank to cover the possibility of a loan
defaulting and is a negative item on the asset side of its balance sheet.
6 Policy Recommendations 187
GP ¼ aDCt þ bCt DSP ð1Þ
where Ct is the outstanding stock of loans at time t, a is the average estimate of

credit loss, b is the historical average of specific provisions and D denotes quarterly
changes. In periods of expanding credit, the difference (bCt − DSP) is positive, and
in recessions (when specific losses start becoming evident in individual loans) it is
negative. Thus in essence, dynamic provisioning supplements the traditional gen-
eral provisions with a positive buffer during expansions and a drawdown during
recessions. Further, details may be found in Banco de Espana (2005), Jimenez and
Saurina (2006) and Gopinath and Singh (2014).
Market Discipline: Since the Austrian school puts considerable faith in the
working of markets, but also emphasizes that they should be “embedded within a
set of complementary social institutions” (Caldwell 2011, p. 9), in the context of the
global crisis, they tend to assign a key role to market discipline as an effective
preventive measure against major crises (see Tamny 2016; Newman 2016, etc.).
Measures which stress market discipline could include
(i) Stress testing exercises to be conducted periodically to monitor leveraging on
an ongoing basis.11
(ii) Improved disclosure requirements for complex structured products.
(iii) An early warning diagnostic system to detect emerging imbalances in certain
financial institutions (see White 2004, p. 5).12 Such a system can contribute
considerably towards containing collateral damage to the rest of the financial
system as well as to real sectors.
(iv) Originators of securitized products be required to take an equity slice in the
products that they sell/distribute.
(v) Better separation of ratings and consultancy activities of credit rating
agencies.
(vi) The establishment of clearing houses in over the counter (OTC) derivatives
markets.
(vii) The instituting of orderly closure rules for important financial institutions (as
prevalent in the US Improvement Act and Competitive Equality Banking
Act).13
11
Stress testing was introduced by the RBI for Indian banks as of 31 March 2008. Details may be
found in RBI (2007).
12
The RBI introduced an Early Warning System under the nomenclature of Prompt Corrective
Action (PCA) in December 2002. For the latest PCA guidelines reference may be made to RBI
(2017).
13
In India, the Insolvency and Bankruptcy Code 2016 was passed by an Act of Parliament in 2016
and goes a considerable way towards strengthening the current bankruptcy regime (see KPMG
2016 for a detailed discussion of the code).
6.3 Real Sector Recommendations
Since one of the primary reasons for the GFC in the USA was overinvestment in the
housing sector, in the Austrian view, the secondary deflation (see above) should be
allowed to play itself out fully. This would permit the much-needed transfer of
resources out of housing construction into sectors which have faced underinvest-
ment during the GFC (such as health and infrastructure, oil exploration and min-
ing), to restore sectoral equilibrium between the broad sectors of the economy (see
Murphy 2008; Barron 2011; Morgan and Negru 2012, etc.). The ensuing decline in
real wages and rentals during this secondary deflation would free up labour markets
and restore entrepreneurial optimism (see, e.g., Murphy 2011). Ultimately, the
natural rate of interest will be brought to a level that is in conformity with saving
and investment propensities of the economy and the economy will be ready for the
next upward phase. Policy interference with this natural process will only lead to an
elongation of this adjustment process, with a short recovery terminating in an even
more severe recession.
7 Conclusion
We have discussed several sets of recommendations from the Austrian school. The
suggestions on macroprudential regulation are very similar to suggestions made by
other schools of thought (though for obviously different reasons), and many of these
have already found acceptance in most countries (both developed and undevel-
oped). The free banking suggestion is hardly likely to be acceptable in any fore-
seeable future, and the suggestion of symmetric stance of monetary policy will
encounter stiff resistance, even if the various communication strategies outlined in
White (2006) are deployed. The real sector recommendation of letting the sec-
ondary deflation play out fully is likely to have few takers, least of all among
policymakers, who would fear the public heat and political fallout of a “do-nothing”
policy.
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Chapter 8
The Crisis: A Minsky Moment?
Abstract Hyman Minsky, in several notable contributions, developed an elaborate

theory of how and why capitalist economies endogenously develop tendencies
towards systemic financial instability. The following key elements of Minsky’s
crisis theory may be identified: (i) financial theory of investment, (ii) systemic
development of financial fragility, (iii) disruption by a “not unusual” event,
(iv) possibility of debt deflation and (v) floors and ceilings. We attempt to show
how Minsky’s theory contributes considerably towards an understanding of several
features of the global crisis.
1 Introduction
As the global financial crisis got underway, it became routine for economists to
describe the unfolding events under the rubric of a Minsky moment, after Hyman
Minsky, who in several notable contributions (see in particular Minsky 1975, 1982,
1986) developed an elaborate theory of how and why capitalist economies en-
dogenously develop tendencies towards systemic financial instability.
While it is not unusual for Minsky to be classified as a post-Keynesian in view of
his close affinity to several Keynesian ideas (see Lavoie 2014; Blecker 2016, etc.),
he himself preferred not to be labelled so, for several reasons. Firstly, he believed
his analysis to be an extension of the Keynesian theory to include financial markets,
financial products and institutions. Secondly, he believed the post-Keynesians had a
tendency to strive for generality of their theories by pushing institutions into the
background, whereas for him (Minsky) no worthwhile theory could be
institution-neutral (see Papadimitriou and Wray 1997). Thirdly, as emphasized by
Palley (2010), Minsky’s analysis was evolutionary and path-dependent, focused on
how the economy proceeds from one cyclical phase to another, rather than the more
traditional focus in mainstream economics (as also much modern post-Keynesian
economics) on how deviations from equilibrium are restored. Minsky’s analysis of
financial instability is of course a keystone of the post-Keynesian explanations of

https://doi.org/10.1007/978-81-322-3920-8_8
194 8 The Crisis: A Minsky Moment?
the global crisis—yet taken of itself, it can provide a sufficiently detailed account of
the crisis to qualify as a distinct explanation in its own right.1
Following Wolfson (2002) and Wray (2011), the following key elements of
Minsky’s crisis theory may be identified:
(i) Financial theory of investment
(ii) Systemic development of financial fragility
(iii) Disruption by a “not unusual” event
(iv) Possibility of debt deflation
(v) Floors and ceilings.
We discuss each of these aspects briefly below.
2 Minsky’s Theory of Investment
Minsky’s theory of the business cycle is often described as “a financial investment

theory of the cycle”. At the core of the theory, is the Levy–Kalecki profits equation
which may be stated as follows2:
Corporate Profits ðNet of taxesÞ ¼ Total Investments þ Dividends

Household Saving Budget Surplus ð1Þ
þ Balance of Trade Surplus ðNet of transfersÞ
(see Levy 2000 for details of the derivation).

This can also be recast into Godley’s (1999) macroeconomic identity as
ðGovernment sector deficitÞ þ ðCurrent account surplusÞ ¼ ðPrivate sector balanceÞ

ð2Þ
In essentially Keynesian fashion, Minsky believed both that investment was

highly unstable and that it was the driving force of the cycle. But he also viewed
investment as the sine qua non of corporate profits, taking the cue from the Levy–
Kalecki profits equation above. Higher investment leads to higher current profits,
the latter in turn generate expectations of higher future profits, and these sanguine
profit expectations in turn stimulate further investment, establishing a more or less
self-reinforcing upward cyclical phase. However, the process does not work the
same way in reverse—an investment decline can never be initiated by a prior
1
Minsky died in 1996, a full decade before the eruption of the crisis. With his remarkable pre-
science, he could foresee the general direction in which the US economy and especially its
financial sector were headed, though, of course, not the details of innovations like CDOs and CDS,
and their devastating potential impacts.
2
This identity is fully discussed in the Appendix to Chap. 1.
2 Minsky’s Theory of Investment 195
decline in expected profits (see Minsky 1982, p. 25).3 This latter feature sets
Minsky apart from Keynes (1936) who had argued that the marginal efficiency of
capital gets depressed as capital accumulation proceeds apace (see Crotty 1986).
3 Financial Instability Hypothesis (FIH)
Since, as seen above, Minsky does not allow expected profits to play a determining
role in the decline in investment that sets off a recession, he has to look elsewhere to
account for such a decline. He locates this source in what he calls as “financing
relations”.
The crux of Minsky’s FIH may be described in Wray’s (2011) cryptic phrase
“stability is destabilizing”. Minsky famously adopted a threefold classification of
the financial position of firms: (i) hedge units were firms who, with their expected
income flows, were in a position to service the both interest payment on their debt
stock and amortization/repayment obligations of their principals, (ii) speculative
units are those who could service the interest payments on their debts from their
income flows but had to seek rollover of the principal and (iii) Ponzi units, who
could service neither interest nor principal, and had to borrow to cover interest costs
(thus leading to ever-increasing debt accumulation).
In the initial stages of a cyclical upturn, memories of the immediately preceding
slump are still fresh in the minds of investors. Firms are therefore careful in
screening investment projects, banks are careful too in granting loans, and debt to
equity ratios remains within prudent limits. At this stage, most of the firms are
essentially in the hedge units category. As the recovery becomes well entrenched,
memories of preceding crises are dimmed. Firms become less risk-averse in the
selection of projects, and banks relax loan screening standards—market risk premia,
based on over-optimistic assessments, become increasingly misaligned with the true
underlying risks. Leverage increases as firms find that internal funds are insufficient
to exploit the increased profit opportunities. The process is spurred on by banks and
financial institutions whose lending standards are relaxed, with loans often granted
without due scrutiny and on the basis of overvalued collaterals. Speculative units
proliferate at this stage, and Ponzi units also emerge on the scene. There is a basic
uncontrollable momentum to this process, as units scramble to gather the hanging
fruit. In Minsky’s terms, financial fragility sets in—a tendency, which he believed
is an endemic feature of capitalist economies with developed financial structures.
This fragility is progressive (unless effectively checked by strengthened regulation
and/or supervision) and ultimately leads to a stage, where the economy is mainly
dominated by Ponzi and speculative units.
3
Real factors like competition or technical progress can only redistribute aggregate profits, but not
increase its quantum. This explains why Minsky termed his investment theory as “financial” but
also lays the theory open to the charge of ignoring the “real” side of the business cycle narrative
(see, e.g. Crotty 1986; Lavoie and Seccareccia 2001; Toporowski 2008).
At this stage, the economy becomes particularly vulnerable to a crisis. As the

boom reaches an advanced stage, the rising commodity and asset prices become an
issue of concern to the monetary policy authority, who would be under government
and popular pressure to raise interest rates. But a rise in interest rates raises the
interest commitments of firms, without raising their income flows. At the same time,
banks and financial institutions develop worries about illiquidity. As the balance
sheets of these latter are highly interconnected, a stress developing in any part of the
system has the potential to bring the entire edifice rolling down.
4 Disruption by a “Not Unusual” Event
The situation now is highly incendiary, with a conflagration likely to be set off by a
“not unusual” event such as the failure of a big corporation or financial institution.
The impacts of such shocks are, in a situation where the financial system is robust
overall, absorbed with limited damage to the overall economy. But in a financially
fragile situation, they are capable of setting up a domino effect, with forced selling
of assets to overcome the liquidity crunch and a sharp downward adjustment of
asset prices. Such adjustments can pull the economy into a major recession (see
Kregel 1998; Wolfson 2002, etc.).
5 Debt Deflation
Fisher (1933) was among the earliest to point out the possibility of a process of debt
deflation during a recession. He describes the entire process of debt deflation in
great detail and identifies the following nine stages in the chain of events.
(i) A general alarm (such as the one caused by a “not unusual event” above) in
a state of extended leverage leads to massive debt liquidation.
(ii) Debt liquidation is usually done at distress prices and involves serious
revaluation of asset prices.
(iii) The above processes lead to bank deposit contraction and a fall in the
velocity of money.
(iv) If not countered by expansionary monetary policy, this can lead to price
deflation.
(v) Price deflation brings in its wake, falling net worth of businesses and
bankruptcies.
(vi) Falling prices lead to contraction in output and employment.
(vii) There is a general loss of business confidence.
5 Debt Deflation 197
(viii) The mood of pessimism leads to hoarding, further depressing the velocity of
circulation.
(ix) Finally in Fisher’s phraseology, there are “complicated disturbances” in the
rate of interest, with nominal rates falling, but not by the same amount as
price deflation, so that real interest rates rise.
6 Floors and Ceilings
While Minsky did believe that financial crises were endemic to capitalist systems,
he also believed that the severity of such crises and, in particular, the possibility of
debt deflations could be alleviated by certain “ceilings and floors” which, in effect,
acted as “circuit breakers”. Among such circuit breakers, he considered two to be
most important, viz. the actions of the central bank (Big Bank) and the government
(Big Government). However, policy has to be adaptive, adjusting itself to a con-
tinuously transforming economy.
So far as central bank actions were concerned, Minsky considered both monetary
policy and financial regulation. While central banks do attempt to set interest rates
pro-cyclically in an attempt to stabilize the economy, Minsky doubted their efficacy
as a stabilizing device. Raising interest rates in a boom increased financing costs of
firms and could move several of them into speculative and Ponzi positions (see
Wray 2011). Correspondingly, lowering interest rates in a depression, Minsky
believed [a la Keynes’s General Theory (1936)] would fail to stimulate investment
if expectations continued to be pessimistic. But the central bank could play a very
useful role as a lender of last resort. By supporting liquidity constrained but
otherwise sound financial institutions, at its discount window, the central bank
could prevent firesales of assets by such institutions. Minsky also strongly believed
in central bank preventing asset price deflations by buying illiquid assets from firms
and banks (quantitative easing). While these policies were essentially to be put in
place once the crisis had already occurred, Minsky also placed considerable
emphasis on prudential regulation as a crisis prevention measure.
One of the problems that Minsky envisaged in the US financial system in the
closing decades of the twentieth century was that the strong regulatory framework
put in place in the post-World War II period had seen considerable erosion, in a
mistaken faith in the self-regulatory ability of corporate and financial institutions
(see Lavoie 2010; and Chap. 5, Sect. 3.3, for details).
Apart from the “Big Bank”, “Big Government” could also act as an important
stabilizing force according to Minsky. Government expenditure as a proportion of
GDP (in the USA) stood at around 20% in 2007 on the eve of the crisis. This meant,
of course, that the government expenditure could play an important role by com-
pensating for the shortfall in private investment. And, in effect, as we saw in
Chap. 5, Sect. 4.3, the US government did undertake extensive fiscal stimuli
(which pushed the government expenditure to more than 26% of the GDP by 2011).
These measures went quite some way in cushioning the US economy against the
more extreme recessionary consequences. Minsky (1986) and Blecker (2016) have
identified three types of positive impacts associated with an increased fiscal deficits
in a recession4:
(i) The “income and employment effect” associated with the direct increase in
aggregate expenditure and its multiplier effects.
(ii) The “budget/cash flow effect” which results from the private sector surplus
(excess of saving overinvestment) generated by the government deficit. From
the Levy–Kalecki profits equation above, this surplus will be distributed
between corporate profits and household savings. This will improve corpo-
rate profitability as well as the net worth of households, and can possibly
spark a recovery in investment.
(iii) The “portfolio/balance sheet effect” results from an increase in the private
sector holdings of safe government securities, which replenishes private
sector balance sheets eroded from the holding of risky equities and
mortgages.
While the above description is intended to capture most of the salient features of
Minsky’s crisis theory, we have yet to examine how well it serves as an explanation
of the recent global crisis.
7 Global Crisis: Collapse of “Money Manager”

Capitalism?
7.1 Background
Minsky died in 1996, a full decade before the eruption of the global crisis yet there
were many features of this crisis that his analysis captures with an uncanny pre-
science. The developments in the US financial sector since 1990 almost faithfully
replicate the essential dimensions of Minsky’s FIH. Since these developments have
been discussed at great length in Chap. 5, we merely touch upon the main elements
of the story.
Firstly, there was the Great Moderation (1983–2007) in which most of the
Western economies experienced low inflation rates accompanied by a noticeable
drop in macroeconomic volatility (as compared to the previous decade and a half).
Such a long period of relative tranquillity bred complacency among economic
agents and produced an increased willingness on the part of financial investors and
institutions to assume greater risks, to seek higher yields via extended leverage and
4
Note that this view of fiscal deficits is in direct opposition to the mainstream views of “crowding
out” and Ricardian equivalence (see Barro 1974; Blanchard 1985; Mankiw 2003, etc.).
7 Global Crisis: Collapse of “Money Manager” Capitalism? 199
often to use derivatives for speculation rather than hedging. This then is a classic
illustration of the Minskyan aphorism “stability is destabilizing”.
A second development refers to a change in the economic intellectual paradigm
that occurred around the 1970s. Keynesian ideas were in the ascendant in the
aftermath of the Great Depression, and in the post-World War II period, they
dominated both the academic and the policy discourses. However, with the collapse
of the Smithsonian Agreement in the early 1970s, and the oil price shock of 1974,
there was a pronounced reversion from Keynesian ideas in favour of freer markets
with a minimalist government presence in the economic sphere. Simultaneously,
under the impetus of Friedmanian ideas (especially his natural rate hypothesis),
policy emphasis shifted from unemployment to inflation and from fiscal policy to
monetary policy.
7.2 “Money Manager” Capitalism
Largely as a consequence of the shift to a laissez-faire ideology, Minsky (1993,

1996) believed capitalism evolved from the stage of paternalistic/managerial cap-
italism in the three decades after the end of World War II to money manager
capitalism. Whereas the former was characterized by a “Big Government” and “Big
Bank” ready to intervene whenever private demand slackened, and by close
supervision and regulation of the financial sector, the defining characteristic of the
latter was the rise of “managed money”, i.e. pension funds, insurance funds,
sovereign wealth funds, etc., which pooled individual, corporate and occasionally
government savings to be managed by professionals with a view to maximizing
returns. Minsky’s theory of money manager capitalism was more fully elaborated
later by Nersiyan and Wray (2010), Wray (2011), Whalen (2010), Lavoie (2016) etc.
Shadow Banking: Four important consequences of money manager capitalism
are identified. Firstly, the huge pools of managed money became an alternative
funding source for commercial enterprises. Because they were subject to less reg-
ulation, they could attract more savings by offering higher interest rates than banks,
and they could engage in securitization (backed by mortgages and other assets) and
other types of financial innovations (CDS, CDOs, interest rate swaps, etc.).
Increasingly, commercial banks started losing their market share of commercial
loans to these shadow banks. Shadow banks also helped commercial banks to
channel many of the loans from their books into special investment vehicles (SIVs)
and special-purpose vehicles (SPVs).
Principal–Agent Problem: The second characteristic feature of money manager
capitalism emerged in the late 1970s was articulated in a series of articles in various
finance journals as the principal–agent problem (see, e.g. Jensen and Meckling
1976; Williamson 1963; Nyman and Silbertson 1978 and also the more recent
works of Griffiths and Wall 2007; Sloman 2006). These articles highlighted the
conflict between management and shareholders, and the “lack of shareholder
control over management, and the pursuit of market share and growth at the
expense of profitability” (OECD 1998, p. 17). But profitability soon lost its tradi-
tional interpretation and increasingly came to be understood as “shareholder value
maximization”. Simultaneously, the extensive process of deregulation of the
financial sector initiated in the USA and Europe around this time led to the
emergence of new financial instruments (e.g. junk bonds) which provided a con-
venient means for hostile takeovers by groups of shareholders who were dissatisfied
with the performance of the management. Additionally, an increasing proportion of
profits was distributed as dividends to keep shareholders satisfied, instead of being
reinvested. In an effort to keep their share prices buoyant, frequent buybacks of
shares were also resorted to. Hostile takeovers became frequent and were often
preceded by substantial “downsizing” of the enterprise. In effect, money manager
capitalism entailed a shift from the earlier “retain and reinvest” philosophy of the
firm to “downsize and distribute” (see Stockhammer 2004, 2006; Dallery 2009;
Clevenot et al. 2010, etc.).
Credit Rating Agencies: The rise of credit rating agencies constitutes the third
important aspect of money manager capitalism. With the continuous emergence of
new complex financial products, investors no longer retained the ability to evaluate
the true worth of these products. Some independent agencies were required to carry
out this task, which explains the rise to prominence of the credit rating agencies.
But with all the expertise at their command, they were in reality engaged in the
impossible task of assigning probabilities to events, which were properly speaking
uncertain in the Knightian sense. Credit rating agencies rapidly became a univer-
sally accepted standard for assessing the risk profiles of the new financial instru-
ments that started proliferating after the 1980s. Increasingly, they (credit ratings)
started substituting for the investors’ own assessment of risk. However, what was
not immediately apparent was the moral hazard inherent in this arrangement. Since
credit rating agencies were unregulated entities, and since their income rose from
their ratings business, to retain their clientele they would be naturally tempted to
give higher ratings than warranted by the true worth of the financial instrument.
Systemic risk was thus in-built into the system by the widely prevalent underpricing
of risk and over-optimistic assessments of returns. Two other related features
aggravated an already perilous situation. One was the “revolving door” policy of
the US government under George Bush and Bill Clinton, with top executives from
Wall Street firms being awarded senior Treasury positions.5 Such appointments
always have the potential to create conflicts of interest situations, and while it may
be unfair to allege that such appointees tend to favour their former employers, it
cannot be gainsaid that their policies are likely to be oversympathetic to the
5
Robert Rubin and Henry Paulson, both senior executives from Goldman Sachs, were US Treasury
Secretaries from 1995 to 1999 and 2006 to 2009, respectively.
financial sector in general. The other possibility is more serious and related to
“actionable” practices such as “shorting” and “synthetic CDOs” (several instances
of such practices are given in Wray 2011, pp. 9–14).6
Lobbying Power of Financial Sector: The most deleterious (from the social
point of view) consequence of money manager capitalism is the lobbying power of
the finance sector in the economic policymaking of the country. This lobbying
power was deployed (first in the USA and then in the developed Western econo-
mies and finally in the EMEs) to remove the various checks and balances imposed
to control the excesses of the financial sector, in the wake of the Great Depression.
This process of deregulation and desupervision was sought to be justified by appeal
to standard market efficiency arguments. Among the most prominent irritants for
the financial sector was the Glass–Steagall Act of 1932, which had been legislated
immediately after the Great Depression. The Act was designed to effect a strict
separation of commercial and investment banking. It prevented securities firms and
investment banks from accepting deposits and commercial banks from dealing in
(i.e. investing, distributing or underwriting) non-governmental securities either on
their own behalf or on behalf of their customers. In short, any kind of affiliation
between commercial and investment banks was prohibited. The Glass–Steagall Act
was essentially repealed in 1999 and replaced by a much more moderate Act, viz.
the Gramm–Leach–Bliley Act (GLBA) which allowed commercial banks, invest-
ment banks, securities firms, and insurance companies to merge and amalgamate.
However, the GLBA also created a significant regulatory gap by failing to give to
the Securities Exchange Commission (SEC) or any other agency the authority to
regulate large investment bank-holding companies like Goldman Sachs, Merrill
Lynch, Lehman Brothers, Bear Stearns.7 Another important deregulation measure
was the phasing out of Regulation Q over the 6-year period 1980–86. Regulation Q
(vide the Banking Acts of 1933 and 1935) prohibited the payment of interest on
demand deposits and authorized the Federal Reserve to set interest rate ceilings on
time and savings deposits paid by commercial banks. Similarly, the Garn–St.
Germain Depository Institutions Act of 1982 deregulated savings and loan asso-
ciations and allowed banks to provide adjustable rate mortgage (ARM) loans.8 In
1983, the Office of the Comptroller of the currency removed almost all limitations
on national banks’ real estate lending. Similarly, after initially proposing to retain
some regulatory requirements such as loan-to-value ratios, the Federal Home Loan
6
Synthetic CDOs are not bundles of MBS (mortgage-based securities) but simply represent bets on
a bunch of MBS as to whether they will go toxic or not. Shorting or short selling simply refers to
dealing in securities that one does not own.
7
In an effort to bridge this gap, the SEC in 2004 created a voluntary programme, the Consolidated
Supervised Entities (CSE) programme. Many policymakers believe that the CSE programme was
fundamentally flawed from the beginning, because investment banks could opt in or out of
supervision voluntarily. This loophole rendered the CSE largely ineffective.
8
We have already seen in Chap. 5, Sect. 3.2, that ARM loans had a significant contribution role in
the global crisis.
Board removed most regulatory requirements for real estate loans except for two—a
loan could not exceed 100% of the appraised value of the real estate, and a home
loan could not have a maximum term longer than 40 years. By 1996, even these
limited requirements were lifted. Several other deregulation measures are reviewed
and discussed in Adjoran (2013), Dilorenzo (2009), Prasad (2012), etc.
According to Wray (2009, 2011), a prominent Minskian, the financial fragility
discussed above was a long-term trend built over several years. In this sense, the
GFC is not so much a “Minsky moment” as the collapse of a prolonged stage of
capitalism which had evolved since the 1970s.
7.3 Triggers for the Crisis
What were the triggers for the collapse in the USA? Wray (op. cit.) posits three
triggers, viz. rising commodity prices (especially oil), rising real interest rates and a
fiscal squeeze. Crude oil prices rose from US$27.22 a barrel in January 2002 to US
$49.07 in January 2003 and further to US$83.67 in January 2006, ultimately
peaking at US$156.34 a barrel in June 2008. US CPI inflation correspondingly rose
sharply from 1.59% in 2002 to 2.27% in 2003, and then to 3.93% in 2005, reaching
a height of 3.84% in 2008. As a, the Fed was obliged to tweak the interest rate cycle
upwards beginning July 2004—US real interest rates rose from 1.55% in 2004 to
2.88% in 2005 and further to 4.74% in 2006 and 5.25% in 2007.
The fiscal squeeze has received relatively little attention from the mainstream
literature. Tax revenues as a percentage of US GDP rose from 10.54% in 1991 to
11.98% in 1995 and to 12.93% in 2000, whereas total revenues rose from 18.64%
in 1991 to 19.96% and 20.51% in 1995 and 2000, respectively. Correspondingly,
the budget deficit declined from US$203 billion in 1994 to US$22 billion in 1997,
before turning into a surplus of US$60 billion in 1998.9 While this fiscal squeeze is
widely touted as a brownie point for the Clinton administration, Minskians (and
post-Keynesians in general) regard it as a trigger for the financial collapse. As
Godley’s reformulation (see (2)) of the Levy–Kalecki identity shows, the falling
budget deficits and the rising current account deficits in the decade of the 1990s put
a squeeze on private sector balances. To sustain their living standards, households
had to increasingly resort to borrowing, while corporates rapidly increased their
leverage.
The 1990s thus set the stage for the crisis with rising debt to national income
ratios, booming asset prices (especially real estate), stagnant real wages and rising
9
The reduction in budget deficit is usually attributed to three factors: (i) the passage of the
Omnibus Budget Reconciliation Act of 1993 which raised income tax rates for top tax brackets
from 31 to 36% for income taxes and from 31 to 38% for corporate taxes, (ii) an exceptionally
strong economy that generated considerably additional taxes from several avenues (GDP growth
soared from −0.74% in 1991 to 4.69% in 1999 and 4.10% in 2000) and (iii) a shrinking military
budget (from 4.54% of GDP in 1991 to 2.93% in 2000).
inequality. The first few years of the 2000s brought in commodity inflation. Finally,
the raising of interest rates in July 2004 acted as the trigger for delinquencies,
defaults and foreclosures on the mortgages. The housing market turned downwards,
and the train of events that defined the GFC was set in motion (see Chap. 5 for the
details).
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Chapter 9
The Global Crisis According
to Post-Keynesians
Abstract The post-Keynesian explanation of the global crisis is centred around six
major themes, viz.: (i) Minsky’s theory of financial fragility with its focus on
institutional features, but extrapolated to households, (ii) financial fragility in the
global context, (iii) herd behaviour of investors, (iv) endogeneity of money,
(v) changes in the distribution of income between workers, capitalists and/or ren-
tiers and (vi) flawed development and lax regulation of the financial sector. In this
chapter, we attempt an explanation of the global crisis by interpreting these themes
against the general theoretical backdrop of post-Keynesianism. We also present an
analysis of Godley’s unsustainable processes and examine their potential useful-
ness as leading indicators of a crisis.
1 Introduction
An exact definition of post-Keynesianism may not be forthcoming—this being a

matter of considerable controversy (see, e.g. Hamouda and Harcourt 1988;
Davidson 2003–2004; Kerr 2005). Gerrard’s (1995) assessment of
post-Keynesianism as a “diverse and continuing research effort, characterized at
times more by its fragmentation and internal division than by any unity of purpose”
(quoted in McDaniel 2012, p. 43) seems quite to the point, and taking this cue, we
also try to view post-Keynesianism as a continually evolving body of doctrines,
often differing in shades of emphasis and in detail yet sharing sufficient com-
monality to be clubbed under a single nomenclature. It is impossible for us here to
go into a detailed discussion of each separate strand of post-Keynesianism; rather,
we focus on the common themes shared by the group as a whole.

https://doi.org/10.1007/978-81-322-3920-8_9
206 9 The Global Crisis According …
2 Post-Keynesian Perspective on the Crisis
The post-Keynesian explanation of the global crisis is centred around six themes.
1. Minsky’s theory of financial fragility with its focus on institutional features, but
extrapolated to households
2. Financial fragility in the global context.
3. Herd behaviour of investors
4. Endogeneity of money
5. Changes in the distribution of income between workers, capitalists and/or
rentiers
6. Flawed development and lax regulation of the financial sector.
These themes have to be interpreted against the general theoretical backdrop of
post-Keynesianism, whose main features include:
(i) The view that effective demand is the main determinant of the macroeco-
nomic dynamics of a country
(ii) A pronounced scepticism about the self-equilibrating properties of markets
(iii) A rejection of Say’s law and the assumption of continuous full employment
(iv) A rejection of the so-called assumption of gross substitution between
non-producible and producible assets in savers’ portfolios (see Chap. 3,
Sect. 2.2 and Davidson 2003)
(v) A strong belief in the fallacy of composition, viz. that macroeconomic
behaviour cannot be reliably inferred from an analysis of the micro-economic
behaviour of a so-called representative agent.
We now turn to a discussion of the six central themes in the post-Keynesian
narrative of the global crisis. Of these themes, the last one, viz. flawed development
and lax regulation of the financial sector, is important in the post-Keynesian nar-
rative of the global crisis, but the theme has been fully developed earlier in Chap. 5,
Sect. 4, and is hence not replicated here. Similarly, since Minsky’s Financial
Instability Hypothesis (FIH) has been fully discussed above in Chap. 8 (Sect. 3), we
merely discuss here its applicability to households and its extensions to the global
context.
3 FIH Applied to Households
As discussed above (see Chap. 8, Sect. 3), Minsky’s FIH viewed the entire issue of
financial fragility in terms of the lender–borrower relationship between banks,
financial institutions and corporate entities (see Papadimitriou and Wray 1997).
Going further, Minsky tended to downplay the role of housing debt in precipitating
a recession. As Dymski (2010, p. 240) puts it “Minsky viewed downturns as caused
by investment cycles, not by housing-price collapses [and] he focused attention on
3 FIH Applied to Households 207
non-financial and financial firms, not on households”. However, as we have seen in

Chap. 5, household indebtedness and the real estate sector were key players in the
unfolding of the recent global crisis. The neglect of this feature in Minsky is
somewhat surprising, since as several scholars have noted, the real estate sector was
a causal factor in most business cycles in the USA in the post-World War II era (see
Palley 1996; Sherman 2010; Lavoie 2016, etc.).
However, even though the subprime crisis does not fit in the original Minskyan
scheme, it can be easily accommodated within this explanation via a few modifica-
tions. In the Minskyan scheme, the concepts of hedge, speculative and Ponzi financing
as applied to firms play a critical role in the development of financial fragility.
McCulley (2009) shows how the same concepts can be carried over to the residential
mortgage markets. According to him, hedge financing in the mortgage market cor-
responds to standard mortgages in which interest and a part of the principal are repaid
every month over a period of 25–30 years. Speculative finance refers to interest-only
mortgages in which only the interest payments are made every month with the
principal being repayable at the end of the mortgage term. Finally, Ponzi financing is
taken to refer to adjustable rate mortgages (ARMs) of the 2/28 or 3/27 variety.1 The
granting of risky mortgages such as interest-only mortgages and ARMs was facilitated
by mortgage-based securitization (or MBS discussed in Chap. 5 earlier) which
removed the inherent risks involved from the balance sheets of the lending banks.
Once this correspondence between mortgage financing and the credit risks asso-
ciated with corporate loans (discussed by Minsky) is made clear, the Minskyan
characteristics of the subprime crisis become evident. The period of Great Moderation
(especially 1994–2006) was a period of relative stability, in which important insti-
tutional changes occurred (such as deregulation, emergence of credit ratings), as also a
great deal of financial innovation (especially mortgage-based securitization) and
over-optimistic “animal spirits” leading to a pronounced decrease in risk aversion.
Thus, in typical Minskyan fashion, the period of relative stability by increasing sys-
temic financial fragility set the stage for the destabilization phase that followed.
4 Financial Fragility in the Global Context
The world was considerably less integrated in Minsky’s lifetime than it is today,
and hence Minsk’s FIH (as originally stated) needs to be amended considerably,
before it can adequately explain the global nature of the GFC. Post-Keynesians
1
An ARM is a type of mortgage that has a low fixed interest rate (teaser rate) for a certain time
period at the beginning of the mortgage, which then becomes a floating interest rate (reference
rate), which might be the 6-month LIBOR, or the 6-month US Treasury yield, plus a certain
spread, called a margin (that depends on the borrower’s credit risk). Both 2/28 ARM and 3/27 are
ARMs with 30-year amortizations, with the difference that the fixed interest rate period for 2/28
ARMs is 2 years and the floating interest rate period is 28 years, while for 3/27 ARMs the fixed
and floating rate periods are 3 and 27 years, respectively.
have grafted this necessary global dimension to the FIH in a fairly straightforward
fashion (see Wolfson 2000, 2002; Caballero and Krishnamurthy 2009, etc.).
Essentially, three features accentuate Minsky’s FIH in a global context and
explain the rapidity and intensity with which the US financial crisis transmitted
itself to the rest of the world (see Chap. 6): (i) free capital inflows and outflows
(capital account convertibility), (ii) restrictive macroeconomic policies to promote
international investors’ confidence and (iii) the role of the IMF.
Capital Account Convertibility: As capital flows are progressively liberalized, a
country is exposed to increasing financial instability on account of the following
five types of risks:
(i) Currency Risk: This refers to the possibility of a sudden precipitous deval-
uation of a country’s currency owing to destabilizing capital flows, often set
off by sudden reversal of foreign investors’ and creditors’ expectations
regarding macroeconomic or political developments in the country. The risk
is particularly pronounced for EMEs embarking on an ambitious programme
of capital account liberalization, without adequate safeguards in place. In
such countries, reserves may be insufficient to cover significant episodes of
investor exit, and additionally, their ability to manage multilateral currency
rescue operations might be limited.
(ii) Maturity Mismatch Risks: Very often, corporates (especially in EMEs) may
be faced with high domestic interest rates. This renders investment financing
a costly affair as it implies locking up funds over long periods at high-interest
rates. There is then a natural tendency to borrow from cheap sources of credit
abroad. However, this credit is usually short term and needs to be rolled over
continuously. This leads to a maturity mismatch (i.e. financing long-term
obligations with short-term foreign credit) risk. A more dangerous mani-
festation of external borrowings is the so-called carry trade in which spec-
ulators borrow funds from countries with low-interest rates and lend them to
entities in countries where interest rates are high (see Stockhammer 2004,
Epstein 2005 etc.).2
(iii) Revaluation Risks: This risk arises on account of foreign currency denomi-
nated loans, which are subject to abrupt changes in value under a freely
floating exchange rate.
(iv) Risk of Non-transparency and Overborrowing/overinvesting: This is ren-
dered possible by the growing derivates and futures markets in recent years
in foreign currency markets, such as currency futures and options, currency
exchange-traded funds, currency interest rate swaps.
(v) Contagion Risk: Finally, contagion risk refers to the possibility of a country
coming under a crisis threat following a crisis in another economy, with
which its trade, investment and finance are closely interlinked.
2
The risks inherent in carry trades are elaborated in several papers, e.g. Dobrynskaya (2014),
Lustig and Verdelhan (2007).
4 Financial Fragility in the Global Context 209
Restrictive Macroeconomic Policies: Very often, domestic governments (espe-

cially in EMEs) face constraints in their ability to pursue independent national
policies because of the allied objective of retaining investor confidence in their
equity and debt markets (see Kregel 1998; Wolfson 2000; Nachane 2007, etc.).
Investors expect assured returns, free from the fear of devaluation and inflation, and
the fear of investor flight can tend to make domestic governments follow con-
tractionary policies, unwarranted by prevailing domestic conditions. Sometimes,
investors may even insist on explicit government guarantees on monetary, trade or
fiscal policy (or even on policies specific to certain sectors such as telecommuni-
cations, oil extraction).
In general, global financial integration implies an impaired ability of small open
economies to pursue countercyclical policies, especially if their business cycles are
out of sync with the business cycles of the major economies. Thus, this aspect can
certainly impart an additional dimension to the underlying fragility of a country’s
financial system.
Role of the IMF: As an international lender of last resort, the role of the IMF in
sovereign bailouts has always been significant. But, in almost all IMF post-crisis
rescue packages in the past, the focus has been on protecting the international
investor rather than the damaged economies. Hence, very often, the so-called IMF
conditionalities were at best ineffective remedies for the underlying problem and at
worst they ended up making a bad situation worse. However, a welcome change has
become noticeable in the last few years, and especially after the Asian crisis, the
IMF has been engaged in a serious rethinking of its policies. After the onset of the
current global crisis, the fund recommended a number of policy measures addressed
to reducing systemic risks and aimed at all systemically important financial insti-
tutions (SIFIs) [for details of these measures, see IMF (2009a b, c, d)]. While this
menu of policies is generally acceptable, there are three specific policy measures
which (according to post-Keynesians) suggest that the IMF is still not completely
out of the neoliberal mindset. These policies refer to
(i) The IMF’s reiteration of faith in the “origin and distribute” model of secu-
ritization which (as we have seen in Chap. 5) wrought havoc during the
unfolding of the crisis
(ii) The (IMF’s) misdiagnosis of global imbalances as the primary source of the
crisis, and its consequent recommendation of rebalancing demand across
surplus and deficit regions through fiscal discipline in deficit countries (such
as the USA) and expansionary policies, including currency appreciation, in
surplus countries (like China). As shown by Acharya and Schnabl (2009) and
Xafa (2010), it was global banking flows rather than global imbalances that
determined “the geography of the financial crisis”, though global imbalances
did help to perpetuate the low-interest rate environment that provided such
fertile ground for the proliferation of complex structured financial products
(an important adjunct of financial instability)
(iii) In the wake of the Asian crisis, the IMF developed a preconception that
currency pegs are crisis-prone and hence started dispensing a blanket recipe
of exchange rate flexibility (and inflation targeting), irrespective of countries’
individual circumstances. For highly dollarized economies and for econo-
mies with undeveloped financial systems and weak regulation/supervision,
such policies could be an invitation for a severe financial crisis.3 an incentive
for domestic residents to borrow in foreign currencies.
5 Herd Behaviour of Investors
Well before the advent of the global crisis, several economists had realized that the
1930s Keynesian description of financial markets as being “casinos” guided by
“herd instincts” is nearer the mark than the efficient-market hypothesis, as a
description of how real-world forex markets operate in modern practice (see, e.g.
Scharfstein and Stein 1990; Russel and Torbey 2002; Huberman and Regev 2001,
etc.). On the theoretical side, there are studies that have shown that, in a market with
noise traders, herd behaviour is not necessarily “irrational”, in the sense that it can
be built upon the optimizing behaviour of agents (see Banerjee 1992; Bikhchandani
et al. 1992; Welch 1992).4 In the model, rational herding arises because of
information-event uncertainty.
The two basic sources of herding behaviour are:
(i) The “safety in numbers” syndrome which arises when returns in markets
cannot be modelled via stable probability laws, i.e. when Knightian uncer-
tainty prevails
(ii) The fact that investors may not be interested in taking a long-term perspective,
but rather in speculating on short-run price behaviour. This typically happens
in financial assets and is specially true in forex markets, where day trading is
the rule rather than the exception (see Chiang and Zheng 2010).
In such a context, investors, far from basing their expectations on prospective
behaviour of the underlying fundamentals, are more likely to base their opinions on
market sentiments (i.e. the opinion of the other members of their group). This lends a
dangerous edge of volatility to financial markets, as any “news” if it affects market
sentiment strongly (in either direction) is likely to produce mood swings in market
sentiment, even if the “news” in question is unlikely to alter long-term fundamentals.
3
Iceland provides a prototype example of this. Its inflation-targeting regime involved large interest
rate differentials with the low-interest rate regimes such as the USA and Europe. These differentials
could not be sustained without opening the doors to large speculative capital inflows in search of
yield and creating.
4
Two useful post-crisis surveys of herding in financial markets are Vives (2008) and Hirshleifer
and Teoh (2009). A structural econometric model for validation of herd behavior in financial
markets is given in Cipriani and Guarino (2012).
5 Herd Behaviour of Investors 211
Herd behaviour is an essential dimension of post-Keynesian analysis, and hence

they accept the inherent tendency towards instability of important asset prices such
as real estate, equities and the foreign exchange rate.
6 Endogeneity of Money
Two broad approaches to the process of money supply determination may be

distinguished in the current macroeconomics literature—an exogenous view
claiming ancestry from Milton Friedman’s monetarism (discussed in Chap. 2,
Sect. 2.2) and an endogenous view dating back even further to Keynes (1930) and
Wicksell (1936) [1898].
The exogenous theory assumes that the monetary base H is almost fully under
the control of the central bank, which, taken in conjunction with the stability of the
money multiplier m, means that within tolerable margins of error, the central bank
can keep money supply on a desired strategy. This is achieved via the fractional
reserves system, under which banks are required to maintain a fixed proportion of
their deposit liabilities as reserves with the central bank. Banks create loans on the
basis of already available deposits, after setting aside the required proportion of
reserves (in practice, banks may also keep an extra cushion of reserves—so-called
excess reserves). By varying the required reserves, the central bank can alter m and
affect the banks’ credit creation capacity. Thus, in this model, the capacity of banks
to create credit is constrained by the availability of prior deposit resources as well as
the required reserves (see Das (2010) for an explanation of this process of money
supply creation in the Indian context).
Empirical evidence for the exogenous theory of money supply seems rather weak
(see Prescott and Kydland 1990; Pollin 1991; Nayan et al. 2013; Shanmugham et al.
2003, etc.). In recent years, there has been a strong revival of interest in the endogenous
theory of money supply determination. As mentioned above, the theory may be said to
originate with Keynes (1930), though its present evolution owes much to the work of
Robinson (1956), Kaldor (1982), Kaldor and Trevithik (1981), Moore (1988), etc.
This theory is explained in detail in several references (see Fullwiler 2013; Fontana
2003; Bourva 1992; Lavoie 2005, etc.), and we only sketch it briefly here.
According to the endogenous theory, the corporate non-financial sector’s
investment decisions are at the centre of the money supply creation process. But
this investment depends on the firms’ profit expectations, which thus determine the
demand for credit. Credit is created by banks “out of thin air”—in other words, the
bank does not base its credit decision on the availability of deposits (as supposed by
the exogenous theory), but first grants the loan at an interest rate which is a markup
over the central bank policy rate (repo rate in India) and then creates a deposit of
equivalent amount in the lender’s name. It then starts looking for the reserves to
support this new deposit. These reserves can either be obtained from fresh deposit
inflows or by the bank borrowing from other banks in the inter-bank overnight
market (the call money market in India) or from the central bank discount window
(either via overdrafts or short-term repo operations5). Of these (demand) deposits

are the cheapest source of borrowing, and the central bank overdrafts the most
expensive. As Fullwiler (2013, p. 177) puts it “… at the level of the individual
bank, the act of lending is not deposit or reserve constrained. Banks do want
deposits, but that is because these are the least expensive liability…”.
A basic tenet of the endogenous theory is the central bank’s responsibility to
keep the national payments system running smoothly. In view of this responsibility,
the central bank cannot let the banking system as a whole run out of reserves.
Hence, whatever reserves are demanded by the banking system, the central bank
supplies them at a price determined by the central bank (viz. the Fed Funds rate in
the USA, the repo rate in India) (see Elgar 2009). Thus, the banking system as a
whole is a price-taker in the market for reserves, and the central bank has no direct
control over the volume of reserves demanded, but can only influence them indi-
rectly by affecting the price at which they are supplied. From this, it can be seen that
the true role of reserve requirements is to aid central banks to maintain the interest
rate target (see Lavoie 2010; Mehrling 2011; Fullwiler 2013, etc.). Thus, whereas in
the exogenous theory of money supply reserve requirements (or money supply) are
exogenous policy variables, in the endogenous theory it is the interest rate which
plays this role.
The endogenous approach is not uniform but considerably differentiated with at
least three distinct schools of thought, viz.
(i) Horizontalism/accommodationism (Kaldor 1982; Moore 1988; Howells
1995, etc.)
(ii) Structuralism (Rousseas 1986; Meulendyke 1988; Pollin 1991;
Panagopoulos and Spiliotis 2008, etc.)
(iii) Circuit theory of money (Robinson 1956; Realfonzo 2016; Graziani 2003;
Gnos and Rochon 2003, etc.).
We do not go into a discussion of these different schools of thought here, since
they differ in details,6 whereas our main interest centres on what bearing the
endogenous view as a whole has on the explanation of the global crisis.
As we have seen above, in the endogenous view, borrowers (mainly
non-financial corporations) motivated by profit expectations approach banks for
credit, which banks supply on the assurance of good collateral and after ascertaining
whether the loan will be profitable given the market rate of interest. The act of credit
creation thus leads to a rise in money supply. But that is not the end of the story.
Banks also actively expand their balance sheets for maximizing their return on
equity (RoE)7, and in this process, they increase their dependence on short-term
5
Repo operations are explained in detail in Euroclear (2009).
6
Palley (2008) offers an authoritative discussion of the controversies among the various schools
within the endogenous fold.
7
As Ingves (2014) aptly puts it “… banks are highly leveraged institutions that are in the business
of facilitating leverage for others”.
6 Endogeneity of Money 213
financing.8 Driven by the urge to maximize profits, banks look for new ways of
financing business and raising funds. This explains the rapid growth of financial
innovations in the USA and Western Europe in the last three decades.
The Great Moderation (a prolonged period of tranquillity) witnessed an explosive
tendency, both for creditors to increase their leverage and for banks to lower their
lending standards and admit increasingly less creditworthy borrowers (in typical
Minskyan fashion as we have seen above). Financial innovation, especially securi-
tization, aggravates this tendency as the riskier loans are sold and taken off the bank’s
balance sheet. In the 1990s, several new financial instruments arrived on the scene
such as CDs, MBS, CDOs (see Chap. 5 for details). As these were near-substitutes for
deposits but not deposits in law, they very often escaped several regulations applicable
to deposits. Thus, a “shadow banking” sector developed which was largely outside the
regulatory ambit of central banks, and yet intimately intertwined with the traditional
banking sector. In short, the supply of money and money substitutes became far more
elastic and unregulated than warranted by financial prudence.9
After a prolonged period of macroeconomic stability (1994–2006) in the USA,
optimistic expectations became entrenched and market sentiments became euphoric
in USA and global financial markets. In this euphoric stage, short-term financing of
long-term positions became routine, new and opaque financial innovations (MBS,
CDOs, CDS and other derivatives) emerged and within a short time proliferated,
and the unregulated shadow banking system rapidly outstripped regular banking
activities. All this contributed to the financial fragility in the first half of the pre-
vious decade and the bust that later occurred with the collapse of the real estate
market (2006 and 2007) and of large financial institutions such as Lehman Brothers,
AIG (2008) (Some econometric evidence relating to the endogenous theory is given
in Sabri et al. (2013)).
Thus, in the post-Keynesian narrative the general failure of mainstream eco-
nomics to recognize the endogenous nature of money supply meant neglecting an
important dimension of the global crisis.10
7 Income Inequality and the Crisis
Most post-Keynesians attach a significant role to income distribution in the

macrofunctioning of an economy. They generally make a distinction between
functional and personal income distribution. Functional income distribution con-
siders national income distribution between three classes, viz. workers, capitalists
8
The importance of leverage for banks is explained in detail by Fullwiler (2013, pp. 172–173),
Kauko (2014), Barth and Miller (2017), etc.
9
The global dimensions of these developments are elaborated by Tokunaga and Epstein (2014)
(see also McGuire and von Peter 2009; Dorrucci and McKay 2011; Borio and Disyatat 2011).
10
Arestis and Glickman (2002) outline a similar set of forces at work during the Southeast Asian
economic crisis.
and rentiers, whereas personal income distribution refers to the distribution of

national income among individuals or households.
Consider functional income distribution first. An increase in real wages can
either have a favourable impact on overall employment and growth (wage-led
growth) or an unfavourable impact (profit-led growth).
Wage-led growth occurs when higher real wages lead to an increase in aggregate
consumption demand (as workers have a higher propensity to consume than cap-
italists and rentiers) and sets in motion a virtuous cycle of:
Greater employment ! more investment by firms ! higher labour productiv-
ity ! further rises in real wages.
A decrease of the wage share, on the contrary, is expected to have negative
consequences on aggregate consumption demand and hence might lead to a crisis
(see Palley 2010).
In profit-led growth by contrast, it is a rise in the profit margins (most likely
attained through lower real wages) which lead to increased overall growth by
buoying upmarket optimism, raising business investment and stimulating exports
(see Dallery (2009), Clevenot et al (2010) etc.).
Economies thus can be wage-led or profit-led, depending on which of these two
forces dominate (see Levy 2000; Bhaduri et al. 2006; Stockhammer 2006: Hein
2012; Goda 2013, etc.). Most empirical evidence tends to favour wage-led growth
(see, e.g. Hein 2011; Onaran and Galanis 2012; Lavoie and Stockhammer 2013),
and going by this evidence, the observed decrease in wage share and rising
inequality in many Western economies since the 1990s could have led to an in-built
tendency towards stagnation in such economies (see Blecker 2016).11
So far, we have focused on increased functional income inequality. An increase
in personal income inequality has similar effects. Since poorer segments of the
population usually have a higher marginal propensity to consume than the richer
segments (see Palley 2002; Goda 2013; Stockhammer 2012, etc.), an increase in
personal income inequality has the potential to depress aggregate demand.
The negative consequences of an increase in income inequality might be kept in
abeyance for some time via debt-financed consumption (the adverse consequences
of which we have discussed in the context of the global crisis in Chap. 5, Sect. 3).
But post-Keynesians also draw attention to a neglected dimension of the inequality
syndrome, viz. the rapid increase in the income of the top 1%. This top-end
inequality resulted in an “expenditure cascade” in which middle-income and poor
households struggled to emulate the consumption patterns at the top by resorting to
large-scale consumption loans (see Barba and Pivetti 2009; Goda 2013; etc.).
According to post-Keynesians, the main reason for the explosion in the demand for
household credit in the decade 1996–2006 was the rise in general income inequality
(personal as well as functional).
The ILO study (Onaran and Galanis 2012, p. 3) states “the global economy in aggregate is
11
wage-led [indicating that there are] limits of strategies of international competitiveness based on
wage competition”.
7 Income Inequality and the Crisis 215
To repay their debts and meet the debt servicing obligations, households put
their faith in a secular rise in housing prices. Ponzi finance became routine and was
sustained by expectations of rising asset prices and financial innovation.
When the day of reckoning came with the Fed increasing interest rates, and the
real estate bubble burst, there was a wave of foreclosures and a collapse of the CDO
market which ultimately flared up into a crisis of global proportions (see Hein and
van Treeck 2008; Horn et al. 2009; Bhaduri 2011, etc.).
Thus in the post-Keynesian view, inequality and debt-financed consumption are
key factors in explaining the pre-crisis growth regimes and the ultimate collapse. As
(Palley 2002, p. 11) puts it “[ultimately] a mass-production economy needs
mass-consumption markets to support it [and] robust mass-consumption markets
rest on a healthy distribution of income”.
8 Godley’s Seven Unsustainable Processes
Formal post-Keynesian models of the crisis have employed an accounting frame-

work in which the Levy–Kalecki profits equation played a fundamental role. Such
models which are referred to as stock-flow consistent dynamic (SFCD) models have
had a long history (see Cripps and Godley 1976; Godley and Cripps 1983; Godley
1999, 2004; Godley and Lavoie 2007; Taylor 2008; Keen 2013, etc.). Following
from simulations based on such models, Godley (1999) identified seven unsus-
tainable processes prevalent in the USA at the end of the twentieth century and
predicted (with remarkable prescience) that a major crisis (in his words a “sensa-
tional day of reckoning”) would occur within the next 8 years (see Blecker 2016).
The seven unsustainable processes that he identified were as follows:
(i) A precipitate fall of saving into negative territory
(ii) A continuous rise in the flow of net lending to the private sector
(iii) The rise in the growth of the real broad money stock M2 relative to M112
(iv) The rise in asset prices at a growth far exceeding that of profits or GDP
(v) The rise in the US government budget surplus
(vi) The rise in US current account deficit
(vii) The increase in the net foreign indebtedness of the USA relative to GDP.
These seven processes can also usefully serve as leading indicators of a
financial crisis in mature economies (see Barbosa et al. 2007; Papadimitriou et al.
2006a, b, etc.).
12
Narrow money M1 may be identified as the transactions component of cash balances, while the
difference between broad money and narrow money (M2–M1) represents the non-transactions
component.
9 Conclusion
While post-Keynesians believe that instability and disequilibrium are inherent in

free market economies, they also believe that state intervention can stabilize the
economic system to some degree. To be more precise, they are strongly supportive
of fiscal stimuli as an important measure to get an economy out of recession. By
contrast, monetary policy is not only deemphasized, but its use for countercyclical
purposes is strongly disfavoured (see, e.g. Rochon and Setterfield 2012).
The reasons for the post-Keynesian scepticism with regard to monetary policy
are twofold. Firstly, they discredit the natural rate of interest theory, which as seen
above is an essential component of mainstream economics and supplies the theo-
retical rationale for inflation-targeting policies (see Rogers 1989; Smithin 1994;
Setterfield 2010). Secondly, the post-Keynesians deny any link between interest
rates and aggregate demand except through the impact of interest rates on income
distribution (see Lavoie 2014). Thus to post-Keynesians, the mainstream rationale
for quantitative easing (QE), viz. the zero lower bound (ZLB) on the nominal
interest rate, seems quite misplaced, and (subscribing as they do, to an endogenous
view of money) they have little faith in QE as a measure to lift an economy out of
recession (see Palley 2008; Rochon 2016)..
Finally, in the post-Keynesian view, a five-pronged strategy to restrain the
amplitude of economic crises within manageable bounds would comprise the
following:
(i)Financial markets are sufficiently regulated.
(ii)Large fiscal surpluses are avoided.
(iii)The current account deficit is kept within limits.
(iv) The real rate of interest should be set equal to the growth rate of labour
productivity. This is called as the Pasinetti rule (see Pasinetti (1974),
Docherty (2012), Rochon and Setterfield (2007), etc.).
(v) The wage share in an economy should be maintained roughly constant over
time. To ensure this real wage growth should be in line with labour pro-
ductivity [the so-called golden rule advocated by Davidson (2003–2004),
Setterfield (2010), Hein and Stockhammer (2011).
While the details of an exact strategy to counteract a major crisis would depend
on the specific circumstances of a country, there is no denying that the above five
principles can serve as convenient guideposts in any such strategy. We try to offer
some suggestions in the Indian context along these lines in Chaps. 15 and 16.
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Chapter 10
Marxian Perspective on the Global
Crisis: “Povorot” or “Perelom”?
Abstract This chapter presents an overview of the Marxian perspective on the

global crisis. Karl Marx had a full-fledged theory of the economic crises of capi-
talism. Authors like Mandel and Clarke have tried to adapt the orthodox Marxian
theory to the characteristics of the kind of “mature” capitalism that prevails in the
developed economies of the West currently. While most of the other theories of
crises regard them as arising from market and/or regulatory failure, greed, specu-
lation or some other aberrations, the Marxian theory regards crises as a dialectical
process, arising from the contradictions between the means and methods of pro-
duction and the social milieu within which this production takes place. Crucial to
the Marxian theory of crises is the proposition that the rate of profit in a capitalist
economy exhibits a tendency to fall, and it is in the efforts of capitalists to counteract
this tendency that the roots of crises lie.
1 Marxian Crisis Theory
Karl Marx in his major works written in the second half of the nineteenth century
(see Marx 1859; 1867) had a full-fledged theory of the economic crises of capi-
talism, stemming from certain irreconcilable contradictions within the capitalist
system itself. Authors like Robinson (1956), Mandel (1975) and Clarke (1990–
1991) have tried to adapt the orthodox Marxian theory to the characteristics of the
kind of “mature” capitalism that prevails in the developed economies of the West
currently.
While most of the other theories of crises regard them as arising from market
and/or regulatory failure, greed, speculation or some other aberrations, the Marxian
theory regards crises as a dialectical process, arising from the contradictions
between the means and methods of production and the social milieu within which
this production takes place. Crucial to the Marxian theory of crises is the propo-
sition that the rate of profit in a capitalist economy exhibits a tendency to fall,
Povorot is Russian for “turning point”, while Perelom stands for “breaking point”.

