Wednesday, 1 October 2008

Financial Inclusiveness, Now Exclusively for You!

Swaminathan S Anklesaria Aiyar has been writing a regular pop-econ-based column every Sunday in the TOI called 'Swaminomics' for ages now, since well before Freakonomics made pop-econ, umm, popular. This Sunday's article is a bit of clunker though, as he tries to lay some of the blame for the current economic crisis at the feet of financial inclusiveness:
Inclusive finance—giving loans to everybody, including the poor­­­—is desired by politicians in India, and in all democracies. Yet the current US financial crisis shows the perils of taking this goal too far.
The crisis arose from the bursting of a housing bubble. That bubble was created, fundamentally, by government policies and institutions seeking home ownership for all Americans, including low-income ones. Politicians rooted for such inclusive finance. But this “inclusion” extended finance to ever more borrowers with fragile and low incomes, causing disaster. This holds lessons for India.
Opening with that line, he goes off on a general re-telling of what happened, mainly laying the blame on Fannie Mae and Freddie Mac via messed-up tax incentives and securitization. While the facts that he lays out are correct, they do not necessarily lead to the conclusion that financial inclusiveness was at the heart of the mess.

To begin with, while the stated intent may originally have been financial inclusiveness, the tax breaks and government regulation eventually set up incentives that were more attuned to getting the middle classes to borrow more than they could reasonably repay - a tax rebate "on the first $ 100,000 of second mortgages", for example, cannot have been targeted at first- generation immigrants just looking for a place to stay. While financial inclusion may be paid some lip service, most banks would rather lend a large amount to a middle-income family looking to buy a second home than a small amount to a poor family with a poor or non-existent credit history. Middle-class Americans were willing to buy larger homes because loans were cheap, and even with a limited ability to repay, they hoped that if the value of their house kept increasing, they could go in for products like reverse mortgages, that would keep them in the clear. These weren't people who needed to be 'included' into the financial system, rather, they formed the sweet spot of commercial banking activity - not low-income households, but households with a decent inflow of money that flowed into the banks' deposit accounts, and a greater outflow of money, accumulated through the banks' lending products like loans and credit cards.

Securitization, per se, was not the problem - after all, without the ability to raise further financing at reasonable rates through transferring their mortgage portfolio to other financial players, the commercial banks would have been limited in their ability to lend anyway (see asset-liability mismatch). For an explanation of securitization, specifically CDOs, see here.The bigger problem was that not enough people who bought the securities knew clearly what the risks associated with them were. That's partly a failure of the credit rating agencies, whose job it was to assign a level of risk to them, the ability of investment banks to sell products that they themselves had no clue about, and the investors' own greed (for an exposition of the latter two points, you could read Michael Lewis' 'Liar's Poker').

The major problem was insufficient regulatory oversight, as banks could get away with taking more risk than was prudent. An alternative approach to the Fed's would have been the one followed by the Spanish central bank (HT Felix Salmon), taking a more active role in monitoring and proscribing where necessary the activities of the nation's banks that it found fault with. To me, this really is what the role of the government (and/or its agencies) should be - setting up the right checks and balances through the regulatory regime that allows the markets to function as they should. The laisse-faire approach meant that people made up the rules as they went along, relying basically on the brand names and selling skills of Wall Street. Nationalization, on the other hand, produces mixed-up incentives for the nationalized firms.

Aiyar concludes his piece, on somewhat flimsy evidence, by saying that financial inclusiveness can be disastrous on a large-scale, and advocates giving the poor grants instead. This is messed-up thinking on two counts: firstly, financial inclusiveness is not just about giving loans to the poor, it's also about allowing them access to other banking facilities like deposits and insurance, which grants do not necessarily accomplish; secondly, grants are not self-sustaining and rely essentially upon the kindness of the rich.

In the Indian context, I don't think the rich are kind enough, or the kind rich enough, for that to go very far.


  1. You may be right, but it is also true that many poor, credit-unworthy people were given loans with cavalier ease. This NPR radio documentary talks about specific examples:

    In one case, a guy was given half a million dollars without even having to prove his income.

