Thursday, August 4, 2011

Crisis Economics

Crisis Economics by Nouriel Roubini & Stephen Mihm. This is the 3rd of series of books which i was reading on the recent Financial crisis.Others being Fooled by Randomness  by Nassim Nicholas Taleb & Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan .

     One common credit for all these authors is that they had in one way or other predicted the economic crisis even before rest of the world . So now its time for them to write books in 'I told you so' tone :). Invariantly all of them try to articulate the reasons for the crisis. Taleb has his own reason - 'Tail risk' or 'Black Swan events' which weren't given enough attention. Mostly he finds fault with probabilistic distribution adopted by the investment bankers. Roubini and Raghuram , both eminent professors , agree between themselves , that fault lines run more depth than what is seen from outside .Entire system is being rotten.And the worst of part of the story is that we havn't cleaned up so far.We are just decorating the skin of a soon to be dead cancer patient and admiring at his recovery.
      Crisis Economics is the best among them and following is excerpts from it .
Crisis are part of parcel of capitalism . He differs from the concept that crisis are black swan events (least random one off events as described by Taleb ) but structural events associated with boom and bust.In the past centuries we have seen boom and bust cycles which occurs in a predictable fashion, off course mostly in the hindsight. Whenever a major invention , discovery , shift in technology happens  ,there is a euphoria associated with it and when it goes beyond the fundamental reasons it turns out to be a boom which invariably land in a bust. Tulips , Industrial Revolution , Rail Road Companies , the recent dot com and finally now the Financial Derivatives,  all follow the same path .Each crisis provides a opportunity to clean up the mess and make the system far more robust. All the major financial controllers ( Federal Reserve , SEC etc ) where formed in response to crisis in the earlier path of 20th century.  Unfortunately this is not happening now.

            Banking sector is in such a mess that they have taken the entire world into ransom. Still there is no one to supervise them effectively and no rules to adhere to. They do what ever they want to maximize  their profit ( inturn  their bonus ) and when the tide changes they go hat it hand to govt to bail them out ( ironically again have large bonus ). Glass–Steagall Act, which was safeguarding the world from the financial system from their inception in 1932 to 1999, prevents banking and investment banking to be under a same company.Now its a writing in the wall that the institutions which have become "too big to fail" came to their current form after this act was removed in 1999.There is no plans for breaking down these evil empires.

     People refrain from doing bad things , not because they are inherently good , but due to fear of getting punished by law. Corporations aren't any exception.When corporations are sure that what ever they do  Fed will be lender of last resort to cleanup their mess , they have little incentive to do their work properly.After the crisis of 2008-09 , we have done so little in eradicating the reason for this crisis , breaking too huge institutions , regulating complex derivatives (correctly predicted as Weapons of mass destruction by none other than Warren Buffet ) , almost of no Govt supervision of these companies ,insane risk management, carry trade , funny rating agencies  and ridiculous compensation system.

        Everyone is interested in reading about predictions . But its quite a experience to read a book of future prediction , when the events predicted were unfolding in front of your eyes .This week will go in the history for all the drama happening in Capitol hill over the issue of increasing the dept limit of US from the existing limit of 14.3 trillion Dollars by Aug 2 deadline . Failing to reach a accord will mean that US Govt will default on its dept. Though there is less than 0.01 probability for this to happen this time ,but one thing is for sure .Status quo of United States being the economic super power and the dollar being worlds reserve currency($) are about to be changed.Only question is , if it be a orderly event spanning over decades or will it be a catastrophe ?  Only time can answer it.

     Last time we faced any such structural change was when US & Dollar took over the baton from the Great Britain & Pound during post World War 2. But now we dont have a clear player to take over the lead.Closest possible is China and its Yuan. But there are several reason for why China cant be a No1 anytime soon - not a democracy , not a open economy , Yuan not being a free floating currency , huge dependence on export.

In order to clean up the mess the author wants the following to be done
     World Financial system to be revamped ,structural cleanup
     Countries to reduce the fiscal deficit/surplus so that a balance is maintained.
But there is no indications of steps in this direction being taken.US continues to increase its deficit and China continuing to increase its surplus. They both are in a parasitic relationship which has become increasingly difficult of both nations to get out of. The more time they continue the more complex it becomes. Unless there is pre planned orderly unwinding  , it could to lead to huge destruction which could make all the past crisis look like a mere hiccups .

 India ..
    India seems to be in a far better shape then the rest of the world . RBI plays the right role of central bank defusing boom by monetary supervision.Banks are better capitalized , thanks again to RBI.Far more self reliant economy than the rest of BRIC with least dependence on export and favorable demographic dividend.