Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

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 is tempting to blame just a few greedy bankers who took irrational risks and left the rest of the world to foot the bill. In Fault Lines, Rajan argues that serious flaws in the global economy are also to blame, and warns that a potentially more devastating crisis awaits if they are not fixed. Rajan shows how the individual choices - made by bankers, government officials, and ordinary homeowners - that collectively brought about the economic meltdown 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 economic growth and stave off global downturns. Alongside, America's growing inequality and thin social safety net create tremendous

Genres: Economics, Nonfiction, Finance, Business, Politics, History, Indian Literature

274 pages, Hardcover

First published May 4, 2010

About the author

Raghuram Govind Rajan is a world-class Indian economist who has also served as the twenty-third Governor of the Reserve Bank of India. He also serves as Eric J. Gleacher Distinguished Service Professor of Finance at the Booth School of Business at the University of Chicago. Rajan is also a visiting professor for the World Bank, Federal Reserve Board, and Swedish Parliamentary Commission. He formerly served as the president of the American Finance Association and was the chief economist of the International Monetary Fund (IMF).

In 1985, he graduated from the IIT, Delhi with a bachelor's degree in electrical engineering, and he completed his MBA at the IIM, Ahmedabad in 1987. He received a PhD in management from the Massachusetts Institute of Technology (MIT) in 1991 for his thesis titled "Essays on Banking".

Reviews

[Joshua · Rating 4 out of 5]

A very nice synopsis of the world economy following the latest financial crisis and directions on where we may be headed.
Some key points I took away:

*Three Major "Fault" lines where tensions create the possibility of future crises:
1) Domestic Political Stresses (need to deal with growing inequality)
2) Trade imbalances (America has been the economic engine by over consuming the rest of the world's output; the developing world needs to consume some of its own output)
3) Different types of financial systems (arms-length vs. relationship)

*The role of credit in America
1) Starting in 1991, recessions have mostly been "jobless", where subsequent increases in output are not accompanied by new jobs. Inefficient jobs are shed and replaced by more efficient technology.
2) Politicians look for quick fixes to unemployment, and instead of focusing on the root cause (retooling workers/ improving grade school education) they promote easy credit so that consumption can increase even without an increase in wage. Promoting home ownership is a key part of this strategy.
3) Low interest rates are an implicit transfer from savers to consumers
4) The lack of a strong safety net (unemployment insurance and health coverage) increase the anxiety of the jobless, and push politicians to more extreme and abrupt actions (putting out fires) instead of more carefully addressing the core issues
5) There has been a change in mentality; no longer possible to become wealthy. Land of opportunity now closed

*The role of Exporting
1) Developing countries need both physical capital (machines) and organizational capital (companies to service those machines and their supply chain)
2) Institutions develop along with economies, not before them
3) Crony (managed) capitalism is an important step in an economics early stages
4) US managed to consume the world's output, financed by their savings

*The Path of Crises
1) excessive investment in a new technology leads to a bubble (railroads, tech stocks, real estate, etc.)
2) One ore more companies begin to falter, creating anxiety among investors who promptly flee the market
3) Economy crashes and currency devalues. Debt burdens increase, and countries are unable to meet their debt obligations

*Reforms Proposed
1) Use contingent regulation (need regulation to automatically be tougher when things are going good and lenient when things are going poorly)
2) Use lagged public disclosure of risk by regulators to maintain the effectiveness of regulators
3) Use bonus escrow accounts, where subsequent losses are clawed back from these pools
4) Public disclosure of a "living will" on how financial companies would unwind under distress to discourage a bailout belief
5) Get government out of housing
6) Do away with deposit insurance (an unfair source of subsidized financing, and unnecessary for investors when there are other equally safe places to invest, such as treasury bills)

[Jim · Rating 4 out of 5]

Rajan does an exceptional job of distilling the factors leading to the 2008 financial sector meltdown, linking the actions of government (both US and world governments) and the private sector, and dispassionately describing the various ways they contributed to the creation and bursting of the bubble. He also makes some very cogent and disturbing points about the lack of correction (and in some cases, exacerbation) of the "fault lines' he identifies in the world economy, which threaten to push us through the entire cycle once again. Having served as Chief Economist of the IMF, his world macroeconomic perspective is broad and very enlightening, as well as impressively non-ideological (unless you think viewing the crisis through the lens of economics is inherently ideological, in which case good luck with fixing economic policy).

Rajan's prescriptions are common-sense, but overly broad in some ways. His discussions of direct monetary, fiscal and trade policies are pretty straightforward, and can be implemented by governments without too much upheaval, but some of the subtler ones are stickier. He talks about improving early education in America, for instance, but without a clear roadmap (politically or policy-wise) for doing so. That would probably require another book all by itself, but you'd like to see him take more of a stand on how to get from here to there. Perhaps he doesn't like to do that without subjecting his conclusions to the same level of rigor, which is fair, but it leaves those sections feeling a bit hollow. All in all, though, it's a pretty short and easy, but comprehensive, analysis of the causes of our current economic woes, and how to avoid subjecting ourselves to further wild, cyclical booms and busts.

[Lobstergirl · Rating 4 out of 5]

Economist Raghuram Rajan was one of the prescient ones: at a central bankers' conference (honoring Alan Greenspan no less) in 2005, he delivered a paper asking "Has Financial Development Made the World Riskier?" His answer was yes. Events proved him correct.

Here, he uses a wide-angle lens to examine the causes of the 2008 financial crisis, and why we're nowhere near out of danger. A stint as chief economist at the IMF means his perspective is global; understanding growth patterns and rates in developing countries, and financial crises such as the Asian meltdown of 1997, help us understand what's happening in the U.S.

