Fault lines

Author: Rajan, Raghuram G.

• I eventually realized that I was committing the economist’s cardinal sin of assuming ceteris paribus, that is, assuming that everything else but the phenomenon being studied, in this case securitization, remained the same.

• In the late 1990s, that someone else was corporations in industrial countries that were on an investment spree, especially in the areas of information technology and communications. Unfortunately, this boom in investment, now called the dot-com bubble, was followed by a bust in early 2000, during which these corporations scaled back dramatically on investment.

• 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.

• Perhaps the most important is that although in the United States technological progress requires the labor force to have ever-greater skills—a high school diploma was sufficient for our parents, whereas an undergraduate degree is barely sufficient for the office worker today—the education system has been unable to provide enough of the labor force with the necessary education.

• 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.

• 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.

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

• Through the late 1990s and the 2000s, though, a significant portion of the increase in U.S. household demand was met from abroad, from countries such as Germany, Japan, and, increasingly, China, which have traditionally relied on exports for growth and had plenty of spare capacity to make more. But, as I argue in Chapter 2, 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.

• 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.

• Public financial information is very limited, perhaps because the government and banks directed the flow of financing during the growth phase and did not need, or want, public oversight then.

• This means that outside financiers, especially foreigners, have little access to the system. Indeed, this barrier is what makes the system work, because if borrowers could play one lender off against another, as in the arm’s-length competitive system, enforcement would break down.

• Rather than borrow from abroad to finance their investment, their governments and corporations decided to abandon grand investment projects and debt-fueled expansion.

• Jobless recoveries are particularly detrimental because the prolonged stimulus aimed at forcing an unwilling private sector to create jobs tends to warp incentives, especially in the financial sector. This constitutes yet another fault line stemming from the interaction between politics and the financial sector, this time one that varies over the business cycle.

• 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.

• 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.

• 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.