INTER PLANETARY ECONOMICS THE MELTDOWN AND BEYOND a popular exposition

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INTER-PLANETARY ECONOMICS:
THE MELTDOWN AND BEYOND
A Popular Exposition

C. T. Kurien

Vikas Adhyayan Kendra


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Inter-Planetary Economics: The Meltdown & Beyond

Vikas Adhyayan Kendra (VAK) established in 1981, is a secular
Voluntary Organisation engaged in the study and research of
contemporary social issues. Geographically, VAK’s activities
are oritented towards Western India, viz, Maharashtra,
Gujarat & Goa.

Inter-Planetary Economics :
The Meltdown and Beyond
A Popular Exposition
C. T. Kurien
Edition: August 2009

Cover Design: Priya Kurien

Published by

Vikas Adhyan Kendra
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Malad West, Mumbai 400 064
Ph: 2882 28 50/2889 86 62
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Cell: 988620 3256


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Preface

This write up was taken up at the suggestion of members
of the family – my wife, daughter and brother – that I should
make the complexities of the global meltdown intelligible
to them. The draft that they found helpful was circulated
over e-mail to other members of the family and a few close
friends, none of them with special knowledge in finance or
economics. To my surprise all of them found it intelligible
and some offered comments also. They felt too that the
material should be made available to a wider readership.
Since I had virtually retired from active academic life almost
a decade ago and had paid only casual attention to the
plethora of writings on the topic, I deemed it necessary to

get critical professional opinion on what I had written.
Hence a modified and slightly polished version was
circulated to about a dozen of my former professional
colleagues who are still active in research, teaching and
writing. Practically all of them responded immediately and
enthusiastically with valuable suggestions urging me to
place the material in the public domain at the earliest. The
text has been further revised in the light of the comments
received.
I am grateful to all of them, members of the family and
friends, for their comments and encouragement; but I am
solely responsible for the piece as it appears now.
When the piece was under circulation over e-mail, I
had suggested to the recipients that they should feel free to
forward it on to any one they thought would be interested
in it. In that process it reached Ajit Muricken with whom I
had contacts some years ago, but had not been in touch for
a while. He immediately called me and asked for permission


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Inter-Planetary Economics: The Meltdown & Beyond

to have the piece brought out as a Vikas Adhyayan Kendra
publication. I am grateful to him for his support.
The cover was designed by my daughter, Priya and I am
deeply indebted to her for it and for being my mentor on all
technical matters.
– C. T. Kurien

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I. The Two Planets

There is a striking passage in the early pages of Niall
Ferguson’s recent book, The Ascent of Money: A Financial
History of the World: “In 2006 the measured economic output
of the entire world was around $47 trillion. The total market
capitalization of the world’s stock markets was $51 trillion, 10
percent larger. The total value of domestic and international
bonds was $68 trillion, 50 percent larger. The amount of
derivatives outstanding was $473 trillion, more than ten times
larger”. Stocks (or shares), of course, are claims to wealth,
and bonds are widely known as debt instruments. Derivatives
may be less familiar although they are widely used and
discussed in financial circles. As the word itself suggests it is
something derived from another word or object. To begin
with, we may note that within the realm of finance a derivative
is a financial instrument derived from another and underlying
instrument such as a debt. Briefly, then, what Ferguson says
is that we have reached a situation where finance is clearly
dominating what is often referred to as the “real economy”
which produces the tangible goods of everyday life and the
services associated with their production. Ferguson puts it
more picturesquely. “Planet Finance is beginning to dwarf
Planet Earth”, he says. The figures given above will make better
sense now.
When Ferguson was writing his book (it was published in

2008) Planet Finance was rapidly expanding at a rate much
higher than that of Planet Earth. “The volume of derivatives
… has grown even faster” he says, “so that by the end of 2007
the notional value of all ‘over-the-counter’ derivatives … was
just under $600 trillion. Before the 1980s such things were
virtually unknown”. If international currency exchanges are


