Fault Lines

Short Note

Raghuram Rajan, in his book, has tried to questions the sufficiency of the
standard explanations for the financial crisis. According to him, fixing the
bankers and forcing them to be less greedy by changing the incentive
systems, and making the regulators more powerful by bringing in more
regulations will not solve the problem endemic in the public policy of not only
the US but also many other countries. According to him, the fault lines
emanate from the government policies, socioeconomic structure, and also
from the international trade system wherein a bunch of countries have
focussed on an export led growth dependent upon excessive consumption in
developed countries.
One of the faults underlying the global socioeconomic structure is the growing
inequality not only in US but more or less every other country in the world. The
90-50 hourly wage differential; i.e. the wage at 90th percentile of the wage
distribution and that at the 50th percentile; has been diverging fast over the
years. The 50-10 wage differential, on the other hand, has remained more or
less flat, unlike the 90-50 differential that is diverging rapidly. This means that
the top 10 percentile of the wage earners have been getting disproportionately
richer as compared to majority of the population. The reason behind the 90-50
inequality, according to him, is not the rapid advances in technology.
Technology has been rapidly evolving throughout the century. Today it is hitech industries like Internet but at the beginning of the 20th century, it was
large, integrated chemical plants that hadn't been seen before. They were as
much of a leap for people moving from agriculture as the new age Internet
technologies are for people moving with a high-school degree into the cities.
Today the number of highly educated people has fallen behind. High-school
graduation rates in the United States have been stagnant since the 1970s.
Effectively, America is falling behind as far as high-school graduates go. But
the 90-50 differential reflects a college-to-high school differential instead of
the dropping number of high school graduates. The graduation rates for males
born in the 1970s are almost same as the graduation rates for males born in
the 1940s. So the number of male graduates has not increased. The reasons
for this phenomenon, according to him, lie in some combination of families
breaking up, communities becoming more dysfunctional, inadequate preschool
preparation, and inadequate K-12 experience. And solving this huge problem
requires massive transformations not only in the education system but also in
the social system and social values.
According to him, in every emerging market bad policy emerges from
inequality and the same dynamics were at work in US too. This reflected in the
subprime prices. As more Americans were left behind there was increasing
polarization in society and this led to increasing political polarization.
Politicians, instead of taking the extremely contentious route of redistribution,
have resorted to populism and their thinking seems to be, If we can't give
them incomes, perhaps we can give them consumption. This consumption
was facilitated by credit growth. The tool that the government had either

directly under it or that it could influence was housing credit. Hence there was
massive push towards housing credit, both from the Clinton Administration and
the Bush Administration, a bipartisan effort.
Many other instruments were created and used to push the consumption
demand. The Federal Housing Administration lowered its lending standards,
thus sending huge amount of money towards low-income housing. The private
sector also pumped in money to finance low-income housing, but the intention
here was not philanthropy. The reason was the fundamentally good intentions
of the government more homeownership but done in a way which
actually created massive distortions in the financial sector. Hence, the fault
line across countries is the rising inequality and the consequent political
pressure to do something to address it.
This fault line accompanied by some other similar systemic and structural
inefficiencies in the US economy and global trade system created the
underlying incentive structure for the financial sector. The reason why the low
quality mortgage-backed securities (MBS) were created was that there was a
huge amount of money being poured into subprime lending to fulfil the
government mandates and all this money supply was not for any profit motive.
Additionally, there was an accompanying money supply coming from the trade
surplus, export focussed countries that were trying to sell more and more
goods to the US. With the huge amount of money flowing into the financial
sector from these countries, much of which was being sent by Central Banks of
these countries that wanted to manage the exchange rate of their currency
against the dollar and maintain its competitiveness. Since all this money was
not solely focused on pricing, it distorted prices in the financial sector. The
financial sector created mortgages which then were financed, and later all of
which turned out to be toxic assets after the housing bubble burst.
Thus, the problem behind the financial crisis was not government and neither
the financial sector. The problem was the interface between the two, which
was affected by the fault lines - inequality and iniquitous access in the society,
unsustainable nature of the export oriented economies, and a relatively weak
social safety net in US.