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.

Deconstructing Financial Crisis

The Myth of the Rational Market, Justin Fox, Harper Business, pp. 340

Justin Fox is the editorial director of the Harvard Business Review Group and a contributor to Time magazine. In this fascinating historical narrative of the financial crisis of 2008 and the events leading up to it, Fox dissects ideas, people and their behavior. The perception of risk and the belief in market rationality is part of both economic thought and cultural history that consolidated the modern world of finance and investment. What the financial crisis did was, not only demolish fortunes, but also ideas put forth by intellectuals who battled to bring in a particular brand of capitalism.

Tracing history

The book is divided into five parts. This section-wise division elaborates the timeline leading up to the financial crisis. In the beginning of the twentieth century, it was unusual to associate the idea of market with rationality. The first serious attempt to apply the logic and reason of science into economics began with Irving Fischer. In his time, the idea that man was infinitely selfish and infinitely far sighted prevailed. Fischer took this assumption by the horns and argued that the uncertainty of the future could be ‘tamed’, if not eliminated. This was the beginning of modeling the future outcomes with variables available in the present.

Fischer’s work was taken a step forward by Harry Markowitz, who introduced the ‘statistical man’ to the market with the help of quantitative approach to investing. The world events of the time prepared such intellectual pursuit because of the emergence of strategic thinking in the Second World War. About a decade later, it was Paul Samuelson, who wrenched the idea of rational market that was on the fringes of the economic thought into the centre stage of academic research. Samuelson, who was in the habit of reading every paper that was published in the Quarterly Journal of Economics, came across the idea of ‘market randomness’. In a case of remarkable serendipity, a doctoral thesis of Henry Bechelier filled with dense description of market behavior caught his attention. He immediately recognized that the randomness of market mathematically described was similar to what Albert Einstein described about the Brownian motion of random particles. This paved the way for the belief in the market as rational and random.

Age of Assumptions

      The decades that followed were notable for two major achievements. Modigliani and Miller came up with a simplifying assumption that argued that the market behaves only based on real considerations of how an investment would actually perform, and not on the packaging of the investment. Eugene Fama, a doctoral student of the Chicago school, proposed that the investor’s choice took random positions along a bell curve. The metamorphosis of the market from being rational to random and from there to being perfect was established. It was this cherished belief that was shattered in the financial crisis of 2008. Alan Greenspan, the chief of the Federal Reserve for 14 years admitted that the economists failed to anticipate the crisis and invite government intervention because ‘it (the market) has been working exceptionally so well’.

This book is an engrossing read that pays rich tribute to well-known and lesser acknowledged economists and thinkers of the twentieth century. The history of ‘risk and reward’ that the book captures brings out a lively account of the protagonists in the financial world and the anatomy of the financial markets.