Monday, December 12, 2016

Fault Lines by Raghuram Rajan (Book Review #74 of 2016)



Fault Lines: How Hidden Fractures Still Threaten the World Economy

This is one of the books on the 2007 financial crisis that is ostensibly worth reading due to the CV of the author-- former IMF Chief Economist, later in charge of Indian monetary policy as Governor of the Reserve Bank of India. (Writing this in late 2016, perhaps PM Modi's botched reforms show how much Rajan was missed in opting to return to academia than return as Governor for a second term). Rajan has international gravitas and has thought about poverty and development in multiple ways. I would probably have enjoyed Saving Capitalism from the Capitalists (2004) more, but this book was available and I trust it contains similar criticisms and policy prescriptions. I read a host of books on the crisis while/after it was happening because I was teaching undergraduate economics full-time. For a list of a few I would recommend with this, see below (or my Financial Crisis bookshelf on Goodreads).

Rajan is famous for showing up at the Federal Reserve's Jackson Hole retreat in 2005 and warning of the CDO time bomb that no one wanted to hear about; it was ticking while everyone just wanted to praise Maestro Greenspan out the door. Mr. Rajan is apparently unwilling just to rest on that career highlight for credibility, he seems to have to throw some bones to the liberal establishment in an effort to be taken seriously while he adopts some critiques of the US government that have been rejected by left-leaning economists. As a result this book pivots from the financial crisis to education and health care reform, sometimes using examples from India as prescriptive and ignoring the various nuances of programs like Medicaid across 50 separate states. He adds little to reform proposals made by others and closes with vague but wide-sweeping policy prescriptions and new spending programs while somehow ignoring the massive risk the US faces in its long-term debt position vis-a-vis Medicare, not to mention trillions in unfunded pension liabilities.

Rajan is interested in identifying systemic fault lines. This is difficult to do in practice, just read a Nassim Taleb book-- even if you identify it you cannot be assured of diversifying it away. (You might reduce volatility in the short run, but make the fat-tail risk larger.)
The biggest fault line is that the goals of capitalism and democratic politics do not align. Another is the rise of inequality, the top 10% relative to the bottom 90% (now the gap is widely debated after Pickety's book came out and Emmanuel Saez put out his paper that the gains to the top 0.1% explains almost all the 90/10 gap). Rajan speculates that the 90/10 wage differential is driven by the increasing college education premium-- those being left behind are largely the lesser-educated. Perhaps 1/3 of the inequality problem may also be a picture of entrepreneurs and graduate students going from very low incomes as they start out to very high incomes later--ie: mobility matters and may make the inequality problem look worse than it really is. Assortive mating may also explain some of the inequality-- similarly educated/income class people marry people from the same class.

Rajan explains the housing bubble as a response to "insecurity" of middle-class wage stagnation. People envy the upper incomes getting richer and compensate by saving less and borrowing more. One way to quence the insecurity is to buy a house. Housing demand aligns with the goals of politicians-- to increase private wealth, property values (and local tax revenue), create jobs for lower and middle class voters (construction), demonstrate "development" and so forth. There is also the belief espoused by every President in the last 100 years of the  "ownership society," when people own rather than rent they take better care of their property and society is better off. Hence, the government likes to find ways to encourage home-building, such as subsidizing low-interest loans and making mortgage interest tax-deductible. (See Ferguson's Ascent of Money for a more complete take on this history in the US in the 20th century.) Rajan begins his blame with the 1960s in privatizing Fannie Mae and Freddie Mac, and the 1970s-1980s deregulation of thrifts. While privatized, there was still an "implicit guarantee" on Fannie and Freddie's debts, particularly in the eyes of foreign creditors. (I once heard a talk by St. Louis Fed President Jim Bullard about the anxious days of the crisis when Bernanke was dealing with such creditors and quite angry. While Paul Krugman and others on the Left wanted to basically absolve Fannie and Freddie from guilt, Rajan rightly holds them and their political enablers accountable. While Rajan blames the Bush administration for further pushing home ownership, he neglects that Mankiw and others tried to deal with the implicit guarantee problem.) The Clinton Administration pushed to dramatically decrease the downpayment required for an FHA loan, and the Bush Administration further accelerated this. From 2002-2005, zip codes with lower incomes saw the most dramatic increase in housing investment. This is politically feasible until the buyer can't make payments, the adjustable interest rates go up, etc.

Chapter Two examines the export-led growth model (for which Yergin and Stanislaw's Commanding Heights is an excellent history and reference). Rajan critiques the "Washington Consensus" of limited government intervention in the economy to stimulate private-sector growth through exporting to the developed world (Stiglitz's Globalization and Its Discontents is another helpful book here). Rajan writes that while an export-led model allows for growth and innovation even in a command economy, export-led economies find it difficult to switch to the service sector after they have matured (ie: after incomes have risen considerably). Japan is one example of this phenomenon, having built an export-led model of exporting vehicles and electronics, and now being dependent on other countries' stimulating their own economies in order for Japan to grow again. This is a major fault line for the world economy. Rajan discusses the Chinese model as well, noting that China's one-child policy boosted its savings rate because the social safety net of parents relying on children can't be present with such a policy. Hence, capital flows to the US and boosts the value of the dollar and helps stimulate Chinese exports. The US' "jobless recovery" of the 2000s, which the Fed responded to with low interest rates, may also have been affected by China's refusal to revalue the yuan during that period.

