THERE is an interesting little story about a media company and its annual awards programme. In the go-go years before giant waves of the mega-financial crisis of 2007-09 crashed on to India’s shores, someone proposed at the meeting of the awards jury that an award should be given to Y. Venugopal Reddy, then governor of the Reserve Bank of India (RBI), for the manner in which he had steered monetary policy. A business titan promptly shot down the idea, saying Reddy was out of touch and out of date, and the other worthies around the table agreed.

Two years later, the awards jury was meeting again – this time when the full-blown crisis had played out. Reddy, now retired and living quietly in Hyderabad, cropped up again as a candidate, and the same titan now agreed that he deserved an award for protecting India from the worst of the carnage. Reddy had seen the problem building up, the jury felt, and had not been taken in by the intellectual fashion of the times. This time, he got the award.

That decision was heavy with irony because, for most of his tenure as the RBI governor, Reddy had been criticized, even pilloried, for being a curmudgeon who would not listen to the latest theories on the markets, who stood in the way of what the markets and market players wanted, and who would not integrate more fully with the western world’s financial sector; in short, someone who would not reform India’s financial sector. His critics heaved a sigh of relief, some even celebrated, when Reddy’s term came to an end in 2008, and when his deputy Rakesh Mohan left soon after.

But fashions change in the world of ideas just as much as they do in other fields, and Reddy is now being given awards for having been a prudent central banker. He is recognized for having publicly warned about the mispricing of risk in the financial markets – which everyone now acknowledges as the root cause of the global financial crisis.

Roll back in time to the Asian crisis ten years earlier, when Reddy’s predecessor as the governor, Bimal Jalan, rejected the currency management options that the marketmen favoured as a theoretical proposition: either a free float of the rupee or a currency board arrangement, whereby monetary policy is subservient to maintaining a fixed exchange rate with a currency like the dollar. Instead, Jalan continued to opt for a managed (or ‘dirty’) float of the rupee. And, contrary to the tide of world opinion at the time, he also insisted that the RBI’s functioning should not be reduced to the single goal of containing inflation.

All this was ideologically unfashionable, and many marketmen scoffed, but the rupee did not tank the way many other Asian currencies did, the country by and large stayed out of the crisis, and the Indian economy has done very well in the past decade. Central bankers now recognize the wisdom of the policy of dirty float, just as the ‘single objective for a central bank’ argument has been discredited somewhat in the last couple of years.

Jalan was also a sceptic when it came to currency markets, arguing that they were heavily influenced by speculators. So, during his six years as governor, he ensured that the RBI was in a position to intervene and drive the currency market if it ever felt the need to do so.

 

These are examples of regulators who had their own ideas on monetary management, and who would not readily accept the propositions put to them by market players. Sometimes, of course, national regulators are powerless. Andrew Sheng, former chairman of the Hong Kong Securities and Futures Commission, said in a recent paper¹ that Hong Kong, Malaysia and South Africa had complained at the time that foreign exchange markets in emerging markets were manipulated by the players in that market (usually western financial service companies), but the vested interests were too strong and their complaints fell on deaf ears.

Cut now to a meeting in New York, in early 2007, with financial sector regulators and the giants of the financial services industry present. Everyone at the meeting recognized that they had a giant problem on their hands – much bigger than the sub-prime housing market issue that had begun to surface in the business press. The regulators were inclined to take action, but the titans of Wall Street argued that they needed time to fix things. According to someone present in the room, it seemed that the titans were dictating terms, with the regulators playing second fiddle – the balance of power seemed to have shifted from the regulators to the marketmen.

These episodes help understand what led to, and created, the financial crisis of 2007-09. There have been plenty of treatises on the systemic risks created by the spread of complicated financial innovations like collateralized debt obligations and credit-default swaps. The world has realized to its cost that financial regulation cannot always keep up with such innovations, and that neither markets nor regulators often understand what is going on.

