Finder of Financial Fault Lines
Finance & Development, March 2015, Vol. 52, No. 1
Laura Wallace profiles Raghuram Rajan, the prescient finance economist now steering India’s central bank
Raghuram Rajan, now the head of India’s central bank, was the IMF’s youngest, and first nonwestern, chief economist.
But when Rajan, then 40, turned up at the IMF’s Washington
headquarters in 2003, many of his peers thought he had entered the wrong
building. The finance professor from the University of Chicago was
reporting to work as the new economic counsellor and director of the
Research Department. But although he was a highly regarded finance
economist, he was filling a job that had always been held by a leading
macroeconomist. And to the macroeconomists who populate the IMF, Rajan
was an unknown entity.
But the IMF picked Rajan for a reason: it wanted to build up its
financial expertise in the wake of the Asian financial crisis of the
late 1990s. Anne Krueger, then the IMF’s second in command as first
deputy managing director, had recently read a book Rajan coauthored with
Luigi Zingales, Saving Capitalism from the Capitalists (2003), so she
called Rajan. When asked if he would be interested in being chief
economist, Rajan says he told her: “Well, Anne, I don’t know any
macroeconomics.” To which Krueger joked, “Neither do I.” He decided to
give it a shot and flew out for an interview.
A decade later, when Rajan reported for his first day as governor
of the Reserve Bank of India (RBI), no one doubted that he had entered
the right building. It was as if all his academic work since his 1991
doctoral thesis on the dangers of cozy bank-firm relationships had been
leading up to this day. Plus his stint at the IMF had given him valuable
experience, not only in policymaking but in engaging with advanced
economies. As one former colleague puts it, Rajan can stand his ground
because “he isn’t in awe” of the major industrial powers. In addition,
he was one of the few economists to have warned about the risks of
financial innovation well before a devastating financial crisis hit the
United States in 2007 and then disrupted the global economy.
The demands on, and expectations for, Rajan are high—domestically
and globally. He is leading India’s central bank as the country tries to
regain its economic momentum, and policymakers around the world look to
him for guidance on reforming the global financial system.
Unsurprisingly, the Chicago professor advocates free markets, but, as he
wrote in the 2003 book, he also views the market as “a fragile
institution, charting a narrow path between the Scylla of overweening
government interference and the Charybdis of too little government
support.”
That said, it is difficult to put Rajan into a particular
economic camp. He likes to call himself “a pragmatist.” As he tells
F&D: “It’s not just economics but the political layer that is
imposed over it that determines outcomes—and the political layer is much
less well understood than the economics. So when you combine the two,
basically it’s a process of navigation. How do I make sure that sensible
economics prevails?”
Saving capitalism
Rajan was born in Bhopal, in central India, in 1963, but spent much
of his early youth in Indonesia, Sri Lanka, and Belgium (his father was
with the foreign office) before returning to India at age 11. He says
his fascination with finance dates to his graduate school days at the
Indian Institute of Management in Ahmedabad, which followed a bachelor’s
in engineering from the Indian Institute of Technology in Delhi. He
recalls reading Nobel laureate Robert Merton’s theory of rational
options pricing (a formula for evaluating options, which are contracts
that give a buyer the right to buy or sell a financial asset at a set
price in the future). He was struck, he said, not only by the theory’s
“mathematical elegance” but also by “its usefulness in the real world.”
In 1991, he received a doctorate in finance at the Massachusetts
Institute of Technology’s Sloan School of Management and became an
assistant professor at the University of Chicago’s Booth School of
Business—both institutions that attracted the top options-pricing
researchers.
For most of the next 12 years, Rajan would make Booth his home,
teaching banking and finance while undertaking much-cited work with such
colleagues as Doug Diamond and Zingales. In January 2003, Rajan won the
American Finance Association’s inaugural Fischer Black Prize for the
leading finance researcher under 40, for “path-breaking contributions to
our knowledge of financial institutions, the workings of the modern
corporation, and the causes and consequences of the development of the
financial sector across countries.”