https://doi.org/10.1007/978-81-322-3920-8_10
222 10 Marxian Perspective on the Global …
but being a tendency it is in principle reversible, and it is in the efforts of capitalists

to counteract this tendency that the roots of crises lie.
In the Marxian schemata, the two factors of production considered are (i) con-
stant capital (c) comprising machinery (amortized value for the production period),
raw materials and intermediate goods (which are consumed in the production
process) and (ii) variable capital (v) which is simply the wages paid to labour. The
total value of production (z) would normally exceed (c + v) for any production to
be undertaken at all.
Marx further defined the concept of surplus value (s) as the excess of total
production over the wages paid to labour, i.e.
s¼zv ð1Þ
Surplus value furnishes profits for capitalists, interest payments on loans, raw
material costs, rents, fees, royalties and various other charges connected with the
production process.
Another key Marxian concept is the rate of exploitation (e) defined as the excess
of labour productivity over the wages paid to labour, defined as
e ¼ ðs=vÞ: ð2Þ
Marx also defines the organic composition of capital (c) as the ratio of constant
to variable capital, i.e.
c
c¼ ð3Þ
v
Finally, the rate of profit (p) is simply

s s=v e
p¼ ¼ ¼ ð4Þ
cþv v þ1
c
cþ1
According to Marxian doctrine, the drive for profits leads to an ever-increasing

process of accumulation and a corresponding increase in the scale of production.
Competition for products and the opening up of new markets (via globalization)
accentuates this process. All this, of course, implies that the constant capital c is
rising in relation to the amount spent on labour v; i.e. the organic composition of
capital c shows a secular rising trend. If the rate of exploitation e remains
unchanged, then the rate of profit p tends to fall. Marx only asserts that there is a
tendency for the profit rate to fall and not that it will inevitably fall. Also, he is not
talking of a “profit squeeze” or a fall in the absolute quantum of profits. Of course,
capitalists will do their best to counter this tendency by raising e either by reducing
the wages paid to labour v or by raising labour productivity through innovation
(more surplus value s generated by the same amount of labour via the introduction
of new machinery, new processes and new products). The innovators succeed
1 Marxian Crisis Theory 223
initially in capturing a greater share of profits in the system. As others follow, the
new techniques become generalized and the leaders’ advantages are lost.
But there is another aspect to this process of capitalist accumulation. A stage is
reached when the desired level of capital required exceeds the capitalist’s own
internal resources (out of previous accumulation), and the capitalist then turns to
either the banking credit avenue or the stock market for augmenting his investible
funds. Bank loans, bonds and equity are termed as “money capital” or “fictitious”
capital by Marx, in contrast to what he calls as “productive” capital or the produced
means of production. Fictitious capital essentially comprises titles to a share in the
surplus value extracted from labour (the sole source of value in Marx) by pro-
ductive capital. Marx recognizes that fictitious capital can and does play a role in the
expansion of the production process (see Marx 1996 [1894], p. 642):
As material wealth increases, the class of money capitalists grows. On the one hand there is
an increase in the number and wealth of the retired capitalists, the rentiers; and secondly the
credit system must be further developed, which means an increase in the number of
bankers, money-lenders, financiers, etc. With the expansion of available money capital, the
volume of interest bearing paper, government paper, shares, etc. also expands, as explained
already. At the same time, however, so does the demand for available money capital, since
the jobbers who speculate in this paper play a major role in the money market. If all
purchases and sales of this paper were simply the expression of genuine capital investment,
it would be right to say that they could have no effect on the demand for loan capital, since
if A sells his paper, he withdraws just as much money as B puts into paper.
But he also recognizes that money capital, additionally, has a life of its own
since profits can be made by trading in the underlying financial assets (equities,
bonds, credit derivatives, etc.), independently of their role in the production pro-
cess. This aspect of money capital can play a pernicious role in the capitalist system
(see Marx 1996 [1894], p. 644):
With the development of the credit system, large and concentrated money markets are
created, as in London, which are at the same time the major seats of dealings in these
securities. The bankers put the public’s money capital at the disposal of this gang of dealers
on a massive scale, and so the brood of gamblers multiplies.
Crises, according to Marx, are a reflection of two distinct but interrelated

imbalances that arise as the process of accumulation gathers momentum (i) the
falling rate of profit and (ii) speculation in money capital leading to the claims of
capital far exceeding the available surplus value (see Beams 2008, p. 8). Only two
alternatives are available at this juncture—intensifying the exploitation of workers
to expand the surplus value pool or eliminating claims on surplus value by a
reassessment of the value of financial assets initially, and then of physical assets.
Since there are sociopolitical limits to the first alternative, the second alternative is
the one that is usually adopted. However, the restoration of the disturbed equilib-
rium via the elimination of claims on surplus value leads to corporate bankruptcy,
bank failure, a meltdown of money markets and stock markets, and a general
payments systems breakdown. This has repercussions for the real sector as well
where there occurs “an actual stagnation and disruption in the reproduction process
and hence …an actual decline in reproduction” (see Marx 1996, p. 363).1 Needless
to say, such crises also have the potential to generate far-reaching sociopolitical
upheavals.
2 Stable Capitalism Phase in the USA (1890–1970)
2.1 Real Wage Trends (up to the Late 1970s)
While the above description tries to briefly outline the Marxian theory of crises, its
particularization to the current global crisis has been attempted by Resnick and
Wolff (2010), Dunn (2009), Ticktin (2009), Harvey (2010), etc. Taking a historical
perspective, Resnick and Wolff (2010) note two key trends of US industry from the
1890s to the late 1970s, viz. the real wages of workers in manufacturing rose by
about 1.8% per annum on an average, while labour productivity rose by about
2.3%. Hence in Marxian terms, surplus value rose annually at about 0.5%. These
trends achieved a twofold purpose—on the one hand the continuing rise in real
wages and associated rise in living standards kept workers’ class antagonisms at
bay, and on the other hand, the ever-rising surplus value afforded capitalists the
means whereby to secure their hold on the system (parts of the surplus being used to
invest in new technologies, new machinery, and corporate bureaucracies to increase
the scale of production, parts being used as bank fees to secure access to public
savings and some portion being utilized for political lobbying, for cultivation of
public opinion in favour of the capitalist ideology and neutralizing the influence of
labour unions).
2.2 Stabilization Strategies of Capitalism
Later, Marxists have identified three strategies adopted by the capitalist class in the
post-World War II period in USA and Western Europe to contain working-class
movements, viz. (i) stratification of the working class, (ii) reducing polarization via
encouraging the emergence of a middle class and (iii) promoting small and medium
scale enterprises.
In the Marxist view, the stratification of workers along the lines of race, sex,
religion, language, caste, etc., has been a strategy long used by the capitalist class to
prevent worker solidarity. But in recent years several countries have put in place
legal impediments to such discrimination, so that the more blatant forms of this
discrimination are on the wane. However, newer stratification strategies have
1
The complete description of the causes and occurrence of crises is given in Chap. 15 of Capital
(vol. 3).
2 Stable Capitalism Phase in the USA (1890–1970) 225
emerged such as divisions between casual, contractual and regular workers, tem-
porary and long-term labour, white-collar and blue-collar employees (see Darity
et al. 2006; Davis 2015; Cope 2015; Arestis et al. 2014, etc.).
The emergence of a middle class has also acted as a stabilization force for
capitalism. As production became technologically more sophisticated, specialists
and supervisors became more important in the production hierarchy and soon
merged with the lower layers of management to create an amorphous class of
better-paid workers. Apart from this class of higher-paid workers, whose interests
became increasingly aligned with the capitalist classes, there was also the
fast-growing class of professionals like lawyers, bankers, teachers, journalists who
produced the services required to sustain the material production. There thus arose
in the late nineteenth century, a class which, while distinct both from both the
proletariat and the capitalist classes, was heavily dependent on the capitalist class
for its survival and flourishing. This “middle class” was quite influential in the
formation of public opinion and in supplying the political base for both authori-
tarian regimes and democratic ones. It thus played an important role in stabilizing
capitalism by acting as a strong pressure group in favour of the status quo (see
Mandel 1975; Giddens and Held 1982; Ticktin 2009, etc.).
The third aspect of the drive to shore up the capitalism system is the attempt to
encourage the growth of a thriving small business sector. In the early 1970s, there
was a fundamental shift in the industrial production structure in the developed
capitalist world. Often referred to as post-Fordism, the system had several aspects
including an emphasis on specialized products and jobs, on economies of scope2
rather than economies of scale, flexible specialization, etc. This shift is interpreted
by Marxists as a self-adaptive strategy of Western capitalism to accommodate
changes such as the increased competition from Asian markets due to globalization,
the end of the post-World War II boom and increasing privatization. Instead of mass
production of standardized goods as in the old Fordist system, firms were now
focused on producing diverse products catering to different groups of consumers, in
conformity with their purchasing ability, preferences and geographical location.
This of course required the build-up of flexible systems of labour and machines that
could quickly sense and respond to special and ever-changing features of consumer
demand. The process made the middle classes, and to some extent the working
classes, socially mobile upwards, by opening up to them the possibility of
becoming micro-entrepreneurs with sanguine prospects of high profits.
2
Economies of scope refer to the efficiencies that a firm can exploit by diversifying its lines of
production, in contrast to economies of scale which arise from expanding the scale of production
of a single good.
3 Marxism and the Current Crisis in the USA
3.1 Reversal of Real Wage Trends (Post-1970s)

and the Eruption of the Current Crisis
By the late 1970s, the trends in US real wages and labour productivity that we have
noted above changed dramatically. While labour productivity shifted into higher
gear growing at an average annual rate of 3.26% from 1980 to 2007, real wages in
the same period were nearly stagnant (see Resnick and Wolff 2010). It is these
changes in trends which give the post-1980s crises in the USA (and other developed
capitalist economies) their special poignancy. Automation, deregulation, reduced
corporate taxes, lowered government welfare spending and the decline of the
bargaining power of unions were all, to a lesser or greater extent, responsible for
these trends. But what concerns us more is the effect that these changing trends had
on the US economy.
So far as the capitalist classes were concerned, a large part of the surplus was
spent on the genuine needs of accumulation and research and development, but a
considerable part also was transformed into the private wealth of corporate man-
agers, promoters and to some extent shareholders via bonuses, salaries, dividends,
rights issues, etc. The increased concentration of wealth in a few hands created the
need for special enterprises to manage the wealth of these new billionaire class, viz.
hedge funds, private equity funds, investment banks. Extensive competition for
getting hold of “funds to manage” among such virtually unregulated enterprises led
them to introduce newer financial instruments such as mortgage-based securities,
credit default swaps, collateralized debt obligations, which as we have seen in
Chap. 5 became easy avenues for large-scale speculation from the 1990s onwards,
encouraged by the Fed’s easy monetary policy and laid-back attitude to regulation.
The end of rising real wages in the US post-1980s confronted the working class
with a dilemma. Accustomed to rising living standards over the past several dec-
ades, they were reluctant to rein in consumption but preferred the debt route to
maintain their living standards in the face of stagnant real wages. The mean
household debt for a white family rose from $70,600 in 1989 to $104,800 in 2001
to a peak of $155,900 in 2010 while for a non-white family the corresponding
figures were $46,700 (1989), $64,700 (2001) and $105,700 (2010).3 In effect, the
US system was compensating the workers for their stagnant real wages with easier
bank loans in a bid to keep labour unrest at bay.
3
The data are from Bricker et al. (2014).
3 Marxism and the Current Crisis in the USA 227
3.2 Weakening of Stabilization Factors
Simultaneously, the traditional stabilization factors of capitalism that we have noted

above were also getting steadily undermined (see Resnick and Wolff 2010; Kiely
1998; Ticktin 2009, etc.) in the closing decades of the last century.
(i) Stratification of the Working Class: Open discrimination among workers
along the lines of race, sex, religion, language, caste, etc., was being
increasingly prohibited by law. As “flexible specialization” became the
watchword in manufacturing with globalization and multi-national supply
chains, very few jobs offered secured tenure—most jobs were either con-
tractual (often related to specific projects) or casual. Simultaneously, with
automation and robotics proceeding apace, the distinction between “white-”
and “blue-”collar jobs tended to get blurred.
(ii) Schism in the Middle Classes: There is evidence since the 1970s of a certain
polarization of the middle class. On the one hand, there has been the rise of
managerial professionals, who receive huge salaries and end up being
absorbed into the capitalist class. On the other hand, the lower and middle
management have lost their job security and are continuously under the
threat of downsizing during downturns. As such, their working conditions
and the problems they confront are similar to that of the working classes.
Thus, effectively there has been a squeeze on the middle class with a small
part being absorbed in the capitalist class, while a much larger part finds gets
proletarized.
(iii) Small and Medium Enterprises: The post-Fordist experiment has also
exhibited several strains in the last two decades. Firstly, small firms tend to
be very susceptible to the downturns in the economy, as they are the first to
be hit in the event of a credit crunch. Secondly, small enterprises in the
consumer goods sector face a limited demand, largely dependent, in fact, on
the old “middle class” since the rich would resort to more sophisticated and
branded products of large firms. Thirdly, with the growth of globalization,
the production advantage has shifted to large transnational enterprises who
can exploit economies of scale, source the best managerial talent and spe-
cialist skills and access finance capital from a multitude of sources. Small
firms have opted for the survival route of becoming ancillaries to the large
firms, depending on the big firms for their inputs and the purchase of their
outputs (e.g. automobile industry, food processing, clothing, electronics).
The conditions of stagnating real wages, profit rates under threat, the erosion of
the influence of the stabilizing forces of capitalism, the growth of household
indebtedness, a proliferating finance sector and above all a runaway process of
speculation under the impulse of securitization created the perfect stage for the
eruption of the current global crisis (whose timeline of events in the USA we have
described in Chap. 5 and whose spread to the rest of the world in Chap. 6).
Whereas the Marxists recognize that the explosion of money capital and especially
the wave of securitization-based financial innovations was a crucial triggering factor
in the current US crisis, they are careful to emphasize that the trends in real wages,
labour productivity and surplus value were the critical structural underlying factors.
4 Marxian Solutions to the Crisis
Marxist opinion is somewhat fragmented on what is the way out of the impasse
created by the crisis. At one end of the spectrum is the clarion call for the end of
working-class exploitation. To quote from Resnick and Wolff (2010, p. 5):
The change we advocate would put workers inside each industrial enterprise in the position
of first receivers of the surplus value they produced in that enterprise… The surplus pro-
ducing workers would become in effect their own board of directors, displacing traditional
corporate boards chosen by and responsible to major shareholders. This is what we mean by
eliminating the capitalist class structure.
Beams (2008) goes even further and talks about a global working-class struggle
against a global capitalist class.
But several other Marxists take a less orthodox position, opting instead for
reforms within the existing capitalist structure, but with a greater role for state
intervention. The package of reforms would call both for action on the national
front and for coordinated action on the international front.4
(i) Typically most Marxists would regard the finance sector as the villain de
piѐce of the crisis—in particular, the existing system of emphasis on market
discipline, voluntary disclosures and self-regulation with an overarching role
for the credit rating structure is called into question. A strong argument is
then made for the outright nationalization of the banking system (see Patnaik
2009; Ghosh 2009, etc.) and for a rigorous regulation of the entire financial
sector (Blackburn 2008).
(ii) Most left-wing economists would also support a large Keynesian type of
fiscal stimulus. Pollin (2008) calls for a massive green public investment
stimulus for the USA5 Patnaik (2009) argues for fiscal stimuli in India and
other developing countries aimed at protecting the living standards of the
poor and at defending the prices paid to peasants. But he cautions that fiscal
stimuli should be coordinated across countries, since uncoordinated stimuli
4
Pettifor (2008) neatly sums up these measures as (i) the “taming” of financial markets, (ii) “up-
sizing” the state and (iii) “downsizing” the global unified market for financial funds.
5
It (such a programme) would defend state-level health and education projects against budget
cuts; finance long-delayed upgrades for our roads, bridges, railroads and water management
systems; and underwrite investments in energy efficiency–including building retrofits and public
transportation–as well as new wind, solar, geothermal and biomass technologies (Pollin 2008,
p. 14).
4 Marxian Solutions to the Crisis 229
are likely to increase protectionism, with countries eager not to let parts of
their own stimuli leak via imports.6
(iii) But it is not only the domestic financial sector which needs stricter regula-
tion. The current crisis has shown that global capital flows are capable not
only of perpetrating crises but of amplifying them. The issue assumes par-
ticular significance when we see how quickly the current crisis became
universalized (see Chap. 6 for an extended discussion). Almost all left-wing
economists argue for some form of capital controls (see Ghosh and
Chandrasekhar 2009; Pettifor 2008; Blackburn 2008, etc.).
(iv) Quite a few authors have sought revival of Keynes’s conception of an
independent international central bank—the international clearing agency
(ICA) (Stiglitz and Greenwald 2010; Pettifor 2008, etc.). The ICA would
hold a mix of reserve assets of different governments, which could serve as
backing for an international currency (say the bancor).7 The ICA would also
be entrusted with two key responsibilities, viz. surveillance on countries to
check the build-up of global imbalances and functioning as an international
“lender of last resort”.
(v) It has also been recognized that there is need for reform in the governance of
international multilateral institutions like the IMF, World Bank, BIS to give a
greater participatory role to EMEs (including the BRICS countries). It is felt
that the Trevor Manuel Committee (IMF 2009) reforms fall short of the
reforms that are really needed at the IMF (see Vestergaard and Wade 2011).
Related to these reforms is the urgent need to supply the IMF and the World
Bank with enough resources and to mandate from them a coordinated
response to any “development emergency” that may result from future
financial crisis in the developing countries.
The above measures advocated by moderate left-wing writers bear some similarity
to the policy recommendations of the post-Keynesians (described in Chap. 9), with the
important difference that the latter seek to perpetuate the capitalist order, while the
former are looking for fundamental structural modifications in that order. Orthodox
Marxists, however, tend to view the above measures as palliatives or even placebos
and at worst as “a program of utopian capitalism to try to block the development of a
mass socialist movement” (Beams 2008, p. 19). Orthodox Marxists believe that the
emergence of speculative money capital and unbridled financialization is a dialectical
process with deep roots in the very principles on which capitalism is based (viz.
extraction of surplus value and the exploitation of labour). In their world view, there is
no way out of severe crises except via mass socialist movements.
6
Coordinated fiscal stimuli can create balance of payments surpluses in some countries and deficits
in others. Patnaik (2009, p. 53), suggests that the surplus created should be distributed to the deficit
countries as grants but with the proviso that these grants should be used for imports and not to
build up reserves. A mechanism to implement such a scheme seems difficult to devise.
7
The introduction of the bancor would reduce considerably the role of the US$ as a reserve
currency.
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debates. Berkeley: University of California Press.
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International Sociology., 13(1), 95–111.
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Chapter 11
The Post-crisis Critique of the NCM:
Theoretical Aspects
Abstract Turbulent economic events in the past have often triggered substantial
changes in ruling economic paradigms. It was expected by many that the Global
Crisis would provoke a similar outcome. We show in this chapter that by and large,
this expectation was belied, and the NCM emerged almost unscathed through the
various criticisms levelled both on its theoretical and policy aspects. This chapter is
devoted to a detailed review of the theoretical criticisms levelled against the main
tenets of the NCM particularly the hypotheses of rational expectations, represen-
tative agent, efficient markets, etc. There is also a detailed critique of DSGE models
as these forms an integral component of the NCM.
1 Introduction1
Turbulent economic events in the past have often triggered substantial changes in
ruling economic paradigms (see e.g. Sowell (1974), Mirowski (1982) etc.). Thus,
following the Great Depression, the Keynesian General Theory became the dom-
inant orthodoxy, edging out the earlier Marshall-Pigou neoclassical framework. The
collapse of the Bretton Woods in 1973 and the oil price shock of the same year, in
turn put the Keynesian fixed-exchange view of the world under strain and ushered
in the era of floating exchange rates (and managed pegs) and more generally kindled
a strong interest in Friedman’s monetarist ideas. It was expected by many that the
GFC would provoke a similar outcome. By and large (as we shall see later), this
expectation was belied, and the NCM emerged almost unscathed through the
various criticisms levelled, both on its theoretical and its policy aspects. We review
these criticisms below. Actually, many of these criticisms pre-date the GFC, but the
crisis revived them under a fresh impetus. We begin by reviewing the theoretical
criticisms in this chapter and then pass on to the policy implications of these
1
This chapter contains excerpts from the author’s working paper WP-2016-004 “Dynamic
Stochastic General Equilibrium (DSGE) Modelling: Theory and Practice”, published by Indira
Gandhi Institute of Development Research (IGIDR), Mumbai in January 2016; with necessary
permissions.

https://doi.org/10.1007/978-81-322-3920-8_11
234 11 The Post-crisis Critique of the NCM: Theoretical Aspects
critiques in the next. Later in Chap. 13, we see how the NCM proponents responded
to this barrage of criticisms, and also advance some tentative explanations for the
persistence of this paradigm.
2 Representative Agent Equilibrium Models

and Reductionism
The NCM lays strong claims to being scientific in the sense that its macroeconomic
models (the so-called DSGE–dynamic stochastic general equilibrium models) are
securely rooted in microeconomic foundations. This is supposed to insulate these
models from the Lucas critique (1976) that macroeconomic relations are ill-defined
unless they capture the microeconomic behaviour of economic agents. This view-
point that aggregate relations are derivable solely from individual behaviour is
termed as “reductionism” by philosophers (see Murphy 2010)2 (see Chap. 3,
Sect. 2.1 where this issue is discussed in detail).
Thus in effect, the NCM-DSGE models are making five strong assumptions, viz.
(i) reductionism, (ii) representative agent, (iii) representative agents as optimizers,
(iv) existence of a general equilibrium and (v) stability of the general equilibrium.
An early criticism of such models comes from Simon (1955) who argued that
rarely do economic agents compute optimal decisions, they instead use “satisficing”
rules of thumb. Even though recognized as an important contribution by econo-
mists,3 this important insight never found its way into mainstream economics, until
very recently (see e.g. Guth 2010).4
As we have seen earlier (Sect. 2.1), the term representative agent is used in at
least two alternative senses. A stronger sense of the term in which all consumers/
firms are identical and a weaker sense in which agents differ, but their preferences
are such that the aggregate of their individual choices is mathematically equivalent
to the decision of one individual.
Such representative agent reductionist models, which are at the heart of the NCM,
postulate that aggregate demand/supply curves can be arrived at by aggregating over
individual demand/supply curves (see Gorman (1953) for an early discussion of this
issue). But this is valid (in the current state of knowledge) only under either the very
restrictive case of exact aggregation or (if preferences are allowed to be heteroge-
neous) under the conditions detailed in Stoker (1993) and Blundell and Stoker
(2005) (Chap. 3, Sect. 2.1) Browning et al. (1999) etc. The violation of these
2
Actually philosophers distinguish between three types of reductionism viz. theory reductionism,
methodological reductionism and ontological reductionism. Economists usually have the last in
mind which Murphy (op. cit) p. 82 defines as denial “that wholes are anything more than their
parts”.
3
Simon was awarded the Nobel for Economics in 1978.
4
There are several interesting applications of “satisficing” models in management science, oper-
ations research, marketing, behavioural psychology etc.
2 Representative Agent Equilibrium Models and Reductionism 235
assumptions can lead to aggregation biases (see Banks et al. 1997). Thus, in most
real-world situations the “fallacy of composition” critique5 (noted in Keynes General
Theory itself and both by early writers such as Lange 1945 and Tarshis 1947, and
more recently by Howitt 2006; King 2012; Skouras and Kitromilides 2014, etc.) is
applicable. Harcourt (2010) stresses how incorporating this key Keynesian insight
can bring to light a macroeconomic theory, much closer to empirical reality than the
NCM (see Godley and Lavoie 2007).
While the question of the existence of a general equilibrium for markets had
been satisfactorily resolved by Arrow and Debreu (1954), the actual process by
which this equilibrium is attained, remains an open issue. After the DSM (Debreu
1974; Mantel 1974; Sonnenschein 1972) result demonstrated that the Walrasian
tatonnement process may not always lead to a general equilibrium,6 the search for
an appropriate set of restrictions which will guarantee such convergence was
intensified. While convergence has, in fact, been mathematically established (via
Smale’s 1976 Global Newton method), the implied restrictions on preferences and
information are generally recognized as excessive and unrealistic (Hildenbrand
1994; Kirman 2006; Saari and Simon 1978; Flaschel 1991, etc.).
Actually, as Colander et al. (2009) correctly point out, a realistic development of
the micro-foundations of macroeconomics, has to take account of the interactions of
economic agents, which in turn will be contingent on agents being heterogeneous in
terms of information sets, motives, capabilities, etc. (see Fisher 1992; Chamley
2002; Aoki and Yoshikawa 2007; Kirman 2011, Anderson and Raimondo 2008
etc.). The obsession with representative agent models has made economists ignore
many vital areas of research such as network theory and complex systems theory,
which could lead to macromodels of greater interest to policymakers.
According to network theory (see Allen and Babus 2008; Ormerod and Helbing
2013; Blume and Durlauf 2006; Helbing and Yu 2009; etc.), the vision (of the
reductionist approach of the NCM of as the economy being composed of inde-
pendent, optimizing agents, is seriously flawed). The real world, on the contrary, is
composed of densely networked, strongly coupled interacting agents. These inter-
actions can produce cascading effects and extreme events, leading to systemic
5
The fallacy of composition is best described in Keynes’ own words “I argue that important
mistakes have been made through extending to the system as a whole, conclusions which have
been correctly arrived at in respect of a part of it taken in isolation” Keynes (1939, p. xxxii).
6
Following Kirman (1992), the DSM theorem may be explained as follows. The foundations of
neoclassical economics rest on the assumption that if individual demand functions satisfy Wald’s
(1936) WARP (weak axiom of revealed preference) (implying individual demand curves are
downward sloping) then a unique stable market equilibrium exists. The DSM theorem asserts that
whereas the WARP is sufficient to ensure the existence and local uniqueness (of a market equi-
librium), global uniqueness and stability are not ensured by WARP (or by even stronger restric-
tions on individual demand functions). In this connection, it is interesting to observe that Wald
(1936) had correctly observed that “there is a statistical probability that from the assumption that
[WARP] holds for every household, the validity of [WARP] for the market follows”. In other words
WARP at the micro level can lead to WARP at the macro level. The later neoclassicals conve-
niently interpreted this possibility as a nomic necessity.
instabilities (see Ormerod and Helbing 2013, p. 6). The stability in the system
depends on the weakest link in the coupling via cascading effects, and the NCM
model just assumes away such (cascading) effects. Theories of economic crises can
be better understood and predicted only after the nature of networks and couplings
in the economy are better understood. This leads to what has been called as the
“dominoes and avalanches” approach to understanding financial crises (see Allen
and Gale 2000; Rotemberg 2009; Caballero 2010, etc.).
Another promising line of thinking emanates from complex systems theory in
terms of agent-based modelling (see Mantegna and Stanley 2000; Rosser 1999;
Gilbert 2007, etc.). In such a framework, the focus is on the self-organizing char-
acter of complex economic systems, based on a relatively stable organization of
interacting agents. In the context of financial crises, these theories would tend to
focus on the complex institutional structure of financial markets and on decision
rules circumscribing the behaviour of market participants. From an operational
point of view, this line of thinking prompts regulators to pay close attention to nodal
interactions within the financial sector and the build-up of systemic risk.
3 Rational Expectations
The rational expectations hypothesis (REH) comprises an integral component of the

NCM. The hypothesis has been discussed in Chap. 3, Sect. 2.3 and its consequences
set out in Sect. 3 of the same chapter. Behavioural scientists (Kahneman and
Tversky 1979a, b; Kahneman and Riepe 1998; Kunreuther 1978; Gleitman 1996,
etc.) have shown in laboratory experiments that decisions under uncertainty suffer
from systematic biases. Actual behavior of economic agents rarely mimics the RET,
with agents failing to discover “rational expectations equilibria” in repeated
experiments.7 More recent empirical evidence from financial markets points to the
robustness of these earlier claims (see Lo et al. 2005; Coates and Herbert 2008, etc.).
Rather than exhibiting rational behavior, individuals seem to function within a
“bounded rationality” framework (a concept developed fully by Simon 1957, 2000).
These considerations have important implications for inflation expectations.
A more realistic assessment of inflation expectations formation will have to contend
with the limits on individuals’ cognitive and computational abilities, as well as their
inability to separate their perceptions of their local environment from the overall
macroenvironment (see Sims 2003; Shiller 1997; Akerlof et al. 2000, etc.). Because
7
Their main findings were that (i) individuals exaggerate the importance of vivid over pallid
evidence (TV montage over reports in newspapers/scientific journals) (ii) there is exaggeration of
probabilities of recent events over those occurring earlier (iii) individuals’ errors are systematic
rather than random (they are reluctant to give up pre-conceived notions, more favourably disposed
towards accepting evidence confirming initial beliefs than contra-evidence etc.) and (iv) individ-
uals react sluggishly to new information, preferring very often to rely on heuristic decision rules in
such cases.
3 Rational Expectations 237
of this, euphoria (irrational exuberance) and panics are both distinct possibilities in
the complex world of modern finance. Thus, essentially individuals have an
“order-of-magnitude less knowledge than our core macroeconomic models cur-
rently assume” (see Caballero 2010, p. 91).
The concept of “bounded rationality” has attracted considerable interest and is
seen by many mainstream economists themselves as a valid criticism of the RET.
Sargent (1993) in an early contribution, while recognizing the limitations of RET
and the validity of the bounded rationality thesis, seeks to salvage the RET by
introducing an “adaptive learning mechanism” for agents (see Evans and
Honkaphja 1998). The question then is whether rational agents, with a limited
knowledge of the economic mechanism, can converge to a rational expectations
equilibrium via an adaptive learning mechanism (see Grune-Yaanoff 2007, p. 545).
A number of later articles have explored this issue in greater detail (see Bray 1982;
Guesnerie 1992; Adam and Marcet 2011, etc.).
Attempts to incorporate insights from psychology and behavioural finance into
macroeconomics are still in the making. Lo (2007), in an important contribution,
proposes the AMH (Adaptive Markets Hypothesis), where economic agents display
“bounded rationality”. In this view, “Financial markets should be viewed within an
evolutionary framework, where markets, policy instruments, institutions and
investors interact dynamically in Darwinian (evolutionary) fashion. … Behaviour
evolves through natural selection … through a process of trial and error, rather than
through “optimizing” behavior.” (see Allington et al. 2011, p. 13).
In a much-cited post-crisis contribution, Stiglitz (2011) questions the applicability
of rational expectations to situations such as the GFC, which are rare (almost
once-in-a-lifetime) occurrences, and for which past experience can be no guide for the
future. Similar considerations apply to a government contemplating a policy never
tried out before. Will there be a full rational expectations equilibrium in which the
reciprocal expectations of the government and economic agents about each others’
behavior is simultaneously achieved? Conditions under which such Nash equilibria
exist and are achieved in finite time seem fairly difficult to achieve in practice (see Bray
1981; Marcet and Sargent 1988; Evans et al. 2012; Hommes 2011, etc. for details).
4 Transversality Condition
As we have seen in Chap. 4, Sect. 5.2 above, NCM models impose a so-called
transversality condition (Blanchard and Fisher 1989, Appendix 2A). This is often
imposed as a boundary condition in infinite horizon dynamic programming problems,
and it postulates (in mathematical terms) that the infinitely distant future is orthogonal
to the current criterion function. Transplanted into the capital asset pricing model of
efficient financial markets, it is taken to imply that the prices in the distant future have
no effect on current asset prices. This results from two related confusions—firstly
between the “shadow prices” from a mathematical optimization problem and the
market prices of a decentralized economy, and secondly, between the purely
mathematical transversality condition and long-term expectations in asset markets.

From this, it is but a small step to the conclusion that in the inter-temporal opti-
mization of the representative individual, all debts are paid in full, thus effectively
leaving no space for money, finance and liquidity to enter the model in a meaningful
way (Mankiw et al. (1985)). Thus, in effect, by assuming the transversality condition,
NCM models rule out the possibility of default and hence financial instability (see
Goodhart 2008; Goodhart and Tsomocos 2011; Stiglitz 2011; Wray 2011, etc.).
By ruling out liquidity constraints, the transversality condition fails to allow for
the endogenous build-up of banking/financial crises (see Buiter 2009; Goodhart
2010, etc.). This renders the NCM model particularly inappropriate to analyse the
real-world problems of credit risk and default. As such the NCM models can only
treat crises as exogenous shocks. There is some controversy as to whether the
sub-prime crisis was a random shock or an endogenous development (Lucas 2009,
Fama 2010 argue for the former viewpoint, whereas, Allington et al. 2011 take the
opposite view). The unfolding of the sequence of events leading up to the collapse
of the LTCM (1997), Northern Rock (2007) and Lehman Brothers (2008) seems
however to strongly suggest that banking and financial crises are usually the out-
comes of institutional changes, financial innovations and regulatory shortcomings,
which are path dependent, and which therefore, cannot be analyzed within the
framework of the NCM.
5 Nature of Uncertainty
One of the central features of Keynes’ General Theory was the crucial role assigned
to expectations in shaping investment decisions. In view of the fact that Keynes
viewed investors as facing uncertainty in a Knightian sense (or what we have called
in Chap. 4 above as “non-ergodic” uncertainty), he was led to emphasize the
conventional nature of expectations characterized by a belief that there is wisdom in
numbers, leading to herd behavior in financial markets. Taking its cue from the
standardized IS-LM model set forth by Hicks in 19378 and the martingale result of
Samuelson (1965), current mainstream (NCM) economics, however, seems to have
taken a position directly antipodal to that of Keynes. The RET, in particular,
presumes that the future is ergodic and hence predictable (within known error
bounds). Given the inevitability of unanticipated changes in the real world, the REH
if it claims any pretension to realism, requires a mechanism whereby individuals
can quickly acquire complete knowledge of the altered probability generating
mechanisms (see Frydman and Goldberg 2008; Allington et al. 2011, etc.).
The justification of the NCM for the introduction of new complex financial
instruments, such as CDOs and CDS, is very interesting (though often left unsta-
ted). Walrasian general equilibrium theory as expounded in the standard
8
There seems to be some evidence of Hicks having revised his position on this (see Hicks 1979).
5 Nature of Uncertainty 239
Arrow–Debreu (1954) model shows mathematically that all uncertainty can be

eliminated if there are enough contingent claims (which in the world of today are
equated with derivative instruments). From this, it is but an easy step to the strong
belief that the introduction of derivatives enhances social welfare by contributing to
financial stability. Such reasoning conveniently overlooks the fact that the Arrow–
Debreu result applies only to ergodic uncertainty.
The global crisis brought out starkly, the dangers inherent in assuming that
agents possess knowledge of well-defined probability distributions (or at least their
first two moments), over all possible future states (as presumed by the REH). In the
non-ergodic real world, derivatives more often than not, can turn out to be (in
Warren Buffet’s popular phrase) “weapons of mass destruction”. As is now
well-known, the elaborate models used by credit rating agencies to rate/monitor
complex products like CDOs, predicated on complicated multidimensional proba-
bility distributions and copulas,9 were simply inappropriate to foresee the illiquidity
in US money markets, that arose from investor herd behavior in the face of the
non-ergodic uncertainty intrinsic in new complex financial innovations (see
Mackenzie and Spears 2014 for a detailed view on this).10
The foundations of a more realistic macroeconomics need to be based on a
theory of decision making under non-ergodic uncertainty. Such a theory, in a
rudimentary form, was proposed by Hurwicz (1950) and has more recently been
formalized by Gilboa and Schmeidler (1989) under the rubric of “max-min
expected utility”. A promising line of thinking emanating from such considerations
is “agent-based modeling” (see Mantegna and Stanley 2000; Rosser 1999; Gilbert
2007, etc.). In the context of financial crises, these theories would tend to focus on
the complex institutional structure of financial markets and decision rules circum-
scribing the behaviour of market participants. From an operational point of view,
this line of thinking prompts regulators to pay close attention to networks and nodal
interactions within the financial sector, and the build-up of systemic risk (see
Kirman 2011; Fafchamps and Gubert 2007, etc.). However, it must be remembered
that while some of these approaches to non-ergodic uncertainty appear promising,
they have not yet been incorporated into a systematic theoretical macroeconomic
framework.
6 Complete and Efficient Markets
The NCM makes two key assumptions about market organization on which several
of its conclusions rest, viz. complete and efficient markets (see Chap. 4, Sect. 5.2).
In a complete market system, inter-temporal budget constraints are always satisfied
9
For an introduction to copulas and their uses in finance, kindly refer Brigo et al. (2010).
10
We recognize, of course, that securitization was one among several factors leading up to the
crisis. Nevertheless, securitization will continue to be a key element in any narrative of the crisis.
and real-world phenomena like illiquidity, wilful default, insolvency and market
freezes are ruled out a priori.
The hypothesis of efficient financial markets (EMH) posits that current market
prices of financial assets embody all the known information about prospective returns
from the asset (see Fama (1970) and Chap. 4, Sect. 5.2 for a fuller discussion).
The EMH has been fiercely contested, especially after the global crisis.
(i) As noted by Ball (2013) (in an article largely endorsing the EMH), the
hypothesis is remarkably silent about the nature of the information on the
basis of which traders enter the market (i.e. its reliability, frequency,
sources).
(ii) Ball (2013) also notes that the EMH presumes that investment processing is
costless and it is incorporated into traders’ strategies immediately, which is
highly unrealistic.
(iii) Several doubts have been raised about the real-world applicability of the
EMH. Modigliani and Cohn (1979) and later Ritter and Warr (2002),
Campbell and Vuolteenaho (2004), etc. argued that undervaluation of
security prices can be present because of “inflation illusion”. Shiller (1981)
showed that market volatility in reality is far greater than what the EMH
would lead us to expect.11
(iv) In a new perspective (see also De Long et al. 1989), Woolley (2010)
advances an alternative theory based on asymmetric information and prin-
cipal–agent problems. Investors (who are the principals in this view) del-
egate agents such as mutual funds and investment banks to manage their
portfolios. This delegation creates a problem of misaligned incentives and
asymmetric information (as agents are much better informed than princi-
pals). Agents then are incentivised to take on unwarranted risks, creaming
off the “excess profits” while burdening the principals with the possibility of
loss. This, in the opinion of Woolley (op. cit.), is the main reason why
markets are inefficient and explains the occurrence of bubbles and crashes.
(v) Empirical tests of the EMH have usually been conducted on its weak and
semi-strong versions. Most of the empirical tests find little evidence in
support of the EMH whether in developed or emerging markets (for evi-
dence in the case of developed countries see Jensen 1978; Summers 1986;
Grossman and Stiglitz 1980; Lo and Mackinlay 1988, etc.), for evidence in
the case of emerging markets, some typical references are Gupta and Basu
(2007) for India, Nisar and Hanif (2012) (for a sample of countries in South
Asia), etc.
(vi) If the EMH is valid, then one would expect that market prices would
incorporate the effect of excess leverage on the firm’s fundamentals
including its default probability (see Sloan 1996; Hirshleifer 2001, etc.).
However, several empirical studies document a negative relationship
11
Shiller’s work has spawned a phenomenal literature (see e.g. Cochrane 1991; Cooper 1999;
Dumas et al. 2009; Wang and Ma 2014 etc.).
6 Complete and Efficient Markets 241
between excess leverage and future returns (see, e.g. Penman et al. 2007;
Campbell et al. 2008; George and Hwang 2010). The negative relation
between excess leverage and future returns implies that there is a delay in
the reaction of markets to the information content of excess leverage thus
invalidating the EMH (see Caskey et al. 2012 for details).
(vii) A consequence of the EMH, which is not always realized, is that it
underpins the value-at-risk (VaR) model recommended for banking super-
vision under Basel II. In the VaR model, risk is calculated based on a metric
defined on small deviations around the equilibrium values of asset prices
(see Zamagni 2011, p. 302). The implicit assumption of Gaussianity meant
that fat tail probabilities (extreme events) were largely ignored (see
Frydman and Golberg 2007; Ormerod and Helbing 2013, etc.).12
(viii) Actual market participants concerned with equity, forex and derivatives
markets have never been convinced of the appropriateness of the EMH
(efficient markets hypothesis) as a description of trading strategies in these
markets (see, e.g. Fox 2009; Soros 2009; Smithers 2009).13 Behavioural
theories of human decision making (see Kahneman and Tversky 1984;
Rabin and Thaler 2001, etc.) argue that in the face of complex uncer-
tain situations, individuals do not proceed via maximizing expected utility
but using cognitive heuristics. Such heuristics is an aid to reducing a
complex task to a manageable proportion but often introduces systematic
biases.
There is a widespread belief (largely justified), that EMH has been used by its
advocates to build up a case for deregulation (and lighter supervision) of the
financial sector based on two considerations: (i) As pointed out by Wray (2011), the
EMH implies that financial institutions are intermediaries between savers and
investors, efficiently allocating savings to investment projects. Market impediments
(of which regulation is the most prominent) drive a wedge between the interest paid
to savers and that charged on loans to investors. Deregulation of domestic finance
and financial globalization, by reducing this wedge, lead to greater market effi-
ciency and promote growth and (ii) “Market discipline” can be used as an effective
tool in constraining harmful risk taking. Under the EMH assumption, investors,
12
Basel III tries to pay some attention to the fat tails problem.
13
Charles Munger (an American investor, businessman, and philanthropist), who is Vice Chairman
of Berkshire Hathaway, the conglomerate controlled by Warren Buffett, once said in a speech
“Efficient market theory is a wonderful economic doctrine that had a long vogue in spite of the
experience of Berkshire Hathaway. In fact one of the economists who won — he shared a Nobel
Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his
face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-
sigma event.” And then he said we were a three-sigma event. And then he said we were a four-
sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just
because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel
Prize went into money management himself, he sank like a stone.” (http://thereformedbroker.com/
2014/01/03/that-time-buffett-smashed-the-efficient-market-hypothesis/).
creditors, and shareholders can use market stock prices and bond yields to track
changes in a firms’ condition. They can then exercise influence in their respective
ways on the firms to change their policies (especially those related to portfolio
decisions) (see Bliss and Flannery 2001; Nier and Baumann 2006, etc.). Thus, in
the EMH view, market discipline can complement, if not supplant, government
supervision. Excessive deregulation and relaxed supervision are among the factors
recognized as important triggers for the crisis (both by orthodox and heterodox
economists though on different grounds).
In the wake of the current crisis, economists are increasingly turning to the
so-called saltwater view, which is essentially a resurrection of the 1930s Keynesian
description of financial markets as being “casinos”, guided by “herd instincts” (see
the public utterances of highly regarded economists such as Buiter 2009; De Long
2009; Krugman 2009, etc). In the Keynesian view, investors in financial assets are
not interested in a long-term perspective, but rather in speculating on short-run price
behaviour. Far from basing their expectations on prospective behaviour of the
underlying fundamentals, such investors are more likely to base their opinions on
market sentiments (i.e. the opinion of the other members of their group). This lends
a dangerous edge of volatility to financial markets, as any “news” if it affects market
sentiment strongly (in either direction) is likely to produce mood swings, even if the
“news” in question does not alter long-term fundamentals (for further details, see
Lowenstein and Willard 2006 and Chap. 9, Sect. 4). A novel approach (based on
complexity theory) to analyze this problem is suggested in Farmer et al. (2012).
7 RBC and DSGE Models
As we have made clear in Chap. 4, the NCM is an amalgam of two distinct streams of
thinking—the New Classical and the New Keynesian (see Tzotzes 2016). Each of
these streams has a somewhat distinct view of business fluctuations. Directly in the
lineage of the New Classical school is the RBC (real business cycle) theory, devel-
oped by Kydland and Prescott (1982, 1990) in keeping with Lucas’(1976) exhortation
to economists to focus on structural, rather than reduced form models, in order to avert
the Lucas Critique. A great deal of theoretical and empirical work followed in this
tradition (see King and Rebelo 1999; Cogley and Nason 1995; Stadler 1994, etc.).
RBC theory is essentially a stochastic adaptation of the Arrow–Debreu representative
agent atomistic economy, incorporating the REH (rational expectations hypothesis)
and assuming a frictionless, perfectly competitive economy with complete markets.
Business cycles are then supposed to arise through the interactions of rational opti-
mizing agents with real shocks to the macroeconomy (especially to technology and
productivity). However, RBC models have been criticized on several grounds
(i) Firstly, since they assume rational optimizing agents and complete markets
they are subject to all the criticisms that have been levelled against these
hypotheses (see the discussion in Sects. 2 and 3).
7 RBC and DSGE Models 243
(ii) Secondly, a major challenge to RBC models comes from their failure to
replicate the cyclical behaviour of asset prices. Utility specifications
employed in RBC models typically lead to the equity premium puzzle, noted
by Mehra and Prescott (1985, 2003). Attempts to resolve this puzzle via
induction of the hypothesis of habit formation in RBC models (see
Constantinides 1990; Otrok et al. 2002 etc.), have met with only partial
success (see Boldrin et al. 2001).
(iii) Thirdly, the RBC theory treats technology shocks as exogenous forces
driving the business cycles. However, many technology shocks are limited to
specific industries, and it is difficult to imagine that, in practice they would be
of a scale sufficient to produce cycles in the economy as a whole, and
whether they would occur with the regularity needed to generate the peri-
odicity of observed cycles. Besides, in standard RBC models, a positive
technology shock makes both labour and existing capital more productive,
whereas in reality most of technological development is driven by what has
been called as investment-specific technical progress, which has no impact
on the productivity of old capital goods but only on new machinery (see
Greenwood et al. 2000; Fisher 2003 etc.). Of itself, this does not rule out
cycles driven by technology, but it is difficult to believe that they would
produce deep recessions of the kind noted during the Great Depression and
the recent global crisis.
(iv) Fourthly, the neglect of monetary and fiscal policy shocks in RBC models
constitute major lacunae. Researchers have shown that fiscal policy shocks,
monetary policy shocks, and credit frictions, considerably influence the
transmission of technology shocks to the economy (see Baxter and King
1993; McGrattan 1994; Bernanke et al. 1999; Rebelo 2005, etc.).
(v) The empirical performance of RBC models is particularly poor in repro-
ducing stylized facts about labour markets viz. cyclical behaviour of factor
shares, strong co-movements between capital shares and investment varia-
tions, weak correlation between wages and labour productivity over the
cycle, etc. (see Summers 1986; Benhabib et al. 1991; Gomme and
Greenwood 1993 etc.).
Dissatisfaction with many of the above shortcomings led many mainstream
economists to look for alternatives but within the NCM framework. Instead of
discarding RBC models, the choice was made to amend and elaborate the basic
RBC framework but in the New Keynesian tradition, incorporating market
imperfections such as monopolistic competition, staggered price adjustments, habit
formation in consumption, and externalities. Additionally, attention is not limited to
technological shocks, but broadened to include other nominal shocks such as
monetary policy shocks, fiscal policy shocks, exchange rate shocks, etc. This new
generation of models was dubbed as dynamic stochastic general equilibrium models
(DSGE) and rapidly became a favourite tool in the armoury of many central banks
in developed countries and also a few EMEs.
DSGE models retain the standard NCM assumptions of rational expectations,

