Name: Rohan Mhaddolkar

Roll no: 110

Book Review: Fault Lines, How Hidden Fractures Still

Raghuram Rajan has its own blog, and can pride itself for being the centre of a dispute

between a Nobel Prize winner Paul Krugman and a former IMF chief economist – its author.

Today a Chicago University professor, Raghuram Rajan is also famous for having ruined a

2005 Federal Reserve celebration by pointing to the possibility of a “full-blown financial crisis”.

Fortunately he may no longer feel like “an early Christian who had wandered into a convention

of half-starved lions” as the bubble burst, and the book he longed to write on the global

economic fractures came out. Rajan’s central claim is that the actions of Western governments

before and after the global financial crisis were wrong and did nothing but encourage further

disaster. Thankfully, Rajan also comes up with original and important long-term remedies –

arguably more so than Krugman. Where others have delved into the personalities and

perverse systems that led to the financial crisis and then summed up with a half-baked list of

policy ideas, Rajan puts a premium on policy. In fact, nearly half ofFault Lines is dedicated to

policy choices that Rajan believes are not only realistically achievable but likely to be quite

effective. He makes a good case.

Rajan’s book is a bold enterprise in three ways: firstly it aims to explain the US financial

crisis by looking at deep, decade-long fractures in economies and societies; secondly it

suggests well-known but radical solutions that few dare put forward; and finally it supplies

innovative answers to practical questions. Rajan’s explanation for the crisis consists of the
following: since the 1980s US wage inequalities have increased due to a growing gap between

college graduates’ pay and the pay of non-graduates. Jobless recoveries plus an inadequate

safety net have led to rising worker anxiety. The government used a quick and easy solution:

a push for credit. A low-interest rate policy and a government bailout guarantee gave it

strength. Export-led growth in Asia led to a global savings glut, and dollars flowed to the US

looking for high-yield investments. His striking conclusion is that the crisis resulted from “a

confusion about the appropriate role of the government and the market”. Indeed, Rajan

believes that the government should have ensured that perceptions of inequalities didn’t

develop as much as they did, getting more people into college to respond to the demands of

technological change, as well as providing for contingent but predetermined unemployment

insurance. By contrast, Rajan also writes that it should have neither intervened in the housing

market nor given the certainty of a government bailout in case of trouble. Now is a good time

to implement these changes. As for global imbalances, the IMF and World Bank could use soft

power to influence emerging countries’ populations into asking for higher and market-driven

interest rates.

Rajan writes with the authority of his credentials: He is both a top-flight economist and one

of the few skeptics who raised frequent and grave concerns about the world’s overleveraged

financial system in the years building up to the crisis. His recollection of the 2005 Jackson

Hole Conference, where he delivered a stern warning about mounting financial risks to an

audience of disbelievers, is both amusing and disturbing: “I exaggerate only a bit when I say

I felt like an early Christian who had wandered into a convention of half-starved lions.”

For the most part, however, Fault Lines is not a behind-the-curtain look at the personalities

behind the financial crisis. Rajan sees the financial crisis through an economist’s prism: He
follows the incentives. There are no villains, per se; just systems, and institutions, and us.

“Somewhat frighteningly,” he writes, “each one of us did what was sensible given the

incentives we faced.”

So the first half of Fault Lines proceeds with a sequence of head-slappers. Rajan notes that

on-the-job happiness tends to be associated with the ability of people to see tangible results

from their work. For a house builder, the satisfaction comes from the house. But what of the

banker? His satisfaction comes chiefly from making money, and lots of it.

When subprime lending looked like a stream of unending profits, everybody jumped in.

Meanwhile, widening income inequality brought pressure to boost middle-class consumption

with easy access to credit. How else would Americans be able to afford their proverbial flat-

screen TVs and SUVs? That the Federal Reserve kept interest rates low for so long leading up

to the crisis was no coincidence, by Rajan’s way of thinking. After all, it was just trying to

fulfill its dual mandate of achieving price stability and maximum employment.

It should be noted that the Federal Reserve comes under quite an attack in Fault Lines, at

one point likened to a gigantic hedge fund. In Rajan’s story, the Federal Reserve joined with

the private sector to drive subprime lending toward “its disastrous conclusion.”

Scores of other financial crisis analysts have more or less stopped their stories right there.

Rajan takes the trouble not only to explain what’s wrong with the system, but to describe

some fundamental ways to change it for the better. Chief among these are ways to ensure

that market players fully appreciate the tail risks they are taking — that is, risks whose

consequences don’t manifest themselves immediately and aren’t apparent to others in the
short term. Tail risks may be quite unlikely, but if they come true can be devastating.

Investors know that if everybody fails, nobody fails because the government will bail

everybody out. As Rajan puts it, “failing in a herd rarely has adverse consequences.”

What gives Rajan’s recommendations force is their place in a coherent, overarching strategy.

“Clawbacks” would force bankers to give up some of their earlier earnings — or have a lot of

income deferred — until the tail risks had faded. Continuous sharing of financial information

with supervisors would fit better with today’s fast-moving financial markets. Beefed-up capital

cushions would keep institutions safer. The value of this book lies in its whole. Between these

policy recommendations and detailed observations about the problems in our global economy,

Rajan takes time to outline the biggest problems — the fault lines. These are indeed wide and

dangerous. The fault lines include the housing crisis, widening income inequality, trade

imbalances, and the way these imbalances are financed across national borders. Any story

that identifies such gaping chasms must of course offer remedies, and that’s where Fault

Lines stands out.

Despite Krugman’s claims to the contrary, Rajan gives a balanced account of the role of the

government in the crisis. He does not absolve bankers; he intelligently remarks that it is for

the government to step in and “make them internalize the full consequences of their actions”.

This remains however something of a hot topic, after the clash between David Cameron and

Ed Miliband over bank bonuses and tax cuts in the House of Commons last week. Perhaps one

problem with Rajan’s analysis is its failure to discuss the consequences of an absence of

government bailout guarantee. This radical solution is put forward as the main deterrent to

tail risk-taking; however it looks like we will have to go through another full-blown crisis, this

one unchecked by the government, to ensure a change in expectations! Krugman is right at

least to discuss the merits of bailout packages; but it is true also that he fails to provide any
long-term solutions. Perhaps Rajan thought that a discussion on the topic might weaken his

argument. But at what cost?

Rajan is careful not to demonize the financial sector. After all, finance provides substantial

benefits — think credit cards and money market accounts. Some innovations may not provide

much value. The only safe financial system doesn’t take risks, and then it ceases to be a

financial system at all. The risks go away, but so do the benefits.

This is a wholly expected premise from a Chicago School economist, the kind that will have

progressives complaining that Rajan’s book is just more of the same. But how to account for

Rajan’s call for universal healthcare? Or early childhood education? It’s clear that Rajan is

interested in being intellectually consistent. If you identify income inequality as a fault line,

you can’t very well ignore it. An honest approach has to take into account the need for both

advancing opportunities so that incomes are less widely dispersed, and then acknowledging

that the financial system requires us to build a stronger safety net for those who find

themselves victims.

Overall, the book will please any reader looking for an inquiry into the deepest causes of the

recession and a consistent account of government’s errors of omission and commission .