Dr. Raghuram Rajan's wisdom in fault lines summarized

1. Fault Lines
-Dr. Raghuram Rajan
Summary by Atul Khanna
+91 9819580970
atulkhanna75@yahoo.co.in

2. Objective of this ppt
• To share Dr. Rajan’s wisdom
• To help individuals take correct decisions thus
helping global economy
• To help promote book
http://www.amazon.in/Fault-Line-Fractures-
Threaten-
Economy/dp/9350291738/ref=sr_1_1?s=books
&ie=UTF8&qid=1439015536&sr=1-
1&keywords=fault+lines+by+raghuram.g.rajan
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, +91 9819580970

3. Introduction
• In Jackson Hole conference, Dr. Raghuram
Rajan presented paper “Has financial
developments made world riskier”. He was
booed but proven correct
• Typical solutions would not solve systemic
issues. Fault lines increased effect of local
optima not being global optima
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, +91 9819580970

4. Contd.
• Background:
• Developing countries had spent using foreign
borrowings. After burning hands, decided to save.
• Developed countries borrowed from developing
countries and invested, especially on IT
• Dot com burst lead to contracting economy. US
fed cut interest rates but instead of reviving
investments, lead to house price bubble
• Securitization spread risk to unsuspecting people
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in,+91 9819580970

5. Contd.
• When Fed raised rates to cool housing market,
banks refused to refinance, people could not
repay and bubble burst
• Questions
? Why money flooded US?
? Why US could not export itself out of recession?
? Why Fed kept rate so low so long?
? Why NINJA loans given?
? Why banks held securities on books?
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in,+91 9819580970

6. Contd.
• Fault lines
– Political stresses
– Trade imbalances
– Different financial systems ( arms length vs.
relationship based) interacted to finance trade
imbalances
• Rising inequality and push for housing credit
• Instead of focusing on difficult / long term
solution, politicians pushed credit to low income
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

7. Contd.
• When easy money of govt. met sophisticated,
competitive amoral financial sector, fault line
developed
• History: when farmers fell behind industrial
workers in industrial revolution, easy credit
caused bank failures during great depression
• Export lead growth and dependency- when
countries depend on foreign consumption, fault
line develops because indebtedness limits further
expansion
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

8. Contd.
• Export dependency because target of rapid
growth at expense of domestic consumption
• Domestic companies limit competition thus
leading to inefficiencies
• Clash of systems
• When there is transparency and easy enforceability of
contracts, transactions do not depend on propinquity,
financiers provide long term finance directly to user
• Where public financial info is limited, enforceability of
contracts depends on long term business relationships,
banks etc. play important part
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

9. Contd.
• So when arms length financiers finance relation
based systems, do so through
• Offer short term loans for quick withdrawal
• Payments in foreign currency to avoid default through
domestic inflation / devaluation
• Lend through local banks which have govt. backing
• Since relationship banking did not evaluate credit
properly, underperformance lead to pulling of
credit hence crises
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

10. Contd.
• Countries then approached IMF which imposed
strict conditions. So governments restricted credit
and boosted exports, increased forex reserves
• Jobless recoveries and pressure to stimulate
• In 2001 recovery, US found jobs lagging recovery (up to
38 months) . Given short duration of unemployment
benefits and healthcare linked to job, huge political
pressure to stimulate economy
• Typically pet projects are promoted impairing long
term benefits to economy
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

11. Contd.
• Problem with stimulation: asset prices around
globe rise
• Low long term cost of funds combined with
government support for low income housing, fed
statement that bubbles cannot be pricked but
government will intervene to prevent implosion,
gave license to financial sector to taking risk
• By focusing on jobs and inflation, fed was true to
mandate but myopic behavior created fault line
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

12. Contd.
• Consequences to US financial sector
• All fault lines converged in US when money flowed
from foreign to US housing through Fannie Mae and
Freddie Mac, banks RMBS (outsiders assumed
efficiency of arms length pricing)
• Since all institutions took same risks, chances of risk
materializing went up significantly i.e. political moral
hazard magnified economic moral hazard
• Source of fragility: interaction between govt. and
finance system, each with its own goals
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

13. Contd.
• Challenges that face us
• To create financial system which balances innovation
vs. safety
• Marry good policies with good economics
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

