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Raghu Rajan

Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

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Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

Dr. Rajan is also currently an economic advisor to the Prime Minister of India. Prior to resuming teaching in 2007, Dr. Rajan was the Economic Counselor and Director of Research (in plain English, 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.

Dr. Rajan’s research interests are in banking, corporate finance, and economic development, especially the role finance plays in it. His papers have been published in all the top economics and finance journals, and he has served on the editorial board of the American Economic Review and the Journal of Finance.  He has written Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press) which won the Financial Times/Goldman Sachs Business Book of the Year 2010 award. He has also co-authored Saving Capitalism from the Capitalists with Luigi Zingales .

Dr. Rajan is a senior advisor to Booz and Co, on the academic advisory board of Moodys, and on the international advisory board of Bank Itau-Unibanco. He is a director of the Chicago Council on Global Affairs and on the Comptroller General of the United State’s Advisory Council. Dr. Rajan is the President (elect) of the American Finance Association and a member of the American Academy of Arts and Sciences. In January 2003, the American Finance Association awarded Dr. Rajan the inaugural Fischer Black Prize, given every two years to the financial economist under age 40 who has made the most significant contribution to the theory and practice of finance.


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August 11

The Paranoid Style in Economics

NEW DELHI – Why do high-profile economist tussles turn so quickly to ad hominem attacks? Perhaps the most well-known recent example has been the Nobel laureate Paul Krugman’s campaign against the economists Carmen Reinhart and Ken Rogoff, in which he moved quickly from criticism of an error in one of their papers to charges about their academic transparency.


For those who know these two superb international macroeconomists, as I do, it is evident that these allegations should promptly be dismissed. But there is the larger question of why the paranoid style has become so prominent.


Part of the answer is that economics is an inexact science, with exceptions to almost every pattern of behavior that economists take for granted. For example, economists predict that higher prices for a good will reduce demand for it. But students of economics will no doubt remember an early encounter with “Giffen” goods, which violated the usual pattern. When tortillas become more expensive, a poor Mexican worker may eat more of them, because she now has to cut back on more expensive food like meat.


Such “violations” occur elsewhere as well. Customers often value a good more when its price goes up. One reason may be its signaling value. An expensive handcrafted mechanical watch may tell time no more accurately than a cheap quartz model; but, because few can afford one, buying it signals that the owner is rich. Similarly, investors flock to stocks that have appreciated, because they have “momentum.”


The point is that economic behavior is complex and can vary among individuals, over time, between goods, and across cultures. Physicists do not need to know the behavior of every molecule to predict how a gas will behave under pressure. Economists cannot be so sanguine. Under some conditions, individual behavioral aberrations cancel one another out, making crowds more predictable than individuals. But, under other conditions, individuals influence one another in such a way that the crowd becomes a herd led by a few.


The difficulties for economic policymakers do not stop there. Economic institutions can have different effects, depending on their quality. In the run-up to the 2008 financial crisis, macroeconomists tended to assume away the financial sector in their models of advanced economies. With no significant financial crisis since the Great Depression, it was convenient to assume that the financial plumbing worked in the background.


Models, thus simplified, suggested policies that seemed to work – that is, until the plumbing backed up. And the plumbing malfunctioned because herd behavior – shaped by policies in ways that we are only now coming to understand – overwhelmed it.


So, why not let evidence, rather than theory, guide policy? Unfortunately, it is hard to get clear-cut evidence of causality. If high national debt is associated with slow economic growth, is it because excessive debt impedes growth or because slow growth causes countries to accumulate more debt.


Many an econometrician’s career has been built on finding a clever way to establish the direction of causality. Unfortunately, many of these methods cannot be applied to the most important questions facing macroeconomic policymakers. So the evidence does not really tell us whether a heavily indebted country should pay down its debt or borrow and invest more.


Moreover, what seem like obvious, commonsense policy solutions all too often have unintended consequences, because a policy’s targets are not passive objects, as in physics, but active agents who react in unpredictable ways. For example, price controls, rather than lowering prices, often cause scarcity and the emergence of a black market in which controlled commodities cost significantly more.


All of this implies that economic policymakers require an enormous dose of humility, openness to various alternatives (including the possibility that one might be wrong), and willingness to experiment. This does not mean that our economic knowledge cannot guide us, only that what works in theory – or worked in the past or elsewhere – should be prescribed with an appropriate degree of self-doubt.


But, for economists who actively engage the public, it is hard to influence hearts and minds by qualifying one’s analysis and hedging one’s prescriptions. Better to assert that one knows, especially if past academic honors certify one’s claims as an expert. This is not an entirely bad approach if it results in sharper public debate.


