At the 2005 Jackson Hole conference that turned into Raghu Rajan (supported by Alan Blinder and Armenio Fraga) vs. the world, Raghu made two big points:
- The past decades of financial deregulation had created a world much more vulnerable to financial crises than we recognized.
- The big thing that needed to be done to guard against disaster was to insure that financiers had their personal fortunes on the line--that every decision maker have not just "skin in the game" but rather a spleen, a limb, a lung, and a heart in the game as well.
Raghu was, it is very clear, very right about (1). I think it was also clear that he was very wrong about (2): Charles Prince and James Cayne and Richard Fuld had plenty of vital organs in the game. And it did not help.
Criticizing Raghu, Larry Summers made some points that he had been making for in some cases decades:
- That the dangers caused by increased financial sophistication, while real, were more than offset by the advantages in the mobilization of capital for investment.
- That the first and most important line of defense against financial crises was and remained active economic management by central banks.
- That since 1979 the world's central banks had demonstrated that they were significantly more powerful and competent than previous generations had thought, and that there was every reason that they could handle whatever problems markets would throw at them.
- That Raghu overestimated the extent to which "vital organs in the game" were a solution--that both the principal case study (LTCM) and the principal analytical paper (Shleifer-Vishny "Limits to Arbitrage") that Raghu were relying on were concerned with situations in which the relevant players did have "vital organs in the game."
- That Raghu underestimated the extent to which additional Brandeisian transparency--conducting financial market transactions in standardized blocks on open exchanges--added to the information flow in a way that would make big crises less likely.
Now I know from direct personal knowledge that Larry had been making point (5) regularly since at least 1988, that he had been making point (4) ever since Andrei Shleifer and Robert Vishny circulated the first draft of their "Limits to Arbitrage" paper, had been making point (3) ever since the largely-successful resolution of the 1997-1998 East Asian financial crisis and the 2000 dot=com crash, and had been making points (1) and (2) on a regular basis since before I started graduate school. Until the fall of 2008, I think, Larry believed all 5 of these points--I know I certainly did. And even now the only one that is clearly wrong is (3). (1) is probably wrong (although it is close), and (2), (4), and (5) look stronger and righter than ever.
So I am surprised to see the Economist's Democracy in America writing:
The corruption of economics: Larry Summers: neo-Keynesian aristocrat: Mr Rajan is a rather more free-market sort of economist than is Mr Summers.... Mr Summers' intemperate reaction certainly seems benighted.... Once we see Mr Summers for what he is--doyen of the neo-Keynesian technocratic aristocracy--it seems rather more likely that his reaction reflected the wounded pride of a social engineer who personally helped design and vet these institutions; he was insulted by Mr Rajan's impertinent suggestion that they don't check out. Mr Ferguson is right to shine a light on the corrupting confluence of elite academic economics, the financial industry, and national politics. But the problem just isn't Larry Summers's ideological aversion to government intervention. The problem is that the Keynesian ideology of expert intervention makes a fattened aristocracy of economic experts inevitable.
When people make points that they have been making for decades in the typical manner of intellectual conference engagement they have engaged in for their entire life, you really don't need to go looking for bizarre unsupported psychological explanations.
Why oh why can't we have a better press corps?
