Fault Lines - I

I recently started reading the book Fault Lines written by Prof. Raghuram Rajan of the Chicago Booth School of Business. This book is an attempt at explaining the possible causes of the economic crisis, by showing how a myriad number of factors came together to produce this outcome.Rajan says that it would be naivete and short-sightedness to blame just a few greedy bankers who took irrational risks to precipitate this crisis. Something much more was involved, the causes were more systemic in nature, and the outcome was the collective result of choices made by bankers,politicians and homeowners. Rajan talks about a flawed and fragile global economic order that provided perverse incentives for those in control. Although a fault line is more of a geological term, here it has been used as a metaphor to represent the deep flaws inherent in the global economy. Rajan goes about detailing those flaws, shows the interplay amongst them, and suggests possible remedies - all of which involve making hard choices for long-term benefit.This post will try to concisely explain what Prof. Rajan terms the first set of fault lines.

Rajan starts by noting that over the years, income inequality has widened humongously in the US. The rich i.e. those in the top 1% income bracket, have become richer over the years while those in the middle and low-income segments have seen their real incomes stagnating or even dwindling. For those who may not know, real income compares the income today to income some years back after taking into account inflation. So, if I earned $100 in 2000 and earn $110 today with overall rate of inflation being 12%,my real income has actually dwindled. I would need to earn $112 today just to keep up with my real income in 2000. The primary factor behind this growing chasm has been unequal access to quality education. This is because technological progress over the years has resulted in ever growing demand for workers more skilled than before; those lacking these skills have found themselves out of jobs, and have not been able to upgrade owing to lack of financial resources to afford college.Most of these now redundant workers possess only a high-school diploma which used to be deemed sufficient for their job some years back. As a result, they have been forced to do jobs much more menial in comparison,and of a lower pay-grade. The falling standard of education in high-schools in US has only served to exacerbate the problem, with a large number of pupils dropping out early and even those obtaining diplomas possessing insufficient skills.

Data shows that the optimism regarding social mobility(moving from one income class to a higher one)amongst Americans used to be very high in the past but has steadily dwindled. Gone are the days when America used to be seen as the land of equal opportunity for all. The growing resentment and pessimism worried politicians who instead of going for long-term reforms in education chose to appease the voters by throwing easy credit at them, a time tested short-term fix but as history shows, disastrous in the long run. Education reforms today will show their effect a decade or so later but hey, no politician can afford to wait that long.The government control of agencies responsible for disbursing credit made them ready tools in politicans' hands to achieve their goals. Politicians sought to expand home-ownership,an integral part of the typical American dream, by facilitating home loans at cheap,affordable rates. It was a laudable initiative in itself, but somewhere down the line, intent and outcomes diverged as the programme was scaled up. Agencies like Fannie Mae, Freddie Mac and FHA were pressured to do more. Being under Congressional oversight and control which enjoyed leverage by way of threatening to expose accounting malpractices, the agencies protested only a bit. To fulfill their mandate and prescribed targets, they bought subprime loans from banks and when these were not available in sufficient quantity, they even bought subprime mortgage-backed securities. However, they had no experience in dealing with this category of loans and hence failed to adjust for the higher risk. The private sector saw this and rushed to cash in by taking out as many loans as possible without checking the borrowers' creditworthiness. This led to deterioration of credit quality.

Everything was hunky dory until house prices suddenly stopped rising. Then came a flood of defaults from borrowers who couldn't pay up and that resulted in foreclosures. The housing market tanked. This had a domino effect. Banks who held these loans on their books couldn't recover their money by selling the collateral against the loan i.e houses because there were no buyers. This resulted in massive losses for the banks who stopped lending out money altogether,even to the corporate sector. In absence of working capital to run their businesses or fund their expansion, companies resorted to cost-cutting and firing employees. People were left homeless and jobless. It turned out that financial institutions across the world had these kind of loans on their books, all of them went down simultaneously and the same scenario was played out in other countries across the world. All the wealth invested in real estate eroded almost overnight, leading to collapse of banks which faced a yawning asset-liability mismatch.

Prof. Rajan however, doesn't blame one person or a set of persons. He rather opines that everybody involved exercised rational choices in the face of the circumstances they faced. What gave rise to these conditions was a skewed global financial order that generated perverse incentives.

The next post will deal with the second set of fault lines. Comments, suggestions and questions are all welcome.

PS: Fault Lines has been a best-seller on Flipkart ever since it was released and its author has not only been the Chief Economist at the IMF from 2003-07 but is also an Economic Advisor to the Prime Minister of India.