Liaquat Ahamed immersed himself in the history of four bankers who derailed the world economy in 1920s. Is he feeling déjà vu?

A NEW BOOK about the origins of the Great Depression is making the rounds of the West Wing. Larry Summers, US President Barack Obama’s chief economic advisor, has read it. It’s been passed among a handful of close policy advisors. Called The Lords of Finance, the book describes how four powerful central bankers steered the world economy into the abyss. For financial thinkers in Washington, it’s a guide to what not to do in a financial crisis. When retired investment fund manager Liaquat Ahamed began research on the book four years ago, he had no idea we’d be facing a similar meltdown.

Sitting in his living room looking out on his leafy Washington DC neighborhood, I expected Ahamed to be a lot gloomier than he was. After all, he spent several years dissecting the origins of an economic collapse and now he was witnessing another one first hand. But the fact that the Dow Jones Industrial Average had lost over half of its value, while shocking, didn’t leave him hopeless. Today, says Ahamed, economists have learned a lot more about how markets work – and don’t work. What concerns him is whether politicians will listen.

“This time around, we understand what to do,” says Ahamed. “The risk is that we plunge into crisis on account of a lack of political will.”

In the 1920s, says Ahamed, bankers were tethered to the gold standard, which restricted the world economic growth to the amount of the precious metal that could be mined every year. Given his historical perspective, I wanted to know what Ahamed himself was doing to weather the storm.

Have you been tempted to stockpile gold bullion in your basement?
Ah, no [Laughs]. Not at all. I believe what John Maynard Keynes said, “Gold is a barbarous relic.”

Your book covers the troubles of the gold standard bringing down the world economy in the 1920s and 1930s. Yet almost a century later there are people who are still discussing going back to the gold standard. One of the presidential candidates in the past US election [Ron Paul] was an advocate of hard currency. Why does the gold standard still hold such a fascination for people?
Well, the gold standard was a discipline. It imposed limits on how much credit could be created, and I think the 1920s proved that those limits were a straightjacket. On the other hand, when we got rid of the straightjacket – particularly when you take the last two decades – we’ve discovered we don’t seem to have any limits. I think those who want to go back to the gold standard are hankering for some set of limits. My view is we should be able to devise a mechanism for limiting credit growth without sticking ourselves into this crazy straightjacket, which has no rationale. Limiting credit growth to the amount of gold that is dug up every year – it just makes no obvious sense.

Give me an example of a couple of ideas of what kinds of breaks could be applied to credit growth.
Here’s what seems to have happened. We actually have central banks that seem to be able to control their balance sheets quite well. Commercial banks seemed to, until very recently, do a reasonably good job of controlling growth of their balance sheet. I think the problem was the growth of a shadow banking system. What seemed to happen was financial innovation was almost a way of bypassing regulation. Financial innovation – there are lots of good things that happen with financial innovation, but it can also be like tax evasion. It’s regulation evasion. And I think we’ve learned our lesson after this experience. There are some things that are just obviously crazy, and allowing banks to start up mini-banks off the books just makes absolutely no sense.

Let’s talk a little about “self-interest.” Alan Greenspan used this phrase to explain his thinking over the past eight years. He told Congress that when he was chairman of the Fed he overestimated the self-interest of banks to protect the equity of their shareholders. Is this a new mistake?
He misunderstood the problem. Bankers are very self-interested. Their self-interest to protect their own net worth is very high. The problem is that the way the system was designed – their interest wasn’t aligned with their shareholders’ interests. They were encouraged to take a gamble with their shareholders’ money. And to the extent that they won, they got very large bonuses. And to the extent that they lost, sometimes they still got very large bonuses [Laughs].

But their shareholders took the bulk of their loses, and obviously if their losses were large enough, the government took their losses. So there was a misalignment of interests.

I think there is a sort of wider issue, which is that market forces work very well for most things. But there are certain dimensions of the finance industry, in banking, for which I think market forces alone are a dangerous phenomenon. Ever since we’ve had central banks, for the last 200 years, we’ve had a lender of last resort. There has been a non-market force to deal with financial crises. And financial crises are an example of market forces breaking down and people doing irrational things out of fear and panic rather than out of rational self-interest. And that is what was underestimated in the capacity of the financial system.

