Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  In sum, multilateral organizations should play a greater role in defining what global economic citizenship means and appeal directly to thinking people around the world, using not obscure, unread papers but modern technological tools. Because my proposal does not preclude the holding of those frenetic international meetings and conferences that achieve little, why not try it?

  Epilogue

  W E LIVE IN AN AGE OF PLENTY. If I reflect on just the changes I have experienced as an academic over the past three decades or so, they boggle my mind. My first experience with a computer came only in the second year of my undergraduate degree in electrical engineering. I say experience because we never actually saw or touched the computer. It was housed in a mysterious air-conditioned room that only the privileged were allowed to enter. We hoi polloi used to write our programs on punch cards and submit them to the computing services desk. When the computer was free of more urgent tasks, the cards would be fed into it. When, pregnant with hope, we got the strangely thin output a few days later, we would realize to our chagrin that we had misplaced a comma on some card in the deck. A simple program that would take a few minutes to debug today took us weeks of hard labor then.

  The advent of the personal computer made an enormous difference to the productivity of academic work. Early word processors let us dispense with typewriters and correction fluid, but they were difficult to use, especially when it came to formulating mathematical equations: I spent many nights as a PhD student trying to make equations look right on the screen, only to find on further analysis that they were technically wrong. Of course, computer games were ubiquitous even then, though far less sophisticated. At least one fellow student took an additional year to finish his PhD because he got hooked on a game called Tetris. I escaped addiction only because I was so bad at the game to start off with.

  Research collaborations across any distance were extremely difficult when I was starting out. The cost of international phone calls was prohibitive, and documents had to be shipped by snail mail, adding enormously to the time taken to complete projects. The search for relevant papers involved hours in the library, and typically we knew only of papers that had already been published, not those in the pipeline. Because of the long lead times for publication, papers in the latest journals had typically been written years before. Imagine my dismay when I found a paper in the Journal of Finance, a few weeks before I went out onto the academic job market, that contained the central idea in my thesis. (Luckily, there were enough points of differentiation that it was clear I had made a contribution, but the experience was still very demoralizing.)

  Today everything has changed. Indeed, the notebook computer on which I am writing this book has thousands of times the processing power of the room-sized mainframe I started out with not so long ago, and costs about one-thousandth the price. To my children, my student life occurred BIE—before the Internet era. They cannot imagine anybody could be that ancient! Technology has changed their lives, and mine, dramatically. The magnitude of the change I have experienced over just the past three decades gives me hope that we will be able to solve many of the problems that seem intractable today.

  Those problems are many. Abject poverty is still a scourge in many developing countries. The poor seem especially damned by nature. The recent earthquake in Haiti killed hundreds of thousands of people. Equally strong earthquakes occur in other parts of the world without killing so many, possibly because buildings are built to withstand shocks. Perhaps the roots of poverty and the cause of nature’s seeming lack of compassion for the vulnerable are the same: the inability in many parts of the world to create the basic governance structures that will allow people to create decent livelihoods—and safe buildings—for themselves.

  Industrial countries have their own problems. Even as government debt mounts in the aftermath of this crisis, populations in many countries are aging rapidly and coming to the realization that their government’s earlier promises of security and health care in old age are likely to be reneged on. As they tighten their belts to provide for the difficult present, the future, if anything, looks bleaker.

  As if this were not enough, the sins of our past are catching up with us. The evidence for climate change, with potentially disastrous environmental and economic consequences, seems compelling. Although there is always a possibility that we will overreact, the richest countries need to think of ways of reducing unnecessary consumption of energy and materials, and developing countries need to consider more sustainable pathways to growth.

  These problems can and will be solved, provided we retain faith in human ingenuity and give it space to express itself. Economic reforms in China and India have unleashed the creative energies of more than a third of humanity. Millions of highly trained Chinese and Indian engineers are putting their brains to work to meet the challenges. Companies in China are now leaders in developing electric car batteries, and companies in India are producing affordable electric cars. When these developments are coupled with the advances in nuclear, solar, and wind energy that are taking place in industrial countries, we should be able to reach the goal of zero auto emissions at a viable cost in the not too distant future. If China and India can reverse centuries of decline in the space of decades, perhaps even Haiti may be able to use the ferment created by its recent tragedy to overcome the greater tragedy of its history.

  Collaboration between countries can help in other areas: health management practices in developing countries could show the way to making health care more affordable in developed countries. “Medical tourism,” whereby patients from rich countries can undergo much-needed medical procedures at significantly lower costs in developing countries, or “retirement migration,” whereby the elderly migrate to retirement communities in salubrious but less expensive countries, helps bring incomes to developing countries while making treatment and old-age assistance affordable. Conversely, the migration of younger workers from developing to industrial countries can provide the tax base to help support aging industrial-country populations while also equalizing incomes globally. Remittances from migrants can help their relatives back home live better lives: entire areas in India, Mexico, and the Philippines have been transformed by remittances. Two-way flows of people can, if properly managed, be an answer to some of the world’s most pressing problems.

