Fault Lines: How Hidden Fractures Still Threaten The World Economy

"The book was written a couple of years ago now, but he begins by pointing to the issue that’s being raised now by the Occupy Wall Street movement. A major fact of the last 30 years is growing income inequality in the US. He argues that in many respects the housing bubble was the direct outcome of this growing inequality because, for various reasons having to do with political culture, Americans don’t like outright redistribution. They’re not comfortable with it the way the Europeans are and therefore they did a stealth redistribution through subsidised mortgage lending, which is the origin of Fannie [Mae] and Freddie [Mac] [US government-sponsored mortgage companies]. He accepts the fact that the crisis had multiple causes but he argues that redistribution done through subsidised lending is one of the most inefficient and dangerous ways to do redistribution. He wouldn’t actually disagree with the notion that the country needs more redistribution, but he would call for different social policy remedies. The book is interesting because it puts the subprime housing market in this larger context of growing social inequality. Yes, it’s clearly right. There was such a bipartisan consensus – which we now forget about – in favour of expanded credit opportunities of home ownership for low-income people. Everybody wanted to create an ownership society, and was willing to take a lot of risks, not apparent at the time, in order to do this. This is not something that only Democrats favoured, this is something George Bush got behind in a big way as well. Rajan says it’s a very American approach to dealing with a problem of this sort. “While nobody wants to have a crisis, it does serve as an opportunity for reform. I would say that one of the big tragedies is that in many respects this was a completely wasted crisis. It wasn’t deep enough.” The other thing that I found interesting about that book is that Rajan is a former chief economist of the International Monetary Fund. He is quite aware – and gives quite a lot of evidence in the book – that ultimately one of the big causes of this crisis was Asia, and all the surplus countries that have been following this export-driven growth model. He says that that growth model is destabilising and is not sustainable for the countries that engage in it. One of the fascinating points he makes is that countries that grow using that model never grow up, in a sense. So Japan, all the way back at the time of the Plaza Accord in 1985, understood that they couldn’t keep exporting to the United States based on a weak yen for ever and that they would have to boost domestic demand. It’s now nearly 30 years later and they still have not succeeded in re-orienting their economy towards greater domestic consumption. That raises some very interesting problems for China because China is even larger than Japan and has been completely dependent on that same export-oriented model. Chinese authorities have been claiming that they understand they’ve got to re-orient towards domestic demand, but I suspect that even though it is an authoritarian state they’re not going to be any more successful than the Japanese were in bringing about this shift. When you grow in that fashion, you create all these big, powerful vested interests, which, in China’s case, are these big coastal export industries. The state is in bed with these people and that’s why I think they’re going to continue to run this extremely unbalanced economy. In the US, we have increasingly concentrated economic and political power. In a democracy, that should get balanced out by the voting power of ordinary people, but that mechanism seems to have broken down. First, there has not been enough recognition of the inequality of power, and second, the way people have mobilised to deal with it, there’s something missing in that as well. The initial response, according to the Rajan book, was to subsidise lending. That is, in effect, a way of not facing the inequality problem openly but trying to deal with it in a covert way. That, for me, is the central puzzle of this whole crisis. You have a crisis that starts on Wall Street and implicates a lot of the deregulated free market institutions that were created since the Reagan revolution. The crisis also had roots in the increasing maldistribution of income in the US. Despite all that, there’s been no mobilisation of people on the left. I really don’t believe Occupy Wall Street represents a broad mobilisation. The particular demographic at issue are the white working or lower-middle class in the US, the so-called Reagan Democrats. In the 1930s, they voted for the New Deal coalition – if they were Europeans, they’d be voting for Social Democratic parties. But in the US, in most elections over the past 30 years, they have voted for Republicans who have pursued policies that largely hurt their interests. That’s the big sociological puzzle about the US, why that phenomenon exists. That’s right. The economist Tyler Cowen has made the point that, in a sense, inequality matters less than it did 100 years ago. If you were at the bottom in terms of income distribution 100 years ago, it was literally a life-threatening situation, in terms of your life expectancy, your vulnerability to setbacks. It’s still the case in large parts of the developing world right now. But here in the US the level of people at the bottom is sufficient that they can still enjoy their smartphones and cheap clothing at Wal-Mart. The issue of inequality becomes much more abstract. They know there are people making billions of dollars, but it doesn’t bother them as directly."

