Fault Lines

Author: Raghuram G. Rajan

Book Link: Amazon

Fault Lines


Rising Inequality and the Push for Housing Credit

The rising wage inequality (characterised by differences in wages of the 90 percentile and 50 percentile) has grown in US dramatically, since technological progress means high school diploma is no longer sufficient and people left behind are starting to lose.

Politicians realise that people measure their well-being not by income by but their consumption. So even if you cannot raise wages, get people access to credit and they will feel prosperous.

This is not the first time such event occurred, even before Great Depression of 1930s, farmers demanded earlier access to credit because they felt left behind their industrial counterparts.

Export Led Growth and Dependency

Countries that practiced exports led growth, have a weak domestic demand and this leads to an over reliance on foreign consumption. This makes the global economy fragile and incentivises other countries to keep borrowing and to consume because these countries are always ready to produce for them, because of the excess capacity.

In other words, export-led growth leads to excess capacity and this excess can be absorbed by consuming societies if only they could have the extra money to spend on these goods. This incentivises borrowing, as producers are willing to supply at reduced costs as well as long as their capacities are being utilised.

This is evident from the fact that these export fuelled countries have global industry leading firms in export dominated sectors, while in sector that service domestic demand such as restaurants or banking or retail, they have no significant brands. In these sectors the incumbents have successfully lobbied to keep competition at bay.

Therefore, even though these economies grew extraordinarily fast to reach the ranks of the rich, as their initial advantage of low wages disappeared and exports became more difficult, their politically strong but very inefficient domestic-oriented sector began to impose serious constraints on internally generated growth.

Not only is it hard for these economies to grow on their own in normal times, but it is even harder for them to stimulate domestic growth in downturns without tremendously wasteful spending. The natural impulse of the government, when urged to spend, is to favour influential but inefficient domestic producers, which does little for long-run growth. Therefore, these countries have become dependent on foreign demand to pull them out of economic troughs.

The Clash of Systems

The industrialised countries have strong financial systems where companies can raise debt and there is trust in the system based on public information (arms-length systems). Developing countries on the other hand need govt and banks to facilitate transactions because lack of strong measures to ensure transparency (relationship systems). This led to developing countries avoid borrowing from industrialised countries and thus not absorbing the excess supply of money in the world economy.

The solution was that institutions from industrialised nations started investing in local banks to fund projects who would then lend to the borrowers. In this way, the developed economy lenders could pull their money and local governments would have to assure the existence of their banks and help the local banks to meet the commitments. They also lend only in USD and only short-term debt. The Indonesian experience taught all developing nations to not trust IMF and instead they started generating surplus capital and goods contributing to global glut.

Job Recoveries and the Pressure to Stimulate

While the economies are recovering fairly quickly from the economic downturns, the loss of Employment during the recessions is not reversed with the same speed. This means that there are long periods of jobless growth. At the same time, the social safety nets are weak and do not support unemployed population for long. This means that there is added pressure on the governments as well the central bankers to provide a stimulus to the industries to boost Employment. This results in the easy money sloshing around in the system and the party in power gets to override the checks and balances in the name of providing relief in an emergency but effectively pushing their agendas aggressively leading to spikes in public policy.

The Consequences to the US Financial Sector

What threatened the US financial markets was not that Banks sold mortgaged backed securities to other but that they kept these for themselves as well and used short term debts to finance these securities. The investment bankers were sure that given US government policy, the mortgage backed securities would be rescued and that that the fed would keep the flow of money going. The probability of risk was low, but the risk was apocalyptic. However, the probability of making money by betting on it was higher so that is what everyone did.

The problem here is that democracy and markets have fundamentally incompatible objectives. Markets punish those who behave recklessly, but governments have to jump in to save people from becoming collateral damage. This incentivises the bankers to exploit the decency of the government. There is a fine balance to be made between the benevolence of the government and the ruthlessness of the market.

Chapter 01: Let Them Eat Credit

The Growing Inequality of Incomes

Incomes are growing at an unequal rate in US due to the college premium, i.e. while incomes are stagnating for most people over decades, the college educated are commanding sharp premium over others. This is in part due to the fact that the rates of high school and college graduation are not growing.

Moreover, most of new rich are not the ones who inherit wealth or earn from other sources (basically idle rich) but the ones that are working and creating businesses. The American economy is rewarding hard work, but it is just that not everyone is participating in the race.

Why is the United States Falling Behind?

Because the students are not ready for rigorous University life. Cost of education has also grown along with “College Premium” rightly so because the colleges cannot scale up. Lastly poverty and lack of education perpetuate themselves over the generations. Rich can afford setbacks, poor cannot.

Other Reasons for Inequality

Deregulation has made the economy more dynamic. This leads to faster entry and exit of firms (and consequently people's earnings) and this can bring in variations in data leading up to one-third of the increase in measured inequality. [https://www.jstor.org/stable/2534657]

Immigrants also lead to rising inequality numbers because they compete for unskilled labor jobs either directly or indirectly (through exports by holding down US wages). They increase the bases over which the values are calculated.

Secondly deregulation and reduction in income taxes has incentivised higher incomes and thus people work harder to earn more, and this has pushed inequality. Also weakening of unions has led to creation of jobs which pay minimum wage or below but the fact remains that if higher regulations and taxes existed these jobs would not even exist at all.

Attitudes towards Inequality

Americans on a whole are not anti-rich because they see themselves becoming rich, Inequality for them is not necessarily in terms of rich and poor but opportunity and achievement. But since the upcoming economy seems increasing stacked against those will lesser education and the access to education is reducing would the same attitude persist?

The Political Reaction

Politicians have recognised the growing inequality in the society, and this has led to deeply partisan legislature. Also, by trying to address the causes of inequality in an effort of avoid the fallout of the inequality, may result in the fallout itself. Politicians have found an easy way out of this by expanding credit because it is more politically marketable than redistribution and also the benefits are now and costs in future - the perfect recipe for politicians. The insurance against such temptation is strong regulatory bodies.

A Short History of Housing Credit

Initially mortgages were financed by Banks and thrift companies as a short term, variable interest loans but post 1930s crises, US created Home Owner's Loan Association (HOLC) - to buy the defaulted loans and Federal Housing Administration (FHA) - to insure the loans so that banks would offer loans at a fixed rate for long term.

The banks and the thrift companies financed these loans from short term deposits. HOLC was succeeded by Federal National Mortgage Association (FNMA, or Fannie Mae) which bought FHA-insured mortgages and financed them by issuing long term bonds to institutional investors. Unlike banks and thrifts, FNMA had longer-term, fixed-rate financing and therefore did not bear much risks.

The system faltered when the short-term interest rates spiked in 1960s (since banks were not allowed to match prevailing market rates) and led to liquidity crunch. To compensate, government split Fannie into two in 1968 - creating Government National Mortgage Association (GNMA or Ginni Mae) to continue insuring and securitising mortgages and a new privatised Fannie Mae that issued bonds to public. This helped take the Fannie related debt off the government books and pay for the Vietnam war. Soon afterwards, Federal Home Loan Mortgage Corporation (or Freddie Mac was created to help securitise mortgages made by the thrifts and eventually it too was privatised.

As inflation rose in 1970s, short term interest rates were increased dramatically and this threatened the thrift companies into ruin, but rather than let them fail, Depository Institutions Deregulation and Money Control Act of 1980 and Garn-St. Germain Depository Institutions Act of 1982 were bought which liberalised thrifts, to allow them a number of loans that they could make and how they could raise money. To let it earn its way back to stability. This had disastrous effects in the long run.

