Raghuram G. Rajan’s Fault Lines: How Hidden Fractures Still Threaten the World Economy, is an attempt to explain the worldwide 2007 financial crisis in terms of problems that are not directly visible but lie deep. These problems, which Professor Rajan appropriately calls fault lines, are hidden and this book is his attempt to uncover them, using logic and insight. Various commentators point to the two crucial factors responsible for the on-going crisis — excessive exposure of banks to risky investments and faulty regulation of financial institutions. Rajan argues very cogently that these two factors are only the tip of the iceberg, and that to understand the full dimensions of the proverbial iceberg, an in-depth analysis is called for. Rajan looks at the crisis through a series of political, economic and sociological developments which have recently become more salient in the US society. He integrates recent economic history, politics of democracy, compulsions of financial integration and globalisation to weave his story of what led to the crisis in a convincing manner.
However, Rajan’s approach may not be acceptable to the pure theorist for the right reasons as there is no theoretical framework in this treatise. It is well known that the crisis of 2007 could not be foreseen by any of the model makers — both analytical and empirical. In order to make their research acceptable to their peers, pure theorists and empirical model makers have to present neat and clean results. This is possible only by assuming away a number of messy realities. It is these realities, however, which many a time hold the key to understanding the phenomena as also help in pointing to the possible solutions.
Rajan traces the roots of different fault lines leading to the collapse of the US economy. Financial exuberance generated by low-interest home loans in the US is suggested to be related to growing income inequality. In the US, the top one per cent of households accounted for 8.9 per cent of income in 1976, and their share grew to 23.5 per cent of income by 2007. The reason for growing income inequality is the fact that the workforce has failed to cope with the technical and educational requirements of fast technological progress. For want of appropriate technical skills, most workers end up as office assistants rather than, say, qualified engineers. Cyclical unemployment has increased job insecurity and with the additional problem of stagnant salaries the worker class is restive. Politicians understand that it is not possible to redress income inequalities or educational disparities very quickly. The political compulsions of democracy thus prompt the political class to legislate for cheap home loans since home ownership is what provides a sense of belonging to the typical American citizen — immigrants included. This is what gave birth to sub-prime loans with full political backing. To this when profit motive of a highly competitive and scheming financial sector is added, the result is indiscriminate securitisation of all kinds of assets — good, not so good and purely toxic. The 2007 crisis is an eruption which, among other things, is related to this fault line.
In the US, one observes a very strong demand for consumer goods and also a growing trade deficit with countries like Japan, Germany and China. Household indebtedness is also pretty high. Rajan’s argument at this stage changes its focus from excessive consumption levels of US households to export-led growth of countries exporting to the US. He calls it dependency of exporting countries on consumption elsewhere and suggests that growth pattern of exporting countries is not balanced. The fact of the matter, however, is that these countries would not have grown so fast without their growing current account balances with a country like the US, with its seemingly insatiable demand for consumer durables and the US dollar being at the top among the preferred reserve currencies. The result is very large trade surplus vis-a-vis the US. This signals another fault line. The domestic standards of living in countries which export to the US are not so high as to absorb the exportable goods. In an integrated world, however, a dip in the US’ demand for imported consumer goods would spell havoc for excessively export-dependent economies.
Rajan acknowledges that the fault lines discussed by him lie deep and domestic political consensus on reforms is not easy to obtain. Yet he reposes faith in multilateral institutions to strive for the same and educate the concerned governments and other opinion makers about the hidden dangers of income inequality and growing trade surpluses with the same zeal which is observed in respect of dangers of climate change. Democracy and market-led capitalism have to learn to co-exist and pinning our faith in economic reforms and technological progress we share the optimism of the author that in the future the world would be a better place to live in.
Fault Lines is a reader-friendly book written in non-technical language. The critical issues of international finance and globalisation are discussed in an interesting style which should be quite intelligible to the common class of readers. For scholars in the area of international finance and globalisation this is a “must read”.
Professor B.L. Pandit heads the Department of Economics, Delhi School of Economics, University of Delhi