complete markets, representative optimizing agents, etc. and proceed within a
general equilibrium framework. Proponents of DSGE models attribute their over-
whelming acceptability, especially in the decade prior to the onset of the GFC, to
several factors. Firstly, unlike some of the widely prevalent econometric models
(such as VAR, or large-scale econometric models), the DSGE models are less
a-theoretic and with secure micro-foundations based on the optimizing behaviour of
rational economic agents. This is supposed to makes the model structural, and
hence less subject to the Lucas critique (see Chap. 3, Sect. 3.3). Several other
advantages are also claimed on behalf of the models, viz. that they bring out the key
role of expectations, and (being of a general equilibrium nature) can help the
policymaker, by explicitly highlighting the macroeconomic scenarios in response to
various contemplated policy outcomes. Additionally, the models in spite of being
strongly tied to theory, can be “taken to the data” (to use a phrase which has
become standard in this literature) in a meaningful way. There is a sprawling
literature covering the theoretical, empirical, and econometric issues arising in
DSGE modelling, and an illustrative list would include Smets and Wouters (2003,
2004), Sborodone et al. (2010), Alvarez-Lois (2008), Ireland (2004), Del Negro
et al. (2013), Nachane (2016) etc.
In recent years, DSGE models have become increasingly complicated, incor-
porating nominal rigidities, monopolistic competition, fiscal policy shocks, unem-
ployment in labour markets, credit and financial frictions, etc. (see Blanchard 2009;
Iskrev 2008; Gali et al. 2007, etc.). The construction of such models can be an
onerous task, involving considerable technical expertise on a wide front, and sev-
eral other resources. The natural question that then poses itself is: Whether the
involved investment in the model construction yields commensurate returns?
Opinion is sharply divided on this. DSGE proponents claim at least four major
advantages for their models.
(i) Firstly, it is claimed that these models are solidly grounded in economic
theory with secure micro-foundations.
(ii) Related to the above, it is maintained that the parameters in the model are
structural, and hence invariant to policy shocks. This by-passes the Lucas
Critique, and enables policy simulations aimed at judging the impacts of
policy changes on key macroeconomic variables. This, it is felt, is a major
advantage over more data-based traditional models such as VAR or simul-
taneous equation models.
(iii) DSGE models seem to record a forecasting performance at least comparable
to other models (the Bayesian VAR is usually chosen as the benchmark in
such comparisons).
(iv) In spite of their elaborate structure, the results of simulations under alter-
native policy scenarios, can be communicated to policymakers in an easily
understood manner.
But in recent years and especially after the global financial crisis, DSGE models
have come in for sharp criticism for their inability to bring out the emerging
financial imbalances in the build-up to the crisis. For ease of discussion, the criti-
cisms may be grouped under two headings—the theoretical/analytical critique and
the econometric critiques.
Since the theoretical basis of DSGE models is strongly grounded in the NCM
(new consensus macroeconomics), criticisms levelled at the latter are automatically
applied to these models. In particular, five features of the NCM (all of which figure
in some form or the other in most DSGE models) have come under heavy weather
from critics, especially after the global financial crisis (see Colander et al. 2009;
Akerlof and Shiller 2009; Stiglitz 2010; Kirman 2011, etc). These five aspects are
(i) rational expectations, (ii) complete and efficient markets, (iii) representative
agent formulation, (iv) ergodic uncertainty and (v) neglect of the financial sector,
shadow banking and the possibility of default (These assumptions and the limita-
tions they imply have already been discussed earlier in this chapter and need not be
repeated afresh.).
We now turn to some of the econometric problems inherent in DSGE models.
(i) One of the major advantages claimed for DSGE models is that their fore-
casting performance (both in-sample and out-of-sample) seems uniformly
good, and hence, they are eminently suited for policy purposes. This
“principle of fit” has been challenged by Kocherlakota (2007),14 who con-
structs two models for an artificial economy—one which gives a perfect fit
and the other with an inferior fit. Yet the inferior fitting model delivers a
more accurate answer to the policy question posed by the author, viz. the
response of output to a tax cut. This happens because the better fitting model,
imposes an identifying restriction which is non-testable but false. Even
though the example constructed is more in the nature of a “thought experi-
ment”, it brings out a crucial and much-neglected dimension of parameter
estimation viz. that parameter estimates depend on the data as well as the
identification restrictions imposed. The fit of the model is silent about the
validity of the latter, and hence a better fitting model might be based on
inappropriate identification restrictions, and the model then fails to deliver
accurate policy assessments or conditional forecast [see Kocherlakota 2007
(footnote number 3); Ohanian’s 2007 comments on Kocherlakota (op. cit.)].
(ii) The “principle of fit” has other questionable consequences. In the drive to
improve the fit, ad hoc features are often introduced. Del Negro and
Schorfheide (2004) provide an interesting example of this. In DSGE models,
price stickiness is often introduced via Calvo pricing (wherein only a fraction
14
This point seems to have been made earlier by Sims (1980) and as a matter of fact was a
recurrent theme in the identification debates of the 1950s (see Marschak 1950; Hurwicz 1950 etc.)
—a point noted by Kocherlakota (op. cit.).
of firms are able to re-optimize their nominal prices, see Calvo 1983). The
high observed persistence in inflation rates in real-world data may not be
fully explained by this assumption. DSGE modellers therefore routinely
follow the stratagem of adding the assumption that non-optimizing firms are
able to index their prices to past inflation rates. While this assumption usually
delivers the trick of improving the fit, it is doubtful whether the indexation
assumption is based on sound micro-foundations. Hence, the parameters may
not be structural and invariant to policy shocks.
(iii) Several authors have questioned the claim that the parameters of a properly
micro-founded DSGE model are truly structural. Chari et al. (2007, 2008) in
particular show that this may not hold in general. Their 2007 article deals with
accounting for observed movements in important macroeconomic aggregates,
via a business cycle model augmented with several reduced form shocks. One
particular shock, the so-called labour wedge, is shown to explain a substantial
portion of the observed movements in employment. In Chari et al. (2008), two
structural New Keynesian growth models are built and a structural shock
appended to the labour supply in each, which is termed as the wage markup
shock. In the first model, the wage markup shock is a consequence of fluc-
tuating government policy towards labour unions and in the second, the same
shock is a reflection of consumers’ changing preference for leisure. It is then
shown that two structural models are both consistent with the same reduced
form labour wedge. But the two structural models have widely different
policy implications, and hence, even so-called structural shocks may not
always lead to unambiguous policy recommendations.
(iv) A more technical econometric criticism comes from what Buiter (2009) dubs
as the “linearize and trivialize” strategy of DSGE models. While nonlinear
DSGE models have now started emerging on the scene (see Lombardo 2010;
Ruge-Murcia 2012; Kollman 2014, etc.), most of the existing models are
based on a process of log-linearization. But linearization, while undoubtedly
simplifying the technicalities and the estimation problem in particular,
introduces a number of not so innocuous trivializations. One such relates to
the scale of the shock. Large shocks have in reality more than proportionate
effects on the dynamics of a system than smaller shocks. Similarly, on the
one hand, there is a critical threshold for shocks to have any effect at all, and
on the other, very large shocks can alter the very structure of a model. By not
providing for these effects, as Buiter (op. cit) notes, the models rule out ex-
definitione important real-world phenomena such as funding illiquidity,
mark-to-market accounting, margin requirements, collateral calls, non-linear
accelerators and the myriad other phenomena that have been advanced to
explain the recent global crisis.
Thus, while DSGE models on a superficial appraisal, do give an impression of
being “scientific”, a closer look casts strong doubts on the validity of such a claim–
rather the theories are scientific but vacuous. Real-world phenomena of crucial
significance to policymakers are side-stepped, including incomplete markets,
bargaining power, strategic interactions and coordination problems between agents,

online learning, etc. Solow’s (1997) characterization of academic economists as
“the overeducated in search of the unknowable” seems particularly apt in the DSGE
context.
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Chapter 12
NCM Critique: Policy Implications
Abstract This chapter is devoted to a post-crisis critique of the policy implications

flowing from the NCM. These implications had shaped actual policies in many
developed and developing countries during the two decades preceding the crisis and
are regarded by many critics as the main architects of the crisis. We examine the
policy aspects of the NCM critique under three major headings: (i) monetary policy,
(ii) regulatory and supervisory policy and (iii) fiscal policy. As the NCM policy
approach is strongly tied to the DSGE framework, in the final section of this chapter,
we also discuss the limitations implicit in the use of these models for policy.
1 Introduction
Following Blanchard et al. (2013), de Paula and Saraiva (2016), etc., we examine
the policy aspects of the NCM critique under three major headings: (i) monetary
policy, (ii) regulatory and supervisory policy and (iii) fiscal policy. As we have seen
earlier in Chap. 4, the NCM policy approach is strongly tied to the DSGE frame-
work. In the final section of this chapter, we therefore also discuss the limitations
implicit in the use of these models for policy.
As we have seen in Chap. 4, a major policy implication of the NCM is the
elevation of monetary policy and the de-emphasizing of fiscal policy. The major (or
perhaps sole) objective of monetary policy is deemed to be the control of inflation
(inflation targeting) and its primary operating instrument a short-term interest rate.
Three further aspects of the NCM view of monetary policy need to be noted.
Firstly, given the various lags involved in the transmission mechanism of monetary
policy, in practice, inflation forecasts become the intermediate targets of monetary
policy (Svensson 1997, 1999). Secondly, since the NCM views monetary policy
rules as superior to “fine tuning”, monetary policy should ideally operate via an
interest rate rule. A typical monetary policy rule is the one originally suggested by
Taylor (1993) with various later emendations (see Rudebusch 2002; Levin et al.
1999, etc.). Thus, effectively, the rate of interest is set exogenously by the central
bank, while the money supply adjusts endogenously to the needs of trade. Thirdly,

https://doi.org/10.1007/978-81-322-3920-8_12
256 12 NCM Critique: Policy Implications
inflation targeting (IT) proponents take some pains to clarify that in practice, IT is
not tantamount to a fixed mechanical rule but allows for “constrained discretion” on
the part of the central bank.1
In contrast to the paramount role assigned to monetary policy, fiscal policy is
downgraded and its role confined to keeping the overall budget balanced. Such a
minimal role for fiscal policy, stems from the so-called Ricardian equivalence theory
(see Barro 1974; Haug 1990; Seater 1993, etc.). According to the theory, increased
government expenditure cannot stimulate aggregate demand, irrespective of whether
this spending is tax-financed or bond-financed. If government expenditure is fully
tax-financed, then the rise in government expenditure is directly offset by the decrease
in private incomes. Even if the government expenditure is financed via bond issuance,
these bonds are not viewed as additions to net wealth—fully rational consumers
anticipate that future interest payments on the government debt (as well as the
amortization charges) will lead to higher future taxes, in anticipation of which con-
sumers raise their current savings. Thus, the rise in government expenditure is matched
by a corresponding rise in private savings, leaving the aggregate demand unaltered.
The NCM attitude to financial markets was that they posed no grave dangers of
instability, being generally self-equilibrating—a belief strongly anchored in the
EMH see Allington et al. (2011). As we have seen above, the EMH also makes out
a strong case for deregulation in the belief that firms guided by self-interest would
adopt behavioural strategies that contributed to overall financial stability (market
discipline). Furthermore (again as discussed above), financial innovation was seen
as aiding the process of completion of markets, and hence, securitization and
shadow banking2 were in general seen as socially beneficial. Finally, in the context
of EMEs, it was believed that financial development could play a defining role in
promoting real growth (see, e.g. Aghion et al. 2004).
2 Rethinking Monetary Policy in the Wake of the Crisis
The monetary policy framework of the NCM is put forth by Clarida et al. (1999),
and its extension to the open economy case has been described in some detail by
Arestis (2007) and Angeriz and Arestis (2007) (see Chap. 4, Sect. 7). Long before
1
2
Shadow banking may be taken to refer to the several financial institutions (such as securitization
vehicles, money market mutual funds, investment banks, mortgage companies) which carry out
diverse traditional banking activities but do so outside the ambit of regulated banking activities.
More precisely, they may not exactly be unregulated but are only loosely regulated (in any case
much less so than commercial banks) (see Goodhart 2008; Pozar and Singh 2011; Adrian and
Ashcraft 2012, etc.).
2 Rethinking Monetary Policy in the Wake of the Crisis 257
the current global crisis set in, it was becoming increasingly evident that this
framework was being rendered rapidly obsolete by the profound institutional
changes, set in motion by the successive globalization waves of the 1980s and
1990s. These developments had considerably eroded both, the manoeuvrability
space and the efficacy of monetary policy, in the advanced and emerging market
economies. The global crisis further heightened the disenchantment with monetary
policy in tackling the several issues raised by volatile asset markets, irrational
exuberance and financial deregulation. We discuss the main issues below.
2.1 “Slipping Transmission Belt”3 Syndrome
The New Consensus Macroeconomics (NCM) came to dominate the thinking of

central bankers in the USA in the post-Volcker era, and in the rest of the world
shortly afterwards. One of the prime consequences of this mode of thought was
inflation targeting. However, whether inflation targeting was interpreted in its
narrow sense as “the single-minded pursuit of price stability” or in the broader
sense of Bernanke’s (2003) “constrained discretion”, there is no denying that an
inflation-focused monetary policy was facing several challenges in the rapidly
changing world of the fin de siècle. A number of institutional developments were at
work, weakening the link between monetary policy, the credit market and the
macroeconomy (see Friedman 1999; D’Arista 2009; Disyatat 2010, etc.). The most
prominent among these developments seem to have been the following:
(i) A relative decline in the role of banks in credit creation. While this trend
seems to have been clearly established in the US (D’Arista 2009, p. 8) and
Europe (Gropp et al. 2007; Jimenez et al. 2007), in many emerging market
economies (EMEs) including India, the role of banks in deposit mobilization
and credit creation continues to be important.4 In many EMEs, foreign
non-bank sources have been gaining in importance as a source of finance for
the commercial sector.5 Foreign credit seems to be slated to play an
3
The term seems to have been originally coined by D’Arista (2009).
4
In India, the share of currency and bank deposits in total financial assets acquired by households
registered a steady decline over the two decades 1980–81 to 2000–01 from about 59 to 45%
(during these decades, there was much talk about “disintermediation” in the Indian context).
However, this trend seems to have reversed in the last decade and a half with greater bank
penetration in rural areas and the entry of private banks. As of 2015–16, the (incremental) share of
currency and bank deposits in household financial assets had reverted to about 54.77%. Over the
secular period of a quarter century (1990–91 to 2015–16), the share of life insurance (in total
financial asset acquisition of households) nearly doubled from about 9.5 to 18.3%, while the share
of equities and debentures (between 6.5 and 8%) as also that of provident and pension funds
(between 15 and 17%) remained more or less constant.
5
Domestic non-bank sources in India comprise (i) public issues of non-financial entities (NFEs),
(ii) gross private placements by NFEs, (iii) net issue of CPs subscribed to by non-bank entities,
increasingly important role in these countries, with the rapid opening of the
capital account and the liberalization of financial services’ imports. A notable
feature of some EMEs lies in the significant role of physical asset savings of
households, India being an important case in point.6 Earlier analysts do not
seem to have attached much importance to physical assets in discussions on
monetary policy, mainly because these assets were then viewed as highly
illiquid. However, the situation has drastically changed over the last decade.
Mortgage-based securitization in the USA, the global emergence of
real-estate hedge funds and the rapid popularity of gold finance companies
(e.g. in India and South-East Asia) now mean that physical assets need not be
necessarily illiquid. As a matter of fact, physical assets now can be easily
resorted to, for gearing up leverage for speculation in asset markets during
booms, and in general can act as an independent source of high-powered
money.
(ii) Rapid financial innovation. The brisk pace of financial innovation has led to
the emergence of several new near substitutes for money. Among such
money substitutes, the assets of money market mutual funds (MMMFs)7 are
the most significant. These very short-term assets are held by banks, financial
institutions, corporates, etc., as a backup liquidity source. As such, they are
close money substitutes, even though they do not figure in conventional
definitions of money supply. Apart from acting as a potential offset to dis-
cretionary liquidity variations by the central bank, MMMFs raise issues of
systemic instability. The latter happens because the investor profile of the
MMMFs is dominated by corporates and banks/financial institutions, whose
liquidity redemption calls can be large and highly correlated (e.g. Gokarn
2011).8
(iii) The rapid growth of securitization. Securitization is another major devel-
opment in financial markets, which has had a profound impact on the
monetary policy transmission mechanism. Asset securitization affects
(iv) net credit by housing finance companies, (v) gross accommodation by four All-India Financial
Institutions, viz. NABARD, NHB, SIDBI & EXIM Bank and (vi) gross investments in corporate
debt by LIC and systematically important non-deposit-taking NBFCs (non-bank finance compa-
nies). Foreign non-bank sources refer to external commercial borrowings (ECBs), ADR/GDR
issues (of non-bank entities), short-term foreign credit, and foreign direct investment (FDI).
6
The proportion of Indian savings in physical assets to total household savings has exhibited a
mean reversion around a figure of 40% or so over the last four decades (see Handbook of Statistics
of the Indian Economy, Reserve Bank of India, successive issues).
7
MMMFs are a special category of mutual funds which are highly liquid as they invest only in
short-term money market instruments.
8
MMMFs were introduced in India in April 1991 and have grown rapidly since then, their total
AUM (assets under management) (as of 31 March 2011) standing at Rs. 183,622 crore repre-
senting about 13.33% of reserve money (2.28% of broad money) (Gokarn 2011). At the end of
August 2017, this figure had grown to Rs. 349,039 crores representing 17% of all assets under
management of mutual funds and 16.11% of reserve money. (source Association of Mutual Funds
in India AMFI Monthly).
monetary policy transmission by reducing the relevance of the bank lending

channel. Firstly, by reducing banks’ funding needs (in the case of a
restrictive monetary phase) and secondly, by allowing banks to transfer part
of their credit risk to other investors, securitization reduces banks’ regulatory
capital requirements (thereby releasing funds for making loans) (see
Altunbas et al. 2004; Estrella 2002; Loutskina and Strahan 2006, etc.).9
(iv) Unrestricted global capital flows. It is a fact well documented in the liter-
ature, that the dismantling of capital controls saddles monetary policy with
the famous “impossible trilemma” (Bernanke 2005; Grabel 2003; Epstein
et al. 2005; BIS 2009). The trilemma in question refers to the impossibility of
maintaining in simultaneous operation (for a given country) all three of the
following policy regimes: (i) an open capital account, (ii) a fixed exchange
rate and (iii) an independent domestic monetary policy. Of course, in prac-
tice, concepts like “openness”, “fixity” or “independence” are not absolute,
but relative or even fuzzy. Hence, the trilemma needs to be interpreted as a
move in one direction having to be compensated by a countervailing move
along another dimension.10 For the advanced economies, the choice seems to
be clear (at least to most academics and policymakers), viz. the benefits of
capital mobility and independent monetary policy exceed whatever costs
may be associated with a system of freely floating exchange rates. For the
LDCs and EMEs, the picture becomes more hazy. One view (see 118.Végh
1992; Dornbusch and Warner 1994; Bernanke 2005) maintains that the best
course for such economies is to overcome their deeply ingrained “fear of
floating” and let the exchange rate float freely. A firm central bank com-
mitment to gear monetary policy exclusively to maintaining a low and stable
inflation rate, would then provide the much-needed “nominal anchor” for the
macroeconomic system. There are two major arguments against a “free float”
for such economies. Firstly, as Sargent (1982) has noted, a fixed (or heavily
managed) exchange rate can be a suitable guard against high inflation and
also commands visibility, and is thus more credible than a direct inflation
target. Secondly, Calvo and Reinhart (2000) have drawn attention to the low
credibility of policymakers in several LDCs, which could mean that a flex-
ible exchange rate could exhibit high volatility (both short term and long
term). The latter is usually recognized as exports–inhibiting and could also
9
From negligible beginnings in the 1990s, the securitization process has accelerated in the last
decade in India, peaking at Rs. 37,876 crores in the FY (financial year) 2012 and then tapering
somewhat to Rs. 17,170 crores in FY 2015, before strongly rebounding to Rs. 24,956 crores in FY
2016. The bulk of structured finance in India (more than 90%) is dominated by retail securitisation
including prominently asset-based securities (ABS) and residential mortgage-based securities
(RMBS), with loan sell-offs (LSOs) showing a continuous decline from their dominant position in
the earlier half of this decade (see Vinod Kothari Consultants Pvt. Ltd. 2016).
10
Obstfeld et al. (2005) present several historical instances of the trilemma.
lead to volatility of capital inflows and in domestic interest rates (if these are
unregulated) via the covered interest parity (Calvo 1996; Kwack 2003;
Cavoli and Rajan 2006, etc.).11
2.2 Inflation Targeting, Asset Prices and Monetary Policy
Inflation targeting (or IT for short) is possibly one of the most important recom-
mendations following from the NCM. It goes considerably beyond merely setting
an inflation target and is best described by the following quote from Bernanke et al.
(1999, p. 4) “(Inflation targeting) is characterized by the public announcement of
official quantitative targets (or target ranges) for the inflation rate over one or more
time horizons and by explicit acknowledgement that low, stable inflation is mon-
etary policy’s primary long-run goal. Among other important features of inflation
targeting are vigorous efforts to communicate with the public the plans and
objectives of the monetary authorities…”. Given the various lags involved in the
transmission mechanism in practice inflation forecasts become the intermediate
targets of monetary policy (Svensson 1997). IT proponents take some pains to
clarify that in practice IT is not tantamount to a fixed mechanical rule but allows for
“constrained discretion” on the part of the central bank.12
Several advantages have been claimed for IT including, most prominently, that it
(i) provides a nominal anchor for monetary policy, (ii) enhances its transparency,
(iii) lends credibility by “locking in” inflationary expectations, while (iv) main-
taining a degree of flexibility in policy (ability to react to unanticipated shocks) (see
Bernanke and Mishkin 1997; Rudebusch and Walsh 1998, etc.).
11
The process of capital account liberalization in India has proceeded more or less in conformity
with the two RBI Reports (1997, 2006), and the various problems likely to be raised by this
process for the conduct of monetary policy are reviewed in Rangarjan (2001), Rakshit (2001) and
Nachane (2007, 2010). There has been in evidence a general movement away from the heavily
managed exchange rate system of the 1980s and early 1990s towards. Currently, the concerns over
the exchange rate are limited to short-term considerations such as the need to smoothen out
excessive volatility and foreclose the emergence of destabilizing speculative activities and are
usually subsumed under the rubric of “overall financial stability”. However even though the RBI
does not have a target exchange rate band in mind, it has not hesitated from proactive intervention
to prevent undue nominal exchange rate intervention, though such episodes of “leaning against the
wind” are becoming increasingly less frequent now as the economy is showing signs of a robust
growth and successful integration with the international economy.
12
Several countries have adopted the IT framework,13 but the empirical evidence
on the success of IT regimes is mixed. Ball and Sheridan (2003) come up with the
finding that “…there is no evidence that inflation targeting improves performance”,
whereas Levin et al. (2004), Hyvonen (2004), Vega and Winkleried (2005), Davis
(2014), etc., report a lowering of inflation persistence, an anchoring of inflationary
expectations and reduced output growth volatility for countries adopting IT.
The choice of the inflation target (in an IT regime) needs to be done with
considerable care—it cannot simply be any low inflation rate. One suggestion is to
use the concept of the optimum long-run inflation rate (OLIR) defined as the
long-run inflation rate that achieves the best average economic performance over
time with respect to both the inflation and output objectives (see Bernanke 2004).
The logic of the OLIR is the creation of a buffer zone against deflation. However, its
exact determination in practice would not be easy. But the idea of a buffer zone
against deflation was revived when US nominal interest rates rapidly hit the zero
lower bound (ZLB) after the onset of the global crisis. Any further lowering of
interest rates is then ruled out, and unconventional monetary policy instruments
(such as QE) have to be called into operation. While unconventional policies might
be somewhat successful in the short run, their prolonged use can lead to some
problems.14 Blanchard et al. (2010) and Ball (2013) therefore, argue that the
inflation target for the Fed should be raised, from the level of 2% to about 4%.
Another interesting line of thought on the choice of the inflation target, arises
from the hypothesis that there could be a trade-off between inflation and unem-
ployment at low rates of inflation, irrespective of whether such a trade-off exists or
does not, at higher rates of interest. We then obtain a so-called
“backward-bending” Phillips curve—the formal derivation of such a curve is
elaborated in Akerlof et al. (2000), Meyer (2004) and Palley (2008). To the left of
the cusp of such a backward bending curve, a higher inflation leads to greater
output and lower unemployment, while to the right higher inflation leads to
increased unemployment. The cusp is then called as the minimum unemployment
rate of inflation (MURI) and becomes a natural candidate for the target inflation rate
(see Coenen et al. 2003, for an empirical estimation of MURI for the Euro Area).
13
Currently, about 30 countries have formally adopted the IT framework. Interestingly, their
composition is heterogeneous including advanced economies, EMEs as well as some LDCs.
A selective list (with years of adoption in brackets) is the following: New Zealand (1989), Canada
(1991), UK (1992), Sweden (1993), Australia (1993), Korea (2001), Brazil (1999), Chile (1999),
Mexico (2001), Thailand (2000), Philippines (2002), Indonesia(2005), Ghana (2007), etc.
14
The increase in liquidity arising from QE can be beneficial as it can help thwart an incipient
deflation, but it has considerable inflationary potential and can also lead to exchange rate depre-
ciation once the economy starts recovering. Unlike the policy rate which can be altered at short
notice, QE unwinding has to be done gradually. Besides its overall effectiveness in a crisis is
debatable (especially if the securities purchased by the government are held by foreign investors),
though it seems to have worked quite well in the USA during the GFC. Of course, it imposed
considerable collateral damage on the EMEs (see Fratzscher et al. 2013; Bowman et al. 2014;
Korniyenko and Loukoianova 2015, etc.).
There is an implicit supposition in the IT framework that central banks (adopting

this framework) should maintain a “hands-off” policy vis-à-vis foreign exchange
markets or, putting it more precisely, should worry about exchange rates only to the
extent that they impact inflation. However, in practice, such a policy may not be
desirable, at least as far as EMEs are concerned. Global capital flows are subject to
violent swings, leading to volatility in exchange rates. Such volatility can lead to
disruptions in real activity (for export-oriented small economies) through the cre-
ation of uncertainty in the exports sector, as well as (for oil-dependent economies)
by leading to violent swings in international commodity markets (especially oil,
copper and aluminium). Additionally, exchange rate volatility can lead to increases
in foreign-denominated liabilities for corporates (as their counterparties would insist
on repayment obligations denominated in dollars or euros) (see Blanchard et al.
2010; Dell’Ariccia et al. 2012, etc.). In short, a “hands-off” exchange rate policy
under a strict IT regime, could make a regime vulnerable to a balance of payments
or a financial crisis. Such vulnerability is enhanced by a weak fiscal revenue base,
implicit financial bailout guarantees, contingent government liabilities, etc. Thus, if
fiscal discipline is relatively lax, then achieving macroeconomic stability by strict
monetary discipline can be counterproductive (see Calvo and Végh 1999; Kumhof
et al. 2007; Mishkin 2008; Frankel 2011, etc.).
There are also formidable political and legal problems involved in installing an
IT regime. Should the target (or a target band) be set by the central bank, the
Treasury/Finance Ministry or the Parliament? What should be an appropriate
incentive-cum-penalty system for success or failure on the part of the central bank
in achieving the target? These and other related issues are discussed in detail in
Buiter (2008), Reichlin and Baldwin (2013), Economic Committee of the National
Assembly and UNDP in Vietnam (2012).
2.3 Monetary Policy and Asset Prices—The Jackson Hole

Consensus15
Perhaps, the biggest flaw in the IT framework is its neglect of balance sheet dis-
orders, arising in the current environment of deregulated financial markets and
financial innovation. The pre-crisis period was marked by a general consensus
among mainstream academics and policymakers regarding three issues, viz. (i) that
commodity inflation control should be the overriding (if not exclusive) objective of
monetary policy, (ii) that asset price bubbles are better left alone as they are difficult
to identify, and misidentification of a change in fundamentals as a bubble might
15
Portions of this section are drawn from the author’s contribution “Monetary Policy, Financial
Stability and Macro-prudential Regulation: An Indian Perspective” in Ratan Khasnabis, Indrani
Chakraborty (eds.) Market, Regulations and Finance: Global Meltdown and the Indian Economy,
published by Springer in 2014.
lead to aborting a genuine upward movement in the macroeconomy and (iii) if, and
when, asset prices burst, central banks should “mop up the mess”, i.e. go into the
“lender of last resort” act (see Greenspan 2004; Blinder and Reis 2005; Mishkin
2007, 2008, etc.).16 It was, of course, recognized that financial imbalances can pose
grave threats to macroeconomic stability (see, e.g. Dupor 2005), but the consensus
view was that (except for the likely effects of these imbalances on general inflation),
monetary policy should not be mandated to deal with them. Rather they should be
dealt with by a separate body such as a financial stability authority or, alternatively
by a separate department of the central bank enjoying a high degree of internal
autonomy.
This viewpoint (which has been referred to as the Jackson Hole Consensus
following Issing 2009) simply stated views price stability and financial stability as
highly complementary and mutually consistent objectives for a central bank.
The global crisis brought out the fatal flaw in this consensus and argued for a
less benign relationship between monetary and financial stability (see, e.g.
Tymoigne 2006). The fundamental lesson for economic policy brought home by the
GFC is that low and stable inflation, combined with robust growth, is no guarantee
against the build-up of financial imbalances. An alternative viewpoint emerged (see
Borio and Lowe 2003; Bean 2004; Reichlin and Baldwin 2013, etc.) sees not only
monetary stability coexisting with financial instability but occasionally also a causal
nexus from the former to the latter. Periods of monetary stability (such as the
so-called Great Moderation spanning the decade and a half from 1990 to 2007),
which are often accompanied by output growth and generate bullish expectations of
future prospects. These, in turn, lay the foundations for booms, especially in equity
markets and real estate. Demand for credit soars for investment in the highly
profitable rising asset markets. Central banks (exclusively focussed on the com-
modity market inflation) may keep interest rates low, stimulating in the process,
high-risk speculative investment.17
This sets the stage for the kind of asset price booms which have preceded many
crisis episodes including those of 1893, 1907, the Great Depression (1929–33), the
Asian Crisis of 1997–98 and of course the current global crisis beginning with the
Lehman collapse of 2007. Set against this background of history repeating itself, it is
indeed a surprise that policymakers in advanced market economies (AMEs) failed to
read the message in the amply visible evidence of high growth rates of credit and
monetary aggregates, deteriorating lending standards, rapidly rising asset prices,
unnaturally low spreads and rising insurance premia etc. (see Hein and Truger 2010).
16
The justification for such a point of view was threefold, viz. (i) the possibility of misidentifying a
bubble and the avoidable weakening of the economy resulting from monetary tightening,
(ii) deflating the bubble may require an interest rate hike of a magnitude that could seriously
jeopardize the post-bubble prospects for recovery, and (iii) bubbles may be confined to a small
section of assets, in which case raising interest rates may dampen asset markets across the board
(including those where the price rise is being driven by fundamentals rather than speculation).
17
Artificially low interest rates (benchmarked say, against a conventional Taylor Rule) enhance
financial fragility by feeding the “disaster myopia” psychology of investors (see Rajan 2005).
The implications of this alternative viewpoint for monetary policy are straight-
forward viz. that the central banker cannot afford to play the combined role of a
bystander while an asset boom is in progress, and a good Samaritan once the boom
goes bust of its own accord. But agreement on this general principle, still leaves
open the question of the exact form of central bank intervention in asset markets.
We will look into these and other related issues in detail in the Chap. 14, when we
discuss the emerging thinking on monetary policy in the aftermath of the global
crisis.
3 Redefining the Role of Fiscal Policy
We have already seen in Chap. 3 in Sect. 3.5, that the new classical theory did not
place much trust in fiscal policy, owing to their subscription to the twin hypotheses
of crowding out and Ricardian equivalence. This trend in economic thinking set the
tone for a limited role for fiscal policy in developed countries during the Great
Moderation, when it was generally believed that monetary policy was doing a good
job of keeping the macroeconomy on an even keel and the policy emphasis shifted
to the dangers of ballooning fiscal deficits, high levels of public debt and fiscal
consolidation generally.18 Additionally, it was generally believed that fiscal policy
had long implementation lags, so that by the time a fiscal stimulus was executed and
its effects on the economy played out, the recession might well have turned the
corner (see Romer and Romer 2002; Baunsgaard and Symansky 2009; Blanchard
et al. 2013, etc.).
During the GFC, policy rates in many advanced countries rapidly reached the
zero lower bound (ZLB), and unconventional policy measures could not be con-
tinued indefinitely. Additionally, given the prolonged nature of the depression, the
long lags of fiscal policy lost much of their relevance (see DeLong et al. 2012;
Bernanke 2009; Christiano et al. 2009, etc.). Hence, several countries (both
developed and EMEs) adopted fiscal stimuli to hold up aggregate demand (see
Chaps. 5 and 6). In analysing the macroeconomic impacts of the fiscal stimulus,
several considerations have to be borne in mind.
Firstly, the fiscal stimulus, strictly interpreted, comprises discretionary measures
implemented and/or announced in response to the crisis. Thus, it should exclude
changes in fiscal balance brought about by automatic stabilizers, as well as dis-
cretionary measures which cannot be considered as a response to the crisis (such as
measures announced prior to the GFC but implemented during the crisis years).
Thus, the fiscal stimulus has to be distinguished from the overall increase in fiscal
deficit, as the latter also includes the effect of automatic stabilizers and pre-crisis
policy announcements (see IMF 2009).
In EMEs, fiscal policy has been traditionally to serve growth, rather than countercyclical
18
objectives.
3 Redefining the Role of Fiscal Policy 265
Secondly, in deciding upon the necessity of a fiscal stimulus, two considerations

are paramount—the strength and effectiveness of automatic stabilizers,19 and the
manoeuvrable fiscal space (which depends on several factors such as the size of the
fiscal deficit, the public debt in relation to GDP, the interest-servicing burden,
government contingent liabilities, the sovereign rating etc.).
Thirdly, the composition of the fiscal stimulus can have an important bearing
both on the size of the fiscal multiplier (i.e. change in the GDP per unit increase in
fiscal spending) and on general welfare.
Chapter 6 (Tables 1 to 3 and 15) presents detailed results on the size of the fiscal
stimuli adopted and the associated fiscal multipliers for a selection of developed
countries and EMEs during the global crisis, computed by the OECD (2009) and
ILO (2011) adopting slightly different methodologies.
However, adopting fiscal measures for countercyclical stabilization entails cer-
tain problems, of which the most important is the issue of fiscal dominance raised
by Dixit and Lambertini (2003), Mishkin (2012), Combes et al. (2014), etc. Large
fiscal stimuli may lead to a situation where public debt builds up to unsustainable
levels; i.e. the taxes required to settle the debt in the future may be well beyond the
economic and political taxable capacity of the nation. Only three possibilities then
remain: (i) debt monetization via central bank purchasing of government bonds
(dated securities or Treasury bills), which measure has considerable inflationary
potential, (ii) avoidance of debt monetization, which would mean that government
bond investors would have to be paid higher interest rates to persuade them to hold
the bonds—the resulting rise in interest rates could “crowd out” private investment
and lead to contraction of economic activity—and (iii) debt default which could
have drastic political consequences.
To avoid fiscal dominance, three measures have been suggested in the literature
(i) The first measure is the creation of “fiscal space” to deal with crisis-like
situations, by running a countercyclical fiscal policy, i.e. reducing the public
debt-to-GDP ratio in periods of economic growth. This space can then be
used to inject fiscal stimuli in crisis times, without the public debt reaching
precarious proportions (see Blanchard et al. 2013; Ostry et al. 2010; Guerguil
et al. 2016, etc.).
(ii) Another possible measure is the introduction of medium-term fiscal adjust-
ment plans based on fiscal rules. Such fiscal rules are classified into various
types such as balanced budget rules (BBR), debt rule (DR), expenditure rule
(ER), revenue rule (RR), cyclically adjusted balanced budget rule (CAR).
(For a detailed typology of such rules see IMF 2009, Bergman and Hutchison
2015; Budina et al. 2012, etc.).
(iii) Designing better automatic stabilizers is yet another measure (see Auerbach
and Feenberg 2000; Blanchard et al. 2013; McKay and Reis 2016, etc.). Such
19
Automatic stabilizers are the in-built countercyclical features of taxation and public expenditure
systems.
automatic stabilizers could include cyclical investment tax credits,

pre-legislated tax cuts, strengthened unemployment insurance, etc.
4 Regulatory and Supervisory Policy
Regulation of the financial sector in the developed world began seriously in the
aftermath of the Great Depression of the 1930s. Spong (2000) details a fourfold
rationale for bank regulation, viz. (i) depositor protection, (ii) monetary and
financial stability, (iii) development of an efficient and competitive banking system
and (iv) consumer protection. A number of regulatory measures were put in place in
the USA towards these objectives,20 the main ones being (i) the Glass–Steagall Act
of 1933 which imposed a strict separation between investment banking and com-
mercial banking, in order to protect bank depositors from possible speculative
investments by banks, (ii) the Financial Institution Reform, Recovery and
Enforcement Act of 1989, following the thrift crisis of 1988, which increased the
enforcement authority of bank regulators vis-à-vis savings and loan associations,
etc. (see Guse 1992) and (iii) the Federal Deposit Insurance Corporation
Improvement Act of 1991 which greatly improved protection for depositors by
introducing new regulations relating to capital requirements, depositor solicitation
and insider activities (see Benston and Kaufman 1998).
The financial liberalization philosophy that came to prevail almost universally in
the decades following the 1970s had its intellectual roots in the twin NCM
hypotheses of rational expectations and efficient markets. According to this financial
intermediation paradigm, financial developments are best left to the open markets
with freedom from too much “regulatory oversight”. There was also an implicit
belief that systemic risks could be unbundled through the instruments of derivatives
and securitization (what Volcker 2008 calls “slicing and dicing”), so that risk is
allocated to those most willing and capable of bearing it. Any market inefficiencies
can be overcome by allowing full play to arbitrage avenues. If this were done, the
possibility of financial crises cannot, of course, be avoided (these being an integral
part of any capitalist system), but their amplitude and frequency can be considerably
attenuated. The financial structure in the USA and other developed countries since
the 1980s, has evolved under this financial intermediation philosophy.21 As this
financial super-structure developed, it started straining at the earlier tight regulatory
system. Under intense pressure from the financial industry, the earlier stiff regula-
tions were rapidly dismantled (see Bhide 2009). In a landmark development in the
20
See Bentley (2015) for a detailed discussion.
21
The pattern was replicated also in many EMEs in the 1990s, under pressure from the IMF and
other multilateral agencies, and also by a paradigmatic shift in outlook of policymakers in
countries such as India, from inward looking socialist policies to more outward looking
market-oriented policies.
4 Regulatory and Supervisory Policy 267
USA, the Glass–Steagall Act of 1933 was replaced with the much less stringent
Gramm–Leach–Bliley Act (GLBA) in November 1999. The new act removed most of
the barriers to consolidation between banking, insurance and equity companies.
Earlier, the enactment of the Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 had removed several obstacles to banks opening branches in
other states, and provided a uniform set of rules regarding banking in each state.
Similar steps in the direction of deregulation were undertaken in the EU and in
many EMEs. In India, for example, wide-ranging liberalization measures were
initiated in the money market, the banking sector, the capital market and the foreign
exchange sector (see Sen and Vaidya 1998; Mohan 2004, etc.).
The financial sector was quick to respond to these measures. There was a flurry
of consolidation and exploitation of scale and scope economies, new financial
instruments emerged with clockwork regularity, and aggressive risk-taking became
the norm. The financial system developed a number of stress points including most
prominently (i) securitization on an extensive scale, especially mortgage-based
securitization (MBS), (ii) new and complex financial products (such as collateral
debt obligations (CDOs), interest rate swaps (IRS), credit default swaps (CDS etc.))
most of which were imperfectly understood by many market participants, (iii) ex-
cessive securitization led to the emergence of a parallel/shadow banking system,
which was not subject to the same degree of regulatory and supervisory controls as
depository banks, including most importantly, special-purpose vehicles (SPVs),
special investment vehicles (SIVs) etc. (iv) excessive leverage well beyond pru-
dential norms, (v) overriding role of credit rating agencies and (vi) perverse
asymmetric incentives in the financial sector which rewarded risk-taking per se,
with little accountability for financial managers and dealers.
Against this backdrop, the financial system in the years leading up to the crisis
developed quite a few anomalies, some of which were critical to the build-up of
systemic risk (see Chap. 5 Footnote 14 for a definition) in the entire macroeconomy
(see Akerlof and Shiller 2009). Primarily oriented to the norms laid out under
Basel I and Basel II frameworks, with their emphasis on micro-prudential regula-
tion, the regulatory and supervisory system fell considerably short of forestalling
the crisis (see Chap. 5, Sect. 4.5 for further discussion on this point).
5 Limitations of DSGE Models for Policy22
While the DSGE models superficially do give an impression of being “scientific”, a

closer look casts strong doubts on the validity of such a claim—rather the theories
are scientific but vacuous. Real-world phenomena of crucial significance to poli-
cymakers are side-stepped, including incomplete markets, role of bargaining power,
22
This section draws from the author’s working paper WP-2016-004 “Dynamic Stochastic General
Equilibrium (DSGE) Modelling: Theory and Practice”, published by Indira Gandhi Institute
of Development Research (IGIDR), Mumbai, in January 2016; reused with permission.
strategic interactions, coordination problems between agents, online learning etc.

The DSGE modellers would possibly plead that they recognize the importance of
these problems, but they are analytically intractable (see e.g. Alvarez-Lois et al
2008). Economic policy is “hard” in the sense of being difficult to solve formally
(see Rust 1997 for a definition of “hard”). Faust (2005) has introduced two
approaches in this context: (i) Type A approach in which a simplified version of the
problem is solved formally and (ii) Type B approach in which the problem is not
simplified, but non-formal solutions are admitted.
The DSGE approach seems a typical Type A approach, based on the implicit
assumption that successively elaborating the simple prototype model and solving it
formally will ultimately converge to the ideal solution.23 A more pragmatic
approach would be the Type B approach, where all (or at least most) of the
interesting real-world features are retained but solution methods are less than fully
formal. In other words, models to be of relevance to the real world must essentially
rest on two pillars: (i) the micro-behaviour of individuals and (ii) the structure of
their mutual interactions (see Colander et al. 2008).
Two such approaches are emerging in the literature. The first is the econophysics
literature which shifts the focus away from individual equilibria to systems equi-
libria, wherein evolving unstable micro-dynamic interactions are consistent with
macroequilibrium. Micro-foundations are abandoned in favour of dimensional
analysis, and the use of traditional topological methods is replaced by the methods
of statistical physics (see Farmer et al. 1988; Aoki and Yoshikawa 2006; Colander
2006).
A second and perhaps more promising approach is the agent-based computa-
tional economics (ACE) put forth by Epstein and Axtell (1996), Tesfatsion and
Judd (2006), LeBaron and Tesfatsion (2008). ACE modelling allows for a varie-
gated taxonomy of agents, including a spectrum of cognitive features ranging from
passive cognition to the most sophisticated cognitive abilities. A second important
aspect of ACE modelling is that it examines the evolution of macrodynamics as the
number of interacting agents increases and as their interactions become more
complex. The method relies heavily on experimental designs to make inferences
about the behaviour of different agents. The interactions are determined by the
agents’ internal structures, information sets, beliefs and cognitive abilities. Agent
behaviour is not restrained by artificial external boundary conditions such as
homogeneity, stability or transversality. Using the so-called Zipf distribution, Axtell
(2001) reports a model with millions of interacting agents (see also Adamic 2011)
Nevertheless, neither of the above two approaches really validates the data in a
manner that could satisfy the rigorous demands of our profession. This deficiency is
important and will possibly not be long in getting satisfactorily resolved.
Meanwhile should we persist with the DSGE approach in spite of its problematic
foundations? Solow in his testimony before the US House of Representatives
23
Mathematically speaking if the Kolmogorov complexity of the problem is polynomially boun-
ded, this approach will succeed (see Garey and Johnson 1983).
5 Limitations of DSGE Models for Policy 269
Committee on Science, and Technology severely indicts the DSGE enterprise. “The
point I am making is that the DSGE models have nothing useful to say about
anti-recession policy, because they have built into its essentially implausible
assumptions, the “conclusion” that there is nothing for macroeconomic policy to do.
… There are other traditions with better ways to do macroeconomics.” (quoted in
Garcia 2011). Similarly talking about the Bank of England’s disillusionment with
DSGE models in the aftermath of the global crisis, Buiter (2009) refers to “the
chaotic re-education” at the institution.
This “re-education” could usefully incorporate three fundamental considerations,
viz. (i) lesser reliance on preselected formal models and greater scope for
exploratory data analysis, (ii) robustness across model specifications in policy
choices and (iii) ethical responsibility of economic researchers.
One approach which is less formal (than DSGE models) and which gives greater
scope for exploratory data analysis is the cointegrated VAR (CVAR) approach
developed by Johansen (1996) and elaborated in Juselius (2006) and Hoover et al.
(2008). It is shown in Juselius and Franchi (2007) that the assumptions underlying a
DSGE model can be translated into testable hypotheses in a CVAR framework.
A second approach by Del Negro and Schorfheide (2004) (DSGE-BVAR) seems
even more promising. Here, the estimated parameters from a DSGE model are used
as priors in an associated Bayesian VAR. A hyper-parameter k controls the tight-
ness with which the priors are imposed. These priors are fed into the likelihood
function of the VAR to obtain the posterior distribution of the parameters. The
shape of the posterior distribution for k can help us adjudge the suitability of the
tested parameters of the underlying DSGE (from the point of view of
goodness-of-fit as well as model complexity). While neither of the above two
approaches can claim to be perfect, they have the merit of going beyond the narrow
DSGE view and allowing greater room for the data to speak.
The issue of robustness across model specifications is a largely neglected issue
in the literature. In the real world, policymakers are uncertain about the model(s)
that they use. This uncertainty has several dimensions, viz. parameter uncertainty,
uncertainty about the persistence of shocks, uncertainty about the data quality etc.
In such a situation what is required is a method to study the sources of model errors.
The Model Error Modelling literature from control theory can be useful here (see
Ljung 1999). Introducing robustness considerations in economics has been studied
from a different viewpoint in McCallum (1988) Hansen and Sargent (2002),
Onatski and Stock (2002), etc. These ideas however have not yet filtered down to
real-world policymaking.
Finally, the recent global crisis has brought to the fore the ethical responsibility
of the economics profession. As the financial wizards went into top gear with their
innovations in the build-up to the crisis, the regulators failed to get adequate and
timely warning about the potential for systemic damage in these developments,
from macroeconomists in general. Are we to believe that the leading lights of our
profession were simply ignorant about the dangers posed by an overleveraged,
oversecuritized and skewedly incentivized financial sector, or as is more likely, they
simply looked the other way? Either view does not redound to the profession’s
credit. Perhaps, economists should take their ethical responsibilities far more seri-
ously than they do now, and issue timely warnings to policymakers and the general
public of developments which (in their opinion) are fraught with serious conse-
quences for society at large.
Solow’s (1997) characterization of academic economists as “the overeducated in
search of the unknowable” is apt in the current context. Economists would be more
usefully employed if instead of pursuing the Holy Grail of the true but unknown
and formally perfect model, they set up a more modest agenda of studying the
knowable. The lines of thinking noted briefly in the previous paragraphs (viz. the,
ACE, CVAR and DSGE-BVAR models) represent precisely this line of thinking.
One could not agree more with Colander (2000, p. 131) when he sets up an agenda
for those he terms the New Millennium economists as “ … search for patterns in
data, try to find temporary models that fit the patterns, and study the changing
nature of those patterns as institutions change”.
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Chapter 13
Post-crisis NCM Theory Adaptations:
Evolutionary, Revolutionary
or Cosmetic?
“The belief that there is only one truth, and that oneself is in
possession of it, is the root of all evil in the world”.
—Max Born, physicist
Abstract The global crisis virtually put the mainstream New Consensus
Macroeconomics (NCM) in the dock, as in the popular mind the crisis was mainly
associated with the pre-crisis macropolicy framework, whose architecture was
largely based on the recommendations emanating from academics and policy-
makers strongly committed to the NCM theology. It was widely expected that just
as the Great Depression of the 1930s sounded the death knell for the Marshall–
Pigou paradigm of neoclassical economics, the GFC would do something similar
for the NCM. This chapter shows that this expectation has been belied, though
some changes to the NCM have indeed occurred—a few on the theoretical front but
more on the policy front. This entire process of mainstream persistence with a few
adaptations, is best understood in a Lakatosian framework. To do this, in this
chapter we take stock of how the mainstream profession reacted to the GFC—in
particular what explanations were offered for its occurrence and how the major
criticisms against the orthodoxy were countered.
1 Introduction
Writing in the wake of the Great Depression, Keynes (1936) captured the mood of
the entire Western world in his usual succinct but prescient phraseology “At the
present moment people are unusually expectant of a more fundamental diagnosis;
more particularly ready to receive it; eager to try it out, if it should be even
possible” (quoted in Heise 2014, p. 2). As the world struggles to recover from the
effects of the recent global crisis, the universal sentiment could also be described in
identical words. However, whereas the Great Depression paved the way for the
“Keynesian revolution”, no such revolution seems to be forthcoming currently,
consequent to the GFC. The regime of the ruling orthodoxy (NCM) continues to
prevail, in spite of the several serious challenges presented to its hegemonic

https://doi.org/10.1007/978-81-322-3920-8_13
278 13 Post-crisis NCM Theory Adaptations: Evolutionary, Revolutionary …
dominance by alternative viewpoints (see, e.g. Bresser-Pereira 2010; Kirman 2010;