Rajan recounts the controversial IMF decisions aiding the East Asian financial crisis of the 1990s. Surprisingly, Rajan never mentions the role of the collapse of Bretton Woods (under Nixon) in the capital imbalance problem. The US "closing the gold window" on the balance of payments made the US dollar the default reserve currency of the world and boosted it to a seemingly permanently strong status relative to other countries, which helped start the export-led model in the first place, as well as America's penchant to borrow to fund its deficits. These are not easily reversible. Rajan also seems to ignore the effects lifting of capital controls during the same time period. As a result of these things, which Rajan does not spell out clearly, the Federal Reserve's monetary policy is exported to the rest of the world. Rajan blames the Fed for "blowing up the housing bubble" without spelling out the history clearly.

In examining Fed policy, Rajan critiques the "Greenspan put," and the willfull ignorance of rapidly increasing asset prices at the end of the Greenspan era. Rajan essentially makes contradictory statements about the Fed's ability to identify and limit asset bubbles. He blames the Fed for not deflating the housing bubble while acknowledging the problems of such a policy change. He writes the Fed should have triple mandate of looking at asset prices and risk as well as inflation and unemployment. (Many economists have written on the difficulty of such a policy.)The Fed ignored the effects of strengthening the 1977 Community Reinvestment Act that was pushing banks into loans in communities where they would most likely be defaulted on. (Congress basically absolved the CRA, as did Ben Bernanke, but conservative economists and politicians have tended to agree with Rajan.)

He doesn't just blame the Fed, he examines why so many banks kept risky assets on their books, buying into their own fantasies (see The Big Short for how different arms of banks took sometimes opposing trading positions). The main problem was that the risk was not properly priced into the assets. Credit default swaps were undervalued and houses were overvalued. Rajan also explores the problem of "too big to fail" and systemic risk. Does the financial sector allocate capital efficiently? No, not if assets are mispriced due to the undervaluing of risk. He proposes the common-sense solution of ending government subsidies to financial institutions anad implicit guarantees. Given that little has been done to reduce the subsidization of housing in the US and institutions like the FHA still take very low downpayments and banks were allowed to get even bigger, even common sense solutions run into political realities and cognitive dissonance. Nevermind the "cycle-proof regulations" that Rajan proposes.

Beyond government subsidies, Rajan encourages actions in the private sector as well. We have to find ways to eliminate the temptation of bankers to take on "tail risk." That would require a real change in how CEOs are compensated. Rajan wants corporate boards to have members with more financial expertise. He also wants standardization of assets to make them easily comparable and easy to see what's inside. He calls for breaking the problem of "cognitive capture" of regulators and policymakers. He wants to end "too big to fail" and prohibit mergers and somehow measure intertwined exposures to measure the real systemic risk of institutions. Perhaps thinking from an IMF standpoint, he proposes a limited "systemic bailout fund." (The Fed and Treasury were able to use such thinking when they bailed out Mexico under the Clinton Administration.) But, how big should such a fund need to be and wouldn't it be tempting for Congress to tap into it for bailing out, say, an auto industry or defense contractor? Rajan doesn't give many details. All of these proposals have been echoed by economists and politicians on the Left and Right since 2010, but little has been done. Whatever little Dodd-Frank did to increase regulations of the financial sector, President-elect Trump publicly put immediate repeal into his platform.

Sadly, he would rather the Federal Reserve pursue the more complex triple mandate and makes no mention of the idea of a Nominal GDP target which is disappointing to me (a market monetarist whor reads Scott Sumner and David Beckworth). Instead, he goes on a longer rant with little to do with economic or monetary policy and sounds like he's running for public office with a bunch of vague policy prescriptions: We need to "work on things that work." The US needs a longer school year and better teachers. We need universal preschool and subsidies for nutrition education and free lunch. We need to reduce unequal access to education to attain human capital. Universal health care and other health care reforms that (look a lot like the Affordable Care Act). We need to examine a value added tax and a carbon tax to reduce the deficit (without mentioning how much wider the deficit would be with his other policy proposals). At the same time we need to reduce the deficit, we need to increase household savings. There's not much call for sacrifice here. No mention of the $2-$3 trillion in unfunded pension liabilities the 50 state governments and various localities have to deal with. I could go on.

Rajan closes by explaining IMF policy and the various debates and controversies that surround it. He advocates customized policy and not "one size fits all," "Washington Consensus"-style policies. He encourages multilateral cooperation, which always conflicts with the local politics of sovereignty, but multilateral agencies like the UN, IMF, World Bank "should be given the benefit of the doubt." Rajan doesn't seem to notice that history often repeats itself worldwide and people are largely ignorant of history. If he really thought about all the systemic risks out there, and how we're ignoring them (unfunded pensions, climate change, the growth of nationalism, etc.) it would basically spell doom for us. He somewhat addresses this in the epilogue, but not satisfactorily. Three stars out of five. He has succeeded in identifying several global financial fault lines but also ignored or not seen others.

----------------------
Other books on the global macroeconomy and financial crises I recommend as a prerequisite for this book:
The Commanding Heights by Yergin and Stanislaw.
The Ascent of Money by Niall Ferguson
Fooled by Randomness (or other works) - Nassim Taleb
The Misbehavior of Markets - Benoit Mandelbroit
Globalization and Its Discontents - Joseph Stiglitz
Irrational Exuberance - Bob Shiller
Specific to 2008 crisis:
Slapped by the Invisible Hand - Gary Gorton (recommended by Ben Bernanke)
13 Bankers - Johnson and Kwak (Johnson former IMF Chief Economist)
The Big Short - Michael Lewis
The Subprime Solution - Bob Shiller

No comments: