Fault Lines: How Hidden Fractures Still Threaten the World Economy Paperback – August 28, 2011

In his previous book, Raghuram Rajan wanted to save capitalism from the capitalists. As he and his coauthor described, market forces can be annihilated by those bent on rent seeking and monopoly power. A few years after this first book, and in the midst of a world financial crisis, there is still ample proof that capitalists hold predatory views on capitalism, and that they want to hijack the system for their own private interest. But instead of distributing the blame for the crisis that befell upon us, Rajan argues that our post-crisis world economy needs to be saved from a new kind of threat: a combination of populist-driven politics and of geopolitical power shifts that create deep and lasting imbalances. These are the areas where he situates the fault lines that lie at the origin of the current world crisis and that, if unattended, may well provoke the next one.In geology, fault lines are breaks in the Earth's surface where tectonic plates come in contact or collide. In using a geological metaphor, the author suggests that the cracks and imbalances in the world economy cannot be easily mended, and that they are almost beyond our control. But if mankind cannot prevent tectonic moves and earthquakes, we can build resistant buildings and improve the resilience of our economic systems. This is what Rajan proposes, in a set of recommendations that goes well beyond the usual fix in the financial sector that is now commonly discussed.As Raghu Rajan emphasizes, his proposals are neither from the right nor from the left. They derive from his long experience as an academic originator of cutting-edge economic research, and as a decision-maker who, during three years, occupied the number-two seat at the IMF in Washington. His personal background as a US non-resident Indian also shows throughout the book. He mentions in passing that he is the director of a company, Heymath, that is based in Chennai in India and that helps teachers around the world to create teaching materials for math lessons and homework assignments. More generally, he insists that economists should analyze the US economy with the same tools and frameworks that they use for emerging countries. US policy-makers could also learn a thing or two from developing economies. For instance, health management practices in India could show the way to making US healthcare more affordable. Or conditional cash transfers in Mexico could encourage poor parents in American urban ghettos to pay more attention to their children's nutrition, health, and education by making welfare payments conditional on parents meeting certain milestones. Neither left nor right, many of his prescriptions are from the South.It is unlikely that people from the radical left will read this book, but they should. For a start, the metaphor of "fault lines" is close to the Marxist concept of contradiction. For Marxists, capitalism is branded by an immanent want of balance, of crippling contradictions. This is exactly why it changes and develops incessantly: constant development is the only way for it to resolve and come to terms with its constitutive imbalance. Contradictions and fault lines are not digging capitalism's grave; on the contrary, they highlight its flexibility and adaptability, and also show the amount of work required in sustaining it. Similarly, Rajan's own explanation of the financial crisis comes close to the concept of overdetermination. For psychoanalysts, a phenomenon is overdetermined if it is caused by a combination of multiple factors, which taken in isolation cannot account for the effect alone. The financial crisis originates in the follies and excesses of the financial sector, but also in the "other scene" of growing domestic inequalities and global imbalances.Although he quotes neither Marx nor Freud, Rajan shows up as a skilled dialectician. For him, politicians are part of the problem, and yet they are the ones that we must rely on to provide the solution. Likewise, our current predicament derives from the planet's growing interdependence, but the way out is to be found in more globalization, not less. Or to take another example, fixing finance from the consequence of financial engineering gone wild requires more financial innovation, albeit of a different, more inclusive kind. The art of the dialectical reversal is also displayed in the author's disregard for conventional ideas and political party lines. In Saving Capitalism, he argued that capitalist rent-seekers' best friends were the trade unions and antiglobalizers pushing for trade protection and anticompetitive practices. Likewise, he argues in Fault Lines that the IMF and the World Bank should seek their best supporters among the civil society organizations and media outlets that are so often found vociferating against the dictates of the Bretton Woods institutions.I will not try to sum up the argument or reproduce some of the reasoning, because all chapters seem equally worthwhile. In every book I read, there are parts that deserve less attention and that I tend to read in a more cursory way, taking less notes and time to ponder the reasoning. Not so in Fault Lines: my scrapbook was full of notes, and there was not one passage where I felt left out or in need of additional explanation. The writing is never dull or technical, and there are real gems in style and composition. The author has a real talent for catching the attention of the reader head on and keeping him alert until the very last page. This is not only the best book on the financial crisis I have read so far, but also one of the most stimulating and readable economic volume that I have had the opportunity to review.

