Why Raghuram Rajan had to go


Raghuram Rajan, the governor of the Reserve Bank of India(RBI), announced on Saturday evening (June 18, 2016) that he won’t be taking a second term, and would return to his teaching job at the University of Chicago.

In a letter to the RBI employees, which was released to the press, Rajan said: “I want to share with you that I will be returning to academia when my term as Governor ends on September 4, 2016.”

Since the letter has been released a small industry has cropped up, trying to figure out, why has this happened. Other than being the RBI governor, Rajan is also a public intellectual in his own right. Given this, he had things to say on a wide variety of issues and from the looks of it, some of these things haven’t gone down well with the government of the day.

More than one minister has publicly criticised Rajan for having an opinion on a wide range of issues. Take the case of a comment he made in April
this year. “I think we have still to get to a place where we feel satisfied. We have this saying — ‘In the land of the blind, the one-eyed man is king.’ We are a little bit that way,” Rajan told Marketwatch.com. Rajan was referring to India’s fast economic growth, in a slow growing world.

This did not go down well with the government and Nirmala Sitharaman, the commerce minister, told the press: “I may not be happy with his choice of words. I think whatever action is being taken by this government is showing results.”

Rajan perhaps forgot that he was working with a government which is extremely sensitive to criticism. He later clarified what he really meant in another speech, where he said: “My intent was to signal that our outperformance was accentuated because world growth was weak, but we in India were still hungry for more growth. I then explained that we were not yet at our potential, though we were at a cusp of a substantial pick-up in growth given all the reforms that were underway.” But by then the damage had already been done.

There were other similar occasions where his comments did not go down well with the government of the day, and that seems like the major reason for his early exit. It needs to be pointed out here that no RBI Governor since 1992 has had just a three-year term. C Rangarajan at four years and 334 days, has had the shortest term after Rajan. Bimal Jalan, YV Reddy and D Subbarao all got terms close to five years. In fact, Jalan’s term was close to six years.

So letting the RBI governor go in a period of three years, is clearly unprecedented. Something of this sort has not happened in close to 25 years. In the recent past, the maverick Member of Parliament, Subramanian Swamy, has run a rather slanderous campaign for his removal. That seems to have had its impact as well. Further, a section of the government has never liked Rajan, given that he was appointed by the previous Congress led United Progressive Alliance government.

Rajan’s tenure had many good things about it. First and foremost, as soon as taking over, he handled the rupee crisis very well. Inflation has been brought under control from the earlier double digit levels, though that was not only because of the RBI. The bad loans mess in the public sector banks has been brought into the open. And for the first time in India’s history, banks have gone aggressively after crony capitalists, who defaulted and are still defaulting on bank loans.

This is unprecedented. In the past, the show would have just gone on. Crony capitalists would have defaulted only to borrow again a few years later, and the taxpayers would have taken on the tab. This remains Rajan’s biggest achievement. It will be interesting to see if the next RBI Governor continues to be aggressive on this front. For now, India’s crony capitalists will be breathing a sigh of relief and opening champagne bottles for sure.

Over and above this, Rajan has an international stature. He is the only central banker who has openly spoken out against the massive amount of money printing that has been carried out by the Western central banks and the ill effects of the same.

Rajan’s outspokenness on issues, as many in India feel, is not a recent phenomenon. In August 2005, at a Federal Reserve of Kansas’s annual symposium at Jackson Hole, Wyoming, in the United States, Rajan had criticised the policies of Alan Greenspan, the then Chairman of the Federal Reserve of United States.

Greenspan was considered as god in banking circles at that point of time and the Jackson Hole symposium was supposed to be a sort of a send-off for him, before he retired in 2006. Rajan spoilt Greenspan’s party by saying: ““The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis.”

Three years later, the financial crisis which the world is currently dealing with, started with Lehman Brothers, the fourth largest investment bank on Wall Street, going bust. The US government had to then come to the rescue of the American financial system. Rajan’s warning came to be true.

Of course, when Rajan spoke out against Greenspan, he was severely criticised by other economists attending the symposium. As he would later admit in his bestselling and brilliant book Fault Lines: “I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what’s going on before their eyes.”

Something similar seems to have been happening in India as well, where the critics of Rajan seemed to have closed their eyes to the issues that the country is currently facing and want to hear good things about the Indian economy all the time.

There justification for Rajan’s removal is that India has enough good economists to fill his shoes. Of course, it does. But there is no one who has the same respect as Rajan has globally.

