Swami's Article

Who murdered the financial system?

Dated: October 22, 2008

Leftists claim that the global financial crisis was caused by reckless deregulation and greed. Rightists blame half-baked financial regulations and perverse incentives. Actually, the financial sector is deeply regulated, with major roles for both the state and markets. It was not one or the other that failed but the combination.

The best metaphor for the mess comes from Jack and Suzy Welch, who recall Agatha Christie’s “Murder on the Orient Express.” In this novel, 12 people are suspects in a murder. And 12 turn out to be guilty. What starts as a whodunit concludes as an everybody-dun-it.

In the same spirit, allow me to present the 12 murderers of the US financial system.

1. 1. The Federal Reserve Board. Alan Greenspan, Fed Governor in 1987-2006, was once hailed as a genius for keeping the US booming, but is now called a serial bubble-maker. He presided over bubbles in housing, credit, and stock markets. He said it was difficult to identify asset bubbles in advance, so anti-bubble policies might be anti-growth. It was better to let bubbles build, and sweep up after they burst. Bernanke, like Greenspan, ignored the US housing bubble till it burst.
2. US politicians. Envisioning a home for every American, regardless of income, they provided excess implicit and explicit housing subsidies. One law forced banks to lend to sub-prime poor borrowers. Legislators created Fannie Mae and Freddie Mac, government-sponsored entities that bought or underwrote 80% of all US mortgages, and enjoyed exemption from normal regulations. Politicians ignored Greenspan’s warning that such a dominant role for two under-regulated giants posed a huge financial risk.
3. Fannie Mae and Freddie Mac. They resisted regulation, and spent over $ 2 million lobbying legislators against any tightening of rules. As mortgagers of last resort they should have been especially prudent. But they bought stacks of toxic mortgage paper—collateralized debt obligations (CDOs)—seeking short-term profits that ultimately led to bankruptcy.
4. Financial innovators. Their ideas provided cheap, easy credit, and helped stoke the global economic boom of 2003-08. Securitisation of mortgages provided an avalanche of capital for banks and mortgage companies to lend afresh. Unfortunately the new instruments were so complex that not even bankers realized their full risks. CDOs smuggled BBB mortgages into AAA securities, leaving investors with huge quantities of down-rated paper when the housing bubble burst. Financial innovators created Credit Default Swaps (CDSs), which insured bonds against default. CDS issues swelled to a mind-boggling $ 60 trillion. When markets fell and defaults widened, those holding CDSs faced disaster.
5. Regulators. All major countries had regulators for banking, insurance and financial/ stock markets. These were asleep at the wheel. No insurance regulator sought to check the runaway growth of the CDS market, or impose normal regulatory checks like capital adequacy. No financial regulator saw or checked the inherent risks in complex derivatives. Leftists today demand more regulations, but these will not thwart the next crisis if regulators stay asleep.
6. Banks and mortgage lenders. Instead of keeping mortgages on their own books, lenders packaged these into securities and sold them. So, they no longer had incentives to thoroughly check the creditworthiness of borrowers. Lending norms were constantly eased. Ultimately, banks were giving loans to people with no verification of income, jobs or assets. Some banks offered teaser loans—low starting interest rates, which reset at much higher levels in later years—to lure unsuspecting borrowers.
7. Investment banks. Once, these institutions provided financial services such as underwriting, wealth management, and assistance with IPOs and mergers and acquisition. But more recently they began using borrowed money—with leverage of up to 30 times—to trade on their own account. Deservedly, all five top investment banks have disappeared. Lehman Brothers is bust, Bear Stearns and Merrill Lynch have acquired by banks, and Morgan Stanley and Goldman Sachs have been converted into regular banks.
8. Rating agencies. Moody’s and Standard and Poor’s were not tough or alert enough to spot the rise in risk as leverage skyrocketed. They allowed BBB mortgages to be laundered into AAA mortgages through CDOs.
9. The Basle rules for banks. These international negotiated norms provided harmonized regulatory checks on financial excesses across countries. The first set of norms, Basle-I, was widely criticized as too rigid and blunt. So countries agreed on Basle-II, which allowed banks to use credit ratings and models based on historical record to lower the risk-ratings of many securities. This dilution of norms led to excesses everywhere. Iceland’s banks went bust holding loans/securities totaling 10 times its GDP. The dilution of risk-rating in Basle-II helped inflate the financial bubble.
10. US consumers. Their savings used to be 6% of disposable income some time ago, but more recently has been zero or even negative. They have gone on a huge borrowing spree to spend far more than they earn. This excess is reflected in huge, unsustainable US trade deficits.
11. Asian and OPEC countries. They undervalued their currencies to stimulate exports and create large trade surpluses with the US. They accumulated trillions in forex reserves, and put these mostly into dollar securities. This depressed US interest rates, and further fuelled borrowing there.
12. Everybody. Consumers, corporations, banks, politicians, the media--indeed everybody-- was happy when housing prices boomed, stock markets boomed, and credit became cheap and easily available. Bubbles in all these areas grew in full public view. They were highlighted by analysts, but nobody wanted to stop the lovely party. Everybody liked easy money and rising asset prices. This trumped prudence across countries.

