Summary: Fault Lines: Review and Analysis of Raghuram G. Rajans Book
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Rajan knocks it out of the park. By using simple yet illustrative anecdotes and explanations carefully chosen to illustrate the given phenomenon! Maligned at the time by many policymakers and academics, his speech proved prescient, and is now outlined for a broader audience to understand after the fact what he saw before. Further, it illuminates how these factors are still generating risk in the financial sector today.
With policymakers still too focused on basic factors such as unemployment and inflation in economic policy — instead of financial factors that exhibit highly dynamic and critical behavior — we are applying the wrong tools to the wrong target. This is exacerbated by the continued institutional misalignment of incentives in markets and political systems. Tying the present and past versions of these problems into a compelling narrative, Rajan explains how the same weaknesses culminating in the crisis of may strike again — then outlines both a set of fixes, and the roadblocks we should expect in their implementation.
Rajan proposes the interaction of an eclectic cocktail of factors ranging from economics and political science to psychology and education when constructing his explanation. The first of these is a credit expansion generated by the combination of inequality and short-term political incentives, while the rest of the book discusses factors that grew this expansion into vast imbalances then the largest crisis in recent memory.
Inequality has risen for decades. Accelerating technological development increased the need for high productivity workers above the capacity of an inadequate educational system to supply them, all while markets expanded due to Globalization. This led to an outsized portion of gains from growth to be accrued to these skilled workers at the upper end of the income distribution. Credit issuance was forced up and risk evaluations were forced down in a myopic attempt at placating the poor, distorting financial activity enough a tipping point was passed - tilting this initial expansion into a bubble, which fed on itself until large enough to tank the global financial sector.
International Trade and Financial flows — and therefore their role in the crisis - cannot be looked at in isolation. As developing countries became a larger part of the global economy, their export-led model required increased industrial country spending while generating excessive savings. This insatiable appetite for safe U. Lowered risk brings inflows.
Increased asset values and credit issuance often lowers risk evaluations through increased liquidity. Then lowered risk brings more inflows, and the cycle continues until it collapses. This initial distortion may not have occurred were it not for idiosyncrasies within the U. With the safety-net too weak to handle long-term unemployment unlike European economies the U. A heavily stimulative monetary and fiscal response pushed interest rates down and deficits up.
When financial markets have large credit growth or asset appreciation present throughout this time , the resultant demand alone can encourage more risk-taking — begetting more credit growth, asset housing appreciation, and risk-taking that perpetuate the cycle. When outside factors such as large stimulus further increase demand, the vicious cycle accelerates. By dealing with unemployment instead of well-masked financial imbalances, policymakers piled on the growing bubble.
With earnings as the sole measure of professional success in the financial sector unlike, say, teaching or engineering , maximizing self-worth, and therefore incentives both monetary and non-monetary , purely centered on maximizing returns. This can be done by beating the market, or by taking on excessive risk then misevaluating it knowingly or not to masquerade as having beat the market. With risk related to large-scale movements manifesting rarely, it can be difficult to tell the two apart.
After years of underrated systemic risk with losses pushed onto others, voices of moderation in the field were cast out as profit-killing pessimists. This culminated in mortgage companies pushing loans onto those completely unable to pay, which were bundled and sold as safe assets to investors unaware of their risk.
The initial credit boom, already further inflated by other expansionary factors, was pushed beyond dangerous territory. Low-rate policy put excessive pressure on financiers to generate returns by taking on high risk, while the implicit promise of bailouts from the government lowered the costs to doing so, eliminating the standard market mechanisms punishing those misevaluating risk.
This combination acted as a taxpayer subsidy to the financial sector — money managers reaped the gains from risky investments knowing taxpayers were on the hook if the risk manifested. Corporate structure in the banking sector, misaligned to reward short-term benefits to shareholders over long-term benefits to society, exacerbated human fallibility associated with risk assessment by pushing incentives away from socially optimal behavior. Human behavior is guided by incentives.
Any attempt to change it must start there. Absent this tool, monetary policy must acknowledge financial cycles then raise rates between recoveries — even at the cost of higher unemployment. Preventing institutions from becoming systemically important, while building buffers for when the system is stressed, requires avoiding government guarantees that drive excessive risk but still ensuring liquidity is available when needed — a difficult mechanism to design. Focusing on linkages, rather than institution size, and requiring the selling of instruments undertaking debt to equity conversions when stress thresholds are surpassed is a strong start.
