‘Fault Lines’ by Raghuram G. Rajan

Read our article in the Cayman Financial Review Magazine, eversion 

Much has already been written about the causes and cures of the financial crisis of 2007-8, but little of it provides as deep an insight and breadth as does Raghuram Rajan in his book “Fault Lines: How Hidden Fractures Still Threaten the World Economy1.”

Rajan raises many of the familiar questions:

“What happened to the usual regulatory checks and balances?

What happened to the discipline imposed by markets?

What happened to the private instinct for self-preservation2?”

His answers, rendered in plain English and illustrated with clear and concrete examples, focus on the incentives faced by economic and political actors.

“Somewhat frighteningly, each one of us did what was sensible given the incentives we faced…. Responsibility for some of the more serious fault lines lies not in economics but in politics3.”

“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 fulfil political goals, when it becomes a participant in the 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 the pass: regulators became enamoured of the ideal of the self-regulating market and stood on the sidelines as it self-destructed…. Yet the bulk of the damage was done as the sophisticated financial sector tried to seek an edge that the US government, driven by political compulsions, was only too willing to provide4.”

Rajan presents clear examples of the impact of “tail risk”, in the presence of “we win or the tax payer looses (moral hazard)” on the risks taken in the market and provides concrete suggestions for re-establishing or strengthening market discipline of borrowing and lending behaviour including the problem of “too big to fail”.

“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 generates5.”

The government created the macroeconomic conditions for asset bubbles (low interest rates and excessive credit to borrowers of marginal credit worthiness), overly encouraged home ownership, and then bailed out the mortgage lenders who took on those underpriced risks (thus it was really the tax payers who bore the risks and took the losses).

Why did the government do this? Ragan offers very interesting answers to this question by extending his systematic analysis of incentives to the public/political sector (public choice theory).

“The most important example of the first kind of fault line…is rising income inequality in the United States and the political pressure it has created for easy credit6.”

Rajan attributes rising income inequality largely to an increase in the demand for skilled labour that has outstripped America’s ability to generate an adequate supply. Thus incomes of the well trained have increased significantly relative to untrained, low skill labour.

“The education system has been unable to provide enough of the labour force with the necessary education…. Politicians feel their constituents’ pain but it is very hard to improve the quality of education, for improvement requires real and effective policy change in an area where too many vested interests favour the status quo….

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 develops7.”

Reflecting on our recent financial crisis, Rajan notes that:

“The combination of an activist Congress, government-supported private firms hungry for profits, and a weak and pliant regulator proved disastrous8.”

The solution to growing income inequality is not, according to Rajan, to redistribute it, which would undermine the source of our wealth, but to improve education and strengthen our social safety net. He offers specific and practical suggestions for doing so. Failure to do so, he says, risks undermining the social consensus upon which the American system of capitalism is built.

“Envy has historically been un-American, largely because it was checked by self-confidence. As self-confidence withers, can envy, and its close cousin, hatred, be far behind9?”

Rajan’s rigorous analysis of the rationality of behaviour given the incentives faced makes his discussion more interesting and plausible than most, but he does not stop there.

“Why,” he asks, “are poorer developing countries like China financing the unsustainable consumption of rich countries like the United States10?”

Having been the Economic Counsellor and Director of the Research Department of the International Monetary Fund from 1 October, 2003 to 29 December, 2006, it is not surprising that Rajan provides a detailed and clear explanation of the contribution of global imbalances (large foreign trade deficits and surpluses) to the housing bubbles in the US, UK, Spain and a few other countries. This is the third major fault line.

Currently the IMF only has leverage to encourage countries with balance of payments deficits to make the exchange rate or macroeconomic policy adjustments needed to achieve better external balance. When deficit countries run out of foreign exchange reserves for defending their exchange rate they often turn to the IMF for funds (“balance of payments support”).

IMF lending of foreign currency reserves to such countries is conditional on their making the necessary policy adjustments and structural reforms. Surplus countries don’t need to borrow from the IMF and can thus ignore IMF advice.

Rajan recommends expanding the IMF’s audience to whom it presents its analysis and policy recommendations from country officials to the general public in order to build bottom up support for the adjustments needed.

Rajan’s discussion of the causes and consequences of the crisis and his suggested policies for reducing the risks of repeats in the future are thoughtful and thought provoking. His text is accessible to the layman, who should find it easy reading, but a second careful reading will reveal deeper insights as well.

His analysis is strongest and most compelling with regard to the fault lines in the financial sector and weakest – because too brief – when discussing education and the social safety net. But readers will quickly see why this book was the Financial Times winner of its Business Book of 2010 award.

Endnotes:
Princeton University Press, (Princeton and Oxford), 2010.

  1. Page 4.
  2. Page 4-5.
  3. Page 228.
  4. Page 228.
  5. Page 8.
  6. Page 8-9.
  7. Page 35.
  8. Page 30.
  9. Page 7.

 

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