Fannie and Freddie

Fannie and Freddie (known as government-sponsored enterprises) had private shareholders to who the profits belonged but they had government benefits and public duties. They were supposed to buy loans from banks so that banks could lend more, and they bundled the loans that conformed their specifications into mortgage-backed securities and sold to others. They were exempted from state and local income taxes and also had a line of credit from the US Treasury, reducing their cost of borrowing excessively.

They also started borrowing directly from the market and invested in mortgage backed securities underwritten by other banks. Because the mortgages were sound, they were fairly safe and extremely profitable activities. Much of profits stemmed from low cost of financing derived from the implicit government guarantee.

The Affordable Housing Mandate

As part of affordable housing mandate of successive governments, Freddie and Fannie may were allowed to venture into sub-prime loans by the congress and their targets for investments in these sectors were to be set by a regulator in Department of Housing and Urban Development(HUD), whose budget was controlled by congress.

Initially hesitant, Fannie and Freddie soon realised that by fulfilling the government wishes of financing the under-financed they had stumbled upon a very lucrative business (which was inherently very risky). They happily complied with the directives to fund greater number of subprime and alt-a loans.

Alt-a loans are those loans were the applicant refuse to furnish all the documents and instead choose to pay a higher premium.

The National Home Ownership Strategy

The Clinton administration set an ambitious target to push homeownership to historically unprecedented levels by making a number of policy decision including forcing banks to lend to low-income households and even reduce the requirements in income and premiums for the mortgages. All these steps gave rise to a boom in low-income housing construction and lending.

The Ownership Society

The steps taken by Bill Clinton and his administration came to fruition during George W Bush's presidency. He further pushed the low-income lows proportion to 56% of their assets in 2004. Fannie and Freddie complied partly because a number of accounting scandals made the much more pliant to the demands of congress.

Moreover, the problem could not be detected earlier and quickly because Fannie, Freddie and the FHA classified sub-prime loans as sub-prime not if they were sub-prime in nature but if the lending agency dealt in subprime and Alt-A loans. This let a number of sub-prime and alt-a loans go undetected. At its peak, the mortgage giants were exposed to $2.7 trillion in subprime and Alt-A loans. This was a market driven largely by government, or government-influenced money.

Lending Goes Berserk

Since more money started flowing into sub-prime loans private players also started lending. This led to unprecedented growth in sub-primes loans, which was twice as high as that in prime ZIP codes. This also led to increase in prices even though demand was the same and forced more people to take up loans in these sub-prime areas to take up loans, starting a vicious cycle.

In the end bubble burst and government took control of the Fannie and Freddie and essentially bailed out all the loans. Government lending to those who are not serviced in normal times is understandable but what escapes logic is government contributing to a situation where there is a lending frenzy and exacerbating it.

Interesting Differences in the United States

An interesting observation is that prior to the Mortgage crisis of 2008, the prices of low-income houses grew at a faster pace than the high-income houses and similarly post-crash, the prices also fell greatly in the low-income neighbourhoods.

Apart from the obvious consequences, it had one more effect I it is rise and fall. In these areas, as the values of houses increases people used the home equity to raise further loans and this led to a greater ruin to those people. The worst hit in the crises were poor people. This was consequence of government trying to help poor households by providing them with a method to boost consumption even though their incomes were stagnant or falling.

Similar examples are found in other countries too, including India where Farm loans are distributed by state-owned banks especially in areas where there is a tough fight expected and around election time. Post-election when farmers are unable to pay back the loans the government then moves in and waives off the loans.

Summary and Conclusion

Income inequality stemmed from unequal access to education and politicians tried a quick fix with cheap housing credit, but it burst in our face. Politicians were not wrong in their intent, but easy credit is a very costly way to redistribute. Too many poor families who should not have been lured into buying homes eventually lost their savings and homes. The Government Sponsored agencies were not adept in dealing with sub-prime risky loans but when they initially made huge profits everyone jumped in to abuse the opportunity including the home buyers who applied for such loans. For poor countries, a similar analogy is foreign aid which has been proven to increase dependency, indebtedness, and foreign aid. An upcoming solution is micro-credit, but even micro-credit cannot be scaled up and one needs to be skeptic of it.

Inequality is a serious problem and needs to be worked on but with long term solutions that work, rather than looking for scapegoats.

Chapter 02: Exporting to Grow

The Elusive Search for Growth

Many of today's wealthy nations are rich today not because they grew fast but because they grew steadily over a long period of time.

Japan's per capita grew at 8% per year in 1950-1973 but other nations like Chile, Taiwan have exceeded it. But the fundamental question is - what make poor countries poor?

Is More Capital the Key to Growth?

Rich countries have more physical capital (giant buildings public infrastructure, machines etc.). Poor countries lack that. But even if one were to invest in physical infrastructure in poor countries the actual returns would be less than that in rich countries even though on face value the productivity gains would be much higher in poorer nations and should therefore lead to greater returns than that in richer nations.

Organisational Capital

The X factor that the rich nations seem to possess is the organisational capital which manages the physical capital and generates returns. These include managers to manage, suppliers, guards etc. to make the plant work. But these in turn need financial infrastructure (electric power, transport, communication network) and government Institutions to facilitate and protect them.

How the Early Developers Built Organisational Capital

Institutions, however, are not a precursor to growth. India under British had almost all the desired institutions and yet there was no growth, rather decline. Most of the early developers (UK, US, etc.) grew institutions while they were growing. Institutions were fostered because need arose for them. Government facilitated local companies, even aiding monopolies initially and withdrawing them later on. The crucial point between early and late developers is the extend of government support. You need a little government support in the beginning but over time industries have to aim to be self-reliant.

The Strategy of Late Developers

Late developers did not have patience to let their institutions grow at the pace of earlier developers even though the path to prosperity was the same. They had two choices, either to setup government enterprises to undertake business activities or to direct the existing financial wealth towards a few favoured players and let them grow unhindered.

Governments also protected their domestic markets from foreign imports through high tariffs and import restrictions.

The Commanding Heights

In developing countries government often is the best developed organisation (usually thanks to the colonisers) and therefore it makes an intuitive sense to let it manage the business activities through state-owned enterprises.

But bureaucrats do not have the same incentives as an entrepreneur and there is virtually no competition. As a result, there is a lot of wastage and industries rarely become competitive.

In the rare cases that things do work out it is usually because the organisation acts like a private entity, incentivising innovation, and efficient management; the only remnant of government is in the ownership.

State enterprises did work efficiently in some cases, notably Stalin's Russia but there the reasons were patriotic fervour or the threat/fear of consequences due to an authoritative regime. Such factors may work in short duration but do not work in the long run.

Favouring the Few

Relationship or managed capitalism involves selecting a few champions (or creating them) and sticking to them, helping them out by erecting barriers to entry, subsidising input, facilitating exports, providing cheap loans.

This approach may help if the companies learn to grow and support themselves as are some cases around the world, but it often leads to crony capitalism where resources are wasted in helping friends and family.

Also, the victims in such a system are households as they get low wages, the benefits enjoyed by the favoured industries are paid through the taxes of households. Since the focus is on exports, the households are not even allowed to enjoy the products since the consumption is discouraged. This also deprives firms of local large domestic markets.

Export-Led Growth and Managed Capitalism

Managed Capitalism is disciplined when it is forced to compete at a global level (since its domestic position is secure). So, the countries have to aim that such firms that have been given an extra support are globally competitive, leading to an export-led growth which helps nations climb out of poverty. However, it is not an easy strategy to execute.

