Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  Second, the dominant academic orthodoxy indicated that so long as inflation was quiescent, central bankers had nothing to worry about. Indeed, to worry was to destroy the purity of the theoretical system that had been built, for that would admit of multiple objectives and lead to market confusion. Instead, central bankers should keep their eyes fixed on inflation (or the lack thereof) and let bank supervisors worry about risk taking. Unfortunately, the supervisors had been muzzled, this time on the ideological grounds that they would do more harm than good by restraining the private sector.

  The bottom line is that the debate over monetary policy, which was once thought settled, will have to be reopened again. Among the most pressing issues are the trade-offs between policies intended to generate investment and employment and policies intended to ensure financial stability. Asset-price inflation will have to enter the policy debate. Moreover, the Fed will have to consider whether it is setting policy only for the United States, or, in reality, for a much larger global economy. Much needs to be done.

  Academia’s Failings

  This is as good a point as any to try to understand the failings of academic economists in the macroeconomic sphere. Many commentators have gone overboard in poking fun at economists’ models, deriding them as oversimplified. Others wonder about the excessive mathematical complexity of some modeling, and yet others combine the criticisms by arguing that human behavior is too complex to be captured by mathematical models.

  The most realistic model would be one that details all individuals and their whimsical behavior, and all institutions, but it would be hopelessly complex and of little value in analysis. The whole point of economic modeling is to create useful simplifications of the economy that allow us to analyze what might happen under varying policies and conditions. The test then is whether the model is a useful simplification or an oversimplification.

  Many past macroeconomic models had a single representative agent making all decisions. The representative-agent models were easy to work with and did offer useful predictions about policy, but they took for granted the plumbing underlying the industrial economy—the financial claims, the transactions, the incentive structures, the firms, the banks, the markets, the regulations, and so on. So long as these mechanisms worked well, the models were a useful simplification. And during much of the “Great Moderation” that Bernanke referred to, the plumbing worked well and served as a good basis for abstract reasoning.

  But as soon as the plumbing broke down, the models were an oversimplification. Indeed, the models themselves may have hastened the plumbing’s breakdown: with the Fed focused on what interest rates would do to output rather than to financial risk taking (few models had a financial sector embedded in them, let alone banks), financial risk taking went unchecked.

  In a haunting parallel to Robert Lucas’s famous critique of Keynesian models, in which he argued that those models would break down because modelers did not account for how the economy would react to policies that attempted to exploit past correlations in the data, modeling that took the plumbing for granted ensured the breakdown of the plumbing. In coming years, macroeconomic modeling must incorporate more of the plumbing, which has been studied elsewhere in economics.

  The danger is that monetary economists will try to wish away the links between monetary policy, risk taking, and asset-price bubbles. Bernanke came close to doing so in his 2010 speech to the American Economic Association, where he argued that it was not the Fed’s defective monetary policy—which he considered entirely appropriate, given the Fed’s views on inflation—but its inadequate supervision that helped trigger the crisis. He concluded: “Although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explained by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policy and the pace of house price increases.”20

  Of course, no one claims that the Fed alone was responsible for the housing debacle. Government policies favoring low-income housing, as well as private-sector mistakes, contributed significantly. But to suggest that it had no role is disingenuous. Indeed, a detailed study published in the Federal Reserve Bank of St. Louis Review in 2008 presents evidence that “monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off the perceived risks of deflation in 2002–2004 has contributed to a boom in the housing market in 2004 and 2005.”21

  Moreover, there is no reason why there should be a strict relationship across countries between monetary policy and the rate of house-price growth over any common period of time: the rate of price growth might depend on a variety of factors that are specific to each country, including how high house prices already are.22 The broader point is that monetary economists need to take note (as they are now doing) of the other channels through which monetary policy might have effects.

  Summary and Conclusion

  As developing countries cut back on demand following their crises in the 1990s, and as industrial-country corporations worked off their excess investment following the dot-com bust, the world’s exporters searched once again for countries that would reliably spend more than they produced. The United States, which was already pushing to encourage household consumption to appease those left behind by growth, had added reasons to infuse substantial fiscal and monetary stimulus in response to the downturn: the jobless nature of the recovery and the weak U.S. safety net. In addition to a substantial fiscal stimulus that pushed a government budget that was temporarily in surplus into large fiscal deficits, the Fed kept its foot pressed on the monetary accelerator, even while giving all sorts of assurances to the markets on its willingness to maintain easy monetary conditions and to step in to provide liquidity in case the financial markets had problems. These assurances had the desired effect of leading to an explosion of lending, which unfortunately continued expanding and deteriorating in quality even after the Fed started tightening. For an unsustainable while, though, the United States provided the demand the rest of the world needed.