The author did a great job in explaining the whole picture of what was going on and how the bits and pieces came together, without getting down to ideologies. The villains are poor education, politicians who dare not to challenge vested interests and government intervention in the U.S. and elsewhere. Heroes are innovations. He refers to the term "organizational capital" in explaining how an economy grows on factors apart from physical and human capitals, etc., which I find fascinating.In the final chapters, his policy proposal can pretty much be summed up into keeping American healthy and educate them better, -- kind of vague. I have truly expected something more closely integrated to the underlying problems so brilliantly analyzed in the previous chapters.Perhaps, a graphical presentation visualizing how the "fractures" play out and how the proposed policy can help the crisis from returning would be helpful.All in all, a concise, smart, enjoyable read.

I found this book a highly stimulating read. It represents possibly the most thought-provoking contribution in the aftermath of the crisis that started in 2007 and that yet engulfs us. Let me first summarize some of the most salient points it makes, then talk about its strengths, and finally, why everyone should read it.The epilogue of the book summarizes the book best - "The crisis has resulted from a confusion about the appropriate roles of the government and the market. We need to find the right balance again, and I am hopeful we will." The book presents two important government distortions - the push for universal home ownership in the United States and the push for export-led growth in some countries such as Germany and China that have left to massive "global imbalances", with some countries suchas the United States, the United Kingdom and Spain persistently being in deficits and borrowing from the surplus, exporting nations. While pursuit for home ownership affordability and growth are nothing to complain about per se, the book makes sharp observations that they are occurring at the expense of something more, or as, important. In the United States, the book argues, there has been a growing income inequality, which combined with a relatively feeble safety net for the poor, has created pressure on politicians to bridge the inequality. Instead of improving the competitiveness of labor force in a global market with changing mix of industries and required skills, governments have adopted the option "let them eat credit" (Chapter One's title). The presence of government-sponsored agencies in the United States enabled exercising such an option readily through a push for priority lending to the low-income households (sub-prime mortgages). In case of surplus countries, the single-minded focus on exports has led governments to ignore the domestic sector, preventing sufficient redeployment of surplus for internal development and somewhat perversely, boosted domestic savings rates significantly due to lack of adequate safety nets (at least in case of China, if not in case of Germany). The savings have thus had no place to go but to outside and ended up resulting in massive capital inflows that fueled the housing sector expansion in the US, the UK and Spain.While these government "failures" are themselves pretty interesting to have observed and highlighted, what is fascinating is how they interacted with each other - and with the financial sector - in fueling the expansion to levels that can be called massive housing bubbles. The idea here is that the invisible hand operating through the price when the price is distorted can lead to massive distortions in allocation of capital also. The financial sector in developed world is so sophisticated and amoral (a great choice of word by the author) that its dispassionate pursuit of profits leads it to direct capital to wherever there is a relative mis-pricing. So if governments are subsidizing home ownership, efforts will be made to deploy pretty much all available free capital of the world to that sector. If some governments are finding it cheap to borrow because savings are seeking them out, the financial sector will grow at a sufficient rate to absorb and support expansion through the capital inflows. While clearly there are some incentive-based distortions, especially short-term nature of accounting-based compensation that ignores true long-term risks, the book takes the stand, and explains it well, that the bigger issue was that the imbalance of capital flows and the ease of pushing sub-prime home ownership - both due to government distortions - meant the financial sector was essentially the conduit to make happen what the rest of the world was seeking to achieve. In the process, it made a ton of bad loans (but the governments were happy with that till it all really blew up). And some parts of the financial sector pursued this role even more aggressively than one could have imagined due to the steady entrenchment of too-big-to-fail expectations --- large banks being repeatedly bailed out through government and regulatory