Fault lines: how hidden fractures still threaten the world economy

Raghuram Rajan interviewed by Romesh Vaitilingam, 06 August 2010

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Romesh Vaitilingam interviews Raghuram Rajan for Vox

July 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5381]


Romesh Vaitilingam:  Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Professor Raghuram Rajan of the University of Chicago's Booth School of Business.

Raghuram and I met in London in July 2010. We spoke about his new book Fault Lines: How Hidden Fractures Still Threaten the World Economy.

Raghuram Rajan:  I think people have focused on the problems in the financial sector. And clearly there are some big problems there that need fixing. But we have to ask why these problems emerged now. Why they emerged in what is thought to be the most sophisticated financial sector system in the world. And why the institutions let permit this, the regulators, political structures ‑ all of them failed in preventing this crisis.

I think it's important because we have a theory of growth, we have a theory of development which says: You fix the institutions and then you are there, and the problem with emerging markets is they don't have these good institutions and that's why they keep getting held back and poor developing countries never created them in the first place.

So, this book is an attempt to first understand what happened and second to say that therefore this casts some suspicion on our moral of institution‑based development that creates the institutions and then you are there. It's saying institutions in many ways are a creature of the political consensus. And they are not outside the political consensus, though we would like to think of them as outside. That when the political consensus gets fractured, sometimes the institutions get pushed, maybe don't break, but get pushed in a certain direction.

So, what do I mean? I argue that the political forces in the United States over this time will pretty strongly motivate it in certain directions. So, where do the political forces come from?

One, growing inequality. Now, this is to some extent a function of the technological change which is pretty steady which requires people to have higher skills. But it is also a function of the fact that the supply of people with higher skills, with graduate degrees for example, has not kept pace with the demand for them.

So, what we've seen in the United States is the educated segment of the population, the ones with bachelor's degrees and higher, have been growing in income at a much faster rate than the people who don't, the people who have only a high school education.

So, the top is running away from the middle and this is in many ways a problem. To some extent the middle is not just losing in relative terms, sometimes it's losing in absolute terms. As a result there is a fair amount of anxiety in the United States. The stagnant median wage has been an issue for a long time.

Well, what is the natural response to growing inequality in many countries? It's tax and redistribution. Tax the rich, redistribute towards the less well off. And so you get consensus and growth. Well, in the United States, over the eighties and nineties there has been very strong opposition to taxing and redistribution.

Remember this is the Reagan era moving into the Clinton era. You are trying to get people off welfare and not a whole lot of desire to do tax and redistribution.

My argument is credit was another way that politicians sort of found their way into as a way of dealing with this problem of growing anxiety of the people left behind. Credit, especially housing credit, had number of positives. And housing? This was the great American dream, owning a house. When you lent to them, people could borrow against that house. They could essentially fund better lifestyles and after all, we economists think, consumption is what matters rather than income. So, consumption could be kept high. But it wasn't necessarily consumption with your feeling that you were borrowing a lot, because after all your house was growing in value, so your debt, net debt, was not that high given the assets that you had.

So, it gave the illusion of progress. It gave households the ability to ignore the stagnant wage and made everybody sort of better off, so from the Democrats, this was good thing. It was money going to their favorite constituencies. From the Republicans, this was an attempt to make people property owners and therefore vote Republican.

So, I think inequality was the first fault line, created a push for credit and that push for credit was something politicians on both sides of the aisle supported, but also used the instruments of the government ‑ Fannie, Freddie, the FHA. That eventually created problems for the economy and we'll come to that.

Second fault line:  I talked about just now the structural desire for the US to consume. There is also the fact that recessions in the US have changed in nature. Recovery used to be very fast. Eight months from when you had the bottom of the recession, all the jobs that were lost were back typically in past recessions.

From 1991, it became increasingly jobless. It took 23 months for jobs to come back in 1991. It took 38 months in 2001. Again, the political pressure from people who've lost jobs, given the thin safety net in the United States, six months on unemployment benefits. Typically, you lose medical benefits immediately. Political pressure to create jobs has been tremendous.

Now, politicians initially didn't respond. '91, remember George Bush the elder won the first Gulf War but lost the presidential election because he was out of touch. Didn't put stimulus after stimulus package. James Carville had that inimitable phrase, "It’s the economy, stupid." Everybody has recognized that now.

So, politicians understand if you don't get the jobs back, you are toast. So, what we have is stimulus package after stimulus package. But also, perhaps more problematic, the Fed stays on hold. Remember the Greenspan Fed stayed on hold at one percent for a sustained period.

