Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  The Fault Line Deepens: The Divide between Developing Countries

  In sum then, in a developed country, especially one with well-functioning capital markets and financial institutions, foreign investors typically have information and rights similar to those of domestic investors. They do not demand special rights and privileges; nor do they try to get implicit government backing (by lending via domestic banks) or explicit backing by lending to the government. Firms and households borrow directly, forcing foreign investors to make careful decisions. If they don’t, they have only themselves to blame and have no recourse to the government.

  In a developing country, by contrast, foreign borrowing is typically a last resort. Because foreign investors worry that they know far less than the well-connected domestic banks and are less able to enforce payment, they try to improve the security of their claims by requiring payment in foreign currency and by shortening the maturity of their loans. Paradoxically, the underdevelopment of the domestic financial system allows the late-arriving foreign investors to demand and receive privileges that typically eat into the value of the existing domestic investors’ claims or, via the implicit guarantees offered by the government, into the taxpayers’ wealth. Moreover, the protection they receive makes them less careful about what they finance. In turn, because borrowers, whether the current government or banks, do not face the full cost of foreign borrowing, they have a tendency to overborrow.

  Parenthetically, readers will note that the U.S. subprime market, with its substantial quasi-government presence, was a departure from the developed-country norm and in many ways reflected the deficiencies present in developing countries. This is precisely the analogy that needs to be drawn. I return to these issues later in the book.

  Reforms

  The crises of the 1990s had a differential impact on economies. Countries that were saving too little were forced into much-needed reforms. For countries like India, which experienced a crisis in 1991 as a result of large government and current-account deficits, and Latin American economies like Brazil, whose vulnerability stemmed from too little saving, the crises were a signal that the old model of managed but inward-looking capitalism was broken. Both India and Brazil liberalized their economies, reducing government control and ownership, removing price and interest-rate controls, bringing greater competition into the financial system, opening up to imports and foreign investment, and letting the exchange rate float. They also adopted more sensible macroeconomic policies, cutting government deficits (for a while at least) and improving monetary management.

  During the long period of protected managed growth, they had built strong corporate organizations that were fully capable of prospering as competition increased. And enhanced competition brought out the best in these companies. Tata Steel (before it acquired the European steel giant Corus) had one of the lowest costs of steel production in the world, while Embraer, a privatized Brazilian aircraft manufacturer, developed a strong market in midsized planes around the world.

  These late liberalizers had large enough domestic markets that they did not have to favor the export sector. Both Brazil and India “managed” their exchange rate, but they did not try to gain a serious competitive advantage by trying to hold it down. Moreover, with firms already strong, they did not have to repress the household sector—not that their now-vibrant democracies would have allowed them to! They liberalized deposit interest rates, cut taxes on households, and allowed the financial sector to expand household credit. As a result, both Brazil and India have healthy levels of private consumption and domestic-oriented production sectors that are almost as efficient as their export-oriented sectors. Although a boom in commodities has led to a rapid expansion in Brazil’s exports, its economy is diversified and resilient enough to weather a temporary drop in commodities prices if it comes. For both these countries, the silver lining in the cloud of having missed the right moment to switch to exports is that they have not had to switch back. They now enjoy more balanced economies, less dependent on exports for growth.

  The East Asian economies, with the exception of Indonesia, recovered quickly: their devalued currencies made them very competitive, and they expanded exports even while replacing imports with cheaper domestic production. They also slashed investment—on average, across Korea, Malaysia, and Thailand, investment came down from 41 percent of GDP in 1996 to 24 percent of GDP in 1998, and it stayed low. Domestic savings picked up a little initially, from 38 percent of GDP to 41 percent of GDP, but drifted down over time to below 1996 levels. This is important, for the reason for their rising trade surpluses is not that East Asian households cut back dramatically on consumption and increased their savings. Instead, governments and corporations cut back on investment. The net effect on the world’s supply of savings was the same—from being net borrowers from the world economy, the East Asian economies started pumping their savings into it. But demand for investment goods—for hard assets such as plant and equipment—plummeted. These were typically goods that had been imported, so the reverberations were felt around the globe. The global supply glut again went looking for countries that would overspend.

  Summary and Conclusion

  Countries that had focused on export-led growth learned an important lesson. It is a fool’s game to succumb to the temptation of cheap goods and easy money: rapid debt-fueled spending invariably ends in tears. More specifically, because managed capitalism was hard for foreign investors to understand or navigate, they responded by retaining the right to exit at short notice, holding equity or short-term debt claims. And exit they did, sometimes without full regard to the country’s fundamentals, so that financing with flighty foreign capital was akin to running a small bank without deposit insurance—a recipe for fragility. Although the exporters did understand the need for financial-sector reform, they did not believe that the crises indicated any problems in the broader strategy of export-led growth. Instead, the crises reinforced their beliefs that generating trade surpluses was even better than simply being export oriented, for it allowed the country to build foreign exchange reserves. The route to such surpluses was to cut back on investment, which also helped these countries avoid the boom-bust cycle in investments to which they had been prone.

