“The Downside Was Not Worked Out”: Economist Jagdish Bhagwati’s Thoughts on the Current Financial Crisis

This interview is from Professor Jagdish Bhagwati’s website ( http://www.columbia.edu/~jb38/ ) and was previously published in Portuguese in a Brazilian newspaper. Professor Bhagwati answered several additional questions asked by Michael Collins.

QUESTION: How big is the U.S. crisis?

BHAGWATI: It is really big in the sense that it has led to panic on an immense scale among nearly everyone who has any assets in the banks or mutual funds, or mortgages on their homes, which means the bulk of the population in the U.S., and also among commercial and investment banks who risk failure. My tax lawyer, a wise man, told me that, even though I was recovering from a knee replacement surgery, I should withdraw moneys from Mutual Funds and then walk on my crutches down Broadway (the big Avenue near Columbia University which has many banks) and open up several bank accounts, each with $100,000 deposits (that being the limit of the deposits covered by the Federal Deposit Insurance Corporation)! No matter whom you talk to, the sense is that this crisis is reminiscent of the Great Crash of 1929.

Yet, there are no real parallels: the crisis this time around is complex but is being contained. At the outset, the 1929 crisis resulted in terrible consequences in massive unemployment and economic distress. So far, we have managed to confine the lost jobs principally to the layoffs in the commercial and investment banks: the unemployment rate has not been affected significantly. Second, the 1929 situation witnessed a tight monetary policy which accentuated the depression, and there was no sense that fiscal policy should be expansionary because the Keynesian insights were a result of the experience with the Great Crash and were not available to countervail the Crash! Third, the trade policy went berserk in 1930 with the passage of the Smoot-Hawley Tariff by the U.S. which led to retaliatory tariff-raising elsewhere, beggaring everybody. This time around, there is no willingness to indulge in such destructive, crisis-worsening trade policy. Liberalizing trade is going to be more difficult; but moving backwards into protection is most unlikely. Fourth, the policymakers, led by Fed Chairman Ben Bernanke (who narrowly missed being my student at MIT) and Treasury Secretary Paulson, are totally pragmatic and determined to do whatever is necessary to stop the crisis in its tracks.

QUESTION: What does this crisis tell you about how to prevent future crises?

BHAGWATI: No one knows where the next crisis will come from. My old teacher Professor Kindleberger, who wrote the famous book about Panics, Manias and Crises, was writing about financial crises that had occurred in history. Each time, he went back still further. So, I joked with him that he might one day work back to the Garden of Eden but that, while Adam and Eve certainly had a crisis, it was not a financial one!

In recent times, we have had four major crises, including the present one. In the October 1987 crisis, the “Black Monday” when stocks collapsed, everyone thought Capitalism had collapsed: it did not. Then, we had the LTCM [Long term Capital Management] Hedge Fund Crisis, where the problem was highly leveraged investments by this hedge fund, with pension funds and banks heavily invested in LTCM and the fear of systemic spread of the crisis was enormous. Then, we had the East Asian Financial Crisis which began in July 1997 and went through 1998. And we finally have the current crisis.

What is the common theme? In each case, the problem was that we succumbed to the euphoria that surrounds each “innovation” in financial policy or financial instruments, rather than simple “deregulation.” Thus, during the Asian financial crisis, the IMF pushed for capital account convertibility, thinking it was clearly a major innovation in policymaking. But, when disaster struck even though these countries had sound fundamentals, the reason was that the banking systems were fragile and not ready to support the convertibility. No one had considered this downside. Again, when the LTCM crisis happened, a good friend of...