Further, is that really the point? When was the last time a board fired a well-performing CEO, because he did not agree with their views all the time?

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared on BBC on June 20, 2016

Property prices must fall: Rajan reads out the riot act to real estate wallahs

Vivek Kaul

Raghuram Rajan, the governor of the Reserve Bank of India (RBI), merely stated the obvious when he said today (August 20, 2015): “It would be a “great help” if realty developers sitting on unsold stock bring down prices…Once the prices stabilise, more people will be keen to buy houses.”

The RBI governor added that property prices need to fall before interest rates on home loans come down, any further. “I think we need the market to clear. With growing unsold stock, we need to see the ways to do it. Some of it might be by making loans easier, but we also don’t want to create a situation where prices stay high at the level which means demand can’t pick up,” he said.

There are multiple points that need to be made here: First is that Rajan was essentially replying to all the real estate wallahs (real estate companies, lobbies and others associated with the sector) who demand interest rate cuts at a drop of a hat. The message from the RBI governor is loud and clear. The home prices are in a bubble zone and he does not want to inflate the bubble further by cutting interest rates. Home prices need to fall.

Also, it is worth mentioning here that even at high interest rates home loans given by banks continue to grow at a very brisk pace. The Reserve Bank of India (RBI) puts out the sectoral deployment of credit data every month. As per these numbers, the total amount of home loans given by banks grew by 15.6% to Rs 6,53,400 crore, over the last one year. In comparison, the overall lending by banks grew by just 7.3%. These numbers were as of June 2015.

How was the situation in June 2014? Home loans had grown by 17.1% to Rs 5,65,000 crore. In comparison the overall lending by banks had grown by 12.8%. What this clearly tells us is that even though the overall lending growth of banks has crashed from 12.8% to 7.3%, home loans continue to grow at a fairly brisk pace.
Further, banks have given out Rs 88,400 crore of home loans in the last one year. This formed around 21% of all the lending carried out by banks. For a period of one year ending June 2014 and June 2013, home loans formed around 12.7% and 12.2% of the total loans given by banks.

What this clearly tells us that banks are giving out a greater amount of home loans as a proportion of their overall loans, than they were in the past. And if this hasn’t led to a fall in inventory of unsold homes, the only reason is that home prices have gone up way beyond what most people afford. Hence, even though the total amount of home loans has gone up, the total number of home loans being given out may have even fallen (This data is not available).

The only way this situation can be corrected is if home prices fall, which is precisely what Rajan said.

The other interesting point that needs to be made here is that central bank governors normally stay away from calling a bubble, a bubble. Alan Greenspan, the Chairman of the Federal Reserve, from 1988 to 2006, was a pioneer in this school of thought. He told the US Congress in June 1999: “Bubbles are generally perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.”

So, the Federal Reserve could not spot the dotcom bubble, explained Greenspan. But once it had burst, steps could be taken to ease its fallout, Greenspan felt. As he said in a speech titled Economic Volatility on August 30, 2002: “The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. Instead, we noted in the previously cited mid-1999 con­gressional testimony the need to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’”

There is a fundamental problem with this argument. Greenspan was basically saying that the Federal Reserve could not recognize a bubble, but it could figure out when the same bubble had burst.

Raghuram Rajan exposes the flaw in this argument in his book Fault Lines. As he wrote: “This speech seemed to be a post facto rationalization of why Green­span had not acted more forcefully on his prescient 1996 intuition: he was now saying the Fed should not intervene when it thought asset prices were too high but that it could recognize a bust when it happened and would pick up the pieces.” Greenspan had used the term “irrational exuberance” to describe the dotcom bubble in a speech he had made in December 1996, and then chosen to do nothing about it.

Rajan clearly does not believe in the fact that a central bank cannot identify a bubble. What he said today regarding property prices being high and that they need to fall, before people can start buying homes again, clearly proves that.

Further, the real estate wallahs seem to have come up with a new explanation for why real estate prices cannot fall any further(they have barely fallen to start with). As Shishir Baijal, chairman and managing director of Knight Frank India, a real estate consultancy, told Mint recently: “Theoretically, if prices come down, perhaps the demand can increase. But I’m not sure if developers have any leeway left now for reducing prices. This is because input cost has increased quite a lot over the past few years— be it cost of labour, construction and material, or even the historical cost of land itself, which is very high. It does not look like there is any scope left for a serious correction in prices.”

