Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  7 See David Backus and Jonathan Wright, “Cracking the Conundrum,” New York University Working Paper, New York, 2007.

  8 See Claudio Borio and Haibin Zhu, “Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism?” Bank of International Settlements Working Paper 268, Basel, 2009; Raghuram Rajan, “Has Financial Development Increased Risk Taking?” Proceedings of the Jackson Hole Conference (Kansas City, MO: Federal Reserve Bank of Kansas City, August 2005), 313–69.

  9 I thank Rakesh Mohan, former deputy governor at the Reserve Bank of India, for pointing out this trend to me.

  10 P. Gourinchas and H. Rey, “From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege,” NBER Working Paper 11563, National Bureau of Economic Research, Cambridge, MA, 2005.

  11 B. Bernanke, M. Gertler, and S. Gilchrist, “The Financial Accelerator and the Flight to Quality,” Review of Economics and Statistics 78, no. 1 (February 1996): 1–15.

  12 Studies using detailed banking data now show that low interest rates cause riskier lending. See G. Jimenez, S. Ongenga, J. Peydro, and J. Saurina, “Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say about the Effects of Monetary Policy on Credit Risk?” CEPR Discussion Paper No. 6514, Center for Economic Policy Research, London, 2007; V. Ionnadou, S. Ongenga, and J. Peydro, “Monetary Policy, Risk Taking and Pricing: Evidence from a Quasi-Natural Experiment,” paper presented at IMF Annual Research Conference, Washington, DC, November 2008.

  13 See Raghuram G. Rajan, “Investment Restraint, the Liquidity Glut, and Global Imbalances,” remarks presented at the Conference on Global Imbalances, Bali, Indonesia, November 16, 2006.

  14 See. A. Shleifer and R. Vishny, “The Limits of Arbitrage,” Journal of Finance 52, no. 1 (1997): 35–55, for a theory as to why arbitrageurs may find it difficult to bring asset prices back in line even without short-sales constraints.

  15 See Claudio Borio and Philip Lowe, “Asset Prices, Financial and Monetary Stability: Exploring the Nexus,” BIS Working Paper 114, Bank for International Settlements, Basel, July 2002.

  16 See, for example, Bernanke, “Asset Price Bubbles and Monetary Policy.”

  17 Alan Greenspan, speech at the American Enterprise Institute, December, 5, 1996.

  18 Alan Greenspan, The Age of Turbulence: Adventures in a New World (New York: Penguin Press, 2007), 176–78

  19 Alan Greenspan, “Opening Remarks,” Federal Reserve Bank of Kansas City symposium, Jackson Hole, WY, August 2002.

  20 Ben Bernanke, “Monetary Policy and the Housing Bubble,” speech delivered at the annual meeting of the American Economic Association, January 3, 2010.

  21 Marek Jarocinski and Frank Smets, “House Prices and the Stance of Monetary Policy,” Federal Reserve Bank of St. Louis Review 90, no. 4 (July–August 2008): 319–65.

  22 However, studies have identified a clear relationship between the level of interest rates and the level of house prices across countries.

  Chapter Six. When Money Is the Measure of All Worth

  1 This example relies on Peter Hoffman, Gilles Postel-Vinay, and Jean-Laurent Rosenthal, Surviving Large Losses: Financial Crises, the Middle Class, and the Development of Capital Markets (Cambridge, MA: Belknap Press, 2007), 149–51.

  2 Adam Smith, An Inquiry into the Causes of the Wealth of Nations (Chicago: University of Chicago Press, 1976), 18.

  3 Dan Ariely, Emir Kamenica, and Dražen Prelec, “Man’s Search for Meaning: The Case of Legos,” Journal of Economic Behavior and Organization 67, no. 3 (September 2008): 671–77.

  4 See James Chanos, “Prepared Statement: U.S. Securities and Exchange Commission Roundtable on Hedge Funds,” U.S. Securities and Exchange Commission, www.sec.gov/spotlight/hedgefunds/hedge-chanos.htm, accessed March 10, 2010.

  5 Jill Riepenhoff and Doug Haddox, “Risky Refinancings Deepen Financial Hole,” Columbus Dispatch, June 2, 2008.

  6 See Allen Frankel, “The Risk of Relying on Reputational Capital: A Case Study of the 2007 Failure of New Century Financial,” BIS Working Paper 294, Bank for International Settlements, Basel, 2009.

