Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  It should come as no surprise, then, that a number of developing countries decided to never leave themselves at the mercy of international financial markets (or the IMF) again. Rather than borrow from abroad to finance their investment, their governments and corporations decided to abandon grand investment projects and debt-fueled expansion. Moreover, a number decided to boost exports by maintaining an undervalued currency. In buying foreign currency to keep their exchange rate down, they also built large foreign-exchange reserves, which could serve as a rainy-day fund if foreign lenders ever panicked again. Thus in the late 1990s, developing countries cut back on investment and turned from being net importers to becoming net exporters of both goods and capital, adding to the global supply glut.

  Investment by industrial-country corporations also collapsed soon after, in the dot-com bust, and the world fell into recession in the early years of the new millennium. With countries like Germany and Japan unable to pull their weight because of their export orientation, the burden of stimulating growth fell on the United States.

  Jobless Recoveries and the Pressure to Stimulate

  As I argue above, the United States was politically predisposed toward stimulating consumption. But even as it delivered the necessary stimulus for the world to emerge from the 2001 recession, it discovered, much as in the 1991 recovery, that jobs were not being created. Given the short duration of unemployment benefits in the United States, this created enormous additional political pressure to continue injecting stimulus into the economy. As I argue in Chapter 4, jobless recoveries are not necessarily a thing of the past in the United States—indeed, the current recovery is proving slow thus far in generating jobs. Jobless recoveries are particularly detrimental because the prolonged stimulus aimed at forcing an unwilling private sector to create jobs tends to warp incentives, especially in the financial sector. This constitutes yet another fault line stemming from the interaction between politics and the financial sector, this time one that varies over the business cycle.

  From 1960 until the 1991 recession, recoveries from recessions in the United States were typically rapid. From the trough of the recession, the average time taken by the economy to recover to pre-recession output levels was less than two quarters, and the lost jobs were recovered within eight months.7

  The recoveries from the recessions of 1991 and 2000–2001 were very different. Although production recovered within three quarters in 1991 and just one quarter in 2001, it took 23 months from the trough of the recession to recover the lost jobs in 1991 recession and 38 months in the 2001 recession.8 Indeed, job losses continued well into the recovery, so that these recoveries were deservedly called jobless recoveries.

  Unfortunately, the United States is singularly unprepared for jobless recoveries. Typically, unemployment benefits last only six months. Moreover, because health care benefits have historically been tied to jobs, an unemployed worker also risks losing access to affordable health care.

  Short-duration benefits may have been appropriate when recoveries were fast and jobs plentiful. The fear of losing benefits before finding a job may have given workers an incentive to look harder and make better matches with employers. But with few jobs being created, a positive incentive has turned into a source of great uncertainty and anxiety—and not just for the unemployed. Even those who have jobs fear they could lose them and be cast adrift.

  Politicians ignore popular anxiety at their peril. The first President Bush is widely believed to have lost his reelection campaign, despite winning a popular war in Iraq, because he seemed out of touch with public concerns about the jobless recovery following the 1991 recession. That lesson has been fully internalized by politicians. In politics, economic recovery is all about jobs, not output, and politicians are willing to add stimulus, both fiscal (government spending and lower taxes) and monetary (lower short-term interest rates), to the economy until the jobs start reappearing.

  In theory, such action reflects democracy at its best. In practice, though, the public pressure to do something quickly enables politicians to run roughshod over the usual checks and balances on government policy making in the United States. Long-term policies are enacted under the shadow of an emergency, with the party that happens to be in power at the time of the downturn getting to push its pet agenda. This leads to greater fluctuations in policy making than might be desired by the electorate. It also tends to promote excess spending and impairs the government’s long-term financial health.

  In Chapter 5, I explore the precise ways in which U.S. monetary policy is influenced by these political considerations. Monetary policy is, of course, the domain of the ostensibly independent Federal Reserve, but it would be a brave Federal Reserve chairman who defied politicians by raising interest rates before jobs started reappearing. Indeed, part of the Federal Reserve’s mandate is to maintain high employment. Moreover, when unemployment stays high, wage inflation, the primary concern of central bankers today, is unlikely, so the Fed feels justified in its policy of maintaining low interest rates. But there are consequences: one problem is that a variety of other markets, including those abroad, react to easy policy. For instance, prices of commodities such as oil and metals are likely to rise. And the prices of assets, such as houses and stocks and bonds, are also likely to inflate as investors escape low short-term interest rates to invest in anything that offers a decent return.

  More problematic still, the financial sector is also prone to take greater risks at such times. In the period 2003–2006, low interest rates added to the incentives already provided by government support for low-income housing and fueled an extraordinary housing boom as well as increasing indebtedness. In an attempt to advance corporate investment and hiring, the Fed added fuel to the fire by trying to reassure the economy that interest rates would stay low for a sustained period. Such assurances only pushed asset prices even higher and increased financial-sector risk taking. Finally, in a regulatory coup de grâce, the Fed chairman, Alan Greenspan, effectively told the markets in 2002 that the Fed would not intervene to burst asset-price bubbles but would intervene to ease the way to a new expansion if the markets imploded. If ever financial markets needed a license to go overboard, this was it.

