#
Before we move on with this episode of The Scene in the Unseen, do check out another
#
awesome podcast from IVM Podcast, Cyrus Says, hosted by my old buddy Cyrus Brocha.
#
I was a professional poker player for a few years and even though I was a winning player,
#
one of the many reasons I left poker was that I felt I was engaged in an unproductive activity
#
that contributed nothing to the world.
#
Poker is a zero-sum game, even a negative-sum game if one considers a rake charged by the
#
house and the only way a person can win is if someone else loses.
#
Basically, you have to exploit the mistakes of others.
#
The real world is not like this.
#
In everything else I do, whether it's writing or podcasting or producing journalism, I only
#
make money if I provide value to others.
#
When I benefit, so do others.
#
It's a positive-sum game.
#
No wonder, then, that gamblers are looked upon with suspicion by non-gamblers.
#
Not that there's anything morally wrong with gambling, for even the losers are consenting
#
adults, but it's true that a poker player doesn't make the world a better place by
#
Now, there are many things in common with the world of gambling and the world of finance,
#
and many people view finance professionals in the same way, as if they are just gamblers
#
in a giant casino, creating nothing of value and often bringing the rest of the world crashing
#
down, such as when there's a financial crisis.
#
And yet, this could not be further from the truth.
#
Welcome to The Scene and the Unseen, our weekly podcast on economics, politics and behavioral
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Please welcome your host, Amit Padma.
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Welcome to The Scene and the Unseen.
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My subject today is the importance of finance, a field that is often misunderstood and misrepresented.
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My guest is one of the thinkers I admire most in India, though I often disagree with him
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Ajay was my guest in a previous episode a few weeks ago talking about creative destruction,
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and I hope to make him a regular guest on The Scene and the Unseen.
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Before we cut to this conversation though, let's take a quick commercial break.
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This episode of The Scene and the Unseen is brought to you by Storytel.
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Storytel is an audiobook platform which you can listen to on your Android or iOS app.
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They have thousands of audiobooks that you can listen to on your mobile, including hundreds
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in local languages like Hindi and Marathi.
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An unlimited monthly subscription costs only Rs 2.99 per month.
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And you can also get a 30-day free trial if you hop on over to storytel.com slash IBM.
#
I actually use Storytel myself regularly, so as long as I sponsor the show, I'm going
#
to recommend one book a week that I love.
#
The book I'm going to recommend today is Born Standing Up by Steve Martin.
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I haven't actually read it, but my producer Abbas Momin says it's a beautiful moving autobiography
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and I intend to listen to it now that I've found it's on Storytel, you do the same.
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And remember, you get a 30-day free trial only at storytel.com slash IBM.
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Ajay, welcome back to The Scene and the Unseen.
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My pleasure to be here.
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So Ajay, you're a big fan of the world of finance and the world of finance is, according
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to one kind of popular notion, a world full of villains where nothing productive is produced
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and it's like a giant casino where you have hot shot bankers playing with the real lives
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of people who have no control over what's going on.
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Does finance deserve this kind of a bad rep?
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My claim would be that finance is the best example of The Scene and the Unseen, that
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the grand drama playing out in financial markets and financial firms is the ultimate foundation
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of all the prosperity and technology and innovation that we see around us today.
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That's a grand claim, so start breaking it down for me.
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So we are used to the world of things.
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We have a coffee, we have a cell phone, we buy things from firms and our immediate experiences
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are always about those things.
#
We see the market economy as a world of things and we appreciate and admire and marvel at
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all the things that the wonderful market economy produces for us.
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My shirt, my pants, all these joys, all these pleasures are given to us by the market economy.
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But now we should go one level deeper and ask, how does all this come about?
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Where do the firms come from?
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Where do the innovations come from?
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Where do the decisions of the firms come from?
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And this is where we get to finance.
#
So it is finance that puts the firms there.
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It is finance that tells the firms what to do.
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It is finance that creates the incentives for the innovation.
#
So my first level idea would be that the scene world is being invisibly controlled and shaped
#
and influenced every day by the world of finance.
#
And so let me start with the simplest of all examples.
#
I want to go back to the 1990s when somewhere in the late 1990s, people started getting
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the idea that, you know, you could build a software services company in India.
#
This was not a mainstream idea for a long time.
#
Most people don't remember that in 1994, when Infosys did the IPO, it actually did not succeed
#
It was not a hot IPO in 1994, as you might imagine today.
#
It's only by the late 90s that the idea got around that you can actually run a big, successful
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software services company in India and make a lot of money.
#
Where did that idea go off?
#
It went off in the heads of the finance guys.
#
They drove up the prices of the shares of the software services companies, the early
#
So what that did was it created this publicly visible price, the share price, the valuation,
#
the PE ratio, the price to book ratio of these software services companies was stratospheric.
#
And all around the country, there were people who started looking at those prices and wondering,
#
you know what, should I be doing something there?
