Critical Dialogues

Critical Dialogues is a series of conversations with members of the Chicago Booth community who play key roles in shaping business and economic policy worldwide. This discussion features professor Raghuram Rajan, former economic counselor of the International Monetary Fund, and clinical professor of economics Brian Barry.

By Patricia Houlihan and Melissa Bernardoni
Critical Dialogues

Photos by Matthew Gilson

Professor Raghuram Rajan, author of the Financial Times best business book of 2010, Fault Lines, and Eric J. Gleacher Distinguished Service Professor of Finance, talks with professor Brian Barry, Executive Director, Chicago Booth’s Initiative on Global Markets, about the causes of the financial crisis—and the threats that remain.

Barry: Many people have given single-cause explanations for the crisis. You prefer to think in terms of “fault lines.”

Rajan: We have the sense the crisis is about good and evil, a few bad people. It’s more problematic—it’s systemic. It’s many things coming together in a perfect storm. We can deal with some of the narrow proximate causes, but that leaves the big fractures to be dealt with. That’s why the metaphor “fault lines” made sense.

Barry: It’s where different systems come into contact with each other. Different ways of doing things.

Rajan: And different stresses within society. A main focus is how inequality creates enormous problems. Inequality can be a good thing—when you see people making money because they’re working hard, you work harder. However, if you have pervasive inequality stemming from access to basic rights—education, opportunity—it’s a two-tier society. Then you can get a lot of pernicious forces working in society.

Barry: You talk about how education-driven in-equality has interacted with a tendency for U.S. recessions to lead to more unemployment for longer and how that has exacerbated these political problems.

Rajan: Right. I’m trying to understand why the U.S. has become the consumer of first and last resort for the world. Part of it is inequality, which, in the United States, is being driven by unequal access to education. Some people simply don’t have the education it takes to succeed.

The right thing to do is to create more capacity to generate incomes amongst the people who are falling behind. Rebuild skills for, say, the auto worker or construction worker. But it’s not easy. There are many ways we’ve tried, and they have not been effective. So what can we do? We can expand credit. The enormous expansion of credit, especially housing credit, which fueled the consumption boom in the U.S. and led household savings to go below zero, was in many ways the political and social response to a lack of income generation.

The difference between income and consumption is made up by credit—consumption inequality increased far less than income inequality. This can go on until you’ve overborrowed, until the houses have been bought, they’ve increased in price, they’ve been able to borrow against that—but eventually everything ends. Some of the policies that led up to this, the enormous thrust on housing, especially housing for subprime segments of the population, were driven by this implicit impulse—it may not be explicit—among politicians. If people are happy, why stop? If regulators started to talk about Fannie and Freddie being a problem, or the kind of mortgage lending that was going on, politicians would reel them in and say, “This is going well. Don’t intervene.”

Also, the U.S. has not been structured to tolerate deep, prolonged recessions. Typically, lost jobs were regained after eight months. That’s why the United States could live with a very thin safety net—six months’ unemployment insurance and no health insurance. This gave enormous incentives to go look for a job.

Barry: This was connected to a flexible labor market that was once considered one of America’s strengths.

Rajan: It’s still an important strength. Flexible labor markets work well when you have cyclical recoveries, but the nature of recoveries has changed. The 2001 job recovery took 38 months. If it takes a long time, jobs come back in different areas from the one that fired you, and the safety net will likely prove inadequate. We’re seeing that now with long-term unemployment becoming really high. The thin safety net no longer translates into more incentive to look for jobs, because they aren’t there. It translates into tremendous pressure on both the Fed as well as the administration. In the process, sober policy making suffers, and we’ve given up the chance to do something more reasonable about longer-term fiscal problems.

Barry: You say it would be better to have an unemployment safety net plan in advance that would operate as an automatic stabilizer in down times, and that would be more efficient than this kind of ad hoc stimulus planning.

