Fault Lines: How Hidden Fractures Still Threaten the World Economy, by Raghuram Rajan, Princeton University Press, RRP£18.95
You can tell the story of the financial collapse in many ways. It can be a tale of Wall Street greed or incompetence; of innovation run amok; of failed regulation; of hubristic faith in market forces. You can tell a macroeconomic story of too much spending in the US and too much saving in China. You can dwell on the Federal Reserve’s errors in monetary policy, or the US obsession with owner-occupation, or the US tax code’s fondness for debt.
What caused the crisis? All of the above. There is an embarrassment of causes – especially embarrassing when you recall how few people saw where they might lead. Raghuram Rajan, a professor at the University of Chicago’s business school and a former chief economist of the International Monetary Fund, was one of the few to sound an alarm before 2007. That gives his novel and sometimes surprising thesis added authority. He argues in his excellent new book that the roots of the calamity go wider and deeper still.
He arranges his analysis around three fundamental stresses or “fault lines”. The first, improbably, is widening income inequality in the US. The second, more familiar, is trade imbalances – though with the twist that these should be understood as the outcome of slow historical forces not momentary policy mistakes. The third is the clash between the “transparent, contractually based, arm’s length financial systems” of the US and Britain, and the directed or relationship-based financial systems of countries such as China and Japan. Here his point is not that one model of finance is better than the other, but that things can go wrong when they come into contact.
Rajan’s account of the crash is not an alternative to the standard theories. He runs through the familiar narrative, discussing the usual suspects, but puts them in a bigger, encompassing frame. He prescribes as well as describes, suggesting changes in policy on many fronts. This is an ambitious project for a book of only 260 pages. It is clear and accessible, but not relaxing; or encouraging. Arguing, as he does, that the deeper causes of the crisis are politically and culturally entrenched underlines how difficult they will be to remedy.
Rajan’s discussion of US income inequality is typically thought-provoking. In recent decades, he explains, the benefits of US economic growth have accrued disproportionately to the rich. Middle-class earnings have been stagnant, and job insecurity has worsened too. Bad in themselves, these trends were also a political problem. The response of successive governments was not to deal with the fundamentals – a persistent skills shortage and a failing education system – but to offer the palliative of easy credit.
This especially took the form of subsidised mortgages – tax breaks, government guarantees, Fannie and Freddie, affordable housing mandates, George W. Bush’s “ownership society”, and so forth. Loans were used not just to buy houses but, through withdrawal of equity, to finance consumption. The subprime collapse started the crash. Pressing questions about financial innovation and regulation have to be addressed, Rajan agrees, but risky innovation and careless regulation did not cause the subprime surge, they only facilitated it.
He therefore goes beyond suggesting improvements to regulation of mortgage lenders and ways to tamp down risk-taking in finance. He also wants education reform, to address the underlying malaise of stagnant middle-class wages. He calls for improvements in the US safety net as well, to lessen economic insecurity.
As you can see, the book requires an open mind. Naming income inequality as a principal cause of the crash has instant appeal for left-leaning critics of capitalism. By warning, well before the crisis, that financial innovation was making the world riskier, Rajan had already proved he was no cheerleader for “markets know best”. His book points to systemic flaws in business as usual – and yet he is an economic liberal. “The basic ideas of the free-market system are sound,” he states. “Governments have to do more to help their citizens build capabilities that will allow them to be productive. But they also have to step back in other areas to allow the market to function effectively.”
The circle of blame goes wider than greedy bankers and negligent regulators, Rajan emphasises. It includes you and me, and the politicians we elected. Almost all the culprits acted in good faith and even rationally, given the circumstances, he argues. If this were not the case, avoiding the next crisis would be much easier. We could thump the villains and move on. If only it were so simple.
The writer is an FT columnist