Fault Lines: How Hidden Fractures Still Threaten the World Economy (2 page)
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Authors: Raghuram G. Rajan
The U.S. financial sector thus bridged the gap between an overconsuming and overstimulated United States and an underconsuming, understimulated rest of the world. But this entire edifice rested on the housing market. New housing construction and existing housing sales provided jobs in construction, real estate brokerage, and finance, while rising house prices provided the home equity to refinance old loans and finance new consumption. Foreign countries could emerge from their slump by exporting to the seemingly insatiable U.S. consumer, while also lending the United States the money to pay for these imports. The world was in a sweet but unsustainable spot.
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.
This narrative leaves many questions unanswered. Why was the flood of money that came in from outside the United States used for financing subprime credit? Why was the United States, unlike other economies like Germany and Japan, unable to export its way out of the 2001 recession? Why are poorer developing countries like China financing the unsustainable consumption of rich countries like the United States? Why did the Federal Reserve keep rates so low for so long? Why did financial firms make loans to people who had no income, no jobs, and no assets—a practice so ubiquitous that it attracted its own acronym, NINJA loans? Why did the banks—the sausage makers, so to speak—hold so many of the sausages for their own consumption when they knew what went into them?
I attempt to address all these questions in this book. Let me start by saying that I do not have a single explanation for this crisis, and so no single silver bullet to prevent a future one. Any single explanation would be too simplistic. I use the metaphor of
fault lines.
In geology, fault lines are breaks in the Earth’s surface where tectonic plates come in contact or collide. Enormous stresses build up around these fault lines. I describe the fault lines that have emerged in the global economy and explain how these fault lines affect the financial sector.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. Because different financial systems work on different principles and involve different forms of government intervention, they tend to distort each other’s functioning whenever they come into close contact. All these fault lines affect financial-sector behavior and are central to our understanding of the recent crisis.
The most important example of the first kind of fault line, which is the theme of
Chapter 1
, is rising income inequality in the United States and the political pressure it has created for easy credit. Clearly, the highly visible incomes at the very top have gone up. The top 1 percent of households accounted for only 8.9 percent of income in 1976, but this share grew to 23.5 percent of the total income generated in the United States in 2007. Put differently, of every dollar of real income growth that was generated between 1976 and 2007, 58 cents went to the top 1 percent of households.
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In 2007 the hedge fund manager John Paulson earned $3.7 billion, about 74,000 times the median household income in the United States.
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But although the gargantuan incomes at the very top excite public interest and enrage middle-class columnists, most Americans rarely meet a billionaire hedge fund manager. More relevant to their experience is the fact that since the 1980s, the wages of workers at the 90th percentile of the wage distribution in the United States—such as office managers—have grown much faster than the wage of the 50th percentile worker (the median worker)—typically factory workers and office assistants. A number of factors are responsible for the growth in the 90/50 differential. 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. The problems are rooted in indifferent nutrition, socialization, and learning in early childhood, and in dysfunctional primary and secondary schools that leave too many Americans unprepared for college.
The everyday consequence for the middle class is a stagnant paycheck as well as growing job insecurity. 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 favor the status quo. Moreover, any change will require years to take effect and therefore will not address the current anxiety of the electorate. Thus politicians have 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. 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 benefits—growing consumption and more jobs—were immediate, whereas paying the inevitable bill could be postponed into the future. 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. Politicians, however, want to couch the objective in more uplifting and persuasive terms than that of crassly increasing consumption. In the United States, the expansion of home ownership—a key element of the American dream—to low-and middle-income households was the defensible linchpin for the broader aims of expanding credit and consumption. 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.
This is not, of course, the first time in history when credit expansion has been used to assuage the concerns of a group that is being left behind, nor will it be the last. In fact, one does not even need to look outside the United States for examples. The deregulation and rapid expansion of banking in the United States in the early years of the twentieth century was in many ways a response to the Populist movement, backed by small and medium-sized farmers who found themselves falling behind the growing numbers of industrial workers and demanded easier credit. Excessive rural credit was one of the important causes of bank failure during the Great Depression.
There are usually limits to debt-fueled consumption, especially in a large country like the United States. The strong demand for consumer goods and services tends to push up prices and inflation. A worried central bank then raises interest rates, curbing both households’ ability to borrow and their desire to consume. 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.
The global economy is fragile because low domestic demand from traditional exporters puts pressure on other countries to step up spending. Because the exporters have excess goods to supply, countries like Spain, the United Kingdom, and the United States—which ignore growing household indebtedness and even actively encourage it—and countries like Greece—which lack the political will to control government populism and union demands—tend to get a long rope. Eventually, high household or government indebtedness in these countries limits further demand expansion and leads to a wrenching adjustment all around. 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.
Why are so many economies dependent on consumption elsewhere? Their dependence stems from the path they chose toward rapid growth, out of the destruction created by World War II or out of poverty. Governments (and banks) intervened extensively in these economies to create strong firms and competitive exporters, typically at the expense of household consumption in their own country.
Over time, these countries created a very efficient export-oriented manufacturing sector—firms like Canon, Toyota, Samsung, and Formosa Plastics are world leaders. The need to be competitive in foreign markets kept the exporters on their toes. But although global competition limited the deleterious effects of government intervention in the export sector, there were no such restraints in the domestic-oriented production sector. Banks, retailers, restaurants, and construction companies, through their influence over government policies, have managed to limit domestic competition in their respective sectors. As a result, these sectors are very inefficient. There are no large Japanese banks, for example, that rival HSBC in its global reach, no Japanese retailers that approach Walmart in size or cost competitiveness, and no Japanese restaurant chains that rival McDonald’s in its number of franchises.
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.
The future does not look much brighter. As populations in these countries age, not only will change become more difficult, but their dependencies will also worsen. 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.
In the past, fast-growing developing countries were typically not net exporters, even though their factories focused on producing to meet demand elsewhere. The fast pace of growth of countries like Korea and Malaysia in the 1980s and early 1990s entailed substantial investment in machinery and equipment, which were often imported from Germany and Japan. This meant they ran trade deficits and had to borrow money on net from world capital markets to finance their investment.
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 the competitive financial systems in countries like the United States and the United Kingdom, the accent is on transparency and easy enforceability of contracts through the legal system: because business transactions do not depend on propinquity, these are referred to as “arm’s-length” systems. Financiers gain confidence because of their ability to obtain publicly available information and understand the borrower’s operations and because they know that their claims will be protected and enforced by the courts. As a result, they are willing to hold long-term claims, such as equity and long-term debt, and to finance the final user directly rather than going through intermediaries like banks. Every transaction has to be justified on its own and is conducted through competitive bidding. This description is clearly a caricature—transparency was missing during the recent crisis—but it reflects the essentials of the system.