The following are excerpts from Raghuram G Rajan’s book Fault Lines:
From 1960 until the 1991 recession, recoveries from recessions in the United States were typically rapid. From the trough of the recession, the average time taken by the economy to recover to pre-recession output levels was less than two quarters, and the lost jobs were recovered within eight months. The recoveries from the recessions of 1991 and 2000-2001 were very differ-ent. Although production recovered within three quarters in 1991 and just one quarter in 2001, it took 23 months from the trough of the recession to recover the lost jobs in 1991 recession and 38 months in the 2001 recession.
Indeed, job losses continued well into the recovery, so that these recoveries were de-servedly called jobless recoveries. Unfortunately, the United States is singularly unprepared for jobless recov-eries. Typically, unemployment benefits last only six months. Moreover, because health care benefits have historically been tied to jobs, an unemployed worker also risks losing access to affordable health care.
Short-duration benefits may have been appropriate when recoveries were fast and jobs plentiful. The fear of losing benefits before finding a job may have given workers an incentive to look harder and make better matches with em-ployers. But with few jobs being created, a positive incentive has turned into a source of great uncertainty and anxiety?and not just for the unemployed. Even those who have jobs fear they could lose them and be cast adrift. Politicians ignore popular anxiety at their peril. The first President Bush is widely believed to have lost his reelection campaign, despite winning a popular war in Iraq, because he seemed out of touch with public concerns about the job-Is recovery following the 1991 recession. That lesson has been fully internal-ized by politicians. ?……………….
For one of the weaknesses of the arm’s-length system, as I explain in Chapter 6, is that it relies on prices being accurate: but when a flood of money from un-questioning investors has to be absorbed, prices can be significantly distorted. I lere again, the contact between the two different financial systems created fragilities.
However, the central cause for the financial panic was not so much that the banks packaged and distributed low-quality subprime mortgage-backed secu-rities but that they held on to substantial quantities themselves, either on or off their balance sheets, financing these holdings with short-term debt. This brings us full circle to the theme of my Jackson Hole speech. What went wrong? Why did so many banks in the United States hold on to so much of the risk?
The problem, as I describe in Chapter 7, has to do with the special character of these risks.
The substantial amount of money pouring in from unquestion-ing investors to finance subprime lending, as well as the significant government involvement in housing, suggested that matters could go on for sonic time with-out homeowners defaulting.
Similarly, the Fed’s willingness to maintain easy conditions for a sustained period, given the persistent high level of unemploy-ment, made the risk of a funding squeeze seem remote. Under such circum-stances, the modern financial system tends to overdose on these risks. A bank that exposes itself to such risks tends to produce above-par profits most of the time. There is some probability that it will produce truly horrible losses.
From society’s perspective, these risks should not be taken because of the enormous costs if the losses materialize. Unfortunately, the nature of the reward structure in the financial system, whether implicit or explicit, emphasizes short-term advantages and may predispose bankers to take these risks. Particularly detrimental, the actual or prospective intervention of the gov-ernment or the central bank in certain markets to further political objectives, or to avoid political pain, creates an enormous force coordinating the numerous entities in the financial sector into taking the same risks. As they do so, they make the realization of losses much more likely. The financial sector is clearly centrally responsible for the risks it takes. Among its failings in the recent crisis include distorted incentives, hubris, envy, misplaced faith, and herd behavior. But the government helped make those risks look more attractive than they should have been and kept the market from exercising discipline, perhaps even making it applaud such behavior. Government interventions in the aftermath of the crisis have, unfortunately, fulfilled the beliefs of the financial sector. Politi-cal moral hazard came together with financial-sector moral hazard in this cri-sis. The worrisome reality is that it could all happen again. Put differently, the central problem of free-enterprise capitalism in a mod-ern democracy has always been how to balance the role of the government and that of the market.
While much intellectual energy has been focused on defin-ing the appropriate activities of each, it is the interaction between the two that is a central source of fragility. In a democracy, the government (or central bank) simply cannot allow ordinary people to suffer collateral damage as the harsh logic of the market is allowed to play out.
A modern, sophisticated financial sector understands this and therefore seeks ways to exploit government de-cency, whether it is the government’s concern about inequality, unemployment, or the stability of the country’s banks. The problem stems from the fundamen-tal incompatibility between the goals of capitalism and those ofdemocracy. And yet the two go together, because each of these systems softens the deficiencies of the other. I do not seek to be an apologist for bankers, whose hankering for bonuses in the aftermath of a public rescue is not just morally outrageous but also politi-cally myopic. But out rage does not drive good policy. Though it was by no means an innocent victim, the financial sector was at the center of a number of fault lines that affected its behavior. Each of the actors?bankers, politicians, the poor, foreign investors, economists, and central bankers?did what they thought was right. Indeed, a very real possibility is that key actors like politicians and bankers were guided unintentionally, by voting patterns and market approval respec-tively, into behavior that led inexorably toward the crisis. Yet the absence of vil-lai ns, and the fact that each of these actors failed to bridge the fault lines makes finding solutions more, rather than less, difficult. Regulating bankers bonus pay is only a very partial solution, especially if many bankers did not realize the risks they were taking.
The challenges that face us
If such a devastating crisis results from actors’ undertaking reasonable actions, at least from their own perspective, we have considerable work to do. Much of the work lies outside the financial sector; how do we give the people falling be-hind in the United States a real chance to succeed? Should we create a stronger safety net to protect households during recessions in the United States, or can we find other ways to make workers more resilient? ?……………………The picture is not all gloom. There are two powerful reasons for hope today: technological progress is solving problems that have eluded resolution for cen-turies, and economic reforms are bringing enormous numbers of the poor di-rectly from medieval living conditions into the modern economy. Much can be gained if we can draw the right lessons from this crisis and stabilize the world economy. Equally, much could be lost if we draw the wrong lessons. Let me now lay out both the fault lines and the hard choices that confront us, with the hope that collectively we will make the right difference. For our own sakes, we must.
(Excerpted from Raghuram G Rajan?s book Fault Lines with permission from the publishers HarperCollins Publishers India)