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Inter-Planetary Economics: The Meltdown & Beyond

also brought into Planet Finance, they increased from $500
billion per day in 1990 to $1500 billion in 1998 and to a
whopping $3.2 trillion in 2007. Indeed, in those heady days
of Planet Finance, reports about it, especially its innovation,
expansion and achievements were greatly overshadowing the
rather slow moving and, at any rate, the older and less
fascinating Planet Earth. It was as though Planet Finance had
its own and somewhat mystifying laws of motion which were
far beyond the grasp of the uninitiated.
Then suddenly in the last quarter of 2008 there were
signs of panic in Planet Finance – some of its major parts
collapsed; resuscitation attempts became visible; and there
was a crash! It is part of the prevailing confusion that the crash
is also referred to as “the meltdown”. But even those who do
not know what has happened recognize that the glamour is
gone. The mood now is one of depression.
Major Issues
In this context there are many things that call for

explanation. The most obvious is the spectacular rise of Planet
Finance in the few years immediately preceding 2008 and its
sudden collapse in the last quarter of that year, as noted above.
Equally important to consider is whether some kind of revival
is likely, and if so when. More important is whether Planet
Finance and Planet Earth are independent of each other, and if
that is not the case, what is the nature of interdependence
between the two. And third, since these entities are “planets”
only as metaphor, how are they related to the realities that we
all know and experience? In particular, how are they related
to other realities that we deal with, administration and
governments in our country and globally?
This article deals with these issues, not necessarily in the
order mentioned above, but in such a way that any interested
reader will be able to follow it. No professional training in
economics or finance is expected of the reader.


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II. The Banking System and Credit

By way of background it may be useful to have an
understanding of banks and related institutions in the working
of a modern economy. A bank is an intermediary between
those who wish to deposit their funds with it and those who
are eager to borrow funds (credit). Credit is required because
there is a time lag between what is needed now and the ability
to repay later or over time. Hence what credit does is to link
the present and the future: indeed, because what is lent

now was generated earlier, credit links the past, present
and future. Providing this temporal connection is crucial
for the smooth functioning of a modern economy.
But if there are many who have funds to lend and many
who are eager to borrow why do they not establish contacts
directly instead of going through an intermediary? At least for
three reasons. The first is that an individual or any other unit
that has funds to lend may not know the person or unit who
requires credit and vice versa. An intermediary connects
those who have funds and those who require credit. We may
think of a bank also as an institution that pools information
about lenders and borrowers and makes it available to those
who need such information. Actually, the bank pools
borrowings from large numbers of lenders (that’s why it is a
bank) so that the borrower does not have to know anything
about individual lenders and lenders won’t know who is
borrowing their funds. The bank as an intermediary, thus,
performs the important task of gathering and
processing information and that plays a major role in the
effective functioning of an economy.
The bank plays a second and more important role.
Lending of funds to a strange or even a well-known borrower


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Inter-Planetary Economics: The Meltdown & Beyond

is a risky thing to do: you may never get back what is yours!
The bank may also lose funds that it lends, but there is a sort of

safety in numbers. What you do when you lend to the bank,
the intermediary, rather than to an individual borrower, is to
reduce risk considerably. Of course, you are taking the risk
that the bank may fail, but if you are into the business of taking
risks you know that you are calculating probabilities, and you
know from experience that a bank failing is less likely than an
individual borrower disappearing or going bankrupt.
Thus information (gathering) and processing and risk
reducing are the crucial functions of a bank as an intermediary.
The Bank provides these valuable services not free of cost, but
for a consideration. The bank pays you (a specified rate of
interest) for the deposit you make (usually a higher rate for a
longer period of deposit). The bank charges a higher rate of
interest to those who borrow from it. The margin between the
lending rate and the deposit rate is (part of) the earnings of the
bank for the services it renders.
We may note also that when there are several banks they
come to have additional roles and powers that individual
banks may not have. The banking system as a whole can create
credit; you leave your money with the bank trusting that it
will be safe and sure that you will earn something by way of
interest; the bank knows that you will not withdraw your
money immediately and lends it for a while to those who can
use it. A group of banks or the banking system as a whole can
generate more credit than a single bank can do. For these and
other reasons banks come under regulations from higher
authorities, usually from a central bank (the Reserve Bank of
India in our case) which is an independent body, but finally
responsible to the government.
Features of Intermediation

