Marginalia are brief notes written in the margin of a book or article. John Vandenbrink, Deputy Dean of GLOBIS University, will share his notes on topics that have caught his attention in his readings on finance, business, and economics.
What caused the global financial crises of 2008? This question has continued to intrigue me. My understanding has centered on the U.S. financial system itself: flawed securitizations, failures of corporate risk management and governance, excess liquidity courtesy of central banks, and so on. However, as I read reviews of books on the crisis, I came to feel that my understanding was not comprehensive. The reviews pointed me to one title that was particularly highly recommended: Fault Lines, by Raghuram G. Rajan, which won the Financial Times and Goldman Sachs award for the best business book of the year in 2010.
Rajan is a financial economist at the University of Chicago’s Booth School of Business, so he is familiar with the U.S. financial system. In addition, he served as chief economist at the International Monetary Fund from August 2003 to December 2006, so he brings a global perspective to his analysis. Rajan offers a broad framework for understanding the factors that came together to precipitate the global financial crisis. He argues that the key causes—the “fault lines”, as he calls them—are structural and remain in place, largely unaddressed by the reforms that have followed the crisis.
Rajan explains that in the late 1990s developing countries, mainly in Asia, burned by the Asian Financial Crisis of 1997–1998, resolved to save rather than to borrow, as traditionally they had done. They added to the already sufficient global pool of savings provided by Japan and Germany, with their export-oriented manufacturing economies, and by the oil-exporting countries. Thus, any country that wished to borrow had ample sources of funding.
Meanwhile, U.S. corporations and shareholders, caught up in the dot-com frenzy, were investing heavily in technology and communications. When this asset bubble collapsed in 2000, the U.S. Federal Reserve—overly confident of its ability to smooth business cycles and under pressure to sustain employment—cut interest rates sharply. Corporations, however, had no appetite for further investment and hence did not borrow. Instead, U.S. consumers took advantage of low rates to buy houses, pushing up home prices and creating another asset bubble. Much of this housing demand came from segments of the population with weak credit histories—individuals who normally could not qualify for a loan.
How could savers in Japan, Germany, and the export-oriented economies of the Asia finance low credit quality borrowers in the United States, in a housing market that they knew little about, asked Rajan? Connecting these two worlds was the role of the “sophisticated” U.S. financial system, which applied the technique of securitization. U.S. financial institutions pooled together housing loans from varied locations, thereby diversifying the risk across many borrowers. They also structured the cash flows from these pools of loans hierarchically, so that the first flows went to holders of the highest credit quality securities, the subsequent flows went to holders of the second level of securities, and so on down to the holders of the riskiest securities. Credit rating agencies, using complex statistical models, applied ratings to each level. Often the highest level would be rated AAA. For a time, this system seemed to work. In the rising housing market, defaults did not exceed the levels assumed in the models. Even conservative foreign investors became comfortable purchasing securities that packaged up U.S. home loans.
In this way, the U.S. financial sector “bridged the gap between an overconsuming and overstimulated United States and an underconsuming, understimulated rest of the world . . . Foreign countries could emerge from their slump by exporting to the seemingly insatiable U.S. consumer, while also lending to the United States the money to pay for these imports.” (p. 6)
This unsustainable situation ended when the Federal Reserve finally increased interest rates. Housing prices fell, triggering loan defaults. Securities based on pools of housing loans proved to be far riskier than believed, and their value fell sharply. It soon became apparent that U.S. financial institutions held large quantities of these securities. Short-term lenders to these institutions withdrew their funds, triggering a systemic liquidity crisis, U.S. government bailouts of financial institutions, and a global recession.
Rajan’s narrative is not only an explanation of the origins of the financial crisis—which was my initial interest—it is also his framework for presenting remedies. The subtitle of his book is, “How Hidden Fractures Still Threaten the World Economy.” Part of the solution, he argues, is for Americans to build human capital: educate youth better and provide more retraining for older workers, to make them more competitive in the global economy. He devotes a full chapter to these remedies, because the root cause of American overconsumption, he argues, is policy driven by growing public perception of inequality and insecurity.