  The U.S. political system is acutely sensitive to job growth because of the economy’s weak safety nets. The short duration of unemployment benefits in the United States, as well as the substantially higher costs of health care for those who do not have jobs, were not excessively painful when recessions were short: they gave laid-off workers strong incentives to find new jobs even while U.S. businesses created them. But if recessions are likely to be more prolonged than in the past, the system has to change, if only because the old social contract—short-duration benefits in return for short recessions—is breaking down.

  One reason is simply moral. No modern economy should force workers who lose their jobs to make such painful decisions as choosing which of their children to protect with medical insurance. Not only is this situation barbaric, it is also unsustainable, for those who lose out economically have every incentive to use political means to regain what they have lost. While a democratic system eventually responds, the response can be unpredictable, adding to worker uncertainty. There is a strong case for strengthening the U.S. safety net in ways that will not hamper the flexibility of the economy greatly.

  Another problem with a weak safety net is that the United States tends to overreact, and other nations underreact, to downturns. Because every country knows that the politically vulnerable United States has to respond with expansionary policies and that some U.S. demand will spill over to the rest of the world, their incentive to change the structure of their economy, or their policies in downturns, is commensurately less.

  But perhaps the most important problem is that the ad hoc policies the United States is forced into do enormous damage to the long-term health of the economy, both directly and through their effects on the financial sector. One could argue that discretionary fiscal and monetary policy in the midst of a downturn gives the United States the abilit
y to calibrate its response to the severity of the downturn. But fiscal policy undertaken at the point of a gun is rarely as dispassionate or as well thought out as one might like. Yes, Congress could simply extend unemployment benefits, as it has done in the current recession. But politicians often want to do more. And the public’s anxiety gives them the license to bring out all their pet projects, all the favors to special interests, and all the schemes their ideological leanings and political connections predispose them to.

  Similarly, as we have seen, the Federal Reserve, though ostensibly independent, has a very difficult task. It is extremely hard to ensure rapid job growth in an integrated, innovative economy where firms use recessions to refocus on becoming more productive or to strengthen their global supply chains, shifting jobs elsewhere. Moreover, the new technologies employed in hiring allow firms the luxury of waiting to fill positions. The sustained easy monetary policy that is maintained while jobs are still scarce has the effect of increasing risk taking and inflating asset-price bubbles, which again weaken the fabric of the economy over the longer term. If the United States cannot tolerate longer bouts of unemployment, but those bouts are here to stay, we risk going from bubble to bubble as the Federal Reserve is pressured to do the impossible and create jobs where none are forthcoming.

  It is now time to turn to vulnerabilities in the financial sector to see why the fault lines came together to make banks take the risks they did. I focus on two issues. First, why did mortgage lending go berserk (which is the subject of the next chapter)? Second, why did the banks take on so much default and liquidity risk (which is the subject of Chapter 7)?

  CHAPTER SIX

  When Money Is the Measure of All Worth

  WHEN THE FRENCH MONARCHY was strapped for money in the eighteenth century, it found more and more creative ways to raise funds.1 One of these was to sell annuities—government bonds that paid out a fixed amount until the death of the person on whom the annuity was written. Annuities were very popular with the public, for they offered beneficiaries a guaranteed income for life in a time before there were old-age pensions. The monarchy liked them because it received payment up front.

  The monarchy targeted these annuities at wealthy men—typically in their early fifties—who had the means to buy an annuity and who, given low life expectancies at that time, typically did not have very long to live. Annuities were priced so that they were a fair deal for such men. However, it was possible for the buyer of the annuity to make the payments dependent not on his own life span, but on that of someone else. Perhaps this loophole was not inadvertent, for it increased demand for the annuities: for example, it might have made annuities attractive to a wealthy merchant who wanted to settle his daughters for life. But it did mean that the clever investor could make money off the government. He could pick as beneficiaries healthy young girls (then as now, women lived longer than men) whose family history suggested a genetic predisposition to long life, and who had survived early childhood (infant mortality was very high in those times) as well as the dreaded smallpox. He could then buy annuities on their lives from the French government. A carefully selected, healthy ten-year-old girl would have much higher odds of surviving for a long time than the typical beneficiary of the annuity, and the payments received during her lifetime would far exceed the cost of the annuity.

  This is indeed what a group of Geneva bankers did. They selected groups of thirty suitable girls in Geneva and purchased a life annuity on each from the French government. They then pooled the annuities so as to diversify the risk of accidental early mortality among the girls and sold claims on the resulting cash inflows to fellow citizens of Geneva. This early form of securitization thus allowed the bankers to create a virtual money machine, buying policies cheaply from the French government and reselling them for a higher price to investors. The investments were popular—especially because the bankers were reputable and the underlying annuities were claims on the government—and sold well.

