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Fault Lines: How Hidden Fractures Still Threaten the World Economy

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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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In the Sept 2010 issue of the New York Review of Books, Paul Krugman & Karen Wells reviewed Fault Lines. Below is Rajan's reply to their review:

Paul Krugman and Robin Wells caricature my recent book Fault Lines in an article in the New York Review of Books.

First, Krugman starts with a diatribe on why so many economists are "asking how we got into this mess rather than telling us how to get out of it." Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates. The article, and their criticism, however, do have a lot to say about Krugman's policy views (for simplicity, I will say "Krugman" and "he" instead of "Krugman and Wells" and "they") which I have disagreed with in the past. Rather than focus on the innuendo about my motives and beliefs in the review, let me focus on differences of substance. I will return to why I believe Krugman writes the way he does only at the end.

My book emphasizes a number of related fault lines that led to our current predicament. Krugman discusses and dismisses two - the political push for easy housing credit in the United States and overly lax monetary policy in the years 2002-2005 - while favoring a third, the global trade imbalances (which he does not acknowledge are a central theme in my book). I will argue shortly, however, that focusing exclusively on the imbalances as Krugman does, while ignoring why the United States became a deficit country, gives us a grossly incomplete understanding of what happened. Finally, Krugman ignores an important factor I emphasize - the incentives of bankers and their willingness to seek out and take the tail risks that brought the system down.

Let me start with the political push to expand housing credit. I argue that in an attempt to offset the consequences of rising income inequality, politicians on both sides of the aisle pushed easy housing credit through government units like the Federal Housing Administration, and by imposing increasingly rigorous mandates on government sponsored enterprises such as Fannie Mae and Freddie Mac. Interestingly, Krugman neither disputes my characterization of the incentives of politicians, nor the detailed documentation of government initiatives and mandates in this regard. What he disputes vehemently is whether government policy contributed to the housing bubble, and in particular, whether Fannie and Freddie were partly responsible.

In absolving Fannie and Freddie, Krugman has been consistent over time, though his explanations as to why Fannie and Freddie are not partially to blame have morphed as his errors have been pointed out. First, he argued that Fannie and Freddie could not participate in sub-prime financing. Then he argued that their share of financing was falling in the years mortgage loan quality deteriorated the most. Now he claims that if they indeed did it (and they did not), it was because of the profit motive and not to fulfill a social objective. Let me offer details.

In a July 14, 2008 op-ed in the New York Times, Krugman explained why Fannie and Freddie were blameless thus:

"Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income. So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works."

Critics were quick to point out that Krugman had his facts wrong. As Charles Calomiris, a professor at Columbia University and Peter Wallison at the American Enterprise Institute (and member of the financial crisis inquiry commission), "Here Krugman demonstrates confusion about the law (which did not prohibit subprime lending by the GSEs), misunderstands the regulatory regime under which they operated (which did not have the capacity to control their risk-taking), and mismeasures their actual subprime exposures (which he wrongly states were zero)."

So Krugman shifted his emphasis. In his blog critique of a Financial Times op-ed I wrote in June 2010, Krugman no longer argued that Fannie and Freddie could not buy sub-prime mortgages.v Instead, he emphasized the slightly falling share of Fannie and Freddie's residential mortgage securitizations in the years 2004 to 2006 as the reason they were not responsible. Here again he presents a misleading picture. Not only did Fannie and Freddie purchase whole sub-prime loans that were not securitized (and are thus not counted in its share of securitizations), they also bought substantial amounts of private-label mortgage backed securities issued by others.

Of course, one could question this form of analysis. Asset prices and bubbles have momentum. Even if Fannie and Freddie had simply ignited the process, and not fueled it in the go-go years of 2004-2006, they would bear some responsibility. Krugman never considers this possibility. When these are taken into account, Fannie and Freddie's share of the sub-prime market financing did increase even in those years.
In the current review piece, Krugman first quotes the book by Nouriel Roubini and Stephen Mihm:

"Clearly, Fannie and Freddie did not originate sub-prime mortgages directly - they are not equipped to do so. But they fuelled the boom by buying or guaranteeing them. Indeed, Countrywide was one of their largest originators of sub-prime mortgages, according to work by Ed Pinto, a former chief credit officer of Fannie Mae: "The huge growth in the subprime market was primarily underwritten not by Fannie Mae and Freddie Mac but by private mortgage lenders like Countrywide. Moreover, the Community Reinvestment Act long predates the housing bubble.... Overblown claims that Fannie Mae and Freddie Mac single-handedly caused the subprime crisis are just plain wrong."

For instance, consider this press release from 1992, and participated from very early on in Fannie Mae's drive into affordable housing:

"Countrywide Funding Corporation and the Federal National Mortgage Association (Fannie Mae) announced today that they have signed a record commitment to finance $8 billion in home mortgages. Fannie Mae said the agreement is the single largest commitment in its history...The $8 billion agreement includes a previously announced $1.25 billion of a variety of Fannie Mae's affordable home mortgages, including reduced down payment loans...

