Fault Lines

Title: Fault Lines – How Hidden Fractures Still Threaten The World Economy

Author: Raghuram G Rajan

Publisher: Collins Business 2010 (First)

ISBN: 978-81-7223-973-2

Pages: 243

A really splendid book from an author of Indian origin. Raghuram G Rajan is a Professor of Finance at the University of Chicago’s Booth School of Business. He was the Chief Economist at the IMF from Sep 2003 until Jan 2007. He was an economic adviser to the prime minister of India. This book is a thorough analysis of the financial crisis and depression which rocked American and world economies in 2008, the clutches of which the world still struggles to get free. The crisis came as a surprise to many, since the renowned economists in the U.S. and abroad couldn’t see it coming. Since the day of globalization dawned in the 1990s, the financial systems of every country is intertwined and the trouble signals in one part of the world soon gets transmitted to far off regions. This is particularly so in the case of U.S. economy which leads the global financial business. Naturally hence, the reasons for the sudden downfall is a topic of interest to readers everywhere.

Rajan begins from the 1980s when the growing inequalities of income of American households became noticeable. This disparity is attributed to lower levels of education which put them at a disadvantage in an economy increasingly tilted towards the employment of cutting edge technology. With the growth of new-age industry, higher education was mandatory. This unbalance gradually became a political issue a decade later. However, politicians always try to find out a quick wayout which was impossible in this case. Growth of education takes several years, spanning several presidencies, making the issue difficult to encash in an election. This forced the Clinton and Bush administrations to come out with a palliative in the mean time. Easy credit was extended to poor and lesser income households for buying houses. The increased purchasing power masked the income disparities temporarily, but the financial institutions were forced to extend credit to people whose properties were sub-prime, that is, those which fell below the minimum credit-worthiness standards. To help private banks and insurance companies which jumped on the bandwagon, Fannie Mae and Freddie Mac, which are federal institutions absorbed the high-risk home loans to these subprime creditors. Securities were issued based on the loans.

While the American economy was firing up, the rest of the world fanned it. Newly industrialised and world-war ravaged countries like Germany and Japan tried an export-oriented path to progress. Domestic consumption was frowned upon, with state spending limited to providing organisational capability for export. As long as surplus labour thrived in agriculture, industrial wages were low, giving the manufacturing sector a definite cost advantage. When such agri-surplus dried up, wages rose. Manufacturing went looking for poorer states. Germany and Japan grew to be world’s 2^nd and 3^rd largest economies for a time, but they had a dismal domestic sector. East Asian countries like Malaysia, Indonesia and Thailand began investing in a huge scale at the end of the 1980s. However, the money was not flowing from domestic savings, but from international lending. Foreign lendors, however, didn’t intervene directly. They issued credit to local banks, who had to return the money in foreign currency, while disbursing it in local currency to investors. These short-term loans flew from the country at the moment it became clear that many of the projects were not viable. The Asian tigers were brought to their knees and was extricated from the mess through IMF loans, which came attached with humiliating conditions. The economies were sound though, and the restructured system began producing large savings, which had to be invested abroad. This money found an outlet in the U.S. housing securities.

Just after the dot-com bust om 2000, U.S. reduced short-term interest rates making bank deposits unattractive and real-estate deals very promising. House prices boomed, but was offset with easy loans to those who applied. As long as the prices were going up, the music sounded good, as the borrowers could refinance their loans, thus postponing repayments. These loans were in fact sold to overseas investors, backed with mortgage based securities which were highly rated. Banks heavily invested, even though they knew that the practice was unhealthy. Everyone was counting on the bailout the government would offer to save large, systemic enterprises which couldn’t be allowed to fail one fine morning. When the soaring prices, however touched the ceiling, all hell broke loose. Refinancing dried up and repayments were defaulted. Many borrowers couldn’t even pay one single instalment. The securities based on these loans became not even worth the paper on which they were printed. The system collapsed in which many institutions were bankrupt and many were rescued by the government with taxpayer’s money.

Rajan lists many suggestions to avoid such recurrings in the future. Transparent regulators are an essential requirement. Government should not give the impression to rogue traders that whatever may happen, their enterprises would be bailed out. This encourages audacious managers in large, systemic institutions to expose themselves to undue risk taking. On the other hand, the basic problem of lower education standards must be addressed quickly. Educational reforms should be put in place to ensure access to the less-privileged. Americans need to spend less and save more, a piece of good advice they might find extremely irritating! To address global economic inequalities, multilateral agencies like the IMF should pay a greater role by addressing directly to the people, instead of dealing only with financial ministers of those countries. Current technology offers many platforms through which the people of a country may be exposed to financial information from such agencies.

The author then moves forward to examine the road ahead for India, which is on the verge of fast economic progress. Land acquisition is identified as a cause for concern. However, the reason given does not seem to be valid in India’s case. Rajan proposes the poor maintenance of land records as the root cause of the problem, which is far from the experience. Even though most of the offices are not computerised, locating a land record is not a hard deal, in my opinion. If you bribe the clerks, they would mine any record, however old, in no time! Also, the universities must regain their credibility. Reining in corruption should be India’s prime priority by providing more transparency in government dealings and also empowering proper NGOs.

The book is superbly researched and bear the marks of the hand of a very knowledgeable person. The structure is splendid and logical. All the aspects of the problem at hand is expressed in good detail and the reasons are elucidated in magnificent detail. On the negative side, it may be said that the financial terms strewn everywhere in the text with little regard to the lay reader’s background of financial ideas.

The book is highly recommended.

Rating: 3 Star