  However, buyers had not reckoned with the risk of government default. When the French Revolution broke out in 1789, the monarchy was overthrown, and the revolutionary government soon fell behind in its annuity payments. It eventually made payments in worthless currency. The Geneva bankers, who owed investors in harder Swiss currency, did not have the wherewithal to pay, and they defaulted, as in turn did many of the investors who had borrowed to invest in the “sure” thing.

  There are four important and enduring lessons from this historical mini-crisis. First, few have a better nose for a good moneymaking opportunity than bankers. It is not that bankers are excessively greedy. Even though Adam Smith did put self-interest at the heart of capitalism when he wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,” few businesspeople are entirely without concern for the impact of their activities on their societies.2 Rather, their willingness to exploit any advantage that will help them make money, however dodgy (albeit legal) it may be, stems partly from the nature of competitive banking, where there are few easy opportunities to make money, and partly from the way banker performance is measured—almost exclusively by how much money the banker makes rather than by her impact on real activity. The disconnect between banking and real lives and livelihoods is most apparent in the arm’s-length financial systems that are found in countries like the United States and the United Kingdom.

  A second lesson is that bankers invariably find the biggest edge in taking advantage of unsophisticated players or players who do not have the same incentive to make money. Clearly, individuals who are unschooled in finance are a potential target, but often these individuals realize their ignorance and give their custom only to trusted intermediaries. Moreover, they typically have too little money to be of interest to the smartest bankers. More attractive targets are the moderately schooled managers of large pools of funds, such as pension funds or foreign state-owned funds, who know not that they know not and are thus easily taken advantage of. But perhaps the most attractive target of all is the government itself. The government has nonmarket, noneconomic objectives, and however astute its representatives may be, these make it easy prey for clever bankers. Moreover, whereas a naive individual is soon relieved of all his money, the government has deep pockets, and exploiting them can sustain many a banker’s luxurious lifestyle for a long time.

  Third, banker behavior tends to be self-reinforcing, at least for a while. In the example of the annuities, as the profits from the first insurance scheme become apparent, they not only attract more bankers to the activity but also push up the prices of the securities issued by the first scheme, sending a still stronger signal to bankers. Similarly, as initial housing loans start to look profitable, more banks extend loans, thereby pushing up house prices and making the initial loan look even more solid. This behavior can exaggerate investment trends and move prices far away from fundamentals. Early movers may convince themselves they are geniuses, even though they are only the leaders of a herd that is rapidly headed toward a cliff. But the growth of the herd itself can make what would have been a minor loss by some adventurous bankers and their investors into a much more serious loss for the community.

  Finally, there is safety in numbers, because the responsible government cannot let all its bankers fail, given the likely collateral damage to the citizenry. So even the revolutionary government in France continued paying the hated monarchy’s debts for as long as it was able. This is not necessarily to imply that bankers start out with the expectation that they will fail and be bailed out: bankers understand that failure is never pleasant, however forgiving the government. It may well be that the thought of a bailout really does not cross their minds. Rather, the problem created by the anticipation of government intervention is that the bankers, caught up in the herd’s competitive frenzy to cash in on the seemingly lucrative opportunity, are not slowed by more dispassionate market forces—what I have referred to as the unintentional
guidance of the key actors’ actions by markets or voters. In such a situation, lenders to banks do not demand proper compensation for the risks the banker takes, because they know the blow will be softened by the government—and in behaving thus, lenders facilitate risk taking and herd behavior. The normal disciplinary role of markets (which themselves may sometimes be caught up in the frenzy) is dulled by repeated government intervention.

  I draw modern parallels in this chapter and the next. The sophisticated U.S. financial sector responded to the government’s desire to promote low-income housing, as well as to foreign demand for highly rated debt securities. The edge the financial sector exploited was the unthinking, almost bureaucratic, way both the mortgage agencies and foreign investors evaluated the issued securities. Market discipline broke down as mortgage brokers found they could peddle all sorts of junk, especially because the deterioration in credit quality was masked by the immense amount of money pouring into the sector. When the crash eventually came, the government and the Federal Reserve, unable to stand by and see homeowners suffer, stepped in to prop up the price of homes and of mortgage-backed securities, validating much of the extraordinary insouciance of the market.

  In this chapter, I explain why the fault lines we have examined earlier, acting on an amoral financial sector with a finely honed eye for opportunity, combined to cause a steady deterioration in the quality of mortgage lending. In the next, I explain why banks held on to so many of the risky asset-backed securities on their own balance sheets.