forbearance and enjoying Central-Bank monetary stimulus each time markets turned south. In essence, one walks away with an explanation of what brought about the perfect storm.Some may question the basis of this argument by saying - why did we see credit expansion across board and not just in low-income households. There are two important points the book makes. One, that once risk is mispriced for one investment (by governments for sub-prime lending), financial sector must demand similar return elsewhere. That is, there will be mispricing of risk across board. Second, the book focuses on a rather fascinating recent phenomenon that recent recoveries from recessions, especially in the United States, have remained "jobless" for extended periods of time. Perhaps as a subconscious response to this (or due to ideologies in other cases), Central Banks have tended to provide massive monetary stimulus to get the financial sector to push the real sector hard through greater lending and intermediation. Such stimulus, unfortunately, again serves to transfer rents from households to the financial sector (by keeping interest rates low) and produces mispriced risk and the economy moved "From Bubble to Bubble" (Chapter Five title), until the most recent bubble could not be mopped up by anyone, in spite of the efforts to do so.Those who have read Raghu Rajan's earlier book and research would recognize that his writings are always cogent and based in sound set of facts. But this book is more special in the sense that here he paints on a much larger canvas, covering bases from distributional issues within income strata of society, to the persistent capital imbalances across large countries of the world, and the power and ruthless profit-maximizing incentives of modern market-based financial sector. The point of Fault Lines is that these are slow-moving tectonic plates, neither movement might seem dangerous by itself, but that when these plates come together and collide, global economy can get badly shaken. To most minds that are focused narrowly on their own positions, let alone the movements of the plate they stand on, the earthquake - like this crisis - may seem sudden. The beauty of the book is in explaining that when viewed carefully, the crisis was not a pure accident and that more may arise in future unless the root causes are addressed sufficiently soon.While the book is worth it even just for its explanation of why we had a crisis now rather than at some other points of time in the past, it goes the extra mile and proposes valuable reforms - once again focusing on all three issues - building a better safety net in the United States (see in particular, the suggestions to improve education access to all), reducing the global imbalances, and improving the regulation of the financial sector so that they (and their financiers) pay for mopping up of "bubbles" that they create, rather than governments and Central Banks passing on these costs to taxpayers.As you can tell from this review, there is a lot going on here. But it is written with great examples and cases - almost allegorical at times (even has a fascinating poetry recounted in the chapter "The Fable of the Bees Replayed" ), and should be accessible to one and all. Not all may find it easy to agree with every single point (as it will certainly question some long-held biases about different countries and societies), but it is hard to not take a deep breath and ponder once you have read it all. In many ways, it shows that when economic conditions so demand or induce, developed world behaves much the same way as developing world: they are both after all driven by choices of human beings and the book lays out some common patterns of global economic behavior - in households, markets and governments.In summary, I recommend the book extremely highly and comment and thank Raghu Rajan for putting together this brilliant painting of global economy and finance, surrounding the arena of the recently witnessed crisis.- Viral Acharya, Professor of Finance, New York University Stern School of Business([...])

This book elaborately describes the underlying causes of the Global Financial Crisis - the income inequality, worsening of poverty, and the easy-and-quick (and wrong) political remedy by both President Clinton and President JW Bush. In short, this book forcefully demonstrates that GFC is a result of many structural issues that today's America - and to some extent Japan - face. And perhaps China. This sheds a light on how income inequality and easy access to credit is a toxic combination, and how AIG, Goldman Sachs, and all those big buys on the Wall Street managed to walk out of the crisis with a massive amount of bonuses and packages. As Jon Stewart said, we can no longer socialize the losses and privatize the profit. Moral and Economics is increasingly getting intertwined, and this is a great book to start to understand the interaction between them. This book also contains Asian Economic stagnation, which is less relevant, but you can skip those. Extremely well-written. Highly recommended!