He argues that interest rates were kept very low - credit very loose - in order to help the lower class get a leg up. Since their income had stagnated, and since better education to pull them into the middle and upper classes is a very long-term solution and thus extremely difficult to achieve politically, policymakers helped low-income Americans achieve a higher standard of living by allowing them to buy homes and pull equity out of their homes. Needless to say, this went on too long, and the real estate bubble was created. Americans overconsumed, took on onerous debt, and thus enabled the countries we were buying from, mainly Germany, Japan, and China, to shortchange their own economies by relying too much on growth from exports.

If we had a stronger safety net in the U.S., Rajan argues, we wouldn't need to rely on fiscal and monetary policies to provide stimulus to the poor and/or unemployed. When the Fed, the Treasury, and politicians use stimulus this way during jobless recoveries, whether by keeping interest rates extremely low or passing legislation to pump billions into the economy, it has unintended and damaging consequences: it creates bubbles, it advantages debtors and disadvantages savers, it's a gigantic giveaway to the banks, it artificially props up the housing market and housing prices, and it warps incentives in the financial sector.

Rajan urges reforms in two areas: the financial sector, and the safety net. In the financial sector, incentives are dangerously aligned with taking on risk. Wall Street assumes that certain institutions will be bailed out if they fail, and they are correct in this. Rajan uses the phrase "too systemic to fail" rather than "too big to fail," because it's not size but interconnectedness that determines when government will step in and rescue. Government rescues must stop, because they distort the entire financial sector. Financial institutions should know what their risk exposures are, and this information should be made available to the markets on a regular basis; during the financial crisis, many companies had no idea how much risk they had taken on. If this information is widely known, it can be used to prevent institutions from becoming "systemic." He proposes that financial institutions have a "living will:" in the event that they are going to fail, such a "will" would involve regulators in quickly winding down (resolving) the company without massive, systemic damage. In order to more properly align individual risk-taking with compensation, he proposes holding a significant chunk of a financial company's bonuses in escrow, to be paid out only after it is clear that trading positions have been profitable. He also suggests phasing out bank deposit insurance, since a money-market fund invested in Treasury bills is just as safe as guaranteed bank deposits.

Reforming the safety net needs to be another top priority. Recessions have changed, in that the last few recoveries have been jobless, and our current system of unemployment benefits is inadequate in the face of extended periods of joblessness. Politicians respond to the needs of the unemployed in ad hoc ways, and as we've seen recently, they have held benefit extensions hostage to the passage of other, unrelated legislation. Rajan suggests that we tie benefits to a formula which would take into account the extent of overall job losses, "the proportion of jobs created to jobs lost, and the time elapsed since the recession began." He also proposes a system of universal healthcare, given that job loss nearly always comes with a loss of health insurance as well.

I enjoyed Fault Lines. I found it highly readable. There are some areas where, although clearly informed, Rajan seems a little out of his element (the discussion of healthcare, perhaps). He also is overly wedded to the notion that Fannie and Freddie and the affordable housing mandate are to blame for most of the mortgage crisis: "It is difficult to reach any other conclusion than that this was a market driven largely by government, or government-influenced, money." Indubitably Fannie and Freddie have to take some of the blame, but as others have demonstrated, it was Wall Street which created the intense and insatiable demand for subprime mortgages; Fannie and Freddie were actually latecomers to the subprime frenzy. As Bethany McLean and Joe Nocera showed in All the Devils Are Here: The Hidden History of the Financial Crisis, Fannie and Freddie raced to get involved in subprime mortgages because they feared being left behind by their private sector competition.

[Anushree Rastogi · Rating 5 out of 5]

Very well articulated, Prof Rajan had not hesitated from making his opinion on most aspects quite clear. Hence the book is not just another case of fiscal and monetary policy levers explained, it takes a stand and from what I see 7 years later in 2017, quite a prophetic stand at that.
Provides for an insight into the paths countries use to develop, asset pricing and the role Central Bank needs to play in asset price regulation and where the government should draw a line when deciding on economic policy.

[Dorotea · Rating 3 out of 5]

Rajan raises some very good points that are sources of concern - fault lines as he calls them, namely: 1. Income stratification leads to loss of the belief that hard work will payoff
2. Education system (also see stagnating college graduation rates) > more low-income
3. Cheap credit (quick fix)
4. Lack of social safety net (unemployment insurance and health coverage)

I agree with the fundamental message (he financial sector was at the center of the last ciris, but it simply responded to implicit and explicit incentives that the system created, therefore we must look for deeper causes in the system).
But to the day, Fantacci's work (both The End of Finance and his paper ' From the Great Depression to the current crisis: more than analogy, genealogy') remain the foremost thinking on the topic.

[Venky · Rating 4 out of 5]

In the year 2005, the annual Jackson Hole Conference - a prestigious event where there is an assorted convergence of highly reputed bankers, economists and financial journalists - was supposed to be a swansong bash celebrating the achievements of the Federal Reserve Board Chairman, Alan Greenspan. Speaker after speaker showered adulation and sang praises of the man who stymied all efforts to regulate the spawning of esoteric financial instruments and who also ironically coined the now legendary epithet, "irrational exuberance". However an economist who was also the chief advisor to the International Monetary Fund ("IMF"), proved to be the canary in the coal mine pouring cold water over the warm sentiments of the participants at the conference. Raghuram Rajan presented a paper which boldly cautioned the optimists that the global economy was sitting at the cusp of a disastrous recession. As expected Rajan was roundly criticized and scorn was heaped over his analysis. In 2007, the world plunged into an abyss of economic crisis, the last of which was experienced in the year 1929. The Cassandra from the IMF was proved to be the prophet - albeit of doom.

In this book, Rajan delves deep into what he terms to be "faultlines" rupturing the fragile financial and economic fabric of the world. Overheated economies banking on producer bias, monetary policies deliberately keeping interest rates at ridiculously low levels with an intent to creating stimulus, predatory lending policies followed by avaricious bankers and mortgage brokers, a revolving door policy which ensures that there is no clear lines between those signing off billion dollar bailouts and recipients of such largesse, are a few telling factors which Rajan identifies as causing a clear and present danger to global economies.