The prize announcement noted that “even while many economists
were extolling the virtues of bank finance, Rajan pointed out in his
influential Ph.D. thesis that there might be a downside to cozy
bank-firm relationships of the kind that one saw in Japan.” It goes on
to cite his work with Diamond that “knits together the microtheory of
banking with macroeconomic theory,” along with shedding more light on
“the role banks play in the provision of liquidity, why this function
makes banks so prone to systemic crises, and why changes in monetary
policy have such a significant effect on bank lending.” And it cited his
work with Zingales that provided “a new method of pinpointing the
effect of institutions on economic growth” and showed that “industries
dependent on external finance grow faster in countries that have a more
developed financial system,” thereby helping to “debunk the belief that a
country’s financial system is a sideshow with little effect on its
economic growth.”
Rajan and Zingales built on these findings in their 2003 book,
which argues that many countries have underdeveloped financial systems
because of the political opposition of the elite, who fear losing their
position if access to finance becomes freer and they face competition.
Rajan believes that the book is just as relevant today given the
post–financial crisis swing into what he considers “overtaxed and
overregulated economies,” when what is really needed is “to keep our
economies flexible to find the solutions.”
Rajan would go on to win numerous other awards, including
India’s Infosys Prize for Social Sciences-Economics in 2011 and the
Deutsche Bank Prize in Financial Economics in 2013. At the Frankfurt
award ceremony, Diamond, one of the presenters, said Rajan’s work
“always is done with a clear view of how the research topics and the
results can help make the world a better place.” He also called Rajan
“incredibly fair” and “the voice of reason in our faculty”—noting that
at the University of Chicago, and especially at Booth, “he has hardly an
enemy despite taking strong positions on controversial views.”
From academia to the IMF
In August 2003, Rajan took over as IMF chief economist from Harvard’s
well-known Kenneth Rogoff. Rajan admits that “it was an interesting
transition.” He recalls, with a smile, that “the reaction was—after Ken
Rogoff, this gigantic macroeconomist—‘Who’s this guy?’ You know, ‘Rajan
who?’” He says that “one of the first things that I had to establish was
that I knew some macroeconomics,” and he worked hard to keep—and
attract—a good team. “When people started wanting to come in [to the
Research Department], I realized that we had turned the corner.”
With the global economy relatively calm—the turmoil finally
subsiding from an Argentine default at the end of 2001—Rajan was able to
step up financial sector research and explore how to integrate
financial sector issues into the IMF’s economic country models. This
might have seemed doable given that the IMF already had models for
handling fiscal and monetary issues. But creating a model for financial
issues turned out to be much tougher. As a result, while Rajan is
credited with laying the groundwork, the issue is still very much a work
in progress, not just for IMF researchers but for hundreds of
academics.
The big difference is that a decade ago creating such a model
lacked urgency, whereas now it is a high priority. As Rajan wrote in a
Project Syndicate column in August 2013: “In the run-up to the 2008
financial crisis, macroeconomists tended to assume away the financial
sector in their models of advanced economies. With no significant
financial crisis since the Great Depression, it was convenient to take
for granted that the financial plumbing worked in the background.
Models, thus simplified, suggested policies that seemed to work—that is,
until the plumbing backed up. And the plumbing malfunctioned because
herd behavior—shaped by policies in ways that we are only now coming to
understand—overwhelmed it.”
IMF Chief Economist Olivier Blanchard says that “we’ve made a
lot of progress in how we look at the financial system, at isolating
some kinds of risks, and getting the data that allow us to do more work
in real time. But it’s not as if we have a complete understanding of the
issues, and the integration of the two is progressing but it’s not
there yet.” The fundamental problem, Blanchard says, is that “we’re not
sure what financial stability means.” He also worries that a
macrofinancial model could remain elusive—that “it’s going to be a
cat-and-mouse game forever”—because “maybe if we identify the risks
today, maybe in two years it’s a different set of risks in a different
part” of the financial system.
What makes Rajan a key figure in these financial debates is what
some colleagues say is his ability to see the forest for the trees.