Your book is full of colorful characters like Bank of England Governor Montagu Norman who traveled under a pseudonym, wore a pointy beard and once told a colleague he could walk through walls. Are we lacking such colorful characters in the financial world today?
You know, probably not quite as colorful as that. But some of the things that Montagu Norman would say! For example, when he had to testify in front of a parliamentary committee, one MP asked him: “What is your reason for this?” And he tapped his nose and said, “I don’t have reasons, I have instincts.” Frankly, Alan Greenspan never said that, but that’s almost what he meant in his convoluted answers to questions in front of Congress. It was, in some sense, an indication that he basically had instincts. In some respects he had great instincts. He kept the economy on track for many years. He had great instincts on some things and terrible instincts on others.

There seems to be a pattern here. Financial minds are praised as heroes when the market is good and villains when things turn bad. Looking at Alan Greenspan’s legacy, do you see that happening?
Oh, yeah. It is very easy to criticize the Fed because they’re making decisions not knowing the future. They are steering the economy in a fog. Under Alan Greenspan, they did a very good job of keeping the economy on track – until the very last decision, when they drove off the cliff.

Can you point to one decision that the Fed made that left us where we are now?
I think it was the decision to keep interest rates too low in the early part of this decade. They misinterpreted the low inflation and they thought that pointed to a risk of deflation from lack of demand. My view is the low inflation at the early part of this decade was actually what one might call good deflation that came from a massive expansion in supply to the world of goods from China, certain services from India and goods from all over East Asia. That caused a shift in supply which shows up in lower prices, but that’s not something to worry about. And that’s why they lowered interest rates too fast. Basically they started lowering interest rates after the Internet bubble broke and they just kept their foot on the accelerator too long. Even though the economy was recovering. They were worried about deflation, and that was a mistake.

The subtitle of your book is “The Bankers Who Broke the World.” The four main characters, they’re not heroes, and yet you don’t depict them as villains either. Reading it you get this sense that they’re making decisions with the information they have in front of them.
Look, I probably got a little carried away with the subtitle [Laughs]. They were imprisoned by an ideology. They were trying to do the best they could. It’s just their ideology just didn’t encompass doing the sorts of things that were necessary. In their case the ideology was the gold standard. And in my book I use John Maynard Keynes as an example of someone who had broken free of that ideology. Remember that was John Maynard Keynes before Keynesian economics. He invented Keynesian economics, wrote the general theory in 1936. In the 1920s he was a mainstream economist, but he had an intellectual approach, which was to look at problems with a new and fresh eye and not to trumpet an ideology. It’s a little bit like today. You have people who insist that free markets are best. They are very good, and they’re very good for most things, but to always use that as a mantra rather than analyze the situation is not the right way to run it.  And I think that was the problem for these four bankers.

Can individuals and intellects like Keynes, Norman, Greenspan, Paulson, Bernanke and Geithner really effect the big picture of how markets operate?
Oh, I think enormously. I say at some point in the book that the Great Depression was a failure of intellectual will. Keynes – who is largely the hero at the middle of this book, in part because of his intellect and in part because he is such a charming character in his own right – he once said that we got ourselves into a terrible muddle because we found ourselves running a machine that we don’t understand. You might want to look up that quote.

But that’s the point. The economy is like a machine. It’s not mechanical, but it requires understanding and it’s not always very simple. And time and time again we see people drive the economy into a ditch because they don’t quite understand what levers we need to pull. And we see quite a bit of that in the current stimulus plan. We see it in the debate about the bailout plan. Part of it is just lack of understanding. Part of it is a political process by which people want to extract revenge on the people who got us into trouble rather than getting us out of the ditch. And those two things are not the same thing.

You believe stimulus is an important part of the solution to the current downturn. Why isn’t just pushing liquidity into banks enough?
Because periodically monetary policy loses all traction. It happened in the Great Depression in 1931. It happened in Japan in the 1990s. There are several reasons why that can happen. One is that prices are falling and we’re getting deflation. Interest rates can’t fall below zero, so if prices are falling and the cost of money is still too high, there’s nothing the central bank can do to get it lower. The other situation, which is probably what we have now, is that banks are so gun-shy that you can pump lots of money into the banking system, and it doesn’t come out the other end. Or, it comes out the other end at a very high price because banks are losing lots of money, and they are worried about losing even more, so they charge a very high credit premium. That didn’t happen in Japan, but it’s happening here. In the Great Depression we had both things going on.

