A Revolution in Monetary Policy: Lessons in the Wake of the Global Financial Crisis

Introduction: This speech by Prof. Joseph E. Stiglitz was delivered at RBIs fifteenth C.D. Deshmukh Memorial lecture. Mr. Deshmukh was RBIs first governor who set the foundation for a culture that has made RBI as exemplary among the central banks of the world as it is today. Prof Stiglitz elaborates that the fact that RBI plays a role that goes much beyond a mere handling of finances came to light during the global economic crisis of 2008, which was largely caused by a failure of central banks in USA and Europe. This was mostly because of the mentality of its first governor, Mr. Deshmukh, who understood the importance of the states role in providing credit for the development of the nation. Through this lecture, Prof. Stiglitz wanted to explain his view of how central banks should function, especially in the aftermath of the 2008 global crisis. He says that the Global Economic crisis was just one of the examples that have led to the discovery of the flawed existing economic paradigms, which caused the failure of the world economy in the first place. Thereafter Prof. Joseph suggests 14 lessons for monetary policy that will help countries respond to economic crisis, especially since the world is on the verge of yet another recession. Stiglitz has deduced these measures from the great recession of 2008. They are: 1. Self regulation doesnt work: The first thing that Prof. Stiglitz dismisses is the notion that financial markets are selfregulating. Initially it was believed that the financial sector had become highly regulated due to conflicts of interest and predatory practices. However, advances in economic theory eventually explained why markets were likely to be unstable. In the 1970s and 80s, the general theory of imperfect and asymmetric information was developed which showed that whenever information is imperfect and asymmetric, and risk markets incomplete, the economy is unlikely to be Pareto efficient. Such markets were also not fully efficient and were characterised by the phenomenon of rationing and severe agency problems. Professor Stiglitz further elaborates how information is at the core of the operation of financial markets. These operations consist of dealing with the allocation of scarce capital resources and managing risk, which is difficult to do in the presence of distorted information. Stiglitz says that it was the presence of such a kind of imperfect information that eventually led to the downfall of Americas economy in 2008, with the involvement of a number of banks.

The more alarming thing, says the professor, is that these failures of the financial markets are not contained and lead to large externalities on the rest of the economy. Owing to this, Professor Stiglitz underlines the need for strong governmental regulation of financial situations. 2. Regulation is needed for a well-functioning market and economy: In this next lesson, the professor highlights how exactly the regulations should be designed for a sector like the financial market, which is troubled by large market failures with systemic consequences. He says that such regulations should ensure the safety and soundness of individual banks, ensure competition in the market, promote accessibility, protect consumers and investors from exploitation, and enhance transparency in transactions. Professor Stiglitz says that the banking and financial sector tends to indulge in a great deal of risk and a short sighted outlook. This was one of the reasons, which, according to him had led to the 2008 global financial crisis. There is a widely accepted notion that increased capital requirements will increase the cost of borrowing, which is a reflection of the various flawed perceptions that plague the financial market at the moment. Such a flawed perception could be a result of a lack of understanding of risk among those in the banking community. This in turn implies that there should be strong regulations on the incentive structures of banks. Stiglitz suggests that levying a higher deposit insurance fee on banks engaging in higher levels of risk taking may discourage excessive risk taking. However, this would curb risk taking only to a certain extent, beyond which stronger measures need to be developed in the form of regulations such as curbing excessively rapid expansion of a banks assets. Thus, in this way Prof. Stiglitz stresses on the need for thorough reforms in the form of corporate governance laws