Human Mind: Perceptions, misperceptions, prejudices, stereo-types

Gurumurthy Kalyanaram - Unfortunately, once the human mind forms an opinion/perception it is difficult to dislodge that. That's how myths, prejudices and stereo-types are born and survive.

One of the persistent misinformation is that President Barack Obama is of Islamic faith. Of course, this is not true at all. But it has been impossible to complete disabuse the individuals and the society of this falsehood.

Brendan Nyhan, Jason Reifler, and their coauthors show in a recent study (The Effects of Semantics and Social Desirability in Correcting the Obama Muslim Myth) that mis-perceptions are stubborn and persistent.

The U.S. and Global economic Maelstrom

The three main causes of our economic maelstrom in the U.S., and the world at large are --

(1) Banking, investment and insurance activities had become inseparable and unproductively overlapping creating transparency and moral hazard problems. The repeal of Glass-Steagall Act in 1999 was the final straw in the inexorable march that had begun in early 1980s.

(2) The financial derivatives and securitization of loans had grown monumentally without even minimal regulation and supervision. Such derivatives created over-stated and bubble assets. The Commodity Futures Modernization Act, and the imprudent sub-prime loans accelerated the growth of the derivatives.

The estimated value of the derivatives was about 1 trillion in 2002, and the value grew to about 33 trillion in 2008. The U.S. Congress considered regulation of derivatives in 2003 but finally decided that market forces are best regulating mechanisms.

(3) SEC increased the permitted leveraging by banks from 10 percent to 30 percent. The banks took immediate advantage of this, and soon this action added to the the bloating of the over-leveraged economy.

A confluence of all these three elements has created a glut in global savings and corresponding sharp decline in demand and investment. The global economy now faces a situation deeper than the periodic recession.

However, the United States though appears to be better placed to stimulate the economy through timely and proportionate monetary (e.g., zero interest bank lending rates), fiscal (e.g., economic stimulus packages) and financial (e.g., recapitalization of the banks) policies. Europe, comparatively, has lagged in timeliness and magnitude of response -- so it is more likely that the recovery in Europe will take longer. President Barack Obama, the Congress, and the Federal Reserve Bank deserve some credit for responding to the crisis prudently though more bold actions (e.g., letting zombie banks wither away instead of accepting the burden of their toxic assets) would have been even productive.

U.S. Banks, Financial Services Industry, and U.S. and Global Economy

As the U.S. awaits the stress tests of the banks, the debate on how to restructure the U.S. and Global financial services industry continues.

The restructuring of the U.S. and Global financial industry will probably be successful only when two major issues are reviewed. The first relates to (generally non-transparent and sometimes excessive) securitization of loans, and the second relates to (sometimes indiscriminate and unsound) integration of banking, investment and insurance activities under one umbrella. Lack of evident transparency, and serious moral hazard problems make these two issues major challenges.

There are two empirical and policy questions. One, does regulated and transparent securitization of loans help in the credit flow (with some multiplier effect) and business in general? Two, does regulated and prudent level of integration of banking and investment activities add more value to the economy?

The answers are not evident, and the policy and expert opinions appear to be evolving as the evidence is not clear.

The vibrancy of the financial services industry and the U.S. economy from about 1981 (when President Ronald Reagan encouraged deregulation and liberalization) to about 2007-2008 appear to indicate that securitization and integration of financial activities have helped the U.S. and global economy. What my have undone it are the excesses and complete dergulation. So the answer to the structural issues might be consideration and legislation of thoughtful regluation(s) and regulatory mechanisms. That's the approach of Secretary Tim Geithner, and President Barack Obama's economic team (they appear to tacitly agree that repeal of the Glass-Steagall Act, and the enactment of Commodity Futures Modernization Act may have accelerated such excesses).

The other view is that securitization of loans is empirically and theoretically unsound, and that banking and investment activities must be separated. No amount of regulation will help if these fundamental changes are enacted. Krugman says, "Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption."

Joseph Stiglitz observes, "In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option."

Economic Growth Models of China and India: Role od Foreign Direct Investment

India has been growing about 6 percent annually, compared to China’s much more impressive10 percent average annual growth rate. India has achieved its growth through a combination of improvement of skill sets, diversification of the economy, stimulation of consumer demand, entrepreneurship and competition. China’s growth comes from almost twice the amount of domestic investment in new factories and equipment, and almost ten times higher (compared to India) foreign direct investment (FDI). China has adopted the model of investing resources to propel growth and India has adopted a model of efficiency and productivity to stimulate growth.