The dark side of such certitude, however, is how it pushes these influential economists to deal with contrary opinions. How do you convince your passionate followers if other, equally credentialed, economists take the opposite view? All too often, unfortunately, instead of recognizing the other side’s points and challenging them, the road to easy influence is to impugn the other side’s motives and methods. Instead of fostering public dialogue, and educating the public, such an approach leaves the public in the dark. And it scares off younger, less credentialed economists from entering the public discourse.


In their monumental research on centuries of public and sovereign debt, the normally very careful Reinhart and Rogoff made an error in one of their working papers. The error is in neither their prize-winning 2009 book nor in a subsequent widely read paper responding to the academic debate about their work.


Reinhart and Rogoff’s research broadly shows that GDP growth is slower at high levels of public debt. While there is a legitimate debate about whether this implies that high debt causes slow growth, Krugman turned to questioning their motives. He accused Reinhart and Rogoff of deliberately keeping their data out of the public domain. Reinhart and Rogoff, shocked by this charge – tantamount to an accusation of academic dishonesty – released a careful rebuttal, including online evidence that they had not been reticent about sharing their data.


In fairness, given Krugman’s strong and public positions, he has been subject to immense personal criticism by many on the right. Perhaps the paranoid style in public debate, focusing on motives rather than substance, is a useful defensive tactic against rabid critics. Unfortunately, it spills over into countering more reasoned differences in opinion as well. Perhaps respectful debate in economics is possible only in academia. The public discourse is poorer for this.


Comments (2)

  • 9/10/13 - dkochharWhat are your thoughts on the unintended consequences of welfare economics followed by some...  Show Full Comment
  • 9/5/13 - tusheet_sarafMr. Krugman for all his due is also a relentless basher of economists who have predicted an...  Show Full Comment
June 30

Grounded Central Bankers

NEW DELHI – Markets are in turmoil once again, following the US Federal Reserve’s indication that it might reduce its bond purchases toward the end of the year. The intensity of the market reaction was surprising, at least given the received wisdom about how the Fed’s quantitative-easing policy works. After all, the Fed was careful to indicate that it would maintain its near-zero interest-rate policy and would not unload its holdings of bonds.


The dominant theory of how quantitative easing works is the portfolio-balance approach. Essentially, by buying long-term Treasury bonds from private investors’ portfolios, the Fed hopes that these investors will rebalance their portfolios. Because a risky asset has been removed and replaced with safe central-bank reserves, investors’ unmet risk appetite will grow, the price of all risky assets (including remaining privately-held long-term Treasury bonds) will rise, and bond yields will fall.


A central element of the theory is that the stock of bonds that the Fed has removed from private portfolios, not the flow of Fed purchases, will determine investors’ risk appetite. Unless investors thought the Fed was going to buy bonds forever, news about a reduction in Fed purchases should have had only a mild effect on their expectations of the eventual stock of bonds the Fed would hold. So why such a violent reaction in markets worldwide?


Possible answers are either the volume of monthly Fed purchases also matters for global asset prices, or that investors around the world read far more into the Fed’s statements than the Fed intended. Either answer is worrisome, because it would suggest that central banks – which are now holding trillions of dollars in assets – have less ability to manage the process of exit from  quantitative easing than we would wish. Perhaps Winston Churchill might have mused about quantitative easing, “Never in the field of economic policy has so much been spent, with so little evidence, by so few.”


Quantitative easing has truly been a step in the dark. Given all the uncertainty around it – why it works, how to make it most effective, and how to exit -- this raises the question of why central bankers, for whom “innovative” is usually an epithet, have departed from their usual conservatism.


One possible explanation is that in the past, crises typically occurred in countries that lacked the depth of economic training of, say, the United States or Europe. When emerging economies’ policymakers were told that they needed to implement significant austerity, as well as widespread bank closures, to cleanse the economy after a crisis, they did not protest, despite the prospect of years of high unemployment. After all, few had the training and confidence to question the orthodoxy, and those who did were considered misguided cranks. Multilateral institutions, empowered by their control over funding, dictated policy from the economic scriptures.  In sum, those determining policy were distant from the pain.


When the crisis hit home, Western economists were much less willing to accept that pain was necessary, or so the explanation goes. Keynesianism, which promises painless answers, was resurgent once again. The Fed, led by perhaps the foremost monetary economist in the world, proposed creative solutions that few in policy circles, including the usually conservative multilateral institutions, questioned. After all, they no longer had the power of the purse or the advantage in economic training.


But this is not an entirely satisfactory explanation. After all, Nobel laureates like Joe Stiglitz did protest very publicly about the kind of austerity that Indonesia was subject to. While many more now protest austerity today, it was not that smart economists were totally oblivious of the pain emerging economies were going through when they were hit by crisis.


Consider another explanation: Perhaps central bankers’ success in preventing the collapse of the financial system after the 2008 crisis secured them the public’s trust to go further. Perhaps their successful rescue of the banking system also misled some central bankers into believing that they possessed a Midas touch. After all, despite their natural conservatism, it would have been hard for central bankers to do nothing if they believed there was something, anything, they could do to improve growth and reduce employment.


