Fault Lines: How Hidden Fractures Still Threaten the World Economy

Fault Lines: How Hidden Fractures Still Threaten the World Economy Review

Several books have been published in the last couple of years in the wake of the global financial crisis of 2008. While the crisis originated in the United States of America, it soon spread across continents thanks to the close inter linkages of economic and financial globalization.

Raghuram Rajan analyses the situation from a very different perspective, never attempted in any of the recent books on the topic. There is no single explanation to the crisis or a single silver bullet to prevent one in the future. This is because, just as in geology, there are several "fault lines" deep below the earth's visible surface, where the collision of tectonic plates causes severe jolts on the surface, there exist such fault lines in the global economy, argues the author.

First there is an excellent analysis of the American economy. Recessions and recoveries are a part of the economic cycles. However one needs to distinguish recoveries in output, versus the recovery in lost jobs. What seems to be happening in the recent decades is that recovery in lost jobs is taking substantially larger time spans than recovery in output. This means, there is a fundamental change in the structure of the economy as it recovers, rendering a portion of the earlier labor pool redundant. The economy needs skills backed by higher education, and those who are employed, contribute to the recovery due to higher productivity. Several jobs have disappeared as technology and innovation have changed the complexion of employment.

No wonder then that there is rising disparities in income with every economic cycle and higher levels of unemployment. The people at the bottom quartile are left jobless and poorer. Politicians come into picture at this stage. In the recent crisis, with no other option left, the political policy makers pushed for affordable housing for the poor. This policy directive soon translated into the housing bubble that we all know was at the root of the recent crisis. The interesting aspect of the book is that the author argues convincingly that it is unfair to blame only the banking system for the credit and asset bubbles. This was only a rational response from a sophisticated banking system to maximize their share of gains in the opportunity provided by the political mandate. Debt became so easy that "even a dog could get a loan".

Global financial system being closely linked, thanks to the electronic speeds of banking and innovative "products", what started as securitized debt soon was nothing but snake oil freely flowing into the coffers of unsuspecting investors across the globe. Bankers were looking for the edge and acting on incentives to maximize their "Alpha" by taking on more "Tail risk".

This is one excellent example of a dangerous financial fault line that occurs when politically motivated stimulus comes into contact with a sophisticated financial sector.

The second set of fault lines emanate from export oriented economies (typically the late developers) that are fueling the spending spree of the highly indebted developed countries. Countries like China, South Korea and Taiwan are now government directed, producer biased export oriented economies with "managed capitalism" that encourages exports and distorts global trade balances. Most of these countries had bitter experiences when short term foreign funds were withdrawn causing the Asian crisis in the late 1990's. The strategy now is do build up substantial foreign exchange reserves.

In the case of China, the thrust on export orientation has led to a weak renminbi policy. The Chinese central bank PBOC buys dollars of exporters and gives them renminbi to prevent it from appreciating. To avoid inflation, it issues its own debt to "sterilize" the excess renminbi. Holding a huge dollar reserve, it looks to invest in the United States where interest rates are low. This forces low interest rates on domestic renminbi, pushing up asset prices. The fault lines have now successfully traversed oceans and continents.

The final set of fault lines analyzed is those that develop when different types of financial systems come into contact to finance the global trade imbalances.

While countries like the United States and the United Kingdom have arms-length financial systems with high levels of transparency, the rest of the world has less transparent relationship based banking. These systems not only work on different principles, but also have different forms of government interventions, that inherently have a tendency to distort each other's functioning when they come into close contact, explains the author.

This book is a comprehensive, in-depth, impartial and a rigorous study of the current global economy and financial systems. In addition to the analysis, there are also a set of recommendations to avoid global financial disasters in future. While these recommendations are based on sound principles, their implementation will pose a huge challenge since there is no single global regulator who has the authority to regulate global financial markets. Independent countries will continue following policies that benefit them, even at the cost of hampering long term global stability and growth.

I rate this book as one amongst the best in the first decade of the twenty-first century. It can make a huge difference, if policy makers pay attention to the fault lines before we are jolted by a more severe and painful global economic quake.

Fault Lines: How Hidden Fractures Still Threaten the World Economy Feature

• ISBN13: 9780691146836
• Condition: New
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Fault Lines: How Hidden Fractures Still Threaten the World Economy Overview

Raghuram Rajan was one of the few economists who warned of the global financial crisis before it hit. Now, as the world struggles to recover, it's tempting to blame what happened on just a few greedy bankers who took irrational risks and left the rest of us to foot the bill. In Fault Lines, Rajan argues that serious flaws in the economy are also to blame, and warns that a potentially more devastating crisis awaits us if they aren't fixed.

Rajan shows how the individual choices that collectively brought about the economic meltdown--made by bankers, government officials, and ordinary homeowners--were rational responses to a flawed global financial order in which the incentives to take on risk are incredibly out of step with the dangers those risks pose. He traces the deepening fault lines in a world overly dependent on the indebted American consumer to power global economic growth and stave off global downturns. He exposes a system where America's growing inequality and thin social safety net create tremendous political pressure to encourage easy credit and keep job creation robust, no matter what the consequences to the economy's long-term health; and where the U.S. financial sector, with its skewed incentives, is the critical but unstable link between an overstimulated America and an underconsuming world.

In Fault Lines, Rajan demonstrates how unequal access to education and health care in the United States puts us all in deeper financial peril, even as the economic choices of countries like Germany, Japan, and China place an undue burden on America to get its policies right. He outlines the hard choices we need to make to ensure a more stable world economy and restore lasting prosperity.

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