Global Economic Recession - Lessons and Impacts

[This article was originally written as an essay by my friend, teacher and guide on all things related to economics – Devanshi Madan. A quick guide on the financial crisis of 2009 along with a unique view on the principal-agency problem makes this a very interesting article for the average person. I have added a few lines, deleted a few and modified a few more before reproducing it here, all the matter published here has been the original work of the above mentioned author …]

Recessions and business cycles

Recessions are the outcomes of business cycle fluctuations. Business cycle fluctuations are naturally occurring crests (positive growth) and troughs (negative growth) in the revenues and growth of a business. These fluctuations in the business cycle have been well documented. A progression from a crest to a trough leads to a slowdown in economic growth and in extreme cases, as it was in 2008; cause a deep economic recession with global repercussions. Whereas slowdowns and recessions have been around as a naturally occurring economic phenomenon, the global recession of 2008-2009 was exacerbated by the fact that the fundamentals of the financial markets were thrown to the wind in the face of uncontrolled greed.

The global recession of 2009

The origins

It all started with the housing loan crisis, more commonly called the “sub prime mortgage” crisis. American banks and agencies started indiscriminately issuing housing loans to people who did not meet the required eligibility criteria to secure such loans. They slashed interest rates on these housing loans and the demand for these loans shot up. Banks ignored the “credit worthiness” of the applicant and gave loans which were backed by the house bought as the underlying security. These loans were offered at 3% the same rate as the inter bank rate!

The modus operendi of the lending banks and agencies was to lure people by showing much lower variable interest rates on housing loans for a certain period. However hidden behind this promise, as per the fine print, by the time the loan reached its maturity, the total amount repaid would have been the same as the total amount that would have had to been repaid in the case of a high interest fixed rate loan.

This process of ensuring that total cash flows were large and yet it looked to be small in the initial period was done by the process of “negative amortization”. As opposed to normal amortization in negative amortization the principle balance and hence the interest keeps increasing every month. With the lure of lower EMI’s in the initial years, the banks managed to play with peoples psyche and lead them to believe that they were actually getting a very cheap loan. This in turn led to a dramatic increase in the demand for housing.

After a certain amount of time the housing bubble burst, people were unable to pay back these loans and abandoned their houses. As a result, the supply of houses far outstripped the demand for houses, this drove the real restate prices down. The mortgaged houses were redeemed by the banks, albeit as non performing assets. The house prices were much lower than the loan value plus the cost of maintaining the houses would have had to be incurred.

In such a scenario, banks were collapsing due to the large number of non performing assets being added in the form of foreclosure of housing loans. In order to save the banks from collapsing, they were bought out or taken over by other banks and the Federal Reserve. The government intervened later with bail out packages running into billions of dollars to save the banks from bankruptcy.

What are the key lessons to be learnt in analyzing the cause for such a financial catastrophe?

In my opinion it is the misperception and the mismanagement of risk, the low level of interest rates and the indiscriminate de-regulation of financial systems leading to a skew in the market demand that is biased towards a price increase which is artificial and unsustainable.

Today’s world is highly interdependent. Instability in one institution will cause instability in many others. It’s the case of the “ripple effect”. It’s the human psychology around risk perceptions. Individual actions, such as the decision to forward loans to non credit worthy individuals, cannot be viewed in isolation. A global perspective is required in assessing the potential long term impacts over the short term gains that are achieved.

Too greedy in the present - future repercussions

The primary cause for the authorization of risky short term financial decisions would be the greed of the management to show phenomenal revenues and expected future profits. I would call it a managerial greed and callousness. CEOs and other senior managerial personnel rely on compensation received from the companies in the form of salary and other perks. They do not hold any significant stake in their companies. The banking and insurance companies are joint stock companies which have the system of collective ownership.

The “Principal Agency theory”, where the management top teams are just the managers but not the owners, comes into play here. They are the decision makers but they do not bear the burden of the losses incurred by the company. The risk is borne by them and the shareholders, who are collectively the “owners” of the company. The management team earns a percentage of the profits/sales of the Company. Incorrect and greedy decisions made on the part of the management for personal “short term” gain without paying any heed to the long term implications of such decisions, has lead to the financial meltdown in the “developed” countries. There needs to be a principle change in the laws that govern the structure of business institutions at an international level. There is a need to redefine the laws of management and ownership.

Given these observations, it is imperative to have a balance in the principal-agency relationship. Short term profits should not be the sole driver to determine the compensation of the top management team. Shareholders need to be more vigilant and governments need to introduce more stern rules with regard to the regulation of management compensations when linked with the performance of the company.

Experienced Trade-offs !!!

Experience is the biggest asset a manager has on his side. As much as I learn the nuances of "business" and "management" at my MBA course (the PGSEM) at IIMB, nothing will ever be able to take the place and role that time learned experience would play in shaping the characteristics i would like to develop as a good manager (and leader).

I believe that making the right decisions in the face of available trade-offs will always be an art that will be the most visible source of differentiation between managers!