Empirical studies have shown that the relationship between economic growth and the amount of foreign direct investment (FDI) is ambiguous at best. Foreign Direct Investments in primary sector appear tend to have a negative effect on growth but investments in manufacturing sector appears to be positive. But the impact on the service sector is ambiguous. There are several macro-economic illustrations of the tenuous relationship between FDI and growth. For example, Japan, Korea, Taiwan and others achieved remarkable growth with relatively low FDIs. On the other hand, Brazil which was the darling of FDIs in 1960s stumbled. In the 1980s, China received very little FDI, and yet the country grew faster and more virtuously than its later growth.

Thus FDI appears to be neither strongly correlated to nor be causative of the economic growth. Generally, FDI is a result of growth. In summary, China may have achieved substantial growth in 1990s and in the last decade through huge (but not so efficient) infusion and utilization of FDI.

Poverty Alleviation Programs, and the Economies of China and India

While India has been consistent in liberalizing its economy in the last two decades, it has also kept its attention on the challenge of poverty. Accordingly, India has designed and implemented poverty alleviation programs with varying degrees of success. India’s focus on alleviating poverty as growth program is both effective and prudent given the large numbers -- over 300 million Indians live in poverty (The comparable number for China is about 100 million). China, on the other hand, has focused more on top-down economic trickle down with aggressive tax rebates and other incentives to large firms.

Per recent World Bank Reports (2007 and 2008), a 10 % reduction in poverty would both boost the growth rate by about 1% and increase the foreign direct investment by about 8%. So far India to continue its impressive growth, one of the critical components of the strategy has to be poverty reduction programs that add assets to the society (Prahalad 2004, Sen 1997). And this is where political pluralism has been so advantageous. The relentless focus on the poor and disfranchised by various political parties particularly the Indian socialist and regional parties has been very beneficial for economic growth. The balance that the Indian political and economic policy makers have achieved is now the recommended economic strategy by the recent World Bank Reports (2007, 2008). This policy is a direct result of the wonderful pulls and pushes created by the political democracy.

Overall, political pluralism and democratic polity have proved to be excellent prescription for India’s economy (Huang 2008). Sure there have been many false starts and erroneous policies but there have been no calamitous decisions. The country has not gone through traumatic experiences of Latin America (where many economies collapsed because they followed market-economy without adequate supervisory mechanisms) or other parts of Asia (Asian currency crisis) or East European countries (inflation and stagnant growth). As Sen (2005) has observed, “India's long argumentative tradition and toleration of heterodoxy, going back thousands of years, has greatly helped in making democracy flourish with such ease.” China does not have the benefits of political pluralism.

The U.S. and Global Financial Services Industry

Reported below are some interesting (recent) observations U.S. and Global Banking Challenges, and Potential Restructuring Plans.

In sum, the restructuring of the U.S. and Global financial industry will probably be successful only when two major issues are reviewed. The first relates to securitization of loans, and the second relates to integration of banking, investment and insurance activities under one umbrella. Lack of evident transparency, and serious moral hazard problems make these two issues major challenges.

Professor Paul Krugman (Princeton University), New York Times, March 27, 2009
"Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption."

Professor Joseph Stiglitz (Columbia University), New York Times, April 1, 2009
"In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option."

Economist Keiichiro Kobayashi, voxeu.org, April 1, 2009
"However, as we move beyond the emergency response stage and face the challenge of correcting the fundamental problems that caused the financial crisis, things appear to be quite different. Watching how President Obama has had to continually struggle to work with Congress, I cannot help but realize, all things considered, that politicians in the US, or those in Europe for that matter, are not much different from their Japanese counterparts."

Professor Peyton Young (Oxford University), Financial Times, April 1, 2009
"A more straightforward plan would be strongly to encourage banks to auction off tranches of toxic assets without providing subsidies to the purchasers. This would involve fewer gimmicks and produce prices that more nearly reflect the assets’ true economic value. If these auctions do not generate enough activity to clean up the banks’balance sheets, the government will have to seize control of insolvent institutions temporarily and sell off their bad assets over a period of time, as happened in the wake of the S&L debacle of the 1980s."

Professor Jeffrey Sachs (Columbia University), The Huffington Post, April 6, 2009
"The earlier criticisms of the Geithner-Summers plan showed that even outside bidders generally have the incentive to bid far too much for the toxic assets,since they too get a free ride from the government loans. But once we acknowledge the insider-bidding route, the potential to game the plan at the cost of the taxpayers becomes extraordinary. And the gaming of the system doesn't have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi's assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same."

Greetings, and Return to Posting and Writing

Greetings.

Belated as it may be, I wish you a prayerful Passover, Easter, and New Year (various parts of India celebrate New Year in the months of March and April such as Baishaki, Vishu).

I got very busy with some personal and professional matters, and hence I have not written or posted for the last eight months or so. However, I am returning to writing and posting

Thank you for your understanding.