A tight rope between greed and fear

Economic history brings out two broad types of development: the capitalist model exemplified by Adam Smith in the 18th century and the totalitarian model after the Soviet Revolution in the 20th century. Under the capitalist model, the industrial revolution brought unprecedented prosperity.

With advances in diverse fields such as industry, transport, shipping, power and consumer goods, the colonial powers reached a standard of living not seen before as the capitalist society developed. The capital markets grew rapidly, and brokers and capital market players emerged to support the growth of a capital-owning class.

At the same time, society felt the negative effects of unbridled capitalism. Various types of fraud came to light, as did social ills such as sweat labour. The word "scam" itself is of unknown origin and means a dishonest scheme or fraudulent practice. The earliest scam, recorded in 1720, was the South Sea Bubble in which large numbers of investors lost their money to scamsters. The British government finally had to intervene to save the exchequer.

Not just that. Shareholding in large companies led to cornering of shares by a few rich owners. Unethical practices were common and the class of robber barons began to emerge in the Western world.

The totalitarian system was not without blemish. There was the privileged leader class, whose lavish lifestyles matched those of the elite of the capitalist society. While the State took care of the basic needs of the people, there was no scope for private enterprise.

Soon, it was clear that both systems needed remedial action by the government. On the one hand, there was a need for the State to play a greater role to rein in profiteering. On the other, there was need to open up opportunities for private enterprise and for less State intervention in economic matters.

The recent scandals in the financial sector in the United States have caused many tremors round the globe. Even in the past, scams in the world's largest economy have arisen from the greed of a few, who bet the money of others on untenable schemes and systems. When these collapsed, the lives of thousands, if not millions, were affected. The list goes on: from junk bond creator Mike Milken to hedge fund Long Term Capital Management to Enron to Fannie Mae/Freddie Mac to the sub-prime bubble that led to the collapse of the likes of Lehman Brothers. This time, the problem was compounded affecting even whole economies - Ireland, Greece and Spain, for instance.

The effects were felt to a lesser degree in better-regulated economies such as India. But Indian entrepreneurs and market players are no less unscrupulous than their Western counterparts. Wealth manager Bernie Madoff 's fraud in the US reminds one of Gopala Rao, a former clerk who duped thousands in the princely state of Mysore in the 1940s by offering attractive interest on deposits, and the Sanchaita Investments scam of the 1970s in Calcutta, a Ponzi scheme that made interest payments on exisiting depositors from fresh deposits. Ponzi schemes get their name from Italian scamster Charles Ponzi who set up his business under "Securities Exchange Company" a few years before the US Securities Exchange Commission was set up in 1934.

Human behaviour is like entropy and tends towards anarchy, while regulations are anti-entropy

In the last 20 years, India has seen various types of fraud both against individuals and banks like the Harshad Mehta scam, or against the State, like the 2G spectrum scam. Nobody now wants to give up all regulation, but at the same time many fear that excessive regulation or incompetent or dishonest regulation may throttle initiative and affect economic growth and private initiative. Many Western countries that were critical of the "excessive regulation" in the developing countries, have now come to realise the need for stronger regulation, and, more importantly, greater vigilance and better enforcement of laws in developed countries.

For those who are still not convinced, there are some important lessons to be learnt from the recent crises in Western countries. These are:

• Governments should live within their means and limit their debt levels to acceptable limits. The International Monetary Fund should monitor the finances of countries with incipient financial sickness and hoist the red flag at the very first sign of danger. Ditto with regulators in a country. For example, the 1996 statement of Alan Greenspan, then chairman of the Federal Reserve, about the "irrational exuberance in the US market", went unheeded by the powers-that-be.
• The methodology of credit rating of companies and governments has to be made more effective.
• Equally, banking systems should be under stricter surveillance of the central banks, which, together with shareholders, should review penalties for individual bank officials responsible for bad lending decisions.
• Stock exchange regulations should be as simple as possible and administered in a transparent manner.
• Insurance, microfinance companies and cooperative banks should be watched closely, as the common man is more likely to be affected by scams in these institutions.
• The government should be transparent in selecting the heads of the market regulators, and involve Parliament and the judiciary. It is a matter of history that the inaugural Chairman of the US regulator, the Securities and Exchange Commission, was a renowned businessman and market player, Joseph P. Kennedy Sr., who did not let his personal interests affect his role as regulator.
• Regulations should provide for initiative and enterprise while at the same time put in place systems that keep market players on the straight and narrow path in the interests of investors. It should be realised that human behaviour is like entropy and tends towards anarchy, while regulations are anti-entropy for keeping order in the financial markets.
• Care should be taken, however, to see that the baby is not thrown out with the bath water.