Simply put, trade-offs are choices that need to made between available alternatives in scenarios where the consequences of the choice that is made is not fully known. Decision trees have been used extensively in many of my classes to define evaluation of alternatives at decision points in a business flow. It all looks hunky-dory in a classroom scenario where the consequences at each decision point are well defined and the end result neatly mapped out by the professor on the whiteboard!In the real world, there is absolutely no way of knowing the consequences of each decision! Not only are the consequences not well defined, it is also impossible to really know the full breadth of alternatives that can be taken at a decision point.

As we move deeper into the information world, it is not the owner of the cache information who has the ultimate edge as a manager, rather the one who knows how best to derive results from that huge cache of information that holds to key to future managerial success.

My management education provides me the tools and frameworks that help in gathering the required knowledge and information along with the partial ability to derive some form of results from the information that is gathered. However it has to be experience that will enable me to take the right choice more often.

Given that experience is time bound, i am reminded of the classic dilemma that a fresh graduate faces. Every employer wants to recruit someone with a minimum threshold of experience for exciting roles that involves certain amount of responsibility. A fresh graduate wants an exciting job of responsibility, and is possibly capable of it, but has no way to satisfy the "experience" requirement of the potential employer.

If I were to draw parallels, as a manager, the ability to make the right decision choice (in a world of imperfect information) would rest largely on experience gained while having made a large number of decisions in the past. Failure is but a small price I will have to pay in order to gain the "experiential wisdom" that I require for the long run. I will have to take risky choices knowing that the consequences may or may not be favorable, and not be afraid while facing the consequence.

Gandhian Thoughts

I had a chance to attend the Gandhi Colloquium at IIM Bangalore. The theme of the colloquium was “Gandhi, Governance and the Corporation”. I was impressed by some of the thoughts that the eminent speakers (Prof Dwijendra Tripati, Prof N Balasubramanian, Prof Peter DeSouza, Prof Pratap Bhany Mehta) put forth as a part of the introductory session in the morning.

Key takeaways from the lectures:

- Gandhian philosophies have not had a widespread acceptance in the corporate world

- The philosophy of trusteeship is focal point for corporate embracement of Gandhian thought

- Trusteeship involves a sense of debt to society; an organization exists to serve the society and the context of the society in which it exists

- Gandhi believed that an individual or a corporation had to earn just as much as was “reasonably” required and any amount earned in excess of this was expected to be returned to the society, since it was “excess” wealth that was accumulated unduly and it belonged to the society and not the corporation or the individual (Contrast this with socialism, looks like Gandhi’s philosophy was geared towards voluntary actions for equitable distribution of wealth unlike the “socialist” thought of Government enabled distribution of wealth!)

- Gandhi was perhaps the only political figure who was aware of the communal tinderbox that India could evolve into at the time of independence

- Gandhi placed a great emphasis on the aspect of friendship, friendship across groups to which an individual belonged

I find myself resonating with a lot of the thoughts that were put forth. I believe that socialism, an excellent concept, can never be imposed. Voluntary socialism as espoused by the “trusteeship” philosophy is perhaps sustainable. It is perhaps necessary that this philosophy is inculcated as a way of life in Indian society. Is it going to be successful? Gandhi was convinced that it would succeed, yet today 50 years after his death there is still no clear answer. Even I am not fully convinced of the efficacy of “trusteeship”.

To get a wider perspective on trusteeship:

http://www.gandhi-manibhavan.org/gandhiphilosophy/philosophy_trusteeship.htm

Summed up in one paragraph:

“Supposing I have come by a fair amount of wealth—either by way of legacy, or by means of trade and industry—I must know that all that wealth does not belong to me; what belongs to me is the right to an honorable livelihood, no better than that enjoyed by millions of others. The rest of my wealth belongs to the community and must be used for the welfare of the community.”

The Conversion Dilemma: A Possibly Mishandled Situation?

Of late there have been a lot of attacks against Christians in India on the supposed issue of forced conversions. There has been a huge hue and cry raised against the practice of conversion as is supposedly followed by the Christians of our country.

Before going ahead I would like to clarify my stand on the moot point of conversions. I believe in a personal God (whatever is the form that he or she takes, a force, a presence, a higher conscience, nature) and I am of the opinion that religion is just the means to achieve this end. My opinion on conversions derives from this; to me conversion is a change in the way in which an individual seeks to find God. It is an intangible value that aids an individual to perform better on more tangible things like, work output, social interactions, etc.

I have always been an admirer of the Christian mission work in India; missionaries that I have interacted with have been selfless individuals who have truly believed that it is their moral (and not religious!) duty to bring about social development in the backward regions of India through education and primary health care. Mind you, I use the word moral and not the word religious, because that describes the motivation of a true missionary; religion just gives him/her a platform. In the course of a missionary’s work, if those that have benefited from the mission choose to have a conversion in their quest to find God, what moral right does anyone have to stop an individual from pursuing his fundamental right in the secular state of India?

(This does not endorse money induced conversions; rather this defends conversions that are of a different nature. I will always be against money endorsed conversions, and to be honest I believe that money induced conversions will never cause a major demographic shift in the religious break up of India, it is simply not sustainable economically!)

