Nobody has learnt any lesson from the crisis: Raghuram Govind Rajan

“This crisis was the icing on the cake or the straw that broke the camel’s back, whichever way you want to put it… And we could say that we may have even bigger crisis building because nobody has learnt any lessons from what just happened,” says Raghuram Govind Rajan, Eric J Gleacher Distinguished Service
Professor of Finance at the University of Chicago’s Booth School
of Business.

Rajan is also currently an economic advisor to the prime minister. Prior to resuming teaching in 2007, Rajan was the the chief economist at the International Monetary Fund (from 2003). Since then, he has chaired the Indian government’s Committee on Financial Sector Reforms, which submitted its report in September 2008 and has just written a book, Fault Lines: How Hidden Fractures Still Threaten The World Economy. In this interview, he speaks with R Jagannathan and Vivek Kaul. Excerpts:

In your book Fault Lines, you write easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly. Can you explain that?
What I argue is that the middle-class in the United States, if you take the middle-class as up to the sixtieth or the seventieth percentile of income distribution, has actually been falling back relative to the people from the sixtieth to the hundredth percentile. The key question is why? In many ways the answer is that the middle-class in America is basically not very well educated and typically has education up to high school.

The kind of jobs that are emerging in the US economy, typically require skills which are much more demanding than a high school education. For example, an analyst, a marketing analyst nowadays has to understand what Google hits are, and how the statistics play out, a much deeper job than used to be the case in the profession.

Similarly, clerks, it used to be a very common middle class job, had to add up figures on the left hand side and right hand side of the balance sheet. The job no longer exits. It has been replaced by the spreadsheet everywhere. The requirements for job skills have gone up. The supply of people with that kind of education hasn’t.

What has happened because of that?
Two things. One, the incomes of the guys who have the skills are
going up much faster than the guys who don’t have the skills. Second, the people, who don’t have the skills, not only are they falling back. Obviously there is a lot of anxiety among these people
and there is a great uncertainty whether there jobs will continue. They have pushed on politicians to do something.

And what is that?
I argue that the hard solution is to give them the skills, but that takes a long time and it not going to happen in the short run. Politics is all about the possible in the short run. Somewhat less hard, but still hard, is taxation and redistribution. No appetite for that in the US at that time. Regan era, Clinton era, if you mentioned taxes, you lost the elections. So what is left? What is left is disguised taxation and redistribution.

In a sense that was what the credit boom was all about. Give these guys credit. They go out and buy houses. House prices appreciate. They feel better. They can borrow against it. They can consume. Incomes are stagnant, doesn’t matter. They feel wealthier. They are consuming. Now this can be maintained for sometime and everybody is happy. The bankers are happy because they are making the loans, the borrowers are happy because they are getting it and the politicians are happy because the voters are happy.

This is the great secret that America is not willing to confront that the political pressure to expand credit was enormous. So everybody was willing in this. So when people come down to the blame game, there’s Was it A? Was it B? I say there is a plenty of blame to spread. It is important when checks and balances break down, you have to ask why they break down. Just saying that it was Alan Greenspan on the job and he didn’t sort of regulate the sector, is too easy.

You have to ask what were the pressures on Greenspan? Why was the rest of the Federal Reserve keeping quiet? Because there was across-the-board pressure on controlling credit expansion.

The US Federal Reserve along with the US government is still trying to prop up house prices both indirectly through low interest rates and directly by lending into the housing market. How dangerous is that going to be?
In some sense, the danger is that with asset prices you don’t know what the level should be. And the Federal Reserve kept on saying when the real estate boom was on we don’t know what the level is and so how can we combat appreciation.

Of course once the housing market collapsed, they seemed to suddenly know what the level is and kept propping up Fannie and Freddie. They also continue lending and that is direct government support. So you still have this crazy lending in housing and the adjustment process is not being allowed to take place.

People are not selling houses because they say, oh maybe things will come back, instead of adjusting to the fact that prices have to fall. That prevents construction from adjusting. It reflects the notion that lets just paper over the problems and once we get the economy back on track things will be fine. It’s the modern version of Keynes’ statement “In the long run, we are all dead.”