"We are delighted to participate in this historic event, and we are particularly proud that a substantial portion of the $8 billion commitment will directly benefit lower income Americans," said Countrywide President Angelo Mozilo..."We look forward to the rapid fulfillment of this commitment so that Countrywide can sign another record-breaking agreement with Fannie Mae," Mozilo said.

"Countrywide's commitment will provide home financing for tens of thousands of home buyers, ranging from lower income Americans buying their first home to middle-income homeowners refinancing their mortgage at today's lower rates," said John H. Fulford, senior vice president in charge of Fannie Mae's Western Regional Office located here.

Of course, as Fannie and Freddie bought the garbage loans that lenders like Countrywide originated, they helped fuel the decline in lending standards. Also, while the Community Reinvestment Act was enacted in 1979, it was the more vigorous enforcement of the provisions of the Act in the early 1990s that gave the government a lever to push its low-income lending objectives, a fact the Department of Housing and Urban Development (HUD) was once proud of (see the HUD press releases below).

Perhaps more interesting is that after citing Roubini and Mihm, Krugman repeats his earlier claim; "As others have pointed out, Fannie and Freddie actually accounted for a sharply reduced share of the home lending market as a whole during the peak years of the bubble." Now he attributes the inaccurate claim that Fannie and Freddie accounted for a sharply reduced share of the home lending market to nameless "others". But that is just the prelude to changing his story once again; "To the extent that they did purchase dubious home loans, they were in pursuit of profit, not social objectives--in effect, they were trying to catch up with private lenders." In other words, if they did do it (and he denies they did), it was because of the profit motive.

Clearly, everything Fannie and Freddie did was because of the profit motive - after all, they were private corporations. But I don't know how we can tell without more careful examination how much of the lending they did was to meet government affordable housing mandates or to curry favor with Congress in order to preserve their profitable prime mortgage franchise, and how much was to increase the bottom line immediately. Perhaps Krugman can tell us how he determined their intent?

Interestingly, before the housing market collapsed, HUD proudly accepted its role in pushing low-income lending through the various levers that Krugman now denies were used. For instance, in 2000 when it announced that it was increasing Fannie and Freddie's affordable housing goals, it concluded:

"Lower-income and minority families have made major gains in access to the mortgage market in the 1990s. A variety of reasons have accounted for these gains, including improved housing affordability, enhanced enforcement of the Community Reinvestment Act, more flexible mortgage underwriting, and stepped-up enforcement of the Fair Housing Act. But most industry observers believe that one factor behind these gains has been the improved performance of Fannie Mae and Freddie Mac under HUD's affordable lending goals. HUD's recent increases in the goals for 2001-03 will encourage the GSEs to further step up their support for affordable lending."

And in 2004, when it announced yet higher goals it said:

"Over the past ten years, there has been a `revolution in affordable lending' that has extended homeownership opportunities to historically underserved households. Fannie Mae and Freddie Mac have been a substantial part of this `revolution in affordable lending'. During the mid-to-late 1990s, they added flexibility to their underwriting guidelines, introduced new low-downpayment products, and worked to expand the use of automated underwriting in evaluating the creditworthiness of loan applicants. HMDA data suggest that the industry and GSE initiatives are increasing the flow of credit to underserved borrowers. Between 1993 and 2003, conventional loans to low income and minority families increased at much faster rates than loans to upper-income and nonminority families."

If the government itself took credit for its then successes in expanding home ownership then, why is Krugman not willing to accept its contribution to the subsequent bust as too many lower middle-class families ended up in homes they could not afford? I agree there is room for legitimate differences of opinion on the quality of data, and the extent of government responsibility, but to argue that the government had no role in directing credit, or in the subsequent bust, is simply ideological myopia.

Let me move on to Krugman's second criticism of my diagnosis of the crisis. He argues that the Fed's very accommodative monetary policy over the period 2003 to 2005 was also not responsible for the crisis. Here Krugman is characteristically dismissive of alternative views. In his review, he says that there were good reasons for the Fed to keep rates low given the high unemployment rate. Although this may be a justification for the Fed's policy (as I argue in my book, it was precisely because the Fed was focused on a stubbornly high unemployment rate that it took its eye off the irrational exuberance building in housing markets and the financial sector), it in no way validates the claim that the policy did not contribute to the manic lending or housing bubble.

A second argument that Krugman makes is that Europe too had bubbles and the European Central Bank was less aggressive than the Federal Reserve, so monetary possible could not be responsible. It is true that the European Central Bank was less aggressive, but only slightly so; It brought its key refinancing rate down to only 2 percent while the Fed brought the Fed Funds rate down to 1 percent. Clearly, both rates were low by historical standards. More important, what Krugman does not point out is that different Euro area economies had differing inflation rates, so the real monetary policy rate was substantially different across the Euro area despite a common nominal policy rate. Countries that had strongly negative real policy rates - Ireland and Spain are primary exhibits - had a housing boom and bust, while countries like Germany with low inflation, and therefore higher real policy rates, did not. Indeed, a working paper by two ECB economists, Angela Maddaloni and José-Luis Peydró, indicates that the ultra-low rates by both the ECB and the Fed at this time had a strong causal effect in relaxing banks' commercial, mortgage, and retail lending standards over this period.

