- The Washington Times - Monday, July 26, 2010

By Raghuram Rajan
Princeton University Press, $26.95, 272 pages

Few people were able to foresee the recent economic downturn. Raghuram Rajan, professor of finance at the Booth School of Business and former chief economist for the International Monetary Fund, was one of them. This makes his new book, “Fault Lines,” worthy of consideration amidst the rampant speculation about the causes of the financial crisis.

The author claims that discretionary stimulus spending by the government has tended to be “based on ideology and on past obligations or interests rather than attuned to the needs of the moment.” He thinks expanding the U.S. welfare system would more effectively address the needs of Americans than would bank bailouts or government spending projects that people could hardly count on to benefit them individually.

Although Mr. Rajan admits that “the gap between government intents and outcomes can be very wide indeed,” he simultaneously advocates a stronger individual safety net, saying, “No modern economy should force workers who lose their jobs to make such painful decisions as choosing which of their children to protect with medical insurance.” He notes that our welfare system lags behind those of other developed countries and, “There are holes even in the relatively scant unemployment benefits on offer in the United States.”

The author hardly considers the economic costs of such reform, which would result in decreased incentives for people to work and be productive members of society. People also would save more if they couldn’t count on the government to bail them out, although Mr. Rajan explicitly denies this, merely citing a claim by the McKinsey Global Institute that two-thirds of those born between 1945 and 1954 will not have enough assets to retire “comfortably.” “Comfortably” is a highly subjective term, and Mr. Rajan’s evidence is embarrassingly flimsy for his sweeping and insulting assertion that Americans don’t know how to save sufficiently for their futures.

Although he’s silent about the economic costs of policies he supports, he understands the importance of incentives, arguing that banks will take risks if they think the government will take measures to prevent industrywide collapse. He says, “Banks that remembered the Fed riding to the rescue in 2001 were not wrong in anticipating that they would be helped out of a tight corner yet again.” The author knows that the recent bailouts only made the problem worse, encouraging banks to be risky in the future and leading to more dramatic economic busts.

Although he doesn’t question their intentions, Mr. Rajan doubts whether recent Wall Street alumni who are working for the government or Federal Reserve can allow their decisions not to be biased by their former training and continued consultation with one-time colleagues in the financial industry. The government’s willingness to bail out Wall Street is a reflection of the “crony capitalism” the author describes.

Mr. Rajan is sure to point out that “bankers are not the horned, greedy villains the public now sees them to be” and bemoans that those in finance work for money, not for the satisfaction of helping others that people in professions such as medicine sometimes experience. He finds it morally repugnant that executives clamor for bonuses during times of hardship and explains, “The very anonymity of money, the fact that it is fungible and its provenance hard to trace, also makes it a poor mechanism for guiding employees’ activities toward socially desirable ends.”

The fact is, however, that banks can only make profits by providing services that others value. Even if they could stay in business, bankers who would act based on personal values probably would lead society further astray than if they merely pursued earnings.

The author calls for the government to prevent banks from pushing unaffordable loans on customers. Clearly, in the years leading up to the recent housing crisis, people were buying homes they couldn’t afford using loans they could obtain far too easily. Indeed, from 1997 to 2006, housing prices increased by an average of 19.4 percent every year while average income remained nearly constant. In a free market, banks wouldn’t be making loans unlikely to be repaid, and people wouldn’t have bought homes that, according to Mr. Rajan, turned out to be “like millstones around their necks, drowning them in a sea of debt.”

Mr. Rajan correctly criticizes the Federal Reserve for keeping interest rates extremely low and appropriately blames the government-sponsored Fannie Mae and Freddie Mac for buying enormous amounts of subprime mortgage securities in order to meet government quotas. Yet he also says the housing market, unlike other markets, doesn’t allow speculators to bring down prices by taking the short position. He attributes this to the fact that the market is so heavily affected by bank lending and that because just a small percentage of houses change hands every year, a small percentage change in the housing stock can lead to dramatic price fluctuations.

The author doesn’t explain why these two points are important, and indeed, the latter seems of little relevance for a country of 300 million people. However, the housing market’s reliance on lending may indeed make it particularly vulnerable to manipulation by the government. Alas, the crisis doesn’t appear to have changed much, with Fannie and Freddie lending hundreds of billions of dollars since September 2008 in an attempt to raise housing prices to their absurdly high previous levels.

Mr. Rajan is conflicted about the role of government, as he shows through his simultaneous opposition to bailouts and advocacy of the welfare state. He thinks the government needs to take care of Americans because they don’t have the foresight to save for their futures. The author needs to provide better evidence for these and other assertions and would have done better to narrow the scope of his book, which segues from the financial crisis to economic inequality and then to education and health care reform. “Fault Lines” is valuable primarily for its clear explanation of unintended economic consequences from well-meaning government intervention.

Roger Lott is a writer in Pennsylvania.

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