In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., Raghuram Rajan presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the University of Chicago economist observed that financial innovation had delivered unquestioned benefits, but also had produced undeniable risks.
“It is possible these developments may create … a greater (albeit still small) probability of a catastrophic meltdown,” he told the assembled central bankers and academics. “If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions.”
It was a discordant note at a forum celebrating Alan Greenspan’s tenure as Fed chairman; many deemed his conclusions “misguided.” But history, of course, proved that Rajan’s analysis was dead on. ...
Here is a blunt assessment of the Jackson Hole episode.
Here are a few sections from the (much longer) interview:
... Doubts about Diminishing Risk
[Ron] Feldman: In a prominent Jackson Hole paper,2 you talked about some of the technologies of banking that people thought were going to distribute risk widely and therefore diversify it, making the financial system and financial institutions less risky. It was less clear to you that risk reduction was actually occurring. Could you talk about how you came to that view and how important you think that was in the current crisis?
[Raghuram] Rajan: One of the things I was asked to do was to look at the development of the financial sector, and I have great admiration for some of the things that have happened. There have been good things in the financial sector which have helped us. But to some extent there was a feeling that when you distribute risk, you’ve reduced the risk of the banking system.
My thought was, what business are the banks in? They’re not in the business of being plain-vanilla entities, because they can’t make any money that way. They are in the business of managing and warehousing risk. So if it becomes easier to lay off a certain kind of risk, the bank better be taking other kinds of risk if it wants to be profitable. And if the vanilla risk is going off your books, presumably the risks that you’re taking on are a little more complex, a little harder to manage.
That was the logic which led me to argue ... that distance-to-default measures didn’t look like they were coming down despite all this talk about securitization and shifting risk off bank books. That struck me as consistent with my view that maybe the risks that banks were taking on were more complicated. Whether they were excessive or not, I couldn’t tell.
Also, as I saw the mood, I became worried. Having studied past financial crises, I knew that it’s at the point when people say, “There’s no problem,” that in fact all the problems are building up. So that was just another indicator that we should be worried.
I should add that while I thought we could have a crisis, I never thought that we’d come to the current pass. However, I did argue that it could be a liquidity crisis..., and even though banks in the past had been the safe haven, they could be at the center of this problem.
So, one strand of my argument was based on the business of banks, but the second strand was to think about the incentive structure of the financial system and say that while we have moved to a compensation structure that penalized obvious risk, risk that you could see and measure, that may have made employees focus on risks that could not be measured. An example of that is “tail risk,” because you can’t measure it until it shows up, and it shows up very infrequently. So part of the reason I was worried was that people were taking more tail risk; an insurance company writing credit default swaps was just one example of that.
It didn’t require genius at that point to look around and say the insurance companies were writing these credit default swaps as if there was no chance on earth that they would ever be asked to pay up, so they were really taking on tail risk without any thought for the future. AIG should not have been such a surprise to the Fed.
Feldman: Ex post it was clear to everyone that the incentives were aligned so that firms were taking on risk that people didn’t understand, but at the time there was push-back to what you were saying. ...
Rajan: There were two reasons for the push-back. One was just the venue. This conference was almost a Festschrift [farewell tribute] to Greenspan, and it seemed to some—though it wasn’t intended as such—that I was raining on the parade. This was his farewell, and I was talking about problems that had arisen during his tenure.
But the bigger issue was the collective sense that the private sector could take care of itself, and if not, the Fed would be able to clean up. We had been through two downturns: the 1998 emerging market crisis and the 2000-2001 dot-com bust, and we had understood the tools that were required. In 1998, it was a short reduction in interest rates, not a dramatic one. In 2000-2001, it was a dramatic reduction. And these “successes” led to a feeling that “the Fed can take care of it.”
You know the argument: Typically, the private sector will have the right incentives. Why would they blow themselves up? Regulators aren’t that capable: They’re less well-paid and less informed than the private sector, so what can they do? And finally, if worse comes to worst, the Fed will pick up the pieces.
I think there are three things wrong with this argument, one for each of those elements. Private sector—yes, it can take care of itself, but its incentives may not be in the public interest; may not even be in the corporate interest if corporate governance is problematic. So the trader could fail the corporation, could also fail society. That’s one problem.