  7 James R. Hagerty, Ruth Simon, Michael Corkery, and Gregory Zuckerman, “Home Stretch: At a Mortgage Lender, Rapid Rise, Faster Fall,” Wall Street Journal, March 12, 2007.

  8 Riepenhoff and Haddox, “Risky Refinancings.”

  9 For arguments and evidence along these lines, see U. Rajan, A. Seru, and V. Vig, “The Failure of Models That Predict Failure: Distance, Incentives and Defaults,” University of Chicago working paper, 2009.

  10 Even the credit score of a borrower could be “managed,” with arrangements sometimes being made for a borrower to piggyback, for a fee, on the loan of a stranger with higher credit quality. See Frankel, “The Risk of Relying on Reputational Capital”; David Streitfield, “In Appraisal Shift, Lenders Gain Power and Critics,” New York Times, August 19, 2009.

  11 Riepenhoff and Haddox, “Risky Refinancings.”

  12 Bradley Keoun and Steven Church, “New Century, Biggest Subprime Casualty, Goes Bankrupt,”Bloomberg.com, www.bloomberg.com/apps/news?pid=20601087& refer=home&sid=aXHDSbOcAChc, accessed March 10, 2010.

  13 See Atif Mian and Amir Sufi, “The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis,” Quarterly Journal of Economics 124, no. 4 (November 2009): 1449–96.

  14 For a model of how volume can swamp incentives, see Andrei Shleifer and Robert Vishny, “Unstable Banking,” NBER Working Paper 14943, National Bureau of Economic Research, Cambridge, MA, 2009.

  15 See Frankel, “The Risk of Relying on Reputational Capital.”

  16 Peter Wallison, “Barney Frank: Predatory Lender,” Wall Street Journal, October 16, 2009.

  Chapter Seven. Betting the Bank

  1 This example borrows from Joshua Coval, Jakub Jurek, and Erik Stafford, “The Economics of Structured Finance,” Harvard Business School Working Paper 09–060, Cambridge, MA, 2008.

  2 Tim Rayment, “The Man with the Trillion Dollar Price on His Head,” Sunday Times, May 17, 2009.

  3 Ibid.

  4 Shareholder Report on UBS’s Writedowns, UBS, Zurich, April 18, 2008.

  5 See the colorful account in Lawrence McDonald and Patrick Robinson, A Colossal Failure of Common Sense (New York: Crown Business, 2009).

  6 Eric Dash and Julie Creswell, “The Rush to Riches that Undid Citigroup: Banking Giant’s Management Failed to Monitor the Risks Tied to Its Deals,” International Herald Tribune, November 24, 2008.

  7 Andrew Ellul and Vijay Yerramilli, “Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies,” Indiana University working paper, Bloomington, 2010. Available at Social Science Research Network, http://ssrn.com/abstract=1550361.

  8 Rudiger Fahlenbrach and Rene Stulz, “Bank CEO Incentives and the Credit Crisis,” NBER Working Paper 15212, National Bureau of Economic Research, Cambridge, MA, July 2009.

  9 McDonald and Robinson, Colossal Failure.

  10 Calvin Trillin, “Wall Street Smarts,” New York Times, October 14, 2009.

  11 Ibid.

  12 Thomas Philippon and Ariell Reshef, “Wages and Human Capital in the U.S. Financial Industry: 1909–2006,” NBER Working Paper 14644, National Bureau of Economic Research, Cambridge, MA, 2009.

  13 See R. Rajan, “Why Bank Credit Policies Fluctuate: A Theory and Some Evidence,” Quarterly Journal of Economics 109, no. 2 (May 1994): 399–441.

  14 Andrew Ross Sorkin, Too Big to Fail (New York: Viking, 2009), 145.

  15 Michiyo Nakamoto and David Wighton, “Citigroup Chief Stays Bullish on Buyouts,” Financial Times, July 9, 2007.

  16 Gillian Tett, Fool’s Gold (New York: Free Press, 2009), 144–45.

  17 Ibid., 112–13.

  18 I. Cheng, H. Hong, and J. Scheinkman, “Yesterday’s Heroes: Compensation and Creative Risk Taking,” working paper, Princeton University, 2009.

  19 Steve Fishman, “Burning Down
His House: Is Lehman CEO Dick Fuld the True Villain in the Wall Street Collapse?” New York magazine, November 30, 2008, nymag.com/news/business/52603/index3.html#ixzz0XFCXEyhZ.