Why was that? Not because they didn't know the Taylor rule. They were seeing unemployment numbers were high, and no Fed chairman could raise rates with Congress staring at him. And with the mandate, the Fed mandate is maximum sustainable employment. And given that mandate, they had little ability to move away, especially given the frameworks that we are using which was inflation targeting effectively which suggested that there is no inflation in sight.

So, we might as well keep on hold. Of course, that led to asset price booms and so on, which eventually created problems. But the point here is the second fault line is the US not only has a structural desire to expand consumption, it also has a cyclical propensity to push growth and consumption.

Romesh:  With both these fault lines, Raghu, I wonder is this a kind of blame the government story or blame the policy makers or blame the politicians? Because in a way you're saying it's the politicians’ response to the problem of inequality and the safety net and they are going for the easy option because they can't tax and redistribute, they can't establish a bigger safety net.

Raghuram:  I'm not saying it’s so much blame as it’s what comes naturally when you are trying to help people given the alternatives that you have. Expanding the safety net--we've just had a horrendous fight over the health care bill--is a major long‑term project and it's not clear those enough evidence to warrant moving in this direction before. And so people did the short term stuff that came naturally. But you're right, that it's not so much blaming the government as the government has become a much bigger player, implicitly or explicitly, in a number of industrial countries. And we expect the government to be a bigger player.

I am not saying the financial sector’s faultless, in fact I am going to argue that they bear much of the blame in the chapters six, seven and eight in the book, but what I am going to argue is what we haven't worked out well in capitalistic economies: It's not the government or the private sector but how the two interact. Especially how the private financial sector interacts with an activist government, because a private financial sector is always looking for an edge. In an activist government, especially in an activist government which is motivated by concerns other than the financial, gives it that edge, and that's what I think to some extent happened in sub‑prime and took the economy over the cliff.

So let me add this last piece which is the global macroeconomics. The global macroeconomy again is sort of a Greek tragedy where people are doing what comes naturally.

We have a bunch of countries that have focused on exports. I think they're structurally now sort of focused on exports, because even as they've built very muscular export sectors ‑‑ Germany, Japan, Taiwan, Korea, and now China ‑‑ they have neglected their domestic sectors. In fact I argue in the book, there might actually be a relationship, that the same interventions which occurred on the export side in order to built export champions, they were constrained by the foreign competition, so you had to have efficient producers there. But that intervention on the domestic side ended up with a lot of regulation, a lot of constraints and competition in an attempt to protect incumbents and was unconstrained by the discipline of external competition.

So you've you got weak domestic sectors, look at the service sector in Japan, look at the service sector in Germany. I mean, can you name a Japanese restaurant chain for example? The point is that you've got very muscular exporters but not the same muscularity in the domestic side. That makes these countries structurally export‑dependent on the world economy, implies there has to be importers somewhere else.

That's where the third piece comes in ‑‑ the US pushing this stuff, pushing consumption, stimulating in the downturn of 2001. And of course, response to that stimulus is there's a whole lot of goods from outside searching for markets, looking for people willing to spend, and willing to finance it.

So you've got a flood of outside money coming in. The German banks which participated so heavily in the sub‑prime crisis, but also from elsewhere. The Chinese Central Bank’s holding agency paper, lots of money coming into the US.

So where does this all tie into the financial sector? I think two ways. One, the flood of money coming in looking for assets, especially guided by policy into low income segments of the market meet a response from the financial sector. “You want assets? We'll get them for you. And if you don't ask the questions about the quality of assets, we want to give you anything that you’ll buy.” I mean, caveat emptor, right?

And I want to argue that, especially the arm’s-length financial sector is extremely prone to situations where huge amounts of money come in with few questions. That tends to distort prices and take these guys completely off track. In other words, the arm’s-length financial system depends lot on checks and balances, much like the US economy.

The guy originating the mortgage, in a traditional financial system he’ll hold it to maturity, has strong incentives to make the right loans. In the arm’s-length financial system he is selling it off, he is securitizing it to a bunch of buyers elsewhere. His only incentive to pay attention to quality is if the guys at the end of the line pay attention to the quality.

Once they stop paying attention to quality he securitizes any garbage because after all what keeps him honest? He doesn't walk past the house every day, he doesn't walk past the borrowers every day and have to face them. His main interest is, do they want the loan, can I get them the loan, are the guys at the end of the line willing to buy? When there is the huge amount of price-insensitive money coming at the end of line, he securitizes any thing.

