‘I can guarantee India will have its financial crisis’

Liaquat Ahamed, a former investment banker, has gone from being just another man in a dark suit to a much-in-demand author/historian/economic guru ever since his book, Lords Of Finance: The Bankers Who Broke The World, came out in 2009 and won a host of awards, including the 2010 Pulitzer Prize for History. Ahamed is of Indian origin — his ancestors migrated from Gujarat to what was then East Africa. Born in Kenya, he was educated in the UK and the US. In India on a visit, he spoke to DNA about banks and financial crises. Excerpts from the interview:

How did you start writing economic history?
For most of my career, I was into investment management. In this business, you soon realise how little you know. So I started reading up, particularly when we started having the various crises. In the 1990s, we had a series of crises: Mexico, Asian crisis, the tech crisis, and so forth, and I read up on all of them and soon ended up reading about the mother of all economic crises, which is the Great Depression of 1929. I can’t say I always wanted to be a writer but I had often fantasised about being a writer (laughs) and thought it was now or never. So I quit my job and started writing.

We have had so many economic crises and yet we keep making them all over again.
True. First of all, I think it is hardwired into human nature, which causes us to overdo things, especially when things are on the upside, which is why we tend to get bubbles that inevitably burst. But they don’t always lead to an economic crisis. The tech bubble burst did not lead to a crisis. But often, because banks become heavily involved in bubbles, a bursting bubble is seen as a banking crisis. But the crucial ingredients are banks and bubbles.

Is there some way out?
I doubt if we can prevent bubbles from occurring. What we can do is to cushion the consequences through a resilient banking system, and banks that have a large capital and don’t rely too heavily on short-term funding. Countries that have managed to get by without a crisis are those that don’t have too much leverage in their banking. Banks need to have lots of capital, they will be involved in bubbles, and often they will lose money.  The only solution is to make sure they have a cushion to fall back on. The fact is that banks are inherently fragile institutions; it is based on a giant bluff. They take your money promising you that you can have it whenever you want; but if we all tried to withdraw, the banks would collapse! So banks need to develop long-term sources of funding.

India seems to have missed the last economic depression. Did we do something right?
One reason is that most of the banks here were not exposed to many of the instruments that caused the problem. That is a good thing. Does that mean we can pat ourselves on the back and say we have a safe system? Can we argue that we don’t have bubbles here? Just look at real estate here! We know that Indians are prone to bubbles, we know Indians love to speculate, we love to gamble. At some point, I can guarantee there will be a financial crisis in this country. I don’t know when, but I know it will happen.

It happens everywhere. It is part of an economic process.
So is it always negative?
There are good things associated with bubbles. They reflect a certain exuberance and energy. Many of the 19th century bubbles, many of the manias — the railway mania, the radio mania, or even the recent internet bubble — saw massive investment which laid the foundation for their subsequent growth for many years. That is the positive side.

But given that bankers do make errors, do we need a greater role for the government, especially in fiscal policy measures?
No. Government officials are no wiser than bankers. They often do things which make the situation worse. For example, during the last crisis, banks got incredibly leveraged. A bank like Citibank had tiny amounts of capital relative to its asset size. In large parts, this  was caused or encouraged by this whole new buzz about capital adequacy norms which  gave government officials the illusion that because they had these complicated models for calculating how much banks should have in capital, they were on the top of things, whereas they were completely operating in the dark.

We all know that the depression of 1929 led to the rise of fascism which in turn led to World War II. Can such a situation repeat itself?
We haven’t learnt how to prevent bubbles or crises, but we have cushioned their impact. We did not have a great depression this time purely because governments around the world intervened to support their banks, unlike the 1920s, when they left the banks to themselves. Secondly, the government intervened to cut interest rates to the bone, unlike the 1920s when they actually raised interest rates in the middle of the Great Depression. And thirdly, governments had fiscal stimulus, including India, unlike the 1920s when they thought the cure for depression was to cut expenditure.

Isn’t it unfair that the government intervenes to save banks from their own mistakes and million-dollar bonuses even as thousands of businesses collapse?
You know it isn’t fair. Life’s unfair!  An unfortunate side of this is that in saving banks, you save bankers. It is hard to save the banking system and not save bankers. I certainly don’t think there is any value in witch-hunting the bankers. I think the real thing to do is build up capital so that we don’t have to step in and save all the banks.

Surely something can be done…
Certainly in US and Europe, finance has become too large. It’s become something of a Frankenstein. And this is because we are, in effect, implicitly subsidising the banking system — there is always an implicit guarantee that when they get into trouble, governments will bail them out. This allows them to borrow at unusually high rates.

My solution, which has been proposed by the IMF and several other people, is that we tax short-term borrowings. In effect, the tax would be a fee that is being charged for the implicit guarantee that the government is providing. I think it would serve two purposes: dissuade them from borrowing too much in the short-term, and cut their profitability — I think banks were over-profitable. And secondly, it would raise funds so that when banks got into trouble, this money could be used to bail them out.

India has been following economic liberalisation for almost 20 years and the sentiment is that economic disparity has only widened.
Whenever we have high periods of economic growth, in the initial stages, economic disparity does widen as some people take advantage of the opportunities available and we wait for the growth and the benefits to trickle down and the bottom catches. It is clear we are just in the initial stages. On the other hand, there are arguments that poverty has gone down as a consequence of economic growth and I am sure that is the case. The cure for poverty is more economic growth, not less.