#
So I was there and I vividly recollect that the financial system was shouting out to everybody
#
in the country that if you put 100 rupees and build a successful cement company, we
#
will reward you with wealth of 70 rupees.
#
In other words, don't bother building a cement company.
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But if you put 100 rupees and succeed in building a software company, then we'll give you wealth
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That's a price to book ratio of five.
#
And sure enough, there were attentive people all around the country who are watching that
#
drama playing out in the stock prices.
#
And so you had literally thousands of people in India who started wondering, could we start
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Do I have a friend who knows how to build software?
#
Do I have a cousin that knows how to sell software in London or in Sydney and so on?
#
So all across the country, the thought process started springing up that we should really
#
be building a software company and also we should really not be building a cement company.
#
All these decisions all across the country were invisibly coordinated by one thing,
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the stock market, the valuation of the stock market reshaped the thought process, the development
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of business plans all around the country.
#
So would it be fair to say that just as in the marketplace of things per se, let's say
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that I am someone who can make a widget for 40 rupees and I see that day in the market
#
it's selling for 80 rupees and that's an incentive for me to go in.
#
So the prices are giving me that information.
#
So similarly what you're seeing is that what the stock market tells you, what the world
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of finance tells you is that software stocks are shooting up and you're increasing the
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incentives for more and more people to get into it.
#
Is there a danger of reflexivity here in the sense that can you create a vicious cycle
#
where a bubble forms which is then inevitably going to come down as the dot com bubble did?
#
So now I want to go to the thought process inside the stock market and that will give
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The stock market is not some magical construct, it's just composed of people, it's composed
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of people like you and me and the prices at which trades take place reflect the views
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So those are smart people, they are looking at all the available information.
#
So that's your demand side basically reflecting it.
#
I just want to highlight the limitations of the process.
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The people who are trading the shares are looking at the world, are commanding information
#
about the world, are trying to make forecasts about the world and these forecasts will necessarily
#
go wrong and that's perfectly okay.
#
The future will always be unknowable.
#
Some things will go wrong.
#
So every now and then there will be mistakes.
#
We should not think about this as some flawless central planning system where decisions will
#
So yes, what you call a bubble, I call mistakes.
#
Mistakes will always happen that there will be a time when everybody thinks that nanotechnology
#
is going to work and there will be a rush of investment into nanotechnology firms.
#
And some years later, people will think, nah, that didn't really work.
#
We did not really make money in that and there will be money that is wasted and that's okay.
#
The point is that the stock market is the place where a lot of smart people come together
#
and form views about the future and not just write blog articles about those views, but
#
put their money where their mouth is.
#
People do trades with real money and do their best in trying to forecast the future.
#
So there is a remarkable alignment between the personal self-interest of the people trading
#
the market and the connections between the prices that are produced and the allocation
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of resources in society.
#
So there is self-interest part and then there is a positive externalities part.
#
These prices create positive externalities.
#
The whole country benefits because we are able to run a self-organizing system surrounding
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So everybody knows the price to book of a hospital.
#
Now thousands of people all over the country will wonder, should I start a hospital?
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Should I not start a hospital?
#
But doesn't this create a set of two incentives?
#
For example, earlier if you're starting a business, your incentive is can I make a profit?
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Can I create a product for 40 rupees where somebody will buy for 60 rupees?
#
But now there's another incentive which comes in where this profit in the marketplace of
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Can I have an IPO and am I in the sector which is hot right now, which could be dot com once
#
upon a time, which could be say biotech right now and it doesn't matter what the product
#
is and whether it ever makes a profit as long as the stock market values.
#
In the end, people do want profit.
#
So I think the financial system has demonstrated the ability to invest for long time periods
#
in losing propositions.
#
So in fact, 10 years ago, the criticism or 20 years ago, the criticism would have been
#
that the short term attention to profit is a mistake.
#
Well, today we've seen many sectors, most notably clean energy, where the financial
#
system understood maybe 10 years ago that global warming was a problem and there is
#
going to need to be gigantic development of technologies and infrastructure around clean
#
And the financial system was willing to commit very large resources into these firms, even
#
though they were presently not making money.
#
But it was the bet of people in the financial system that give it time, it's going to make
#
So the stock price is just the net present value of all the dividends that are going
#
to come out in the future.
#
Nobody is here for charity.
#
In fact, a great example that you gave me when we were chatting about this before of
#
how a bet by the stock markets actually makes a huge impact in the real world is what happened
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in the late 1990s when optical cabling, for example.
#
So optical communications is late 90s, early 2000s revolution, which was led by the financial
#
People understood that there is going to be an explosion of data and we need a whole new
#
generation of switches and computing capabilities surrounding mind blowing levels of bandwidth.
#
And there was a series of startups which got large investment by the venture capitalists
#
and it actually worked out well and we got that gigantic escalation of capabilities inside
#
many of those engineering companies.
#
So the role of the financial system is to look into the future and translate that into
#
a structure of payoffs for entrepreneurs.
#
So in our old world of high and the world of things, we will be talking the profit rate
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We'll be talking about the profit for one year.