This, after he had said: “there is a mismatch [between demand and supply] because people are finding it unaffordable (to buy).”And this came, after he had said: “If you look at investor demand, property is not their primary choice anymore. This is due to muted price appreciation, high level of unsold inventory, and the fact that there are other more lucrative financial instruments to choose from. Earlier, there weren’t any options as the equity market was not performing.”
So, investors are not buying because they are not getting high returns from investing in real estate, anymore. The end users are not buying because prices are high. But prices will still not fall, say the real estate wallahs. What sort of an argument is that?

If home prices do not fall, the real estate sector will continue to remain in a mess for a much longer period of time. The market will go through what analysts call a longer time correction (i.e. prices will stagnate for a long period), if prices don’t fall. And this can’t possibly be good for anyone—buyers will continue to stay away, and sellers won’t be able to sell.

This will mean that the real estate companies will continue to hold on to unsold homes that they have accumulated over the years. Given this, Rajan was absolutely right when he said if the market has to function, and buy and sell transactions have to happen, home prices need to fall. The sooner the real estate wallahs understand this, the better it will be for all of us.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on Firstpost.com on August 20, 2015

The Gajendra Chauhan syndrome: Why politicians are trying to take over RBI

Gajendra_Chauhan_at_the_Dadasaheb_Phalke_Academy_Awards_2010Vivek Kaul

The politicians are at it again—trying to fill up their people everywhere. The latest casualty of what I will call the Gajendra Chauhan syndrome of Indian politics, is likely to be the Reserve Bank of India (RBI).

During the course of last week, the revised draft of the Indian Financial Code (IFC) was released by the ministry of finance, which is currently headed by Arun Jaitley. Among other things the draft also recommends curtailing the powers of the governor of the RBI. RBI is probably the last institution remaining in the country which still has a mind of its own, and does not toe the government line on all occasions.

As things currently stand, the monetary policy decisions are made the governor of the RBI. John Lanchester in his book How to Speak Money writes: “Monetary means to do with interest rates, and is controlled by the central bank.” Hence, the RBI governor currently decides whether to raise or bring down the repo rate, the interest rate at which the RBI lends to banks. This rate acts as a sort of a benchmark to the interest rates at which banks borrow and lend.
The RBI governor currently makes the monetary policy decisions. He has a technical advisory committee assisting him. Nevertheless, the governor can overrule the committee. World over, this is not how things work. The interest rate decisions of central banks are made by monetary policy committees.

So, the Indian Financial Code wants to move the monetary policy decision making to a monetary policy committee. This makes immense sense given the extremely complicated world that we live in, it is simply not possible for one man (the RBI governor) to understand everything happening in the world around us and make suitable decisions.

This is something that the RBI also agrees with. In a report titled Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee) released by the RBI in January 2014 it was pointed out: “Drawing on international experience, the evolving organizational structure in the context of the specifics of the Indian situation and the views of earlier committees, the Committee is of the view that monetary policy decision-making should be vested in a monetary policy committee.”

On the broad point both the RBI and the ministry of finance which is responsible for the Indian Financial Code are in agreement. It is the specifics that they differ on. As per the Urijit Patel Committee report the monetary policy committee should have five members. As the report pointed out: “The Governor of the RBI will be the Chairman of the monetary policy committee, the Deputy Governor in charge of monetary policy will be the Vice Chairman and the Executive Director in charge of monetary policy will be a member. Two other members will be external, to be decided by the Chairman and Vice Chairman on the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central banking, financial markets, public finance and related areas.”

Hence, the monetary policy committee in the RBI’s scheme of things would have two outside members to be chosen by the RBI governor and the deputy governor in-charge of the monetary policy. The government would have no say in it. This makes immense sense given that world over there is a clear division between the fiscal function and the monetary function. As Lanchester writes in How to Speak Money: “Fiscal means to do with tax and spending, and is controlled by the government.” Monetary, as explained earlier, is controlled by the central bank.

The revised draft of the Indian Financial Code on the other hand talks about a seven member monetary policy committee. Article 256 of the code points out: “The Monetary Policy Committee will comprise – (a) the Reserve Bank Chairperson as its chairperson; (b) one executive member of the Reserve Bank Board nominated by the Re- 20 serve Bank Board; (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and (d) four persons appointed by the Central Government.”

What does this mean? As per the Indian Financial Code the government will have the right to appoint 4 members in the seven member monetary policy committee. This is a clear attempt by the government to take over the monetary policy from the RBI.

