Ex-IMF chief economist was worried enough in 2005 for him to stake his job on his forecast
It was August 2005 and the annual gathering of top US economists at Jackson Hole, Wyoming. That year, the man they were honouring was no less a person than Mr Alan Greenspan, the legendary and long-serving chairman of the United States Federal Reserve who was poised to leave after nearly two decades in the job.
Among the speakers that year was Dr Raghuram Rajan, the chief economist of the International Monetary Fund who was given the job two years earlier at age 40. It was meant to be a celebration of the Greenspan era but what the audience, which included Mr Greenspan, heard from Dr Rajan was a prognosis of dire tidings to come.
Dr Rajan warned against credit-default swaps, which act as insurance against bond defaults, going sour and said there was also immense systemic risk if banks failed to meet their obligations.
His prognostications were dismissed for the most part. Who was this stripling to try to poop the party of the century? Mr Lawrence Summers, the noted economist and former president of Harvard University, was particularly scathing. Others, to borrow the words of a Rajan predecessor as IMF chief economist, thought he was "smoking something not quite legal".
But a little more than two years later, Dr Rajan's forebodings came true when the meltdown in the US financial system triggered the global financial crisis.
"I set out by thinking about it as a speech to celebrate the time Greenspan had been at the Fed and the developments in financial markets," Dr Rajan told me on Friday, during a brief visit to Singapore for seminars organised by the Monetary Authority of Singapore in conjunction with the Chicago Booth School of Business, where he is a tenured professor.
"But, you know, the academic in you dies hard. As I looked, some numbers worried me and that pushed further inquiry. It was a speech I could not avoid giving."
As IMF chief economist, he could not afford to be too alarmist. But he was worried enough about what was going on to stake his job on what he was going to say: "I told my wife as I left for Jackson Hole that this speech will either break me, or make me."
Dr Rajan is being modest, of course. His fame was already "made" when he was appointed the IMF's youngest chief economist in 2003, the year the American Financial Association awarded him the Fischer Black Prize, given every two years to an economist under 40 who has made the most significant contribution to the theory and practice of finance.
The Allan Meltzer Commission had been quite scathing on the IMF's capabilities in finance and the fund knew it had to bolster its expertise in examining financial markets. It also helped that IMF first deputy managing director Anne Krueger had read his first book, Saving Capitalism From Capitalists, and been impressed.
In subsequent years, his global stature would only grow. Indian Prime Minister Manmohan Singh would tap his skills, first as the government's chief economist, then as governor of the central bank. Indeed, the rupee strengthened on the day Dr Rajan took office. Time magazine named him among the world's 100 most influential people.
Last September, Dr Rajan quit as governor of the Reserve Bank of India, apparently after policy disagreements with the Narendra Modi government and despite a public endorsement from Mr Modi that he was a "good teacher" to him. Returning to academia in Chicago, he has imposed on himself a one-year moratorium to discuss the land of his birth.
What would he say if asked to speak at Jackson Hole today?
Dr Rajan points to an extreme reluctance, given the Lehman Brothers collapse and other experiences, to let markets find their direction. This, he says, means central banks are always inflating the markets a little more than they should. Targeted interventions, such as quantitative easing, may also have contributed to distorting asset prices.
"We clearly are in a situation where a mix of fundamentals, as well as policies, has inflated markets," he says. "Fundamentals, because real interest rates may really be quite low now, but also policies in the sense of the 'put' that central banks seem to be preferring to the markets that have elevated things."
In financial industry parlance, a put is an option contract that gives the owner the right, but not the obligation, to sell a specified security at a specified price.
This situation could cut in either of three ways. First, it is possible that fundamentals change in a positive way to reaffirm where asset prices are, which would be the best-case scenario. Two, asset prices move down towards fundamentals in a steady way without obstruction, which is what most people seem to believe may happen. But the third case is that the adjustment is abrupt and creates a fair amount of volatility.
"This worries me," he says. "Central banks will work towards the middle scenario, which is why the Federal Reserve is saying in its latest minutes that any unwinding of the Fed balance sheet will be measured. Question is: Are there market events that will make it hard to be calibrated?"
For instance, he says, given tightness in labour markets - the US is reckoned to be at near full-employment - there could be a sudden spurt in wage growth. Should that increase inflation expectations substantially, it could lead investors to brace themselves for a more rapid pace of monetary policy tightening.
"These unexpected events are what we have to fear, as opposed to the mainline scenario."
Youngest director of research at IMF
Dr Raghuram Rajan, 54, is the Katherine Dusak Miller Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.
Between 2003 and 2006, Dr Rajan was the chief economist and director of research at the International Monetary Fund, the youngest to hold the post.
In 2012, he was named chief economic adviser to the Indian government and, in September 2013, he was appointed governor of Reserve Bank of India (RBI) for a three-year term. During his tenure at RBI, he was also elected vice-chairman of the Bank of International Settlements.
Educated at Delhi Public School, Dr Rajan has an electrical engineering degree from the Indian Institute of Technology and an MBA from the Indian Institute of Management (IIM) in Ahmedabad, India's top business school, where he was awarded the gold medal.
He later went to MIT's Sloan School of Management and earned his PhD in 1991 for his work on banking. The same year, he joined the Booth School of Business at the University of Chicago and went on to become a professor of finance there.
