Charting the Economic Fault Lines

As the son of a diplomat, Raghuram G. Rajan lived outside of his native India for most of his childhood. In 1974, at age 11, he moved back to India from Belgium and got the shock of his young life. The widespread poverty stunned him, but it wasn't just that. Even for middle-class families like his, nothing seemed to work in Indira Gandhi's India, a nation choked by regulation. "I went from seeing the supermarket filled and toys galore to a country where you had to hunt for bread, and milk was a luxury," says Rajan. "Even people who had money had nothing to spend it on."

A light went on in the boy's head: It doesn't have to be this way. "My friends in India were as smart as my friends in Belgium," Rajan says today. "The sense of how bad government can be when it tries to do too much is from those years. But also what good government can do."

At 48, Rajan is still obsessing over the problems that captured his attention as a boy in New Delhi. Only now he's applying his thinking on a global stage. Having served as the chief economist of the International Monetary Fund from 2003 to 2006, he has returned to his endowed chair at the University of Chicago's Booth School of Business and is the author of a much discussed 2010 book, Fault Lines: How Hidden Fractures Still Threaten the World Economy. Those fault lines include rising inequality in the U.S. and the dependence of the wealthy U.S. on loans from poorer China.

Rajan's arguments about what destabilized the financial world and how to respond have emerged from a pack of competing theories to capture the attention of opinion makers. When Foreign Policy magazine asked its 100 "global thinkers of the year" for book recommendations, Fault Lines came out on top, with plugs from Yale University economist Robert J. Shiller and New York University economist Nouriel Roubini, among others. Rajan says he has received congratulatory notes about the book from former British Prime Minister Gordon Brown and European Central Bank President Jean-Claude Trichet.

The high-level attention has made Rajan a player in the debate over how to prevent severe economic crises. Yale's Shiller says the book was cited repeatedly at a Goldman Sachs (GS) conference he attended on Jan. 19. "It's not typical finance-department work," Shiller says. "Raghu is more of a broad intellectual than is typical in business schools." Kenneth Rogoff, a Harvard University economist who preceded Rajan as the IMF's chief economist, says his book "is getting a lot of attention because it presents a particularly deep political economy analysis of the global imbalances....Perhaps he carries the argument too far, but there is certainly a ring of truth to it."

Rajan sat for an interview in January in Denver, a city overrun by dismal scientists attending the annual meetings of the Allied Social Science Assns. As the new president of the American Finance Assn., he was in such demand that he had to hide on a bench behind a partition to get a quiet moment.

American economists have been divided since the 1970s between salt and fresh. The "saltwater" school is more Keynesian, often liberal, and strong in coastal universities such as Harvard, the Massachusetts Institute of Technology, Princeton, and the University of California at Berkeley. The "freshwater" school is more free-market-oriented and began at schools clustered around the Great Lakes such as Carnegie Mellon University and the universities of Chicago, Minnesota, and Rochester. The financial crisis created an opening for an unconventional economist such as Rajan, who pulls together ideas from both schools (call him brackish). "I'm a pragmatic economist," he says. "I've seen too much failure on both sides."

One reason Rajan has drawn so many admirers is his willingness to tackle big themes such as poverty and the power of banks, instead of keeping his head buried in the academic weeds of elasticities, volatilities, and heteroscedasticities. Luigi Zingales, a Chicago Booth colleague and co-author of Rajan's previous book, Saving Capitalism from the Capitalists, says, "There's a tension between saying nothing precise and precisely nothing. The economics profession is going in the direction of saying precisely nothing."

In person, Rajan is calm and genial, even when engaged in debate. He's not timid, though. Fault Lines recounts an episode in 2005 when he was serving as chief economist of the IMF and implied to a reporter that Britain might need to raise taxes. That contradicted the public statements of Gordon Brown, then Chancellor of the Exchequer, who lambasted the IMF at a press conference the next day. Rajan and his boss, Managing Director Rodrigo de Rato, didn't back down. Brown's congratulatory note to Rajan on the scholar's book suggests that the former PM's respect for the author overshadows any hard feelings.

Rajan's family arrived in Indonesia in 1966, a time of political turmoil captured in the book and film The Year of Living Dangerously, when President Sukarno was overthrown and hundreds of thousands of Indonesians died in anticommunist purges. In 1969 the family moved to Sri Lanka. In 1971 it was on to Belgium, a prosperous country that left Rajan ill-prepared for his return to India three years later.

