Fault Lines: How Hidden Fractures Still Threaten the World Economy (3 page)

The financial systems in countries where government and bank intervention was important during the process of growth are quite different. Public financial information is very limited, perhaps because the government and banks directed the flow of financing during the growth phase and did not need, or want, public oversight then. Even though in most of these countries the government has withdrawn from directing financial flows, banks still play an important role, and information is still closely guarded within a group of insiders. Because of the paucity of public information, enforcement of contractual claims largely depends on long-term business relationships. The borrower repays the lender or renegotiates in good faith to avoid the loss of the relationship, and the adverse consequences it would have, in a system where relationships are the currency of exchange. This means that outside financiers, especially foreigners, have little access to the system. Indeed, this barrier is what makes the system work, because if borrowers could play one lender off against another, as in the arm’s-length competitive system, enforcement would break down.

So what happens when arm’s-length, industrial-country private investors are asked to finance corporate investment in a developing country with a relationship system, as was the case in the early 1990s? Foreign investors who do not understand the murky insider relationships do three things. They minimize risks by offering only short-term loans so that they can pull their money out at short notice. They denominate payments in foreign currency so that their claims cannot be reduced by domestic inflation or a currency devaluation. And they lend through the local banks so that if they pull their money and the banks cannot repay it, the government will be drawn into supporting its banks to avoid widespread economic damage. Thus foreign investors get an implicit government guarantee. The threat of inflicting collateral damage is what makes arm’s-length foreign investors willing to entrust their money to the opaque relationship system.

The problem in the mid-1990s in East Asia was that foreign investors, protected by such measures, had little incentive to screen the quality of ventures financed. And the domestic banking system, whose lending was until recently directed and guaranteed by the government, had little ability to exercise careful judgment, especially when borrowers were climbing the ladder of technological sophistication and investing in complex, capital-intensive projects. Borrowers were obviously happy with the free flow of credit and had no desire to ask questions. But when the projects financed by this poorly directed lending started underperforming, foreign investors were quick to pull their money out. Therefore, developing countries that relied substantially on foreign money to finance their investments suffered periodic booms and busts, culminating in the crises of the late 1990s.

Those crises were both devastating and humiliating. For example, the fall in Indonesian GDP from peak to trough was close to 25 percent, similar to the fall experienced by the United States during the Great Depression. But Indonesia’s fall occurred in the span of only a year or so. As the economy tipped into free fall, with millions of workers becoming unemployed without any form of support, Indonesia experienced race riots and political turmoil. To cap it all, a proud country that felt it had liberated itself from its colonial masters and had achieved some measure of economic independence had to go hat in hand to the IMF for a loan and, in order to get it, was forced to submit to a plethora of conditions. Some of these were dictated directly by industrial countries to favor their own interests, leaving Indonesians seething about their perceived loss of sovereignty.

It should come as no surprise, then, that a number of developing countries decided to never leave themselves at the mercy of international financial markets (or the IMF) again. Rather than borrow from abroad to finance their investment, their governments and corporations decided to abandon grand investment projects and debt-fueled expansion. Moreover, a number decided to boost exports by maintaining an undervalued currency. In buying foreign currency to keep their exchange rate down, they also built large foreign-exchange reserves, which could serve as a rainy-day fund if foreign lenders ever panicked again. Thus in the late 1990s, developing countries cut back on investment and turned from being net importers to becoming net exporters of both goods and capital, adding to the global supply glut.

Investment by industrial-country corporations also collapsed soon after, in the dot-com bust, and the world fell into recession in the early years of the new millennium. With countries like Germany and Japan unable to pull their weight because of their export orientation, the burden of stimulating growth fell on the United States.

As I argue above, the United States was politically predisposed toward stimulating consumption. But even as it delivered the necessary stimulus for the world to emerge from the 2001 recession, it discovered, much as in the 1991 recovery, that jobs were not being created. Given the short duration of unemployment benefits in the United States, this created enormous additional political pressure to continue injecting stimulus into the economy. As I argue in
Chapter 4
, jobless recoveries are not necessarily a thing of the past in the United States—indeed, the current recovery is proving slow thus far in generating jobs. Jobless recoveries are particularly detrimental because the prolonged stimulus aimed at forcing an unwilling private sector to create jobs tends to warp incentives, especially in the financial sector. This constitutes yet another fault line stemming from the interaction between politics and the financial sector, this time one that varies over the business cycle.

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.
⁷

The recoveries from the recessions of 1991 and 2000–2001 were very different. 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.
⁸
Indeed, job losses continued well into the recovery, so that these recoveries were deservedly called jobless recoveries.