If inequality resulting from an inadequate education system — and the use of credit to cover it up — sowed the seeds of the pre-crisis boom, expanding access to education must be part of the solution. This goes deeper than increasing funding to education. Most ills in modern society will not be solved with merely an increase in funding.
Gaps between the richer and poorer of society begin early; children of poorer parents often fall behind both cognitively and socially due to a variety of socioeconomic factors.
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When these gaps grow, they often last a lifetime. Early childhood and low-income family targeted measures are essential. Increasing worker retraining and mobility reducing barriers to relocation such as worker certification while restructuring the safety net account for the need for lengthened in a rule based system benefits — but only in serious downturns — will reduce the anxiety that forces heavy stimulus and drives bubbles. Policy change of this nature though is easier said than done. Higher hurdles stand in the way of international policy reform.
Economists have always been aware the actions of countries are interconnected — in this case export-led high-savings countries flooded low-savings countries like the U. However no mechanism exists to push net saving countries into increased spending to ease the burden of supplying global demand from industrial countries; indeed developing countries such as China and Vietnam argue a depreciated currency and export subsidies are necessary to grow in a world with built-in structural and first-mover advantages for industrial countries. Moderating capital flows presents even greater challenges; the integration of radically different financial cultures and institutions causes wires to cross with billions on the line.
Investors seek to avoid this risk by using flighty short-term debt, allowing wild financial flows that generate these crises. Were a perfect solution available political actors are still hamstrung by domestic constituencies — at the cost of global financial stability. Pushing reforms constituents fear through a system from which entrenched interests benefit is a herculean task — and international institutions have little leverage.
Rajan recounts his ill-fated pre-crisis series of globe trotting meetings to attempt just that as Chief Economist of the IMF. Rajan illustrates how the complex interactions of politics and economics melded with institutional incentives and human nature to culminate in the Great Recession. By acknowledging the difficulty of policy reform amidst a nod to the validity of both partisan narratives, he avoids the blame game in favor of an even-keeled discussion of why the crisis happened with ideas to avoid the next.
Why should you and I care about the rising economic inequality in the society?
Thoughtful, and beautifully written. Events proved him correct. There's nothing inherently morally culpable about agents rationally pursuing their own individual ends, nor are large institutions exempt from failure - Bear Stearns was hardly big, but its reach was pervasive enough for it to precipitate the financial crisis. This will lead to greater consumption and such changes which will fuel the world Economy. The book is full of insights with an optimistic discourse on future of economy. Only one word for it- fantastic! Oct 01, Anvesh rated it it was amazing.
In addition to the moral reason, Raghuram Rajan logically argues how economic inequality is one of the root causes of financial crisis and can ultimately make everybody including you and I worse off. His argument goes as follows. When there is rising economic inequality, the poor demand higher standards of living. To politically appease them, the government provides short-term solutions, in this case, easy credit fo Why should you and I care about the rising economic inequality in the society?
To politically appease them, the government provides short-term solutions, in this case, easy credit for housing so that everyone can own a house. The finance companies and banks have the incentive to take high risks in housing credit because i they expect the government to bail if housing credit system fails and ii there are many export-led economies Japan, Germany, China that have trade surpluses with the US that they want to invest.
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Finally, the housing credit system does break, pushing people out of their houses thier collateral , costing the US govt. Each one of these is a fault line in Raghuram Rajan's perspective and touches upon a variety of reasons that contribute to these fault lines. He talks about how the US was affected more due to its weak social security system, how risk is rewarded but not adequately punished in the financial sector, how trade imbalances can affect the global economy and the role that multilateral institutions like the IMF and World Bank can play.
Raghuram Rajan's breadth and depth of knowledge in this book is inspiring. However, the book does get a little dense with financial concepts in some places. A highly recommended read for anyone interested in general economics and finance. Aug 01, Ashutosh Dwivedi rated it it was amazing. Rajan writes in simple and easy to understand language relating concepts not just from financial economics but also from development, growth and welfare.
He takes turn by turn an opportunity to identify each of the players responsible for the sub prime crisis and provides an unbiased view of what happened and who was to blame, breaking down each concept and how it flowed through the system to cause the ripple effects that it did. A must read for all econ Brilliant.
A must read for all economics and finance enthusiasts to get an idea of how the bigger picture in the financial world looks like. Oct 22, Manognya Deepthi G rated it liked it. Unbiased book with a lot of insights. Definitely not an easy read for ones without a strong background in Economics. Sep 05, Raj Sinha rated it it was amazing.
