|TIME magazine / Friday, May. 21, 2010
Economic Seer Says U.S. Not Addressing Cause of Crisis
By Barbara Kiviat
In 2005, Raghuram Rajan stood before a room of prominent economic
policy makers celebrating Alan Greenspan's legacy and presented a
paper about how the world was headed for financial disaster. The
University of Chicago economist was roundly scoffed at even though, as
it turns out, he was right. Now that the crisis he predicted has
abated, is he more optimistic? Not necessarily, because, as he argues
in a new book, the real causes of the crisis aren't yet being
addressed. TIME spoke with him about the conclusions he draws in Fault
Lines: How Hidden Fractures Still Threaten the World Economy.
You write that growing income inequality in the U.S. fed the housing
and financial crises. How so?
People at the 90th percentile of income distribution, typically your
office managers, are pulling away in terms of income from people at
the 50th percentile of the distribution, typically your grocery shop
clerk or manufacturing worker. Much of this is because of education.
People with high school degrees and those without high school degrees
are falling behind those who have a bachelor's degree and those who
have higher degrees. The educational system hasn't kept up with the
demand for highly skilled workers, and housing credit was an easy
solution to that problem. People looking at their rising house prices
pay less attention to their stagnant paychecks. This wasn't
Machiavellian, but it was the path of least resistance. Bush called it
the ownership society, and Clinton called it affordable housing, but
they both focused on making loans for housing.
[Rajan's explanation of increasing inequality is pretty orthodox --
and thus pretty weak.]
Is there historical precedent for using cheap credit as a political
palliative, as you call it?
Absolutely. Both across countries and within the United States. In
many ways, farmers toward the end of the 19th century were falling
behind the rest of the population. A big piece of the Populist
platform was to push for more credit. The result was a tremendous
expansion of banks in the early 20th century. Some would argue that
the immense extension of credit to the farm sector in the 1910s and
'20s was a precursor to the Great Depression.
So what's a better way of dealing with income inequality?
To tackle the problem at the source. A large part of the population
doesn't have the skills to compete in the modern economy. It's partly
that they haven't kept pace with the technological change that's
happening, and it's partly that people in the rest of the world are
competing with them now. Being unskilled in the United States is a
recipe for a life of stagnant wages and lots of uncertainty; we need
to provide better skills to the population. One of the numbers that I
cite, which is frightening, is that the fraction of people graduating
from high school hasn't increased over the past 30 years. But it's not
just fixing the schools, it's about families and the communities kids
grow up in. It's a very big social problem, and that's why politicians
say, "It's going to take too long to tackle this, let's try something
[ditto what I said above.]
You also find a big problem stemming from the jobless recoveries we keep having.
We don't fully understand these jobless recoveries, but the United
States has been increasingly having them. After 1991, it took 23
months for the jobs to come back, while historically it's only taken
about 8 months. In the 2001 recovery, it took 38 months for the jobs
to come back. The problem is, the U.S. safety net is geared towards a
very short recovery — people get their employment insurance but by the
time the benefits run out, the jobs have started to come back. In a
situation where it takes longer for the jobs to come back, there's a
real question of whether the safety net is adequate. So there's
political pressure to do the job of the safety net with stimulus. You
stimulate the economy in various ways until the jobs come back,
regardless of whether it creates risks of different kinds. In the 2001
recovery, monetary policy was on hold for a really long time, mainly,
in my view, because the jobs hadn't come back. The Fed was doing
everything it could, including saying if there is a dip, we'll come to
your rescue with tons of liquidity. I think we are in a similar
situation now. It is a real question, whether the kind of [loose]
monetary policy we have is encouraging investment by firms and the
growth or jobs or the kinds of risk-taking that led to the previous
[The Fed's fear of deflation had nothing to do with its low rates after 2001? ]
What other fault lines are out there?
The first two: a ton of money into housing because of income
inequality, and accommodative monetary policy because of the
inadequate safety net, tended to push overconsumption fueled by debt
in the United States. But there is another side to this, which made
the problem worse — the rest of the world. The fault line here is that
the fastest path to growth in the post-WWII world has been export-led.
You've had a number of countries do this — Japan, then Germany, Korea,
Taiwan and now China. The problem is that some other country has to
step up to buy these big surpluses. In a sense, the exporting
countries are looking for other countries that are willing to splurge
and go into debt. In the 1990s, it was the emerging markets, the Latin
American and Asian countries, and many suffered deep crises. In the
2000s, who were the countries that stepped up? The United States, the
United Kingdom, Iceland, Latvia, and of course now, Greece, Spain,
Portugal. These countries all ran large trade deficits and found that
even industrial countries couldn't run them on a sustained basis and
escape trouble. Even now, these surpluses are looking for buyers
How do you rate the financial re-regulation coming out of Washington?
Because what you're talking about doesn't sound like what Congress is
I would ask a more fundamental question than is being asked, which is
why were markets so oblivious of the risks being taken? I would argue
a big reason was because they believed the markets would be bailed out
by the government, and that expectation has been confirmed, with the
government intervention in the housing markets and the credit markets
and the Fed pushing enormous amounts of liquidity. The primary thrust
of reform has to be to convince the private sector you will never do
it again. That you will, in fact, force the private sector to face up
to the risks it's taken, to impose losses, including on bonds. There
are some ideas in the Senate bill that go in this direction, but
unfortunately there are some ideas that go the opposite way, and
entwine the government more directly in the financial and housing
sectors. To me, that's extremely dangerous because it just means to be
that we are again going to get into a situation where profits are
privatized and losses are socialized.
But my main message is you have to take a bigger perspective of this
crisis. I think there is too much of a focus on being punitive. Greedy
bankers are a constant — what changed was the external environment.
Yes, there are things we should reform within the financial sector,
but we should also think about the forces outside of the system that
are pushing it in the direction of trouble. Some of the regulations
we're talking about are of the kind,
Can the borrower afford to pay back his loan?
Well, people should be making loans they expect will be paid back. If
you need a regulation for that, then your system is totally broken. In
a society that makes these sorts of loans the problem isn't just with
the brokers or the bankers. The forces are much deeper and broader.