Missing the Turn

Countries like India built large firms with organisational capabilities, but the system was so fraught with corruption that the firms were not competitive at all. Since the domestic markets were closed, these firms faced no threat and did not aim at efficiency even when they had grown up considerably.

What Happens When the Exporters Get Rich: Germany and Japan

Japan and Germany got destroyed in the World War 2 but since they had already developed organisational structures and had required technologies, they rebuilt back, and post-war climate helped keep wages down. In Germany, banks and firms had stake in each other and thus helped each other, keeping new competition out of picture. In Japan, the ministries of finance and industry orchestrated the cooperation.

But after a while (Germany - 1970, Japan 1990) wages of workers had matched that of developed countries (US etc.) so the competitive edge was lost. The countries kept rising up the value chain, but the international market had only so much to offer. Their weakness lay in the fact that lack of domestic markets in non-export industries (like hotels, restaurants, barbers) meant that the service sector could not grow at the same rate and the policies that helped and worked in manufacturing provided disastrous in service sector. As a result, domestic consumption was unable to absorb the products that the manufacturing industries had an advantage in and were producing.

It is an effect of one arm of a body growing to be too efficient for the body and at the expense of the other, leading to a fault line.

The Fault Line: The Case of Japan

As Japan realised that it needed to move away from exports, it started remedial steps. The first was to cut interest rates sharply to boost stock and real estate markets. Instead, this led to a real estate bubble. At the same time companies did not use the easy money for investing in Japan, instead choosing to invest in other poor Asian countries to boost profits.

Similarly, banks were used to dealing with existing customers and leveraging past relations and social norms. They did not know how to lend to new customers and estimate risk.

As a result, Japan has historically been unable to pull itself out of slump and services only when US bails out its economy thereby boosting consumption which aids Japan.

There is no natural, smooth, and painless transition of labor from manufacturing to services industries and the wages in domestic sector are often too high for them to be productive. Consumers also have been trained to be cautious about spending.

Even though the newer generations of Japanese are spending, the purse still stays with the elderly and the indefinite pension is making even the new generations conscious spenders.

Will China Deepen the Fault Line or Bridge It?

China is now the second largest economy and it may define a new path for late developing nations. But historically Chinese consumers spend less even than other developing nations. This is often attributed to incorrect data being collected by the Chinese government but still the consumption is very low.

This may be due to the one-child policy of China which has resulted in one child often having 4 dependents (two parents and two grandparents) to support. The rising incomes may lead to better social safety nets, but Chinese citizens are not yet used to it and thus wary of spending.

Moreover, China kept its wages low to support the export led growth, but this means that the households have less income as a proportion of national income. Further to facilitate the firms, interest rates are also kept low, so households earn less income from interest. Couple this with the fact that health and education benefits are no longer free, and we realise that there is very little scope for discretionary spending.

For now, China has been keeping its economy running by building big ticket infrastructure projects, but the demand is not increasing, and such a model is doomed, the question is of “when” and not “if”.

Summary and Conclusion

Late developers were not innovators initially. The technology was already developed by rich countries, so they borrowed it but set to work on organisations to drive growth. But the organised posed a danger of never growing due to lack of competition. In the cases where there was an authoritative regime, they were forced to compete globally but the reliance on external demand has handicapped them as households were repressed and domestic markets did not grow. The Trade imbalance is a serious fault line threatening the global economic order.

Chapter 03: Flighty Foreign Financing

The surplus generated by exporters like Japan and Germany was diverted to other nations who needed the money to fund their consumption. This was usually done on Governmental level. However, with the rise of petrodollars from the middle east, Western banks and “one-arm” investors such as pension funds and mutual funds started investing in these economies. Since the domestic financial institution of developing nations had not been allowed to develop there was not a lot of transparency. As a result, some countries faced debt crisis wherein they were unable to service their debt (expansion of consumption) while others used the money to further invest in export capabilities than what was necessary contributing to deepening of the Trade imbalance. (expansion of investment).

Saving and Investment

Ideally savings and investments of a country should not be related but it is observed that in case of developing nations, more a country saves the higher is the investment. It was noticed that countries with current account surplus invested more and had higher growth rates while those who saved less grew less.

This can be explained by the fact that in giving preference to producers, developing countries do not have strong financial systems and hence the funding for projects cannot be generated domestically. Moreover, foreign funding (except FDI) comes when governments back the projects and in those cases the creditworthiness of the countries come into picture and not the project specifics.

Furthermore, the countries that rely on foreign funding grow slower than those that rely on domestic savings (probably because domestic savings can be channeled to projects that are needed rather than those selected by a central authority).

The Financial Sector in a Producer-Biased Economy

In a producer biased economy the government sets the interest on deposits at a low rate to reduce the cost of capital but the lack of competition among borrowers (since government decides who to lend to) leads to a bloated to and inefficient banking system one that taxes domestic households because they don't have the government guarantee that producers have and the banks have no mechanisms in place to assess risk. This drives households into the arms of informal and unregulated moneylenders.

Saving Little and the 1994 Mexican Crisis

Since domestic financial institutions are not developed in developing countries retail credit is not easily available, therefore governments cannot carry out their populist measures. Therefore, the benefits are passed in the form of subsidies and the governments are forced to run large fiscal deficits.

The foreign lenders lend their money reluctantly therefore they demand extra protection from governments, such as very short durations, loans in dollars as opposed to local currency, etc. In 1994 Mexico was heading into elections and the government went into a spending spree financed by foreign debt. They offered bonds that were lined to dollar-peso index to pacify the foreign investors but a number of events (assassination of a presidential candidate, armed peasant rebellion and increase in interest rates by the FED) led to foreign investors pulling out their money leading to Mexico defaulting. Eventually US Treasury and IMF came to the rescue, but domestic lenders had to take huge losses who had held on to peso-dominated debt.

Corporate Investment and Managed Capitalism

In producer-biased economies, bank funds are very expensive for everyone in general (even though the producers are at an advantage). AN immediate consequence of this is that new entrants do not get an easy access to funds. As for existing corporations, a preferred method thus is to funnel existing profits to fuel further growth. This reduces the cost of capital and this system in general incentivises profit making corporations. A drawback of this approach is that sometimes corporations may keep doing it and build overcapacity. This risk is sometimes mitigated in case of small economies as the world is a big enough market for the extra capacity but in case of big countries like China it is a clear and present danger.

Corporations mitigate such risks by diversifying in a number of businesses (such as South Korea's chaebols or India's family owned businesses like Tatas and Birlas) essentially replicating the role of financial systems by creating an internal capital market within the conglomerates.

Investing Too Much and the 1998 East Asian Crisis

East Asian countries were growing at a rapid pace and domestic savings did not suffice. The firms started borrowing internationally, sometimes directly and at other times through domestic banks that they had relationships with, who in turn borrowed from international lenders. The international lenders lend in dollar which insures against the possibility of the borrower nation devaluing its currency. This puts foreign lenders at a privileged position versus the domestic lender and in this case the foreign investors did not lend carefully fully aware that their investments were relatively safe.

The managed capitalism worked for a small economy that had a shortage of funds but when a lot of money rushed into these good performing economies, a lot of unviable projects were taken up by the industries (and in some cases the governments as well).

