Speech by an Economist

This blog post is a transcript of a speech by Professor Raghuram Rajan (Professor of Finance, Chicago Booth School of Business, and formerly governor Reserve Bank of India) about the root causes of the global financial crisis and the emerging new world order at the event, "New Insights in Business Finance" (organized by the newspapers De Tijd and L'Echo, with the support of Ernst & Young and Petercam).

I do not consider this speech to reflect the very best of Prof. Raghuram Rajan, on the contrary I find the speech as full of half developed ideas and confused rhetoric not backed by fact based arguments. I chose to transcribe this speech mainly for my personal understanding of the global financial crisis (Raghuram Rajan was one of the earliest known voices of the growing resentment in the unregulated explosion in derivatives trading and piling debt in US economy. He rightly predicted the consequences of tail risks should anything untoward happens.). I am quite confident that, reading this lecture in its entirety will give reader some useful ideas as starting points in further intellectual exploration.

This is not a verbatim transcription.....All errors are mine

We do not know for sure what is going to be the new world order in the future?  What we know is about the forces that are emerging to define the new world order. We can also surmise that a study of evolution (as the forces collide and compete) of these systems of forces will lead to better understanding of the new system of world order and help define some of its broad characteristics. 

We have some broad understanding of the forces that led to the current financial crisis. But superficial facts such as a bunch of greedy bankers, conflict of interests and liberal regulators fed by dose of Ayn Rand philosophy as responsible, fail to answer (and the charge that financial sector were essentially unregulated) the following  important questions. Why did the crisis happen now, and why did it occur in one of the most sophisticated and competitive market systems in the world? More sophisticated market systems are supposed to solve such conflicts of interests by self evolved system of checks and balances, regulations and governance, then why did this system fail? Also what was the subprime  why did the crisis start here? What were the reasons behind universal affinity for subprime loans? If it was just a matter of a bunch of greedy bankers and lax regulations, then some exemplary punishments and tightening of regulations would have solved the issue. So this crisis is a much deeper problem with a set of socio economic developments acting as precedents. It can be argued that, at least three major forces came together to cause the present financial crisis. Two of them are specific to United States economy and third one is a more global emerging force. Force Number 1 is the rise in income inequality in United States and how owned housing was used as palliative to ease the pain caused by widening income gap, without addressing the root cause of the issue. In the last 30 years, income inequality in United States has widened. If examined in detail we can find that top 10 percentile of earners as a group has seen their income rising much more rapidly than the middle and lower income group. So it is not just the super rich who grew richer. There is a social reason behind this. In the race with technology and education, education is falling behind in the United States. Disruptive growth in technology in 20th century was one of the biggest catalysts in the industrialized growth of rich countries. Telecommunications, revolution in transportation etc affected lives and caused enormous changes and chartered nature and course of economies of the industrial world. Consequent to the growth in technology was the growing need for knowledge based workers. This caused an explosion in education and United States was one of the first countries to take advantage of advanced education to expand in the tide brought out by new 20th century technology. US became the most educated country in the world in 1920s when most proportion of its men and women went through high school. 

Jobs can be broadly divided into a 2*2 matrix classified based on skills and scale  of routine work. The classifications are unskilled routine jobs, unskilled non routine jobs, skilled routine jobs and skilled non routine jobs. Unskilled routine jobs were increasingly substituted by new technology, which displaced huge number of jobs in the 70s-90s. Also routine skilled jobs were transformed by competition, technology and globalization. Jobs, that once were populated by clerks accountants etc were seen increasingly shifted abroad. For example, a skilled work such as analysis of balance sheet can be done much more cost effectively in Shanghai or in Mumbai, India. So what left out were the non skilled non routine jobs, which cannot be transferred anywhere, jobs such as drivers, cooks, gardeners, farming etc – where wages grew much slower on an average and the non routine high skilled jobs, which demanded much more specialized university level education. And the need for education also shifted from high school to workers with university degrees who can do skilled jobs with non routine tasks, and be creative and think in their roles as consultants, professors, lawyers etc. This has caused the hollowing out of jobs in the middle level who were employed doing routine skilled jobs and an increasing number of such people are finding themselves unemployed or doing less skilled jobs with lower pay. To give some statistics, in the age group of 26--54 males with no high school degree, 35% are unemployed in US. For all people aged between 24-54 age groups  24% are unemployed. These are staggering number of unemployed working age people in an industrialized economy. The broad level of education hasn't been changed in last 20 years. Number of people with university degree remained stagnant in the last 40 years with only one silver lining that more women are getting higher degrees than men. These social changes lead to stagnant incomes of middle and lower middle class in US and put tremendous pressure on politicians to find a workable solution to the rising income inequality. The gulf between the have and have-nots, those who grew along with technology and better educations and those who were left behind, is still a worrying concern in the States. Who will not want to fix the problems of common man when his next month paycheck remained stagnant for years on end? This was also a key moment in American politics with transition from Reagan years to Clinton years. The prevailing policy to tinker with taxation to redistribute income was resisted from both camps. In fact taxes were cut. So how did the politicians try to solve the issue of lower growth of income and subsequent decline in spending power of an average American family? The enlightened answer was to expand credit. Predictably, no one objected to this easiest of solutions and also felt no guilt in giving liberal housing credit as an ingenious solution to increase in assets and equity. This enabled the home owners, though in debt, to borrow against their house simultaneously feel that they are borrowing against an asset, not just piling debt on debt. So the end result of this debt enabled social changes were that consumption inequality did not increase in line with income inequality. As people started getting loans, US household saving rate went to zero and even touched negative. Clinton government pushed for affordable housing with the mandate aim was to enable more teachers, firemen, policemen to buy houses, by extending credit to people with lower repayment capacity. Both sides of political spectrum supported this housing push and Bush government went even further towards an ownership society. It also helped that the property owners were deemed to be conservative in outlook and thus were favored to vote for republicans. Thus they pushed for more housing credit by using the instruments of government such as Fannie Mae and Freddie Mac to drive housing credit often with government money.  Thus fault line number one was the much looser credit as the beginning roots of the problems.

