Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  Greater immigration and trade have also played a part because immigrants, competing directly for unskilled jobs, and unskilled workers far away, competing through trade, have both served to hold down wages of unskilled U.S. workers. Most studies see the magnitude of these effects as small.15 Unskilled immigrants have, however, contributed to inequality in a different way. They typically occupy the bottom of the income distribution and thus contribute to measured inequality.16 Paradoxically, although their incomes are often higher than their incomes in the home country, they swell the ranks of those who appear down and out in America.

  The reduction in the punitive postwar marginal tax on high incomes (from a top rate of 91 percent through much of the 1950s and the 1960s, through a number of ups and downs, to 35 percent at the time of writing) has increased incentives to earn higher incomes and may thus have contributed to the growing entrepreneurship and inequality.17 The weakness of unions may also have reduced moderately educated workers’ bargaining power, though the loss of high-paying unionized jobs probably has more to do with increased competition and entry as a result of deregulation, as well as competition from imports. A relatively stagnant minimum wage has certainly allowed the lowest real wages to fall (thereby also ensuring that some people who would otherwise be unemployed do have a job), though only a small percentage of American workers are paid the minimum wage. Finally, the entry of women into the workforce has also affected inequality. Because the well-connected and the highly educated tend to mate more often with each other, “assortative” mating has also helped increase household income inequality.

  The reasons for growing income inequality are, undoubtedly, a matter of heated debate. To my mind, the evidence is most persuasive that the growing inequality I think the most worrisome, the increasing 90/10 differential, stems primarily from the gap between the demand for the highly educated and their supply. Progressives, no doubt, attribute substantial weight to the antilabor policies followed by Republican governments since Ronald Reagan, whereas conservatives attribute much of the earlier wage compression to anticompetitive policies followed since Franklin Roosevelt. Neither side would, however, deny the importance of differential educational attainments in fostering inequality.

  Attitudes toward Inequality

  Americans have historically not been too concerned about economic inequality except when it becomes extreme—as it did toward the end of the nineteenth century. Through a variety of means such as antitrust laws and estate taxes, they have ensured that wealth generated from corporate ownership does not become so highly concentrated that it upsets the distribution of political power. The government has repeatedly intervened to limit the power of banks—as in Andrew Jackson’s fight to close the Second Bank of the United States (after he accused it of political meddling), the creation of the Federal Reserve in 1913 so that banks had an alternative to J. P. Morgan as the lender of last resort, and the Glass-Steagall Act of 1933, which broke up the most powerful banks. Similarly, through antitrust investigations, most famously against John D. Rockefeller’s Standard Oil and Bill Gates’s Microsoft, the government has sought to rein in the power of big business. But with the exception of some episodes—for example, during the Great Depression—the government and the public have not been strongly predisposed toward punitive taxation of the rich to achieve a more equitable distribution of income.

  “Soak the rich” policies have seldom been popular among the less well-off in America, not necessarily because they have great sympathy for the rich but perhaps because the poor see themselves eventually becoming rich: Horatio Alger’s stories of ordinary people attaining great success in the land of limitless opportunity had broad appeal.18 Although such optimism may always have been unrealistic, the gulf between the possible and the practical might have been small enough in the past that Americans could continue dreaming. According to the World Values Survey, 71 percent of Americans believe the poor have a good chance of escaping poverty, while only 40 percent of Europeans share this belief.19 These differences are particularly surprising because cross-country studies suggest that people in the United States are not much more mobile across income classes than in European countries, and indeed the bottom 20 percent of earners may be unusually immobile in the United States.20 Nevertheless, the idea of income mobility was deeply ingrained in the past. That great observer of America, Alexis de Tocqueville, remarked that in America, “wealth circulates with astounding rapidity and experience shows it is rare to find two successive generations in the full enjoyment of it.”21

  Over the past 25 years, though, more and more Americans have come face to face with the bitter reality that they are trapped by educational underachievement. The Newsweek columnist Robert Samuelson has argued that “on the whole, Americans care less about inequality—the precise gap between the rich and the poor—than about opportunity and achievement: are people getting ahead?”22 Yet inequality in education is particularly insidious because it reduces opportunity. Someone who has had an indifferent high school education cannot even dream of getting a range of jobs that the new economy has thrown up. For Americans, many of whom “define political freedom as strict equality but economic freedom as an equal chance to become unequal,” inequality of access to quality education shakes the very foundation of their support for economic freedom, for they no longer have an equal chance.23

  If Americans no longer have the chance to be upwardly mobile, they are less likely to be optimistic about the future or to be tolerant of the mobility of others—because the immobile are hurt when others move up. When others in town become richer, the cost of everything goes up, and the real income—the income in terms of its purchasing power—of the economically immobile falls. Matters are even worse if the immobile measure their worth in terms of their possessions: my Chevrolet becomes much less pleasurable when my neighbor upgrades from a Honda to a Maserati.24 Envy has historically been un-American, largely because it was checked by self-confidence. As self-confidence withers, can envy, and its close cousin, hatred, be far behind?

