Fault Lines: How Hidden Fractures Still Threaten The World Economy

by Raghuram G. Rajan

Responsibility for some of the more serious fault lines lies not in economics but in politics.

The gravy train eventually came to a halt after the Federal Reserve raised interest rates and halted the house price rise that had underpinned the frenzied lending. Subprime mortgage-backed securities turned out to be backed by much riskier mortgages than previously advertised, and their value plummeted. The seemingly smart bankers turned out to have substantial portions of these highly rated but low-quality securities on their balance sheets, even though they must have known what they contained. And they had financed these holdings with enormous amounts of short-term debt. The result was that short-term creditors panicked and refused to refinance the banks when their debts came due. Some of the banks failed; others were bailed out even as the whole system tottered on the brink of collapse. Economies across the world went into a deep slump from which they are recovering slowly.

Cynical as it may seem, easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly.

But when easy money pushed by a deep-pocketed government comes into contact with the profit motive of a sophisticated, competitive, and amoral financial sector, a deep fault line develops.

Excessive rural credit was one of the important causes of bank failure during the Great Depression.

the ability of these countries to supply the goods reflects a serious weakness in the growth path they have followed—excessive dependence on the foreign consumer. This dependence is the source of the second fault line.

But so long as large countries like Germany and Japan are structurally inclined—indeed required—to export, global supply washes around the world looking for countries that have the weakest policies or the least discipline, tempting them to spend until they simply cannot afford it and succumb to crisis.

Therefore, even though these economies grew extraordinarily fast to reach the ranks of the rich, as their initial advantage of low wages disappeared and exports became more difficult, their politically strong but very inefficient domestic-oriented sector began to impose serious constraints on internally generated growth. Not only is it hard for these economies to grow on their own in normal times, but it is even harder for them to stimulate domestic growth in downturns without tremendously wasteful spending. The natural impulse of the government, when urged to spend, is to favor influential but inefficient domestic producers, which does little for long-run growth. Therefore, these countries have become dependent on foreign demand to pull them out of economic troughs.

And China, which is likely to be the world’s largest economy in the not too distant future, is following a dangerously similar path. It has to make substantial policy changes if it is not to join this group as an encumbrance on, rather than an engine of, world economic growth.

Even export-led developing countries thus initially helped absorb the excess supply from the rich exporters. But developing countries experienced a series of financial crises in the 1990s that made them realize that borrowing large amounts from industrial countries to fund investment was a recipe for trouble. In Chapter 3, I explain why these economies moved from helping to absorb global excess supply to becoming net exporters themselves and contributing to the problem: essentially, their own financial systems were based on fundamentally different principles from those of their financiers, and the incompatibility between the two, the source of the fault line, made it extremely risky for them to borrow from abroad to support investment and growth.

In politics, economic recovery is all about jobs, not output, and politicians are willing to add stimulus, both fiscal (government spending and lower taxes) and monetary (lower short-term interest rates), to the economy until the jobs start reappearing.

it would be a brave Federal Reserve chairman who defied politicians by raising interest rates before jobs started reappearing. Indeed, part of the Federal Reserve’s mandate is to maintain high employment. Moreover, when unemployment stays high, wage inflation, the primary concern of central bankers today, is unlikely, so the Fed feels justified in its policy of maintaining low interest rates.

How did tremors on all the fault lines come together in the U.S. financial sector to nearly destroy it? I focus on two important ways this happened. First, an enormous quantity of money flowed into low-income housing in the United States, both from abroad and from government-sponsored mortgage agencies such as Fannie Mae and Freddie Mac. This led to both unsustainable house price increases and a steady deterioration in the quality of mortgage loans made. Second, both commercial and investment banks took on an enormous quantity of risk, including buying large quantities of the low-quality securities issued to finance subprime housing mortgages, even while borrowing extremely short term to finance these purchases.

Put differently, the central problem of free-enterprise capitalism in a modern democracy has always been how to balance the role of the government and that of the market.

