Tuesday, June 15, 2010

Fault Lines Review

Raghuram Rajan, a professor at the University of Chicago Booth School of Business, has become famous for his prescient warning in 2005 of a possible future financial meltdown. Many of his views vindicated, he has written a new book, Fault Lines, which offers a more definitive account of the structural problems in global political economy that make financial crises all but inevitable.

Unlike many other books in the growing genera of financial crisis retrospectives, Rajan does not labor over specific events, or allocate blame between particular people. Rather, he isolates the specific “fault lines” or systemic stresses that, over time, lead to distorted outcomes.

These problems cannot be reduced to simple market or government failure. After all, when have market participants not made mistakes, or regulators failed in their duties? Rather, the stresses Rajan emphasizes relate to the construction of an integrated economic and political architecture on a global scale. Aligning incentives so that what is best for individuals is also best for society as a whole is relatively easy in a small, closed society. Incentives in the global marketplace bound by far-flung financial ties, however, too often lead to consistently poor outcomes over an extended period of time.


The first of these fault lines is income inequality. Rajan begins by observing that unequal access to education led to stagnant wages. His new and controversial spin is that politicians in turn responded to stagnant wages through an unprecedented period of populist credit expansion. By loosening the credit spigot at the government-backed mortgage agencies Fannie Mac and Freddie Mae, politicians of both parties were able to ensure that their constituents—though they did not see rising wages—could at least purchase larger homes.

This is a plausible and consistent narrative, and undeniably has an element of truth to it. Political efforts to extend the supply of credit have a long pedigree in American politics, from the deregulation of banking in the early 20th century, to the surge in thrift lending, to the present day. Yet it is exactly the omnipresence of populist lending which calls into doubt the causal role of inequality in this story. In the 1996 election, Dole ran on a platform of capital gains cuts, and Clinton ultimately drastically increased the exemption for capital gains tax for housing investment (a reform Vernon Smith blames for part of the subsequent housing bubble). As Rajan notes, Clinton also increased the share of government agency loans going to low-income borrowers. Yet this growth in populist lending happened during the most durable period of income growth in the last thirty years. Even if stagnant wages may drive politicians decisions on populist lending to an extent; it’s not clear that these populist pressures would suddenly disappear in the presence of rising wages.

Finally, there is the question of what role populist credit expansion itself had on the overall crisis. Government expansion of mortgage lending was a horrible idea that has cost taxpayers millions—both from the lost revenue from not collecting income and capital gains taxes on housing investments, as well as the direct costs of bailing out Fannie and Freddie—which have reached $145 billion at the latest count. Aside from the direct effects of their lending, the GSEs assisted the growth of aggregators like Countrywide that packaged loans for resale. Yet the GSEs actually lost market share in during the boom in mortgage lending from 2002-2006. The role of the GSEs was significant; but the were hardly the greatest contributor to the housing mess. Loans held by the GSEs did not spark a financial crisis.

Rajan has since responded to these critiques by noting the presence of the GSEs in the low-income sector. For Rajan, the spread of mortgage credit into previously unprofitable lower income buckets is a key piece of evidence that a government sponsored credit was driving unprofitable loan decisions. He relies heavily on the work of former chief credit officer of Fannie Mae, Edward Pinto, who argues that Fannie and Freddie constituted a sizable chunk of the subprime market.

Yet as James Kwak has pointed out, the loans Pinto classified as “subprime-like” (and which Rajan calls subprime) were actually prime loans with poor attributes. The GSEs had limited investments in subprime Mortgage-Backed Securities. But private companies handled the vast majority of the origination and securitization in this sector, and it was their failure to manage risk that directly led to the financial crisis. A more likely explanation for the rise of low-income lending rests in the fact that the demand for credit in higher-income brackets had been completely saturated.

Income Inequality may, however, have had another, more direct role in the rise of consumer debt over the past decade. Mike Konczal has argued that as households faced stagnant wages, they turned to credit cards and mortgage debt in order to maintain their purchasing power.

