Financial Instability – Is it actually instable!!? -article by Raka De (2nd prize winner of Ecosynthes)

The world economic outlook has been shadowed by rising debt problems in the Euro region and with the contagion expected to affect the other PIIGS nations as well.  There are also concerns about United States’ unsustainable fiscal deficits, which is one of the greatest challenges it faces. The US’ problems have been further aggravated with the unresolved debate on debt-ceiling creating an impression of US’ default on public debt. Back home, the Indian economy grew by 8.5% in FY2011, which is lower than expected but better than the global growth standards. In the backdrop of higher inflationary pressures in the system, RBI continued its monetary tightening measures because of the high domestic inflation which is much above the comfort zone. It increased the repo rate & reverse repo for the 12th time in the last 1.5 years by 25 bps to 8.25% & 7.25% respectively, and has left the doors open for another possible hike of 25bps by the end of FY2012. Other emerging economies such as China and Brazil have also been battling inflation for the past one year.

The financial crises are generally blamed on inefficient banking system, financial deregulation, crony capitalism and others. While all of these elements may be true, the recent preceding and current financial instability overlooks its fundamental reasons. They lie in the distribution of income across individuals and social classes. Deregulation, just intensified the crisis. Of the many origins of the global crisis, one that has received comparatively little attention is income inequality. Attention has to be paid to the impact of inequality on the likelihood of crises. The linkage between income inequality, high and growing debt leverage, financial fragility, and ultimately financial crises, cannot be overlooked. Borrowing and higher debt leverage appears to have helped the poor and the middle-class to cope with the erosion of their relative income position by borrowing to maintain higher living standards. Meanwhile, the rich accumulated more and more assets and in particular invested in assets backed by loans to the poor and the middle class. The consequence of having a lower increase in consumption inequality compared to income inequality has therefore been a higher wealth inequality. As borrowers’ debt leverage increases, the economy becomes gradually more vulnerable to the risk of financial crises.

The historical divide

Recent reports and studies on income distribution in many countries have pointed to stagnating or declining wages, growing rural-urban income differentials, increasing Gini coefficients and other indicators of worsening income disparities. At the same time, discussions are full on the need to provide a decent living for the poor segments of society. In recent years, we have seen new policies and projects targeting income inequality. These include minimum wages policies, cash transfers to poor families, public works for basic employment, micro credit schemes for micro enterprises and others. The justice based criticism on widening of income disparities is joined by macro-economic arguments calling for a new growth model.

Traditionally, many economists have taken an optimistic view concerning the future of global income inequality. A pattern of faster growth in poorer countries is predicted by the traditional Solow growth model. According to elaborations of that theory, a given increase in the manufactured capital stock should lead to a greater increase in output in a country that is capital-poor than in a country that is already capital-rich. Therefore, some economists have reasoned, it is just a matter of time until “less developed” countries catch up with the countries that have already “developed”. The idea that poorer countries or regions are on a path to “catch up” is often referred to as convergence. Describing low-income countries as “developing” assumes that they are on a one-way path towards greater industrialisation, labour productivity, and integration into the global economy.

So, is it right to say that “developing” countries are, in general, catching up with the “developed” countries? A number of studies of GDP per capita growth rates have concluded that lower-income countries are catching up to higher-income countries. However, this has largely been due to the strong growth rates experienced by the very populous countries of China (categorized as a middle-income nation) and India (a low-income nation). Because these two countries have such large populations, they have a disproportionate influence on the average growth rates for low- and middle-income nations. If, on the other hand, we count each country equally, the results suggest that convergence is not occurring in the majority of developing countries. In fact, if we count each country equally the average annual growth rate of real GDP per capita (PPP) over the last decade was 4.8% in the low-income nations, 7.2% in the middle-income nations, and 2.8% in the high-income nations – suggesting further divergence rather than convergence.

Capital Controls

Capital flows never come in at the exact time or in the precise quantity the economists and financial sector wants. Although, there are no immediate imbalances that threaten growth in India, on a contrary of having the only areas of concern are inflationary risks and supply-side constraints.

