arunabha bagchi
SEPTEMBER 15, 2008 was the most dramatic event in the history of international banking in living memory. The “Big Five”, America&’s five investment banks that ruled global finance, suddenly got reduced to two. Only Goldman Sachs and Morgan Stanley stood precariously intact after abandoning their “special status”. The other three were not that lucky. In a surprise move, the greatest champion of free market, the US government, forcibly sold Bear Sterns to JP Morgan Chase in a fire sale in March 2008. The final drama came when Merrill Lynch and Lehman Brothers experienced a seesaw of fate when the US government could finally force Bank of America to buy Merrill Lynch and let Lehman Brothers collapse on the same fateful day.
Now who cares about Lehman Brothers? How many mortals have ever heard of Lehman Brothers in India? If you are not one of them, do not feel embarrassed that you are part of Bharat. Not many mortals in the US and Europe heard about the iconic investment bank before its collapse either. It is now a household name in the West simply because of the Great Recession resulting from that event. Berenberg bank in Germany has recently calculated that the economic loss worldwide following the bankruptcy of Lehman Brothers has already crossed 3,800 billion dollars. In fact, another Great Depression has been avoided by unconventional fiscal and monetary measures, pouring billions of dollars/euros/pounds of taxpayer money to minimise further bank failures and causing untold suffering to the (lower) middle class families in the West.
There is no point in recounting the history of the crisis as that has been repeated ad nauseam. So much has been written about the causes of the crisis that one wonders why hardly any serious economist had inkling about the impending catastrophe. One key player responsible for the eventual crisis, Robert Rubin, once made the cover of the Time magazine that declared him the greatest US Treasury Secretary ever. The other, former Chairman of the Federal Reserve Alan Greenspan, became a cult figure in his heydays with Wall Street reacting even to his facial expressions, let alone his formal statements. The third one of the trio, Larry Summers with his illustrious career, had to finally pay some price when he had to withdraw his candidature from the Chairmanship of the Federal Reserve last month under intense pressure from the US Congress.
The shockwave generated by the collapse of Lehman Brothers immediately engulfed Europe. Globalisation forced European banks to be active players in the Ponzi scheme created in the US by the sub-prime lending, and the ensuing securitisation of these (mostly) worthless assets. They had to have healthy quarterly results to retain competitive stock prices. The ensuing credit crunch and the resulting recession caused the booming housing market of the peripheral coastal countries of the Eurozone to collapse. Most banks in Southern Europe and many in the North became virtually insolvent. In panic, countries took unilateral decisions to save their national banks and Euro was brought literally to the precipice. Years of painful negotiations, often forced by external events, brought some semblance of normalcy to the Euro.
How did the policies of the US Treasury and the Federal Reserve, along with the casino games played by the Western banks during the last fifteen years affect our economy? We can only answer this question by looking at the process in phases. Let us start with the repeal of the Glass-Steagall Act engineered by the Rubin-Summers duo at the turn of the last century. The Act was introduced in 1933 at the height of the Great Depression to prohibit the same financial institution from being involved in investment banking, commercial banking and insurance activities simultaneously. Repeal of the Act caused huge conflict of interest that was largely ignored by the regulatory agencies. It is euphemistically referred to as the start of free market finance. This encouraged reckless behaviour of Western banks, along with outright fraud. Despite our economic liberalisation from 1991, our banks still play no role in international finance. This saved us from a banking catastrophe. Bank nationalisation of 1969 came surprisingly to our rescue. Instead of admitting the truth, our free market gurus in government attributed our escape from a banking disaster to insightful decision-making on their part.
The next trigger was the monetary policy followed by the Federal Reserve under the stewardship of Alan Greenspan. To minimise the recessionary impact of the dot-com bubble and the aftermath of the 9/11 attack, the Federal Reserve reduced interest rates in quick succession to a record low level. The inflation that was supposed to follow was tamed by exploiting the cheap labour of the Chinese in the largest transfer of manufacturing activities in history. This was a classic win-win situation for both China and the West. But it resulted in abundant cheap money flooding the Western markets, with hardly any return in the environment of absurdly low interest rates. A substantial part of this easy money found its way to the high interest yielding emerging economies, with India being one of the major beneficiaries. This led to almost double digit yearly growth of our economy in the 2005-2008 period. Our government experts, of course, attributed this to their brilliant policy initiatives.
