Fault Lines: How Hidden Fractures Still Threaten the World Economy (4 page)

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 government 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. Political moral hazard came together with financial-sector moral hazard in this crisis. The worrisome reality is that it could all happen again.

Put differently, the central problem of free-enterprise capitalism in a modern 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 defining 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 decency, whether it is the government’s concern about inequality, unemployment, or the stability of the country’s banks. The problem stems from the fundamental incompatibility between the goals of capitalism and those of democracy. 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 politically myopic. But outrage 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 respectively, into behavior that led inexorably toward the crisis. Yet the absence of villains, 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.

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 behind 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? How can large countries around the world wean themselves off their dependence on exports? How can they develop their financial sectors so that they can allocate resources and risks efficiently? And, of course, how can the United States reform its financial system so that it does not devastate the world economy once again?

In structuring reforms, we have to recognize that the only truly safe financial system is a system that does not take risks, that does not finance innovation or growth, that does not help draw people out of poverty, and that gives consumers little choice. It is a system that reinforces the incremental and thus the status quo. In the long run, though, especially given the enormous challenges the world faces—climate change, an aging population, and poverty, to name just a few—settling for the status quo may be the greatest risk of all, for it will make us unable to adapt to meet the coming challenges. We do not want to return to the bad old days and just make banking boring again: it is easy to forget that under a rigidly regulated system, consumers and firms had little choice. We want innovative, dynamic finance, but without the excess risk and the outrageous behavior. That will be hard to achieve, but it will be really worthwhile.

We also have to recognize that good economics cannot be divorced from good politics: this is perhaps a reason why the field of economics was known as political economy. The mistake economists made was to believe that once countries had developed a steel frame of institutions, political influences would be tempered: countries would graduate permanently from developing-country status. We should now recognize that institutions such as regulators have influence only so long as politics is reasonably well balanced. Deep imbalances such as inequality can create the political groundswell that can overcome any constraining institutions. Countries can return to developing-country status if their politics become imbalanced, no matter how well developed their institutions.

There are no silver bullets. Reforms will require careful analysis and sometimes tedious attention to detail. I discuss possible reforms in
Chapters 8
to
10
, focusing on broad approaches. I hope my proposals are less simplistic and more constructive than the calls to tar and feather bankers or their regulators. If implemented, they will transform the world we live in quite fundamentally and move it away from the path of deepening crises to one of greater economic and political stability as well as cooperation. We will be able to make progress toward overcoming the important challenges the world faces. Such reforms will require societies to change the way they live, the way they grow, and the way they make choices. They will involve significant short-term pain in return for more diffuse but enormous long-term gain. Such reforms are always difficult to sell to the public and hence have little appeal to politicians. But the cost of doing nothing is perhaps worse turmoil than what we have experienced recently, for, unchecked, the fault lines will only deepen.

The picture is not all gloom. There are two powerful reasons for hope today: technological progress is solving problems that have eluded resolution for centuries, and economic reforms are bringing enormous numbers of the poor directly 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.

J
ANE IS AN ASSISTANT
in a large nonprofit research organization, where she has worked for the past thirty-two years. She was an excellent typist in school and took a few courses in business practice. After spending a semester in college, she decided that the cost of an undergraduate education was not worth the benefits; jobs for typists were plentiful, and the money seemed attractive. Her first job was with the nonprofit, where she initially worked for two bosses. Her primary tasks were to type up reports and research papers, file the enormous amount of paperwork that kept accumulating, and answer the phones.

Over the years, many of those who started in positions similar to Jane’s have lost their jobs. The advent of the computer—first the mainframe, then the personal computer—eliminated much of the routine work of assistants. Midlevel supervisors and managers learned to type their own documents. Presentations and basic analysis were outsourced, sometimes to far-off countries, where workers did what was necessary overnight. Most files became electronic, stored on disks rather than in physical cabinets. And as Jane’s bosses turned to communicating by e-mail, phone calls became rarer and rarer: they were not in a fast-moving business requiring constant verbal contact with their clients. As a result, Jane’s secretarial job too became endangered, and eventually she was laid off.

