Tuesday, June 29, 2010

Getting Capitalists to Act Like Capitalists

There is a common argument against austerity and in favor of further fiscal stimulus going around resting on this equation:

Net Private Sector Financial Position - Net Government Deficit = Current Accounts Surplus (ie, net exports)

The idea is that, as a matter of arithmetic necessity, the balance sheet of the private sector must match that of the government sector, plus that of any external trade.

Martin Wolf, among others, have used this as a case for further government stimulus. The private sector, the argument goes, is deleveraging as a matter of necessity after a severe shock. The export channel may be a useful boost for certain countries, but cannot be helpful on a global scale since the exports of one country necessarily match the imports of another. Additional government borrowing remains the only way to sustain a proper global recovery.

Rob Paranteu, referenced by Steve Waldman, cautions us on this interpretation. As an arithmetic identity, this equation must necessarily be true. Yet nevertheless it elides certain distinctions within the private sector.

Paranteu reworks this equation to arrive at the following form:

Net Household Income = Current Account Surplus + Net Government Deficit + Change in Business Non-Financial Assets

The interpretation here is that the private sector can be divided up into households and firms. Rather than "the private sector getting rid of debt"; instead we should think about what is going on within the private sector. Are households gaining income? Or are businesses losing the value of their assets? This is a more complicated story than one involving only the private sector and government, but it brings out the fact that we really care about the income in the household sector as the final output, and that can come about through several channels.

Certainly, exports and government debt are two of these channels. But another, under-explored area lies in boosting the value of business assets.

Here, I think, we can draw a line to the fact that business are now hoarding record amounts of cash. Rather than re-investing profits, and thus driving economic recovery, firms remain cautious. The net effect of everyone remaining cautious is a damp economic recovery. Fiscal stimulus would work by putting unused capacity to work either directly or indirectly as a result of government intervention. But we can imagine alternate stimulus programs that boost the economy by raising firms propensity to invest and garner assets.

In other words--we need capitalists to act like capitalists. We need firms to invest capital to create productive investments.

Parenteau recommends that we impose taxes on firm earnings that go uninvested for long stretches of time, or else tax them for unproductive casino-finance style investments--ie, ways to force firms to invest more today. Steve Waldman calls for measures to improve the value of private sector assets, such as inflation or rising productivity.

I think this is the right way to think about it. Rather than merely shoveling money around, trusting that it will have an effect by way of hydraulics; or trying to retain a pre-crisis level of government which is clearly unsuitable for today's needs--it would be better to think of what sort of targeted interventions can bolster productivity and investment. I can think of a few ways to do so:

1) Monetary Stimulus: Waldman gives this a bad name, but as David Beckworth notes, reasonable measures of inflation show that monetary policy was unduly tight during the critical period from late 2008-2009, while expected inflation remains very low today. As long as money remains tight, firms and households are more likely to hoard money. Simple price level targeting, as Bernanke advised Japan, would have the effect of boosting aggregate demand, raising the value of firm assets, and raising the confidence level of firms so that they are willing to invest today.

2) Prioritize Investment in the Tax Code: Martin Wolf has an excellent proposal on this issue, which I'll reproduce here:

First, it would be extremely helpful to reform the taxation of companies, to promote investment. In an interesting discussion of this issue, Andrew Smithers of Smithers & Co argues that a radical reform of corporation tax, to end interest deductibility, offset by a lower rate of tax, would reduce indebtedness and lower the pre-tax return needed to achieve a given post-tax return on equity. The result should be a bigger capital stock. Such a measure could be combined with higher deductibility of investment, which would be helpful to manufacturing.

Though mentioned in a different context, I think it is very relavent here. The Lib Dem/Tory government, it should be noted, also have a related proposal: they are pushing a rise in the VAT forward, so as to increase consumer spending now; while cutting corporate taxes today, encouraging investment right now as well.