  20 Sorkin, Too Big to Fail, 273.

  21 Andrea Beltratti and Rene Stulz, “Why Did Some Banks Perform Better during the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation,” NBER Working Paper 15180, National Bureau of Economic Research, Cambridge, MA, July 2009.

  22 See editorial, “‘No Line Responsibilities’: What Robert Rubin Did for His $115 Million,” Wall Street Journal, December 3, 2008, http://online.wsj.com/article/SB1228266 32081174473.html.

  23 See Viral V. Acharya, Thomas Cooley, Matthew Richardson, and Ingo Walter, “Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–09,” working paper, New York University Stern School of Business, 2009.

  24 Caroline Baum, “Fed Should Read Its Own Memo on Rising-Rate Risk,” Bloomberg.com, January 19, 2010, www.bloomberg.com/apps/news?pid=20601039&sid=aygo_Qm9sZ9I.

  25 See Tom Braithwaite, “Banks Face Probe over Trading in Tarp Frenzy,” Financial Times, February 1, 2010.

  26 Ibid.

  27 Henry Paulson, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System (New York: Business Plus, 2009), 293.

  28 D. Diamond and R. Rajan, “Fear of Firesales and Credit Freezes,” NBER Working Paper 14925, National Bureau of Economic Research, Cambridge, MA, 2009.

  Chapter Eight. Reforming Finance

  1 Matt Taibbi, “Inside the Great American Bubble Machine,” Rolling Stone, July 2, 2009.

  2 See the discussion in Donncha Marron, Consumer Credit in the United States: A Sociological Perspective from the 19th Century to the Present (New York: Palgrave Macmillan, 2009), 3–5.

  3 Benjamin Franklin, The Way to Wealth, Wealth Reader, wealthreader.com/book/the_way_to_wealth/1, accessed March 10, 2010 (italics in original).

  4 See Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government (Oxford: Oxford University Press, 1987), 179.

  5 For an excellent paper on tail risk, see Viral V. Acharya, Thomas Cooley, Matthew Richardson, and Ingo Walter, “Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–09,” working paper, New York University Stern School of Business, 2009.

  6 Raghuram Rajan, “Bankers’ Pay Is Deeply Flawed,” Financial Times, January 9, 2008.

  7 Dennis Berman, “Where Was Lehman’s Board?” Wall Street Journal, September 15, 2008, blogs.wsj.com/deals/2008/09/15/where-was-lehmans-board/.

  8 The ideas on disclosure are based on a working paper by the Squam Lake Working Group on Financial Regulation, “A New Information Structure for Financial Markets,” Council on Foreign Relations, www.cfr.org/publication/18568/new_information _infrastructure_for_financial_markets.html, February 2009.

  9 See Andrew Ross Sorkin, Too Big to Fail (New York: Viking, 2009), 304.

  10 See D. Diamond and R. Rajan, “Illiquidity and Interest Rate Policy,” NBER Working Paper 15197, National Bureau of Economic Research, Cambridge, MA, 2009.

  11 This is a proposal made by the Squam Lake Group in its forthcoming report, to be published by Princeton University Press.

  12 Banks should benefit by committing to their clients that they will not trade using their information or against their interests. Some boutique investment banks use the fact they have no conflicts of interest as a selling point. Perhaps this trend will catch on, in which case regulation will be unnecessary.

  13 For a detailed explanation of why equity capital is costly in banks, those familiar with the Modigliani-Miller theorem can consult D. Diamond and R. Rajan, “A Theory of Bank Capital,” Journal of Finance 55, no. 6 (December 2000): 2431–65.

  14 See the proposal “An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities,” Council on Foreign Relations, www.cfr.org/ publication/19002/expedited_resolution_mechanism_for_distressed_financial_firms.html, April 2009.

  15 See A. Kashyap, R. Rajan, and J. Stein, “Rethinking Capital Regulation,” paper prepared for the Federal Reserve Bank of Kansas City symposium “Maintaining Stability in a Changing Financial System,” Jackson Hole, WY, August 21–23, 2008.

  16 See Aaron Wildavsky, Searching for Safety (New Brunswick, NJ: Transaction Books, 1988).

  17 See Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, “Perspectives on the Recent Financial Market Turmoil,” speech at the 2008 Institute of International Finance Membership Meeting, Rio de Janeiro, Brazil, March 5, 2008.