So I think discipline broke down in the market. It broke down because guys at the front of the line had poor incentives, that's part of the problem. But the guys back of the line make those incentive worse by being willing to buy anything and who are the guys at the back of the line? It was entities like Freddie and Fannie. It was foreign investors who didn't ask, you know…the Landesbank had similar kinds of incentives, "Go out and buy." They were told, "Don't compete with our domestic banks here, you need to take your money outside," because that was the nature of what was happening in Germany.

The bottom line here is that the financial sector was corrupted. It was not an innocent victim, it was part of this whole process and it went into it with eyes wide open. We need to fix those problems. And I talk in the book also about the second question that you want to ask: why do the banks who knew all this garbage was being created hold onto so much of it. That’s a further breakdown in incentives and we need to fix that.

But I do want to say if we don't fix these other problems we have the possibility of a crisis somewhere else. Maybe not in sub‑prime but somewhere else. It may not even be a financial crisis but there are these deep problems which are complicating the world economy, and we don't have ways without recognizing them of actually dealing with these problems. I think it’s important we come to terms with them and start acting on them.

Romesh:  Well we need to talk about some potential solutions and sense that there is one set of solutions focused on the US economy dealing with these biggest issues of high inequality and lack of a safety net putting pressure on policymakers to come up with quick solutions. You say basically the solution there is about education and that's a really long‑term one. How can you square that circle, if you like?

Raghuram:  Well this is the whole problem, right? This is the whole problem that we are looking for silver bullets, and there may not be any. And some people look at the identification of the problem and say, "Aha. Now you've identified the problem, what's your solution?" They expect you to have an immediate solution.

Well, there are lots of experiments under way to improve education and so on. It's a complicated issue and it's going to take time. And there are people who are not going to benefit from this. The 47‑year‑old GM worker who’s lost his job is not going to be reeducated into a commensurate job somewhere else, for the most part. There will be some who will.

So what do you do about them? I think first thing is to recognize we do have a problem and recognize that we have to start looking for creative solutions.

One is the long‑term fix, and we need to put that in place now. I think education across industrial countries, but especially in America, is falling behind and the only way standards of living are going to keep up, giving the enormous competition that's going to emerge from the emerging market is if in fact you move upscale.

This is Dornbusch Samuelson Fischer, not all the population needs to move upscale, there will be a role for service providers to the upscale population. A role for cooks, chauffeurs, gardeners etc, but also a need for people to be generating that income. We need more of people to generate that income, which means more kids from the ghettos have to get a good education, rather than be a permanent underclass.

That is an enormous problem to solve, but in the meantime we are also going to have another problem, which is that you are going to have these people who are used to a comfortable standard of living. But whose jobs are no longer competitive jobs and therefore they have made redundant and they have to find some way out.

Now I don't think there is an appetite, either on their part or on the part of the governments to put them on permanent dole. They will in many cases, have to adjust downwards to a lower standard of living. But is there a way that we can make their transition easier? Can we use some of their skills, in ways which are better than what the private sector can offer now?

Now there is a role for thinking about clever ways of retraining. Retraining has not proved particularly successful so far, but can we think about it? Can the universities play a role on this? Can the vocational schools play a role on this? These are all things we need to think harder about. And sometimes the "what can you do for me now" tends to come in the way of, we need to also think about the bridge to the medium and long‑term.

In terms of what can we do now, I think may be part of the answers we need to accept some pain. That we have been trying to reflate the economy, every time there is a downturn and say, "Oh we got to pump it up, we got to pump it up." And we have the hubris of economists of saying, "We have the tools, market policy and fiscal policy, just do it and we will get back." But in the whole point of stimulus of this kind is you are pumping up aggregate demand again.

But what about supply, was supply the right kind, was demand the right kind, are we pumping up demand which is unsustainable, for example, for housing and should we in a sense let the economy adjust? There is no appetite for letting economies adjust, without constant intervention because we think, ah, the government has to play a bigger role, and this across the political spectrum.

But in fact we may need to let the economy adjust and focus on age‑old issues such as trying to make it more flexible, more competitive. There might be some government money involved in some of this in allowing the adjustment process. But trust a little more that the adjustment will take place over time, instead of saying, we have to pump it up all over again.

