Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

One set of fault lines stems from domestic political stresses, especially in the United States. Almost every financial crisis has political roots, which no doubt differ in each case but are political nevertheless, for strong political forces are needed to overcome the checks and balances that most industrial countries have established to contain financial exuberance. The second set of fault lines emanates from trade imbalances between countries stemming from prior patterns of growth. The final set of fault lines develops when different types of financial systems come into contact to finance the trade imbalances: specifically, when the transparent, contractually based, arm's-length financial systems in countries like the United States and the United Kingdom finance, or are financed by, less transparent financial systems in much of the rest of the world.

We have long understood that it is not income that matters but consumption. Stripped to its essentials, the argument is that if somehow the consumption of middle-class householders keeps up, if they can afford a new car every few years and the occasional exotic holiday, perhaps they will pay less attention to their stagnant monthly paychecks.

Therefore, the political response to rising inequality—whether carefully planned or an unpremeditated reaction to constituent demands—was to expand lending to households, especially low-income ones.

The problem stems from the fundamental incompatibility between the goals of capitalism and those of democracy. And yet the two go together, because each of these systems softens the deficiencies of the other.

this was a market driven largely by government, or government-influenced, money.

The problem with using the might of the government is rarely one of intent; rather, it is that the gap between intent and outcome is often large, typically because the organizations and people the government uses to achieve its aims do not share them.

Relative to other industrial countries like Ireland, Spain, and the United Kingdom, all of which had house-price booms that turned to busts, U.S. house prices overall were nowhere as high relative to fundamentals.48 But the boom was concentrated in those least able to afford the bust. The U.S. boom was different, at least in its details.

Populism and credit are familiar bedfellows around the world.

Generally, institutions seem to develop along with, and in response to, the need for them.

But because the protected Indian domestic market was large, at least relative to that of the typical late developer, firms were perfectly happy exploiting their home base despite government attempts to encourage exports.

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.

Second, the Fed actively encouraged the financial markets to believe it would follow an asymmetric policy: it would not lean against a potential unsustainable rise in asset prices, but it would remain ready to pick up the pieces if a bubble burst.

Greenspan put

In his autobiography, Greenspan admits wondering whether the market would understand what he was getting at.18 It did—and ignored him!

But there does seem to be some incompatibility between the monetary policies that encourage real investment and growth—maintaining predictably low interest rates over a sustained period and expressing a willingness to flood the market with liquidity when it is tight—and the monetary policies that discourage the coordinated one-way bets by financial market participants that have proved so damaging—pursuing unpredictable policies with no assurance of liquidity support.

Finally, it is not clear that ultralow nominal interest rates (around 0 percent) offer a significantly greater incentive for firms to invest than merely low interest rates (2 to 3 percent), but the difference in risk taking between ultralow and low interest rates could be enormous.

the model is a useful simplification or an oversimplification.

The edge the financial sector exploited was the unthinking, almost bureaucratic, way both the mortgage agencies and foreign investors evaluated the issued securities.

Financial sector performance, especially in an arm's-length system where the financier does one-off transactions and rarely has a long-term relationship with the final customer, can often only be measured by how much money the financier makes.

Somewhat ironically, the developing country central banks did to the United States what foreign investors had done to them in their own crises.

Aggressive pay practices seem to have gone together with aggressive risk taking and subsequent poor performance during the crisis, much as my earlier discussion suggests.

In the jargon of economists, that the market is believed to have rational expectations about events does not mean that it has perfect foresight.

However, it is not competition per se, but rather the distorted banker incentives and the distorted price of risk that led to the creation of these instruments.

For instance, the Squam Lake Working Group (a non-partisan group convened by Professor Ken French of Dartmouth College after the recent crisis to propose reforms) has suggested not only holding back some portion of top management bonuses and reducing them if there are future losses—much like the clawbacks I discussed earlier—but also writing these “holdbacks” down if the firm has to be bailed out in any way. Thus the holdbacks would serve as junior equity and give strong incentives to management to take precautions to avoid a bailout.

the exercise of monetary policy should be rethought to take into account its effects on risk taking by the private sector.

The best way to keep institutions from becoming systemically important might not be through crude prohibitions on size or activity but through the collecting and monitoring by regulators of information about interinstitution exposures as well as risk concentrations in the system.

Cognitive capture is a better description of this phenomenon than crony capitalism.

American overconsumption is driven by policies that were framed in reaction to growing public perceptions of inequality and insecurity, and these policies have contributed to financial-sector excess.

The United States does not have the political weaknesses of the Weimar Republic, but the broader point is that without global economic cooperation when change is needed, countries could descend into opportunistic nationalism to the detriment of the global economy and the global political environment. Nationalism, coupled with great faith in the power of the government to enact domestic bargains between labor and capital, has been seen before: it was called fascism then. It is a development to be avoided at all costs.

Cf economic nationalism

When strong, multilateral organizations have not been independent; and when independent, they have been largely irrelevant. The growing power of developing countries like China and India is unlikely to change this situation because they too have little desire for their policies to be scrutinized.

Because other Asian economies also intervene in their currency's exchange rates and subsidize their exporters to remain competitive with China, poor households across Asia are effectively taxed to transfer benefits to exporters and are thus subsidizing the consumption of rich households in industrial countries. This situation is neither efficient nor fair.