Bare Talk woke up on Saturday morning to an email from a friend pointing to the critique of Raghuram Rajan’s Fault Lines: How Hidden Fractures Still Threaten the World Economy by Paul Krugman and Robin Wells, and Rajan’s response to it.
I tend to side with Rajan in this exchange with Krugman and Wells. Economists can find common ground, or at least zero in on where they differ, only if they stick to facts and interpretations rather than motivations. It should be possible to verify whether Freddie Mac and Fannie Mae contributed to the subprime bubble. There is no need to argue about facts.
Also Read V Anantha Nageswaran’s earlier columns
Krugman and Wells are on a stronger wicket when they point to the global nature of the bubble. Hence, there is some merit in seeking to find a common ground on the global bubble rather than on the US causation alone. But bubbles could have both common and idiosyncratic grounds. Hence, it is disappointing to note that they focus almost exclusively on the global savings glut as the cause behind the crisis. That is too easy—it evades all individual, societal and national responsibilities for the crisis.
Yes, one can always trace the 2008 crisis to China’s decision to devalue the renminbi by 45% on 27 December 1993. From there (among other things) flowed Asian trade and current account deficits, the Asian crisis, the exchange rate devaluation, the reserve accumulation, the investment of those reserves in US treasurys and agency debt by foreign central banks, the impact of that on US interest rates (it caused them to drop), the US lending boom and borrowing binge, and, bingo, the crisis.
But it is a glaring omission to ignore the US’ monetary policy stance then and now, as Krugman and Wells do. Rajan is correct that the European Central Bank was only marginally different from the Fed in policy easing. I have displayed a slide in numerous speeches that shows how real short rates were well below the long-term average for the US, Europe, Switzerland and Japan (not to mention the UK, Australia and others) in 2001-04.
Now the question is why all of them engaged in exceptional policy loosening. Clearly, the chief reason is that they were reacting to the Federal Reserve’s stance. Had they not done so, their currencies would have appreciated even more than they had versus the US dollar. Thus, the Fed not only engineered a very loose monetary policy for the US, but also for the world, given the role of the US dollar as the global reserve currency.
To blame the other without acknowledging one’s own errors, as both the East and the West are doing, might be fair game in global or local politics, but it is not recommended practice for academics.
Surprisingly, both Krugman and Wells, and Rajan, seem to have overlooked one (very) important common thread between them.
This is what the former write in their piece: “In late 2005, just a few months before the US housing bubble began to pop, he declared—implicitly rejecting the arguments of a number of prominent Cassandras—that housing prices ‘largely reflect strong economic fundamentals’. And like almost everyone else, Bernanke failed to realize that financial institutions and families alike were taking on risks they didn’t understand, because they took it for granted that housing prices would never fall.”
This is what Rajan wrote in his response: “My book suggests that many—bankers, regulators, governments, households and economists among others—share the blame for the crisis.”
The question is why so many stakeholders got it wrong—central bankers, financial institutions, other intermediaries, borrowers and lenders—as both Krugman and Rajan seem to acknowledge.
The answer lies in the evolution of the hubris, encouraged by policymakers and thought leaders in the financial industry, that through their efforts and risk management, these stakeholders had conquered business cycles, achieved “great moderation” and diffused risk to an insignificant minimum through diversification across many participants.
But the truth is that risk persists, and nothing has been done to dispel this false belief in human infallibility. Reading history would help. William Bernstein’s The Four Pillars of Investing would be a good place to start for policymakers, financial industry practitioners and investors. But their narrow, short-horizon focus blinds them to the truths out there.
To the extent that they are completely ignoring these consequences of their recommendations, Krugman and Wells’ prescriptions are dangerous and harmful.
To the extent that the diagnosis and prescriptions of people such as Rajan do not focus on this aspect, their analysis and conclusions are incomplete.
To the extent that policymakers are willing to repeat their erroneous practices, they are being dishonest and doing a disservice to the nation and the people they profess to serve.
To the extent that we are willing to remain ignorant and uninformed, we are not only failing to evolve into better human beings, but are also causing harm to our own financial wealth.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org