Fault Lines: How Hidden Fractures Still Threaten the World Economy

How Hidden Fractures Still
Threaten the World Economy

RAGHURAM G. RAJAN

PRINCETON UNIVERSITY PRESS
Princeton and Oxford

ACKNOWLEDGMENTS

 

A
BOOK IS ALMOST ALWAYS
a collective effort, even if it has only a single author. I owe many of the ideas in this book to the stimulating environment at the University of Chicago’s Booth School of Business, where I have spent the best part of my academic life. The work I have coauthored with Douglas Diamond and Luigi Zingales is also central to some of my thinking here. Comments from Anil Kashyap, Richard Posner, Amit Seru, and Amir Sufi were very useful. I owe special thanks to Viral Acharya at New York University’s Stern School of Business, who gave me very detailed comments on the chapters on finance. I have also benefited greatly from conversations with Marshall Bouton, John Cochrane, Arminio Fraga, Shrinivas Govindarajan, David Johnson, Randall Kroszner, Charles Prince, Edward Snyder, Joyce van Grondelle, Robert Vishny, Martin Wolf, and Naomi Woods. I thank Rishabh Sinha and Swapnil Sinha for their research assistance.

The time I spent at the International Monetary Fund between August 2003 and December 2006 taught me a lot about the politics of international finance. I learned a great deal from Anne Krueger and Rodrigo de Rato, as well as from my colleagues in the research department there, especially Timothy Callen, Charles Collyns, Kalpana Kochhar, Paolo Mauro, Gian Maria Milesi-Ferretti, Jonathan Ostry, Eswar Prasad, David Robinson, and Arvind Subramanian. Ken Rogoff, my predecessor at the Fund, has always been generous with his time and has been a source of very useful advice.

Seth Ditchik, my editor at Princeton University Press, has been invaluable in shaping my ideas into a coherent book. Peter Dougherty, the director, has been very supportive throughout the process. I also thank the other staff members of Princeton University Press and members of Princeton Editorial Associates who have helped bring the book to publication.

This book would not have been written without the support, encouragement, advice, and detailed comments I received from my wife, Radhika. She has been a true partner every step of the way. Finally, I thank my children, Tara and Akhil, for putting up with my work—maybe it was a relief to them because it prevented me from giving their lives my undivided attention. At any rate, they give me two great reasons to try to make the world better for the generations to come.

Chicago, February 2010

Introduction

 

T
HE FINANCIAL COLLAPSE
of 2007 and the recession that followed left many economists on the defensive. News programs, magazines, pundits, and even the Queen of England all asked some variant of the question, why didn’t you see it coming? Some in the economics community wrote articles or convened conferences to examine how they could have gotten it so wrong; others engaged in a full-throated defense of their profession.
¹
For many who were hostile to the fundamental assumptions of mainstream economics, the crisis was proof that they had been right all along: the emperor was finally shown to have no clothes. Public confidence in authority was badly shaken.

Of course, it is incorrect to say that no one saw this crisis coming. Some hedge fund managers and traders in investment banks put their money instead of their mouths to work. A few government and Federal Reserve officials expressed deep concern. A number of economists, such as Kenneth Rogoff, Nouriel Roubini, Robert Shiller, and William White, repeatedly sounded warnings about the levels of U.S. house prices and household indebtedness. Niall Ferguson, a historian, drew parallels to past booms that ended poorly. The problem was not that no one warned about the dangers; it was that those who benefited from an overheated economy—which included a lot of people—had little incentive to listen. Critics were often written off as Cassandras or “permabears”: predict a downturn long enough, the thinking went, and you would eventually be proved right, much as a broken clock is correct twice a day. I know, because I was one of those Cassandras.

Every year, the world’s top central bankers get together for three days at Jackson Hole, Wyoming, along with private-sector analysts, economists, and financial journalists, to debate a set of topical papers commissioned for the event by the host, the Federal Reserve Bank of Kansas City. Following each day’s presentations, participants go on long hikes in the beautiful Grand Teton National Park, where, amid the stunning mountain scenery, they talk central-banker shop: intense arguments about the Wicksellian rate of interest mingle with the sounds of rushing streams.