Rajan does not merely identify the current and probable ailments. After diagosing the disorders with precision, he also goes on to prescribe remedial measures. Appropriate levels of financial regulation, more recognition to risk managers instead of for traders, diversification of credit and a rational and measured access to credit targeting the low income group borrowers are some of the primary ameliorating mechanisms suggested by Rajan. In addition to economic prescriptions, Rajan also holds forth on social aspects such as improving the access to and quality of education, keeping in check poverty and race based discrimination and adult education.

Following the epilogue is a fascinating chapter on the future prospects of and for India as it marches onward with great determination towards being not only an economic behemoth but also a socioeconomic superpower having an indispensable influence over the global economy and world markets.

"Fault Lines..." - Makes for a tectonic impact!

[Justin Tapp · Rating 3 out of 5]

This is one of the books on the 2007 financial crisis that is ostensibly worth reading due to the CV of the author-- former IMF Chief Economist, later in charge of Indian monetary policy as Governor of the Reserve Bank of India. (Writing this in late 2016, perhaps PM Modi's botched reforms show how much Rajan was missed in opting to return to academia than return as Governor for a second term). Rajan has international gravitas and has thought about poverty and development in multiple ways. I would probably have enjoyed Saving Capitalism from the Capitalists (2004) more, but this book was available and I trust it contains similar criticisms and policy prescriptions. I read a host of books on the crisis while/after it was happening because I was teaching undergraduate economics full-time. For a list of a few I would recommend with this, see below (or my Financial Crisis bookshelf on Goodreads).

Rajan is famous for showing up at the Federal Reserve's Jackson Hole retreat in 2005 and warning of the CDO time bomb that no one wanted to hear about; it was ticking while everyone just wanted to praise Maestro Greenspan out the door. Mr. Rajan is apparently unwilling just to rest on that career highlight for credibility, he seems to have to throw some bones to the liberal establishment in an effort to be taken seriously while he adopts some critiques of the US government that have been rejected by left-leaning economists. As a result this book pivots from the financial crisis to education and health care reform, sometimes using examples from India as prescriptive and ignoring the various nuances of programs like Medicaid across 50 separate states. He adds little to reform proposals made by others and closes with vague but wide-sweeping policy prescriptions and new spending programs while somehow ignoring the massive risk the US faces in its long-term debt position vis-a-vis Medicare, not to mention trillions in unfunded pension liabilities.

Rajan is interested in identifying systemic fault lines. This is difficult to do in practice, just read a Nassim Taleb book-- even if you identify it you cannot be assured of diversifying it away. (You might reduce volatility in the short run, but make the fat-tail risk larger.)
The biggest fault line is that the goals of capitalism and democratic politics do not align. Another is the rise of inequality, the top 10% relative to the bottom 90% (now the gap is widely debated after Pickety's book came out and Emmanuel Saez put out his paper that the gains to the top 0.1% explains almost all the 90/10 gap). Rajan speculates that the 90/10 wage differential is driven by the increasing college education premium-- those being left behind are largely the lesser-educated. Perhaps 1/3 of the inequality problem may also be a picture of entrepreneurs and graduate students going from very low incomes as they start out to very high incomes later--ie: mobility matters and may make the inequality problem look worse than it really is. Assortive mating may also explain some of the inequality-- similarly educated/income class people marry people from the same class.

Rajan explains the housing bubble as a response to "insecurity" of middle-class wage stagnation. People envy the upper incomes getting richer and compensate by saving less and borrowing more. One way to quence the insecurity is to buy a house. Housing demand aligns with the goals of politicians-- to increase private wealth, property values (and local tax revenue), create jobs for lower and middle class voters (construction), demonstrate "development" and so forth. There is also the belief espoused by every President in the last 100 years of the "ownership society," when people own rather than rent they take better care of their property and society is better off. Hence, the government likes to find ways to encourage home-building, such as subsidizing low-interest loans and making mortgage interest tax-deductible. (See Ferguson's Ascent of Money for a more complete take on this history in the US in the 20th century.) Rajan begins his blame with the 1960s in privatizing Fannie Mae and Freddie Mac, and the 1970s-1980s deregulation of thrifts. While privatized, there was still an "implicit guarantee" on Fannie and Freddie's debts, particularly in the eyes of foreign creditors. (I once heard a talk by St. Louis Fed President Jim Bullard about the anxious days of the crisis when Bernanke was dealing with such creditors and quite angry. While Paul Krugman and others on the Left wanted to basically absolve Fannie and Freddie from guilt, Rajan rightly holds them and their political enablers accountable. While Rajan blames the Bush administration for further pushing home ownership, he neglects that Mankiw and others tried to deal with the implicit guarantee problem.) The Clinton Administration pushed to dramatically decrease the downpayment required for an FHA loan, and the Bush Administration further accelerated this. From 2002-2005, zip codes with lower incomes saw the most dramatic increase in housing investment. This is politically feasible until the buyer can't make payments, the adjustable interest rates go up, etc.

Chapter Two examines the export-led growth model (for which Yergin and Stanislaw's Commanding Heights is an excellent history and reference). Rajan critiques the "Washington Consensus" of limited government intervention in the economy to stimulate private-sector growth through exporting to the developed world (Stiglitz's Globalization and Its Discontents is another helpful book here). Rajan writes that while an export-led model allows for growth and innovation even in a command economy, export-led economies find it difficult to switch to the service sector after they have matured (ie: after incomes have risen considerably). Japan is one example of this phenomenon, having built an export-led model of exporting vehicles and electronics, and now being dependent on other countries' stimulating their own economies in order for Japan to grow again. This is a major fault line for the world economy. Rajan discusses the Chinese model as well, noting that China's one-child policy boosted its savings rate because the social safety net of parents relying on children can't be present with such a policy. Hence, capital flows to the US and boosts the value of the dollar and helps stimulate Chinese exports. The US' "jobless recovery" of the 2000s, which the Fed responded to with low interest rates, may also have been affected by China's refusal to revalue the yuan during that period.