Why does the government want a majority in a committee that decides on the monetary policy of the country? The answer is fairly straightforward. Politicians all over the world want lower interest rates all the time. And this is not possible if the central bank is independent. Since May 2014, the finance minister Arun Jaitley has been publicly pushing for lower interest rates, but the RBI hasn’t always obliged.

Alan Greenspan, the former chairman of the Federal Reserve of the United States, recounts in his book The Map and the Territory that in his more than 18 years as the Chairman of the Federal Reserve, he did not receive a single request from the US Congress urging the Fed to tighten money supply and thus not run an easy money policy.

In simple English, what Greenspan means is that the American politicians always wanted low interest rates. India is no different on that front. Arun Jaitley has talked about the RBI working towards lower interest rates almost every month since May 2014, when the Narendra Modi government came to power.
Politicians look at the economy in a very simplistic way—if interest rates are lower, people will borrow and consume more, businesses will do better and the economy will grow at a faster rate. And this will increase the chances of their getting re-elected. But things are not as simple as that.

The link between low interest rates and economic growth is weak. As Barry P. Bosworth points out in a research paper published by the Brookings Institute: “there is only a weak relationship between real interest rates and economic growth.” Hence, keeping interest rates does not lead to economic growth necessarily. On the flip side, lower interest rates do lead to massive asset price bubbles as has been seen in the aftermath of the financial crisis that started in September 2008. Bubbles aren’t good for any economy.

Further, the trouble is that politicians (or their appointees) asking for lower interest rates are often batting for their businessmen friends. As the current RBI governor had said in a February 2014: “what about industrialists who tell us to cut rates? I have yet to meet an industrialist who does not want lower rates, whatever the level of rates.”

Also, the draft of the Indian Financial Code does not seem to take into account the agreement entered by the RBI and the government earlier this year. As per this agreement, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.
Now how is the RBI supposed to meet this target with a monetary policy committee dominated by members appointed by the government? And who are more likely to bat for low interest rates rather than what is the right thing to do at a given point of time.

To conclude, I have a feeling that the finance ministry bureaucrats obviously want to control things and that explains the monetary policy committee structure that they have come up with in the revised draft of the Indian Financial Code. Given that, the Indian Financial Code is still a draft, the final version as and when it comes up, will be somewhere in between what the RBI wants and what the ministry of finance wants.

I sincerely hope it tilts more towards the RBI than the ministry of finance. We don’t need any more Gajendra Chauhans.

(Vivek Kaul is the writer of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on July 27, 2015