So monetary policy has lost all traction. To go back to my analogy, think of the economy as a car, and you’re driving along and the accelerator is a perfectly good mechanism for guiding your car. But if you drive yourself into a ditch, no matter how hard you press on the accelerator, you’re never going to get out of the ditch. You need a tow truck, and the stimulus package is like a tow truck to get us back on track.

Is the current crisis being overstated? You’ve looked closely at the 1920s and 1930s. Are the comparisons to the Great Depression alarmist?
I don’t know whether they’re alarmist. So far, let’s look at some of the statistics. Real GDP fell 25 percent in the Great Depression. I suspect when it’s all over we will have seen real GDP in the US has fallen somewhere between five percent and 10 percent. Unemployment rose by 20 percentage points. I suspect that by the time this is over unemployment will have risen by six or seven percentage points. Profits in the Great Depression: in 1929 US corporations had US$9 billion in profits, in 1932 they had zero. Profits went to zero. So far, when you look at S&P earnings, we’ve fallen by about 50 percent. So all of these add up to a picture that says we’ve got somewhere between a quarter and a third of a Great Depression.

And there are lots of reasons and lots of mechanisms to prevent us from going further. Government is a bigger player. We have unemployment insurance. Taxes are more responsive. But we also are doing the right things. The virtue of the Great Depression is we have it as an example of what not to do. They let the banks go under. We’re not going to let the banks go under. We tried it once with Lehman Brothers with disastrous consequences. No one is going to let the banking system collapse in disorganized way as they did in 1931 and 1932.

So those are the lessons. The second big lesson was that countries then crucified their own economies on exchange rates. Britain and Germany raised rates by substantial amounts while in the middle of the Great Depression to try to hold on to their gold reserves. No one is going to try that this time. They will let their currency fall rather than raise interest rates.

Thirdly everyone was quite obsessed by balanced budgets, so Hoover raised taxes. Even Roosevelt raised taxes to fund the New Deal. I don’t think we’re going to do anything like that. We’re going to be willing to enter into budget deficits. So there was a whole series of lessons we’ve learned. Well, never say never [Laughs]. There is some small probability that we may screw it up.

Is there a danger of trying to borrow too much from our future earnings?
I don’t think so because the debt to GDP ratio of the US is still manageable. I think the things that could derail what we’re trying to do have less to do with lack of understanding and more to do with politics. For example, I could see a situation where there is so much political public outcry about injecting capital into the banks that we don’t inject enough capital, and we just prolong the banking crisis. I could see the situation where there is a lot of political pressure to try and protect jobs at home and try to export the unemployment problem abroad, and then our trading partners will try and export it back to us by raising tariffs and we’ll just be passing the parcel around.

The way you talk, you sound like you’re convinced this will turn around. How long will it take? Five years?
Even shorter. We entered the Great Depression in the middle of 1929. We hit bottom the moment Roosevelt took office in March 1933.  But actually, essentially we hit bottom by the middle of 1932, the last wave of bank crises. So the bear market lasted two and a bit years. Bear markets and depressions occur much more quickly than recoveries. You end up sinking into a hole far quicker than you recover. But they always end, and if you take the recovery after Roosevelt took office, by 1936 GDP was back to its level of 1929. The first four years of Roosevelt’s term were the fastest growth for any presidency of this century. Unemployment was still too high. That’s because it just took too long to get all those people employed. And some of the things that Roosevelt did raised the cost of labor. But the conservative myth that Roosevelt prolonged the Great Depression is bogus and doesn’t match the facts.

This time we’ve got a stimulus package, I think we understand the need to build the banking system. But I am a little worried that will go somewhat slower than it needs to. So, my view is within a year we’ll be getting out of this.  Now, will the stock market go back to where it was in September 2007?  No. It will take some time. But we will be on our way to recovery. And by the way, the greatest returns in the stock market always occur as the economy is coming out of a recession. If you bought stocks in March 1933 when Roosevelt took office, your money would have gone up more than three times. That’s how Keynes made his fortune.

Speculating?
Yeah. Betting on the growth.

So are you saying buy now, or wait a year?
Um, buy a little bit every month between now and a year.