As an MBA student at Chicago Booth, I was delighted to see a full article on Professor Raghu Rajan from Chicago Booth on page 2 of the Wall Street Journal. He is credited with presenting a paper as far back as 2005 on the dangers of a looming financial crisis. Prof. Rajan has spent much of his prestigious academic background studying liquidity and capital in the banking system, providing him with the background to present such views that sounded outlandish in 2005. He has written a book on the Financial Crisis called “Fault Lines: How Hidden Fractures Still Threaten the World Economy” that will be published in July as detailed below by WSJ’s David Wessel.

I am lucky to be taking a new course at Chicago Booth called “Analytics of Financial Crises” focused on the different dimensions of the financial crisis. The class was created by Professor Anil Kashyap and is a model class on the financial crisis for MBA programs. Last week, David Wessel from the WSJ, was a guest speaker for this class. He spoke to us about his book, “In Fed We Trust,” which is the textbook we use for class. He was happy to share his views on potential regulatory changes and his outlook on the financial industry.

I am also taking a class “Money and Banking” taught by Professor Randy Kroszner, one of the five members of the Federal Reserve during the Financial Crisis from 2007-2009. He was in the room when the key decisions were made during the crisis. I am the beneficiary of hearing his insights on a weekly basis. It is a particularly valuable and unique experience with the regulatory changes being discussed.

One of the reasons I chose the MBA program at Chicago Booth was for its thought leadership during the financial crisis. I feel fortunate to be able to take classes with outstanding faculty such as Raghu Rajan, Anil Kashyap and Randy Kroszner.

Professor Finds Many Fault Lines in Crisis

April 22, 2010 by David Wessel, Wall Street Journal

The left has figured out who to blame for the financial crisis: Greedy Wall Street bankers, especially at Goldman Sachs. The right has figured it out, too: It was government’s fault, especially Fannie Mae and Freddie Mac.

Raghuram Rajan of the University of Chicago’s Booth School of Business says it’s more complicated: Fault lines along the tectonic plates of the global economy pushed big government and big finance to a financial earthquake.

One lesson from the crisis: When nine of 10 experts say everything is fine, the press should devote more than 10% of its coverage to those who say it isn’t fine. I should have paid more attention to Mr. Rajan, who famously ruined a 2005 Federal Reserve celebration of Alan Greenspan’s career by suggesting that big banks might be steering the world economy off the cliff. (”I felt like an early Christian who had wandered into a convention of half-starved lions,” he says.)

Mr. Rajan, a Massachusetts Institute of Technology Ph.D., sees the crisis through an unusual lens. He spent his childhood in India, studied electrical engineering there and still advises its government. He later did a few years as chief economist of the International Monetary Fund. More than most economists, he sees ways in which rich countries behave similarly to poorer ones and sees the roots of the crisis as global.

In a conversation a few days after the government pointed the finger of blame at Goldman Sachs, Mr. Rajan previewed arguments he’ll make in a book (”Fault Lines: How Hidden Fractures Still Threaten the World Economy“) to be published in July.

“We miss the point if we find a scapegoat in the financial sector. It was doing what so many people wanted. And not many people were asking questions,” he says.

To him, this was a Greek tragedy in which traders and bankers, congressmen and subprime borrowers all played their parts until the drama reached the inevitably painful end. (Mr. Rajan plays Cassandra, of course.) But just when you’re about to cast him as a University of Chicago free-market stereotype, he surprises by identifying the widening gap between rich and poor as a big cause of the calamity.

The first Rajan fault line lies in the U.S. As incomes at the top soared, politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn’t easily raise incomes—Mr. Rajan is in the camp that sees better education as the only cure and that takes time—politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.

This has happened before: Farmers’ grievances led to a U.S. government-backed expansion of bank credit in the 1920s; India’s state-owned banks pump credit into poor constituencies in election years. But one thing was different: “When easy money pushed by a deep pocketed government comes into contact with the profit motive of a sophisticated, amoral financial sector, a deep fault line develops,” Mr. Rajan writes. House prices shot up, banks borrowed cheaply and heavily to build leveraged mountains of ever more risky mortgage-linked securities.

The second fault line lies in the relentless exporting of many countries. Germany and Japan grew rich by exporting. They built agile export sectors that compete with the world’s best, but shielded or strangled domestic industries such as banking and retailing. These industries are uncompetitive and inefficient, and charge high prices that discourage consumer spending.

China and others got to a similar place by a different route. Financial crises in the 1990s showed them the dangers of relying on money flowing from rich countries through local banks to finance factories, office towers and other investment. So they switched strategies, borrowed less and turned to exporting more to fuel growth. This led them to hold down exchange rates (that makes exports more attractive to others). So doing meant building huge rainy day funds of U.S. dollars.

The result: A lot of money abroad looking for a place to go met a lot of demand for borrowing in U.S. A lot of foolish loans were made.

A third Rajan fault line spread the crisis. The U.S. approach to recession-fighting—unemployment insurance and the like—and its social safety net are geared for fast, quick recoveries of the past, not for jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates. This leads big finance to assume, consciously or unconsciously, that the government will keep the money flowing and will step in if catastrophe occurs.

Compounded by hubris, envy, greed, short-sighted compensation schemes and follow-the-herd habits, these expectations that the government will save us all leads big finance to borrow cheaply and take ever bigger risks. No democratic government can let ordinary folk suffer when the harshness of the market brings the party to an end, as it inevitable does. Big finance exploits what Mr. Rajan calls this “government decency” and bets accordingly.

If he’s right, changing the rules, incentives and innards of major economies to reduce the risks of repeating the recent crisis is not going to be easy.

Write to David Wessel at capital@wsj.com