Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  Summary and Conclusion

  How do we preserve the benefits of the democratization of finance while ensuring that the system does not permit excessive risk? The answers I propose in this chapter are not so dramatic as doing away with the private sector or gagging and binding it, as suggested by Progressives, or doing away with all government and regulation, as suggested by the ideological Right. The problems emanated at the interfaces between the private sector and the government—the location of the fault lines—but since we cannot do away with either side, realistic reforms have to work on managing the interface. We are, however, in the position of someone asking for directions and getting the response, “Well, I wouldn’t start from here.”

  The supercharged financial sector, having taken full advantage of the implicit guarantees embedded in the government’s desire to push housing credit and promote employment growth, has ended up flat on its back. The government has then delivered on the guarantees to the best of its ability and, in fact, done more. It now has the task of convincing the financial sector that it will not do so again.

  But the government has not withdrawn from housing finance: in fact, it is even more tightly enmeshed now. Even if it were to take care of the political compulsions that draw it in to supporting some markets and hence the financial sector, it still has to convince the financial sector that no entity is too systemically important to be allowed to fail. So the key question in financial sector reform is, How do we get the private sector to price risk properly again, without assuming government intervention? The proposals in this chapter offer a path.

  The thrust has to be using transparency to draw the interested public into monitoring the relationship between the government or regulator and the financial sector. Much of what I propose falls short of the dramatic remedies that some desire. But the words of Justice Louis Brandeis, from a letter of 1922, are as apt for financial-sector reform as elsewhere: “Do not believe that you can find a universal remedy for evil conditions or immoral practices in effecting a fundamental change in society (as by State Socialism). And do not pin too much faith in legislation. Remedial institutions are apt to fall under control of the enemy and to become instruments of oppression.”22 His proposed alternative was what we would now call transparency, which he referred to as publicity: “Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policemen.”23

  I now turn to the reforms that are needed in the U.S. economy, focusing on how to improve access to quality education and how to strengthen the safety net.

  CHAPTER NINE

  Improving Access to Opportunity in America

  I ARGUE IN CHAPTER 1 THAT the pressures created by relatively stagnant incomes for many in the United States mirrored those in the typical developing country; they led U.S. politicians to push credit as a palliative. Subprime mortgage lending was the symptom, dwindling economic opportunity for many the cause.

  Not all forms of income inequality are economically harmful. Higher wages serve to reward the very talented and the hardworking, identify the jobs in the economy that need the most skills, and signal to the young the benefits of investing in their own human capital. A forced equalization of wages that disregards the marginal contributions of different workers will deaden incentives and lead to a misallocation of resources and effort.

  However, when the only pathways to high wages are seen to be birth, influence, luck, or cheating, wage differentials may not act as a spur to effort. Why bother when effort is not the route to rewards? Indeed, as the political economists Alberto Alesina and George-Marios Angeletos argue, perceptions in a democracy as to how high wages or wealth are obtained can create self-reinforcing patterns.1 If society believes people earn high wages as a result of their training and hard work, it is less willing to tax high earners, thereby ensuring they have strong incentives to acquire skills and exert effort. If society believes people earn high wages because of connections, chance, or crookedness, then it will tax incomes more heavily, and since few of the honest will then bother to work hard, only those with influence, the lucky, or the cheats will flourish.

  Indeed, one reason why the U.S. electorate today seems so receptive to proposals to make the rich pay much more in taxes is that perceptions of who is rich may have changed. Not so long ago, the prototypical rich person in the United States was the local self-made entrepreneur who owned the car dealership and the movie theater and who came from the same high school as everyone else. Today, it is the distant, overpaid CEO, the greedy banker, or the hedge-fund manager who thrives on insider trades. Stereotypes and perceptions matter: the rich are no longer us, they are them.

  The United States needs to prevent further social polarization, both in reality and in perception. The precise way of doing this does matter. If the rise in the wage inequality most people experience stems from the relative scarcity of workers with more human capital, as I argue in chapter 1, then the response has to be to improve the quality of human capital of the workforce. Heavy taxation solely to equalize wages will do little to tackle that problem and will reduce incentives to work or acquire human capital. This is why I will take as a given that the best way of reducing unnecessary income inequality is to reduce the inequality in access to better human capital.