At the first sign of trouble, post japan devaluing its Yen against dollar in 1995 making Japanese exports cheaper hurting the east Asian economies, foreign lenders started leaving and this left a gaping hole in the economy and the governments were forced to intervene (as predicted by the foreign lenders) thereby socialising the losses. The governments were forced by IMF to accept atrocious terms for bailouts as it termed managed capitalism as crony capitalism and also took key steps to help its majority shareholders aka developed nations like US by making abolition of domestic monopolies and protective tariffs as preconditions for a bailout.

The Fault Line Deepens: The Divide between Developing Countries

In a developed market the domestic and foreign lenders have the same information and thus lend on similar terms, however in a developing market the foreign lender have very little information or faith and thus lend at very serious terms such as repayment in foreign currencies and very short duration loans. This allows the foreign lenders to eat into the value of domestic lenders and thus foreign borrowing is seen as a last resort of borrowing. An interesting analogy is the US subprime market which was a departure from the developed country norm of lender aware of information and the borrower responsible for the funds the borrow. Instead lenders did not have information and borrowers (as well as lenders) had been incentivised by the implicit guarantee of quasi-government bodies.


Post these crises countries like India and Brazil liberalised their economies and this led to increase in domestic consumption and stabilising economies. The fact that these countries were democracies helped spread the benefits of growth a little more equitably and stop the orchestration of their economies.

The East Asian economies reduced their foreign borrowings primarily by devaluing their currencies and exporting as well as by reducing the investment expenditure. But the result of these two acts was that they turned from borrowers to lenders and now the world started looking for new spenders.

Summary and Conclusion

The export led economies of the world learnt their lesson and stopped relying on foreign funds. But their export orientation led to massive buildup of foreign exchange and willingness to fund those who wanted to consume beyond their means and US (along with UK and Spain to a certain extend) proved to be ideal candidates due to their weak social safety nets.

Chapter 04: A Weak Safety Net

The Willingness to Stimulate

Compared to other developed nations United States has a weak social safety net, aimed at helping displaced workers in the short run but not in the long run. There also is very less tolerance for loss making firms in a downturn. This has helped propel the most profitable firms to the fore and promote efficiency. But since 1990s US is noticing that post downturn, while the economy recovers fairly quickly, the unemployment rates take a long time to fall leading to prolong distress.

George H Bush lost his presidency due to the worker dissatisfaction and this has meant that US government is willing to follow prolonged expansionist monetary policy to allow job recoveries and support consumption. Will rest of the world in a slump, US becomes the consumer of first and last resort raising the demand for debt as well as consumer goods therefore providing the incentive for export oriented nations to stick to their strategy as well as providing the wrong incentives to its financial sector.

The Weak Safety Net

US workers have weaker safety nets. The unemployment benefits cover 50% of wages and last six months which is significantly lower than other developed nations. Moreover, healthcare costs in US are very high and health insurance is available primarily through employment, which makes unemployed Americans a very difficult lobby.

Jobless Recoveries

There are various theories about 1990-91 and 2001 recessions. Some have called them as structural recessions leading to change in industries and thus change is skills demanded. The evidence for it is plausible but week. Another theory is that since recessions have a cleansing effect on the economy, these two recessions came after prolonged periods of prosperity and therefore took more time for recovery. But this is refuted by the fact that post war periods saw both prolonged prosperities and quick job recoveries.

Finally one theory summarises that the rise of internet and information technology revolution means that firms can now be more selective of the candidates they want to hire and also wait for the demand to pick up before hiring workers leading to rise of temporary workers and freelancers.

Why is the Safety Net Weak?

Economic Reasons The weak safety net in United States is probably because of the hard-capitalistic nature of its economy that acts on the principle of arm's length. That is, hard data and information is given precedence over relationships and when one has to choose between improving numbers and keeping relationships the choice is obvious.

The Europe follows an opposite approach. Arm's length system may be decried as heartless, but it fuels rapid innovation as it ensures resources are not wasted (on incumbents and relationships) and rather quickly allocated to the where recovery (and growth) can stem from.

Political Reasons

US politics has a libertarian outlook where socialist politics has never had a stronghold because there are no strong class divisions and hence never has there been a need for taxing one class to help others as workers never felt that they could not rise. Moreover, it could be argued that for most of its history the different class divisions in US have had racial boundaries and these boundaries have often resulted in the poor being disenfranchise whether due to slavery laws or immigration.

Moreover, being a federation US has a competing economic system and no state can tax its employers for the fear of tax revenues loss. Instead heathy firms mean that the state earns higher revenue and that has incentivised keeping the firms healthier.

In case of the New Deal by FDR, the worker nationwide were suffering due to depression for a prolonged period, secondly benefits and social safety nets were enforced nationwide thereby reducing the fear of competition and in some cases to accommodate racial lobbying certain workers were left out of it such as farming which employed greater proportion of blacks. Moreover, firms supported the move to nationalise social safety because it taxed every firm and thus smaller firms had higher risk of having their profits diminished which incentive the bigger firms to support the move.

The Problem with Discretionary Stimulus

Discretionary stimulus, as the name suggests, is discretionary and thus has no structure to it and seldom is well thought off. More often than naught, it is used to compete and ideological goal or fund pet project which may not necessarily be funded normally. Secondly, such stimulus keeps the workers in ambiguity because they do not know if the upcoming recession and the following destruction would be serious enough that the government will intervene. Finally, focusing on stimulus rather than social safety nets, US is forced to generate demand that helps not just US but other nations as well which piggyback on US chickening out first in the time of a crises.

Chapter 05: From Bubble to Bubble

The Federal Reserve's Objectives

Federal Reserve's mandate is to keep an economy healthy - that is, keep inflation low and growth high (along with ensure stability of the financial system.)

Phillip's curve is used to represent the tradeoff between growth and inflation. In 1960-70, the Philips curve started breaking down and “rational expectations” took over which suggested that high growth fuelled by high inflation was basically fooling the workers and eventually the ruse would fall.

The new thought was that economies had a potential growth rate - rate at which unemployment was at it minimum (growth) and inflation was low. If actual rate exceeded the potential growth rate there would be an inflation and if it fell below it, wages would fall. The central bank aim was thus to maintain this, and the potential growth rate was stable as long as the structure of the economy did not change (i.e. the composition of dominant industries in an economy).

The central banks had only one tool - short term interest rate and since data had lags, they form a horizon for two-to-three years and operate based on those assumptions. For financial stability, other “prudential” measures such as capital requirements were given to the regulatory departments of the central banks.

The Interest Rates and Its Effects

Fed conducts monetary policy through short term interest rates which are used to determine long term interest rates (10-year period). If the short-term interest rates are expected to be low for a long period of time, then long-term interests will be low. This reasoning is known as “expectations hypothesis”.

Low long-term investments mean:

· The value of today's assets will decline slowly.

· It increases household wealth and incentivises spending over saving thereby growing demand.

· Higher profitability for companies, which incentivises them to invest further and also boosts ability to borrow.

Short term interest rates also have other effects, such as interest payment on adjustable-rate mortgage falls if short term interest rates are low leaving more money in the hands of markets. It also allows banks and finance companies to make illiquid term loans.

The Response to the Dot-Com Bust

Post the 2001 dotcom bust Fed decreased the interest rates from 6.5% (Jan 2001) to 1% (June 2003). The US economy had recovered quickly but jobs did not return until 2003. The reasons included changes in the US economy, the moving of manufacturing jobs to other countries etc. The Fed which should have been concerned with the output (which had recovered quickly) instead kept stimulating demand, which led to job creation and growth all around the world but US. This led to over stimulation of the world economy and since Fed was concerned with only US it did not stop to check the effects of its policy on world economy.