  The attempt by these exporters to achieve safety, though, has increased the rest of the world’s vulnerability. The supercharged export-led growth strategy they have subsequently followed not only increases the burden on the rest of the world to create demand for their goods, but it also accentuates the domestic distortions the strategy previously created, which were highlighted in the previous chapter.

  The new strategy also led to an enormous buildup of the exporters’ foreign-exchange reserves. These reserves went looking for a home around the world. To attract them, a country had to be willing to spend much more than its own producers could supply, and it needed a strong financial system capable of attracting the inflows and reassuring the exporters that their savings would be safe, safer than the developing countries had been. The obvious candidate was the United States (along with, to a lesser extent, Spain and the United Kingdom).

  The United States, with growing inequality making the political environment favorable to more debt-financed consumption (as I argue in Chapter 1), was a prime candidate to be the new demander of last resort. However, the policies in the early years of this century that pushed it firmly into the role of the world’s new designated spender were driven by a new phenomenon: recoveries in the United States were increasingly “jobless,” and the U.S. safety net was wholly inadequate to cope with them.

  CHAPTER FOUR

  A Weak Safety Net

  BADRI ENTERED THE UNITED STATES as a student more than a quarter century ago.1 After obtaining a handful of degrees, including a PhD in metallurgical engineering, he got a job in 1997 in a joint venture between a German firm and an American firm near Washington, DC, making state-of-the-art memory chips. Badri’s first job was to help set up the fabrication line for a new set of
chips and to reduce the fraction of defective chips produced. The task made full use of his considerable knowledge and skills because it required troubleshooting really complicated processes and machines. Seventy-hour weeks were common.

  Over time, the American partner sold out. The German firm spun off the joint venture into a separate firm with its own traded shares, and later this firm split into two, with one part focusing on logic chips while the other part focused on the capital-intensive memory chip. So even as Badri spent years specializing in memory-chip fabrication, making smaller and smaller chips from larger and larger wafers, the company also shrunk—from being a joint venture between two large, deep-pocketed firms to being a diversified chip maker and eventually a stand-alone, narrowly focused, heavily indebted firm, in a capital-intensive industry with a history of feast-and-famine cycles.

  The inevitable happened. After making a huge investment in the latest new technology, Badri’s employer found itself in financial difficulties in early 2008. It had the choice of shutting down either its U.S. plant or its German plant. Knowing that it would face greater difficulties in shutting down the German plant and that it might be able to bargain for subsidies from the German government, it laid off all the workers at its U.S. plant.

  Overnight, Badri found his six-figure income gone. Because the firm declared bankruptcy, it did not have to provide severance pay to compensate him for the 11 years he had worked at the firm. All he had now was a weekly unemployment check of $400, out of which he had to support his family of four as well as pay a mortgage. Even more worrisome was health insurance. He had been paying $50 a month for health insurance provided through his firm, which would no longer cover him and his family. As he turned to private insurance companies, he found that they refused to cover him because he had an elevated blood-sugar level and was at mild risk for diabetes. Even without this complication, private insurance would cost $1,100 per month for the family, which would eat up two-thirds of his unemployment insurance. Badri really needed a job, at the very least so that he did not have to play Russian roulette with his health and finances by remaining uninsured. He sent out hundreds of résumés, but no one was hiring. His unemployment insurance was running out, and he would have to eat into the savings set aside for his son’s college education. In this respect, Badri was one of the lucky ones. Unlike many Americans in his situation, he had some savings!

  In the meantime, his firm’s U.S. assets were liquidated piecemeal, with other chip manufacturers buying some of the expensive machines for their own fabrication plants. These assets were quickly redeployed into new, profitable uses. Many months after closing the U.S. plant, the firm was forced to recognize the inevitable—that its business was uneconomic—and it closed the German plant also.

  The Willingness to Stimulate

  We saw in the last chapter that in the late 1990s and early 2000s, the surpluses of the traditional exporters, augmented by the goods the developing countries were no longer buying, were looking for a market. With the world in recession after the dot-com bust, the United States pursued extremely expansionary fiscal and monetary policies over a sustained period, thus creating the excess demand to absorb the surpluses, financed with the savings that surplus countries were generating. In part, as I have argued, the United States had no option but to be the world’s demander of last resort, because countries like Germany and Japan could not pull their weight. But the United States did not follow expansionary policies out of a sense of global citizenship. Instead, it was driven by its own domestic compulsions to stimulate to excess.