Even if you believe that government stimulus is all you need--it's worth thinking about multiple ways to boost growth. And if you are at all worried about the high levels of government debt, yet also think that 10% unemployment is unacceptable--this seems like the thing to do.

Monday, June 28, 2010

The Use and Misuse of Models

Numerous others have picked up on this essay by Kartik Athreya which argues that bloggers are uninformed loons.

I think this suffers from the problem of conflating the person who writes something, and the medium they use. After all, there are plenty of highly trained economists who choose to blog--Gary Becker, Paul Krugman--as a medium of reaching their audience. It seems what Kartik really has a issue with are non-credentialed economists, who use new platforms to reach readers.

But there is another problem here, I think. It's that economists of all stripes prove unwilling to endorse their own models when engaging with the public, and instead resort to folk wisdom. Unfortunately, economists are no better at folk wisdom than anyone else.

What I'm primarily thinking of here--and I steal this entirely from Scott Sumner--is the repeated mention of stimulus programs as having a "delayed" effect. You see this in numerous Paul Krugman posts, which implicitly assume that the stimulus will have an effect proportionate to the amount of government spending in any given month.

Yet in the New Keynesian models which have dominated macroeconomic thinking--which Krugman has contributed to--this should not be the case. Fiscal stimulus, in these models, has an effect purely through the change in expectations among market actors, and so should have an effect on the economy the moment it is announced. The 2009 stimulus should not work with a "lag" over time, but should have had the entire effect in the first quarter of that year--at least, if you believe New Keynesian models.

Krugman, as academic, is skeptical and careful. Here he is on Japan:

But anyway, as a practical concern the main point about fiscal policy in Japan is that it is clearly nearing its limits. Over the course of the past 7 years Japan has experienced a secular trend toward ever-growing fiscal deficits; yet this has not been enough to close the savings-investment gap. One need not claim that fiscal policy is completely ineffective: as Adam Posen has emphasized, fiscal expansion has pushed up Japanese growth when tried. But how much fiscal expansion can the government afford? Between 1991 and 1996 Japan's consolidated budget went from a surplus of 2.9 percent of GDP to a deficit of 4.3 percent, yet the economy was marked by growing excess capacity. When the Hashimoto government, alarmed by the long-run fiscal position, tried to narrow the deficit in 1997 the result was a recession; now fiscal stimulus is being tried once again. But projections already suggest that Japan may be heading for some awesome deficits - say 10 percent of GDP next fiscal year - with no end to the need for fiscal stimulus in sight. Given that Japan is already in far worse fiscal shape than, say, Brazil on every index I can think of - not just current deficit, but debt to GDP ratio and hidden liabilities arising from an aging population, the need for bank and corporate bailouts, etc., one has to wonder where the fiscal-expansion strategy is leading.

Yet replace "Japan" with "America"; and Krugman the blogger will call you a dangerous Republican lunatic (Yes, I know there are differences between Japan and America, but still). When he blogs, Krugman is implicitly throwing out his academic experience, and is relying on a hydraulic view of the world, in which expectations don't exist; GDP = C + I + G + X; and so government spending automatically boosts GDP.

You see this everywhere you look. Ben Bernanke, when advising the Japanese government on how to deal with slow growth and deflation in the aftermath of a banking crisis, advocated higher inflation targets and better monetary handling. Now, as America faces similar conditions, he believes that there is this enormous looming problem of inflation that prevents these same policies from working.

This isn't limited to blogging. Christina Romer, in her research, has emphasized the role of monetary over fiscal stimulus in the Great Depression; and has found that tax cuts have a large effect on economic recovery. Yet in her policy-making, she is much more willing to endorse fiscal policy; based on "multipliers" that are estimated on an ad hoc basis, rather than coming from rigorous models.

I don't want to commit too much to these cases, as there may be excellent reasons that these brilliant people have different views in different cases. And I don't want to pick on left-wing economists too much either--there are plenty of lists like this out there for Chicago-school economists too, if you're interested. My point is only that it's very difficult to see what sort of model prominent economists are using for the policy pronouncements.