Stijn Claessens, an assistant director of the IMF’s Research Department,
says Rajan is one of “a small set of people who academically as well as
professionally have the skills to be able to talk about macroeconomics
and know finance in the sense of the institutional details, plus see the
links and how they interface and work together.” Says Chicago’s Anil
Kashyap (also a Rajan coauthor): “The arguments about setting interest
rates are usually pretty simple. In contrast, the evolving debate over
how to deliver financial stability is much more nuanced, in part because
we do not have a standard workhorse model to rely upon. Raghu has the
great advantage of having a clear vision of the financial system and
what does well and where it poses challenges. I think this is why he has
been at the forefront of many of the financial stability debates.”
Showdown at Jackson Hole
Not that Rajan’s vision is always well received. In August 2005, he
came in for heavy criticism following what turned out to be a prescient
speech about the dangers lurking in the financial system. He was invited
to speak on how the financial system had evolved under Alan Greenspan
(the soon-to-retire chairman of the Federal Reserve Board) at the annual
symposium of central bankers and other high-powered economists in
Jackson Hole, Wyoming. He says he had expected to find that the dramatic
expansion in financial markets had reduced the risks for banks, but
instead, the figures that his staff assembled showed the opposite.
With Greenspan in the audience, Rajan delivered a talk based on his
paper “Has Financial Development Made the World Riskier?” He warned
that recent financial innovations (such as credit default swaps, which
act as insurance against bond defaults) could create “a greater (albeit
still small) probability of a catastrophic meltdown.” This message did
not go down well in some quarters. Former U.S. Treasury Secretary
Lawrence Summers called Rajan’s premise “slightly Luddite” and “largely
misguided.” Federal Reserve Board Vice Chairman Donald Kohn suggested
that Rajan was nostalgic for the old days of bank-dominated
systems—which Rajan strongly denied.
Rajan has written that he left Wyoming with some unease—not because
of the criticism, but because “the critics seemed to be ignoring what
was going on before their eyes” (see box). Several years later, his
warning came true: the U.S. market for subprime mortgage securities
began to implode in 2007, leading to the global financial crisis.
Not ready for the red flags
Was there anything Raghuram Rajan could have done to ensure that his
message was heard at Jackson Hole? He thinks not, for two reasons.
First, economic times were good, so it was difficult to persuade
people to take steps that might slow growth to address a low-probability
risk. After all, the Federal Reserve had just dealt with the dot-com
crisis by pumping liquidity into the market, and there was a widely held
view that “if another crisis erupted, it could be dealt with in the
same way—even though the problem this time was bank credit, not a loss
of market value,” he tells F&D.
Second, the remarks were delivered at a fete honoring Federal Reserve
Chairman Alan Greenspan, who held a widely shared belief “that the key
players in the financial system had no incentive to go off track”—and
trying to convince the audience otherwise was a tall order. “These are
smart guys. They’re from Goldman Sachs. They’re from JPMorgan. They’re
paid a ton of money. They’re the smartest kids in the room. Why would
they blow up their business? And who are we, you know, low-paid
regulators, thinking that we know more about their business than they
do? And the answer is no, we don’t know more about their business than
they do, but we have different incentives. They’re locked into this
competitive frenzy. And we’re the guys who can stop them.”
Of course, Rajan’s time at the IMF was about far more than Jackson
Hole. He says it was a tremendous on-the-job learning experience during
which he sharpened his macroeconomic skills. He also immersed himself in
the art of global economic policymaking—for example, leading a team to
try to help some major economies reduce their huge (and unprecedented)
balance of payments imbalances. It was also his first stint as a
manager—a hundred people worked for him in the Research Department. But
that number must now seem incredibly small, as he oversees 17,000
staffers at the RBI.
Former IMF colleagues say that what is so remarkable about Rajan is
his humility, integrity, and intellectual curiosity and rigor. Jonathan
Ostry, a deputy director of the Research Department, says that Rajan
“will let people go forward with their ideas, giving them virtually all
of the credit, even when he had significant input.” He was also “willing
to take controversial positions both internally and, within the limits
of his position, externally, to an extent that, frankly, I’d never seen
before.”