I admit that there is much less consensus on whether the Fed helped create the housing bubble and the banking crisis than on whether Fannie and Freddie were involved. Ben Bernanke, a monetary economist of the highest caliber, denies it, while John Taylor, an equally respected monetary economist insists on it. Some Fed studies accept responsibility while others deny it. Krugman, of course, has an interest in defending the Fed and criticizing alternative viewpoints. He himself advocated the policies the Fed followed, and in fact, was critical of the Fed raising rates even when it belatedly did so in 2004.

Then, as he does now, Krugman emphasized the dangers from a Japanese-style deflation, as well as the slow progress in bringing back jobs.

Finally, if he denies a role for government housing policies or for monetary policy, or even warped banker incentives, then what does Krugman attribute the crisis to? His answer is over-saving foreigners. Put simply, trade surplus countries like Germany and China had to reinvest their financial surpluses in the United States, pushing down long term interest rates in the process, and igniting a housing bubble that eventually burst and led to the financial panic. But this is only a partial explanation, as I argue in my book. The United States did not have to run a large trade deficit and absorb the capital inflows - the claim that it had to sounds very much like that of the over-indulgent and over-indebted rake who blames his Then, as he does now, he advocated more stimulus. Then, as he does now, Krugman ignored the longer term adverse consequences of the policies he advocated.

creditors for being willing to finance him. The United States' policies encouraged over-consumption and over-borrowing, and unless we understand where these policies came from, we have no hope of addressing the causes of this crisis. Unfortunately, these are the policies that Krugman wants to push again. This is precisely why we have to understand the history of how we got here, and why Krugman wants nothing to do with that enterprise.

There is also a matter of detail suggesting why we cannot only blame the foreigners. The housing bubble, as Monika Piazzesi and Martin Schneider of Stanford University have argued, was focused in the lower income segments of the market, unlike in the typical U.S. housing boom. Why did foreign money gravitate to the low income segment of the housing market? Why did past episodes when the U.S. ran large current account deficits not result in similar housing booms and busts? Could the explanation lie in U.S. policies?

My book suggests that many - bankers, regulators, governments, households, and economists among others - share the blame for the crisis. Because there are so many, the blame game is not useful. Let us try and understand what happened in order to avoid repeating it. I detail the hard choices we face in the book. While it is important to alleviate the miserable conditions of the long-term unemployed today, we also need to offer them incentives and a pathway to building the skills that are required by the jobs that are being created. Simplistic mantras like "more stimulus" are the surest way to detract us from policies that generate sustainable growth.

Finally, a note on method. Perhaps Krugman believes that by labeling other economists as politically extreme, he can undercut their credibility. In criticizing my argument that politicians pushed easy housing credit in the years leading up to the crisis, he writes, "Although Rajan is careful not to name names and attributes the blame to generic "politicians," it is clear that Democrats are largely to blame in his worldview." Yet if he read the book carefully, he would have seen that I do name names, arguing both President Clinton with his "Affordable Housing Mandate" (see Fault Lines, page 35) as well as President Bush with his attempt to foster an "Ownership Society" (see Fault Lines, page 37) pushed very hard to expand housing credit to the less-well-off. Indeed, I do not fault the intent of that policy, only the unintended consequences of its execution. My criticism is bipartisan throughout the book, including on the fiscal policies followed by successive administrations. Errors of this kind by an economist of Krugman's stature are disappointing.

Fault Lines is the best book to appear so far on current economic challenges. While the author is very focused on US policy, good and bad, he offers the lay reader a very solid understanding of how the global system has responded to this crisis. His "fault lines" are not American problems alone but rather deep fissures in the international banking and finance systems. Europeans will be espeically interested and provoked by Rajan's arguments for a stronger American saftety net. Yes, he believes that it is morally correct to protect workers and their families who are displaced by economic turmoil. But, his primary argument is that a stronger safety net would dampen political pressure for short-term and often poorly targeted stimuli. In addition, he believes that larger, longer unemployement benefits would also make it less likely that policy makers would use easy credit as a mechanism for addressing increasing economic differences within American society. Fault Lines is a thoughtful introduction to macroeconmics, a critical analysis of current policies and a compelling call for major reforms in how the US and the world manages the global economic system.

In his previous book, Raghuram Rajan wanted to save capitalism from the capitalists. As he and his coauthor described, market forces can be annihilated by those bent on rent seeking and monopoly power. A few years after this first book, and in the midst of a world financial crisis, there is still ample proof that capitalists hold predatory views on capitalism, and that they want to hijack the system for their own private interest. But instead of distributing the blame for the crisis that befell upon us, Rajan argues that our post-crisis world economy needs to be saved from a new kind of threat: a combination of populist-driven politics and of geopolitical power shifts that create deep and lasting imbalances. These are the areas where he situates the fault lines that lie at the origin of the current world crisis and that, if unattended, may well provoke the next one.

