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Thursday, May 13, 2010

Raghuram Rajan identifies the fault lines of the financial crisis

This [financial crisis]was a Greek tragedy in which traders and bankers, congressmen and subprime borrowers all played their parts until the drama reached the inevitably painful end. (Mr. Rajan plays Cassandra, of course.) But just when you're about to cast him as a University of Chicago free-market stereotype, he surprises by identifying the widening gap between rich and poor as a big cause of the calamity.
The first Rajan fault line lies in the U.S. As incomes at the top soared, politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn't easily raise incomes—Mr. Rajan is in the camp that sees better education as the only cure and that takes time—politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.
This has happened before: Farmers' grievances led to a U.S. government-backed expansion of bank credit in the 1920s; India's state-owned banks pump credit into poor constituencies in election years. But one thing was different: "When easy money pushed by a deep pocketed government comes into contact with the profit motive of a sophisticated, amoral financial sector, a deep fault line develops," Mr. Rajan writes. House prices shot up, banks borrowed cheaply and heavily to build leveraged mountains of ever more risky mortgage-linked securities.
The second fault line lies in the relentless exporting of many countries. Germany and Japan grew rich by exporting. They built agile export sectors that compete with the world's best, but shielded or strangled domestic industries such as banking and retailing. These industries are uncompetitive and inefficient, and charge high prices that discourage consumer spending.
China and others got to a similar place by a different route. Financial crises in the 1990s showed them the dangers of relying on money flowing from rich countries through local banks to finance factories, office towers and other investment. So they switched strategies, borrowed less and turned to exporting more to fuel growth. This led them to hold down exchange rates (that makes exports more attractive to others). So doing meant building huge rainy day funds of U.S. dollars.
The result: A lot of money abroad looking for a place to go met a lot of demand for borrowing in U.S. A lot of foolish loans were made.
A third Rajan fault line spread the crisis. The U.S. approach to recession-fighting—unemployment insurance and the like—and its social safety net are geared for fast, quick recoveries of the past, not for jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates.
From David Wessel's article on the forthcoming book of Raghuram Rajan in WSJ
To read the full article click here.
Raghuram Rajan was one of the few economists who warned of the global financial crisis before it hit. Now, as the world struggles to recover, it's tempting to blame what happened on just a few greedy bankers who took irrational risks and left the rest of us to foot the bill. In Fault Lines, Rajan argues that serious flaws in the economy are also to blame, and warns that a potentially more devastating crisis awaits us if they aren't fixed In Fault Lines, Rajan demonstrates how unequal access to education and health care in the United States puts us all in deeper financial peril, even as the economic choices of countries like Germany, Japan, and China place an undue burden on America to get its policies right. He outlines the hard choices we need to make to ensure a more stable world economy and restore lasting prosperity.. More

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