The 2007 financial collapse and subsequent recession led to widespread scrutiny of

economists, many of whom failed to foresee the crisis. Despite some experts like Rogoff,
Roubini, Shiller, and White warning about risky levels of U.S. house prices and household
debt, their concerns were largely ignored by those benefiting from the booming economy.
Rajan highlighted skewed incentives in the financial sector and the potential for a major
crisis, indicating that deregulation and increased competition had driven banks to take on
greater risks, contrary to the belief that securitization would make them safer.
Rajan argues that the crisis was not just a result of individual failures but of systemic “fault
lines” or underlying vulnerabilities within the global economy. These fault lines, influenced
by domestic politics, trade imbalances, and conflicting financial systems, created a precarious
environment. Rajan’s work aims to illuminate these underlying problems and propose
necessary reforms to stabilize the global economy and prevent future crises.
Rising Inequality and the Push for Housing Credit
Rising income inequality in the United States has created significant political pressure for
easy credit. The share of income held by the top 1 percent grew from 8.9 percent in 1976 to
23.5 percent in 2007. While extreme top incomes draw attention, a more widespread issue is
the growing wage gap between higher-skilled workers and the median worker. Technological
progress demands higher skills, but the education system has failed to keep up, leading to
stagnant wages and job insecurity for many.
Politicians, unable to swiftly improve education, sought to appease constituents through
expanded lending, particularly to low-income households. This boosted consumption and
jobs in the short term, deferring the cost to the future. Expanding home ownership became
the politically palatable means of increasing credit and consumption, promoting it as part of
the American dream. However, this intersection of government policy and the profit-driven
financial sector created a deep economic fault line.
This pattern of addressing deeper economic anxieties with easy credit, rather than substantial
reforms, highlights a recurring systemic fault line.
Export-Led Growth and Dependency
Export-led growth strategies, particularly in countries like Germany, Japan, and China, have
created significant global economic dependencies. These countries rely heavily on foreign
consumption to sustain their growth, producing goods for export rather than fostering
domestic demand. This dependency forms a crucial fault line in the global economy. When
large countries like the United States import these goods, their consumer demand is met
without driving up domestic prices and inflation excessively. However, this arrangement also
encourages higher household indebtedness, leading to economic instability.
Historically, post-World War II or poverty-stricken nations chose rapid export-led growth,
prioritizing the creation of competitive firms over domestic consumption. This led to the
development of efficient export-oriented sectors, exemplified by companies like Toyota and
Samsung. However, domestic sectors in these countries, including banks, retailers, and
restaurants, remained inefficient due to limited competition and government protection.
As these export-driven economies matured, their reliance on low wages diminished, and their
inefficient domestic sectors constrained internal growth. During economic downturns, these
governments often resort to wasteful spending to stimulate growth, further entrenching their
dependency on foreign demand. With aging populations and such policies, countries like
China risk worsening this global economic vulnerability in the absence of substantial policy
changes.
The Clash of Systems
In the past, rapidly growing developing countries like Korea and Malaysia were not net
exporters despite focusing on producing goods for foreign markets. They ran trade deficits
and borrowed heavily from global capital markets to fund their substantial investments in
machinery and equipment. However, the financial crises of the 1990s taught these countries
the dangers of borrowing extensively from industrial nations. This experience revealed a fault
line due to the fundamental differences between their financial systems and those of their
lenders.
Developing countries' financial systems relied heavily on government and bank intervention,
lacking the transparency and legal enforceability of the "arm’s-length" systems in countries
like the US and UK. In these developed markets, transactions depend on publicly available
information and legal protections, enabling direct financing and competitive bidding.
Conversely, developing nations operated on insider relationships, with information closely
guarded and enforcement dependent on long-term business ties.