An economic system characterised by intermediaries or
the role of intermediation has some characteristics which we
must note. If an important function of an intermediary is to
gather and process information, it becomes an information


The Banking System and Credit

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specialist in selected spheres. A bank is a specialist on credit
just as a real estate broker is a specialist on matters relating to
that market. Where intermediation is general, therefore, one
must expect information asymmetry, and not a uniform
spread of information as is usually assumed by some widely
touted economic theories.
A second feature of intermediation is closely related. An
intermediary who is a specialist in some areas tends to use it
for his own advantage. After all, he too is an economic agent!
And, if distorting information is to his advantage why expect
him not to use it to his benefit? This common sense
understanding of the behaviour of an economic agent goes
under the name of Agency Problem in technical literature
which states that an agent may (usually does) become more
concerned with his own interest rather than the interest of the
principal whom he is supposed to be representing. We shall
soon see how this agency problem plays a role in an
understanding of Planet Finance.
Third, intermediation has a tendency to proliferate. We
noted that by resorting to the intermediation of a bank the

depositor reduces risk. The bank must find ways of reducing
its risk of lending. One thing it can do is to turn to an insurance
agency to cover the risk, of course for a payment. So another
intermediary emerges. A second possibility for a bank (usually
a big one) is to repackage the debt instruments it holds
according to differences in the rate of interest, the date of
maturity, risk profile and pass on the repackaged “products”
to other agencies. Agencies twice or more removed from the
original principals come to the scene handling new financial
instruments – “derivatives” – thus contributing to the glamour
and rapid expansion of Planet Finance. In the next section we
shall trace how such changes actually happened, particularly
in the USA.


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Inter-Planetary Economics: The Meltdown & Beyond

III. The American Scenario

The last two decades of the past century saw many
changes in the credit and banking systems in the US, and many
other parts of the world. We shall concentrate on the changes
themselves, not much on the why and the how. One major
factor responsible for the changes was the large surplus that
petroleum producing countries came to have following the oil
price rise of 1973. Although the US dollar then was not as
strong as it was in the immediate post-Second World War
decades, it was still the international currency, readily

convertible to any other in the world. Hence those who had
large surpluses preferred to park them in US banks (as also the
financial instruments of the US government). US banks,
therefore, became flush with funds and were willing and eager to
expand credit and make it available to those who required it.
The lending and borrowing spree of the early 1980s led to severe
debt crisis for several poor countries, especially African countries
towards the end of the decade. Credit expansion led to new credit
instruments and institutions. Since they have a bearing on the
meltdown we are concerned with, let us try to understand the
credit growth phenomenon and related issues.
When a bank makes credit available to a person or any other
economic entity, it is done on the basis of a collateral. Usually
the collateral is some tangible asset like land or buildings. The
title of the asset concerned is passed to the bank which ensures
that it is not sold till the loan is repaid. Banks assist in the purchase
of assets from third parties by paying that party and recovering
the payment in instalments over time. The borrower’s ability to
repay is ensured by providing proof of the ability to pay by way
of a salary certificate, for instance. Banks also accept non-tangible
assets such as shares as collateral for credit, although since the


The American Scenario

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value of shares fluctuates, the risk involved is likely to be greater.
The point to note is that the lending bank will usually have
collaterals of various kinds that considerably differ in terms of

