Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  25 McCarthy, Poole, and Rosenthal, Polarized America.

  26 Aristotle, Politics, book V, parts 1–5 (New York: Cambridge University Press, 1988). Indeed, Abhijit Banerjee and Esther Duflo argue in “Inequality and Growth: What Can the Data Say?” (NBER Working Paper 7793, National Bureau of Economic Research, Cambridge, MA, 2000) that changes in inequality in either direction tend to be associated with reduced growth.

  27 See R. Green and S. Wachter, “The American Mortgage Market in Historical and International Context,” Journal of Economic Perspectives 19, no. 4 (2005): 93–114.

  28 See, for example, James R. Barth, S. Trimbath, and Glenn Yago, The Savings and Loan Crisis: Lessons from a Regulatory Failure (Los Angeles: Milken Institute, 2004).

  29 Bethany McLean, “Fannie Mae’s Last Stand,” Vanity Fair, February 2009.

  30 Steven Holmes, “Fannie Mae Eases Credit to Aid Mortgage Lending,” New York Times, September 30, 1999.

  31 Wayne Barrett, “Andrew Cuomo and Fannie and Freddie: How the Youngest Housing and Urban Development Secretary in History Gave Birth to the Mortgage Crisis,” Village Voice, August 5, 2008.

  32 National Home Ownership Strategy (Washington, DC: Department of Housing and Urban Development, 1995), chapter 4. I thank Professor Joseph Mason of Louisiana State University for bringing my attention to this document and for first highlighting these issues.

  33 See Lawrence McDonald and Patrick Robinson, A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers (New York: Crown Business, 2009).

  34 Neil Bhutta, “Giving Credit Where Credit Is Due? The Community Reinvestment Act and Mortgage Lending in Lower-Income Neighborhoods,” Federal Reserve Board Working Paper 2008–61, Washington, DC, 2008. Also see Peter Wallison, “Deregulation and the Financial Crisis: Another Urban Myth,” American Enterprise Institute, www.aei.org/outlook/100089, October 2009.

  35 George W. Bush, “America’s Ownership Society: Expanding Opportunities,” June 17, 2004, georgewbush-whitehouse.archives.gov/news/releases/2004/08/20040809–9.html.

  36 George W. Bush, “Remarks by the President on Homeownership,” speech at the Department of Housing and Urban Development, Washington DC, June 18, 2002.

  37 Ibid.

  38 See Peter J. Wallison and Charles W. Calomiris, The Last Trillion Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac (Washington, DC: American Enterprise Institute, September 2008).

  39 Edward Pinto, “Sizing Total Exposure to Sub-Prime and Alt-A Loans in U.S. First Mortgage Market as of 6.30.08,” American Enterprise Institute, www.aei.org/docLib/ Pinto-Sizing-Total-Exposure.pdf, accessed March 10, 2010.

  40 Edward Pinto, “High LTV, Sub-Prime and Alt-A Originations over the Period 1992–1997 and Fannie, Freddie, FHA, and VA’s Role,” American Enterprise Institute, www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf, accessed March 10, 2010.

  41 Ibid.

  42 Atif Mian and Amir Sufi, “The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis,” Quarterly Journal of Economics 124, no. 4 (November 2009): 1449–96.

  43 Peter Wallison, “Barney Frank, Predatory Lender,” Wall Street Journal, October 16, 2009.

  44 Ibid.

  45 Of course, some of the change is also accounted for by the greater willingness of lenders to accept higher loan-to-value ratios as the credit market boomed. See James MacGee, “Why Didn’t Canada’s Housing Market Go Bust?” Federal Reserve Bank of Cleveland website, www.clevelandfed.org/research/commentary/2009/0909.cfm, December 2, 2009.

  46 Nicolas P. Retsinas and Eric S. Belsky, eds., Borrowing to Live: Consumer and Mortgage Credit Revisited (Washington, DC: Brookings Institution Press, 2008), 14.

  47 Tim Landvoigt, Monika Piazzesi, and Martin Schneider, “The Housing Market(s) of San Diego,” presentation at Stanford University, 2009.

  48 See, for example, IMF World Economic Outlook (Washington, DC: International Monetary Fund, September 2004), 76.

  49 See, for example, Joseph Stiglitz, Free Fall (New York: Norton, 2010).

  50 See Seymour Lipset, Agrarian Socialism: The Cooperative Commonwealth Federation in Saskatchewan; A Study in Political Sociology (Berkeley: University of California Press, 1951). I thank Rodney Ramcharan for this reference.