Second, the public sector has different incentives from the private sector, and that’s a strength of the public sector. When we’re talking about regulators, because they’re not motivated in the same way as the private sector, they can stand back and say, “Well, I don’t fully understand the risks you’re taking, but you are taking lots of risk—stop.” So I think we’ve made too little of the incentive structure of regulators which should be different, can be different, which gives them a role in this, rather than saying they’re incompetent and they can’t do it. I think they can.
But the third aspect was that I think we overestimated the ability of monetary policy to pull us out of a serious credit problem. The previous problems we had dealt with in the U.S. were not credit problems. They were standard, plain-vanilla recessions. The bank system was still active, so monetary policy wasn’t pushing on a string: The Fed brought down interest rates, and things did come back up.
When credit problems arose—and real estate was central to credit problems because of the real estate securities which ended up on bank balance sheets—then the banks were incapable of being part of the transmission process, and now monetary policy lost a lot of traction, so it wasn’t simply a matter of cutting interest rates and seeing everything come back.
Feldman: People might have thought after the banking crisis of the 1980s and early 1990s—which did not have the same macroeconomic effect as this crisis—that they could respond effectively.
Rajan: Exactly. I guess we didn’t see anything as big, as deep in the recent past. And there was a certain amount of hubris that we could deal with this.
Why was the Crisis so Severe?
Feldman: Why do you think this financial crisis was more severe? There are lots of potential explanations. Some observers point to the failure of credit rating agencies; others point to flawed incentives in compensation and to the creation of new financial products as examples. If you had to list the two or three things that you think really underlie why there was so much risk-taking, why more risk-taking than people thought, what’s the deep answer for that?
Rajan: You can go right to the meta-political level, but let me leave that aside for now. If you hone down on the banking sector itself, I think it was a situation where it was extremely competitive. Every bank was looking for the edge. And the typical place to find the edge is in places where there are implicit guarantees. ...
I think the most damaging statement the Fed could have made was the famous Greenspan doctrine: “We can’t stop the bubble on the way up, but we can pick up the pieces on the way down.” That to my mind made the situation completely asymmetric. It said: “Nobody is going to stop you as asset prices are being inflated. But a crash is going to affect all of you, so we’ll be in there. By no means go and do something foolish on your own, because we’re not going to help you then. But if you do something foolish collectively, the Fed will bail you out.”...
People were acting as if liquidity would be plentiful all the time. And my sense of what the Fed does, in part, by reducing interest rates considerably is help liquidity, and so there was a sense that, well, we can take all the liquidity risk we want, and it won’t be a problem. Of course, it turned out that not just interest rates mattered; the quantity of available liquidity or credit also mattered at this point. And that was the danger. ...
Corruption, Ideology, Hubris, or Incompetence?
Feldman: One thing you haven’t mentioned as a proximate cause is issues around “crony capitalism.” Some seem to argue that banks were allowed to grow large and complex because they were run by friends or colleagues of people who were in power. And for similar reasons, these firms got bailed out—because they had colleagues and friends in “high places.” Given that you’ve thought a lot about that in your own writing, given that you were at the IMF [International Monetary Fund] where you had the ability to look across countries where it is an issue, how important would you say crony capitalism is in the U.S. context in the current crisis?
Rajan: Let me put it this way. There is always some amount of regulatory capture. The people the regulators interact with are people they get to know. They see the world from their perspective, and, you know, they want to make sure they’re in their good books. And so it’s not surprising that across the world, you have a certain amount of the regulators acting in the interest of, and fighting for, the regulated.
Beyond that: Is there naked corruption, or less naked corruption? “If you do my work for me as a regulator, then you can come and join me as a senior official in my firm, and I’ll pay you back at that point.” I’m sure there were stray instances of that, but that to my mind, wouldn’t be the number one reason for this crisis.
I think I would put more weight on a sense of market infallibility which pervaded the economics profession, not just regulators. ... I think across the field of economics, we stopped worrying about the details in industrial countries because we said, by and large, things get taken care of. Yes, there is the occasional corporate fraud or misaligned incentives, but those are aberrations rather than a systemic problem. So I think this view, that you couldn’t have a large systemic problem, this was the problem.