their nature, payment schedules and risks. The bank can
repackage these collaterals and pass them on if there are other
agencies willing to take them over. Thus, when credit expands
and collaterals increase, a new secondary credit market for
collaterals emerges with new purchasers who then can become
sellers if there are other buyers. In other words, a new financial
“product” would become available as long as there was demand,
and there would be demand as long as entering into the market
was considered profitable. Since “production” in this case was
almost costless, it was a demand-generated phenomenon where
differing perceptions about risks and profitability were the sole
considerations. The generic name for these newly engineered
synthetic financial instruments is collateralized debt
obligations (CDO) and soon there emerged CDOs, CDO2,
CDO 3, each variety being a further step removed from the
original lenders and borrowers of Planet Earth. Since branding
became unavoidable even for these “products” new ones
started appearing such as Collateralized Loan Obligations
(CLO), Collateralized Mortgage Obligations (CMO),
Collateralized Mortgaged-Backed Securities (CMBS) and so on
indicating proliferation and the standard productdifferentiation. The process was facilitated by breakthroughs
in desktop computing and the entry of a group of highly
qualified academics into the realm of finance who could
rearrange asset classes depending on even slight differences
in the stock prices of companies or of the rate of interest. Planet
Finance appeared to be emerging as a separate entity with a
law of motion of its own, moving up and up as creating paper
assets was an easy task and virtual assets even easier. It was
not only business concerns that were involved with these new
forms of assets. As recently as the mid 1980s, 75 per cent of

household savings in the US was in the form of savings accounts
or fixed-interest securities; by the end of the 1990s the position
changed substantially with about the same per cent chasing
high profit, though risky, paper assets around the globe.


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Inter-Planetary Economics: The Meltdown & Beyond

The process also meant that a penumbra of agencies was
emerging around the banking system, the most prominent and
powerful among them being “hedge funds”. Hedge funds are
essentially private partnerships with each partner contributing
usually upward of $1 billion. They specialize in dealing with
high risk financial instruments or securities as their funds
enable them to take up greater risk for higher payments. The
most widely known among them was Long Term Capital
Management (LTCM) founded in 1993, famous then because
its core members included two economists who had won the
Nobel Prize in the subject for their contributions to the
understanding and treatment of risk. It collapsed by 1998
because its management of risk proved to be a failure!
Intervention by the government gave it a new lease of life.
There are other hedge funds also that have continued, because
as they are huge and influential, they can raise loans way
beyond their capital base, the process referred to as leveraging.
Without going into the processes involved, it may just be
pointed out that at one stage LTCM controlled $125 trillion in
derivatives on a capital base of just around $5 billion.

New Financial Architecture(NFA)
Now, if they are big risky enterprises, there will have to
be insurance companies to insure them against risk, agencies
that specialize in assessing risks, credit rating agencies and so
on. Demand created its own supply and many agencies of this
kind emerged in the 1980s and 1990s and there were frequent
references to America’s new financial architecture (NFA).
But note that though many of them were engaged in the
banking function of creating and administering credit
(enterprises that simply packaged loans into securities and
made them available styled themselves as investment banks,
though they were neither banks nor did any investing) they
did not come under the formal regulatory regime that banks
had to subject themselves to. Hence it may be appropriate to
refer to them as “shadow banks”. The scene was dominated
by huge and powerful private bodies, well-known corporations
such as Lehman Brothers, Goldman Sachs, Merrill Lynch, not


The American Scenario

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accountable to any external agency or to the public at large.
This state of affairs was justified on the belief that “the Market”
would discipline them by rewarding those who performed
well with high profits and punishing those who did not. Belief
in the efficacy of the market was so entrenched that many
regulations that existed were withdrawn or ignored.
One more feature of the NFA deserves attention. Banks

that are subject to regulatory authorities have to submit their
audited statements of accounts and balance sheets to those
authorities and so financial auditors have a major role in
informing the management of the banks, their share-holders
and the regulatory authorities about the soundness of the
business that each bank does. The auditors are assumed to be
external agencies doing their professional job independently.
Over time the auditors had evolved a procedure to assess the
soundness of their clients. But the emergence of “shadow
banks” introduced many grey areas where it was not easy to
decide on the soundness of banking transactions and
investment operations. Auditors could be persuaded to go as
the bank wanted. From the point of view of the auditors, the
business was large, the fee substantial and the prestige
irresistible. They retained the façade of independence, but
for all practical purposes became business partners with their
clients. After all, auditing firms also had to show that their
profits were increasing so that their share prices would go up!
If this was the case with banks with some sense of public
accountability, it was not surprising that enterprises not
subject to regulations found it easy to persuade risk-rating
companies and auditors to go along with them. A risk-rating
firm, for instance, was not taking any risk by providing a
favourable opinion to a hedge fund, but was retaining good
business. Profit-making became the only objective for many
“independent” professional service firms. All was fair when
the going was good, but all would collapse when something
went wrong somewhere.