Despite an early interest in social and economic tensions, Rajan took what he calls "the road to safety" and got his first degree, in 1985, in electrical engineering. Two years later, still hankering for economics, he earned an MBA from the elite Indian Institute of Management in Ahmedabad. Classmate Srinivas Shastri recalls him as "a damn compassionate guy." Shastri wrote in an e-mail: "I still remember how he dismissed me with the slower ball in a cricket match"—the equivalent of an off-speed pitch in baseball—"and later apologized!" Another classmate, Radhika, became the love of his life. "We argued so much we decided we could never be in the same group again, but eventually did get married," Rajan says. The couple has two teenage children.

After Ahmedabad, Rajan went to the U.S. and in 1991 got a PhD in economics from MIT. Then he got a teaching job at the University of Chicago, whose Gothic-style campus in the Hyde Park neighborhood has been his base ever since. In 2003, the same year he began his three-year stint at the IMF, he was named the first recipient of the American Finance Assn.'s Fischer Black Prize for the person under age 40 who has contributed the most to finance theory and practice.

In addition to presiding over the American Finance Assn. this year, Rajan is an economic adviser to Indian Prime Minister Manmohan Singh. He chaired an Indian committee on financial reforms that produced a report called A Hundred Small Steps. He's also an academic adviser to the U.S. Comptroller General, Moody's Investors Service (MCO), Brazil's Bank Itaú-Unibanco, BDT Capital Partners, which invests in closely held companies, and Booz & Co., the strategic consulting firm. "I do try and protect space for research and continue writing a few academic papers a year," Rajan says.

On Aug. 27, 2005, Rajan gave a speech that made his reputation as someone with a special understanding of the global economy. It was a dispassionately delivered warning to the world's central bankers at their annual retreat in Jackson Hole, Wyo. Most of the speakers lavished praise on attendee Alan Greenspan, who was completing a much lauded final year as Fed chairman. Rajan used his turn at the lectern to present a paper called "Has Financial Development Made the World Riskier?" "Something as intimate as credit risk is now being traded with strangers," he said, noting that banks, displaced from conventional lending, were relying on riskier profit-making strategies such as providing backup lines of credit for corporate commercial paper. "Competition," he continued, "forces them to flirt continuously with the limits of illiquidity."

He observed that investment managers' returns were "convex," meaning their personal upside for taking more risk was great and their downside was trivial. Although markets seemed tranquil, Rajan warned against complacency, noting "the absence of volatility does not imply the absence of risk." His advice: Be wary of keeping interest rates too low, and fix the incentives in regulation—for example, by requiring investment managers to invest a portion of their pay in the assets they manage and barring them from pulling the money out until a year after they quit.

He was treated like a skunk at the party. Lawrence Summers, the former Treasury Secretary who was then the president of Harvard University, said he found "the basic, slightly Luddite premise of this paper to be largely misguided." After several other speakers piled on, albeit more politely, Princeton University economist Alan Blinder defended Rajan from what he called "the unremitting attack he is getting here for not being a sufficiently good Chicago economist" ("Chicago" being shorthand for free-market). In Fault Lines, Rajan writes, "I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions."

Of course, Rajan was soon proven correct. Fault Lines is not, however, just a 260-page I-told-you-so. It's an attempt to identify the roots of the crisis and propose ways to make the system less vulnerable to another cataclysm. It's also an attempt to heal the intellectual fault line between market libertarians, who have no faith in government, and social liberals, who have no faith in unfettered markets.

Rajan champions the "freshwater," free-market argument that Federal Reserve Chairman Ben Bernanke is risking another dangerous asset bubble by keeping interest rates too low for too long. That puts him in the same camp as such conservatives as John B. Taylor, Treasury Under Secretary for International Affairs in the George W. Bush Administration. Rajan faults Fannie Mae (FNMA) and Freddie Mac (FMCC) for pumping too much money into subprime mortgage loans and the Community Reinvestment Act for pressuring banks into extending credit to supposedly underserved communities.

