“Innovation and risk taking, with controls, are good for growth”

Raghuram Rajan

The financial crisis that swept across the globe two years ago did not just come out of the blue. One of few economists who, as early as 2005, had foreseen the dangers of an epic financial collapse arising from the combination of easy credit, complex investment products and a lack of confidence in the inter-bank markets was Indian-born economist Raghuram Rajan. At the time Chief Economist at the International Monetary Fund (IMF), he was criticised, fiercely, for the predictions he made at a conference of central bankers. Now vindicated, he has put forward his thesis in his new book, Fault Lines: How hidden fractures still threaten the world economy, arguing that politicians and bankers could again take the global economy to the brink of disaster unless we recognise what went wrong and take the steps needed to correct it.

Global: In your book Fault Lines you describe an American economy and a world economy that are out of rational alignment, providing perverse and ultimately destructive incentives to the private financial sector. This implies that the US financial sector has such overwhelming weight and influence that every crisis involving American banks will inevitably cause massive damage not only to the global economy but also to the financial sectors of Europe and other countries too. How do you explain the absence of effective counterweights to this structural imbalance?

Raghuram Rajan: US financial markets are very deep, and provide a source of both risk management and investment opportunities for countries running large surpluses, so those connections get made because the United States is itself running a large deficit. This is not just because of its need to finance its trade or current account deficit but because the US invests a substantial amount in other countries. The US is a global venture capitalist over and above its role as a borrower that needs to finance its excess consumption. People like to come into the United States – this crisis notwithstanding – because of its liquidity, its ability to offset risks, its more complete financial markets and so on.

Why hasn’t the euro area replaced the US? My guess is that if London combined with the euro area and the UK joined the common currency, it could well be a counterweight. But the financial centres in Europe – Frankfurt or Paris – don’t have the heft that a London or New York has, or even, increasingly, that the combined Hong Kong, Shanghai and Singapore have. These are growing in weight but are still not completely effective counterweights. So it is because of the financing needs of the US economy and the investment needs of the rest of the world (as well as the innovation needs in finance and risk management), that the US financial markets still play such an enormous role.

You argue for a shake-up of the ways in which the global economic powers define their fundamental policy priorities. At this delicate stage of recovery in 2010, with the leading economies already seemingly embarked upon divergent courses – some insisting on fiscal consolidation and others wanting to maintain the stimulus agreed upon in 2009 – is this the right time to attempt such a readjustment, or will we have to wait for another crisis to bring it about?

I do think there are really no good times, politically speaking, for full policy adjustment. Typically, you don’t want to add pain to pain, which is why a number of countries are putting off the kind of adjustments they will have to make and trying to get back to the status quo ante before they make deep changes. You can see that in China, which is trying to push exports back up before it allows the renminbi to appreciate significantly. And you can see that in the US still trying to get consumption back up before it worries about the longer-run need to save the economy.

So everyone is hell-bent on getting back to the status quo before this crisis happened, which leads to the question: Was that so stable to begin with, and is that a good place to go back to? The economic alternative, which may be slower and more painful, but more stable, is hard, because it involves taking decisions domestically for things that may not be within the political horizon. And it is important to know if other countries will do similar things which are not likely to pay off in their time either. In that sense, the readjustments may be forced, as for example in Greece and Spain, where they are now making real structural changes to their economies, but countries that can avoid this, that aren’t at the limit, are trying to avoid such readjustment. They would like to keep the fiscal stimulus to create jobs, as the US is trying to do, even though the structural problem remains, because a number of the unemployed are in fact unemployable without acquiring new skills. Could we be in a sense doing the wrong thing right now?

Is there a feasible political route to getting the USA to wean itself off its addiction to cheap credit and over-consumption at a time when it also needs to maintain the fiscal stimulus to prevent a long-running recession?

There would need to be a consensus about the right way forward for the US and, right now, there isn’t a consensus. The whole argument about keeping interest rates at near zero is that we need to get credit back at least to the levels where it was. It seems the banks are being a lot more conservative than they were, although we don’t quite know what the right point of conservatism is! They were clearly excessively exuberant before the crisis. The important question is: Are low interest rates going to do the job or is the problem somewhere else? Is it that the banks are under capitalised and fear higher capital requirements and are therefore holding back on making loans? The way to get them to become more neutral and less risk-averse is probably to fix their capital problem, rather than having ultra-low interest rates.

The political impulse is to do the short-run things and create jobs but maybe it’s not so easy to create the jobs. There is some amount of infrastructure work that can be done but we have to be very wary about these temporary jobs. We’re looking at high unemployment stretching until 2015 and maybe we should be thinking about making it more feasible and attractive for people to re-skill themselves and retrain themselves.

Is the G20 likely to see the need to address those fault lines you describe over the longer term – especially as you are critical about the short-sightedness of policy-makers in the USA and China?

We need to give the politicians time. One shouldn’t dismiss the G20 entirely. I think there is a role it plays in preventing some terrible actions from taking place. We could have descended into much worse protectionism and we could still do so. With the US growing slowly and China growing fast, the politicians may decide they want to be seen as taking action, and often that means various forms of protectionism. This is where organisations like the G20 can limit some of the worst impulses of politicians. To the extent that they don’t do anything silly, for example starting to erect trade barriers, that is a contribution.

I think the Chinese rebalancing goes far beyond simply allowing the renminbi to appreciate and involves changing the pattern of growth. To some extent, the Chinese have given far more thought to this and they understand what they need to do, much better than perhaps some of the industrial countries do. They have a plan which is more long-term and I think they will embark on that although there are strong vested interests against it. Many of the corporations benefiting from cheap credit, cheap energy and cheap land don’t want to give up their profits or to be taxed more.

The reason I’m sceptical about the G20 is that, as we’ve already seen, once we got away from the immediacy of the crisis and the need to spend, we came to the point where the pace of different countries’ actions differed and the more important countries were required to undertake structural reforms. It’s very hard for the G20 to have any influence over this process as things stand. Who is going to exhort the US government to spend more time thinking about educational levels or about not keeping interest rates so low? These are domestic political decisions. It is not clear that the politicians that go to the G20 meetings have the ability to commit anything. There is no stick that the leaders can wield collectively at these gatherings.

If we want more progress, we should think of how the debate can enter the countries themselves in a more effective way rather than stay at the rather ethereal level of the leaders and the central bank governors, whose main job is to stonewall others when they are asked for action and to point a finger at everyone else – which becomes very negative.

You propose broadening the intellectual framework of the IMF by recruiting outside the USA and by allowing it to engage in public debate in its member countries. And you call for “an international agreement about how domestic policies can by influenced by multilateral agencies to incorporate the global good”. Do you think this is possible the way the IMF is currently constituted?

The IMF has little leverage over the large countries of the world unless they desperately need its funding and the emerging markets also don’t seem like they are going to need it in the short-to-medium run either. Secondly, there is no consensus about what the appropriate policies should be. And so there are no effective rules of the game that will be agreed to by all the countries of the world and there is not much enforcement capability. Ultimately when you rule out the obvious possibilities you have to start searching for the non-obvious ones. I think the way you want to do this is to create a tail wind behind the politicians walking into the room, a tail wind that pushes for the global good. And this is why I think we need to explain better – through the various ways we have of expanding democratic interaction and through technology – to the people of different countries why a certain course of action makes sense. If more of this was sold domestically it could give them more impetus. This requires countries to sign on, not to a strict sense of rules, but to allow discourse to take place domestically.

At first sight, you do not seem to be calling for a radical reform of the banking system and you are clearly wary of too much financial regulation. Are there not more straightforward rules available to governments and regulators that can be brought into play, such as those that might reintroduce clear lines between different activities, which when consolidated created those very institutions  that were deemed to be “too big to fail”?

My perspective is that clear and blunt rules have the problem that they tend to throw the baby out with the bathwater. Financial innovation, financial risk-spreading and risk-taking, with proper controls, are good for growth. It is financial excess, by its very definition, that becomes problematic. So how do you get the good without the bad? This is why I am against proposals to make finance boring. I think that the allocation of risk and the spreading of risk that finance does can be very beneficial. This is why the more radical proposals, such as making all banks small, are not particularly useful. You might have too many banks [which could] fail rather than banks that are too big to fail! Be careful what you wish for.