Concerns about excessive capital flows into emerging markets have recently been more acute as a result of new US attempts to avoid deflation through aggressive monetary expansion, while the emerging markets have already been living with these problems since the last recession. The capital flowing out of emerging markets supplied the initial impetus to the financial crisis, but the flawed institutions and incompetent regulators aggravated and catalysed the issue. Speculative capital flows simply increase the risks of policy mistakes. The US, of course, is betting that prudent management of these risks is going to favour policies that would help unwind imbalances in the world economy and allow the American economy to de-leverage without having to fall into deflation or recession over and over again.

For India, the short-term surge of capital flows is an opportunity as well as a potential threat. From a longer term perspective, purchases of Indian shares by international institutional investors are uniquely important for the Indian economy. Equity capital flows into the country are already constrained by percentage limits on ownership in industries like banks and media, and by the relatively small free float of the Indian stock market. Foreign borrowing by the Indian companies, always the riskier option vis-a-vis equity flows, is still effectively controlled and capital controls are and will be imposed for the sake of financial stability.

Areas of Concern

Two years into the official recovery, some things about the great recession are well known. Many other vital facts and contours are only beginning to emerge. A very distressing, on-going feature of the downturn is the havoc it is wreaking on the young – a mancession.  A lesser well known fact is that the recession continues to debilitate younger working populous of the countries. Employment, home ownership, and wage increases are bypassing the youth.  The combinatio­n of high operating costs due to taxes, restrictiv­e regulation­s, and government mandated charges are raising the entry cost to hire and acquire an additional unit of labour. The result is less employment­. The minimum wage, a noble effort to increase the living standards of workers, has done the opposite by pricing the unskilled youth out of those jobs with low marginal value, producing higher unemployme­nt, and not less. 88% of those people on minimum wage have no college degree, implying that a lack of education is reducing the labour-force to its lowest-and­-worst use.

Future economic stability and growth depends on putting people to work and raising labour productivi­ty. The higher productivi­ty will raise the GDP per capita, thus ensuring higher tax collections, without causing adverse implications on the standard of living. After raising taxes, loopholes in income and corporate taxes, will move significant amounts of capital away from commodities, options, futures, derivatives and into emerging markets that are  to be looked forward to by the end of this decade.

World Economics

The latest Global Economic Prospects report, projects that global real GDP growth (in 2005 U.S. dollar terms) will moderate to 3.3% in 2011, after a strong 3.9% rebound in 2010 that was led by 7% gains in developing countries. Looking ahead, developing countries are projected to continue outpacing high income countries through 2012. A recovery in foreign capital inflows supported the rebound in developing countries, but flows were highly concentrated among a small subset of larger middle-income countries with deep financial markets. And left unchecked, excessive flows can lead to destabilizing asset bubbles and abrupt currency valuation swings that can do lasting damage to economies. Annual double-digit price increases for food price inflation is pressuring low-income households. And if global food prices continue to increase, a repeat of the conditions of the 2008 “food crisis” cannot be ruled out.

Over the past 30 years the globalised economy has been predicated on unending expansion, and many argue that the resulting wealth is in fact illusory. Whilst economic expansion remains the goal of a growth-based economy, inflation – its antithesis – is paradoxically an inevitable consequence of economic growth.  The battle to keep inflation low has become a major preoccupation for governments the world over.


The debate on global imbalances in the world economy and the need for reducing current account surplus and deficits has linked the controversy on income inequality within societies into a macro-economic perspective. In some countries, increasing current account surplus are linked to declining real wages and less social welfare benefits. In order to push for a more balanced growth, increases in the wage level and expenses in social security may be one of the ways forward.

As financial instability plays out on the world stage, it is likely to become increasingly apparent that a stable and more equitable system of finance must be a key feature of a sustainable future economy. The role of money should be overhauled so that it works to facilitate the global exchange of goods and services without unduly rewarding those private interests which control it. A small tax on financial speculation, would go a long way to reducing the damaging effects of short-term speculation whilst simultaneously creating a fund which can be used for any number of humanitarian purposes.

A further suggestion would be to limit the type and quantity of resources which are traded and speculated upon in financial markets. If essential resources such as oil and gas, and basic agricultural produce such as rice and wheat, are produced not primarily for profit but to ensure that basic needs are secured around the world, then the market speculation and price fluctuations of these essential resources would be significantly reduced, imparting a particular benefit to those in the developing world.

Author details

Raka De

Name of the Institute  :  International Management Institute

Course                         :  Post Graduate Diploma in Management (PGDM)

Year                            :  2nd Year


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