  Badri’s experience suggests an important reason why. Unlike workers in other rich industrial economies, workers in the United States are not automatically supported if a recession is deep and prolonged.2 Americans have historically opposed substantial welfare: as a result, the country’s safety net, including unemployment benefits, is weak. Since World War II, its economic system has been structured so that it reacts quickly and nimbly to adversity. Banks cut off poorly performing firms from new loans, while venture capitalists pull the plug on underperforming start-ups. Existing firms are shut down, and their assets are liquidated and sold to those who can use them better, as happened with Badri’s firm. All this activity creates space for new firms to emerge. And because unemployment benefits do not last long, workers who lose jobs have strong incentives to find new ones, even if it involves a pay cut, changing careers, or moving across the continent.

  Perhaps as a result of these circumstances, postwar recoveries prior to 1990 were rapid—on average, output recovered to pre-recession levels within two quarters, and lost jobs were recovered eight months after the recession trough.3 Government and central bank policy were meant to help in downturns, but only at the margin. Most of the brief pain was meant to be borne by banks, firms, and workers.

  However, the 1990–91 recession broke this postwar mold. Output growth came back quickly, but jobs did not. Whereas production recovered within three quarters in 1991, it took 23 months from the trough of the recession to recover the lost jobs in 1991 recession. Those out of work or facing job losses are understandably anxious as they face potentially long periods of unemployment with few savings, a very limited period of unemployment benefits, and no health insurance. Politicians ignore the concerns of the anxious citizenry at their own peril. George H. W. Bush learned this the hard way: despite presiding over the end of the Cold War and a decisive victory in the first Gulf War, he lost his reelection campaign to Bill Clinton, largely as a result of voter dissatisfaction over job losses during the recession of 1990–91. One of Clinton’s guiding principles, set forth by the campaign strategist James Carville, was “It’s the economy, stupid.” That lesson has been firmly absorbed. The view that the current unemployment rate is central to reelection prospects dominates thinking in Washington.

  The weak safety net and the emergence of jobless recoveries imply that the American electorate has far less tolerance for downturns than voters in other industrial countries. The reason that stimulus was applied so long during the recovery from the 2001 recession was that even though output recovered in just one quarter in 2001, it took 38 months after the trough of the 2001 recession for all the lost jobs to be restored. Indeed, job losses continued well into the recovery. In an attempt to induce recalcitrant firms into creating jobs, both the government and the Federal Reserve, especially the latter, ended up aiding and abetting a house-price bubble and the financial crisis.

  As the United States struggles with near-double-digit unemployment at the time of writing, there is panic in the corridors of power in Washington. Meanwhile, the capitals of continental Europe, where unemployment safety nets are stronger, seem to be taking similar levels of unemployment in their stride. Once again, there is extraordinary political pressure on Congress and the Federal Reserve to somehow produce jobs. Although there are some virtues to retaining the flexibility to tailor policy to the situation, policy made under the political gun and with political rather than economic objectives typically does not produce effective policy. It has two important effects: first, as I argue in this chapter, it tends to make the United States the reliable stimulator of first resort for the world, taking the burden off other countries and giving them less incentive to alter their growth strategies. Second, as I argue in the next chapter, the excessive political incentive to stimulate produces monetary policy that warps incentives in the financial sector and contributes to the kind of financial disaster we have just experienced.

  The Weak Safety Net

  An important historical difference between the United States and most continental European countries has been the level of unemployment benefits. For example, a comprehensive study over the period 1989–94 shows that U.S. unemployment benefits were not only somewhat lower than in most continental European countries—the United States, on average, replaced 50 percent of lost wages, while France replaced 57 percent and Germany 63 percent—but these benefits ran out much more quickly. In the United States, on average,
benefits ran out in six months, whereas in France benefits lasted for up to three years, and in Germany they lasted indefinitely. Since that study, German reforms have brought down the duration of benefits to one and a half years, but the maximum wage-replacement rates in both France and Germany have been increased somewhat, with little change in the United States.

  There are holes even in the relatively scant unemployment benefits on offer in the United States. Although more than 90 percent of workers are covered by unemployment insurance, only about 40 percent of them receive benefits when they become unemployed. Some don’t qualify for benefits because they have not worked long enough, others because they left voluntarily, yet others because they are involved in labor disputes, and still others because they do not make themselves available for work while unemployed.4

  The worry for someone who loses a job in the United States is compounded by the absence of universal health care or affordable private medical insurance. Because America’s tax code subsidizes health insurance provided through employers, the unemployed have to pay several times more to get the same benefits they obtained previously through their jobs. Moreover, even when individuals can afford it, private insurers can refuse them coverage if they have even a mild preexisting medical condition, as Badri did. Given that even the apparently healthy could have a preexisting condition they are unaware of, most Americans are understandably anxious about potential unemployment, and the desire of the unemployed to rejoin the ranks of the employed is immense. And when Americans are anxious, they are not shy about letting their representatives know. As unemployment mounts, so too does the pressure on politicians to do something.