(When I use the word missionary, I think I imply any person who does good for another human in the forgotten rural lands of India, without expecting any tangible benefit in return. Religion, be it Hinduism through ISKON or Christianity through Missions, offers a platform that could also be provided by a non religious organization like the IRC, Medicine Sans Frontiers etc. Atheists too could be missionary except that they lack religiosity ;) …)

This brings me to the events that have transpired in Karnataka and the subsequent handling of the situation by the Chief Minister of Karnataka and the arch Bishop of Bangalore.

Firstly I am angry with the Chief Minister (CM) of Karnataka. The first thing that a man of political wisdom would do in a situation like this (desecration of a church and vandalism) is bring the culprits to book and then make any statements of bravado. The path taken by the CM is one of brazen offense in which the Christian community is made to look like the villain! For crying out loud perhaps he has forgotten that it is a Christian church that has been desecrated by vandals! Given the history of Christians in India, a grave (in terms of religion) event such as this will never be met by violence, why then has the CM issued warnings against the Christian community for making statements that he claims are inflammatory?! Bring the culprits to book Mr. CM, it is only then that you would have the moral high ground to warn the Christian community on anything!

(On a side note, I realize that the statements made by the CM were directed more against a former BJP MP who happens to be Christian!)

Secondly I am confused by the way in which the archbishop of Bangalore reacted to the situation. Giving the CM of a state the cold shoulder in full media glare may have been a good tactic to express the ire and frustration of the Christian community, but it is also a strategic blunder. In a secular country like India, whenever there have been incidents of violence against Christians, the collective conscience of the nation has been pricked by the calm and humble resolve with which Christians have reacted to the situation. By showing open aggression I believe that the Bishop has hurt that perception, a perception that serves the Christian community in India really well (Christians end up holding the moral high ground!).

The PR officer of the arch diocese of Bangalore made a public statement on a TV news channel stating that the state government has failed and called for central intervention in this matter, another strategic blunder! The right way ahead should have been to convey the message that the as much as the Christian community is perceived to be calm it will not tolerate a soft attitude of the state government towards the perpetrators of the crime. The wordings of the public statements that were made should have been chosen very carefully! The threat of central government intervention should have been done at a much later stage; it would have held a lot more credibility. Overall I am disappointed by the public statements and actions of the arch diocese of Bangalore. In the game of political strategy I believe they have lost.

This is a political game, and a game that should be played with calmness and a certain amount of guile, the Christian community needs to understand that. A short term victory will not lead to a long term solution, but could easily turn into a tit-for-tat cycle that could easily spiral out of control. Our (yes I am a part of the Christian community!) tried and tested methods of holding the high moral ground through a calm and dignified reaction is best way in which we can get a lasting solution to the current problem. Play politics the right way, the way in which we know we win with minimal losses!

An EPIC queue

A new initiative is underway in India to provide every single eligible and enlisted voter with photo ID cards. It is quite an ambitious and good move on the part of the election commission.

For those in Bangalore, details on "the hows and whys and whats" of the card can be found at:

http://bangalorevoterid.org/

As much as i believe that the every eligible citizen must exercise his/her right to vote, this post is not about the ills of voting/not voting. This post is to highlight an interesting incident that occurred when i went along to collect my voter ID card.

I had taken the day off (well not technically off, since i was working from home, using a fairly trustworthy and fast VPN connection) and at around four i decided to go and stand in queue for the voter ID card.

The scene was one of organized chaos, there was a queue, and queue looked like it comprised of three to four lines. It took me a while to realize that this was due to the fact that people were standing in line as proxies, as and when a known friend or family member came along, an extra space was created for them in the line!!!!

My sister had left half an hour ahead of me in order to get her photo ID done, by the time i had reached the place, my sis was quite close to the actual issuing counter. It was quite tempting for me to jump ahead and behave like the general crowd by taking up a proxy position in front with my sister. However a very interesting reason (other than my principled approach to such situations!) prevented me from doing so!

If you observe the inserted photograph very carefully there is a gentleman who has been circled in red. The gentleman who is highlighted in this photograph is none other than Mr. H. T. Sangliana, (http://en.wikipedia.org/wiki/H.T._Sangliana) member of parliament (MP)!

It was heartening to see Mr. Sangliana standing in the queue just like any ordinary citizen and waiting his turn to collect his photo ID card ... very uncharacteristic of an Indian politician!!!! During the last election i had voted for this man inspite of his affiliation with the hindu nationalist party BJP; a party whose religious ideology does not strike a chord with me. It was the sheer stature of this IPS officer who had done so much for Bangalore city that had influenced my choice. Looking at this man, stand in queue just like any other ordinary citizen gave me a sense of satisfaction that i have never experienced before; I voted for the right kind of human being (i am not going to go into the details of his performance as an elected representative, this post is not intended to do that).

Mr. Sangliana (and his family, wife and a nephew) waited patiently for more than an hour in that queue before collecting their id cards.

Side Note: I am proud of Mr. Sangliana's stand in the no-confidence motion against the incumbent national government on the nuclear deal issue. As my elected representative, he did what i would have wanted him to do. Thank you sir!