Hidden Fractures, Global Eruptions

Raghuram Rajan (2010). Fault Lines, Princeton University Press, Princeton and Oxford, pp. 279

Raghuram Rajan has essayed many diverse roles with panache- as a distinguished professor of monetary economics at the University of Chicago, Chief Economist at the IMF and the Governor of the Reserve Bank of India, to name a few. He has been at different vantage points of conceptual analysis as an academic, policy maker and independent regulatory authority. In this book, he examines the financial crisis of 2007 and the role of different agents in building up the crisis. The core argument of the book is that not only was the financial crisis a result of problems of regulation and management, it was also the result of failure of neoclassical economic theory to understand the real-life enactment of its principles. For instance, even when individual agents behaved rationally in a given situation, the aggregate impact was often sub-optimal. What flows from this argument is that while short-term policies aim at quick recovery by reaffirming the status quo, in the long-term the structural fault lines that underpins the economic system needs to be re-examined.

Three fault lines

Using a geological metaphor to illuminate the hidden fundamental forces that are evolving, Rajan identifies three different types of ‘fault lines’ that the global economic system has to contend with. The first is the hidden fractures of politics that deals with regulation of economic systems around the world. Providing illustrations from various contexts, Rajan points out how political considerations trump rational economic policies because of short-term and domestic concerns. For example, many developed economies have grown on the strength of globally competitive manufacturing market while retaining domestically inefficient markets in retail, banking, construction and restaurant-chains. This creates monopolistic or cartel-like industries that are inefficient and productive competitive industries not just in the same economic system but in the same political jurisdiction.

The second fault line lies in the trade imbalances that different type of economies has with each other. Ideas about growth trajectory, role of the state, priorities of investment and regulatory architecture is determined politically across countries. There are forces of tension that arise out of different types of rationale as well as between the cohort of developed and developing countries.

The third fault line is observed when different economic systems are allowed to interact with each other. There are economies with an ‘arms-length’ regulatory system of state intervention with a relatively high degree of transparency in information available to investors. Compared to this, there are other types of publicly regulated economies in which information is mediated through networks. When these types of systems come into contact with each other for investment, there is a lot of asymmetric information and inability to effectively regulate the system.

The importance of understanding the idea of fault line is that it is not easily observable, is fundamental to the entire system and leaves deleterious effects on every one involved in terms of a crisis. Going beyond speculation, creation of bubbles and role of different sectors, Rajan argues for a more fundamental redesigning of risk distribution in the system. His policy prescriptions include stronger social security nets, increasing access to opportunity for different segments within a country as well as different countries and reforming how banking and finance is enacted in the real world. In an era, when the dissonance between theoretical assumptions and actual decisions are increasingly apparent, Rajan illustrates how theory can enlighten itself from practice and how getting the fundamentals rights might be the key to the future.