Rajan recounts the controversial IMF decisions aiding the East Asian financial crisis of the 1990s. Surprisingly, Rajan never mentions the role of the collapse of Bretton Woods (under Nixon) in the capital imbalance problem. The US "closing the gold window" on the balance of payments made the US dollar the default reserve currency of the world and boosted it to a seemingly permanently strong status relative to other countries, which helped start the export-led model in the first place, as well as America's penchant to borrow to fund its deficits. These are not easily reversible. Rajan also seems to ignore the effects lifting of capital controls during the same time period. As a result of these things, which Rajan does not spell out clearly, the Federal Reserve's monetary policy is exported to the rest of the world. Rajan blames the Fed for "blowing up the housing bubble" without spelling out the history clearly.

In examining Fed policy, Rajan critiques the "Greenspan put," and the willfull ignorance of rapidly increasing asset prices at the end of the Greenspan era. Rajan essentially makes contradictory statements about the Fed's ability to identify and limit asset bubbles. He blames the Fed for not deflating the housing bubble while acknowledging the problems of such a policy change. He writes the Fed should have triple mandate of looking at asset prices and risk as well as inflation and unemployment. (Many economists have written on the difficulty of such a policy.)The Fed ignored the effects of strengthening the 1977 Community Reinvestment Act that was pushing banks into loans in communities where they would most likely be defaulted on. (Congress basically absolved the CRA, as did Ben Bernanke, but conservative economists and politicians have tended to agree with Rajan.)

He doesn't just blame the Fed, he examines why so many banks kept risky assets on their books, buying into their own fantasies (see The Big Short for how different arms of banks took sometimes opposing trading positions). The main problem was that the risk was not properly priced into the assets. Credit default swaps were undervalued and houses were overvalued. Rajan also explores the problem of "too big to fail" and systemic risk. Does the financial sector allocate capital efficiently? No, not if assets are mispriced due to the undervaluing of risk. He proposes the common-sense solution of ending government subsidies to financial institutions anad implicit guarantees. Given that little has been done to reduce the subsidization of housing in the US and institutions like the FHA still take very low downpayments and banks were allowed to get even bigger, even common sense solutions run into political realities and cognitive dissonance. Nevermind the "cycle-proof regulations" that Rajan proposes.

Beyond government subsidies, Rajan encourages actions in the private sector as well. We have to find ways to eliminate the temptation of bankers to take on "tail risk." That would require a real change in how CEOs are compensated. Rajan wants corporate boards to have members with more financial expertise. He also wants standardization of assets to make them easily comparable and easy to see what's inside. He calls for breaking the problem of "cognitive capture" of regulators and policymakers. He wants to end "too big to fail" and prohibit mergers and somehow measure intertwined exposures to measure the real systemic risk of institutions. Perhaps thinking from an IMF standpoint, he proposes a limited "systemic bailout fund." (The Fed and Treasury were able to use such thinking when they bailed out Mexico under the Clinton Administration.) But, how big should such a fund need to be and wouldn't it be tempting for Congress to tap into it for bailing out, say, an auto industry or defense contractor? Rajan doesn't give many details. All of these proposals have been echoed by economists and politicians on the Left and Right since 2010, but little has been done. Whatever little Dodd-Frank did to increase regulations of the financial sector, President-elect Trump publicly put immediate repeal into his platform.

Sadly, he would rather the Federal Reserve pursue the more complex triple mandate and makes no mention of the idea of a Nominal GDP target which is disappointing to me (a market monetarist whor reads Scott Sumner and David Beckworth). Instead, he goes on a longer rant with little to do with economic or monetary policy and sounds like he's running for public office with a bunch of vague policy prescriptions: We need to "work on things that work." The US needs a longer school year and better teachers. We need universal preschool and subsidies for nutrition education and free lunch. We need to reduce unequal access to education to attain human capital. Universal health care and other health care reforms that (look a lot like the Affordable Care Act). We need to examine a value added tax and a carbon tax to reduce the deficit (without mentioning how much wider the deficit would be with his other policy proposals). At the same time we need to reduce the deficit, we need to increase household savings. There's not much call for sacrifice here. No mention of the $2-$3 trillion in unfunded pension liabilities the 50 state governments and various localities have to deal with. I could go on.

Rajan closes by explaining IMF policy and the various debates and controversies that surround it. He advocates customized policy and not "one size fits all," "Washington Consensus"-style policies. He encourages multilateral cooperation, which always conflicts with the local politics of sovereignty, but multilateral agencies like the UN, IMF, World Bank "should be given the benefit of the doubt." Rajan doesn't seem to notice that history often repeats itself worldwide and people are largely ignorant of history. If he really thought about all the systemic risks out there, and how we're ignoring them (unfunded pensions, climate change, the growth of nationalism, etc.) it would basically spell doom for us. He somewhat addresses this in the epilogue, but not satisfactorily. Three stars out of five. He has succeeded in identifying several global financial fault lines but also ignored or not seen others.

----------------------
Some other books on the global macroeconomy and financial crises I recommend as a prerequisite for this book:
The Commanding Heights by Yergin and Stanislaw.
The Ascent of Money by Niall Ferguson
Fooled by Randomness (or other works) - Nassim Taleb
The Misbehavior of Markets - Benoit Mandelbroit
Globalization and Its Discontents - Joseph Stiglitz
Irrational Exuberance - Bob Shiller
Specific to 2008 crisis:
Slapped by the Invisible Hand - Gary Gorton (recommended by Ben Bernanke)
13 Bankers - Johnson and Kwak (Johnson former IMF Chief Economist)
The Big Short - Michael Lewis
The Subprime Solution - Bob Shiller (on how to better price risk)

[Fateh Mann · Rating 5 out of 5]