I think that some clever thinking about dealing with the problems in this crisis can mitigate the risks a little more, but there are some things you can’t change, such as the fact that regulators are part of the system and will eventually get captured. And you can’t change the fact that the financial system is constantly looking for ways to arbitrage the existing constraints. You have to be cognisant of this. It is too tempting, when everybody is risk-averse in the middle of a recession, to put in a whole bunch of rules. People may have learnt but they have learnt only for about 15 minutes and, once we get away from this the same logic will apply, that this time is different, that we need to take on these risks and so on. You need a system that is, in a sense, robust to the irrational exu-berance or the political forces that spread through the system. There is a variety of reforms, some quite dramatic. I would argue that it is important to get the [US] government out of housing. Some would seem less radical but would actually make a difference, for example these so-called ‘living wills’ could force banks to be a lot more careful about the risks they take and about the complexity of their institutions. So I think there is no one silver bullet but if you add some of these things up you get a bunch of possibilities.

On interest rates, you are critical of the policy of cutting them to near zero and leaving them there. What targets should the central banks be aiming for in the next phase – in the US, Europe and the emerging markets?

I am not against cutting rates to the bone in panic-like situations and I’m not averse to the central bank intervening to provide financing support. I think the first order of action in such situations is to avert the collapse of the system. But once the collapse is averted and once the panic-like conditions are averted – and I think we are still at an uncertain point and you don’t want to roil the markets at this point – you have to remember that moving to negative real interest rates wasn’t always the focus of central banks. Under the logic that you want to push on the accelerator it seems as if, whenever there is a downturn, you want to cut down to zero, because you’re accelerating the economy. But there are trade-offs.

The central banks have been focused on inflation but I am arguing that in addition to inflation there are several more things that you need to think about. One is resource allocation – the interest rate sets a price for capital and this affects decisions about savings, investment, the capital intensity of projects and we seem to set those things as second order. You need to get activity back but the rate is going to change the nature of the activity and you need to worry about that.

Second is the fact that many of the channels through which the interest rate works are things such as reducing risk-aversion and increasing asset prices and increasing the riskiness of loans. Some of this is warranted if banks are extremely risk-averse and asset prices have collapsed and so on, but how do you know how much is enough? Raising rates doesn’t shut it off. You can’t be staring inflation, risk-aversion and asset prices in the eyeballs when you start raising rates, as it’s too late by then. Things have a momentum of their own.

The third reason is incentives – if every time there’s a bust you say I’m going to flood the market with really low rates you basically have created a situation where companies don’t see the need to maintain a liquid balance sheet and you are creating a gigantic moral hazard. The final and most damaging issue is maybe you are not doing what you need to – Japan kept its interest rates low for ten years without getting its economy out of the doldrums. The real issue is structural reforms rather than interest rates.

While the American economy limps back to growth, with Europe caught up in its own crisis of excessive debts and deficits, what are the near-term prospects for China and India?

It’s probably wishful thinking to think that China and India will provide the growth to lift the world economy back to its old levels of growth in the short run. I think in five or ten years from now that may be more appropriate. My sense is that China, with the measures it has taken, will slow from the 10 percent that it has been growing at, to around 8 percent, and the Chinese will be very happy with that because it will take some of the excesses out of the economy. But there is a danger that it could slow even further and we should keep that possibility in mind. India, on the other hand, is less dependent on the world economy than is China but is probably reaching the limits of its infrastructure sooner, and so the Indian economy will grow at what seems to be close to its potential of 8 or 9 percent. But it has to improve the quality of its labour and its infrastructure if it is to grow at faster, Chinese-like, rates.

About the author:

Raghuram Rajan is Professor of Economics at the Booth School of Business, University of Chicago. Rajan has also worked as economic adviser to the current Prime Minister of India, Manmohan Singh, and he is president-elect of the American Finance Association.


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October 12, 2010 10:00 pm

Surely as long as the banking industry is populated by individuals who are incentivized purely on greed, rather than contribution to growth (or at least avoidance of recession, economic crises etc.) then we cannot be suprised when occasionally the industry fails the economy and therefore society? Until banking ‘success’ from top to bottom is judged and rewarded on wider positive socio-economic results, rather than short-term, isolated gain there will be periodic ‘corrections’ in which as well as asset values getting a realistic reassessment, the true value of the ‘valuers of assets’ themselves gets exposed!

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