May 04, 2012

Fault Lines: Two Years Later, Some Scenarios

Patrick Marren
Partner

Scenario fodder for the week: Raghuram Rajan's Fault Lines: How Hidden Fractures Still Threaten the World Economy won many awards as best business book of 2010. Rajan, an economist at the University of Chicago, had warned of potential instability in the financial system at a 2005 Jackson Hole conference honoring Alan Greenspan's stewardship of the Fed; after presenting his contrarian paper, he exited the conference with a back full of arrows from such luminaries as Lawrence Summers, who brusquely dismissed his concerns. Two years later, Rajan was proved right and Summers wrong – and Summers got called in to fix the economy, while Rajan returned to academe. What a world. 

A couple of years on, it's worth examining Rajan's major theses to see how they have played out.

In "Fault Lines," Rajan identified three major fissures that in his estimation caused the (still-evolving) financial and economic crisis, and that he felt could still cause major havoc in the world economy. These were:

  • Domestic Political Stresses: Increasing inequality and the push for housing credit caused the government to enter the housing market in a major way – under both Democratic and Republican administrations and Congresses. As home values rose and income inequality also rose, the average American household could not afford to buy houses at historical levels; this threatened the housing industry, and more to the point, the political careers of those who were in office while things were getting harder for the average household. George W. Bush called it "The Ownership Society," and hailed the record percentage of American households that owned their own homes; Democratic president Clinton and Democratic lawmakers also pushed to loosen terms on higher-risk loans. 
  • Trade imbalances between countries stemming from prior patterns of growth: Export-led growth and dependency was the result of the 1998 Asian-Russian crisis. Southeast Asian countries had formerly been net importers, soaking up exports from the developed world. But when their less-than-transparent economies suffered huge currency shocks, causing widespread deep recessions, most of them vowed: Never again. They changed their strategy to export-led growth, and managed their currencies to ensure that their exports were cheaper than those of developed countries. Thus the situation changed to one in which developed countries ran trade deficits while developing countries ran massive surpluses.
  • Different types of economic systems come together to finance the resulting trade imbalances: The clash of economic systems – one relatively open and transparent, the other secretive and without rule of law – makes the financing of trade imbalances problematic. 

The emergence of jobless recoveries and the pressure on government to stimulate, in the context of a financial sector looking for any edge, also made the coming period very dangerous, according to Rajan.

So how have these fault lines shifted, if at all, since 2010?  And what plausible scenarios might one write about each of them?

The government's involvement in the housing sector has indeed, if anything, increased – out of necessity, as default rates have refused to shrivel despite some historically large stimulus and miniscule interest rates. But it has not caused a new bubble in housing. If anything, as of this writing, housing prices are still on the decline. One quite plausible scenario for housing is a long-term slump, lasting more than a decade, as Baby Boomers are forced to sell en masse as they liquidate and head off to Del Boca Vista. Another plausible scenario might be that the current slump is simply a deeper but still typical cyclical economic event, and that within a couple of years prices will have rebounded. Still another might be across-the-board inflation benefiting the housing market as people look for something tangible in which to invest. 

But one scenario that does not, at this moment, seem plausible, is that the current government involvement in the housing market will set off anything like a return to pre-2007 bubble conditions in the housing market. Stimulus has been historically large, but apparently it has not been of sufficient magnitude to reinflate that bubble; the programs and aid extended by the federal government to date have done almost nothing to bring growth back to the housing sector; and political realities seem stacked against the federal government doing much, if anything, more than it has done to date.

So any fear on Rajan's part that the feds might reinflate the bubble out of "domestic political stresses" so far seem unjustified by the evidence.

Rajan's other two fault lines seem so closely entangled that we should deal with them together.

On Export-Led Growth and Dependencies, there have been some shifts in the ground. China's currency has been allowed to shift a bit to make its exports slightly less competitive. This of course makes them more expensive to Americans and others, which lowers the buying power of American consumers. Politicians here scream about the artificially depressed level of Chinese currency, but if the renminbi were truly allowed to float freely, the result, while somewhat nice for American manufacturers and their workers, would be gigantically disruptive to the world economy, as tens of millions of Chinese are thrown out of work, imports to the US increase in price by an order of magnitude, and political chaos ensues. That's one scenario for you – and it may be very plausible indeed, over a long enough haul.

Rajan's third fault line, integrally related to the second, was the clash of open/transparent and closed/opaque economic systems. Rajan blames this imbalance for the 1998 meltdown of Southeast Asian economies. "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.... [they offer] only short-term loans so 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 local banks...so the government will be drawn into supporting its banks to avoid widespread economic damage." Foreign investors, depending on the local government bailing them out, had little need to closely evaluate risk in such a situation. The first result was a major economic disaster in 1998 for the Southeast Asian nations who had borrowed heavily from the developed world, as their loans were called and their economies collapsed. The second result was a "never again" attitude: these countries devalued their currencies and kept them low in order to keep their exports competitive. 

Japan and Germany, the two largest non-US economies at the time, were also on an export-led footing; their consumption could not possibly swallow the developing world's growing massive manufacturing exports. That left one possible candidate: the US of A.  With its deep liquid currency, the US was the "consumer of last resort" upon which the entire world seemed to depend – and still does to this day. But this arrangement would seem to be unsustainable over the long term. What are the plausible scenarios here? 

One big question is the time scale on which such an adjustment occurs. We owe China (and many others) a lot of money in dollars, which we will have to print, which will mean either we inflate our way out of things, or we'll have to knuckle down and work our debt off while maintaining a strong dollar. (Most scenarios would seem to have us inflating our way out to some extent – one Chinese official told American economists "We know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do" (Cohen and DeLong, The End of Influence, 2011).) One scenario is that the adjustment could happen gradually and relatively painlessly for all sides. Another plausible scenario is a sudden "short sharp shock" as the US goes on an inflationary spree in the face of Baby Boom retirements, economic depression, war, or something else. Probably the least plausible scenario is that we knuckle down and pay off the nut so our creditors will like us.

But there's another side to this. What of all these countries whose whole economic model has been based on Americans (and Europeans, to a lesser extent) being rich enough to endlessly buy more things from them than they themselves buy from Americans, while financing the Americans' expenditures by buying dollar-denominated assets? A number of unpleasant scenarios leap to mind as to how this arrangement might end, and most are far more unpleasant for the export-surplus crowd than they are for the US. Political instability and mass unemployment and war tend to accompany such adjustments, historically. When we think about scenarios of how this imbalance plays itself out, we would do well to remember that it's still probably going to be better to be us than it might be to be them. 

So far the world economy has not utterly cratered, so we know that something seems to be working, at least for now. The big questions for us scenarioistas would appear to be: how long can this merry-go-round continue to rotate; but maybe even more: why in heaven's name is it still rotating now?

We highly recommend Professor Rajan's book as a primer on the current crisis – and for imagining scenarios for its resolution (or lack thereof). As always, we welcome comments by our readers – especially any who might know whereof they speak.

Thoughts?