Fault Lines

University of Chicago economist Raghuram Rajan made news recently for his perplexing call on major central banks to raise interest rates (see here and a response from Paul Krugman here).  While his monetary policy advice might be a bit unorthodox, his recent book on the financial crisis stands out from the recent crop of titles as an important read.   The book is Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press).   The introduction is available for free download from the publisher’s website.    

What makes the book stand out is his attempt to look beyond the usual proximate causes to deeper determinants – or what he calls “fault lines”.   One may not always agree, but he is always provocative.   His fault lines include: the use of expansionary macro policies to (cheaply) ease distributional tensions in response to rising income inequality; an export-driven growth model in emerging economies that made it hard to absorb capital in non-traded sectors; and the legacy of the Asian crisis that convinced emerging-economy governments to build war chests of foreign reserves.  He also puts great emphasis on the role of implicit government guarantees in incentivising the taking of “tail risks”. 

I think the book is a good complement to the Honohan and Regling & Watson reports.   With differing emphases, the reports rightly point to the failures of key agents – bank managements, regulators and government.   But while the reports are good at describing what happened, the why was largely beyond their briefs.  

Rajan’s book is helpful in part because it makes us look beyond the more obvious agency failures to the failures of key principals – bank shareholders, politicians and voters (including their fourth-estate watchdogs).   What would the shareholders of the big two banks have done if management had refused to get involved in highly profitable development lending in the lead up to 2007?  What would politicians – government and opposition – have done if regulators had moved to curb credit expansion and prick a suspected property bubble?   What would voters have done if the government had moved to tighten fiscal policy while running budget surpluses?    There is a bit too much wisdom after the fact.  

A couple of extracts from the introduction give a flavour of the argument: 

[T]he central problem of free- enterprise capitalism in a modern democracy has always been how to balance the role of the government and that of the market. While much intellectual energy has been focused on defining the appropriate activities of each, it is the interaction between the two that is a central source of fragility. In a democracy, the government (or central bank) simply cannot allow ordinary people to suffer collateral damage as the harsh logic of the market is allowed to play out. A modern, sophisticated financial sector understands this and therefore seeks ways to exploit government decency, whether it is the government’s concern about inequality, unemployment, or the stability of the country’s banks. The problem stems from the fundamental incompatibility between the goals of capitalism and those of democracy. And yet the two go together, because each of these systems softens the deficiencies of the other.  (p.18)

We also have to recognize that good economics cannot be divorced from good politics: this is perhaps a reason why the field of economics was known as political economy. The mistake economists made was to believe that once countries had developed a steel frame of institutions, political influences would be tempered: countries would graduate permanently from developing-country status. We should now recognize that institutions such as regulators have influence only so long as politics is reasonably well balanced. Deep imbalances such as inequality can create the political groundswell that can overcome any constraining institutions. Countries can return to developing-country status if their politics become imbalanced, no matter how well developed their institutions. (p.19)

7 replies on “Fault Lines”


Your questions are rhetorical as we all know the answers – the bank managements would have been fired and replaced by personnel prepared to deliver quick buck returns to the shareholders. Politicians would have had their careers dramatically shortened; drummed out of their respective parties, savaged in the media and sneered at in the streets. Even as it was, there was a media campaign run by Independent newspapers in 2006/7 demanding the total abolition of stamp duty. The political class in general, government and opposition, were relentless in their demands for more and more government spending, lower income taxes, removal of more lower paid earners from the tax net entirely; removal of stamp duty up to purchase levels of €400k and so on. It’s the ‘ordinary hardworking people being put upon by a Scrooge-like uncaring government’ thesis. it just adopts different guises in varying circumstances.

The only tricky one is the voters. A lot of people, especially anyone working directly in or connected to the construction industry, knew that the game was up by 2007. What they were interested in was which set of parties in government was most likely to conserve as much as possible of what they had gained from the boom years. In the event, they voted for the less expansionary FF/PD menu rather than the ‘Mullingar Accord’ alternative. Not that it mattered since the whole thing went belly-up anyway.

I’m not convinced that social inequality creates as deep an imbalance in our society, or those of most other EU countries, as may be the case in the US so I’m not certain how Rajan’s argument applies to our situation.

@John McHale,

Many thanks for highlighting Prof. Rajan’s new book. And I think you are spot on about the current volume of “wisdom after the fact”. Not surprisingly, Prof. Rajan is very good on how the tide of financial de-regulation in the US and the political desire to conceal growing inequality swept away many of the time-hallowed checks and balances in the US system, but he is also good on the clash between “arm’s-length” and “relationship”-based transaction systems and the structural inefficiencies in the sheltered and non-traded sectors of export-focused economies.

