Fault Lines: How Hidden Fractures Still Threaten the World Economy
Fault Lines: How Hidden Fractures Still Threaten the Planet Economic climate
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Raghuram Rajan was a single of the number of economists who warned of the international financial crisis ahead of it hit. Now, as the planet struggles to recover, it really is tempting to blame what occurred on just a few greedy bankers who took irrational risks and left the rest of us to foot the bill. In Fault Lines, Rajan argues that significant flaws in the economic climate are also to blame, and warns that a potentially much more devastating crisis awaits us if they are not fixed.Rajan shows how the individual alternatives that collectively b...
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Hoping for More,
Having read Rajan breathtaking paper from the Fed's Jackson Hole Conference, I rushed to buy his book when it was finally published expecting insightful in-depth analysis of the leading banking proposals. Instead, what he gives us are brief summaries of the existing laundry list of proposals - hardly the in-depth analysis I expected that carefully considers the unintended secondary repercussions of each proposal. When he strays from his expertise - banking - his analysis grows even more superficial.
Even worse, the most important issue - how can the US best recycle short-term debt into its most productive uses - never hits his radar. Instead, he simply asserts that exporters like China should stop subsidizing exports, reduce savings and encourage domestic consumption - presumably to reduce the offsetting supply of cheap capital to the US. He also proposes reducing government guarantees of banks and deposits to discourage banks from taking tail risk - tail risk that is only created by utilizing short-term debt. Ok, but at what cost? This central issue never seems to cross Rajan's mind. But we saw what happened when short-term debt withdrew from funding US borrowing and sat idle to avoid risk. The economy contracted, unemployment rose and growth slowed - some now predict for a decade. That appears to have been a very high price to pay, especially so relative to the estimated once-in-75-years (less than) $100B net cost of crisis-induced government guarantees. How can he leave that central tradeoff wholly unaddressed?
It's clear that Rajan believes the use of short-term funds predominately affects only an unsustainable increase in household consumption. Perhaps, but he recognizes rising levels of debt without acknowledging that the market values of assets grew faster than debt and household net worth rose, even at post recession asset values. From the narrow focus of his discourse - discourse that never once mentions the acceleration in US productivity - one can only infer that he believes that monetary policy is the predominate driver of asset values even though post-recession asset values including real estate have remained surprisingly high by historical standards despite a dearth of credit. I found his monetary argument unpersuasive although others might not.
Rajan is one of the first writers (along with Reinhart and Rogoff and I'm sure others) to rightly link the rising trade deficit and its effect on the supply of short-term credit to the financial crisis when those short-term funds panicked and withdraw from financial intermediation. He also acknowledges the role of the government - through Fannie and Freddie - in distorting mortgages market credit standards that were critical to banks given the growing self-funding of business (an alternative use for the funds), which many demagogues surreptitiously ignore. But from a macro perspective - the chosen emphasis of his book - I believe he completely misses the major shift in US production to intangible investment to discover innovation (mistakenly counted as the intermediate cost of production) and its real effect on productivity, assets values, growth, wages, and employment (including the employment of Mexico and China). As a result, he doesn't see any link between business using domestic employment for increased innovation instead of households selling assets (to each other in a more close economy) and competing with business to buy domestic goods and services for increased consumption rather than borrowing offshore funds against the increased value of their assets to buy offshore goods. Said differently, in the face of capacity constraints, he fails to see the value of the US offshoring less valuable production for consumption in order to continue growing more valuable intangible investment domestically and the resulting effect that tradeoff necessarily has on debt AND assets. Had we simply borrowed from offshore exporters to consume their goods as Rajan seems to assert, household net worth would have declined steadily. As such, he sees little if any cost to discouraging the use of short-term funds. It's ok to disagree after thorough analysis; it's not ok to completely overlook alternative hypotheses central to the issue - issues, no less, that explain the slow recovery of employment, which leaves him scratching his head.
Nevertheless, when Rajan sticks to what he knows - banking and finance - he provides a fairer portrait of the issues than the many diatribes of demagogues masquerading as pundits. Me, I still think moral hazard is an unpersuasive explanation of the crisis - an explanation upon which Rajan relies heavily - but at least he presents it and other banking-related issues maturely. I only wish he would have stuck to banking and used his 230 pages to dig a lot deeper into what he knows instead using 40% of the book to address issues outside the scope of his expertise where I would describe...
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|The most thought-provoking recent book.,
I found this book a highly stimulating read. It represents possibly the most thought-provoking contribution in the aftermath of the crisis that started in 2007 and that yet engulfs us. Let me first summarize some of the most salient points it makes, then talk about its strengths, and finally, why everyone should read it.
The epilogue of the book summarizes the book best - "The crisis has resulted from a confusion about the appropriate roles of the government and the market. We need to find the right balance again, and I am hopeful we will." The book presents two important government distortions - the push for universal home ownership in the United States and the push for export-led growth in some countries such as Germany and China that have left to massive "global imbalances", with some countries such
as the United States, the United Kingdom and Spain persistently being in deficits and borrowing from the surplus, exporting nations. While pursuit for home ownership affordability and growth are nothing to complain about per se, the book makes sharp observations that they are occurring at the expense of something more, or as, important. In the United States, the book argues, there has been a growing income inequality, which combined with a relatively feeble safety net for the poor, has created pressure on politicians to bridge the inequality. Instead of improving the competitiveness of labor force in a global market with changing mix of industries and required skills, governments have adopted the option "let them eat credit" (Chapter One's title). The presence of government-sponsored agencies in the United States enabled exercising such an option readily through a push for priority lending to the low-income households (sub-prime mortgages). In case of surplus countries, the single-minded focus on exports has led governments to ignore the domestic sector, preventing sufficient redeployment of surplus for internal development and somewhat perversely, boosted domestic savings rates significantly due to lack of adequate safety nets (at least in case of China, if not in case of Germany). The savings have thus had no place to go but to outside and ended up resulting in massive capital inflows that fueled the housing sector expansion in the US, the UK and Spain.
