Raghuram G. Rajan -- Fault lines: How hidden fractures still threaten the world economy
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Like most books on the financial crisis, this one provides both an
analysis of what caused the problem and a few suggestions about how
to prevent it from happening again.  What's a little special about
Rajan's analysis is that he attempts to show how the political
system is structured so as to almost inevitably produce the
results we have seen recently: an asset boom and bust.

Rajan repeatedly emphasizes the interplay between consumer driven
economies that borrow (the U.S. especially) and export driven
economies, some of which lend to the consumers.  But, he has little
in the way of suggestions on how to make them change.  Telling them
to grow up, to act responsibly, and to engage in some shared
sacrifice will not cause any changes.

Rajan spends a bit of time talking about the rising inequality of
wealth in the U.S. and a few of its consequences, e.g. unequal
access to education.  But, in a political system that has become
increasingly partisan, we are not likely to see much balancing of
income and wealth.  At both the state and the federal level, no one
seems willing to compromise, let alone sacrifice.  Increases in
taxes, for example, are blocked.  And, the idea of a more
progressive tax system seems out of the question.

Rajan is especially good at explaining how the political system in
the U.S., which is unable to make sustainable improvement to the
stagnant incomes of middle class Americans, has settled for
unsustainable fixes, e.g. the extension of ever more easy credit.
Increasing debt in lieu of increasing incomes, whether in the way of
home mortgages (and refinancing, and equity mortgages) or credit
cards debt, can only be a short-term solution, as we've recently
found out. But, in a society where no one is willing to give up
anything for the good of the whole, there are possibly no
alternatives.

Rajan is also good at showing how our political system is effective
at giving us what we want, or what *someone* wants, even when that's
not what we need in the long term.  The extension of massive amounts
of credit and debt in the years prior to the financial crisis is an
example.  That was done during both Republican and Democratic
administrations of the U.S. federal government.  We'd like to blame
the Federal Reserve Board and Alan Greenspan for allowing that loose
lending to happen, and we should blame him, but he was pressured by
members of Congress to do so, and that is not likely to change, no
matter who is head of the Fed.

It's significant, I believe that Rajan's main attempt at prescribing
solutions is a chapter on improving our education systems and on
increasing and broadening access to education.  We need both, but
that's stating the obvious.  And, it's not likely that our political
system is going improve much with respect to education.  However, I
suspect that he proposes fixes to our education systems because he
believes that a capitalist-democratic system cannot be fixed.  Such
a system responds to the wishes and pressures of constituents,
voters, campaign contributors, pressure groups, lobbyists, etc.
After all, that is what a democratic system is designed to do.  But,
by doing so, it will inevitably drift toward instability: increased
leverage, higher risk, faster transactions, closer tolerance,
tighter couplings, and tighter connections.  And, now, apparently,
it will also drift toward looser regulation and less over-sight.  We
should expect to see more of the fault lines and the booms, busts,
and crises that Rajan describes.

And, as far as improvements to our education systems as a fix, I'm
very much in favor of improving schools and broadening access to
higher education.  But, I don't think we should be fooled into
thinking that this is a fix for everything.  In particular, some of
us are more capable of making use of higher education than others,
just as some of us are more capable of being reliable workers, or
physically strong workers, or skilled craftsmen, or excellent
artists.  But, if we shift toward an economy in which only the
highly educated are capable of earning a decent standard of living
(doing so by sending all non-skilled jobs overseas), then lots of us
will not be able to earn a living.  We are likely to see an even
more unequal distribution of income and wealth.  That's terrible for
those who can't compete for those jobs that require high levels of
education and knowledge, and it is terrible for our economy, because
not enough of us will be able to afford to buy the goods and
services that will make the economy go.

Rajan does explain why some of the cures that we'd think are obvious
ones do not work.  For example, the Fed's attempts to get the
economy moving by keeping interest rates low is made ineffective by
the fact that the Fed, whose mandate is only to help the U.S.
economy, actually effects the global economy.  In addition, and this
is what frightens me, those low interest rates and easy credit are
being used by banks and corporations that have learned to increase
production and profits through capital investment and technology,
but without additional hiring.  I fear that this kind of "recovery",
specifically improving production and profits with minimal job
creation, is what our recovery from future "busts" is going to be
like.  Our problem, with respect to the Fed and its policies, is
that lower interest rates creates output growth without job growth.

One of the anomalies in the recent boom and bust, and I think Rajan
is correct to call attention to this, is that the boom was an
inflation of a particular kind of asset: houses.  But houses are not
a normal investment asset in at least two ways: (1) We live in our
houses, so that "investment" is sticky in the sense that we often
will not want to sell when the market tells us that it's wise to do
so.  (2) With other investment asset there is a mechanism, vehicle,
or instrument which can be used to "short" the asset, and that has
the effect of limiting inflation and asset bubbles.  But, selling
short on housing stock is not easy to do.

Rajan does describe what needs to be done (to the global financial
system, not to education), but he is not optimistic that such
reforms will happen.  These changes all require sacrifice in
the short term, and perhaps even in the long term.  Since we,
especially in the U.S., have a political system that responds best
to immediate wishes of political players (voters, lobbyists, special
interest groups, etc), it's not likely that we'll make these
changes.  But, even if that were possible, we in the U.S. or our
political system is not likely to make sacrifices for the benefit of
others in the *global* system.  It's a bit of a law of the
commons and prisoner's dilemma problem.  We're going to take as much
as we can get until the last blade of grass in the common pasture is
gone, because we can't count on others to match our own sacrifices,
even if we were far-sighted enough to make those sacrifices.

We may just have to accept the fact that our financial and political
systems, taken together, are designed to produce high risk,
instability, and boom-bust cycles.  That's not a happy conclusion.
But, perhaps it's just the way our system works.  Rajan at least
does us the service of showing this rather clearly.

Rajan's final hope is that multi-lateral, financial organizations
such the IMF and the World Bank should take an active role in
influencing countries and the domestic financial systems to make the
needed sacrifices, to be more far-sighted,  and to act more
responsibly.  That seems, to me, to be a bit of a "hail mary" pass
and a low probability option.

I believe that we can expect more of the shocks produced by the
fault lines that Rajan describes.

04/14/2011

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