India's new RBI chief has a lot of expectations on his shoulders, and this book shows why. His analysis is holistic, comprehensive, convincing and rational. He traces the roots of the crisis to at least 40 to 50 years before, and takes it from there on. For a person who hasn't actually studied economics, it will prove to be a terribly difficult read because 1) in terms of writing style, he's not exactly a Rushdie and 2) For the prevalence of many complex terms. This book isn't for the casual reader, but persist and you will be rewarded with a rich knowledge of the crisis, coming from a man with incredible pedigree

[Abhijeet · Rating 5 out of 5]

Great reading which covers events outside the US as well highlights the hidden faultlines in the global economy. This could be described as Rajan's pitch for the CEA/RBI guv role given the wide ranging problems highlighted and solutions proposed. Cash transfers to the poor are proposed and land acquisition issues as an impediment to growth are currently highlighted given this was written 5-6 years ago. The aside on India personally was of great interest to me but even the piece on China was quite informative. The book is as centrist a solution as can be proposed by an academic and is commendable given it was written when the US had plumbed to the depths of the crisis.

[Anvesh · Rating 5 out of 5]

I'm glad to have finished my 31st book for the year 2018 and it turned out to be really insightful one. Having seen so many news about how greed of bankers is blamed for crisis vs ineptitude of government regulations, finally someone who provided a view of systematic fault lines that could cause one more such crisis if not addressed to early.

The explanation of fault lines along with economic lessons in each chapter really makes you think if there is a better topic than macro economics and better teach than RR. A must read for everyone who is interested in economics/general politics/awareness.

[Anand Iyer · Rating 4 out of 5]

Fault Lines provide a flawless albiet a theoretical analysis of Financial Markets, Governments and their interfaces. While issues he raised relèvent, solutions are more academic in nature which he concedes as a platform for initial discussion than a panacea. While some after thoughts of the crises is mired in its myopic observations, others especially views on developing economies and multi national organisations prescient and accurate.
Any aspiring Financial or Economic graduate must have this on their must-read shelf!

[Manish · Rating 5 out of 5]

One if the best book for understanding recent economic crises and what may be in store for future!!

[SWAROOP CHOUGULE · Rating 5 out of 5]

Raghuram Rajan, the rockstar ex-RBI governor was one of the few economists who warned of global financial crisis of 2007-08 before it hit. In Fault lines, Rajan says just like fault lines in tectonic plates run the danger of earthquakes; global economy has some deep fault lines which led to economic crisis in 2007-08, and if not fixed could lead to more devastating crisis. Rajan shows how choices made by bankers, government and homeowners were rational responses to incentives to take on risks brought about the financial meltdown. In all, he suggests, to make the global financial order robust some hard choices need to be made by getting the policies right, and focusing on long term prosperity over short term gains.

[Samridhi Khurana · Rating 4 out of 5]

As an economist and exemplary academician, Rajan has looked beyond the convenience of targeting the government and greed of the finance world as the only reasons for the financial crisis of 2007. He hasn't shied away from holding them responsible, but at the same time has provided a more holistic view to explain the global economic meltdown of 2007.
Thoughtful, and beautifully written.

[Smit · Rating 4 out of 5]

Surprisingly succinct and insightful. The lessons from crisis seem completely relevant even today. The author does a good job of covering the different factors at play though I feel the socio-political complexities were a little glossed over.

[Karthik · Rating 5 out of 5]

Why should you and I care about the rising economic inequality in the society? In addition to the moral reason, Raghuram Rajan logically argues how economic inequality is one of the root causes of financial crisis and can ultimately make everybody (including you and I) worse off. His argument goes as follows.

When there is rising economic inequality, the poor demand higher standards of living. To politically appease them, the government provides short-term solutions, in this case, easy credit for housing so that everyone can own a house. The finance companies and banks have the incentive to take high risks in housing credit because i) they expect the government to bail if housing credit system fails and ii) there are many export-led economies (Japan, Germany, China) that have trade surpluses with the US that they want to invest. Finally, the housing credit system does break, pushing people out of their houses (thier collateral), costing the US govt. (and taxpayers) a fortune and affecting the global economy that invested in this market.

Each one of these is a fault line in Raghuram Rajan's perspective and touches upon a variety of reasons that contribute to these fault lines. He talks about how the US was affected more due to its weak social security system, how risk is rewarded but not adequately punished in the financial sector, how trade imbalances can affect the global economy and the role that multilateral institutions like the IMF and World Bank can play. Raghuram Rajan's breadth and depth of knowledge in this book is inspiring. However, the book does get a little dense with financial concepts in some places. A highly recommended read for anyone interested in general economics and finance.

[Jayesh · Rating 5 out of 5]

Was good to read right after Goliath: The 100-Year War Between Monopoly Power and Democracy. Gives a somewhat different perspective which seems less one sided. However mostly agrees:

> The fault lines that have led to the global trade imbalances and created today’s Mandevillean world are deep. Moreover, because the imbalances are the result of deeply embedded strategies, change will be painful. It is not just a matter of raising an interest rate here, a tax there, or an exchange rate somewhere else. It is tempting for the international establishment to treat adjustment as a simple matter and then express continuous surprise that change does not occur. It also gives politicians the dangerous impression that change is easy for the other side, so punitive trade sanctions can help persuade. We should have no illusions: change is difficult for all countries, though they all stand to gain in the long term, not just from a more stable world economy but also from a more sustainable domestic growth strategy.

This was written a decade ago and as we are on a brink of another recession, one realizes that no lessons were really learnt from 2008.

[Kevin Tharayil · Rating 5 out of 5]

In 2005, the author, at an elite economists gathering honoring the then Fed Reserve governor, Alan Greenspan, made the point that financial development had made the world riskier. He met with scorn and as the documentary 'Inside Job' showed, accusations of being a luddite!