In geology, fault lines are breaks in the Earth's surface where tectonic plates come in contact or collide. In using a geological metaphor, the author suggests that the cracks and imbalances in the world economy cannot be easily mended, and that they are almost beyond our control. But if mankind cannot prevent tectonic moves and earthquakes, we can build resistant buildings and improve the resilience of our economic systems. This is what Rajan proposes, in a set of recommendations that goes well beyond the usual fix in the financial sector that is now commonly discussed.

As Raghu Rajan emphasizes, his proposals are neither from the right nor from the left. They derive from his long experience as an academic originator of cutting-edge economic research, and as a decision-maker who, during three years, occupied the number-two seat at the IMF in Washington. His personal background as a US non-resident Indian also shows throughout the book. He mentions in passing that he is the director of a company, Heymath, that is based in Chennai in India and that helps teachers around the world to create teaching materials for math lessons and homework assignments. More generally, he insists that economists should analyze the US economy with the same tools and frameworks that they use for emerging countries. US policy-makers could also learn a thing or two from developing economies. For instance, health management practices in India could show the way to making US healthcare more affordable. Or conditional cash transfers in Mexico could encourage poor parents in American urban ghettos to pay more attention to their children's nutrition, health, and education by making welfare payments conditional on parents meeting certain milestones. Neither left nor right, many of his prescriptions are from the South.

It is unlikely that people from the radical left will read this book, but they should. For a start, the metaphor of "fault lines" is close to the Marxist concept of contradiction. For Marxists, capitalism is branded by an immanent want of balance, of crippling contradictions. This is exactly why it changes and develops incessantly: constant development is the only way for it to resolve and come to terms with its constitutive imbalance. Contradictions and fault lines are not digging capitalism's grave; on the contrary, they highlight its flexibility and adaptability, and also show the amount of work required in sustaining it. Similarly, Rajan's own explanation of the financial crisis comes close to the concept of overdetermination. For psychoanalysts, a phenomenon is overdetermined if it is caused by a combination of multiple factors, which taken in isolation cannot account for the effect alone. The financial crisis originates in the follies and excesses of the financial sector, but also in the "other scene" of growing domestic inequalities and global imbalances.

Although he quotes neither Marx nor Freud, Rajan shows up as a skilled dialectician. For him, politicians are part of the problem, and yet they are the ones that we must rely on to provide the solution. Likewise, our current predicament derives from the planet's growing interdependence, but the way out is to be found in more globalization, not less. Or to take another example, fixing finance from the consequence of financial engineering gone wild requires more financial innovation, albeit of a different, more inclusive kind. The art of the dialectical reversal is also displayed in the author's disregard for conventional ideas and political party lines. In Saving Capitalism, he argued that capitalist rent-seekers' best friends were the trade unions and antiglobalizers pushing for trade protection and anticompetitive practices. Likewise, he argues in Fault Lines that the IMF and the World Bank should seek their best supporters among the civil society organizations and media outlets that are so often found vociferating against the dictates of the Bretton Woods institutions.

I will not try to sum up the argument or reproduce some of the reasoning, because all chapters seem equally worthwhile. In every book I read, there are parts that deserve less attention and that I tend to read in a more cursory way, taking less notes and time to ponder the reasoning. Not so in Fault Lines: my scrapbook was full of notes, and there was not one passage where I felt left out or in need of additional explanation. The writing is never dull or technical, and there are real gems in style and composition. The author has a real talent for catching the attention of the reader head on and keeping him alert until the very last page. This is not only the best book on the financial crisis I have read so far, but also one of the most stimulating and readable economic volume that I have had the opportunity to review.

Having read Rajan breathtaking paper from the Fed's Jackson Hole Conference, I rushed to buy his book when it was finally published expecting insightful in-depth analysis of the leading banking proposals. Instead, what he gives us are brief summaries of the existing laundry list of proposals - hardly the in-depth analysis I expected that carefully considers the unintended secondary repercussions of each proposal. When he strays from his expertise - banking - his analysis grows even more superficial.

Even worse, the most important issue - how can the US best recycle short-term debt into its most productive uses - never hits his radar. Instead, he simply asserts that exporters like China should stop subsidizing exports, reduce savings and encourage domestic consumption - presumably to reduce the offsetting supply of cheap capital to the US. He also proposes reducing government guarantees of banks and deposits to discourage banks from taking tail risk - tail risk that is only created by utilizing short-term debt. Ok, but at what cost? This central issue never seems to cross Rajan's mind. But we saw what happened when short-term debt withdrew from funding US borrowing and sat idle to avoid risk. The economy contracted, unemployment rose and growth slowed - some now predict for a decade. That appears to have been a very high price to pay, especially so relative to the estimated once-in-75-years (less than) $100B net cost of crisis-induced government guarantees. How can he leave that central tradeoff wholly unaddressed?