 

The world has also absorbed the price that has to be paid when countries and consumers live beyond their means, when they print money to keep consumption going, when they pile up massive personal and country debt, and persist with these unsustainable patterns for years and decades, building up liquidity in the system, keeping interest rates low and thereby encouraging the build-up of asset price bubbles (in real estate, stocks, commodities like oil), till the wisdom of the old saw is driven home – that what can’t go on forever won’t go on forever.

There is disagreement over whether the United States is to blame for living beyond its means, or China for a mercantilist policy that has focused on generating massive and sustained trade surpluses. Ben Bernanke, the chairman of the US Federal Reserve, has blamed East Asia for the savings glut and high liquidity that led to deterioration in credit quality, but Sheng said that this was like ‘a banker blaming his excess liquidity on his depositors. What the banker did with his balance sheet was the banker’s responsibility, over which the depositors have little say.’²

 

Whatever the rights and wrongs of what the US and China did, the nuts and bolts of the global economic crisis can therefore be summed up in a paragraph or two. It was triggered by long standing problems in the financial sector, unchecked financial innovation that neither the innovators nor the regulators fully understood, the consequent mispricing of risk in financial instruments, the network effect of interlocking derivatives transactions and poor regulation flowing from a lack of understanding. There were larger, macroeconomic consequences that followed, and inevitably fiscal policy came into play. If one has to look for ‘lessons’, therefore, one must look at all these issues.

But the most important lesson may lie elsewhere: in the rise to dominance of the financial sector in key economies of the world, and the simultaneous growth of its influence on the world of ideas; indeed, a fusion of the two worlds. Regulators began to bow to market players when it came to deciding what should or should not be done, in part because the market players had become big and powerful, and in part because regulators felt the market players knew better. In the build-up to the crisis, laws and regulations were repeatedly changed in line with what the market players wanted.

The Glass Steagall Act of 1933 (which had flowed out of the attempts to deal with widespread bank failures during the Great Depression, and which separated investment banking and commercial banking) was repealed in 1999 by the US Congress, although there were clear dangers in uniting wholesale and retail banking – as many people now recognize. Then, banks were permitted to leverage their assets much more than before, thereby increasing risk quite sharply.

Sheng recalls that the US Securities and Exchange Commission (SEC; see note 1) even left it to the financial players to value their derivatives according to their own risk models! He adds that perhaps only managements understood their true leverage, because right up to the Bear Stearns rescue in early 2008, the SEC chairman was insisting that it had adequate capital. (We will see shortly that managements were as clueless as the regulators!)

 

The power that marketmen had developed over regulatory thinking and action showed up in other ways. Sheng recounts how data put out by the Bank for International Settlements showed that at the end of 2007 financial derivatives were 14 times global GDP, whereas conventional financial assets were only four times GDP. But ‘market traders reassured everyone that the gross market value of such derivatives were actually much smaller’ (only a quarter of GDP!).

This coming together of intellectual and financial capital was both caused by, and resulted in, new fashions among economists and mathematicians, one result being the swing of economics research towards market-oriented subjects, a trend reflected in the Nobel prizes awarded for economics. This fusion was reflected also in the arrival of an intellectual species that came to be called ‘quants’ in the Wall Street firms – people who built financial products and trading models, assessed risk and predicted market movements, all of it involving a lot of high-level ‘quantitative’ maths.

The result was the rapid growth of derivatives products which were supposed to offset risk. The combination of brain power, high-end maths and massive computer-based modelling meant that Wall Street was redefined. So was investment banking, and the financial world now had a claim to intellectual brilliance that it had not claimed before. In one way or another, this soon came to be reflected in the growing belief that Wall Street knew what it was doing, that it had the answers, and that the markets told the truth and were never wrong.

 

The fusion also showed in the dramatic rise to prominence of hedge funds, the theoretical underpinning for the exploding market for portfolio insurance being provided by the Black-Scholes formula (two of whose creators won the Nobel and who later played a stellar role in the collapse of Long-Term Capital Management, which was the precursor to the crisis of 2007-09). Also, it was argued, and believed, that macroeconomic policy had become so good that serious recessions were as good as history – and this found expression in terms like the ‘Great Moderation’ in economic policy.