This book written in the aftermath of the subprime crisis is a call to understand that until the root of the problems - The Fault Lines that exist are not addressed, any recovery from the economic mess will be short lived. The easy scapegoats (bankers, capitalism, greed and fear) aside, the push for housing credit by the political class without revisiting the monetary policy acted as enablers for the entire system to justify winning incentives by scoring the maximum points. The debt fissures due to trade imbalances only add burden over and above the private transfer of debt to the tax payers.

A very well thought out and clear read which is a must to try and understand the core issues leading to financial crises and suggestions on how to deal with them.

[AJ · Rating 3 out of 5]

Rajan gives an adequate explanation of inequality, excessive risk, and the financial debacle. But a portion of his central argument is that the financial collapse was attributed, in part, to the mandated lending by the Community Reinvestment Act (CRA) and the subsequent actions of Fannie Mae and Freddie Mac. The numbers simply do not add up: the government-sponsored-enterprises and their affordable housing subsidies out performed any other sector in the residential mortgages. And by a large margin. Whereas the private label mortgages victimized those by "predatory lending," the evidence does not allow Rajan to posit that the reckless behavior by these mortgage giants were the harbinger for largest credit losses seen in almost 80 years.

[Hrishikesh · Rating 3 out of 5]

Good study, but not the best commentary on global economic structure that I have come across. For instance, Ruchir Sharma was much better.

Dr. Rajan, in my opinion, focuses far too much on the Financial sector. Thereby, his entire arguments - although accurate and well-defined - are localized essentially around the US and Western Europe. Therefore, the book becomes more of a commentary on "post-2008 fault lines" rather than the larger super-set of global fault lines.

Having said this, interesting read. Dr. Raghuram Rajan is one of the world's tallest academicians and a proven authority on the 2008 crisis.

To paraphrase Sherlock in a lighter vein, when the chips are down, I am glad that Raghoba dada remains not only on the side of the angles, but also one of them.

[Brian · Rating 4 out of 5]

(4.0) Good review of US/global economy in 1990s and 2000s, including financial crisis

Some of this was thought provoking (please respond to my notes and highlights!). Don't have the energy (now, at least) to attempt a summary.

[Jake Meyer · Rating 5 out of 5]

In 2010 Raghuram Rajan set out to explain how structural instabilities in the global financial system led to the largest crisis in recent memory. With Fault Lines: How Hidden Fractures Still Threaten the World Economy he succeeded.

It’s easy to write a partisan manifesto outlining a left or right wing perspective of “what happened” in 2008 someone with no background in economics can understand and enjoy. It’s far trickier to write a balanced and accurate analysis for other economists. It’s comparatively impossible to write a balanced and accurate analysis someone with no background can both understand and find engaging. Rajan knocks it out of the park.

By using simple yet illustrative anecdotes and explanations (carefully chosen to illustrate the given phenomenon!) as stand-ins for complex economic theory, the current Governor of the Reserve Bank of India and former IMF Chief Economist morphs models into stories, and analysis into narrative as he brings to life the “fault lines” in the global financial system he famously warned of in 2005. Maligned at the time by many policymakers and academics, his speech proved prescient, and is now outlined for a broader audience to understand after the fact what he saw before.

Further, it illuminates how these factors are still generating risk in the financial sector today. With policymakers still too focused on basic factors (such as unemployment and inflation) in economic policy – instead of financial factors that exhibit highly dynamic and critical behavior – we are applying the wrong tools to the wrong target. This is exacerbated by the continued institutional misalignment of incentives in markets and political systems. Tying the present and past versions of these problems into a compelling narrative, Rajan explains how the same weaknesses culminating in the crisis of 2008 may strike again – then outlines both a set of fixes, and the roadblocks we should expect in their implementation.

Rajan proposes the interaction of an eclectic cocktail of factors ranging from economics and political science to psychology and education when constructing his explanation. The first of these is a credit expansion generated by the combination of inequality and short-term political incentives, while the rest of the book discusses factors that grew this expansion into vast imbalances then the largest crisis in recent memory.

Inequality has risen for decades. Accelerating technological development increased the need for high productivity workers above the capacity of an inadequate educational system to supply them, all while markets expanded due to Globalization. This led to an outsized portion of gains from growth to be accrued to these skilled workers at the upper end of the income distribution. With increased redistribution politically and financially costly, policymakers used a combination of populist measures aimed at expanding lending to the poor, and subtle arm-twisting of the closely tied financial sector to allow those left behind in income to “keep up” in consumption through increased (risky!) borrowing – especially for mortgages. Credit issuance was forced up and risk evaluations were forced down in a myopic attempt at placating the poor, distorting financial activity enough a tipping point was passed - tilting this initial expansion into a bubble, which fed on itself until large enough to tank the global financial sector.

International Trade and Financial flows – and therefore their role in the crisis - cannot be looked at in isolation. As developing countries became a larger part of the global economy, their export-led model required increased industrial country spending while generating excessive savings. The U.S. picked up the slack – partially through demand from the credit bubble, while developing countries searched for a safe place to park these savings – given domestic financial underdevelopment ruled out keeping it home. They found U.S. debt markets.

This insatiable appetite for safe U.S. debt by high-savings countries (emerging markets + Germany and Japan) was satisfied by turning these risky-mortgages into securities, as a misunderstanding of risk correlations in systemic events allowed them to be bundled and treated as “safe debt.” Flows into the U.S. from high foreign savings further eased already over-eased credit, increasing demand and strengthening the lethal combination of rising asset prices and falling risk assessments that builds into an irrational exuberance. Lowered risk brings inflows. Higher inflows increase asset (housing) values/credit issuance. Increased asset values and credit issuance often lowers risk evaluations through increased liquidity. Then lowered risk brings more inflows, and the cycle continues until it collapses.

This initial distortion may not have occurred were it not for idiosyncrasies within the U.S. political and economic system. Given the U.S.’s relatively weak safety net and cutthroat business environment, U.S. businesses and workers are (respectively) created/destroyed and hired/fired by the bundle relative to other countries. The result has been one of the world’s most flexible and innovative economic systems. In the recessions of the early 90s and 2000s this system sputtered, giving “jobless” recoveries to recessions. With the safety-net too weak to handle long-term unemployment (unlike European economies) the U.S. political system is highly sensitive to its presence. The Federal Reserve and Federal Government’s hands’ were forced.

