America at the Fault Lines

A review of Fault Lines by Raghuram Rajan

By Seth Wideman

America's liberal tradition has had the aid of wise words from many outsiders: Thomas Paine was British, Alexis de Toqueville was French, and Friedrich Hayek was Austrian. Raghuram Rajan's new book, Fault Lines, is to the world economy and the U.S. economy what those books were to the United States; a fresh look is critical The book provides a distinctive account of the causes of the global financial crisis because Rajan is a sort of universal outsider: born and raised in India, he received his undergraduate degrees and MBA from Indian universities before getting his Ph.D. in economics from MIT, before spending his career teaching at the business school—Booth—long considered the ideological and methodological opposite of MIT's. Despite conducting path-breaking, acclaimed research in financial economics—he was the inaugural recipient of the Fischer-Black prize presented by the American Finance Association—he has never been afraid to advocate perspectives heretical among his fellow economists, most notably by predicting an impending financial crisis in 2005.

Each year, the world's leading central bankers and monetary economists meet at the Jackson Hole Conference in Wyoming. Alan Greenspan had just announced that he would step down as chairman of the Federal Reserve and the implicit purpose of the conference was to celebrate his legacy. He had presided over "The Great Moderation"; during his tenure, the U.S. economy had seen relatively steady growth interrupted only by short and shallow recessions in 1990-1991 and 2001. The contrarian Rajan presented a paper arguing that the financial system had, in fact, become increasingly unstable, as low interest rates had encouraged companies to take on excessive amounts of "tail risk". This meant companies were producing higher returns simply by taking bets on risky assets, which produced higher-than-average returns in good economic times, but had very low probabilities of producing enormous losses (two typical examples are mortgage-backed securities and credit default swaps). Given that many companies were placing similar bets,—in mortgage-backed securities, for example—if the underlying economic conditions which gave these assets their value worsened, liquidity could quickly dry up and the financial sector could be pushed to the brink. Criticized at the time (most savagely by Larry Summers), Rajan's presentation now seems remarkably prescient.

In Fault Lines, Rajan tells the story of the 2008 Financial Crisis not as fortune teller but as an economic historian. His account of the events leading to the financial crisis stretches back much farther than most others', and casts a far wider net of blame. Due to technological advancement, which has disproportionately rewarded skilled workers, and inadequate investments in education to help the workforce keep pace with the new skills required of it income inequality has risen substantially in the United States since the 1970s. Rajan does not fall into the usual trap of focusing on incomes at the very top, instead noting that both the "90/50 differential"—the difference between what workers at the 90th percentile of the income distribution and the 50th percentile make—and the "90/10 differential" have increased substantially. Putting aside questions of whether consumption inequality has actually increased (as opposed to income inequality), this shows that there is at least a justified perception that inequality has increased. This has naturally led the American public to lean on their politicians for more income redistribution. Given, however, that Americans have an instinctive aversion to crude redistribution, politicians have turned to credit, especially for housing, as a means to indirectly help their constituencies without directly taxing the rich to give to the poor. This is especially true because jobs that are lost during recession take increasingly longer to recover. This problem is, of course, still with us: if another sudden recession were to strike, Rajan argues, the inevitable pressure on politicians to extend inefficient short term solutions, such as stimulus packages, would still be there. This is a major fault line, still threatening to destabilize the world economy.

This is one area in which Rajan overstates his case. It is true that the United States has experienced increases in income inequality in the past several decades, and it is true that, to some extent, this inequality has led to corresponding declines in equality of opportunity. However, there is a much simpler explanation for why the government has been using credit to redistribute income, and one that has nothing to do with inequality of opportunity—politicians always have incentives to redistribute income to the middle class to garner support for votes. Indeed, this explanation is consistent with the evidence; from 2001 to 2007, the percentage of income used to finance debt payments actually fell slightly among the lowest income quintile—on the other hand, it had the highest rise among the second-highest quintile, the "60-80" quintile. Thus, most of the people to whom credit was extended could not justifiably be said to be the victims of a lack of opportunity, even if Rajan's points about inequality increasing are correct. Nonetheless, if the extension of credit was in fact driven by normal political calculations and not reversible trends such as income inequality, this fault line could be even deeper and more serious than Rajan states.