Romesh:  So intractable problems at the national level, but perhaps even more intractable problems at the global level. How do we confront this second big set of fault lines you mentioned around global imbalances. That's something you said you were very much focused on when you were chief economist of the IMF and it's very much of the heart of this of this process. How do you deal with it?

Raghuram:  Well we see the debate alive today in Europe, I mean Germany, should it be spending more? Does it have a role to play given its large surpluses or is it fine? Again, the short‑term fix seems so obvious, but doesn't seem to me that it is the long‑term fix. The short‑term fixes will say, Germany should open the coffers and spend more.

But I am not sure that at this stage, the response of German consumers, will not be to retrench even more, saying if our government is spending so much, it must be they are going to tax us down the line.

We know that there's more regarding equivalence closer to fiscal limits, then when you're far away from it. But also I think Germany's real problem, is its underdeveloped domestic sector. That has to become more competitive.

I think what this means is, increasing competition in services, reducing the regulations, I mean as you know, until recently there were substantial regulations on shopping hours in Germany.

I mean, that's the kind of change I think which will add to German growth. Make the domestic focused economy productive, move employment to those areas away form export‑led employment, and essentially allow Germany to have more internal growth in that sense, because it relies less on world growth for its own growth. Make it a bigger contributor to world growth.

These are all long‑term again. The problem of course is that, countries don't have an incentive to move away from existing strategies, especially if the strategy involves short term pain and competition is always painful.

So for Germany or Japan, I mean Japan has been doing stimulus package after stimulus package has had low interest rates for 10 years. I think the lesson from Japan is unless you do the reforms to make the uncompetitive parts of the economy more competitive ‑‑ I am using the word competitive in both ‑‑ you need to increase competition, as well as make it more efficient.

Japan has shown in some sense the difficulty of using government-aided stimulus to pump an economy which has deep structural problems back into growth. If you look at when Japan's grown over the last 20 years typically in the world has pulled it out, rather than when it has pulled it out itself.

So these countries has to change. What is going to force them to change? Unfortunately I don't think our international organizations are up to the task. And so change is going to come almost by default, either because they wake up, they understand the deep problem. Maybe Japan after 20 years of zero growth ‑‑ zero nominal growth at least ‑‑ is going to start thinking of what it needs to do.

But I think that we need to rethink our international organizations and how they might function. One of the points I argue in the book is, it's not clear to me that a rules‑based approach is going to work. Because the Indias and the Chinas are asking who set the rules. And it is also not clear to me that you can have one-size-fits-all set of rules for the economy.

If you say China is manipulating the exchange rate, couldn't you on the same token argue that the US is manipulating its interest rate? And are both fair game or are neither fair game or is one fair game and the other not?

I think these are questions that in our framework, we sort of say, "Oh China manipulating it's exchange rate is bad. Interest rate policy is good." But both are interventions, right? And so what is allowed and not allowed? I don't think we can get agreement on such an international framework.

And so to me, it seems as if the only hope is sort of to try and persuade countries. Persuasion is not just at the top because if you persuade at the top, without persuasion at the middle, you know, the intelligentsia, the influential, I think you are not going to get very far. So what I talk about in the book is the hope that we can create an organization. Or rather than an organization, a structure that can work within countries, on the broader task of persuading them about global policies.

It's not just macro imbalances that we are talking about, it's things like water. Water is going to become a source of major conflict over the years. How do we persuade countries, internally, about the need for cooperation on this?

Investment, trade, these are all issues that are going to become bigger sources of frictions over the next few years. We need more global cooperation on this. But, for some of these issues, global cooperation needs domestic support.

When Hu Jintao walks into that room, he has to know that more people in the country support the kinds of international policies, as with the U.S. I mean, there is no constituency for the global economy in the U.S. right now, even though the U.S. is such a big part of the global economy. It's: “Those guys out there. Why should we order our domestic monetary policy in order to benefit them?”

Romesh:  Well, I wonder if the appetite for this kind of fundamental reforms that you're calling for is going to be there. I mean, in a way, there's a feeling that 2008 was a terrible time, but the governments and central banks and international organizations of the world responded, and, as some politicians said, "saved the world".

Saved the world, and financial regulation, to some extent, has happened, as you said, in the US, healthcare regulation, huge battles to do those. Is their appetite going to be there for fundamental reform?

Raghuram:  There is no appetite. So, I mean, one way to end the book is to say, "Look, these are deep problems, we're never going to fix them, all hell will break loose at some point." I'm a little more optimistic.