Galbraith 2013 etc.). Our concern in this chapter is exclusively with theory. The
policy implications have been reserved for the next chapter. To derive a better
understanding of the extent to which there have been modifications to the theo-
retical NCM framework in the light of the recent crisis, it is worthwhile to
undertake a brief excursion into economic methodology.
2 Methodological Considerations
Early thinking on methodological issues among economists was guided by logical

positivism, a school of thought originating with Wittgenstein’s philosophy of lan-
guage and developed by the so-called Vienna circle in the 1920s. This view laid
great stress on the principle of verification, admitting as scientific only those phe-
nomena which were empirically verifiable van Quine (1961). Theoretical (unob-
servable) concepts derived meaning only if they could be transfigured into
observable components via well-defined correspondence rules. Hutchinson (1938)
is usually credited with being one of the earliest to apply logical positivist ideas in
economics, followed a little later by Friedman (1953) (see Blaug 1980; Backhouse
1994; Caldwell 1982, etc.).
However, the influence of logical positivism began to wilt among philosophers
in the 1960s, following the strong criticisms of Popper (2002) [1935], Kuhn (1970),
Lakatos (1968, 1978) and others. Popper’s work in particular, gave the initial
stimulus to the retreat from positivism, to be succeeded later by Kuhn and Lakatos.
Popper rejected the method of induction,1 proposing instead a four-stage deductive
procedure for the testing of theories2 (see Popper 1959, pp. 9–10):
(i) Checking the internal consistency of the system
(ii) Investigation of the logical form of the theory, to determine whether it is a
scientific theory (i.e. capable of being empirically refuted) or whether it is
simply tautological
(iii) A comparison with other theories, so as to assess whether the theory would
constitute a scientific advance, should it survive the various empirical tests
(iv) Finally, there is the testing of the theory by way of empirical applications of
the conclusions, which can be derived from it.
If the conclusions of the empirical tests turn out to be supportive of the theory,
then the theory is retained at least temporarily, but if the tests falsify the conclusions
1
Induction proceeds from particular experimental or observational results to universal statements
such as theories or hypotheses.
2
Popper does not concern himself overmuch with the actual discovery/invention of new theories
“…the act of conceiving or inventing a theory, seems to me neither to call for logical analysis nor
to be susceptible of it…My view may be expressed by saying that every discovery contains ‘an
irrational element’, or ‘a creative intuition’” (see Popper 1959, p. 7 and 8).
2 Methodological Considerations 279
(of the theory) the theory is rejected. This is the principle of falsification, which
constitutes the central theme of Popper’s contribution. Thus, for a theory to qualify
as scientific, it must be falsifiable/refutable by empirical observation and testing.
The influence of Popper’s ideas on economic methodology is substantial as dis-
cussed in Latsis (1976), de Marchi and Blaug (1991), Caldwell (1982), etc.
However, following the publication of Kuhn’s The Structure of Scientific
Revolutions (1970), and the widespread acceptance of his ideas of scientific pro-
gress through a succession of paradigms among the physical sciences, economists
increasingly tried to apply his methods to the growth of economic knowledge.
According to Kuhn, the concept of a paradigm represents a general theoretical
viewpoint (or what he later referred to as a disciplinary matrix) that members of the
community of scientists subscribe to. Scientific revolutions involve the replacement
of one paradigm by another and occur when the established paradigm starts
accumulating anomalies and paradoxes. These paradoxes cannot be explained by
the existing paradigm, which is then replaced once an alternate paradigm emerges
that is able to account for them. One example of such an anomaly in Newtonian
physics is the so-called problem of the precession of the perihelion of the planet
Mercury (see Synge 1960; Roseveare 1982, etc., for a discussion of this problem).
The resolution of this anomaly was proposed as one of the three tests of the General
Relativity Theory by Einstein (1916).3 The measured records of this precession
over 1697–1848 showed that it was much better explained by the Relativity Theory
than by Newton’s gravitational mechanics and Kepler’s laws. These, together with
the observed solar deflection of light during the total eclipse of September 1922,
were important factors in shifting the physics paradigm away from the Newtonian
theory to Einstein’s General Relativity theory in the 1920s. The successful appli-
cation of Kuhn’s methodology to the natural sciences stimulated interest in the
application of this methodology to social sciences, especially economics. Several
attempts were made to apply Kuhnian ideas to the development of economic
thought (see Sweezy 1971; Eichner and Kregel 1975; Lee 2009, etc.). However, in
general, such attempts have been viewed with considerable scepticism. One ground
for criticism of the application of Kuhn’s methodology to economics, is the
vagueness associated with his concept of a “paradigm” (see Stigler 1969; Blaug
1975, p. 149; Redman 1993, etc.). Another argument advanced against the
methodology is that the history of economic thought is not one where paradigms are
destroyed and replaced with new ones—rather it is characterized by the continuing
accumulation of knowledge and the coexistence of several competing paradigms
(see Weintraub 1979; Glass and Johnson 1989, pp. 112–170, etc.). In a gradual
manner, economists started switching over to Lakatos’ methodology of competing
scientific research programs (SRPs) around the 1980s (for a detailed review of this
3
The other two tests were (i) the deflection of light by the sun and (ii) the gravitational redshift of
light. The total solar eclipse of September 1922 in Australia afforded astronomers an opportunity
to verify the solar deflection of light while the gravitational redshift of light of a white dwarf star
Sirius-B was done by the astronomer Greenstein in 1971 using the powerful Hubble telescope.
process, reference may be made to Drakopoulos and Karayiannis 2005; Heise 2014;
Nightingale 1994, etc.).
Lakatos (1978) advanced a methodology that purports to resolve the perceived
conflict between Popper’s falsification principle and Kuhn’s view of scientific
progress through successive paradigm replacements. The central concept in his
(Lakatos’) methodology is that of a scientific research programme (SRP) which
comprises three features (see Heise 2014):
(i) a hard core of central theses that are deemed irrefutable. The hard core lies
beyond the ambit of falsification, either because the scientists subscribing to
that SRP are reluctant to abandon the constituent hypotheses or because the
hypotheses are devoid of empirical content (a good example of such a
hypothesis in the NCM is ergodic uncertainty).
(ii) a number of auxiliary hypotheses/theories that support the SRP but which are
falsifiable (in the Popperian sense) and which are termed the protective belt
or periphery and
(iii) a methodology that is deemed admissible or “scientific”.
SRPs in the Lakatosian schemata are modified via a process called heuristics,
which includes both a positive and a negative aspect. The negative heuristic
specifies that a subset of theories within the SRP are insulated from revision or
“tinkering” (hard core), while the positive heuristic refers to revision of the theories
comprising the periphery. The logic of such heuristics is rooted in the Duhem–
Quine thesis (see Duhem 1954 [1906]; Quine 1951).
The Duhem–Quine (DQ) thesis states that empirical evidence can never con-
clusively refute a single theoretical hypothesis ðH0 Þ in isolation, since the empirical/
experimental observations invariably involve the particular hypothesis in con-
junction with other auxiliary hypotheses say G1 ; G2 ; . . .GN . Thus, any of the
auxiliary hypotheses Gj ; j ¼ 1; 2. . .N rather than the particular hypothesis H0 could
be responsible for the empirical anomaly. Thus, empirical evidence cannot refute or
confirm H0 , and an empirical refutation of H0 cannot be interpreted as supporting an
alternative hypothesis H1 . Rather the refutation points to an alternative conjunction
of hypotheses say G0k ; k ¼ 1; 2. . .N 0 which may or may not involve H0 (for a
detailed discussion of the DQ thesis, see Harding 1976, while Cross 1982 offers an
illuminating presentation of the thesis in the context of monetarism).
The DQ thesis plays an important role in the Lakatosian scheme. Suppose an
empirical observation refutes the predictions of a Lakatosian SRP i.e. the hard core,
together with the auxiliary hypotheses constituting the periphery, entail an empir-
ical anomaly. The DQ thesis tells us that the conjunction of the hard core plus the
protective belt is untenable. We can then either retain intact the hard core or the
protective belt. As seen above, Lakatos’ negative heuristic implies retention of the
hard core and attempts at modification of the auxiliary hypotheses in the protective
belt (the positive heuristics). An SRP is said to be progressive if the modifications
to the hypotheses in the protective belt achieve better overall explanatory/predictive
power and/or lead to the prediction of new phenomena. If the modifications are
2 Methodological Considerations 281
simply made in an ad hoc manner to protect the hard core from refutation, but do
not contribute to improved prediction or the uncovering of new phenomena, then
the programme is said to be degenerating (see Musgrave and Pigden 2016).
Many economists feel that the Lakatosian scheme serves better than the Kuhnian
approach in explaining the accumulation of economic (and econometrics) knowl-
edge (see de Marchi 1991, p. 15; Drakopoulos and Karayiannis 2005, p. 12; Hendry
1993, etc.). Of course, it has not escaped its share of criticism (see in particular
Steedman 1991; Salanti 1994; Drakapoulos and Karayiannis 2005, pp. 18–21, etc.),
but still retains a great deal of its popularity with economic methodologists. In this
chapter, we try to understand the effects of the crisis on the NCM (both in its
theoretical and policy aspects) using the Lakatosian methodology.
3 Mainstream Reactions to the Crisis
The GFC virtually put the mainstream/orthodox4 New Consensus Macroeconomics

(NCM) in the dock, as in the popular mind the crisis was mainly associated with the
pre-crisis macropolicy framework, whose architecture was largely based on the
recommendations emanating from academics and policymakers strongly committed
to the NCM theology (see, e.g. Arestis et al. 2011; Stiglitz 2011; Pedrosa and Farhi
2015). It was widely expected that just as the Great Depression of the 1930s
sounded the death knell for the Marshall–Pigou paradigm of neoclassical eco-
nomics (see the quotation from Keynes in the opening paragraph of this chapter),
the GFC would do something similar for the NCM. As we shall see in this chapter,
this expectation has been belied, though some changes to the NCM have indeed
occurred—a few on the theoretical front but more on the policy front. This entire
process of mainstream persistence with a few adaptations is best understood in a
Lakatosian framework. To do this, we need to take stock of how the mainstream
profession reacted to the GFC—in particular what explanations were offered for its
occurrence and how the major criticisms against the orthodoxy were countered.
Following Fine and Milonakis (2011) and Tzotzes (2016), the mainstream
responses may be broadly classified into three categories: (i) the first group of
loyalists (to use Tzotzes’ terminology) maintains that the GFC did not expose any
flaws in the orthodoxy (NCM) and hence no change in the NCM is warranted,
(ii) the second group (moderates) concedes that the crisis did expose some short-
comings in the NCM, but these were not of a fundamental nature and could well be
accommodated with a few inessential modifications, and (iii) lastly, there is the
4
We use the terms mainstream and orthodox synonymously though some authors (see Davis 2008;
Lawson 2006; Lee 2009, etc.) distinguish between the dominant (conventional) professional
approach to the discipline (orthodoxy) and the professionally successful areas of the discipline for
which the term mainstream is preferred. Thus, evolutionary economics, behavioural economics
and experimental economics are part of the mainstream though not of orthodoxy. In general,
following common usage, we prefer not to pursue this distinction here.
group of insider critics which admits that the GFC did expose major flaws in the
NCM; but even this group tries to preserve the main structure of the NCM,
incorporating the modifications felt necessary to allow for the possibility of such
extreme events in the future.
3.1 The Loyalist’ Stand
Let us examine the stand taken by the first group (the loyalists) most of whom
(though not all) seem to be adherents of the Chicago school. The economists in this
group include many eminent names (such as Lucas, Sargent, Fama, Maskin,
Cochrane, Murphy, Taylor)5 on whose works most of the current generation of
economists has been reared. We begin by noting that much of the loyalist rallying
around the NCM, is concerned with two of its central hypotheses, viz. the
efficient-market hypothesis (EMH) and the rational expectations hypothesis (REH),
both of which together constituted the weakest link in the NCM structure and were
thus the focus of the most vitriolic attacks by its critics (these criticisms have been
discussed in detail in the preceding two chapters). In reply to the following question
posed by Cassidy (2010a): “The two biggest ideas associated with Chicago eco-
nomics over the past thirty years are the efficient markets hypothesis and the
rational expectations hypothesis. At this stage, what’s left of those two?”,
Cochrane’s response may be taken as representative of the general feeling of most
of those in the loyalist camp “I think everything. Why not? Seriously, now, these
are not ideas so superficial that you can reject them just by reading the newspaper.
Rational expectations and efficient markets theories are both consistent with big
price crashes”. The reasons advanced by the group for the GFC are better under-
stood in the light of this characteristic remark.
One favourite loyalist explanation was to asseverate the GFC as a rare tail event
or a black swan event (in the terminology made popular by Taleb 2008). This strand
is clearly evident, for example, in Cassidy’s interview with Fama (see Cassidy
2010b), where Fama says “I don’t think any of this (possibly meaning the sub-
prime bubble)6 was particularly predictable…Again, its economic activity—the part
we don’t understand. So the fact we don’t understand it means there’s a lot of
uncertainty about how bad it really is. That creates all kinds of volatility in financial
prices, and bonds are no longer a viable form of financing”. Or again we have
Murphy saying (interview with Cassidy 2010c): “But the fact is that much of the
variation in the market is unpredictable. In finance research, it’s a major victory if
you can explain half of one per cent of the price variation with your model. The
idea that you can’t beat the market, or predict it—that part of the efficient-market
hypothesis is very much alive and well”. Similarly, Lucas (2009) in a widely quoted
5
Included in this list are three Nobel Laureates (Lucas 1995; Sargent 2011; Fama 2013).
6
Italics mine.
3 Mainstream Reactions to the Crisis 283
op-ed in The Economist (6 August 2009) has this to say about the Lehman collapse
“One thing we are not going to have, now or ever, is a set of models that forecasts
sudden falls in the value of financial assets, like the declines that followed the
failure of Lehman Brothers in September. This is nothing new. It has been known
for more than 40 years and is one of the main implications of Eugene Fama’s
“efficient-market hypothesis” (EMH), which states that the price of a financial asset
reflects all relevant, generally available information. If an economist had a formula
that could reliably forecast crises a week in advance, say, then that formula would
become part of generally available information and prices would fall a week earlier.
(The term “efficient” as used here means that individuals use information in their
own private interest. It has nothing to do with socially desirable pricing; people
often confuse the two)”. A number of quotations with a similar message can be
located in the mainstream writings around this time. The black swan viewpoint is
possibly the greatest argument for retaining the status quo, for if the crisis was
totally an exogenous unpredictable shock, then it is no more a challenge to the
NCM orthodoxy, than say a stray meteor shower is to Kepler’s second law of
planetary motion.
A somewhat similar otiose defence is given of the rational expectations
hypothesis (REH). To quote Cochrane again “It (REH) is the statement that you
cannot fool all the people all the time…The principle that you can’t fool all the
people all the time seems a pretty good principle to me”. To deny all the solid
empirical and experimental evidence that has been accumulated against this thesis
by behavioural scientists such as Kahneman, Tversky, Rabib, Thaler etc. hardly
seems good scientific practice.7
The steadfast justification of the EMH and REH as also the assumption of
continuously clearing markets, leads to conclusions which are truly startling.8 To
take the most blatant, it leads one to suppose that the huge unemployment registered
during the years 2008–2011 in the USA and Europe was structural and voluntary,
viz. the problem would be solved if workers agreed to real wage cuts (a throwback
to the pre-Keynesian Pigovian thinking of the late 1920s). Or the ten per cent
unemployment in the USA was actually a case of workers voluntarily substituting
leisure for work. Apart from challenging the ten per cent figure, Cochrane has really
very little to offer by way of explanation “Right now, ten per cent of people are
unemployed. Many of them could find a job tomorrow at Wal-Mart but it is not the
right job for them—and I agree, it is not the right job for them. That doesn’t mean
the world would be right if they took those jobs at Wal-Mart. But some component
of unemployment is people searching for better fits after shifts that have to happen.
7
Some of the leading references from a vast literature are Rabin 2002; Schleffer 2012; Thaler 2015
(see the discussion outlined in Chap. 11, Sect. 3).
8
The assumption of continuously clearing markets is not strictly part of the NCM. But the NCM
adherents constitute a wide spectrum of persuasions, ranging from those distinctly close to new
classical thinking to those more sympathetic to the neo-Keynesian viewpoint. The assumption of
continuously clearing markets is a new classical fundamental and still claims the allegiance of
many mainstream economists.
The baseline shouldn’t be that unemployment is always constant. So that is a big

and enduring contribution—some amount of fluctuation does come out of a per-
fectly functioning economy” (see Cassidy 2010a).
So far we have seen the loyalist arguments in favour of the markets. Let us now
turn to the arguments against the government (and especially Fed intervention). One
of the important factors often held responsible for the global crisis is the conduct of
US monetary policy under Alan Greenspan (see, e.g. Taylor 2009, 2012, 2014;
Bibow 2013 etc.). Greenspan succeeded Paul Volcker to the Chairmanship of FRB
in June 1987 and systematically began a process of reversing his predecessor’s
conservative monetary policies, following the October 1987 Wall Street Crash. In
his hard-hitting critique, Taylor (2013) demonstrates that the real interest rates were
much lower than warranted by the traditional Taylor rule especially in the wake of
the dot-com bubble burst in September 2001.9 Within a span of about 3 years, the
Fed Funds rate (the key FRB monetary policy target) was down from 3.5 to 1%.
Not surprisingly, this provoked a boom in asset markets, including housing prices,
and a corresponding fall in the US dollar. Taylor (op. cit) quotes evidence from the
empirical studies of Jarocinski and Smets (2008) and Kahn (2010), to substantiate
his point that this relaxed monetary policy directly fed the US real estate boom.
Such low real interest rates, apart from leading to excessive credit expansion and
asset booms (the traditional credit channel), also affected banks’ risk-taking (the
so-called risk-taking channel of monetary policy).
Ahrend (2010) shows that in Europe too, the ECB kept interest rates too low for
Greece, Ireland and Spain.
However, the important aspect overlooked by Taylor and others in heaping
blame on Greenspan, is that the latter’s policies were more or less in line with the
NCM orthodoxy which strongly advocated a “hands-off” policy as far as asset price
bubbles were considered (the Jackson Hole consensus described in Chap. 4,
Sect. 6.3). In mid-2004, Greenspan reversed the interest rate cycle and in the
process brought about a hard landing of housing prices, shortly after his tenure
ended in January 2006.
Somewhat surprisingly, Taylor (2013) and Wallison (2011) give due attention to
the problems arising in the financial sector but attribute the irregularities to regu-
lators “for permitting violations from existing safety and soundness rules” (Taylor
2013, p. 54). The financial sector escapes with little blame. To pillory the gov-
ernment and the Fed for all that went wrong and to exonerate the market seems to
be the name of the game played by this group.10 To take an example, when
questioned by Cassidy about the excessive bank lending for home buying, Fama
bluntly puts the blame at the door of the government “That was government policy;
that was not a failure of the market. The government decided that it wanted to
9
On 10 March 2000, NASDAQ reached its peak at 5048, but went into a continuous side thereafter
falling to 68% of its peak value on 17 September 2001.
10
Most of the loyalist group also strongly attacked the fiscal policy stimulus undertaken by the US
Government, believing it to be ineffective at best and at worst threatening a debt overhang in the
future.
expand home ownership. Fannie Mae and Freddie Mac were instructed to buy
lower grade mortgages” (see Cassidy 2010a). There is virtually no reference in
Fama’s interview to mortgage-based securitization, credit default swaps, CDOs and
all the rest of the mess that the financial sector created of its own initiative. Even
excessive leverage is not singled out for blame by Fama (op.cit.), for he says “There
are other people here who think that leverage is an important part of the system.
I am not sure I agree with them”.
Of course, the Fed’s actions were not totally fault-free. In particular, its ad hoc
and arbitrary bailout policies,11 generated a great deal of uncertainty among cred-
itors and contributed to the freezing up of the commercial paper market in
September 2008 (see Kacperczyk and Schnabl 2010, 2013 for details of this epi-
sode) and thus acted as an important trigger to the crisis.
3.2 The Position of the Moderates
We now turn to the group of moderate critics whose overall stance may be char-
acterized as a willingness to admit some shortcomings in the NCM, but to leave the
main framework intact (see Tzotzes 2016). Rajan, Becker, Bernanke, Blanchard
and Heckman may be taken as the most prominent representatives of this
group. One common feature of their respective positions is not to go in for
monocausal explanations of the crisis, but to admit a variety of causes working in
conjunction. Rajan (see Cassidy 2010d), for example, takes the position that “…
there are so many different explanations for why this happened. Whether it was an
agency problem in the banking system itself. Whether it was markets going haywire
—irrational exuberance of one kind or another. Or whether it was government
intervention—the story about pushing credit to the less well off segments of the
population. My sense is, if you think seriously about this, all parts of it are
important”.
There is a mild sort of defence of both the EMH and the REH, but certainly not
with the fierceness of the loyalist group. Becker (see Cassidy 2010e) admits that
“The people who argue that markets were always efficient and there was no
problem, that was an extreme position—something a lot of people at Chicago had
recognized before. The weaker notion that markets, particularly financial markets,
usually work pretty well, and it’s very hard to beat them by investing against them,
that I think is still very powerful”. Heckman (see Cassidy 2010f) takes a similar
position “I tend to think of it (EMH) more in terms of the market reacting too
slowly. Certainly, from the end of 2007 onwards, when it was clear that problems
were emerging, many Wall Street professionals steered away from mortgage
securities. For a long time, though, the market was sending the right signals”.
11
Bear Sterns was bailed out but Lehman was not.
The views of this group regarding rational expectations are summed up in

Becker’s (op. cit.) cryptic remark. “I think most of it is still valid. It depends on
what you mean by rationality”. He goes on to elaborate “But if you take the view
that consumers, on the whole, react to incentives in the way you would predict they
would respond—you get very misled in the world if you don’t put a lot of emphasis
on that…Not all investors are (rational)—surely not. But I think it’s not very easy to
do better than the market. If you look at the behavioral economists who run hedge
funds, I don’t think, on the whole, they have done much better than others”.
Heckman (op.cit) illustrates his position with an anecdote about Milton Friedman “I
could tell you a story about my friend and colleague Milton Friedman. In the
nineteen-seventies, we were sitting in the Ph.D. oral examination of a Chicago
economist who has gone on to make his mark in the world. His thesis was on
rational expectations. After he’d left, Friedman turned to me and said, ‘Look, I
think it is a good idea, but these guys have taken it way too far’.”
While the moderates do not hesitate to admit market failures, they appear to lay
the major share of the blame for the crisis at the door of the regulators. Becker (see
Cassidy 2010e) makes this position abundantly clear “I think the last twelve months
have shown that free markets sometimes don’t do a very good job. There’s no
question, financial markets in the United States and elsewhere didn’t do a good job
over this period of time, but if I take the first proposition of Chicago economics—
that free markets generally do a good job—I think that still holds”. But he takes care
to emphasize later in the interview the pernicious role of the regulators “I don’t
think the government did a good job in the run-up to the crisis…we’ve seen another
example where free markets didn’t do a good job: they did a bad job. But to me
there is no evidence the government did a good job either, leading up to or during
the process”. He substantiates this assessment of regulatory failure with two specific
instances, viz. Greenspan’s low-interest rate policy and the failure of the SEC (the
US Securities Exchange Commission). Heckman (see Cassidy 2010e) also blames
regulators “Also, I think you could fault the regulators as much as the market. From
about 2000 on, there was a decision made in Washington not to regulate these
markets. People like Greenspan were taking a very crude and extreme form of the
efficient-market hypothesis and saying this justified not regulating the markets. It
was a rhetorical use of the efficient-market hypothesis to justify policies”.
But the position is far from clear as to whether deregulation of the financial
markets was the regulators’ fault, or they were misled by an oversell of the
orthodoxy by academic economists in the lead-up to the crisis. Rajan (see Cassidy
2010d) takes a somewhat nuanced position, attributing some part of the blame to
regulators for encouraging excessive consumption and investment in housing
through overextended bank lending and for the neglect of what he calls “the
plumbing” (meaning institutional details). Rajan has elaborated this position in his
book (Rajan 2010). According to him, skill-biased technological change which had
occurred since the 1970s had caused income distribution to shift in favour of the
high-skilled workers leading to widening income inequality. To assuage the
resultant political discontent, the government intervened via relaxation of mortgage
standards and supplying increased consumption loans to the low-income house-

holds, which provided the impetus to the housing price bubble.
Bernanke (2010) draws a neat distinction between economic science (the realm
of economic theory and empirical generalizations), economic engineering (com-
prising mainly regulatory frameworks and the risk-management systems of banks,
financial institutions and corporate) and economic management (actual operational
aspects of the private sector and the online supervision of the private sector by
regulatory and supervisory agencies). He then goes on to state that “the recent
financial crisis was more a failure of economic engineering and economic man-
agement than of what I have called economic science” and thus, that “calls for a
radical reworking of the field go too far”. Bernanke (2005) also advanced the
famous saving glut hypothesis which was elaborated by many later writers as an
important cause of the GFC (see Chap. 5, Sect. 2.2 for a full discussion).
3.3 The Insider Critics
We now turn to a discussion of the insider critics. Their criticisms often parallel the
criticisms of heterodox schools such as the post-Keynesians, structuralists and
others.12 What sets the insider critics apart from the heterodox critics is that while
the latter argue for an overthrow of the ruling NCM paradigm and its replacement
by an alternative, the insider critics want to maintain the basic NCM structure intact
but by introducing a few major and several minor modifications.
The list of insider critics is a long one including many distinguished names like
Krugman, Stiglitz, Eichengreen, Kobayashi, De Long, Buiter, Posner, Thaler etc.
Krugman (2009), in his hard-hitting article, set the tone for the extended debate that
followed. According to him, “As I see it, the economics profession went astray
because economists, as a group, mistook beauty, clad in impressive-looking
mathematics, for truth…the central cause of the profession’s failure was the desire
for an all-encompassing, intellectually elegant approach that also gave economists a
chance to show off their mathematical prowess. Unfortunately, this romanticized
and sanitized vision of the economy led most economists to ignore all the things
that can go wrong. They turned a blind eye to the limitations of human rationality
that often lead to bubbles and busts; to the problems of institutions that run amok; to
the imperfections of markets—especially financial markets—that can cause the
economy’s operating system to undergo sudden, unpredictable crashes; and to the
dangers created when regulators don’t believe in regulation”. The EMH is espe-
cially singled out as Panglossian euphoria.13 “The field (of finance) was dominated
by the ‘efficient-market hypothesis,’ promulgated by Eugene Fama of the
12
As these criticisms are discussed fully in a later chapter, we only briefly mention them here.
13
Dr. Pangloss is a character used by Voltaire in his satirical novel Candide (1759) to parody
Leibniz’s philosophy of optimism.
University of Chicago, which claims that financial markets price assets precisely at
their intrinsic worth given all publicly available information. (The price of a
company’s stock, for example, always accurately reflects the company’s value
given the information available on the company’s earnings, its business prospects
and so on.) And…because financial markets always get prices right, the best thing
corporate chieftains can do, not just for themselves but for the sake of the economy,
is to maximize their stock prices.” In other words, finance economists believed that
we should put the capital development of the nation in the hands of what Keynes
had called a casino. Later on in the article, Krugman blames regulators’ blind faith
in the efficiency of financial markets for the wave of deregulation that was initiated
almost universally in the 1980s and 1990s. “Finance theorists continued to believe
that their models were essentially right, and so did many people making real-world
decisions. Not least among these was Alan Greenspan, who was then the Fed
Chairman and a long-time supporter of financial deregulation, whose rejection of
calls to rein in subprime lending or address the ever-inflating housing bubble, rested
in large part on the belief that modern financial economics had everything under
control”. DeLong (2011) is even more explicit “My name is Brad DeLong. I am a
Rubinite, a Greenspanist, a neoliberal, a neoclassical economist. I stand here
repentant. I take my task to be a serious person and to set out all the things I
believed in three or four years ago that now appear to be wrong. I find this dis-
tressing, for I had thought that I had known what my personal analytical nadir was
and I thought that it was long ago behind me”.
Posner (see Cassidy 2010g) echoes a similar scepticism about market efficiency,
but also emphasizes the neglect by regulators of externalities in the banking system
(an indirect reference to systemic risk) and failure to recognize the Knightian nature
of uncertainty. Thaler (see Cassidy 2010h) comes down very heavily on the rational
expectations hypothesis for its neglect of the many contributions made of late by
behavioural scientists towards understanding the motivations of consumers and
investors. He apportions a major share of the blame for the crisis to human frailty
(meaning irrationality and cupidity). “Human frailty comes into play at two levels.
One, the people who were taking out the subprime mortgage loans—many of them
didn’t understand what they were doing. Two, the C.E.O.s clearly didn’t understand
what their traders were doing. I call that the ‘dumb principal’ problem. Go down the
list—A.I.G., Citigroup, Bear Stearns, Lehman Brothers. These companies were
destroyed or devastated by a small part of the firm that was hurtling forward and
was risking the entire firm. The people in charge were either greedy or stupid, or
possibly both”. Thaler’s assessment of bubbles is particularly insightful “It’s not
that we can predict bubbles—if we could we would be rich. But we can certainly
have a bubble warning system. You can look at things like price-to-earnings ratios,
and price-to-rent ratios. These were telling stories, and the story they seemed to be
telling was true”. Stiglitz (2011) presents a comprehensive critique of the orthodox
NCM viewpoint in the light of the crisis. His critique is essentially centred on five
points, viz. (i) rational expectations, (ii) the representative agent model and its
variants, (iii) DSGE models, (iv) neglect of institutions and (v) neglect of distri-
butional considerations. He particularly emphasizes his own contributions related to
information asymmetries and incomplete markets. Buiter (2009) apart from strongly
criticizing the REH and the EMH, also introduces two new critical features. The
first he calls the terminal boundary condition or the auctioneer at the end of time,
which he feels is an artefact adopted by the NCM to preclude speculative bubbles:
“The friendly auctioneer at the end of time, who ensures that the right terminal
boundary conditions are imposed to preclude, for instance, rational speculative
bubbles, is none other than the omniscient, omnipotent and benevolent central
planner. No wonder modern macroeconomics is in such bad shape…Confusing the
equilibrium of a decentralised market economy, competitive or otherwise, with the
outcome of a mathematical programming exercise should no longer be acceptable”.
Secondly, he also draws attention to the linearize and trivialize aspect of DSGE
models: “When you linearize a model, and shock it with additive random distur-
bances, an unfortunate by-product is that the resulting linearised model behaves
either in a very strongly stabilising fashion or in a relentlessly explosive manner…
The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy
had not exploded without bound in the past, and concluded from this that it made
sense to rule out…the explosive solution trajectories. What they were left with was
something that, following an exogenous; random disturbance, would return to the
deterministic steady state pretty smartly: No L-shaped recessions, No processes of
cumulative causation and bounded but persistent decline or expansion. Just nice
V-shaped recessions”. Eichengreen (2013) puts forth similar views but somewhat
mutedly “A further observation relevant to understanding the role of the discipline
in the recent crisis is that we haven’t done a great job as a profession of integrating
macroeconomics and finance. There have been heroic efforts to do so over the
years, starting with the pioneering work of Franco Modigliani and James Tobin.
But neither scholarly work nor the models used by the Federal Reserve System
adequately capture, even today, how financial developments and the real economy
interact. When things started to go wrong financially in 2007–08, the consequences
were not fully anticipated by policymakers and those who advised them—to put an
understated gloss on the point”.
However, it must be underlined, that even though on occasions the insider critics
are quite strident in their assertions, they stop short of a thorough overhaul of the
orthodoxy of the NCM (see e.g. Federal Reserve Bank of Cleveland 2013).
Krugman (2014), for example, admits that paradigming is hard and suggests that the
main framework be retained but with incorporation of behavioural insights “So how
do you do useful economics? In general, what we really do is combine
maximization-and-equilibrium as a first cut with a variety of ad hoc modifications
reflecting what seem to be empirical regularities about how both individual
behavior and markets depart from this idealized case. And people using this kind of
rough-and-ready approach have done really well since 2008, on everything from
inflation to interest rates to the effects of austerity”.
Kobayashi (2009b), using the Japanese experience of the 1990s, cautions against
the type of policies deployed in the USA during the GFC, viz. overreliance on fiscal
policy, bank nationalization and bank bailouts. He also feels that a new approach to
macroeconomics is called for: “the crisis we are currently experiencing may call for
a change in the theoretical structure of macroeconomics. In my view, a macroe-

conomic approach that encompasses financial intermediaries and places them at the
centre of its models is necessary”. However, his theoretical model only makes a
single (but important) departure from the mainstream by assuming that “assets such
as real estate now function as media of exchange given the development of liquid
asset markets but are unable to fulfil this function during a financial crisis (see
Kobayashi 2009a)”. A financial crisis then is characterized by the evaporation of
these media of exchange, which triggers a sharp fall in aggregate demand. His
reluctance to depart more fundamentally from the orthodoxy is highlighted by his
subsequent noting that “the new approach should make it easy to embed a model of
financial crises into the standard business cycle models (i.e., the dynamic stochastic
general equilibrium models)” (see Kobayashi 2009a).
Stiglitz, at first sight, may appear to be an exception to this viewpoint. In Stiglitz
(2010), he explicitly argues for a paradigm shift “Changing paradigms is not easy.
Too many have invested too much in the wrong models. Like the Ptolemaic
attempts to preserve earth-centric views of the universe, there will be heroic efforts
to add complexities and refinements to the standard paradigm. The resulting models
will be an improvement and policies based on them may do better, but they too are
likely to fail. Nothing less than a paradigm shift will do”. However in Stiglitz
(2011), we get a better idea of what such a shift envisages, viz. a detailed modelling
of credit and banking, inclusion of mechanisms such as financial accelerator and
constraints, labour market imperfections and some aspects of behavioural finance.
In essence, he is arguing for a New Macroeconomics which builds on the NCM
structure by incorporating the features arising from asymmetric information,
endogenous market frictions and incomplete markets.
4 The NCM Controversy in a Lakatosian Framework
4.1 The Lakatosian Framework
The Lakatosian framework outlined above, is particularly suitable for putting the
NCM critique and defence in a methodological perspective. This has been
attempted earlier by De Paula and Saraiva (2016) and Heise (2014). However, our
approach is considerably its different from theirs, and goes into greater details. We
begin by attempting to put the pre-crisis NCM in this framework and then see what
changes (if any) to this framework have been accumulated in the light of the crisis
(see Table 1). The hard core has been defined as the group of central theses that are
considered inviolable. In a strictly Lakatosian interpretation, these are not empiri-
cally falsifiable because they are either tautological or axiomatic or devoid of
empirical content. However, such a view becomes too restrictive in the social
sciences and hence a more flexible interpretation of the Lakatosian hard core is
adopted to include also those hypotheses which are strictly speaking empirically
falsifiable, but which the proponents of the scientific research programme (SRP) are
4 The NCM Controversy in a Lakatosian Framework 291
Table 1 Scientific research programme (SRP) of the new consensus macroeconomics (NCM)
Pre-crisis SRP of the NCM Post-crisis SRP of the NCM
Central C1. Markets are complete, with C1 to C4 retained intact by the
hypotheses perfect information and in negative heuristics
(hard core) continuous equilibrium C5. Retained but with some attempts
C2. Ergodic Uncertainty to incorporate insights from
C3. Representative rational behavioural economics, information
optimizing agent economics and evolutionary
C4. Micro-foundations and economics, etc
reductionism C6. Some recognition of its
C5. Rational expectations limitations in the strong version. But
C6. Efficient markets a strong belief retained in a weaker
version (that by and large markets
are efficient in the long run, though
there could be some glitches in the
short run) (see in particular the
views of Becker and Heckman
above)
Auxiliary A1. Classical dichotomy/NRH A1. Some attempts to reconcile the
hypotheses (natural rate hypothesis)/Long-run hypothesis with observed facts but
(periphery) verticality of with the Phillips curve the positive heuristics may be
A2. Transversality condition (see considered degenerative
Chap. 2 for a discussion) A2. Hypothesis considerably
A3. Irrelevance of income modified via a progressive positive
distribution for explaining business heuristics
fluctuations A3. Relevance of income
A4. Institutional features are distribution admitted to some extent
irrelevant in explaining business (arguably a progressive positive
cycles heuristics)
A4. Relevance of institutions fully
recognized (a progressive positive
heuristics)
Methodology DSGE DSGE
reluctant to abandon (see Weintraub 1985; de Paula and Saraiva 2016). The
assumption of ergodic uncertainty underlying the NCM is an example of a central
hypothesis in the strict Lakatosian sense, whereas rational expectations and efficient
markets are admissible as central hypotheses under the flexible interpretation.
Adopting the flexible Lakatosian scheme, we may list the following theses as
central hypotheses of the NCM as it stood in the pre-crisis period14:
(i) Representative rational optimizing agent
(ii) Micro-foundations and reductionism
(iii) Ergodic uncertainty
(iv) Rational expectations
(v) Complete and efficient markets.
14
The NCM is discussed fully in Chap. 4.
Opinions differ as to the hypotheses constituting the periphery. As we have seen

above (Footnote 8), there is some difference of opinion about the precise status of
the assumption of continuously clearing markets within the NCM. A similar zone of
disagreement is also evident in the case of the NRH and long-run verticality of the
Phillips curve. However, those among the mainstream, who would like to take it
(NRH) as a hard core hypothesis, would find it difficult to formulate auxiliary
hypotheses in the protective belt to explain the high levels of unemployment that
prevailed in Europe and the USA during the Great Depression as well as the recent
global crisis. Hence, following Cross (1982, p. 330), we categorize this hypothesis
in the protective belt as subject to empirical falsification. Similar remarks apply to
the transversality condition, which postulates that in the inter-temporal optimization
of the representative individual, all debts are settled in full, thus effectively leaving
no space for money, finance and liquidity to enter the model in a meaningful way
(see Chap. 2 above). A fairly acceptable list for the periphery would then include:
(i) Classical dichotomy/Natural rate hypothesis/Long-run verticality of the
Phillips curve
(ii) Transversality condition (see Chap. 4, Sect. 5.2 for a discussion)
(iii) Irrelevance of income distribution for explaining business fluctuations
(iv) Irrelevance of institutional features in explaining business cycles.
The inclusion of categories (iii) and (iv) is justified following the criticisms
levied by Stiglitz (2010), Rajan (2010), Bernanke (2010) and others on lack of
attention to these issues in the NCM.
The methodology adopted by the NCM in recent years is the dynamic stochastic
general equilibrium (DSGE) which combines a formal deductive mathematical
approach with sophisticated empirical testing, using micro-econometric calibration
techniques and stochastic simulation.
Let us for the sake of completeness, also list the policy implications emanating
from the above NCM scheme (these have already been discussed in detail in
Chap. 4, Sect. 6)
(i) Potency of monetary policy
(ii) Jackson Hole consensus
(iii) Inflation-targeting and Taylor rule
(iv) Central bank independence
(v) Ricardian equivalence and the ineffectiveness of fiscal policy
(vi) Regulation with a “light touch” and emphasis on market discipline
(vii) Benign view of financial innovations as devices to complete markets
(viii) The downplaying of financial regulation as a macroeconomic policy tool.
4.2 The NCM and the Post-crisis Critique
It is now generally agreed that the recent crisis did not provoke any major change in
the prevailing NCM orthodoxy. Certainly, the negative heuristics was very much in
evidence in protecting the central hypotheses in the hard core, as is evident from
the opinions recorded above of the mainstream loyalists as well as the moderates.
The insider critics did subject the two central hypotheses of rational expectations
and efficient markets to serious questioning, and to a lesser extent, the hypothesis of
ergodic uncertainty. However, in view of their adherence to the deductivist for-
malist DSGE methodology and the reluctance to sacrifice the reductionist
micro-foundations based on the representative agent (see Chap. 1, Sect. 2 for a
discussion), they were not very successful in their avowed objective of grafting the
insights from behavioural finance, Knightian uncertainty, Keynesian herd beha-
viour, etc., onto the DSGE framework.
The auxiliary hypotheses in the periphery did undergo some modifications, i.e.
the positive heuristics was very much in evidence. Let us take the transversality
condition first. As detailed in Chap. 2, this amounts to postulating that in the
inter-temporal optimization of the representative individual, all debts are paid in
full, thus effectively leaving no space for money, finance and liquidity to enter the
model in a meaningful way. This rendered the model particularly inappropriate to
analyse the real-world problems of credit risk and default. There have been many
efforts to provide coherent accounts of banking crises (especially the GFC) by
incorporating the banking sector within the DSGE framework. An early generic
model along these lines is due to Bernanke et al. (1999), wherein banks charge
corporates a risk premium depending on the net worth of the latter. Grafting this
generic model on to a modified version of the Smets–Wouter (2007) model, Le
et al. (2012) develop a DSGE model to analyse the global crisis and find that the
origins of the crisis in the USA lie mainly in non-banking shocks relating to
technical productivity, labour supply, real wage “push”, external finance premium,
etc. Other models of financial crises in the DSGE framework are the MAPMOD
model of the IMF (see Benes et al. 2014), a model for the EC by Roeger (2012) and
multi-country models for the Euro Area by Merola (2014), Matthieu et al. (2016),
etc. This part of the positive heuristics may be deemed progressive as it helps to
explain/predict the phenomenon of banking crises, which were left unexplained in
the previous model versions.
The group of moderates and insider critics (see previous section) have also
attempted to apply some positive heuristics to the role of inequality in business
cycles. As Palley (2013) points out, inequality was a non-issue for mainstream
economists, being viewed as a natural consequence of skill-biased technical change
occurring throughout the world in the last four decades of the previous century.
Rajan (2010), however, attempts to bring it into the narrative of the global crisis as
an explanatory factor. In his view, the widening inequality (brought about by the
previous decades of skill-biased technical change) led to a degree of political unrest

among the lower income strata of the American population, which the government
tried to douse by increased access to cheaper consumer finance and less stringent
mortgage requirements. This, combined with a largely unregulated shadow banking
sector, led to the real estate bubble and the subsequent collapse. Kumhof and
Rancière (2010) provide a slightly different version of the role of inequality. The
starting point of their analysis is the increase in observed inequality in the USA over
the three concluding decades of the last century documented in Piketty and Saez
(2003). This is attributable to several factors including most prominently (i) an
increase in the share of performance pay (e.g. bonuses) (see Lemieux et al. 2009),
(ii) an increase in the return to post-secondary education (see Lemieux 2006),
(iii) increased foreign competition and offshoring of jobs (see Borjas and Ramey
1995; Reich 2010, etc.) and above all (iv) the steady decline in unionization power
since the mid-1970s (see Card et al. 2004). The macroeconomic implications of
increased income inequality for the USA are then worked out through a DSGE
model. The underlying driving mechanism for the crisis is the rising leverage (via
new consumer loans) of poor- and middle-income groups in their attempts to
maintain their consumption standards. This process gives rise to new financial
instruments as well as institutions, which are sustained by the recycling of the
additional incomes accruing to the higher income groups. The rising leverage
coupled with the emergence of shadow banking and proliferation of complex
opaque financial instruments contribute to an increasing probability of banking
crises. The introduction of income inequality into the analysis does contribute to a
better understanding of financial crises, and the associated positive heuristics may
thus be considered progressive.
Prior to the crisis, institutional features were largely neglected, being considered
as having little bearing on business fluctuations. The crisis did promote some
rethinking of this attitude among mainstream economists. Rajan (see Cassidy
2010d) in the Chicago interviews discussed above, admits that “The fault of the
macroeconomics profession was…to ignore the plumbing…The mistake was that
we thought the economy works reasonably well, and we could ignore the institu-
tional details. We learned that was wrong”. Stiglitz (2011, p. 604) spells out the
issue in greater detail “The Standard Model (i.e. the NCM based DSGE model)
assumes that institutions don’t matter; but institutional details are often of first-order
importance”. He then goes into some detail about the US mortgage market and the
conflicts between the interests of various types of mortgage holders and the issuers.
He concludes insightfully that models which ignore such institutional features “will
give too much credence to the ability of the markets to work everything out for the
best, and provide little guidance to what government might or should do”. Posner
(see Cassidy 2010f) too makes essentially the same point. He wonders “whether
modern economists have lost interest in or feel for institutional detail that might be
very important. I don’t know how many of these economists really knew anything
about how modern banking operates, how the new financial investments operate—
collateralized debt obligations, credit default swaps, and so on”. From this, he is
also led to essentially the same conclusions as Stiglitz (op. cit.). “Modern
economics is, on the one hand, very mathematical, and, on the other, very sceptical
about government and very credulous about the self-regulating properties of mar-
kets. That combination is dangerous. Because it means you don’t have much
knowledge of institutional detail, particular practices and financial instruments and
so on. On the other hand, you have an exaggerated faith in the market”.
Many of the institutional changes that have been occurring worldwide since the
1980s, have increased the fragility of the financial system, by making it more
sensitive to large and correlated shocks. Among such institutional changes, the
following deserve special mention, viz. (i) the repeal of the Glass–Steagall Act in
1999 and its replacement with the much less stringent Gramm–Leach–Bliley Act,
which led to increased banking concentration and the emergence of financial
conglomerates (to exploit economies of scale & scope), (ii) corporate management
compensation schemes which encouraged excessive risk-taking and short-termism
(see Bebchuk and Spamann 2010; Chesney et al. 2010, etc.), (iii) the change from
defined benefit to defined contribution pension systems in the USA and many EU
countries meant that individuals had to bear much of the risk of asset prices
volatility (Ocampo and Stiglitz 2008), (iv) growth of “shadow banking” institutions
especially hedge funds (see Gorton 2010; Pozsar and Singh 2011; Financial
Stability Board 2012, etc.), (v) increased reliance on “credit rating” agencies (see
Papaikonomou 2010; Baber 2014, etc.), (vi) large-scale integration of financial
markets (Stiglitz 2011, p. 622, (vii) the US Bankruptcy Law of 2006 which by
strengthening credit rights removed lenders’ incentives to maintain due diligence
about borrower creditworthiness (see Acharya et al. 2009; Davydenko and Franks
2008, etc.).
There is no denying that the work cited in the previous paragraph draws attention
to various institutional features in the USA, Europe and in many EMEs which
played an important triple role in the inception of the recent crisis, its amplification
and finally its perpetuation. Many of these features may be difficult to incorporate
fully into formal models. Yet there is a good case for considering this aspect of the
positive heuristics as progressive, for the various mechanisms elaborated in the
work cited (and other related work) will not only help academics in understanding
past crises but also provide useful guideposts for regulators in devising new reg-
ulatory mechanisms, which can reduce the probability of the incidence of new
crises, and mitigate the consequences if and when they occur.
Let us now come to a discussion of the peripheral hypothesis of the natural rate of
unemployment. This of course, is a restatement in more formal terms of the classical
Say’s law of markets which denies the possibility of a general lack of aggregate
demand. How are actual recessions then explained? An early explanation given by
Lucas (1972) centred on the inability of agents in physically separated markets to
distinguish between price changes resulting from relative (real) demand shifts and
nominal demand shifts. This confusion (which Lucas assumes is temporary) would
lead to a short-run downward-sloping Phillips curve exhibiting the usual inflation–
unemployment trade-off. Lucas is careful, however, to remind us that “…classical
results on the long-run neutrality of money, or independence of real and nominal
magnitudes, continue to hold” (Lucas 1972, p. 103). Lucas’ position is thus what
Gurley (1961, p. 307) had expressed a decade earlier as “Money is a veil, but when
the veil flutters, real output sputters”. Later orthodox economists under the real
business cycle school aegis, rejected even this interpretation of the (short-run
downward-sloping) Phillips curve insisting that price changes or demand fluctua-
tions had no bearing on business fluctuations (see Kydland and Prescott 1982, 1990;
Long and Plosser 1983, etc.). As we have seen above, most moderates and insider
critics have realized the futility of reconciling the assumption of the classical
dichotomy with the observed reality of recessionary unemployment. To invoke
Krugman (2009) again “(According to the orthodox theory) the business cycle
reflects fluctuations in the rate of technological progress, which are amplified by the
rational response of workers, who voluntarily work more when the environment is
favorable and less when it’s unfavorable. Unemployment is a deliberate decision by
workers to take time off. Put baldly like that, this theory sounds foolish—was the
Great Depression really the Great Vacation? And to be honest, I think it really is
silly”. Blanchard (2008), more of a moderate critic of orthodoxy, also admits that “It
is hard to ignore facts. One major macro fact is that shifts in the aggregate demand
for goods affect output substantially more than we would expect in a perfectly
competitive economy” (p. 5). He is therefore in favour of the introduction of nominal
wage rigidities in the basic model as done by the New Keynesians (see Chap. 4). But
in addition to nominal rigidities, Blanchard (op. cit.) also emphasizes the presence of
real wage rigidities arising due to the decentralized nature of the labour market.15
The combination of nominal and real wage rigidity implies that aggregate demand
shifts can have significant and persistent effects on real output. Stiglitz (2011) is also
very critical of the orthodox NCM treatment of unemployment “Any model worth its
salt has to be able to explain and predict movements in unemployment…A model
that assumes that labour markets clear will be of little help…” (Stiglitz, op. cit.
p. 608). He has little use for the wage rigidities (nominal or real) explanation of
unemployment which he feels to be ad hoc. “Such an explanation is suspect: in the
Great Depression (of the 1930s) wages fell a great deal—they could hardly be called
rigid. And in the Great Recession (i.e. the GFC) the United States has been plagued
by high unemployment, even though it has claimed to have had one of the most
flexible markets, and has the weakest unions, among the advanced industrial
countries” (Stiglitz, op. cit. p. 608).
Perhaps, the crucial point to emerge from Stiglitz’s paper (Stiglitz, op. cit. p. 604
and 617) is that the natural rate hypothesis is a direct consequence of the central
hypothesis of complete and continuously clearing markets with perfect information.
If we are unwilling to introduce imperfect information and asymmetric information,
then it will not be possible for us to study the out-of-equilibrium and destabilizing
behaviour of labour markets observed during deep recessions. This argument we
find quite persuasive. Hence (in our opinion), the positive heuristics of explaining
observed unemployment during recessions by a sudden upward shift in workers’
15
This is the so-called Diamond–Mortensen–Pissarides (DMP) model the details of which may be
found in Hall (2003), Mortensen and Nagypal (2007), Pissarides (2009), etc.
preference for leisure (as implied by the strict version of the NCM orthodoxy) or by
wage and price rigidities (nominal and real) as attempted by the moderates, does
not really improve our understanding of the reality of high unemployment observed
either in the Great Depression or the recent crisis. This heuristic may therefore be
considered degenerative in the Lakatosian sense.
It should be evident from the discussion in this section that within the body of
mainstream NCM, the crisis has had a marginal effect on the theoretical framework
(by contrast, as we shall see in the next chapter, the rethinking on policy matters has
been much more significant). Even the most vociferous of the insider critics, like
Krugman and Stiglitz (see the discussion in Sect. 3.3 above), are stopping short of
recommending a shift to an alternate paradigm. Mishkin (2011, p. 32) in his defence
of flexible inflation targeting also supplies an indirect defence of the NCM “The
arguments supporting central banks’ adherence to the principles of the New
Neo-Classical Synthesis (i.e. the NCM) are still every bit as strong as they were
before the crisis”. Bernanke (2010, p. 2) seems to reflect the general thinking of the
mainstream economists when he says “I think that calls for a radical reworking of
the field go too far”, while Krugman (2014) cryptically describes what most
economists currently do (and will continue to do for quite some time) “So how do
you do useful economics?…Combine maximization and equilibrium as a first cut
with a variety of ad hoc modifications reflecting…empirical regularities about
how…individual behavior and markets depart from this idealized case…”.
5 Perpetuation of the NCM Paradigm
The Great Depression, it is widely believed, led to a mainstream paradigm shift

from Marshallian–Pigovian neoclassicism to the Keynesianism of the General
Theory. The upheaval under the recent global crisis was on a scale comparable to
the Great Depression and yet no paradigmatic shift is in evidence. In this con-
cluding section, we try to understand some of the reasons advanced for the per-
petuation of the NCM orthodoxy. At a somewhat formal level, the question can be
approached within the field of the sociology of scientific knowledge (see Bourdieu
1988; Lamont and Molnar 2002; Lawson 2006, etc.). Davis (2008) historically
identifies periods in which a single economics approach was dominant and those in
which a plurality of approaches prevailed. He finds that dominant and pluralistic
epochs alternate, though not exactly in a regular fashion. But he also notes that
dominant epochs create conditions for their own subsequent fragmentation, whereas
pluralistic epochs generate conditions leading to the emergence of a single domi-
nant approach.
The last three and a half decades might be considered as an example of a
dominant epoch in which the NCM has ruled the roost in both academic as well as
policy circles. However, while the GFC was a circumstance which could have been
expected to lead to a fragmentation of the orthodoxy and a succeeding period of
pluralism, such an expectation has not been born out. Instead, the NCM orthodoxy
continues to be perpetuated through the teaching and research programmes in the

top universities. To quote Caballero (2010), who gives a detailed critique of this
pretence of knowledge syndrome, “What concerns me of my discipline, however, is
that its current core…has become so mesmerized with its own internal logic that it
has begun to confuse the precision it has achieved about its own world with the
precision that it has about the real one”.
Several explanations have been put forth for this phenomenon. Palley (2013), a
prominent NCM critic, puts forth a particularly appealing explanation––the
so-called gattopardo syndrome.16 The central message of this syndrome is that if
ideas are to remain powerful, they must adapt but retain their central thrust. Palley
gives several examples to illustrate how the NCM has made some changes to
accommodate persistent and inconvenient criticisms but has yet retained its central
structure intact. We briefly discuss two of these here. The first refers to the role of
inequality. We have seen how Rajan (2010) and Kumhof and Rancière (2010) have
attempted to introduce income inequality into the explanatory narrative of the
global crisis. Palley (op. cit.), however, considers this as a change introduced to
keep things the same. In his view, both the Rajan and Kumhof & Rancière, versions
treat income distribution effects as unanticipated shocks to income that forces
workers into a debt trap that increases financial fragility. Neither version recognizes
the role of income inequality in depressing aggregate demand, which would have
implied a move away from the natural rate hypothesis in the direction of Keynesian
General Theory. The second example of the “gattopardo syndrome” is the savings
glut hypothesis of Bernanke (2005). The glut hypothesis postulates that rise in
saving propensity in China and other East Asian countries was an autonomous
phenomenon unrelated to the developments in the West, when in fact it was also
partly a reflection of the huge US current account deficits and the fall in the US
savings propensity in the two decades preceding the crisis (see Chap. 5, Sect. 2.2).
The governments of these countries (particularly China) mopped up domestic
household savings via sales of government securities, and this allowed these
countries to resist appreciation of their real exchange rates, in pursuance of their
export-led growth strategies. This further built up their current account surpluses by
stimulating exports and reducing imports. The resultant forex surplus was rein-
vested in US Government securities as well as US mortgage-based securities
(especially those issued by Freddie Mac and Fannie Mae which were viewed as
particularly safe by Asian investors), which kept US interest rates low and inflated
the US property bubble. Superficially, this theory seems to wear Keynesian fea-
tures. Both see the trade deficit as a cause of the low-interest rates, but the
Keynesian reasoning focuses on the weakening of the US manufacturing sector by
Chinese import penetration over the last three decades of the twentieth century. The
result was wage stagnation and income inequality which led to a “structural demand
16
The famous Italian novel Il Gattopardo (The Leopard) by Lampedusa depicts how the Italian
aristocracy of the 1860s retained control over the peasantry by aligning itself with the new urban
elite.
5 Perpetuation of the NCM Paradigm 299
gap”. The low US interest rates over the period 2001–04 are seen as a policy
response to fill this gap by consumer loans and asset inflation, and thus to ward off a
recession in the manufacturing sector. Thus, whereas the Keynesian explanation
focuses on the economic weaknesses of the US manufacturing sector and wage
stagnation, the saving glut hypothesis is centred on the bond and property market
distortions (see Palley 2013, pp. 20–22). Thus, the saving glut hypothesis does not
mark any significant departure from the NCM—any such departures being purely
illusory. Thus, in the “gattopardo” view, the mainstream has just made a few
marginal changes to preserve the essence of the status quo ante.
There are other more sociological explanations for the persistence of the NCM.
We will briefly discuss three of these.
The first explanation refers to the “conflict of interests” that arises for those
academic economists who play a dual role, viz. that of commenting on economic
matters in the popular media and dispensing policy advice to the government and
regulators on one hand, and on the other, having lucrative and responsible con-
nections with financial firms. In an important study Carrick-Hagenbarth and Epstein
(2012) surveyed a sample of 19 very influential financial economists in the USA, 15
of whom were closely associated with the financial sector, indicating the widespread
prevalence of this practice. Two features identified by the study are particularly
disturbing—firstly, over the period 2005–09 only 4 out of the 15 economists with
financial sector connections, disclosed these in their academic and popular writings,
and secondly, the opinions expressed are all uniform in advocating policies of
regulatory and supervisory forbearance, encouragement of financial innovation and
neglect of systemic risk. Such policies tend to favour financial sector interests often
at the expense of those of the economy as a whole (the important documentary Inside
Job by Charles Ferguson brings this out in vivid details).
The second factor is sometimes referred to as “cognitive capture” (see
DeMartino 2011; Otsch and Kapeller 2010; Carrick-Hagenbarth and Epstein 2012),
whereby syllabi in leading US universities are often one-dimensional focused on
the unique neoclassical perspective (general equilibrium micro-economics and
NCM macroeconomics). Students are deprived of any alternative perspectives (see,
e.g. Wilson and Dixon 2009; Kapeller 2010) and in the words of Leijonhufvud
(1973) a candidate is “not admitted to adulthood until he has made a ‘model’…
acceptable to the elders of the ‘dept’ in which he serves his apprenticeship. Those
who fall in line are rewarded with degrees, those who do not are thrust into the
wilderness. The pattern continues in later life—mainstream journals will not publish
anything that does not toe the general accepted line and positions, promotions,
awards and association memberships are all dependent on a candidate’s mainstream
publications”. Most researchers are thus strongly drawn into the camp of main-
stream adherents. The leading US universities set the benchmark for other US
universities to follow, and in most of Europe and the rest of the world, economics
education often closely mimics the developments in the USA.
The final feature that we consider is what Palley (2013) dubs as the sociology of
citation. The citation index is widely used as a measure of professional acceptance
of an academic. But mainstream economists rarely acknowledge work from
heterodox perspectives (such as post-Keynesian, evolutionary, structural or

