Ep 119: Financial Crises: Why They Happen, How They Unfold, What to Do

**Amit Varma** (0:00)
Welcome, you're listening to the audio version of Everything is Everything. This show is a video show, there are sometimes visuals that help you appreciate the content better, but mostly the audio should be enough. Please, please, please do subscribe to us on YouTube also.
Gentle readers, welcome to Everything is Everything. I am Amit Varma, and this is my good friend, Ajay Shah. And you know, in a manner of speaking, even though I addressed you as gentle readers, I am actually one of you, because while we do the show, I often find myself, you know, just being a gentle listener, as it were, listening to Ajay's wisdom, learning from him. I mean, I can, I have lost count of the number of TIL moments that I have gained during the show, just sitting opposite this man and listening to him, and the number of insights, and it's really expanded my brain beautifully. I'm sure you will agree if you are a regular viewer. If you don't agree, why are you a regular viewer? It's because of me, isn't it? I'm so hot. But anyway, we've done a bunch of great episodes on finance. A bunch of episodes are on firms which is related, but our episode 21, The Beauty of Finance, is to me a foundational episode, and how we think about finance is one of the most popular episodes of the show, as well by our model standards. We've also done a great episode diving deep into the journey of Indian finance, in which you were actually a player, you had skin in the game, you shaped that field, you wrote a great paper on the shaping of that field and the part you played in it, and we did a wonderful episode on it, so please check that out. Today, what we are going to talk about, which excited me a lot when Ajay brought the idea up, is about financial crisis, that every once in a while, it will seem like the world is falling apart, the financial crisis is over, inflation is over, this is over, bailouts, this, that. What does it all mean? Why does it happen? Is someone screwing up, or is it the natural order of things that just as a wave, crescent, troughs, a similar thing will happen? So Ajay has designed this great episode based on something that he knows intimately. He doesn't know this from books of study or getting a degree about it. He knows this from being in this field for 30 years, being a player in this field, being a participant and not the cause of financial crisis, but being a participant of different financial crisis, most notably the 2008 crisis, where we discussed his role both in my episode with him on the scene and the unseen, and in my episode with KP Krishnan, if I remember, which was a classic episode. So he is a player in the game. He is an insider. He is not just a thinker. He is an actor. He is a doer. He is reflected on the doing, and he has come up with a set of thoughts I can't wait to hear more about. At the same time, before we start, I will also say that there are different schools of thought on what causes financial crisis and how you should deal with them. And on many of the things he is going to talk about, I actually disagree with him. So now, through the course of this episode, I am not going to bring those differences up or belabor them. I am a sceptical outsider. I have never had skin in the game. I have never been part of the field. He is a man to talk about it, which he will do so. But right at the end, what I will do is, I will do a brief chapter talking about some of the differences and pointing you to resources and saying, hey, please read this stuff, make up your own mind. But in the meantime, this is not in my estimation of what is going to unfold, not just going to be a master class, but also another glimpse at a personal journey, which you have taken, Ajay.

**Ajay Shah** (3:32)
And this, General Reader, is why Amit Varma is the most loved man in the country, because unlike most men, he knows how to listen. His superpower is listening. And it is a rare skill to have, okay? Every young man learn from Amit, learn to listen.

**Amit Varma** (3:52)
And yes, I was also going to say things to young women, but never mind.

**Ajay Shah** (3:57)
Okay, so on to our main material of financial crisis.
Financial crisis tend to hit the headlines. For an analogy, we notice planes and civil aviation when an Air India plane crashes into a medical college hostel in Ahmedabad. And our attention span tends to be limited, we tend to forget. Okay? It's an interesting and important field. The world has been shaped by financial crises. Okay? It's like if you play for stories and situations and problems where the fate of the world is on the line, you have to take interest in financial crisis. Okay? They are that big. So, financial crises are upstream of wars and revolutions and all the great dislocations of the world. So, this stuff matters. And so, I think all of us should take interest in this. And then, as an individual, it turns out that we have skin in the game. So, you may not be interested in finance, but the financial system is interested in you. And when the financial system glitches, it imposes externalities upon firms and individuals all over the landscape. So, this is a field that we should take interest in. Not least as an employee of a financial firm, but really about everybody. So, let's start with the basic concepts and definitions. To define a financial crisis, I need to define finance. We've done that in The Beauty of Finance. But just a succinct version is, finance is the brain of the economy. Finance does the resource allocation. Finance picks winners. So, who gets money? What industries get money? What technologies are prioritized? Finance points the nose of private entrepreneurs, that this industry is a price to book of 10 This industry is a price to book of 1 I ought to be investing in the industry that is priced to book of 10 So, finance controls the resource allocation of the country. Finally, as we emphasized in The Beauty of Finance, finance solves problems for real people. And roughly speaking, these problems are moving money across time, overcoming the problem of risk, mobilizing money for large complex projects. These are financing problems. And the job of a financial system is to solve those problems. With this definition in hand, I just want to stick to the headlines, finance is the brain of the economy, finance does resource allocation, finance solves financial problems. With this definition in hand, I want to define a financial crisis. A financial crisis is when there is a sudden and nonlinear impairment of the functions of finance. So, if one financial firm fails, that's not a financial crisis. If even an entire industry collapses, it need not be a financial crisis if the world is able to reroute its activities through other institutional forms and mechanisms, through other ways of getting things done. But the point is to get things done. We have no loyalty to finance as a means. We have a loyalty to the ends, which is, are you able to be the brain of the economy by making prices? Are you able to allocate resources wisely? Are you able to solve the financing problems of the people? As long as that is getting done, we are fine. A financial crisis is when that breaks down. So, when there is a sudden and nonlinear impairment of the ability of finance to perform its functions, that's called a financial crisis. And, like hell, what could be bigger than finance? There is nothing in any economy that is bigger and more important than finance. Finance is the brain of the economy. So, an impairment in finance is pretty important. It's huge. That when I've described these functions, make the prices, allocate the resources, solve financing problems, this is huge. The fate of the world is on the line. So, when the financial system gets impaired, it has huge consequences. And that is why financial crises are important. So, this is our definition of what we're going to do. And in this episode, we're going to go through some amount of history. We will get a little bit of the historical experience of financial crisis. There are iconic stories that really everybody should know a little bit about. Then I'm going to put up a classification scheme. There is a clean classification. There's a script that runs in each kind of financial crisis. It's very useful to know the script. It literally gives you a sense of what's coming one move ahead. So I am thrilled to report that at my age today, I see financial crisis the way a doctor sees a cancer. You know how this is going to unfold. It's not every day comes as a surprise. So there is something that can be learned and it is a superpower to be able to look at the world and just have that common sense of what are the forces at work? How is this thing grinding against itself and creating a big mess?