For right-wing economists, this means an urge for "austerity" and "policy moderation"--not because they have much evidence for these views, but because these seem intuitively plausible as gut impressions. Left-wing economists similarly promote government spending because that, too, seems reasonable. In both cases, academic credentials are used to bolster views held on op-ed pages, in policy positions, and on blogs: yet those views are in many cases simple folk wisdoms that economists are not better at commenting on than anyone else.

Sunday, June 27, 2010

Was Hitler Keynesian?

It’s understandable that as we face a shock comparable in magnitude to the Great Depression, there will be a push to look at the policy responses of that period as a guide for current action. That's why it's to get that interpretation straight. In the case of Nazi Germany, commentators like Brad DeLong have emphasized how Hitler’s Keynesian policies brought the country out of Depression.

This interpretation is misleading, as laid out by Adam Tooze in his wonderful book on Nazi economic policy, The Wages of Destruction. As Tooze shows; Germany did, indeed, recover from the Great Depression while under Nazi rule. But the nature of that recovery was not particularly “Kenynesian” as we understand the term today; and offers a limited guide for current policy.

The impact of Nazi make-work schemes and infrastructure building has been drastically overstated—including by Nazis themselves. While these schemes served as great propaganda pieces, they competed with funding with the Nazi military buildup. As Nazi Germany faced competing demands between guns and butter, it systematically chose to prioritize military spending while downplaying civilian consumption.

The impact, too, of these programs on unemployment was limited. Even by the 1930s, technology improvements were already lowering the need for unskilled workers at construction sites. Fiscal stimulus may have had an effect on reducing unemployment in backward regions, like East Prussia, but was of more limited use in the more developed regions of Germany. Tooze documents that unemployment changed relatively little in urban areas during the early recovery period. Even autobahn construction required relatively few workers--under 40,000 a full year after construction began. At their peak, make-work schemes constituted a minority of all employment. Of course, infrastructure construction today is even less intensive in workers today, and a stimulus might be even less effective.

The systematic effects of Germany’s prioritization of military aims led to devastating outcomes for German consumers. Remember; Keynesian stimulus is generally advocated out of the idea that we need to increase consumption today. German economic recovery was actually ongoing as Hitler gained power--but household consumption was then sharply curtailed in order to boost military spending. Private demand accounted for less than half of the growth in aggregate demand from 1933-1934. Germany's economy had recovered in 1935 to the level it had been in 1928--a marginally better performance than America. Yet private consumption and investment were below pre-Depression levels, while state spending was 70 percent higher, led by the military.

Perhaps one could argue that though the aim of Nazi Germany’s stimulus was misdirected towards the armed forced; it still had net effects on economic growth. A different policy which matched the Nazi drive for stimulus, but which redirected it towards public goods, may have worked equally well without the war side effects.

Perhaps—though Tooze cautions us on this score as well. The reality is that many different governments, each following different economic policies, ultimately recovered from the Great Depression. It is impossible to know the counterfactual policy—but scholars such as Barry Eichengreen and Christina Romer have convincing work that suggests that monetary boosts, in the form of exiting the Gold Standard, formed the primary basis for international economic recovery.

This is not to say that further fiscal stimulus now would be a bad idea. But the lessons of 1930s Germany are not exactly an ironclad defense of the wisdom of spending your way to prosperity.

Friday, June 25, 2010

Konczal on Mortgages

I had hoped to write an angry post in response to Mike Konczal’s latest missives on mortgages; but his pieces are far too reasonable and well-done. Instead, I’ll agree with many of his points and make some hay over small differences.

The way I think about mortgage debt generally is through an Irving Fisher perspective. Prices for assets and goods are determined in competitive markets, and so can fluctuate over a business cycle. Contracts like debt, on the other hand, remain fixed in nominal terms. This causes huge problems in a real estate slump combined with recession, as you see more households struggling to make payments on now-unprofitable properties.