#
What finance does is it takes profits over many years and turns that into a net present
#
value and also it brings the word risk into the equation, which is of course important.
#
So risk and reward come together in finance and what finance does ultimately is it creates
#
a structure of incentives for what industries should expand, what kinds of tools and technologies
#
and products are going to be important in the future and it sends out incentives for
#
firms and managers and entrepreneurs to build those kinds of capabilities.
#
And that's the invisible way in which the phrase is used that Wall Street runs Main
#
That Wall Street figures out these prices and then Main Street responds to those prices.
#
And it seems to me that those incentives also work in drawing the best minds to finance
#
because there is so much money to be made, the best minds come to finance and when they
#
are putting their money where their mouth is, you have to take that seriously.
#
So in a sense, you have the best minds coming together for good incentives, setting the
#
I have mixed feelings on this.
#
So first, I don't think that there's a shortage of minds.
#
So I think there's a very large supply of wonderful people in the world and I don't
#
think that there is a shortage of minds.
#
Some good minds come into podcasting as well.
#
So I think that there is a great deal of brilliant and wonderful humans all over the world in
#
many, many lives and careers and professions.
#
So some people have a negative view that there's a PhD physics guy who's now trading in a hedge
#
fund and that's a bad use for society.
#
I think there's no shortage of talent.
#
My second point is that, yes, exactly as you say, you need to bring in some of the best
#
capabilities into finance because finance is that important.
#
Finance has to think about the world, form views about the future and reshape the world
#
So we see this most vividly in the high technology space where many a successful engineer and
#
entrepreneur starts a second life as a venture capitalist.
#
So for example, the great engineer Bill Joy, who was one of the key people in BSD Unix,
#
one of the founders of Sun Microsystems, then turned into a partner at Kleiner Perkins.
#
And that's the kind of genius that is applying its mind to thinking about what investments,
#
Like his co-founder at Sun, Vinod Khosla, who is also a venture capitalist.
#
And you've described finance as the brain of the economy and use venture capitalism.
#
Joseph Stiglitz says that finance is the brain of the economy.
#
So break that down for me.
#
So all this thinking work is what Joseph Stiglitz calls the brain of the economy.
#
It is finance that has to think.
#
It is finance that awards valuations.
#
It is finance that is like the commanding heights of the economy, to use a Nehruvian
#
So what you would have thought the planning commission would do, that the planning commission
#
will decide that, you know what, we need to build integrated circuits.
#
We need a VLSI fab in India.
#
We don't need a VLSI fab in India.
#
These are all the things that are ultimately now controlled by the financial system.
#
So that is why Joseph Stiglitz calls finance the brain of the economy.
#
My good friend, Josh Feldman, tells a very interesting story.
#
He says that suppose there was an earthquake, I think you were there when he told this story.
#
He said, suppose there is an earthquake and the entire Bombay gets destroyed, okay?
#
And suppose we had to pick up the pieces and start over, what is the first thing that we
#
Answer, we would rebuild the financial system.
#
Because the financial system would then fund everybody else and the rest of Bombay would
#
So before you build the schools, build the banks.
#
Everything will flow from there.
#
The first thing you've got to get in place is the financial system.
#
And that's sort of a very telling analogy of a planning commission as say something
#
that's doing central planning, but it's centralized and it cannot possibly have access to all
#
the information and therefore it invariably messes up.
#
But this is sort of the brain of the economy, but all the information is decentralized.
#
So it's a self-organizing brain, okay?
#
So we combine the brain, but yet it's a self-organizing system.
#
And there's no compulsion.
#
Everybody's free to look at the system of prices and disagree that no, I don't agree.
#
I think aluminum is much more important than you guys think it is.
#
Put your money where your mouth is.
#
Buy aluminum futures or buy the shares of aluminum companies.
#
And where does a VC get his signals from?
#
Where does he get his...
#
What are his incentives?
#
Where does he get his knowledge from?
#
By looking at the world.
#
So the VC's job is supposed to be to look at the world and figure, I think these technologies
#
are going to be important.
#
These business models are going to be important.
#
And the markets are a reflection of that, the stock markets.
#
So the VC turns around and shapes the projects.
#
The VC is looking in the future.
#
And also remember the VC likes to take his project ultimately IPO.
#
So the VC needs to look at the stock market.
#
So the stock market says what kind of price to book ratios are attractive and the VC is
#
guided by the possibility.
#
For example, Indian healthcare, Indian NBFCs, when these price to book ratios were very
#
high, we got a surge of private equity funds building projects in these areas.
#
So what about more arcane forms of finance like derivatives or like the kind of complex
#
instruments that led to the 2008 crash?
#
So far I've talked about the stock market, I've emphasized the share price.
#
Now there are two more things that need to go into this and both of them connect to derivatives.
#
The first is that, okay, suppose you're this super smart guy and you have an opinion that
#
the share price of Infosys is going to do well, you have two choices.