14. Let Them Eat Credit
• Technology advances has increased productivity &
eliminated lots of traditional jobs. So income
inequality has become severe
• During industrial revolution, people upgraded to
high school diploma but very few people can now
upgrade to higher education
• Reasons for US falling behind in education:
• Poor quality of learning experience
• High cost of higher education
• Rigor of higher education
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

15. Let Them Eat Credit
• Family instability in America, especially with poor
• Creative disruption leading to earning volatility
• Immigration
• Reduction in tax on higher income
• Entry of women in workplace
• Weakening of unions
• Supportive attitude of USA
• Anti trust laws and estate taxes reduces concentration
(refer Capital in 21st century)
• Since education is long term & difficult solution,
Politicians have expanded housing credit
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

16. Let Them Eat Credit
• In US earlier, variable rate house loans were
available for 5 yrs. with single repayment at
maturity and 50% of price as loan
• In 1930 depression, home loan defaults lead to
creation of HOLC and FHA. HOLC would
restructure loans into fixed rate fully amortizing
loans. FHA would provide insurance for default.
HOLC closed on 1936 followed by Fannie Mae
which issued long term bonds to investors
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

17. Let Them Eat Credit
• Rising interest rate in 1960 lead to money flow out
of banks and thrifts. Govt. brought direct financing
by splitting Fannie into Ginnie Mae (which insures
packages & securitizes) and Fannie Mae. In
Vietnam war time, Fannie and Freddie were
privatized
• In 1980, Paul Volker raised rates to fight inflation.
But Saving & loan industry went bankrupt. So
politicians reacted with Deposit Insurance
deregulation to liberalize loans and borrowings
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

18. Let Them Eat Credit
• In 1992, “Federal housing enterprise safety and
soundness act” pushed “Housing and Urban
development” into loans for poor by reducing
capital requirements.
• Also Community Reinvestment Act (CRA) required
banks to lend to low income local markets. Clinton
administration pushed this further
• Ownership society push by George Bush in 2004
pushed low income mandate to 56% of Fannie and
Freddie assets
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

19. Let Them Eat Credit
• Lending goes berserk: Private sector joined party
of low risk and high returns
• Households borrowed against home equity,
especially as they did not have access to prior
credit. But subsequently they lost homes as well
• Solution: Microcredit
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

20. Exporting to grow
• Elusive growth: Historically countries grew
between 1-2%. However exporting countries grew
between 5-8% for some time
• Countries remain poor because
• Poor human capital not poor physical infrastructure
• Poor organization capital
• How early developers built org capital
• Over time when existing people demanded
• Foreign pressure
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

21. Exporting to grow
• Strategy of Late developers
• Start with low cost technologies to frontiers of
innovation
• Country saving were directed through largely captive
financial system to favored few firms
• Government protected firms through import tariffs and
restrictions
– The commanding heights- only France and Taiwan
grew rich because of contribution by state firms
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

22. Exporting to grow
• Typically government officials are not measured
and incentivized for efficiency and are rule bound.
Also government is monopoly and cannot run out
of money
• Typically information required is distributed in
society. Reporting to govt. distorts information
while market prices reflect the information
without biases
• Taiwan supported textile through tariff, easy loans
and purchasing goods. Also created PVC plant
which became Formosa plastics group
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

23. Exporting to grow
• Philippines: corruption resulted in favors to
inefficient people
• Since households do not grow, low earned income
and interest income plus high taxes lead to low
consumption.
• Exports make firms efficient and work at scale.
Also incentives like forex, export credit etc.
provided by govt. add to growth
• Missing turn: With large domestic markets, Brazil
and India were slow to push firms towards export
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, +91 9819580970

24. Exporting to grow
• When exporters get rich: Germany and Japan:
wages rise, trade surplus leads to appreciating
currency, move up value chain BUT domestic
sectors remained inefficient
• Japan: elevator ladies example. When large
countries export, then world has to consume.
After plaza accord of 1985, Exchange rate up so
BOJ cut rates. It lead to massive stock and RE
bubble. When rates increased, bubble burst
leading to lost decades
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, +91 9819580970