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IV. The Boom and the Bust

We can now move on to the recent boom and bust of
Planet Finance which originated in the United States, but
quickly spread to the rest of the world. The American
economy is quite used to booms and busts. Who hasn’t heard
of the Great Depression of 1929-32 which caused massive
unemployment and a fall of one third in the GDP of the
United States? Franklyn Roosevelt’s New Deal projects and
the stimulus received during the Second World War
succeeded in reviving the economy and put it on a high
growth path that lasted till the end of the 1960s. The 1970s
turned out to be turbulent and in the 1980s and 1990s there
were some ups and sharp downs. During the last few years
of the century there was the much celebrated dot-com boom
that led many to think that technology would provide
uninterrupted upward movement of the economy; but by
the turn of the century there was a crash! And the economy
was caught in a recession.
A standard way to fight recession is for the banking
system to bring down the rate of interest hoping that it
would encourage investment and thus revive the economy.
Reduction of the interest rate is signalled by the Federal
Reserve Board (commonly referred to as “the Fed” and in
terms of its role fairly similar to our Reserve Bank) and it
brought down its rate of lending to banks from 6.5 percent

to 3.5 percent within a span of a few months. The events of
9/11 (2001) led to further cuts and by 2003 the rate was
just 1.0 percent with inflation-adjusted short-term rate
actually turning out to be negative. What more incentive
must banks have to lend when there were many institutions
ready to purchase debt instruments from them? All that was


The Boom and the Bust

15

needed was to persuade someone to turn to the banks to
borrow. Who would that be?
The Real Estate Boom
No problem. In a country where “property owning
democracy” is something of a national creed, there would be
many willing and, indeed, eager to take a housing loan if the
terms appeared to be reasonable. With property developers
ready to make land, or if needs be even buildings available,
and salaried people and commercial concerns wanting land
and buildings, the real estate market would be the natural
sphere of activity for the banks. Banks would lend, but instead
of holding the loan in their books, they would package them
into CDOs and sell them to other agencies. They, in turn, would
pass them on also.
On the other side, as interest rates came down, the
demand for housing loans increased and construction
activity picked up leading to land prices going up and the
real estate market booming. Thus economic activity overall

received a stimulus, causing employment and incomes to
go up. As on all previous boom periods known in history,
there was a great deal of speculative trading (this time not
much in commodities but in financial papers) that yielded
huge profits. Those who had the institutional facilities to
play with other people’s money (OPM) made enormous
profits too. Share prices appeared to be steadily soaring
and dividends were increasing. Market activities appeared
to be bringing all round advantage and prosperity. Alan
Greenspan, the widely known and highly respected Chairman
of the Fed gave his enthusiastic encouragement to what he
called “a new paradigm of active credit management”. Of
2006 Forbes magazine proudly announced: “This is the
richest year ever in human history” as the number of
billionaires had risen 19 per cent to 946 over the previous
year’s 793 and their combined net worth climbed by $900
billions to $3.5 trillion, adding, “never before in human
history has there been such a notable advance”.


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Inter-Planetary Economics: The Meltdown & Beyond

In the meanwhile, rate of interest on housing loans started
coming down further as the banks were competing to secure
more business. Refinancing (or “refi”) schemes became
popular. Lower interest rates made it possible to borrow more
for the same monthly payment, pay off the old loan, and still
be left with an extra sum to go on a vacation or buy a new car.