Rajan also offers a full set of remedies for the U.S. financial sector. Foremost on his agenda is eradicating the expectation that the government will step in to rescue financial institutions and prop up markets. Taxpayers should not be the uncompensated guarantors of last resort, he argues, and no institution should be deemed too systemically important to fail. (Rajan wrote his chapter on U.S. financial reform before the passage of the Dodd-Frank Financial Reform Bill in July 2010, which put in place some measures to dampen the dangerous distortions created when firms are too important to fail, but which did not go as far as Rajan argues is necessary.) In the wake of the largest financial rescue in almost a century, with its enormous injection of moral hazard into the financial system, full implementation of this regulatory concept would seem to be a very tall order. On the other hand, the willingness of American taxpayers to bear downside systemic risk, leaving upside gains for bankers and other participants in the economy, has sharply diminished. The November 2010 elections in the United States strengthened the hand of vociferous opponents of financial rescues, thus likely restricting the powers of the government to step in should financial crisis recur. From this perspective, squeezing moral hazard out of the financial system, and soon, must be a high priority; and Rajan’s analysis is instructive.
Also high on Rajan’s agenda is preventing the systemic taking of tail risk, which was at the heart of the 2008 financial crisis. Taking tail risk is the all too common, sometimes hidden practice of banks and traders collecting premiums in exchange for insuring against statistically unlikely events, for example, writing credit default protection on AAA-rated bonds. The probability of having to pay may be very low, but the payout itself may be exceedingly high. Rajan proposes paying out traders’ bonuses over long time horizons subject to the performance of their positions. He makes a similar case for paying the bonuses of managers of financial institutions over long time horizons, with provision for “holdbacks” if the firm has to be bailed out.
U.S. Jobs, U.S. Politics, and Unbalanced Economies Abroad
Rajan argues that one of the key fault lines in the global economy is an inordinate political sensitivity in the United States to unemployment, which leads U.S. politicians and policymakers to stimulate the economy excessively and inefficiently, with global implications. His argument is novel. Because U.S. workers lack a strong safety net, he says, they are quick to pressure their elected officials whenever unemployment rises. The officials hastily cobble together ill-timed, often politically colored discretionary stimulus measures; and the Federal Reserve, which is mandated to maintain maximum sustainable employment, reduces interest rates. Rajan points out that the recessions of 1990–91 and 2001 have been so-called jobless recessions: they required 23 months and 38 months, respectively, for lost jobs to be replaced. This means, he says, that employment-focused stimulus stays in place for very long periods, well after production has recovered. For the global economy, this means that export-oriented countries can count on the United States to over-stimulate and to import their products, and thus they can escape the pressure to strive for balanced growth within their own economies. This is not a healthy situation for the United States or for the global economy, he argues, and it is a fault line that persists today.
Does the Federal Reserve in fact overstimulate? In their review of Rajan’s book, economists Robin Wells and Paul Krugman challenge Rajan’s assertion, arguing that in the wake of the dot-com collapse in 2000, very low inflation and risk of a deflationary trap justified the Federal Reserve’s decision to keep interest rates very low into 2004. (“ The Slump Goes On : Why?” The New York Review of Books, September 30, 2010.) However, in my experience as a banker (I retired from the industry in early 2007), I saw not just the Federal Reserve but also central banks in other developed countries keeping interest rates low, thereby pushing investors into riskier and riskier assets. I cannot assess the risk of a deflationary trap, but in my experience, this part of Rajan’s narrative rings true.
Rajan’s analysis generally conforms to my own experience in finance. It helped me understand the global dimensions of the financial crisis. Although I do question some of Rajan’s remedies (e.g., elimination of deposit insurance, which should not go unmentioned), and although I wonder if some of them are achievable, I did find their general direction to be correct. The world needs to understand the causes of the financial crisis and prevent recurrence. Rajan’s book deserves the praise it is receiving.