Ideological orthodoxy on the part of the world's leading central bankers in the 1930s was partly to blame for the Great Depression, the biggest 'economic event' of the 20th century. And a similar ideological orthodoxy — in particular, a blinkered aversion to 'nationalisation' of insolvent banks — could prolong the current economic agony, says Liaquat Ahamed, a professional investment manager for 25 years who has worked at the World Bank and author of Lords of Finance: The Bankers Who Broke the World (The Penguin Press, 2009).

In this second part of an interview to DNA Money's Venkatesan Vembu (the first part appeared in Wednesday's edition), Ahamed frames his Great Depression narrative in the context of the current economic crisis, and shares his perspective on whether in trying to avert another Great Depression, the world is opening itself up to other risks. Excerpts:

The four central bankers who are the subjects of your book were victims of the economic orthodoxy of their times. Are we today similarly bound to an economic orthodoxy that we don't yet realise is dragging us down?

We got into this one because we were bound to an economic orthodoxy: the economic orthodoxy of the market. The one place where market failures tend to be particularly pronounced is in finance. Markets overreact on the upside and the downside. Financial markets are prone to booms and to periods of panic. A more effective system of regulation and of tempering market forces may have been the right thing to do.

Second, I'm a little worried that we're falling into a trap all over again: bailing out the banking system is going to require massive injections of capital. Basically, banks are broke, they are insolvent, they need equity capital, but given the size of the hole and given the uncertainty about the size of the hole, the private sector does not want to put in money. That leaves only two sources of potential capital. The first is a massive financial restructuring, which would wipe out the bond-holders and use that as a source of equity capital. The second is the government. But there's such an obsession about the 'N' word — nationalisation. I'm worried that we're doing things that don't tackle the problem head on because of this set of ideological blinkers about nationalisation.

What's the risk in not nationalising soon enough?

Evidence from all past financial crises, including the Great Depression, is that drip-feeding the stuff doesn't work. You've got to take the bull by the horns. In 1932, the Fed chairman, Eugene Meyer, wanted to have an expansionary monetary policy and inject a whole lot of capital into the banking system. But the problem was that 1932 was three years into the Great Depression, and he'd left it too late. They injected all this liquidity and capital, but the banks just sat on it; they had lost so much, they were gun-shy and they refused to lend it out. The same problem, I think, is occurring now. We're trying to tackle this piecemeal. The longer you drag it out, the more expensive it's going to be.

Despite billions of dollars thrown at banks to recapitalise, lending hasn't picked up. Why is that and what more needs to be done?

You've got to see this in perspective. Back in the 1930s, bank lending collapsed by 40%; it's not collapsing by 40% at the moment, even though it's falling. I'm not sure that this criteria of saying that lending actually has to increase is the right one — because we know that people borrowed too much. What we're trying to do is ensure that the market doesn't overreact . We know that a lot of bad lending was made and that the banks were overexpansionary. We now want to make sure that the pendulum doesn't swing too far to the other side. We don't know what that precise number is, but it seems to me that we have to replace the capital they've lost. The banking system needs equity. And if you thought the banking system was undercapitalised earlier, it actually needs more equity than it had before. We not only have to replace the equity they've lost but add some more equity. Which is why I say that eventually we'll need to inject $2 trillion of equity - and I'm scratching my head trying to work out where that's going to come from.

There's been some speculation that we've either returned or are on our way to the Great Depression. Are we there yet?

Let's compare the statistics of then and now. During the Great Depression, unemployment went from 5% to 25%; employment fell by the equivalent of 10% of the population. Whereas this time, even the most pessimistic estimates suggest that employment will fall by 10 million — which is 2-3% of population.

Back then, real GDP fell 25% in the US, 25% in Germany, 10% in the UK. We're not seeing that this time.

Industrial production fell 50% then; this time, it will probably fall by between 10% and 20%.

Corporate profits in the US went from $10 billion to zero. This time, they might fall 50% but they won't go to zero.

Add all this up, and you get something like a quarter to a third of the Great Depression. It's bad, but it's not quite the Great Depression.

But is there any set of economic conditions that might tip us into the hole?

You can always envisage some crazy things happening. The things that made the Great Depression "great" were that, first, they allowed the banking system to collapse; second, they raised interest rates in the middle of the Great Depression in order to protect their currency; third, they refused to let their budget deficits expand; and fourth, there was no international lender of last resort, so eventually Germany, the third largest economy in the world, defaulted, all of Europe defaulted, and all of Latin America defaulted.