  Vibrant financial markets can provide the risk capital needed by the innovators across the world as well as the savings instruments needed by the aging and the currency-transfer facilities needed by migrants. But finance is in disrepute. Calls to shackle it are being heard from every quarter. More dangerous is the possibility that industrial countries, especially the United States, could lose faith in the financial system that has made them what they are. A misbegotten sense of the inadequacy of markets and competition is leading to ever more faith being placed in the government. Although there are certain things government can (and must) do, leading dynamic change and innovation is not among them.

  It is an easy step for countries whose governments fail to meet the now-heightened expectations to seek to keep what they have by means of assertive nationalism and protectionism. Instead of embracing the growth of developing countries and keeping their domestic markets open, industrial countries could turn inward, to the detriment of all. According to polling by the Pew Foundation, 49 percent of Americans think their country should mind its own business internationally, a proportion 30 percentage points higher than when the question was first asked in 1964.1 Equally, instead of accepting greater responsibility as their economic might grows, developing countries could prompt a stronger reaction by behaving as if their policies continue to have little effect on the world. We could yet convert hope into conflict, then despair, as the world has done many times before.

  Economic stagnation is the breeding ground for conflict. To prevent history from mimicking itself, we have to understand the causes of the recent crisis and act on that understanding. Financial markets and democratic government are not incomp
atible. The role of financial markets is to allocate resources to those most capable of using them, while spreading the risks to those most capable of bearing them. The role of democratic government is to create a legal, regulatory, and supervisory framework within which financial markets can operate. However, democratic government has other roles, including limiting the most inequitable consequences of the market economy through taxes, subsidies, and safety nets. It is when democratic government uses these other tools inadequately, when it tries to use modern financial markets to fulfill political goals, when it becomes a participant in markets rather than a regulator, that we get the kind of disasters that we have just experienced.

  Some argue that it was laissez-faire ideology that led us to this pass: regulators became enamored of the ideal of the self-regulating market and stood on the sidelines as it self-destructed. They are only partly right. Although it ought to be the duty of regulators to lean against the prevailing winds of optimism (and sometimes pessimism), regulation in the United States was driven by the misplaced view that markets would take care of themselves, a view that time and time again makes the ideological Right play into the hands of the ideological Left. Yet the bulk of the damage was done as the sophisticated financial sector tried to seek an edge that the U.S. government, driven by political compulsions, was only too willing to provide.

  Progressives in the United States blame the bankers, while conservatives blame the government and the Federal Reserve. The worrying reality is that both are to blame, but neither may have been fully cognizant of the fault lines guiding their actions. Changing the actors, or trying to change their incentives directly, may have limited effect: we need to bridge the deeper fault lines. Unless we reestablish the proper role of the government and the financial sector, as well as fix the imbalances between nations, what happened may happen again.

  The financial sector needs to know that it will bear the full consequences of its actions, which means that it, and not the taxpayer, will have to bear the losses it generates. The U.S. government has to re-create the access and opportunity for all its people that has historically been the hallmark of its economy while helping those who fall behind. This will reduce the pressure on the government to intervene in financial markets or to stimulate the economy excessively.

  Other countries have to implement reforms that will help rebalance the world economy while reducing their own dependence on global growth. In this, as with the other challenges that the world faces, we will need international cooperation. The world’s great powers, both the established ones and the emerging ones, have to recognize that their policies do not add up to a coherent whole. They have been reluctant to create strong global institutions that might impose constraints on their policies. To counter this reluctance, we need to broaden the policy debate across the world, persuading civil society in each country to push its government to enact policies that further the global good.

  I write these last lines in a Lufthansa Airbus, flying back to the United States from a conference in Moscow. It is late in the evening, and the gentle rays of the wintry setting sun, toward which we are headed, glint magically off the plane’s giant engines. The venue of the conference reminds me how far we have come. Three decades ago, Moscow was virtually closed to academics from the West. When I landed yesterday, the main problem was getting from the airport to the city, because the road was clogged, seemingly with all the millions of cars Muscovites have acquired since the fall of communism. That is progress, though clearly progress has brought new problems.

  Such scenes should remind us that the past three decades have brought immense improvements to countries around the world, as they have harnessed the power of global markets and finance while obtaining economic freedom. Unfortunately, we have allowed political imbalances to develop within countries and economic imbalances to grow between countries. In many rich countries, insecurity and despair have replaced hope. We should not let what has gone wrong obscure all that can go right, or reverse the progress we have made. But to preserve and rebuild trust in the market system, we have to make fundamental changes. Governments have to do more to help their citizens build capabilities that will allow them to be productive. But they also have to step back in other areas to allow the market to function effectively. This crisis has resulted from a confusion about the appropriate roles of the government and the market. We need to find the right balance again, and I am hopeful we will.

  NOTES

  Introduction

  1 For examples, see Paul Krugman, “How Did Economists Get It So Wrong?” New York Times, September 6, 2009, www.nytimes.com/2009/09/06/magazine/06Economict.html; John H. Cochrane, “How Did Paul Krugman Get It So Wrong?” University of Chicago Booth School of Business, faculty.chicagobooth.edu/john.cochrane/ research/Papers/krugman_response.htm, accessed March 5, 2010.