Yet this, too, seems to be only a partial explanation. Few among the lay public were happy that the bankers were rescued, and many did not understand why the financial system had to be saved when their own employers were laying off workers or closing down.


Indeed, perhaps a better explanation is that instead of creating more room for central bankers, the banking rescues narrowed their political room for manoeuver. Perhaps what forced central bankers to act creatively was the political difficulty of doing nothing after having spent billions rescuing private bankers. After all, how could one let a technical hitch like the zero lower bound on nominal interest rates stand in the way of rescuing Main Street when innovative financing facilities had been used to save Wall Street? Once central bankers undertook the necessary rescue of banks, perhaps they became irremediably entangled in politics, which made quantitative easing an inevitable outcome.


As with much concerning recent unconventional monetary policies, there is a lot about which we can only guess, including why it has happened. The bottom line is that if there is one myth that recent developments have exploded it is probably the one that sees central bankers as technocrats, hovering independently over the politics and ideologies of their time. Their feet too have touched the ground.

June 30

Crockett Lecture: A Step in the Dark

I delivered the inaugural Andrew Crockett Lecture at the Bank for International Settlements on June 23 2013.

May 29

Conflict Management and Downturns

NEW DELHI – One of the most interesting aspects of the prolonged economic crisis in Europe, and of the even longer crisis in Japan, is the absence of serious social conflict – at least thus far. Yes, there have been strikes, marches, and growing anger at political leaders, but protests have been largely peaceful and constitutional.


While that may change, the credit for social peace must go to institutions such as elections (“throwing the rascals out” is a non-violent way to vent popular anger), responsive democratic legislatures, and effective judiciaries. All of these institutions have successfully mediated political conflict during a time of great adversity in advanced countries.


This suggests that one of the major reasons for underdevelopment may be that such institutions, which allow countries to cope with distress, are missing in poor but growing economies. Fortunately, in a growing economy, differences between social actors are papered over. A downturn, though, usually exposes or sharpens latent social tensions.


Why the benefits of growth seem to be easier to share than the burdens of adversity is not a trivial question. Perhaps the answer lies in human psychology. If consumption is shaped by habit, an income loss is very hard to bear and one might fight to avoid it, while fighting for additional gain when one is doing well is less important. Also, because conflict may destroy growth opportunities, it may be seen as costlier when growth is strong. For example, squabbling between workers and management may drive away investors – and thus the chance to start new projects. But if there are no new investment opportunities on the horizon, squabbling is less costly, because the existing plant and machinery is already a sunk cost.


Regardless of why conflicts are greater in times of economic adversity, how a society deals with them depends on the scope and quality of its conflict-management institutions. The Oxford University economist Paul Collier has shown that years of weak economic growth typically precede civil war in poor countries. Even after concluding a peace, the probability of these states relapsing into conflict is high.


Not surprisingly, these states typically have weak conflict-management institutions – patchy law enforcement, limited adherence to democratic principles, and few meaningful checks and balances on the government. Similarly, Harvard University’s Dani Rodrik finds that the countries that experienced the sharpest declines in growth after 1975 had divided societies and weak conflict-management institutions.


Societies with well-functioning institutions allocate the burden of distress in predictable ways. For example, people who suffer the most adversity can fall back on an explicit social safety net – a minimum level of unemployment insurance, for example. In the United States, federal and state legislatures prolonged unemployment benefits as joblessness persisted.


Similarly, debtors and creditors can rely on credible bankruptcy proceedings to determine their relative shares. With an explicit institutional mechanism in place to dictate the division of pain, there is no need to take to the streets.


By contrast, when institutions are too weak to offer predictable and acceptable settlements, or protect existing shares, everyone has an incentive to jockey for a greater share of the pie. Outcomes will be mediated more by actors’ relative bargaining power than by pre-existing implicit or explicit contracts. Often, bargaining will break down. Everyone is made worse off by strikes, lockouts, and even violent conflict.


Can countries without a reliable and effective legislature or legal system do better to protect against downturns?


One answer may be to use arrangements that depend in a limited way on the legal system for enforcement. For example, labor contracts in many developing countries effectively prohibit employers from firing workers. This is regarded as inefficient because firms cannot adjust quickly to changing business conditions.


Often, such prohibitions are attributed to overly strong unions that hold the economy hostage. But, if slow or corrupt courts mean that a worker who is wrongfully dismissed has no legal recourse, perhaps the prohibition on firing – enforced by mass protests against violations, which are easily and publicly observable – is the only way to protect workers from arbitrary decisions by employers.


Job tenure may also serve as a form of social security, because the government does a miserable job providing a safety net, while private insurance markets do not exist. Thus, an inflexible contract can protect workers when the preponderance of bargaining power is with firms.