We also have to recognize that good economics cannot be divorced from good politics: this is perhaps a reason why the field of economics was known as political economy.

Education plays a far greater role than simply improving an individual’s income and career prospects: it has intrinsic worth of its own, allowing us to make use of our finer faculties. In addition, studies show that the educated typically take better care of their own health, are less prone to indulging in criminal activities, and are more likely to participate in civic and political activities. Moreover, they influence their children to do the same, so that their education has beneficial effects on future generations also. So as it falls behind in education, America is diminishing the quality of its society.

The period leading up to the Great Depression was also a time of great credit expansion and, perhaps not coincidentally, one of substantial income inequality.

As housing boomed, the agencies found the high rates available on low-income lending particularly attractive, and the benign environment and the lack of historical experience with low-income lending allowed them to ignore the additional risk.

Unfortunately, the private sector, aided and abetted by agency money, converted the good intentions behind the affordable-housing mandate and the push to an ownership society into a financial disaster.

The greater expansion in mortgage lending to subprime ZIP codes is associated with higher house-price growth in those ZIP codes. Indeed, over the period 2002—2005 and across ZIP codes, house-price growth was higher in areas that had lower income growth (because this is where the lending was focused). Unfortunately, therefore, all this lending was driving house prices further away from the fundamental ability of household income to support repayment. The consequence of all this lending was more default.

Nevertheless, subprime lending and the associated subprime mortgage-backed securities were central to this crisis. Without any intent of absolving the brokers and the banks who originated the bad loans or the borrowers who lied about their incomes, we should acknowledge the evidence suggesting that government actions, however well intended, contributed significantly to the crisis.

But for a while, the problems were hidden by growing house prices and low defaults—easy credit masked the problems caused by easy credit— until house prices stopped rising and the flood of defaults burst forth.

You cannot simply buy a complicated, high-speed machine tool and hire a smart operator to run it: you need a whole organization surrounding that operator if the machine is to be put to productive use. You need reliable suppliers to provide the raw materials, buyers to take the output from the tool and use it in their production lines, managers to decide the mix of products that will be made, a maintenance team to take care of repairs, a purchasing team to deal with suppliers, a marketing team to deal with buyers, a security outfit to guard the facility at night, and so on.

Joseph Schumpeter argued that capitalism grew through innovation, with newcomers bringing in creative new processes and techniques that destroyed the businesses of old incumbents.

India had among the lowest import tariffs in the world in 1880. As a result, India’s private sector simply did not have the encouragement or the requisite cover behind which to develop organizational capital.

Their strategy for advancement, though, was clear: climb the same ladder the rich countries had done, step by step, moving from the least sophisticated technologies to the frontier of innovation, using low labor costs to stay competitive until technologies improved and the available capital stock, including human capital, increased.

The primary role of the government is to ensure that the superstructure that facilitates private activity—including public security, the functioning of markets, and the enforcement of contracts—functions efficiently.

The export-led growth strategy does not mean that government reduces its support to industry. Indeed, exports may initially require more support if domestic firms are to be competitive globally. Some countries have provided a general subsidy by maintaining an undervalued exchange rate or holding down wages by suppressing or co-opting unions;

Although Nehru reserved industries like steel and heavy machinery for the state sector, he never actively suppressed the private sector. Instead, a system of licensing—the infamous “license-permit raj”—was put in place, ostensibly to use the country’s savings carefully. This meant guiding investment away from industries that bureaucrats thought were making unnecessary consumer goods (even durable ones such as cars), and instead into areas that could lay the basis for future growth, such as heavy machinery.

After growing rapidly just after independence, the Indian economy got stuck at a per capita real growth rate of about 1 percent—dubbed the “Hindu” rate of growth.

there was a much higher positive correlation between a country’s investment and its savings than one might expect if capital flowed freely across countries.

We found a positive correlation for developing countries: the more a country finances its investment through its own domestic savings, the faster it grows. Conversely, the more foreign financing it uses, the more slowly it grows.