The sex appeal of large amounts of money being made in the big financial firms, the cheerleading of the success stories by an unquestioning business press, the quiescence prompted by many years of above-average growth and below-average inflation, and the intellectual props provided by market-oriented economists and market theorists came together to create a level of market success that bred extraordinary hubris, which then swept all before it.

 

No one paid heed to the theory put forward by Hyman Minsky³ in the 1970s, that long periods of financial and economic stability lowered assessments of risk, which encouraged people to take on fresh debt, till so much debt had been built up to finance speculative investments that a major sell-off began. That would lead to a dramatic collapse in asset prices and a sharp drop in liquidity. In short, stability created instability. In the spring and summer of 2007, commentators (including Nouriel Roubini of New York University) began to ask whether the markets had reached a Minsky moment. But Wall Street traders, benefiting from easy money, had long ago begun to think they were, in Tom Wolfe’s phrase, ‘Masters of the Universe’. How could anything go wrong in their world?

That world was a small, exclusive one. Fifteen large banks and investment banks accounted for more than two-thirds of the trading in financial derivatives. In six years to 2007, they tripled their balance sheets and increased their leverage levels. Sheng calculates that, including off-balance sheet items, the leverage level had reached 88 times capital! Having built houses of cards, the managements of these firms were telling regulators what should and should not be done – and the regulators were getting beguiled.

In the early stages of the financial crisis, these ‘Masters of the Universe’, having spun their theories into a web of convictions, argued that an occasional downturn or crisis was a price worth paying for the sustained benefits of an innovative and efficient financial sector, and the supporting structure of appropriate monetary and macroeconomic policy. But as the price tag for the ‘correction’ grew to unimaginable proportions, this argument is no longer being aired – though some may still quietly cling to their beliefs.

 

By one estimate, the total bill comes to $14 trillion, or about a quarter of the world’s GDP. The support packages doled out in the US have totalled 73 per cent of that country’s GDP, 74 per cent in the UK, and 18 per cent in the euro area. Even China, perhaps the least affected economy, had to announce a stimulus package equal to a sixth of its GDP.

The bill has been massive because the problems that the smart guys in the financial sector create, wreak havoc on the other parts of the economy. Even though the recession has officially ended in the leading western economies, unemployment in the US is still 17.5 per cent, and in Spain (to take another example) 20 per cent. Fat bonuses may have returned to Wall Street, but there are millions out there looking for work.

Even economies which were not linked to Wall Street, or to troubled markets like the sub-prime housing sector in the US, have had to pay a heavy price. In markets like India, economic growth rates have been shaved off by 2 percentage points, exports have tanked, and there has been widespread loss of jobs. Regaining the earlier economic momentum could take two to three years, if not more.

So while it is important that the rules governing the financial sector are rewritten, incentive structures changed, and risk levels reduced, the more important challenge may be to course correct in the world of ideas.

 

In his whimsical take on the ideological divide among economists,⁴ Paul Krugman distinguishes between ‘saltwater economists’ (those at universities on either the East or West coast of the US) and ‘freshwater economists’ from inland places like the University of Chicago – with the freshwater category (followers of Milton Friedman’s monetarism, mostly) being the villains of the piece. The view which they articulated and which became dominant among economists and those who analyzed markets, was that catastrophic failures were not possible in a market economy because any deviations from the path of prosperity would be corrected, that markets were inherently stable and transparent, and therefore the prices correct. It sounded neat and clean, and plausible when all the mathematical bells and whistles were added to the basic proposition.

But as the economist Robert Solow had warned much earlier, ‘the best and brightest in the [economics] profession proceed as if economics is the physics of society’.⁵ Krugman has now echoed that by saying that economists ‘mistook beauty, clad in impressive-looking mathematics, for truth.’ Their ‘romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong’, the limitations of human rationality, the problem of institutions that run amok, the imperfections of markets and regulatory failures. By late 2008, of course, Alan Greenspan was admitting in ‘shocked disbelief’ that ‘the whole intellectual edifice’ had ‘collapsed’.