A genius is one who can convert the HCF highest common factor of anything into its LCM lowest common multiple , be it economics, pure science, emotions, art form, anything Raghuram Rajan, by this definition , is pure genius. So if you are a layman and want to get some understanding about world economics, then read this simple book on a complex subject. Though a bit outdated first published almost 7 years ago I think , it still answers and yes it still warns. In a nutshell there are 5 reaso A genius is one who can convert the HCF highest common factor of anything into its LCM lowest common multiple , be it economics, pure science, emotions, art form, anything In a nutshell there are 5 reasons threatening the stability of world economy.
Huge income disparity between the rich and poor. Stagnant incomes of middle class. To make the middle class feel less cheated, economies or govts give cheap loans for cars, housing etc. Middle class forgets stagnant incomes. But one day the bubble bursts: The govt stops the sops, raises interest rates, prices go up So the first fault-line is the wrong and populist approach taken by the drivers of the local economy to give the middle class a misplaced sense of well being through cheap loans. One reason for huge income disparity is the difference in educational attainment in view of high technological demand for skills.
- Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram G. Rajan?
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Attainment of these skills through education is both expensive and beyond capability of the average person. Govts have pushed exports as an easy way out of a struggling economy due to undeveloped local organized structures and systems or even education that can create or sustain growth. Two outstanding examples are China cheap labour and tyrant govt and Japan Electronic and Mechanical expertise. In the pursuit of exports, these economies neglect domestic efficiencies Local business houses, due to lack of international benchmarking, continue to dominate locally in spite of being inefficient.
For example, Japan does not have an efficient banking system locally, China does not have an automobile of its own which can compete with international makes: China's main population continues to be poor. The rule of one child per family is making adults very savings conscious because of uncertain future well being.
All this has reduced domestic demand and consumption. On the other hand state owned or sponsored enterprises are investing in glamour areas: Will there be future well being to sell all this domestically when exports dry up? Japan did try to boost domestic demand by reducing interest rates so that people could take loans and buy and business houses would invest in industry but the underdeveloped banking industry could not judge well where to lend and where not to!
Hence when export demand goes down, these economies may well collapse. The third fault line - Developed countries have always exported more than importing because of superior products and better efficiencies. They were helped in their exports by developing countries seeking raw material and sophisticated machinery for giving them ability to become stronger and bigger global exporters and superior products for international benchmarking. But these countries had to borrow from foreign investors to have the money to buy machinery etc from developed countries.
But problem happened because the foreign investors mainly international banks flushed with the petro-dollar surpluses made investments in a highly one sided manner - this meant that because they were not confident of the countries they were investing in, the terms of investment were such that they could withdraw their investments at the first signs of things not going as per expectations.
This is what happened by and large. Developing countries were left with half completed or inefficient projects and also resultant large scale unemployment. Developing countries could not export to these countries anymore. Hence both developed and developing countries were left with overcapacity. Hence a global recession resulted. In this regard, India was relatively better off because as soon as foreign investments started getting available, it quickly liberalised and opened industries to the private sector.
Hence by withdrawing its own investments and spending, it did not further add to over capacity and surpluses and this lessened the negatives of global recession. It's domestic demand more or less took care of the additional capacities created through foreign investments. The 4th faultline is described as "jobless economic recovery". By economic recovery is meant the resurgence of demand after recession and hence re-creation of jobs. The 4th faultline is that in spite of economic recovery, in recent times it's been seen especially in the States jobs are not recovered in equal measure and as quickly as earlier times.
There are three main reasons for this: Old industries are giving way to new - from "steel" to "software" so to speak. Laid off workers find themselves ill equipped to handle these new job opportunities. They naturally find a lot of unproductive jobs that get created over a period of time in all organizations, especially if recession comes after a fairly long time.
So organizations permanently erase these jobs to cut cost. Therefore when economy recovers these slots remain unfilled because they have been identified as redundant. Hence even though demand for goods resurfaces, these jobs do not get recovered! They wait till the last moment and hence jobs do not get re-created as fast. Internet has also opened up the work force available in other countries. Hence jobs that do not involve physical presence at all, get outsoured. There is a fifth fault line.
Fault Lines: How Hidden Fractures Still Threaten the World Economy
That of rewarding investment bankers for generating super normal returns. Sounds paradoxical - but only so long as the issue is not examined more closely in the context of the great economic collapse as witnessed by America recently. For the layman this is best explained by the following example - a portfolio manager sells Insurance Policies against earth quakes. He promises high returns and collects premium from a huge band of investors. Earthquake Insurance is to be treated here as a simplified example. Since his logic is that earthquakes will not happen, all the premium collected by him are profits for the bank and it's investors!