When Fed eventually started raising the interest rates, it repeatedly stressed that it would keep interest rates low for a considerable pace so that the long-term interest rates did not increase sharply. But rather than fuel anxiety about the long-term interest yields, the risk premium fell and make risks tolerable.

Finally, when the interest rates started rising and Fannie and Freddie tempered their purchase of mortgage backed securities, the house prices stopped rising and the loan defaults started.

Did the Fed Make Mistakes?

The Fed cannot be blamed entirely for its actions. It was facing low inflation (even possible deflation) and high unemployment and thus it continued to keep interest rates low. However, the mistake that it can be accused of is to ignore the asset prices.

Rising Asset Prices

Low interest rates meant that money was available cheaply and a number of financial institutions with long term liabilities were worried that they would not be able to make their commitments. To chase growth, they started investing in developing nations and other riskier instruments such as mortgage backed securities. But the central banks in these countries kept buying dollars that their firms got from exports to keep its prices higher than their local currencies and instead invested it back in US government and agency bond. The money leaving the US looked for riskier assets for growth while the same dollars kept coming back for safety.

House prices also started rising dramatically. Buoyed by the fact that Fed had promised to keep the interest rates low, people started taking adjustable rate loans and kept refinancing based on the appreciated asset prices which were appreciating because of the easy money available in the system.

Other manifestation of this was CLO (collateralised loan obligations) wherein backs encouraged private equity investors to acquire firms and sold debt securities against them. This resulted in larger and larger acquisitions.

The Departure of Asset Prices from Fundamentals

Normally asset prices are kept in check by the short markets, who bet against the rising prices. However, housing market does not have a short market and central banks have traditionally clarified their inability to determine asset prices for housing. The warning sign, however, could have been credit growth. If an asset price and the growth of credit for it increase it could be a warning sign, but Fed had stopped tracking it because it was not a good measure for predicting inflation. However, it should have been used on its own to check for bubbles as is done by EU central bank and RBI.

Another problem is that central banks don't expressly aim to fight asset price inflation like they fight goods price inflation and therefore if the fed had an express commitment for it, raising interest rates even fractionally would have sent a signal in the market and there would have been corrective behaviour. Secondly, bubbles develop due to “greater fool” theory and by promising cheap credit for prolonged periods, Fed had promised a supply of the fools.

The Greenspan Put

Alan Greenspan, the chair of the Fed had recognised in 1996 that there was a price bubble but did not act on it. Subsequently he made an implicit guarantee that Fed would not intervene if the prices rose too high, but it would surely act if they fall too low. This led to the widespread notion that bankers and private players need not limit their gains, but Fed would be there to limit their losses. Moreover, but promising cash, it incentivised the banks to not store for the rainy day, instead invest all in. This led to a leverage build up throughout the system.

Monetary Policy and Financial Stability

As stated previously, the role of the fed is to facilitate growth (while curbing inflation) as well as ensure financial stability. However, by forcing overly on unemployment numbers and keeping interest rates low for prolonged period of time as well as enforcing the Greenspan put, the Fed has abandoned its goal of ensuring Financial stability. This therefore begs the question that the balance between monetary policy and financial stability as well as the Feds responsibility for it needs to be revisited.

Academia's Failings

Academia needs to accept the shortcomings in its models of the effects of monetary policy. At the very least if even the effect of monetary policy on financial sector and banks is not considered we could continue to be blindsided. The is some correlation between the Fed's monetary policy and the pace of house price increases and this calls for revisiting what we know of monetary policy and incorporate further factors in the existing models.

Summary and Conclusion

Developing countries started saving more post 1990s and the producers of the world needed new consumers who would consume more than what they could produce. US filled that role and by trying to stimulate its economy it ended up stimulating world economy as a result firms around the world did not restructure and US kept consuming.

Moreover, since US has weak safety nets and a strong democracy those who are left out economically will seek redressal in politics and that can bring in a lot of bad economics. The United States cannot afford to live from bubble to bubble, trying to stimulate its and world economy, in hopes that its workers get employed because it cannot directly expand the social safety nets.

Chapter 06: When Money is the Measure of All Worth

Bankers look to make money in any scenario and their performance is measured mostly in the money that they make and not in the value that they generate for the society. This can be a fault line as bankers are then tempted to boost their profits at any cost. They thus fleece any investor starting with small investor moving up to pension fund managers to even the government. In the 2008 crises, banks kept pushing for risky investments because they could make more money and also because the lenders were not evaluating the risk that was being taken with the money (and therefore raise the cost at which they were giving their money to the bankers.)

Eventually bankers defaulted and the government had to intervene to make good of their promises, this corruption of incentives as well as reduction in risks for bankers is a potential fault line is the current financial system.

Pecunia Non Olet

The Latin saying “Pecunia Non Olet” translates to money has no odour and implies that (for a banker) there is no difference between money earned through hard and honest ways or easy and socially damaging way. This tends to disorient their moral compass and since bankers and other agents (such as short sellers etc.) derive meaning in their work by measuring the money they can make (since they don't having anything tangible for them to measure their worth), it makes making the wrong choice more tempting even though the person may not be fundamentally bad.

Brokers and What Went Wrong

Initially banks used to make judgement calls about whether to make a loan or not based on judgment call by the loan officer but increasingly this task was outsourced to loan broker who would process the documents. The loan brokers were selected by realtors and others based on who could process the documents quickly and this eventually led to these loan brokers such as New Century Financials to process loans that had no background checks at all. To make up for requirements they would fake job details and sometimes raise the prices of the homes to maintain loan ratio. Their only metric was processing fee and that is what they focused on.

Assigning Blame

Brokers in an arm-length system do not forge a long-term relationship with their customers and what they did in the lead up to the crisis was not illegal at all. They acted in their best interest, as is expected. They should have been kept in check by the competition, but the rush of money ushered by governmental agencies did away with that.

Same goes for banks that should have looked at who they were lending too. Investors too are to be blamed for not being diligent enough to ask questions as to how they were getting high returns at such low risk. Their willingness to pump money also contributed to the problem, as does it with the homebuyers who took loans on homes that they could never pay for.

Summary and Conclusion

Financial sector acts in an arm's length system where short-term profits and hard facts are given a preference over long term relationships, as a result the brokers and the bankers did not consider the social implications of their actions.

Foreign investors, especially central banks had large amounts of dollars and proceeded to invest it in US debt in an effort to make a little profit on all the dollars that they had accumulated. They were blindsided by the implicit governmental guarantee that these instruments carried. Equally problematic were private investors who

Chapter 07: Betting the Bank

Betting the Bank

In corporate bond markets the ratio of AAA rated bonds is usually 1% of total bonds but in case of MBS 60% bonds were rated AAA. This was primarily because the bonds were structured as a junior-senior paid where the risk was minimised using diversification. The idea is that if there is a loss the junior security would take the hit. The senior security suffers only if both mortgages default and since the mortgages were ideally supposed to be independent, the probability of both securities suffering had to be extremely low.

In normal times, the correlation between residential mortgage default is low. But in this case the securities covered very poor-quality mortgages and any disruption in economy or downfall in house prices would have and affected most of the mortgages.

The banks were exposed to the same diversified pools and this increased the risk correlation as most banks would suffer losses originating from the same source and this would push a collective response which would affect the their lending and refinancing abilities which would reinforce the problem.

Another willing victim was AIG (American International Group) and especially AIGFP (its financial products unit) that sold insurance through credit-default swaps as it was sure that the risk of default was negligible. As the bonds market plummeted AIGFP's liabilities skyrocketed and in the end was the recipient of the largest monetary bailout in US history, receiving more than $150 billion from the US government.