  18 See, for example, the proposed House Financial Regulatory Reform Bill of 2009.

  19 See Sorkin, Too Big to Fail, 490.

  20 Prime Reserves, a money-market fund, suffered losses on its Lehman debt holdings after the Lehman collapse. Because it paid out $1 for every dollar invested instead of the $0.97 or so that the investments were now worth, investors rushed to the exit to avoid being forced to bear the losses. If the fund had marked its assets to market and paid out only $0.97, there would have been less of a panic. Again, in a crisis, perhaps no asset is safe without a government guarantee, including money-market funds that are invested in anything other than Treasury bills.

  21 I thank Viral Acharya for suggesting this term.

  22 Louis D. Brandeis to Robert W. Bruere, Columbia Law Review 31 (1922): 7.

  23 Louis D. Brandeis, Other People’s Money: And How the Bankers Use It (Washington, DC: National Home Library Foundation, 1933), 62.

  Chapter Nine. Improving Access to Opportunity in America

  1 Alberto Alesina and George-Marios Angeletos, “Corruption, Inequality and Fairness,” working paper, Harvard Institute of Economic Research, Harvard University, 2005.

  2 See R. Rajan, “Rent Preservation and the Persistence of Underdevelopment,” American Economic Journal: Macroeconomics 1, no. 1 (January 2009): 178–218.

  3 This section relies extensively on R. Haskin and I. Sawhill, Creating an Opportunity Society (Washington, DC: Brookings Institution Press, 2009), and J. Heckman and A. Krueger, Inequality in America (Cambridge, MA: MIT Press, 2005).

  4 David Barker, “In Utero Programming of Chronic Disease,” Clinical Science 95, no. 2 (1998): 115–28; David Barker, “Maternal and Fetal Origins of Coronary Heart Disease,” Journal of Royal College of Physicians 28, no. 6 (1994): 544–51; David Barker, “The Fetal Origins of Adult Hypertension,” Journal of Hypertension Supplement 10, no. 7 (1992): S39–44.

  5 James Heckman, “Lessons from the Bell Curve,” Journal of Political Economy 103, no. 5 (1995): 1091–120.

  6 Haskins and Sawhill, Creating an Opportunity Society, 134.

  7 See Santiago Levy, Progress against Poverty: Sustaining Mexico’s Progresa-Oportunidades Program (Washington, DC: Brookings Institution Press, 2006).

  8 James S. Coleman, Educational Equality of Opportunity, U.S. Department of Health, Education, and Welfare, 1966.

  9 James Heckman, “Schools, Skills, and Synapses,” NBER Working Paper 14064, National Bureau of Economic Research, Cambridge, MA, 2008.

  10 Heckman and Krueger, Inequality in America, 95; S. Bowles and H. Gintis, Schooling in Capitalist America (New York: Basic Books, 1976).

  11 J. Coleman and T. Hoffer, Public and Private High Schools (New York: Basic Books, 1983).

  12 See Haskin and Sawhill, Creating an Opportunity Society, 144–45.

  13 Barack Obama, speech at Democratic National Convention, quoted in Washington Post, July 27, 2004, www.washingtonpost.com/wp-dyn/articles/A19751-2004 Jul27.html.

  14 Anthony Bryk, Penny Bender Sebring, Elaine Allensworth, Stuart Luppescu, and John Easton, Organizing Schools for Improvement: Lessons from Chicago (Chicago: University of Chicago Press, 2009).

  15 Doris Entwisle, Karl Alexander, and Linda Olsen, Children, Schools, and Inequality (Boulder, CO: Westview, 1997).

  16 Alan Krueger, “Inequality: Too Much of a Good Thing,” in Heckman and Krueger, Inequality in A
merica.

  17 Much of what follows is based on the report of the Teaching Commission, a private nonpartisan group chaired by Lou Gerstner, former CEO of IBM. Their 2004 report “Teaching at Risk: A Call to Action” can be found at www.csl.usf.edu/teaching%20at%20risk.pdf.

  18 See Atila Abdulkadiroglu, Joshua Angrist, Susan Dynarski, Thomas Kane, and Parag Pathak, “Accountability and Flexibility in Public Schools: Evidence from Boston’s Charters and Pilots,” NBER Working Paper 15549, National Bureau of Economic Research, Cambridge, MA, 2009.