He should not have been surprised. The low interest rates had spread into the housing market, where the sub-prime and Alt-A segments (which had the worst risk profiles) had quadrupled from about 10 per cent of the market to 40 per cent. Martin Feldstein pointed out shortly before the crap hit the fan that something like a half of US consumer spending was being financed by second mortgages on houses whose prices had gone up. Some other numbers suggest that three-quarters of the increase in house prices may have surfaced as fresh debt.

Robert Shiller of Yale identified the housing bubble as early as in 2005, and warned of painful consequences if it were to burst. He was pooh-poohed. In the same year, Raghuram Rajan of the University of Chicago too warned that the financial system was taking on potentially dangerous levels of risk, but he too was dismissed. Krugman quotes a 2007 interview in which Eugene Fama of Harvard, the ‘father’ of the efficient market hypothesis, declares that ‘the word "bubble" drives me nuts’!

 

Looking back, it is easy to see that there was a long and dangerous build-up to the eventual situation in which between 30 and 40 per cent of all corporate profits in the US came from the financial sector. Instead of finance serving the real economy, the tail was wagging the dog. It was an unnatural situation that could not have lasted.

Piergiorgio Alessandri and Andrew G. Haldane of the Bank of England⁶ recount how the financial services industry grew beyond the bounds of reason in Britain. For almost a century, banks’ balance sheets remained at about 50 per cent of British GDP. From the early 1970s, however, this pattern started changing and by 2000 bank balance sheets had grown to more than five times the country’s GDP – a ten-fold rise in relation to GDP.

This growth came with greater risk – in fact, it would not have been possible without greater risk. For the banks’ capital ratios fell by a factor of around five in both the US and UK. This would not have been possible without a change in regulation (which allowed banks to leverage their capital much more than before – the new rules being the result of active lobbying by Wall Street) and by the fact that clever bankers kept parts of the financial system outside the purview of regulations on capital adequacy, thereby increasing leveraging and risk even more.

These and other developments resulted in the returns on bank equity rising from less than 10 per cent (which was in line with returns in the non-financial sector) to more than 20 per cent after the 1970s, and then close to 30 per cent.

 

The pattern that Alessandri and Haldane point to is clear. Banks leveraged their assets more in order to expand their balance sheets, thereby increased the level of risk, and in return trebled their returns to shareholders. But the natural corollary to higher risk is greater volatility in bank returns, which too trebled over 40 years. It is easy to see that the game was getting more dangerous – with the unhappy result that when the time came to pay the bill, it was society at large that had to cough up (hence the charge of ‘privatizing profits while socialising losses’).

A vital question flows from having a banking system that has become bigger than the economy itself, and which therefore brings with it the danger of the whole economy going belly up. Everyone is familiar with the phrase ‘too big to fail’ – which means that since a truly large financial institution will wreak general havoc if it fails, the government must step in and save it, in the larger public interest. What the latest financial crisis has taught us is that such institutions might also be too big to save.

 

Who, after all, is going to do the saving? The answer is national governments. But what if a bank is bigger than a national budget can handle, indeed bigger than a national economy – as was the case in Iceland? And as is the case in Britain? Does the German government have the ability to save Deutsche Bank if it gets into serious trouble? If not, should these organizations be allowed to grow so big, on the back of complex financial transactions that are sold as aids to efficiency and risk mitigation, but which in truth add to risk rather than any value to the rest of the economy?

The truth, which few if anyone suspected, was that even as the efficient markets hypothesis was being propounded, chief executives of Wall Street firms were all too often quite ignorant about the risks their traders were taking, and therefore underestimating and mispricing risk in ways that threatened the very survival of the firms. In a book that should be essential reading for everyone in the financial world,⁷ Richard Bookstaber points to what was around the corner in 2007. He argues the fundamental point that financial innovation increases complexity. At the same time, greater financial integration across markets and speed of execution, when combined with greater complexity, is an open invitation to accidents. And because many innovative instruments are in the form of derivatives with conditional and non-liner payoffs, it is difficult in an accident-hit market to understand how the prices of these instruments will react.

