Raghuram Rajan Is My Guru Now...
Milton Friedman became lord king guru of the world's economists by standing up at the end of 1966 and warning everybody that the high-pressure economics of the Kennedy-Johnson administration was about to make inflation a real problem.
Raghuram Rajan stood up in 2005 and warned everybody that increased financial complexity had made the world's financial markets riskier places. He is now my guru--along with Michael Mussa.
Justin Lahart tells the story:
Mr. Rajan Was Unpopular (But Prescient) at Greenspan Party: o outline his fears about the U.S. economy, Raghuram Rajan picked a tough crowd. It was August 2005, at an annual gathering of high-powered economists at Jackson Hole, Wyo. -- and that year they were honoring Alan Greenspan. Mr. Greenspan, a giant of 20th-century economic policy, was about to retire as Federal Reserve chairman after presiding over a historic period of economic growth.... Rajan... chose that moment to deliver a paper called "Has Financial Development Made the World Riskier?" Mr. Rajan quickly came under attack as an antimarket Luddite, wistful for old days of regulation. Today, however, few are dismissing his ideas....
He says he had planned to write about how financial developments during Mr. Greenspan's 18-year tenure made the world safer. But the more he looked, the less he believed that. In the end, with Mr. Greenspan watching from the audience, he argued that disaster might loom. Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly. He pointed to "credit-default swaps," which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred.
Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said: "The interbank market could freeze up, and one could well have a full-blown financial crisis." Two years later, that's essentially what happened....
The Jackson Hole contretemps followed by a few months another set of attacks on Mr. Rajan for a study he co-wrote at the IMF that concluded foreign aid didn't help developing countries grow. Mr. Rajan says the twin controversies didn't deter him. At the IMF, he pushed the research department to focus on financial-sector issues, and continued to sound alarm bells about financial-market risks. By summer 2007, as the crisis began unfolding in earnest, Fed bank presidents Janet Yellen and Gary Stern were citing Mr. Rajan's critiques in their speeches....
Mr. Rajan is now focused on coming up with ways to avoid a regulatory backlash akin to what happened during the Great Depression, when governments around the world threw up protectionist barriers and clamped down on financial markets. Instead of heavy regulation, he says, the incentives of Wall Streeters need to change so that punishments for losing money are in line with rewards for earning it... bonuses that financial workers make during boom times should be kept in escrow accounts for a period of time. If the firm experienced big losses later, those accounts would be drained.
Facing withering criticism over the bonuses paid out in the boom, financial giant UBS and Wall Street firm Morgan Stanley have recently announced they're adopting policies along the lines of what Mr. Rajan proposed...
