OBSERVARE

Universidade Autónoma de Lisboa

ISSN: 1647-7251

Vol. 2, n.º 1 (Spring 2011), pp. 151-155

Critical Review

Rajan, Raghuram G. (2011). Linhas de Fractura – As fracturas escondidas

que ameaçam a economia mundial (Fault Lines: How Hidden Fractures Still

Threaten the World Economy). Lisbon: Babel: 429 pp. ISBN 978-972-22-

3024-7 (Translated by Carla Pedro)

by Amadeu Paiva

Lecturer in the Department of International Relations

of Universidade Autónoma de Lisboa

This is the Portuguese edition of a book about, according to the first words written on

, "the financial collapse of 2007 and the "Great Depression" that followed". In other

words, this is a book about the newly enshrined word, the "crisis" which shook the

financial world in the U.S. and Europe, and which, due to the configuration of the world

economy, impacted on virtually all sectors of society worldwide, something we are still

experiencing.

It is a very compelling book, essential for anyone wishing to know more about this

issue. The author has a PhD in economics from MIT, and he has been the IMF's chief

economist, professor of finance at the University of Chicago and contributor to the

Indian government as an adviser and chairman of the committee for the regulation of

the financial sector. Such a curriculum, in addition to winning the Fischer Black Prize

awarded by the American Finance Association, leaves him particularly well placed to

deal with this topic.

However, this is also due to the fact that he was one of the economists who predicted

this crisis. The episode of his participation in the 2005 meeting of the Jackson Hole

conference is often cited. This conference annually brings together the governors of

main central banks, and experts in the fields of economics and finance are invited to

submit their contributions. The work he presented at this meeting - titled “Has financial

development made the world riskier?” – advanced that prediction and had a visible

impact on the audience because, as the author writes in his Introduction, "it was not in

tune with the general tone" which, at the time, marked the discussions on issues

relating to the financial industry.

What makes this book indispensable is the recognition it attained, having been

considered the best business book of 2010 and awarded the Financial Times/ Goldman

Sachs Prize.

The original book is Rajan, Raghuram G. (2010). Fault Lines: How Hidden Fractures Still Threaten the

World Economy, Princeton University Press. The edition from which the translation into Portuguese was

made is not mentioned.

JANUS.NET, e-journal of International Relations

ISSN: 1647-7251

Vol. 2, n.º 1 (Spring 2011), pp. 151-155

Critical Review

Amadeu Paiva

152

The book was written for an audience broader than just specialists in this area, and

focuses on the economy of the United States

, the home of what is deemed to be the

most sophisticated financial system in the world. Accordingly, the main question that

occurred to me when I was asked to make a presentation for janus.net, was to know

whether a book that was just written in February 2010, when the crisis is not yet over,

and centred on the North American reality, could be of interest to Portuguese speaking

readers who are not specialists in this field, because, should that be the case, they

would have already read the English version. And I also wondered about the

contribution the book could make to readers who are experiencing the crisis from a

Portuguese and European perspective.

Portuguese readers who are aware of the news and debates in the general media, are

exposed to the social environment, have seen the film "Inside Job", and read the

references and jokes circulating on the internet

, not to mention the Memorandum of

Understanding agreed between Portugal and the "Troika"

, will not find that the topics

exposed in the book or even the language used constitute big news. However, I think

readers will benefit from the reflections that may arise from reading the book, and from

the comparisons they will be able to make between events described in the book and

those currently experienced in Portugal and elsewhere in Europe. Nevertheless, readers

should not stop being critical, because both the arguments used and the theses are not

irrefutable

The book focuses on the forewarnings resulting from the crisis and proposes a set of

reasons for explaining it, putting them in context and analyzing them. This analysis is

the starting point from which the author presents what he believes to be the difficult

political choices that will fight the real causes of this and potential future crises.

The approach method the author uses is based on the concept of 'fault lines', i.e., sets

of interacting forces which cause huge tensions which, in turn, generate crises, like the

fault lines created by the contact or collision of tectonic plates on the Earth's surface,

which result in earthquakes. He believes that these fault lines are in fact systemic, and

he moves away from the explanation he classifies as simplistic, according to which the

crisis could be explained only by the behaviour of individuals or specific institutions.

Besides an "Introduction" and an "Epilogue", the book is divided into ten chapters. In

the first seven, the author explains all three sets of fault lines he has examined. The

last three chapters are dedicated to reforms and other proposed policy measures.

These three sets of fault lines are the result of the contact (i) between politics and

financial markets, (ii) between countries, especially among the economies that

consume too much, like the United States, and those that do not consume enough,

such as Germany and Japan and, increasingly, China; and (iii) between different types

A useful book with a non-American perspective of the financial system, based on the experience of

European countries, is: Dewatripont, Mathias; Rochet, Jean-Charles and Tirole, Jean (2010). Balancing

the bank: global lessons from the financial crisis, Princeton University Press.

Subprime Crisis by Bird and Fortune (http://www.youtube.com/watch?v=mzJmTCYmo9g) is quite an

interesting example.

On this, see the commentary on Collaterized Debt Obligations and on the European Financial Stability

Facility (EFSF) by Zingales, Luigi, published in Negócios Online (Online Businesses), on 7 January 2011,

titled A alquimia financeira da Europa (The financial alchemy of Europe).

(

http://www.jornaldenegocios.pt/home.php?template=SHOWNEWS_V2&id=461849)

On this it is interesting to read Paul Krugmam’s critiques of some of the theses and arguments advanced

by Rajan in his book (http://www.nybooks.com/articles/archives/2000/sep/30/slump-goes-why/) and

also Rajan’s actual reply (http://forums.chicagobooth.edu/faultlines?entry=24).

JANUS.NET, e-journal of International Relations

ISSN: 1647-7251

Vol. 2, n.º 1 (Spring 2011), pp. 151-155

Critical Review

Amadeu Paiva

153

of world financial systems, specifically between transparent and non-favoured financial

systems – like in the U.S. and in the UK - and less transparent financial systems that

exist in most part of the world, given that they operate based on different principles

and are subject to different forms of government intervention, which means they tend

to distort the functioning of each other whenever they finance each other.

The most important example of the first type of fracture line is the one that results

from rising income inequality in the United States – which the author attributes to the

insufficient results of undifferentiated socialization of education and learning in general,

which has been generating deficits in the human capital that the U.S. economy needs -

and the political pressure that was created to facilitate credit giving.

In this situation, the political response to rising inequality was to use credit as a

stopgap: consumption not supported by a low income may be supported by affordable

credit. "The benefits - increased consumption and more jobs - were immediate,

postponing the payment of the bill into the future" (p. 24). In particular, the author

discusses the controversial policy to promote wider access to home ownership.

Another example of fracture resulting from contact between politics and financial

markets, to which the author gives great importance for its harmful effects, is precisely

how the U.S. monetary policy is influenced by political considerations, along the same

lines of credit facilitation, in order to respond to a situation where economic recovery is

done without an increase in jobs, in a country where the duration of unemployment

benefits is short and medical care benefits are not available to the unemployed. Hence,

a policy of low interest rates stimulates job creation, but in a deregulated financial

market, it turns out to have adverse effects by causing the price increase of raw

materials, the price of assets that are not remunerated by interest, the tendency for

the financial sector to take more risks and make credit more easily available.

Going beyond mere economic logic, "the economic recovery has everything to do with

jobs, not with production, and politicians are prepared to offer fiscal and monetary

incentives to the economy until jobs start to reappear" (p. 34). The second series of

fault lines emanates from the contact between economies with high levels of

consumption and economies with relatively lower levels of consumption. In the first

case, we have the United States, which, according to the book and as a result of their

relative scarcity of savings, funded "... their expenditure in 2006 by borrowing about

70% of the world's surplus savings" (p. 363). In the second case, the author refers in

particular to Germany, Japan and China, countries that have based their growth on

exports. This means they had surplus production capacity with regard to their domestic

consumption, which enabled them, in the late 1990s and in the 2000s, to meet an

important part of U.S. demand. In this context, the author finds a second fault line: the

excessive dependence of countries with growth based on exports vis-à-vis foreign

consumers, which undermines the global economy for the pressure that these countries

exert on importing countries to maintain their pace consumption, since their protected

and inefficient domestic markets are unable, by themselves, to promote the growth of

their own economies.

The last set of fault lines was brought about by the contact between different types of

financial systems. On this topic, three main sets of considerations stand out in the

book. The first deals with "the flighty unpredictable foreign funding”, putting emphasis

on the reasons why, in the process of "developing countries" seeking financing, the

JANUS.NET, e-journal of International Relations

ISSN: 1647-7251

Vol. 2, n.º 1 (Spring 2011), pp. 151-155

Critical Review

Amadeu Paiva

154

tensions and confrontation between the consequences of their “less transparent

financial systems", which is the result of assistance given by banks and governments -

and the "more transparent" financial systems of the lenders, contributed to those

countries becoming net exporters, and thus cease to contribute to the absorption of

global oversupply.

The second set of considerations exposes one of the weaknesses of “transparent and

non-favoured" financial systems: the fact that investors trust, without much scrutiny,

their safety, in addition to the ratings they attribute to assets traded in these systems,

as well as the market prices that are formed therein, leaving them unprepared when

something does not work that well.

Finally, the author examines the explanations advanced for the behaviour of financial

agents who helped trigger the crisis, leading them to exaggerate their risk taking.