It's clear that Rajan believes the use of short-term funds predominately affects only an unsustainable increase in household consumption. Perhaps, but he recognizes rising levels of debt without acknowledging that the market values of assets grew faster than debt and household net worth rose, even at post recession asset values. From the narrow focus of his discourse - discourse that never once mentions the acceleration in US productivity - one can only infer that he believes that monetary policy is the predominate driver of asset values even though post-recession asset values including real estate have remained surprisingly high by historical standards despite a dearth of credit. I found his monetary argument unpersuasive although others might not.

Rajan is one of the first writers (along with Reinhart and Rogoff and I'm sure others) to rightly link the rising trade deficit and its effect on the supply of short-term credit to the financial crisis when those short-term funds panicked and withdraw from financial intermediation. He also acknowledges the role of the government - through Fannie and Freddie - in distorting mortgages market credit standards that were critical to banks given the growing self-funding of business (an alternative use for the funds), which many demagogues surreptitiously ignore. But from a macro perspective - the chosen emphasis of his book - I believe he completely misses the major shift in US production to intangible investment to discover innovation (mistakenly counted as the intermediate cost of production) and its real effect on productivity, assets values, growth, wages, and employment (including the employment of Mexico and China). As a result, he doesn't see any link between business using domestic employment for increased innovation instead of households selling assets (to each other in a more close economy) and competing with business to buy domestic goods and services for increased consumption rather than borrowing offshore funds against the increased value of their assets to buy offshore goods. Said differently, in the face of capacity constraints, he fails to see the value of the US offshoring less valuable production for consumption in order to continue growing more valuable intangible investment domestically and the resulting effect that tradeoff necessarily has on debt AND assets. Had we simply borrowed from offshore exporters to consume their goods as Rajan seems to assert, household net worth would have declined steadily. As such, he sees little if any cost to discouraging the use of short-term funds. It's ok to disagree after thorough analysis; it's not ok to completely overlook alternative hypotheses central to the issue - issues, no less, that explain the slow recovery of employment, which leaves him scratching his head.

Nevertheless, when Rajan sticks to what he knows - banking and finance - he provides a fairer portrait of the issues than the many diatribes of demagogues masquerading as pundits. Me, I still think moral hazard is an unpersuasive explanation of the crisis - an explanation upon which Rajan relies heavily - but at least he presents it and other banking-related issues maturely. I only wish he would have stuck to banking and used his 230 pages to dig a lot deeper into what he knows instead using 40% of the book to address issues outside the scope of his expertise where I would describe his understandings as pedestrian at best (although that has no bearing on my rating). Still, the book is superior to most.

Fault Lines by Prof. Rajan is one of an ever increasing number of books recounting the financial collapse of the past few years. Unlike many of the others, Prof Rajan is both knowledgeable and experienced having been at the IMF in a senior role during a portion of this period. Thus this book is written from the perspective of a highly credible professional as well as a hands on operative.

Overall it is well written and avoids the finger pointing polemics that we are forced to endure from the journalist types who have their points to make. Rajan writes in a clear and well structured manner and details the problems, as well as recommending solutions. As the title says the system has certain enduring fault lines that need to be avoided rather than rebuilding upon.

Chapter 1 is the introduction and he lays out the history well. Especially he has a balanced position on who should take the blame and on p. 42 he calls the Government and its actions as the "elephant in the room". He does not take the Progressive's stance and blame the lack of regulation as the sole cause and he does not take the Conservative cause agreeing that all regulation is an anathema. Like any complex system which we will never really understand there must be circuit breakers, and that means some form of balanced regulation. Rajan states on p 43 at the end of Chapter 1:

"Growing income inequality in the United States stemming from unequal access to quality education led to political pressure for more housing credit. This pressure created a serious fault line that distorted lending in the financial sector."

I would strongly disagree with this statement. The US has one of the most open educations systems in the world and despite the less than stellar grammar and secondary systems the university systems are without equal. The problem here was demanding that credit be given to anyone on the part of the Government. Frankly when the Government opens the faucet to individuals who have no idea what responsible lending even means it is in and of itself a recipe for a disaster.

Chapter 2 discusses the whole issue of exports and Rajan's personal recollections regarding the controlled economy of India are telling. India was and to some degree is still a socialist centrally controlled state. It is a window to what can go wrong in an economy centrally controlled. On p 50 he states: "The great Austrian economist Joseph Schumpeter argued that capitalism grew through innovation, with newcomers bringing creative new processes and techniques that destroyed the business of old incumbents." This is creative destruction. The Progressive movement of the early part of the 20th century rebelled against the railroad tycoons but understanding Schumpeter one could have just as easily said, "this too shall pass". Namely in a Hegelian sense each action has a reaction and a resolution. Rajan on pp 54-55 discusses the sometimes success of the old Soviet system. As I was wont to tell my Russian employees that I was trained in the Joe Stalin school of management, never fail, the results would be tragic!