While these government "failures" are themselves pretty interesting to have observed and highlighted, what is fascinating is how they interacted with each other - and with the financial sector - in fueling the expansion to levels that can be called massive housing bubbles. The idea here is that the invisible hand operating through the price when the price is distorted can lead to massive distortions in allocation of capital also. The financial sector in developed world is so sophisticated and amoral (a great choice of word by the author) that its dispassionate pursuit of profits leads it to direct capital to wherever there is a relative mis-pricing. So if governments are subsidizing home ownership, efforts will be made to deploy pretty much all available free capital of the world to that sector. If some governments are finding it cheap to borrow because savings are seeking them out, the financial sector will grow at a sufficient rate to absorb and support expansion through the capital inflows. While clearly there are some incentive-based distortions, especially short-term nature of accounting-based compensation that ignores true long-term risks, the book takes the stand, and explains it well, that the bigger issue was that the imbalance of capital flows and the ease of pushing sub-prime home ownership - both due to government distortions - meant the financial sector was essentially the conduit to make happen what the rest of the world was seeking to achieve. In the process, it made a ton of bad loans (but the governments were happy with that till it all really blew up). And some parts of the financial sector pursued this role even more aggressively than one could have imagined due to the steady entrenchment of too-big-to-fail expectations --- large banks being repeatedly bailed out through government and regulatory forbearance and enjoying Central-Bank monetary stimulus each time markets turned south. In essence, one walks away with an explanation of what brought about the perfect storm.
Some may question the basis of this argument by saying - why did we see credit expansion across board and not just in low-income households. There are two important points the book makes. One, that once risk is mispriced for one investment (by governments for sub-prime lending), financial sector must demand similar return elsewhere. That is, there will be mispricing of risk across board. Second, the book focuses on a rather fascinating recent phenomenon that recent recoveries from recessions, especially in the United States, have remained "jobless" for extended periods of time. Perhaps as a subconscious response to this (or...
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|Rajan's Reply to Krugman Re: Fault Lines,
In the Sept 2010 issue of the New York Review of Books, Paul Krugman & Karen Wells reviewed Fault Lines. Below is Rajan's reply to their review:
Paul Krugman and Robin Wells caricature my recent book Fault Lines in an article in the New York Review of Books.
First, Krugman starts with a diatribe on why so many economists are "asking how we got into this mess rather than telling us how to get out of it." Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates. The article, and their criticism, however, do have a lot to say about Krugman's policy views (for simplicity, I will say "Krugman" and "he" instead of "Krugman and Wells" and "they") which I have disagreed with in the past. Rather than focus on the innuendo about my motives and beliefs in the review, let me focus on differences of substance. I will return to why I believe Krugman writes the way he does only at the end.
My book emphasizes a number of related fault lines that led to our current predicament. Krugman discusses and dismisses two - the political push for easy housing credit in the United States and overly lax monetary policy in the years 2002-2005 - while favoring a third, the global trade imbalances (which he does not acknowledge are a central theme in my book). I will argue shortly, however, that focusing exclusively on the imbalances as Krugman does, while ignoring why the United States became a deficit country, gives us a grossly incomplete understanding of what happened. Finally, Krugman ignores an important factor I emphasize - the incentives of bankers and their willingness to seek out and take the tail risks that brought the system down.
Let me start with the political push to expand housing credit. I argue that in an attempt to offset the consequences of rising income inequality, politicians on both sides of the aisle pushed easy housing credit through government units like the Federal Housing Administration, and by imposing increasingly rigorous mandates on government sponsored enterprises such as Fannie Mae and Freddie Mac. Interestingly, Krugman neither disputes my characterization of the incentives of politicians, nor the detailed documentation of government initiatives and mandates in this regard. What he disputes vehemently is whether government policy contributed to the housing bubble, and in particular, whether Fannie and Freddie were partly responsible.
In absolving Fannie and Freddie, Krugman has been consistent over time, though his explanations as to why Fannie and Freddie are not partially to blame have morphed as his errors have been pointed out. First, he argued that Fannie and Freddie could not participate in sub-prime financing. Then he argued that their share of financing was falling in the years mortgage loan quality deteriorated the most. Now he claims that if they indeed did it (and they did not), it was because of the profit motive and not to fulfill a social objective. Let me offer details.
In a July 14, 2008 op-ed in the New York Times, Krugman explained why Fannie and Freddie were blameless thus:
"Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income. So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works."
Critics were quick to point out that Krugman had his facts wrong. As Charles Calomiris, a professor at Columbia University and Peter Wallison at the American Enterprise Institute (and member of the financial crisis inquiry commission), "Here Krugman demonstrates confusion about the law (which did not prohibit subprime lending by the GSEs), misunderstands the regulatory regime under which they operated (which did not have the capacity to control their risk-taking), and mismeasures their actual subprime exposures (which he wrongly states were zero)."
So Krugman shifted his emphasis. In his blog critique of a Financial Times op-ed I wrote in June 2010, Krugman no longer argued that Fannie and Freddie...
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