So, forget the left-versus-right or regulations-versus-markets debate on the financial crisis. States, institutions, markets and everybody else was guilty. These actors will for some years don sackcloth and ashes, adopt stiffer regulations, and listen to lectures on the virtues of prudence and restraint. But after seven to ten years of the next business upswing, I predict that we will once again have a new generation of bubbles, evading whatever new checks have been put in place. When everybody loves bubbles, they are both irresistible and inevitable.

School vouchers are ideal solution for poor

An article on school voucher By Jaithirth Rao | Conservative Corner

The provisioning of education by the public sector at the primary level has broken down

I continue with the theme of niti (laws) and nyaya (just outcomes) as propounded by Amartya Sen. His diagnosis of the problems facing the underprivileged children of India apropos of their education is spot on; his suggested solution is quite simply dead wrong. In his recent lecture in Delhi he has referred to the fact that the provisioning of education by the public sector at the primary level has broken down. This breakdown is particularly prevalent in the schools where the poor, the lower castes and first-generation learners constitute the bulk of the enrolment. While there are honourable exceptions, it is an established fact that the majority of teachers in these state schools are more often absent than present. When they do turn up, they are usually late. Having arrived late, they rarely bother to teach and when they teach, they are not concerned about elementary outcomes, e.g. can the students read or count?
Prof. Sen comes up with the novel and eminently impractical suggestion that “dialogue” with the teachers’ unions will result in a massive behavioural change on their part. He derives great comfort from meetings that he and his NGO have had with the worthy union leaders in the “advanced” state of West Bengal (a state where education at least is in an “advanced” state of decay). Come, come, Prof. Sen…you are an economist of standing. Do you seriously believe that just because these folks are nice to you during your visits to India, they are going to alter their behaviour when there is no economic incentive whatsoever for them to work hard (will they be paid more, promoted earlier or at least given a Padma Shri if they work diligently...no chance of that) and there is no disincentive for being lazy or absent (their salaries will not be reduced, their promotions will still occur based on seniority, they can never be sacked…this their strong union will ensure)?
I have no experience of the state of affairs in contemporary West Bengal as I have a singular aversion to Stalinism which has been the prevalent ideology in that unfortunate state for three decades now. I am acquainted with schools run by the Brihan Mumbai Nagarpalika (BMC, or Bombay Municipal Corporation, for old time believers in simple English). Some of the teachers are dedicated and conscientious. I even know one teacher in a Gujarati medium section who uses his own slender personal financial resources to help children. But for every one such example, there are twice or thrice as many teachers who for all practical purposes can be categorized as ghost employees. They draw salaries, or someone draws it for them. Beyond that their commitment to their vocation is zilch.
Why not opt for the obvious solution of allowing parents and students to choose on their own which school they will patronize? If the government gave the parents vouchers which could be cashed either in state schools or in private schools, then the poor parents would have the same measure of choice that their affluent fellow-citizens have. I would take a wager that each and every member of Prof. Sen’s family in India has sent their children to private schools. Incidentally, 80% of government schoolteachers themselves send their own children to private schools! How can we argue that it is a just outcome in keeping with the spirit of “nyaya” if we condemn poorer citizens to opt for educational services for their children differently from the way we choose for our children?
The “efficiency” argument is even stronger than the moral one. We now have evidence that in Delhi poorer parents who have been given vouchers have largely chosen private schools for their children. Incidentally, for every voucher there were 400-odd applicants giving an indication of how desperately poor parents want “choice”. The children were chosen by random lottery in order to confront the argument that private schools do well because they select better students. Initial studies appear heartening. We seem headed for better reading/writing/maths outcomes at one-third the cost of state schools. We have a decent mobile phone offering for Indian citizens because there is choice and competition in mobile telephony. The same rules will apply in education. State schools may even improve once it becomes obvious that parents will opt for other choices, as incidentally has happened with telecom firms BSNL and MTNL.
Prof. Sen: you have rightly identified the enormous failure of the Indian state in educating its citizens. Why not go full hog wearing your moral philosopher’s hat and support “choice” for poor Indian parents, a choice that you and I have exercised with our children, which your relatives in India have exercised, which 80% of government school teachers exercise? That would indeed be “nyaya” not the “matsya nyaya” which now in place.
Jaithirth Rao, a former banker and technology entrepreneur, divides his time between Mumbai, Lonavla and Bangalore. Send your views on this column at conservativecorner@livemint.com

To read Jaithirth Rao’s earlier columns, go to www.livemint.com/conservativecorner

Pains Of A Slowing Miracle Economy!