  By focusing only on jobs and inflation—and, in effect, only on the former—the Fed behaved myopically, indeed politically. It is in danger of doing so again, even while being entirely true to the letter of its mandate. Although the Fed has a limited set of tools and therefore pleads that it should not be given many potentially competing objectives, it cannot ignore the wider consequences to the economy of its narrow focus: in particular, low interest rates and the liquidity infused by the Fed have widespread effects on financial-sector behavior. As with the push for low-income housing, the fault line that emerges when politically motivated stimulus comes into contact with a financial sector looking for any edge is an immense source of danger.

  The Consequences to the U.S. Financial Sector

  How did tremors on all the fault lines come together in the U.S. financial sector to nearly destroy it? I focus on two important ways this happened. First, an enormous quantity of money flowed into low-income housing in the United States, both from abroad and from government-sponsored mortgage agencies such as Fannie Mae and Freddie Mac. This led to both unsustainable house price increases and a steady deterioration in the quality of mortgage loans made. Second, both commercial and investment banks took on an enormous quantity of risk, including buying large quantities of the low-quality securities issued to finance subprime housing mortgages, even while borrowing extremely short term to finance these purchases.

  Let me be more specific. In the early 2000s, the savings generated by the export-dependent developing countries were drawn into financing the United States, where fiscal and monetary stimulus created enormous additional demand for goods and services, especially in home construction. Foreign investors looked for safety. Their money flowed into securities issued by government-sponsored mortgage agencies like Fannie
Mae and Freddie Mac, thus furthering the U.S. government’s low-income housing goals. The investors, many from developing countries, implicitly assumed that the U.S. government would back these agencies, much as industrial-country investors had assumed that developing-country governments would back them before the crises in those countries. Even though Fannie and Freddie were taking enormous risks, they were no longer subject to the discipline of the market.

  Other funds, from the foreign private sector, flowed into highly rated subprime mortgage-backed securities. Here, the unsuspecting foreign investors relied a little too naively on the institutions of the arm’s-length system. They believed in the ratings and the market prices produced by the system, not realizing that the huge quantity of money flowing into subprime lending, both from the agencies and from other foreign investors, had corrupted the institutions. For one of the weaknesses of the arm’s-length system, as I explain in Chapter 6, is that it relies on prices being accurate: but when a flood of money from unquestioning investors has to be absorbed, prices can be significantly distorted. Here again, the contact between the two different financial systems created fragilities.

  However, the central cause for the financial panic was not so much that the banks packaged and distributed low-quality subprime mortgage-backed securities but that they held on to substantial quantities themselves, either on or off their balance sheets, financing these holdings with short-term debt. This brings us full circle to the theme of my Jackson Hole speech. What went wrong? Why did so many banks in the United States hold on to so much of the risk?

  The problem, as I describe in Chapter 7, has to do with the special character of these risks. The substantial amount of money pouring in from unquestioning investors to finance subprime lending, as well as the significant government involvement in housing, suggested that matters could go on for some time without homeowners defaulting. Similarly, the Fed’s willingness to maintain easy conditions for a sustained period, given the persistent high level of unemployment, made the risk of a funding squeeze seem remote. Under such circumstances, the modern financial system tends to overdose on these risks.

  A bank that exposes itself to such risks tends to produce above-par profits most of the time. There is some probability that it will produce truly horrible losses. From society’s perspective, these risks should not be taken because of the enormous costs if the losses materialize. Unfortunately, the nature of the reward structure in the financial system, whether implicit or explicit, emphasizes short-term advantages and may predispose bankers to take these risks.

  Particularly detrimental, the actual or prospective intervention of the government or the central bank in certain markets to further political objectives, or to avoid political pain, creates an enormous force coordinating the numerous entities in the financial sector into taking the same risks. As they do so, they make the realization of losses much more likely. The financial sector is clearly centrally responsible for the risks it takes. Among its failings in the recent crisis include distorted incentives, hubris, envy, misplaced faith, and herd behavior. But the government helped make those risks look more attractive than they should have been and kept the market from exercising discipline, perhaps even making it applaud such behavior. Government interventions in the aftermath of the crisis have, unfortunately, fulfilled the beliefs of the financial sector. Political moral hazard came together with financial-sector moral hazard in this crisis. The worrisome reality is that it could all happen again.

