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Fault Lines: Losing Faith In The Financial System

Book excerpt: Fault Lines author Raghuram G. Rajan offers insight on the role a democratic government must have in modern financial markets to avoid the kind of disasters that we have just experienced.

The following commentary is an excerpted Epilogue from the book entitled FAULT LINES by Raghuram Rajan, published by Princeton University Press. Copyright © 2010. Printed by Permission.

Finance is in disrepute. Calls to shackle it are being heard from every quarter. More dangerous is the possibility that industrial countries, especially the United States, could lose faith in the financial system that has made them what they are. A misbegotten sense of the inadequacy of markets and competition is leading to ever more faith being placed in the government. Although there are certain things government can (and must) do, leading dynamic change and innovation is not among them.

Raghuram Rajan It is an easy step for countries whose governments fail to meet the now-heightened expectations to seek to keep what they have by means of assertive nationalism and protectionism. Instead of embracing the growth of developing countries and keeping their domestic markets open, industrial countries could turn inward, to the detriment of all. According to polling by the Pew Foundation, 49 percent of Americans think their country should mind its own business internationally, a proportion 30 percentage points higher than when the question was first asked in 1964. Equally, instead of accepting greater responsibility as their economic might grows, developing countries could prompt a stronger reaction by behaving as if their policies continue to have little effect on the world. We could yet convert hope into conflict, then despair, as the world has done many times before.

Economic stagnation is the breeding ground for conflict. To prevent history from mimicking itself, we have to understand the causes of the recent crisis and act on that understanding. Financial markets and democratic government are not incompatible. The role of financial markets is to allocate resources to those most capable of using them, while spreading the risks to those most capable of bearing them. The role of democratic government is to create a legal, regulatory, and supervisory framework within which financial markets can operate. However, democratic government has other roles, including limiting the most inequitable consequences of the market economy through taxes, subsidies, and safety nets. It is when democratic government uses these other tools inadequately, when it tries to use modern financial markets to fulfill political goals, when it becomes a participant in markets rather than a regulator, that we get the kind of disasters that we have just experienced.

Some argue that it was laissez-faire ideology that led us to this pass: regulators became enamored of the ideal of the self-regulating market and stood on the sidelines as it self-destructed. They are only partly right. Although it ought to be the duty of regulators to lean against the prevailing winds of optimism (and sometimes pessimism), regulation in the United States was driven by the misplaced view that markets would take care of themselves, a view that time and time again makes the ideological Right play into the hands of the ideological Left. Yet the bulk of the damage was done as the sophisticated financial sector tried to seek an edge that the U.S. government, driven by political compulsions, was only too willing to provide.

Progressives in the United States blame the bankers, while conservatives blame the government and the Federal Reserve. The worrying reality is that both are to blame, but neither may have been fully cognizant of the fault lines guiding their actions. Changing the actors, or trying to change their incentives directly, may have limited effect: we need to bridge the deeper fault lines. Unless we reestablish the proper role of the government and the financial sector, as well as fix the imbalances between nations, what happened may happen again.

The financial sector needs to know that it will bear the full consequences of its actions, which means that it, and not the taxpayer, will have to bear the losses it generates. The U.S. government has to re-create the access and opportunity for all its people that has historically been the hallmark of its economy while helping those who fall behind. This will reduce the pressure on the government to intervene in financial markets or to stimulate the economy excessively.

Other countries have to implement reforms that will help rebalance the world economy while reducing their own dependence on global growth. In this, as with the other challenges that the world faces, we will need international cooperation. The world’s great powers, both the established ones and the emerging ones, have to recognize that their policies do not add up to a coherent whole. They have been reluctant to create strong global institutions that might impose constraints on their policies. To counter this reluctance, we need to broaden the policy debate across the world, persuading civil society in each country to push its government to enact policies that further the global good.

Raghuram G. Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business and former chief economist at the International Monetary Fund. He is the coauthor of Saving Capitalism from the Capitalists. Photo by Dan Dry. © University of Chicago Booth School of Business.

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