You can see that in this Federal Reserve report. Household net worth plunged in this recession, led by large drops in real estate assets. But household real estate liabilities—their debt burden—remained relatively constant.

That’s where the push for modifications, for Right to Rent, for cramdown, etc. comes from—an attempt to lower the principal balance on homes so that housing stays a reasonable bets for owners, rather than albatrosses holding down spending and consumption.


I think the best way to make this happen would be if mortgage servicers got on the phone with delinquent borrowers and wrote down seriously underwater homes to a level that would induce people to keep making payments. Servicers should have a great deal of interest in cutting these deals; these types of haircuts happen all of the time for other types of debt; and they used to happen for mortgages as well.

But there are variety of reasons this isn’t happening now, or at least aren’t happening effectively. Banks are reluctant to expose real estate losses, because that would force them to realize accounting losses on their balance sheets. One suspects that many American banks are insolvent and are trying as hard as possible to avoid exposing that issue. Other problems include coordination problems with securitized loans. The act of chopping up a loan, combining it with others, and selling it as a security makes it much harder to monitor the original loan and come up with a deal if necessary. Then there is Fannie and Freddie’s inability to properly use HAMP, which makes no sense.

Banks really have no business harassing “strategic” borrowers given the cynical attitude they hold towards going bankrupt if necessary, and lapping up federal funds if possible. The real estate mess is their own fault for not negotiating win-win deals with customers who have problems, which is something they are perfectly willing to do for corporate clients.

For these reasons, I’m becoming more willing to look at Konczal’s preferred solution of a cramdown—allowing judges in bankruptcy courts to write down the principal on homes themselves if someone files for a Chapter 13 plan. I still find this a less appealing option than giving servicers the proper incentives to do it on their own, but we’ve seen how well that strategy has worked.

There are a couple of problems with this approach that Konzcal skips over, and a couple of ways to fix them. One big problem is that the vast majority of Chapter 13 plans fail, and we don’t have a good sense of why this is. Cramdown in bankruptcy would only apply for people who fully complete their bankruptcy plan, so this fix would just kick the problem down the road for most people. I suppose you could argue that the reason bankruptcy plans fail is because the home wasn’t written down enough; but it seems more likely that people become unemployed/lose income, and are using bankruptcy purely as a delaying tactic.

Then there are the problems that changing the bankruptcy code would have on the willingness of people to file for bankruptcy, and the willingness of banks to extend future credit. The more we make mortgages disposable, the more expensive it will be to get a mortgage. Of course, that will have the positive effect of reducing the number of risky borrowers. But it will also raise the pressure to get the government more heavily involved in mortgage lending, and force even safe borrowers to pony up more monthly income to rent payments. As Konzcal never tires of telling us, the steady rise of payments going to service secured debt eats away at disposable income.

A good way to fix these problems would be to make cramdown retroactive—only available, say, to mortgages purchased before 2008. We could even think about tying cramdown rules to zip code level price changes to reduce judicial discretion—though one suspects judges already apply fairly simple and consistent rules.

Costs of Default
But I want to push against two ideas—that the concern over strategic default is entirely unwarranted, and that subprime mortgages are a horrible deal. The problem is that mortgages come embedded with the “option” of default, since you can walk away at any time, usually without legal recourse (though, of course, your credit score will take a hit).

Homeowners in the past have exercised this option sparingly, as they want to stay in their homes, and because of social norms which argue against mortgage default. Indeed, banks relied heavily on these norms as they rolled out an unprecedented expansion in home mortgages and home equity lines of credit. These norms are shifting as delinquencies and foreclosures skyrocket. We have some evidence now that mortgage default gaining popularity relative to credit card default. For an individual borrower, looking at your home through a pure profit-loss perspective is the way to go. But when everyone starts doing this, that induces more and more people to walk away, which lowers prices, which makes even more people walk way. Ultimately, if mortgage debt was no more secure than credit card debt, it would be prohibitively expensive for all but a narrow minority of people. This may be an attractive world to move to, but the costs of getting there in the middle of a housing bust would be large.