A heavily stimulative monetary and fiscal response pushed interest rates down and deficits up. When financial markets have large credit growth or asset appreciation (present throughout this time), the resultant demand alone can encourage more risk-taking – begetting more credit growth, asset (housing) appreciation, and risk-taking that perpetuate the cycle. When outside factors such as large stimulus further increase demand, the vicious cycle accelerates. By dealing with unemployment instead of (well-masked) financial imbalances, policymakers piled on the growing bubble.

While mistakes by policymakers in generating, then failing to correct to, credit and asset imbalances bears the brunt of the blame in the early part of Rajan’s analysis, the financial sector itself is far from blameless. With earnings as the sole measure of professional success in the financial sector (unlike, say, teaching or engineering), maximizing self-worth, and therefore incentives (both monetary and non-monetary), purely centered on maximizing returns. This can be done by beating the market, or by taking on excessive risk then misevaluating it (knowingly or not) to masquerade as having beat the market. With risk related to large-scale movements manifesting rarely, it can be difficult to tell the two apart. Individual compensation mechanisms minimizing decision makers’ share in downside risk, and insufficient monitoring from deep-pocketed foreign investors made checks on reckless behavior minimal, and falling as the credit boom grew. After years of underrated systemic risk with losses pushed onto others, voices of moderation in the field were cast out as profit-killing pessimists. This culminated in mortgage companies pushing loans onto those completely unable to pay, which were bundled and sold as safe assets to investors unaware of their risk. The initial credit boom, already further inflated by other expansionary factors, was pushed beyond dangerous territory.

Given the linkage between financial markets and policy, it’s difficult to understand the behavior of financiers independent of the institutional structure they operated within. Low-rate policy put excessive pressure on financiers to generate returns by taking on high risk, while the implicit promise of bailouts from the government lowered the costs to doing so, eliminating the standard market mechanisms punishing those misevaluating risk. This combination acted as a taxpayer subsidy to the financial sector – money managers reaped the gains from risky investments knowing taxpayers were on the hook if the risk manifested. Corporate structure in the banking sector, misaligned to reward short-term benefits to shareholders over long-term benefits to society, exacerbated human fallibility associated with risk assessment by pushing incentives away from socially optimal behavior.

Reforming these incentives tops the list in Rajan’s proposed financial sector reforms. Human behavior is guided by incentives. Any attempt to change it must start there. Compensation structures focused on longer-term success, removing the implicit assumption of a bailout, and greater transparency of banks’ balance sheets will all increase the cost, thereby reducing the presence, of excessive risk-taking. One promising “in vogue” option – a new Federal Reserve policy tool to shift leverage or equity requirements counter-cyclically is left out. Absent this tool, monetary policy must acknowledge financial cycles then raise rates between recoveries – even at the cost of higher unemployment. Preventing institutions from becoming systemically important, while building buffers for when the system is stressed, requires avoiding government guarantees that drive excessive risk but still ensuring liquidity is available when needed – a difficult mechanism to design. Focusing on linkages, rather than institution size, and requiring the selling of instruments undertaking debt to equity conversions when stress thresholds are surpassed is a strong start.

If inequality resulting from an inadequate education system – and the use of credit to cover it up – sowed the seeds of the pre-crisis boom, expanding access to education must be part of the solution. This goes deeper than increasing funding to education. Most ills in modern society will not be solved with merely an increase in funding. Gaps between the richer and poorer of society begin early; children of poorer parents often fall behind both cognitively and socially due to a variety of socioeconomic factors. When these gaps grow, they often last a lifetime. Early childhood and low-income family targeted measures are essential. Increasing worker retraining and mobility (reducing barriers to relocation such as worker certification) while restructuring the safety net account for the need for lengthened (in a rule based system) benefits – but only in serious downturns – will reduce the anxiety that forces heavy stimulus and drives bubbles. Counter-intuitively, these expansions of benefits may then be likely to strengthen the government’s fiscal position by minimizing both the costly bust and fiscal response to it. Policy change of this nature though is easier said than done.

Higher hurdles stand in the way of international policy reform. Economists have always been aware the actions of countries are interconnected – in this case export-led high-savings countries flooded low-savings countries like the U.S. with liquidity, fueling credit booms then busts. However no mechanism exists to push net saving countries into increased spending to ease the burden of supplying global demand from industrial countries; indeed developing countries such as China and Vietnam argue a depreciated currency and export subsidies are necessary to grow in a world with built-in structural and first-mover advantages for industrial countries. Moderating capital flows presents even greater challenges; the integration of radically different financial cultures and institutions causes wires to cross with billions on the line. Investors seek to avoid this risk by using flighty short-term debt, allowing wild financial flows that generate these crises. Were a perfect solution available political actors are still hamstrung by domestic constituencies – at the cost of global financial stability. Pushing reforms constituents fear through a system from which entrenched interests benefit is a herculean task – and international institutions have little leverage. Rajan recounts his ill-fated pre-crisis series of globe trotting meetings to attempt just that as Chief Economist of the IMF.

Rajan illustrates how the complex interactions of politics and economics melded with institutional incentives and human nature to culminate in the Great Recession. By acknowledging the difficulty of policy reform amidst a nod to the validity of both partisan narratives, he avoids the blame game in favor of an even-keeled discussion of why the crisis happened with ideas to avoid the next. Fault Lines: How Hidden Fractures Still Threaten the World Economy deserves its award as the 2010 Financial Times/Goldman Sachs business book of the year.