This story would explain certain puzzling facts about consumption and debt over the past decade. Retail sales and consumption rose at a steady clip. This belies the simple narrative that overconsumption of flat-screen TVs was responsible for the crash, or that there was any sort of spending binge.

However, maintaining living standards came at a huge cost, because growth in income lagged behind.

As the above graph shows, growth in consumption was actually far lower in this period than in the past. The difference is that this decade saw a large drop in the growth of wage income, to the point that growth in consumption outpaced income. Rising levels of consumer debt accounted for this difference.

Atif Mian and Amir Sufi, either former or current colleagues of Rajan at Chicago, have documented related changing dynamics in mortgage debt. Low-income borrowers started receiving unprecedented levels of home credit; and a large portion (perhaps a fourth) of rising home equity was ultimately extracted by new borrowing and used largely for consumption and home improvement. While for Rajan this is evidence that government-induced lending was the problem; it is equally possible that consumers themselves turned to lending--which lenders were happy to meet for a variety of their own reasons (Mian and Sufi themselves stress the rise of securitization). This borrowing would have been unnecessary had wage income grown the past decade as it did in previous decades.

But it’s worth digging deeper into the sources of lagging wages. Poorly structured education, as Rajan emphasizes, is clearly an important factor. But so are the various forms of deductions and distortions embedded in the tax code. Surprisingly, as Scott Winship shows, compensation as a whole actually rose during the last thirty years at a steady clip. Yet these benefits did not translate into rising wages for individuals because they were diverted into fringe benefits like healthcare, or spent on mortgage payments. Crucially, both payments can be exempt from income taxes.

So the problem is not that the amount of national income going to workers was stagnant. The problem is that political pressure encouraging home ownership and health coverage has pushed too much of income into non-consumption benefits. As long as health premiums remain untaxed, employers have a strong incentive to pay marginal benefits in the form of additional health coverage; and as long as mortgage payments remain tax-deductable, households have strong incentives to take on these illiquid, highly levered investments.

The upshot of this is that whether one believes Rajan that stagnant wages lead to political pressures for undue lending, or Konczal that they lead to consumer demand for more debt to maintain spending--it’s clear that stagnant wages pose broader economic problems. Rajan’s solution to improve educational outcomes is an important long-term solution to this problem. But other solutions are needed as well. We need—as Reihan Salam emphasizes—thoroughgoing reform of the web of deductions and implicit benefits that characterizes the invisible welfare state, and turn them into explicit benefits whenever possible. This calls for health vouchers rather than a tax-deduction on employer-provided health coverage; and government assistance in the form of explicit wage subsidies and cash assistance rather than deductions.

Though Rajan does not raise this issue, these arguments call for caution before looking to a Value Added, or sales, tax. Many economists consider a broad-based consumption tax to be a more efficient way of raising income, and some see it as a necessary prerequisite for serious attempts to solve budget crisis. But to simply add on a Value Added Tax to the existing tax code would destroy the real consumption ability of the middle class. If the argument I’ve sketched here is correct, consumers will simply shift towards other forms of debt to make up for this difference—either through government provided or private means.

Monetary Policy

Rajan more plausibly links public hardship with government actions in the case of monetary policy. He echoes numerous other critics in condemning the Federal Reserve for holding interest rates low for an extended period of time after the dot-com bubble burst.

But Rajan shows a more shrewd understanding of the political compulsions borne by the Federal Reserve at the time. To be sure, complacency about asset bubbles may have been a factor in leaving rates too low, and Rajan emphasizes that asset prices ought to play a larger role in determining monetary policy. But the nature of the recovery was a serious issue as well. The recovery after the 2001 recession was “jobless”, and left higher-than expected unemployment for years afterwards. The Fed left rates low in large part to respond to this economic dislocation indirectly. Unlike other countries, America’s weak safety net means that extended unemployment is a jarring experience with possibly severe political effects. An overhang in unemployment forced stronger pressure on the Federal Reserve than in comparable central banks.

