The Italian Prime Minister, Mr Silvio Berlusconi, has resigned after 17 years in office. Most people blame him for ruining his country's economy. However, Italy has not been alone: Greece, Spain, Ireland, Iceland or even the US are in no better condition.

For instance, Iceland had a reputation of very low unemployment and an equally low crime rate. Its population is about only 320,000; yet, its GDP was over $13 billion in 2010. When its banks were deregulated, they took loans 10 times the country's GDP and ultimately incurred losses of a $100 billion. Now, Iceland is a country in distress.

I doubt whether many people have seen the documentary film Inside Job even though it has won many awards, including the Oscar Academy award in 2011. The film review and criticism website called ‘rotten tomatoes' gave it an extraordinary approval rating of 97 per cent. The film's concern was about the global economic crisis of 2008 which cost tens of millions of people their savings, their jobs and their homes.

GAMBLING ON DERIVATIVES

It all started when bankers heard of a new phenomenon known as derivatives. Actually, trading in derivatives is age-old. For instance, farmers take loans from the village money lender with a pledge to repay it with grain when the harvest comes in. That is risky: The prices may rise and the farmer may lose; alternately, prices may fall and the lender may lose. However, the system, based it was on a single transaction, has worked well.

In recent years, the system has become far more sophisticated. Complex computer calculations indicated that by combining a large number of risky transactions into what were called Collateral Debt Obligations (CDO), the overall risk may be reduced. The whizkids forgot to mention that their dreams worked only for small changes and they could become a nightmare when movements were large.

However, many bankers who knew little about mathematics and less about derivatives suddenly were fascinated by the possibility of making huge profits by trading in derivatives. For instance, the venerable owners of the ancient Barings Bank – bankers to the monarchs of Britain – were fascinated by the winnings that their agent Nick Leeson produced. When his gamble failed, the bank went broke. A traditionally conservative bank which had operated for centuries became bankrupt.

In the 1970s, a bond trader had to work as a train conductor at night as his income was not sufficient to look after his three children. Ten years later he was making millions of dollars. Understandably, bankers thought – quite wrongly as it turned out – that they had discovered the Midas touch. Unfortunately, no lessons have been learnt from the disasters that ensued.

LETHAL CHANGE IN LAW

For forty years, the Glass-Steagall Act of 1933 kept the US economy stable by regulating banking and prohibiting them from speculating with depositors' money. Once the bankers and the financiers tasted the illicit fruits of derivatives, that salutary act was repealed by the Gramm-Leach-Bliley Act of 1999. In fact, even before that Act came into force, the CitiBank was allowed to merge with Travelers Insurance to become CitiCorp. That was not legal but was permitted in the expectation that the Gramm-Leach-Billey Act will come into effect. That did happen a year later to clear the way for many more future mergers of similar type.

That deregulation doubled the National Debt of the US and tripled the rate of unemployment. Yet, credit rating agencies gave very high ratings, even AAA ratings, for derivative products and for housing and savings institutions like Freddie Mac and Freddie Mae, both of whom collapsed within days of receiving such extraordinary ratings. The tragedy was not that the rating agencies made any mistake but that they would not admit it.

“What we gave was merely an opinion” was their defence. Further, those that created this disaster were not punished. They got huge bonuses from over $50 to as much as $485 million as a parting gift. These disasters were not unforeseen. Ms. Brooksley Born, who was Chairman of the Commodity Futures Trading Commission (CFTC), proposed regulation of derivatives trading. She was overruled by her boss – an even more famous economist who is a household name.

Three equally famous topmost officials of the government – all former employees of large banks – formally issued a statement condemning Born. They said they seriously questioned the scope of the CFTC's jurisdiction and insisted that derivatives remain unregulated. I am not mentioning their names – you can find them out by seeing the documentary film.

THE MELTDOWN

As Professor Satyajit Das has stated, these financial titans initiated a titanic battle to prevent regulation of derivatives. In fact, Dr. Raghuram Rajan presented a thoughtful paper titled Has Financial Development Made the World Riskier? He was ignored. Thus, bankers who had never heard of CDOs bet on riskier Credit Default Swaps (CDS) – a new insurance that protected them if the CBOs failed. Some banks actually sold CDS as legitimate investments on which they themselves took bets their own CDOs will fail.

In year 2008, they did fail. Lehman Brothers and the AIG, two of the largest corporations of the US, collapsed even as they had credit rating of A2. As pointed out before, the perpetrators were well rewarded. In fact, the whole thing was a giant Ponzi scheme which permitted huge private gains at the expense of an equally huge public loss. It created something out of nothing. Banks became so powerful that they had captured the political system of the US.

In India, the Reserve Bank of India has been cautious. But Nifty allows trading in derivatives, assuring us that it is not risky because it has been designated in rupees. That, I believe, is a farce.

(To be continued)

(This is 316th in the Vision 2020 series. The last article appeared on November 5.)

(The author is a former Director, IIT, Madras. Response to > indiresan@gmail.com and >blfeedback@thehindu.co.in )

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