How an era of easy money, low interest rates and smug policies led to income imbalances and excess debt
Five years into the global financial crisis, the market suffers from a surfeit of books. Indeed, it is more and more difficult to write another book unless the author could bring new insight or facts about the crisis. In the absence of centralized and accessible information on financial flows which led to the crisis, every researcher has to plough a lonely furrow and dig for material.
This is what Prof. Andrew Farlow, the author of this book, seeks to do. He is not dreamy-eyed about the “free market” or its self-correcting ability. In fact, years earlier he had warned about the growing instability in the financial market and the rising “bubbles” in the housing market, especially in emerging markets. His articles date back to 2003 and 2005. He had warned about the rising debt and fiscal deficits of the U.S. economy and how they were turning unsustainable. He refers modestly to these earlier contributions in the Preface and at some pages in the book. This shows that he did not follow the ‘herd’ or share the view that financial globalization would last forever and benefits to all.
He is more than aware of the complexities attached to the imbroglio as also their messy interconnectedness. He does not simplify his analysis to reach quick fixes. As he explains, “The causes and consequences of the recent crash are multi-dimensional, entangled like a ball of string, layered like an onion ... We have to prise the individual bits, stretch them out, put them to the page — one after the other — and sometimes with tears in our eyes, try to make sense of the blur.” Farlow does it with the flair of a novelist or a journalist. Indeed, his book is a bridge between an academic treatise and a journalistic account. While doing this, he does not sacrifice the nuances of financial analysis or the rigours of an economist.
The first part of the book (Chapters 1 to 3) describes the seeds of the crisis. He has no hesitation in laying the blame at the doors of the long cherished “Great Moderation.” It refers to the Greenspan era of easy money, low interest rates, price stability and inflation targeted policies. Monetarists, i.e. Central Bankers, acted as “the masters of the universe” smug in their belief that they had all the tools at their command to control the economies. Unfortunately, what they had not bargained for was the imbalances it bred, nationally and globally. Farlow’s special contribution is in drawing attention to the income inequalities it created in the U.S. and in other countries, especially China. Dr. Raguram Rajan had also drawn attention to this factor in his book (Fault Lines: How Hidden Fractures Still Threaten the World Economy).
China as ‘villain’
Among others, it led to precipitous fall in demand for goods and created a perverse pattern. Advanced economies saw fall in production (deindustrialisation or hollowing out)) which was filled by cheap supplies from emerging economies like China. It created trade deficits for the U.S. and surpluses for emerging economies. These surpluses had to be kept in U.S. Treasuries for want of other alternatives. This was capital flowing upstream! Bernanke floated the hypothesis of global “savings glut” and was unmindful of the growing imbalances within his own fief. China was blamed as the villain of the piece and elaborate exercises were foisted to study and correct its imbalances! The IMF indeed was at the forefront and these were of no avail. This was in part because China was unyielding to external pressures and, in greater part, to economic realities which overtook their bravadoes and put them on their back foot. There were currency wars on China and incessant advisories to rebalance its economy. Sadly, the physician could not heal himself.
The causal chain is mind-boggling. Easy money and low interest rates created excessive debt. Low rates created incentives to “innovate” and create new products to improve the returns. There were “special investment vehicles” (SIVs), “swaps” and “currency default swaps” (CDS) and an explosion of derivatives. Rating agencies joined the fray and rated junk bonds as triple A and collected their commissions. Even major banks (wizards of finance!) did not know the value of the scrip held by them. Their executives collected fat bonuses and compensation packages. All these were fanned by deregulation or benign neglect. Greenspan admired innovations, specifically, as he imagined, for their role in diversifying risk! Ben Bernanke also shared this view. It was left to the economists in the Bank for International Settlements (BIS) to warn in successive Annual Reports about the unsustainable levels of derivatives and the risks flowing from counter party credit standing. These warnings went unheeded. As Farlow says, “CDS market was a hall of broken mirrors.”
The bubble burst openly in mid-2008. In fact, Farlow traces its origin back to 2007 or to a couple of years earlier. When the bubble burst, it was “like a car crash in slow motion, defaults would appear from the underlying borrowers, then for those who had bought the CDS, and on.” Hedge funds which had remained the buffers in earlier times were also in the pit begging for credit. Credit froze and all hell broke on smug central bankers and drove them into bail-out mode. Since then there has been no return.
The era of the rise of “excessive financialisation” (as Dr. Y.V. Reddy was fond of describing it) deserves a deeper sociological study. For nearly three decades it suited the West, the U.S. in particular, to perpetuate the arrangements to ensure its dominance in the global markets with the dollar as the reserve currency. It suited the U.S. middle class who could access easy credit and hoped to live by credit alone. They could buy (though regret later) houses on easy terms. It suited the politicians not to raise taxes or take strong fiscal measures to discipline the economy. It was a cuckoo world and did not last long.
There were many circumstances or beliefs which nurtured this predicament. Farlow captures a few in the last chapter. In his view, this was due to their faith in the “efficient market hypothesis.” (EMH) The faith in the EMH was “the sanctifying cloth to hide the nakedness of ‘light touch’ regulation and all the benefits that it would bestow.” Moreover, they had too much faith in the depth of the financial market and its ability to withstand shocks. What they did not anticipate was the multi-dimensional nature of the new threat, its ramifications and global reach. It had as much to do with liquidity as with insolvency.
His chapters on the crash and rescue (4 to 6) provide original material on the crash and the efforts to “save the Gods.” It is pathetic to watch the roll call of falling banks (heads!) and their approach to the Fed to seek bailout. The most interesting account relates to the collapse of Lehman Brothers which many take as the beginning of the crisis. Farlow is clinical in his analysis and portrays the quagmire which Lehman had created and from which it could not be salvaged. Despite the predisposition of the Treasury/FED to bail out all Wall Street worthies, they were helpless. There were intractable financial and legal roadblocks which the Treasury and the FED could not overcome. They had to allow the company to go for bankruptcy as in a Greek tragedy. The present reviewer has not come across a similar account of Lehman collapse in any other study.
Farlow decries the attempt to describe that crisis as sub-prime. He shows that mortgage collapse was a very small part of the total collapse and derivatives ran to several trillion dollars. The toxic detritus left behind by the crisis are yet to be cleared and it is doubtful when or whether they would be cleaned. In any case, it is an instance of socialising private losses at the cost of taxpayers or posterity. He has gone deep into the bail-out attempts and takes a dim view of the approaches and results. On date, these bail-outs are a work in progress with no idea as to what lies at the end of the tunnel. Similarly, his discussions on the quantitative easing (QE) are balanced and incisive. It is significant that he relates the QEs to the earlier currency wars on China and developing countries.
On the whole, this is a scholarly book which enriches our understanding of the crisis. Farlow does not suggest any ultimate solution. He says he would be happy if the book serves as a collective memory of the crash and its bitter aftertaste and acts as guidance or warning to handle future crises. Indeed, he has succeeded.
CRASH & BEYOND — Causes and Consequences of the Global Financial Crisis
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