The period 2008-2009 saw a serious decline in our growth rate. This was the worst crisis right after the Lehman Brothers collapse and the economic malaise was a worldwide phenomenon. In response to the economic decline, all emerging economies used huge fiscal stimulus to get out of the impending recession. They learnt the lesson of the 1997 crisis when they were caught in the vicious spiral of withdrawal of foreign money and huge fiscal deficit. This time around, they had comfortable foreign exchange cushion and low budget deficit due to healthy tax return during the boom years of 2005-2008. India was no exception and our economy picked up the 8-9 per cent growth trajectory. Our Prime Minister was elated and attributed this to the sagacity of government decision to defy the crisis in the West. Economists at IMF and World Bank even coined a new term, called “decoupling”. They claimed that emerging markets have developed their own dynamics and reached a stage where they could insulate their economies from the effects of slowdown in the West.
This ridiculous theory was discredited 2011 onwards. As the economic slide continued and rating agencies threatened to downgrade our sovereign debt to junk status, our Finance Minister frantically visited rich countries to plead them from withdrawing funds and increasing their investment. When repeated forecasts of economic turnaround failed to materialise, blame game started. The easy scapegoat was Pranab Mukherjee, presumably because of his inability to get involved in political squabbling with his current exalted position as the President of India. Despite our pretension to follow the Westminster style of democracy, even our Prime Minister forgot about ministerial responsibility and remained mute, as usual, in the face of criticism of his former Cabinet colleague. The fact of the matter is that our economy is totally at the mercy of the policy decisions of the West. Despite our high economic growth during the last two decades, we have been persistently importing far more than we could export. During this period, manufacturing goods from Asia, with the notable exception of India, flooded Western markets. With low interest rate and huge liquidity during the regime of Alan Greenspan, foreign currency flowed into the Indian market hoping for better returns. This, along with repatriation of hard earned money of our compatriots working under miserable conditions in the Arab countries, gave us a comfortable foreign exchange cushion. Economists apparently remain unperturbed by this unstable arrangement. Chinese policy makers must be an exception in this regard.
After the collapse of Lehman Brothers, the West was in a dilemma about the appropriate policy initiative to tide over the acute crisis. All countries poured billions of government money to save their financial institutions. Fiscal deficits rose without bound. There was no scope of new deal type fiscal spending that rescued the United States during the Great Depression. Ironically, Ben Bernanke, a renowned authority on the Great Depression, now headed the Federal Reserve. He took desperate measures with no precedent in modern monetary history. He first brought the prime interest rate to (almost) zero. This helped US banks somewhat in building up desperately needed capital, but failed to stimulate the economy. He then started printing money under the respectable sounding name of quantitative easing (QE). This again caused a glut of easy money with no avenue of investment in the West. India, as before, became a favourite destination of this money looking for healthy return. Our business houses, lured by virtually zero interest rates, also borrowed heavily in the Western markets.
After a long delay, the economy of the United States has finally started to recover. Although Paul Krugman characterised this as the Rich Man&’s Recovery, and President Obama is advocating the need of the fruits of the recovery to trickle down to the middle class, international finance does not discriminate between the natures of recovery. Money is moving back to the US. In fact, the Federal Reserve was confident enough to think aloud about slowly withdrawing from the QE operation. All hell broke loose and FII money was withdrawn from our country at a rapid pace. We saw rupee tumbling and losing 50 per cent of its value in three months. This caused double jeopardy with the loans taken by our business houses ballooning in rupee terms. Now that Ben Bernanke has decided against reducing QE operation for the time being, our new RBI Governor got welcome temporary reprieve. But the fundamental problem remains and we are dancing to the tune of Western economies as they adjust their policies in response to the prolonged effects of the collapse of Lehman Brothers.

The writer is ex-dean and professor of applied mathematics at the University of Twente, The Netherlands.