Fault Lines: A Review
Raghuram Rajan’s book is an attempt to explain the financial crisis and, in so doing, identify the underlying structural problems which led to the global economic turmoil – the ‘hidden fractures’. Given that we seem to be embarking on a renewed credit crunch and a W shaped recession, it is safe to say that whatever these fractures are, they have not been fixed. But Rajan’s contribution to the burgeoning literature on making sense of, and assigning blame for, the GFC makes several interesting arguments. Rajan himself has excellent credentials, although he has the dubious honour of the fact that he is former IMF Chief Economist, he nonetheless can claim to have raised concerns about troubles ahead before the crisis broke and been mocked by Alan Greenspan for his troubles – a prestigious accolade indeed.
But what’s his angle on 2008’s car crash of CDOs and commercial paper? Well, leaving aside the ramblings of gold-bugs and those who blame the crisis on some combination of Gordon Brown and Greek pensioners, there are broadly two kinds of explanation for the crisis: meso and macro. Meso-level explanations blame the regulatory framework governing finance in the Anglo-Saxon world, lending practices in theUSsub-prime sector, monetary policy decisions by central banks and so on. Macro-level explanations blame global imbalances of one sort or another, as did Ben Barnanke when he talked of the ‘global savings glut’.
At the macro-level, Rajan provides a very interesting account of the distortions within two kinds of economies: the high-savings exporter-creditors and the consumption-oriented debtors. In the most interesting section of the book, Rajan explains how the export-oriented development path adopted byJapan– the only real model for successful industrialisation within the world economy anyone has really found – brings with it a set of problems, namely stagnant domestic consumption and uncompetitive domestic firms. Nations adopting this model are addicted to exporting and, with low consumer borrowing, have built up large balance of payments surpluses. This is one of the strongest sections of the book, as it uses development economics to explain how deeply the ‘global imbalances’ are rooted in the political economies of many of the world’s major trading nations. On the other end of the rope is the big debtor on the global stage, the US, whose addiction has been fed by T-bill purchases by the exporters – particularly in Asia (I think everyone knows this story by now).
The problem with the political economy of the US, Rajan claims, is the dangerous interaction between inequality, credit and politics. Middle-income earners have been falling behind due to trade with labour-abundant economies and technological change that renders skills obsolete. But due to the maladies of the US educational system, workers have not been able to gain the skills they need before joining the workplace or retrain later. Much of the US workforce therefore fell behind during the two jobless recessions preceding the crisis, from which theUSrecovered only slowly and through bubble-stokingly loose monetary policy due to its lack of automatic stabilisers in the form of social safety nets. Rising inequality creates pressure on political representatives to ease the pain through credit, as this is much easier than deep reforms of education or health. Rajan argues this led to a political push to lend to subprime households.
This would already have been ungood, but it was made double plus so by a financial sector that amplified and distributed the risks through securitisation, CDSs and the rest of the pantheon of exotic instruments. Rajan is reasonably blunt here: many in the financial sector were making one-way bets on supposed ‘tail risks’ which they were totally unable to cover when the dice came up snake-eyes. The culture of excessive risk grew until it was a juggernaut that nearly collapsed the global banking system. Indeed, kudos to Rajan for having the guts to hint that there may have even been a degree of surreptitious, informal collusion amongst major financial institutions, who he suggests probably realised that collectively loading up on tail-risks would make taking out such risks safer and safer – especially with an interest slashing Fed waiting in the wings if a crisis were to occur.
There are some pretty big problems with Rajan’s analysis, however. He persists in describing the distress in the sub-prime sector which tipped the world into crisis as a tail-risk, albeit a tail-risk that the financial sector increased the probability of and which extreme leverage massively amplified. But these ‘tail-risks’ can instead be seen as the end stage of a classic Minsky bubble, an inevitable step in a process rather than an unlikely random occurrence.
Second, the idea that the US government played a central role by promoting sub-prime house ownership as a lazy form of redistribution is problematic. Rajan’s problem here is that he dismisses but offers no evidence for the idea that the expansion of sub-prime credit was demand driven, i.e. low income households were hungry for credit to offset their worsening relative position. Indeed, the massive rise in unsecured credit card debt that Rajan notes support this view. Even if the US government hadn’t pushed and subsidised home ownership, poorer households would likely have ended up over their heads – especially in the context of excess savings elsewhere in the world.
Third, Rajan’s explanation of rising inequality in the US is basically flawed. It hews to an idea that became almost a religious tenet over the past two decades: rising inequality in the West is caused by increasing ‘returns to skill’ due to technology. According to Rajan the real problem was the rising inequality between the 90 and the 10% rather than the 99 and the 1%. These claims have been picked apart by other commentators such as Krugman, but some choice quotes show the untenability of Rajan’s position: ‘the supply of college-educated workers has not kept pace with demand… Those who are fortunate enough to have bachelor’s and advanced degrees have seen their incomes grow rapidly as the demand for graduates exceeds supply.’ This is derisory.
The alternative is that income growth and job creation was concentrated in the financial sector and in industries providing services to the wealthy. So some other high-skill professionals, cosmetic surgeons, yacht designers or architects say, may have seen their incomes rise whilst job creation elsewhere mainly consisted of low-skill service sector positions – and why bother getting an education for those jobs? This is the account that Robert Reich presents in Supercapitalism.
So these problems render many of his conclusions and suggestions moot. Rajan openly states that many of his suggestions for fixing the hidden fractures rely on the view that much financial activity is not pointless and does generate something of value for the wider economy. This is at least questionable. The economy obviously relies on many functions of finance, but even Bank of England Economists have wondered aloud about the net contribution finance actually makes over the economic cycle:
For the largest 25 or so global banks, the average annual subsidy between 2007-2010 was hundreds of billions of dollars; on some estimates it was over $1 trillion (Haldane 2011). This compares with average annual profitability of the largest global banks of about $170 billion per annum in the five years ahead of the crisis.
Taking risks is not itself an activity that warrants reward, especially when losses are passed on to the public. Rajan seems to suggest that cutting the poor off from credit would do more harm than good. Well, maybe, but I can’t really see how curtailing haute finance would necessarily eliminate payday loans. Funnily enough, life went on before Glass-Steagal was repealed.
Rajan’s suggestions for improving the US education system are worthy but rest on some of his more dubious assertions about the cause of the crisis for their plausibility. He is however quite insightful in his observations that global compromises are necessary to move from a situation where the US is ‘consumer of last resort’, soaking up exports and savings. He’s enough of a realist to note, however, that although government officials realise that movement away from a world where the US provides the world’s demand is necessary, they are eager to pass the buck for the problem. This can be witnessed in the current mess, particularly in the intransigence ofGermanyfaced with the imbalances within the Eurozone. But the half-hearted solution, that the IMF become an educator of civil society and an inspiration for global citizens is pretty limp stuff – for some reason the IMF isn’t actually very popular with NGOs or actual civil society activists where it has operated in the past. But like other books in this genre, it’s a book aimed at political elites and the frequent flier class: the scary spectre of populism crops up once again. For my money, more solutions will come from angry citizens than the same elites who presided over the GFC.
So a strange and lopsided account of the crisis, radical and daring in places but far too wedded to discredited orthodoxies and shibboleths of the economics profession. Irritating ‘both sides are to blame’ posturing crops up in several sections. Undoubtedly, the biggest contribution of Rajan’s book is explaining how the global imbalances are connected to the different strategies for national development of states within the world economy. This made the book a worthwhile read in and of itself.