Key Messages
Uncovering The Deep Systemic Flaws Behind The 2008 Global Financial Crisis
All around the world, people are still feeling the repercussions of the global financial crisis of 2008.
To this day, people have been left with unanswered questions about what caused it and why it happened in the first place.
Instead of looking at individuals or bankers to blame for it, we must look deeper into the fault lines that were present within the U.S.
economy as well as the global economy at the time.
Just like an earthquake has its cause deep beneath the earth’s surface, so too did these fault lines have their roots underneath.
In this summary, you’ll learn exactly how German and Japanese auto manufacturing factors into this equation; how bonuses handed out by bankers encouraged risky behavior; and why it all seemed to take so long to be recognized by people around the world.
By discovering what caused these fault lines appear and become more dangerous over time, we can better understand the true source of this 2008 financial crisis.
The Growing Income Gap In The U.S. Led To Cheap Credit And A Spending Spree That Had Dire Global Consequences
One of the major fault lines that led to the global financial crisis was the rising income inequality in the United States.
To address this problem, banks began introducing easy and cheap loans, which were heavily encouraged by politicians.
This so-called subprime lending became popular as interest rates were lowered.
People now had more access to money and could spend more, resulting in a surge in economic growth.
However, this growth was unsustainable as it was fueled by debt and people simply postponing paying their bills.
Both banks and politicians played an active role in creating this fault line that led to an economic crisis with implications around the world.
The Global Imbalance Of Trade And Investment Preceded The 2008 Financial Crisis
In Fault Lines, the book outlines how global manufacturing became another fault line in the 2008 financial crisis.
This was due to an imbalance between countries that exported more of their goods and services than they imported, and those that imported more than what they exported.
This issue came about after World War II when places like Germany and Japan started focusing on production in order to recover economically.
They then acted as an example to other developing nations who also decided to utilize cheap labor costs and become exporters, leading them to earn big surpluses from exports.
What happened next was these exporting countries wanted to invest in other economies, yet post 1997 investors were wary of developing Asian nations as their financial systems weren’t entirely transparent.
Thus pouring into the United States but while it absorbed some of the surpluses, it couldn’t take-on all of them and this was a burden for an American economy already facing overstimulation issues.
How Low Interest Rates Led To The Global Financial Crisis: A Review Of Fault Lines
Low interest rates were responsible for creating a housing boom in the U.S., by making mortgages cheaper and more accessible than ever before.
This caused an influx of money being poured into real estate investments, as investors across the globe saw American real estate as a very profitable prospect.
The low interest rates were also a result of the Federal Reserve Bank’s mission to ensure high employment, which was then emphasized by politicians under pressure to create more jobs.
It wasn’t until later that people realized what this could cause – an overheated U.S.
housing market, leading to the eventual bubble burst which triggered the global financial crisis.
How We Failed To Anticipate The 2008 Financial Crisis: The Role Of Subprime Mortgages, Debts, And Political Placation
Subprime mortgages served the short-term needs of politicians and people, but they did great harm in the long run.
Though they made it possible for those with bad credit scores to have access to housing, they came with extremely high interest rates.
This not only put people in debt, but also set off a ripple effect which brought many other financial fault lines together and caused a full-on economic crisis in 2008.
The introduction of subprime mortgages placated politicians who had been unable to create more jobs, as well as satisfied foreign exporters who had export surpluses and were looking for investments.
The booming housing market led investors to buy subprime mortgage-backed securities – bundles of these loans that banks sold off to third parties – all while consumption (fueled by these seemingly cheap loans) was skyrocketing.
But this “win-win” situation was too good to be true, and the consequences of such reckless actions should have been foreseeable from the get go.
Indeed, subprime mortgages served short-term goals but caused drastic damage too quickly for anyone to be able to truly appreciate what had happened until it was already too late.
Ignoring Accurate Pricing & Predictions Led To The Global Financial Crisis
Financial models rely on past behavior to anticipate what will happen in the future.
However, when it came to the pre-crisis economy, there was no data at all on which to base the models.
Subprime lending had become a new concept and most of the investors that bid up the prices for subprime mortgage-backed securities typically came from export nations looking to invest their surpluses.
So when these investors put money into subprime securities, there were no old market data points that could be used to calculate risk.
This left us without any way of accurately predicting what would happen in the future, making calculations completely arbitrary.