Then, there’s the issue of how to think about subprime borrowers who took out these loans and are now suffering. Again—I think the right way to think about them is to realize that these borrowers bought a product with an embedded option. They had the ability to walk away if things ever went south for them—and, in many cases, they are now exercising that exit option.
I think this better fits a story of predatory borrowing, rather than predatory lending. Remember that it’s difficult to gauge the success of an investment from a purely ex post perspective. We only observe one particular economic outcome, but many other outcomes were possible when you made the investment. Had housing prices kept going up, subprime borrowers would have done very well indeed—and they did in fact do quite well for a number of boom years. Sure, they didn’t build equity—but they they pulled tons of cash out from their home to consume more than they could otherwise. That sounds like a pretty good deal to me. Allowing people to get a product with great upside and limited downside sounds like a far worse deal for the banks doing the lending than for the people buying the product.

This is also why I'm much more excited about FHA's threat to deny mortgage insurance to strategic defaulters. Ideally, I would like FHA to deny mortgage insurance to anyone who has gone delinquent on a mortgage in the past. I'm skeptical of the idea that the GSEs were the "cause" of the real estate meltdown, but they are clearly sinking ships, and any attempt to raise their underwriting standards would be welcome.

What Next
I want to go a little further than Konczal and argue that our failure to deal with debt generally is an issue. America’s debt-to-GDP is around 300%. These aren't the catastrophic levels of Iceland or even England, but is a serious issue. Replacing private debt with public debt doesn't entirely deal with this issue either. We need serious attempts--default, bankruptcy, or inflation--to erode the value of debt contracts; and then tax reform or regulations to limit the system-wide desire to take on additional debt. I used to be skeptical of this idea, but debt-fueled growth really is not sustainable, and destroys an economy's resilience.

Wednesday, June 16, 2010

Why Rajan and Pinter Are Wrong About GSEs and Subprime

I’ve already discussed this a little in my review; but I thought it might be worthwhile breaking this section out a little. The question is whether Fannie and Freddie in some manner “caused” the housing bubble or the financial crisis.

I’m actually fairly sympathetic to this view. Certainly, whatever the answer to that question is—it’s clear that Fannie and Freddie are horrible ideas. They’ve eaten up something like $140 billion in taxpayer dollars, and may eventually cost up to $1 trillion.

Here’s the argument Rajan makes: economists Mian and Sufi have shown that the period from 2002-2005 saw an extraordinary burst in low-income lending. At the same time, Pinter—a former credit officer from Fannie and Freddie—has documented how the GSEs actually invested far more in subprime mortgages than other people think.

Yet there are good reasons to doubt these links. Mian and Sufi themselves point to rising securitization—rather than government involvement—for the expansion in lending to low-income households. After flooding other income groups, private lenders had nowhere left to go but down.

Meanwhile, it’s clear that Pinter’s analysis is misleading. As James Kwak has shown; the mortgages that Pinter classifies as “subprime like” (and which Rajan treats as subprime) were actually prime mortgages with poor credit qualities. Other than some investments in subprime MBS—the GSEs basically left the entire subprime field entirely.

Again, this is not mean to absolve the GSEs of any misdoing entirely. It’s clear that they loaded up on numerous credit risks they didn’t understand. Their involvement in subprime MBS boosted their market. Their role in purchasing mortgages on a secondary market had the effect of fueling an the mega-lender model in housing (think Countrywide or WaMu).

But to grant them a central role in the crisis is probably a little much. We had an extraordinary boom in all sorts of credit markets—including credit cards, commercial real estate, and auto debt. Fannie and Freddie have been around for decades. Their presence is bad enough without their being implicated in currently high unemployment.

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.