25. Exporting to grow
• Banks, services and domestic producers remain
inefficient. So huge rich countries remain
dependent on foreign demand hence foreign
depression leads to local thus global depression
• China: export lead growth and now trying to shift
to domestic consumption. But six adults
dependent on 1 worker, no pensions, rising health
care & education costs, low wages, no dividend
income
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

26. Flighty foreign financing
• Developing countries used to get low cost loans
from IMF. Subsequently western banks recycled
petro dollars to these at arms length.
• Savings and investment: Even after developing org
capital, countries limit foreign borrowings as
inefficient use forces problems during repayments
• Financial sector is producer based economy: Brazil
spread is 10%. Households find difficult to borrow.
No credit histories, poor judicial system, borrow
from money lenders @high rates
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

27. Flighty foreign financing
• Mexican crises: domestic savings dropped to 3.3%,
foreign investors reduced money so govt.
converted short term debt to short term bonds
indexed to dollar peso rate. But when foreigners
withdrew, reserves depleted and US+IMF gave
loan
• China: Overcapacity is dangerous
• Conglomerates like Tata, Birla have huge
advantage because of poor domestic financial
system
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

28. Flighty foreign financing
• East Asian crises: ‘Arms length’ financing
‘relationship based’ banking, exacerbated by
depreciation of Japanese Yen leading to Japan
being popular with investors
• Reforms: India liberalized leading to efficient
producers and borrowing consumers.
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

29. Weak safety net
• US unemployment benefits are short term (since
made in depression to make things efficient). But
now jobs are taking long time to recover (23
month 1991, 38 months 2001). When politicians
internalize lessons (Bush Sr.), push for low int.
rates thus bubbles. Also healthcare tied to jobs
• With Internet, just on demand hiring and
temporary jobs
• US: politics, absence of strong unions, poverty
concentrated in races, large and mobile economy
etc.
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

30. Weak safety net
• US did not have to develop class consciousness to
overcome domestic elites and had right to vote.
They give generously to charities where they know
the recipients
• Workers who feel safer and are healthier work
better
• Safety net was supported by business as costs
could be offloaded to state, all firms big or small
would be subject to costs reducing competition
for incumbents
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

31. Weak safety net
• Problem with discretionary stimulus: Workers
don’t know how long recession will be, lag of fiscal
and monetary policy, discretion tends to abuse. Ex
cancer, RE breaks.
• Also foreign countries dependent on US wait for
stimulus deepening fault line
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

32. From Bubble to bubble
• Bernanke explanation of good times: lucky,
efficient industry and better mgmt. of monetary
policy
• Reasons for delayed withdrawal by Fed after 2001:
Political forces and sticking to its mandate gave
signal of low int. rates to market
• Fed’s objectives: Maintaining stable employment
and stable prices in US. But both are incompatible
• So try to keep economy at its potential growth
rate by targeting inflation
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

33. From Bubble to bubble
• Int. rates: Through controlling sort term int. rates,
influence long term int. rates. And low rates mean
more wealth retention and creation, less
attractive to save
• Response to .Com burst: Low int. rates lead to
increase in house prices but jobs were not
available and inflation low. Because imports were
cheap and were forcing industries to become
productive
• When started increasing int. rates by 25bps, risk
premium fell hence long term rates fell!
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

34. From Bubble to bubble
• Increasing rates reset home repayments stopping
home price appreciation leading to defaults
• Increased asset prices because of many factors
like increased risk taking, more foreign money and
expanding credit
• So money going abroad for riskier assets (more
returns)came back to US making US into hedge
fund (investing in risky assets financed by debt
issued
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

35. From Bubble to bubble
• Housing: reinforcing cycle of prices, no way to
short prices rise easily.
• No check on credit growth as a) relation between
credit growth and inflation was tenuous and b)
assumption that credit problems are history with
arms length banking
• Even if very high inflation, small movement of int.
rates changes future expectations drastically
• Greater fool theory
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

36. From Bubble to bubble
• Greenspan Put: Will continue supporting short
term int. rates, will not prick bubbles but support
the fall out. So wall street went on overdrive
• Monetary policy and financial stability: to give up
role of party popper is politically easy but risky to
economy
• Academia failing: over simplified models, wrong
theories
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