The policy measures the author proposes to remedy and especially prevent future

crises, presented in Chapters 8, 9 and 10, leave, somehow, a feeling of dissatisfaction.

Let us examine how they are presented right in the “Introduction”:

"There are no miracle solutions. The reforms will require careful analysis and

sometimes a tedious attention to detail. I shall examine this topic (...) by focusing on

more comprehensive approaches. My proposals, if implemented, could substantially

transform the world we live in and make it leave the path of deepening crisis for a path

of greater economic and political stability and cooperation. (...).Reforms will require

societies to change their way of life, how they grow and how they make choices. They

will involve a significant short-term pain, but, in exchange, we will attain enormous and

widespread long-term gains. These reforms are always difficult to sell to the public, so

they are not very attractive to politicians. But the cost of doing nothing is perhaps a

worsening of the turbulence we experienced recently, because the fault lines, if not

identified, only tend to deepen even more"(p. 42).

When we read these proposals, some seem superficially presented, and some side

effects appear to have been neglected; and those steps that appear necessary to make

are few and far between, especially those outside the scope of strictly monetary and

financial matters. This is further aggravated by the fact that some have not been

implemented and others were so skewed that fail to guarantee that, as originally

worded, they would have been effective.

Chapter 8 is about reforming the financial sector, and considers that the main issue is

to make the private sector re-evaluate risk properly, without assuming that the

government will intervene. “Transparency will need to be encouraged to make people

interested in monitoring the relationship between the government - or the regulator -

and the financial sector. Much of what I propose falls short of the expectations of those

who want drastic solutions" (p. 326).

The author then presents a list of measures that are certainly not alien to the reader

and which were in general widely referenced in the media, whose implementation has

been attempted or achieved. These measures are related to salaries and incentives for

managers of financial firms, to the distortions in assessing risk, managing the

expectations of government intervention, the end of government subsidies and

privileges to financial institutions, the introduction of a type of regulatory mechanism

JANUS.NET, e-journal of International Relations

ISSN: 1647-7251

Vol. 2, n.º 1 (Spring 2011), pp. 151-155

Critical Review

Amadeu Paiva

155

that is cycle-proof, comprehensive, non-discriminative, and cost-effective, and also to

measures related to competition and innovation...

It is interesting that the author suggests that "one possibility is to keep the deposit

guarantees for small banks which, in turn, should pay a fair insurance premium,

reducing them gradually in the case of larger banks, until they are phased out "(p.

322).

The chapter titled "Improving access to opportunities in America" proposes reforms in

the U.S. economy, which, as expected and given the prominence given to the

respective fault lines, are related to quality improvement of human capital and

strengthening the safety net both for the protection of the unemployed and for access

to health care, security of pensions, labour mobility, and, marginally, to encouraging

savings and fiscal policy.

In the last chapter ("The fable of the bees replayed"), the author addresses the

question of current international economic relations, the role of multilateral

organizations and, in particular, the positioning of China in this context, without

explaining who will make a change in the status quo and how.

Two final considerations:

One may argue whether this crisis is more or less similar to previous ones or if it is

completely different. Reading this book also helps to reflect on this. At least apparently,

when one casually leafs through a book on financial history, the general features of all

crises are alike. Does the germ of the crisis in the financial industry have a congenital

and chronic nature?

Consider, for instance, this description referring to an event that took place in the

eighteenth century: "Warsaw organized a major bills of exchange business, which was

based on, and aimed to guarantee, the usury of bankers. In order to get money they

could lend to the great squandering lords at an interest rate of 8% and above, they

sought and found outside the country bills of credit that were not based on any trade in

goods, and that the foreign drawer accepted indulgently until the remittances obtained

by means of speculation failed. With the bankruptcy of Tepper and other highly

reputable bankers in Warsaw, they paid dearly for this business”

One may equally argue whether “the financial sector actually contributes to economic

growth and well-being or whether it is only a secondary element, largely irrelevant,

that only makes its presence felt when it periodically implodes" (p. 282).

It would be highly desirable not to have any doubts about these two issues.

How to cite this Critical Review

Paiva, Amadeu (2011). Critical Review of

Rajan, Raghuram G. (2011). Linhas de

Fractura – As fracturas escondidas que ameaçam a economia mundial. Lisbon:

Babel: 429 pp. ISBN 978-972-22-3024-7 (Translated by Carla Pedro)

, JANUS.NET e-

journal of International Relations, Vol. 2, N.º 1, Spring 2011.

Consulted [online] on date

of last visit,

observare.ual.pt/janus.net/en_vol2_n1_rec3.

Büsch, J. G. (1808). Theoretisch-praktisehe Darstellung der Handlung..., 3rd ed., volume II, Hamburg:

232s pp., quoted in Marx, Karl. The Capital, Book 3, vol. 5, Ed. Civilização Brasileira / Centro do Livro

Brasileiro.