Governor Honohan, in the part of his report where he seeks to refute accusations of blatant corruption, implicitly describes a “relationship”-based approach. The edifice of financial regulation was simply a facade to give the impression of an “arm’s-length”-based approach. But the regulatory system did provide teeth; the regulator was expected, and encouraged, not to bite. We are very fortunate to now have a regulator who is not afraid to; but he and Governor Honohan could do with more powers, particularly in the area of bank resolution.

There is considerable scope for increased efficiency in the sheltered and non-traded sectors – and “captured” regulation and an under-empowered competition authority are part of the problem. The political will does not seem to exist to tackle these, but even partial privatisation of some entities might shake things up.

As regards checks and balances in the political system, Ireland’s fiscal and economic sovereignty now resides in Brussels and Frankfurt – and possibly Berlin and Paris.

We’ll just have to wait for Sean Lemass’s rising tide and hope the oul boat isn’t too leaky – or too heavily ballasted by the blanket guarantee.

What would the shareholders of the big two banks have done if management had refused to get involved in highly profitable development lending in the lead up to 2007?  What would politicians – government and opposition – have done if regulators had moved to curb credit expansion and prick a suspected property bubble?   What would voters have done if the government had moved to tighten fiscal policy while running budget surpluses?  

As distinguished as he may well be, I don’t know if this economist has every taken a serious risk in his life.

Looking at his CV, he is on a lot of advisory boards and an adviser to the Indian PM – – he appears to be a good networker at least.

People take risks as entrepreneurs and yes, politicians sometimes do as Richard Bruton testifies to and front bench colleagues who have risked the chance of a ministerial career.

“I would rather be right than President,” Senator Henry Clay once said and a critic retorted: “Don’t worry. You’ll never be either!”

The status quo is however, the most comfortable position for most people.

Most times, few give a damn for sacrificial lambs, particularly when the money and conventional wisdom are sailing in unison.

So the big shareholders in banks are represented by what effectively have been deadbeat fund mangers, hewing to the consensus and having an overrepresentation in Irish equities; they generally were like pussycats when the news flow was good and it was only when the DCC insider trading issue became a public controversy, that they were compelled to act.

Of course, only a small number can beat index funds; so why would any of them do other than go with the flow – – just expect banks go on producing double-digit returns.

As for regulation in Ireland, there was never a chance that people who had spent decades in the civil service going with the flow, were going to change stripes in the autumn of their careers.

There is merit in Rajan’s argument that 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 US financial sector, with its skewed incentives, is the critical but unstable link between an overstimulated America and an underconsuming world.

McHale, you appear a mercantilist dupe. Thank you for making this clear by attempting to foist on us your cats paw, trying to worm his way into US favour.

You have let yourself down, but not your espoused “profession”.

You appear to fail to understand the nature of banking. No wonder the government of this country was so stupid. All it needs is a chorus of “economists” like you!

I would be hesitant to sing the praises of any ex-post analysis of the collapse done by anyone from Chicago or Minnesota.

Seems to be a school of freshwater ” too much gov” red herrings.

I left a related comment on John McHale’s subsequent blog entry, on Krugman v Rajan.

I bought ‘ Fault Lines: How Hidden Fractures Still Threaten the World Economy’ upon my daughter’s request (she is a post graduate student of Economics), but I too was interested in getting an idea of the book, because of the author’s star reputation.

I greatly valued the chapter on India (as far as I can recall, it’s called India: what lies ahead) as one of the best summing up of the socio economic situation of India at present. I found it illuminating and quite brilliant. Many of the things I had personally experienced, but not clearly understood, became crystal clear thanks to Mr Rajan’s exposition. For example, it’s the poor people who need the public sector (government) services, much more than the middle and upper classes, for example, health care. All the services we middle classes have access to because of affluence, which we obtain from the private sector, are denied to the poor, who have to rely on the indifferent, poor quality, degrading services provided by the government. Because of this, our (middle classes) lives are so much easier and better. In fact, with money, life in India is not bad at all but quite alright!
Mr Rajan has made it quite clear that India cannot really progress as a nation with such stark inquality in its society.

Mr Rajan’s grasp of the socio economic reality of present day India is masterly and presented in effortless and fluent language anybody can understand.

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