Austrian), even if it has a close bearing or even academic precedence over their own
work. Several specific examples of this are given in Palley (op. cit.).
Thus, in effect, mainstream economics has struck very deep roots in a wide range
of spheres—not only academics, but also policy circles, multilateral institutions
(such as the IMF, BIS, World Bank), international think tanks, vast sections of the
media, NGOs and above all else the corporate and financial sectors. This set of
circumstances creates a network of interconnectedness of vested interests, which
makes any fundamental change in the ruling paradigm almost impossible. Keynes,
writing in the General Theory (1936, p. 384) strongly believed in the power of ideas
to transform the world “I am sure that the power of vested interests is vastly
exaggerated compared with the gradual encroachment of ideas”. Maybe his was an
accurate description of the world of the 1930s, but the world of today, eight decades
later, is different. Good ideas are not lacking but their power to trump vested
interests has evaporated. Thus, whereas many well-respected economists have felt
that the economic crisis is a crisis for economic theory (the title of a paper by
Kirman 2010), the mainstream profession has managed adroitly to deflect this
looming threat and to maintain its precedence virtually unchallenged.
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& Co.
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presented at the First International Conference in Contemporary Social Sciences. Rethymnon,
Greece: University of Crete.
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International Review of Economics Education, 8(2), 91–105.
Chapter 14
Revisiting Domestic and Global
Macroeconomic Policy in the Aftermath
of the Global Crisis
Abstract As the recent global crisis (GFC) unfolded, a consensus was forged
among a group of developed countries and EMEs, under the aegis of the G20, to
tackle the associated issues on a coordinated basis. The main partners in such a
coordinated response were envisaged to be: (i) national policy-making bodies, viz.
central banks, national and subnational Governments (especially Finance
Ministries), and Financial Regulatory & Supervisory Authorities and (ii) interna-
tional bodies comprising (a) an IMF reformed so as to give EMEs and LDCs a
greater say in its policies and greater participation in its governance structure,
(b) influential international advisory groups such as the Financial Stability Board
(FSB) and G20 and (c) international financial standard-setting bodies such as the
Basel Committee on Banking Supervision (BCBS), International Association of
Insurance Supervisors (IAIS), International Organization of Securities Commissions
(IOSCO). This chapter is devoted to an extended discussion of how successful were
the national and international bodies in facing the several challenges involved in a
coordinated response to maintaining global financial systemic stability.
1 Introduction
Perhaps the most significant difference between the Great Depression of the 1930s
and the recent global crisis (GFC) was that as the latter unfolded, a consensus was
forged among a group of developed countries and EMEs, under the aegis of the
G20,1 to tackle the associated issues on a coordinated basis. The first G20 Leaders’
Summit held at Washington in the immediate aftermath of the outbreak of the crisis
in the USA (14–15 November 2008) identified three objectives and an action plan
for its members to mitigate the seriousness of the impending global fallout.
1
The G20 was formed in December 1999 and involves an annual meeting of the central bank
governors and finance ministers of its members (the EU and 19 other countries including India)
and occasional meetings of heads of member states.

https://doi.org/10.1007/978-81-322-3920-8_14
306 14 Revisiting Domestic and Global Macroeconomic Policy …
The three objectives pertained to

(i) Restoration of global growth
(ii) Strengthening the international financial system and
(iii) Multilateral institutional reform.
The objectives were to be achieved via an action plan that involved
(i) Enhancing prudential regulation and supervision of financial institutions by
increasing transparency and accountability and promoting integrity
(ii) Greater stress on international cooperation
(iii) Urgent reform of multilateral institutions (especially the IMF) and
(iv) Establishment of the Financial Stability Board (FSB)2 to monitor interna-
tional critical imbalances and to advise national governments on emerging
global and domestic threats to financial stability.
It is best to clarify that, though originally some G20 members were inclined to
attribute a supranational decision-making authority to the body, subsequent delib-
erations tended to veer towards a view of its role as one of coordinating decisions
made by individual countries, and reconciling different national views and interests
(see Véron (2014)).
The main partners in such a coordinated response were envisaged to be:
(i) National policy-making bodies, viz. central banks, national and subnational
Governments (especially Finance Ministries), and Financial Regulatory &
Supervisory Authorities and
(ii) International bodies comprising:
(a) an IMF reformed so as to give EMEs and LDCs a greater say in its
policies and greater participation in its governance structure
(b) Influential international advisory groups such as the Financial Stability
Board (FSB) and G20 and
(c) International financial standard-setting bodies such as the Basel
Committee on Banking Supervision (BCBS), International Association of
Insurance Supervisors (IAIS), International Organization of Securities
Commissions (IOSCO).
2 Role of National Policy-Making Bodies: Post-crisis

Perspectives
Following Blanchard et al. (2013), de Paula and Saraiva (2016), etc., we examine
the role of national macro-policy-making authorities under three major jurisdictions
(i) central bank jurisdiction—monetary policy
2
The FSB was established at the Second G20 Leaders’ Summit held in London (2 April 2009).
2 Role of National Policy-Making Bodies: Post-crisis Perspectives 307
(ii) Financial Regulatory & Supervisory Authority (which could be the central
bank)—financial regulatory and supervisory policy and
(iii) Government (usually in consultation with the central bank and the Financial
Regulatory & Supervisory Authority)—fiscal policy, exchange rate policy and
policy on capital flows.
As we have seen in Chap. 4, a major policy implication of the NCM is the
elevation of monetary policy and the de-emphasizing of fiscal policy. The main (or
perhaps sole) objective of monetary policy is the control of inflation (inflation
targeting), and its primary operating instrument is a short-term interest rate. Three
further aspects of the NCM view of monetary policy need to be noted. Firstly, given
the various lags involved in the transmission mechanism of monetary policy, in
practice inflation forecasts become the intermediate targets of monetary policy
(Svensson 1997, 1999). Secondly, since the NCM views monetary policy rules as
superior to “fine tuning”, monetary policy should ideally operate via an interest rate
rule. A typical monetary policy rule is the one originally suggested by Taylor
(1993) with various later emendations (see Rudebusch 2002; Levin and Wachter
2011, etc.). Thus, effectively the rate of interest is set exogenously by the central
bank, while the money supply adjusts endogenously to the needs of trade. Thirdly,
inflation-targeting (IT) proponents take some pains to clarify that in practice IT is
not tantamount to a fixed mechanical rule but allows for “constrained discretion” on
the part of the central bank.3
In contrast to the paramount role assigned to monetary policy, fiscal policy is
downgraded and its role confined to keeping the overall budget balanced. Such a
minimal role for fiscal policy stems from the so-called Ricardian equivalence theory
(see Chap. 3, Sect. 3.5). According to the theory, increased government expendi-
ture cannot stimulate aggregate demand irrespective of whether this spending is
tax-financed or bond-financed.4
The NCM attitude to financial markets was that they posed no grave dangers of
instability being generally self-equilibrating—a belief strongly anchored in the
EMH. As we have seen above, the EMH also makes out a strong case for dereg-
ulation in the belief that firms guided by self-interest would adopt behavioural
strategies that contributed to overall financial stability (market discipline).
Furthermore (again as discussed in Chap. 11, Sect. 6) financial innovation was seen
as aiding the process of completion of markets, and hence, securitization and
3
4
If government expenditure is fully tax-financed, then the rise in government expenditure is
directly offset by the decrease in private incomes. Even if the government expenditure is financed
via bond issuance, these bonds are not viewed as additions to net wealth—fully rational consumers
anticipate that future interest payments on the government debt (as well as the amortization
charges) will lead to higher future taxes, in anticipation of which consumers raise their current
savings. Thus, the rise in government expenditure is matched by a corresponding rise in private
savings. Leaving the aggregate demand unaltered.
shadow banking5 were in general seen as socially beneficial. Finally, in the context
of EMEs, it was believed that financial development could play a defining role in
promoting real growth (see, e.g. Aghion et al. 2004).
Following the cataclysmic event of the GFC, contrary to popular expectations,
the mainstream NCM continued largely to maintain its academic sway though some
marginal exceptions and changes were accommodated (as we have discussed in
Chap. 13). The analysis of policy by contrast cannot afford to distance itself too far
from reality. Driven by political and economic exigencies in the wake of the crisis,
policy thinking adjusted itself partly on pragmatic lines but could not shake off the
NCM hold completely. What emerged was therefore something of a patchwork
compromise, involving pragmatic and immediate concerns analysed within the
context of DSGE models, largely guided by the NCM analytical framework though
often trying to incorporate some post-Keynesian insights in an ad hoc manner. The
new thinking6 that emerged in the immediate aftermath of the crisis essentially
reflects the extensive deliberations in four detailed reports, viz.
(i) Report of the de Larosiere Group (Feb. 2009) in the EU
(ii) Report of the Working Group 1 of the G20 (March 2009)
(iii) Squam Lake Report (2010) and
(iv) Colander et al. Report (2009).
While the reports certainly differed in several aspects, a broad implicit common
denominator seems to have emerged which has largely been espoused by the
community of policymakers of the G20. This consensus might be encapsulated in
the following nine point agenda classified according to the respective jurisdictions:
Central Bank Jurisdiction:
1. Some important revisions in the monetary policy framework especially as
regards asset prices and systemic financial stability
Financial Regulatory & Supervisory Authority Jurisdiction
2. A shift from micro-prudential to macroprudential regulation
3. Strengthening and expanding the scope of regulation and supervision (R&S)
4. Reinforcing prudential standards for financial institutions
5. Devising market incentives for prudent behaviour
6. Early Warning Systems and Prompt Corrective Action
7. Reducing costs of financial failures
5
Shadow banking may be taken to refer to the several financial institutions (such as securitization
vehicles, money market mutual funds, investment banks, mortgage companies.) which carry out
diverse traditional banking activities but do so outside the ambit of regulated banking activities.
More precisely, they may not exactly be unregulated but are only loosely regulated (in any case
much less so than commercial banks) (see Goodhart 2008; Posar and Singh 2011; Adrian and
Ashcraft 2012, etc.).
6
We are confining ourselves here to issues bearing on national policy-making. International
aspects are discussed later.
2 Role of National Policy-Making Bodies: Post-crisis Perspectives 309
Government Jurisdiction
8. Reinstating the role of countercyclical fiscal policy and a renewed emphasis on
automatic stabilizers
9. Rethinking full capital account convertibility.
The agenda only lays down the broad policy contours and is sufficiently flexible
not to erode the suzerainty of national authorities, while at the same time retaining
considerable room for international policy coordination.
We now discuss each of the nine items in the above agenda in greater detail.
3 Central Bank Jurisdiction: Rethinking Monetary

Policy7
The first aspect in the post-crisis rethinking of monetary policy pertains to the issue
of inflation targeting. The critique of inflation targeting has been discussed in detail
in Sects. 2.1 and 2.2 of Chap. 12 and hence not repeated here. In general, one could
say that the community of policymakers has been somewhat influenced by this
critique, but on the whole the response has been lukewarm. On other aspects of
monetary policy, however, some concrete rethinking is noticeable.
3.1 Asset Prices and Financial Fragility—the Jackson

Hole Consensus (JHC)
Prior to the global crisis, the thinking on monetary policy was relatively clear-cut
and was reflected in what was termed as the Jackson Hole Consensus (following
Issing 2009) (JHC for short). The major dimensions of the JHC were the following:
(i) That commodity inflation control should be the overriding (if not exclusive)
objective of monetary policy (inflation targeting)
(ii) That asset price bubbles are better left alone as attempts to control (or worse
“prick”) such bubbles could lead the economy to dangerous territory and
7
This sections draws from (A) the author’s paper “Global Crisis, Regulatory Reform
and International Policy Coordination” published in 2016 in Volume 5, Issue 1 of SAGE journal
South Asian Journal of Macroeconomics and Public Finance and excerpts are reproduced here
with permission, and (B) the author’s contribution “Monetary Policy, Financial Stability
and Macro-prudential Regulation: An Indian Perspective” in Ratan Khasnabis, Indrani
Chakraborty (eds.) Market, Regulations and Finance: Global Meltdown and the Indian Economy,
published by Springer in 2014.
(iii) If, and when, asset prices burst, central banks should “mop up the mess”, i.e.
go into the “lender of last resort” act (see Greenspan 2004; Blinder and Reis
2005; Mishkin 2007, etc.).
The intellectual roots of the JHC are based on a conventional Friedmanian
argument that financial instability is the outcome of unexpected shocks to the
inflation level, mainly arising from overenthusiastic central banks trying to stim-
ulate the economy beyond its natural rate (see Friedman and Schwartz 1963;
Schwartz 1998, etc.). In the NCM view, constant inflation is optimal in the sense of
being consistent with a zero output gap.8 Bernanke and Gertler (1999) cryptically
summarize this viewpoint as “central banks should view price stability and financial
stability as highly complementary and mutually consistent objectives”.
As is now universal knowledge, the global crisis brought out the fatal flaw in this
Consensus. Perhaps the biggest flaw in the JHC framework was its neglect of
balance sheet disorders arising in the current environment of deregulated financial
markets and financial innovation. Even before the global crisis, strong empirical
evidence was building up to the effect that even prolonged episodes of price sta-
bility could conceal severe imbalances building up in the financial sector through
asset price bubbles. Thus, monetary stability could not only coexist with financial
instability, but there could also occasionally be a causal nexus from the former to
the latter (see, e.g. Borio and Lowe 2003; Laeven and Valencia 2008 for empirical
illustrations). This can eventuate because periods of monetary stability (such as the
Great Moderation spanning the two and a half decades from the early 1980s to
about 2007) are often accompanied by robust output growth and correspondingly
bullish expectations of future prospects, which in turn, lay the foundations for
booms especially in equity markets and real estate. Demand for credit soars
especially for investment in highly profitable and rising asset markets. Central
banks (exclusively focused on commodity market inflation) may keep interest rates
low, which can enhance the “disaster myopia” psychology of speculative investors
(see Rajan 2005). This sets the stage for the kind of asset price booms which have
preceded many crisis episodes (in the USA) including those of 1893, 1907, the
Great Depression (1929–33), and of course the current global crisis beginning with
the Lehman collapse of 2007.
With the benefit of hindsight, it is now clear that central banks cannot afford to
play the combined role of a bystander, while an asset boom is in progress and a
Good Samaritan once the boom goes bust of its own accord. In short, the facts
argue for a more proactive role for central banks in asset markets (see Bean et al.
2010; Buiter 2008, etc.).
The issue of monetary policy responsiveness to asset prices essentially hinges
upon the role of asset prices in predicting future consumer prices inflation. In their
seminal paper, Alchian and Klein (1973) criticize the conventional definition of a
consumer price index (CPI) as a measure of the yearly cost of living index and seek
8
The output gap is defined as the difference between the actual output and potential output (the output
level that would prevail in the absence of nominal rigidities) (see Blanchard and Galí 2010, p. 3).
3 Central Bank Jurisdiction: Rethinking Monetary Policy 311
to replace it by the notion of a lifetime cost of living index. This, in turn, implies
expanding the definition of the consumer basket to include expected future con-
sumption. In an important paper, Shibuya (1992) shows that a lifetime cost of living
index can be approximated by a weighted sum of conventionally measured inflation
and asset price inflation. Asset prices thus enter the proposed index as proxies for
the unobservable future consumer prices. The entire case for including asset prices
in an overall measure of inflation,9 by this logic, hinges on an essentially empirical
question: How good are asset prices as a measure of expected future consumption
prices? While some supporting empirical evidence is indeed found in select cases
(see Filardo 2000 for evidence in the Japanese and UK experiences of the late
1980s, Bryan et al. 2002 for the USA and RBI 2010 for some Indian evidence),
there are three important reasons why the link between asset prices and commodity
prices may be a highly tenuous one. Firstly, even though the ideal theoretical
measure of Alchian and Klein’s index includes the entire spectrum of asset prices
available to a consumer, in practice, because of data limitations, only two assets are
considered, viz. real estate and equity. Secondly, real estate and equity markets may
be influenced by a number of factors apart from inflation expectations. Finally, asset
prices may affect consumer prices with long (and variable) lags. But even if the link
between asset prices and general inflation is not very direct or strong, a monetary
policy of benign neglect of asset prices could be doing more harm than good, as
brought out amply by the Japanese “lost decade” experience of the 1990s and the
recent global crisis, especially as it unfolded in the USA.
While some kind of a loose consensus seems to have built up in the post-crisis
years around the desirability of a monetary policy responsive to asset prices, the
distinction between explicitly targeting asset prices and using them as mere indi-
cators is often slurred over. In the latter viewpoint, which also seems to be the
majority one, asset prices figure in the monetary policy calculus to the extent that
they are informative about general inflation. By contrast, the use of asset prices as
targets has definite welfare connotations attached to the levels of asset prices.
Thus, in practice, central bank intervention in asset markets could assume either
of three forms (including combinations).
(i) Firstly monetary policy could be made responsive to asset price develop-
ments, either by using asset prices as explicit targets (as originally suggested
by Goodhart 1995) or minimally as indicators by incorporating them in a
Taylor rule (see Siklos 2009; Strauss-Kahn 2011; Singh and Pattanaik 2010,
etc.).
(ii) Secondly, a stricter system of controls on capital requirements in banks and
other financial institutions could be instituted and
(iii) Thirdly, restrictions could be imposed on certain types of trades in asset
markets (see Friedman 2010).
9
The methodology of how this is to be done is expounded in Shibuya (1992), Bryan et al. (2002)
etc.
While the last two modes of intervention command support to varying degrees
and are now likely to become established under the Basel III regime, there is
considerable difference of opinion as to whether asset prices should figure as
explicit targets or merely as indicators of monetary policy. Though (as noted above)
the majority opinion seems to favour their use as indicators, there are two points
which, in our opinion, seem to be in favour of using asset price inflation as an
explicit monetary target in EMEs. Firstly, affordable housing prices are a key
component in social welfare of societies with large sections of the poor and middle
class. Secondly, in a situation where asset prices are rising but the general com-
modity inflation is stable, a rise in interest rates may be difficult to justify to the
public if asset prices are being merely used as an indicator (as outlined in
Yamaguchi 1999 and Okina et al. 2000, this reservation seems to have been
important in the Bank of Japan’s inertia with respect to monetary tightening in the
late 1980s). With asset inflation as an explicit target, it would be relatively easier to
provide such justification. There seems to be some limited evidence (see Lo 2010;
Siklos 2010; Akram and Eitrheim 2008, etc.) that including real estate price
inflation in an augmented Taylor rule10 could lead to some improvement in overall
macroeconomic performance and the case for including equity price inflation in a
monetary policy reaction function dates back to Tobin (1974).
3.2 IT and Nominal Exchange Rate11
Under a pristine flexible inflation-targeting (FIT) regime, the exchange rate should
be left freely floating. However, in most EMEs such an option is precluded on
pragmatic grounds, as the exchange rate is an important channel of monetary
transmission. However, while a de jure floating regime with de facto managed
features retains appeal as a workable arrangement, it has to be remembered that in a
globally integrated open economy with extensive external commercial borrowings,
the exchange rate can move idiosyncratically, out of sync with domestic price
movements. Imagine the strain on central bank credibility, if in a situation of
inflation above the central bank target it is forced to lower interest rates to cap an
exchange rate appreciation (due to an exogenous influx of foreign inflows occa-
sioned by a global liquidity surge).12
10
There seems to be some confusion as to whether the use of asset prices explicitly in the Taylor
rule corresponds to their use as a target or as an indicator. We feel that explicitly using it as a
separate variable is tantamount to using it as a target. If it were treated as an indicator, it would not
figure explicitly in the rule—only implicitly through its effect on general inflation or sometimes
through some temporary ad hoc adjustments by the central bank to the rule.
11
Sections 3.2 and 3.3 are from the author’s 2014 article “Flawed Cartography? A New Road Map
for Monetary Policy”, available at http://xaam.org/flawed-cartography-new-road-map-for/.
12
This possibility assumes particular relevance, when the domestic economy business cycles are
not aligned with international cycles.
3 Central Bank Jurisdiction: Rethinking Monetary Policy 313
3.3 IT and Fiscal Dominance
FIT regimes are likely to run into fiscal roadblocks, if public debt (as a proportion
of GDP) is high. The logic of this fiscal dominance operates through the so-called
risk premium channel (see Blanchard 2005), wherein a high interest rate burden on
public debt imposed by an inflation-anxious central bank could raise the sovereign
risk premium and in extreme cases even lead to capital outflows. A freely floating
exchange rate (a necessary adjunct to a FIT regime) could then depreciate sharply,
frustrating the very objective of inflation control. That this is not a pure academic
point is illustrated by the Brazilian case surrounding the period of the 2002 crisis,
documented by Zoli (2005). At this time, Brazil was on an inflation-targeting
regime and its public debt stood at 79.8% of GDP.
4 Financial Regulatory & Supervisory Authority

Jurisdiction
4.1 From Micro-prudential to Macroprudential Regulation
One of the great lessons brought home by the GFC was that a regulatory system that
addresses itself merely to the soundness of individual institutions but largely
ignores inter-institutional interactions is likely to provide a fertile breeding ground
for financial crises. The regulatory system in most countries prior to the outbreak of
the GFC was largely a micro-prudential one, i.e. focused exclusively on individual
financial institutions. The string of successive failures of financial institutions in the
USA and Europe subsequent to the Lehman collapse highlighted the inadequate-
ness of a micro-prudential regulatory structure, geared to addressing idiosyncratic
risks specific to individual FIs. Individual institutions taking decisions in the
interest of their own prudent risk management are not a guarantee for ensuring the
stability of the entire system. Inter-institutional linkages, accompanied by low
capitalization and an excessive reliance on short-term sources of funding (maturity
mismatch), often lead to general rollover problems, thus creating a potential for
financial crises. It was also becoming increasingly clear that financial crises tend to
be typically characterized by a Domino scenario in which the collapse of a few key
FIs (financial institutions) is followed by a general collapse of the financial system
(see Whelan 2009). As such a shift in the regulatory system to a broader one
(macroprudential) concerned with the overall health and stability of the financial
system was urgently required. The Squam Lake Report (2010, p. 24) possibly
reflects the general trend of thinking when it puts forth that “The role of the
systemic regulator should include gathering, analysing and reporting information
about significant interactions and risks among financial institutions; designing and
implementing systematically sensitive regulations, including capital requirements;
and coordinating with the fiscal authorities and other government agencies in
managing systemic crises”.
In this context, there has been much discussion of two related but distinct issues,
viz. systemic risk and financial stability. Let us look at systemic risk first. This has
been defined in several ways. An early definition, antedating the crisis, is that given
by the G10 (2001) “[Systemic risk is] the risk that an event will trigger a loss of
economic value or confidence in, and attendant increases in uncertainty about, a
substantial portion of the financial system that is serious enough to quite probably
have significant adverse effects on the real economy”. This definition closely par-
allels the definition later used by the ECB in its Financial Stability Report (see
Smaghi 2009). For policy purposes, the slightly more detailed definition suggested
by the IMF-FSB-BIS (2009) for the G20 is widely used. This identifies systemic
risk as “A risk of disruption to financial services that is (i) caused by an impairment
of all or parts of the financial system and (ii) has the potential to have serious
negative consequences for the real economy”.13
Blancher et al. (2013) and De Bandt et al. (2013) identify several major sources
of systemic risk, viz. those arising from: (i) risk build-up in financial institutions;
(ii) too rapid growth in asset prices; (iii) sovereign risk (due to political unrest,
policy uncertainty, etc.); (iv) macroeconomic risk factors (recessions, stock market
crashes, adverse shocks, etc.); (v) cross-border linkages (quantum, composition and
volatility of capital flows, exchange rate arrangements, degree of openness, etc.);
(vi) information opaqueness of financial contracts and securitization; (vii) degree of
leverage and extent of inter-linkages in the financial sector, shadow banking
institutions, etc. and (viii) light-touch regulation, loose monetary and fiscal policy,
etc.
Several alternative models have been proposed for the measurement of systemic
risk. Among the major ones, mention might be made of (i) the marginal expected
shortfall model, (ii) codependence risk model, (iii) delta conditional VaR (value at
risk) model, (iv) lower tail dependence model, (v) the default intensity model,
(vi) the network approach and (vii) the approach based on a distress-dependence
matrix.14 The various financial stability authorities may differ in their choice of an
appropriate model to measure systemic risk, but they are unanimous in their
agreement that the objective of macroprudential policy is to limit system-wide
financial risk by enabling policymakers to know better when to act and to identify
the stress points in the financial system (see IMF 2011).
Related to the concept of systemic risk is the issue of financial stability. The two
are not synonymous (though they are often treated in popular writings as if they
were)—the latter concept is somewhat broader, as we will see below. To understand
financial stability, it is important to remember that the financial system encom-
passes a number of facets including the financial infrastructure, payment systems,
13
Some limitations of this definition are discussed in Whelan (2009).
14
Detailed comparative reviews of these models are given in Gray and Jobst (2011), Bisisas et al.
(2012), Kleinow et al. (2017), etc.
4 Financial Regulatory & Supervisory Authority Jurisdiction 315
the banks and financial institutions, hedge funds, stock, bond and money markets,
the central bank and the Treasury markets, all bound together by an elaborate
system of legal rules, conventions and market practices. Any failure (even of a
transient nature) in any of these multifarious units/processes can lead to severe
distortions. Financial stability has been defined in several ways (see, e.g. Chant
2003; Houben et al. 2004; Schinassi 2004; Borio and Drehmann 2009; RBI 2010,
etc.) of which the following definition given in Schinassi (2004, p. 8) seems to
claim wide acceptance: “A financial system is in a range of stability whenever it is
capable of facilitating (rather than impeding) the performance of an economy, and
of dissipating financial imbalances that arise endogenously or as a result of sig-
nificant adverse and unanticipated events”. In other words, financial stability refers
to a financial system’s self-corrective ability to maintain its key functions (efficient
allocation of economic resources and pricing, managing and effectively distributing
financial risks), unimpaired in the face of adverse shocks.
Financial stability as an explicit concern of central banks certainly antedates the
recent global crisis in most advanced countries and several EMEs (including India).
The crisis however has brought it into a much sharper focus. The Basel II frame-
work (2004) did play an important role in putting (globally active) individual FIs
(especially banks) on a sound footing, but with its emphasis on micro-prudential
regulation, it fell short of forestalling the global financial crisis. Both the US Dodd–
Frank Act (2010) and the proposed Basel III framework seek to steer financial
regulatory (and supervisory) structures towards macroprudential regulation. We do
not go into the details of these proposals here. (interested readers may consult BIS
(2010) which outlines the Basel III proposals and Acharya et al. (2011) who present
a critical evaluation of the Dodd–Frank proposals).
4.2 Strengthening and Expanding the Scope of Regulation

and Supervision
There is increasing awareness in the global community that crisis prevention and
management requires a considerable strengthening of the national financial regulatory
and supervisory framework. This would essentially involve a three-pronged approach:
1. Entrusting a special regulatory authority (either an existing one or a newly
constituted one) with an explicit financial stability mandate
2. Ensuring coordination between different regulatory authorities
3. Expanding the scope of regulation to include credit rating agencies and private
pools of capital (including hedge funds) via a system of registration, disclosure
requirements and oversight.
The defining feature that sets the current crisis apart from other crises of com-
parable intensity in the past is the critical role played by the shadow banking sector.
In the last three decades or so, there has been a proliferation of non-deposit-taking
financial intermediaries, which engage in lending but (in the absence of access to
public deposits or central bank funding) rely on funding via asset-backed com-
mercial paper or in the repo market against collateral. The institutions typically
constituting the shadow banking sector are hedge funds, money market mutual
funds, private pension funds, special-purpose vehicles (SPVs), etc. The growth of
such institutions is attributable to several factors including the emergence of
securitization and new financial products (such as credit derivatives, collateralized
debt obligations (CDOs)) as well as the proliferation of the universal banking
syndrome (see Gorton and Souleles 2006; Papadopoulos 2011, etc.). In times of
liquidity panics, such asset-backed commercial paper markets are prone to collapse
(as happened in the US financial crisis of 2008) (see Brunnermeier and Pedersen
2009; Covitz et al. 2013, etc.). As such, it is critical for financial stability to bring
the shadow banking sector under the regulatory pale. The large number of insti-
tutions in the shadow banking sector and the opacity of their operations pose
formidable obstacles in the way of placing them on a regulatory par with traditional
depository institutions.
4.3 Reinforcing Prudential Standards
Improving the Quality of Bank Capital: Common equity (defined as common

shares plus retained earnings minus goodwill) is generally regarded as higher
quality capital than preferred equity. Hence, given the objective of helping banks
recapitalize quickly in the event of stress, it may be desirable to increase the share
of common equity in bank capital. Reflecting this logic, the Basel III proposals have
increased the ratio of Tier 1 capital-to-total risk-weighted assets from 6% under
Basel II to 8.5%, while simultaneously putting in place a staggered system of
restrictions on distribution of earnings if the ratio of common equity in Tier 1 (to
risk-weighted assets) falls short of the minimum of 7%. Additionally, Tier 2 capital
has been strengthened, while Tier 3 capital has been dropped altogether (see BIS
2014).15
Pro-cyclicality of Capital Requirements: That the capital standards imposed
under Basel I and II tended to be pro-cyclical has been well-known to economists
for quite some time (see Borio et al. 2011, for an early critique of this feature). They
can hence be a possible accentuating factor in any crisis, by leading to shrinkage in
the size of bank balance sheets. As the current crisis runs its course, there is a
greater realization among central bankers globally that ways have to be found to
counter this pro-cyclicality. At least, three operational suggestions have been made
in this context:
15
The RBI has already agreed to move to a Basel III framework on the internationally agreed
timeline.
(i) Requiring financial institutions to build up capital buffers during economic

expansions, (which could then be unwound in times of recession) (Ghosh
and Nachane 2003; Gordy and Howells 2006; Tente et al. 2015, etc.)
(ii) Capital insurance wherein a bank insures against a capital shortfall via a
collateralized (insurance) policy (see Kashyap et al. 2008 for a detailed
exposition of this concept) and
(iii) Introducing the so-called contingent convertibles (securities that are issued as
debt by a bank but which are automatically convertible into equity if regu-
latory capital of the bank falls below a certain threshold (see Flannery 2005;
French et al. 2010; Hanson et al. 2011, etc.).
Leverage of Financial Institutions: An important amplification factor for the
recent global crisis has been not only the high degree of leveraging of many
financial institutions, but also the fact that this leveraging has very often been quite
opaque (see, e.g. Kalemli-Ozcan et al. 2011). Reflecting the need for more accurate
measures of balance sheet exposures, the following suggestions have emerged: (i) a
stronger focus by regulators on loan-to-value ratios (LTVs) and (ii) limits on
leverage ratios of banks. In tune with this thinking, Basel III proposes to introduce a
minimum Tier 1 leverage ratio of 3% defined as ratio of Tier 1 capital to total
exposure (on- and off-balance sheet).
Other Prudential Measures: Several other prudential measures have also been
suggested and discussed in detail in the literature. An indicative list would
comprise:
(i) Higher loan-loss provisioning norms (Saurina 2009). In India, for example,
loan-loss provisioning has been steeply raised by the RBI in the wake of the
crisis. (It currently stands at 70%).
(ii) Imposing higher capital requirements on systemically important financial
institutions (see Pennacchi 2010; Bullard et al. 2009, etc.). Once again
referring to the Indian case, systemically important non-bank financial
intermediaries are subject to a higher CRAR (capital-to-risk-weighted assets
ratio) of between 12 and 15%, as opposed to the regularly applicable CRAR
of 9% for banks.
(iii) Stress testing exercises to be conducted periodically to monitor leveraging on an
ongoing basis (Lopez 2005; Matsakh et al. 2010, etc.). In India, stress testing for
banks is being done regularly by the RBI since 2007. The tests (in India) are
designed to test the resilience of the banking system against macroeconomic
shocks. Two adverse scenarios are considered (medium and severe) around a
baseline scenario involving 10-year historical data. The macrovariables included
are the GDP, inflation, interest rate and merchandise exports (to GDP) ratio, with
the two adverse scenarios being based, respectively, on 1 and 2 [standard
deviations] around the baseline. The stress variables examined are the credit
risk, foreign exchange risk, interest rate risk, liquidity risk and market (equity
price) risk. The exercise is done separately for scheduled commercial banks,
urban cooperative banks and non-bank financial companies.
(iv) Disclosure requirements for complex structured products and reducing

pro-cyclicality of accounting standards (Borio and Tsatsaronis 2005; Novoa
et al. 2009, etc.). Accounting standards in India for financial entities are
aligned with those of the Institute of Chartered Accountants of India (ICAI).
Unfortunately, these are not widely accepted internationally. Convergence to
international standards (IFRS) has commenced from April 2013, and in the
interim, the RBI has been periodically issuing prudential guidelines on asset
classification, income recognition, provisioning and investment valuation.
The RBI also lacks access to external auditors’ working papers and the
power to rescind auditors’ appointments. These can, and often do, impose
effective limits on the RBI’s supervisory powers.
(v) Risk concentration limits involving ceilings on growth of particular types of
exposures (BIS 2006; Bonti et al. 2006, etc.).16
(vi) Finally, the establishment of clearing houses in over-the-counter
(OTC) derivatives markets (see Norman 2011; Pirrong 2011, etc.). About
75% of the OTC derivative contracts in India are routed through a centralized
exchange, viz. The Clearing Corporation of India Ltd. (CCIL).
4.4 Devising Market Incentives for Prudent Behaviour
The issue of market discipline was brought into the forefront of debates on sound
regulatory practices by the great emphasis laid on it by Basel II, as one of its three
pillars (Pillar III) of sound prudential regulation. Market discipline is a generic term
referring to the monitoring of financial institutions by market participants and in the
Basel II schemata was sought to be achieved by imposing various kinds of dis-
closure requirements on financial institutions (most particularly banks) relating to
their capital, assets, credit risk, market risk, operational risk, etc. The rationale for
disclosures is to provide adequate information to enable counterparties (mainly
depositors, shareholders and occasionally junior/subordinated debt holders) to
assess whether the available capital is sufficient to meet measured and
non-measured risks. To the extent that such disclosures are comprehensive and
objective, it is expected to assist market participants in judging how a bank’s
management of its capital adequacy relates to its other risk management processes
and its ability to withstand future volatility. The BIS has elaborated considerably on
the recommendations of the Accord concerning the nature of information which
16
As was pointed out by the FSAU of the IMF (2013), the current exposure limit (in India) for
large loans of 55% of a banking group’s capital is far in excess of global practices of 10–25% and
should be brought down in stages. The Report also observed (p. 49) that the issue of “connected
exposures” was not getting enough attention in the case of the Indian financial system. More
specifically, “cross-guarantees” between financial entities should be sufficiently highlighted as
these result in financial interdependency and commensurate concentration of risk.
should be disclosed under this pillar. The salient components of this information
(for a bank) comprise: (i) the structure and components of bank capital, (ii) the
terms and main features of its capital instruments, (iii) the accounting policies used
in the valuation of assets and liabilities and for provisioning and income recogni-
tion, (iv) qualitative and quantitative information about risk exposures and strate-
gies for risk management, (v) capital ratios and other data related to capital
adequacy on a consolidated basis and (vi) a breakdown of risk exposures. The
information needs to be supplemented by an analysis of factors affecting the banks’
capital position. Moreover, banks are encouraged to disclose ways in which they
allocate capital among their different activities. The disclosures envisaged under
this pillar are required to be made on a semi-annual basis.
Monitoring of banks can also occur through shareholders as well as deposit
holders. Monitoring by shareholders traditionally occurs via responses of equity
values to changes in the perceived risks of banks. If market discipline is effective in
improving bank governance, then we must have publicly listed banks (with con-
stantly available market signals from their equity and bond prices) assuming less
risk than similarly placed non-publicly traded banks. There have been several
empirical tests of this and similar hypotheses (see, e.g. Nier and Baumann 2006;
Park and Peristiani 2007; Stephanou 2010). While the empirical conclusions vary
somewhat, nevertheless there seems to be a fairly broad consensus around two
propositions, viz. (i) lack of a significant difference in the risk profile between
publicly traded and non-traded banks and (ii) publicly traded banks often tend to
have worse supervisory ratings than non-publicly traded banks.17 There is also the
possibility that shareholder activism may create pressure on banks to maximize
short-run shareholder value by taking on unnecessary and indiscriminate risks (see
Beltratti and Stulz 2012; Bebchuk et al. 2013; Roman 2015, etc.).
Monitoring of banks by deposit holders does not occur directly but rather
through deposit insuring bodies. The role of deposit insurance (DI for short) in
supporting market discipline has been investigated in great detail (see Karels and
McClatchey 1999; Keeley 1990 etc.). A dominant view in this regard is that DI
creates a moral hazard by making bank shareholders and managements complacent
17
In a typical moral hazard framework, bank management acts in the interest of shareholders that
have voting power. If the shareholders of a bank are interested mainly in the dividend payout, the
bank’s management may be induced to oblige them by increasing the bank’s risk profile—this is
especially true in the absence of a risk-based deposit insurance system (see Flannery 1998; Park
and Peristiani 2007; etc.). This tendency is counterbalanced by the fact that bank managements (as
well as shareholders to some extent) are also concerned with the banks’ charter value (viz. the ratio
of an organization’s market value of equity to its book value of equity) (see Keeley 1990; Demsetz
et al. 1996; etc.). In the event of bank failure, bank managers lose prestige and shareholders forfeit
charter value. Thus, the consideration of preservation of charter value acts as a restraint on the risk
assumption of banks. Depending on which tendency dominates, supervisory ratings will tend to be
positively or negatively correlated with dividend payouts. The empirical evidence cited in the
above and related papers seems to bear out that risk-averse banks tend to exhibit a positive
correlation between bank share earnings and supervisory ratings, while the opposite is true for
banks with riskier portfolios (or lower bank capital).
about leverage and riskiness of investments and loans in the pursuit of profits. The
key question then becomes how to avoid the moral hazard. Three alternative
measures have been suggested in this regard, viz. (i) risk-based deposit insurance
premium, (ii) regulatory capital linked to bank risk profile and (iii) bank reserves
tied to the riskiness of its assets (see Fischer and Fournier 2002; Mehran et al. 2011,
etc.).
A flat-rate deposit insurance premium (as is currently the case in countries like
India) imposes a uniform premium on deposit insurance for all banks, irrespective
of the riskiness of their loan and investment portfolios. Such a system subsidizes
high-risk, poorly run institutions at the cost of their well-run counterparts. A better
deposit insurance premium pricing system would involve (a) banks paying pre-
mium indexed to their own levels of risks and (b) a premium level that ensures a
continually solvent insurance fund (see, e.g. Demirguc-Kunt and Huizinga 2004).
However, it is difficult to assess individual banks’ risks accurately ex ante, i.e.
before problems emerge. Thus, risk-based premium (RBP) systems should be
viewed as a complement to, rather than a substitute for, other methods of checking
excessive risk-taking like risk-based capital requirement prescriptions, strong
supervision and direct restraints on risky activities.18 So far as tying up bank
reserves to the risk profile of banks is concerned, this is rarely discussed as reserve
requirements are primarily viewed as monetary policy instruments rather than
regulatory ones.
An interesting additional way to strengthen market discipline is via the so-called
Chicago Fed Plan (see Keehn 1989), which proposes the inclusion of a mandatory
subordinated debt (i.e. debt that is unsecured and has lower order of claims than
other debts in the event of closure) component in bank capital requirements (see
also Calomiris and Powell 2000; Evanoff and Wall 2000, etc.). Interestingly sub-
ordinated debt can act as an important market disciplining factor, since as perceived
risks of a bank increase, holders of subordinated liabilities will require a higher
return to compensate for the extra perceived risk. Several studies (Jagtiani and
Lemieux 2001; Evanoff and Wall 2000; Sironi 2003, etc.) have noted that issuance
and secondary market risk premia on traded subordinated debt are correlated pos-
itively with risk measures such as asset portfolio composition, credit ratings,
probability of undercapitalization and/or failure.19
18
There is an increasing move towards risk-based premium systems (RBPs) across the globe, and
moving towards an RBP system could be an important move in the direction of strengthening
market discipline in India.
19
In India, as in other South Asian countries, as of now, there is no mandatory requirement for a
subordinate debt component in regulatory capital, and it is a suggestion worth careful consider-
ation as to whether such a mandatory requirement be imposed in the interests of market discipline.
4.5 Early Warning and Prompt Corrective Action System

(EWPCAS)
Early Warning Systems purport to detect underlying financial fragilities well in

advance of a crisis, permitting central bankers to initiate appropriate pre-emptive
action in prompt fashion (see Bussiere and Fratzscher 2006, etc.). Early Warning
System indicators (EWSI) have been introduced earlier in a number of countries.
These were usually based on a wide set of macroeconomic indicators which could
be categorized into five main groups:
(i) Real sector—percentage change in the GDP growth rate, unemployment rate,
changes in investment-to-GDP ratio, etc.
(ii) External sector—nominal exchange rate, real exchange rate, external
debt-to-GDP ratio, current account-to-GDP ratio, etc.
(iii) Government sector—fiscal deficit (as % of GDP), outstanding government
debt (as % of GDP), tax revenue (as % of GDP), etc.
(iv) Financial sector—rate of inflation, real interest rate, house price index, stock
price index, credit to private sector (as % of GDP), rate of growth of money
supply (M1 or M3), price/equity ratios.
(v) Global factors—global growth rate, global inflation rate, oil prices inflation,
international commodity prices inflation (especially aluminium and copper),
global capital inflows.
However, there are several problems with the use of an EWS. Firstly, at the
conceptual level, it is not clear whether these indicators should be used exclusively
by the central bank or whether the signals emanating from an EWS should be made
public. Several proponents seem to believe that making the signals public could
avert impending crises by inducing market stabilizing behaviour by rational
investors. But it seems equally (if not more) likely that the herd mentality and
proclivity to panic behaviour noted famously by Keynes could actually result in
precipitating the crisis that the EWS was intended to forestall in the first place.
Secondly, as pointed out by Grabel (2004) the presence of an EWS (whether
exclusive or public) might prompt investors to assume a more than normal risky
behaviour as long as the EWS does not indicate a looming crisis. Finally, the actual
prediction performance of EWS over the period of 1990–2005 seems to be mixed
(see, e.g. Sharma 1999; Edison 2000; Gaytán and Johnson 2002; Demirgüç-Kunt
and Detragiache 2005, etc.)
Following the global crisis, the imperative for designing Early Warning Systems
assumed a degree of urgency, and several countries initiated the process of
implementing such schemes. Learning from past failures of such indicators, more
elaborate and sophisticated early warning and Prompt Corrective Action schemes
(EWPCAS) were designed. One such scheme is the so-called six-pack system
adopted in the EU, which we describe in some detail, because we believe it could
serve as a guidepost for several other middle-income countries and EMEs such as
India.
As is well known all EU members are bound by the Stability and Growth Pact
(SGP) enjoining upon member states the obligation to maintain their fiscal deficits
within 3% of GDP and government debt below 60% of GDP. Four of the EU six-
pack measures20 (implemented in 2011) are aimed at improved compliance with the
provisions of the SGP by (i) strengthening surveillance of budgetary positions,
(ii) speeding up and clarifying the excessive deficit procedure21, (iii) enforcement of
budgetary surveillance in the Euro Area and (iv) establishment of complete and
reliable public accounting practices for all subsectors of general government for the
production of high-quality statistics that are comparable across member states (to be
implemented by 31 December 2013).
The remaining two measures in the EU six-pack refer to:
1. Alert Mechanism Report (AMR): Member states are screened for potential
imbalances against a scoreboard of 11 indicators, as well as 19 auxiliary indi-
cators and other information, to assess the development of macroeconomic
imbalances. The 11 main indicators are as follows: (i) percentage change over
3 years of the REER (real effective exchange rate) relative to 35 other industrial
countries, (ii) evolution of member state’s share in world export markets,
(iii) export performance vis-à-vis non-EU advanced counties, (iv) terms of trade
(percentage change over 5 years), (v) three-year backward moving average of
the current account balance as percentage of GDP, (vi) private sector debt,
(vii) total financial credit to private sector, (viii) housing prices, (ix) foreign
direct investment inflows, (x) unit labour costs (percentage change over
3 years), (xi) unemployment (percentage change over 3 years)
The scoreboard rates each member state against a stipulated threshold for each
indicator. Members violating thresholds are identified as exhibiting macroeco-
nomic imbalances. Thus, the AMR is in effect an Early Warning System.
2. Prompt Corrective Action (PCA)22: The second stage of the system is now
initiated against those member states identified in the AMR, in order to examine
in further detail the accumulation of imbalances and the related risks for growth
and financial stability. If the imbalances are deemed excessive, then an exces-
sive imbalance procedure (EIP)23 can be launched. In this case, the member
state concerned is enjoined to draw up a corrective action plan, indicating a time
frame for implementation of the corrective measures. This corrective action plan
must be endorsed by the European Commission and the EU Council of
Ministers. The Commission checks throughout the year whether the policies in
20
See EU (2013).
21
Introduction of numerical benchmarks for the fiscal deficit and debt targets, which take into
account the stage of the business cycle, and which provide a criterion against which to assess
whether the excessive deficit and debt ratio are sufficiently diminishing and approaching the
reference value at a satisfactory pace.
22
The PCA system in India is in force since 2002.
23
The EIP applies only for all Eurozone member states.
the plan are being implemented. Fines apply only as a last resort and are levied
for repeated failure to take action and can amount up to 0.1% of GDP a year.
4.6 Reducing Costs of Financial Failures
The welfare costs of financial crises are generally severe and fall disproportionately
on disadvantaged groups in any society, and the current crisis is hardly an exception
(see Government of India 2008; ILO 2009; Nachane 2009, etc.). The EWPCAS
system discussed earlier is a system-wide approach, but this needs to be supple-
mented with a micro-approach focusing on emerging stress areas in individual
financial institutions. The first signs of stress in an institution are the emergence of
non-performing assets (NPAs). We therefore discuss in the first half of this section,
the issues related to early identification of stressed assets and their appropriate and
expeditious treatment once they are identified. But in spite of the best regulatory
efforts to resolve the NPA problem, bank failures will continue to occur and we
need efficient procedures to deal with such contingencies. Issues related to bank-
ruptcy are therefore taken up for discussion in the latter half of this section.
Special Attention to Non-Performing Assets (NPAs): NPAs constitute an
important dimension of financial stability, apart from affecting the overall efficiency
and profitability of the banking system. Currently, there seem to be no consistent
standards across jurisdictions for classifying problem loans. This creates problems
for national supervisors in interpreting data pertaining to international banks with
presence in several jurisdictions. In response to this issue, the BIS appointed a task
force to identify bank practices in regard to NPAs across jurisdictions and to
suggest a uniform harmonized classification code. The recommendations of this
task force are given in BIS (2016).
The report identifies a default on a loan/exposure if either (i) the bank considers
that recovery of the full loan will necessitate recourse to actions such as realizing
the collateral on the loan or (ii) the loan is past due24 for more than 90 consecutive
days on any credit obligation (related to the loan).This period can be extended to
180 days for loans by public sector entities at the bank’s discretion.
Another relevant concept is the materiality threshold. National jurisdictions have
the authority to define thresholds for reckoning loans as past due. A materiality
threshold must involve both an absolute and a relative component. The absolute
component refers to the sum of all amounts past due on an exposure for more than
90 days (or 180 days in special cases).25 The relative component pertains to the
24
An exposure is past due when any amount due under the contract (interest, principal, fee or other
amount) has not been paid in full at the date when it was due.
25
Illustratively, the European Bank Authority (EBA) has fixed (i) the absolute component at €100
for retail exposures, and €500 for all other exposures and (ii) the relative component at 1%, which
in certain cases could be raised to 2.5%. (see EBA 2016).
amount past due as a percentage of all credit obligations of the borrower. Both of
the limits need to be breached to start the counting of the 90 consecutive days limit.
The BIS (2016) Report then goes on to define NPAs as
(i) Loans/exposures that are “defaulted” in the sense defined above
or
(ii) All exposures that are credit-impaired (in simple terms as having experienced a
downward adjustment to their valuation due to deterioration of their creditworthi-
ness since the date of acquisition or more technically using the definition of credit
impairment as given in the US GAAP FASB Accounting Standards Codification
Topic 326).
In India, the problem of NPAs, which had lain dormant in the high growth phase
of the last decade, seems to have resurfaced since the global crisis of 2008–09. Two
trends are particularly worrisome—firstly, the fact that the problem has not sub-
sided with the tapering off of the global crisis but instead accentuated especially in
2011–13; secondly, India is among the few countries in Asia to display such a
trend, most other countries showing a moderation in NPAs over 2009–12. The
problem of NPAs in India is discussed in detail in the next chapter.
Several issues come to the fore as soon as an asset is qualified as an NPA. (i) The
first issue pertains to the accounting norms for recognizing any income that may
occur from the NPA either pre- or post-restructuring (Income Recognition).
(ii) Since an NPA represents a potential (partial/total) loss asset, the accounts of the
bank should be adjusted to take cognisance of this possible loss (Provisioning).
(iii) The third and easily the most contentious issue pertains to the restructuring of
an account—specifically, under what circumstances an asset has claims to be so
restructured and what should be its accounting status post such restructuring
(Restructuring). (iv) Banks are always engaged in the recovery efforts on NPAs.
These can either be through legal recourse or market-based sell-offs (Recovery).
(v) Finally, banks need to take a decision on the write-off of NPAs which have been
overdue for long, with a view to save provisioning costs and to economize on
regulatory capital requirements (Write-offs).
Certain general principles have been suggested in the literature to deal with the
resolution of the NPA problem (see Fell et al. 2016, 2017; Mallon et al. 2017;
Baudino and Yun 2017, etc.). Such resolutions involve debt restructuring or
out-of-court settlements.
Restructuring refers to changes in the terms of the loan by mutual agreement
between the lender bank(s) and the borrower. Two types of restructuring are gen-
erally distinguished—general debt restructuring and troubled debt restructuring.
The former involves no loss to the bank and is implemented via extension of the
repayment period or lowering the interest rate on the loan. It is usually undertaken
to enable the borrower to tide over a temporary financial difficulty. Troubled debt
restructuring by contrast imposes a loss on the creditor bank(s) and is achieved by a
reduction in the accrued interest, a reduction of the collateral, or conversion (of the
loan or part thereof) to equity.
Out-of-court settlements can be of two types. The so-called London approach
(see Smith 1996; Garrido 2012; Baudino and Yun 2017, etc.) is a voluntary par-
ticipative approach in which a debt restructuring plan is worked out by a steering
committee of lender banks and approved by the official supervisory authority. In the
hybrid approach, a restructuring plan for a corporate debtor is subject to a desig-
nated court’s approval (see Bergthaler et al. 2015; Aiyar et al. 2015; McCormack
et al. 2016, etc., for details).
Orderly Closure Rules: Chapter 2, of the Financial Stability Board (October
2011), lays down certain broad principles for the resolution of insolvency problems
in financial institutions. These are (i) the resolution of financial institutions should
proceed in an orderly manner with minimal contagion fallouts on the rest of the
macroeconomic system; (ii) critical economic functions of non-viable institutions
need to be continually maintained; (iii) losses should fall mainly on the share-
holders and uninsured and unsecured creditors; and (iv) minimal exposure of
general taxpayers to losses arising from financial failures.
The recently installed Indian Bankruptcy Code (The Insolvency And Bankruptcy
Code, 2016) will be discussed fully in the next chapter. Here, we confine ourselves
to a discussion of general principles, using the EU and US codes as prototypes.
In the USA, resolution of deposit-taking institutions (mainly banks and saving
institutions) is subject to the Federal Deposit Insurance Corporation Improvement
Act (FDICIA) of 1991, whereas the resolution of systematically important financial
institutions (SIFIs) is addressed by the Dodd–Frank Wall Street Reform and
Consumer Protection Act 2010 (Dodd–Frank Act for short) (DFA) under a new
resolution framework termed the Orderly Liquidation Authority (OLA). The scope
of OLA covers all SIFIs including securities’ brokers and dealers, and other
non-bank financial companies (see Krimminger and Nieto 2015).
The EU has installed a two-tier system: (i) The Bank Recovery and Resolution
Directive (2014) (BRRD), applicable to all EU members and (ii) The Single
Resolution Mechanism (SRM) Regulation (2014) which applies only to the Euro
Area countries.
Under both the US and the EU frameworks, resolution authorities proceed by
(i) suspending certain obligations, (ii) transfer of assets and liabilities to new pur-
chasers or to bridge financial institutions and (iii) temporary suspension of certain
rights of counterparties to the failed company (such as enforcement of collateral and
termination of contracts).
In both the US and EU systems, bankruptcy resolutions in the financial sector are
primarily funded from resources drawn from the financial system itself. In the USA,
the Federal Deposit Insurance Corporation’s Deposit Insurance Fund is funded via
a risk-based insurance premium system from member banks and provides protection
to insured depositors as well as funds for bank resolutions. Similar roles are played in
the EU by the Single Resolution Fund (operating under the Single Resolution
Mechanism) established in 2014 and the Deposit Guarantee Schemes (DGSs).
Shareholders and creditors bear the brunt of the losses from the failed financial
institutions by having their claims impaired in proportion to the institution’s losses.
There are, however, two essential differences between the EU and US systems:
(i) firstly, in the USA, legal provisions prohibit any loss to taxpayers from the
liquidation process. No such provision exists in the EU, although the use of public
funds under the BRRD is supposed to be limited and subject to burden-sharing
clauses with private investors (Articles 43 and 44 of the BRRD) (ii) Secondly, in
the EU, measures to prevent the failure of a credit institution are permitted via a
recapitalization of the existing credit institution without involving a formal insol-
vency (receivership) proceeding (open bail-in). By contrast, under the OLA and
FDIC resolutions in the USA, apart from capital-based triggers, there are stipula-
tions ensuring that banks are closed before it is too late (i.e. before they go into
negative worth territory). The brunt of the loss is borne by shareholders, and the
FDIC becomes the receiver. A temporary bridge bank is set up to pay off depositors
and creditors and organize the fire sale of assets. Thus, a new holding company is
capitalized by bailing-in pre-existing creditors, with a restructured balance sheet,
and the existing troubled institution is liquidated (closed bail-in).26
5 Measures Under Government Jurisdiction
The two most important macroeconomic measures under government jurisdiction