A great and important read!

A plethora of books have been written about the recent and ongoing financial crisis. I recently read three in a row, from Martin Wolf, Hans-Werner Sinn and now this, from Raghuram Rajan. I'd like to compare these three authors. Each one of them brings a point of view, that is formed by their careers as economist as well as by their origin (British for the first, German for the second and India (but also US) for the latter. To put in a nutshell, the first of these authors could be characterized as an accountant (a mercantilist he was also called), the second is the classic (orthodox) economist - in German you'd probably also use the term Nationalökonom), but Mr Rajan among the three is the only modern economist. He understands that economics, first and foremost is a social science. In his elegantly written text, he touches a wide range of issues releated to this (these?) crisis. He not only touches the basic economics (balance of payments - which is all Mr Wolf has anything to say about), but also talks of institutions, human beings behaving in different situations, reacting to incentives. In a few sentences he better explains the workings of balance of payment issues than Mr Wolf in his whole book, but also explains other aspects of this crisis (risk taking by financial institutions, international economics, governance, etc). In short: a must read. It is by far a more complete Account of what happened and still happens then most others, bringing a fresh, modern, and truly international approach.

This review is for Rajan's other book - Saving Capitalism from capitalists, which is equally good.This book is an impassioned and erudite defense of the free markets enterprise system. Raghuram Rajan, a Chicago economist, currently the governor of the Reserve Bank of India, presents a breathtaking bird’s view of the development of the arm’s length financial system, variedly known as capitalism, globalization or the free markets system.The book’s title is revealing. Saving capitalism from the capitalists. The authors contend that capitalism’s worst enemies are the capitalists themselves. Who are these capitalists? The industrial and financial incumbents in a national economy, who conspire to stave off the financial markets so as to choke the sorely needed finance to those innovators and entrepreneurs who seem to threaten the existing economic order. These status quoists present the mortal danger to capitalism, the authors aver.The book is divided into 4 parts. The first part emphasizes the basic premise that finance liberates and goes on to prove it with empirical analyses. They beautifully juxtapose a poor stool maker in Bangladesh against the savvy MBA graduate in America, and draw an economic comparison that transcends narrow socio-political factors. Theirs is a simple, yet powerful argument. The arm’s length financial system, which they define as the one where the lender is at an arm’s length from the borrower (a Chinese wall so to speak), as seen in the equity and debt capital markets, enables even the most downtrodden in the society to rise above the perennial curse of poverty, when financial innovation and engineering work to present the needy with the capital to undertake simple entrepreneurial activities that would ensure his survival, and providing the investor with the requisite returns on the risks so taken.The authors’ main contribution is the delineation between the arm’s length and the relationship based financial systems in the capitalist world. The authors tear the mask off of the pretentious capitalists, thereby bringing clarity in the existing obfuscated notions about capitalism. Arm’s length financial system works by marrying capital and entrepreneurship without having them in direct contact. The capital markets such as debt, and equity epitomize this, where the investors or lenders in all probability never meet the entrepreneurs who are the ultimate users, underpinned by a solid, vigorous financial system, capable of evaluating and diversifying risk, through myriad players including credit ratings agencies, and regulators. Collusive practices borne out of years of constant touch, rampant in even the most regulated (in fact, even more so in the over regulated) of banking environments are minimal. A pre-emptive strike against corruption is achieved. The authors present the example of post war Japan. The Japanese banks connived to tie the Japanese corporations permanently to them. The public, reeling under economic hardship, were convinced that the villain was the capital market. The political class got together with the incumbents to form a Bond committee, whose permission would be required for corporations to issue equity or debt in Japanese markets, effectively placing the wolf in charge of the chicken coop. AAA rated Japanese companies like Toyota were forced to seek finance from the banks at extortionate costs of capital, said to be akin to daylight robbery by some historians. The general public had one important avenue of investment cut off. This went on unchecked for decades, the banks