Chapter 4 discusses the US and its "weak safety net" which is a double edged sword. We in the US have limited unemployment benefits. It is in many ways Darwinian in that it is also a force to drive people back to work or seek other alternatives. In Germany, where I ran one of my companies, you cannot fire anyone. It is impossible. That frankly is a barrier to entry for an entrepreneur. Only the large incumbents can work in such an environment. Rajan seems to vacillate between the benefits of the US approach and the need for more social benefits. He discusses the discretionary stimulus approach of the US where the Government chooses who to pay and who not to pay. These he alludes may be seen as political payoffs and may not in any substantial manner truly stimulate.

Chapter 7 is quite interesting. He opens the chapter, pp 124-125, with a simple explanation of the reasons for the collapse of the derivatives. Let me paraphrase:

Consider a company which buys a pool of ten mortgages, all most likely subprime. Now the chance of any one going under is 10%. That means on average only one of the 10 will not pay back. This does beg the question of what factual basis was used to determine this but alas that was left to Wall Street and the rating agencies. Now we create two tranches, bundles, one which get a great interest rate but bears the losses, and second which gets a lower but still good interest rate and has its losses hedged by the first tranche. This works well except that the model is wrong!

What really happens is a Markov chain where when the first guy goes bankrupt, then the probability of another going is not the same but higher, and when a second goes bust it goes even higher. This means that instead of the first tranche bearing all the risk, the risk is moved to the second tranche which never thought it would have any! And then an AIG insures the second, and we know that there is a high probability of at least a 50% loss, a number AIG would never have imagined. Dumb quants! Yes, and on pp 142-143 Rajan details the Trillin conjecture that the changes in Wall Street over the past 30 years resulted in the dumbest guys moving upward relative to the Merlin's mixing their brews in the quant rooms. Rajan rejects that conjecture somewhat but there is considerable truth in it...just look at some of the folks who left and ended up in Government.

Chapter 8 discussing the reforming of the financial world. On p 164 he details a suggestion which should be adopted, the altering of compensation to reflect the risk over time. In Chapter 9 he returns to how to improve things in the US and on p 189 he speaks of the major problem in secondary education, the lack of competent instructors. To teach in a public school you need an education degree. Even if you had a PhD, held faculty position in a half a dozen universities and taught for over twenty years you still needed to learn how to operate an overhead projector and prepare a lesson plan. Thus the lack of educational advantage he posits in Chapter 1 is in many ways a result of the teachers unions barriers to entry of competent folks. Yet he never takes that leap. On pp 192-193 he posits the expansions of unemployment and benefits. Here I would disagree. Just look at the results in Germany, Greece, and other countries. In Russia I could fire a bad employee in Greece he was there until the return of Homer!

Rajan overall does a superb job at presenting the problems, the continuing faults and discussing solutions and safeguards. He deals with facts and logic and he does not tell stories as is typical of the wandering journalist. This is worth a read and for some worth a detailed study.

Fault Lines is a remarkable book. The recent crisis that was experienced and is being worked through has brought forward a library of books on the causes and consequences of it. Many of these books add valuable perspective to the mechanics of what happened whether it be trade imbalances or leverage increase or incentive misallignment at the micro economic level etc etc. This book stands out in its analysis by trying to analyze the real roots of the issues. It discusses the housing bubble as an outgrowth of increasing wage disparity in the US, it discusses the reason why many export led growth economies have under developed domestic consumption markets, it discusses why arms length financial transactions lead to the deterioration in due diligence and finally it goes into the policy fixes. Ill discuss the major themes a bit to give some clarity.

The author attributes the housing bubble to be at its root, a product of the growing disparity in wages between the 90th percentile and 10th percentile in the US over the last 25 years and the Fed's dual mandate of low inflation and full employment. In particular, he argues that the easiest way to deflect attention to growing divergence between economic classes is through easy credit as it normalizes purchasing power in the absense of real economic normalization, this manifisted itself in politics pushing easy credit to homebuyers of lower income status. This in combination with the fact that the post internet bubble recession/recovery was a jobless one and a jobless recovery allowed the Fed to justify keeping rates too low for too long given its dual mandate which led us to a bubble in housing credit. The author discusses the fact that perhaps, the philips curve doesnt drive the relationship between the two anymore and we need to rethink the dual mandate goal. The author is extremely well thought out in his analysis of the structure of the economy and where foundational stresses lie. The interpretation of easy credit as an outgrowth of political will to renormalize purchasing power is a deep and intriguing thought.

The author discusses the structural issues at the heart of export economies as well with great precision. In particular he believes that export led growth economies funnelled preferential credit/subsidies to chosen businesses which has led to lack of investment to consumption dominated parts of the economy. The deposit rates relative to lending rates and the lack of investment options by depositors leads to reallocation of a populations savings to these export businesses and thus feeds on itself at the expense of other parts of the economy. Looking at japan and the rates and modus operandi of consumer finance businesses is a strong example of how a banking system without a focus on consumer credit can lead to lending networks at both extremely high rates and low transparency, stifling consumption.

