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What caused the financial meltdown
In his book Fault Lines, Raghuram G Rajan, currently RBI Governor designate, talks about economic fault lines across the globe and outlines some suggestions to avert future crisis.
Raghuram G Rajan (50), formerly chief economist of the International Monetary Fund, is now the Reserve Bank of India’s new Governor. Gold medalist both at IIT and at IIM, he received his doctorate from the Massachusetts Institute of Technology in 1991. In 2005, Rajan famously foresaw the impending global financial crisis. The Wall Street Journal has had high words of praise for him. Rajan has crossed swords with Paul Krugman and it needs to be seen how he will manage the Indian banking system at its most crucial juncture.

Most of the incidents mentioned in this book relate to the financial crisis in USA during 2008, which he had famously predicted.  Here’s the listing and the lessons:

 

1. Rising inequality and push for housing credit

 

Over the years, economic inequality in USA has increased. In 1976, the top one per cent of the households accounted for nine per cent of total income; by 2007, they accounted for 24 per cent. Politicians realised that making easy credit available would provide immediate and widely distri

buted benefits. This was the genesis of Fannie Mae and Freddie Mac. Successive governments supported them, which led to the boom in low income lending. The huge housing boom was not led by surge in demand but a great willingness to supply credit. This crisis proved to be a costly way to redistribute wealth; the poor households who were lured into buying a house, were subsequently evicted after losing their savings and have become homeless.

 

2. Export-led growth and dependency

 

An export-led strategy has been the primary path that has elevated countries from developing to developed category in the post World War II era. Examples include Germany, Japan, South East Asian countries and currently China. During early periods of this strategy, exports were low value add items, but they slowly moved up the innovation ladder. However, the problem arises when exporters become stinking rich, like Germany and Japan. With increasing trade surpluses, their currencies appreciated. To stay competitive, they had to continuously move up the value chain of innovation. And too much of focus on foreign demand resulted in poor domestic services sector innovations. With lower domestic consumption, these economies begin to depend too much on global demand for their products.

 

3. Flighty foreign financing

 

The surpluses generated by exporters were looking for avenues to be utilised. At the same time, emerging countries needed foreign financing to fund their private sector growth ambitions. The foreign investors, to minimise their risk, preferred to lend at shorter durations and in their home currency. This set the backdrop for the East Asian crisis. Thailand, Korea, Malaysia and Indonesia were running huge investment to GDP ratio, which could not be funded by domestic savings. As most of the investments became technology intensive, the domestic governments withdrew from funding them. Foreign investors stepped in, but to avoid currency risk and duration risk, they funded through their domestic banks. So, their risk was minimised. This had all ingredients for a classic bubble – excessive investment financed by short-term debt with the additional risk of foreign currency mismatch.

    The bubble eventually burst and the currencies depreciated. Foreign investors started pulling out their money and speculators joined in. The countries tried to defend exchange rates, but quickly depleted their foreign exchange reserves in the bargain. Eventually many firms that had borrowed in foreign currency went bankrupt and banks realised they had to repay foreign investors themselves. In summary, the export-focused countries realised the perils of falling to the temptation of easy and short-term money.

 

4. US safety net

 

The unemployment benefits in developed economies have evolved over time and in line with their culture. The US culture did not believe in elitism; it always believed America to be a land of unlimited opportunities where reward is commensurate with effort. So, unlike Europe, unemployment benefits offered by US was significantly lower. This made people adaptable to change and quickly build skill sets required for a new role. So, a weak safety net in US and its political willingness to simulate jobs makes US the simulator of global consumption. Many economies hitch themselves to the US engine to simulate their own.   

 

5. Regulators reactions to bubbles

 

Another fault line is the role of the regulator per se. The Federal Reserve has a mandate to maintain maximum sustainable employment and stable prices. Post dot-com crisis, interest rates were reduced to unprecedented low levels. While the Fed attempted corporates to invest through ultra-low interest rates, the prices of financial assets and housing were skyrocketing. Also, the money that was exiting US in hunt for riskier pasture that would yield higher return was returning to the US now looking for seemingly safe, high yielding mortgage backed securities. The Fed made statements, suggesting their support if a crisis happened (called ‘Greenspan put’). So, substantial fiscal and monetary stimulus led to an explosion in lending, and the quality of lending continuously deteriorated.

 

6. Reforming finance

Finance should be for the benefit of the largest number of people while minimising risk of instability. The industry should remain competitive, but incentive structures should be modified in line with long term benefits, rather than short term profits. While government subsidies to financial institutions should end, the regulations should be cycle-proof. Fed’s mandate should include financial stability, along with employment and inflation. The institutions should be transparent and should carry a ‘living will’, a plan that would enable handling failures. Also, the nexus between bankers and regulators (who often inter-change roles) should be broken to improve the trust in the system.

 

8. Improving access to opportunities

There are several social steps that could correct some of the fault lines in the system. These include focus on education, building non-cognitive skills and improving the quality of teaching. The weak US safety net, the short duration of unemployment benefits and high cost of health care, are a big risk if recessions lasted longer. This calls for changes in the present structure of unemployment insurance and health care. Current household savings rate and the social security payouts are not sustainable. Some tough steps like extending retirement age and slowing the rate of increase of benefits are required. America has always been able to reboot itself from adversity and it can do so again.  

 

9. What lies ahead for India

There are numerous reasons to be optimistic about India, but its growth cannot be taken for granted. If we can create jobs in manufacturing or high-value services, where productivity is higher, households can generate higher income simply through movement from low-productivity sectors to high productivity ones. There are serious impediments: land acquisition, insiders dealing in infrastructure projects, large unproductive public sector, etc. The vibrant private sector needs to be given regulatory support to flourish.  Steady deterioration in India’s universities need to be reversed; thousands of students who leave India are a lost opportunity. The creation of an underclass, that does not have access to nutrition, health care, governance, is a recipe for political and social conflict.

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