The 2005 Jackson Hole Conference was to be the last for the Federal Reserve Board chairman, Alan Greenspan, and the theme, therefore, was the legacy of the Greenspan era. I was the chief economist of the International Monetary Fund (IMF) at that time, on leave from the University of Chicago, where I have taught banking and finance for the best part of two decades. I was asked to present a paper on how the financial sector had evolved during Greenspan’s term.

The typical paper on the financial sector at that time described in breathless prose the dramatic expansion of financial markets around the world. It emphasized the wonders of securitization, which allowed a bank to package its risky housing or credit card loans together and sell claims on the package in the financial market. Securitization allowed a bank to get the risky loans off its books. At the same time, it allowed long-term investors in the market, such as pension funds and insurance companies, to take on a small portion of the risky claims that they, by virtue of having longer horizons and holding a diverse portfolio of other assets, could hold more easily than the bank. In theory, with the risk better spread across sturdier shoulders, investors would demand a lower return for holding the risk, allowing the bank to charge lower loan rates and expand borrowers’ access to finance.

In preparation for writing the paper, I had asked my staff to prepare graphs and tables. As we looked through them, I noted a few that seemed curious. They were plots of different measures of the riskiness of large U.S. banks, and they suggested that banks had become, if anything, more exposed to risk over the past decade. This was surprising, for if banks were getting risky loans off their balance sheets by selling them, they should have become safer. I eventually realized that I was committing the economist’s cardinal sin of assuming
ceteris paribus,
that is, assuming that everything else but the phenomenon being studied, in this case securitization, remained the same. Typically, everything does not remain the same. Most important, deregulation and developments like securitization had increased competition, which increased the incentives for bankers (and financial managers more generally) to take on more complex forms of risk.

Once I saw this trend, the paper quickly wrote itself and was titled “Has Financial Development Made the World Riskier?” As the
Wall Street Journal
reported in 2009 in an article on my Jackson Hole presentation:

Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products, with potentially big payoffs, which could on occasion fail spectacularly.

He pointed to “credit default swaps” which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred.

Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said. “The interbank market could freeze up, and one could well have a full-blown financial crisis.”

Two years later, that’s essentially what happened.
²

 

Forecasting at that time did not require tremendous prescience: all I did was connect the dots using theoretical frameworks that my colleagues and I had developed. I did not, however, foresee the reaction from the normally polite conference audience. I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself, for one develops a thick skin after years of lively debate in faculty seminars: if you took everything the audience said to heart, you would never publish anything. Rather it was because the critics seemed to be ignoring what was going on before their eyes.

In part, I was criticized because I was off message. Some of the papers in the conference, in keeping with the Greenspan-era theme, focused on whether Alan Greenspan was the best central banker in history, or just among the best. Someone raining on that parade, suggesting all was not well and calling for better regulation, was unlikely to attract encomiums, especially given Greenspan’s known skepticism about the effectiveness of regulation. In part, the reaction was defensive, for if the financial sector had gone so far off track, were the regulators not at fault for being asleep at the switch? In part, it was hubris. The Federal Reserve had dealt successfully with the downturn caused by the dot-com bust in 2000–2001 and felt it knew how to rescue the system relatively painlessly if it got into trouble again.

Although I worried about banker incentives in my talk and regulatory motives in its aftermath, and although many more commentators and regulators have since come around to my point of view, I have come to believe that these issues are just the tip of the iceberg. The true sources of the crisis we have experienced are not only more widespread but also more hidden. We should resist the temptation to round up the most proximate suspects and pin the blame only on them. Greedy bankers can be regulated; lax government officials can be replaced. This is a convenient focus, because the villains are easily identified and measures can be taken against malfeasance and neglect. What’s more, it absolves the rest of us of our responsibility for precipitating this crisis. But this is too facile a response.

We should also resist the view that this is just another crisis, similar to every financial crisis before it, with real estate and foreign capital flows at its center. Although there are broad similarities in the things that go wrong in every financial crisis, this one centered on what many would agree is the most sophisticated financial system in the world.
³
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-preservation? Is the free-enterprise system fundamentally broken? These questions would not arise if this were “just another” crisis in a developing country. And given the cost of this crisis, we cannot afford facile or wrong answers.

