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Easy Credit, Hard Landing

The financial insights of Raghuram Rajan.

Jul 26, 2010, Vol. 15, No. 42 • By CHRISTOPHER CALDWELL
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In 2005, University of Chicago finance professor Raghuram Rajan published a paper in the proceedings of the Federal Reserve Bank of Kansas City called “Has Financial Development Made the World Riskier?” Rajan, then the chief economist at the International Monetary Fund, warned bluntly that incentive structures in the banking profession were leading to reckless credit expansion, herding, and other “perverse behaviors.” He was frostily received when he presented his findings at the Federal Reserve’s annual summer retreat in Jackson Hole that year. The Fed-linked experts who snorted at Rajan’s warnings were sure that financial innovations helped “spread risk” in a way that made the world safer. There was a fixed amount of risk in the world, they seemed to believe, and the more widely distributed it was, the better off we were. Rajan, too, thought the new products and practices “spread risk,” but in a different and more dangerous way: They multiplied it.

Easy Credit, Hard Landing

Raghuram Rajan

Rajan is worth reading not just because he was correct when few were but also because his writing is clear as a bell, even to nonspecialists. His new book, Fault Lines: How Hidden Fractures Still Threaten the World Economy, is not a coherent argument so much as a bunch of independent-minded essays on various topics in contemporary global finance. Some are excellent (his essay on the misaccounting of “tail risk” on corporate balance sheets, for instance). Others are not so hot (his suggestions on improving access to education or his plea for giving IMF analysts more power to impose their views on recalcitrant nations).

Most notably, in the course of this book Rajan offers a bold and convincing diagnosis of how a screw-up in the regulation of poor people’s mortgages in one country has brought the world to the brink of economic disaster, where it teeters still. He goes beyond the proximate causes of the problem—the subprimes and derivatives and trade imbalances and the like. The ultimate cause, Rajan convincingly argues, is a widening of economic inequality that American politicians of both parties found politically intolerable, and chose to fix by turning the credit market into an under-the-table welfare state.

The growth in inequality has been large, Rajan shows. The top 1 percent of the population have laid hold of 58 cents out of every dollar in income growth since the Ford administration. Rajan shows no interest in being patted on the back for pointing this out. Moralizing is not his intent, and there are no Gilded Age clichés here about the undeserving rich. In fact, as a professor of finance rather than economics, he is able to show us some unfamiliar statistics about the way rich people are rich, and one of the most interesting is that we do not have a particularly big class of idle remittance men. “Even for the richest 0.01 percent of Americans toward the end of the twentieth century,” he points out, “80 percent of income consisted of wages and income from self-owned businesses, and only 20 percent consisted of income from arm’s-length financial investments.”

Rajan is describing not the moral problems of capitalism but the political problems. The median American is losing ground. And while people at the 90th percentile have never had it so good, Americans in the 10th percentile have endured a punishing economy for about a third of a century now. Their problems become particularly acute during recessions. For reasons that are not fully clear, recessions have changed in nature in the last 20 years. Historically, Western economies returned to full employment within a few months of hitting a recession’s trough. Losing a job was a calamity, but a calamity of short duration. Since 1992, however, all recoveries have been “jobless recoveries”—in the 2001 recession, it took more than 38 months for the economy to return to full employment. 

And, as Rajan puts it with some understatement, “the United States is singularly unprepared for jobless recoveries.” This is only partly because the United States has a weaker welfare state than other industrialized countries. It is also because the American safety net—in which government provides fewer health and retirement benefits but incentivizes employers to fill the gap—winds up placing all of a person’s eggs in the basket of his job. Lose your job and you lose not only your income but also your (and your children’s) health insurance and possibly (as in several scandalous recent cases) your pension.

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