Raghuram Rajan: Fault Lines

Summary by Robert Shiller:

The first of them is political, and the politics that lead to rising inequality. That's been a trend in recent years in most nations of the world. Inequality has been getting worse, particularly in the US, but also in Europe and Asia and many other places. One thing that this has done is it has encouraged governments, who are aware of the resentment caused by the rising inequality, to try to take some kind of steps to make it more politically acceptable. He gives other examples as well, but historically, that has often taken the form of stimulating credit: instead of fixing the problems of the poor, lending money to them. He has a chapter entitled "Let them eat credit."

The US in particular has stimulated the housing market, it has subsidised lending to people, which drove up home prices in an unsustainable way. And there wasn't that much concern about, or understanding of, the sustainability of this. That's his first fault line.

The second one is trade imbalances. Here he looks in particular at the developing world, notably China, that has an export-led growth policy. The Chinese noted that the export-led growth model was a huge success for other countries like Japan, Korea, Singapore -- and so they want to follow that model. But it involves them running a trade surplus -- and so, by implication, the rest of the world has a trade deficit. Advanced countries like the US then become dependent on this constant inflow of capital. That's another imbalance which is also fundamental.

The third set of fault lines comes from a clashing of systems. In the US, and in advanced countries, there is more of a sense of trust, and advanced financial solutions can be achieved better than in a developing world where people are still mistrustful. In the developing world, people prefer to make only short-term loans because they don't trust tying up their money. It often needs to be denominated in foreign currencies so they won't be devalued on, and they like to lend to local banks rather than to international ones because they know the local banks will be bailed out if there is ever a crisis. But that means the economies are more fragile. He's talking about the Asian financial crisis in particular, of course -- but there are other examples. Because people can withdraw their money quickly, there's too much reliance on "too big to fail," so the economies don't function right.

posted 2011-06-19