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...

Comments

[Robert Waldmann]

I can't that he's my guru now (and Friedman was never *your* guru). Unless he is grossly misquoted (always very possible) he is grossly lumping things together here

"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."

Some of that "clamping down" was introducing the institutions and regulations which kept capitalism going until people found a way around them [what is the different between AIG writing a CDS and AIG selling AIG bonds and buying the risky asset ? None in terms of the risks to which AIG is exposed. A whole lot (order of $ 3 trillion) in terms of AIG's balance sheet. If they had done what they did with old fashioned instruments they could have protected the firms that bought CD insurance but no way would a firm with over $ 3 trillion in debt be rated AA. Financial engineering is just a polite word for cooking the books].

Now the reference to Rajan's current concerns isn't a direct quote, so it is likely that Rajan explained what clamping down on financial markets he opposed (I'd guess it was the kind that caused such a disaster in Malaysia in 1997 except that it worked fine).

I personally don't see any risk of over regulation. In fact I don't think there is any chance of optimal regulation, since it would cost to many rick operators their jobs.

[chrismealy]

Well then, since "Fooled by Randomness" came out in 2001, I guess that makes Taleb your god!

OK, the bulk of his screed wasn't directly about systemic risk, but I'm pretty sure that was clear enough.

(btw, love the new comments)

[Shalom P. Hamou]

Sorry, Chairman Ben S. Bernanke, But Quantitative Easing Won't Work.

In a Liquidity Trap although Saving (S) is abnormally high investment (I) is next to 0.

Hence, the Keynesian paradigm I = S is not verified.

The purpose of Quantitative Easing being to lower the yield on long-term savings it doesn't create $1 of investment.

It does diminish the yield on long-term US Treasury debt but lowers marginally, if at all, the asked yield on savings.

This and other issues are explored in my tract:

A Specific Application of Employment, Interest and Money
Plea for a New World Economic Order

Abstract:

This tract makes a critical analysis of credit based, free market economy, Capitalism, and proves that its dysfunctions are the result of the existence of credit.

It shows that income / wealth disparity, cause and consequence of credit and of the level of long-term interest-rates, is the first order hidden variable, possibly the only one, of economic development.

It solves most of the puzzles of macro economy: among which Unemployment, Business Cycles, Stagflation, Greenspan Conundrum, Deflation and Keynes' Liquidity Trap...

It shows that no fiscal or monetary policy, including the barbaric Quantitative Easing will get us out of depression.

A Credit Free, Free Market Economy will correct all of those dysfunctions.

The alternative would be, on the long run, to wait for the physical destruction (through war or rust) of most of our productive assets. It will be at a cost none of us can afford to pay.

A Specific Application of Employment, Interest and Money
http://www.17-76.net/interest.html

[ryan]

Without trade barriers, wouldn't Keynesian stimulus primarily have flowed outside the country offering the stimulus, therefore creating enormous disincentives to Keynesian methods for ending the depression?

It seems we need either global Keynesianism or national markets and regulatory environments. Isn't current German policy a sign that we haven't found the right mix? With open borders, won't our stimulus flow to the Chinese and Germans?

[christofay]

Bringing greater light to Rajan in 2005 would have been prescient, 2009 when a lot of things have obviously have gone wrong, ehh.

2005 of course the wise men of Washington had political capital to spend, full faith and credit, ehh. 2004 of course is when Greenspan dog whistled "go out and play." Rajan was responding negatively to the dog whistle.

Contra Rajan, Greenspan:

"Greenspan is, of course, an uber-villager, married to one of the most important beltway media mavens and who, for the past two decades, was considered a living example of the the non-partisan wise man. Except,of course, he was actually an Ayn Rand extremist who grubbed around in politics with as much glee as any Louisiana congressman. But you couldn't say that. In fact, during the 2000 election we came close to having him legally declared a living God --- a Pharoah of Finance, who could not be questioned lest the sun turn cold.

"Why anyone ever thought that a man who openly followed a creed which literally claims that captains of industry can do no wrong because capitalism is a moral system based upon self-interest was anything but a fool is beyond me, but they didn't. He was in a state of "shocked disbelief" when that turned out not to be true...."

And:

"He is one of the reasons I no longer have any trust at all in the great man theory. I know that people need heroes, but in our celebrity worshiping culture we take it to such ridiculous extremes that it turns dissent and questions into heresy. I no longer find it particularly useful to think in those terms much at all.

"Greenspan may be one who stands out considering the horrifying ramifications, but there are many of these elders whose "reputations" have led us straight into disaster. (Colin Powell comes to mind.) Maybe it's time America gives the hero/wise man/guru concept a rest."

Heretics and Heroes, by digby, Hullabaloo

A lot of those chumps, Lieberman, my senator John Kerry, are still there. Some of those after a hiatus in New York "Small Change" Rubin are back. Did Kerry vote for all of the Bush horrible legislation just so he could be against it later?

[christofay]

Not everyone was sporting the rose white and blue sunglasses during the Bush/Greenspan/Cheney years, or to extend the time frame, the Markets Triumphant era, Reagan thru Bush.

A Bear Saw Around the Corner, By STEPHEN KOTKIN
http://www.nytimes.com/2009/01/04/business/04shelf.html?ref=business

If you want to be informed on markets and money you read Grant's Interest Rate Observer.

It's not economicsism.

[Oskar Shapley]

I have the impression that academics ignore non-academics which whom they afraid to be confronted. Like NN Taleb and P Schiff.

Why is that? Not legitmate enough? DeLong does not ignore D Luskin whenever that guy said something stupid. (oh, and he did, so many times).

A confrontation of opinions would be productive. Right now we have the dilemma whether to follow Krugman's Keynesianism or Schiff's Austrian school.

[s9]

"...and warned everybody that increased financial complexity had made the world's financial markets riskier places. ..."

I got that message in 1997 by reading Martin Mayer's The Bankers: The Next Generation all the way through to the end.

[Ken Houghton]

Jesus Effing Cristofay, Rajan is your guru because he said that in =2005=???

In 2004 (at latest), Dean Baker sold his condo, and very publicly officially went short real estate.

_The Dark Side of Valuation_ was published in 2001; rather more relevant that the Taleb, same year.

The Argentine debt crisis of 2001 was in, uh, maybe, er, 2001? The trickle-through effect on EM portfolios is the MBS blowup in microcosm.

Let's ignore Obama classmate Jason Zweig's "Is the S&P500 Rigged?" (13 Jun 2001), which gives you a good idea of the game being played in equities.

And skip all those articles from the mid-1990s about the time bomb that was derivatives even before CDSes were traded actively.

Totemizing Rajan for a speech in 2005 is like declaring that Columbus discovered America: not only are the multiple other cultures with prior claims, there is an endemic population declaring this cannot go on.

[KC]

Rajan's comments are certainly interesting, but what I find more interesting is how quickly other economists were to slag him off:
http://visnumerorum.wordpress.com/2009/01/06/a-herd-of-economists/

Especially Larry Summers who will be pulling quite a few strings now

K

[Alon Levy]

Ken: if Baker went short on real estate in 2004, then with a few more months of falling housing prices, he'll finally see a profit.

[Mohit Jain]

Hats off to Rajan but a true genius would be one who can tell steps to avert such a colossal financial crisis.

http://www.FreeMillionaireMakerDVD.com/go