Predicting the Financial Crisis: A Q&A With Fault Lines Author Raghuram Rajan

In 2005, Raghuram Rajan, a University of Chicago economist and then-chief economist of the International Monetary Fund (IMF), presented a paper at the Jackson Hole Conference, an annual gathering of central bankers, economists and private-sector players that is sponsored by the Federal Reserve Bank of Kansas City. Rajan’s paper “Has Financial Development Made the World Riskier?” warned that recent developments in the financial sector “create a greater (albeit still small) probability of a catastrophic meltdown.” He criticized the incentive structure of investment managers and banks’ practice of holding credit default swaps on their books, and cautioned against complacency.
According to Rajan, the paper wasn’t particularly well-received back then. He writes in his book that many conference participants believed Alan Greenspan had succeeded in creating a crash-proof economy.
Today, it’s easy to wonder if Rajan had a crystal ball back in 2005. Fault Lines, his new book, explains the factors that led to the crisis and warns that “hidden fractures still threaten the world economy.” He has agreed to answer some of our questions about the book:

Income inequality has been on the rise in the U.S. for some time, but it’s not often identified as a contributor to the financial crisis. What’s the link between income inequality and the crisis? What kind of reforms would you suggest to address this problem?

The housing boom and bust was at the center of the crisis. This was an atypical boom and bust in that the up-and-down movement of house prices for the poorest people was much more than the movement for people at the top. Why did the “greedy” bankers suddenly develop a social conscience and start lending to poor people? The answer is that they were guided to lending to the poor by the money directed into low-income housing, much as sharks are drawn to blood. And why did so much money flow to the low-income housing? Because the government was trying to solve a deeper problem – growing income inequality.
Since the 1970s, the wages of workers at the 90th percentile of the wage distribution in the United States – such as office managers-have grown much faster than the wages of the 50th percentile worker (the median worker) – typically factory workers and office assistants. A number of factors are responsible for the growth in the 90/50 differential. Perhaps the most important is that although in the U.S. technological progress requires the labor force to have ever greater skills – a high school diploma was sufficient for our parents, whereas an undergraduate degree is barely sufficient for the office worker today – the education system has been unable to provide enough of the labor force with the necessary education. The reasons range from indifferent nutrition, socialization, and learning in early childhood to dysfunctional primary and secondary schools that leave too many Americans unprepared for college.
The everyday consequence for the middle class is a stagnant paycheck as well as growing job insecurity. Politicians feel their constituents’ pain, but it is very hard to improve the quality of education, for improvement requires real and effective policy change in an area where too many vested interests favor the status quo. Moreover, any change will require years to take effect and therefore will not address the current anxiety of the electorate. Thus politicians have looked for other, quicker ways to mollify their constituents. We have long understood that it is not income that matters, but consumption. A smart or cynical politician knows that if somehow the consumption of middle-class householders keeps up, if they can afford a new car every few years and the occasional exotic holiday, perhaps they will pay less attention to their stagnant monthly paychecks.
Therefore, the political response to rising inequality – whether carefully planned or the path of least resistance – was to expand lending to households, especially low-income ones. The benefits – growing consumption and more jobs – were immediate, whereas paying the inevitable bill could be postponed into the future. Cynical as it may seem, easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly.
Politicians, however, prefer to couch the objective in more uplifting and persuasive terms than that of crassly increasing consumption. In the United States, the expansion of home ownership – a key element of the American dream – to low- and middle-income households was the defensible linchpin for the broader aims of expanding credit and consumption.
More low-income housing credit has been one of the few issues that both the Clinton administration, with its affordable housing mandate, and the Bush administration, with its push for an “ownership” society, agreed on. Before the recent crisis, politicians on both sides of the aisle egged Fannie Mae and Freddie Mac, the giant mortgage agencies, to support low-income lending in their constituencies. The wall of money flowing into low income housing helped create the easy money that drew the bankers in until it consumed them. The bankers were not blameless, of course, but they did what they do naturally – follow the money.
Why did the United States not follow the more direct path of redistribution, of taxing or borrowing and spending on the anxious middle class? In the United States, there have been strong political forces arrayed against direct redistribution in recent years. Directed housing credit was a policy with broader support, because each political group thought it would benefit. The Left favored flows to their natural constituency, the Right welcomed new property owners who could, perhaps, be convinced to switch allegiance. In the end, though, the misguided attempt to push home ownership through credit, to lessen the pain of stagnant wages, has left the United States with houses that no one can afford and households drowning in debt.
The broader implication is that we need to look beyond greedy bankers and spineless regulators (and there were plenty of both) for the root causes of this crisis. And the problems are not solved with a financial regulatory bill entrusting more powers to those regulators.

