The book “Fault Lines” by Raghuram Rajan, is a succinct account of how many storylines across time and geography converged to cause the meltdown.
A whirlwind tour through the making of the perfect storm –
Plot 1: In the US inequality is on the rise. The salaries of the 90th percentile worker have grown much faster than that of the 50th percentile worker. The government decides that easy credit and low-income housing are the ways to ensure that the façade of the ‘American dream’ is not shattered. This plot created the giant demand for money
Plot 2: At the same time productivity improvements in US manufacturing reduced the price of manufactured output. So Manufacturing in the US became a declining industry and the thrust was to move towards services. Services are not exportable and manufactured goods had to be imported. This created an imbalance of payments (current account deficit).
Past instances of financing economic growth with foreign money has led to disaster in emerging countries (East Asian crisis, Latin American crisis). The over-riding message to these countries was, Export and hoard foreign exchange to secure your future.This plot created the giant supply of money
Plot 3: Banks were the intermediaries that were connecting supply to demand.
The deregulation of the financial sector allowed them to create a superstructure of derivatives on the meagre real economy that existed (remember manufacturing was declining). The superstructure of derivatives were probably valued more than the hard assets that they were based on. For example a mortgages of house A appears in MBS, CDS, CDS^2 etc…
The banks surely should have realized that the base was too small to support such a massive superstructure? Well, They realized that risk taking is the most rational course of action. While the music is playing (easy credit mandated by the government) they would reap giant returns for the tail risk they are taking and when the music stops the government will intervene to distribute the pain across tax-payers (bail-out). This plot created the moral hazard.
Plot 1 + Plot 2 + Plot 3 = ’08 Meltdown
It amazes me how through the course of history, time and again Credit has been abused to bring an economy immense pain. Excessive Credit is a great short term tool for political leverage which can cause long term pain. The malaise exists not just in emerging countries but in the developed world as well.
A book could be (or has been) written on how excessive credit has caused havoc through history, I will contend with a fictitious example set in the future.
While Economics is destined to remain subservient to politics, It can never be good politics to believe in bad economics.
Credit has to be looked through the circular corridors of time. Only then can you see that too-much of this ambrosia has a bitter aftertaste.
#PS: The concept of impatient capital
This concept, highlighted in the brilliant and lucid book by Ha-Joon Chang – “23 things they dont tell you about capitalism” is germane in this discussion. The manufacturing sector is much slower than the financial sector. It takes years to build an industry, however capital invested in that industry can move in a heartbeat. This creates impatient capital. It is contested that value creating through the real economy takes time and we need patient capital to back it. Else capital will keep chasing immediate short term returns.
Is this case enough for Tobin Tax (financial transaction tax)? Will it reduce the relative speed gap between te manufacturing layer and financial layer?