Yellen does a Greenspan, talks about “irrational exuberance” in the stock market

yellen_janet_040512_8x10Vivek Kaul

Janet Yellen, the chairperson of the Federal Reserve of the United States, said yesterday: “equity market valuations at this point generally are quite high…There are potential dangers there.” This is the strongest statement that Yellen has made against the rapidly rising stock markets in the United States and other parts of the world.
In February earlier this year Yellen had said that the stock prices where “somewhat higher than their historical average levels.” In March, she had followed this up by saying that the stock market valuations were “on the high side”.
Central bank governors don’t say things just like that on the stock market, like the stock market analysts tend to do. When a central bank governor makes his view public on the stock market, the idea is to temper down the expectations of stock market investors in some way.
Take the case of a speech that Alan Greenspan, who was the Chairperson of the Federal Reserve between 1988 and 2006, gave on December 5, 1996. In this speech Greenspan said:
Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance[emphasis added] has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade.”
Greenspan was essentially saying that the stock market level might have run way ahead of the kind of earnings that were being generated by companies. And hence there was an “irrational exuberance”.
Greenspan recalls in his autobiography
The Age of Turbulence that at the end of the speech, he wondered whether people would understand what he was trying to get at. They sure did.
The Japanese stock market, which had opened by the time Greenspan finished his speech, reacted instantly. The Nikkei index dropped 3.2 percent. The Hang Seng in Hong Kong dropped 2.9 percent. The DAX in Germany went down four percent and so did the FTSE 100 in London.
The next day, when the stock markets in the United States opened for trading, the Dow Jones Industrial Average, America’s premier stock market index, was down 2.3 percent.
The NASDAQ Composite Index, where most of the technology companies listed, was down 1.8 percent at opening.
By the close of trading, NASDAQ Composite Index was down 0.9 percent and had recovered half of its losses. When the stock market opened for trading again on December 9, 1996, after the weekend, it was back trading at the levels it had been at before Greenspan made the “irrational exuberance” speech.
Various explanations have been offered over the years as to why the stock market investors chose to ignore what Greenspan had said and continued to stay invested in the dotcom bubble. One is that Greenspan did not immediately back his speech with the concrete action of raising interest rates. This argument is not totally correct because Greenspan did raise interest rates a couple of months later, although he did not do anything immediately. The second reason given is that by the time Greenspan raised the red flag, the market was already irrationally exuberant. It had already formed a mind of its own and was in no mood to listen. As the economist Ravi Batra writes in
Greenspan’s Fraud:The lure of free lunch is so powerful that it clouds our vision. For once Greenspan had offered words of wisdom, but in doing so he lost his audience. The master bartender wanted his customers to sober up. They wanted more: whiskey, champagne, rum, just bring it on.”
The stock market needed a little more than just one Greenspan speech to sober up. A series of interest rate hikes might just have done the trick. But this can only be said with the benefit of hindsight. Nobody likes to spoil a party that is on. Greenspan too was human, and he did not want to be a killjoy.
So what is it that we can learn when we compare Greenspan’s warning with those made by Yellen in the recent past. Yellen’s warnings on the stock market like that of Greenspan might also have come a little late in the day. But unlike Greenspan who just made one warning and then more or less kept quiet, till the dotcom bubble burst in 2000, Yellen has come up with a series of warnings. If she keeps saying the things she has been the investors will eventually take her seriously. The only question is when.
Further, just talking about stock market being overvalued won’t help. If Yellen has to rein in the stock market then the Federal Reserve also needs to start raising the interest rates. The trouble is that with the American gross domestic product(GDP) growing by just 0.2% between January and March 2015, Yellen and the Fed are not really in a position to start raising interest rates.
In fact, what makes the economic situation even more worse than it actually looks is the fact that even a 0.2% economic growth is overstated. This is primarily because it includes a huge inventory build up. Inventory essentially refers to goods which are being produced but not being sold.
Inventories during the period January and March 2015 went up by $110.3 billion. They had risen by $80 billion during the period October to December 2014. An increase in inventory adds to the GDP. Nevertheless what it also means is that there will be production cuts in the months to come, which in turn will pull the GDP down. Albert Edwards of Societe Generale estimates that without this unprecedented rise in inventories, “GDP would rather have declined by some 2½%!” He also said in a recent research note that: “The US economy is struggling and the Fed will ultimately re-engage the QE spigot.” QE or quantitative easing is the technical term that economists use for a central bank printing money and pumping that money into the financial system to keep interest rates low.
Until October 2014, the Federal Reserve had been printing money and pumping money into the financial system by buying government bonds and mortgaged backed securities. The idea was to flood the financial system with money by buying bonds and drive down interest rates. At lower interest rates, people were more likely to borrow and spend money. This would help businesses and in turn, the overall economy. While this happened to some extent, what also happened was that institutional investors borrowed money at low interest rates and invested them in financial markets all over the world. This led to stock market rallies all over the world.
Hence, while Yellen might keep making statements about the stock markets being overvalued, she needs to back it up with some concrete action(like raising interest rates) for investors to take her seriously.
The trouble is Yellen can’t raise interest rates. At least, not in near future. Given the American economic growth scenario, an era of low interest rates and easy money is likely to continue in the days to come. And what this means is that BSE Sensex just might go back to rallying despite the recent fall.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on May 7, 2015