The second problem was the inadequate safety net in US society. So if a person loses job and he/she also loses access to such essential services as health insurance. This thin safety net had historically worked when US had short recessions often followed by sharp recoveries, which was an observed pattern of economic growth in post World War II economic recovery. This forced workers to be very active in seeking jobs, as on average within 8 months of end of recession, most jobs were back in economy. But something structurally changed in 1991 when it took 23 months for the jobs to come up. George Bush Sr ignored economy at the peril of losing his reelection. This lesson was a bitter pill to be swallowed for both parties and since then, politicians could not ignore the economy, even the slightest hint of slowing down in job growth numbers. The active intervention of government to loosen up fiscal policy by fiscal expansion, monetary expansion, in response to the 2000 recession is a case in example. The famous Greenspan put, which was a free option to the stock market, to the effect that government is there to support asset prices in case they fall, was not an exercise to arrest sliding asset prices. It was more an exercise to revive the job growth as an assurance was given to industries that, no matter what happens to general level of demand and prices, government will support companies, so that companies can concentrate on spending and creation of new jobs. Job creation was the sure way to emerge out of these recessions.  But the 2008 story turned out to be different that even most aggressive interest rate cuts and fiscal policy easing, jobs were no longer getting created in sufficient speed to recover from the recessionary spiral. So the 2000 Greenspan put changed to Bernanke put. The Greenspan put was responsible for speculation in housing market in 2001-04 which created a housing bubble. The present monetary easing has started creating bubbles in bond markets, emerging market and in farmland. Though the policy is made with very good intention, its consequences are often problematic. 

All the blame for slow economic recovery cannot be laid on US. Other export oriented economies too played their part. For example, Japan followed export led growth policy for decades. As a country torn after the devastating war, Japan rebuilt their economy entirely relying on foreign demand and created dozens of strong companies and by exporting products to stimulate domestic growth. Positive repercussions of this export led growth were the rise of extremely strong manufacturing companies who were very successful in global markets. But if we think about any prominent service oriented Japanese firm, such as a Japanese consulting firm, or hotel chain, etc we will surprisingly find that none rule the global market and none even elicit any sort of global recognition when compared to the famed manufacturing counterparts.  Japanese service sector found it hard to grow due to cartelisation. Cartelisation helped manufacturing to be disciplined for better tackling foreign competition by producing extremely good products. For domestic service sector, this combination of government supported cartelisation proved a detrimental to their growth. An interesting side story is to examine the high cost of Japanese haircuts. They are costly due to existence of a barber cartel. Yes, new entrants tried to challenge the cartel by offering cheap haircuts in Tokyo. The barber cartel decided to fight back in an ingenious way, in a fit of genius, they declared that having haircuts without having shampoo is unhygienic and made it mandatory for all barber shops to have shampooing facilities. This immediately meant that the new entrants have to invest in shampooing facilities and the resulting time for investment will put them out of business for an extended period. This is a symbol of a more general problem in service sector that has kept the domestic demand from expanding. This similar problem could emerge in an export led economy such as China, and would be a common problem for any export led nation. Lower domestic demand in export led industrialized countries forced them to rely on United States as the last resort consumer. So once the US started going into recession, their woes compounded and led them and global economy deeply into trouble.