I do think it's hard to see silver bullets, and people are always looking for silver bullets, one neat, simple thing we can do. I think that's part of the problem. I think we've been too focused on silver bullets, and I think, unfortunately, a fault of economics, especially macroeconomics, is that we've promised those silver bullets. We can have the Great Moderation. We can have our cake and eat it, too, and there's going to be no problem.

And this has prompted greater activism, and I think the activism gives us the sense that we've solved the problem, when, in fact, the problems are festering in deeper. And so, I'm going back to an older school, which is saying that, "Look, activism is well and good, in small doses, but there are also structural issues we need to take care of, and that will require deeper reform." And we've been able to postpone those reforms, for a long time.

But now that countries... I think the growth of India and China is asking big questions on adaptation for the industrial economies. So now that's happening. And now that we're becoming more integrated and our problems are spilling over, what processes do we have to solve these problems? And I think we are coming up against the inadequacies of the processes we have in place.

I mean, the G20 meeting last week, essentially, was a non‑event. Much as we can put gloss on it and say that nobody fought with each other, nobody threw a pie at each other, they were really polite to each other, and we had this statement which suggested they were all on board. Yes, they all want growth, they all want trade, they want all the good things.

But how do we get there, and keep that stuff going? Of course, once you get to the details, you find that there's not a whole lot of detail, and a whole of agreement on pleasant stuff.

So, I think that we do really need to think about whether we have the reforms in place and the institutions in place. And we can't be complacent, I think, in industrial countries, that just because we've reached development, it will continue that way.

I don't want to be alarmist, but I do think that there is a potential for much greater social conflict down the line than we have right now. There is also going to be that potential, without the government having the capacity that it had until recently. I mean, one of the things the crisis has done is insure there's limited government capacity going forward.

So how do you deal with all these issues? And I think it's just plain hard work. First, point out the problems, which I'm trying to do, and second, start working on them. There are no silver bullets, but there are lots of small things one can do, which, when added up, make a big difference. And that's what I hope we see.

Romesh:  Final question, Raghu. You say in the book, basically, we're all to blame; we're all complicit in this crisis. But I'd like to ask you particularly about the role of the economics profession. In 2005 you foresaw some of the things that might happen, and then did come to pass, and the economics profession rather scoffed at you. They’ve treated you as a Cassandra. Where was the profession at fault, do you think?

Raghuram:  Well, I have to say, it's not so much the economics profession, I think it was more regulators and so on for the most part. But the problem with the economics profession is not that it was complacent; it wasn't engaged, in my view. That's really the problem, that we've got a separation of much of the profession from the practical economists.

In fact, none of us would want to be known as one of those practical economists who forecast, "Are we going to have a double‑dip?" The problem is, every time we venture into the public arena, those are the kinds of question we are asked. Rather than questions we actually know the answers, or at least some of the answers, to.

And, as a result, I think, economists, by and large, don't engage in the public discourse. Yes, a few do. Paul Krugman does, to his credit, and a few others do, but it's a very small set of people who engage in the public discourse. And as a result, I think that we are largely irrelevant.

We do affect that discourse through research, which feeds into central bank thinking, which sometimes feeds into fiscal policymaking, but only in a very limited way. And most of us don't really opine on the problems of the day and how to solve them. We're happy talking to each other, but we don't talk more broadly.

I think that crisis is changing some of that pretty dramatically. I'm not saying that every junior professor should now go and talk about his latest paper, in an attempt to get everybody to do what that latest paper suggests. But I do think that we have a responsibility to engage more widely, and I think Vox is part of that process, to engage more widely and not leave the field to those who, perhaps, have spent less time on these kinds of issues.

By all means, we will be forced out of our level of comfort, out of our zone of comfort, by questions that we don't really know the answer to, but we have to make guesses. But I would say that so long as you make an honest effort at trying to do that, the profession shouldn't see anybody who goes out as tainted by the real world, and, therefore, an outcast, a pariah. We used to do that in India, anybody who had crossed the seas and therefore was now tainted and could never come back.

That notion that if you cross into the public domain, ever, you are too loose for the profession, I think it just diminishes the influence of the profession. It's terrible, and I think we should do more to engage. Not sell our souls to the public demand for information and so on, but at least engage more.

Romesh:  Raghu Rajan, thank you very much.

Raghuram:  Thank you.


Topics:  Financial markets Global crisis Poverty and income inequality

Tags:  financial crises, US inequality, systemic problems

Related research here [1]. [1] http://press.princeton.edu/titles/9111.html

Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Graduate School of Business


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