#
Case one, you will put down a hundred rupees and buy the shares of Infosys.
#
Case two, you will put down 25 rupees and get a position on a hundred rupees of Infosys.
#
So you get a four times leverage.
#
By only putting 25, you get position of 100.
#
You're going to prefer the leveraged position.
#
So for people with too much brains and not much money, you are benefited by having a
#
leveraged position and that is what the derivatives do.
#
So financial derivatives allow the injection of knowledge and ideas into the process of
#
price discovery while giving a magnification where people who have more brains and not
#
enough money are able to participate in the price formation process.
#
The other side of the derivatives is derivatives trading on physical commodities, whether it
#
is aluminum or wheat or butter or eggs.
#
These are very important markets that directly link to the physicals.
#
So there you directly see that six months from now eggs are going to be expensive.
#
So you start getting incentives to build more eggs starting from today.
#
So the derivatives markets, they're directly connected into the world of things.
#
And this is not some abstract thing, you know, people sitting in Wall Street offices do.
#
This has a very real impact and one field in which you've pointed out where it could
#
There was an episode on this a long, long time ago with Kartik Shashtar on futures markets
#
in agriculture, where, you know, people just hear the phrase futures market in agriculture
#
and they're like, what the hell, you know, we have, you know, at the agriculture is in
#
a crisis, you need to kind of, you know, there are enough problems in the real world.
#
Why would you gamble with it?
#
But your point is that a lot of the problems of agriculture and the problems of the common
#
humble farmer can be sorted out if there are futures markets in agriculture.
#
And I would tell that in two steps.
#
So let's start from the world of things.
#
I think it is useful to see that there are two very big decisions that are made in the
#
Question one, what do I sow?
#
Question two, what do I store?
#
These are the two decisions that are made.
#
So I sow something, but the rain doesn't come or the locusts come, so there are many other
#
shocks that come along.
#
But in terms of the decisions made by real people in the world of food, there are two
#
Question one, what to sow?
#
Question two, what to store?
#
How do you make those decisions?
#
For these decisions, you need to have a view about the future.
#
You need to have a forecast about the future.
#
What we see in India every now and then is something that comes out of a model that was
#
written by the economist Paul Samuelson many, many decades ago.
#
He calls it the cobweb model.
#
That's a story that runs like this, that there's a shortage of tomatoes.
#
The tomatoes are very expensive.
#
So lots of farmers rush in and sow tomatoes.
#
So then you get a great surge.
#
You get a huge crop of tomatoes.
#
The price of tomatoes crashes, and then farmers get very unhappy.
#
And then they do not sow tomatoes.
#
And then the cycle starts all over again.
#
This is called the cobweb model.
#
And this is just a cycle of sadness that you're screwed when there's a glut of tomatoes, you're
#
screwed when there's a shortage of tomatoes, and this thing just goes on.
#
How do you break this cycle?
#
The answer lies in futures trading.
#
What you need is a futures market to say that, look, six months from now, we believe the
#
price of eggs will be so much.
#
Six months from now, we are able to see the prospective outcome of the kharif harvest
#
Now, if that information was produced by a deep and liquid and active market, then a
#
sowing decision could be taken by using that public good of the price.
#
So as a farmer, I could choose to use that information.
#
What will be the price of wheat?
#
What will be the price of rice?
#
What are all my alternatives?
#
What are all the future prices?
#
From October, when the kharif harvest comes out, I see all the futures prices.
#
And based on that, I work out my profits and I choose to sow one.
#
That's an incredible information resource.
#
So your farmer is then guided by the wisdom of crowds, whereas otherwise, look, the farmer
#
But here he has far more information if there are good futures markets for him to gamble.
#
And it's much more than information.
#
The futures market is not just an opinion.
#
It's not an opinion poll.
#
People are putting their money where their mouth is.
#
So the farmer can choose to actually enter into a contract to sell goods at Dashera when
#
the kharif harvest comes out, at that price that is visible in the futures market.
#
So it's not just an opinion poll.
#
It's not a hypothetical view of the future.
#
It is people putting their money where their mouth is.
#
And then he's guaranteed that, okay, I will get that price and he's going to sell it.
#
There is a crop failure problem.
#
There is a locusts problem, many other problems.
#
But at least price risk is something that futures markets excel at doing.
#
And again, the seen and the unseen.
#
Many people want that proof of truth.
#
They want to see if the farmer is directly selling goods on the futures market, you think
#
the futures market is useful.
#
And I think that's a very incomplete view of the world.
#
The futures market is useful if it reshapes the structure of information.
#
If it changes the way people think, full stop, you don't have to have direct participation.
#
And now let me come to part two, which is the storage decision.
#
So I'm a person who has capital, who has a warehouse, and I see a price of wheat on the
#
spot market today, and I see the price of wheat six months into the future on the futures
#
And if I see a good gap between the two, then I think to myself, why don't I buy goods on
#
the spot market and put them in a warehouse?
#
That's a storage decision.