Rajan: Right. The political system is supposed to be very flexible here. When unemployment is long and persistent, for example, we vote for unemployment benefits to be extended. In practice, there’s so much fear about the consequences of persistent unemployment—rightly so—that we do anything to deal with it. The U.S. focuses on pushing consumption because people are falling behind, and in downturns, this goes into overdrive because people are losing their jobs and we want someone—the government or other households—to spend.

Barry: You talk about how this structural, consumption-driven approach has interacted in an unhappy way with the structural, more production-driven approach of other countries.

Rajan: When some U.S. economists look for causes of the crisis, they point outside the country and say, “They sent us cheap money and made us consume.” That’s partly right. We’ve had a massive crisis partly because we overspent. But there is something right about this explanation. The world has gotten used to an overspending United States and has taken the opposite position of saving a considerable amount and relying on the U.S. to be the source of demand. Other countries have also overspent, and they’re all in trouble: Iceland, Ireland, Spain, Portugal. The question is: Why are countries like China and Germany saving so much and getting others to do the spending for them? That’s the strategy for growth they’ve latched on to. It’s successful because others can get into trouble by overspending while you have a more stable structure.

Barry: You argue that China’s strategy is not an ideal one for them beyond a certain point.

Rajan: It makes you dependent. And you become relatively weak because you’re limited in your growth. You can’t grow on a broad front because the strategy requires creating a very competitive externally oriented center, and it becomes competitive because you mollycoddle them at home but tell them to go out and become efficient by competing with global markets. That creates efficient producers. Government protection is tempered by the need to compete with outsiders as far as the external production segment goes. On the domestic side, because you can keep out the competition, it creates substantial inefficiency.

Most of us can name some Japanese manufacturers: Toyota, Mitsubishi, Fujitsu, Honda. It’s not as easy to name a Japanese consulting firm. They have a super-efficient manufacturing sector, typically in traded goods where they compete worldwide, and a grossly inefficient domestic sector. They don’t experience the same degree of competition internally. That creates a two-tier society. By the time you become rich like Japan has, it’s too late to change the portion that’s not competitive because the vested interest to maintain the status quo is enormous. It’s time for them to reform this sector, and they haven’t summoned enough political will to do it.

Barry: In the book you talk about long-term reasons for why the export-led economies have gotten this way. They had a model that worked for a long time that has created a structure where countries like Japan find it hard to change. But you also note that many emerging markets learned a powerful lesson from the Asian crisis a decade ago that has given them a further impetus to be surplus-driven economies.

Rajan: Emerging markets have already learned the lesson that industrial countries are learning now: Relying on foreign financing for growth is dangerous. Foreign financing invariably found a way to finance its growth by relying on government guarantees, implicit or explicit. Think of the Asian crisis. The Asian crisis was a strong signal to those countries that it was unwise to finance even investment with foreign money.

Barry: There’s a parallel to the problem that you talked about earlier with the United States. The U.S. and other countries are now saying, you sent us all this money and made us consume.But you’re saying that at the time these emerging markets said, “You sent us all this money and made us invest, and it wasn’t good for us.” Right?

Rajan: Absolutely. Emerging markets decided never again to run large current account deficits. The Philippines went from running a current account deficit of 10 percent of GDP to running a surplus of 2 percent within a few years. That’s enormous. It was felt at that time that industrial countries had strong institutions, good regulators, and could deal with this kind of problem and run a large deficit for a sustained period of time. The U.S. has been at the forefront in part because people trusted the U.S. and were willing to pour money into it. The United States has justified that trust by bailing out Fannie and Freddie, but that’s expensive to taxpayers. Think of the parallel in Asia happening to the U.S. In Asia the foreign investors were lending to the banks. For the U.S. they were buying agency securities and saying there’s no way the U.S. will let these guys go under. Money was pouring into the agencies, and the agencies were funneling it into the housing sector. When push came to shove, the U.S. said we can’t let these guys go under. There are too many people who’ve trusted us. We never explicitly promised to bail out Fannie and Freddie, but we’d roil the markets if we did, so let’s take them over. Now Fannie and Freddie are as good as the full faith and credit of the U.S. government explicitly. This is the problem when financial systems collide. Outsiders demand protection and governments are too willing to provide that protection. That takes off the discipline of finance.