are fiscal policy and capital account liberalization. The role of fiscal policy has
already been discussed fully in Chap. 12, Sect. 3. There we saw that there is now a
general recognition that fiscal policy can be deployed with good effect in severe
recessions, especially since in such situations monetary policy is likely to reach its
limits fairly soon. We now turn directly to the issue of capital account
convertibility.
5.1 Revisiting Full Capital Account Convertibility
Advocacy of open capital accounts is based on the neoliberal view that free global
capital markets enable EMEs and LDCs to get cheaper access to international
credit, thereby promoting growth and stability. This view, always of dubious the-
oretical merit (see Arteta et al. 2003; Nachane 2007; De Long 2009, etc.), was
seriously challenged both by the currency crises of the 1990s in Latin America and
Asia (see Ocampo et al. 2008) and the recent global crisis. In the wake of the last
crisis, as the developed world struggled with a tepid industrial recovery, weak
26
On these aspects, reference may be made to Avgouleas and Goodhart (2015), Gleeson (2012)
etc.
5 Measures Under Government Jurisdiction 327
financial systems, burgeoning fiscal deficits and unsustainable debt-to-GDP ratios,

it was becoming increasingly clear that part of the burden of the painful adjustment
to global imbalances was likely to be shifted to the EMEs. The low interest rates,
quantitative easing of credit and frequent bailouts in the USA and Europe—all these
measures—injected massive amounts of global liquidity which wended its way
inexorably to EMEs, driven by the search for greater returns and the relatively
sound macroeconomic fundamentals of the latter. Confronted with capital flow
upsurges, several EMEs imposed some form of capital restrictions (most notably
Brazil, Venezuela, Thailand, Indonesia, South Korea and Taiwan), though India
remained a notable exception, with official pronouncements repeatedly reaffirming
commitments to further capital account liberalization.
The received theoretical literature and empirical evidence available at the time
(see BIS 2009a) were broadly pointing to a rethinking on the benefits of full capital
account liberalization, with a more nuanced consensus emerging on three issues:
(i) the benefits of capital account liberalization in EMEs have been vastly over-
stated; (ii) they (benefits) are circumscribed by too many conditionalities which are
unlikely of fulfilment in many EMEs and LDCs; and (iii) controls over capital
inflows can effectively reduce the vulnerability of economies to financial crises. As
a result, full capital account liberalization need not be some kind of an ultimate goal
for all developing economies.
Capital management is a broad term used to refer to a policy which seeks to
manage the capital account as warranted by the overall domestic and global
macroeconomic situation. As a matter of fact, it is well to take cognisance here of
some of the well-known benefits of such an approach:
1. Capital inflows typically confront an economy with a dilemma on the exchange
rate front. As complete sterilization of large inflows usually raises domestic
interest rates (and thereby stimulates further inflows) and entails a fiscal burden,
central banks have either to resort to incomplete sterilization and risk inflation or
allow the real exchange rate to appreciate. Most central banks, whether inflation
targeters or not, are inclined to favour the latter alternative. A secular rise in
REER is fraught with serious consequences for the economy. Firstly, it dampens
exports and hence growth. Secondly, it raises the prices of non-tradeables
(especially real estate and labour) versus tradeables. The implied relative rise in
wages is likely to affect labour intensity adversely. Thus, employment faces a
double jeopardy from an appreciating REER, viz. reduced labour intensity and
falling aggregate demand. Capital management techniques can resolve this
dilemma by moderating inflows and thereby controlling REER appreciation.
2. One of the important beneficial fallouts of capital management is that if used
appropriately it can reinforce financial stability—as the stabilization of REER
via capital controls can considerably dampen carry trade in the concerned
currency. This dampening occurs because REER stabilization sets at rest
speculation centred around expected one-way movements in that currency,
thereby mitigating the possibility of currency crises.
3. Capital controls by cutting the Gordian knot of the impossible trinity can pro-
vide additional space for domestic monetary policy (see Epstein 2009; Reinhart
and Rogoff 2008, etc.).
There are other, more general, advantages to capital management techniques.
They lead to an overall reduction in the political power of the financial community,
especially foreign investors and multilateral institutions. This creates vitally needed
space for the interests of other groups (such as the peasantry, urban poor, SMEs) to
play a role in the design of economic and social policy.
Turning now to a discussion of capital management techniques, it is important to
emphasize that the focus of these measures is on preventing banking and currency
crises. They are not designed to address the issue of the salvage measures that need
to be adopted once a country is actually overcome by a crisis. Preventive measure
comprise two aspects (i) the actual content of these measures and (ii) a mechanism
for their activation.
A variety of capital controls have been suggested in the theoretical literature, and
many of these have been invoked by different countries at various periods in the
post-World War II period (see Epstein et al. 2005 for details).
Perhaps the oldest such proposal is the Tobin tax on capital inflows, suggested
by Tobin (1978) in an influential article. Other types of capital controls (on inflows)
include (i) unremunerated reserve requirements (URR) which require a certain
percentage of inflows to be deposited with the domestic central bank for a lock-in
period (usually not less than a year) (see Guillermo Le Fort and Lehmann 2003;
Vithessonthi and Jittima 2013, etc., for details), (ii) taxes on external commercial
loans, (iii) sectoral regulation of FDI, (iv) interest equalization taxes, (v) restriction
on domestic spending of NRI deposits.
Controls on outflows are less common but have nevertheless been resorted to
under times of duress by countries such as Malaysia, Taiwan and Singapore. They
could include (i) exchange controls, (ii) restraints on domestic institutions from
extending credit (denominated in domestic currency) to non-residents, (iii) gradu-
ated exit levies (inversely) proportional to length of stay of the investment in the
country, (iv) repatriation waiting periods, etc.
Two broad mechanisms have been suggested in the literature to activate these
preventive capital management techniques. The first is the Early Warning Systems
(EWS) approach initiated in an early paper by Sachs et al. (1996) and elaborated in
several later papers by Goldstein et al. (2000), Edison and Reinhart (2001), Abiad
(2003), etc. The essential logic here is simply to identify a group of variables
relevant for crisis prediction and then use probit/logit models or signal extraction
methods to recognize particular patterns associated with banking/currency crises.
Thus, EWS methods (see Sect. 4.5 above) can, in principle, be used by central
banks (or financial stability authorities) to identify situations that have the potential
to lead up to a crisis.
The second approach has been somewhat colourfully termed the trip wires—
speed bumps (TW-SB) approach, whose essence rests on the idea that specific
changes in policy ought to be activated to curtail particular financial risks as soon as
5 Measures Under Government Jurisdiction 329
the vulnerabilities become evident. The approach has been exciting increasing
interest among economists in recent years (see Grabel 2003; Magud et al. 2006;
McCauley 2010; Epstein 2012, etc.). The TWs are usually simple indicators that are
designed to warn policymakers of impending risks.27 Under the approach, when-
ever TWs cross predetermined critical thresholds, various regulatory actions called
speed bumps (SBs) are called into play.28 The idea has parallels in the typical
circuit breakers employed routinely in several stock exchanges around the world
(including the BSE and NSE in India), to stabilize excess market volatility. In
contrast to the EWS, this approach does not presume that the self-correcting actions
of market agents will prevent financial risks from developing into full-blown crises.
Instead, it assumes that the actions of private sector agents in response to evident
financial vulnerabilities can actually trigger instability. It, therefore, assigns to
regulators the task of activating regulatory measures as signs of financial vulnera-
bility start to emerge.
6 Role of the IMF and Proposed Reforms
So far we have discussed the role of the national regulatory and supervisory
authorities in ensuring financial stability. However, in a world dominated by an
overarching financial superstructure, emergent distress in one country can easily
transmit itself to other countries, often with amplificatory effects. The role of global
multilateral institutions becomes particularly relevant in containing such contagion.
Of late, many of these institutions have also been active in striving for adoption of
harmonized best global practices by national regulators, while maintaining (within
limits) the rights of national authorities to adapt and modify these practices in
consonance with their specific national circumstances. As one of the oldest and also
the most influential multilateral organizations, the role of the IMF is particularly
crucial and to this we now turn.
There has been a general feeling of dissatisfaction with the role of the IMF in
handling financial crises among LDCs and EMEs. It has long been felt that the IMF
plays an asymmetric role in handling crises, being more interested in protecting the
interests of international lenders/bankers and imposing conditionalities on
27
Among suggested TWs, we may prominently mention (i) ratio of official reserves to total
short-term external obligations (foreign portfolio investment and total—i.e. private plus public—
short-term hard-currency denominated foreign debt), (ii) ratio of foreign currency denominated
debt to domestic currency denominated debt (appropriately weighted by maturity), (iii) ratio of
short-term debt to long-term debt and (iv) ratio of total cumulative foreign portfolio investment to
gross equity market capitalization.
28
SBs could take several forms including (i) requirements on borrowers to unwind positions
involving locational/maturity mismatches, (ii) curbs on foreign borrowings, (iii) restrictions on
certain types of FPI (foreign portfolio investment) and (iv) import curbs (in exceptional
circumstances).
crisis-afflicted countries that often have the unintended consequence of drawing

these countries into prolonged structural problems. Another source of perennial
concern among LDCs and EMEs is about inadequate representation of their point of
view. The main demands of the LDC and EME group of countries are threefold:
(i) Radical changes in access, pricing and conditionality for IMF borrowers,
with a particular emphasis on the introduction of flexible credit lines (FCL)
(ii) Raising quotas/votes of EMEs and LDCs as a group
(iii) Negating the US veto on crucial IMF decisions.
[Note: To have a better understanding of these issues, it is worthwhile to
examine how the quota and voting rights of each country are determined.
The quota is reckoned in terms of SDRs (in millions), and each country’s quota
share is calculated by the formula:
CQS (calculated quota share) = [0.3 GDP (at market prices) + 0.2 GDP (at
purchasing power parity (PPP) prices) + 0.3 Openness + 0.15 Economic
Variability + 0.05 International Reserves] K
(where K is a compression factor usually set at 0.95).
(see IMF (2015) for detailed definitions of the variables involved)
The voting rights of a country are related to the quota but in a slightly indirect
manner via the following formula:
Number of votes (of a country) = Basic votes (5.502% of total votes) + 10 votes
(per million SDRs)]
The Committee on IMF Governance Reform (under the Chairmanship of Trevor
Manuel), which submitted its Report on 24 March 2009, made an honest effort to
address several of these concerns, though in what form these will be finally
incorporated in the IMF Charter is as yet unclear. Among the major recommen-
dations of the Report are the following:
(i) Several changes in access, pricing and conditionality for IMF borrowers
(with a more liberal use of flexible credit lines).
(ii) With a lowering of threshold on critical decisions from 85% to 70–75%, the
US veto is proposed to be annulled (as the USA had 16.7% voting power
then).
(iii) Doubling of quotas and shifting of 6% of voting power to dynamic EMEs.
(iv) A proposed tripling of basic votes (number of votes every country has qua
member) which would increase developing country votes from 32.3 to 34.4%
(the corresponding World Bank figure is 42.6% and proposed to be raised to
43.8%).
(v) Some countries have also argued for the adoption of a double majority voting
process for major IMF decisions. Double majority implies both a majority of
weighted votes (as prevails currently) as well as a majority of country votes.
The system prevails at the Inter-American Development Bank, ADB, African
Development Bank, etc., and is applied in crucial matters such as the election
of a new president/head (see Birdsall 2009).
6 Role of the IMF and Proposed Reforms 331
At its 2010 Seoul Meeting, the G20 pledged to implement an IMF governance
reform centred on the following three-point agenda:
(i) Shifts in quota shares to dynamic EMEs and LDCs of over 6%
(ii) A doubling of quotas (the financial resources of the IMF) and a review of the
quota formula by January 2014
(iii) Greater representation for EMEs and LDCs at the Executive Board by
reducing the number of advanced European chairs by two. Further, moving
to an all-elected Board with a commitment to maintain the Board size at 24
chairs.
However, the Euro crisis distracted policymakers from the IMF governance
agenda to more pressing intra-Eurozone issues. A complicating factor impeding
progress on the IMF reforms is that in most IMF member countries, many of the
proposed changes require parliamentary approval, which can be a very slow pro-
cess. Currently, only about half of the G20 members have taken action on the
approval process.
At the 14th General Review of Quotas (December 2010) while the above
three-point agenda was approved, three conditionalities were imposed before the
provisions could become operational, viz. (i) the quota increases must have the
consent of members with an aggregate quota holding of at least 70% of the total
quotas; (ii) the 2008 Amendment on Voice and Participation must have entered into
force; and (iii) the acceptance of the amendment to reform the Executive Board by
three-fifths of the members with more than 85% of the total voting power.
As of April 2013, 146 of the 188 IMF members holding 77.07% of quotas had
consented to the quota increases, while the 2008 Amendment on Voice and
Participation entered into force in March 2011 (see IMF Annual Report 2013).
Thus, of the three conditionalities listed above, only the last conditionality remained
to be fulfilled. But this could not be done without the approval of the USA (as
mentioned above, it holds 16.7% of the voting share). The IMF itself was partic-
ularly keen to complete the reforms process. IMF Managing Director Christine
Lagarde had called the “2010 governance and quota reforms a must” and expressed
the hope that they would be completed in 2015.29 While the then President Obama
had expressed support for the IMF reforms, a Republican-dominated US Congress
was reluctant to accord its approval initially but finally gave its assent in December
2015. The long-pending reforms (agreed to at the 14th General Review of Quotas -
2010) were thus finally implemented in January 2016.
29
“2010 governance and quota reform is an absolute must. It has to be implemented and everybody
knows that it is currently stuck before the U.S. Congress. We very much hope that the different
branches of the U.S. authorities … will understand the relevance of having an IMF that is
representative of the global economy.” Christine Lagarde quoted in The Financial Times (9
October 2014).
The salient features of the reforms are the following:

(i) The representation of the BRIC countries is increased significantly. India’s
voting rights raised from 2.30 to 2.64% (CQS raised to 2.76%), while
China’s voting share goes up from 3.80 to 6.09% (CQS raised to 6.41%).
Correspondingly, there has been a marginal reduction in the voting share of
the USA from 16.70 to 16.52% (quota reduced to 17.46%).
(ii) More than 6% of the quota shifted from the USA and Europe to developing
countries and EMEs.
(iii) Aggregate quota or capital resources of the IMF doubled from US$329
billion to US$659 billion.
(iv) In addition, the selection process for executive directors on the IMF’s board
will change. Once the reforms are in place, all positions will be determined
by election, rather than the previous system where the member countries with
the five largest quotas would each appoint an executive director.
7 International Advisory Groups
7.1 G20 and Its Role
The historical evolution of G20 proceeds from the informal forum for discussion (G20
Finance Group) formed among officials from the G7 countries and a select group of
“systemically significant” developing countries as a response to the 1997 East Asian
crisis. The G20 Finance Group was informal with no formal rules of membership or
authority for resolving international disputes. The G20 Finance Group was the
institutional precursor of the G20 formed in 1999. The G20 comprised finance min-
isters and central bank Governors representing 19 countries and the EU. It is supported
by several international organizations such as the UN, IMF, WB, ILO, OECD, WTO,
FSB, BIS that provide policy advice. The G20 also engages with several
non-government groups from business (B20), civil society (C20), labour (L20), etc.
The G20 is primarily an international forum initially designed for setting the
agenda for reforms in the international financial system and global economic
governance issues. This general agenda was broadened and simultaneously
sharpened at the G20 Washington Summit held in November 2008, in the imme-
diate aftermath of the Lehman collapse. This was the first meeting of the G20
Leaders, and it set a new agenda for detailed action by international organizations
(IMF, WTO, WB, etc.) in response to the crisis.
While the first (Washington) summit focused on “short and medium term
responses to the crisis”; the second summit (London, April 2009) reached a con-
sensual agreement on a crisis management plan for the medium term, as also an
ambitious agenda for the long term to rejuvenate the global trading and investment
systems, while maintaining financial stability and moderating global imbalances.
The main components of this long-term agenda were:
7 International Advisory Groups 333
1. A substantial increase in IMF resources ($750 bn + $250 bn SDR allocation) as

also of the multilateral development banks (MDBs) ($100 Bn)
2. Greater flexibility in IMF support programmes (flexible credit lines)
3. Strengthening financial supervision and regulation (regulatory oversight of
credit rating agencies, action against non-cooperative jurisdictions and tax
havens, improving accounting standards, and establishment of a new Financial
Stability Board (FSB))
4. Supporting growth in EMEs and LDCs by helping to finance countercyclical
spending, bank recapitalization, infrastructure, etc.
5. Countering rising protectionism among developed nations in response to the
post-Lehman crisis
6. Reaffirmation of Millennium Development Goals
7. The establishment of an effective mechanism to monitor the impact of the crisis
on the poorest and the most vulnerable sections in developing countries.
Since then, a number of further summits have been held (as of 2017, twelve in
all) and the G20 has been effectively transformed from a “crisis management
forum” to a “global governance steering forum” (see Jorgensen 2013), striving for
the creation of “a new framework to correct global imbalances, taking steps to
address food security issues, and eliminating fossil fuel subsidies” (Preamble (p. 9)
to the Fourth G20 Toronto Summit (2010) Declaration).
Assessments of the G20 show considerable variation (see in particular Cho and
Kelly 2012; Woods 2010; Alexander et al. 2014, etc.). There seems to be general
agreement that the Mutual Assessment Process (MAP) initiated under the G20
auspices at its Pittsburgh Summit (2009) by ensuring greater cooperation among
members on key post-crisis issues (such as fiscal stimulus, financial reform, etc.)
prevented the world sliding into a repeat of the Great Depression. Similarly, the
G20 deserves credit for its repeated emphasis on inadequate supervision of “shadow
banking” activities as the primary cause of the recent crisis. This set in train
important improvements in the financial regulatory landscape such as Basel III and
the Dodd–Frank Act. Additionally, the continual rhetoric at the G20 against a
renewal of protectionism fended off the kind of tariff conflicts witnessed in the
post-Depression era. Finally, it has also provided a forum for EMEs to better
coordinate their own positions on global issues and thus negotiate more effectively
for beneficial changes.
However, the G20 has not been able to make much headway in certain key
dimensions of global stability such as
(i) The design of an equitable and credible international debt-resolution mech-
anism (in particular, alleviating the fallouts of the crisis on the Third World)
(ii) Striking a proper balance between fiscal consolidation and the need to use
fiscal policy as a component of countercyclical macroeconomic policies
(iii) Reducing the global dependence on US macroeconomic policies stemming
from the use of the US dollar as a reserve currency
(iv) Recognition of the threats to financial stability of the LDCs posed by

pro-cyclical cross-border capital flows and
(v) Removal of major impediments to international movement of labour.
Finally, it may be noted that the informal nature of the G20 is both an advantage
and a disadvantage. The disadvantage being that unlike the WTO it has no legal
machinery to enforce compliance with its recommendations. However, the more
formal institutions like the IMF and WTO have their authority limited to a pre-
determined set of mandates and cannot trespass on each others’ turfs. The G20 can
thus function in some limited (mainly advisory) capacity as a coordinating mech-
anism between these multilateral institutions (see Alexander et al. 2014).
7.2 Financial Stability Forum (FSF)/Board
The Financial Stability Forum (FSF) was founded in 1999, as a group consisting of
about a dozen highly industrialized nations (USA, Japan, Germany, UK, France,
etc.), who participated through their central banks, finance ministries, Treasury
departments and securities regulators together with some international financial
standard-setting bodies, with a view to promote international financial stability.
The FSF sought to facilitate discussion and cooperation among member countries in
the supervision and surveillance of financial institutions, transactions and processes.
Amidst the financial turbulence that followed the Lehman and AIG failures, the
G20 London Summit (2009) decided to transform the FSF into the FSB (Financial
Stability Board), with a much enlarged membership of nations (24) including
several EMEs (the BRICS nations, Indonesia, Turkey, etc.) and quite a few inter-
national organizations, viz. World Bank, IMF, BIS, OECD, International
Organization of Securities Commissions (IOSCO), ECB, European Commission.
Thus, the FSB can command an overview of several areas of economic activity and
brings together on a common platform both national regulators and the major
international advisory, regulatory and standard-setting bodies. As such it is ideally
suited to monitor the stability and soundness of the global financial system (see
Brummer 2010; Carrasco 2010; Cho and Kelly 2012, etc.). Members regularly
interact with the FSB via periodic conferences and meetings, and information
exchange among member jurisdictions occurs frequently as per well-laid out
norms.30
The main concerns of the FSB may be described briefly as follows:
(i) Current market developments and vulnerabilities: The FSB regularly mon-
itors macrofinancial developments and structural weaknesses in the global
and national financial systems.
30
India is an active member of the FSB having three seats in its Plenary represented by Secretary
(EA), Deputy Governor—RBI and Chairman-SEBI.
7 International Advisory Groups 335
(ii) Global systemically important financial institutions (G-SIFIs): A major task

of the FSB is to address the systemic risk issues for G-SIFIs. For this pur-
pose, the FSB identifies and updates on a regular basis a list of global
systemically important banks (G-SIBs) and global systematically important
insurance companies (G-SIIs). The FSB (November 2015) has issued
guidelines on total loss absorbing capacity (TLAC) of G-SIBs, with the aim
of resolving their problems, without recourse to public funding (see FSB
2015).
(iii) Structural vulnerabilities from asset management activities: Very recently
(January 2017), the FSB has published guidelines for addressing structural
vulnerabilities arising from liquidity mismatches, excess leverage, securiti-
zation, etc., in asset management companies (see FSB 2017a) covering
mutual funds, hedge funds, pension funds, etc.
(iv) Central clearing counterparties (CCPs): A central counterparty clearing
(CCP) is a financial institution specializing in managing counterparty credit
risk for trades in foreign exchange, securities, options and derivatives (see
Rehlon 2013). The CCPs are an important source of systemic risk and the
FSB has published guidelines on their resolution in the event of their going
insolvent (see FSB 2017b).
(v) Addressing Misconduct Risks: The FSB has been actively concerning itself
with ways to ensure that financial institutions comply with both the letter and
spirit of regulations. In particular, the FSB is exploring the link between
compensation and conduct, possibly including tools such as a malus31 sys-
tem and clawbacks provisions (see FSB 2017c).
8 International Financial Standard-Setting Bodies
International standard-setting bodies have also been fairly active in promoting

financial stability around the globe, and in redesigning the global financial archi-
tecture in response to specific episodes of global turbulence.
8.1 The Bank for International Settlements (BIS)
BIS was formally created on 20 January 1930, at the Hague Conference to overview
the reparation payments of Germany to Allied countries, agreed upon at the Treaty
of Versailles (1919) at the conclusion of World War I. BIS was created as a
31
A malus system is an arrangement whereby parties enter into a contract, where payment is related
to certain key performance indicators. By contrast, under a clawback provision, part of the contract
money already paid is required to be returned in the event of non-fulfilment of certain conditions.
commercial bank, though its operations are not governed by the Swiss banking
laws, but by international law, enjoying certain privileges and immunities indis-
pensable for the discharge of its functions. Over the years, these functions have
been evolving gradually and one may distinguish three phases in this evolution (see
Howell 1992; Baker 2002; Felsenfeld and Genci 2004):
1. From its inception up to 1988, it undertook banking functions and confined itself
to general advice on the international banking system.
2. Starting in 1988, it took on the mantel of an unofficial international bank reg-
ulator. Its edicts, though lacking official status, were usually abided by its
member country banking regulators,32 and very often by regulators in
non-member countries too.
3. Subsequent to the Asian crisis, the BIS began to be increasingly considered as a
global banking regulator and in spite of lacking enforcement powers, local,
national and international banks came increasingly under the purview of its
edicts (such as Basel 1 and 2)—not directly, but via the authority exercised over
these institutions by their respective national regulators.
Perhaps, at some future date, like the transformation of the GATT into the WTO,
the BIS may also acquire formal enforcement authority.
The BIS currently performs three important functions:
1. Financial Stability: The BIS promotes international cooperation among mone-
tary authorities and financial supervisory officials, with a view to fostering
sound regulatory and supervisory standards. Cross-border cooperation among
financial authorities can enhance adoption of efficient macroprudential standards
in individual countries and hopefully help national policymakers better antici-
pate and adapt to global financial shocks.
2. Research and Data Dissemination: These functions are addressed to the per-
ceived needs of monetary and supervisory authorities for data and policy insight.
3. Banking Functions: The BIS actively performs a number of banking functions
such as (see Felsenfeld and Genci 2004, Lessambo 2015, etc.)33
(i) To purchase, sell, open accounts and maintain custody of gold, on its own
behalf and/or the central banks’ behalf
(ii) Lending to and borrowing from the member central banks
(iii) To deal in (purchase/sell and discount/rediscount) negotiable securities,
and short-term instruments (bills of exchange, promissory notes, checks)
on its own and on behalf of member central banks’ account
(iv) To create and maintain bank accounts with the member central banks and
to accept deposits of these entities
32
Currently 60 countries (including India) are members of the BIS.
33
However, BIS, unlike a central bank, is prohibited from printing currency; loaning or opening
accounts to governments; acquiring a significant interest in any business transaction; or engaging
in real estate transactions.
8 International Financial Standard-Setting Bodies 337
(v) To act as agent or correspondent of the member central banks

(vi) To act as trustee or agent in international settlements and
(vii) To act as “agent” of the IMF and World Bank, for arranging bridge loans
for member states and emerging market countries, thereby speeding up
these countries’ access to IMF and World Bank credits.
The BCBS of BIS has been particularly active in promoting good governance in
the financial sector, especially the banking sector. In the aftermath of the recent
global crisis, it put forth a new blueprint for bank regulation, supervision and
governance, viz. Basel III, which goes considerably beyond its predecessors Basel I
and II. The central feature of Basel III is its focus on “systemic risk”, which was
largely neglected in the earlier Basel accords. This is sought to be accomplished
through several important measures including
(i) Improvement of the “quality of capital” (insisting that Tier I capital should
include a mandatory “common equity” component).
(ii) Raising the “Minimum capital” ratio (from the current level of 8% under
Basel II to 10.5%). The additional minimum capital of 2.5% constitutes the
so-called capital conservation buffer.
(iii) Additional capital requirements for systematically important financial insti-
tutions (SIFIs) via the issuance of “contingent capital”.
(iv) Reduction of pro-cyclicality of capital requirements by introducing (in
addition to the minimum capital ratio) a “countercyclical buffer” (composed
of Tier 1 capital of between 0 and 2.5% (at the discretion of national reg-
ulator) of risk-weighted assets
(v) Introduction of a minimum leverage ratio (LR) of 3% {LR = (Tier 1 Capital)/
Total exposure (on- and off-balance sheet)}.
(vi) In addition, a liquidity coverage ratio (LCR) of 100% is introduced
{LCR = (Stock of high-quality liquid assets)/(Total net cash outflows
expected over next 30 calendar days)}.
While the general level of performance of the BIS is regarded as
non-controversial and quite up to the mark, there is always room for improvement.
The BIS therefore recently commissioned two reviews an internal peer review (BIS
Expert Peer Review Group 2016) and a review by external experts (Allen et al.
2016).
The main recommendations of the internal peer review were fivefold:
1. A consistent embedding of programme evaluation in the policy design process,
using theory-based models, with greater clarity on policy objectives.
2. Peer reviewers placed considerable emphasis on collection, use and monitoring
of data, from secondary sources as well as administrative data sets and data sets
from online private sources. It was also felt that counterfactual scenarios using
control groups not participating in the specific programme would yield useful
insights into the programme’s achievements.
3. Transparency was another key concern of the peer review panel. An important
recommendation was that all evaluation reports be accompanied by technical
appendixes, to facilitate a formal assessment. While the provision of sufficient
technical information is clearly important, reviewers also noted that there is a
balance to be achieved between rigour and readability in final reports.
4. Both the quantum and the distributional impact of the policy under evaluation
should be reported in full detail.
5. A final suggestion relates to presenting evaluation material on a more systematic
basis. This would facilitate greater engagement of the BIS with interested parties
and also invite insights from external experts.
The terms of reference for the External Review Panel (Allen et al. 2016) were
(i) to conduct a qualitative evaluation of BIS research, benchmarked against the
research in other central banks and (ii) to give an assessment of its value for policy
analysis.
The Review Panel were satisfied that the BIS research was of high professional
standards, occasionally even path-breaking, and of considerable value in policy
decisions. However, it felt that room for improvements was considerable. As a
matter of fact, the Report made 24 detailed recommendations in this regard, of
which the following seem to be the most important:
(i) The need for a clear long-term focus in the research programme, rather than a
short-term (somewhat ad hoc) orientation.
(ii) The research programme is often fragmented with different aspects of the
programme lacking integration. A more holistic approach needs to be
therefore implemented.
(iii) A serious criticism made by the Panel is that much of the research tends to be
inclined towards endorsing the prevailing in-house view. A more open
culture is needed with a willingness to accommodate pluralistic views.
(iv) The Panel also recommended enhancement in the existing in-house
macroeconomic forecasting and simulation capabilities, with a view to
lend greater credence to BIS policy advice to individual countries.
(v) More of the internal analysis for Governors meetings, etc., should be put into
the public domain.
(vi) BIS staff should be encouraged to seek avenues for publication in profes-
sional journals. This will have the twin benefits of enhancing the quality of
BIS research as well as increasing the impact in the broader economics
profession.
(vii) There should be greater involvement of outsiders in the BIS research
programme.
However, neither of the two panels draw attention to the key issues of concern to
the EMEs and LDCs, viz.
(i) The fact that the BIS recommendations (such as the 3 Basel accords) are
often of the “one hat fits all heads” variety, making few allowances for
special features of the financial systems in EMEs and LDCs such as
indigenous banks, land banks, cooperative credit banks, etc.
(ii) Similarly in its efforts to encourage adoption of harmonized financial and
accounting standards, the BIS fails to account for the fact that most of the
costs of adjustment fall on this group of countries. A proper cost-benefit
analysis is needed to assess whether the benefits of adopting harmonized
standards are worth the costs.
(iii) Very often the stabilization policies adopted in the developed world can pose
policy dilemmas for monetary and exchange rate policy in the EMEs, as was
evidenced during the post-crisis QE and tapering episodes. The BIS had little
advice to offer in this matter.
Of course, these criticisms are not confined to the BIS, but are more generally
applicable to all the multilateral standard-setting bodies to varying extents.
8.2 International Organization of Securities Commissions

(IOSCO)
The IOSCO emerged in 1983 from a decision of the eleven securities regulators
from South America and North America, comprising the Inter-American Regional
Association to transform the association into an international body, transcending the
American continents. The IOSCO currently has three types of membership:
(i) Ordinary members: The primary regulators of securities and future markets
in a jurisdiction.
(ii) Associate members: Other regulators of securities and future markets in
jurisdictions which have more than a single regulator.
(iii) Affiliate members: These include stock exchanges, self-regulatory organiza-
tions, other governmental bodies with an appropriate interest in securities
regulation and various stock market industry associations.
The total IOSCO membership currently (January 2018) stands at 216 (127
ordinary members, 25 associate members and 64 affiliate members).
IOSCO is recognized today as one of the world’s key international
standard-setting bodies. Cooperation and transfer of expertise, in particular between
developed and emerging markets, are at the heart of its mission.
In 1998, the IOSCO adopted the Objectives and Principles of Securities
Regulation (referred to popularly as IOSCO Principles), which is recognized as a
benchmark by the global financial community. This is updated frequently, and the
latest update is discussed in OICV-IOSCO (2017a). According to the IOSCO
Principles, the main objectives of the IOSCO may be put forth as follows:
1. The protection of investors

2. Ensuring that markets are fair, efficient and transparent
3. To ensure cooperation among members to promote high standards of regulation
4. The reduction of systemic risk.
The last objective relating to mitigating systemic risk was introduced in July
2010 in the aftermath of the global crisis.
The Principles are quite comprehensive and relate to
(i) Regulators (highlighting their responsibilities, independence, accountability,
enforcement powers, etc.)
(ii) Standards of fairness and confidentiality for self-regulatory organizations
(iii) Cooperation among regulators (between domestic regulators and their for-
eign counterparts)
(iv) Issuers (accurate and timely disclosure of financial results, risk and other
information that is material to investors’ decisions)
(v) Credit rating agencies (to be subject to registration, adequate levels of
oversight and online surveillance)
(vi) Auditors (to be subject to adequate levels of oversight and to maintain high
and internationally acceptable standards)
(vii) Exchanges, clearing and trading systems (should be subject to ongoing
regulatory supervision aimed at ensuring the integrity of trading through fair
and equitable rules that strike an appropriate balance between the demands of
different market participants and reduce systemic risk).
The mitigation of systemic risk as an IOSCO objective has assumed consider-
able importance in the post-crisis years. National securities regulators were
expected to have the mitigation, management and monitoring of systemic risk as a
primary component of their mandate. The IOSCO (see OICV-IOSCO 2011) has
outlined a five-point strategy for securities regulators to meet this mandate:
1. Realizing that disclosure and transparency are critical to identifying the devel-
opment of systemic risk, the IOSCO asks regulators to promote disclosure and
transparency at the level of products (i.e. equity instruments) as well as market
participants (stock brokers, dealers, exchanges, etc.).
2. Regulatory supervision of business conduct is essential to managing conflicts of
interest, and the build-up of undesirable incentive structures within the financial
system.
3. Financial innovation can be a double-edged weapon. Useful products and
processes that are efficiency-enhancing can be encouraged, but the perimeter of
regulation should be enlarged to monitor innovations that involve opacity and/or
are susceptible to mispricing of the risk they carry.
4. Securities regulators should work with other supervisors to improve the overall
understanding of the securities markets in their jurisdiction, with a view to
identifying their vulnerabilities and their interconnections with the broader
financial sector and the real economy.
5. Regulators should continually strive to develop key risk measurement param-

eters, which will enable them to identify emergent signs of systemic risk in
securities markets.
9 Conclusion
This time is different is a common refrain in discussions following every major

crisis (and is also the title of an interesting book written in response to the current
one (see Reinhart and Rogoff 2009). However, in one essential regard, the recent
crisis is indeed different from its predecessors, viz. that for the first time, nations
have come together to chalk out a coordinated global effort to fight the crisis,
instead of each country attempting to build walls of insulation around its own
domestic economy. In the immediate wake of the crisis, certain facts emerged with
stark clarity—in particular the inconsistencies in regulatory systems across coun-
tries and clear conflicts of interests between regulators across borders, as well as
between regulators and financial markets. The need was quite evident for a new era
of global financial coordination to deal with global systemic risk. The major issues
that seemed to call for inclusion in the agenda of such an endeavour were:
(i) Regulation of domestic financial markets and the coordination of regulations
across intra-national and international jurisdictions to avoid regulatory
arbitrage
(ii) Regulation of cross-border capital flows
(iii) To device global lenders of last resort mechanisms to supplement emergency
liquidity financing of national central banks
(iv) To ensure adequate global debt-resolution mechanisms
(v) To ensure coordination of debt-resolution tools as well as coordination in
depositor and investor protection
(vi) To provide frameworks for enhanced information sharing among regulators
and
(vii) To work towards an international financial architecture that addresses
international stability considerations in a fair and forthcoming manner, with
special attention to EMEs and LDCs.
The global coordination process was envisaged as involving five major partners
(see Sect. 1 above), viz. (i) National Regulatory & Supervisory Authorities,
(ii) IMF, (iii) Financial Stability Forum (FSF)/Board (FSB), (iv) international
standard-setting bodies like the Basel Committee on Banking Supervision (BCBS)
of Bank of International Settlements (BIS), International Organisation of Securities
Commissions (IOSCO) and (v) Globally influential organizations like G20.
This chapter has gone into an extended discussion of the range of tasks con-
fronting each of the partners involved in the conduct of the overall mandate of
global stability. Difficulties abound in both conception and enforcement of the
cooperative ideal, but significant signs of progress are also discernible. While it is
premature to prognosticate on the likely success of this ambitious endeavour, one
cannot but welcome the overall efforts at facilitating consensus building among the
comity of both developed and developing nations.
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Chapter 15
Sustaining Growth with Monetary
and Financial Stability in India:
An Appraisal
Abstract In the last three decades, the main objectives of Indian policy makers
have been often articulated as promoting sustainable and equitable growth with
monetary and financial stability, the last being particularly emphasized after the
global crisis. We have already had occasion to examine (in previous chapters) the
crucial role of monetary stability and financial stability in sustaining the trend rate
of growth and enhancing social welfare in any society. Thus, it is of paramount
importance to have a policy framework in place which will safeguard monetary and
financial stability. In the present chapter, we try to appraise what has been done and
what is proposed to be done in this regard in the Indian context.
1 Introduction
In the last three decades, the main objectives of Indian policy makers have been
often articulated as promoting sustainable and equitable growth with monetary and
financial stability, the last being particularly emphasized after the global crisis. We
have already had occasion to examine (in previous chapters) the crucial role of
monetary stability (price-level stability/inflation control) and financial stability1 in
sustaining the trend rate of growth and enhancing social welfare in any society.
Thus, it is of paramount importance to have a policy framework in place which will
safeguard monetary and financial stability. In Chap. 14, these issues have been
examined in a general setting. In the present chapter, we shift the focus to the Indian
context and try to appraise what has been done and what is proposed to be done, in
as objective a manner as possible.
This chapter draws from the author’s paper “Global Crisis, Regulatory Reform and International
Policy Coordination” published in 2016 in Volume 5, Issue 1 of SAGE journal South Asian
Journal of Macroeconomics and Public Finance and are reproduced here with permission.
1
As clarified in Chap. 14, financial stability refers to a financial system’s self-corrective ability to
maintain its key functions (efficient allocation of economic resources and pricing, managing and
effectively distributing financial risks) unimpaired in the face of adverse shocks.

https://doi.org/10.1007/978-81-322-3920-8_15
356 15 Sustaining Growth with Monetary and Financial …
The three major levers that policymakers can operate in the short and medium
term are
(i) Monetary policy
(ii) Fiscal policy
(iii) Financial regulatory and supervisory policy.
In addition, Indian policymakers have also attempted to institute certain
long-term changes in the policy framework via a system of institutional reforms.
2 Monetary Policy
2.1 Brief History
India’s monetary policy framework has evolved through several successive stages
and now seems poised for a major metamorphosis. Broadly, we may distinguish
four phases in this evolution [for details, reference may be made to the four vol-
umes dealing with RBI history (RBI 1998, 2005a, b, 2013a, b, c)], viz.:
Phase 1(1947–57): This phase was characterized by an exchange rate anchor
(1947–57) under a proportional reserve system.2
Phase 2(1957–85): From 1957–85, credit aggregates were the nominal anchor,
with a host of instruments including the bank rate, cash reserve ratio (CRR),
selective credit control, credit authorization, etc. The period 1971–85 was a period
in which monetary policy became virtually a handmaiden of fiscal policy, with
deficit financing and high inflation induced seignorage leading to a pre-emption of
banking funds by the public sector, and crowding out of private investment.
Phase 3 (1985–98): Against the above backdrop, the RBI moved to a system of
monetary targeting largely following the recommendations of the Chakravarty
Committee (see Reserve Bank of India 1985). Broad money (M3) became the
intermediate target while reserve money was one of the main operating instruments
for achieving control on broad money growth. However, as brought out by
econometric studies of that period, the monetary targeting framework ran into
difficulties because of the instability of both the demand for money function and the
money multiplier (see, e.g. Nachane 1992). This instability essentially stemmed
from the RBI’s inability to exercise any effective control on government borrowings
(from the RBI and commercial banks). Consequent to the gradual liberalization of
capital inflows, the control of RBI over the monetary base was eroded even further.
Financial innovations rendered the money demand function amorphous. Overall,
the system of monetary targeting was rapidly becoming an anachronism.
2
Under this system, at least 40% of the note issue has to be backed by reserves in gold and pound
sterling.
2 Monetary Policy 357
Phase 4 (1998 onwards): The period prior to the initiation of structural reforms
in 1991 was characterized by overarching fiscal dominance of monetary policy.
Since then, this dominance moderated somewhat owing to three major develop-
ments, viz. (i) a general deregulation of interest rates and a greater role for market
forces in the determination of both interest and exchange rates (ii) the phase out of
ad hoc Treasury Bills from April 1997 onwards, which put a check on the automatic
monetization of the fiscal deficit and (iii) the passage of the FRBM Act (2003)
which sought to put ceilings on the overall fiscal deficit.
Against this background, the RBI thought the time propitious for the adoption of
a “multiple indicators approach”, which was installed formally in April 1998. This
approach attempts to form an assessment of the growth, inflation, market liquidity
and financial stability profile of the economy with several different kinds of indi-
cators such as:
(i) Quantity Indicators: Monetary and credit aggregates, fiscal deficit, rainfall
index, industrial production, service sector activity, exports and imports,
balance of payments and capital flows, etc.
(ii) Rate Indicators: Various money market interest rates, yields on government
securities, bank lending rates, various sectoral inflation rates, asset prices,
exchange rate, etc.
(iii) Forward Indicators: These are based on information from various business
surveys on industrial outlook, capacity utilization, etc., as well as the RBI
Inflation Expectations Survey.
(iv) Time Series Models Forecasts: These involve forecasts generated from
various internal models.
This combination of information is then used by the Monetary Policy Committee
(previously, the Technical Advisory Committee on Monetary Policy) to assess the
current macroeconomic situation and decide on monetary policy actions accord-
ingly (see Mohanty 2010 for a full explanation of this approach).
There was little dissatisfaction with the multiple indicators approach as long as
the economy was on an even keel (i.e. up to 2008–09). However, as growth faltered
thereafter (from the third quarter of 2008–09 to be precise) and inflation flared up
dramatically in 2009 (and continued unabated till 2013), monetary policy was
hauled up as one of the culprits (though not the only one). The multiple indicators
framework received its share of the blame, as not providing a nominal anchor for
monetary policy as well as not providing enough constraints on the discretion of the
RBI in setting policy rates.
In the last two decades or so, many central banks have migrated to a system of
inflation targeting. Following this general trend of thinking both the high-level
Committees appointed by the Government of India (viz. the Percy Mistry
Committee 2007 and the Raghuram Rajan Committee 2009) strongly argued in
favour of a shift towards an inflation-targeting framework. In the wake of the global
crisis (as we have discussed in Chap. 12, Sect. 2.2), the entire inflation-targeting
framework came under heavy fire. As a matter of fact, as late as 2013, we find the
RBI taking a very critical position on the issue (see RBI 2013b, p. 116):
In short, the global financial crisis seems to have underscored the need to expand the
mandate of central banks from the single objective of price stability to multiple objectives
of price stability, financial stability and sovereign debt sustainability. However, achieving
these objectives are no less than a trilemma, as there is vast scope for trade-offs between
these policy objectives. Central banks may not be able to determine the degree of precision
for inter se priority to be accorded to each of the three objectives under different sets of
circumstances.
2.2 Urjit Patel Committee (2014)
Taking the cue from the then Prime Minister’s remarks3 at the release of the fourth
volume of the RBI’s history (17 August 2013), exhorting the RBI to revisit the
conduct of monetary policy, an Expert Committee (henceforth the UPC–Urjit Patel
Committee) with this precise mandate was appointed. The much-awaited Report
made several far-reaching suggestions relating to the conduct of monetary policy:
1. Foremost among its recommendations was a switchover to a flexible
inflation-targeting framework (FIT) (rather than strict inflation targeting) for
monetary policy. Flexible inflation targeting means that monetary policy aims at
stabilizing both inflation around the inflation target and the real economy/
resource utilization around a normal level, while maintaining financial stability.
In practice, effective flexible inflation targeting has to rely on forecasts of
inflation and the real economy (see Svensson 1997, Vega and Winkelreid 2005).
2. The nominal anchor metric should be the new official CPI (combined) and the
target set at 4%, with permissible deviations of 2% around this target. Since
inflation was fairly high (around 10%) at the time of the Report’s publication
(Jan 2014), the Report recommended a transition path of 24 months before
adoption of the formal framework.
3. The Committee also exhorted the government to hold a commitment to the
Fiscal Responsibility and Budget Management (FRBM) Act 2003 and the
elimination of administered setting of wages, prices and certain interest rates.
4. It also argued for the establishment of a Monetary Policy Committee (MPC),
which would be a largely independent body and fully responsible for decisions
on monetary policy. The Committee lays down the composition of the MPC and
specifies that it will be held accountable for failure to maintain inflation within
the target zone.
3
“The time has come to look at the possibilities and limitations of the monetary policy in a
globalised economy and dealing with the constraints of the macro economic problems. That is
where a fresh thinking is called for.”
5. The operating framework envisaged by the Committee is based on a policy rule

