Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  The market should theoretically encourage good risk management and penalize excessive risk taking. But tail risks are difficult to control for two reasons. First, they are hard to recognize before the fact, even for those who are taking them. But second, once enough risk is taken, the incentive for the authorities to intervene to mitigate the fallout is strong. By intervening, the authorities reduce market discipline, indeed inducing markets to support such behavior. Bankers may in fact have been guided into taking tail risks as markets anticipated government intervention in the housing market and liquidity and lending support from the Fed and the FDIC.

  This argument is not meant to absolve bankers. Some understood the risk they were taking and ignored it; many did not recognize it but should have. What is particularly alarming is that the risk taking may well have been in the best ex ante interests of their shareholders. One should judge the Citigroup’s board’s competence not only by the fact that its share price sank below $1 in the midst of the crisis but also by the fact that the price reached the mid-$50s just before the crisis in the spring of 2007. The stock market is not an anonymous, distant entity: it is us, and collectively we feted activities that eventually proved highly detrimental to society. Indeed, bank CEOs who remained conservative were doing the right thing by society but quite possibly not by their shareholders. Certainly, this seems to have been the market’s view before the crisis hit.

  Put differently, solutions are fairly easy if we think the bankers violated traffic signals: we should hand them stiff tickets or put them in jail. But what if we built an elaborate set of traffic signals that pointed them in the wrong direction? We could argue that they should have used their moral compass, and some did; but, as I indicated in the previous chapter, the industry’s entire system of values uses money as the measure of all things. Solutions are much more difficult if it turns out that the signals are broken, at least from the perspective of our collective societal interests.

  Moreover, I do not mean to suggest, by attributing some of the crisis to bankers’ and market confidence in a government bailout, that the authorities should sit back and watch the economy collapse. Rather, I want to emphasize that the combination of incentives for high-powered performance that are inherent in the modern financial system and the unwillingness of a civilized government to let failure in the financial sector drag down ordinary citizens generates the potential for tail risk taking and periodic, costly meltdowns. Even as I write, the enormous amounts of taxpayer money being directed at the housing market and the banks are creating new expectations about government and Fed behavior in the next crisis. Our central focus in any reforms should be on dispelling such expectations, and that is the topic I turn to now.

  CHAPTER EIGHT

  Reforming Finance

  WE HAVE MADE A FULL TOUR DE TABLE in searching for the underlying causes of this crisis. As I write, financial sectors around the world have been brought back from the brink through a combination of government guarantees, injections of capital, and central bank lending. Rock-bottom interest rates continue to bail out banks at the expense of savers: if banks can borrow at almost no interest and lend at a hefty spread, it is hard for them not to make money. Government spending across the world seems to have helped maintain activity, though it is still uncertain whether heavily indebted households, especially in the United States, will take up the task of spending when the government stimulus runs out. The most likely prognosis is for a period of relatively slow growth and mounting government debt obligations in industrial countries. Fortunately, though, we have stopped following the path of the Great Depression. Costly as this crisis will prove, it could have been worse.

  The fault lines and fragilities I have identified will not, however, simply go away with the passage of time. Some of them, indeed, are deepening. They will need to be addressed directly. But even while politicians sense the need for reforms, public distrust is growing for anything that has to do with the status quo. Radical proposals traverse the blogosphere—though with all the upheaval, the public tolerance of the additional uncertainty associated with change is also low.

  The public has lost faith in a system where the rules of the game seem tilted in favor of a few. Some of the bailout proposals, put together over sleepless weekends, seem poorly thought through at best and tainted by corruption at worst. Rolling Stone’s Matt Taibbi has called Goldman Sachs—a bank with alumni in every corner of the government, and, despite its protestations to the contrary, a significant beneficiary of the rescue—a “blood-sucking vampire squid.”1 The epithet seems to have stuck, epitomizing the public mood. Tin-eared bankers have not helped, paying themselves huge bonuses soon after being rescued by an ongoing public bailout, and, perhaps more infuriatingly, expressing surprised hurt at the public reaction.

  The private sector, however, is not alone in deserving blame. There is substantial evidence that government intervention and regulatory failure had as much of a role to play in this crisis as private-sector failure: indeed, it was the coming together of the two that had the most severe consequences. The temptation for politicians, however, will be to blame, and reverse, every precrisis trend on the grounds that it is somehow associated with, and hence responsible, for the crisis—and the trend was toward a greater role for the private sector. The targets for the forces of reaction are obvious. The public has expressed widespread revulsion against the liberalization that led to more vibrant financial markets and freer financial institutions. The forces against globalization—the greater integration of countries through trade, multinational firms, capital flows, and migration—are also regrouping, gaining succor from the natural willingness to look abroad for the roots of one’s problems. Diehard socialists are celebrating the grand crises that they see as harbingers of the collapse of capitalism.