Barry: You’ve made a more subtle point that it’s not just about who’s supplying the capital and who’s accepting it. It’s also about the nature of the financial systems in rich industrial countries like the U.S. and their arms-length systems, which tend to be different from the systems in many of the countries now supplying the capital. This is a main fault line.

Rajan: There are differences between systems, but there is an important similarity in that the outsider who doesn’t understand the system almost always wants protection. Ultimately the protection comes from the government through the taxpayer, and that distorts the market. Distortions are particularly problematic in the arms-length system because prices there are key.

The U.S. market-based system relies on getting the prices right. If prices go off track, decisions can go off track. Take the real-estate broker making a $200,000 loan to a guy who occasionally works as a gardener. Why was that loan made when he knew the man couldn’t afford it? Well, the gardener and his wife wanted it, and told the broker, “We have jobs now and can generate the payments. Homeowners are making 10 percent a year on appreciation, why should we be denied this part of the American dream?” The broker says, “You need a loan. There are guys at the end of the line willing to buy it. I need to ensure that you have good credit quality. Take a little of this money, pay down your other loans, stay clean for a month. Your credit quality will improve, and we’ll find a good appraiser who will put a high value on your house so you can get the mortgage you need.” Everybody’s cooperating. You take the mortgage and send it down the line. Somebody at the end of the line says, “All I need is a good rating, and I can buy the stuff and this gives me 20 basis points over my cost of capital and I have my year-end bonus.”

Barry: Based on the prices that were established from all of these arms-length transactions?

Rajan: Yes. Somebody is not paying attention. We blame the broker, but at the end of the line people weren’t asking enough questions. The system is dependent on people paying attention throughout.

Barry: One of the strengths of the arms-length system is that in most situations, most of the time, prices do an excellent job of carrying the information you’d want people to consider. But there is something about situations like this one where it doesn’t work. Somewhere along the chain people aren’t pricing things the way they should. For example, if politicians were to say we want to get people into houses even if they can’t afford it, and we’re going to be explicit about that subsidy and give them the money, then the pricing would still be clear and correct, right?

Rajan: That would work well, but it would absolve the private sector from making credit decisions and, instead, convert it to a political decision.

Barry: So the problem was some hidden subsidy or unclear subsidy, and everyone then did the wrong thing with it?

Rajan: Absolutely. There’s a lot of blame we should fix on the brokers, the bankers—by no means is this an attempt to absolve the private sector. But you asked the right question: why did the private sector go off track? If they were making loans that they would eventually have to hold on to and suffer the consequences directly, would they have been so eager? A lot of money was coming in, which was much less attuned to the risks that were being created. For example, Fannie and Freddie had this enormous government-induced subsidy from their cost of finance. Everybody thought they were government backed, and therefore they were getting close to the government’s rate of financing for whatever paper they issued. This they could then take and put into prime financing, their bread and butter, enormously profitable because it was government guaranteed. However, Congress saw this and said, we want them to start moving toward poorer people, make housing more affordable.

The lever we have is the enormous government subsidies they get, so we’ll threaten to take away these subsidies and move them into line. In fact, it’s hard to tell how much was Fannie and Freddie pushing, saying, we’ve got to do something or Congress is going to remove our basic source of rents. It was a love fest between the two. That’s one aspect where you corrode the pricing because Fannie and Freddie need to do this in a big way, need to do it quickly. They’re not doing it necessarily for the profits, but because they have a mandate. Then take the big banks, UBS, which basically has the whole investment banking division, saying, “We’re getting 20 basis points more on these mortgage-backed securities than the AAA. And our risk management is not asking us to hold any additional capital against it. This is money for nothing. Let’s load up.” Perverse incentives across the system creates mispricing, and the system gets into deep difficulty.

Barry: Where were shareholders in this process?

Rajan: Egging it on. They are in for the money. This process was generating enormous amounts of money while the going was good.