  Put differently, the central problem of free-enterprise capitalism in a modern democracy has always been how to balance the role of the government and that of the market. While much intellectual energy has been focused on defining the appropriate activities of each, it is the interaction between the two that is a central source of fragility. In a democracy, the government (or central bank) simply cannot allow ordinary people to suffer collateral damage as the harsh logic of the market is allowed to play out. A modern, sophisticated financial sector understands this and therefore seeks ways to exploit government decency, whether it is the government’s concern about inequality, unemployment, or the stability of the country’s banks. The problem stems from the fundamental incompatibility between the goals of capitalism and those of democracy. And yet the two go together, because each of these systems softens the deficiencies of the other.

  I do not seek to be an apologist for bankers, whose hankering for bonuses in the aftermath of a public rescue is not just morally outrageous but also politically myopic. But outrage does not drive good policy. Though it was by no means an innocent victim, the financial sector was at the center of a number of fault lines that affected its behavior. Each of the actors—bankers, politicians, the poor, foreign investors, economists, and central bankers—did what they thought was right. Indeed, a very real possibility is that key actors like politicians and bankers were guided unintentionally, by voting patterns and market approval respectively, into behavior that led inexorably toward the crisis. Yet the absence of villains, and the fact that each of these actors failed to bridge the fault lines makes finding solutions more, rather than less, difficult. Regulating bankers’ bonus pay is only a very partial solution, especially if many bankers did not realize the risks they were taking.

  The Challenges That Face Us

  If such a devastating crisis results from actors’ undertaking reasonable actions, at least from their own perspective, we have considerable work to do. Much of the work lies outside the financial sector; how do we give the people falling behind in the United States a real chance to succeed? Should we create a stronger safety net to protect households during recessions in the United States, or can we find other ways to make workers more resilient? How can large countries around the world wean themselves off their dependence on exports? How can they develop their financial sectors so that they can allocate resources and risks efficiently? And, of course, how can the United States reform its financial system so that it does not devastate the world economy once again?

  In structuring reforms, we have to recognize that the only truly safe financial system is a system that does not take risks, that does not finance innovation or growth, that does not help draw people out of poverty, and that gives consumers little choice. It is a system that reinforces the incremental and thus the status quo. In the long run, though, especially given the enormous challenges the world faces—climate change, an aging population, and poverty, to name just a few—settling for the status quo may be the greatest risk of all, for it will make us unable to adapt to meet the coming challenges. We do not want to return to the bad old days and just make banking boring again: it is easy to forget that under a rigidly regulated system, consumers and firms had little choice. We want innovative, dynamic finance, but without the excess risk and the outrageous behavior. That will be hard to achieve, but it will be really worthwhile.

  We also have to recognize that good economics cannot be divorced from good politics: this is perhaps a reason why the field of economics was known as political economy. The mistake economists made was to believe that once countries had developed a steel frame of institutions, political influences would be tempered: countries would graduate permanently from developing-country status. We should now recognize that institutions such as regulators have influence only so long as politics is reasonably well balanced. Deep imbalances such as inequality can create the political groundswell that can overcome any constraining institutions. Countries can return to developing-country status if their politics become imbalanced, no matter how well developed their institutions.

  There are no silver bullets. Reforms will require careful analysis and sometimes tedious attention to detail. I discuss possible reforms in Chapters 8 to 10, focusing on broad approaches. I hope my proposals are less simplistic and more constructive than the calls to tar and feather bankers or their regulators. If implemented, they will transform the world we live in quite fundamentally and move it away from the path of deepening crises to one of greater economic and pol
itical stability as well as cooperation. We will be able to make progress toward overcoming the important challenges the world faces. Such reforms will require societies to change the way they live, the way they grow, and the way they make choices. They will involve significant short-term pain in return for more diffuse but enormous long-term gain. Such reforms are always difficult to sell to the public and hence have little appeal to politicians. But the cost of doing nothing is perhaps worse turmoil than what we have experienced recently, for, unchecked, the fault lines will only deepen.

  The picture is not all gloom. There are two powerful reasons for hope today: technological progress is solving problems that have eluded resolution for centuries, and economic reforms are bringing enormous numbers of the poor directly from medieval living conditions into the modern economy. Much can be gained if we can draw the right lessons from this crisis and stabilize the world economy. Equally, much could be lost if we draw the wrong lessons. Let me now lay out both the fault lines and the hard choices that confront us, with the hope that collectively we will make the right difference. For our own sakes, we must.

  CHAPTER ONE

  Let Them Eat Credit

  JANE IS AN ASSISTANT in a large nonprofit research organization, where she has worked for the past thirty-two years. She was an excellent typist in school and took a few courses in business practice. After spending a semester in college, she decided that the cost of an undergraduate education was not worth the benefits; jobs for typists were plentiful, and the money seemed attractive. Her first job was with the nonprofit, where she initially worked for two bosses. Her primary tasks were to type up reports and research papers, file the enormous amount of paperwork that kept accumulating, and answer the phones.