  Finance, markets, globalization, and free-enterprise capitalism will endure beyond this crisis. But recent events do ask us to make hard choices, not about capitalism itself, but about the form of free-enterprise capitalism we desire. If we do not mend the fault lines, we could well have another crisis, albeit different in its details from the current one. Another crisis will tax already stretched public and household finances, as well as the fraying political consensus behind the system, perhaps to breaking point. Reform will then be much harder. Instead of testing providence, we should take this crisis as a wake-up call for reform.

  We have hard choices to make, as the good and the bad are typically closely intertwined. Radical positions that see the system as fundamentally broken are popular. They fit in with the public mood, and they are easy to tout in these times, their greatest merit being their distance from the current system.

  In defending the basic structure of a system that has failed, I face the risk of being dismissed as a conservative, an unregenerate apologist, or worse, a toady of banking interests that favor the status quo. But although systemic failure does imply the need for serious reform, it does not mean that a radically different system would be better. I believe we have to work to fix the system, but there is a lot worth keeping. So the choices I propose are not necessarily meant to shock: they are meant to fix the problems I have identified, which are serious indeed. I start with the financial sector, where so many fault lines meet.

  To begin, we have to take a stand on whether the financial sector actually helps the process of economic growth and well-being or whether it is just a sideshow, an irrelevance that makes its presence felt only by imploding periodically. If the latter is the case, then reform is easy: prohibit many of the current activities of the financial sector, create a few stable monopolies, regulate all remaining activities very closely, and forget about the sector for the next few decades. Serious economists and policy makers have called for such reforms, broadly under the rubric of “making finance boring.” If the financial sector is central to economic growth, though, reform becomes more challenging, because we have to limit finance’s ability to do damage while harnessing its creative energies. This is the chall
enge I address in this chapter.

  To make the debate more concrete, I outline polar-opposite positions on a specific issue: expanding access to credit. I argue that it is both democratic and efficient to continue to expand the range of choices people have. Regulatory reform that attempts to do otherwise will not survive in the long run, especially in a democracy. The real issue confronting us, therefore, is how to harness the benefits from financial development while limiting its instability. I outline some of the principles that reforms will need to respect and then take on the concrete issue of how we can reduce the incentive to take on tail risk that was so pervasive during the current crisis. I end with thoughts on how to make the system resilient to unforeseen dangers.

  Democratization versus Debt

  The financial sector is, in many ways, the brain of a modern economy. When it functions well, it allocates resources and risk effectively and thereby boosts economic growth while also making lives easier, safer, and more fulfilling. It broadens opportunity and attacks privilege. It works for all of us. Of course, when it works poorly, as it has done recently, it can do enormous damage while benefiting a very few.

  A narrower concern, but one that touches every household, is whether access to finance is so dangerous that some people should be kept from it, or their access severely regulated. Diametrically differing views exist on whether broadening access to borrowing through developments such as credit cards, home equity loans, and payday lending is good or bad. One view is that the democratization of credit is an eminently desirable development.2 It allows households to borrow against future income and smooth their consumption and expenditure over time, while also affording small entrepreneurs the ability to start their ventures: many a small venture has been started through borrowing on credit cards.

  Proponents of this view make the fundamental assumption that most households are rational and responsible: they will borrow only as much as they need, with full awareness of the consequences. Any attempt to constrain their choices is paternalistic and unwarranted. Indeed, proponents of this view use the term credit to denote borrowing. Credit, according to the Random House Dictionary, is defined as “confidence in a purchaser’s ability and intention to pay,” and the term accords well with traditional American optimism about the future. If the best is yet to come, why not borrow against it and make today better still?

  The opposite view is that borrowing is immoral, a giving in to temptation. Those who are indebted have no self-control and no sense of personal responsibility. Some of the blame goes to financiers (cast as loan sharks), who hold out easy access to lending, and some goes to marketers and advertisers who instill in the unsuspecting public desires for goods they do not need. Nevertheless, the overall consequence of broadening access to financing is, according to this view, overconsumption and overindebtedness, a temporary, illusory prosperity that leads eventually to poverty and remorse. Proponents of this view prefer the term debt, denoting obligation. There is a long tradition reflecting this view in the United States, epitomized by Benjamin Franklin in Poor Richard’s Almanac: “But, ah, think what you do when you run in debt; you give to another power over your liberty. If you cannot pay at the time, you will be ashamed to see your creditor; you will be in fear when you speak to him, you will make poor pitiful sneaking excuses, and by degrees come to lose your veracity, and sink into base downright lying; for, as Poor Richard says, the second vice is lying, the first is running in debt.”3

