Book: Fault Lines
Author: Raghuram Rajan
This is an easy book to love. Most of us have read several books on the 2008 financial crisis and why it came about (reasons abound from use of credit derivatives to lack of leadership). But, this book takes a slightly bigger sweep of history and talks about the underlying problems in the economic structure that caused the problem, and of course the ones that still remain. This quote in the book is key to the students of this crisis – “Somewhat frighteningly, each one of us did what was sensible given the incentives we faced.” Rajan shows that, as usual, reality is more complex, and there are few easy villains.Rajan explains several concepts so well in the book that it will be shame for me to rephrase them. Hence, more so in this book summary than others, I have copied several lines directly from the book. This is only to preserve clarity of Rajan’s thought, and not for any other reason. I don’t get any advertising share from wordpress.
Why did the Fed keep the interest rate so low for so long?
Many people cite this as a big problem behind the subprime bubble and cite how Fed’s policy was out of step with the Taylor Rule. But, the rule is merely an estimate and the ideal rate is often a reasonable guess.
The ideal central-bank policy is to keep the economy perpetually at its potential growth rate. When the potential growth rate is reached, the economy is effectively at maximum sustainable employment, and any effort to further accelerate growth causes inflation. But, no one really knows what the potential growth rate is, though they have reasonable guesses. And this rate can change if the structure of the economy changes, for example, if the industries that are dominant in the economy change. The best indicator for a central banker is inflation. But, U.S. faced benign inflation. The Fed kept adding stimulus to a world economy that was growing strongly, with jobs being created elsewhere but not in the United States. Commodity prices around the world started a steady rise, suggesting that worldwide economic slack was decreasing. If the Federal Reserve, the world’s central banker in all but name, had been focused on sustainable world growth, it should have been tightening monetary policy by raising interest rates. But its mandate covered only the United States. In truth, the problem was that output growth had not resulted in job growth. And the Fed was focused not on output, as the Taylor rule would suggest, but on jobs.
One could say that the Fed should have looked at prices of financial assets and housing that were skyrocketing. But the orthodoxy suggested asset prices could be ignored. Greenspan learned this lesson when a 25bps rate increase led to mayhem on the street, and hence kept his foot on the pedal.
What did these interest rates do to international capital flows?
Even as the Fed pushed dollars out, central banks in developing countries pushed them back in. In a number of industrial countries, private entities recycled the dollar inflows: German banks and Japanese insurance companies bought seemingly safe U.S. mortgage-backed securities with the dollars their customers deposited. The money leaving the United States looking for riskier assets around the world thus came back to the United States, looking for seemingly safe but higher-yielding debt-like securities. In some ways, Federal Reserve policy was turning the United States into a gigantic hedge fund,
Why did the money come back to the U.S. and not someplace else?
In the 1970s and 1980s, Western banks, recycling the mounting petrodollar surpluses of Middle Eastern countries, assumed more of the lending to developing countries. In the 1990s, foreign arm’s-length investors such as mutual funds and pension funds increased their share of lending to developing countries by buying their government and corporate bonds. Thus foreign financing of developing countries became increasingly private and arm’s-length.
So what happens when arm’s-length, industrial-country private investors are asked to finance corporate investment in a developing country with a relationship system, as was the case in the early 1990s? Foreign investors who do not understand the murky insider relationships do three things. They minimize risks by offering only short-term loans so that they can pull their money out at short notice. They denominate payments in foreign currency so that their claims cannot be reduced by domestic inflation or a currency devaluation. And they lend through the local banks so that if they pull their money and the banks cannot repay it, the government will be drawn into supporting its banks to avoid widespread economic damage. Thus foreign investors get an implicit government guarantee. The threat of inflicting collateral damage is what makes arm’s-length foreign investors willing to entrust their money to the opaque relationship system.
It should come as no surprise, then, that a number of developing countries decided to never leave themselves at the mercy of international financial markets (or the IMF) again. Rather than borrow from abroad to finance their investment, their governments and corporations decided to abandon grand investment projects and debt-fueled expansion. Moreover, a number decided to boost exports by maintaining an undervalued currency. In buying foreign currency to keep their exchange rate down, they also built large foreign-exchange reserves, which could serve as a rainy-day fund if foreign lenders ever panicked again.
In the meanwhile, in the U.S., income did not rise with GDP in 90s and 00s. Thus politicians looked, or been steered into looking, for other, quicker ways to mollify their constituents. We have long understood that it is not income that matters but consumption. Therefore, the political response to rising inequality, whether carefully planned or an unpremeditated reaction to constituent demand, was to expand lending to households, especially low-income ones. Let them eat credit. And eat they did. This credit binge helped pull Japan pull out of its deflationary spiral, by exporting its way out of trouble.
But this does not seem like a good way to make public policy, does it?
The organizations and people the government uses to achieve its aims do not share them.
Long-term policies are often enacted under the shadow of an emergency, with the party that happens to be in power at the time of the downturn getting to push its pet agenda. This leads to greater fluctuations in policy making than might be desired by the electorate. It also tends to promote excess spending and impairs the government’s long-term financial health.
Why doesn’t China spend more?
China also faces a more traditional problem related to export-led growth strategies. As a proportion of the total income generated in the Chinese economy, household incomes are low. Wages are low because they are held down by the large supply of workers still trying to move from agriculture to industry. Household income is further limited because the subsidized inputs to state-owned firms, like low interest rates, also mean households receive low rates on their bank deposits. Moreover, a number of benefits such as education and health care are no longer provided for free by the state, eating further into discretionary spending. Finally, consumption may be low because Chinese households feel poorer than they actually are. State-owned firms do not pay dividends to the state and because households do not own their shares directly, they do not see the extremely high profits made at state-owned firms as part of their own wealth. Of course, in the long run, it is hard to believe that the wealth created by these state-owned firms will not be recaptured for the public good. For now, though, households believe they have no part in it, and they consume less than they might if they believed they were richer.
A government-directed, producer-biased strategy of growth tends to stunt the development of that country’s financial sector. Because banks are told whom to lend to, and because domestic competition among producers is limited anyway, banks tend not to seek out information or develop their credit-evaluation skills. The legal infrastructure to close down weak borrowers, or to enforce repayment from recalcitrant ones, is virtually nonexistent.