The author also does a very good job discussing the financial sector and what has been going on there for the last 2 decades. He discusses the repurcussions of arms length finance and discusses the behavioural finance repurcussions of what it can do to people. At the heart of it the author argues that we are a product of our environment and arms length transactions removes us from the end results of our actions and thus makes dollars and cents (on short time horizon) the only measurable quantity of productivity and value add. This part of the book is less "unique" to the extent that incentive problems in finance and allignment of interest in arms length financial systems is discussed frequently by many authors.

The author then goes into the solutions to the fault lines that he sees as being the reason we are where we are. The auhor is very disciplined in distancing himself with popular fixes and restrictions that dont address the causes of the issues. I wont go into too many specifics but the local fixes for the US economy are a combination of reworking the safety net that the US provides, being all too minimal right now, and incentive reallignment in the financial sector. In the global setting, it is a broadening of mandate and audience of the World Bank and IMF to discuss the required policy changes through more grass roots communication. People are willing to sacrifice something immediate for something long term when there is mutual discussion and more importantly trust, right now the IMF talks to leaders who's terms are shorter than the required policy thus making allignment of interest more difficult/impossible. People need to understand the need for policy for politicians to be able to push through the legislation and the need for the experts at the IMF to be able to communicate with the population directly, the author sees as a means to effect greater change. All in all this is a must read. I havent read a book so insightful and eye opening in a while and I think if more people thought and communicated the way the author does, we would have far fewer problems. This is an excellent an highly memorable work.

Fault-Lines is one of a handful of must-read books on the recent financial crisis. What makes this book a tour de force is that it goes beyond the surface-level explanations of the sources and origins of the crisis- such as the greedy bankers and inept regulators- to describe the interplay between the economic and political forces that brought about the crisis. The central thesis of the book is that the fissures that led the world economy to the brink of collapse still exist and will- unless the world's leading nations enact fundamental reforms- continue to pose a grave threat.

The first fissure that Rajan identifies is the growing income inequality within the US. Since the 1980s, the wages of workers with advanced education- for instance, workers with a college degree- have grown rapidly while the wages of workers without advanced education- for instance, college dropouts- have remained stagnant. Add in the emergence of off-shoring, the sharp decline in the pace of job creation and the weak-safety nets and the result has been an anxious middle and working class. Rajan observes that politicians of all stripes responded to the growing income inequality- if, for different reasons- by encouraging government-sponsored agencies (such as Fannie Mac and Freddie Mac) to provide the working classes with easy access to housing credit. Throw in the private sector- which saw an opportunity to originate and securitize housing loans- and the result was a boom in sub-prime lending. Inevitably, the good times could not last and the result was a surge of defaults by sub-prime borrowers that ultimately led to the sharp decline in value of a whole range of assets. Rajan notes that improving access to better schools and colleges for the middle and working classes is the only direct solution to rising income inequality but acknowledges that this solution is only a long-term fix and, importantly, does not address the predicament of the current generation of workers without adequate education. One lesson I take from Rajan's book is that in a less than ideal world (in the parlance of economics, a world of second-best) a modest level of (direct and indirect) fiscal transfers to the working classes may not be so bad after all.

The second fissure that Rajan identifies can be traced to the growth strategies of the world's largest economies. Germany, Japan and, most recently China, have relentlessly pursued an export-oriented growth strategy and have been unwilling (or unable) to stimulate domestic consumption. In contrast, the US (and the UK) have relied on a consumption-driven growth strategy and have been all too willing to tolerate an increase in household and government indebtedness. One consequence of the inevitable build-up in trade (and current account) deficits in the US, etc., and the trade (and current account) surpluses in Germany, etc., is the surge in economic and political pressures directed at both sets countries to correct these imbalances. Marshalling evidence from the experience of other countries- most notably, Indonesia, Mexico and South Korea- Rajan asserts that in the absence of serious economic and political reforms, the end result is usually an economic crisis. To avert such crises, Rajan proposes that the IMF go beyond its role as a lender of last resort to engage in a debate with the citizens of nations (with serious economic imbalances)-a-la Oxfam- on the economic and political compromises necessary to avert such crises. While such debate could alleviate the economic and political pressures that lead to a crisis, it is unclear whether the IMF is prepared for such a role.

Fault Lines is a beautifully written book that traverses through history, geography (and literature!) to describe the complex economic and political relationships within and across nations. I highly recommend it.

I spent some time considering whether to give this book four or five stars, but decided on four to balance some of the unreasonably favorable reviews here. I give the book a five for quality - the author is erudite and wise, and conveys this through his language and content. However, the book is thickly written in what unfortunately has become the standard style for academic monographs, and his arguments are equivocal almost to a fault. Also, his prescription for change is so abstract and lofty to almost be laughable (basically a sermon on the mount by the reinvented IMF to the people of the world). I don't disagree with the intent, but there is little consideration of the path from A to Z - I think a forceful and convincing argument of what A to B should be, and how to get there, would be a more relevant contribution.