  Credit as a key to opportunity and as a means to the consumption you deserve, or debt as sin and as a mortgaging of a future you will never have—these two opposing views run through American history, with the former gaining ascendancy during boom times and times of rising inequality, and the latter gaining ground in downturns, when sobriety or rank pessimism returns. They represent a way of rephrasing the question I started with earlier: do we want to harness finance’s creative energies, or do we think finance is so dangerous that most people should not have access to it and it should be stuffed back in the box it came from? Society’s attitude toward financial reform hinges on whether it believes people and firms, by and large, can be trusted to make sensible financial decisions when given the means to do so.

  The academic debate on this question is not conclusive. Even as research in behavioral economics tells us that some people make consistent mistakes in their financial decisions, it also tells us that a lot of behavior is rational and sensible. Indeed, as I argue throughout this book, it is typically not the rationality of the decision makers that is a problem. Rather, it is whether the apparent payoffs from decisions fully reflect the costs and benefits to society. Our goal should be to make decision makers internalize the full consequences of their decisions, rather than prevent them from making decisions altogether.

  More generally, even if we conclude that some people took on too much debt during the boom, shutting off their access to some markets or limiting their financial choices (typically through legislation restricting the products, prices, or institutions they have access to) is paternalistic, undemocratic, and the surest way to ensure that the protected never have the opportunity to learn or improve themselves. Of course, we need to ensure they are given every opportunity to understand why certain choices are poor choices and to recognize the mistakes people traditionally make so that they can change their behavior. We should also ensure that they are protected from rank predators. But limiting choice is not the answer.

  Free societies do revert to more paternalism and more constraints on choice following a crisis. It is natural to blame the crisis on the greater freedom to choose: if only choice had been more restricted (and, of course, with hindsight, it is crystal clear what the restrictions should have been), we would not have made the bad choices that were made, or so goes the thinking. The overall trend in civilized democratic societies, however, is to expand choice for all, not constrain it, let alone constrain it for only some. From a practical standpoint, regulations that limit choice may be popular in the aftermath of a crisis but will inevitably be whittled away as the memories of the crisis fade. And enacting regulations that will soon be outmoded and voted down carries an inherent cost: it creates a momentum for deregulation among the public that could go too far. It is better to get regulation right than to err in either direction.

  In sum, if we reject the view that finance is a largely useless activity, or that we can keep its benefits only for a select and knowledgeable few, then the purpose of reform should be to draw out what is best in finance for the largest number of people while minimizing the risk of instability.

  Broad Principles of Reform

  What guiding principles must reforms adhere to? Let me outline the key ones and then go on to a concrete example.

  Should We Limit Competition

  A healthy financial system that benefits citizens requires competition and innovation. Oligopoly implies easy profits for the incumbents, profits they are loath to jeopardize by taking on risk. By contrast, the goal of broadening access, to reach new and underserved customers as well as future innovators, requires a financial system that is willing to take reasonable risks, and thus it requires competition. This is not a popular view at a time of crisis in a free-market economy, for the natural tendency is to blame the market and factors like competition that make it free.

  One of the main concerns during the Great Depression was that prices were too low, and the mistaken diagnosis was excessive competition. The New Deal solution was to prop up prices by forming cartels. To smooth the political path for the needed legislation, words like “economic cannibalism” and “cut-throat price slashing” were used to describe competition.4 Formerly “rugged individualists” became “industrial pirates.” Regulations meant to create cartels and suppress competition became “codes of fair competition,” while various forms of officially sanctioned collusion were described as “cooperative behavior.” Of course, incumbent firms were fully complicit in the regulation and cartelization of the economy, for it made thin
gs easier for them.

  The concerns during the recent crisis centered primarily on the underpricing of risk. Once again, it would be tempting but wrong to blame competition between banks. The right approach would be to reduce the various distortions to the pricing of risk that stem from actual and potential government intervention, as well as from herd behavior. We should not worry so much about rugged individualism as about undifferentiated groupthink, for that is the primary source of systemic problems.

  A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs. This proposal probably goes too far, as many products are minor tweaks on previous ones, are not life threatening, and cannot really be understood until tried out. Modest and free experimentation should be allowed but proliferation limited until regulators are satisfied they understand the innovation well, and the systemic risks it poses have been dealt with.