Author of numerous books and research papers, his scholarly interests are in banking, corporate finance and economic development, especially in the role finance.
A keen sportsman in his student days, he is married to Dr Radhika Puri Rajan, who he met as a fellow MBA student at IIM.
I point out that the VIX - the Implied Volatility Index of the S&P 500 based on options prices - is hovering below 10 per cent, about the levels it was at in January 2007 before the unexpected and traumatic outbreak of the global financial crisis. That suggests investors are rather sanguine.
Dr Rajan counters that VIX is also an actively traded index and it is hard to tell whether its current level is because investors truly expect volatility to be low, or there is some gaming on.
"The point people miss is that there is a fair amount of policy uncertainty. You don't know which way the US or some European governments may move on a number of things - Brexit, for instance. The big discrepancy is between the very low VIX versus policy uncertainty being so high."
He refuses to be drawn into commenting directly on Fed policy, saying it is more important to understand what it is trying to accomplish. The Fed, he says, is aware that the global economy is still not robust. At the same time, the domestic labour market could tighten significantly and things could change rapidly on the price front, especially if the Trump administration goes for a large fiscal expansion. The Fed must stay prepared and be ahead of the curve.
"It is important that the Fed normalises policy when it can. Otherwise, the market will anticipate where the Fed needs to go and that creates disruptions," he says, swatting away suggestions that he could be a potential replacement for Fed chairman Janet Yellen, saying "I am not a US citizen".
The US aside, the elephant in the room clearly is China. Last week, for the first time since 1989, Moody's Investor Service cut the country ratings on China a notch, citing worrying debt in the world's No. 2 economy.
The swift climb in the credit-to- GDP ratio seen in China since 2008 is making markets nervous. Dr Rajan says that although most of it is internal credit, the IMF, nevertheless, has considered it important to point out that this is associated with financial turbulence. It has him worried as well.
"It is not an iron law of economics but the fact that China's large banks still have very low non-performance asset ratios suggests that some of the problem is yet to be recognised," he says. "The problem may be outside the Big Four Chinese banks but as you saw with the US, these things cannot be isolated. Something that infests one part will eventually go to other parts."
Beijing is, of course, aware of the enormity of the issue and has tried to tackle it by tightening liquidity and moving to clean up the shadow financial system. But that leads to an element of policy tension because firm measures will, without question, slow an already slowing economy.
"History shows that it has been a losers' game to bet against the Chinese authorities," he says. "But this time, it could be different. That's a worrying thought."
I steer the conversation back to the US financial sector and President Donald Trump's vows to loosen restrictions on banks.
Given his track record of warning against excessive risk and too-high compensation for bankers, I expected him to sound a word of caution. Instead, I got a considered response that wasn't anywhere close to negative.
Central banks will work towards the middle scenario, which is why the Federal Reserve is saying in its latest minutes that any unwinding of the Fed balance sheet will be measured. Question is: Are there market events that will make it hard to be calibrated?
DR RAGHURAM RAJAN, on how central banks are likely to react to current markets.
Dr Rajan says regulators tend to overload on regulation after a crisis. Typically, in good times, regulation weakens and adds to the exuberance and, in bad times, regulation makes the system more risk averse. Ultimately, though, banks have to shoulder risk and it is not for regulators to neuter them.
"The Trump administration has made different kinds of noises but it is clear that they aim to reduce the regulatory burden on small and medium-sized banks. The US has fragmented regulation and the extent of their compliance requirements has increased tremendously. When you put together all that a bank has to do, it gets quite difficult for them, so these are steps in the right direction."
He also expects some tweaks to the so-called Volcker Rule that curbs banks' speculative activities, saying he sees a "temptation" to simplify it.
There also has been talk of cutting the big banks down to size, but given that all sides to the argument are well-represented in the administration, there is not much likelihood of movement on that aspect.
Overall, he says, the US and global banking system have become safer from a decade ago. "But it is a certain kind of safety that you have to be careful about. If they do not make money, their ability to enhance equity positions over time, or inspire confidence in investors, also diminishes. That means taking a bit more risk but managing it very carefully."
Son of a police officer who spent most of his career in intelligence work, Dr Rajan's early years included a time in Jakarta, during that nation's turbulence of the mid-1960s. His father's physical and moral courage, combined with a strong work ethic, and his mother's compassion both influenced his formative years, he says.
His next book, tentatively called The Third Pillar, will focus on the social aspects of the economy as opposed to government and political influences.
Last year, India's ruling Bharatiya Janata Party, impatient to show growth and unhappy that the central bank governor did not cut rates fast enough, began to attack him, unleashing a maverick politician named Subramaniam Swamy to do the hit job. Dr Swamy suggested in media interviews and in a letter to PM Modi that Dr Rajan was "mentally not fully Indian" and had "wrecked the economy".
It is a hurt that Dr Rajan will perhaps always carry, although he is careful not to show it. Holder of a US green card for years, citizenship there would have been a cinch. Last week, he was trying to sort out issues relating to getting a visa to China on his Indian passport.
"Sometimes, people in India do not understand how hard it is to keep an Indian passport," he told me. "(But) it is a small price to pay if you really feel your sense of identity is bound with India."
A version of this article appeared in the print edition of The Sunday Times on May 28, 2017, with the headline 'Man who foresaw 2008 financial crisis'. Print Edition | Subscribe
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