Lower rates also enabled the more enterprising to go in for a
second house as a form of investment. Refis shot up from
around $15 billion in 1995 to nearly $250 billion a decade
later. It was all achievement and affluence, America!
Sub-prime Lending
Soon housing loans came to be at rates below the prime
mortgage rates of banks (sub-prime lending, also known as
teaser loans). For long banks continued to make careful
scrutiny of the economic credentials and repaying capacity
but the belief that land prices would only move upwards led to
light-documentation mortgages, the extreme form of it
came to be known as ninja loans – no income, no job, no
assets. Sub-prime lending which amounted to $145 billion in
2001 soared to $ 625 billion in 2005, accounting then for
some 20 per cent of the loans.
Some of the sub-prime mortgages were tricky in nature;
the low rates were applicable only for the first year with
interest rates gradually going up later making it difficult for
some borrowers to close the mortgages. Instances of
borrowers not being adequately informed about these
arrangements were not rare. Soon defaults became not
uncommon and by 2007 doubts were beginning to be
expressed about the sustainability of the real estate and
housing boom. By middle of that year it was public knowledge
that two mortgage hedge funds were in trouble. The problem
spread to CDOs linked to sub-prime mortgages which, in turn,
had its impact on some investment banks. By the fourth
quarter, well-known financial institutions like Citigroup,
Merrill Lynch, Lehman Brothers, UBS, and Bank of America
had to announce major write downs. The Fed and other official

The Boom and the Bust

17

agencies had to take note and attempt remedies, mainly making
available credit to institutions in need through the first half of
2008.
The Crash
The crash came in the second half of the year, mid
September with Lehman Brothers going bankrupt. Lehman
was one of the leading commercial paper makers. It was a
counterparty to many CDS contracts, and a prime broker
providing finance to hedge funds. But being outside the banking
system it could not get the support of the Fed or the US
Treasury. When Lehman became insolvent its clients also faced
difficulties. George Soros, the financier called the fall of Lehman
“the game changer” because it changed the complexion of the
crisis by introducing serious uncertainty about how things
would turn. Next to go under was AIG, the giant insurance
firm with global operations. To ward off further calamity there
were hectic attempts at mergers and buyouts. Merrill Lynch
was taken over by Bank of America. Panic was spreading and
spilled over immediately to the stock market. The credit
squeeze and the lay offs affected the households also, those
relying on credit cards in particular. The drastic reduction in
spending led to a deflation which soon turned into a recession.
Pension funds, endowed funds of universities, foundations,
religious organisations and many more were also impacted

losing anywhere between 20 and 40 percent of their assets
within a couple of months.
The government took a standoffish position in the early
stages partly because of the ideological consideration that the
market would correct itself, but also because there was strong
opposition to spending public money to save or support
private firms like Lehman. But the crisis and panic was so
intense that a wait and watch position was no longer tenable.
The Fed brought down its rate to close to zero. The Treasury
decided to pump in $700 billion to enable banks to lend more,
but on the assumption that the crisis was one of liquidity. The
real issue, however, was the insolvency of many big names as


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Inter-Planetary Economics: The Meltdown & Beyond

a result of profit-chasing recklessness. The failure to grasp the
distinction made public policy ineffective, if not counter
productive. By the end of 2008 Planet Finance and its NFA,
America’s great pride and success symbol was in shambles.
Planet Finance – Planet Earth Links
But it will be a mistake to think that the problems were
confined to Planet Finance. Planet Earth was also in doldrums.
The most widely reported was the upscale Chrysler Motor
Company going bankrupt. More recently General Motors (yes,
GM about which it used to be stated that what is good for GM is
good for America!) followed suit. And think of the millions
who lost their jobs and the thousands who had no choice

except to move out of their homes as they were in no position
to pay the instalments of their mortgages.
There was irony too which can be appreciated only from
a Planet Earth perspective. While all the merry-making was
going on in Planet Finance, down below inequalities of income
were sharply rising. Charles Morris points out that between
1980 and 2006 the top tenth of the population’s share of all
taxable income went up from 35 to 46 percent, an increase of
almost a third. What is even more striking was the disparity
within the top ten. Almost all of the top tenth’s share of gains
went to the top 1 percent who doubled its share from 9 to 20
percent; and the top tenth of that 1 percent tripled its share!
And not surprising either. Top executives of Planet Finance
firms were getting (more realistically, assigning themselves)
fabulous salaries, perquisites and bonuses not only when their
companies were doing well, but even at times of liquidation.
Even “doing well” was a matter of perception. According to a
well documented case, a private equity firm “created value”
of some $100 million by laying off workers and the two
partners gave themselves a bonus of $1 billion (no mistake
here) for their commendable performance! We see how the
problems associated with intermediation dealt with earlier,
particularly information asymmetry and agency problem
played a role in the rise and fall of Planet Finance.