Overlaid on this was the view that regulation was less and less important. We put excessive weight on the private sector getting it right on their own without understanding that the private sector can also break down—the board may not know what management is doing, management may not know what the traders are doing, so that process can break down. But even if everybody is working in the interests of the corporation, the corporation may not be acting in the interests of the system. We’ve seen all these things happen. So the regulatory system had a role to play, and it did not play that as much as it should have. ...
I’m positive that there were situations that we will discover in hindsight where excessive influence was used. There’s cronyism. In a crisis like this, it’s hard to escape it. But I’m less convinced that systematic cronyism was the reason for this. I think ideology was part of the reason we went wrong, as also was the hubris built up over decades of fairly strong growth and deregulation. ...
I guess I’m paraphrasing Churchill, but my tendency is not to attribute to malevolence what can be more easily attributed to incompetence. I think there are a fair number of situations where things didn’t work out as advertised.
Feldman: But you’re talking about more than incompetence, right? You’re talking about the incentive structures within firms that would lead people to act as if they were incompetent.
Rajan: I’d even go one step further and say you don’t have to offer an explanation that relies on evil people or corrupt people. The entire crisis can be explained in terms of people who were doing the right things for their own organizations. You can even argue that it was not that they were misdirected by their own distorted compensation structures; they thought they were doing the right thing for their organization. But when you added it all up, it didn’t add up to doing good for society. And that’s where we have the problems. ...
The Economics Profession
Feldman: We just talked about the economics profession and what has worked well or hasn’t worked well. There’s been a lot of discussion about saltwater and freshwater schools in economics recently.4 I think you have an interesting background to talk about that since you’re at the [freshwater] University of Chicago business school and you’ve done a lot of work about financial systems, but you got your Ph.D. at [saltwater] MIT. Do you have a view about what the economics profession didn’t do well? And what the economics profession ought to be focused on going forward?
Rajan: I have a take on this, yes. But first, one has to remember that the saltwater economists, so to speak, were crowing victory in 1969. You see quotes from Paul Samuelson and Bob Solow [at MIT] saying essentially that the business cycle is dead; we have learned how to deal with it. And we know what happened after that.
I think there is a problem with economics when it thinks it has solved all the traditional problems. That’s when economics slaps you in the face and says, “Not so fast!” The reason rational expectations in macroeconomics and efficient markets in finance are under attack now is not so much because people can tie specific failings to these theories but because they’re the dominant part of the economics or finance profession right now. So I think debate has gone a little off track, in the sense of saying, “You were responsible.”
Would any of the neo-Keynesians have done any better? There were many of them in the Clinton administration where some of this stuff built up. Would anybody pin all this on the Bush administration only? No, it’s a systemic problem. So, I think the debate about “economics is to blame.” well, yes, it is to blame to the extent that it didn’t pick up on some of what happened. But this crisis is problematic for all broad areas of macroeconomics or even of finance.
It is clear that there are many areas of economics that have studied the problems we saw in this crisis. For example, the banking and corporate finance guys have looked at agency problems, looked at banking crises, etc. The behavioral theorists have inefficient markets and irrational markets. So, again, the profession as a whole, I don’t think, deserves blame. It has been studying some of these things.
The central question is why certain areas of economics, particularly macroeconomics, abstracted from the plumbing, which turned out to be the problem here. My sense is that that abstraction was not unwarranted given the experience of the last 25 to 30 years. You didn’t have to look at the plumbing. You didn’t have to look at credit. Monetary economists thought credit growth was not an issue that they should be thinking about. Interest rates and inflation were basically what they should be focusing on. The details of exactly how the transmission took place were well established, and we thought they would not get interrupted. Well, we’ve discovered they can get interrupted.
The natural reaction is now to write models which have the details of the plumbing, and you see more of that happening. So I think what the macroeconomists did was not because they were in the pay of the financial sector or consultants of whatever [laughter], as some have said. But I think it was that that was a useful abstraction given what we knew, and it’s no longer an abstraction that we can ever undertake now. ...