Fault Lines

I devoured Raghuram Rajan’s Fault Lines: How Hidden Fractures Still Threaten the World Economy in a very short span of time last night. It’s brief, well-written, and extremely interesting. I would definitely recommend adding it to your financial crisis reading list.

The book is a little bit hard to classify, since Rajan writes in the style of a member of the political right and has a couple of wingnutty preoccupations, but the bulk of his ideas would fit comfortable on the progressive agenda. His main point is to abstract away from the “financial crisis” and focus on the big macroeconomic trends that set the stage for the crisis. He sees growing income inequality in the United States—particular the tendency of the top ten percent to pull away from the middle class—as a key driver here that compelled politicians to look on cheap credit as a way of maintaining middle class consumption even in the face of wage stagnation. A related key is America’s threadbare safety net which makes prolonged periods of elevated unemployment intolerable. Then on the other side, you have Germany, Japan, and China committed to export-led growth models with the first two in particular featuring powerful interest-group lobbies that prevent their non-tradable sectors from facing competition. It all added up to spending a decade after the dot-com boom with low policy rates from the Fed spurring unsustainable asset price booms, consumption levels, and trade flows.

His proposed solutions, unfortunately, seem unlikely to materialize any time soon. He puts a lot of emphasis on the need to improve the performance of our education system, especially through provision of high-quality preschool and things like prenatal health care and child nutrition. I bet we’ll make some progress on these fronts, but as he observes it takes decades for this stuff to pay off if it works at all. After the fight to the death over ObamaCare we’re certainly not going to see congress want to undertake further controversial measures to delink health care and employment. I see no signs of political interest in reforming the Unemployment Insurance system. As he notes, the problems of “global imbalances” have been well-understood for years and nobody seems interested in doing anything about them. Indeed, one implication of his argument (albeit one he doesn’t emphasize) is that many of the key pre-crisis policy errors were being made by other countries and not even the U.S. government has the ability to fix the global economy.

I do have some doubts about his argument. One concerns the aforementioned wingnutty preoccupations with Fannie & Freddie and the Community Reinvestment Act. This is well-trod territory in the blogosphere and I don’t have anything original to say about it at this point. Nor do I disagree that in principle it would be better to get the federal government out of the business of subsidizing homeownership. Much more important, Rajan’s argument that the government made a mistake in responding to the “jobless recovery” of 2002-2003 by keeping interest rates low until people had jobs seems problematic to me. His idea seems to be that we can make this acceptable by just making UI benefits longer-term and more-generous. This seems like a recipe for creating the aspects of the 1990s-vintage European economic situation that nobody liked—very high persistent levels of unemployment and a political dynamic that ends up focusing on protecting the jobs of incumbent insiders.

The other thing about that is that if policymakers tighten monetary policy in the face of high unemployment and in the absence of inflation, then I don’t see how middle class wages are never going to go up no matter how well-educated we become. Better human capital lets you command better pay in the long-run, but the causal mechanism still has to be actual bargaining power in the labor market which can’t happen unless policymakers aim for employment. Since Rajan deems rising inequality to be among the threatening fault lines, this seems like a big problem.