Fault lines – How hidden fractures still threaten the world economy

In 2005, a man was roundly scoffed at by a group of luminaries who had gathered to celebrate Alan
Greenspan’s legacy. His crime? In those heydays of financial prosperity, he claimed that the world was
headed for financial disaster. As it turned out two years later, he was right. This man was none other
than Raghuram Rajan, the current economic advisor to the Prime Minister of India.

Through his latest book ‘Fault Lines’, Raghuram Rajan argues that the roots of the calamity can be traced
back to three sets of fault lines. The first set of fault lines stems from domestic political pressures,
especially in the United States. Under this, the author talks about the rising income inequality in the
United States. The rising inequality combined with poor safety net creates pressures on politicians.
However, instead of improving the competitiveness of labor force, the government has chosen the
easier option of enabling credit to sub-prime borrowers. So, the first set of fault lines leads to easy credit
to fuel consumption. The second set of fault lines emanates from trade imbalances between countries.
Here the author focuses on trade surplus countries, such as Germany, Japan and China. These countries
rely on exports for growth and so are excessively dependent on the foreign consumer. Now this excess
supply is absorbed by the borrowers in US, UK and Greece which results in a bubble. The indebtedness
grows to the point where these countries cannot afford any further spending and the bubble bursts. The
third and final set of fault lines develops when different types of financial systems come into contact to
finance these trade imbalances. In this case the foreign investors into US implicitly assumed that the US
government would back the mortgage agencies like Fannie Mae and Freddie Mac. Consequently, the
funds from the foreign private sector flowed into the highly rated mortgage-backed securities. Finally,
you bring these three dots together and this is how the story goes - United States is politically
predisposed towards stimulating consumption, the surplus countries depend on foreign consumption
for growth and finally, investors from developing countries finance sub-prime mortgages. So,
consumption in US increases till it is no longer affordable. The bubble bursts and crisis precipitates.

To summarize, the book traces the crisis to three sets of fault lines – domestic political pressures, trade
imbalances and incompatible financial systems. At the end of it all, you might not agree with every single
point that the book makes but the book will definitely make you think and question your biases against
particular countries.