relinquishing their control only in the 1980’s in the face of international competition, which enabled Japanese companies to circumvent local markets and issue bonds in Europe. The authors conclude that for capitalism to succeed in improving welfare, vibrant capital markets must take root.Prominent economists such as Joseph Stiglitz, Amartya Sen prescribe sequencing of financial reforms to prevent crises such as the East Asian one in the late nineties and the one in Russia post the Soviet Union collapse. They posit that the domestic economy be exposed to stiff foreign competition only after the local companies have become stronger. The authors aver that it is precisely this policy that allows the incumbents to steal the thunder right under the nose of the avuncular, credulous public. They have enough clout to get protectionist bills passed through to the detriment of the larger public, have policies enacted that favor them. The existing banks have material private information about companies seeking finance due to the long term nature of their relationship, enabling them to hold these companies hostage. For should they refuse them finance, no outside entity would step in. After all, if the bank with its open access, deems the corporation unfit for financing, why would anyone else? The lot of the corporations is also not so bad. They may effectively be tied to the bank, but this lack of access to outside finance also means fewer upstarts competing for a share of the market. A cozy relationship emerges among the incumbents who all go to the same elite clubs and hatch closed door deals, putting a spanner in economic growth. Transparency is the first victim. And then the dark side of finance emerges-wastage of resources, value destruction, concentration of political power (resources) in the hands of the inefficient, prompting those with economic power to undertake fewer entrepreneurial ventures. The Bombay club in India, formed in 1993, was such an offshoot of the progenies of incumbent industrialists who had made merry during the license raj era and were now frightened at the prospect of foreign competition.Obscene corporate excesses and scandals, resulting in social and political upheaval become the norm. And the system becomes socialistic in character, albeit under the guise of capitalism.And uprooting these incumbents proves an even more daunting task than at the beginning. Only international competition forces them to give up their hold on power. A sequential reforms policy thus brings more harm than good. Trade and capital liberalization is the way forward for rapid strides in the economic arena.Give the capitalist system a chance, the authors plead. Not all financiers are the Shakespearean Shylocks. Excesses do happen and exacting a pound of flesh is surely an excess. But in a world where no effective mechanism exists for a guarantee of repayment of the invested capital, nobody would be willing to part from his capital, even at the most tempting rates, fearing moral hazard. It is also the financial system that comes up with innovations like reverse mortgage that give the elderly a shot at a respectable retired life, viatica that supplies the terminally ill with the much needed medicines, and health care.The question must come to the enquiring mind –if the capital markets are so good, why did it take them so long to arrive and why are they continuously challenged and threatened. And the authors do not disappoint on this score. They take the reader on an enchanting odyssey through the late nineteenth century to the present. Critically presenting, analyzing and dissecting the financial history. Their analysis of the emergence of free capital markets in the 1890’s, the flourishing in the first half of the twentieth century, and the subsequent suppression in the period between the two world wars that extended to the 1980’s is nothing but superb. They finely critique the process by which capital markets emerge-the resistance they face early on; the continuous challenges posed by the incumbent industrialists and financiers; and how circumstances conspire to tie the interests of the naturally antithetic classes ‘the industrialists and the workers’ together leading to their commingling. They join hands to demand protection from insalubrious competition-domestic and foreign. The politicians are spurred to action- imposing restrictions, quotas, tariffs. Financial markets are deliberately suppressed. The authors cite multiple empirical studies that show how such actions inexorably lead to an economic crisis.The arguments are persuasive, finely backed as they are, with empirical studies. After showing how the markets were suppressed till the 1980’s, they go on to show how the failure of Bretton Woods agreement led to their revival. The spectacular global economic rise in the past 3 decades was seen because of the reemergence of free capital markets. To put things in perspective, India’s own superlative economic performance came about only when the archaic license raj structures were pulled down in the early 1990’s. India’s public sector banks had also