You also write “we could well have another crisis, albeit different in its details from the current one.” Could you elaborate?
In some sense the broader picture is that the hubris the industrial countries had is that we have learnt how to manage the economy.
We have learnt to moderate it. The great moderation…

The famous last words…
Absolutely. And the great moderation was based on selective interventions on the monetary side and it was thought that with these interventions we could only have mild recessions. What people didn’t pay attention to was that as you did more of this, the private sector understood what was going on and took bigger and bigger risks. And the buffer was being provided in a sense by the government balance sheets.

So if you look at the government debt in the industrial countries, it has been extending steadily since the 70s and now it is north of 100% of the gross domestic product. This crisis was the icing on the cake or the straw that broke the camel’s back, whichever way you want to call it. The point is that the buffer was being provided with the hope that it would stabilise the economy. But if you provide the buffer, then private sector understands they are providing the buffer and so let me take more risk.

So in a sense this crisis was a reaction in some ways to what happened in reaction to the last crisis. And we could say that we may have even bigger crisis building because nobody has learnt any lessons from what just happened. In fact, before the European crisis, covenant light loans were back.

The big payouts in investment banking were back. The guaranteed bonuses were on their way in. That is suggesting that basically the financial sector is up and running again and is pretty happy to take all the risk it was taking. You haven’t conveyed the lessons.

You also are against reining in the size of big banks. Why is that?
I don’t think the problem is in all cases too-big-to-fail. If the small banks take the same risks as the big banks, it becomes too many
to fail rather than too big to fail. In fact, this was the problem with the United States during the depression.

There was a very strong sense that they were too many small banks and the US needed a few big banks. So I think the real issue is how do you control the risk-taking by the big banks.

You could find ways to reduce the extent to which banks become large on a subsidised basis and this is where reducing deposit insurance once the banks become more than a certain size or increasing capital requirement, those are reasonable things to do. I think the blanket bank on size is more problematic.

In the past, governments have been known to inflate away their debts by simply printing more money. Do you see the US and the UK doing that at some point of time?
They could. The cost of doing that is that you lose credibility for a long, long time. And so while your current debts go down, people when they demand interest rates in the future, will have absolutely no belief that you are going to make any inflationary control and will want an inflation risk premium.

It is more of a possibility for the United Kingdom which has public debt which is long term; in the US the public debt is short-term because they have issued more short-term paper in recent years, it becomes a lot harder to do it because you inflate away the current debt but before you know it, it’s repricing. So you don’t get that much of a bang from inflating away public debt.

In the US it could help in the sense of inflating away the household debt which is tremendous. So it is a possibility. But the long term cost would way weigh on the country and I think the Fed would be reluctant to go that route on its own.

One of the interesting things in the US is that a lot of people who run the finance part of the US government are drawn from Wall Street (the likes of Robert Rubin, Henry Paulson and so on). You seem to suggest that this nexus of sorts should be broken. Why?
I don’t think there is naked, out-and-out corruption in the sense that the treasury secretary or the chairman of the Fed saying that how can I go out and help Goldman Sachs because they are my friends and buddies and are going to give me a job when I leave.

But I think there is a certain extent to which the regulators are excessively cozy with the regulated. And so the regulator and the regulated see everything with the same eyes and that could lead to a wrong decision being taken. So the regulator has to be a little distant from the regulated.

Henry Paulson in his book (On the Brink) talks a lot about the many phone calls he made to various Wall Street banks while he was figuring out what to do. Now the charitable view of that is he is gathering information on what is going on. The uncharitable view is that if those are the only guys he talks to, what are the decisions he is going to make other than finding ways to help them as opposed to doing what is the best for the system?

I think in truth there is an intermediate position, you have to know what is going on, you can’t be a complete novice of the system, but you also have to maintain a wide set of contacts across the economy, so as to know what others think, other than Citibanks and the Lehmans of the world, that is where I argue that perhaps you need a little more cross-fertilisation in treasury from people don’t necessarily come from investment banks.