When foreign investors, unfamiliar with these opaque systems, financed corporate
investments in developing countries, they mitigated risks by offering short-term loans,
denominating payments in foreign currency, and lending through local banks. This setup led
to poorly directed lending and investment booms followed by busts, culminating in the late
1990s crises. In response, developing nations shifted to net exporters, boosting exports and
building foreign-exchange reserves to avoid dependency on foreign capital, thus adding to the
global supply glut and economic imbalances.
Jobless Recoveries and the Pressure to Stimulate
The United States has faced significant political pressure to stimulate consumption, especially
during periods of jobless recoveries. After the 2001 recession, despite economic recovery, job
creation lagged, mirroring the 1991 recovery. This created political urgency to continue
economic stimulus. Jobless recoveries, where jobs are not created quickly despite economic
growth, warp financial incentives and create a fault line between politics and the financial
sector. Historically, recoveries from recessions were rapid, with jobs returning swiftly.
However, post-1991 and 2001 recessions saw prolonged periods before employment levels
normalized, leading to significant anxiety and political pressure.
The U.S. unemployment benefits system, designed for quick recoveries, exacerbates this
anxiety, as benefits are short-term and tied to job-linked healthcare. Politicians, aware of the
electoral risks of appearing disconnected from public concerns, respond with fiscal and
monetary stimuli to spur job creation. This can result in long-term policies enacted under
emergency conditions, promoting excess spending and undermining financial health.
Monetary policy, influenced by political pressures, often leads to prolonged low interest rates
to maintain employment, impacting other markets and encouraging risky financial behavior.
The Federal Reserve’s focus on employment and inflation can inadvertently inflate asset
prices and increase financial-sector risk-taking, creating systemic dangers.
Consequences to the US Financial Sector
The near-collapse of the U.S. financial sector resulted from multiple fault lines converging.
Firstly, a massive inflow of money, driven by government-sponsored mortgage agencies like
Fannie Mae and Freddie Mac, fueled an unsustainable housing boom and the deterioration of
mortgage loan quality. Secondly, both commercial and investment banks took on excessive
risk by heavily investing in low-quality subprime mortgage-backed securities and financing
these investments with short-term debt.
Foreign investors, seeking safety, poured money into U.S. housing markets, believing in the
implicit government backing of agencies like Fannie Mae and Freddie Mac. Additionally,
foreign private sector funds invested in highly rated subprime securities, not realizing that the
massive inflow of capital had distorted the market.
A critical issue was that U.S. banks retained substantial quantities of these risky assets,
financing them with short-term debt, which created a fragile financial structure. The
perceived safety net provided by the Federal Reserve’s easy monetary policies and the
government’s housing goals led banks to underestimate the risks.
Government interventions, while aiming to stabilize the economy, often distorted incentives,
leading banks to take on greater risks. The interaction between government policies and
market behavior created a hazardous environment, culminating in the financial crisis. This
underscores the inherent tension between the goals of capitalism and democracy, where
government efforts to mitigate market harshness can inadvertently encourage risky financial
practices.
The Challenges That Face Us
The financial crisis underscores the need for significant reforms across multiple sectors. The
challenge lies in ensuring opportunities for those falling behind in the U.S., potentially
through stronger safety nets or other measures to enhance worker resilience. Additionally,
large export-dependent countries need to diversify and develop efficient financial sectors to
allocate resources better. The U.S. must also reform its financial system to prevent future
global economic devastation.
A completely risk-free financial system is not desirable as it would stifle innovation and
maintain the status quo, impeding our ability to tackle major issues like climate change, aging
populations, and poverty. We need a dynamic, innovative financial system that manages risks
without excessive behavior.
Good economics must integrate with good politics. Deep imbalances, such as inequality, can
disrupt institutions and regress countries to developing status. Comprehensive reforms are
necessary to shift away from recurring crises towards sustainable economic and political
stability. These reforms will require societal changes, entailing short-term pain for long-term
gain, which can be challenging to sell politically.
Despite the difficulties, Rajan says there are two powerful reasons for hope today:
technological progress, as well as economic reforms lifting people from poverty. Learning the
right lessons from the crisis is essential to address future challenges.