  2. You don't necessarily have to be poor to be credit- 'unworthy'. Given that most people have credit histories and a credit score, credit worthiness is not so much a question of 'do you lend or not', it's a question of 'how much should you lend, and at what rate'. Most loans would have gone to people whose credit scores and income did not warrant the amount of money they were lent - but they may have been able to pay off a smaller loan. The problem was that they were willing to borrow, and banks were willing to lend, more than they could reasonably repay given their income.
    A NINJA loan doesn't mean that the borrower doesn't have a job or an income stream - it means that the lender opted not to ask for sufficient documentation of the same, instead just looking at the borrower's credit score and minimal documentation like repayment records on other debt such as credit cards. While that shows that you have a willingness to repay, that doesn't guarantee your ability to repay if the loan amount is higher. Again - those kinds of loans go to people who have already got some kind of credit history and/or debt, ie people who already are part of the financial system, not people who need to be 'included' in any way.

    My point was that aiming for financial inclusiveness was not the cause of the problem. Not unless you define inclusiveness as 'making people who already have some sort of debt believe that they can keep taking on even more debt even if they can't reasonably pay it off, because that's the American Way'.

  3. pretty much agree with everything here.

    The problem really lies, I think, with the general lack of regulation in the US. Companies don't like being told what to do by government in any country, but the US has always been rabidly anti-regulation.

    This crisis is one of the more serious outcomes of that. In most instances where public regulation needs to be stronger - insurance, telecommunications to name two other person irritants of mine - there is a complete lack of foresight/planning.

    The coolest thing is how Mccain is going to handle this, considering how he went around tearing up every regulation he saw.

    And, what of 970 billion dollars? Who is going to pay for that? And that is an estimate the actual bail out may be more.

    You may be interested to know that 2 profs in the econ dept have designed an auction mechanism to sell off whatever fancy financial security that people don't know the value of at the moment. And one of them has been talking to Obama. Cool, what?

  4. And, this particular statistic is a little alarming - China apparently owns 49% of Merrill-Lynch. I don't know what that means i.e. what exactly do they own and in what form.

    But, it does make you think. If the US continues to run its trade deficit and China continues to buy up US securities, then a devaluation of the dollar is going to happen sooner or later.

    One reason why Obama would be a good choice for president, is that virtually every economist is on his side, and you need some good economists to figure out how best to handle this sort of devaluation. I'm pretty sure this crisis is going to affect the trade account of the US, and it would be interesting to see how and if the crisis is dampened so as not to affect the price of the dollar.

  5. Thanks for the show of support, anon. it would help if I knew for sure who you were - that would narrow down which econ dept it was you were referring to.
    The Chinese government owns an equity stake in Merrill through it's sovereign wealth fund. I think the equity stake is ok - at least they can throw their weight around in case those investment bankers try selling them some dodgy debt again ;-)

    As for a devaluation in the dollar, it's a little ironic to think that the US was only a while ago accusing the Chinese of keeping the value of their currency artificially low which allowed them to export so much. If the dollar does get devalued and oil stays expensive, we might see a change in the pattern of world trade all over again - manufacturing might boom again in (or closer to) the US, and outsourcing jobs might get too expensive. Wonder what happens then. Maybe now is a good time to invest in Mexico...

    As for Obama vs McCain, I think the world would be a much more cynical place if McCain wins. As for the economists, the subject's been getting a lot of bad press lately, so hopefully they will be able to contribute something.

  6. Ah yes but a devaluation of the dollar will also imply a devaluation of the Chinese currency whatever it is called since this is tied to a basket of currencies which is basically the dollar. Whatever happens to world trade in the next 30-50 years is going to be very interesting.

    More interesting facts - the US cap on public debt is now 11.5 trillion dollars. Putting this into perspective, world GNP ~9 trillion dollars.

    Somethings got to give, it would seem...

    really? you cannot tell my identity what will all this talk about eco and profs in the econ dept and all?

  7. Well, kracker, I live in the fond hope that there will be more than one person in an econ dept somewhere who would be willing to comment on my blog posts. If you're so damn lazy about signing into google, have you tried the 3rd option that blogger offers, 'Name/URL', just above 'Anonymous'? You can just type in your name there. Unless you're scared that the University of Maryland will take you down for commenting on macroeconomic matters without completing your PhD.

    As for the Chinese, if they have been maintaining an artificial peg for the renminbi against the dollar, they could just stop buying up so much American debt and allow the currency to appreciate, just in case they ever end up facing issues with inflation due to rising prices of imports.

    Though that does bring up a question: is inflation a major problem only for democracies?