An Interview with Raghuram Rajan

Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business. Dr. Rajan is also currently an economic advisor to the Prime Minister of India. He chaired the Indian government’s Committee on Financial Sector Reforms, which submitted its report in September 2008. Dr. Rajan was also the Economic Counselor and Director of Research (in plain English, the Chief Economist) at the International Monetary Fund. He is a director of the Chicago Council on Global Affairs, on the Comptroller General of the United State’s Advisory Council, Vice President of the American Finance Association, and a member of the American Academy of Arts and Sciences. In January 2003, the American Finance Association awarded Dr. Rajan the inaugural Fischer Black Prize, given every two years to the financial economist under age 40 who has made the most significant contribution to the theory and practice of finance.

The Politic: Firstly, where do we stand today? Is the worst of the economic crisis over?

RR: I think what we’re seeing is a shift where a private sector crisis is slowly morphing into a public sector crisis because of the extent of government expenditures. Now, a public sector crisis tends to be less dramatic at one level, since no large governments are currently on the verge of failure. On the other hand, public sector crises are drawn out over longer periods of time and can therefore be more painful because of the adaptations that have to be made. We are already starting to see this in U.S. states such as California, whose state budget crisis is hurting its universities. We also see it in the United Kingdom, where concerns are being raised over whether the government’s finances are in good shape, and a lot will depend on the outcome of their upcoming elections. If the election results in a fragile and fragmented parliament, it will create more tension in the United Kingdom. So, as all of this happens, we’re seeing scrutiny move from the private sector to the public sector.

The Politic: Modern housing booms and busts typically occur in wealthier segments of the population. What broader factors caused the ongoing housing crisis to be so concentrated in sub-prime, one of the poorest segments?

RR: I think that as government policy actively pushing for expansion in housing, the instruments that the government used to push this policy led to a private sector reaction that took the fundamentally good intentions of government to expand housing into places where that intent probably didn’t need or want to go – namely, housing for people who couldn’t afford the payments down the line that they would have to pay. There has been a secular push since the 1980s to compensate for the stagnant incomes amongst the lower income segments of the population. These citizens’ incomes have been stagnant for a variety of reasons, but I think access to education is an important one. The U.S. also has relatively thin safety-nets, so when you have downturns, unless the downturn is short and quick, there tends to be a lot of political pressure to take action, where fiscal policy ultimately becomes sustained monetary policy. The problem is that in the last two recessions in 1991 and 2001, you haven’t seen the response that quickly. I think policy has moved into excess.

The Politic: You have dismissed the notion of just using “big” in determining what is “too big to fail.” Firstly, can you discuss the factors that you believe make a financial institution “systematically important” and how to recognize them? Then, what should regulators do to respond to failures of institutions that are perceived to be too systematically important to fail?

RR: One major factor is being relatively important in a key market. That often makes an institution “systematic” or “systemic,” regardless of its size. If that institution has the potential to roil a market that is central to economic activity, then that institution, to some extent, becomes systemic, unless you can find ways for those activities of that institution to continue, even while the rest of the institution is saved. Another factor is not knowing where the bodies are buried. If an institution has a lot of liabilities, both on and off its balance sheet, which are hard for the market to understand and large enough to create a certain sense of panic if you are unsure who is exposed to those liabilities, this could create widespread uncertainty and to some extent, panic. If the exposures are large enough and widespread enough, then you have the problem of – “not only do I not know who your counterparties are, but I also don’t know who the counterparties of your counterparties are,” and so on, which can create economy-wide panic. So a mix of complexity and lack of transparency is particularly deadly. I don’t think it’s possible to define in precise legal language which institutions are too big to fail. I don’t think that size by itself is enough, as there are very large institutions that could be failed at a moment’s notice, and there are much smaller institutions that are central, and would by most counts, need to be preserved in some form or fashion to avoid a wider crisis.