Tail Risk

The reasons why banks held on to such risky securities as well as financed them using short term which was a probable source of threat was that the probability of the risks actually happening were considered negligible. The only case in which such investments would go bad was if all of the housing market crashed or if all the liquidity were sucked out of the markets for banks to function. The risk of that happening was extremely low.

Yet since banks and investors made their decisions based on the assumptions that these risks were tail risks (so low on the probability distribution that they occur on the tail of probability distribution), the increased the likelihood of these risks by acting in the way that they did.

Why Did Bankers Take on Tail Risk? Searching for Alpha

Alpha (or the Alpha ratio) is a measure returns adjusted for risks with a benchmark index. The fund managers thus aim for higher alphas by taking “tail risks”. Higher risks mean higher returns, and since tail risks by definition are rare, the fund managers could ensure higher returns at lower risks. The consequences of ignoring tail risks could be (and were) dire, but fund managers live from quarter to quarter, earning bonus on a fiscal, so they can keep making money each year, until the D-day and most of them did not have an exit plan, and the competitiveness of the market did not incentivise the prudent ones either.

Risk Taking on the Front Lines

Ideals risks should be balanced in a firm but in a number of financial firms such as AIG, Bear Stearns, Citigroup and Lehman Brothers, the risk auditors were seen as doom-sayers and the ones impeding growth. They were thus not taken seriously by top management, often asked to report to the people whose risky actions they warned against. They were also paid low, so the talent never makes its way into such an essential function.

Another reason is that while bankers are rewarded on the profits they rake in, they are almost never penalised when they make a loss. This incentivises risk fuelled profits because the bankers know they are not responsible for the losses.

Risk Taking at the Top

There are many explanations as to why those at the top allowed the kind of risks that were taken in run up to the Great Recession. One explanation, though unsatisfactory, is that the top management entered the industry when banking was boring and thus represent the left-over talent. But post 1980's deregulation, the financial sector invited the best talent and thus the smart people were working for less than smart folks.

Another explanation is that the CEOs and other top management had too much skin in the game that they kept hoping that the risks that paid off for them in past would continue to work for them in the future. As a result, those advocating for moderation were often sidelined and ridiculed. Firms like JP Morgan, which fostered a culture of risk moderation also faced pressure of employees leaving as they went looking for greener pastures. As such CEOs also had pressure from their employees to allow risk taking.


Shareholders ideally should have punished the risk-taking banks but since they do not have any liabilities for the risks taken, they allowed the situation by pushing up stock prices. The boards too did not do anything, either because they were incompetent, or they did not feel the risks posed immediate threats.

The markets did see increased volatility in the futures starting 2005, which should have been an indication that something was not right, but investors held on. More puzzling is the fact that holders of long-term, unsecured debts, who had their capital at risk without any return for the risks, stayed on too.

How the Helping Hand of Government Hurts

It is a reasonable assumption that if a systemically important institution is under threat the government will rush in to save it, regardless of the cost. Armed with this knowledge the bankers took excessive risk and also betted heavily on the housing market, which again would invite government intervention if it failed.

Moreover, the low capital requirements for investing in mortgage backed securities. The market deemed them riskier (as they were) and hence rewarded credit interest on it while the regulator deemed it safe. The mismatch in interest rates lured the bankers into it. Moreover, the guarantee that the government and the fed would come to rescue in case of a system wide failure that could occur in case of a tail risk, meant that it made sense to bet heavily because if you failed the government would have to come to rescue you, but while you were safe you could keep making more money.

Moreover, since the shareholders were safe from the debt liabilities, they too did not care if the banks were loaded on them. They were happy with the handsome returns and kept rewarding the banks that took more risks with higher share prices.

Summary and Conclusion

Tail risks are difficult to recognize and when they occur it is highly probable that the governments will intervene, but this information can lead the financial market in the wrong direction. If the interests of the shareholders and the society are at odds with each other, it is not enough to blame the bankers, the system is broken. The government intervention in such cases while avoidable should have also dispersed any future expectations.

Chapter 08: Reforming Finance

The fallout of the Housing Finance crisis is that radical proposals are gaining ground which aim to rein in the world of finance and “make it boring” but to do so would be to limit its creative energy (in an effort to constrain it's potential for destruction). A more appropriate response according to Rajan is to reform finance, specifically on the issue of expanding access to credit.

Democratization versus Debt

There are two streams of thought regarding debt and the access to financial markets and innovations that are prevalent. One idea is that since people are rational beings and governments should not illiberal there is a case to be made for greater financial freedom and deregulation. Hoverer, the recent crises have highlighted that finance is a powerful force in an economy with tremendous scope for progress and betterment of the society but also for destruction if used improperly

The other is to think that people are incapable of making rational choices and thus there should be legislative action to limit their choices in hopes of limiting their exposure. But multiple studies have shown that even if people make irrational choices it is mostly based on the skewed payoffs that are at play. Moreover, shutting access to finance is undemocratic and thus the aim should be reform finance rather than to shut it.

Broad Principles of Reform

Should We Limit Competition

There is a tendency to blame the crises on Competition, that because of Competition the prices have dropped so much that the risk is not priced appropriately. Post Great Depression, New Deal aimed to cartelise sectors and restrict competition to raise prices. However, the real culprit is not the competition arising due to risk taking individuals, but an undifferentiated groupthink encouraged by governmental intervention.

Competition ensures innovation and while innovation can lead to dangers and opportunities and maybe there is a case for monitoring innovations, stifling it would mean killing the economy because lack of adaptation would mean rendering it unstable.

Reduce Incentive and Price Distortions: Manage Expectations of Government Intervention

The recent crisis was due to a governance failure both internally in the banks as well as external governance. The main reason for systemic failure in the recent crisis was the underpricing of risk caused by the exuberance that is propped up by governmental intervention in case of a meltdown.

End Government Subsidies and Privileges to Financial Institutions

Just like government intervention, governmental support is also detrimental to a financial institution. An implicit or explicit protection from the government to an institution means that it does not have to bear the consequences of its actions and this means that people are fewer questions and given them greater resources.

Enact Cycle-Proof Regulations

Regulations are mostly brought in at the low point (when there should be fewer) of economic cycles and ignored at the peak (when there should be a greater emphasis).

Regulations should be comprehensive, non-discretionary, contingent, and cost-effective. Regulations that are comprehensive and apply throughout reduce the risk of trouble in some sectors while others are watched upon. Non-discretionary regulations have a greater chance of being implemented, and public as well as media can monitor the progress more transparently. Contingent regulations kick in only when some conditions are met and this means that the regulated spend less ingenuity to evade it and even when the regulations kick in they know what they need to do in the short term to comply. Finally cost-effect regulations that reduce the cost of compliance on past of the regulated as well as the cost of administration on the regulator have a greater chance of success.

Reduce the Search for Tail Risk

Risk build up happens when firms wish to monetise their risk and sell it to others who promise to pay for the losses when the damage occurs in lieu of payment for buying the risk. The firms taking up the risks can make huge profits if no risks materialise but face the danger as well. But if a number of firms chase the same risk (in search of returns) the cost that the risk seller takes in the form of premium drops and by more and more firms partaking in the risk pie they make it into a systemic threat inviting potential governmental intervention. The aim thus is to take more and more tail risk before others join in and the returns reduce (with the assumption being that everyone will eventually join in the risk insurance thereby the potential payout will be less).

