I have written a summary of the main arguments of Mian and Sufi in “House of Debt”. This book provides the answer to the question “How does macro-economics need to change, in light of the Global Financial Crisis?” This has been asked of many but none have given a satisfactory answer. Mian and Sufi analysis is to the GFC what Keynes was to the Great Depression — in fact Mian and Sufi provide the first satisfactory explanaton for both events. My full length review is available from SSRN at: http://ssrn.com/abstract=2517476.. Below I provide an excerpt from my review which gives the history of the Global Financial Crisis, linking it causally to the East Asian Crisis.
Financial de-regulation in the Reagan-Thatcher era led to a vast expansion of capital available for investment in the USA and UK. Rates of return to investments in the western world were low, and capitalists sought to open up foreign markets, where higher rates were available. In particular, a combination of carrot and stick were used by USA and IMF to force the highest growing East Asian economies to open up to foreign investments in the 1990’s. As a result, millions of dollars flowed into these economies, creating asset price bubbles in lands, buildings, and stock markets. Eventually the bubble burst, leading to massive capital flight out of the East Asian countries. This sudden withdrawal of foreign capital created an economic crisis. In a strange twist of fate, this crisis eventually led to the GFC via a causal chain described by Mian and Sufi that is discussed in the next section.
Islam stresses that earnings must relate to provision of products or services. Ownership of capital is not considered a service to society; thus, earnings on capital are permissible only if the lender shares in the risk of business. Had the principle of equity based loans been followed by investors in East Asia, the resulting crisis could have been averted. However, investment was done on the basis of standard debt contracts, which guarantee returns to the investor, regardless of whether the investment succeeds or fails. This is inherently unjust since the wealthy parties providing the loans get returns without risk, while the debtors suffer extremely adverse consequences in case of failure. This leads to dramatic increases in poverty and inequality following financial crises, as has been repeatedly observed empirically in the past few decades.
Sudden withdrawal of money leads to a collapse in asset prices which depresses aggregate demand in an economy. It also threatens viability of financial institutions, like banks, which operate on trust. Central Banks respond to these crises by providing liquidity – they create high powered money and provide it to financial institutions by various means, so as to avert financial crisis. In the East Asian crisis, financial institutions had liabilities in dollars, and Central Banks did not have sufficient foreign reserves to rescue them. They were forced to appeal to the IMF, which did provide the required liquidity, but at the cost of extremely stringent conditions. All over the world, governments respond to crises by providing relief, and liquidity. To protect interests of the foreign creditors, East Asian governments were forced to do the opposite – IMF required them to raise the interest rates and taxes, and balance budgets by cutting social welfare programs precisely when they were most needed.
The misery inflicted by painful austerity measures forced on East Asia by IMF was noted all over the world. To avoid being caught in a similar trap, Central Banks all over the world sought to increase their holdings of dollars. From 1990 to 2001, central banks bought around $100 billion annually. From 2002 to 2006, the rate of reserve accumulation just about septupled. Central Banks prefer to hold dollars in highly liquid, but also extremely safe interest bearing assets, rather than cash which has zero interest. Thus, there was a massive increase in demand for super-safe assets denominated in dollars.
It is worth noting that in retrospect, this was the wrong response to the East Asian crisis. Many of the proposals made in the aftermath of the crisis suggest that various types of capital controls were necessary to prevent the crisis, and also to resolve the post-crisis economic problems. At the moment, Central Banks all over the world are over-loaded with dollars, which has allowed the USA virtually unlimited leverage in using seigniorage and the inflation tax to finance wars and bailouts for the wealthy. However theories of liberalization, the Washington Consensus, and the might of the multinational institutions prevented even the contemplation of solution based on restrictions on capital flows, which were the root of the problem.
A new asset – a near money – was created to satisfy this massive increase demand. A new type of security which was backed by mortgages (MBS) was created. The theory was that this was a super-safe security. The MBS utilized diverse pools of mortgages, thereby lowering risks. They also utilized complex prioritized payoff structures, which supposedly provided further safeguards against failure. All mortgages required insurance, which was another guarantee against failure. The ratings agencies also gave these “private label” securities the highest AAA ratings, certifying them as super safe. These financial gimmicks deceived investors, and created a huge demand for these mortgage backed securities, which paid much higher returns compared to the safer government issued treasury bills. As money poured into these MBS, over the five years from 2002 to 2007, mortgage debt doubled from $7 trillion to $14 trillion.
Say’s law also operates in the reverse: demand generates supply. The multi-trillion dollar demand for MBS led to the creation of the supply of mortgages. Prior to 2002, default rates in the mortgage industry in USA never went over 6.5% historically. However, in the five year period preceding the crisis, the rules were re-written. Mortgage initiators found that mortgages could be resold to these security agencies with no questions asked. The mortgage packaging agencies in turn sold these mortgages bundled into securities, to investors seeking dollar backed securities. In this supply chain of mortgages, no one had primary responsibility to ensure that the underlying mortgage was sound. The presence of mortgage insurance added to the apparent safety of these investments. In fact, in presence of insurance, it was rational for investors to ignore the probability of default – the insurance would pay in event of default.
Over the period of 2002 to 2007, these enormous inflows of money to purchase “private label” MBS created a huge amount of “toxic” debt. These were mortgages that all informed parties knew would never be repaid. The easy availability of loans for mortgages led to a dramatic rise in values of property – an asset price bubble which may be termed the “revenge of East Asia”. Eventually, defaults started piling up. In 2007, a new phenomenon was observed: defaults on mortgages occurred within months of origination of the mortgage. Default rates reached historic highs of over 10%. As jittery investors moved out of these mortgage-backed securities, the entire market for them collapsed. The sudden withdrawal of credit led to a collapse in values of housing to the tune of $4 trillion. With this collapse in housing values, about a quarter of the mortgagers went “under-water” ! That is, the amount of debt they owed on their houses was greater than the value of the house which had been pledged as collateral for the debt. On a narrow cost-benefit basis, it would be rational from them to stop payments on their mortgage loans and allow the bank to foreclose on their property.
The collapse of market for MBS led to the global financial crisis. It also had huge negative impacts on the US Economy, leading to a massive increase in unemployment. Today, seven years after the crisis, unemployment, homelessness, hunger and poverty are at the highest levels seen in the USA since the great depression. In addition to piecing together the story outlined above, the key contribution of Mian and Sufi is to explain exactly how the collapse of asset price bubble in housing led to an economy wide crisis.