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)