The investor enjoys high returns, the bank earns high profits, the bankers get huge bonuses And this happens on a large scale. But earthquakes do happen.
The must-read summary of Raghuram G. Rajan's book: “Fault Lines: How Hidden Fractures Still Threaten the World Economy”. This complete summary of “Fault. The must-read summary of Raghuram G. Rajan's book: “Fault Lines: How Hidden Fractures Still This complete summary of “Fault Lines” by Raghuram G. Rajan.
And when that happens , the banks have to pay out such high redemptions to the many to whom the earthquake policies were sold that they go bankrupt! The faultline here is the difficulty in keeping a close track on the quality of the risks taken by investment bankers. So long as the going is good no one is bothered and in fact those are rewarded who actually lead to the collapse of the financial base itself. In the context of the World Economy, the USA, UK and Spain have been spending consuming more than they produce or earn, thus borrowing to finance the difference. China and Vietnam on the other hand have been doing exactly the opposite.
In the economic context these two sets of countries are at opposite ends of the global economy. Beyond a point the absence of an equilibrium will lead to collapse and this is what happened. So the way out is to reverse the equation. High deficit countries like the USA should reduce consumption and encourage savings this will lead to inflation and higher prices but for the long run this pill will have to be swallowed while developed economies like Japan and Germany with relatively low consumption should start consuming more.
As we have seen, these economies have developed through exports. They should now develop domestic industries like banking and retail for example and inject domestic growth and well being. This will lead to greater consumption and such changes which will fuel the world Economy. Their growth will become consumption led and the USA's economy will gradually come out of its high and unsustainable trade deficits.
To understand this point from another angle consider the following - China must induce domestic capability to consume or other developing countries should, to use up its huge production because America will not be able to consume so much of its production anymore. America and such like should cut debt based consumption and start producing more. China, Japan and such like should start consuming more Trade surpluses in some economies e.
China and trade deficits in others e. It's like asking the sales manager in the North zone to allow the sales manager in the South zone to sell in North because the first sales manager has crossed his target.
If both reach targets, all will get incentives for overall performance but the North zone sales manager will lose his personal extra incentive which he would earn if he does not let the south counterpart sell in his reserved territory! This is the reason why the International Monetary Fund IMF and World Trade Organization WTO are so ineffective in bringing about an understanding for global corrections in the world wide economy through global economic summits The solution is to make the bitter pill acceptable to the people so that their politicians lose the fear of losing their seats if they take local economic measures which are inconvenient to their people in the short term but which will eventually benefit them in the long term and in a more permanent manner because globally the economy will get balanced.
The way to get people to accept such measures is through the use of modern methods of communication and engagement with non political intellectuals and opinion leaders of countries. In short, the world needs Statesmen not Politicians. Ele, diferentemente dos outros, vislumbra o sistema financeiro apenas como um instrumento de um conjunto de incentivos perversos que criaram as bases para a crise. Experts analyse and debate recent developments across UK government, politics and policy.
Google Books limited preview Amazon Publisher Not only is Fault Lines the subject of countless reviews, but it was also named the Business Book of the Year by the Financial Times, 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.
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Sorry, your blog cannot share posts by email. We use cookies on this site to understand how you use our content, and to give you the best browsing experience. To accept cookies, click continue. To find out more about cookies and change your preferences, visit our Cookie Policy. But, the private sector must also bear responsibility for the fault lines that developed. Now, a mortgage banker originates the loan and sells the loan to a financial institution that will collect the payments made on the loan, but will then package the loan with other mortgages, sell the resulting security to someone else who will then receive the payments on the loan until this someone else decides to sell the security to another party.
Take the mortgage business, for example. A company that buys securities backed by mortgages assumes that the mortgages backing the security are well diversified geographically. However, if widespread household distress occurs, mortgages around the country begin to default and the riskiness of a portfolio of mortgage-backed securities increases. Liquidity risk may also increase at such times because the marketplace may not be able to handle the sale of lots of securities all at once.
Systemic risk is exacerbated as the combined increase of credit risk and liquidity risk compounds the problem. Many of the financial innovations created in the past fifty years have been purchased under the assumption that the securities acquired are independent of other instruments. We have learned that these instruments are not always independent of one another. The probability that these securities will not be independent may not be very high, but the potential costs of this loss of independence may be quite large.
The government has introduced moral hazard into this picture by providing protection against the downside.