—the exact policy rule is left unspecified but is most likely to be some variant of
the Taylor rule. Of course, a rule such as the Taylor rule includes the output gap
and sometimes the exchange rate. So, it may be claimed that FIT is not totally
oblivious to “real” variables. But there is a difference of emphasis–output (and
exchange rate) enters the rule only to the extent that they matter for inflation and
not in their own right. Thus, inflation targeting under a rule is a hierarchical
ordering of goals with inflation being the overriding one.
6. This framework is expected to be implemented in two phases—in the first of
which the repo rate will be the single policy rate and the average call rate would
continue as the operating target, and in the second, the policy rate would also be
the target rate for the short end of the money market. Detailed procedures are
laid down for the implementation of both the phases.
The opening remarks of the UPC seem to point to a fairly balanced approach and
almost leads one to expect that it would favour a monetary policy moving away
from a “narrow focus on inflation towards a multiple targets-multiple indicators
approach” (see Para II.3). However, the theoretical framework espoused by this
Report closely follows that of its antecedents, viz. the Percy Mistry Committee
Report and the Raghuram Rajan Committee Report and drives it inexorably to the
FIT framework (i.e. one where the inflation target is expected to be maintained on
the average over the business cycle). This theoretical framework, rooted in the twin
hypotheses of rational expectations and efficient markets [the main pillars of the
New Consensus Macroeconomics (NCM)], we believe stands largely discredited in
the post-crisis era (see, e.g. Allington et al. 2011; Arestis and Karakitsos 2011;
Nachane 2013a, etc.). The RBI quote above (see previous page) also seems to echo
a general lack of faith in inflation targeting. Since we have offered a very detailed
critique of FIT in an earlier chapter (Chap. 14, Sect. 2.2), we do not revisit the issue
here.
2.3 Alternatives to Inflation Targeting
Given the various objections that have been raised against IT especially in the
aftermath of the crisis, it is not surprising that a number of alternatives have been
exhaustively discussed. While it is recognized that the multiple indicator approach
is diffuse in its focus on monetary policy objectives, IT goes to the other extreme of
focusing on a single objective. The general thinking now seems to be to move
towards a few carefully selected objectives, which while giving due regard to
inflation do pay sufficient attention to aspects of the real economy which matter for
social welfare.
One prominent alternative to inflation targeting is nominal GDP growth tar-
geting which in effect constitutes a dual mandate since nominal GDP growth
depends both on output growth and inflation.4 Prominent advocates of this

approach include Røisland (2001), Jensen (2002), Guender (2007), Honkapohja
and Mitra (2014), Billi (2015), etc.
Another alternative is employment targeting which seems particularly relevant
for countries like India, where job creation is an important objective of national
policy. Monetary policy certainly has a role to play here (even though the NCM in
its strict version rules this out). Effectively, since inflation is also an important
consideration in LDCs and EMEs, what is being suggested in fact is a dual mandate
for central banks (employment and inflation) (see Epstein 2007, 2008; Dervis 2012;
Voyvoda and Yeldan 2006, etc.).
These two alternatives by no means exhaust the list of possible alternatives to IT.
Other alternatives which have been suggested are price-level targeting in which
monetary policy tracks a prescribed price-level trajectory (see Côté 2007; Evans
2012, etc.), average inflation targeting in which average inflation over a fixed
horizon is targeted (see Nessen and Vestin 2005; Evans 2012, etc.) and exchange
rate targeting (see Epstein and Yeldan 2009; Pétursson 2000, etc.). For a detailed
survey and comparative review, see Garin et al. (2016), Resende et al. (2010),
Andersson and Claussen (2017).
After the global crisis, controlling financial imbalances has emerged as an
additional responsibility of central banks. Thus, in effect, a nominal GDP target or
employment target is not a dual but a ternary mandate. What is often not realized is
that in the current context, with the phasing out of quantity-based instruments (such
as the CRR, SLR, bank rate, credit ceilings, and selective credit controls), the rate of
interest has emerged as the sole operating instrument of the Central Bank. Saddling
the central bank with too many objectives in relation to the instruments at its
disposal leads to the celebrated Tinbergenian instrument-targets mismatch problem
since the number of instruments falls short of the number of targets (see Tinbergen
1963). In strict Tinbergenian terms (equality of targets and policy instruments)
central bankers now confront a shortage of instruments. Relying on the interest rate
alone to control both monetary and financial stability can lead to what are called
“blunderbuss” effects.
A number of suggestions have emerged as a way out of the targets-instrument
mismatch. Some economists have suggested tweaking capital requirements for
macroeconomic purposes (e.g. Gersbach and Hahn 2011; Cecchetti and Kohler
2012) especially in response to supply-side (but not demand-driven) shocks, but
this has always been a controversial point. Hanson et al. (2011) for example, argue
against resorting to capital requirements for macroeconomic purposes, on grounds
that they may lead to avoidable cutbacks in bank lending, while van den Heuvel
(2008) emphasizes the welfare costs of such measures, arising out of their cur-
tailment of banks’ ability to create liquidity.
4
The difference between a dual mandate and a hierarchical mandate (as under IT) is that under the
former alternative the central bank is responsible for attaining both objectives, while in the latter
case it is accountable only for the primary objective.
More direct instruments have been used in the past such as selective credit
controls, which essentially involve the central bank establishing sectoral credit
targets for banks and other financial institutions to attain specific objectives (in the
case of an employment targeting approach, for example, selective credit controls
could involve targets for lending to employment-intensive sectors). However, the
experience with selective credit controls has not been very happy in the past, as they
involve very detailed supervision by the central bank which may not always be
feasible.
Perhaps the most promising suggestion in this regard has been made by a
prominent group of macroeconomists led by Palley (2004) which deserves serious
attention (see D’Arista 2009; Galati and Moessner 2011; Nachane 2013a;
Gevorkyan 2016, etc.). They recommend an entire overhaul in monetary policy
thinking, by shifting reserve requirements from the liability side of banks to the
asset side, and further imposing such asset-based reserve requirements (ABRRs,
for short) on all important financial institutions (especially savings and mortgage
institutions, pension funds, insurance and leasing companies, hedge funds, etc.).
Before we turn to the feasibility aspects of ABRRs, let us examine how exactly they
are supposed to restore the potency of monetary policy.
ABRRs are a form of balance sheet regulation, which link reserve requirements
of a financial entity to the composition of its assets. They are thus a link from the
asset side of a firm’s balance sheet to its asset side [loans ! reserves]. By contrast,
the current concept of reserves based on deposits is a link from the liabilities side to
the asset side and hence may be termed LBRRs (liability-based reserve require-
ments).5 Palley (2004, pp. 48–50) demonstrates via a simple micro-economic model
of the firm, that there is a fundamental difference between ABRRs and LBRRs.
A rise in LBRRs effectively raises the marginal cost of deposits to the financial firm
leaving the costs of loans unchanged, whereas ABRRs act in exactly the opposite
fashion. Thus, the typical response of financial firms to a rise in LBRRs would be to
lower interest rates on deposits, leaving the interest charged on loans intact.
Obversely, the response to higher ABRRs would be a rise in interest rates on loans,
leaving the rate on deposits intact. This basic fact has a number of important
consequences for the conduct of monetary policy.
Firstly, as we have seen above, one of the key factors behind the increasing
effeteness of monetary policy is the weakening demand for central bank reserves
due to the declining role of commercial banks in the credit creation mechanism (see
Friedman 1999). The problem with the traditional reserve requirements on deposits
are that these can be levied only on that part of the financial system which accepts
deposits (mainly banks), and this part is shrinking fairly rapidly. By contrast,
ABRRs can, in principle, be devised to apply to the entire financial system, since
loan-based assets are created by virtually all financial intermediaries. Thus, a sys-
tem of ABRRs would immediately buttress the sagging market for central bank
5
Margins are another instance of (non-bank) LBRR requirement. Risk-based capital requirements,
by contrast, constitute an asset-to-liability link.
reserves and in the process re-establish the central bank’s effective control over the
transmission channel of monetary policy (Nachane 2013b).
ABRRs as an additional macroeconomic instrument can also reinforce financial
stability. In a typical situation where pressure is building up in certain asset markets
threatening financial stability, while inflation continues to be subdued, raising
general interest rates is an unviable option (because of the “blunderbuss” effects
referred to above). What is needed is a more targeted instrument, which is precisely
what the ABRR is.6 It bolsters financial stability without imposing on the economy
any adverse consequences for growth likely to arise out of raising interest rates.
Thus, the ABRRs are a promising additional instrument for monetary policy pur-
poses. One may also add that negative ABRRs could be used to encourage lending
to identified sectors such as those with high employment potential [for some
reservations about ABRRs kindly refer Toporowski (2007)].
In short, we believe that inflation targeting is an inappropriate monetary policy
strategy in the context of EMEs like India, and that monetary policy should have a
broader ternary mandate (such as inflation, employment and financial stability) and
not hesitate to deploy more instruments. In particular, ABRRs offer a potentially
powerful tool in the central bank armoury, which deserves serious consideration.
3 Fiscal Policy
Until the outbreak of the global crisis, issues of financial stability were rarely
discussed in the context of fiscal policy. The crisis highlighted sharply how fiscal
slippages and financial systemic risk can mutually interact to generate the so-called
doom loop (see Adelino and Ferreira 2016; BIS 2016, p. 87), as was very much
evident in the recent Euro debt crisis (2009–11). The two-way loop can be
explained as follows (see Reinhart and Rogoff 2011; Bordo and Meissner 2016;
BIS 2016, etc.).
Financial crises impose fiscal stress: The first leg of the loop arises from the
observation that a financial crisis inevitably puts a great deal of strain on the fisc.
(i) Firstly, fiscal resources are utilized to bailout critical financial institutions,
and these bailout costs can be substantial. The bailouts may involve gov-
ernment repurchases of troubled assets (e.g. TARP programme in the USA),
recapitalization of banks and government supported lender of last resort
operations by the central bank.
6
Thus suppose a real estate boom is building up to alarming proportions, the central bank can raise
the ABRRs against loans to this sector, leaving ABRRs in other sectors unaffected. This will raise
interest rates on loans to the real estate sector (by a specific markup varying linearly with the
ABRR) relative to other sectors. Several further refinements are in order. For example, retail
housing loans could be exempt from the ABRR provision (in order not to dampen homeowner
aspirations), or the ABRRs could differentiate between loans granted for urban and rural
construction.
3 Fiscal Policy 363
(ii) Apart from bailing out financial institutions, governments may need to repair
corporate balance sheets as also support various “safety net” schemes for the
poorer households.
(iii) Tax receipts shrink directly with the contraction in output and employment,
while government expenditures cannot be rolled back for fear of aggravating
the contraction by a further fall in aggregate demand.
(iv) In the event of a serious crisis (such as the recent GFC), the scope of
monetary measures may soon be exhausted and then the governments have
no option but to fall back on Keynesian measures such as fiscal stimuli (as
happened in the USA, UK, Japan, India, and several other countries during
the recent crisis).
(v) There is also an important link between the fiscal situation and asset prices
(see Eschenbach and Schuknecht 2002). The collapse of an asset price boom
leads to a diminution in receipts from profit taxes, corporate taxes, dividend
taxes, capital gains taxation, asset turnover taxation, etc. Asset price changes
can also lead to wealth-related effects on consumption, which influence
indirect taxes such as the sales tax, VAT. Asset price declines can also lead
to balance sheet strains on corporations, and if the government has stood
guarantee for the borrowings (especially external commercial borrowings) of
such entities, then these guarantees will have to be honoured through fiscal
outlays.
(vi) Finally, if private sector debt is foreign currency denominated, a domestic
currency depreciation (a not unusual occurrence in financial crises) may
compel the sovereign to honour any government guarantees on such debt for
fear of triggering ratings downgrades.
Fiscal deterioration leads to financial stress: Let us now turn to the second leg
of the doom loop.
(i) A signification deterioration in fiscal balances (high ratio of public debt to
GDP and/or high gross fiscal deficits) can lead to loss of perceived credit-
worthiness of the sovereign and corresponding rating downgrades. This
pushes up the cost of external commercial borrowings, and impinges
adversely on corporate balance sheets. Weakness in corporate balance sheets
can increase bank NPAs and put them under stress.
(ii) Banks and other financial institutions are significant holders of government
debt. If sovereign ratings plunge, yields on government securities can stiffen
and banks may incur heavy losses on their security holdings (there is an
inverse relation between the yields and prices on securities) and suffer a
weakening of their balance sheets.
(iii) Higher sovereign risks also means a reduction in the value of the collateral
that banks can offer to obtain access to wholesale funding abroad and central
bank liquidity.
(iv) Sovereign downgrades also reduce the worth of government guarantees on
external borrowings of banks.
(v) Persistent fiscal deficits also have well-known inflationary consequences and
add to inflation volatility and uncertainty (see Catao and Terrones 2001;
Fatas and Mihov 2003, 2012; Rother 2004, etc.).
(vi) Lastly, an adverse fisc can lead to a stoppage of capital inflows or in extreme
situations even to capital flight (see Lau and Nelson 2011; Makin and
Narayan 2013; Tang and Lau 2011; Tang 2014, etc.).
We have seen earlier that fiscal stimuli can play an important role in the sta-
bilization of an economy hit by a deep recession. But the effective deployment of
fiscal stimuli (as we have seen in Chap. 14) depends crucially on three factors, viz.
the creation of fiscal space, the introduction of fiscal rules and designing better
automatic stabilizers. Let us now see what efforts have been made in this direction
in India.
The Indian government’s concern with fiscal slippages dates back to the
mid-eighties and the decade of the 1990s, when the gross fiscal deficit of the centre
averaged about 5.7% (of GDP) and in years such as 1993–94 and 1998–99 scaled
upwards of 6.5%. Simultaneously, the revenue deficit was rarely below 2.5% (of
GDP). To address these concerns, the Government of India passed the Fiscal
Responsibility and Budget Management (FRBM) Act in 2003. Its major original
provisions were, respectively, the following:
(i) A target reduction of the gross fiscal deficit (of the centre) to 3% of the GDP
by 31 March 2008 to be accomplished via an annual reduction of 0.3% (of
GDP).
(ii) Revenue deficit (of the centre) to be eliminated by 31 March 2008 to be
achieved with a 0.5% reduction (of the GDP) annually.
(iii) The central government shall not give guarantees aggregating to an amount
exceeding 0.5% of GDP in any financial year beginning 2004–05.
(iv) The central government shall not assume additional liabilities (including
external debt at current exchange rate) in excess of 9% of GDP for FY
2004–05 and in each subsequent financial year, the limit of 9% of GDP
shall be progressively reduced by at least one percentage point of GDP.
(v) Reasons for breaching the above targets (such as climatic catastrophes,
security concerns) have to be provided by the Finance Minister in his
Budget Speech along with corrective actions to be taken.
(vi) The Government has also to set appropriate targets to reduce its contingent
as well as total liabilities.
(vii) The RBI was not to subscribe to the primary issues of the central govern-
ment securities after 2006. With the termination of the RBI’s involvement in
the primary market for government securities, a new scheme was initiated to
handle the various issues germane to the primary market. This is the
so-called Revised Scheme of Underwriting Commitment and Liquidity
Support (see RBI Notification dated 4 April 2006).
(viii) The Government to terminate its borrowing from RBI except for temporary
purposes—the so-called WMA (ways and means advances). There are
limits imposed on the WMAs for states (the limit for the period April to
3 Fiscal Policy 365
September 2017 for example was set at Rs. 60,000 crores), and they are
usually repayable within 3 months and charged at a rate closely linked to
the repo rate. So far as the loans to the Centre under the WMA scheme are
concerned, the limits are worked out by direct negotiation between the
central government and the RBI.
The fiscal consolidation under way was severely interrupted by the global crisis
in 2008. The Indian policy response was multi-pronged involving monetary policy,
regulatory firewalls and fiscal stimuli (this has been fully discussed earlier in
Chap. 6). Three fiscal stimuli were undertaken—the first in December 2008 (esti-
mated at Rs. 30,700 crores), the second immediately after in January 2009 (totalling
Rs. 20,000 crores) and the third in February 2009 (amounting to Rs. 29,100 crores).
To this may be added the sanctioning of Rs. 30,000 crores expenditure on infras-
tructure by the public sector Indian Infrastructure Finance Company (IIFC) (via the
issuance of tax-free bonds). The total size of the fiscal stimulus thus amounted to a
sizeable Rs. 109,800 crores. While the fiscal stimuli certainly helped to contain the
contagion from the global crisis, it also resulted in a considerable deterioration of
the FRBM targets. From 2.54% in 2007–08, the gross fiscal deficit swelled to
5.99% in 2008–09 and further to 6.46% in 2009–10. Similarly, the revenue deficit
widened from 1.05% of GDP in 2007–08 to 4.50 and 5.23% in the succeeding two
years (see Table 1).7 As Table 2 shows, however, the rise in public debt over the
crisis years was not significant.8
There were a number of points of contention with the FRBM Act of 2003. One
pertained to the fact that under the prevalent accounting system, all grants from the
Union Government to the state governments/union territories/local bodies are
treated as revenue expenditure, even though a substantial part of these grants are
utilized for capital asset creation. In the Budget of 2011–12, the concept of the
effective revenue deficit (ERD for short) was introduced. It is defined as the revenue
deficit minus the component of union grants to states, union territories, local bodies,
etc., allotted for capital assets creation. The FRBM act was correspondingly
amended in 2013 with the following revised targets (for the Centre) (see
Government of India 2016a, b):
(i) Elimination of the ERD by 31 March 2018, with reduction by an amount
equivalent to 0.5% or more of GDP at the end of each financial year
beginning with FY 2015–16.
7
The combined deficit of the Centre and States rose correspondingly from 4.0% of GDP in 2007–
08 to 8.3 and 9.3%, respectively, in the next two years.
8
This seems anomalous but admits a simple explanation. The ratio of public debt to GDP is
measured as the ratio of total liabilities of the Centre and states to the GDP (at current prices).
Thus, whereas in the years 2008–09 and 2009–10, the combined total liabilities (domestic and
external of centre and states) rose by as high as 14.10 and 12.49%, respectively, the rate of growth
of GDP at current prices was even higher at 15.7 and 15.2%, respectively (see RBI Handbook of
Statistics on Indian Economy 2016–17).
9
See Reserve Bank of India (2013a, b, c).
366
Table 1 Combined deficits of central and state governments (as percentage to GDP)
Year GFD GPD RD
Combined Centre States Combined Centre States Combined Centre States
2007–08 4.0 2.54 1.51 −1.2 −0.88 −0.49 0.2 1.05 −0.86
2008–09 8.3 5.99 2.39 3.3 2.57 0.56 4.3 4.50 −0.23
2009–10 9.3 6.46 2.91 4.5 3.17 1.17 5.7 5.23 0.48
2010–11 6.9 4.80 2.07 2.4 1.79 0.47 3.2 3.24 −0.04
2011–12 7.8 5.91 1.93 3.2 2.78 0.36 4.1 4.51 −0.27
2012–13 6.9 4.93 1.96 2.3 1.78 0.45 3.5 3.16 −0.20
15
2013–14 6.7 4.48 2.20 1.9 1.14 0.70 3.3 3.18 0.09
2014–15 6.7 4.10 2.63 1.0 0.87 1.10 3.3 2.94 0.37
2015–16 7.5 3.89 3.61 2.7 0.67 2.02 2.7 2.51 0.23
2016–17 6.5 3.52 2.98 1.6 0.34 1.30 2.2 2.05 −0.14
2017–18 NA 3.24 NA NA 0.14 NA NA 1.91 NA
Source RBI Handbook of Statistics on Indian Economy 2017 (June)
Notes: 1. (i) RD (revenue deficit)—denotes the difference between revenue receipts and revenue expenditure. (ii) GFD (gross fiscal deficit) is the excess of total
expenditure (including loans net of recovery) over revenue receipts (including external grants) and non-debt capital receipts. Since 1999–2000, GFD excludes
States’ share in small savings as per the new system of accounting. (iii) GPD (gross primary deficit) is defined as GFD minus interest payments
2. Figures for Centre and States do not add up to the combined position due to inter-Government adjustments. The adjustments refer to: (i) revenue receipts of
the States and revenue expenditure of the Centre are adjusted for grants from the Centre to the States, (ii) revenue expenditure of the States and revenue
receipts of the Centre are net of interest payments to the Centre by the States, (iii) capital receipts of the States and capital disbursements of the Centre are
adjusted for loans from the Centre to States, and (iv) capital disbursements of the States and capital receipts of the Centre are net of repayments of loans by the
States to the Centre, (v) the tax revenue for 2000–01 onward is net of amount transferred to National Calamity Contingency Fund (NCCF)91.
Sustaining Growth with Monetary and Financial …
3 Fiscal Policy 367
Table 2 Select debt indicators of the central and state governments (as percentage to GDP)
Year Domestic External Total Combined total
liabilities liabilities liabilities liabilities
(Centre) (Centre) (Centre) (Centre and States)
2007–08 54.65 4.21 58.86 71.44
2008–09 53.93 4.69 58.62 72.21
2009–10 52.42 3.85 56.27 70.60
2010–11 48.58 3.58 52.16 65.60
2011–12 49.76 3.70 53.46 67.36
2012–13 49.21 3.34 52.55 66.65
2013–14 48.83 3.33 52.16 67.06
2014–15 48.57 2.94 51.51 66.70
2015–16 48.91 2.97 51.88 68.61
2016–17 47.52 2.78 50.30 68.56
2017–18 45.84 2.60 48.44 NA
Source Reserve Bank of India (2013a, b, c)
(ii) RD (revenue deficit) of not more than two per cent of GDP by 31 March
2018 with annual reduction by an amount equivalent to 0.4% or more of
GDP at the end of each financial year, beginning with FY 2015–16.
(iii) Gross fiscal deficit (GFD) of not more than three per cent of GDP at the end
of 31 March 2018, with annual reduction by an amount equivalent to 0.4% or
more of GDP at the end of each financial year beginning with FY 2015–16.
The targets related to guarantees, total liabilities and borrowings from RBI were
left intact.
Over the years, it was increasingly realized that greater flexibility needed to be
introduced in the FRBM Act to account for the volatility in domestic climatic,
political and other circumstances as well as the uncertainty in the global environ-
ment. Instead of fixed targets, a target zone was felt to be better. There was also a
feeling that fiscal targets should not be divorced from the prevailing state of the
economy, and should be coordinated with credit expansion or contraction, without
sacrificing the basic commitment to fiscal prudence and consolidation.
The need for flexibility is dramatically underlined by the recently announced (24
October 2017) government programme of bank recapitalization, to meet (at least
partially) the huge NPAs overhang in the Indian public sector banks (estimated at
about Rs. 7 trillion). The total recapitalization plan amounts to Rs. 2.11 trillion
(spread over two years) which, though sizeable, only covers about a third of the
total public sector banks’ NPAs. The approximate funding of the recapitalization
plan is as follows: Rs. 0.18 trillion (direct budgetary support) plus Rs. 0.58 trillion
(disinvestment of government stakes in public sector banks) plus Rs. 1.35 trillion
(recapitalization bonds). Of these three components, only the first is a direct burden
9
See Reserve Bank of India (2013a, b, c).
on the fisc10 and amounts to about 6% of the estimated capital expenditure of Rs.
3098 billion for the budget year 2017–18. But the future interest burden on the
recapitalization bonds (estimated at around Rs. 90 billion annually) will be a charge
on the fisc. While of itself this burden may not seem substantial, it can build up over
time if the NPA problem is not resolved in the near future and recapitalization
becomes a recurrent need.
To address the various dissatisfactions evident in the implementation of the
FRBM Act 2003 (see Government of India 2016a), the government appointed the
FRBM Review Committee (under the chairmanship of N. K. Singh) which sub-
mitted its Report in January 2017 (see Government of India 2017).
It made a number of recommendations of which the most important are listed
below:
1. The introduction of targets on public debt, which had not been done in the
earlier FRBM Act. The target for states was fixed at 20% of their state GDP,
whereas for the Centre it was fixed at 40% of the national GDP—the combined
target (Centre and states) being thus 60% of the GDP [as compared to the level
of about 68% in 2016–17 (see Table 2)]. The target achievement date has been
fixed at 2023.
2. To achieve the debt target by 2023, the fiscal deficit was targeted to be reduced
progressively over 2017–18 to 2022–23 from 3.0% of GDP to 2.5% of GDP,
with the revenue deficit (over the same period) also progressively reduced from
2.1 to 0.8% of GDP.
3. The Committee argued strongly for the establishment of an autonomous Fiscal
Council, entrusted with the tasks of: (i) preparing multi-year fiscal forecasts
(ii) recommending changes to the fiscal strategy (iii) improving quality of fiscal
data (iv) advising the government if conditions exist to deviate from the fiscal
target and (v) advising the government to take corrective action for
non-compliance with the Bill.
4. To ensure adherence to the targets, while not sacrificing flexibility, the
Committee suggested that the circumstances in which the government can
deviate from the targets should be clearly specified and such deviations would
be contingent upon the approval of the Fiscal Council. Apart from climatic or
other national calamities, the Committee also allowed for deviations in reces-
sionary conditions (specifically when real output declined by more than 3% of
the previous 4 quarters average). Further, the deviations were restricted to a limit
of 0.5% of GDP in a year.
5. Borrowings of the government from the RBI were restricted to exceptional
circumstances.
10
The final decision about the manner of bond issue is yet to be reached. Still, it is likely that the
bonds will be issued by a holding company that is specifically created to hold government equities
in PSBs. If such a company issues the bonds, the bond issue will not come under government debt
and thus the debt will not add to fiscal deficit. The remaining component of recapitalization, viz.
disinvestment proceeds, are treated as part of capital receipts.
3 Fiscal Policy 369
The case for fiscal prudence on the part of the Indian government at the current
juncture is emphasized by the several problems looming large over the economic
horizon, such as the adjustments to the after-effects of the GST, the oil price hike,
the agrarian credit delivery crisis, etc. (see Bhoi 2018). These naturally create
pressures for populist quick-fix solutions, which a well-delineated schemata of
fiscal consolidation (such as that proposed by the FRBM Review Committee above)
can enable the government to resist. The forthcoming Budget (2018–19) will be
carefully watched by domestic as well as foreign investors as a pointer to the
seriousness of the government’s commitment to fiscal prudence.
4 Financial Regulatory and Supervisory Policy
4.1 Introduction
There is increasing awareness in the global community that crisis prevention and
management requires a considerable strengthening of the national financial regu-
latory and supervisory framework. This would essentially involve a thrust in several
areas11:
1. Entrusting a special regulatory authority (either an existing one or a newly
constituted one) with an explicit financial stability mandate.
2. Ensuring coordination between different regulatory authorities.
3. Strengthening and expanding the scope of regulation to include shadow banking
(private pools of capital—including hedge funds) via a system of registration,
disclosure requirements and oversight.
4. Reinforcing prudential standards for financial institutions.
5. Devising market incentives for prudent behaviour.
6. Reducing costs of financial failures.
7. A shift from micro-prudential to macroprudential regulation.
4.2 Special Regulatory Authority
On the first two of the above aspects, the Indian authorities have been particularly
active. The Board for Financial Supervision (BFS) had already been established as
early as Nov. 1994, and the RBI carries out its financial stability mandate under the
general guidance of the BFS. The latest Financial Stability Assessment Update
11
Of the listed aspects, (3) to (6) have already been discussed in a general context in Chap. 14.
Here we discuss these aspects specifically in the Indian context.
(FSAU) of the IMF12 (2013), while expressing overall satisfaction with the regu-
latory and supervisory process in India highlighted several important lacunae in this
regard (IMF 2013, pp. 24–32). As regards, the banking sector, for example, the
FSAU felt that (i) Indian banks operating in overseas jurisdictions display a con-
siderable lack of communication with the overseas supervisory authorities.
(ii) Legal provisions of the Banking Regulation Act (1949) limit the de jure
independence of the RBI from the central government, and (iii) similarly, while
deposit-taking NBFCs (non-banking financial companies) had been brought under
the ambit of prudential regulation, regulatory gaps and latent arbitrage opportunities
were present in the interconnected operations of non-deposit-taking NBFCs, which
could pose systemic risks to the financial sector.
4.3 Coordination Among Regulators
Any modern economy is characterized by a diversity of financial institutions, each

under a possibly different regulatory and supervisory (henceforth R and S)
authority. In India, the R and S mandate for the financial sector is vested in several
different bodies with reasonably well-delineated domains. The apex R and S bodies
along with their main domains are (i) Reserve Bank of India (RBI) (banks,
non-banking finance companies (NBFCs) and micro-finance institutions (MFIs))
(ii) Securities and Exchange Board of India (SEBI) (securities markets)
(iii) Insurance Regulatory Development Authority of India (IRDAI) (insurance
sector) (iv) Forward Markets Commission (FMC) (forward commodity markets)
(v) Pension Fund Regulatory and Development Authority (PFRDA) (pension
funds) and (vi) Insolvency and Bankruptcy Board of India (IBBI) (overseeing
insolvency proceedings involving Individuals, Companies, Limited Liability
Partnerships and Partnership firms).13 29 September 2015 marked the amalgama-
tion of the FMC (the erstwhile commodities regulatory body) with SEBI, an idea
first floated in 1997 in the wake of the Asian crisis.14
In addition to these apex bodies, there are a number of Tier 2 bodies performing
certain R and S functions under the overall directions of an apex body such as the
National Bank for Agriculture and Rural Development (NABARD), Deposit
Insurance and Credit Guarantee Corporation (DICGC), National Housing Bank
12
In jurisdictions with financial sectors deemed by the Fund to be systemically important (India is
one such), financial stability assessments under the FSAP are a mandatory part of Article IV
surveillance, and are supposed to take place every five years. The 2013 FSAP for India is thus the
most recent available.
13
It was established on 1 October 2016 and given statutory powers through the Insolvency and
Bankruptcy Code, which was passed by Lok Sabha on 5 May 2016.
14
For a brief history of the rationale for this merger and the chronology of events leading up to the
merger see The Economic Times (30 June 2015, Article by D. Narayanan) and Business Standard
(24 March 2015, Article by R. Bhayani).
4 Financial Regulatory and Supervisory Policy 371
(NHB), etc. The Ministry of Finance is also a key player in the finance sector, being
responsible for financial planning and legislation.15
Until the establishment of the Financial Stability and Development Council
(FSDC), coordination between the three major regulators, viz. Reserve Bank of
India (RBI), Securities and Exchange Board of India (SEBI) and Insurance
Regulatory Development Authority of India (IRDAI) was weak and potentiality for
conflicts not ruled out. The rise of hybrid products in recent years has considerably
raised the possibility of turf wars or inter-regulatory conflicts in a multiple regu-
latory system.16
Keeping these considerations in mind, the Indian government established the
Financial Stability and Development Council (FSDC) as an apex level body in
December 2010. The FSDC is chaired by the Finance Minister and its members
include the heads of all the five (viz. RBI, SEBI, IRDAI, PFRDA and IBBI)
institutions mentioned above in addition to the Finance Secretary, Secretary
(Department of Financial Services), Secretary (Ministry of Corporate Affairs), and
the Chief Economic Advisor. Most of the operational matters of the FSDC are
handled by a subcommittee, chaired by the RBI Governor. In addition, there are
several working groups focused on special issues such as the Inter-regulatory
Technical Group (IR-TG), the Inter-regulatory Forum for Monitoring Financial
Conglomerates (IRF-FC), the Macro-Financial and Monitoring Group (MFMG),
etc.
4.4 Strengthening and Expanding the Scope of R and S

to the Shadow Banking Sector
As we have emphasized in Chap. 14, the defining feature that sets the current crisis
apart from other crises of comparable intensity in the past, is the critical role played
by the shadow banking sector. The institutions typically constituting the shadow
banking sector are the non-banking financial companies (NBFCs), hedge funds,
money market mutual funds, private pension funds, special purpose vehicles
15
Of the six apex regulatory bodies listed above, four have been established as statutory bodies via
parliamentary enactments, viz. the RBI (via the RBI Act 1934), SEBI (via the SEBI Act 1992),
IRDAI (via the IRDA Act 1999), and IBBI (under the Insolvency and Bankruptcy Code 2016),
while the remaining two are part of Government of India ministries. The FMC (prior to its merger
with the SEBI) fell within the purview of the Ministry of Consumer Affairs, Food and Public
Distribution, while the PFRDA is under the Ministry of Finance.
16
An important case in point is the well-known controversy in India over ULIPs (or unit-linked
insurance plans), which are similar to mutual funds with an added insurance component. In August
2009, a turf war erupted between the SEBI and IRDAI over an order issued by SEBI banning 14
insurance companies from issuing ULIPs, with the IRDA countermanding this order. The matter
was ultimately decided in favour of the IRDAI through government intervention in June 2010.
(SPVs), etc. In India, regulation and supervision of the shadow banking sector has
been traditionally weak and riddled with loopholes.
We first discuss the NBFC sector.17 In recent years, these have emerged as
important financial intermediaries, particularly for the small-scale and retail sectors.
Currently, NBFCs account for about 15% of the total credit, with an annual growth
rate of about 19% (see ASSOCHAM 2016; Mohan and Ray 2017, etc.). Their
regulation has evolved over several years beginning with the passage of the 1964
Chapter III B of the Reserve Bank of India (RBI) Act, 1934, to regulate
deposit-accepting NBFCs. The regulatory norms on NBFCs currently in force
include (i) entry point norms (EPNs) (ii) detailed regulations with respect to
acceptance of deposits with an objective to have a focused supervision of
deposit-accepting NBFCs (iii) mandatory registration with the RBI (iv) maintaining
a prescribed liquidity ratio (liquid assets to deposits) (v) capital requirements for
fresh registration of Rs. 2 crores and above (vi) maintenance of a reserves fund
(vii) additionally, those NBFCs which are members of the Bombay Stock Exchange
(BSE) and National Stock Exchange (NSE) have to maintain several types of
margins with these Exchanges, including most prominently daily margins,
mark-to-market margins, carry forward margins, ad hoc margins, etc.
The FSAU (IMF 2013, p. 27) has highlighted several basic shortcomings in the
NBFC sector such as (i) loose supervision of mutual funds and other fund managers
(especially hedge funds) (ii) frequent non-compliance of security issuers with
reporting and disclosure requirements (iii) much-needed upgradation of accounting
and auditing standards (iv) weak enforcement of criminal procedures and
(v) unusually light sanctions, etc.
Partly in response to the FSAU notings above, the RBI undertook a compre-
hensive review of the NBFC regulations in 2014. The revised regulatory framework
makes a broad distinction between systematically important NBFCs (defined as
those with total assets in excess of Rs. 500 crores) and non-systematically important
non-deposit-accepting (NSI-ND-NBFCs). The latter are now subject to a
light-touch regulation, with the earlier capital adequacy and credit concentration
norms withdrawn, though the existing provisioning and asset classification norms
continue to apply along with a leverage ratio of 7.18 On the other hand, for sys-
tematically important deposit accepting (SI-D-NBFCs), the prudential and asset
classification norms have been strengthened to be on a par with those applicable to
commercial banks. Simultaneously, their Tier I capital requirements have been
17
As per the RBI definition “A Non-Banking Financial Company (NBFC) is a company registered
under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or other mar-
ketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does
not include any institution whose principal business is that of agriculture activity, industrial
activity, purchase or sale of any goods (other than securities) or providing any services and sale/
purchase/construction of immovable property.” (see https://www.rbi.org.in/Scripts/FAQView.
aspx?Id=92).
18
The leverage ratio is defined as the ratio of total outside liabilities to net owned funds.
raised to 10%. In addition, in line with the suggestion of the Thorat Committee (see
RBI 2011a, b, c), each SI-D-NBFC is required to have the following three com-
mittees in place, viz. audit committee, risk committee and nomination committee.
Overall, the idea of introducing the category of SI-D-NBFCs is welcome and
will go some way in reassuring depositors and investors and in reinforcing financial
stability.
Hedge funds are a special category of NBFCs, but their potential to destabilize
the financial sector has been highlighted both in the Long-Term Capital
Management (LTCM) crisis (1998), and the recent global crisis (2008). Recognizing
this destabilizing potential, the Securities and Exchange Board of India (SEBI)
promulgated in 2012 its alternative investment funds (AIF) regulations, governing
hedge, real estate, and private equity funds. Three categories of AIF were
distinguished
(i) Category I (mainly infrastructure funds): funds receiving incentives from the
government
(ii) Category II (comprising private equity, debt and venture capital funds):
funds which operate in the country on the understanding that they will not
undertake leverage/borrowing (except for meeting day-to-day operational
requirements) and
(iii) Category III (almost exclusively onshore and offshore hedge funds): funds
that may employ leverage through investment in listed or unlisted derivatives
including commodity derivatives (since June 2017).
There was a rapid growth in the hedge funds market in 2017 and as of 30 June
2017, Category III AIFs had raised commitments worth INR 150.6 billion, more
than twice the commitments received up until June 2016.
A major difference between the categories is in their tax treatment. Categories I
and II are accorded tax pass-through status19 but not Category III. The tax liability
of the Category III funds depend on their respective legal status (i.e. whether
company, trust, limited liability partnership, and so on).
Several regulations have now been placed on hedge funds employing leverage.
They are obligated to set up a comprehensive risk management framework and the
private placement memorandum (PPM) must contain information regarding the risk
management tools proposed to be deployed. The following risk aspects must be
reported to investors in detail as well as the strategy for managing these risks:
(i) concentration risk (ii) foreign exchange risk (iii) leverage risk (iv) realization risk
(that is any change in exit conditions or exit environment) (v) strategy risk (i.e. risk
consequent to any change in business strategy) (vi) reputation risk and (vii) extra
financial risks including environmental, social and corporate governance risks.
19
Tax pass-through entities avoid double taxation by not paying income taxes at the corporate
level. Instead, corporate income is allocated among the owners, and income taxes are only levied at
the individual owners’ level.
Further, in order to ensure transparency, hedge funds must disclose the following
information to the investors:
(i) Financial, risk management, operational, portfolio and transactional infor-
mation on fund investments.
(ii) Fees charged by the manager or sponsor or any associate of the manager or
sponsor and
(iii) Annual report to investors within 180 days from the year end.
There was a general feeling among the investor class that the regulations per-
taining to AIF Category III investors were unduly restrictive. In response to con-
tinuous pressures from the investors and hedge funds lobby, SEBI constituted a
standing committee ‘Alternative Investment Policy Advisory Committee’ (AIPAC)
under chairmanship of Shri. N. R. Narayan Murthy in March 2015. AIPAC sub-
mitted its first report to SEBI with various recommendations in December 2015,
and the second report in November 2016 (see SEBI 2015, 2016). As expected, the
AIPAC signalled a considerable softening of the regulatory stand on AIFs in
general and hedge funds in particular.20 This prepared the way for four major
reforms in the regulatory framework of AIFs (see Khaitan & Co. 2017):
(i) As per the SEBI Circular dated 21 June 2017, Category III AIFs were
permitted to participate in all commodity derivatives products that are traded
on commodity derivatives exchanges in India.
(ii) Currently, Regulation 37 of the SEBI (Issue of Capital and Disclosure
Requirements) Regulations 2009 (ICDR Regulations) mandates a one-year
lock-in period for the entire pre-issue capital held by non-promoters in case
of initial public offers (IPOs). However, Category I AIFs were exempt from
this lock-in requirement. In June 2017, this exemption was also extended to
Category II AIFs.
(iii) Certain amendments in rules for valuation of unquoted equity shares.
(iv) There were also some modifications to the listing requirements for all AIF
categories.
It is too early to judge to what extent this relaxation of the regulatory stance will
expand the base of the AIF investors and whether it will jeopardize financial
stability.
4.5 Reinforcing Prudential Standards for Financial

Institutions
This aspect has several dimensions, and we discuss each of them briefly here.
As a matter of fact the Second Report was hailed as a “bag of goodies and festive cheer for the
20
AIF industry” (Khan 2016).

Improving the Quality of Bank Capital: As discussed in Chap. 14, the Basel III
proposals have increased the ratio of Tier 1 capital to total risk-weighted assets from
6% under Basel II to 8.5%, while simultaneously putting in place a staggered
system of restrictions on distribution of earnings, if the ratio of common equity in
Tier 1 (to risk-weighted assets) falls short of the minimum of 7%. Additionally, Tier
2 capital has been strengthened, while Tier 3 capital has been dropped altogether
(see BIS 2014). The RBI has already agreed to move to a Basel III framework on
the internationally agreed timeline. In an important circular (RBI 2014), it had been
stipulated that the minimum Common Equity Tier 1 (CET1) of Indian scheduled
commercial banks should be raised from the March 2014 level of 5–5.5% by March
2015 and maintained at that level thereafter. A capital conservation buffer (CCB) of
0.625% was introduced in March 2016, to be progressively raised to 2.5% by
March 2019. Additionally, the minimum total capital (Tier 1 + Tier 2 + CCB)
would be raised from the current (March 2017) level of 10.25–11.5% by March
2019. To help banks meet these recapitalization needs as well as to tackle the
burgeoning NPA problem, the government recently announced (24 October 2017) a
massive programme of bank recapitalization amounting to Rs. 2.11 trillion (spread
over two years) which though sizeable only covers about a third of the total public
sector banks’ NPAs (estimated at approximately Rs. 7 trillion).
Leverage of Financial Institutions: As we have seen earlier (in Chap. 5,
Sect. 4.2), the leverage of financial institutions can play an important amplificatory
role in perpetrating a crisis. Reflecting the need to monitor balance sheet exposures,
the RBI now imposes two types of restrictions on leverage:
(a) A cap on the loan to value ratio (LTV)21 for a loan by a commercial bank
against the purchase of an asset, with the risk weights on exposures (for cal-
culation of capital adequacy) varied according to the LTV ratio. The cap as well
as the risk weights is varied according to both the category and the size of the
exposure. For example, the LTV ratio for housing loans carries a cap of 80%
(and a risk weight of 35%) for loans up to Rs. 75 lakhs, and a cap of 75% (and
risk weight of 50%) for loans exceeding Rs. 75 lakhs (see RBI 2017a, b, c, d).
Similarly, the cap on car loans is 90%, while that for gold purchase loans is
75%.
(b) Limits on leverage ratios of banks. In tune with this thinking, Basel III proposes
to introduce a minimum Tier 1 leverage ratio of 3% defined as ratio of Tier 1
capital to total exposure (on- and off-balance sheet). It is interesting to note that
as of January 2015, this ratio stood at slightly more than 4.5% for scheduled
commercial banks in India. To ensure conformity with Basel III norms by
March 2019, banks in India are required to publicly disclose their leverage ratio
on a consolidated basis from April 1, 2015.
Stress Testing: In India, stress testing for banks is being done regularly by the
RBI (on a quarterly basis) since 2007, in accordance with the guidelines laid down
21
The LTV is defined as the ratio of the loan sanctioned to the value of the asset purchased.
in RBI (2007). The tests are designed to test the resilience of the banking system
against macroeconomic shocks. There are broadly two categories of stress tests
used in banks, viz. sensitivity tests and scenario tests. These may be used either
separately or in conjunction with each other.
Sensitivity tests are normally used to assess the impact of a change in one
variable (for example, an adverse weather shock, or unusually large capital flows,
or a strong boom in the stock market index, etc.) on a bank’s financial position.
Scenario tests include alternative scenarios of a group of variables moving in
tandem (e.g., equity prices, oil prices, foreign exchange rates, interest rates, trade
imbalances, capital flows) based on alternative scenarios. Two types of scenarios,
together with the assessment of their impact on a bank’s financial position, are
considered: (a) historical scenario based on a single event experienced in the past
(e.g., natural disasters, stock market crash, depletion of a country’s foreign
exchange reserves) or (b) hypothetical scenario relating to a plausible market event
that has not yet happened (e.g., collapse of communication systems across the entire
region/ country, sudden or prolonged severe economic downturn).
Two adverse scenarios are considered (medium and severe) around a baseline
scenario involving 10 year historical data. The macrovariables usually included are
the GDP, inflation, interest rate and merchandise exports (to GDP) ratio, with the
two adverse scenarios being based, respectively, on one and two standard devia-
tions around the baseline.
The stress tests are conducted covering the following risks (see RBI 2011b):
• Credit risk, which estimates the impact on capital adequacy by stressing the
non-performing advances (NPAs) for the entire credit portfolio. This was done
using scenario analysis, multivariate regression models and a vector autore-
gressive (VAR) approach.
• Interest rate risk, which estimates the erosion in economic value of the balance
sheet for a given interest rate shock using the “Duration of Equity” method, both
at the system and the individual bank levels.
• Liquidity risk, using different scenarios, which include sudden withdrawal of
deposits on account of loss of confidence due to adverse economic conditions.
The resilience of the commercial banks in response to certain shocks to the
balance sheet and profit and loss account is studied from the above three per-
spectives. The analysis covers all scheduled commercial banks. Single factor sen-
sitivity analysis on credit risk of scheduled urban cooperative banks and
non-banking financial companies are also conducted.
The RBI has also prescribed remedial actions that banks may consider necessary
to activate when the various stress tolerance levels are breached, and include the
following measures (see RBI 2007):
(a) Reduction of risk limits;
(b) Reduction of risks by enhancing collateral requirements, seeking higher level of
risk mitigants, undertaking securitisation and hedging;
(c) Amending pricing policies to reflect enhanced risks or previously unidentified

risks;
(d) Augmenting the capital levels to enhance the buffer to absorb shocks;
(e) Enhancing sources of funds through credit lines, managing the liability struc-
ture, altering the liquid asset profile, etc.
Risk Concentration Limits: These involving ceilings on particular types of
exposures. As was pointed out by the FSAU of the IMF (2013), the then prevailing
exposure limit (in India) for large loans (of 55% of a banking group’s capital) was
far in excess of global practices of 10% to 25% and should be brought down in
stages.22 The Report also observed (p. 49) that the issue of “connected exposures”
was not getting enough attention in the case of the Indian financial system. More
specifically “cross-guarantees” between financial entities should be sufficiently
highlighted as these result in financial interdependency and commensurate con-
centration of risk. To address these twin issues, the RBI revised the limits on large
exposures as follows (see RBI 2016a, b): (i) The sum of all the exposure values of a
bank to a single counterparty must not be higher than 20% of the bank’s available
eligible capital base (i.e. Tier 1 capital) at all times. In exceptional cases, Boards of
banks may allow an additional 5% exposure of the bank’s available eligible capital
base, and (ii) the sum of all the exposure values of a bank to a group of connected
counterparties must not be higher than 25% of the bank’s available eligible capital
base at all times.
Clearing Houses for OTC Derivatives: An over-the-counter (OTC) deal is
a direct bilateral contract (i.e. without the intermediation of an exchange) in which
two parties (or their brokers or bankers acting on their behalf) agree on the terms
and modality of settlement of the particular deal. OTC trades can occur in stocks,
government securities, foreign exchange, commodities and derivatives of such
products. It is the OTC trade in derivatives (we refer to this as OTC-D) which poses
specialized risks, calling for careful regulation. The need to pro-actively regulate
the OTC-D market, was starkly brought home during the recent global crisis.
Trading in OTC-Ds constituted a large proportion of the global derivatives trade.
This trade was complex, often opaque and counterparty risks were systematically
camouflaged. According to many, it draws a major share of the blame for the
collapse of global capital markets in 2007–08 (see Norman 2011; Pirrong 2011;
Gregory 2014, etc.). At the Pittsburg Summit in 2009, G-20 leaders agreed that (see
FSB 2010):
All standardized 23 OTC derivative contracts should be traded on exchanges or
electronic trading platforms, where appropriate, and cleared through central
22
As a prudential indicator, what is relevant is the ratio of the exposure limit to the size of the
bank’s capital, rather than the exposure limit per se.
23
The concept of standardization involves legal uniformity (i.e. standard transaction documenta-
tion), process uniformity (this includes straight-through-processing, matching, confirmation, set-
tlement and event handling) and product uniformity (i.e. standard valuation, payment structures
and dates).
counterparties by end 2012 at the latest. OTC derivative contracts should be

reported to trade repositories. Non-centrally cleared contracts24 should be subject
to higher capital requirements. We ask the FSB and its relevant members to assess
regularly implementation and whether it is sufficient to improve transparency.
As emphasized in the above quotation, one way to overcome the lack of
transparency and default risk inherent in OTC derivatives is to route their settlement
via setting up a central clearing party (CCP)/clearing house. CCPs are highly
regulated institutions that specialize in managing counterparty credit risk between
parties to a transaction, and provide clearing and settlement services for trades in
foreign exchange, securities, options and derivatives. Margins are levied by the
regulator/CCP on both parties to safeguard the funding position of the CCP (see
McPartland 2009). In India, the CCP for the OTC derivatives is the CCIL (Clearing
Corporation of India Ltd. established in 2001) and the margins (in the form of cash,
government securities, or equities) levied for OTC derivatives routed through the
CCIL are the initial margin, mark-to-market (MTM) margin and the volatility
margin.25 The CCIL is regulated and supervised by the RBI and in the interests of
good governance, it follows the norms set down by the International Organisation
of Securities Commission (IOSCO) (see Arora and Rathinam 2011; Price
Waterhouse Cooper 2017, etc.).
In an important discussion paper released in May 2016 (see RBI 2016a, b), the
RBI has signaled its intentions to streamline the OTC-D segment.
(i) Firstly, all standardized OTC derivatives are to be cleared through the CCIL.
(ii) Secondly, it is proposed to impose margin requirements (both initial margin
and variation margin26) on all non-centrally cleared derivatives. For the time
being, it is proposed to apply the margin requirements, in a phased manner,
to all transactions where at least one of the counterparties is a financial entity
(like banks, insurance companies, mutual funds) and certain large nonfi-
nancial entities (i.e. those entities having aggregate notional amount of
outstanding non-centrally cleared derivatives at or more than INR 1000
billion, at a consolidated group wide basis). However, MSMEs (micro-small
24
A non-centrally cleared derivative refers to an over-the-counter (OTC) derivative product that is
not cleared through a central counterparty.
25
(i) Initial Margin constitutes the margin obligation required to be fulfilled by a member in
relation to its outstanding trades accepted for guaranteed settlement, so as to provide cover against
any future potential risk/loss in value caused due to adverse price/rate movement. (ii) Mark to
Market Margin (MTM) constitutes the margin obligation required to be fulfilled by a member to
cover the notional loss, if any, in the outstanding trades portfolio due to movement of swap rates.
(iii) Volatility Margin is imposed by the CCIL in case of sudden increase in volatility in interest
rates (see CCIL 2018).
26
Variation margin (VM) means the collateral that protects the parties to non-centrally cleared
derivatives from the current exposure, that has already been incurred by one of the parties from
changes in the mark-to-market value of the derivatives after the transaction has been executed. The
amount of variation margin reflects the size of this current exposure, which can change over time
depending on the mark-to-market value of the derivatives at any point in time.
and medium enterprises) will be exempt from the margin requirements

subject to periodic review.
(iii) Thirdly, margin requirements will not be applicable to an OTC-D transaction
in which one of the counterparties is a sovereign, central bank, multilateral
development bank or the Bank for International Settlements.
(iv) Fourthly, only variation margin requirements will be applicable to foreign
exchange forwards and swaps which are physically settled (they will not
attract initial margin requirements).
(v) Finally, with the implementation of Basel III in India (March 2019), capital
requirements applicable to banks for non-centrally cleared derivative trans-
actions will become much higher in comparison to what is applicable to
centrally cleared transactions.
The implementation will proceed in a phased manner from September 2016
beginning with entities having aggregate notional amount of non-centrally cleared
derivatives exceeding INR 200 trillion over the past 3 months, and will be fully
implemented (i.e. applied to all non-centrally cleared OTC-Ds) by September 2020
(see RBI 2016a, b).
4.6 Market Incentives for Prudent Behaviour/Market

Discipline
As we have already seen in Chapter 14, Sect. 4.4, market discipline can usefully
complement capital regulation. Basel III tries to ensure market discipline via a set of
key disclosure requirements, which allow market participants to assess how a bank
is measuring and managing its risks. A key feature of the Basel III Accord is the
materiality concept, which refers to that segment of information, whose omission or
misstatement could adversely affect the decision of any agent using that
information.
The Reserve Bank of India recognizes the need for a qualitative judgment on the
materiality of disclosures from the point of view of the user (user test). With a view
to facilitate smooth transition to greater disclosures as well as to promote greater
comparability among the banks’ Pillar 3 disclosures, the materiality thresholds have
been prescribed for certain limited disclosure mainly related to capital requirements.
These are described in a template (see Annex 1 of RBI 2013c) and are applicable
from 31 March 2017. The template is very detailed and broadly covers the fol-
lowing: (i) Common Equity Tier 1 capital, (ii) Tier 2 capital, (iii) total RWAs
(risk-weighted assets)—broken down into credit RWAs, market RWAs and oper-
ational RWAs, (iv) on-balance sheet items (excluding derivatives but including
collateral), (v) derivatives exposure, (vi) other off-balance sheet exposures,
(vii) total exposures, (viii) common equity Tier 1 (as a proportion of total RWAs),
(ix) Tier 1 capital (as a proportion of RWAs), (x) Institution specific buffer
requirement (minimum CET1 (common Tier 1 equity)) requirement plus capital
conservation buffer (see above) plus countercyclical buffer requirements27 plus