So the pertinent question is, what is this all got to do with financial crisis? How were all the low quality mortgage securities created? Relatively price insensitive government money was used as fund this credit expansion. Money from outside US came pouring in to invest in US securities and no questions were asked. Some of the banks only cared to ask for AAA rated US securities to invest in. With all the flush of money looking for US assets, the brokers who make these loans realized that credit quality was not important.  Customers were willing to buy any loan with no questions asked and brokers were getting the fee regardless of the quality of assets, and thus it was no one’s responsibility to check the quality of underlying assets. Therefore discipline broke down in the financial sector. Beset with greed, banks ended up creating products that the buyers wanted. Another critical question to be asked is, banks who were most probably be aware of the fact of the bad credit quality of the underlying assets, continued to hold the assets even with full knowledge that these assets might default with higher probability? This is a very serious question in need of a long answer. 

Now the third factor was the slow building of a crisis in public finance which started brewing from Europe, where they had the issue of taking care of an increasingly ageing population. Public debt has increased in all G7 countries since 1970s. This is also a realization of a larger crisis. We have used the government balance sheet to moderate the volatility or economic shocks. Government balance sheet is full of debt and a significant rethink is needed to effect and to move away from this over reliance on public debt, and towards a more self sustainable economy. We thought that we understood the European strategy as “lets try and muddle through for some time. when there is some daylight (or when growth returns) we will fix the problem, otherwise we can always restructure and eat the losses”, sort of thinking. Germany’s stance changed with the change in domestic political scene and with Merkel losing elections. It became apparent that private markets were not willing to fund Greece Portugal or Ireland, so in effect sovereign bonds were increasingly being bought by official institutions. What was a private sector problem became a public sector problem. Assuming that bonds need to be written off, these losses were to be imposed on public money expenditure rather than on private sector. This was one of the reason for continued calls for immediate restructuring rather than wait for all private sector institutions to bail out without having to pay for the financial mess. People have toyed with this idea that the European financial crisis is likely to be contained, which is a sort of muddling through the whole issue, with the thinking that indebted countries can grow their economy and service the debt own their own. The probability of this happening is very low. Other issues is that the accommodative economic policy in US had unanticipated consequences throughout the world. With the very low interest rates in States, the emerging market rates have also stayed low, on account of which their economies are growing fast with consequent global increase in commodities prices. This is the reason for high oil prices and reduction in disposable income of average consumers. Industrial countries have serious problems, they were excessively accommodative in their fiscal and monetary policies and any tightening of which will slow down their growth.

To compensate for the slow domestic growth, industrialized countries have to see that emerging markets are rising fast. One big issue is how to take advantage of the growth in emerging markets?  US has recently become cost competitive in manufacturing, as costs are low because of depressed economy. This is quite an opportunity to produce and market products suitable for emerging markets with their consumer needs in mind. The old strategy of thinking stratification of society and looking at classes with western lifestyles and targeting them, wont work. For example, emerging market middle class is a huge market, with 600 million strong in China and 300-400m in India. The question to be answered is “how am I going to service that market, when the market is middle class by their own considerations rather than by western standards". An interesting example of selling a product suited for emerging market is the story of an innovative refrigerator for rural markets, produced and marketed by Godrej Industries in India. In most of Indian villages, electricity comes for only 9 hours a day that too in random times. The question is, how do one run a refrigerator with such an inconsistent supply of electricity? Godrej engineers found out that consumers primarily used refrigerator to keep food cool for at most a day and they had no need for ice and freezer. Once the need for ice is eliminated, the fridge can be run at 6-7C and therefore can be cooled by fans running on batteries. This type of innovative frugal technology is being developed by MNCs such as GE, who has their own product design center in India. It is an enormous challenge for the industrialized countries to move design of a product 8000 miles away which is about decentralizing controls.

The second big issue that has become relevant is about rethinking of governments in rich countries. In United States, there is enormous distrust in elites from both left and right sides of political spectrum, which he calls (Raghuram Rajan’s term) Sarah Palinization of politics. It is a fact that nobody has paid the price for the economic mess that US in and there is fear that the elite (Washington and Wall Street) might further collude together.Sarah Palin emphasizes the fact that she is not from an elite background and most of her family upbringing strikes a chord with an average American. This is causing a polarization and a lack of structured dialogues in divergent political views, such as the left arguing for taxing the rich and a proper redistribution of income, and right arguing for cutting back on spending. This political polarization is accompanied at the same time by the skilled and unskilled disparity and the spread of disparity between the haves (those who are benefiting from globalization and technological changes) and have nots. It is a dialogue that could spread to other countries. These are enormous challenges faced by today's government. The promise of social mobility is shattering and bottom of the pyramid in developed countries are in danger of struggling for education and access healthcare, which are essential in order to create people with capabilities. So government has to spend to keep up the demand and also to raise living standards of the bottom of the pyramid by way of support, but government spending is not unlimited. This would mean radical rethinking of entire tax and incentive structure in a way such that government can work more efficiently and focus on the most important things at hand.  Also the demand to shift and reorient industrial production with an east ward look is essential. Emerging markets also have their own problems in managing their own demand, for example, over consumption and over expansion led to Latin American and Asian financial crises. There will be relative loss of position for industrialized countries, which could be hard to accept for them and can also spur the forces in bottom half to rig protectionist barriers which might stifle growth. US has resisted the call for protectionism at least for now, but years of slow growth and protectionism in capital flows and asking of banks to invest in more Government securities will be construed as over alarmist. There is a worry that such conditions will call for a revolution unless government is seen working hard providing fair chance for upward mobility via education, health care, infrastructure services for all.

