ONE of the few redeeming consequences of the present global financial crisis has been that it has re-kindled the debate on macro-economic issues which had long been tabooed in developing countries, especially Pakistan.

The macro-economic orthodoxy promoted by the IMF and the lingering influence of the Washington Consensus have continued to hold sway in the policy corridors, as well as among research and academic institutions.

Now that the developed countries, including the United States, have discovered that the reliance on the market’s self-correcting ability in face of large fluctuations and misallocations can hardly be treated as axiomatic and that the state needs to intervene whenever there arise significant discrepancies between social and private returns, the fallacies of the IMF-World Bank’s old recipes has become even more obvious.

The paradigm change taking place in macroeconomic management policies in developed countries in the wake of the financial crisis in the US since last fall, is truly remarkable. Not only have some of the most glittering icons of modern capitalism from Bear Sterns and Lehman Brothers to the latest securities scam of a $50 billion Ponzi scheme by Bernard Madoff Investment Securites (BMIS), fallen like nine pins, but the state has been asked to step in to pour in billions of dollars to save collapsing banks and industrial giants, like GM, Ford and Chrysler.

Even this may not be sufficient to save the US economy from the worst depression since the 1930s, unless the neo-classical belief in market infallibility and abhorrence for state intervention are abandoned.

One of the main architects of the current global economic crisis, Alan Greenspan, the Federal Reserve Board Chairman, who presided over the birth of two and demise of one financial bubbles during his 12-year reign, openly admitted last October, to his considerable regret, that he had ‘discovered a flaw in the model’ of liberalisation and self-regulation and ‘made a mistake in presuming that the self-interest of organisations, specifically banks’ would protect ‘shareholders and equity in the firms’.

A return to Keynesian economics – which was all but discarded not only as a policy instrument, but denigrated as a theoretical construct – university reading lists explicitly excluded references to Keynes’ writings in macroeconomic courses – now is becoming fashionable and everyone is claiming we are all Keynesians now (some go as far as saying “we are all Marxians now”).

Keynes was a firm believer in the role of government intervention and disputed the market’s ability to self-correct itself. According to him “to suppose [as the conventional wisdom does] that there exists some smoothly functioning automatic [free market] mechanism of adjustment which preserves equilibrium if only we trust to methods of laissez-faire is a doctrinaire delusion which disregards the lessons of historical experience without having behind it the support of sound theory”.

Keynes held the view that financial markets are not self-correcting in troubled times and argued that if an economy was operating at less than full employment, then the nation’s central bank, while maintaining the stability of financial markets, should focus on providing all the liquidity that the economy can absorb in order to reach full employment. Keynes was, however, skeptical about the effectiveness of monetary policy in case of a severe downturn, when the economy gets stuck in a liquidity trap – signifying the inability of monetary authorities to induce an increase in the supply of credit in order to raise the level of economic activity. When the recession is mild, monetary policy instruments work and central bank rate-cutting helps to raise output and employment, but when the problems are more systemic – as in the present crisis – they become almost redundant.

In such circumstances, fiscal policy is the more effective instrument. But not all fiscal policies are equally effective. In the US and other developed countries, the more frequently used fiscal instrument in the post war years has been a tax cut for stimulating consumer expenditure. With an overhang of household debt – both mortgage and credit-card related – along with high uncertainty, tax cuts are likely to be ineffective (as they were in Japan in the 1990s). Last February’s US tax cut failed to make any significant impact on economic activity or stave off the oncoming recession.

A salient feature of the recent financial crisis has been that it has been led by the unusually high growth of the financial sector and that the economy has been highly leveraged by debt creation. Although credit has played an increasingly important role in the past crises, such as those of the Great Depression, the savings and loans crisis of the 1980s and after the dotcom bust the late 2001, it has played a much larger role in the present crisis.

The wealth and income gains from the easy and unregulated availability of credit were highly concentrated in the financial sector, which accounted for 40 percent of American corporate profits in 2006, and also partly contributed to the doubling of the share of income going to the top one per cent of the population.

Even more significantly, the credit intensity of gross domestic product, or the amount of credit required per $1 of GDP growth, which had remained at about $1.50 for decades after 1950, eventually rose in the 1980s, peaking at $3 during the 1990s. The credit machine went into top gear during the sub prime credit explosion and by 2007, nearly $4.50 of credit was being generated per $1 of GDP growth.

Fuelled by the euphoria about financial liberalisation (read deregulation and lifting of capital controls), the financial sector assumed an unprecedented ascendance in the economy.

Hyman Minsky, whose work on financial instability has won belated and reluctant recognition from mainstream economists, has highlighted the relationship between unregulated credit expansion and the chronic instability of the capitalist system.

Essentially, Minsky builds his analysis around the Ponzi scheme and shows how financial firms attract investment by promising unrealistic returns, which ultimately leads to their defaulting on their contracts, triggered by a change in economic conditions or a loss of confidence in the firms’ ability to pay.

Minsky shows that there is systemic instability in a developed capitalist economy because of the increasing fragility of their liability structure over the duration of a boom. The fragility results from an increase in payment commitments relative to gross profits due to a gradual increase in debt financing, especially short-term debt financing. Increased fragility of individual firms implies that the economy as a whole becomes financially unstable as well, increasing its vulnerability to a financial crisis.

Financial crises, then, are endogenous, not exogenous, to a developed capitalist economy. Minsky’s hypothesis of an inherent instability in the capitalist system is different from the Marxian instability hypothesis, which is based on the class contradictions in the capitalist system. An important corollary of the Myinsky hypothesis is that stabilisation efforts are bound to fail if the underlying cause of instability – indiscriminate private credit creation is not addressed.

With the unraveling of the financial melt-down in the US and the prospect of a recession comparable to the Great Depression of 1930s becoming ever more probable, President-elect Obama’s economic team has been busy putting together a massive stimulus package, comparable in scope to President Roosevelt’s New Deal. Economies world-wide have launched large fiscal stimulus packages to prevent a global recession. China has announced a package of $586 billion over the next two years – spending about seven per cent of GDP each year on infrastructure and other projects.

India and Pakistan, however, have been much more timid. India has announced a fiscal stimulus package of $4 billion, while Pakistan has decided to curtail development spending by more than $1 billion, as part of the recently-signed agreement with the IMF.

However, even traditionally neo-liberal economists in India,like Surjit Bhalla, are arguing for a more vigorous stimulus package. Pakistani macroeconomic policies, however, remain heavily constrained by the IMF agreement.

The fear of red ink is more pervasive in Pakistan as a result of the profligacy and corruption in the disbursement of public expenditures.

However, this needs to be controlled through proper accountability procedures. The development baby does not have to be thrown out with the bath water the corruption and mismanagement.

Dr Hafiz Pasha’s Panel of Economists seems to be erring on the side of over caution and extreme prudence and submission to the IMF orthodoxy in its emphasis on fiscal responsibility and reducing development expenditure to lower the fiscal deficit.

Pakistan’s development process has suffered greatly in the past few decades by insufficient development expenditures on public infrastructures and human development, which is the only sustainable way of alleviating poverty and reducing social inequalities. This can be done not through fiscal prudence but through aggressive public spending which would promote employment expansion and improve human resource development.

One of the top priorities in this regard should be the strengthening of the public educational system to end the present glaring disparity in standards with the private institutions, which does not receive much attention in the Panel’s recommendations.