Putting out forest and financial fires

Mains Paper 3: Economy
Prelims level: 2008 financial crisis
Mains level: Indian Economy and issues relating to planning, mobilization of resources, growth,
development and employment. Inclusive growth and issues arising from it

Context

•  The recent forest fires in California that killed more than 60 people, The Economist observed that one of the reasons that wild fires had become more frequent in the last several decades was that, before Western settlers arrived, fires used to happen naturally.
•  That had two advantages.
•  One was that such fires used to regenerate forests and, more importantly, they helped reduce the availability of fuel for future fires.
•  In the past century, settlers have tended to suppress fires leading to the “buildup of dry bush making the average wildfire much likelier to turn into a raging mega-fire.
•  Not only that, in the last few decades, more people have been allowed to build homes in spaces abutting nature.

Need to maintain economic stability

•  There are obvious parallels to financial markets and macroeconomics.
•  In the last three decades, central bankers, falsely attributing lengthy economic expansions to their apparent ability to tame consumer price inflation, have become more determined to avoid economic slowdowns or recessions.
•  They had begun to view them as indictments of their monetary policy prowess.
•  In this endeavour, political incumbents, financial investors and commentators have colluded.
•  Witness, for example, how President Donald Trump has made out the Federal Reserve as the villain of the piece, while candidate Trump was against the ‘low interest rate’ monetary policy and the speculative profits it conferred on the Wall Street.
•  Attempts to avoid economic slowdowns or recessions are similar to not allowing brush fires to happen.
•  Persisting with low interest rates even after the threat of recession has passed or well after a recession has ended is similar to allowing homes to be built in fire-prone areas.
•  Both are examples of excessive risk-taking as both make light of the dangers involved. In general, when humans interfere with or take liberties with natural laws, only grief follows.

 Analysing the crisis

•  Economic recessions are healthy in the sense that they clear excess inventory, stop the production of wrong goods and expose malinvestment.
•  They prepare the economic soil for the next upswing just as brush fires help regenerate forests.
•  Further, they temper excessive risk-taking by investors and businesses such that systemic risk never reaches dangerous levels in the upswing that follows.
•  Whereas persistence with low rates create bubbles in so many asset classes that is hard to keep track of, making it impossible to contain the fallout when they burst.
•  How do developers find the money to pay huge premiums to existing apartment owners to vacate?
•  They have kept interest rates low enough to persuade some of the developers to borrow in foreign currencies.
•  In its recent Financial Stability Report, the Monetary Authority of Singapore had warned of the risk of high levels of foreign currency borrowing in Singapore.
•  While these are two prominent and recent examples, numerous private equity funds and venture capital funds have had their returns flattered in the last decade by low interest rates.
•  Many companies around the world have borrowed money to make expensive acquisitions.
•  Servicing the debt will become onerous once business conditions turn sour and/or interest rates rise. When the tide withdraws, we will know the swimmers’ garb.
•  When these bubbles burst, they leave a lot of debris, some of which may not be cleared easily because some of them are social debris.
•  Wealth and income inequality, excessive drug usage and dependence, etc.
•  The central bankers may not be able to clean up after bubbles but they can lean against them.
•  That is why it is surprising and even disappointing to find an experienced investor like Stanley Drucken miller say that the Federal Reserve should wait and see what happens before tightening further.

Way forward

•  It will not be easy to raise interest rates once central bankers have got investors addicted to low rates.
•  However, persisting with it for fear of a market meltdown will make an eventually inevitable market correction and economic contraction all the more painful and prolonged.
•  There is no way this habit can be kicked without a painful de-addiction interlude. The Federal Reserve should continue to set off those brush fires and mini avalanches.

Online Coaching for UPSC PRE Exam

General Studies Pre. Cum Mains Study Materials

Prelims Questions:

Q.1) "Vulture funds" generally invest in
A. Upcoming start-ups in the sunrise sector
B. Institutions that promote organized crime
C. Distressed assets
D. Large cap segment of the stock markets

Answer: C

Mains Questions:
Q.1) It will not be easy to raise interest rates once central bankers have got investors addicted to low rates. Critically analyse the statement.