 

Counter-intuitively, attempts to build in safeguards or regulation to prevent disasters actually add to complexity and therefore can end up with the opposite of the intended result. As Bookstaber says, ‘The natural reaction to market breakdown is to add layers of protection and regulation. But trying to regulate a market entangled by complexity can lead to unintended consequences, compounding crises rather than extinguishing them because the safeguards add even more complexity, which in turn feeds more failure.’

And, of course, financial risk is higher because, while the efficient market paradigm assumes that investors will take on all information and behave rationally, the fact is that ‘people do crazy things all the time’.

Bookstaber should know. He was an egghead (a Ph.D. from MIT who became the head of risk management at Salomon Brothers), and his book is an eye-opening account of how the big Wall Street firms are run by people who run into one disaster after another, but continue on their merry way. ‘Virtually all mishaps over the past decades had their roots in the complex structure of the financial markets,’ he says, adding that ‘Financial markets have seen a tremendous amount of engineering in the past 30 years but the result has been more frequent and more serious breakdowns.’

Thus, a single rogue trader in the early 1990s caused the eventual death of Kidder, Peabody (then a subsidiary of General Electric) as a Wall Street name; Nick Leeson sank Barings; UBS was the victim of index-amortizing swaps; Long-Term Capital Management (set up by the economists who won the Nobel for the Black-Scholes formula) was ironically killed by relative-value trades in the Russian bond market, and so on down a long list.

 

The heart of the argument is that occasional crises are part of the design of an increasingly complex financial system, and the crises have got bigger each time. In a complex financial world, Bookstaber’s view is that ‘the real risk is the one you can’t see’, but Michael Lewis, best known for Liar’s Poker, writes (in portfolio.com) about how scams were going on in broad daylight, without anyone paying attention even when there were whistle-blowers around. It is instructive to read Lewis’ account of those who cried wolf, without anyone on Wall Street paying heed – perhaps because the quants’ maths and the theories on markets knowing best had taken up all the available mental space.

Lewis writes of Harry Markopolos, an investment banker who tried for nine long years to convince the SEC that Bernard Madoff had to be a fraud. Markopolos sent a 17-page letter to the SEC in 2005, more than three years before Madoff’s Ponzi scheme was finally exposed.

He writes about Steve Eisman and his team, a bunch of financial nobodies, who could clearly see that the sub-prime market was about to go belly up with high default rates. They went to the rating agency Moody’s, they attended sub-prime conferences, and they talked to whoever would listen, and many who wouldn’t, about how the whole market was waiting to implode.

 

Eventually, people did begin to listen. For there is the story of Meredith Whitney, an obscure financial analyst who said in 2007 (and she must have been a brave person) that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. Four days later, Citi’s CEO had to resign, and the dividend did get slashed. Lewis concludes that the real problem with the people on Wall Street is not that they are corrupt, but that they are stupid.

Smart people can be stupid, of course. But the reason why the higher risk involved in the growing markets for innovative financial instruments, the fevered speculation and deal-making, was that no one really knew or understood what was going on. Krugman argues, correctly perhaps, that banking has to return to being a boring subject; whenever it gets exciting and attracts the smart brains, it creates trouble for everyone else.

Bookstaber himself says that, ‘A better approach for regulation is to reduce the complexity in the first place, rather than try to control it after the fact… Linked to the need to reduce market complexity is the need to relax tight coupling. The easiest course for reducing tight coupling is to reduce the speed of market activity… A less disruptive course of action is to reduce the amount of leverage… Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets… [These] will create a market that is more robust and survivable.’

Sheng echoes both Krugman and Bookstaber and rues the fact that, even post-crisis, regulators are adding layers of complexity instead of simplifying things. He also argues that finance has to serve the real economy rather than drive it, that the bulk of banking has to stay retail (to protect depositors and serve corporate borrowers, especially in the small and medium sector), and that Wall Street should not be paid more than Main Street because the incentive structure has to be evenhanded.