In December 2006, with his IMF contract done, Rajan returned to
Chicago, where he had the time and academic freedom to delve further
into the repercussions of financial innovation. The result was Fault
Lines, which won the Financial Times and Goldman Sachs prize for best
business book in 2010. Rajan cautions against making the financial
sector (“bankers gone mad”) the scapegoat for the crisis, because the
blame rests with complex and wide-ranging fault lines that include
● domestic political pressures (arising from income inequality) that create easy credit;
● export-led growth strategies (as in China, Germany, and Japan) that rely on indebted U.S. consumers; and
● greater financial risk-taking fed by a belief that governments will save the day.
Back to India
Rajan may have made his career in the United States, but he never
forgot India, making it a frequent topic of speeches and research. He
says that he was drawn to economics because it offered a way to help
India enter the “pantheon of nations.” In 2008 he got the chance to help
shape India’s financial sector when he chaired a high-level government
committee on financial sector reforms. The committee report, “
A Hundred Small Steps,”
suggested that the RBI should target a single objective—low and stable
inflation—rather than juggling multiple mandates (such as inflation, the
exchange rate, and capital flows).
It also proposed that India promote the availability of financial
services—including credit, saving, and insurance products—to a wider
number of people (especially in rural areas, where most people lack
access to formal sources of credit and insurance); reduce the heavy
government presence in the banking system; and step up foreign
participation in its financial markets.
In September 2013, he took the helm at the RBI, after five years of
advising Prime Minister Manmohan Singh from Chicago and a year as chief
economic advisor in the Finance Ministry in Mumbai. At that point,
India’s markets were in turmoil because of rising inflation, large
fiscal and current account deficits, and a slowdown in growth. But he
moved quickly to stabilize the rupee, reduce inflation sharply, and
build up foreign exchange reserves—earning him the sobriquet “rock star”
in the local media. He also wasted no time in laying the groundwork for
adopting an inflation target and is pursuing many other reforms
suggested in “A Hundred Small Steps.”
Rajan’s hope is that the RBI can help India create jobs by ensuring
macroeconomic stability. In the process, World Bank Chief Economist
Kaushik Basu hopes that Rajan can encourage the RBI to be “a bit more
experimental.” Basu, who preceded Rajan as India’s chief economic
advisor, says emerging market economies need not rely so heavily on the
monetary practices that worked well in the major industrial countries,
although the risks of central banking efforts to guide an economy are
such that “most central banks play it tame by going by those rules.”
Basu says central banks might say, “This policy worked very well in a
rich country but may not work well in my country, and I’m going to try a
slightly different intervention in the interest rates,” playing around
“with new policies to see if they work. Raghu is in a position to do
that given his background.”
In global financial circles, Rajan made headlines early in 2014,
when he told Bloomberg TV India that “international monetary cooperation
has broken down”—a reference to the Federal Reserve’s indication that
it was contemplating withdrawing some of the stimulus it had employed to
reinvigorate the U.S. economy. Later, he publicly scolded the major
central banks for focusing solely on what was good for their own
economies without taking into account the financial turmoil their
low-interest-rate policies were unleashing in emerging market economies.
These economies had to cope with massive inflows of funds seeking
higher yields. And he is calling for central banks in countries that are
the source of those funds “to reinterpret their mandates to consider
the medium-term effects of recipient countries’ policy responses, such
as sustained exchange rate intervention.”
As Rajan put it in a June 2013
lecture
at the Bank for International Settlements: “In a world integrated by
massive capital flows, monetary policy in large countries serves as a
common accelerator pedal for the globe. One’s car might languish in a
deep ditch even when the accelerator pedal is fully pressed down, but
the rest of the world might be pushed way beyond the speed limit. If
there is little way for countries across the globe to avoid the
spillover effects of unconventional policies emanating from the large
central banks, should the large central banks internalize these
spillovers? How? And will it be politically possible?”
Rajan now has an opportunity afforded few academics—to put in
practice what he has long preached. The RBI (as well as central banks in
other emerging market economies) may not be the most powerful car on
the block, but for Rajan, this chance to be an exemplary driver is the
opportunity of a lifetime!
