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Saturday, August 14, 2010

Fault Lines, by Raghuram Rajan

by Viral Acharya.

Raghuram Rajan's book Fault Lines (Princeton University Press for the international edition, and Harper Collins for an Indian edition with a special chapter on India) is possibly the most thought-provoking contribution in the aftermath of the economic and financial crisis that has engulfed the West after 2007 with significant global repercussions.

The epilogue of the book summarizes its punch line:
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 key idea of Fault Lines is to focus on slow-moving tectonic plates in the global economy: consumption by borrowing in countries with fiscal deficits, excess savings in exporting countries that are fiscally in surplus, and growing sophistication of the financial sector. None of these movements might seem dangerous in itself, but when these plates come together and collide, the global economy can get badly shaken. To most players focused narrowly on their own positions, leave alone the movements of the plate they stand on, the earthquake - like this crisis - may seem an unfortunate happenstance. In the analytical framework of Fault Lines, the crisis was not a pure accident and that more severe crises could arise in future unless the root causes are addressed sufficiently soon.

The book presents two important government distortions in the global economy and their underlying causes. These are (i) the push for universal home ownership in the United States, and (ii) export-led growth in countries such as Germany and China. Together, these policies have led to massive "global imbalances", with some countries such as the United States, the United Kingdom and Spain persistently being in deficit, and borrowing from the surplus, exporting nations. While pursuit for home ownership affordability and growth do not necessarily have to be distortionary, the book makes the sharp observation that these have been occurring at the expense of something more important but subtle.

In the United States, there has been growing income inequality, which combined with a relatively feeble safety net for the poor and unemployed, has created pressure on politicians to find quick ways to bridge the inequality. Instead of improving the long-run competitiveness of labor force for a global market with a changing mix of industries and required skills, governments have adopted the short-run option "let them eat credit" (the title of Chapter One). The presence of government-sponsored financial firms in the United States (Fannie Mae and Freddie Mac, in particular) 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, it has been the problem of exporting to grow (the title of Chapter Two). Their single-minded focus on exports has led governments to ignore the domestic sector, preventing sufficient redeployment of surplus for internal development, and somewhat perversely, even boosted domestic savings rates significantly due to lack of adequate safety nets (at least in case of China, if not in case of Germany). As someone mentioned in a recent dinner conversation: Each child in China is saving to fund post-retirement expenses not just of two parents but also of four grandparents. These savings have thus had no place to go but outside, giving rise to massive capital inflows that fueled the housing sector expansion in the US, the UK and Spain.

What is fascinating is that Fault Lines explains how these lop-sided government policies of two separate sets of countries have interacted with each other - and with the financial sector - in fueling the expansion to levels of unsustainable housing bubbles. The idea here is that the invisible hand operating through the price when the price is distorted can also lead to massive distortions in the allocation of capital. 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 all free capital of the world to the housing 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 of housing credit through these capital inflows.

Clearly there have been incentive-based distortions in the financial sector, especially due the short-term nature of accounting-based compensation that ignores true long-term risks. The book explains, however, that the bigger issue was something else: 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 a conduit to making happen what the rest of the world was seeking to achieve. In the process, banks 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 forbearance and enjoying central-bank monetary stimulus each time markets turned south.

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? Here, Fault Lines focuses on a rather fascinating phenomenon that recoveries from recent recessions, especially in the United States, have remained "jobless" for extended periods of time. Perhaps as a subconscious response to this (or due to ideologies in other cases), central banks have tended to provide massive monetary stimulus to get the financial sector to push the household consumption and real sector investment harder and harder through greater lending and intermediation. Such stimulus, unfortunately, again serves to transfer rents from households to the financial sector (by keeping interest rates low) and produces mispriced risk. Thus, the economy moved "from bubble to bubble" (the title of Chapter Five), until the most recent bubble could not be mopped up by anyone, not even the most innovative Central Bank of all, despite its own best efforts.

In essence, Fault Lines connects the dots visible to all of us in a rather ingenious manner to provide an explanation of what brought about the perfect storm we have recently weathered.

While the book is worth it even just for its explanation of why we had a crisis now rather than at some other points of time, it goes the extra mile and proposes valuable reforms, focusing on all three issues: building a better safety net in the United States (see in particular, the suggestions to improve education access to all and extend a greater level of unemployment insurance), reducing the global imbalances, and improving the regulation of the financial sector so that it (and its financiers) pay for mopping up of bubbles it fueled, rather than governments and Central Banks passing on these costs to taxpayers.

The book also helps understand why export-based Chinese and German growth, and their effective vendor financing of consumption in the US and Euro-zone countries, may ultimately face limits as consumption slows. These countries are now being forced to become the stimulators of growth and run the risk of planting seeds of bubbles in their own economies. This is how hidden fractures still threaten the world economy, as the book's subtitle goes. It also leads one to reconsider that India's slower growth rate than China, while not entirely faultless, might however be more balanced given its lack of extreme export reliance.

Raghuram Rajan's writings are always cogent and based in sound set of facts. But this book is special in the sense that here he paints on a much larger canvas, covering bases from distributional issues within income strata of society, to the persistent capital imbalances across large countries of the world, and the ruthless profit-maximizing incentives of modern market-based financial sector.

There is a lot going on in the book. But it is written with great examples and cases - almost lyrical at times (even has a fascinating poem recounted in the chapter "The Fable of the Bees Replayed"), and should be accessible to one and all. It will certainly question some long-held biases about current state of economic conditions in Western countries. But it is hard to not take a deep breath and ponder once you have read it all. In many ways, it shows that when economic conditions so demand or induce, the developed world behaves much the same way as the developing world: they are both after all driven by choices of human beings and the book lays out some common patterns of global economic behavior - in households, markets and governments.


  1. lol@ too much savings.

    I haven't read the book but what you have said is not factual.

    Yes, there was a push for home-ownership in the US but it was done to paper over the stagnation that came after the dot com bubble burst.

    Most of the subprime business was pushed by the private sector. There was even an article where Countrywide executives were shown to have pretty much threatened Freddie Mac (or was it Fannie Mae) with consequences if the latter doesn't go along with their push to go into the subprime market.

    Blaming government regulations is easy but the truth is that regulations were rarely if ever enforced. The saintly private sector did not regulate themselves as we were told over the past decade.

    Did Mr Rajan touch on the huge expenditure by the US on its military and defense? I am sure being the establishment-academic (similar to courtiers of the past), he must have been quiet about that.

    Whether a child in China saves for 4 grandparents or 2. The fact remains that somebody has to save to pay for the retirement. Money doesn't grow on trees though it can be printed in large amounts. When it comes to paying out, there is virtually no difference between individuals saving money and the government doing the same.

    Moreover, privately managed pension funds have been the rage in among academics. By those standards China is heaven where people manage their own retirement savings rather than make the government do it. Right?

    The lies of these academics is something to behold. Don't these people have any shame?

  2. Whoever you are Mr Anonymous, clearly you lack the ability to distinguish between analysis and opinions and between public policy and private business

  3. First Anon: You must read the book. The push for home ownership, the hunt for yield, the need for lesser-skilled US workforce not feel left behind by giving them home equity, the "too systemic to fail" setup - all good stuff.

    The book is incredible. My only complaint is that he writes so much in each paragraph I have to stop and let my thoughts wander through the picture he creates.

    I'm not sure I agree with all his conclusions, especially his asides on efficient markets, but the book does make you think. I also felt that some of the suggestions he provides in terms of regulatory overhaul or market reform are either easily game-able or too difficult to enforce. (That's another blog post) The book, though, is a must read.


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