  As more and more Americans realize they are simply not equipped to compete, and as they come to terms with their own diminished expectations, the words economic freedom do not conjure open vistas of unlimited opportunity. Instead they offer a nightmare vision of great and continuing insecurity, and growing envy as the have-nots increasingly become the have-nevers. Without some change in this trend, destructive class warfare is no longer impossible to contemplate.

  The Political Reaction

  Politicians have recognized the problem posed by rising inequality. Because African Americans and Hispanics have been harder hit by poor schooling than other groups, their lack of progress is also conflated with race. Nevertheless, politicians have understood that better education is part of the solution. A number of presidents have taken up the cause, but without making much of a dent. Moreover, even if they could make a difference, the changes would take effect too late to alter the lives of today’s adults.

  Taxation and redistribution could be an alternative; but, as the political scientists Nolan McCarthy, Keith Poole, and Howard Rosenthal argue, growing income inequality has made Congress much more polarized and much less likely to come together on matters of taxation and redistribution.25 Even as I write this, the Senate is divided completely along party lines in its attitude toward health care reform, with Democrats unanimous in support, and Republicans equally unanimous in opposition. Politicians are coming to terms with something Aristotle pointed out: that although quarrels are more likely in an unequal society, striving to rectify the inequality may precipitate the very conflict that the citizenry wants to avoid.26

  Politicians have therefore looked for other ways to improve the lives of their voters. Since the early 1980s, the most seductive answer has been easier credit. In some ways, it is the path of least resistance. Government-supported credit does not arouse as many concerns from the Right at the outset as outright income redistribution would—though, as we have experienced, it m
ay end up as a very costly way to redistribute, imposing harm on the recipient and costs on the taxpayer.

  Politicians love to have banks expand housing credit, for credit achieves many goals at the same time. It pushes up house prices, making households feel wealthier, and allows them to finance more consumption. It creates more profits and jobs in the financial sector as well as in real estate brokerage and housing construction. And everything is safe—as safe as houses—at least for a while.

  Easy credit has large, positive, immediate, and widely distributed benefits, whereas the costs all lie in the future. It has a payoff structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure. Rich countries have, over time, built institutions such as financial-sector regulators and supervisors, which can stand up to politicians and deflect such short-term myopia. The problem in the United States this time was that the politicians found a way around these regulatory structures, and eventually public support for housing credit was so widespread that few regulators, if any, dared oppose it.

  A Short History of Housing Credit

  The period leading up to the Great Depression was also a time of great credit expansion and, perhaps not coincidentally, one of substantial income inequality. Mortgages were different then. Residential mortgages were offered by banks and thrift companies (also known as savings and loans associations). Mortgages were available for only a short term, about five years, and featured a single capital repayment at maturity, unless the borrower could refinance the loan. Moreover, most loans were at variable rates, so the borrower bore the risk that interest rates would change; and lenders did not typically lend more than 50 percent of value, so homeowners bore much of the risk of house-price fluctuations.27

  In the 1930s, as the Depression worsened, refinancing dried up, valuations plummeted, and homeowners, strapped for the cash to repay maturing loans, started defaulting in droves. With 10 percent of the nation’s housing stock in foreclosure, the government intervened in the housing market to save it from free fall. Among the institutions it created initially were the Home Owner’s Loan Corporation (HOLC) and the Federal Housing Administration (FHA).

  HOLC’s role was to buy defaulted mortgages from banks and thrifts and restructure them into fixed-rate, 20-year fully amortizing mortgages (in which the principal is paid over the term of the loan). The long maturity and the fully amortizing payment structure meant that homeowners were not confronted with the disastrous refinancing problem. The government was willing to hold these mortgages for a while, but it did not see itself in the loan business in the long term and had to find a way of making the mortgages palatable to private-sector lenders. Private lenders, historically averse to making long-term loans, had to be persuaded to trust borrowers.

  The solution was that the FHA would bear the default risk by providing mortgage insurance—essentially assuring lenders that it would repay the loan if the homeowner defaulted. The FHA protected itself by charging an insurance premium, setting strict limits on the maximum loan it would finance (initially 80 percent of the property value), and the amount of the loan it would insure. This restriction also ensured that a private market emerged for the mortgages, or portions thereof, that the government would not insure.

  Thus the banks and the thrifts that bought FHA-insured mortgages had to bear only the interest-rate risk—the risk stemming from the fact that they were financing fixed-rate long-term mortgages with short-term, effectively variable-rate deposits. So long as short-term rates did not spike, this was a profitable business.

  The HOLC was wound down in 1936. To provide a financing alternative to banks, the Federal National Mortgage Association (FNMA, later Fannie Mae) was set up to draw private long-term financing into the mortgage market once again. Essentially, FNMA bought FHA-insured mortgages and financed them by issuing long-term bonds to investors like insurance companies and pension funds. Unlike the banks and thrifts, FNMA had longer-term fixed-rate financing and therefore did not bear much interest-rate risk even if it held the mortgages on its books.