In general, there is hope for a happier and better world.

Brain Teasers - 1

Anyone with some interest in mathematics and logic will find solving brain teasers a very rewarding way to pass time. Yes, it is fraught with some dangers of over exertion on some very fiendish puzzles, as is the case with most puzzle solvers worth their salt, they just cannot shut down the process of thinking about a puzzle unless they solve it in some satisfactory way. I too am a little enthusiastic about solving puzzles, though I claim no special intelligence or special skills to demand to be any exceptional in this case. My experience of solving any puzzle has taught me some valuable lessons in structured thinking in solving general problems. For example I will just describe how the following puzzle was solved by me and the corresponding learning from the method employed to solve it.

When a brain teaser or puzzle is posed, Ones' initial aim is to find the key idea to solve this problem. A problem could be solved based on combinatorial reasoning, probabilistic reasoning, pigeon hole principle, logic etc, which is almost always clearly asked for in the problem statement itself. But in some cases, a translation of the problem to some analogical problem only will lead to clues as to the general method to solve it. Some of the guidelines, as followed in good puzzle books, to solve brainteasers are 1) Try to start from simple cases and then generalize to find patterns 2) Try to start from an analogical problem based on your experience in solving puzzles 3) Trying to work backward from the result to construct a method to solve the problem 4) Use of conditions in a clever way, unanticipated in a superficial reading of problem, to lead the way to the key of the puzzle etc etc

Puzzle

There are 60 blue ribbons in a box such that  all 120 ends are hanging out and you cannot see which ends belong to which ribbons. You randomly join all 120 ends together into pretty bows and dump out the box. Depending on chance you will form anywhere from 1 to 60 loops. How many loops would you expect?

Ok. This sounds like a difficult puzzle. Why? This problem sounds very neat and quite simple to understand though. Atleast according to me, a superficial thinking about the puzzle will leave one clueless about the mechanism of increase in number of loops in each step. There are 120!/2^30 different ways of joining the ends of 60 ribbons, a number so large that any cursory glance at solving sigma(P)E(P) will be an undoubtedly daunting task beyond your limit. So we evidently cant solve this problem, using pen and paper by brute force method. (We could very well simulate it in computer but I think this is cheating in a way to solve a puzzle). I grappled with the creation of loops in each step and the expected increase in number of loops for some time. I tried to start from an arbitrary step, where "k" number of ribbons are joined with E(k) number of loops and finding expectation of E(k+1) based on transitional probability. This didnt work without a key idea. That is - How many free ends can one expect at the end of "k" number of ribbons are joined? It is a simple idea, the solving of which was the key to the puzzle. Suffice to say, I wrestled with steps 1, 2 and 3 (as indicated above) in many combinations and performed some messy calculations till step 3 to no avail. I started from backwards, middle (general case), try to think of analogical puzzles (none came to my mind) and was stumped for some time. The key idea still eluded me and thus the solution to puzzle.

But working out the solution using different ways finally had its result.

Pattern recognition is one key component of successful solution of may problems. For example E(1) = 1/119 and E(2) = 2*118/119*117 or 1/119+1/117 which points to a way to solution. Another key thing is to understand the physicality of the whole problem and try visualize the knotting of ribbons and forming of loops in an abstract way. By this time, it became apparent to me that, whether a new ring in formed or not, at every step, the number of free ribbons reduces by 1 each. This was the key idea that I was waiting for, then the expectation calculation can be easily derived for a general case.

Now, coming back to all of earlier reasoning, it was a simple exercise to write a recursion relation for expected knots at the end of tying k ribbons together as follows

E(k) + 1*(60-k)/2*(60-k)*(119-2k)/2 = E(k+1) ------>; (1)

Simplifying

E(k) + 1/(119-2k) = E(k+1) -----------> (2)

Now E(0) = 0. E(1) = 1/119

Thus E(60) = 1/119+1/117+.....+1/3+1 = 3.028933 loops on average, as the answer.

This is a simple and elegant answer which makes immediate sense.

For example, we can see that on an average it is very difficult for the rings to form in beginning, but ring formation will be more common as we reach the end of this exercise.