  Equalizing access can head off brewing conflicts. For instance, if rich parents can pay for better schools, extra tuition, and eventually good universities for their children while poor parents cannot, the poor will become more intolerant of high incomes and wealth. Apart from increasing conflict between the haves and the have-nevers, unequal access may also increase resistance to economic reforms that expand opportunity. For instance, the poor urban worker who does not have access to a university education may care little for reforms that make it easier to open small businesses, because she has no chance of obtaining the financing to open one.2

  What we prefer politically depends on where we stand: if we stand at very different places, it is harder for us to come together as a society to make mutually beneficial decisions. And more than the quality of its institutions, what distinguishes a developed country from a developing one is the degree of consensus in its politics, and thus its ability to take actions to secure a better future despite short-term pain. Unequal access, and the resulting inequality, destroys consensus. And although this chapter focuses on the United States, the issues addressed here are relevant in many countries, including developing ones like China and India.

  The problem is that the political and economic costs of any effort to improve access—for instance, providing quality preschool care for poor children—are incurred up front, whereas the benefits lie in the future. It is hard to get the public, and consequently politicians, excited about such undertakings, especially at a time of straitened public finances. But if nothing is done, inequality will feed on itself. The costs of redressing deficiencies will only increase, and many citizens will be left irremediably ill-equipped for a productive life in society. Put differently, the status quo entails unacceptable and growing costs, and avoiding those very visible costs has to be part of the cost-benefit calculus.

  In arriving at solutions we should resist two seemingly attractive but dangerous notions. One is that government spending will fix all problems. The truth is that money is rarely the key missing ingredient, as we saw with the growth of developing nations. Indeed, government largesse can crowd out, if not corrupt, individual and community initiative. That does not mean, however, that all societal problems will be solved by spontaneous voluntary initiative, the second dangerous notion. Government effort (and sometimes money) is needed at key leverage points to coordinate individual and community action. Again and again, we see that successes involve a coming together of key players, a broader definition of the problem (and hence solutions) than what seems apparent initially, and a restructuring of incentives such that all players work together rather than at cross-purposes.


  Improving the Quality of Human Capital

  Human capital, as described in chapter 1, refers to the broad set of capabilities, including health, knowledge and intelligence, attitude, social aptitude, and empathy, that make a person a productive member of society. Schools and universities play a part, as do families and communities: it does take a village to create the values and attitudes that allow children to get the most out of their education! And once individuals complete their formal education, employers play an important role in training them further and encouraging them to continue building their human capital on the job. Such on-the-job development will become more important as the length of our working life increases: the typical knowledge worker may now work for nearly half a century after formal education ends. In what follows, I describe some of the important ways the quality of human capital can be improved in the United States.3

  Disadvantages Begin Early

  The foundation for success in life is laid early. We cannot do anything about the genes a child is endowed with, but nutrition during pregnancy and in early childhood makes an enormous difference to a child’s intelligence and health later in life. Poor nutrition in a child’s early years seems to be associated with the early onset of the degenerative diseases of old age such as coronary heart disease and diabetes.4 Poor habits of expectant mothers, such as drinking and smoking, also contribute to the long-term impairment of their children’s health. Unfortunately, because these problems are likely to be more severe among the children of the poor and the poorly educated, they perpetuate the cycle of poverty. To break it, more resources have to be devoted to very young children in poor families, whether in the form of nutritional supplements, medical monitoring and treatment, or parental education.

  Early education also seems to matter considerably. By age eight, intelligence, as measured by standard metrics, seems pretty well set.5 Therefore it is critically important that young children have access to quality pedagogic resources. Studies show that early childhood learning programs tend to reduce the likelihood that a child will drop out of high school, increase the likelihood that the child will enroll in college, and increase earnings.6 They also make it less likely that the child will become delinquent, a criminal, a drug addict, or a teenage mother.

  Although evaluations of the government’s Head Start program—a national program that promotes school readiness by enhancing child development through the provision of educational, health, nutritional, social, and other services—are still mixed, it is hard to believe that more attention to creating good day-care centers and preschool programs for poor children, funded by government resources, with scope for local experimentation and regular evaluation, will not produce benefits. Mexico has had tremendous success in encouraging poor parents to pay more attention to their children’s nutrition, health, and education by making welfare payments conditional on parents meeting certain milestones.7 Similar conditional cash transfers are being tried by Mayor Bloomberg in New York using donated funds, and although it is too early to tell whether they are effective, the success of similar programs around the world suggests that more experimentation is warranted.