Such views have not won him praise from the "saltiest" thinkers. Princeton's Paul Krugman, the Nobel laureate and New York Times columnist, blasted Fault Lines in The New York Review of Books, scolding Rajan for "buy[ing] into what is mainly a politically motivated myth." Rajan responded in The American, the magazine run by the conservative American Enterprise Institute, with "Many Are the Errors." "Perhaps Paul Krugman believes that by labeling other economists as politically extreme, he can undercut their credibility. But his is badly weakened by the myriad errors he makes," ran the story's subhead. It was just the kind of language you'd expect from an economist with a signed poster of Milton and Rose Friedman on the wall of his office.

If Rajan has the heart of a conservative, it's also a heart that bleeds. He says the excesses in subprime lending were a misguided attempt to deal with what he considers a very real problem, namely rising income inequality. He produces statistics showing that Americans in the upper income echelons are doing fine, while those in the middle and the bottom are losing ground. Borrowing by those less successful groups allowed them to spend as if they were better off than they really were, but it couldn't last. It would be far wiser, Rajan argues, to deal with the root causes of inequality by helping the poor and middle class get a better education so they can be more competitive in the now-global labor market.

Rajan argues that the Fed's cheap-money policies are a bad solution to another acute problem—namely, the weakness of America's social safety net. If the net were stronger, as it is in Europe, he says, being jobless would be less painful, and the Fed could allow the economy to recover at a natural pace without feeling political pressure to overstimulate the economy in the hope of creating jobs.

So while parts of Fault Lines sound positively Ron Paul-ish, others could have come from the liberal wing of the Democratic Party. "In this debate," Rajan writes, "few legislators have asked how U.S. society can remain healthy and humane with a sick and unprotected immigrant population in its midst. If nothing is done, inequality will feed on itself."

Maybe that's his Indian background peeking through. MIT economist Abhijit Banerjee says poverty and inequality are central concerns for most Indian-born economists across the political and economic spectrum. "I'm a creature of the country I grew up in. You know there has to be an answer," Rajan said in Denver.

If there's a fault in Fault Lines, it's in Rajan's proposed solutions. Some are doable but not sufficient to fix the problem, while others might be enough to fix the problem but are not especially doable. Among his ideas: withhold traders' bonuses for a few years until it's clear their initially winning trades don't lead to disaster later, break up Fannie Mae and Freddie Mac, close the revolving door between Wall Street and the regulatory agencies, devote more resources to very young children in poor families, pay teachers more for outstanding performance, promote charter schools and vouchers, make health insurance universal, consider a value-added tax and a carbon tax, and phase out deposit insurance to expose banks to more market discipline.

One of his most ambitious proposals is for the IMF to gain influence by "appealing more directly to a country's citizens," including China's "thinking middle class." It might not work, writes Rajan, but "in going beyond their comfort zone, multilateral organizations have little to lose but their irrelevance."

Rajan faced a tough crowd at January's meetings in Denver. On a Friday morning at 8 a.m. he made a slide presentation of his thesis using charts and equations. "Society tends to look for scapegoats and then shoots them. But what if the problem goes deeper?" he asked the audience of about 80 people.

Then two of the top economists of his generation took shots at him with their own slide presentations. It was the economics profession's equivalent of the National Basketball Assn.'s slam-dunk contest: Top that! In your face!

After praising Rajan, MIT's Daron Acemoglu questioned whether he had his causality wrong. Instead of trying to help the poor by stoking the subprime lending craze, Acemoglu said, perhaps members of Congress were trying to fuel the business of the financial elites who pay for their election campaigns. Acemoglu cited a line attributed to Republican Senator Mark Hanna (1837-1904): "There are two things that are important in politics. The first is money, and I can't remember what the second one is."

Edward Glaeser of Harvard University and the free-market Manhattan Institute also lauded Rajan—and then hit him from a different direction, citing data showing that lax lending practices explain only a small portion of the bubble in U.S. housing prices.

A day later, Rajan seemed to have taken the Acemoglu/Glaeser one-two punch in stride. "The differences of opinion are smaller than they appear," he said. He conceded that some pieces of his argument, in particular the assertion about Congress's motive in promoting subprime mortgage lending, were not as nailed down as they would have been in a refereed academic paper. "I'm making a leap. That's what a book allows me to do," he said. Echoing his earlier co-author Zingales, Rajan said, "You have to have an expertise. But there have to be some people who can talk about the broader structure."

As an economic seismologist, Rajan isn't satisfied just identifying the fault lines in the global economy. He wants to heal them, too. "The cost of doing nothing," he writes, "is perhaps worse turmoil than what we have experienced recently" because "unchecked, the fault lines will only deepen."

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