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Fault Lines
Fault Lines
How Hidden Fractures Still Threaten The World Economy
Submitted by Francesca R
14th August 2013
Fault Lines

This reviewer never read many books about the financial crisis of 2008 (and beyond). Having been up-close to it, and working on "Lehman Sunday" (14 Sept 08) netting out derivatives positions with that institution for her then employer (it worked out just fine), she was for a long time put off by the proliferation of diagnoses from others, as well as having no ready means to narrow the choice of accounts down. (She has read "Whoops" by John Lanchester, a novelist, and "Fool's Gold"--more about JPM and CDOs--by Gillian Tett, journalist, and now this one by an academic).

Fault Lines is itself about various adverse incentive structures in parts of the world that were--as it happened--critical in setting off the perfect storm of last decade's implosion, but these are of interest in their own right because they have not been addressed or corrected, according to the author, whether or not they portend a repeat of the same thing. Rajan's selling point though appears to be status garnered as a predictor of the crisis, thanks to a paper presented (and ignored) at a 2005 central bankers conference. That lends authenticity to the story woven together in the book's chapters, though it was not a pre-requisite

It appears that there are five fault lines worthy of mention--not explicitly numbered hence a list is appropriate here. Two of these lie underneath the United States, one across the export heavy growth engines of China, Germany and Japan, a further rift is embedded in emerging countries' FX reserves. And the fifth seems to be everywhere--a mix of excessive financial innovation supported by the lure of tail risk under background conditions of moral hazard. If she was into principal components analysis, this reviewer would collapse that one into the others and merge the two US ones, getting three fault lines not five (still plenty for a big quake).

Receiving top billing is the political extension of easy credit to assuage the have-not side of ballooning income inequalities, in particular via home lending. Typically this is a right-of-centre diagnosis, seeking to load blame on too much government rather than not enough, but it has truth enough, the result being too much correlated risk spread among those who would not have chosen it all by themselves. Second place--those large economies which, mostly for legacy reasons, export to the world in order to grow. Apparently this puts pressure on non-exporters to spend (not so convincing--this reviewer has so far resisted BMW's attempts to impose a trade surplus on herself). But it also renders these economies (read: China) highly likely to be severe lame ducks in a global downturn, the longer they export (save / don't spend) and the older (demographically) they get. This lowers the breadth, or diversification (not the author's terms--your reviewer's) of the world economy, and narrowness is fragile.

Third--developing countries scarred by the IMF's pre-2007 diktats became suppliers of capital--hot money at that--instead of destinations for it; wholly out of kilter with relative returns and therefore a further source of apple-cart unbalancing, but less surprising given the foregoing, plus the relative paucity of domestic institutions which form the desiderata of capitalism (contract sanctity and rights). And fourth (similar to the first in this reviewer's eyes)--a US which is far less tolerant of recessions and jobless recoveries than anywhere else, mostly because of its weak social safety net (by rich world comparison), and manifest through fault line #1 above, and an asymmetrically easy Federal Reserve.

The final fault line is the incentive of all manner of individuals (though frequently condensed to "bankers") to take correlated tail risk in a background where transactions are anonymous (referred to in the text as arm's-length) and the measure of efficacy is stripped down to money. Of course, since this is an identical description to the "invisible hand" which is supposed to maximise output, it leaves the reader wondering what is different about finance, and concluding anything ranging from too much state meddling (moral hazard backstops in particular but also the desire to push home ownership) to too little regulation and various combinations thereof. This reviewer found the proposed remedies to be mostly tinged with a won't-happen blemish ("hard choices" is something of a give-away in that regard), but she appreciated this politically-balanced account of the origins of what remain today's vulnerabilities.
Raghuram G Rajan
By Francesca R on 15th August 2013, 11:18 AM
(Shortly before this review was written, Rajan was appointed governor of India's Reserve Bank)
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