Faulty project fails to reach the core
The author offers a lucid account of the financial crisis, but his analysis is constrained by conventional economic theory and fails to delve beneath surface events and develop the science.
Fault Lines has a strong claim to be the economics book that best caught the spirit of 2010. Raghuram Rajan’s receipt of the Financial Times and Goldman Sachs annual business book award only confirmed his book’s widespread popularity.
It is not hard to see why so many people liked it. Fault Lines eschews hyperbole for a lucid and balanced account of the crisis. Rather than focus on a single factor the author, a professor at the University of Chicago and former chief economist at the International Monetary Fund, identifies three “fault lines”: domestic political stresses, trade imbalances stemming from prior patterns of growth and the interaction of different types of financial systems. Rajan then proposes policy solutions designed to tackle the weaknesses he identifies.
”Economic events can be driven by underlying forces of which the participating individuals are unaware”
The first fault line relates primarily to America. He argues that the most important factor here is the rise of income inequality. The stagnation of incomes among the mass of the population created an incentive for the government to encourage easy credit. Such an expansion all too easily turned into a credit bubble, particularly in the housing sector, which eventually burst with devastating consequences.
This section is particularly valuable as it provides a useful corrective to the common one-sided obsession with greedy bankers. Rajan shows how the authorities helped a credit bubble in several ways including keeping interest rates low, encouraging wider home ownership from the early 1990s and relaxing lending standards. Government sponsored agencies known as Fannie and Freddie also played a role by providing backing for greater lending. (article continues below)
The next fault line relates to trade imbalances between countries with large deficits (such as America and Britain) and those with large surpluses (such as Germany and many emerging East Asian countries including China). In many respects this is the flip side of America’s consumption boom. While America is both consuming and importing too much the surplus countries are consuming too little and exporting too much. Another way of putting this problem is that the strong exporters are saving too much and spending too little.
Finally, the effect of such trade imbalances are compounded by different types of financial systems in the Anglo-Saxon world and other countries. British and American banks emphasise transparency and the enforceability of contracts. In other countries, where financial institutions have often worked closely with the state to promote growth, public information is more limited.
For Rajan it was the combination of these fault lines that created the conditions for the financial instability and consequent economic downturn of 2008-09. In particular it meant that the American financial system experienced a sharp inflow of capital at the same time as it was taking excessive risks.
In many respects this is contemporary economics at its best. However, it also illustrates two pervasive and related weaknesses of the discipline.
First, the overemphasis on the financial system and corresponding lack of interest in the real economy. Rajan does not even consider the possibility that financial turmoil could be an expression of more fundamental productive weaknesses.
Second, the blithe acceptance of the conventional economic maxim that “people respond to incentives”. The point here is not that, as many behavioural economists argue, humans often behave irrationally. It is that economic events can be driven by underlying forces of which the participating individuals are unaware.
The goal of developing an economic science should be to penetrate beneath superficial appearances of how events unfold. Despite the comprehensive scale of Rajan’s analysis he fails to attempt this task.