#
So thousands of storage decisions all around the country are taken by using the futures
#
price as a reference, and maybe entering into a contract also to sell through the futures
#
exchange, but it doesn't need to be.
#
The futures price is a public good, and it can reshape the decisions of storage.
#
And you can see how the sewing decision and the storage decision are both very important.
#
So if people will not store at the right time, it will generate a glut on the spot market.
#
So you want this entire machinery that in June when the kharif sewing is being done,
#
you want a good sewing decision.
#
In October when the crop comes out, you want a good storage decision.
#
All these decisions are coordinated by the futures market.
#
How do agriculture future markets work in other countries?
#
This is exactly how they work in other countries.
#
And what is sort of, is it again a mindset problem for why Indian policymakers don't
#
let these happen, or are there interest groups which benefit from these not happening?
#
So I think we have a lot of baggage, emotional baggage around hoarding of food.
#
We have a skepticism about trading.
#
I think we think trading is a bad thing.
#
So some of these primeval fears keep coming up from time to time.
#
And we've done a great deal of government interventions that have limited the ability
#
of the futures market to work.
#
We'll take a quick commercial break and we'll come back in a minute.
#
Welcome to another great week on the IVM Podcast Network.
#
If you're not following us on social media, please make sure you do.
#
We're IVM Podcast on Twitter, Facebook and Instagram.
#
We'd like to thank our sponsors for the month, Sawadi, Storytel and Paytm Money.
#
Thank you for your support.
#
Also guys, we're still hiring and as I've mentioned before, I think IVM Podcast is probably
#
the best place to work in the world.
#
So if you're interested in joining our team, we're looking for producers, content creators,
#
audio engineers, developers, we're looking for business development people, we're looking
#
for data scientists, we're looking for all kinds of roles.
#
So if you're interested, send us an email to careers at indusvox.com and we shall get
#
back to you hopefully and get you on board.
#
We have a brand new show launching called The Origin of Things.
#
It's hosted by one of the co-hosts of Simplify, Deepak Gopal Krishnan, better known as Chuck.
#
On this show, he'll be focusing on the origin of famous brands.
#
Chuck will drop fascinating hits throughout the episode, but the brand is revealed only
#
Will you be able to guess the brand before the reveal?
#
Find out by tuning in to the first episode, launching on Wednesday, 19th of June.
#
And keeping the queers back with season 3, the new season has more of everything from
#
stories to debates to discussions.
#
The show also has two hosts now, Navin Narona and Farhad Karkaria.
#
Tune in to the first episode of their reunion.
#
On Siders Says, filmmaker Jaydeep Sarkar talks to Siders about his early days in showbiz,
#
why he enjoys making ad films more than features, and his recent launch film for Times of India's
#
Times Out and Proud campaign.
#
On Business Start Next, by Bloomberg Quinn, Govindra Jathiraj talks to co-author of the
#
best-selling book Fish, Harry Paul.
#
They talk about the importance of a culture of excellence in an organization and how it
#
is one of the most integral parts of employee management.
#
On Edges and Sludges, our new cricket podcast, Ashwin Varun and DJ are talking to the cricketeers
#
and Aatif Nawaz about the ongoing ICC Cricket World Cup.
#
On the 99th episode of the Prakriti Podcast, Pawan is joined by Dr. A.P.
#
Ashwin Kumar from the Centre of Learning Futures to unpack nationalism, language and identity.
#
Nationalism is also the topic of discussion on episode 39 of Puliyabazi, where Pranay
#
and Saurabh are joined by Nitin Pai, director of the Takshashila Institution.
#
On this episode, they specifically look at liberal aspects of nationalism.
#
On show near 1, Sheila, Diti and I are joined by Pranav Khosri, founder of Flick and co-founder
#
We talk about Flick, the world's smartest button and Pranav's future plans in India.
#
And with that, let's continue with your show.
#
Welcome back to The Scene in the Unseen.
#
I'm chatting with Voldemort Ajay Shaw about the evil world of finance, which sucks hope
#
In your case, that's quite the opposite.
#
I think that finance is the invisible knowledge and information system that runs the market
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One interesting point that you made, which I'd like you to elaborate on, is that financial
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markets also set the price of time.
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I want to borrow money today that I will repay you next year.
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So that's an interest rate.
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That's the price of that delay of one year.
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And it could be two years.
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It could be five years.
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This price is discovered on the bond market.
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So there is a giant edifice called the bond market where there are traders.
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Some people in the economy want to put money in today and get it out tomorrow.
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Some people want to take money today and return it tomorrow.
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And all these relationships are sold out on the bond market.
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And bottom line, the bond market delivers a number to the economy.
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It's an information system that delivers the price of time to the economy.
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So whether you're going to take a home loan or you're going to build a bridge, this is
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the infrastructure that makes it possible.
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So the noisy tumultuous process of trading and speculation and bond market, bond futures,
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all that stuff, results in one outcome.
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And that outcome is the economy understands the price of time.
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And that is, again, not an opinion poll.
