Fault Lines

I am back from France and it is back to "work". I have just finished another book concerning the 2008 financial crisis that I believe is a serious presentation of the crisis and what should be done about it.

Raghuram G. Rajan, “Fault Lines: How Hidden Fractures Still Threaten the World Economy” Princeton Univ Press, 2010, 229 pp plus 17 pp of notes.

Winner of the 2010 Financial Times and Goldman Sachs Business Book of the Year Award Raghuram G. Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business and former chief economist at the International Monetary Fund. He is the coauthor of Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (Princeton).

Raghuram Rajan was one of the few economists who warned of the global financial crisis before it hit in 2008. Since then, Rajan points out that there has been a great degree of blame heaped on the private sector—think bankers, rating agencies, mortgage brokers. Yet, there is substantial evidence that government intervention and regulatory failure had every bit as much of a role to play. Additionally, Rajan argues that serious flaws in the economy are also to blame, and warns that a potentially more devastating crisis awaits us if they aren't fixed. The fault line that emerges when politically motivated stimulus comes into contact with the financial sector looking for any edge is an immense source of danger.

Rajan shows how the individual choices that collectively brought about the economic meltdown--made by bankers, government officials, and ordinary homeowners--were rational responses to a flawed global financial order in which the incentives to take on risk are seriously out of step with the dangers those risks pose. Financial workers reaped rich rewords for making money but were only lightly penalized for losses—privatization of winnings and socialization of losses. He traces the deepening fault lines in a world overly dependent on the indebted American consumer to power global economic growth and fend off global downturns. He exposes a system where America's growing inequality and thin social safety net create tremendous political pressure to encourage easy credit and keep job creation robust, no matter what the consequences to the economy's long-term health; and where the U.S. financial sector, with its skewed incentives, is the critical but unstable link between an over stimulated America and an under consuming world.

In Fault Lines, Rajan demonstrates how unequal access to education and health care in the United States puts us all in deeper financial peril, even as the economic choices of countries like Germany, Japan, and China place an undue burden on America to get its policies right. He outlines the hard choices we need to make to ensure a more stable world economy and restore lasting prosperity.
My notes:

Pg. 2: In 2005 the typical paper on the financial sector described the dramatic expansion of financial markets around the world. It emphasized the wonders of securitization, which allowed a bank to package its risky housing or credit card loans together and sell claims on the package in the financial market.

Securitization allowed a bank to get the risky loans off its books. At the same time, it allowed long-term investors in the market, such as pension funds and insurance companies, to take on a small portion of the risky claims that they, by virtue of having longer horizons and holding a diverse portfolio of other assets, could hold more easily than the bank. In theory, with the risk better spread across sturdier shoulders, investors would demand a lower return for holding the risk, allowing the bank to charge lower loan rates and expand borrowers’ access to finance.

Pg. 12: What happens when arm’s-length, industrial-country private investors finance corporate investment in a developing country with a relationship system, as was the case the early 1990’s? These foreign investors do three things:
1. They minimize risks by offering only short-term loans so that they can pull their money out at short notice.
2. They denominate payments in foreign currency so that their claims cannot be reduced by domestic inflation or currency devaluation.
3. They lend through the local banks so that if they pull their money and the banks cannot repay it, the government of the subject country will be drawn into supporting its banks to avoid widespread economic damage. Thus foreign investors get an implicit government guarantee.

Thus the problem in the mid-1990s in East Asia was that foreign investors, protected by such measures had little incentive to screen the quality of ventures financed. (Just like the impact Fannie and Freddie have had on investors in the U.S.).

Pg. 14: From 1960 until the 1993 recession, recoveries from recession in the U.S. were typically rapid. From the trough of the recession, the average time taken by the economy to recover was less than two quarters, and the lost jobs were recovered within eight months.

The recoveries fro the recessions of 1991 and 2000-2001 were very different. Although production recovered within three quarters in 1991 and just one quarter in 2001, it took 23 months to recover the lost jobs in 1991 recession and 38 months in the 2001 recession. These recoveries were deservedly called jobless recoveries.
Unfortunately the U.S. is singularly unprepared for jobless recoveries. Typically, unemployment benefits last only six months. Moreover, because health care benefits have historically been tied to jobs, an unemployed worker also risks losing access to affordable health care.

Pg. 65: The reason Chinese household consumption is so low and savings so high is a result of the government policy of allowing most couples only one child. Therefore six adults (four grand-parents and two parents) now depend on one child for future support—they do not have social security).

Pg. 183: The pressures created by relatively stagnant incomes for many in the U.S. mirrored those in the typical developing country; they led U.S. politicians to push credit as a palliative. Subprime mortgage lending was the symptom, dwindling economic opportunity for many the cause.

Pg. 191: Quintile: One of the four numbers (values) that divide a range of data into five equal parts, each being 1/5th (20 percent) of the range.
Only 34 percent of youths from households in the bottom quintile of income distribution enroll in college, whereas 79 percent of those from households in the top quintile of family income do so Moreover, only 11 percent of youngsters from the bottom quintile graduate, whereas 53 percent for the to do so.