That men do not learn from the lessons of history is the most important of all the lessons of history
- Aldous Huxley
September 15, 2008 is burnt into the consciousness of governments, bankers, economists and practically everyone who handles money. It was the day Lehman Brothers Holdings Inc (LB), a global financial services firm in the US with assets reported at $600 billion, filed for bankruptcy, consequent to its desertion by clients and massive losses in its stock (called the 'Crisis' hereafter). Due to the absence of prudential regulation, it had a leverage ratio of 31.1 by the end of 2007. It unleashed a tsunami of financial failures and output losses from which the world is yet to recover. The major factor was the recklessness of LB and other financial investment banks in their operations in pursuit of profits by exploiting innovative financial procedures with no regard for risk. There was heavy involvement of the institutions, led by LB, in financing home mortgages that were booming due to the low-interest regime of the US Federal Reserve.
To deal with the problem of unemployment, the federal funds rate had been reduced to one per cent in 2004. When home prices started rising due to excess demand, supported by bank loans, there were many failures and foreclosures leading to what is called the sub-prime crisis - the issue of loans to non-creditworthy borrowers.
Apart from the fact that sub-prime loans were issued, these were also packaged into units with some good ones and circulated as derivative instruments with attractive yields passing from one institution to another. Called credit default swap (CDS), anyone could purchase it, even if he didn't hold the loan instrument and, therefore, had no direct insurable interest. It was called "naked" CDS. By 2006, $60 trillion worth of CDS were written to cover just $6 trillion of debt -a CDS multiplier of 10. Unlike in the case of money multiplier where the value converges to a finite number because of leakages, the CDS multiplier is explosive.
According to some experts, the pieces of the burst bubble are still being picked up after five years and even now, no one knows who owes how much to whom.
In the aftermath of the Crisis, the US Fed was forced to undertake policy measures that were never dreamt of. It resorted to unusual, unorthodox and innovative ways of injecting money into the system, thereby turning central banking on its head on many counts, ignoring the traditional norms. It became the lender of last resort for the rest of the world, issuing loans of $580 billion to foreign central banks and $309 billion to individual foreign banks with subsidiaries in the US. The European Central Bank also played its part in this transformation of central banking.
Since a near-zero rate of interest did not work, there have been three tranches of quantitative easing (QE) to inject money into the system and encourage investment. These have not mitigated the economic problems of the US. The output level is barely what it was before the onset of the Crisis. I have argued given the inter-industry relationships (input-output matrix) of the US economy, QE has conferred more benefits on the rest of the world than on itself. ("Will the Fed's QE work?", Business Standard, September 20 2012.) This conclusion is confirmed by the rattled reaction in developing countries to the possibility of a phasing out of QE.
In India, there was a panicky overreaction to the Crisis in both the government and the central bank, not warranted by the domestic economic situation that was completely different from that in the US. There were no sub-prime mortgage problems of either domestic or external origin. There had been tightening of credit before the Crisis due to inflation that was aggravated by advance tax payments and the absorption of liquidity through the sale of forex in the open market to deal with the appreciation of the rupee. However, fiscal stimulus packages amounting to about three per cent of GDP (gross domestic product), supplemented by primary liquidity released by the Reserve Bank of India (RBI) to the extent of seven per cent, came on top of an already announced expanded safety net for the rural poor, a farm loan waiver package and salary increases for government staff. That the humongous creation of money wasn't justified was evident from banks' excess investment in government securities, some of the facilities being either not availed of or utilised only to a limited extent and the round-tripping of money released by RBI through the reverse repo operations for quite some time. The persistence of inflation in recent years is the spill-over from the monetary excesses of 2008-09. The chickens have come home to roost.
The world never learns, as Huxley said. The US embarked on reforming the financial system. One important result was the Dodd-Frank Act of 2010. Due to lobbying against the legislation, Congress weakened the Volcker Rule, prohibiting commercial banks from trading securities on their own account. The Securities and Exchange Commissioner (SEC) said though Congress had passed the Act, the SEC was yet to study whether to implement the law. There have been legal challenges to the Act. The Crisis is not the first of its kind, nor is it going to be the last.