Rajan's independent streak comes through in his description of the other fault lines. Commentators usually take a one-sided view of phenomena such as the U.S. savings rate, which has been spectacularly low in the past several decades as homeowners have used the increasing values of their houses to borrow and our government spending has grown like ivy. But there are two sides to every economic transaction: if one country spends more than it saves and therefore borrows, the rest of the world must on net save more than it spends to make up the difference. Thus, U.S. consumption cannot merely be driven by private and public U.S. demand; equally important are the savings and investment decisions of the rest of the world. Similarly, when the U.S. imports more than it exports, it sends more dollars overseas than it brings in; those dollars are held by foreign investors, who reinvest those dollars in the U.S. through dollar-denominated assets. Thus, Rajan's list of fault lines takes into account the inherent interdependency of the world economy—if the rest of the world saves more than it spends, the U.S. must necessarily spend more than it saves, which in turn means it must necessarily import more than it exports. It is with this framework of the interdependency of the global economy in mind that Rajan gives a panoramic, comprehensive, and endlessly insightful tour of the worldwide economy in the past several decades. The book is worth reading for this section alone, and it additionally leads Rajan to his next fault line.

Since World War II, many countries, most notably Asian countries such as Japan, South Korea, Taiwan, and more recently China, have had periods of growth at rates rivaling anything else achieved in human history. They accomplished this largely by subsidizing and favoring export-focused industries, which allowed them to grow despite weak domestic markets. This has led to not only some spectacular success stories, but also huge distortions. Japan is a perfect example: while it grew spectacularly from 1950 to 1973, today the only strong Japanese industries are those focused on exports. For example, most readers could name several Japanese and Asian car companies off the top of their heads, but likely couldn't name a single major, international, private Asian financial institution or consulting firm. These growth policies not only left these countries' economies vulnerable, but because a country that exports more than it imports must necessarily save more than it invests, they created a savings glut that found its way largely into the U.S. Treasuries. This was a major factor in keeping interest rates low throughout the late 1980s and 1990s, leading to the housing bubble. Before the economy can stabilize, Rajan argues, countries such as Japan and China must make their economies less dependent on exports.

Rajan's unique perspective as an outsider comes through most in the way he writes about the United States. The accounts of the financial crisis one reads in the United States—the stuff of the editorial pages of the Wall Street Journal and the New York Times—usually implicitly promote or subscribe to the myths we have about our political system. The United States, an argument might go, is a country in which the government has done much to ensure equality of opportunity through encouraging homeownership and subsidizing higher education; nonetheless, Republicans have insisted on not regulating the financial sector, allowing their free market ideology to blind them to the obvious excesses in which Wall Street was indulging at the expense of Main Street. On the other side, stories abound about how the United States is a country in which free enterprise has always promoted growth, innovation, entrepreneurship, and a higher standard of living, whereas liberal Democrats' attempts to redistribute income through the extension of credit have been neutral at best and, at worst, counterproductive and dangerous by distorting the operations of the free market. Rajan at first appears to be "in the middle"—he argues that the policies of subsidizing housing credit fueled the housing bubble, but also notes that both the Greenspan Fed and the compensation structure of Wall Street encouraged the kinds of risks that endangered the financial system. Implicit in Rajan's analysis, however, is a deeper argument about the United States' place in the world. Rajan's story of the financial crisis, as far as the United States is concerned, is one of a country which is a victim to both the short-term aspirations of its politicians and longer-term economic forces. Even more generally, the United States is not a country with exceptional ideals and potential that has simply been derailed by misguided policies; rather, the incentive structures in place in the U.S. economy—incentives both political and purely financial—led actors following their own self-interests to nearly derail the sophisticated financial system of which they were a part. Overall, Rajan writes about the United States as if it were a developing country—that is, instead of a country in charge of her own destiny, the United States is populated by the same self-interested actors, misguided though well-intentioned leaders, and opportunistic investors that have been the causes of financial crises for all of history. To that extent, Fault Lines is a refreshing pitcher of water to the face, sure to sober up partisans on either side of the aisle who think that we can avoid a similar crisis simply by passing particular packages of legislation. Nonetheless, this perspective leads to rather fatalistic conclusions about the U.S. government. Why did they allow themselves to get into this mess? Much as an American journalist might write about the Asian financial crisis or a recession in India, Rajan's answer is: they simply couldn't help themselves, as they didn't know what they were doing.

Currently the United States is headed toward running the largest deficit in its history, on top of the fault lines Rajan highlights in the book. The question of whether the U.S. can change course and avoid a similar disaster in the future hinges most generally on whether American institutions remain corrupted, like those of a developing nation, or whether we take the needed reforms to seal the domestic and international fault lines.