Barry: These were good bets for them?

Rajan: Yes. The problem was that these bets were very risky and eventually it didn’t work out.

Barry: What about debt holders? In many circumstances we can count on them to act in opposition to shareholders when they’re taking risks that might not be in the best interest of the overall value of the firm. But in this case it didn’t work that way.

Rajan: Absolutely. Part of it was this greater belief that these entities were too big to fail, that the government would come in, which also explains the shock with Lehman. Wall Street had convinced itself none of these guys would be let go of, which completely eliminated market discipline. Turns out that they weren’t paying much attention. If there was one technical fix to some of the problems that we saw in the crisis, it would be to let debt holders price in the risk. This is where I think we need to work actively on creating the instruments which will ensure that they take the risk and hit.

Barry: Have we done anything to impose different incentives on debt holders?

Rajan: Some of us have been pushing for a contingent convertible, or co-co. A number of banks are issuing them without being forced to by regulators, and regulators themselves are pushing hard to establish rules. At least on the debt side, we’re going toward a technical solution. It seems minor, but if we can get a class of debt to fully reflect the risk of the institution, it will be a big step forward.

Barry: Let’s return to the surplus economies. Do you see progress in either developed countries like Germany or the emerging surplus countries?

Rajan: The center of attention in all these debates is China, which has taken away a sound lesson from this crisis. My Chinese friends say they learned from the 1998 crisis never to be dependent on foreign financing. That’s why they started building up a more export-led economy. From the 2008 crisis they learned never to be dependent on foreign demand. At some point domestic demand has to be the source of Chinese growth.

Barry: Do you see them taking concrete steps that are consistent with that?

Rajan: Yes. People focus on the exchange rate only, but this is about changing the strategy for growth, which has to become less producer-oriented in China and more focused on consumer and domestic competition.

Barry: On the question of global imbalances overall, you seem pessimistic about the chances of traditional multilateral bargaining among countries helping to address these imbalances.

Rajan: In an integrated world, what’s good for the country in the short term typically is not necessarily good for the global economy and vice versa. Politicians therefore have an incentive to ignore global problems and focus on the short-term problems of their own country. What’s the first thing we do as we emerge from this crisis? We go back to the status quo—pushing spending—because that’s the easiest thing to do and there are millions unemployed. You can talk about a rule-based approach to international policy making, but it’s doomed to fail because it’s not clear what rules every country will subscribe to before the fact. If you leave the rules fuzzy enough to be enforced by some community of nations or by an appointed agent like the IMF, it implies a substantial loss of sovereignty that no big country will agree to.

Barry: Given that, can I suggest an alternative view? One way to look at international trade and the World Trade Organization would be to say that even though these trade treaties have done some good, they’re based on a falsehood. The falsehood is that if I unilaterally open up my own country to more trade, that won’t help me—that free trade only benefits me if I can get you to open up to my exports. Many people would argue that’s a false premise—that all countries tend to gain if they open up unilaterally—but that it’s politically difficult to do so, so we have these treaties that imply that you’re helping me, and I’m helping you, but that’s only to offset various domestic interests.

Rajan: Absolutely.

Barry: Why not take the same approach to international financial issues? You can argue that politicians just need to be more intelligent about explaining and doing what is in the interest of their own countries, and that pretending that somehow we’re doing this to help someone else—that the U.S. is doing this to help China or vice versa, for example—actually backfires politically.

Rajan: That’s right, but we’re actually talking about difference in horizon. Many countries are focused on the long term. What they need to do is perfectly consistent with what the world needs over that horizon.

The problem is political horizons are much shorter, and what they want to do in the very short term can be very much against what the world needs. Nevertheless, I am hopeful that so long as no one does anything stupid (and there is always plenty of room for that), we are moving to a more sustainable growth path where emerging markets spend far more and industrial countries save more.

Read related article: "Developing a Theory of Risk and Reward: Rajan on poverty, options pricing, and predicting the crash of 2008".

Last Updated 3/3/11