Rethink required on imitating the American model of development

Recent events show a failure of many of the model’s basic premises

The evolving crisis in the American financial system is only a symptom and the disease is more deep rooted.

The American model of development is itself in doubt. It is based on many important premises, some of them related to concepts such as “market is always right,” “lower taxation,” “trickledown effect,” the role of the “hidden hand,” issues of “moral hazard” and of course the greatness of “consumption driven society.” It is also stressed that prudential self-regulation will guide the affairs than prescriptive regulations.

The recent crisis has to a large extent shows the king without clothes. The way institutions are bailed out by the government makes us wonder about the role of “moral hazard”. The senior executives who are partly responsible have not been adequately punished, nor their retirement benefits confiscated. The low-saving American household has been rudely made to accept the reality that consumption cannot just be continued with multiple credit cards. The algo traders and swap insurers needed more prudent regulations. The regulator needed more knowledge of the products and the over-the-counter products actually needed more disclosure and clearing mechanisms. But these are symptoms. The basic malaise is deeper. Throughout the seventies and eighties, it was globalisation of product markets and manufacturing facilities.

The anecdotal evidence often told in many a business school classroom used to be something like this: The doors of the Ford car are made in Barcelona, the seat cushions near Budapest, gearbox in the suburbs of Paris, music system in Osaka and the assembly is done at Kula Lumpur, and the car is sold in Shanghai. So, what’s American about it? It is transnational and the geographical boundaries are crumbling. Think global and act local, we were told, and bringing in the term “glocal.”

This was the ultimate in the process of global integration of economic activities through integration of manufacturing facilities to reduce cost, take advantage of specialised skills and pool the resources available in the global market. It was to move manufacturing nearer to material centres or to markets. It also argued about “standardisation” of lifestyles - mostly the American standards - in terms of jeans, processed food and cola drinks; heated food became the in thing and not hot food.

The nineties saw the globalisation of financial markets. If you wanted to set up a facility in Mumbai, you could now think of raising funds from New York stock exchange if the project was attractive enough. Funds were looking for markets and “geographical diversification” became the buzzword. The correlations between stock indices of New York and Timbuktu were constructed to justify that low correlated Timbuktu offer good portfolio possibility along with New York since low or ideally negative correlation implies risk reduction. This whole development was initiated by the USA and sincerely followed by countries like India. It premised on the belief that free financial markets and flow of funds would facilitate faster growth.

Then came the idea of consumption-led growth and greed as the norm. On May 18, 1986, Ivan Boesky gave the commencement address at the University of California at Berkeley’s business school. “I think greed is healthy,” he told his enthusiastic audience. “You can be greedy and still feel good about yourself.” A few months later, Boesky was indicted on the charges that would land him in Southern California’s Lompoc Federal Prison, also known as Club Fed West. But greed continued to be the norm rather than the exception. The pure interest rate or the inter-temporal expectations became very large and waiting time became shorter and the so called “get rich quick” attitude took over. To achieve those aims domestic markets were not found to be adequate. Hence the search for “geographical allocation” wherein it was felt that risk should be reduced by spreading it across territories and across product lines. The more financial markets integrated, the less they became attractive for diversification since the correlations were becoming more positive. The earlier idea of geographical diversification is not working since events in New York are impacting Shanghai and Mumbai. Hence we need to closely re-look at the issue of integrated Financial Markets.
May be segmented markets with some tenuous ties might not have created such a global meltdown since contagion effect would have been lesser. Actually, the lower impact on India is to a large extent the lower integration of our markets with those of others, except through the FII and trade routes.

At the same time, the traditional notions of banks doing banking work and insurance companies doing insurance work, etc were thrown out to embrace universal institutions where anybody can do anything. Insurance companies were active in swap markets, banks in insurance and pension funds in stocks. It was argued that these reduce risks. But it was not so, as the problems of AIG reveal. Its problems did not arise out of insurance, but out of other financial derivative products. Our own private airlines are suffering since they have leased aircraft from a subsidiary of AIG and lease rentals have shot up since they are at floating rates linked to the London Inter Bank Offer Rate. Hence, there is a need to re-look at the universal banking idea.

The issue of trickledown effect seems to be an asymmetrical argument. When the going is good, it is expected to trickle down from business tycoons to the poor labourer. But when the going is tough, it is the poor labourer who is punished first. During bad times, suffering seems to be slowly trickling up. Actually, the senior executives and owner managers should take a huge cut in their pay packets before advocating “pruning” of human sources. Perhaps we should go for the Scandinavian model of high taxation and larger social security net since our business leaders have moved away from dharmic (the right course, as prescribed by religion) methods to asuric (pertaining to demons) ways. It is unimaginable that many of our business owners and executives are flaunting their wealth in an obscene fashion and suggesting tightening of belt to lower level employees.

We need to rethink on integrating our financial markets with global markets since their embrace can be that of vish-kanya (the mythical poison woman whose very touch was lethal). We should re-look at the universal banking model where the contagion could be more stressful. We must re-emphasise the importance of saving and welfare of families rather than just the rights of individuals and a possibility of government rescue. Executive remuneration should be within our own parameters and not based on the “greed is good” policy. If corporates refuse to see the point, then the government must step in to apply the brake. Overall, social stability and harmony are far more important than page-3 obscenities in our context.

The writer is professor of finance, Indian Institute of Management - Bangalore, and can be reached at vaidya@iimb.ernet.in. Views are personal.