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It is people who are putting their money where their mouth is.
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So when you build a bridge and you are going to borrow for 10 years or 20 years in order
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to be able to pay for that bridge upfront, you are the user of this market in time.
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So all long dated projects which involve borrowing ultimately feed off the giant public markets
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in the form of the bond market.
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How does the central bank fit into all this then if they're setting interest rates and
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The central bank controls the short term interest rate.
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In a proper market economy, the central bank should only control the short term interest
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So it could be at a one day horizon, it could be at a one week horizon.
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All other rates should be discovered by the market economy.
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Now, this may often not be the world that we live in.
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We may often have interventions by the government in trying to reshape interest rates at different
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But that's part of the larger agenda of the role of the price system in India.
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But in a conceptual frame and what we see happening in mature market economies all over
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the world is that the role of monetary policy is to control the short term interest rate.
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After that, all other rates are produced by the private sector.
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And perhaps this is a subject for a separate episode on its own.
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But the thing is that if we know that just allowing markets to function and set the price
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of everything is overwhelmingly good for society and any interference with that is a problem,
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then why an exception in the case of the central bank setting short term interest rates?
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That is subject for a separate episode.
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It turns out that the creation of fiat money intrinsically comes with that one lever.
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So in the olden days, we used to say the central bank controls the printing presses.
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The moment you decide to build fiat money, you control that printing press.
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We are now in what is called a Vixelian world, where the printing press is controlled by
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this decision to set the short rate and it turns out that by controlling the short rate,
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we are able to exercise a stabilizing force on the business cycle.
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So that's why that one rate is special.
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Now tell me about, you so far told me how the financial system is the brain of the economy.
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Wall Street today determines what Main Street will do tomorrow, how the information plays
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out, how the incentives play out.
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Now whenever I hear, whenever I think of well functioning markets, I also worry about a
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well-meaning state messing it all up.
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What are the different ways in which the state can interfere with financial markets?
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So I have described a world where the financial markets work well.
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By default, financial markets do not necessarily work well and there are market failures.
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So the classes of market failure that we see in finance is there is an externalities problem
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if there is a collapse of a financial firm or a collapse of the financial market system,
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it imposes harm upon innocent bystanders.
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So there is an externalities problem.
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There is an asymmetric information problem in that when you are the user of a bank, you
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do not know the soundness of the bank.
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You do not know whether the bank will actually live up to its promises.
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So it's an unreasonable amount of effort.
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It's a bit like a food safety thing that if you and I go buy medicines in a shop, we can't
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be expected to test the purity of the medicine.
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So like that, there is an asymmetric information problem in the statements that the financial
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firms make to their consumers.
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So these two problems require a set of regulatory interventions.
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And the regulatory interventions in finance basically fall into four categories.
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Case one is called consumer protection, where you're just helping households be protected
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against unfair trade practices.
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Case two is called microprudential regulation, where we don't allow the financial firms
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Element three is called resolution, which is a specialized bankruptcy code for financial
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And case four is called systemic risk regulation, where you deal with the possibility of the
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entire financial system collapsing in a crisis.
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These four functions are required to be performed by a government apparatus.
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Now what goes wrong is all too often such government apparatus turns into central planning.
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That is indeed where we came from.
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Not so long ago, there was not a whiff of a normal financial market system in India,
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and all we had was central planning.
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And we are constantly torn between these impulses.
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So what we in India are at is the early stages of understanding what is the role of finance
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in society, and of reorienting the government machinery away from central planning, from
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controlling all the prices of time rather than only being in the short end, and actually
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producing these four kinds of responses correctly and efficiently.
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And many things go wrong.
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So I'm not here to say we are sorted.
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I'm not here to say we have a well-functioning financial system in India.
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I'm not here to say that our government machinery for doing these four kinds of things is in
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But I am here to say that this is the kind of role that the financial system should be
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playing in a market economy.
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And this is the kind of world that we have to build around us in India.
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So one of the dangers you pointed out of an unregulated financial system and where the
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government needs to step in is externalities.
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And again, this brings me to the example of the 2008 crisis.
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And again, your points two and four, microprudential and then systemic risk.
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And the US government, of course, bailed out AIG and Fannie and Freddie and so on in 2008,
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allowed Lehman to collapse because there was what they called a systemic risk and then
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pumped in a lot of money and basically bailed the whole lot of them out.
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Instead of letting them collapse, as you would expect if you just followed the path of creative
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destruction, as you described in a previous episode.
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So my question is that, doesn't this lead to moral hazard, where you're basically privatizing
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profits, socializing losses, and therefore any big financial firm or bank can just say
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that, hey, I'll do whatever, I'll gamble with my money.
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If I lose, the government's bailed me out.
#
There's no question that there is a threat of moral hazard, but let me first show the
#
problem in its most extreme form and then let's think about what governments have done
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and how you would do things differently.
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Here's the most extreme form.
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I'm a trader working in a bank.
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I am given a million dollar bonus if I make a lot of money.