To deal with such issues, we need to check the incentives of bankers, make banks accountable for the risks that they take in search of return. While turning bankers into bureaucrats is not a great idea, banks should be encouraged to create contingencies for the risks they are taking.

Altering Incentives Generated by Compensation

One idea is to hold a major fraction of the bonus that traders make on great performance in an escrow, to be paid annually based on the investments over time so that they're forced to look at risks from a longer timeframe.

Incentives at the Top

Top management in build up to the crises have abetted rather than impeded risk taking. One idea is to hold their compensation in a “holdback” fund similar to that of traders. Next, the board is supposed to be a check on the management but often the board is either filled with outsiders with no experience or insiders with too much skin in the game. So, appointing better board members is an essential reform. Moreover, board should interact with mid-level management without the top management to ascertain the practices employed. Moreover, externally regulators should take a proactive measure in monitoring the health of financial institutions. They should be forced to demand (at least aggregated) data so that they can monitor industry wide trends and suggest corrective measures. The same data can also be shared with public after anonymisation or after delay so that journalists and others can point out aberrations in time, creating public pressure for banks and financial institutions to take corrective action. Public pressure can also mitigate the bias in regulators.

The Repricing of Financial Claims and Incentives

Banks and financial firms should be forced to keep required equity aside if they are taking tail risks, so that they can absorb the losses of their actions. Similarly, short term unsecured debt suppliers should also be forced to feel the pain if their investments fail. The assumption that even if they lend to risky ventures of a systemically important institution leads to risk-taking to be seen as a value-maximising activity. This should be strongly deterred by making it clear that government will not intervene to absorb the losses.

Government Intervention in Markets

Government should reduce its intervention in the markets and also break up monoliths like Fannie, Freddie and Ginnie as well as shrink them. The government intervention acts like a distortion. Moreover, financial stability should become an explicit part of Fed's mandate along with employment and low inflation. If Fed is decreasing interest rates to help the economy, it should raise the interest rates at the same rate if need arises. It needs to eliminate the bias it has against savers in favour of debtors. These reforms are difficult to bring about, but the problems need to be handled before the next crisis hits.

Eliminating “Too Systemic too Fail”

Ideally there should be no systemic institutions because it gives them an advantage over non-systemic institution at the same time incentivising risk taking. Three ways of dealing with such problems is firstly to prevent institutions from becoming systemic if they become systemic force them to have private-sector buffers to minimise losses and finally to allow them to fail if they are still distressed.

Keeping Institutions from Becoming Systemically Important

Limiting banks by size is not a good idea because big banks have advantages to them as well and small banks can cause issues as well. There is precedent of a small bank being rescued (Bear Stearns) but a trillion-dollar family owned mutual not being designated systemic because bank was well connected to different sectors of the economy.

Equity should also not be a criterion, because it would promote inefficient banks or force the banks to manipulate the balance sheets. The best idea is to create a regulator with power to break a bank or prevent its M&A in case it seems to be error prone. The idea is to have a regulator that disincentivizes risk taking and has systemic data for a bird's eye view. Such a regulator should be under legislative and judicial review and the data should be publicly released for public oversight.

Building Better Buffers

Systemic firms should be forced to set aside certain level of capital as buffer. This could be done through raise equity, which can negate the low costs that big institutions get and remedy the unfairness and also save taxpayer from paying for it. Alternatively, banks can be forced to create contingent capital which would kick in incase banks capital ratio falls below a certain value. Banks can also be asked to issue bonds for contingent debt but it has to be ensured that banks don't hold on to the debt of other banks, instead other class of investors such as mutual funds, pension funds, and sovereign wealth funds can hold on to it.

Making Financial Firms Easier to Resolve

There are times when a firm might fail despite all the efforts and oversight. In such a case it is essential to “resolve” it, that is to sell its assets and inflict losses on investors, quickly before the assets lose value. In such a case courts are not the best choice as legal issue can linger for years.


We cannot always anticipate the source of next crises, and crisis can still occur despite best efforts, as such it is necessary to make a system fault resistant.


Governments should have resources that they can deploy in a crisis, but at the same time relief should not be as easily available as to make people careless.


There should be multiple checks and balances and regulators and not a single point of failure. At the same time, regulators can coordinate the regulated into making the same mistakes. Therefore, while there should be a regulator, the prescriptions should be minimal.

Phasing Out Deposit Insurance

Deposit Insurance is an archaic concept, as deposits can now choose to invest in other safe options such as bonds and papers linked to treasury bonds or another safe bill. But at the same time depositor insurance may be retained for small banks to give protection while larger banks should be able to take care of themselves. Moreover, large banks already have a chance of getting rescued, so they do not need a depositors insurance to instill confidence.

Caesar's Wife

Government is usually considered above suspicion and the revolving door between employment in government and private sector is usually welcome but during a crises it can lead to a loss of faith and thus steps to mitigate it are needed and perhaps a little diversity so that decisions do not reflect “cognitive capture”.

Chapter 09: Improving Access to Opportunity in America

The crisis had its roots primarily in the stagnant wage s that the politicians did nothing to address, rather just added cheap credit. Need is to improve access to education and opportunity to reduce social polarisation, which leads to radical politics. Unequal access destroys consensus as different segments of politics (and electorate) come from different places and have different views.

This is important as to solve social issues costs need to be paid now and benefits will be reaped in future. As such consensus is very important.

Improving the Quality of Human Capital

Disadvantages Begin Early Good nutrition, education and stable family are positively correlated with future success, therefore there is a case to be made for government action in support of these. A number of programs around the world have should varying levels of positive success including Mexico where cash transfers are conditional, provided parents achieve certain milestones.

Non cognitive skills Non cognitive skills such as discipline, motivation, etc. can be taught and the school and non-school matter a lot. Mentorship programs, better schools and an overall emphasis on education is needed and can help to support children in growing as responsible adults.

Amount of Schooling Poor and Rich students learn equally in elementary school but overtime the differences increase and this can be attributed to extra schooling (books, private tuitions, summer school) that rich enjoy but not the poor. Therefore, efforts in this direction should be evaluated, such as increasing school days or incentivising poor parents to spend extra on education.

Quality of Teaching Teachers need to be incentivised based on subjects they teach as well as areas they serve. At the same time more talent needs to be attracted and clears as well as rewarding career paths created. School system too needs to be overhauled, with performance measures introduced but absolute performance as well as improvement in performance needs to be measured.

Help for and in college Less poor students enrol and graduate from college. Mentorship/guidance as well as access to financial aid can help, as well as simplification to apply for aid. College subsidy can also help in improving outcomes.

Job Apprenticeship and Training Incentivise keeping apprentices even after knowing that they might leave soon.

Determine what works All ideas should be subject to common sense as well as periodic review.

Security and Safety Net

US does not and cannot have the safety net of Europe because of worker mobility. But certain steps can help disadvantaged worker navigate any crisis successfully.

Contingent but Predetermined Unemployment Insurance If the recent recoveries are indeed jobless then there is a case to be made for changes in social safety net especially expanding the duration. However, currently the unemployment benefits are extended in an ad hoc manner, this cab instead be made more transparent so that workers can plan accordingly.

Secondly health benefits need to be expanded to provide universal healthcare. Obamacare is a good step but a program that only discusses benefits without detailing the costs cannot be permanent or even good. Debate is needed on this issue.

Universal Healthcare Universal healthcare, a system of universal insurance is difficult to conjure because of adverse selection problem (many high-risk individuals sign up while few healthy people join). Universal healthcare is important as it reduces anxiety in downturns and also ensures better preventive care. US also has higher administrative costs and therefore even though cost of healthcare has increased in relation to peer countries, outcomes have not.

