Article by Finanz und Wirtschaft Raghuram Rajan, Professor of Finance at the University of Chicago and former governor of the Reserve Bank of India, warns of more turmoil ahead if the developed world fails to adapt to the fundamental forces of global change.
It is a pivotal moment on the eve of the financial crisis. In the late summer of 2005, the world’s most influential central bankers and economists gather in Jackson Hole at the foot of the Rocky Mountains. The atmosphere is carefree. Financial markets have nicely recovered from the bust of the dotcom bubble and the global economy is humming. Under the topic »Lessons for the Future» the presentations celebrate the era of Federal Reserve chairman Alan Greenspan, who has announced to resign in a few months. Since 1987 at the helm of the world’s most powerful central bank, he presided over a period of continuous growth and was one of the leading forces of deregulation in the financial sector.
Financial Crisis
But when Raghuram Rajan steps to the podium the mood suddenly turns icy. At that time the chief economist at the International Monetary Fund, the native Indian warns that unpredictable risks are building up in the financial system and that the banks are not prepared for an emergency. His dry analysis draws spiteful remarks. »I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions», he recollects.
Soon, however, his prediction turns out to be correct. Less than one year later, the US housing boom runs out of steam which triggers the worst recession since the Great Depression. Today, Mr. Rajan who governed the Reserve Bank of India until last fall and now teaches finance at the University of Chicago, is reputed as one of the most distinguished economic thinkers on the planet. So what prompted him to voice his concerns at that time in Jackson Hole? Where does he think the world stands in the spring of 2017? And what is his outlook for the coming years?
Dr. Rajan, in the late summer of 2005 hardly anyone noticed the bomb that was ticking in the global financial system. What made you ring the alarm?
At that time, people were aware of the exuberance in the financial markets. I don’t think I was the only one who noticed it. So I was just speaking out what other people were also seeing. But I went one step further and said that this bubble was different from the one we had seen with the dotcom bust.
How did you come to this conclusion?
Far too many people were complacent because they remembered the experience during the dotcom bust. Remember, Alan Greenspan had warned about irrational exuberance as early as 1996. So investors had seen that exuberance. But they also witnessed the run-up in stock prices and that the final results were not that serious. The losses after the dotcom bubble burst were comparably quickly recovered. The Federal Reserve cut interest rates and managed to revive the economy. Some kind of complacency set in: »We could deal with the dotcom bust which means we can deal with the next bust as well», was the general thinking. »We just have to cut interest rates and things will pick up. Let’s not worry too much.»
What was different this time?
There was a new doctrine which stated that we can’t really identify financial bubbles. Accordingly, it doesn’t make sense to try to prick them. We will just pick up the pieces after they collapse. As soon as you hear that as a financial market player you think: »Wonderful, they’ve given me a chance to make a lot of money.» But this time the difference was debt. The dotcom bust had some elements of debt too, but very localized in the telecom industry and a few related sectors. Now, there were significant levels of debt across the household sector. People were borrowing against housing with the firm belief that real estate prices never fall across the United States. But then we discovered that none of that was true. House prices did fall and debt proved to be a significant burden. The households stopped consuming and that spread quickly through the economy and we had the financial sector meltdown.
So what was the reason for the financial crisis? Just a few Wall Street bankers who once again got too greedy?
It’s all too easy to say the bankers were responsible and just put the blame on them. They were responding to an environment which essentially was telling them to go out and take risks. The same politicians who were screaming at Wall Street after the financial crisis were the ones cutting ribbons at every new development project that was financed by the banks. So the system was essentially encouraging the banks to reduce their constraints on lending. This is true not only for US, but also for Spain, Ireland and other countries which experienced a huge construction boom.
And why of all things was it housing that was in the center of the exuberance on Wall Street?
There are a bunch of nice things about housing. First, nobody feels bad when prices go up: Neither the banker nor the households nor the politician. That’s also true for a stock market boom but a housing boom is easier to engineer by expanding credit. Second, a housing boom creates a whole lot of construction activity. It creates moderately skilled jobs like work for the bricklayer or for the guy setting up the foundation. So it provides a lot of employment for people who were being laid off and that’s very good because it takes pressure off of the system. If this goes on forever it’s fantastic. But how many houses can you build in an industrial country? At some point it reaches an end and that’s the problem.
Next came the worst financial crisis since the 1930s. Where do we stand today, ten years after the first big banks had to announce severe losses in the US mortgage market?
If you talk narrowly about the financial sector we are certainly in a better place today. The capital ratios that we asked the banks to move towards have helped to bring leverage down to more reasonable levels. What’s more, we’ve tried to deal with some of the difficulties we had in resolving financial institutions, for example with respect to derivative positions. So there has been a substantial amount of progress in resolving, cleaning up and to some extent giving financial institutions incentives not to take on too much risk. However, the job is only half done.
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