Swami's new article. Great stuff to read.

I am not usually a pessimist. But I predict that India will suffer a lot of pain in the next 18 months, as the economy slows down along with the current global slowdown.

The US, Europe and Japan are sinking into recession together. Forget claims that India has decoupled from the US and can keep growing fast regardless. India and most developing countries are indeed much less dependent on the US economy than in the past. So, Indian growth will be dented rather than smashed. GDP growth will slide from 9 % last year to 7% this financial year, and to maybe 6% next year.

Now, 7% is a miracle growth rate by historical standards. You might think that declining from super-miraculous to merely miraculous growth cannot be particularly painful. You would be dead wrong. The direction of change matters more than the absolute level. Rising from 5% to 7% is blissful, but falling from 9% to 7% is painful. And a subsequent tumble to 6% will be more painful still.

To appreciate why the direction of change matters so much, recall the 1990s. India went bust in 1991, reformed by globalising, and reaped the reward of fast growth. GDP growth averaged 7.5% in the three-year period 1994-97. India’s growing integration with the world economy enabled it to share in the global economic boom of those years. Foreign institutional investors flooded into all emerging markets, including India, sending stock market prices spiraling.

Indian optimists thought that miraculous growth was here to stay. But along came the Asian financial crisis in 1997, and the Indian economy slumped along with the global economy. Indian GDP growth averaged just 5.5% in the next five years.

Now, 5.5 % may not sound too bad, just a modest deceleration from the 7.5% of the preceding boom. Indeed, India’s 5.5% at the time was one of the fastest growth rates in the world. Yet the change in direction, from acceleration to deceleration, caused enormous pain.

Industrial growth crashed in 1997-98, and barely limped forward for years. Many industries had borrowed massively during the mid-1990s boom to invest in world-class new plants, for which there was suddenly no demand. Huge projects were abandoned unfinished, with companies defaulting on mega-loans. These financial defaults brought the lending institutions also to the verge of bankruptcy, from which they were saved mainly by creative accounting and a friendly RBI. Medium and small companies crashed along with their larger brethren. Employment went into a tailspin. Stock markets crashed and companies stopped repaying fixed deposits, so household investors suffered trauma.

The budgets of the central and state governments assumed steady growth of revenue year after year. But the 1997 slowdown hit tax collections. Meanwhile, a bumper Pay Commission award hugely inflated the wage bills of central and state governments. So, governments, corporations, employees and households investors were all sucked downward into a whirlpool of distress. The only saving grace was the IT boom, sparked by the global YK2 scare. But that turned out to be a bubble, and it burst in 2001.

Difficult though these years were, they did not witness economic collapse. India did not revert to the old Hindu rate of growth of 3.5% witnessed in the three decades after independence. GDP growth in 1997-02 averaged a solid 5.5%. But the direction of change was downward, not upward, and that was enough to cause widespread distress.

I fear we are about to see a repetition of that process. As in the 1990s, a booming world economy first lifted Indian growth (and stock markets) to new heights for several years, giving rise to the illusion of permanency. As in the 1990s, the subsequent global slump is going to cause an Indian slump too. As in the 1990s, the fiscal problems of the government are going to be exacerbated by a Pay Commission award.

However, we are much better prepared for this downturn than in the 1990s. Our foreign exchange reserves are almost $ 300 billion, cushioning our balance of payments. Corporations have not gone on a borrowing spree paying 20% interest, as they did in the 1990s—they have large cash reserves, modest debt-equity ratios, and interest rates are much lower today. The banking system is in relatively good shape today. The latest Pay Commission award this time is less onerous than the 1997 one. Our savings rate has crossed 30%, and can keep financing a healthy rate of investment. Infrastructural sectors like telecom, power, roads, and ports will be only minimally affected by a recession.

Nevertheless, pain will be widespread and sometimes deep. Income and job opportunities will slacken, sometimes dramatically. Many companies will suffer shrinkage or bankruptcy, especially small ones. Boom sectors like transport, restaurants, trade, real estate and exports will go into reverse gear. Credit will tighten, for consumers as well as companies. Corporate profits will slump. The revenues of central and state governments will fall, curbing their ability to alleviate distress. The stock markets will fall further, and the Sensex may fall below 10,000. Tighten your seat belts: we are running into rough weather.