Reasons for higher costs are:

  1. higher input (i.e. higher compensation for doctors)
  2. hospitals getting paid for services as opposed to outcomes and because insurance picks up the tab, over-utilisation of health services, and
  3. adopting innovation even with less evidence of effectiveness.

A good bill would encourage competition, a move to paying for outcomes rather than input (as well as a deductible cost to user per visit to encourage sound judgement) and greater focus on using proven methods.

Super-specialty hospitals bring down costs as doctors specialise. India has proven that, US however, requires full-service hospitals and this increases costs.

Finally, malpractice suits increase costs for doctor and also encourage wastefulness as doctors are more focused on avoiding lawsuits than determining the best treatment.

Improving Portability of Benefits and Worker Mobility Delinking worker pension and other benefits from the health of the firm as well as improving mobility of funds by employing diversification by having investments in mutual funds. Moreover, having health insurance independent of firms can reduce recession related anxiety and need to bail out firms to protect the workers.

Another factor is mobility. Workers that own homes that they cannot sell cannot move easily and this hurts in downturn. An Employment insurance that insures future income growth could be a cushion while workers re-skill.

As workers start working more years and industries keep changing rapidly there will be need for workers to keep re-skilling. Conducive environment needs to be created for re-skill sabbaticals. Tax credit for workers who have worked for certain years is an idea.

Savings Savings need to be encouraged and not just illusionary increase in worth/wealth. Social security needs to be reformed as it is not sustainable currently where current payer fund payment to current retirees. Painless methods do not exist (funds will have to be invested in equities).

Government Capacities Government coffers need to be refilled after the crises and a number of harsh measures need to be taken. New taxes especially value added tax and carbon tax may need to be introduced.

Chapter 10: The Fable of Bees Replayed

The world is divided into over-spenders and over-savers, but this situation cannot last long. Therefore, spenders will need to save and reduce debt, while savers will need to boost internal consumption. The expectation that developing nations will demand excess money is unrealistic and dangerous as it incentivises poor lending and distorted allocation of funds which then has to be funded by taxpayers.

Foreign investors have started becoming vary of the US debt and corrective steps are needed to be taken before the trust evaporates. US keeping interest rates artificially low or China manipulating its currency are unstable and unsustainable steps. Corrective measures are impossible to avoid for long. Japan proves that exporters cannot rely on exports for long.

The G-20 and the IMF

G20 has resolved to solve the Trade imbalances with help from IMF but in reality, IMF had predicted and tried to co-ordinate steps in 2006 but while countries agreed in principal no one was ready to take the hard steps first. Also, the steps that needed to be taken can't be taken without a fundamental shift in global awareness as the decisions rest with multiple stakeholders with different incentives, not all of whom can be brought on table to an international agreement/conference. The changes may occur but too slowly or costly. The answer may lie I the fundamental remake of institutions like the IMF and the ways they interact with sovereign countries.

Multilateral Institutions and Their Influence

There are two kinds of multilateral institutions. First are Quasi-legal bodies like WTO who work on a set of trade agreements between countries, act as arbitrators and can fine offenders. The nations too can blame WTO if their local lobbies protest a decision.

IMF on the other hand is more of an advisor and hence irrelevant. Also, since it deals with macroeconomic issues, the chances of countries giving up sovereignty to an institution with power to regulate such broad topic is nearly impossible.

Moreover, since IMF (or any other such policy institution) needs cohesive vision, there would be loss of diversity in ideas and there might be limited experience as economists might have may have biases which may not work in some cases.

Lastly, since IMF does not have power to punish it cannot force anyone and its prescriptions may be bitter and less palatable than the fines slapped by WTO to its offenders.

Also, since finance ministers are answerable to local electorate, they have often been shameless at IMF. The answer thus is not to be like WTO, rather be like Oxfam and use soft power to connect to citizens.

Obtaining Global Influence

Multilateral Institutions like IMF should reach out to citizens in a country to persuade the public, with help from local celebrities etc., to shape public opinion. As long as these institutions maintain objectivity and neutrality, their views will be taken seriously and force governmental action. With the rise of internet, a virtual democracy is being established, this can be leveraged to have a globally coherent vision.

Reforms to Global Economic Governance

Reforms need to be made to how Global Economic Governance institutions are structured as well as how they operate. To start with they should hire people from a diverse economic background and not just United States. Secondly, there has to be a global consensus in letting IMF or other institutions play a part in framing policies and shaping public discourse. There will be resistance from big countries or especially the undemocratic countries but someone (maybe the non-G20 members) will have to take the responsibility and drive the change. Old contracts (that created IMF and other institutions) may have to be renegotiated and a lot of restructuring to be undertaken. But without a global consensus on the right measures we risk the world to become more insular and inefficient every time a crisis strikes.

China and the World

China is undervaluing it's currency and this is seen as an unfair advantage by others but a case can be made for devaluing currency as that the institutions in a country may be so underdeveloped that it cannot compete under ‘normal' circumstances, thereby making resorting to undervaluing currency for infant industries inevitable.

However, undervaluing currency to boost exports taxes households and household savings as well as consumption. This also means that the lobby for undervaluation grows stronger.

The Costs of Undervaluation

Undervaluation happens when PBOC buys dollars from Chinese Exporters and gives them renminbi in return. This creates an excess of Renminbi in the market and to suck it up it issues its debt. The process is called “sterilised intervention”. PBOC invests the dollars in US assets to earn interest and gives interest on its Bond it issues for debt. But since US has low interest rates, PBOC can give high (or more realistic) interest rates on its debts because it will lead to losses, therefore it loses its independence in monetary policy and has to ape US.

This leads to artificially low interest rates in china and a supply of cheap capital. This leads to growth of Capital-Intensive industries in a country with excess labor which results in fewer jobs created. This also means that financial industries can't get credit without connections, hampering the transparency and neither can banks give reasonable interest on deposits which leads to excess thrift to save for retirement which in turn leads to a lack of growth in domestic demand. This means that china is forced to rely on export led growth.

Persuading China

Given the previous information, multilateral institutions should reach out to Chinese people because they have nothing to lose but everything to gain from the economic reforms. If the currency undervaluation and other measures are addressed, there will be a short phase of transition, but it can help China boost domestic consumption and end reliance on imports. Chinese state-owner corporations are sitting on a lot of cash so they can absorb the shock easily. Moreover, with the world turning protectionist it is in Chinese interest to address their issues. It fears going the Japanese way, but it is to be noted that Japan took too long to take the right steps and when it did it opened the flood gates.

Multilateral institutions on their part have only their irrelevance to lose. To persuade China, they also need to persuade other countries to take the corrective steps. China owns large amount of foreign debt; it is in its interest to see countries behave responsibly. IMF and other multilateral institutions can use this opportunity to address the issues and to gain a stronger say in the fiscal policies of the nations.


These notes are based on my reading of the book and were originally for meant for my personal use only. As such there may inadvertently contain any biases or errors. I'd be grateful if you point out errors (if any) as well as discuss any point that you may not agree with.

Just to be absolutely sure, please note that I have not proof-read these notes, but simply copied them verbatim from my notes app to cut down the time taken. At the time of writing these notes were purely for personal consumption and/or further enquiry. So if you find any sentence/reference/comment to be offensive, please contact me first before "calling me out". I'll remove it if I agree with you or at the very least will try to make my case

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