D-SIB buffer requirement28 (expressed as a percentage of RWAs).
It may be noted that beyond disclosure requirements as set forth above, banks
are also responsible for conveying their actual risk profile to market participants.
The information banks disclose must be adequate to fulfil this objective. In addition
to the specific disclosure requirements as set out in the RBI guidelines, banks
operating in India should also make additional disclosures in the following areas:
(i) Securitisation exposures in the trading book; (ii) Sponsorship of off-balance
sheet vehicles; (iii) Valuation with regard to securitisation exposures; and
(iv) Pipeline and warehousing risks with regard to securitisation exposures.
It may be safe to conclude that the disclosure component of market discipline
seems to be fairly in place in India. But it has to be remembered that while
disclosures do contribute to greater transparency in financial sector operations, and
to that extent to better monitoring by all counterparties, they constitute only a
necessary condition for market discipline. Basel III more or less reiterates the
Basel II approach to market discipline, but emphasizes more the regulators’ role. On
balance, such an assessment seems appropriate in a country like India, where
financial markets are riddled with too many inefficiencies, and where excessive
reliance on market discipline may prove of limited value.
Monitoring of banks and financial institutions by depositors in India is weak,
primarily because of the prevalent flat-rate deposit insurance premium, which
imposes a uniform premium on deposit insurance for all banks, irrespective of the
riskiness of their loan and investment portfolios. Such a system subsidizes
high-risk, poorly run institutions at the cost of their well-run counterparts. An ideal
deposit insurance premium pricing system would involve (a) banks paying a pre-
mium indexed to their own levels of risks and (b) a premium level that ensures a
continually solvent deposit insurance fund (see, e.g. Demirguc-Kunt and Huizinga
2004). However, it is difficult to assess individual banks’ risks accurately ex ante,
i.e. before problems emerge. Thus, risk-based premium (RBP) systems should be
viewed as a complement to, rather than a substitute for, other methods of checking
excessive risk taking like risk-based capital requirement prescriptions, strong
supervision and direct restraints on risky activities. There is an increasing move
towards risk-based premium systems (RBPs) across the globe and moving towards
an RBP system could be an important move in the direction of strengthening market
discipline in India.
27
The countercyclical capital buffer (CCCB) is determined by the RBI depending mainly on the
credit-to-GDP gap (i.e. the deviation of the credit-to-GDP ratio from its trend value) and banks are
usually given 4 quarters of notice for achieving this buffer, which would be in the range of 0–2.5%
of the RWAs of a bank (see RBI 2015a, b, c).
28
Currently there are 3 D-SIBs (domestic systematically important banks) in India, viz. the SBI,
ICICI and HDFC. They are currently levied a D-SIB capital buffer of 0.30%, 0.10% and Nil (of
RWAs), respectively. This is proposed to be raised to 0.45% for the SBI and 0.15% for the ICICI
and HDFC from 1 April 2018 (see RBI 2017b).
Table 3 Revenue and capital expenditure of the central government (Rs. billion)
Year Revenue Capital Total Interest
expenditure expenditure expenditure payments
2007–08 5944.33 1182.38 7126.71 1710.30
(23.99%)
2008–09 7937.88 901.58 8839.56 1922.04
(21.74%)
2009–10 9118.09 1126.78 10244.87 2130.93
(20.80%)
2010–11 10407.23 1566.05 11973.28 2340.22
(19.55%)
2011–12 11457.85 1585.80 13043.65 2731.50
(20.94%)
2012–13 12435.14 1668.58 14103.72 3131.70
(22.20%)
2013–14 13717.72 1876.75 15594.47 3742.54
(24.00%)
2014–15 14669.92 1966.81 16636.73 4024.44
(24.19%)
2015–16 15377.61 2530.22 17907.83 4416.59
(24.67%)
2016–17 17345.60 2798.47 20144.07 4830.69
(23.98%)
2017–18 18369.34 3098.01 21467.35 5230.78
(24.37%)
Source Reserve Bank of India (2013a, b, c)
4.7 Reducing Cost of Financial Failures
Special Attention to Non-Performing Assets (NPAs): NPAs constitute an impor-

tant dimension of financial stability, apart from affecting the overall efficiency and
profitability of the banking system. In India, the problem of NPAs, which had lain
dormant in the high growth phase of the last decade, seems to have re-surfaced
since the global crisis of 2008–09. A particularly worrisome fact is that the problem
has not subsided with the total gross NPAs outstanding at Rs. 7198 billion or at
9.3% (as a percentage of gross advances) (see Appendix Table V.1 in RBI 2017c).
As per the existing guidelines of the RBI (see RBI 2015b), a loan/advance slips
into the NPA category if the interest and/or instalment of principal repayment
thereof, remain overdue for a period exceeding 90 days. NPAs are further classified
as (i) substandard (an asset with NPA status of up to 12 months) (ii) doubtful (an
asset which has been classified as substandard for more than 12 months) and
(iii) loss asset (an asset on which loss has been identified by the bank, its auditors or
an RBI inspection team but the amount has not been written off wholly).
A new asset category has been introduced since 2012, viz. Special Mention
Accounts (SMAs) with three sub-categories (i) SMA-1 (Principal/or interest
payment overdue between 31 and 60 days) (ii) SMA-2 (Principal/or interest pay-
ment overdue between 61 and 90 days) and (iii) SMA-NF (accounts which signal
certain non-financial signs of stress, e.g. delays in submission of stock statements,
devolvement of deferred payment guarantees, shortfalls in projected sales/profits).
Additionally, a new entity called Central Repository of Information on Large
Credits (CRILC) was established in 2014 to collect/disseminate data relating to
large borrowers (exposures exceeding Rs. 50 million). Any account slipping into
the SMA category will be immediately reported to CRILC by the concerned bank
setting in motion the formation of Joint Lenders’ Forum (JLF) among the creditors
(including banks as well as systematically important NBFCs). The JLF will work
out a Corrective Action Plan (CAP) and decide on the appropriate course of action,
viz. rescheduling, restructuring, recovery or write-off.
Several issues arise in connection with the management of NPAs:
1. Income Recognition: The first issue pertains to the accounting norms for any
income that may occur from the NPA either pre- or post- restructuring.
Following international norms, income from NPAs is not recognized on an
accrual basis but is booked as income only when it is actually received (even if
the account carries a government guarantee).
2. Provisioning: Since an NPA represents a potential (partial/total) loss asset, the
accounts of the bank should be adjusted to take account of this possible loss.
The provisioning requirements currently in force are detailed in Table 4 which
is based on RBI (2015b). It is interesting to note that a small provisioning
requirement is also imposed on standard assets [i.e. those loans which are “in
order” (i.e. non-NPAs)]. With a view to forestalling the abuse of the asset
Table 4 Provisioning norms for NPAs in Indian Banks

Type of asset Provisioning norm (as % of
total loan outstanding)
Standard (i.e. non-NPA) Agricultural loans 0.25
Loans to SMEs (small and 0.25
micro-enterprises)
Commercial real estate 1.00
loans
Residential housing loans 0.75
All other loans 0.40
Substandard NPA 15
Doubtful Period for which Less than 1 ear 25
NPA NPA is doubtful between 1 and 3 years 40
More than 3 years 100
Loss If written off 0
asset If retained on books 100
Source: Reserve Bank of India (2014)
restructuring facility by borrowers/creditors, accelerated provisioning norms

were introduced in 2012. These are to be applied to
(i) Banks/financial institutions (FIs) that do not intimate the SMA status of
problem accounts to CRILC in a timely fashion.
(ii) Creditors who renege on the terms of an agreed CAP, or retreat from
agreements already negotiated under inter-creditor agreements (ICA) or
debtor-creditor agreements.
(iii) Bank exposures to companies whose directors/promoters figure more
than once in the list of defaulters.29 Similar treatment will apply to
exposures to borrowers classified as non-cooperative. RBI proposes to
compile a list of such directors/promoters/borrowers to be disseminated to
all lenders.
Company auditors involved in falsification of accounts/mis-certification of stock
statements will be reported to ICAI for disciplinary action, while their identity
will be made public to all banks (see RBI 2012).
3. Restructuring: The third and easily the most contentious issue pertains to the
restructuring of an account—specifically under what circumstances an asset has
claims to be so restructured and what should be its accounting status post such
restructuring. In 2012, the entire process for NPA restructuring was streamlined
(see RBI 2012). Among the important new features put on line for NPA
restructuring, the following may be noted.
(i) The existing corporate debt restructuring (CDR) mechanism30 was made
accessible also to non-members on a transaction to transaction basis.
(ii) Time lags involved at various stages in the CDR decision-making process
were proposed to be drastically shortened.
(iii) Restructuring of accounts with exposure exceeding Rs. 5 billion would be
evaluated by an Independent Evaluation Committee (IEC) comprising
experts fulfilling certain eligibility conditions.
(iv) Greater emphasis was placed on promoters either infusing fresh equity
into the stressed company or transferring part of their equity to creditors.
(v) Possibility of ushering in a shift in management control, if favoured by a
majority of lenders.31
29
This list is to be compiled by banks as per the details specified by RBI (2015c).
30
The Corporate Debt Restructuring (CDR) Mechanism is a voluntary non-statutory system based
on Debtor-Creditor Agreement (DCA) and Inter-Creditor Agreement (ICA) and the principle of
approvals by super-majority of 75% creditors (by value) which makes it binding on the remaining
25% to fall in line with the majority decision. The CDR Mechanism covers only multiple banking
accounts and syndication/consortium accounts, where all banks and institutions together have an
outstanding aggregate exposure of Rs. 100 million and above.
31
As of 1 April 2015, all restructured loans will have to be treated as NPAs. The provisioning for
such loans will accordingly be raised from 5% (as prevails currently for restructured assets) to
15%.
4. Recovery: Banks are always engaged in the recovery efforts on NPAs. As per
the existing arrangements in India, recovery of losses on NPAs can proceed via
three channels, viz.
(i) Sale of assets to securitization companies (SCs) and asset reconstruction
companies (ARCs) (established under the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFAESI) Act 2002): Under the SARFAESI Act, banks/ FIs can sell
NPAs (and even standard assets under certain stipulated conditions) to
SCs/ARCs. The sale can be on mutually agreed terms, though the selling
banks/FIs have to show any shortfall in sale price below the net book
value (NBW32) in their Profit and Loss account.
(ii) Debt Recovery Tribunals (DRTs): The Debts Recovery Tribunals have
been established under an Act of Parliament (The Recovery of Debts Due
to Banks and Financial Institutions Act, Act 51 of 1993) with a view to
providing an avenue for banks and financial institutions to salvage a part
of their losses on assets through a process of expeditious adjudication and
recovery. Currently, there are about 33 DRTs across the country.
Additionally, the DRTs can also function as a court of appeal for creditors
seeking redress for sales of assets under the SARFAESI Act and
(iii) Lok Adalats: These were established under the Legal Services Authorities
Act, 1987, and are basically designed to settle outstanding debt issues via
arbitration between small borrowers33 in distress and banks/FIs. Such
borrowers are also entitled to receive legal services provided that the
concerned authority is satisfied that the person involved has a prima-facie
case to prosecute or to defend. The system is a multi-tiered one, com-
prising the National Legal Services Authority at the apex, and State,
District and Taluk Legal Services Authorities at the lower rungs of the
hierarchy. Lok Adalats within a Taluk are organized by the respective
Taluk Legal Services Committee.
The dominant role in NPAs recovery is played by the SARFAESI channel (see
RBI 2013a, b, c, p. 69). Out of a total NPA recovery of Rs. 19, 757 crores in 2015–
16, about Rs. 13,179 crores (or about 66.7%) was accounted for by the SARFAESI
channel. Further, the share of this channel in total NPAs is likely to increase even
more in the future with the increased popularization of the securitization route.
However, asset sales to securitization companies/asset reconstruction companies
(SCs/ARCs) are hampered by the fact that the market in distressed asset sales is not
really well developed. One modification which suggests itself is a more liberal
regulatory treatment of asset sales to SCs/ARCs, with a view to encouraging banks/
32
NBW of an asset is its book value minus the provisions held against it.
33
This category includes (a) a member of a Scheduled Caste or Scheduled Tribe (b) a victim of
trafficking in human beings or beggar as referred to in Article 23 of the Constitution (c) a woman
or a child (d) a mentally ill or otherwise disabled person (e)a person in receipt of annual income
less than rupees nine thousand, etc.
FIs to recover losses on NPAs via this route. Some progress in this direction is
already evident. The RBI has promised to allow lenders to spread losses on such
asset sales over two years (instead of one year as at present). Leveraged buy-outs
will be permitted for acquisition of stressed assets. Further, greater leeway is pro-
posed for private equity firms in the distressed asset sales market. Finally, the
Finance Ministry has already raised the foreign investment limit in ARCs to 74%
(from 49% earlier) in August 2013, and now intends to ease the norms for nominee
directors in ARCs (Economic Times, 30 Jan. 2014).
(iv) Write-offs: Finally, banks need to take a decision on the write-off of NPAs which
have been overdue for long, with a view to save provisioning costs and to
economize on provisioning and regulatory capital requirements. Write-offs are
proving increasingly popular as a cosmetic device for cleansing balance sheets,
though they impose the moral hazard of slackening the efforts at recovery.
Bankruptcy Code: In recent years, both borrowers and creditors had been taking
increasing recourse to restructuring under the CDR mechanism. While not denying
the case for genuine restructuring in times of distress conditions beyond the control
of the borrower, evidence seemed to be mounting that some large borrowers might
be actively engaged in attempts at ever-greening of loans with the active con-
nivance of the creditors. To remedy this situation on a long-term basis, the
Insolvency and Bankruptcy Code (IBC) was enacted in 2016. The Code makes a
clear distinction between insolvency and bankruptcy—the former is a short-term
inability to meet liabilities during the normal course of business, while the latter
points to a systematic failure of the business. The objectives of the IBC have been
set out as
(i) quick resolution of NPAs
(ii) higher recovery rates on problematic loans and
(iii) higher levels of debt financing involving a wider variety of debt instruments.
The organizational structure under which the IBC is proposed to be opera-
tionalized is as follows (see the Ernst and Young Report 2017 for full details):
At the apex is the Insolvency and Bankruptcy Board of India (IBBI) which will
be involved in accrediting the IPs and IUs (see below) and ensuring transparency
and good governance in the administration of the code.
(i) Information Utilities (IUs) which are centralized repositories of financial and
credit information of borrowers; they are expected to validate the information
and claims of creditors vis-à-vis borrowers, as and when needed.
(ii) Insolvency Professional Agencies (IPAs) are professional bodies registered
by the IBBI to promote and regulate the insolvency profession and which
will be entrusted with enrolling IPs.
(iii) Insolvency Professionals (IPs) are licensed professionals regulated by the
IBBI. IPs function as a crucial link in the resolution process by acting as
liquidators, appointed by CoC (see below) and will assume the powers of
board of directors during the liquidation process.
(iv) Committee of creditors (CoC) consists of creditors who will appoint and
supervise the actions of IPs and whose approval is needed for the resolution
plan.
(v) The Adjudicating Authority (AA) would be the National Company Law
Tribunal (NCLT) which is empowered to admit or reject any insolvency
application, approve/reject resolution plans and decide in respect of claims.
The resolution process proceeds in several stages (see Government of India
2016a, b). Once a default by a borrower occurs, any creditor can file an application
with the AA for insolvency, stating the name of an interim IP in the application,
subject to the approval of the AA. If the insolvency application is admitted by the
AA, a moratorium period of 180–270 days is declared from the commencement of
insolvency to the completion of the insolvency.34 A CoC is now formed which
formulates and submits a resolution plan with the approval of a minimum 75%
majority. If the plan is not approved by the CoC and submitted to the AA within the
Corporate Insolvency Resolution Process (CIRP) period (normally 180 days but
extendable to 270 days), the borrower company is put into liquidation, with a
clearly defined priority of claims.
In August 2017, the Banking Regulations Act 1949 was amended to authorize
the Reserve Bank of India (RBI) to issue directions to banks to initiate the insol-
vency resolution process under the Insolvency and Bankruptcy Code 2016.
Following the earlier ordinance promulgated in May 2017, the RBI had identified
12 accounts each having more than Rs. 5,000 crore of outstanding loans and
accounting for 25% of total NPAs of banks. These have now been taken up for
immediate referral for resolution under the Bankruptcy Code. The fact of the
government and the RBI together being seriously seized of the problem and
engaged in working out jointly a series of effective measures aimed at addressing
both the micro- and macrodimensions of the NPA problem is of course a matter of
considerable satisfaction. However, these efforts may fall short of the mark, unless
banks/FIs as creditors respond with a greater sense of responsibility towards credit
appraisal, credit monitoring, credit risk management and information systems to
quickly identify assets under stress and initiate remedial actions.
4.8 Emphasis on Macroprudential Regulation
Financial stability as an explicit concern of central banks certainly antedates the

recent global crisis in most advanced countries and several EMEs (including India).
The crisis, however, has brought it into a much sharper focus. Even more impor-
tantly, the crisis emphasized the imperative of a macroprudential approach to
regulation (constituting a general-equilibrium approach to regulation aimed at
34
During the moratorium period, there will be prohibitions on Institution of legal suits, any
transfer/recovery of assets or foreclosure under the SARFAESI Act.
safeguarding the financial system as a whole) as a substantive supplement to the

already prevalent micro-prudential approach (essentially centred on a partial-
equilibrium approach to regulation aimed at preventing the costly failure of indi-
vidual financial institutions).
In India, without awaiting cues from Basel III, the RBI in collaboration with the
subcommittee of the Financial Stability Development Council (FSDC), has been
seriously engaged in identifying, anticipating and attempting to moderate systemic
financial risks since 2011. This is being done at three levels:
(i) Firstly, a systemic risk survey is conducted six-monthly (the thirteenth and
most recent in this series being concluded in October–November 2017)
involving experts’ and market participants’ assessment of systemic risk
spanning five dimensions—global risks, macroeconomic risks, market risks,
institutional risks and general risks (natural disasters, social unrest, etc.).
(ii) Secondly, stability maps are constructed for the scheduled commercial banks,
scheduled urban cooperative banks and non-banking financial companies. For
scheduled commercial banks stability is adjudged along five dimensions, viz.
soundness, asset quality, profitability, liquidity and efficiency.
The indices (ratios) used for the various dimensions are
(a) soundness (CRAR, ratio of Tier 1 capital to Tier 2 capital, and leverage
ratio)
(b) asset quality (net NPAs to total advances, gross NPAs to total advances,
substandard advances to gross NPAs, and restructures standard advances
to standard advances)
(c) return on assets, net interest margin, and growth in profits
(d) liquidity (liquid assets to total assets, customer deposits to total assets,
non-bank advances to customer deposits, and deposits of less than a year’s
maturity to total deposits) and
(e) efficiency (cost to income, credit plus deposits to staff expenses and staff
expenses to total expenses).
The stability of the banking system is then ascertained (along these five
dimensions) to risks emanating from (i) global factors (ii) domestic macroeconomic
factors (iii) financial markets risk (iv) institutional risks and (v) general risks (these
are listed out fully in RBI 2017d). Similar analyses are conducted for the urban
cooperative banking sector and non-bank financial companies sector, with some
differences in detail.
(iii) Systemic risk posed by the interconnectedness of the financial system is
sought to be ascertained via two approaches, viz. solvency contagion anal-
ysis and liquidity contagion analysis. In the first approach, the gross loss to
the banking system owing to the domino effect of a bank failure is assessed,
whereas in the second, the corresponding loss is calculated in the event of the
failure of a net lender. A sophisticated network analysis methodology forms
the basis of both approaches (see Annex 2 RBI 2017d).
The approach adopted by the RBI besides being in conformity with Basel III
norms strikes a nice balance between the micro-prudential and macroprudential
aspects of regulation but has somehow proved inadequate in providing a bank
supervision system capable of detecting major frauds in the banking system. This
serious lacuna needs to be paid much greater attention in the future by incorporating
legal and auditing standards in the systemic risk simulations.
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Chapter 16
By Way of Conclusion: Selected Issues
in Designing a New Architecture
for the Indian Financial Sector
Abstract As the threat of the global crisis receded in India, issues of financial
architecture have become dominant, with the inception of the FSDC and the
announcement of the FSLRC. We make out a case for a highly calibrated approach
to the far-sweeping agenda marked out by the HPEC and CFSR (and largely but
also more cautiously) endorsed by the FSLRC, especially as regards three issues:
(i) the shift towards a principles-based system of R&S, (ii) instituting an integrated
financial supervisory system and (iii) divesting the RBI of its banking supervision
and public debt management responsibilities. The future success of financial
reforms in India will be crucially contingent upon how successfully the regulatory
architecture adapts to the competing dictates of financial development and finan-
cial stability, and the extent to which the regulatory and supervisory system
succeeds in maintaining its independence from the government as well as market
participants.
1 Introduction1
Till the early 1990s, the Indian financial system was characterized, inter alia, by
administered interest rates guided by social concerns, high intermediation costs, a
low base of capital, directed credit programmes for the priority sectors, high degree
of non-performing assets, low intensity of technologies, stringent entry barriers for
new entrants, and strict regulations. Since the early 1990s, financial sector reforms
have been initiated with the explicit objective of developing a market-oriented,
1
The author expresses his gratitude to Wiley Publishing co. and Springer Publishers for their kind
permission to use excerpts from the following two publications in this chapter: (i) the author’s
paper “India’s Financial Sector: The Regulatory and Supervisory Landscape” published
in the Wiley journal The World Economy, vol. 35, No. 1, p. 32–43, Jan. 2012 and (ii) the author’s
article “Monetary Policy, Financial Stability and Macro-prudential Regulation: An Indian
Perspective”, published by Springer in 2014.

https://doi.org/10.1007/978-81-322-3920-8_16
394 16 By Way of Conclusion: Selected Issues in Designing …
competitive, well-diversified and transparent financial system. Financial liberal-

ization2 was viewed as an integral component of overall liberalization, in the twin
beliefs that (i) liberalization in the real sector could not proceed satisfactorily in the
absence of financial liberalization and (ii) financial liberalization was an “enabling
condition” for faster economic growth, as it increases competition, transfer of
know-how and transparency (Nachane and Islam 2011).
As the Indian financial sector started evolving rapidly under the market-oriented
liberalization initiated in the 1990s, the regulatory and supervisory framework (RSF
for short) which had evolved under four decades of democratic socialist planning,
began to increasingly come under stress. With a view to identify and address
deficiencies in this framework and suggest remedies, the Government of India
appointed two committees in quick succession in the last decade, viz. (i) The
High-Powered Expert Committee on Making Mumbai an International Financial
Centre (2007) (Chairman: Percy Mistry) which we refer to in short as HPEC and
(ii) The Committee on Financial Sector Reforms (2009) (Chairman: Raghuram
Rajan) or CFSR for short.
2 HPEC and CFSR Reports: A Critical Appraisal3
2.1 General Features
While the two committees differed considerably in their scope, coverage and
emphasis, their broad thrust was very similar. The main deficiencies in the Indian
financial system identified in the two reports may be briefly summarized as follows:
(i) Low tolerance for innovation and excessive micro-management by
regulators.
(ii) Regulatory gaps and overlaps.4
(iii) Multiplicity of regulators.
(iv) Inter-regulatory coordination.
(v) Paucity of effective risk management practices and
(vi) Inadequate investor protection.
2
The process of financial liberalization is usually viewed as encompassing four dimensions:
(i) financial deregulation, (ii) financial innovation, (iii) market making and (iv) financial
supervision.
3
This section draws from the author’s previous publications—(a) author’s contribution “Monetary
Policy, Financial Stability and Macro-prudential Regulation: An Indian Perspective” in Ratan
Khasnabis, Indrani Chakraborty (eds.) Market, Regulations and Finance: Global Meltdown
and the Indian Economy, published by Springer in 2014; and (b) author’s paper “India’s Financial
Sector: The Regulatory and Supervisory Landscape”, published in 2012 in Vol. 35, Issue 1
of the journal The World Economy, by Blackwell Publishing Ltd. (John Wiley & Sons, Inc.). Used
here with permissions.
4
Several examples of regulatory gaps and overlaps are furnished in CFSR (Chap. 6).
2 HPEC and CFSR Reports: A Critical Appraisal 395
To address these deficiencies, several fundamental amendments to the

Indian RSF were suggested in the two reports.
1. Shift from a Rule-Based System to a Principles-Based System: Firstly, both the
above committees make a strong pitch for a move from the current rule-based
system to one based primarily on principles, wherein financial entities would be
evaluated on the quality of their output, and their fulfilment of certain
well-articulated principles, rather than on a strict adherence to the letter of the
regulation [the contours of this controversy are laid out in many standard ref-
erences such as Kaplow (1992), FSA (2009), Braun et al. (2015), Dill (2017)].
2. Consolidation of Regulation and Supervision of Financial Trading Activities
under SEBI: The CFSR argued strongly in favour of unification of all regu-
latory and supervisory functions bearing on financing trading activities (in-
cluding equities, corporate bonds, government securities, currencies,
commodities) into a single agency, identifying SEBI as the most appropriate
agency for the purpose.
3. Separation of Monetary Policy Responsibility from Banking Regulation and
Supervision: The CFSR opined that, even though the prevailing system of the
RBI being jointly responsible for monetary policy and banking supervision,
seemed to be working fairly well, the system comprised inherent conflicts of
interest. It therefore recommended a separation of these two functions in the
medium term.
4. Introduction of Mechanisms for Accountability of Regulators: Both the reports
felt that accountability of regulators is important, and to this end, all financial
regulators and supervisors should be accountable to a standing committee of the
Parliament, and additionally an appellate tribunal was recommended to check
regulatory overkill.
5. Coordination among Regulators: The need for coordination among regulators
in India had been a long felt necessity. A High-Level Coordination Committee on
Capital Markets (HLCC) was accordingly set up in 1992, but it did not have any
statutory backing nor a dedicated secretariat. The CFSR recommended the setting
up of a Financial Sector Oversight Agency (FSOA) entrusted with wide-ranging
responsibilities,5 embodying a legal status and having a permanent secretariat.
While the above five constituted the main recommendations of the two com-
mittees, there are a number of supplementary recommendations including incen-
tives for regulators, consolidated regulation of pension funds, streamlining of Tier 2
regulations, etc.
The two committees laid out an ambitious agenda for financial liberalization in
general and regulatory reform in particular. So far as the last two recommendations
listed above are considered, there seems to be a general consensus about their
5
The list of responsibilities would be both macroprudential and supervisory and include periodic
assessment of macroeconomic risks, the monitoring of large systemically important financial
conglomerates and arbitration on inter-regulatory conflicts.
appropriateness.6 As a matter of fact, the last issue (of coordination among regu-
lators) was settled on a permanent basis by the establishment of the Financial
Stability and Development Council (FSDC) in 2010 (see Chap. 15 for details). By
contrast, the first three recommendations have attracted considerable controversy.
Accordingly, in this section we give a critical assessment of these three proposals
(for various other points of view, please refer Mohan and Ray (2017), Shah and
Patnaik (2011) etc.).
2.2 Principles-Based Versus Rules-Based Regulation
Even though it is fashionable in the economics and accounting literature to speak of

principles versus rules-based regulatory systems, legal theorists emphasise the
futility of pursuing such a binary classification (see, e.g., Cunningham 2007).
Several criteria have been advanced to classify given provisions as rules or prin-
ciples, including most prominently temporal orientation,7 the levels of abstract-
ness, specificity, universality (as opposed to particularity), vagueness and scope of
discretion.8 Since most provisions would partake of these characteristics to varying
degrees, actual legal systems are collections of hybrid provisions located along a
continuum. Bearing this in mind, the existing Indian financial legislative system
may be classified as rules-heavy, while what the HPEC and CFSR advocated is a
transition to a principles-loaded system. Even if it is conceded that such a transition
will not be immediate and would be accomplished in a phased manner, neverthe-
less, there are certain reasonable grounds for scepticism about a principles-loaded
system for India as a long-term goal:
1. A principles-based system vests considerable discretionary power with the regu-
lator and does require a supra-regulatory mechanism for resolving conflicts of
interpretation between regulators and compilers. Such a supra-regulator is currently
available for capital markets in the Securities Appellate Tribunal (SAT) and indi-
cations are that a Financial Services Appellate Tribunal (FSAT) for all the financial
regulators might emerge in the near future. But even with a supra-regulator in place,
much of the litigation involving regulators are likely to be disruptive of efficiency,
given the notoriously slow judicial system in India—a fact acknowledged by the
CFSR itself (p. 130) (see Debroy 2000; Armour and Lele 2008, etc.). Of course,
conflicts of interpretation arise also within a rules-based framework, but are much
less likely to be severe if rules are well-specified and exhaustive.
2. Rules are also appealing because of their relative predictability and certainty.
This certainty is especially important in modern financial markets dealing with
6
Similar remarks apply to the supplementary recommendations.
7
Rules define boundaries ex ante, while principles define them ex-post (Kaplow 1992).
8
Principles generally place more discretion at the hands of the regulator as compared to rules
(Nelson 2005).
complex structured products, where risk-assessment tools are of the essence and
one key risk dimension is regulatory and enforcement risk (BIS 2009).
3. An important argument in favour of a rules-based system is the judicial
ascendancy of interpretive textualism.9 While not solely focused on the literal
definition of a statute, judges display reluctance to deal with fuzzy principles,
preferring not to deviate too far from the conventional meaning embodied in the
statute (see Nelson 2005).
4. As noted by Wallison (2007), there is the safe haven effect of a rules-based
system. Rules, which are well specified and unambiguous, reduce the scope for
discretionary interpretation by regulators. Compliance with such transparent
rules, gives the regulated entities a sense of absolution, which is never fully
present in a principles-based system, where the threat of interpretative issues
arising ex-post is ever looming.
5. Finally, in many emerging market economies, such as India, there is a concerted
move to involve regulated entities in the promulgation of financial legislation. In
this new atmosphere of collaborative governance, there is a demand from
regulated entities that the articulation of provisions be free of vagueness,
explicitly stating exceptions, riders and qualifications. Such perceptions would
favour a rules-based system of regulation and supervision over a principles-
based one.
Thus, while the distinction between principles and rules-based systems is not as
sharp in reality as made out in the HPEC and CFSR, on a balance of considerations,
the case for a switchover of the Indian regulatory system to a principles-based one
in the foreseeable future is far from clear.
2.3 Integration of Financial Trading Regulation

and Supervision
Both the HPEC and the CFSR make out a strong case for integrated regulation and
supervision of the financial sector (in which a single agency is responsible for reg-
ulating and supervising banking, securities and insurance business), and additionally
recommended that this agency be distinct from the RBI. The latter, of course, is
tantamount to saying that the RBI be divested of its supervisory responsibility
towards the banking sector. Hence, the third recommendation above is actually
nested within the second. Hence, we consider the two recommendations together.
The case for integrated regulation and supervision, derives from the rapid pace
of modern financial innovations, in which hybrid products (such as ULIPs in
9
According to Ghoshray (2006), “Anchored in the text, structure and history of the statute, tex-
tualism seeks the most literal meaning, free from the perceptive idealism of broader social
purpose”.
India)10 often create inter-regulatory conflicts of turf, in a multiple regulatory

system. The rise of financial conglomerates also poses special regulatory and
supervisory challenges in the traditional multiple regulatory model. Increasingly,
therefore, a number of developed countries have opted for integrated financial
regulation and supervision under a financial services supervisory agency (see, e.g.,
Grunbichler and Darlap 2003). A priori, there is no reason why such an integrated
agency should be located outside the central bank (see Masciandaro 2006).
However, pragmatic considerations argue against a central bank also taking over the
regulation and supervision responsibility of the entire financial sector.11
The rationale that the HPEC and CFSR put forth for divesting the RBI of its
banking regulation and supervision mandate, is the apparent conflict of interest
between the monetary policy objective and the objective of maintaining a healthy
banking sector (see p. 138 of the CFSR Report). This oft-repeated argument in the
regulatory literature can be countered by two other equally persuasive arguments.
Firstly, the lender of the last resort function requires for its judicious execution,
access to detailed bank-specific information on the part of the central bank. In
principle, there is no difficulty in envisaging an arrangement under which the
proposed unified financial supervisory agency is required to share sensitive infor-
mation with the central bank. However, such communication can often fail, as
tellingly illustrated in the Northern Rock collapse in the UK in September 2007.
Secondly, it is often contended that the availability of banking supervisory infor-
mation on an online basis, enhances the efficiency of monetary policy.12 These
arguments apply with much greater force in the Indian context, where (i) banks are
major players in the forex, government securities and equity markets and are the
key link in the transmission of monetary policy, (ii) their size and inter-connectivity
lend them a special significance for financial stability and (iii) the market for
government bonds is largely an inter-bank market with a majority of the bonds
arising out of the government’s fiscal operations, the oil subsidies and the steril-
ization operations of the RBI. Thus, in the opinion of many analysts (see Acharya
2008; Ram Mohan 2009; Nachane 2012, etc.), if the RBI is to discharge its
monetary and financial stability objectives satisfactorily, then it is advisable that it
10
Unit Linked Insurance Plans (ULIPs) are similar to mutual funds with an added insurance
component. In August 2009, a turf war erupted between the SEBI and IRDA over an order issued
by SEBI banning 14 insurance companies from issuing ULIPs, with the IRDA countermanding
this order. The matter was ultimately decided in favour of the IRDA through government inter-
vention in June 2010.
11
Firstly, such an arrangement would overload the central bank with too many diffuse responsi-
bilities. Secondly, since responsibility for the different market segments would most likely be
vested in distinct departments of the central bank, old inter-regulatory rivalries and differing
mindsets are likely to be now internalized interfering with the primary responsibilities of monetary
and financial stability.
12
Empirical evidence on this is however, mixed. While Peek et al. (1999) in their empirical
analysis of the Federal Reserve case, uncover complementarity between the R&S and monetary
stability functions, Cihak and Podpiera (2008) find no such evidence in the diverse sample of
countries they consider.
be not relieved of the banking supervisory mandate. This view should be given due
weightage before any drastic changes to the current regulatory architecture are
contemplated. Interestingly, Bimal Jalan and C. Rangarajan (both former Governors
of the RBI) have expressed views disfavouring the introduction of a financial sector
supra-regulator (see Jalan 2012; Rangarajan 2012).
3 Financial Sector Legislative Reforms Commission

(FSLRC)
The Government of India signalled its serious intent of overhauling the financial
regulatory and supervisory architecture, by following up the HPEC and CFSR
committees with the setting up of the Financial Sector Legislative Reforms
Commission (FSLRC), under the Chairmanship of Justice B. N. Srikrishna in
March 2011. In its report submitted to the government two years later (March
2013), the FSLRC suggested a broad sweep of reforms spanning several aspects of
the financial system. The general approach of the FSLRC is best described as a non-
sectoral principles-based approach (as opposed to the current sectoral rules-based
one). It reiterated and elaborated on several of the recommendations made by its
predecessors (HPEC and CFSR), most importantly the gradual migration to a
principles-based system and an integrated financial supervisory regime.
But the FSLRC also introduced and emphasized several other aspects of which
the most important are the following:
(i) Consumer Protection for safeguarding the interests of consumers in their
interactions with financial firms. For this, it has proposed a new unified
agency to be termed the Financial Redressal Agency (FRA). This recom-
mendation of the FSLRC was accepted in the 2015–16 Budget, and a task
force to operationalize the concept was established (under the Chairmanship
of Dhirendra Swarup), which submitted its report in June 2016 (see
Government of India 2016). However, the establishment of the FRA along
the lines suggested by the task force is awaited.
(ii) Micro-Prudential Regulation. The FSLRC identified five areas of
micro-prudential regulation which needed strengthening, viz. regulation of
entry, regulation of risk-taking, regulation of loss absorption, governance
rules and regulatory and supervisory independence.
(iii) Resolution Corporation. A new Resolution Corporation was recommended
to look after the unwinding proceedings of firms in financial distress. This
recommendation of the FSLRC was taken up in the Financial Resolution and
Deposit Insurance Bill, 2017 which was introduced in Lok Sabha during the
Monsoon Session 2017. The Bill is currently being examined by a Joint
Committee of the two Houses of Parliament. It seeks to establish a
Resolution Corporation which will (i) monitor the risk faced by financial
firms such as banks, insurance companies and stock exchanges, (ii) pre-empt
identified risks to their financial positions and (iii) resolve these financial
institutions in case of failure (i.e. when they fail to honour their obligations
such as repaying depositors). To ensure continuity of a failing firm, it may be
resolved by merging it with another firm, transferring its assets and liabilities
or reducing its debt. If resolution is found to be unviable, the firm may be
liquidated, and its assets sold to repay its creditors.
(iv) Systemic Financial Stability. The FSLRC proposed to statutorily empower
the FSDC to deal with its mandate of systemic financial stability. The
arrangement that actually emerged is one in which the financial stability
mandate is primarily allocated to the RBI, but the other regulatory agencies
(such as the SEBI, IRDAI and PFRDA) also share the responsibility, with the
overarching responsibility of coordination among the different regulators
being the domain of the FSDC (see SEBI 2010, Subbarao 2011; IMF 2017).
(v) Monetary Policy. The FSLRC seems to have implicitly endorsed an
inflation-targeting strategy. Its recommendation is for the Ministry of
Finance to set up this target, with the RBI entrusted with the task of moni-
toring and implementing this target, with a Monetary Policy Committee
(MPC) aiding the task. The composition of the MPC, its role vis-à-vis the
RBI (whether advisory or executive), and the terms of its appointment have
been left quite vague. This recommendation seems to have been accepted in
principle, except that the choice of the inflation target has been retained with
the RBI (see RBI 2010).
(vi) Public Debt Management. The establishment of a new agency, the Public
Debt Management Agency (PDMA), has been proposed by the FSLRC as it
was felt that under the present system (where the RBI handles all government
debt issues), the RBI faces a potential conflict between its monetary policy
objectives and debt management objectives. This proposal was dropped from
the Finance Bill 2015 by the Finance Minister on 30 April 2015, though it
may be revived again later. While the potential conflict between monetary
policymaking and public debt management cannot be ruled out a priori, there
is considerable evidence that the RBI has acquitted itself creditably in the
role of banker and debt manager to the government, without letting this
impede its primary monetary policy mandate. As a matter of fact, the RBI’s
continued efforts have resulted in the development of an orderly government
securities market, which has streamlined its open market operations for
monetary policy. Several other arguments for a more nuanced and graduated
approach to the establishment of a separate Public Debt Management
Agency (PDMA) have been recorded in an incisive article in the Indian
Express (see Patnaik 2015).
(vii) Unified Financial Agency. The existing sectoral regulatory architecture was
strongly disfavoured by the FSLRC, which proposed a move to a new
system. In the proposed new system, the RBI would be essentially entrusted
with three functions, viz. (i) monetary policy, (ii) regulation and supervision
of banking in enforcing the proposed consumer protection and
micro-prudential measures and (iii) regulation and supervision of payment
3 Financial Sector Legislative Reforms Commission (FSLRC) 401
systems in enforcing these two laws. The FSLRC recommended the estab-
lishment of a Unified Financial Agency to implement the consumer pro-
tection law and micro-prudential law for all financial firms other than
banking and payments. This agency was envisaged to take over the work of
organised financial trading from the RBI in the areas related to the
Bond-Currency-Derivatives Nexus, and from FMC for commodity futures,
leading to unification of all organised financial trading including equities,
government bonds, currencies, commodity futures and corporate bonds. The
government is actively planning to experiment shortly, with the idea of a
unified regulatory agency on a pilot basis for the GIFT city (Gujarat
International Finance Tec-City).
4 Regulatory and Supervisory Independence:

A Neglected Issue
We now turn to a discussion of, what we believe, is an extremely important issue

for an EME like India, viz. regulatory and supervisory independence. This has most
surprisingly received only scant attention in the CFSR (and fails even to get a
mention in the HPEC), though it has been discussed (somewhat inadequately) in the
FSLRC.
Regulatory and supervisory independence (RSI)13 refers to the independence of
the regulatory and supervisory structure from not only the government, but also
from the industry and financial markets (regulatory capture). Unfortunately, the
academic literature in this area has been almost exclusively focused on central bank
independence (CBI),14 to the virtual neglect of RSI.15
The neglect of RSI assumes importance when one considers the fact that almost
all episodes of financial distress have been associated with a weak RSI.16 While
independence of the regulatory (and/or supervisory) agency is now recognized as
the sine qua non of successful regulation in all spheres, the need for such inde-
pendence is paramount for financial sector regulator(s), since financial stability
13
RSI is often confused with central bank independence (CBI), though as stressed in the literature
(see Lastra 1996; Taylor and Fleming 1999; Quintyn and Taylor 2002), the two are conceptually
distinct and need not necessarily coexist even when the regulation and supervision functions and
the monetary policy functions are vested in the same authority.
14
There is a prolific literature on CBI. We only mention three recent publications, viz. Masciandaro
and Volpicella (2016), Masciandaro and Romelli (2015) and Fels (2016).
15
A few important references on Regulatory capture/RSI are Baxter (2011), Etzioni (2009), Potter
et al. (2014), etc., apart from the classic papers of Stigler (1971) and Becker (1985).
16
See De Krivoy (2000) for the Venezuelan experience of the mid-1990s, Lindgren et al. (1999)
for the East Asian experience, Hartcher (1998) for Japan etc.
partakes of the nature of a public good (Goodhart 2004). The received literature
views RSI as spanning four areas (see Quintyn and Taylor 2002), viz.
(i) Regulatory Independence: This refers to the autonomy enjoyed by the
agency in formulating regulations (which involve both prudential regulations
as well as disclosure requirements) within the overall legal framework of the
country.
(ii) Supervisory Independence: The supervisory functions of an agency involve
several areas including on-site inspection, off-site monitoring, sanctions and
their enforcement, granting and revoking of licences. Independence from
government and market entities is particularly crucial in the discharge of this
function for effective financial stability (see, e.g., BIS 2009).
(iii) Institutional Independence: This refers to the status of the agency being
independent of the executive and legislative branches of the government and
is reflected in the manner and terms of appointment of senior executives,
governance structure and transparency of decision-making.
(iv) Budgetary Independence: This refers to the funding sources of the regula-
tory agency, viz. whether it is self-financing, or supported through the
general government budget, as well as the degree of control exercised by the
agency over the disbursal of its funds.
Each of the above aspects of independence can be compromised to varying
extents by interference from the government as well as market participants. The
overall legal framework is particularly relevant in determining the operational
independence enjoyed by each regulatory agency. A commonly employed dis-
tinction in legal theory is that between common law and civil law systems (see
Debroy 2000). The former refers to a system where law is interpreted and thus
“written” by judges, their judgments in specific cases serving as precedents for
future similar cases. The civil or codified law system is one where laws are written
into statutes and are strictly interpreted by judges of that country. While the two
systems are of course overlapping, for taxonomic purposes it is the practice to
classify systems according to which of the two forms predominates. By this cri-
terion, the Indian system is usually classified as a common law system (see, e.g.,
Galanter and Krishna 2003). In the field of financial legislation in India, the process
of judicial adjudication for legal reform has been largely inactive. Some significant
changes in the laws relating to financial practice have been accomplished through
parliamentary amendments or enactments such as the Foreign Exchange
Management Act (1999), Competition Act (2002), Securitisation Act (2002).
However, the most successful mechanism for enacting new laws in India has been
the delegation of quasi-legislative powers to regulators such as the RBI and SEBI.
Of the four apex regulatory bodies in India, three have been established as
statutory bodies via parliamentary enactments, viz. the RBI (via the RBI Act 1934),
SEBI (via the SEBI Act 1992) and IRDA (via the IRDA Act 1999), while the
PFRDA is under the Ministry of Finance. Thus, the first three might be said to enjoy
a fair degree of regulatory and supervisory autonomy (in terms of the four
4 Regulatory and Supervisory Independence: A Neglected Issue 403
dimensions of autonomy set out above) from the government. However, this
realization has to be tempered by three facts—(i) firstly, an element of indirect
control of the government does exist by virtue of the fact that almost all senior
executive positions in these three organizations are appointed by the executive
(usually the Cabinet), (ii) government nominees also figure importantly on the
boards of these agencies and (iii) if the mandate of the newly established FSDC is
broadened to include financial sector development (in addition to the originally
proposed mandates of financial stability and inter-regulatory coordination), then the
regulatory agencies might face considerable emasculation of their power to exercise
a degree of control over the introduction of new financial sector products and
processes. Budgetary sources are also an important dimension of autonomy.
The RBI is self-financed and as such does not depend either on the government or
the market for budgetary support. On the other hand, SEBI and IRDA are mainly
financed through fees and charges collected from the market entities under their
jurisdiction. Thus, all three agencies may be said to enjoy a fair degree of budgetary
autonomy from the government.
But the other major dimension of regulatory and supervisory autonomy, viz.
autonomy from the influence of financial markets is equally important, but rarely
addressed systematically (especially in India where it almost seems shrouded in a
conspiracy of silence).17 Independence from markets is more difficult to ensure than
independence from the government, since the forces operative here are extremely
subtle. The influence of markets on regulators and supervisors can be exerted
through several channels, all of which have been operative in varying degrees in the
Indian context.
(i) Firstly, there could be an overrepresentation of financial sector and corporate
representatives in high-level official committees and bodies, concerned with
the designing of regulatory and supervisory frameworks. This usually takes
place at the instance of a government strongly committed to market-oriented
reforms (whether out of a genuine belief in the efficacy of free markets or as
an outcome of domestic and international lobbying pressures is not always
clear) and is usually done with the ostensible purpose of taking on board the
“financial industry” point of view.18
(ii) Secondly in post-liberalization India, most media outlets are under corporate
ownership, with editorial/broadcasting functions not sufficiently independent
of proprietary control. As a result, large sections of the media are strongly
aligned with corporate interests and are usually successful in setting up a
grading system in which supervisors and regulators are routinely rated
publicly on how friendly they are to markets. As a result, “the needs of
17
In the words of a very famous US central banker “it is just as important for a central bank to be
independent of markets as it is to be independent of politics” (see Blinder 1997).
18
As a matter of fact, if this were the sole purpose, it could be easily accommodated by calling in
such representatives as observers or witnesses and recording their testimonies.
businesses, as opposed to investors and employees, appear to have been

heard most loudly by those responsible for reform” (Armour and Lele 2008,
p. 31).
(iii) Thirdly, the fact that SEBI and IRDA are funded through charges on their
regulated constituents undermines their autonomy from markets at least to
some extent, though as these charges are jointly determined by the regulators
and the government, blatant moral hazards seem to have been avoided.
(iv) Finally, and perhaps most importantly, financial market institutions, industry
bodies and corporate think tanks have in the last decade become involved in
regulatory agenda-setting by organizing seminars, roundtables and work-
shops involving regulators, civil servants, academics and market participants
with a view to achieve a market-centric consensus on various issues of
governance and regulation. This has resulted in both the private sector and
regulators internalizing an ideology favouring “light-touch” regulation (see
Lall 2009). Inherent in such an arrangement is the danger of ultimately
having a regulatory authority overtly sensitive to financial market demands,
to the relative neglect of prudential considerations of financial stability and
general social welfare.
5 Conclusions
Wide-ranging reforms in the Indian financial sector were unleashed in the early
1990s, and their momentum has continued unabated right up to the present, though
at a somewhat moderated pace post-crisis. In line with the evolution of the financial
sector, a need was felt for a corresponding reorientation of the regulatory and
supervisory system. To identify the emerging lacunae and inefficiencies in the latter,
the government appointed two high-level official committees (HPEC and CFSR)
which came up with several proposals of a far-reaching nature. While the two
committees differ somewhat in the details of their proposals, they are both com-
mitted to a philosophy that views rapid financial development as a key ingredient of
economic growth, and consequently propose a regulatory and supervisory archi-
tecture conducive to rapid financial deepening and the proliferation of financial
innovations. The global financial crisis brought in its wake a general disillusion-
ment with the philosophy of efficient financial markets and a corresponding shift in
attitudes to regulatory and supervisory issues, involving greater circumspection
towards complex structured products and a greater emphasis on prudential con-
siderations. We have tried to see how the contours of the Indian financial landscape
were shaped both by the largely growth-oriented vision of the two reports (HPEC
and CFSR) and the more pragmatic dictates of systemic financial stability.
As the threat of the global crisis receded in India, issues of financial architecture
have once again resurfaced, with the inception of the FSDC and the announcement
of the FSLRC. We make out a case for a highly calibrated approach to the
5 Conclusions 405
far-sweeping agenda marked out by the HPEC and CFSR (and largely but also
more cautiously) endorsed by the FSLRC, especially as regards three issues: (i) the
shift towards a principles-based system of R&S, (ii) instituting an integrated
financial supervisory system and (iii) divesting the RBI of its banking supervision
and public debt management responsibilities.
The future success of financial reforms in India will be crucially contingent upon
how successfully the regulatory architecture adapts to the competing dictates of
financial development and financial stability, and the extent to which the regulatory
and supervisory system succeeds in maintaining its independence from the gov-
ernment as well as market participants.
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Critique of The New Consensus Macroeconomics and Implications For India

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India Studies in Business and Economics

More information about this series at http://www.springer.com/series/11234

Critique of the New

ISSN 2198-0012 ISSN 2198-0020 (electronic)

© Springer (India) Pvt. Ltd., part of Springer Nature 2018

Ithaca, USA Kaushik Basu

The above considerations constitute the underpinnings of the proposed book.

leads us to a somewhat critical assessment of the ﬁnancial sector policies followed

Mumbai, India Dilip M. Nachane

“Prof. Nachane has written an extremely thought provoking book on Macroeco-

“The book is a unique and unparalleled treatment of a complex subject by an

“This is a book by a leading economist which is a master piece on macroeconomics –

1 Keynesian Economics: Brief Overview . . . . . . . . . . . . . . . . . . . . . . 1

5 A Monetary Policy Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

7 The Monetary Policy Framework of the NCM . . . . . . . . . . . . . . . . 103

6 Policy Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

11 The Post-crisis Critique of the NCM: Theoretical Aspects . . . . . . . 233

3.2 IT and Nominal Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . 312

4.7 Reducing Cost of Financial Failures . . . . . . . . . . . . . . . . . . . 381

JHC Jackson Hole Consensus

PFRDA Pension Fund Regulatory & Development Authority

WARP (Wald’s) Weak Axiom of Revealed Preference

Dilip M. Nachane is currently Chancellor, University of Manipur, Imphal, India;

In his Presidential Address to the Eastern Economic Association on the occasion of

© Springer (India) Pvt. Ltd., part of Springer Nature 2018 1

earlier neoclassical economics, embodied in the IS-LM framework. We then

2.1 Main Constituents of the Keynesian Framework

If Y S denotes aggregate supply, then the equilibrium condition is

Fig. 1 Aggregate demand and supply

where a and c are constant parameters. c is termed as the marginal propensity to

If investment I now increases by a quantity DI, by the national income identity

multiplier m is greater than or equal to 1. Thus, an increase in investment increases

(see Keynes 1936; Tsoulﬁdis 2008; Fuller 2014, etc.).

Keynes now considers an entrepreneur contemplating the number of machines of

Fig. 2 Marginal efﬁciency of capital (MEC) schedule

M* Demand for Money

Fig. 3 Liquidity preference schedule

3 The IS-LM Synthesis

Immediately following the publication of the General Theory, a number of younger

3.1 Hicks’ IS-LM Synthesis

where N is the total employment in the economy.

If we add a government sector and let G denote the value of government

Investment is assumed to depend on the market rate of interest. Thus

The money supply is assumed ﬁxed by the monetary authority

I ¼ S or hðr Þ ¼ sðr; Y Þ ð18Þ

Lastly, the money market will be in equilibrium if

Fig. 4 IS-LM framework Rate of LM

3.2 Keynes and the IS-LM Analysis

Fig. 5 a Neoclassical special case. b The Keynesian special case

Y ¼ C þ I ¼ uðY; gÞ þ hðr; gÞ ð23Þ

The close resemblance between Hicks’ formalization of the Keynesian system

4.1 Real Balance Effect and Wage Flexibility

Fig. 6 Real balance effect (Pigou–Patinkin): effects of a fall in money wages

4.2 The Phillips Curve

The Phillips Curve

Fig. 7 Phillips’ curve

Thus, the rate of change of money wages is positively related to the

Demand for labour Ld ¼ E þ v ð29Þ

Supply of labour Ls ¼ E þ z þ u ð30Þ

u ¼ 0; and v ¼ z. This would mean that the unemployment rate

where p is the rate of price inflation of that industry.

4.3 Keynes and General Equilibrium

Most of the mainstream macroeconomic research in the decades following the

Bðe; Y Þ þ F ½ðr dÞ r ¼ 0 ð40Þ

pðcorporate profitsÞ ¼ I þ D ½Hs þ GS ðA3Þ

TR ¼ PY ¼ ðACÞY þ ½ðI þ DÞ ðHs þ GS Þ ¼ TC þ ½I ðHs þ GS Þ ðA5Þ

pe ðtÞ ¼ a1 pðt 1Þ þ a2 pðt 2Þ þ þ ap pðt pÞ ð15Þ

p pe ¼ aðU U Þ with a [ 0 ð16Þ