Unfortunately, the United States is singularly unprepared for jobless recoveries. 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 employers. 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 jobless recovery following the 1991 recession. That lesson has been fully internalized by politicians. In politics, economic recovery is all about jobs, not output, and politicians are willing to add stimulus, both fiscal (government spending and lower taxes) and monetary (lower short-term interest rates), to the economy until the jobs start reappearing.

In theory, such action reflects democracy at its best. In practice, though, the public pressure to do something quickly enables politicians to run roughshod over the usual checks and balances on government policy making in the United States. Long-term policies are enacted under the shadow of an emergency, with the party that happens to be in power at the time of the downturn getting to push its pet agenda. This leads to greater fluctuations in policy making than might be desired by the electorate. It also tends to promote excess spending and impairs the government’s long-term financial health.

In
Chapter 5
, I explore the precise ways in which U.S. monetary policy is influenced by these political considerations. Monetary policy is, of course, the domain of the ostensibly independent Federal Reserve, but it would be a brave Federal Reserve chairman who defied politicians by raising interest rates before jobs started reappearing. Indeed, part of the Federal Reserve’s mandate is to maintain high employment. Moreover, when unemployment stays high, wage inflation, the primary concern of central bankers today, is unlikely, so the Fed feels justified in its policy of maintaining low interest rates. But there are consequences: one problem is that a variety of other markets, including those abroad, react to easy policy. For instance, prices of commodities such as oil and metals are likely to rise. And the prices of assets, such as houses and stocks and bonds, are also likely to inflate as investors escape low short-term interest rates to invest in anything that offers a decent return.

More problematic still, the financial sector is also prone to take greater risks at such times. In the period 2003–2006, low interest rates added to the incentives already provided by government support for low-income housing and fueled an extraordinary housing boom as well as increasing indebtedness. In an attempt to advance corporate investment and hiring, the Fed added fuel to the fire by trying to reassure the economy that interest rates would stay low for a sustained period. Such assurances only pushed asset prices even higher and increased financial-sector risk taking. Finally, in a regulatory coup de grâce, the Fed chairman, Alan Greenspan, effectively told the markets in 2002 that the Fed would not intervene to burst asset-price bubbles but would intervene to ease the way to a new expansion if the markets imploded. If ever financial markets needed a license to go overboard, this was it.

By focusing only on jobs and inflation—and, in effect, only on the former—the Fed behaved myopically, indeed politically. It is in danger of doing so again, even while being entirely true to the letter of its mandate. Although the Fed has a limited set of tools and therefore pleads that it should not be given many potentially competing objectives, it cannot ignore the wider consequences to the economy of its narrow focus: in particular, low interest rates and the liquidity infused by the Fed have widespread effects on financial-sector behavior. As with the push for low-income housing, the fault line that emerges when politically motivated stimulus comes into contact with a financial sector looking for any edge is an immense source of danger.

How did tremors on all the fault lines come together in the U.S. financial sector to nearly destroy it? I focus on two important ways this happened. First, an enormous quantity of money flowed into low-income housing in the United States, both from abroad and from government-sponsored mortgage agencies such as Fannie Mae and Freddie Mac. This led to both unsustainable house price increases and a steady deterioration in the quality of mortgage loans made. Second, both commercial and investment banks took on an enormous quantity of risk, including buying large quantities of the low-quality securities issued to finance subprime housing mortgages, even while borrowing extremely short term to finance these purchases.

Let me be more specific. In the early 2000s, the savings generated by the export-dependent developing countries were drawn into financing the United States, where fiscal and monetary stimulus created enormous additional demand for goods and services, especially in home construction. Foreign investors looked for safety. Their money flowed into securities issued by government-sponsored mortgage agencies like Fannie Mae and Freddie Mac, thus furthering the U.S. government’s low-income housing goals. The investors, many from developing countries, implicitly assumed that the U.S. government would back these agencies, much as industrial-country investors had assumed that developing-country governments would back them before the crises in those countries. Even though Fannie and Freddie were taking enormous risks, they were no longer subject to the discipline of the market.

Other funds, from the foreign private sector, flowed into highly rated subprime mortgage-backed securities. Here, the unsuspecting foreign investors relied a little too naively on the institutions of the arm’s-length system. They believed in the ratings and the market prices produced by the system, not realizing that the huge quantity of money flowing into subprime lending, both from the agencies and from other foreign investors, had corrupted the institutions. 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 unquestioning investors has to be absorbed, prices can be significantly distorted. Here 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 securities 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 unquestioning investors to finance subprime lending, as well as the significant government involvement in housing, suggested that matters could go on for some time without homeowners defaulting. Similarly, the Fed’s willingness to maintain easy conditions for a sustained period, given the persistent high level of unemployment, made the risk of a funding squeeze seem remote. Under such circumstances, the modern financial system tends to overdose on these risks.