We need to tackle inequality at its root, by giving more Americans the ability to compete in the global marketplace. This is much harder than doling out credit – we need to reform the education that people get, which involves tackling such difficult issues as dysfunctional schools, broken communities, and unsupportive families – but more effective in the long run.

The United States has a weak formal safety net, but does allow for legislation to provide additional security (extended unemployment benefits etc.) in rough times. What’s wrong with the U.S.’s “discretionary stimulus” model?

First, let us realize that the nature of the U.S. recovery has changed. From 1960 until 1991, recoveries from recessions in the United States were typically rapid. From the trough of the recession, the average time taken by the economy to recover to pre-recession output levels was less than two quarters, and the lost jobs were recovered within eight months. The recoveries from the recessions of 1991 and 2001 were very different. Although output recovered within three quarters in 1991 and just one quarter in 2001, it took 23 months from the trough of the recession to recover the lost jobs in the 1991 recession and 38 months in the 2001 recession. Indeed, job losses continued well into the recovery. The current recovery does not appear different thus far, so all these recoveries are deservedly called jobless recoveries.
The adverse effects of jobless recoveries on the public are very real and the United States is singularly unprepared for them. Typically, unemployment benefits last only six months. Moreover, because health care benefits are often tied to jobs, an unemployed worker also risks losing access to affordable health care. Short-duration benefits may have been appropriate when recoveries were fast and jobs plentiful, for the fear of losing benefits before finding a job may have given workers an incentive to look harder and make better matches with employers. But with few jobs being created, a positive incentive has turned into a source of great uncertainty and anxiety-and not just for the unemployed. Even those who have jobs fear they could lose them and be cast adrift.
Politicians ignore popular anxiety at their peril. The first President Bush is widely believed to have lost his reelection campaign, despite winning a popular war in Iraq, because he seemed out of touch with public hardship following the 1991 recession. That lesson has been fully internalized. Economic recovery is all about jobs, not output, and politicians are willing to push for stimulus, both fiscal (tax cuts or government spending) and monetary (lower short-term interest rates), to the economy until the jobs start reappearing.
In theory, as the question suggests, this is what democracy is all about – policy responding to the needs of the people. In practice, though, the public pressure to do something quickly enables politicians to run roughshod over the usual checks and balances on government policy-making in the United States. Long-term spending and tax policies are enacted under the shadow of an emergency, with the party that happens to be in power at the time of the downturn getting to push its pet agenda. Much of what is enacted – whether tax cuts or spending – has little immediate effect on job creation, even though it is disguised as stimulus, but has a long term adverse effect on government finances.
Equally deleterious to economic health is the recent vogue of cutting interest rates to near zero and holding them there for a sustained period. Alan Greenspan’s Fed did this after the dot-com bust between 2002 and 2004, Ben Bernanke‘s Fed has held rates near zero since 2008. It is far from clear though that near-zero short term interest rates (as opposed to just low interest rates) have much additional effect in encouraging firms to create jobs when deep economic forces make them reluctant to hire. But if corporations are unwilling to hire, prolonged monetary stimulus may foster the wrong kinds of activities. For instance, when the Fed kept interest rates low for a prolonged period after the dot-com bust, it pushed housing prices to unsustainable levels even while the quality of bank lending deteriorated significantly.

What were the Federal Reserve’s biggest mistakes in the years before the meltdown?

