Download Fault Lines

Fault Lines – Raghuram Rajan
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Fault Lines: fault lines are breaks in the Earth’s surface where tectonic plates come in contact or collide. Enormous
stresses build up around these fault lines.
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USA: In American politics, economic recovery is all about jobs, not output, and politicians are willing to add stimulus,
both fiscal (gov’t spending & lower taxes) & monetary (lower short-term interest rates), to the economy until the jobs
start reappearing. The problem was not that no one warned about the dangers; it was that those who benefited from an
overheated economy had little incentive to listen. The weak safety net & the emergence of jobless recoveries imply that
the American electorate is far less tolerant for downturns than voters in other industrial countries. There is
extraordinary political pressure on Congress and the Federal Reserve to somehow produce jobs. The old social contract –
short-duration benefits in return for short recessions – is breaking down. Therefore, the US usually overreacts to issues.
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Easier credit: Politicians have looked to easier credit as the path of least resistance to improve the lives of the voters.
Educational reforms would take decades to produce results, therefore politicians avoid that. Growing income inequality
in the United States stemming from unequal access to quality education led to political pressure for more housing credit,
this pressure created a serious fault line that distorted lending in the financial sector. The boom was concentrated in
those least able to afford the bust. The US financial sector thus bridged the gap between an overconsuming and
overstimulated US and an underconsuming understimulated rest of world through the housing market.
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China: export-led growth, chinese households consumption is very low, wages are low, they (grandparents & parents)
dependent on one child for future support. The chinese economy is excessively dependent on foreign demand. Chinese
bureaucrats have a penchant for glamour projects (fixed-asset investments) – vast airports, fancy modern buildings &
enormous malls. China’s currency (renminbi) is pegged to the dollar. Chinese exporters already enjoy subsidies such as
cheap capital, land, and energy. Currency undervaluation may be the way for developing countries to offset their
institutional disadvantages. Firms that invest on the basis of the competitive advantage obtained from an undervalued
currency are creating an additional inefficient base of production that will remain competitive only if undervaluation
persists. The financial sector in China is left underdeveloped. Exporters that receive dollars exchange them for renminbidenominated claims on the PBOC (central bank) – a process known as sterilized intervention. PBOC then buys interest
earning US assets. China has to mirror the US monetary policy as a result.
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Federal Reserve: The Fed is supposed to promote a healthy economy by focusing on stable employment & stable prices
keeping the US at its ideal potential growth rate. The jobless recovery from the recession of 2001 induced the Fed to keep
interest rates extremely low for a sustained period. Output growth had not resulted in job growth. In an attempt to
stimulate job creation, the Fed spurred on the financial markets to take extreme risk taking. The Fed conducts monetary
policy through one instrument – the short-term interest rate (the overnight federal funds rate) by intervening in the
interbank market for reserve money, in an attempt to influence the long term interest rate (based on the expectations
hypothesis). Lower long-term rates increase the value of long-term assets & consequently spending. The Federal Reserve
policy was turning the US into a gigantic hedge fund, investing in risky assets around the world & financed by debt issued
to the world. The “Greenspan Put” was the Fed’s commitment to a put a floor under asset prices, to flood the market
with liquidity in the event of a severe downturn. And if bankers plunge the system into trouble they will end up getting a
great deal on interest rates. When the Fed focused on what interest rates would do to output rather than to financial risk
taking, financial risk taking went unchecked.
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Arms-length system: Where the financier does one-off transactions & rarely has a long-term relationship with the final
customer, can often only be measured by how much money the financier makes. the very strength of the system that
money is the measure of all things is also its weakness since it’s a poor mechanism for guiding employees’ activities
towards socially desirable ends. Arm’s-length transactions do not foster empathy or a long-term focus. A check on arm’slength transactions is a well-functioning competitive market. What we see in the recent crisis are the problems created
when the arm’s-length system is financed with foreign & domestic quasi-gov’t money that is less sensitive to price & risk.
Many attribute the crash to excesses to greed, but greed/self-interest is the driving force of any type of arm’s-length
transaction, it is a constant & cannot explain a boom or bust. The private sector did what it always does – look for an
edge. The industry’s entire system of values uses money as the measure of all things.
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Tail risk – risks that occur in the tail of the probability distribution (very rare). The structure of incentives in the modern
financial system leads financiers to take this kind of risk & their actions increased the probability of these events
occurring. As managers seek alpha (returns exceeding those of the risk-appropriate benchmark) many take on tail risk.
Bankers are under tremendous pressure to produce risk-adjusted performance, therefore the rewards for those who can
are enormous.
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Too systemic to fail: the essence of free enterprise capitalism is the freedom to fail as well as to succeed. We have to aim
for a system in which no private institution has protection from the gov’t. try to prevent institutions from becoming
systemically important. What is important is not size per se but the concentration & correlation of risk in the system, as
well as the extent of exposure relative to capital. What we need from bankers is competent risk management, not
complete risk avoidance. Herd behavior & undifferentiated groupthink is the primary source of systemic problems.
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“If something is unsustainable, it will stop.” The financial sector is, in many ways, the brain of a modern economy.
When it functions well, it allocates resources & risk effectively & thereby boosts economic growth… a healthy financial
system that benefits citizens requires competition & innovation. We need to develop more transparency between the
gov’t/regulators & the financial sector.