  51 Shawn Cole, “Fixing Market Failures or Fixing Elections: Agricultural Credit in India,” Harvard Business School working paper, www.hbs.edu/research/pdf/09-001.pdf, 2008.

  52 U.S. Census Bureau, “Homeownership Rates for the U.S. and Regions: 1965 to Present,” www.census.gov/hhes/www/housing/hvs/historic/index.html, accessed March 10, 2010.

  53 See, for instance, Raghuram G. Rajan and Arvind Subramanian, “Aid and Growth: What Does the Cross-Country Evidence Really Show?” Review of Economics and Statistics 90, no. 4 (2008): 643–65.

  Chapter Two. Exporting to Grow

  1 See Angus Maddison, “Monitoring the World Economy, 1820–1992,” University of Groningen, Faculty of Economics, www.ggdc.net/maddison, accessed February 2010.

  2 R. E. Lucas Jr., “Why Doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review 80, no. 2 (May 1990): 92–96.

  3 Lant Pritchett, “Where Has All the Education Gone?” World Bank Economic Review 15, no. 3 (2001): 367–91.

  4 There are many antecedents to this view, though not necessarily in the precise way I have formulated it. One of the early formulations is by Albert Hirschman in The Strategy of Economic Development (New Haven, CT: Yale University Press, 1958).

  5 See Angus Maddison, “The Economic and Social Impact of Colonial Rule in India,” chapter 3 of Class Structure and Economic Growth: India and Pakistan Since the Moghuls (New York: Norton, 1971).

  6 E. Glaeser, R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, “Do Institutions Cause Growth?” NBER Working Paper 10568, National Bureau of Economic Research, Cambridge, MA, 2004.

  7 See, for example, David S. Landes, Dynasties: Fortunes and Misfortunes of the World’s Great Businesses (New York: Viking, 2006).

  8 For instance, according to a recent study, 50 to 60 percent of restaurants survive less than three years: see H. Parsa, J. Self, D. Njite, and T. King, “Why Restaurants Fail,” Cornell Hotel and Restaurant Administration Quarterly 46, no. 3 (2005): 304–22.

  9 “Historical Tables: Budget of the U.S. Government—Fiscal Year 2010,” Office of Management and Budget, www.whitehouse.gov/omb/budget/fy2010/assets/hist.pdf, accessed February 2010.

  10 From Daniel Defoe, A Plan of the English Commerce (1728), described in Ha-Joon Chang, Kicking Away the Ladder (London: Anthem Press, 2002), 20–21.

  11 Speech by Shri Syed Masudal Hossain in the Indian Parliament, Lok Sabha website, parliamentofindia.nic.in/lsdeb/ls11/ses5sp/0227089716.htm, accessed February 2010.

  12 See Daniel Yergin and Joseph Stanislaw, The Commanding Heights: The Battle between Governments and the Marketplace That Is Remaking the Modern World (New York: Simon and Schuster, 1998), 12.

  13 See Michael Reid, The Forgotten Continent: The Battle for Latin America’s Soul (New Haven, CT: Yale University Press, 2007), 127.

  14 See Yergin and Stanislaw, The Commanding Heights.

  15 See Robert Wade, Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton, NJ: Princeton University Press), 79–80.

  16 See Yergin and Stanislaw, The Commanding Heights, 176–77.

  17 See Wade, Governing the Market, 80.

  18 Ibid., 81.

  19 See, for example, Alice Amsden, Asia’s Next Giant (New York: Oxford University Press, 1989), 143–45.

  20 For Korea’s main exports in 1970, see Mark L. Clifford, Troubled Tiger: Businessmen, Bureaucrats, and Generals in South Korea (Armonk, NY: M. E. Sharpe, 1994), 60.

  21 See Robert Brenner, The Economics of Global Turbulence (London: Verso, 2006).

  22 See Hiroko Tabuchi, “Japan Strives to Balance Growth and Stability,” New York Times, September 15, 2009.<
br />
  23 Quoted in T. Taniguchi, Japan’s Banks and the “Bubble Economy” of the Late 1980s (Princeton, NJ: Center for International Studies, Program on US-Japan Relations, 1993), 9. Also quoted in Brenner, The Economics of Global Turbulence, 219.

