Free market fundamentalists have time and again argued the self healing nature of markets and have criticised any regulation to the operation of market forces.But as Marx put forward the capitalistic system is a system of crisis.This happens due to the accumalation of production and as there are no takers in the market the investment dries out leading to a collapse.The sub-prime mortage crisis that has affected the US and also the world financial markets is a one that has resulted out from greed for market financial operations without any logic remainds us of the economic crisis of the thirties. For those like me with no knowledge on economics the traditional banking system works the following way any bank has depositors who invest money for long time interests and security.The bank lends this money to those asking for loans based on the logic that the amount of money withdrawn would be far less than the money invested thus guaranteeing that the financial system is stable.But what happens in case of a rumour that investors start demanding money they invested in that case the central bank lends support as the whole process is short-term in nature.The traditional banking system was highly regulated in the aftermath of 1939 economic crisis.But in case of time all regulations were replaced by an adhoc system.
It involves lending loans to buy homes to capitalise on the housing bubble to people without any financial backing to repay the loan.Thus when the housing bubble burst the loans became bad and the financial institutions thriving on sub-prime mortages went bankrupt and the share value of these companies collapsed(For example Bear was taken over by JP morgan for 2$ per share).The complete dichotomy was that those flag bearers of deregulation of the financial system are asking for tax payers money to bail out that system from a complete collapse.The Fed has been reducing the interest rate and trying to improve liquidity without any positives.
Effect On India:
Indian banking system is highly regulated and any moves for capital convertibility will prove fatal for financial stability.The Fed rate cut means dollar value going down against ruppee which has affected our export oriented industry.I think its better to consider some cap on FIIs investing in India it brings a lot of speculative capital into the Financial Market.
The global food crisis coupled with the sub-prime crisis may lead to a situation of stagflation in the world economy we are in tough times .