Jane, however, survived the onslaught of the machines, largely by reinventing herself. She quickly found another job within the organization. She has become a sort of “fixer” for her new bosses, taking on tasks that they have little time or capacity to handle—such as picking the restaurant and ordering the menu for an office dinner, inviting speakers to the organization and managing their schedules, heading off irate clients and ensuring their problems are dealt with, or following up with an obdurate office accountant questioning a bill submitted by one of her bosses. Because Jane has transformed herself into one who takes care of the unusual tasks, ones that machines cannot handle, she has to report to more bosses—nine at last count. Work is exhausting, because demands come from all sides, but Jane is thankful she still has a job. And it is more interesting now.

Jane’s bosses have benefited hugely from the revolution in computers and communications. The research papers and articles they write receive much wider circulation. In the past they had to be photocopied and sent by mail to a small list of the truly interested, but today they are uploaded to a website and quickly seen by many. Their presentations are more colorful and their seminars more interesting, which means that their audiences pay closer attention when they speak. They routinely field requests from strangers who have come across their work somewhere on the Web, to speak, consult, or give expert testimony.

Thus advances in technology have wide-ranging effects across the population. The routine tasks done by secretarial and clerical workers like Jane, typically those with a high school education and perhaps even with some college experience, have been automated. But the nonroutine, creative tasks typically undertaken by those with advanced degrees have been aided by technology. From CEOs, who can see their firm’s latest inventory position by tapping on a few keys, to analysts and consultants, whose reports can be accessed around the world, the influence and reach of the skilled and the creative has increased.
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Technology has increased their productivity even while rendering others redundant.

Typically, however, technological advance is a good thing for everyone in the long run. It eliminates drudgery while giving the worker the time and capacity to make use of her finer talents. We are surely better off posting a document on an accessible website than asking a clerical worker to affix thousands of stamps and destroy so many trees to send physical mail that will ultimately be thrown away. But in the short run, technological advances can be extremely disruptive, and the disruption can persist into the long run if people do not have the means to adapt.

America has adapted to technological change before. As agriculture gave way to manufacturing in the mid-1800s, the elementary school movement in the United States created the most highly educated population in the world. As factory work became more sophisticated, and as demand grew for office workers to handle myriad activities in the emerging large, multidivision firms, the demand for workers with high school training increased. The high school movement took off in the early part of the twentieth century and provided the flexible, trained workers who would staff America’s factories and offices. In 1910, fewer than one-tenth of U.S. workers had a high school diploma; in the 1970s, when Jane started her career, more than three-quarters did.
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Although earlier episodes of adaptation were very successful, the next phase of the race between technology and education, as the Harvard economists Claudia Goldin and Lawrence Katz have put it, has been far less satisfactory in the United States. Recent technological advances now require many workers to have a college degree to carry out their tasks. But the supply of college-educated workers has not kept pace with demand—indeed, the fraction of high school graduates in every age cohort has stopped rising, having fallen slightly since the 1970s.
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Those who are fortunate enough to have bachelor’s and advanced degrees have seen their incomes grow rapidly as the demand for graduates exceeds supply. But those who don’t—seven out of ten Americans, according to the 2008 census—have seen relatively stagnant or even falling incomes.
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Faced with a weak safety net and continuing uncertainty about jobs that could easily be eliminated by the next technological advance or wave of outsourcing, many Americans find it hard to feel optimistic about the future. Although Americans have, by and large, been flexible in their search for opportunity—willing to uproot themselves and travel across the continent to take a new job—the demands on them are far greater now. Many have to go back to school to remedy a deficient high school education before they can derive the full benefit of further education, all for distant and uncertain job prospects. Some lack the fortitude and strength of purpose to do so; others simply do not have the resources. For a single mother of two, for example, who is barely making ends meet with two low-paying jobs, further education is simply not a feasible option.

The gap between the growing technological demand for skilled workers and the lagging supply because of deficiencies in the quantity and quality of education is just one, albeit perhaps the most important, reason for growing inequality. The reasons for rising inequality are, of course, a matter of much debate, with both the Left and the Right adhering to their own favored explanations. Other factors, such as the widespread deregulation in recent decades and the resulting increases in competition including for resources (such as talent), the changes in tax rates, the decrease in unionization, and the increase in both legal and illegal immigration, have no doubt all played a part.
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Regardless of how the inequality has arisen, it has led to widespread anxiety.