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So the game is well understood to me that if I make $5 million in profit this year,
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I will be given a bonus of $1 million.
#
What is the incentive of the trader?
#
The incentive of the trader is to make a Hail Mary pass, to take very, very, very high risk.
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If it works great, I make my organization a lot of money and I make a million dollar
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If the trade doesn't work out, how bad does it get?
#
So there's a fundamental incentive of employees of financial firms to roll the dice.
#
And that's what microprudential regulation is all about, to limit the risks taken by
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And the moment I have said this, you will shake your head in unhappiness that do you
#
really expect officials of some government agency to understand the richness and complexity
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of the risks that are taken by the employees of some private financial firm and really
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be able to limit that risk?
#
So microprudential regulation is hard.
#
And this is the battle that we are placed in, that the basic incentive of private financial
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firms is to take a large risk.
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Now there are structures that will do it better than others.
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For example, I think it's always better if you and I as individuals are traders because
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I've internalized that risk.
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I'm not part of a corporation.
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This is why I always favor more direct individual participation in markets, because once you
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get into institutions, it becomes more complicated.
#
And structures like hedge funds are fundamentally better because the returns are aligned with
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the performance that investors get.
#
And structures like banks are the most dangerous because there is a balance sheet and there's
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a lot of leverage and this is where you get the most trouble.
#
Now when the government fails on its microprudential regulation or when the government fails on
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its systemic risk reduction, you can get some big messes.
#
Most many of us feel very uncomfortable about bailouts by the government.
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It is the clear use of taxpayer money to clean up for the bad things done by fat cats who
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have been buying yachts and private planes.
#
The injustice of this is palpable and there is no way to gloss over it.
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I just want to say to you that from the other side, nobody feels differently.
#
So I worked on the cleanup after the UTI crisis in India and I've had extensive conversations
#
with some of the people who worked in the United States in fixing things after the global
#
There's not a single person there who has the slightest attraction with bailing out
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The point is that the alternative was worse.
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So I am persuaded that if the AIG and other bailouts had not happened in the United States,
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at the cost of a lot of money to the taxpayer in the short run, the alternative would have
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And in the United States, a lot of that money eventually came back.
#
So in India's case also, the public money that went into solving the UTI problem, it
#
eventually came back with interest.
#
So the government made good and in fact made a profit on the UTI rescue.
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So it's not that obvious exposed that a lot of money was put in.
#
But the point is clear in my mind, on the date when these decisions were taken, that
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the alternative was worse.
#
That if you just let UTI flame out without any public intervention, which is closer to
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the sorts of things that a more hotheaded person, namely yours truly, used to think
#
in those days, not doing anything was worse than doing something using public money.
#
So I'm less religious about these matters today.
#
I think we should coldly look at the situation and we should do things that are wise and
#
sensible even when it appears horrible.
#
And there will always be the rhetoric that the fat cats have their yachts and you're
#
using precious taxpayer money to cover up for their mistakes.
#
There is no running away from that rhetoric.
#
And we have to think sensibly despite that.
#
I mean, I look at the sort of the marketplace of things as it were.
#
And the whole idea is that companies which make mistakes, for example, companies which
#
set bad incentives for their employees, like the financial firm as an analogy, which might
#
set a bad incentive for the trader to get his million dollar bonus.
#
When companies in the marketplace of things make mistakes like that, they suffer for it
#
in the balance sheet, they shut down, they're allowed to shut down.
#
And that's a lesson for everybody.
#
And that's how good practices creep into the thing.
#
But your point is that there's so much at stake in this bigger world of finance that
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sometimes you have to bail these guys out and the problem of moral hazard therefore
#
is ever-present and therefore this could just be a cycle.
#
It will assuredly happen again.
#
First, I want to say that please do not underestimate the damage that was caused to the shareholders
#
of AIG, to the top managers of AIG, they were wiped out.
#
So it's not as if they are directly getting money.
#
The more complex thing is they made a bonus the previous year.
#
So for the previous 10 years, they had taken home fabulous bonuses.
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They were buying islands in the Bahamas and nobody can change that.
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Privatized profits and they knew the losses would be socialized.
#
So when AIG got public money, the existing shareholders were wiped out much like a bankruptcy
#
Now the reason why the world of things is different from the world of finance is exactly
#
where we started that finance is the brain of the economy.
#
So the amount of damage that you can do by destroying the financial firms is extreme.
#
So I said that if there was a giant earthquake in Bombay and everything was destroyed, where
#
You would start by rebuilding the financial sector.
#
Now let me flip this around.
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Let me leave the rest of Bombay intact and let me destroy all the financial firms.
#
Let me destroy the financial markets.
#
That would be a catastrophe.
#
The world of things would not work if the world of finance was not there.
#
So because finance is so important, a disruption of the financial system is disproportionately
#
important and it does damage.
#
So there's a really bad problem in what you're describing and you are absolutely correct
#
It's a tough thing that we will need to confront.