"I admire this book because it’s not superficial. It goes for the ultimate causes of the economic crisis we’ve been through. Most people tend to focus in on something approximate. I don’t know that I exactly agree with this emphasis… The title of his book is Fault Lines – so it’s plural. He notes that it’s not one cause; he actually has several different classes of causes. The first of them is political, and the politics that lead to rising inequality. That’s been a trend in recent years in most nations of the world. Inequality has been getting worse, particularly in the US, but also in Europe and Asia and many other places. One thing that this has done is it has encouraged governments, who are aware of the resentment caused by the rising inequality, to try to take some kind of steps to make it more politically acceptable. He gives other examples as well, but historically, that has often taken the form of stimulating credit – instead of fixing the problems of the poor, lending money to them. He has a chapter entitled “Let them eat credit”. The US in particular has stimulated the housing market — it has subsidised lending to people, which drove up home prices in an unsustainable way. And there wasn’t that much concern about, or understanding of, the sustainability of this. That’s his first fault line. The second one is trade imbalances. Here he looks in particular at the developing world, notably China, that has an export-led growth policy. The Chinese noted that the export-led growth model was a huge success for other countries like Japan, Korea, Singapore – and so they want to follow that model. But it involves them running a trade surplus – and so, by implication, the rest of the world has a trade deficit. Advanced countries like the US then become dependent on this constant inflow of capital. That’s another imbalance which is also fundamental. The third set of fault lines comes from a clashing of systems. In the US, and in advanced countries, there is more of a sense of trust, and advanced financial solutions can be achieved better than in a developing world where people are still mistrustful. In the developing world, people prefer to make only short-term loans because they don’t trust tying up their money. It often needs to be denominated in foreign currencies so they won’t be devalued on, and they like to lend to local banks rather than to international ones because they know the local banks will be bailed out if there is ever a crisis. But that means the economies are more fragile. He’s talking about the Asian financial crisis in particular, of course – but there are other examples. Because people can withdraw their money quickly, there’s too much reliance on “too big to fail”, so the economies don’t function right. Those are the main fault lines that he talks about, and these are deep and difficult problems that don’t have easy solutions. They are part of the causes. This is a theme that I stressed in my book Irrational Exuberance (2000) – any big crisis always looks mysterious, because it doesn’t have a single cause. It has multiple causes, and the reason it’s a big crisis is because a number of different events chanced to happen all at the same time and created the extremeness of the event. In my book, I acknowledge these same causes that Rajan talks about, but not with his eloquence. I also emphasise something that is only secondary in his book, and that is the kind of social epidemic that happened, that produces bubbles in speculative markets. So we had a speculative bubble in the housing market in many advanced countries in the early 2000s – as well as in developing countries. I don’t think those really can be explained entirely in terms of these fault line theories. “Let them eat credit” was a factor, but I think that there was something else. There was a change in thinking that explained both the bubbles and the public policy. It’s something more permanent, more sociological. “The reason it’s a big crisis is because a number of different events chanced to happen all at the same time and created the extremeness of the event.” One thing that economists are very poor at is sociology. They don’t read about it and they don’t think about that discipline. But sociology tells us that our culture has its own internal dynamics and drift and we have to appreciate that it can drive things, it can change things. That was the theme in my own book : there were cultural changes that had many dimensions that brought on this crisis. I even brought in some things that might seem peripheral to some people, like the rise of a gambling culture, or a winner’s culture. I didn’t say “winner takes all” – but it’s a culture where we tend to admire the winners, and we have less sympathy with the poor or the unsuccessful. It’s a zeitgeist. I may be getting down even more to ultimate causes here than Raghuram did, but I very much admire his book. It says things that are not in my book, that I hadn’t thought of before. I’ve written several books about this! First of all, I don’t think this crisis is the end of the world. It is serious, but I wouldn’t do anything so radical as to hamper our engine of growth, which is capitalism. In fact, in many ways, I would like to expand it – capitalism has its own solutions to its own problems. Risk management may have failed us recently but the general principles are valid. So a lot of the things I talk about doing involve expanding our markets. For example, I advocated – and we did actually create – a futures market for single family home prices. I think that would actually help stabilise home prices. We have that going on the Chicago Mercantile Exchange, but it’s not a success yet. “Risk management may have failed us recently but the general principles are valid” But beyond that, let me talk more in sync with Raghuram’s book. I think inequality is a huge emerging problem, and that our society has to think about dealing with it in a constructive and real way – not through “Let them eat credit”, not through wishful thinking. We have to understand how we get inequality and what we can do about it."

"Raghuram Rajan is a mainstream orthodox economist and former chief economist at the IMF. He wrote this book in the aftermath of the financial crisis . It’s obvious that the corner that the American financial system got itself into was that easy credit – and the property bubble that resulted – was a way of deluding people in the States, particularly the squeezed middle, that they were more affluent than they were. It disguised the impact of the enormous inequalities that were emerging. This extraordinary financial system that the connivances of successive American administrations and Congresses developed, which overtly compensated for the weakness of the American social safety net and the emergence of this inequality, made people happier to live with a raw social deal. Inequality helped drive the crisis, that is his thesis. One of the reasons, he argues, why the middle got so squeezed in the States was that in a period of globalisation the US completely under-invested in developing the capabilities of what Americans call the middle class – what I guess we [British] would call the upper working class or lower middle class, the great mass of people whose income is around the median. Skills development and education levels in the States have actually regressed, partly because American neoconservatives and Republicans have argued that it’s socialist to offer education – that it should be an individual responsibility and tax levels should be as low as possible. So America has regressed. Its regression led to people wanting to chase the American dream through borrowing, and that led to rising house prices. Then the whole thing shuddered to a halt in 2008. So Rajan does see American inequality, and what caused it, as one of the generators of the financial crisis across the capitalist West. And I think that’s an important argument. It’s been picked up by the IMF and others, and has begun to make concerns about how contemporary capitalism is operating much more legitimate than they would otherwise have been. Fault Lines is a very important book. Oh yes. In Them and Us I set out my agenda for change. I think that if you’re going to have a competitive free market capitalism that has wild ups and downs in economic cycles – and once every 50 or 100 years ends in a calamity like the one we’re living through – then you have to aggressively use monetary and fiscal policy to sort things out. That means the state acting. We’re not there in any way in 2012. We have to think about how the capitalist enterprise is owned, and whether people are taking their stewardship and engagement obligations sufficiently seriously enough, or just taking their money and running. We’ve also got to think seriously about how one supports innovation, because it is innovation that drives wealth. That means everything from schools and universities to networks in the business community. There has to be a 21st century social contract – around the principles of due desert but drawing on Sen’s point that we are investing in people’s capabilities – that permits people to manage the extremities of this new capitalism. And that debate is just beginning. Support Five Books Five Books interviews are expensive to produce. If you're enjoying this interview, please support us by donating a small amount . There are people who have done very well out of the last 20 years who believe that it was because of their genius, and not just because that was the way the whole system was set up. They have no intention of putting any money in the pot because they feel that they deserve their money, and that those who aren’t as privileged as them in some sense deserve it. And that in turn leads to the last of the books."