  24 Why did the dot-com boom not do more to pull Japan out of its slump? In part, Japan was held back by its banking sector, which was in deep trouble. It was only after the banks were recapitalized and had cleared their balance sheets of bad loans in the early 2000s that they were in a position to resume lending.

  25 See Hiroko Tabuchi, “Once Slave to Luxury, Japan Catches Thrift Bug,” New York Times, September 21, 2009.

  26 Marcos Chamon and Eswar Prasad, “Why Are Savings Rates of Urban Households in China Rising?” Brookings Global Economy and Development Paper 31, Brookings Institution, Washington, DC, 2008.

  27 Peter Evans makes this point forcefully in Embedded Autonomy: States and Industrial Transformation (Princeton, NJ: Princeton University Press, 1995).

  Chapter Three. Flighty Foreign Financing

  1 Through much of the 1990s, Germany ran current-account surpluses because of the economic consequences of reunification. By the early 2000s, it was back to running surpluses.

  2 For an excellent introduction to foreign financing, see Barry Eichengreen, Globalizing Capital: A History of the International Monetary System (Princeton, NJ: Princeton University Press, 1996).

  3 I owe the term “boom in busts” to Gerry Caprio of Williams College.

  4 Martin Feldstein and Charles Horioka, “Domestic Saving and International Capital Flows,” Economic Journal 90 (1980): 314–29.

  5 Marc Lacey, “Kenyan Parliament Unites, for More Money,” New York Times, May 22, 2005, www.nytimes.com/2006/05/22/world/africa/22iht-kenya.html.

  6 See, for example, R. Rajan and L. Zingales, “Which Capitalism? Lessons from the East Asian Crisis,” Journal of Applied Corporate Finance 11, no. 3 (1998): 40–48; R. Rajan and I. Tokatlidis, “Dollar Shortages and Crises,” International Journal of Central Banking 1, no. 2 (September 2005): 177–220; D. Diamond and R. Rajan, “Banks, Short-Term Debt and Financial Crises: Theory, Policy Implications and Applications,” Carnegie-Rochester Conference Series on Public Policy 54, no. 1 (June 2001): 37–71.

  7 Tarun Khanna and Krishna Palepu, “Is Group Affiliation Profitable in Emerging Markets? An Analysis of Diversified Indian Business Groups,” Journal of Finance 55, no. 2 (April 2000): 867–91.

  8 The description of Alphatec is drawn from Mark L. Clifford and Peter Engardio, Meltdown: Asia’s Boom, Bust and Beyond (Paramus, NJ: Prentice-Hall, 2000), 136–38.

  9 See Shalendra D. Sharma, The Asian Financial Crisis: Crisis, Reform, and Recovery (Manchester, U.K.: Manchester University Press, 2003), 42.

  10 The photograph is widely accessible, for example on the website of the International Political Economy Zone, ipezone.blogspot.com/2007/09/flashback-camdessus-suharto-pic.html, accessed March 10, 2010.

  Chapter Four. A Weak Safety Net

  1 I have concealed real names here.

  2 The ideas in this chapter evolved out of an initial office conversation with Martin Wolf of the Financial Times, to whom I owe thanks.

  3 Stacey Schreft, Aarti Singh, and Ashley Hodgson, “Jobless Recoveries and the Wait-and-See Hypothesis,” Economic Review, Federal Reserve Bank of Kansas City (4th quarter, 2005): 81–99.

  4 R. Haskin and I. Sawhill, Creating an Opportunity Society (Washington, DC: Brookings Institution Press, 2009), 111.

  5 Erica Groshen and Simon Potter, “Has Structural Change Contributed to a Jobless Recovery?” Current Issues in Economics and Finance, Federal Reserve Bank of New York, 9, no. 8 (August 2003): 1–7.

  6 Kathryn Koenders and Richard Rogerson, “Organizational Dynamics over the Business Cycle: A View on Jobless Recoveries,” Federal Reserve Bank of St. Louis Review 87, no. 4 (July–August 2005): 555–80.

  7 Schreft, Singh, and Hodgson, “Jobless Recoveries.”

  8 Louis Uchitelle, “Labor Data Show Surge in Temporary Workers,” New York Times, December 20, 2009.

  9 Study by the U.K. National Council for Volunteer Organizations and United for a Fair Economy, cited in Alberto Alesina and Edward Glaeser, Fighting Poverty in the US and Europe (Oxford: Oxford University Press, 2004), 45.

