Let me make an attempt to make a case for the “poor little rich bankers” who are currently vilified. First of all, let us not forget that in the last two and a half decades, the financial industry has been innovative on a scale that can only be compared to computers, pharma or software (where too returns and wages have been pretty high). Today, we take for granted mutual funds, index funds, MBOs, venture funding, angel funding and various other developments which have made capital markets more efficient allowing new enterprises to access capital. Twenty years ago, if you were a young person with brains and initiative but did not have a rich family to back you, there was virtually no hope that you could become an entrepreneur. Today, the capital markets will back you in a variety of ways. Twenty years ago rich businessmen with influence and connections had near-monopolistic access to all capital in a country like India — even the capital controlled by state-owned banks and insurance companies. Listed public companies published accounts only once a year and usually late; any money in the stock markets were made by insiders. Today, any middle-class TV-watching Indian can buy into mutual funds where the commissions continue to drop each year. And in countries like the United States, this “democratisation” of financial markets has gone even further.

Ironically, the much-maligned sub-prime loan market which is supposed to have started the current crisis was a democratisation of credit. After working continuously for 35 years, my grandfather used his savings of a life-time to buy a home. Till then he and his family had to make do with a rented home. There was simply no credit market willing to give him a loan when he was in his twenties, taking into account his future income and savings. Contrast this with today. People do not have to postpone home purchases till retirement. Sub-prime mortgages were an attempt to extend this facility which has been available for long to the middle class in the US to poorer sections of society.

In retrospect, scholars may conclude that the real tragedy was that the sub-prime innovation coincided with Alan Greenspan’s ill-conceived attempt to avoid a recession before he retired. By dropping interest rates to all-time lows and encouraging a real estate bubble (to steer away from a recession when the dot-com boom ended) he created distortions in sub-prime pricing making the credit rely on asset price inflation as the basis for its soundness. Ill-informed persons have argued that Greenspan relied on the doctrines of Milton Friedman. Au contraire, Milton Friedman was totally and emphatically opposed to the central bank tinkering with interest rates with the ill-conceived notion that business cycles could be fine-tuned. Friedman wanted central bankers to stick to an announced formula for money supply growth — not keep changing it off and on which was Greenspan’s style.

Intertwined with bad monetary policy has been an atmosphere of crony capitalism. If LTCM (Long Term Capital Management) had not been saved, there would have been a small financial crisis, possibly a recession and most importantly financial market participants would have realised that there is a price to be paid for being on the wrong side of a risky gambit. By bailing out LTCM (ostensibly to help the system), Greenspan and his friends gave a dangerous signal to all participants in financial markets — that they could ignore counter-party trading risks.

There have been other worrisome happenings. As treasury secretary, Robert Rubin backed the deregulation necessary for Citicorp and Travellers to merge. After he retired as treasury secretary, Rubin became a highly paid director of the merged company which has had none too stellar a performance. Henry Paulson, the ex-CEO of Goldman, being treasury secretary has also been a matter of concern. Years ago, the Nobel laureate George Stigler published his empirical findings that senior managers in railway companies became railway regulators and vice versa. Guess what — rail fares went up to higher levels after regulations were introduced to control them. Stigler’s prescient warning that it is dangerous to let the economic actors who are being regulated enter regulatory office needs to be re-emphasised. Walter Wriston, who was one of the greatest American bankers of the 20th century, neither sought nor accepted office involving government oversight. His is the example bankers need to go back to.

Banks face justified criticism for providing their managers with bad incentives that encourage them to focus on short-term gains and indulge in excessive risk-taking. But let it not be forgotten that bad monetary policy and regulatory confusion were the root causes. Defenders of free and well-functioning financial markets are on the defensive today because we have acquiesced in lax monetary policy and incipient crony capitalism. Let us remember that bad money (remember Gresham?) and crony capitalism are greater enemies of free markets than leftwing critics can ever be.

The writer divides his time between Mumbai, Lonavla and Bangalore jerry.rao@expressindia.com