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Fault Lines - Raghuram Rajan


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Raghuram Rajan's book Fault Lines is a great read. It was selected as the 2010 Financial Times and Goldman Sachs Business Book of the Year award, beating out stiff competition.


The global economy is of course a complex machine and Rajan's book offers a interesting look into how it fell off the tracks in the last few years and what we may be able to do about it. The main reasons from the book are as below, but you'll have to read the book to learn about the potential solutions.


1. Income inequality and easy access to credit:

<blockquote> "The everyday consequence for the middle class is a stagnant paycheck as well as growing job insecurity. Politicians feel their constituents' pain, but it very hard to improve the quality of education, for improvement requires real and effective policy change in an area where too many invested interests favor the status quo. Moreover change will take years to take effect and therefore will not address the current anxiety of the electorate. Thus, politicians have looked, or been steered into looking, for other, quicker ways to mollify their constituents. We have long understood that it is not income that matters but consumption... the argument is that if somehow the consumption of the middle-class households keeps up, they will pay less attention to their stagnant monthly paycheck. Therefore, the political response to rising inequality... was to expand lending to households." </blockquote>



2. Export Dependence:

<blockquote>"The ability of countries to supply the goods reflects a serious weakness in the growth path they have followed - excessive dependence on the foreign consumer. Eventually high household or government indebtedness in these countries (the USA) limits further demand expansion and leads to a wrenching adjustment all around. But so long as large countries are structurally inclined to export, global supply washes around the world looking for countries that have the weakest policies or the least discipline, tempting them to spend until they simply cannot afford it and succumb to crisis."</blockquote>

How does this affect the export driven economies?

<blockquote>"Governments intervened extensively in the economies to create strong firms and competitive exporters, typically at the expense of household consumption in their own country. Overtime, these countries created a very efficient export-oriented manufacturing sector, but banks, retailers, restaurants and construction companies have, through their influence over government policies have managed to limit domestic competition in their respective sectors. As a result, these sectors are very inefficient. Not only is it hard for these economies to grow on their own in good times, but it is even harder for them to stimulate domestic growth in downturns without tremendously wasteful spending. Therefore, these countries become dependent on foreign demand to pull them out of economic troughs."</blockquote>


3. Clash of Systems:

<blockquote>"Export-lead developing countries initially helped absorb the excess supply from the rich exporters. But developing countries experienced a series of financial crises in the 1990's that made them realize that borrowing large amounts from industrial countries to fund investment was a recipe for trouble. These economies moved from helping to absorb global excess supply to becoming net exporters themselves and contributing to the problem."


"In the competitive financial systems in countries like the US and UK, the accent is on transparency and easy enforceability of contract through the legal system. As a result, they are willing to hold long-term claims and finance the final user directly rather than going through intermediaries like banks. The financial systems in countries where government and bank intervention was important during the process of growth are quite different. Public financial information is very limited and closely guarded within a group of insiders. Because of the paucity of public information, enforcement of contractual claims largely depends on long-term business relationships. This means that outside financiers, especially foreigners, have little access to the system."


"So what happens when arms-length, industrial-country private investors are asked to finance corporate investment in a developing country with a relationship system? Foreigner investors who do not understand the murky insider relationships do three things:

  • Minimize risks by offering only short-term loans.
  • Denominate payments in foreign currency so that their claims cannot be reduced by domestic inflation or currency devaluation.
  • Lend through the local banks so that if they pull their money and the banks cannot repay it, the government will be drawn into supporting its banks to avoid widespread economic damage. Thus foreign investors get an implicit government guarantee."



4.  Jobless Recoveries and Political Stimulation:

<blockquote>"The US was politically predisposed toward stimulating consumption. But even as it delivered the necessary stimulus for the world to emerge from the 2001 recession, it discovered, much as in the 1991 recovery, that jobs were not being created. Jobless recoveries are particularly detrimental because the prolonged stimulus aimed at forcing an unwilling private sector to create jobs tends to warp incentives."</blockquote>

How long-term, and frequently detrimental policies are enacted.

<blockquote>"Unfortunately, the US is singularly unprepared for jobless recoveries. The public pressure to do something quickly enables politicians to run roughshod over the usual checks and balances on government policy making in the US. Long-term policies are enacted under the shadow of an emergency. This leads to greater fluctuations in policy making that might be desired by the electorate. It also tends to promote excess spending and impairs the governments long-term financial health."</blockquote>

How this promotes the buildup of bubbles.

<blockquote>"Monetary policy is the domain of the Federal Reserve, but it would be a brave Federal Reserve Chairman who defied politicians by raising interests rates before jobs started reappearing. When unemployment stays high, wage inflation is unlikely. But there are consequences... prices of commodities are likely to rise. And so are  the prices of houses, stocks and bonds as investors escape low short-term interest rates. The Fed added fuel to the fire by trying to reassure the economy that interest rates would stay low for a sustained period. Such assurances only pushed asset prices even higher. Finally, in a regulatory coup de grâce, the Fed Chairman, Alan Greenspan, effectively told the market in 2002 that the Fed would not intervene to burst asset-price bubbles but would intervene to ease the way to a new expansion if the markets imploded."</blockquote>


5. Consequences for the US Financial Sector:

<blockquote>"Here, unsuspecting foreign investors relied a little too naively on the institutions of the arms-length system. They believed in the ratings and the market prices produced by the system, not realizing that the huge quantity of money flowing into subprime lending had corrupted the institutions. One of the weaknesses of the arms-length system, is that it relies on the prices being accurate. But when a flood of money from unquestioning investors has to be absorbed, prices can be distorted. However the central cause for the financial panic was not so much that the banks packaged and distributed low-quality subprime mortgage-backed securities but that they held on to substantial quantities themselves, either on or off their balance, financing these holdings with short-term debit."</blockquote> <blockquote>"A bank that exposes itself to such risks tends to produce above-par profits most of the time. From society's perspective, these risks should not be taken because of the enormous costs if the losses materialize. Unfortunately, the reward structure in the financial system emphasizes short-term advantages. Particularly detrimental, the actual or perspective intervention of the government or the central bank in certain markets to further political objectives, or to avoid political pain, creates an enormous force coordinating the numerous entities in the financial sector into taking the same risks. As they do so, they make the realization of losses much more likely. Each of the sectors - bankers, politicians, the poor, foreign investors, economists and the central bankers - did what they thought was right."</blockquote>


6. The Challenges Ahead:

<blockquote>"If such a devastating crisis results from the actors' undertaking reasonable actions, at least from their own perspective, we have considerable work to do. Much of the work lies outside of the financial sector; how do we give the people falling behind in the US a real chance to succeed? Should we create a stronger safety net to protect households during recessions in the US, or can we find other ways to make workers more resilient? How can large countries around the world wean themselves off their dependence on exports? How can they develop their financial sectors so that they can allocate resources and efficiently? And, of course, how can the US reform its financial system so that it does not devastate the world economy one again? There are no silver bullets. Reforms will require careful analysis and sometimes tedious attention to detail. They will involve significant short-term pain in return for more diffuse but enormous long-term gain. Such reforms are always difficult to sell to the public and hence have little appeal to politicians. But the cost of doing nothing is perhaps worse turmoil than what we have experienced recently."</blockquote>



From www.bottomupanalysis.com. Sanjeev, please feel free to remove this post if it violates any forum rules.

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