  10 See, for example, Joe Peek and Eric S. Rosengren, “Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan,” American Economic Review 95, no. 4 (September 2005): 1144–66; Takeo Hoshi and Anil Kashyap, Corporate Financing and Governance in Japan: The Road to the Future (Cambridge, MA: MIT Press, 2004).

  11 See “A Fork in the Road,” Financial Times, December 11, 2009.

  12 See, for example, Clayton Christensen, The Innovator’s Dilemma (New York: Harper Paperbacks, 2003).

  13 National Science Foundation, Science and Engineering Indicators, chapter 5, Appendix Table 5–43, National Science Foundation, www.nsf.gov/statistics/seind10/c5/ c5s4.htm, accessed March 10, 2010.

  14 Alesina and Glaeser, Fighting Poverty, 19.

  15 Talkin’ ’bout My Generation: The Economic Impact of Aging U.S. Baby Boomers, McKinsey Global Institute, Washington, DC, 2008.

  16 See, for example, Louis Hartz, The Liberal Tradition in America (San Diego, CA: Harvest HBJ, 1991).

  17 Alesina and Glaeser, Fighting Poverty, 197.

  18 See Theda Skocpol, Protecting Soldiers and Mothers: The Political Origins of Social Policy in the United States (Cambridge, MA: Belknap Press, 1992), 50.

  19 See Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists (Princeton, NJ: Princeton University Press, 2004).

  20 See Alesina and Glaeser, Fighting Poverty.

  21 See Jacob S. Hacker and Paul Pierson, “Business Power and Social Policy: Employers and the Formation of the American Welfare State,” Politics and Society 30, no. 2 (June 2002): 277–325.

  22 See chart “Unemployment during the Depression,” MSN Encarta, encarta.msn.com/media_461546193/unemployment_during_the_depression.html, accessed December 20, 2009.

  23 See Hacker and Pierson, “Business Power and Social Policy.”

  24 See Peter A. Swenson, “Varieties of Capitalist Interests: Power, Institutions, and the Regulatory Welfare State in the United States and Sweden,” Studies in American Political Development 18 (Spring 2004): 1–29.

  25 See John B. Taylor, “The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy,” CES Info Forum 10, no. 2 (Summer 2009): 9–13.

  26 Elizabeth Drew, “Thirty Days of Barack Obama,” New York Review of Books, March 26, 2009, www.nybooks.com/articles/22450.

  27 Gerald Seib, “In Crisis, Opportunity for Obama,” Wall Street Journal, November 21, 2008.

  Chapter Five. From Bubble to Bubble

  1 Ben Bernanke, testimony before the Senate Banking Committee, Washington, DC, September 23, 2008, banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=7a41ae9e-30b2-4d7f-8f1b-4ef2e8ae28f7&Witness_ID= c52a9dcc-1eb1-474c-a493-461c8fef9afd, accessed March 28, 2010.

  2 Ben Bernanke, “Asset Price Bubbles and Monetary Policy,” speech made at the New York Chapter of the National Association of Business Economists, October 15, 2002.

  3 See Ben Bernanke, “An Unwelcome Fall in Inflation,” remarks made at the Economics Roundtable, University of California, San Diego, La Jolla, California, July 23, 2003.

  4 See “Lessons for Monetary Policy from Asset Price Fluctuations,” chapter 3, World Economic Outlook (Washington, DC: International Monetary Fund, October 2009).

  5 John Taylor, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Stanford, CA: Hoover Institution Press, 2009).

  6 See Alan Blinder, “Monetary Policy Today: Sixteen Questions and about Twelve Answers,” in Central Banks in the 21st Century, ed. S. Fernandez de Lis and F. Restoy (Madrid: Banco de Espana, 2006), 31–72, which cites evidence indicating that the Greenspan Fed was mor
e focused on output and unemployment than inflation. The Fed may be more conscious about unemployment than, say, the European Central Bank. For example, see Joseph Lupton, “The Central Bank Bucket List” (JP Morgan Economic Research Note, Global Data Watch, JP Morgan, New York, September 11, 2009), which shows that the U.S. Federal Reserve started raising rates 20 months after peak unemployment in the 1990–91 recession and 12 months after peak unemployment in the 2001 recession. By contrast, the euro area not only cut rates less but also was quicker to raise rates, doing so 7 months after peak unemployment on average in the 1991 recession and 9 months after peak unemployment in the 2001 recession.