  2 J. Lahart, “Mr. Rajan Was Unpopular (but Prescient) at Greenspan Party,” Wall Street Journal, January 2, 2009.

  3 See C. Reinhart and K. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009) for an excellent study delineating the commonalities between crises through history.

  4 For surveys, see M. Brunnermeier, “Deciphering the Liquidity and Credit Crunch, 2007–2008,” Journal of Economic Perspectives 23, no. 1 (Winter 2009): 77–100; G. Gorton, “Information, Liquidity, and the (Ongoing) Panic of 2007,” NBER Working Paper 14649, National Bureau of Economic Research, Cambridge, MA, 2009; D. Diamond and R. Rajan, “The Credit Crisis: Conjectures about Causes and Remedies,” American Economic Review 99 (2009): 606–10. A number of very good books have been written on the crisis, including Gillian Tett, Fool’s Gold (New York: Free Press, 2009); Richard Posner, A Failure of Capitalism (Cambridge, MA: Harvard University Press, 2009); Andrew Ross Sorkin, Too Big to Fail (New York: Viking, 2009); and David Wessel, In Fed We Trust (New York: Crown Business, 2009).

  5 A. Atkinson, T. Piketty, and E. Saez, “Top Incomes in the Long Run of History,” NBER Working Paper 15408, National Bureau of Economic Research, Cambridge, MA, 2009.

  6 J. Anderson, “Wall Street Winners Get Billion-Dollar Paydays,” New York Times, April 16, 2010, www.nytimes.com/2008/04/16/business/16wall.html.

  7 See Stacey Schreft, Aarti Singh, and Ashley Hodgson, “Jobless Recoveries and the Wait-and-See Hypothesis,” Economic Review, Federal Reserve Bank of Kansas City (4th quarter, 2005): 81–99.

  8 Ibid.

  Chapter One. Let Them Eat Credit

  1 See, for example, Richard Florida, The Rise of the Creative Class: And How It’s Transforming Work, Leisure, Community and Everyday Life (New York: Basic Books, 2004).

  2 See Claudia Goldin and Lawrence Katz, The Race between Education and Technology (Cambridge, MA: Belknap Press, 2009), 231.

  3 Ibid., 330–31.

  4 On educational attainment, see U.S. Census Bureau, “Educational Attainment in the United States: 2008,” www.census.gov/population/www/socdemo/education/cps2008.html, accessed March 5, 2010.

  5 Brink Lindsey, “Paul Krugman’s Nostalgianomics: Economic Policies, Social Norms, and Income Inequality,” Cato Institute working paper, Washington, DC, 2009.

  6 Author’s calculations based on Goldin and Katz, The Race between Education and Technology, 52.

  7 U.S. Census Bureau, “Educational Attainment: People 25 Years Old and Over, by Total Money Earnings in 2008,” www.census.gov/hhes/www/cpstables/032009/perinc/ new03_001.htm, accessed March 5, 2010.

  8 See Goldin and Katz, The Race between Education and Technology, 327.

  9 Ibid., 249–50.

  10 Ibid., 326–28.

  11 T. Piketty and E. Saez, “Income Inequality in the United States, 1913–1998,” NBER Working Paper 8467, National Bureau of Economic Research, Cambridge, MA, 2001.

  12 Ross Douthat and Reihan Salam, Grand New Party (New York: Doubleday, 2008), 55.

  13 See Lindsey, “Paul Krugman’s Nostalgianomics.”

  14 See P. Gottschalk and R. Moffitt, �
��The Growth of Earnings Instability in the U.S. Labor Market,” Brookings Papers on Economic Activity 25, no. 2 (1994): 217–72.

  15 See Goldin and Katz, The Race between Education and Technology; Lindsey, “Paul Krugman’s Nostalgianomics.”

  16 See, for example, Nolan McCarthy, Keith Poole, and Howard Rosenthal, Polarized America: The Dance of Ideology and Unequal Riches (Cambridge, MA: MIT Press, 2008).

  17 See Lindsey, “Paul Krugman’s Nostalgianomics,” 10.

  18 See, for example, A. Alesina and E. LaFerrara, “Preferences for Redistribution in the Land of Opportunities,” NBER Working Paper 8267, National Bureau of Economic Research, Cambridge, MA, 2001.

  19 See Alberto Alesina and Edward Glaeser, Fighting Poverty in the US and Europe: A World of Difference (Oxford: Oxford University Press, 2004), 61.

  20 Ibid.

  21 Alexis de Tocqueville, Democracy in America (New York: Doubleday, 1959), 53.

  22 Robert J. Samuelson, “Indifferent to Inequality,” Newsweek, May 7, 2001, 45.

  23 The quote is from a description by Jennifer Hochschild on what her survey respondents believe, from What’s Fair? American Beliefs about Distributive Justice (Cambridge, MA: Harvard University Press, 1981).

  24 See Robert Frank, Falling Behind: How Rising Inequality Harms the Middle Class (Berkeley: University of California Press, 2007).