Raghuram G Rajan located the fault lines beneath the economic crisis. Jahangir Aziz peers into the chasm
Although it is not as sublime as Saving Capitalism from Capitalists, Raghuram Rajan’s Fault Lines: How Hidden Fractures Still Threaten the World Economy is more expansive and policy-focused and clearly destined to become a must-read on any list of books on the recent global crisis. And there already are many.
Back in 2005, Rajan was one of the few economists who vocally raised the alarm, pointing out that financial engineering, instead of reducing risk was actually increasing the riskiness of bank portfolios, and that the financial system was becoming increasingly vulnerable to a nasty correction. The Jackson Hole meeting where Rajan (in front of the Who’s Who of the financial world, invited to celebrate Alan Greenspan’s years as chairman of the Federal Reserve) made this pronouncement as the then Chief Economist of the IMF has now become part of crisis folklore. Given such antece-dents, one had niggling concerns that the book would be about the author’s experience of being Cassandra. But it isn’t.
Instead, what stands out is Rajan’s deliberate effort to wean the debate away from its current obsession with the symptoms of the crisis — the financial meltdown — and move the debate towards the underlying economic forces — the ‘fault lines’, as the title of the book suggests. And of all the fault lines that the book discusses, the one that grabs the most attention is that growing income inequality in the United States, caused by a jobless expansion since the 1990s, was a key, deep-rooted cause of the financial crisis.
This is not an easy argument to champion, for a number of reasons, but especially if you are Raghuram Rajan — a celebrated Chicago business school professor with impeccable academic and policy credentials. An argument such as this, if not carefully presented, can easily sound like a conspiracy theory, thus damaging the credibility of the author.
Rajan avoids these pitfalls with a well-argued wall of data and theory in a chapter provocatively titled ‘Let Them Eat Credit’. His thesis is that the housing bubble, which was the epicentre of the crisis, was atypical in the sense that boom-bust cycle occurred in a segment of the market to which we do not usually pay much attention — namely, low-income housing. Global banking giants do not suddenly have a change of heart and start lending to the poor. And they didn’t. Instead, it was the unholy alliance of government policies, aimed at alleviating the growing income inequality in the US, and profit motive that propelled the low-income market first to dizzy heights, only to fall as spectacularly.
Since the 1970s, wages of higher-skilled workers have increasingly outstripped those of the lower-skilled. This mismatch was caused, on the one hand, by US technological progress requiring ever-rising human capital, while, on the other hand, the education system failed to provide adequate labour with the necessary skills. As a result, the middle class in the US — the system’s political and social mainstay — saw its paychecks stagnating and job insecurity rising. There were and still are solutions (the books goes into details in various chapters), but these are long drawn-out (education and entitlement reforms such as in pensions, unemployment benefits and health care) and run into powerful special interests.
Seeking more immediate electoral returns, the political system quickly zeroed in on the fact that it is not income that matters but consumption. The cynical but smart political establishment sought and found ways to ensure that the consumption of middle-class households outpaced their largely stagnant paychecks through cheap credit.
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And this is where such an argument usually begins to sound like a conspiracy theory. But Rajan carefully avoids this pitfall by arguing that the political response needn’t have been carefully planned. It was just the path of least resistance. Couched in terms of the noble objective of expanding home ownership and thereby achieving the American dream, tax subsidies to the quasi-government mortgage giants Fannie Mae and Freddie Mac were far more politically defensible than the seemingly ‘liberal’ and ‘socialist’ objective of income redistribution. Ironically, pushing home ownership through credit to lessen the pain of stagnant wages left the US with houses that no one can afford and debt that no one was willing to hold.
Rajan does not excuse the bankers, nor does he let the regulators off the hook. But the point of the book is to look beyond these symptoms to the underlying fault lines. And among all the fault lines that the book discusses and the solutions that it provides (there are several), what stands out and what will be discussed for many years is how credible and central is the thesis that underlying the global crisis was the policy of letting the people eat credit. India, watch out!
A final word: Rajan is skeptical about the current solution of keeping interest rates low for so long (and now for even longer) in order to get the US economy out of the crisis. It isn’t that he is suggesting that rates need to be hiked. Rather, his point is that low interest rates over a long time can by themselves distort investment decisions. This could become costly later. The Fed’s latest statements and actions suggest that it is in no hurry to make its exit. The downside is that if it exits too late, this warning, too, may end up being talked about like Rajan’s 2005 Jackson Hole paper.
Jahangir Aziz is India Chief Economist, J P Morgan Chase. The author’s views are personal
FAULT LINES
HOW HIDDEN FRACTURES STILL THREATEN THE WORLD ECONOMY
Author: Raghuram G Rajan
Publisher: HarperCollins
Pages: 288
Price: Rs 499