10 July 2016

2008 American Financial Crisis (AFC)

In 2005, Raghuram Rajan (IMF's chief economist) warned that America was headed for a major financial crisis. Most American economists ridiculed him. 3 years later, his words came true. The 2008 American Financial Crisis (AFC) was the worst since 1929. And it plunged all the industrialised countries (America, Europe, Japan) into the Great Recession - the worst since the Great Depression of the 1930s.

In 2010, Rajan wrote a book called 'Fault Lines: How hidden fractures still threaten the world economy' to explain the causes of AFC:

1. In 1980, something strange happened in America: the salaries of the majority of Americans stopped increasing - and instead started decreasing. Why? From 1980 onwards, technology started advancing very rapidly. So demand for high-skilled workers (with a college degree) went on increasing and demand for low-skilled workers (with a high-school degree) went on decreasing. So salaries for people with college degrees went on increasing, whereas salaries for people with high-school degrees went on decreasing. Majority of Americans do not have a college degree. Hence their salaries have gone on decreasing.

2. Since 1945, America has been having a recession almost every decade. But every time it recovered quickly: the lost jobs came back within a year. In 1991, another recession struck. But this time, the recovery was much slower: it took 2 years for the lost jobs to come back. As a result, President George Bush (senior) lost the election that year.

3. All industrialised countries have an unemployment support system. That is, the government pays money to unemployed people. America has the weakest unemployment support system among the industrialised countries. Both the money paid and the duration for which it is paid is the lowest. This made problem #2 worse.

4. In 1992, Bill Clinton became President. He had to deal with both the immediate problem #2 and also the longer-term problem #1. The solution for problem #1 (and also problem #2) is to increase the education level of the people. But this requires changing the education system - which is very difficult. So he chose an easier solution: to give low-interest loans to poor people, especially for buying houses. America's central bank - under its chief, Alan Greenspan - supported this solution by keeping the interest rate low.

5. In 2000, the dot-com bubble burst and America had another recession. This time the recovery was even slower than in 1991: it took 3 years for the lost jobs to come back. That year, George W Bush (junior) became President. Faced with a similar (but worse) problem as Clinton, he also opted for the same solution. He not only continued Clinton's scheme, but expanded it. And again, the central bank under Greenspan supported it.

6. Poor American families (mostly black and Latino/Hispanic) with no job, salary or property applied to banks for home loans - and got them. The banks packaged these loans together and converted them into 'financial assets'. They kept some of these 'assets' themselves and sold the rest to other financial companies (mutual funds, pension funds, etc). Rating agencies - whose job is to certify the quality of financial assets - gave these 'assets' a good rating.

7. With the government pushing more and more low-interest loans and poor families buying more and more houses, house prices went on increasing. The bubble went on growing. But at some point, the borrowers had to start repaying their loans - which they obviously could not do. The bubble finally burst in 2008. Borrowers started defaulting on their loans. And the whole process went into reverse gear - at a much faster speed. House prices crashed and the 'financial assets' became worthless overnight - bankrupting the banks and financial companies that owned them. The American government had to step in with a huge rescue package to save the largest banks.

'Fault Lines' is a very good book that dissects a complex topic and explains it in a simple language to people who are not economists.


kaddi said...

Boss, Rajan did not say there will be a crisis, he generally said that the financial system is looking to get into trouble - this is a popular misconception that he was an oracle.

Indian said...