Although I believe that the basic ideas of the free-enterprise system are sound, the fault lines that precipitated this crisis are indeed systemic. They stem from more than just specific personalities or institutions. A much wider cast of characters shares responsibility for the crisis: it includes domestic politicians, foreign governments, economists like me, and people like you. Furthermore, what enveloped all of us was not some sort of collective hysteria or mania. Somewhat frighteningly, each one of us did what was sensible given the incentives we faced. Despite mounting evidence that things were going wrong, all of us clung to the hope that things would work out fine, for our interests lay in that outcome. Collectively, however, our actions took the world’s economy to the brink of disaster, and they could do so again unless we recognize what went wrong and take the steps needed to correct it.

There are deep fault lines in the global economy, fault lines that have developed because in an integrated economy and in an integrated world, what is best for the individual actor or institution is not always best for the system. Responsibility for some of the more serious fault lines lies not in economics but in politics. Unfortunately, we did not know where all these fault lines ran until the crisis exposed them. We now know better, but the danger is that we will continue to ignore them. Politicians today vow, “Never again!” But they will naturally focus only on dealing with a few scapegoats, not just because the system is harder to change, but also because if politicians traced the fault lines, they would find a few running through themselves. Action will become particularly difficult if a more rapid recovery reinforces the incentives to settle for the status quo. This book is, therefore, an attempt to heed the warnings from this crisis, to develop a better understanding of what went wrong, and then to outline the hard policy choices that will tackle the true causes of this crisis and avert future ones.

Let us start with what are widely believed to be the roots of this crisis, which is, in part, a child of past crises.
⁴
In the late 1990s, a number of developing countries (in the interests of brevity, I use the term
developing
for countries that have relatively low per capita incomes and
industrial
for those that have high per capita incomes), which used to go on periodic spending binges fueled by foreign borrowing, decided to go cold turkey and save instead of spend. Japan, the second largest economy in the world, was also in a deepening slump. Someone else in the world had to consume or invest more to prevent the world economy from slowing down substantially. The good news for any country willing to spend more was that the now-plentiful surplus savings of the developing countries and Japan, soon to be augmented by the surpluses of Germany and the oil-rich countries, would be available to fund that spending.

In the late 1990s, that someone else was corporations in industrial countries that were on an investment spree, especially in the areas of information technology and communications. Unfortunately, this boom in investment, now called the dot-com bubble, was followed by a bust in early 2000, during which these corporations scaled back dramatically on investment.

As the U.S. economy slowed, the Federal Reserve went into overdrive, cutting interest rates sharply. By doing so, it sought to energize activity in sectors of the economy that are interest sensitive. Typically, such a move boosts corporate investment, but corporations had invested too much already during the dot-com boom and had little incentive to do more. Instead, the low interest rates prompted U.S. consumers to buy houses, which in turn raised house prices and led to a surge in housing investment. A significant portion of the additional demand came from segments of the population with low credit ratings or impaired credit histories—the so-called subprime and Alt-A segments—who now obtained access to credit that had hitherto been denied to them. Moreover, rising house prices gave subprime borrowers the ability to keep refinancing into low interest rate mortgages (thus avoiding default) even as they withdrew the home equity they had built up to buy more cars and TV sets. For many, the need to repay loans seemed remote and distant.

The flood of money lapping at the doors of borrowers originated, in part, from investors far away who had earned it by exporting to the United States and feeding the national consumption habit. But how did a dentist in Stuttgart, Germany, make mortgage loans to subprime borrowers in Las Vegas, Nevada? The German dentist would not be able to lend directly, because she would incur extremely high costs in investigating the Vegas borrower’s creditworthiness, making the loan conform to all local legal requirements, collecting payments, and intervening in case of default. Moreover, any individual subprime homebuyer would have a high propensity to default, certainly higher than the level of risk with which a conservative private investor would be comfortable.

This is where the sophisticated U.S. financial sector stepped in. Securitization dealt with many of these concerns. If the mortgage was packaged together with mortgages from other areas, diversification would reduce the risk. Furthermore, the riskiest claims against the package could be sold to those who had the capacity to evaluate them and had an appetite for the risk, while the safest, AAA-rated portions could be sold directly to the foreign dentist or her bank.