The Boom and the Bust

19

In the light of this interaction between finance and the
“real” economy, it is necessary to consider whether they are
two distinct planets. If celestial finance impinges on terrestrial
housing so intensely, they must be closely connected. Though
“Planet Finance” and “Planet Earth” are useful metaphorical
descriptions up to a point, they are not, cannot be, separate
and independent entities, but only inter-related aspects of
national economies and the global economy. The role of
finance is to facilitate the functioning of the “real” economy
(another useful expression, but quite misleading if taken
literally, for finance is real too!). However, finance has the
tendency to assert its independence and to dominate the real
economy – a case of the facilitator becoming the boss. It is
also the manifestation of an in-built feature of the kind of
economic order we are dealing with that the few who control
finance - the most abstract and, in a sense the most “useless”
form of wealth - have power over the toil of the masses and the
savings of millions to further enrich themselves.


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Inter-Planetary Economics: The Meltdown & Beyond

V. The Global Dimension

Exclusive attention paid to the USA so far is not because
the problems in the financial sector – the emergence of the
shadow banking system, the proliferation of CDOs, sub-prime
lending etc – happened only there. America, of course led the

way. But the problems surfaced in various forms in other parts
of the world as well, in the UK, and many countries of Europe.
This is not surprising because many of the agencies involved
were already global operators and the global financial system
is controlled by a consortium of financial authorities from the
rich world. And not surprisingly too, the rest of the world had
a tendency to “follow the leader”.
For a more basic understanding of the meltdown we must
link together the global performance of finance with trade of
goods and services and the associated movement of trade
surpluses between nations. Such a treatment is necessary for
a better appreciation of global finance as well.
America Lives Beyond Its Means
Immediately after the Second World War, the US as
the leader of the Allies and about the only country in the
world whose economy had flourished because of the war
efforts, took upon itself the task of reviving and rebuilding
the “free world”, that is those countries that were not part
of the bloc led by the Soviet Union. The Marshall Plan of
transfer of capital from the US to Europe was one of the
measures. The second was the acceptance of the US dollar
as the universal reserve currency (the role that the British
pound played during the heyday of the Empire) as the US
had become the major supplier of the world and thus
practically every country was in need of dollars. Thus US


The Global Dimension

21

capital was moving out to the rest of the world and the dollar
was effectively the global currency.
Today’s world presents a different picture. The dollar
still retains much of its position, though Europe’s euro is
emerging as a serious contender. But the value of imports by
the US is far in excess of the value of its exports which makes it
a nation in debt to the rest of the world. Strange as it may
appear, for several years now the US has been at the top of the
list of countries in debt borrowing around $800 billion a year.
And how does it manage this situation? By other countries,
ironically China lending to it – the irony of a low income
country lending to a rich country or as one writer has
expressed it, communist China lending to capitalist America.
But the mechanics is simple: China exports a wide range of
goods to the US; it does not buy much from the US and thus
has a trade surplus; which it holds as dollars or bonds of the
US government as, for the present, the dollar is the strongest
and most stable currency precisely because China and many
other countries that have a trade surplus “lend” it to the US.
However strange as it may appear, this is one of the realities of
today’s world.
There is another and perhaps more revealing way of
expressing this. American people are living beyond their
means and manage to do so because people from other parts
of the world, with per capita incomes far below the US level
are continuously lending to it. Which means also that surpluses
from the rest of the world are first flowing into the US, enter
into the books of American banks, then going out as capital
flows to the rest of the world. To link this up with our main

story, credit expansion in the US is made possible by the rest
of the world and hence collapse of the credit system in the US
will have a bearing on other parts of the world also, China and
yes, India as well.
To trace these processes will be tiresome and we shall just
illustrate them. And to bring out the implications more
realistically we shall bring the exposition down to the level of the
people whose lives get affected. To begin with we shall examine