Greenspan’s defense of this situation was that the short-term rates targeted by the Fed would not have an effect on long-term interest rates. Rajan dismantles this argument. By influencing interest rates through the buying and selling of Treasury bills, the Federal Reserve sets inflation expectations that govern interest rates of all durations throughout the economy. The low interest rates that resulted had a small impact on profitable investment that would have been made anyway, but provided a boost to speculative and leveraged investments. New homeowners and banks piled up on risk and house prices soared in price.

Greenspan’s error led to another problem, one that Rajan does not specifically raise but bolsters his case: an extended period of low interest rates led to the present problems with deflation. Because interest rates were so low before the crisis began, the Fed had very little ammunition by way of conventional policy tools before running into a liquidity trap. When interest rates are zero and prices are stagnant or falling, the Federal Reserve is left with fewer tools to boost economic growth. Japan was caught in such a deflationary trap for over a decade, and America is in a similar situation. Even without concerns over the housing bubble, accepting a higher inflation target may be an essential insurance policy against being caught in economic conditions like those prevailing today.

Frustratingly, there are few easy solutions to fix monetary policy. Rajan emphasizes broader unemployment insurance to better insulate the Federal Reserve from political pressure, and a monetary policy more tightly set by asset prices.

Yet as Scott Sumner has pointed out; a similar program of monetary policy tightening and greater labor market rigidities contributed to the Great Depression. Developing unemployment insurance along the lines of Europe (or continuing the current expansion of unemployment insurance after the economy recovers) will bring with it Europe-like problems with structural unemployment. Setting monetary policy purely through asset prices can be tricky—since Rajan finished the book, stock markets have plummeted, while inflation remains at a 44-year low. Raising interest rates now would be a serious mistake, and even the European Central Bank is considering unprecedented monetary interventions. The only certainty here is that the Greenspan-Bernanke complacency in macroeconomic management has been seriously shaken.

Financial Institutions

Rajan also labors over the plumbing behind financial institutions. This is the key to understanding why perhaps $1 trillion of subprime losses turned into trillions of dollars of losses for the entire economy. Many other writers have blamed individual bankers or regulators. As Rajan correctly argues; the problem instead lies in the incentives faced by participants in arms-length financial institutions.

Internal corporate governance in financial institutions has failed to prevent risky lending behavior. By using securitization and structural finance, firms are able to underwrite bad loans and offload them to other institutions. Managers were encouraged to make quick profits now and ignore the costs of making poor decisions. Incentives throughout the financial system boosted risk-taking, especially in ways that coincide with the risks others are taking in a herd-like fashion.

Most troubling, it appears that requiring that managers keep equity in their own firm does not appear to dampen risk taking. Rajan points out that stockholders have skewed payoffs. Because equity holders are wiped out if a firm fails anyway, but bear all of the upside if the risks pay off—they have a strong risk bias.

Meanwhile, there are enormous pressures to handle government bailouts in an asymmetric manner. When financial firms do well, no one complains. When they do poorly, they are bailed out. Over time, this leads to systemic incentives to take risks and make poor bets.
There are no easy solutions to fixing finance. But there are some promising directions, particularly in the form of debtor oversight. Debtors have virtually the opposite risk appetite as equity investors. They only make money when the firm avoids catastrophically bad investments, and so can operate as a form of risk-management.

However, a variety of interventions prohibit debtor oversight from fully operating. The FDIC guarantees bank depositors, while many bank creditors were effectively saved through government bailouts. Bankruptcy reform enacted in 2005 privileged derivative and short-term repo contracts in bankruptcy proceedings. As Rajan emphasizes, this represents a conflict between relation-based and arms-length financing. Bank creditors, unwilling to monitor risk, were able to minimize their losses by entering into short-term contracts that would withstand the bankruptcy process. Unfortunately, this led to banks piling up on short-term debt. As in the Asian Crisis of 1998, this short-term lending was ultimately quite fragile and prone to withdrawing at the first sight of trouble. This left over-levered financial institutions, such as Bear Sterns and Lehman Brothers, to face a traditional bank run in 2008, with disastrous consequences.

Ultimately, Rajan argues, “the combination of incentives for high-powered incentives that are inherent in the modern financial system and the unwillingness of a civilized government to led failure in the financial sector drag down ordinary citizens generates the potential for tail risk taking and periodic, costly meltdowns.” This analysis does not offer easy solutions, but it is an accurate, if depressing, account of modern financial practices.