more or less stifled access to finance to all but a few, leading to the emergence of a few dynastic industrial houses, who were in the thick of things to pocket all the government projects and contracts. And in those days, corporate profitability was determined not by market competitiveness but by the government projects seized. A classical sign of the diseased relationship financial system. It’s the unshackling of the economy that led to India’s current position as an economic powerhouse.The book is structured into four parts, the first one champions the case of free capital markets, alleviating concerns about the hedonistic lifestyles and behavior of some financiers. The second is an exposition of how the markets emerge-the challenges (government, incumbents) to be overcome. The third is an analysis of the recorded history when the free markets were again suppressed, which ends with an investigation into the weaknesses of the systems that replaced free markets. The fourth and the most important is on- making markets politically legitimate, socially acceptable, and addressing the risks that are inherent, to make them more palatable.The authors advocate several policies to aid the suffering of those who get displaced in the ‘creative destruction’ of the competitive process. The unemployment debates raging on various political and policy fora are now spilling onto the streets. The cyclic unemployment, part and parcel of business cycles, which though painful, was accepted in the belief that when the economy starts booming again, the unemployed would regain their jobs. However, the 2000’s have shown a worrying trend. Jobless recoveries. Monetary and fiscal measures put the economy back on track, but investment doesn’t pick up, unemployment persists. Structural unemployment is increasingly replacing cyclic unemployment. Jobs are not temporarily unavailable, they are getting permanently lost. Technological innovations, brought about by the free markets enterprise, have made tremendous contribution in enhancing human knowledge and made life easier. But they have also made several human skills redundant. The jobs that are lost now are because of automation, not business cycles. This has made the unemployed see the capitalists as class enemy. Wall Street excesses, accounting scandals and exorbitant salaries highlighted particularly in economic downturns are making the public antagonistic towards the free markets. Calls to restrict foreign trade, protection for industries (championed by both the management and the workers- who fear losing their jobs) are becoming increasingly shrill. The authors provide the penetrating insight that, when everybody has open economies, it is difficult for a single nation to have closed borders. In the same way, when everybody starts enacting beggar-thy-neighbor policies by turning the spigot off, the incentives for domestic pro-free markets agents become weak (whose goods no longer have access to foreign markets) and economies become isolated, reducing the discipline imposed by international trade and competition, effectively putting the clock back.In times such as these, when lampooning globalization has become the latest fashion trend in the august drawing rooms of the intellectuals and the high society, this work is timely, and most sobering. It masterfully exposes the hidden agendas of the incumbents-industrial and financial and how those in whose best interests it is to embrace free markets unknowingly fall prey to them. It is not a diatribe against anyone or anything, which is too often the case with books that purport to educate its readers. It is an impassioned defense but with a healthy dose of dispassionate analysis. This book was written in 2003 (while the Indian revised edition was only recently released, to capitalize on Mr. Rajan’s popularity in India following his elevation as the governor of the RBI), but is even more relevant today with the 2008 financial crisis, Euro zone crisis and weaknesses in global economy, threatening to derail the good work of past decades. Raghuram Rajan who had predicted the 2008 crisis and has written a riveting book on it (Fault Lines), has again proved to be prescient with the kind of drama unfolding today in the debates about economics in a post crisis world that Mr. Rajan prophesied almost a decade back. Anyone with even a passing interest in economics and finance would surely find this book enriching. It also serves as a textbook outlining the financial institutions and markets underpinning the international monetary system. It should in fact be made required reading in business schools. The authors have a humble aim, which is to educate readers. Anyone, who ventured to complete it, would undoubtedly agree that it has done so.

Those who are in finance field I strongly recommend them to read this book once. Those who are not in finanace field I suggest them to read it to gain good knowledge about current economic crisis. Very good analysis by Dr R Rajan who currently hold the RBI Governor position in India. so many credentials on his CV. Really good book to read.