As I just argued, one mistake was to keep interest rates low, focusing on only unemployment and inflation while ignoring the asset price boom and the risks that were being taken by the financial markets. A second was the asymmetric treatment of booms. In a 2002 speech at Jackson Hole, Alan Greenspan argued that although the Federal Reserve could not recognize or prevent an asset-price boom, it could “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.” This speech seemed to be a post-facto rationalization of why Greenspan had not acted more forcefully on his 1996 speech warning of irrational exuberance in markets: he was now saying the Fed should not intervene when it thought asset prices were too high, but that it could recognize a bust when it happened and would pick up the pieces. The logic was not only strangely asymmetrical – why is the bottom easier to recognize than the top? – but also positively dangerous. It fueled the flames of asset-price inflation by telling Wall Street and banks across the country that the Fed would not raise interest rates to curb asset prices, and that if matters went terribly wrong, it would step in to prop prices up. This argument became broadly known as the “Greenspan doctrine,” and the commitment to put a floor under asset prices was dubbed the “Greenspan put.” It told traders and bankers that if they gambled, the Fed would not limit their gains, but if their bets turned sour, the Fed would limit the consequences. All they had to ensure was that they bet on the same thing, for if they bet alone, they would not pose a systemic threat and would not be bailed out.
Equally important, the Fed’s willingness to flood the market with liquidity in the event of a severe downturn sent a clear message to bankers: “Don’t bother storing cash or marketable assets for a rainy day; we will be there to help you.” Not only did the Fed reduce the profitability of taking precautions, but it implicitly encouraged bankers to borrow short-term while making long-term loans, by making them confident the Fed would be there if funding dried up. Leverage built up throughout the system.
By focusing only on jobs and inflation – and, in effect, only on the former – the Fed behaved myopically, indeed politically. It is in danger of doing so again, even while being entirely true to the letter of its mandate. Although the Fed has a limited set of tools and therefore pleads that it should not be given many potentially competing objectives, it cannot ignore the wider consequences to the economy of its narrow focus: in particular, low interest rates and the liquidity infused by the Fed have widespread effects on financial-sector behavior.

You write: “Put differently, solutions are fairly easy if we think the bankers violated traffic signals: we should hand them stiff tickets or put them in jail. But what if we built an elaborate set of traffic signals that pointed them in the wrong direction?” Why did so many bankers fail to accurately predict the risks they were taking? Were they, in fact, behaving rationally?

Obviously, they, and many others (including the people who bought homes), would not have done what they did if they knew the end result for sure – a deep and devastating crisis, in which many banks nearly collapsed, and many bankers lost their jobs. But painful as this crisis has been, it was not painful enough for the bankers and their investors. Securities prices before the onset of the crisis suggested that downside risks were not being priced in. Perhaps bank investors believed the government would step in to bail them out, fearing greater collateral damage to society. Certainly, this is what happened.
The point here is that the markets did not worry enough about the risks the banks were taking. Equity holders were making tons of money from bank profits, and this bet was worth taking because equity’s downside risk is limited (unlike in a partnership, equity holders are not responsible for paying off the debts). Bank debt holders should have worried more, but because they were either insured, or believed their bank was too systemic to fail, did not pay enough attention to the risk taking.
Bankers do not have perfect foresight. They were taking bets, where the payoffs were distorted because the markets believed their own pain would be minimized. The markets were egging them on, applauding the every move of then titans like Chuck Prince of Citigroup and Stan O’Neal. The signals were stuck on green when they should have been red, and the Ferrari of a financial system accelerated rapidly in the wrong direction.

There were many problems in the banks that I talk about in the book. In fact, I was one who warned early on (in 2005) about incentive systems in banks. But it is too facile to pin the problem only on banker incentives and greed. They were responding to a system where the usual market checks and balances simply stopped working.
In a democracy, the government (or central bank) simply cannot allow ordinary people to suffer collateral damage as the harsh logic of the market is allowed to play out. A modern, sophisticated financial sector understands this and therefore seeks ways to exploit government decency, whether it is the government’s concern about inequality, unemployment, or the stability of the country’s banks. The problem stems from the fundamental incompatibility between the goals of capitalism and those of democracy. And yet, the two go together, because each of these systems softens the deficiencies of the other.

You suggest a number of financial system reforms in your book – in your opinion, what are the three most important reforms?

I think as important as financial system reforms are, reforms to the real sector – such as improving access to education, rethinking the safety net, and rethinking Fed policy – are more important. But in the financial sector, my three big reforms would be:

1. Get the government and its agencies out of housing and stop pushing housing as a cure-all.
2. Reduce the possibility that any financial institution will be too systemic to fail, and ensure that there are substantial classes of securities issued by each of these entities that will lose everything if the entity has to be bailed out. In other words, let investors also know they will feel the pain, and thereby give them the incentive to put more constraints on bank risk taking. I would explore the possibility of reducing the extent to which deposits are insured as banks exceed a threshold size.
3. If bank boards will not do it on their own, regulators should press bankers to have more long-term skin in the game (that is, money they will lose if the strategy does not pan out over the long run), and let them have more to lose if their bank is ever bailed out.