The good news is that he gives one of the best explanations that I've seen of the background to the 2007-2009 crisis, with general dismissal of the idea that nefarious actors or plots were behind the problem. He provides powerful arguments that implicit support of the private sector by government, whether acknowledged or not, which has been tested and generally found to be there, has been and remains a critical problem and driver of behavior. He also gives repeated cogent explanations of the good original motivations behind the policies of export-driven emerging economies, and how these shrivel as the economies develop and thus should lead to policy changes that in many actual cases have not come to be. Finally he makes a strong case that the lack of support for education and education reforms in the U.S. are big problems, which have not been properly addressed because there is politically little current upside but large downside in these efforts.

You can't go wrong by reading this book, it's just that I think it could have been something more. In any case some of the material isn't going to have a long shelf life, so read it sooner rather than later.

Raghuram Rajan is a Professor of Economics at the University of Chicago, and former Chief Economist at the IMF. Rajan warns that it wasn't just greedy bankers taking irrational risks that caused the recent global financial crisis, nor bankers plus lazy regulators. In fact, bankers, builders, brokers, and buyers all did what was sensible given the incentives they faced. Other factors included over-dependence on the indebted American consumer, growing inequality, and a weak safety net. These latter factors created political pressure to encourage easy credit and keep job creation robust. Rajan also contends that unequal access to quality education and health care acerbated the situation. Sounds good at first, but the book makes a weak and inconsistent case to support these conclusions. Regardless, "Fault Lines" still adds up to what most everyone has already concluded - that the Federal Reserve kept rates too low for too long, trying to dig out of the prior recession, and the government further acerbated problems by trying to increase the proportion of home-owners.

Rajan's book, does however, report important data involving the top 1% of households, accounting for 8.9% of income in 1976 and 23.5% in 2007. This change represented a growth of 32.2% in real dollars. The data come from a paper authored by Atkinson, Piketty, and Saez, "Top Incomes in the Long Run of History," published in the 1/2010 "Journal of Economic Literature." The authors conclude that the top 1% of income earning families during this period captured 58% of the real income growth between those two periods. During the Bush years this proportion grew to 65%. A second important piece of data concerns the lengthening time required to recoup jobs lost in recessions. From 1960 until 1991, this average about 8 months, measured from the trough of the recession. In 1991, however, the time required became 23 months, and 38 months in 2001. Returning to prior GDP was much faster, requiring only 9 months in 1991 and 3 in 2001. Rajan offers no explanation for the difference; I contend we simply boosted imports faster than hiring. My opinion: The 58%-65% of real income growth going to the top 1% is a major economic, political, and moral problem; Rajan believes it is also responsible for the growth of political polarization. Also important - the increasing times required to restore prior employment levels, coupled with our fragile, compared to other nations, social safety-net.

Meanwhile, those at the 90th income percentile are also gaining on those at the 10th. In 1975, incomes for the former were about 3X those at the latter; by 2005, this had risen to about 5X. Rajan contends this is due to computers displacing former low-paying jobs, accompanied by the lack of improvement in our high-school drop-out rate. I would suggest the influx of millions of illegals also contributed. Rajan then tries to explain why some groups are less likely to graduate than others, and recommends more/better education for reducing income inequality - however, in doing so the author only succeeds in revealing how little he knows about U.S. education and the billions, perhaps even trillions, spent on innumerable, sustained, and unsuccessful efforts to affect improvement. As for Rajan's desire to boost access to health care, that problem has already been addressed in the "Health Care and Education Reconciliation Act of 2010" that expands care, without addressing the need to cut costs by 50%+ and improve outcomes.

Author Recommendations: On 'too big to fail,' Rajan points out that simply breaking up big banks, without taking other actions, is likely to simply recreate the same outcome via many smaller banks taking the same unwise actions. He also suggests ending deposit insurance, except for the smaller banks. Another recommendation is to extend unemployment benefits and make them more generous - reducing political pressure to take quick action leading to long-term problems (eg. cutting interest rates and taxes). He also suggests allowing Medicare and Medicaid to pay for health care delivered cheaper in other nations. (A good thought, but a much more effective change would be to require Medicare/Medicaid providers to take overall care responsibility for their patients for a flat fee (aka HMOs), backed up by much more extensive outcomes research that would support withholding expensive non-productive care, as well as holding down reimbursement rates to levels comparable to other nations.)

Bottom-Line: The biggest lesson from "Fault Lines" is that jobs recovery after a recession is now taking much longer - a serious factor for the present. Rajan fails to adequately examine the key question - "Why has wealth become much more concentrated?" He also assumes we should continue as a trade-debtor nation while building a cumulative trade deficit approaching infinity, instead of trying to mimic at least Germany, if not China. Nonsense - Rajan should read IMF critiques by Stiglitz, Klein, and others. Rajan's data about the top 1% make a compelling case for increasing tax rates on the very top. I'd also suggest sharply reducing the 47% that pay no federal taxes - that also encourages poor decision-making and is unfair to everyone else. Finally, let's get serious about illegal immigration and require either a legitimate 'green card' or U.S. citizenship for employment - this would help those in the U.S. at the bottom of the pyramid.