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Great minds speak as stocks bleed

Oct 23, 2008

Volcker's mantra for rebuilding the system
Paul Volcker, the former Chairman of the US Federal Reserve, is of the view that the US is in an 'unprecedented' financial crisis. And his mantra to repair the same - rebuild the banking system. Another noted economist, Joseph Stiglitz has opined that the economic downturn in the US is unlikely to be as bad as the Great Depression of the 1930s. However, he believes that this is likely to be long drawn and 'probably the worst in a quarter century'.

In a recent speech and as reported on Bloomberg, Volcker has said that moral hazard* is what he is most circumspect about. He says, "People will come to expect bailouts and take undo risk. People will assume they'll be protected in the future. I don't think regulation is the answer to all problems. It's important to come up with rules that won't make the government too intrusive."

* As defined on Wikipedia, "Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his or her car, because the negative consequences of automobile theft are (partially) borne by the insurance company."

In the meanwhile, the US Dow Jones Index closed yesterday with yet another record loss (of over 500 points). Fears of a worldwide recession caused the index to drop 700 points at one point in the trading session. Asian markets, taking cues from the US, are also trading deep in the red currently. Benchmark indices in Hong Kong, Japan and China are down 5%, 3% and 2% respectively.

Sovereign funds - Vehicle for financial bailout?
The International Monetary Fund (IMF), once a saviour to economies in distress, but then relegated to being an onlooker, is suddenly being called back into action. As the list of troubled countries grows, the list of places they can seek help has not.

The IMF is nearing agreements to make emergency loans to Iceland and Ukraine, and discussing aid packages with Pakistan and Hungary. Probably we would not like to forget that it was the IMF that came to India's rescue when we faced the currency crisis back in 1991. However back then, the conditions attached to the bailout were much stricter than those today. It is thus being debated whether the IMF is still the best recourse for bailout for economies where the government cannot fund the same.

The US and Western Europe are in the middle of their own costly financial bailouts. While huge sovereign wealth funds (SWFs) have sprung up in the Middle East and Asia (read China), economists say borrowing from them could prove more painful than borrowing from the IMF. The beleaguered Iceland, for example will borrow from the fund but also supplement that with packages from Russia, Norway and Japan.

The SWFs are government-owned funds set up by the world's leading exporters. Until now China, Japan and other exporting superpowers, along with the big oil exporters in the Persian Gulf, were content to keep most of their trillions of dollars of reserves in safe investments like bank deposits and US Treasury bonds. That is no longer the case.

Increasingly they are channeling investments into the private sectors of other countries to fetch a higher return. With their huge asset base, the government investors can afford to diversify and pursue riskier opportunities. These SWFs are therefore increasingly being approached to bailout distressed economies. However, given that their fundamental structure is not autonomous, unlike the IMF, there are risks attached to the same. Paul Volcker, the former Chairman of the US Federal Reserve, is of the view that the US is in an 'unprecedented' financial crisis. And his mantra to repair the same - rebuild the banking system. Another noted economist, Joseph Stiglitz has opined that the economic downturn in the US is unlikely to be as bad as the Great Depression of the 1930s. However, he believes that this is likely to be long drawn and 'probably the worst in a quarter century'.

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