It wasn’t until after the crisis that economists discovered they should have paid closer attention to price changes as an economic indicator.
If a financial product or service is risky and the probability of a loss is high, then prices should fall – this should have been seen as a warning sign instead of being distorted.
Ultimately, our lack of data regarding the new financial situation left us without any way of accurately forecasting what would come next and helped cause one of the biggest economic disasters in history.
The Ultimate Blame For The 2008 Financial Crisis Can Be Placed On A Multitude Of Factors
Rating agencies had it all wrong when it came to assessing the risks of subprime mortgages, saying they were safe investments and giving them high ratings – up to AAA.
Unfortunately, this miscalculation contributed significantly to the financial crisis of 2008.
The reason why these agencies made such inaccurate signals was due to the way these mortgages were packaged together – a process called diversification.
By doing so, they believed that risk could be reduced, since defaulting would mean a large number of borrowers not managing to pay their mortgages back at once, which seemed unlikely.
It’s easy for us in hindsight, but rating agencies should have known better.
In the end, we can only point our fingers so much and hope for better practices in the future.
The Economic Crisis Was Not Simply Caused By Greed, But Also By A Failed System Of Risk Management And Reckless Interventions By The Government And Central Bankers
When it comes to the global financial crisis that occurred, everyone wants to find someone to blame.
The reality of the situation is that while greedy bankers are partly responsible for taking risks they should have avoided, they weren’t the only ones.
There were a range of incentives in the financial sector that pushed all parties involved – including banks, government officials, central bankers, foreign investors, and economists – to grab as much as they could without raising a red flag.
The government’s intervention into the economy fueled excessive risk-taking in order to make it more attractive.
Low interest rates meant everyone had something to gain.
Furthermore, when mortgage holders took out loans they couldn’t afford, and economists failed to see warning signs in the economy, no one realized just how poor their decisions could actually be for society at large and how much of an impact on taxpayers later on down the line.
Unfortunately, there was no way for anyone in any group of people involved to know better or recognize what were turning out to be detrimental trends within an entire flawed economic system.
Preventing Another Financial Crisis: A Call For Reform Of The Financial System
The financial sector needs to move away from irresponsible risk-taking if our economy is to remain stable in the long term.
As we saw back in 2008, taking big risks with money can have destructive effects that reverberate for a long time.
It’s important that there be an incentive structure in place which penalizes dangerous risk-taking and rewards prudent decision making.
Prior to the crash, bankers were incentivized to take big risks and paid huge bonuses based on short-term profits without considering the potential losses down the line.
To ensure this does not happen again bonuses should not be paid out immediately but rather after several years, so bankers are assessing the long term risks and benefits of their actions.
Public disclosure of banks’ risk exposures could also discourage reckless behavior and encourage more responsible practices within the industry by keeping banks accountable and allowing market forces to impose pressure when necessary.
That said, we must be careful how such data is revealed in order to minimize potential panic, which could occur if it were made public during a downturn period..
The United States Needs More Accessible Education And Social Safety Nets For Long-Term Economic Stability
Fault Lines identifies two main problems that need to be solved in order to achieve greater economic stability and sustainable growth: better schooling opportunities and a more reliable social safety net.
In order for people from lower-income families to succeed economically, they first need access to quality education.
Currently, only 34 percent of people from low-income families make it to college, compared to 79 percent of people from high-income families.
This means having financial aid programs available for youth from disadvantaged backgrounds is essential.
On the other side of the coin, there must also be a reliable safety net available so that when people fall on hard times they don’t have to go through extended periods of joblessness without any income.
The current system in America isn’t adequate enough as it doesn’t insure people against total job loss and lacks sufficient provisions for long-term unemployment benefits which can last longer than just six months.
To ensure the sustainability of future economic growth, politicians need to focus on long-term solutions such as better schooling opportunities and more reliable safety nets so individuals can achieve economic stability regardless of their background or circumstance.
Wrap Up
Fault Lines, the book by Raghuram Rajan, points to one main lesson: The 2008 financial crisis was a result of many fault lines in the global economic system coming together.
Interest rates at historically low levels and an economy that heavily relied on US consumption combined with binging on subprime loans and systemic failure to assess risk were all factors that played into this historic event.
This book serves as a warning for us; if we don’t take steps to repair our global financial system, future crises could be even worse.
Fault Lines is a call to action for all of us who want to avoid similar catastrophes in the future.
