June 8 (Bloomberg)
Chicago’s Rajan, Crisis Cassandra, Sees More Bubbles Ahead by James PressleyDon't miss the rest of Pressley's review of Rajan's book.
Logic can be hazardous to an economist’s reputation, as Raghuram G. Rajan discovered when he predicted the credit crisis two years before it hit.
Far from welcoming the warning, peers savaged the University of Chicago professor for contradicting their sanguine views.
“I felt like an early Christian who had wandered into a convention of half-starved lions,” Rajan writes in “Fault Lines,” a timely look at how the crisis was anchored in a flawed financial order.
It’s fun to play Pin the Meltdown on the greedy bankers, meddling governments and lying homebuyers. Yet these individuals, for all their shortcomings, were only responding to three sets of fault lines, Rajan argues: domestic political pressures, trade imbalances and incompatible financial systems. These fractures continue to threaten the world economy, and “we risk going from bubble to bubble,” he says.
“Progressives in the United States blame the bankers, while conservatives blame the government and the Federal Reserve,” he writes. “The worrying reality is that both are to blame, but neither may have been fully cognizant of the fault lines guiding their actions.”
Rajan knows how to “connect the dots,” as he puts it. That’s how he got into trouble during the 2005 gathering of central bankers at Jackson Hole, Wyoming, where he argued that financial innovation had made the system more risky, not less. The assertion was heresy at a time when Fed Chairman Alan Greenspan was enthusing about how modern markets were dispersing risk and policing themselves. Too bad. Rajan had found a flaw.
‘Market Could Freeze’
Banks weren’t merely passing risk along by selling mortgage-backed securities and collateralized debt obligations to investors, he said. They were holding many of those securities on their own books, exposing them to losses -- and undermining confidence in one another -- if the market sank.
“The inter-bank market could freeze up, and one could well have a full-blown financial crisis,” he said.
Though that is in essence what happened two years later, an audience including Lawrence Summers picked the paper apart. Summers, who now heads the National Economic Council at the White House, derided Rajan’s “slightly lead-eyed premise.”
In “Fault Lines,” Rajan traces some unexpected trends, including college drop-out rates and unemployment benefits. His argument, crudely compressed, goes like this:
The supply of university-educated American workers hasn’t kept pace with demand sparked by technological advances. The shortfall has fed a widening income gap, with pay stagnating or falling for the some seven out of 10 Americans who lack a degree, he says.
How do politicians in the land of the free respond? They speed “the flow of easy credit to those left behind,” Rajan says in chapter one, “Let Them Eat Credit.” And so it was that Presidents Bill Clinton and George W. Bush both pressed Fannie Mae and Freddie Mac to ramp up lending to low-income families.
This is, of course, the conservative take on the crisis, and Rajan knows progressive economists like Joseph Stiglitz won’t buy it. No one in Washington forced Lehman Brothers Holdings Inc. to gorge on commercial property. Nor did the government order American International Group Inc. to issue a blizzard of credit-default swaps. Seeking a middle ground, Rajan faults government and banks alike. [...]
The political calculus has been complicated by jobless recoveries. Until 1990, postwar recoveries were rapid, Rajan says; lost jobs were typically recovered eight months after the trough of a recession. Yet it took 23 months to recover lost jobs in 1991 and 38 months in 2001, he writes. The U.S. is ill prepared for these lags because unemployment benefits typically lapse after six months.
That puts pressure on politicians and the Fed to do something. Faced with a jobless recovery, the Greenspan Fed pushed rates down to 1 percent by June 2003. One upshot:
“The Fed was now effectively adding stimulus to a world economy that was growing strongly, with jobs being created elsewhere but not in the United States,” Rajan writes. Which brings us to another fault line.
Export-driven countries such as Germany, Japan and China depend on foreign consumers. Their supply “washes around the world looking for countries that have the weakest policies or the least discipline, tempting them to spend until they simply cannot afford it and succumb to crisis,” Rajan says. The U.S. thus became the world’s “reliable stimulator of first resort.”
Rajan’s writing is clear and direct, even when he litters the text with numbered points. Yet when it comes to his suggestions for fixing the system, he can be frustratingly incremental and vague.
He does offer some sound ideas about how to strip banks of “perverse incentives” and make them easier to wind down. Yet he largely argues for keeping the current system intact and thus runs the risk, as he says, of “being dismissed as a conservative, an unregenerate apologist or, worse, a toady of banking interests that favor the status quo.”
Let the shouting begin.
“Fault Lines: How Hidden Fractures Still Threaten the World Economy” is from Princeton (260 pages, $26.95, 18.95 pounds). To buy this book in North America, click here.
(James Pressley writes for Muse, the arts and leisure section of Bloomberg News. The opinions expressed are his own.)
To contact the writer on the story: James Pressley in Brussels at email@example.com.