So the basic rules for the financial sector have to be: keep it safe, and keep it simple, and don’t focus on building what Warren Buffet has called the financial weapons of mass destruction. The RBI – pilloried at the time by its critics for being ultra-cautious on many issues – followed these basic rules, and so the Indian financial system felt little of the shocks that swept through the developed economies. Even then, India felt the backwash through shrinking trade (exports collapsed by more than 30 per cent in the initial months) and the drying up of international sources of finance for even routine transactions.

 

As for the role of markets, regulators and governments, Sheng puts it best when he says that ‘free-market fundamentalism has truly been marked-to-market.’ The lesson that has been learnt is that when markets fail on a big scale, it is governments that have to pick up the tab – which means that Keynes (as opposed to Friedman) is back in fashion. Fiscal rectitude is therefore important, because economies can best deal with a crisis if they have a fiscal cushion during more ordinary times. With fiscal balance and a low level of public debt, a government has the elbow room to pump up spending, cut taxes and take on debt in order to deal with a crisis. If, however, the deficit is already too high for comfort, if the national debt is already so high as to risk a debt trap, then the government is severely restricted in what it can do.

In India’s case, it helped that the central fiscal deficit had dropped from 8 per cent of GDP in the early 1990s to barely 2.5 per cent when the crisis broke; the government had the elbow room to boost public spending by taking the deficit up to 6.8 per cent of GDP. It would not have been able to do that – without risking serious macroeconomic instability – if the deficit had already been 8 per cent of GDP at the start of the crisis. As for public debt, a recent RBI study has warned that Indian government debt is over 61 per cent of GDP (add another 25 per cent for the states) – a level that it says quite bluntly is unsustainable, and much higher than exists in the leading economies of Asia. The debt-GDP ratio is 17 per cent in China, 32 per cent in Korea, 41 per cent in Indonesia, 42 per cent in Thailand, and 56 per cent in Malaysia. In other words, India has to bring down the deficit (and therefore borrowing) levels quickly, so that debt level comes down over time.

This essay focuses on the role played by ideas and intellectual fashion in the building of a crisis. It goes without saying that many of those ideas have had to be jettisoned very quickly in order to deal with the crisis. At the end of the day, what keeps economies humming along is not a bloated financial tail that starts wagging the dog, or markets that know all the answers because they are always right. What is needed, it would seem, is the old-fashioned virtue of being safe rather than sorry, of maintaining a healthy fiscal situation, a low level of national debt, and an emphasis on safety and caution when it comes to pushing the financial sector towards greater efficiency. Any economy that follows these simple rules is unlikely to find itself in a crisis situation. And if a crisis is provoked by the mismanagement in other countries, it will be able to deal effectively with the fallout.

 

* Published simultaneously in India 2010, by Business Standard’s Books Division.

Footnotes:

1. ‘An Asian View of the Global Financial Crisis’ at http://www.ssig.gov.my/ssig/kcent/material/Andrew_Sheng_-_GFC_ AftertheCrisis%5B1%5D.pdf

2. Andrew Sheng, ‘From Asian to Global Financial Crisis: An Asian Perspective’. Third K.B. Lall Memorial Lecture, Indian Council for Research in International Economic Relations, New Delhi, 7 February 2009.

3. ‘The Financial Instability Hypothesis: A Restatement’, Thames Papers in Political Economy, Autumn, 1978; Reprinted in H.P. Minsky, Can ‘It’ Happen Again? Essays on Instability and Finance. ME Sharpe, New York, 1982.

4. Paul Krugman, ‘How did Economists Get it so Wrong?’, The New York Times Magazine, 2 September 2009.

5. Robert Solow, ‘Economic History and Economics’, The American Economic Review, 75 (2), May 1985, pp. 328-31.

6. Piergiorgio Alessandri and Andrew G. Haldane, ‘Banking on the State’, paper presented at the Federal Reserve Bank of Chicago 12th annual International Banking Conference on ‘The International Financial Crisis: Have the Rules of Finance Changed?’, 25 September 2009. Available at http://www.banko fengland.co.uk/publications/speeches/2009/speech409.pdf

7. Richard Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation. Wiley, New York, 2007.