Fault Lines – Part Two – Who Should Read This Book?

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram G. Rajan (Princeton University Press, 2010)

Who should read this book? Short answer: Anyone, who like me, wishes to see economists build a model for explaining economics on a world-wide basis.

“Raj” Raghuram is not just examining how the Financial Crisis happened in the first decade of this century. He is also helping to build a global view of economics in his books. Raj is particularly interested in the differences between what economists call “developing” and “developed” countries.

That’s because, as we will see in Part Three of this book review, the previous Financial Crisis was not just limited to the U.S.: it affected the rest of the world as well.

The dominant schools of economic thought in the U.S., Keyesian and Chicago Schools of economics are limited to being national rather than global in scope. But it is much more likely that the next Financial Crisis will be global in scope.

Here’s are short synopsis of Fault Line‘s first five Chapters

Chapter One “Let Them Eat Credit”

Anyone interested in the Financial Crisis of 2007-2009 will gain more insight on that global financial meltdown. You should check out this chapter of Raghuram’s book. This book takes off from where Charles R. Morris’ The Two Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Cash (2008) ended.

Chapter Two “Exporting to Grow”

Interested in both developing and developed countries? This is where Raj gets into the distinctions between developed and developing countries when it comes to relying on exports to grow. He provides case studies of the role that exports played in developed countries such as Germany and Japan after World War II as well as China.

Chapter Three “Flighty Foreign Financing”

Investors in mutual funds or ETFs which consist of foreign stock holdings should read this chapter.

Trying to protect one’s investments from current events in the U.S. by buying into companies or whole countries economies is a dangerous game. Here you’ll find out why the financial crisis became a global crisis in the early part of this century – and how a similar global crisis could come about again.

Chapter Four “A Weak Safety Net”

Americans who have ever been unemployed or fear such a fate in their future should read this chapter.

While France and Germany and others have unemployment benefits that last two to three years, the U.S. unemployment safety net is one year or less. See why this is so and how this disparity negatively affects American workers and capitalists alike.

The lack of universal healthcare not tied to employment, affordable job training, and retirement benefits also weaken the U.S.’ ability to cope with long-term recessions.

Jobs created “under the political gun” of pressure from Congress [or currently the U.S. President] often backfire and lead to over-stimulus in monetary policy. This warps incentives in the financial sector and fosters corruption in the political sector, ultimately leading to financial crisis.

Chapter Five “From Bubble to Bubble”

Do you wonder why so many Americans are just one paycheck away from financial crisis? This chapter explains the relationships between the Fed’s short-term and long-term interest rate curves and the interest rates curve significance.

Short-term interest rates push investors to risk more. Easy credit causes workers and capitalists alike to spend more. A signal in the past of “bubbles about to burst” has been the growth of credit. Another indicator of crisis is the rising use of margin loans by speculators to purchase shares of stock.

The Fed’s role in crisis is one that is notable. Its emphasis on job creation over control of inflation (the emphasis on jobs often caused by political pressure) leads to over-stimulus, particularly in the housing sector [a sector that is currently declining].

Why is the housing market in danger? Because there are few opportunities for investors to “short” (bet against) the housing market. People expect housing prices to go up, and prices do keep rising. So, when the bubble bursts, many get caught by surprise.

The Fed has abdicated its role in preventing crises. The Fed simply prepares to pick up the pieces. Economists too are critiqued by Raghuram. They create models that do not take into account the “plumbing,” i.e. the foundations needed to make realistic economic predictions.

Next post – The last five chapters, “Part 3 of Fault Lines – They’re At It Again!”