September 1, 2010

Finding the balance between government and market

Raghuram Rajan’s book Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press for the international edition, and Harper Collins for an Indian edition with a special chapter on India) is possibly the most thought-provoking contribution in the aftermath of the economic and financial crisis that has engulfed the West after 2007 with significant global repercussions.

The epilogue of the book summarises its punch line: The crisis has resulted from a confusion about the appropriate roles of the government and the market. We need to find the right balance again, and I am hopeful we will. The key idea of Fault Lines is to focus on slow-moving tectonic plates in the global economy: consumption by borrowing in countries with fiscal deficits, excess savings in exporting countries that are fiscally in surplus, and growing sophistication of the financial sector. None of these movements might seem dangerous in itself, but when these plates come together and collide, the global economy can get badly shaken. To most players focused narrowly on their own positions, leave alone the movements of the plate they stand on, the earthquake — like this crisis — may seem an unfortunate happenstance. In the analytical framework of Fault Lines, the crisis was not a pure accident and that more severe crises could arise in future unless the root causes are addressed sufficiently soon.

The book presents two important government distortions in the global economy and their underlying causes. These are, first, the push for universal home ownership in the United States, and second, exported growth in countries such as Germany and China. Together, these policies have led to massive “global imbalances”, with some countries such as the United States, the United Kingdom and Spain persistently being in deficit, and borrowing from the surplus, exporting nations. While pursuit for home ownership affordability and growth do not necessarily have to be distortionary, the book makes the sharp observation that these have been occurring at the expense of something more important but subtle.

In the United States, there has been growing income inequality, which combined with a relatively feeble safety net for the poor and unemployed, has created pressure on politicians to find quick ways to bridge the inequality. Instead of improving the long-run competitiveness of labour force for a global market with a changing mix of industries and required skills, governments have adopted the short-run option “let them eat credit” (the title of the first chapter). The presence of government-sponsored financial firms in the United States (Fannie Mae and Freddie Mac, in particular) enabled exercising such an option readily through a push for priority lending to the low-income households (sub-prime mortgages).

In case of surplus countries, it has been the problem of exporting to grow (the title of the second chapter). Their single-minded focus on exports has led governments to ignore the domestic sector, preventing sufficient redeployment of surplus for internal development, and somewhat perversely, even boosted domestic savings rates significantly due to lack of adequate safety nets (at least in case of China, if not in case of Germany). As someone mentioned in a recent dinner conversation: Each child in China is saving to fund post-retirement expenses not just of two parents but also of four grandparents. These savings have thus had no place to go but outside, giving rise to massive capital inflows that fuelled the housing sector expansion in the United States, Britain and Spain.

What is fascinating is that Fault Lines explains how these lop-sided government policies of two separate sets of countries have interacted with each other—and with the financial sector—in fuelling the expansion to levels of unsustainable housing bubbles. The idea here is that the invisible hand operating through the price when the price is distorted can also lead to massive distortions in the allocation of capital. The financial sector in developed world is so sophisticated and amoral (a great choice of word by the author) that its dispassionate pursuit of profits leads it to direct capital to wherever there is a relative mis-pricing.

So if governments are subsidising home ownership, efforts will be made to deploy all free capital of the world to the housing sector. If some governments are finding it cheap to borrow because savings are seeking them out, the financial sector will grow at a sufficient rate to absorb and support expansion of housing credit through these capital inflows.

Clearly there have been incentive-based distortions in the financial sector, especially due the short-term nature of accounting-based compensation that ignores true long-term risks. The book explains, however, that the bigger issue was something else: that the imbalance of capital flows and the ease of pushing sub-prime home ownership — both due to government distortions — meant the financial sector was essentially a conduit to making happen what the rest of the world was seeking to achieve. In the process, banks made a ton of bad loans (but the governments were happy with that till it all really blew up). And some parts of the financial sector pursued this role even more aggressively than one could have imagined due to the steady entrenchment of too-big-to-fail expectations — large banks being repeatedly bailed out through government forbearance and enjoying central-bank monetary stimulus each time markets turned south.

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