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Fault Lines: How Hidden Fractures Still Threaten the World Economy

In "Fault Lines: How Hidden Fractures Still Threaten the World Economy" (Princeton University, $26.95), Raghuram G. Rajan concludes that the financial crisis erupted "because in an integrated economy and in an integrated world, what is best for the individual actor or institution is not always best for the system."

Like geological fault lines, the fissures in the world economic system are more hidden and widespread than many realize, he says. And they are potentially more destructive than other, more obvious culprits, like greedy bankers, sleepy regulators and irresponsible borrowers.

Mr. Rajan, a finance professor at the University of Chicago and former chief economist at the International Monetary Fund, argues that the actions of these players (and others) unfolded on a larger worldwide stage, that was (and is) subject to the imperatives of political economies.

He cites three fault lines: domestic political stresses; trade imbalances among countries; and the tensions produced when financial systems with very different structures interact. All three came together to damage the financial sector in 2008, he says, and could meet again to cause another crisis.

Yet another fault line occurred with the meeting of two distinct financial systems. The first, which he calls an arms-length system, is based on transparency and legal safeguards, like those of the United States and Britain. The second, a relationship system, relies on close, informal ties among people and institutions. Examples of the latter include China, Japan and South Korea.

Mr. Rajan says foreign investors from arms-length systems who put capital in countries with relationship systems tend to erect safeguards to lower their risk -- like offering short-term loans that can be withdrawn quickly.

"The U.S. political system," Mr. Rajan notes, "is acutely sensitive to job growth because of the economy's weak safety nets," creating pressure for a series of ad hoc policies that have effectively steered the American economy from bubble to bubble and created damaging incentives. With interest rates kept low, financial players sought out riskier investments carrying higher returns. The possibility of government bailouts in the event of catastrophe further distorted attitudes toward risk.

MR. RAJAN unpacks how individual choices made by bankers and monetary authorities around the world can be seen as rational responses to the largely hidden flaws in the global financial system.

A Call to Fix the Fundamentals
Published: July 31, 2010
Raghuram G. Rajan writes that systems and large historical forces were the primary drivers of recent global financial instability.


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