22

Inter-Planetary Economics: The Meltdown & Beyond

the US and China who are major partners in economic
relationships.
Impact on China and India
Once China decided to reverse its initial policy of pursuing
an internally driven growth pattern and opened up to the rest
of the world, exports became a significant share of its GDP,
now over 50 per cent. Exports accelerated after it became a
member of the World Trade Organization (WTO) in 2001 and
by 2003 China was Asia’s largest exporting country replacing
Japan and by 2005 the third largest in the world, next to USA
and Germany. By that year it was supplying a fifth of the USA’s
requirements of manufactured goods and had a trade surplus
of over $100 billion with that country, held largely in the form
of US Treasury bonds. Chinese exports into the US continued
to grow at around 20 percent for the next couple of years as
well.

Let us now turn to what happens when there is a
meltdown in the US, starting in the financial sector, but
spreading rapidly throughout the economy. Jobs are lost and
incomes come down. Goods imported from China and used in
the industrial sector get reduced. People’s spendings go down
and there is less demand for Chinese goods which had invaded
supermarkets – let us say, electronic goods and toys. Factories
producing these export goods in China are affected and workers
are laid off. Millions of Chinese workers from industrial towns
are forced to go back to their rural families. What started in
the posh cities and financial centres in the USA soon reach the
humble dwellings in far away China, and the meltdown has
become a worrisome global phenomenon adversely affecting
the lives of millions of people everywhere.
India has been affected too, but not as much as China
because our exposure to the rest of the world – whether in the
form of capital flows or trade – has not been as high as in the
case of China. When the early signs of trouble in the financial
sector in the US started appearing, there were those who
maintained that India (perhaps China too) could be


The Global Dimension

23

“decoupled” from such calamities because our economy was
essentially internally driven, finance did not play a dominating
role in our system unlike in the US, and our financial system
was thought to be adequately insulated from global finance.

But today it is openly admitted by economists, business
people, administrators, politicians and many more that our
economy has been adversely affected by external factors.
A brief examination of what has happened is worthwhile.
Though in overall terms the rate of growth of the Indian
economy has continued to be a respectable close to 6 percent
per annum, it still is a fall from the near 9 percent we had
achieved before the troubles started and the 10 percent that
we anticipated could be achieved. Our banking sector, on the
whole, still remains robust because of the dominance of the
public sector banks that have been forced to follow the effective
supervisory role of the Reserve Bank that prevented banks
from following adventurous paths. And although the Indian
economy’s total external transactions (value of exports and
imports plus gross capital flows) have increased from around
47 percent of GDP in 1997-98 to over 117 percent in 200708, we have not yet gone in for full convertibility of the rupee.
Hence, so far there has been no banking crisis or shake up in
the financial sector. Only our stock markets which are linked
to their counterparts in the rest of the world have crashed and
have become subject to volatility.
Capital flows into the country, on the other hand, have
declined especially those coming from foreign institutional
investors (FII). In fact, a reverse flow of funds from FIIs had
set in towards the close of 2007. (In this connection a major
difference between India and China may be noted. We relied
largely on financial flows from outside whereas China insisted
on foreign capital going into productive activities.) External
commercial borrowings have also declined. These two have
lowered the level of investment in the country and the growth
of the manufacturing sector has been adversely affected. Our

exports have declined too as Indian exports in which services
account for some 37 percent are very sensitive to levels of


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Inter-Planetary Economics: The Meltdown & Beyond

income in the Western countries. The domestic sectors
affected have been metals and metal products, textiles and
garments, automobiles, gems and jewellery and information
technology. Many business concerns have been affected, IT,
travel and tourism, hospitality and entertainment. Associated
with it has been loss of jobs for which there have been no firm
estimates mainly because close to 90 percent of the total
workforce in the country is in the unorganised sector about
which it is not easy to get clear information. But an official
survey sponsored by the government has estimated that about
1.5 million workers would be thrown out of work between
September 2008 and December 2009. Many consider this to
be a rather optimistic estimate.
Thus, the impact of the meltdown in India has been
largely on the real economy and on the lives of real people
from the lower sections in particular.