I cannot see any of those things happening this time. No one is letting their banking system collapse; no one is going to try to protect their currency by raising interests rates — if anything, we've got probably a slightly different problem, with everyone competing to get their currency lower; third, everyone accepts that budget deficits have to expand. Fourthly, the international debt system is more benign, and although the only faultline — in eastern Europe — is eerily reminiscent of the 1930s, we have the IMF. Even if the IMF is not large enough, and even if it needs more resources, it can stave off large-scale defaults throughout eastern Europe.

In averting a Great Depression-style collapse, are we opening ourselves up to other risks, like hyperinflation?

No. Hyperinflation occurs when you print currency that no one else wants. We're printing currency — that is, we're issuing Treasury Bills — that everyone wants. The demand for safe currency is so high that printing more of it is not a problem.

But here's the issue. The things we're doing — trying to save the banking system and expand the stimulus package — are designed to get the economy back on the road. But many of these things will have to be reversed. The Fed has expanded its balance-sheet from $800 billion to $2 trillion, and it's going to have to shrink its balance-sheet at some point and get out of the business of supporting credit markets.

The budget deficit has gone up to 12% of GDP; it's going to have to come down to 5-6% of GDP. All of those things will be tricky issues once were out of the hole we've dug ourselves into.

Do you see the appetite for T-bills as sustainable?

I think so. What's happened is that people have become highly risk-averse; they're selling risky assets to buy safe assets and what the Fed is trying to do, and the Treasury has been doing as well, is issuing safe assets — Treasury Bills, or issue T-bills to the Fed, which then sells them. And the Treasury and the Fed have been buying the risky assets. It's like they're recycling this money back into the system.

When you expand the budget deficit the way we have, you can tell when you're getting into trouble. You actually have a very clear signal, which is that interest rates start going up, and you progressively find it more difficult to sell your debt. There's no sign at the moment that anyone is having difficulty selling government debt. All governments issuing debt are finding it very easy to raise the money.

So, the market is saying it's sustainable because the market is forward-looking. If it doesn't thinks it's sustainable, it wouldn't buy the debt today because it would say it would be selling it at a loss tomorrow. The fact that interest rates are low is a reflection that the markets view this as sustainable. Actually, the market for bonds is quite efficient and is a good predictor of what's happening.

The Obama administration has unveiled big spending plans to rebuild America, but is it almost writing off the recession, and looking beyond it?

I don't think they're writing it off. Think of fiscal expansion as similar to calling a tow truck to drag you out of the ditch. They're saying that we have to do a massive stimulus package, so if we're going to spend a lot of money, let's not spend it unwisely, let's spend it in ways that reinforce our long-term goals. I think that's very sensible. It's not sensible to say 'we're going to spend this money, let's throw it at things'.

But there's clearly a trade-off. There are some expenditures that have more of a stimulus impact but are less useful in the long run in helping to restructure the economy. There are others, like infrastructure, which are necessary and may have a long-run impact, but may have less of a stimulus effect. To me, they've struck the balance very well.

Does the current crisis mark the 'death of the capitalist system' as some argue?

The capitalist system is a very efficient and productive system. We got a bit off the tracks because we mismanaged that system. It's just a matter of getting ourselves back on the track, and maybe changing the wheel alignment a little so we don't go into the ditch again.

It's quite clear what needs to be done. We need to make the banking system more stable. We need to find some way of dealing with international imbalances. We need to change central banks' behaviour to get them to focus a little more on preventing bubbles and not be too narrowly focussed on inflation-targeting. With modest adjustments we will restore the stays and it will work very well.

Has the science of macroeconomic management gotten better over the decades? Are we learning from our mistakes of the past?

We are learning from our mistakes, but the system is getting more complicated.

As the system becomes more complicated, the scope for making mistakes increases. So we are not making the same mistakes as the last time, we're making different mistakes!

That said, there are certain fundamental characteristics of capitalist economies that are inherently part of human nature. Occasionally, speculative bubbles seem to have the power to derail the whole thing and it seems to happen frequently. The tendency for booms and busts is probably an inherent part of capitalism.

Will we ever be masters of our economic destiny? Do today's policymakers, for instance, know what they are doing?

We know what the right things to do are. We're not always sure about the impact because there's an intangible effect - of confidence. Sometimes I use the analogy of driving the car to describe economic management, but where that analogy breaks down is that this is not a machine. We're dealing with mass psychology of markets, and confidence is a very fragile and intangible force.

How do you manage the ebbs and flows of confidence when that confidence and market sentiment can shift on a dime? This makes it an art, not a science. But we know roughly what the right things to do are.

Venkatesan Vembu / DNA-Daily News & Analysis Source: 3D Syndication