Interestingly, these relationships did not hold for developed countries. Developing countries, at least the ones that grew fast on a sustained basis, seemed to avoid significant foreign financing.

The classic ingredients for a bust were in place: excessive investment financed with short-term debt, with the additional risk of a foreign-currency mismatch.

there is still a short-run trade-off between growth and inflation, stemming from the notion that every economy has a potential growth rate—an inbuilt maximum safe speed. Make the economy go any faster, and wages and inflation start accelerating because demand exceeds productive capacity; slow it down, and wages and inflation start falling.

Long-term interest rates are extremely important in the economy. A lower long-term interest rate increases the value of long-term assets such as equity, bonds, and houses because dividends, interest payments, and the services provided by the house are discounted at a lower rate. It thus increases household wealth and, consequently, spending. A low long-term interest rate also makes it less attractive for households to save and more attractive to consume, thus again contributing to demand.

A debt crisis could have caused a downward spiral of bankruptcies, job losses, and fire sales that might have triggered a deflation. But the effects of a stock meltdown were, and historically have been, much milder.

the Taylor rule (an empirical characterization of past Federal Reserve interest-rate policy, which sees the short-term policy rate as a function of the inflation rate and the gap between the output the economy is capable of and what it actually produces),

Low short-term interest rates pushed investors to take more risk, for a number of reasons.8 Some institutions, like insurance companies and pension funds, had contracted long-term liabilities. At the low interest rates available for safe assets, they had no hope of meeting those liabilities. Rather than falling short for sure, they preferred to move into longer-term riskier bonds, such as mortgage-backed securities, that paid higher interest rates.

One effect of the search for yield was that money moved out of the United States into other countries, especially into the high-yielding bonds, stocks, and government securities in developing countries. But many of these countries were fearful of losing out in the race to supply goods to the U.S. market. Their central banks intervened to hold down the value of their currency by buying the U.S. dollars that were flowing into their countries from the domestic private entities that had acquired them and reinvesting these dollars in short-term U.S. government bonds and agency bonds.9 Thus, even as the Fed pushed dollars out, central banks in developing countries pushed them back in.

In some ways, Federal Reserve policy was turning the United States into a gigantic hedge fund, investing in risky assets around the world and financed by debt issued to the world.10

Banks, in turn, packaged the loans they made—creating collateralized loan obligations (CLOs) – and sold debt securities against them, thus obtaining the funds to make yet more loans.

Thus the money pushed out to developing countries by the Fed’s low-interest policy came back to help expand the agencies’ purchase of subprime mortgage-backed securities. Knowing that the agencies enjoyed the implicit guarantee of the government, the foreign central banks really did not care about the risks the agencies took.

Some smart traders in a number of banks understood and grew increasingly concerned by the risks that were being taken by the units creating and holding asset-backed securities. At Lehman, for example, fixed-income traders started selling these securities short, even while the real estate and mortgage unit loaded up on them.

Risk managers should adjust every unit’s returns down for the risk it takes, reducing perverse incentives to take risk.

In many of the aggressive firms that got into trouble, risk management was used primarily for regulatory compliance rather than as an instrument of management control. At Citigroup, for example, risk managers sometimes reported to operational heads who were responsible for revenue, putting the fox in charge of the chicken coop.

The dynamic associated with systemic risk exposures then kicks in: if everyone is exposed to the same risk in a big way, the authorities have no option but to intervene to support banks and the market if the risk materializes—in which case a bank maximizes profits by increasing exposure to the risk.

We have to recognize that because all areas of the financial sector are intimately interconnected, it is extremely hard to create absolutely safe areas and imprudent to ignore what happens outside supposedly safe areas.

actually favor tail risk taking if the financial firm’s equity cushion is thin relative to the size of the firm: they have little to lose. So a larger capital cushion is necessary to deter risk taking.

But neither equity holders nor debt holders will worry much once risk taking becomes so systemic that the market comes to rely on government intervention to prop up markets when the risk hits.