  Family matters. As far back as 1966, the influential Coleman report concluded that family background was a greater influence on school achievement than any measure of the school environment, including school districts’ per-student expenditures.8 Not only are the incomes of the parents important, but so is the relationship between them, as it influences the family’s access to resources and the kind of environment it provides. Being born to teenage parents, or growing up with one or both parents absent, tends to be detrimental to a child’s chances of success, as is divorce. Again, these problems tend to be more common among poorer families. Although the government has only a limited role, if any, to play in strengthening families (though it certainly should not tax married couples more, as it does now), greater community recognition of the harm done to the children by teenage pregnancies, absentee parents, and broken marriages can be a force for change.

  More generally, as the Nobel laureate James Heckman from the University of Chicago has argued, many of the differences between children are set at an early stage: most of the gaps in abilities observed at age eighteen are already present at age five.9 Furthermore, a child is most malleable when young: it becomes much harder and costlier to alter abilities and behavior as the child gets older. Early intervention is important for changing outcomes successfully.

  Noncognitive Skills

  Interventions are not just about improving the child’s learning abilities. Success in school, as in work life, depends significantly on noncognitive abilities, such as perseverance, determination, and self-discipline.10 And whereas cognitive abilities are relatively fixed early on, noncognitive abilities can be changed for considerably longer.

  Good schools inculcate values that serve students well in later life. Past studies have shown that students from Catholic schools tend to do better than students from inner-city public schools, perhaps because they produce more disciplined and motivated students.11 Substantial improvements to inner-city student performance seem to have been brought about by “paternalistic” schools that insist on discipline: students walk in an orderly way between classes, meet dress codes, sit up straight in class, do homework, use standard English, and are penalized for transgressions.12 There is, however, little systematic evidence on the success of such schools, the key ingredients that make them work, or the environments in which they work best. Nevertheless, it seems a reasonable hypothesis that both the learning environment and the learning of noncognitive skills could be improved through attempts to teach behavior as well as impart knowledge.

  As important as what happens in schools is what happens outside. Dysfunctional families and communities make it more difficult for a child to acquire the values that can help them succeed. After-school programs and mentoring programs—pairing students with successful and caring adults—have helped remedy some of the damage. So too has community leadership and a shared sense of parental responsibility. As a U.S. senator speaking at the 2004 Democratic convention, Barack Obama said: “Go into any inner-city neighborhood and folks will tell you that government alone can’t teach our kids to learn; they know that parents have to teach, that children can’t achieve unless we raise their expectations and turn off the television sets.”13 This kind of parental and community responsibility is needed to make full use of any government support.

  More generally, careful longitudinal studies in Chicago suggest that failing schools can be transformed through collective effort: by leadership that creates an environment where the faculty work with one another to challenge students, where the faculty themselves are encouraged to develop their skills, where the school and other social service organizations work together to attempt to improve the student’s entire learning environment and not just the one in school, and where parents and the community are drawn in to support this effort.14

  Amount of Schooling

  Studies suggest that students from low socioeconomic groups who are enrolled in public schools make as much progress on math and reading exams during their elementary-school years as children from a high socioeconomic background, though they start at a lower level because of disadvantages inherited from early childhood. However, the gap in achievement scores grows over time, primarily because the achievement levels of children from low-income families fall or stagnate during the summer, while those of children from higher-income families continue to increase.15 The learning environment in families differs, with children of high-income parents growing up with educational games, books, private tuition, and summer programs, all of which continue their learning outside school. Some economists have therefore suggested extending the school year: Japan’s school year runs about 240 days, while the school year in the United States is 180 days.16 Others have suggested offering vouchers to poor families so that they can enroll their children in summer programs. Both approaches are worth experimenting with.
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  Quality of Teaching

  Clearly, the quality of teaching also affects a child’s educational experience.17 Motivated, inspiring, knowledgeable teachers make an enormous difference, as many of us know from experience. So does class size.

  Getting good teachers starts with hiring. When other opportunities for women and minorities were limited, many talented people went into teaching because it was a respectable occupation that was open to them. As opportunities for these groups have expanded, it has become more difficult to attract the talented into teaching. Pay has to be one component of a more attractive package. But pay increments should be tied to teacher performance in and outside the classroom, which should be measured in part by improvements in student performance. Additional increments should be given to those who teach difficult but required subjects such as math and science and to those who teach in difficult school environments, such as the inner cities. Teacher unions have resisted pay differentiation, especially on the basis of performance. However, they are slowly becoming more amenable to change.

  As important as pay is a career path that makes full use of a teacher’s experience. Only some teachers like, or are suited for, promotion to school administration. Others could play an important role as mentors to junior teachers, as master teachers conducting classes in pedagogy, or as subject-matter experts. These career paths need to be made clearer and rewarded appropriately.