Fault lines: How hidden fractures still threaten the world economy, by Raghuram Rajan, Princeton University Press, 2010
(I wrote this post many years ago. The excerpts below are direct quotes from Rajaram's book. Am I violating copyright? Hope not. Anyway, I feel this is still relevant, so I am going ahead and posting it many years late.)
What are these fault lines?
Rajan examines these from a retrospective view of the 2009 financial collapse.
Post-2001, why was the US, unlike other countries, unable to export its way out of a recession? Why did money flood into the US to finance the housing market’s sub-prime loans? Why did poorer countries like China finance the consumption behavior of rich countries like the US? Why did banks make loans to people with no income or prospects?
The first fault line stems from domestic political stresses.
The political response to rising inequality was to expand lending to households, especially low-income ones. Easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly. For example, excessive rural credit was one of the important causes of bank failure during the Great Depression. Small and medium-sized farmers found themselves falling behind the growing numbers of industrial workers, and demanded easier credit. When easy money, pushed by a deep-pocketed government, comes in contact with the profit motive of a sophisticated, competitive, and amoral financial sector, a deep fault line develops.
The second fault line stems from trade imbalances between countries.
Usually increased consumption, because of easy credit, leads to increased prices. However, the products were coming from other countries, China, Japan, Germany, who had plenty of capacity to build more product and keep selling at the original prices. However, it made these countries very dependent on the foreign consumer. “Global supply washes around the world looking for countries that have the weakest policies (Greece) or the least discipline (US, UK, Spain), tempting them to spend until they simply cannot afford it and succumb to crisis.” These export-dependent countries support their export companies, which have become very efficient because of international competition. However, their domestic corporations have strong influence over government policies to prevent emergence of competitors, therefore are inefficient, and have no incentive for growth. Japan is a particularly good example. China is increasingly becoming one. This dependence on the foreign consumer is the second fault line.
The third fault line was the interaction between the transparent financial systems of the industrial countries and the opaque ones of the developing countries. In industrial countries, lending is at arms-length, with lenders having access to public information about the borrower, and knowing that courts will enforce the lending contract. In countries like Malaysia, bank lending is based on relationships. When a borrower may default, the lender will renegotiate in order to maintain the relationship. Therefore, lending from industrial countries was accompanied by strict requirements such as loans in foreign (stable) currency, through local banks with guarantees from the local government. Thus loans were often made to questionable projects, that purchased expensive foreign goods and services, under opaque systems, because the lender had little need to worry about the safety of the loan. When the projects failed, the lender recovered their capital, or refined their loans, under conditions humiliating to the local country, including begging for loans from the IMF (International Monetary Fund), itself controlled by the lending countries. These vulnerable countries cut back borrowing for foreign purchases, leading to a significant imbalance in trade, while they expanded local production, and became net exporters.
The problem stems from the fundamental incompatibility between the goals of capitalism and those of democracy. In a democracy, the government simply cannot allow ordinary people to suffer collateral damage while the harsh logic of the market is allowed to play out. However, a modern sophisticated financial system understands this, and therefore seeks ways to exploit government decency, such as inequality, unemployment, or the stability of the country’s banks. Each of the actors did what they thought was right. The absence of villains, and the fact that there is no incentive for them to bridge fault lines, makes finding solutions difficult.