In
geology, fault lines are breaks in the Earth’s surface where
tectonic plates come in contact or collide. In 2011, Raghuram Rajan
has written a book about the fault lines in the global economy and
explains how these fault lines affect the financial sector.
The
book is well written; I especially liked the good mix of storytelling
and academics. Here are some examples of fault lines in the global
economy:
Export-led
growth strategy
Countries
pursuing an export-led growth strategy rely heavily on foreign
consumers to stimulate the local economy. Typical examples are
Germany and Japan after the Second World War and China since 2000.
Export-led
growth typically has two phases:
- First, the exporting country benefits from low local labor costs to sell abroad.
- Second, upon increasing labor costs, the exporting country moves up the value chain of production and to the frontiers of innovation.
On
the upside, an export-led growth strategy creates strong exporting
firms, which are no longer constrained by the size of their domestic
market. In addition, international competition forces exporters to
remain competitive. The downside is an excessive dependence on the
foreign consumer, often coupled with weak local household
consumption.
“There
is no natural, smooth, and painless movement away from export
dependence to becoming a balanced economy.”
Character
of bankers
How
do bankers think? Raghuram tells the following story to explain:
In
the 18th century, the French Government sold annuities.
Annuities were bonds guaranteeing a payment of cash flows by the
French Government until the bond holder’s death. Bankers reacted by
arranging for young healthy women (with high life expectancy) to buy
the annuities. Then, they pooled the annuity claims together and sold
the resulting cash flows to investors. This early form of
securitization actually worked well until the French Government
defaulted, at the outbreak of the French Revolution in 1789.
What
can we learn about bankers from this story?
- Few have a better nose for good moneymaking opportunities than bankers. This stems from the competitive nature of banking where easy opportunities to make money are rare and where a banker’s performance is almost exclusively measured in terms of the money a banker generates.
- Bankers invariably find the biggest edge in taking advantage of unsophisticated players and players who do not have the same incentive to make money.
- Banker behavior tends to be self-reinforcing, at least for a while: Early success drives security prices up higher (often far away from fundamentals), making the business temporarily even more profitable until prices ultimately fall dramatically.
- There is safety in numbers, as a responsible government cannot let all its bankers fail, given the likely collateral damage to the citizenry. This means that prices do not reflect proper compensation for the risks that bankers take.
- “Pecunia non olet” (= “Money has no odor.”) means that the anonymity of money makes it a poor mechanism for guiding employees’ activities towards socially desirable ends.
“Because
their [bankers’] business typically offers few pillars to which
they can anchor their morality, their primary compass becomes how
much money make.”
Why
investment managers must assume tail risk
Investment
managers are paid to generate excess returns (= alpha). This means
that they have to outperform the expected return on the market. How
can they do this? Here comes tail risk into play: Because it occurs
very rarely, investment managers can hide it for a pretty long time
and, thus, use it to generate alpha.
“It
is the very willingness of the modern financial market to offer
powerful rewards for the rare producer of alpha that also generates
strong incentives to deceive investors.”
This
is why risk-adjusted return measurement is so crucial, not only for
regulatory compliance purposes but also as an instrument of
management control.
Some
additional quotes
Resource:
Raghuram
Rajan – Fault Lines – 2011