  The system worked well until rising short-term interest rates in the late 1960s caused deposits to flow out of banks and thrifts—because regulatory depositrate ceilings introduced during the Depression to prevent excessive competition did not permit them to match the higher market interest rates. Financing for mortgages dried up. To compensate, the government tried to bring more direct financing capacity into the market by splitting Fannie into two in 1968—creating a Government National Mortgage Association (GNMA or Ginnie Mae) to continue insuring, packaging, and securitizing mortgages, and a new, privatized Fannie Mae that would finance mortgages by issuing bonds or securitized claims to the public. At a time when President Lyndon Johnson needed funds to pay for the growing costs of the Vietnam War, privatization conveniently removed Fannie Mae’s debt from counting as a government liability, making the government’s balance sheet look a lot healthier. Soon after, Freddie Mac (or the Federal Home Loan Mortgage Corporation, to go by its full name) was created to help securitize mortgages made by the thrifts, and eventually it too was privatized.

  As inflation rose in the late 1970s and early 1980s, the Federal Reserve chairman, Paul Volcker, increased short-term interest rates to hitherto unimagined levels to try to tame it. With much of their portfolio invested in fixed long-term interest-rate mortgages, made when interest rates were low, and much of their financing tied to sky-high short-term interest rates, the savings and loan or thrift industry essentially went bankrupt. The political reaction was not to shut the thrifts down: housing was too important, the industry too well connected, and the hole that the taxpayer would have to fill too embarrassing to own up to.

  Instead, the political system reacted with the Depository Institutions Deregulation and Monetary Control Act of 1980 and Garn-St. Germain Depository Institutions Act of 1982, which liberalized the range of loans that thrifts could make, including mortgages, and the ways they could borrow, to help the industry earn its way back to stability. The sorry history of ensuing developments, in particular the immensely risky and ultimately disastrous gambles that thrifts took in commercial real estate, backed with taxpayer money, has been told elsewhere.28 A sizeable loss for thrifts was converted into a gigantic loss for taxpayers, aided and abetted by politicians. Suffice it to say that as a consequence, the insurers Fannie and Freddie, rather than the thrifts, played an increasing role in mortgage financing.

  Fannie and Freddie

  Fannie and Freddie, variously known as government-sponsored enterprises (GSEs) or agencies, were curious beasts. They were not quite private, though they had private shareholders to whom their profits belonged. And they certainly were not public, in that they were not owned by the government, but they had both government benefits and public duties. Among their perks, they were exempted from state and local income taxes, they had government appointees on their boards, and they had a line of credit from the U.S. Treasury. For the investing public, these links to the government indicated that the full faith and credit of the United States stood behind these organizations. Fannie and Freddie could thus raise money at a cost that was barely above the rate paid by the Treasury. These perks came with a public mandate—to support housing finance.

  Fannie and Freddie did two things to fulfill their mandate. They bought mortgages that conformed to certain size limits and credit standards they had set out, thus allowing the banks they bought from to go out and make more mortgage loans. The agencies then packaged pools of loans together and issued mortgage-backed securities against the package after guaranteeing the mortgages against default. They also started borrowing directly from the market and investing in mortgage-backed securities underwritten by other banks. Because the mortgages were sound, these were fairly safe and extremely profitable activities. But much of the profit stemmed from their low cost of financing, deriving from the implicit government guarantee, and this was a critical political vulnerability.

  The Affordabl
e-Housing Mandate

  As evidence mounted in the early 1990s that more and more Americans faced stagnant or declining incomes, the political establishment started looking for ways to help them with fast-acting measures—certainly faster than education reform, which would take decades to produce results. Affordable housing for low-income groups was the obvious answer, and Fannie and Freddie were the obvious channels. Congress knew it could use Fannie and Freddie as vehicles for its designs because they benefited so much from government largesse, and their managers’ arms could be twisted without any of the agencies’ activities inconveniently showing up as an expenditure in government budgets.

  In 1992, the U.S. Congress passed the Federal Housing Enterprise Safety and Soundness Act, partly to reform the regulation of the agencies and partly to promote homeownership for low-income and minority groups explicitly. The act instructed the Department of Housing and Urban Development (HUD) to develop affordable-housing goals for the agencies and to monitor progress toward these goals. Whenever Congress includes the words safety and soundness in any bill, there is a distinct possibility that it will achieve exactly the opposite, and that is precisely what this piece of legislation did.

  Even though the agencies could not head off legislation, they could shape it to their advantage. They ensured that the legislation allowed them to hold less capital than other regulated financial institutions and that their new regulator, an office within HUD—which itself had no experience in financial-services regulation—was subject to congressional appropriation.29 This meant that if the regulator actually started constraining the behavior of the agencies, the agencies’ friends in Congress could cut the regulator’s budget. The combination of an activist Congress, government-supported private firms hungry for profits, and a weak and pliant regulator proved disastrous.