What central banks can learn from the Indian cricket team


A few days back, a list of thirty probables who could make it to the Indian cricket team for the 50 over cricket World Cup scheduled in Australia early next year, was declared. Interestingly, only four out of the 15 players who had played for India in the 2011 World Cup, made the cut.
This disbanding of the Class of 2011 led to a lot of nostalgia in the media.
In one such piece published on www.cricinfo.com, the writer said: “The class of 2011 has been well and truly disbanded. Only four have made it through to the 2015 list…For the rest, all we have for now are memories.”
I sincerely feel that instead of being nostalgic about the entire thing we should be happy about the situation. The selection of players is just about the only thing that is currently right about Indian cricket, which remains surrounded by a whole host of controversies.
The players who did not perform over the last few years (the likes of Virender Sehwag, Gautam Gambhir, Zaheer Khan, Harbhajan Singh, Munaf Patel and Piyush Chawla who played in the 2011 World Cup) have fallen by the wayside and have had to make way for a new set of players.
And that is how any market should operate. The non-performers need to be weeded out and not rescued. Nevertheless, that is not how the world at large operates. A great example of this are the financial firms all over the world, which had to be rescued by central banks in the aftermath of the financial crisis that started in September 2008, around the time the investment bank Lehman Brothers went bust.
As Nigel Dodd writes in
The Social Life of Money: “Since the collapse of Lehman Brothers in September 2008, the world’s major central banks have been plowing vast quantities of money into the banking system. The U.S. Federal Reserve has made commitments totalling some $29 trillion, lending $7 trillion to banks during the course of one single fraught week…The U.K. government has committed a total of £1.162 trillion to bank rescues. The European Central Bank has made low-interest loans directly to banks worth at least 1.1 trillion.”
Scores of financial institutions across the United States and Europe were bailed out, nationalized, or simply merged to ensure that they continued to survive. If these financial institutions had not been rescued, the trouble would have spilled over to other financial institutions and from there to the general economy. This would have had a negative impact on the economic growth of the countries which they belonged to. Hence, it was necessary to rescue them. This was the explanation offered by central banks and governments which came to their rescue.
Soon after the central banks came to the rescue of financial institutions a quotation “supposedly” from Karl Marx’s
Das Capital went viral on the internet: “Owners of capital will stimulate the working class to buy more and more of expensive goods…until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism.”
As Dodd puts it: “The passage appeared on countless blogs…The quotation was a fake.” Nevertheless, whoever wrote it summarised very well how things had turned out in the aftermath of the financial crisis.
The move to rescue financial firms all over the world built in a huge amount of moral hazard into the financial system. As
economist Alan Blinder puts it in After the Music Stopped : “ [the]central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”
Moral hazard, other than encouraging the insiders of the financial system to take on increased risk gives them the impression of the financial system being a safer place to do business in than it actu­ally is. This is because the financial firms assume that in case of a crisis, the government(s) will come to their rescue. And this is not good for the financial system as a whole.
Interestingly, in the aftermath of the financial crisis, the American government passed the Dodd–Frank Act. The Act, prohibits government bailouts and the form of support that the Fed used to bailout AIG and other financial institutions. In fact, when he signed the bill into law, Barack Obama, the President of the United States said: “The American people will never again be asked to foot the bill for Wall Street’s mistakes.” He went on to add that in the time to come, there would be “no more taxpayer-funded bailouts.”
But former Federal Reserve Chairman, Alan Greenspan, does not buy this at all. In his book
The Map and the Territory, Greenspan writes that “most of the American financial system would be guaranteed by the US government,” in the event of the next crisis. He explains his reasoning through an example.
On May 10, 2012, J.P. Morgan, the largest bank in the United States, reported a loss of $2 billion from a failed hedging operation. The loss barely reduced the bank’s net worth. And more than that, the shareholders of the bank suffered the loss and not its depositors. Nevertheless, the loss was considered to be a threat to the American taxpayers and Jamie Dimon, J.P. Morgan’s CEO, was called to testify before the Senate Banking Committee. Why did this happen?
As Greenspan writes: “The world has so changed that this…loss was implicitly considered a threat to taxpayers. Why? Because of the poorly kept secret of the marketplace that JPMorgan will not be allowed to fail any more than Fannie and Freddie have been allowed to fail. In short, JPMorgan, much to its chagrin, I am sure, has become a defacto government sponsored enterprise no different from Fannie Mae prior to its conservatorship.”
Fannie Mae and Freddie Mac were government sponsored financial firms which the United States government had to take over in early September 2008. Greenspan further points out that: “When adverse events depleted JPMorgan’s shareholder equity, it was perceived by the market that its liabilities were effectively, in the end, taxpayer liabilities. Otherwise why the political umbrage and congressional hearings following the reported loss?”
To conclude, this also explains to some extent why global financial firms have been borrowing money at rock bottom interest rates, and investing them in “risky” financial markets all over the world. They know that if things go wrong, the central banks and the governments are likely to come to a rescue.
As Anat Admati and Martin Hellwig write in
The Bankers’ New Clothes: “It is very difficult for governments to convincingly commit to removing these guarantees. In a crisis it will be even more difficult to maintain this commitment and provide no support to institutions that are deemed critical for economic survival. Once a crisis is present, it may even be undesirable to do so, because letting banks fail in a crisis can be very damaging.”
Or as the Americans like to put it You ain’t seen nothin’ yet”.

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on December 10, 2014