Global Imbalances

Finally, an overarching fault line throughout the book is the role of global imbalances. Over the past decade, a number of developing countries have faced the problem of large amounts of capital inflows. As with lax monetary policy, these inflows have the effect of distorting market prices and encouraging risk-taking.

The pernicious effects of capital inflows are well recognized in the case of developing countries. It was assumed, however, that countries like America were better protected against the problems of speculative investment by virtue of their better-developed financial institutions. This turns out not to be the case.

Rajan points out, however, that these capital inflow imbalances are the direct result of trade imbalances. By arithmetic identity; a trade surplus must necessarily be matched by capital outflows. The current account (the balance of trade) plus the negative of the capital account (net capital outflows) must be equal to zero. So, if a country is a net exporter, it must also necessarily export capital as well.

That is, the net global transfer of capital is matched with a transfer of goods. America, Greece, Ireland, and other capital-importers are also net importers of goods. Not coincidentally, these countries have all seen asset bubbles. These transfers are exactly matched by exports of goods and capital from countries like Germany, China, and Japan. These countries have chosen an export-intensive brand of capitalism that suits domestic constituencies.

This situation is not sustainable. In order for the export-intensive countries to continue growth, they require captive consumer-dependent countries capable of purchasing their goods. Those recipients, in turn, must be willing to remain net importers while sustaining net inflows of capital. Complicating matters further is a currency regime that fixes currency rates in Europe (the Euro) as well as between America and China.

This system has in the past worked out for all members involved. The export-intensive countries were able to engineer enormous advances in productivity, while the import-intensive countries were able to boost debt-fueled consumption. Sadly, the growth for the latter set of countries has proven to be illusory, and they are already facing a reckoning.

But as long as both sets of countries feel that they hold the moral upper ground, and are merely following their own best interests, there is precious little anyone can do about this state of affairs. Rajan felt this difficulty personally in his position as chief researcher at the IMF, when he warned about these imbalances. There is no constituency willing to stand up for resolving these imbalances, and no easy way to resolve them short of global coordination—which has proven impossible on this as well as numerous other issues.


If Rajan is brilliant in diagnosis of the structural problems in the global economy, he is less persuasive in his is prescription. Without a doubt, better education, global coordination, and better-matched incentives in the financial sector would do a great deal to improve global welfare, as well as lowering the odds of suffering another financial crisis. But the odds of these being fully achieved are close to nil.

The goal, rather, must be to create a global system robust to mistakes and stresses--a system which can take the occasional burst of exuberance or fear. In 2000, the US saw the collapse of over-priced tech stocks, yet the global economy did not collapse. As we saw in 2007 with the subprime crisis, and currently with Greece—we now have a global economic system only as strong as its weakest debt obligation. It’s easy to come up with a list of people to blame, or those who made mistakes. But the problems are really more conceptual, and call into question the entire notion of a modern financial system or integrated global economy. The advances that have brought us the ability to sell mortgages or toasters across oceans are invaluable, and have raised the living standards of millions. Yet they have also brought chronic economic instability. Figuring out how to balance these competing agendas is now the central goal for economic policymaking, and Fault Lines is the premier text on how to understand these tensions.


Ari Tai said...

re: stagnant wages.

Any recommended good studies on this?

My sense is regulation is a form of dictated market choice (or a limit of market choice) both of which raise prices and limit substitution for the consumer and for others acting (purchasing) on their behalf. Where the number of regulations affecting individual choice has never been greater.

Where it's not that productivity is not increasing individual rewards, it's just that these benefits are being spent elsewhere. And the effect is most visible on middle-class salaries since these mandated purchases are a smaller fraction for the highly paid.

Arpit Gupta said...

Katz and Goldin, The Race between Education and Technology, is a good place to start.

I'd draw a difference between "regulations" and "forced spending." Regulations might be down from the '50s; taxes certainly seem to be. But mandated purchases are much higher, arguable for good reasons.