[Arun Pandiyan · Rating 5 out of 5]

Written after the global financial crisis, in this book, Raghuram Rajan explores the unresolved fault lines in the financial systems that could potentially disrupt global economy in the future. The book explains five necessities for building robust financial institutions:

Physical capital: Infrastructure, as it is known is the basis of any developing economy, and Rajan argues that the lack of physical capital is one of the primary reasons for underdevelopment and poverty in many countries. In contrast, all the developed countries are well connected through roads, rails, transport, and aviation along with machinery and appliances that reduce labor. Rajan puts forth the argument that physical capital makes the labor force more productive. One could find his argument compelling considering the example that women who have household appliances like refrigerators, washing machines, and mixer grinder tends to spend their productive hours on other important things.

Educational premium: The liberalization of the economy and the global shift from agriculture towards manufacturing and services have placed an advantage on those who are educated. Comparatively, the data suggests that those who are uneducated are earning much less than those who are school-educated, while those with graduate degrees are earning much higher than both. Similarly, those who ascend the educational ladder with post-graduate degrees like an MBA or with PhD end up having the premium of earning more as compared to others. Acknowledging this educational premium, it is important to note that while deep singular expertise produces higher income for a few, desiring to produce a more skilled workforce at the population level is an achievable outcome to increase the per capita income of the many.

Exporting to grow: What is often referred to as the East-Asian miracle is the story of countries such as Singapore, Malaysia, Japan, and South Korea exporting their products across the globe to grow their economy. Similarly, in the past two decades, China has become a giant of export. However, Rajan argues that larger firms within the country should be encouraged by the State to export more by providing targeted subsidies by underpricing raw materials or electricity by providing cash rebates for exports or for importing equipment that is later assembled for export. He calls this "Managed Capitalism".

The curse of easy credit: Historically, politicians have resorted to the option of easy credit whenever the income at the national level is found to be stagnant. This belief is that as long as the consumption of the middle class is higher with each dreaming of buying a house, or car, or affording a vacation with easy credit, the true problem of stagnant income will not surface. Similar to his previous book ‘Saving Capitalism from the Capitalist’, Rajan argues that while credit is essential for growth and asset creation, it is important for financial institutions to know to whom and for what the credit must be issued. Rajan’s emphasis on this puts the spotlight on the recent fault line in India’s higher credit card consumption with unsecured loans for purchasing services and liabilities.

Bearing risk: If financial institutions are lending, should the State bear the risk? Rajan explores the idea of reform where financial institutions are delinked from state control where the lender alone solely bears the risk of lending. Whenever the state comes forward to bail out a bankrupt institution or favor the crony capitalists in writing off the NPAs, the risk is evenly spread along the population. In this regard, Rajan highlights the instances of writing off farm loans before the election and the tricks of lending excessively to politically important constituencies across the country. He offers the solution of delinking (not deregulating) the institutions from state control.

Overall, it is an important read to understand how we can mold our economy to meet the needs of the developing world instead of relying on age-old and failed methods.

[Martin Egeli · Rating 5 out of 5]

Raghuram Rajan, a previous chief economist from IMF and one who warned about the global financial crisis, writes about how serious flaws in the system are to blame. Crisis will come again, just in a different form. The book was written over 10 years ago, but I find it increasingly relevant for the status quo to understand more about the fault lines still existing in the system.

The book focus on several important and interesting concept, including, but not limited to, credit, income inequality, export-led growth, safety net, centralbank politics, bankers perverse incentives, tail risks, US-China relations and the role of multilateral institutions. He believes we need actions with short-term costs for a long-term benefit, but unfortunately, no government wins elections with this way of thinking.

I give this book 5 stars. Not because it was an easy and quick read - it was not - but because I really believe in, and agrees with, his point of view and ways to reform finance and the system. I will certainly return to re-read some parts.

Raghuram ends the book with an afterword. He is hopeful that we will be able to fix the fault lines because the recent crisis gives us little choice not to. Unfortunately, I believe this is one of the few places he took wrong.

[Yates Buckley · Rating 5 out of 5]

I am very late in tha game at reading this text that is primarily looking at the context to the 2008 crisis, which we now know so much about.

But the book remains relevant, and even more important perhaps because the author identifies with foresight the collapse in rational policy making and politics that has afflicted the US in the last years.

The author even offers some very rarional policy answers to reduce the tension of these growing fault lines, some of which were even attempted years after the book was released. But all the solutions proposed rely on: rational decision making that is often bi-partisan something impossible to see in US politics today (2022).

What happened instead is we have been relying more and more on fractioned tribal thinking in which the irrational cause can act as a symbol for cohesion and beats drums in echo chambers.

I think the key point one gets to from this work and the reality of what the world is like after the fact is we need to address higher education so that it is useful for everyone at any point in their career…

[Ashutosh Dwivedi · Rating 5 out of 5]

Brilliant. Simple yet comprehensive. Rajan writes in simple and easy to understand language relating concepts not just from financial economics but also from development, growth and welfare. He takes turn by turn an opportunity to identify each of the players responsible for the 2008 sub prime crisis and provides an unbiased view of what happened and who was to blame, breaking down each concept and how it flowed through the system to cause the ripple effects that it did.

A must read for all economics and finance enthusiasts to get an idea of how the bigger picture in the financial world looks like.

[Shorya Jain · Rating 4 out of 5]

Raghuram Rajan does a terrific job articulating ideas. Every chapter is broken down into a coherent set of independent essays, making it easy to follow without requiring the reader to keep track of a lot of ideas. I especially love the silver bullets he offers from time to time - especially ones around the too big (or as he calls systemically involved) to fail.

[Parag Nawani · Rating 4 out of 5]

A nice read to understand the intricacies involved in the 2008 financial crisis in US and some other financial crises across the world. Not only the financial sector is to be blamed, but other critical players contribute towards these crises!

[Manognya Deepthi G · Rating 3 out of 5]

Unbiased book with a lot of insights. Definitely not an easy read for ones without a strong background in Economics.

[Wenshi Gao · Rating 5 out of 5]

An adequate Education fix a crash derived from joblessness .Read in Blinkist.