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The social policy roots of the financial crisis

Fault Lines
by Raghuram Rajan
(Princeton University Press, 18.95)

Since its publication six months ago, Fault Lines has divided opinion amongst economists and policymakers. While it has been shortlisted for the FT Business Book of the Year award (the winner is be announced on 27th October), it has also attracted sharp recent criticism from Nobel prize-winning economist Paul Krugman. The critics are wrong: Raghuram Rajan's analysis of the global financial crisis remains highly relevant and deserves to be widely read.

Fault Lines borrows a geological term for its title — because, it argues, the crisis was due to a number of economic and political "fault lines" that have been left out of much of the discussion of what went wrong in the global financial system. Rajan, formerly the chief economist at the IMF and now professor of finance at the University of Chicago's Booth School of Business, is not in the blame game. Rather than point the finger at the usual suspects, he believes that many of those whose actions contributed to the crisis acted lawfully and rationally, given their interests, and he worries that many current policy proposals to stop the same thing happening again are hurried, opportunistic and poorly thought out. He wants us to take a broader view of the origins of what went wrong before we take measured actions to lower future risks.

The first chapters of the book identify seven problems, each of which contributed to the financial crisis and each of which need to be addressed. Of these, two deal with US social policy, two with global financial imbalances, two with the banking system and one with failures of monetary policy. The breadth of Rajan's explanatory framework — which is presented cogently and concisely within 230 pages of text — marks this book out from many others that tackle the same themes.

He starts by describing the growth of income inequality in America, which he says is directly caused by the growing inequality in educational outcomes. In the US, levels of earnings are largely determined by levels of education. Since the 1980s, improvements in the average years of schooling across the American population have slowed significantly, from around one additional year per decade from 1930 to 1980, to a third of a year per decade since 1980. This is mostly due to stagnant college graduation levels. Despite an increase in enrolment in higher education, graduation rates for men born in the 1970s are no higher than for men born in the 1940s.

Relative to the rest of the world, American workers are losing the competitive edge that greater educational attainment provides. Investment in human capital is no longer higher in the US than it is in Asia. As a result, those who drop out of the education system early lose out in the global competition for labour. American policymakers could have chosen to reform and improve the education system. Instead they sought to mitigate the consequences for the lower-skilled, less-employable segment of the workforce. Cheap credit, particularly for housing, allowed US workers to live their dreams even though they lacked the skills to secure the jobs that would have paid for them.

There are other contributory factors, which the book also explores in detail: inappropriate exchange rates and trade deficits, weak safety nets for the unemployed, monetary policies targeted at job creation rather than deflating asset bubbles, a banking system that rewarded short-term self-interest rather than stability, and the inability of senior managers in the financial sector to appreciate their companies' exposure to extreme risks.

But, for Rajan, the origins of the subprime crisis are to be found in 20 years of feeble US education policies, combined with a bipartisan determination not to allow those Americans in low-paid jobs, or with no jobs at all, to become cut adrift from the social norm of owner-occupation.

By placing the financial crisis in the wider context of social policy, Rajan provides a convincing account of why the bursting of the bubble in US house prices caused so much damage, both to the financial system and to the wider economy. The financial crisis, as he presents it, was the occasion for a wider crisis of US policy making. Much the same applies to Britain. Policy responses to the crisis that focus exclusively on the financial sector will be limited in their effectiveness. We must treat the causes, not just the symptoms.

In the final three chapters, Rajan sets out recommendations for reform: first, for the financial sector, second for US social policy and third for global institutions such as the IMF and the G20. He is sensitive to the political problems that all reform programmes encounter: while everyone stands to gain in the long run from a more stable global economy, in the short term every change is perceived as a zero-sum game, with winners and losers. Still, he remains optimistic that governments could do more to improve the work skills of their citizens, while resisting the temptation to interfere in well-functioning financial markets.

In an article in September in the New York Review of Books, Paul Krugman and Robin Wells dismissed Fault Lines as an "endorsement of the conservative storyline." This is a partisan reading of a well-argued, well-balanced book. Krugman and Wells's preferred formulation appears to be that "finance gone bad can wreck an otherwise healthy economy." By contrast, Rajan shows that when finance went bad it exposed not just the poor underlying health of the US economy, but the failure of America to invest in its workforce. Policymakers in Britain should take heed: the seeds of the next financial crisis might be sown in the proposed forthcoming cuts to funding for higher education.

© Mark Hannam 2010