#
So my good word will be, can we do better on microprudential regulation?
#
Can we do better on systemic risk management so that these things don't happen to us?
#
And I think there's a lot of headroom for us in India to do these things.
#
That said, yes, I feel pretty certain that in the next 20 years we will have one more
#
Because it is in the nature of finance for these things to happen.
#
Let me say this in a somewhat more sophisticated way.
#
I said that there is a trader in a financial firm and the boss of the trader or the regulator
#
of the bank is trying to control the risk that this guy is taking.
#
But that trader is sitting at the desk and thinking day and night.
#
The trader will always find that complicated oddball position that can be taken, where
#
the risk as calculated by his boss or his regulator will be wrong.
#
So the world is a complicated place.
#
Every attempt by a regulator or by a management to measure and control the risk that is being
#
taken by the decision makers, these attempts will always be crude.
#
And the moment you put in a system, the moment you put in a risk system, there are very,
#
very smart people who are trying to find the chinks of that risk system.
#
And the world will change and there will be opportunities to load up on risk in ways that
#
your risk model does not quite see.
#
And then the cycle will start all over again.
#
So it's just in the nature of the world that the world will change.
#
The class of instruments will change.
#
Every risk system is limited.
#
We will have a mess and then we'll clean up and we'll start over.
#
So now you're someone who's known the Indian financial system intimately, both as part
#
of the establishment and as a reformer and perhaps as a player.
#
So in your view, very broadly, what is wrong with the Indian financial system today?
#
In India, we started at a legacy of a 1934 RBI Act.
#
When the British created that act in a remarkable act of honesty in the first two sentences
#
of the law, they said that as a temporary measure, we create the Reserve Bank of India.
#
So this is not a structure that was intended to be a thorough, well thought out thing.
#
And it has taken many, many years.
#
So we started with that temporary structure in the years of Indian socialism.
#
We built an entire financial system around central planning.
#
So the idea was that the planning commission would decide there needs to be a steel mill
#
and the financial system will serve up the money required to build that steel mill.
#
That's where we started.
#
We started getting some new organizations like SEBI.
#
But in the 90s, when the DNA of the organization was laid, we did not know a whole lot about
#
how to create the processes and the checks and balances of these organizations.
#
I think only in the last five, 10 years, we've developed a good understanding about what
#
I checkpointed the four things to you.
#
We need to do consumer protection, microprudential regulation, resolution, and systemic risk.
#
This clarity is only last five, 10 years.
#
And we also have a lot of clarity on how a regulator should work, how to create checks
#
and balances, how to prevent arbitrary power, how to prevent arbitrary persecution by a
#
These are things that we've only started understanding in the last five, 10 years.
#
So I think only now we're coming to the point where we have a reasonable understanding of
#
what is the task of financial regulation and what is the kind of organizational design
#
and law and public administration that will take us towards state capability, state capacity
#
in doing this kind of work.
#
And in the meantime, there are these incumbents in the landscape, there are public sector
#
firms in the landscape, so there will be resistance.
#
So I see a long, slow journey of building the state capability to do the right things
#
and not do the central planning.
#
What are the big specific reforms you'd carry out if you were in charge of the finance ministry
#
I was a bit player in a very important project that was begun in 2011.
#
It is called the Financial Sector Legislative Reforms Commission.
#
And this blueprint was set up there.
#
This commission was led by Justice Shri Krishna.
#
And the report was submitted in 2013 and the work was completed in 2015.
#
It's a single clean law.
#
It's called the Indian Financial Code.
#
And in my mind, that's a very important reform.
#
To enact this law, it replaces 61 existing laws.
#
And then there would be several years of work on building the agency architecture that would
#
be able to enforce this law.
#
Is it online somewhere where I can link it from episode page?
#
Ajay, thanks so much for coming on the show.
#
I learnt a lot talking to you.
#
If you enjoyed listening to this episode, you can follow Ajay on Twitter at Ajay underscore
#
That's at Ajay underscore Shah.
#
You can follow me at Amit Verma, A-M-I-T-V-A-R-M-A.
#
You can browse past episodes at The Seen and the Unseen at www.seenunseen.in, www.thinkprakati.com
#
and www.ivmpodcast.com.
#
The Seen and the Unseen is supported by the Takshashila Institution, an independent center
#
for research and education and public policy.
#
Takshashila Institution offers 12-week courses in public policy, technology policy and strategic
#
studies for both full-time students and working professionals.
#
Visit takshashila.org.in for more details.
#
We debated between the Chromecast and the Firestick.
#
We gave up on sleeping early so we could stay up watching true crime shows.
#
We got ourselves three cat babies.
#
And basically became the cutest couch potatoes around.
#
In case you guys still haven't got it, we are a TV crazy, Netflix loving, binge watching
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And if like us you snort TV for breakfast, lunch and dinner, this is the podcast for
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Tune in every Thursday on the IVM Podcast app or wherever it is that you get your podcast
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This is Mr. and Mrs. Binge Watch.