I don’t think regulators have many options when one of these institutions actually fails, other than to make sure that every possible way that the private sector can bear the cost is explored. To turn away from that would be to think that the damage to the economy would be really great. The problem is that for the people making the decision, it is in their incentive to say that the costs would be too big, because the downside falls largely on them. If they let something go and it turns out to be a disaster, they get known as the person who precipitated a great depression. If they bail somebody out and it turns out to increase moral hazard, they never get associated with that moral hazard, and are, for the moment, viewed as a savior. So my sense of the incentive structure for regulators and authorities is that, when push comes to shove, they never want to let anybody who might be remotely systemic fail. I think these calculations, both in terms of bailing out almost anybody who might be systemic, and also not taking any chances on imposing costs on any of their private claim holders, have to change, but they have to change by being anticipated beforehand.

The Politic: Last year, you stated, “for some emerging markets, though, especially those that can rely on their own, or regional, demand, this crisis could result in a dramatic improvement in relative economic power.” Given India’s high levels of domestic consumption, will India ultimately “benefit” from the global crisis?

RR: I don’t think anybody benefits in absolute terms. I think that it’s all relative, and India is already being perceived as more stable than people thought because its growth is coming back. I would say that no country can benefit when large segments of the world are in deep trouble, because we are an inter-connected world. In relative terms, perhaps it can benefit, but it is in best interests of India, as well as China, if industrial countries come back stronger.

The Politic: Many recent editorials have criticized Indian politicians for India’s increased deficit spending. How do you view current Indian fiscal policy? What should the Reserve Bank of India be doing from a monetary standpoint?

RR: On the fiscal side, I think that Prime Minister Singh has certainly made the case in many speeches that fiscal policy has to be brought under control. Deficits are huge, public debt is growing, and that needs to be rectified. Some people argue that countries should spend when they’re poor, rather than waiting for when they’re rich. I think that’s a dangerous argument because it tends to play into more populist policies and clearly, in a country as poor as India, there is tremendous tendency for populist policies. At the same time, I think there are some government expenditures that are needed to keep social tensions under control and let people who haven’t benefited from the fruits of growth receive some benefits. The government needs to do more to constrain inefficient and mis-targeted subsidies.

For example, the current petrol subsidy that just goes to people who drive big cars has been grossly mis-targeted. Other subsidies, such as cooking-gas subsidies, go directly to middle class households. It does not make sense for these types of subsidies to go to the middle class, because they will ultimately pay them back in terms of taxes. Why subsidize something, get people to overuse that subsidized product, and then collect taxes from the same people to pay for it all? Another particularly pernicious subsidy is free electricity, which goes to farmers, who use it to dig deeper and over-water their fields, resulting in waterlogging.

These inefficient subsidies need to come under control, and they slowly will, but in the meantime, revenues might actually get a boost from changes in the tax system, including the introduction of a goods and services tax. I think there is a pretty strong sense that the fiscal policy needs to be mended and don’t think people believe that there is an unlimited license to spend. As long as there aren’t any adverse shocks, I think India will tighten its fiscal spending over time. On the monetary side, with inflation where it is and with interest rates somewhat negative right now, it does make sense to tighten.

The Politic: Can you discuss your upcoming book “Fault Lines: How Hidden Fractures Still Threaten the World Economy,“which cautions that an even more destructive economic crisis may be emerging.

RR: I am going to argue in the book that there are both global forces and domestic political forces that create the underlying conditions that propelled the recent financial crisis. When we focus too much just on the financial sector and say that it was the epicenter of the problem and if just fix things there, we should be safe, we miss the broader point that these underlying global and domestic forces remain unsettled and could create the conditions for another crisis. The next crisis may not necessarily be a financial crisis, but perhaps a fiscal crisis or another form of crisis. We need to recognize the underlying forces that are precipitating these tensions and fix the fault lines more directly, even while reforming the financial sector. I will address many of these issues specifically in my upcoming book.

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