37. When money is the measure of all
worth
• Geneva bankers pooled annuities of thirty healthy
girls and sold resulting cash inflows to Geneva
citizens but because of French revolution,
defaulted
• Bankers have nose for making money, they are
measured only by money made (not real goods
produced), they find edge in taking advantages of
unsophisticated players (govt.), banking behavior
tends to be self reinforcing, there is safety in
numbers
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

38. When money is the measure of all
worth
• In experiments, if the work is allowed to endure
than people behave differently
• Short sellers, if proved correct, ensure resources
are taken from bad firms and given to good firms.
In process make money (Enron –James Chanos)
• Pecunia Non Olet: Money has no odor
• New century: gave money for poor quality loans
because of housing policies. Judgment calls of
loan officers are imp but cannot be automated
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

39. When money is the measure of all
worth
• Assigning blame: Arms length banking, if not
retained, does not foster long term thinking
• Rating agencies AAA with high returns was
because of govt. support. Eventual payers are
taxpayers
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

40. Betting the bank
• In normal times, the correlation between
mortgage loans is low. But correlations were
higher because low quality mortgages coming
from concentrated areas
• Banks kept them in books because default was
remote and financing drying up was small
possibility
• Since tail risks, ignored leading to increased
chances of them occurring
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

41. Betting the bank
• Search for alpha: Especially during competition,
Ex: Bernard Madoff
• Risk taking at top: CEO were out of touch :
excellent pay now but top ppl joined when pay
was low and job boring
• Also vying for prestige, pressure form
shareholders : dance when music is playing
• Shareholders: markets having rational expectation
does not mean they have perfect foresight
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

42. Betting the bank
• Board forced to take risk, equity markets pricing
reflected same
• How govt. helping hand hurts: Govt. hand behind
banks, bond holders getting fully paid, herd
mentality for risks
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

43. Reforming finance
• Forces against globalization are regrouping
• Democratization vs. Debt: Financial sector
improves living standard for all but credit becomes
debt if more debt taken than can be repaid
• Limiting competition: Pros vs. cons
• Reduce Incentive and price distortions: Manage
expectation of govt. intervention
• End government subsidies and privileges to
financial institutions
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

44. Reforming finance
• Enact cycle proof regulation
• Reducing search for tail risk
• Altering incentives generated by compensation
• Incentives at top- withholding
• Re-pricing of financial claims and incentives
• Govt. intervention in markets
• Eliminating “Too Systemic to Fail”
• Keeping Institutions from becoming systemically
important- collecting relevant information
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

45. Reforming finance
• Building better buffers
• Making financial firms easier to resolve
• Resilience
• Resources
• Redundancy
• Phasing out deposit insurance- for big banks?
• Ceaser’s wife: above suspicion
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

46. Improving access to opportunity in
America
• Improving quality of human capital
• Disadvantages begin early- family, drugs etc.
• Non-cognitive skills
• Amount of schooling
• Quality of schooling- teachers, pedagogy, class size,
technology, competition
• Help for and in college- access for poor
• Job apprentice & training
• Determining what works
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

47. Improving access to opportunity in
America
• Security and safety net
• Contingent but predetermined unemployment
insurance
• Universal healthcare- cost because inputs,
overutilization because payments, adopts innovation,
admin costs, operational efficiency, threat of
malpractice
• Improving portability of benefits and worker mobility
• Savings
• Government Capacity
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

48. Fable of bees replayed
• US spending more than earning (energy usage)
• G-20 and IMF- Politics is always local.
• Multilateral institutions & their influence
• WTO – quasi legal vs. IMF- politicians accept only
when needed. Countries not ready to give up
independence
• Obtaining global influence- approaching people
directly to build pressure e.g. food prices
• Reforms: all countries representation
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

49. Fable of bees replayed
• China: Cost of undervaluation: loss on US
holdings, mirrors US policy leading to bubbles,
controls credit but harms local firms and people,
banks invest inefficiently
• Persuading China: Has reserves and is export
dependent
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970

50. What lies ahead for India
• Reasons for optimism- demographic dividend,
• Impediments: Infrastructure, clear land titles
• Money from relationship with politicians
• Inefficient government so poor education, health
etc., no options in law/ order/ governance,
corruption, support of few who benefit
• Progress: Panchayats , technology, education,
democracy
Fault Lines – Dr Raghuram Rajan Summary by Atul Khanna, atulkhanna75@yahoo.co.in, 9819580970