I found this book a highly stimulating read. It represents possibly the most thought-provoking contribution in the aftermath of the crisis that started in 2007 and that yet engulfs us. Let me first summarize some of the most salient points it makes, then talk about its strengths, and finally, why everyone should read it.
The epilogue of the book summarizes the book best - "The crisis has resulted from a confusion about the appropriate roles of the government and the market. We need to find the right balance again, and I am hopeful we will." The book presents two important government distortions - the push for universal home ownership in the United States and the push for export-led growth in some countries such as Germany and China that have left to massive "global imbalances", with some countries such
as the United States, the United Kingdom and Spain persistently being in deficits and borrowing from the surplus, exporting nations. While pursuit for home ownership affordability and growth are nothing to complain about per se, the book makes sharp observations that they are occurring at the expense of something more, or as, important. In the United States, the book argues, there has been a growing income inequality, which combined with a relatively feeble safety net for the poor, has created pressure on politicians to bridge the inequality. Instead of improving the competitiveness of labor force in a global market with changing mix of industries and required skills, governments have adopted the option "let them eat credit" (Chapter One's title). The presence of government-sponsored agencies in the United States enabled exercising such an option readily through a push for priority lending to the low-income households (sub-prime mortgages). In case of surplus countries, the single-minded focus on exports has led governments to ignore the domestic sector, preventing sufficient redeployment of surplus for internal development and somewhat perversely, boosted domestic savings rates significantly due to lack of adequate safety nets (at least in case of China, if not in case of Germany). The savings have thus had no place to go but to outside and ended up resulting in massive capital inflows that fueled the housing sector expansion in the US, the UK and Spain.
While these government "failures" are themselves pretty interesting to have observed and highlighted, what is fascinating is how they interacted with each other - and with the financial sector - in fueling the expansion to levels that can be called massive housing bubbles. The idea here is that the invisible hand operating through the price when the price is distorted can lead to massive distortions in allocation of capital also. The financial sector in developed world is so sophisticated and amoral (a great choice of word by the author) that its dispassionate pursuit of profits leads it to direct capital to wherever there is a relative mis-pricing. So if governments are subsidizing home ownership, efforts will be made to deploy pretty much all available free capital of the world to that sector. If some governments are finding it cheap to borrow because savings are seeking them out, the financial sector will grow at a sufficient rate to absorb and support expansion through the capital inflows. While clearly there are some incentive-based distortions, especially short-term nature of accounting-based compensation that ignores true long-term risks, the book takes the stand, and explains it well, that the bigger issue was that the imbalance of capital flows and the ease of pushing sub-prime home ownership - both due to government distortions - meant the financial sector was essentially the conduit to make happen what the rest of the world was seeking to achieve. In the process, it made a ton of bad loans (but the governments were happy with that till it all really blew up). And some parts of the financial sector pursued this role even more aggressively than one could have imagined due to the steady entrenchment of too-big-to-fail expectations --- large banks being repeatedly bailed out through government and regulatory forbearance and enjoying Central-Bank monetary stimulus each time markets turned south. In essence, one walks away with an explanation of what brought about the perfect storm.
Some may question the basis of this argument by saying - why did we see credit expansion across board and not just in low-income households. There are two important points the book makes. One, that once risk is mispriced for one investment (by governments for sub-prime lending), financial sector must demand similar return elsewhere. That is, there will be mispricing of risk across board. Second, the book focuses on a rather fascinating recent phenomenon that recent recoveries from recessions, especially in the United States, have remained "jobless" for extended periods of time. Perhaps as a subconscious response to this (or due to ideologies in other cases), Central Banks have tended to provide massive monetary stimulus to get the financial sector to push the real sector hard through greater lending and intermediation. Such stimulus, unfortunately, again serves to transfer rents from households to the financial sector (by keeping interest rates low) and produces mispriced risk and the economy moved "From Bubble to Bubble" (Chapter Five title), until the most recent bubble could not be mopped up by anyone, in spite of the efforts to do so.
Those who have read Raghu Rajan's earlier book and research would recognize that his writings are always cogent and based in sound set of facts. But this book is more special in the sense that here he paints on a much larger canvas, covering bases from distributional issues within income strata of society, to the persistent capital imbalances across large countries of the world, and the power and ruthless profit-maximizing incentives of modern market-based financial sector. The point of Fault Lines is that these are slow-moving tectonic plates, neither movement might seem dangerous by itself, but that when these plates come together and collide, global economy can get badly shaken. To most minds that are focused narrowly on their own positions, let alone the movements of the plate they stand on, the earthquake - like this crisis - may seem sudden. The beauty of the book is in explaining that when viewed carefully, the crisis was not a pure accident and that more may arise in future unless the root causes are addressed sufficiently soon.
While the book is worth it even just for its explanation of why we had a crisis now rather than at some other points of time in the past, it goes the extra mile and proposes valuable reforms - once again focusing on all three issues - building a better safety net in the United States (see in particular, the suggestions to improve education access to all), reducing the global imbalances, and improving the regulation of the financial sector so that they (and their financiers) pay for mopping up of "bubbles" that they create, rather than governments and Central Banks passing on these costs to taxpayers.
As you can tell from this review, there is a lot going on here. But it is written with great examples and cases - almost allegorical at times (even has a fascinating poetry recounted in the chapter "The Fable of the Bees Replayed" ), and should be accessible to one and all. Not all may find it easy to agree with every single point (as it will certainly question some long-held biases about different countries and societies), but it is hard to not take a deep breath and ponder once you have read it all. In many ways, it shows that when economic conditions so demand or induce, developed world behaves much the same way as developing world: they are both after all driven by choices of human beings and the book lays out some common patterns of global economic behavior - in households, markets and governments.
In summary, I recommend the book extremely highly and comment and thank Raghu Rajan for putting together this brilliant painting of global economy and finance, surrounding the arena of the recently witnessed crisis.
- Viral Acharya, Professor of Finance, New York University Stern School of Business
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