Such inflexible arrangements are not without cost. In a downturn, too many firms will fail, because they cannot shed labor. Alternatively, knowing that they cannot fire permanent workers, firms may remain tiny in order to remain below the authorities’ radar. Or they may hire informal workers who have no rights, or pay inspectors to look the other way (a related point could be made about workplace safety in Bangladesh’s garment factories).


Thus, the attempt to protect workers with rigid labor laws may have the unintended consequence of too few protected jobs. This may be the situation in India, where most workers have few rights, and the few large firms that are established in the formal sector tend to use a lot of labor-saving capital to avoid hiring protected workers.


Change is not easy. The protected have no reason to give up their benefits. Moreover, removing rigid protections without offering alternative, contingent safety nets and judicial redress is a recipe for conflict. At the same time, some protection is better than none, and if most workers are unprotected, change becomes necessary to avoid even worse conflict.


Sustainable change in developing countries requires reforming not only specific arrangements, such as rigid labor laws, but also more basic institutions, such as the legislature and the judiciary, to make them more responsive to people’s needs. If developed countries want to feel slightly better about their slow growth and high unemployment, they should contemplate how much worse matters could be without the institutions that they have.

May 01

Why India slowed.

NEW DELHI – For a country as poor as India, growth should be what Americans call a “no-brainer.” It is largely a matter of providing public goods: decent governance, security of life and property, and basic infrastructure like roads, bridges, ports, and power, as well as access to education and basic health care. Unlike many equally poor countries, India already has a strong entrepreneurial class, a reasonably large and well-educated middle class, and a number of world-class corporations that can be enlisted in the effort to provide these public goods.


Why, then, has India’s GDP growth slowed so much, from nearly 10% year on year in 2010-11 to 5% today? Was annual growth of almost 8% in the decade from 2002 to 2012 an aberration? I believe that it was not, and that two important factors have have come into play in the last two years.


First, India probably was not fully prepared for its rapid growth in the years before the global financial crisis. For example, new factories and mines require land. But land is often held by small farmers or inhabited by tribal groups, who have neither clear and clean title nor the information and capability to deal on equal terms with a developer or corporate acquirer. Not surprisingly, farmers and tribal groups often felt exploited as savvy buyers purchased their land for a pittance and resold it for a fortune. And the compensation that poor farmers did receive did not go very far; having sold their primary means of earning income, they then faced a steep rise in the local cost of living, owing to development.


In short, strong growth tests economic institutions’ capacity to cope, and India’s were found lacking. Its land titling was fragmented, the laws governing land acquisition were archaic, and the process of rezoning land for industrial use was non-transparent.


India is a vibrant democracy, and as the economic system failed the poor and the weak, the political system tried to compensate. Unlike in some other developing economies, where the rights of farmers or tribals have never stood in the way of development, in India politicians and NGOs took up their cause. Land acquisition became progressively more difficult.


A similar story played out elsewhere. For example, the government’s inability to allocate resources such as mining rights or wireless spectrum in a transparent way led the courts to intervene and demand change. And, as the bureaucracy got hauled before the courts, it saw limited upside from taking decisions, despite the significant downside from not acting. As the bureaucracy retreated from helping businesses navigate India’s plethora of rules, the required permissions and clearances no longer came through. In sum, because India’s existing economic institutions could not cope with strong growth, its political checks and balances started kicking in to prevent further damage, and growth slowed. 


The second reason for India’s slowdown stems from the global financial crisis, which caused an abrupt fall in growth. Many emerging markets, which were growing strongly before the crisis, responded by injecting substantial amounts of monetary and fiscal stimulus. For a while, as industrial countries recovered in 2010, this seemed like the right medicine. Emerging markets around the world enjoyed a spectacular recovery.


But, as industrial countries, beset by fiscal, sovereign-debt, and banking problems, slowed once again, the fix for emerging markets turned out to be only temporary. To offset the collapse in demand from industrial countries, they had stimulated domestic demand. But domestic demand did not call for the same goods, and the goods that were locally demanded were already in short supply before the crisis. The net result was overheating – asset-price booms and inflation across the emerging world.


In India, matters were aggravated by the investment slowdown that began as political opposition to unbridled development emerged. The resulting supply constraints exacerbated inflation. So, even as growth slowed, the central bank raised interest rates in order to rebalance demand and the available supply, causing the economy to slow further.


To revive growth in the short run, India must improve supply, which means shifting from consumption to investment. And it must do so by creating new, transparent institutions and processes, which would limit adverse political reaction. Over the medium term, it must take an axe to the thicket of unwieldy regulations that make businesses so dependent on an agile and co-operative bureaucracy.


One example of a new institution is the Cabinet Committee on Investment, which has been created to facilitate the completion of large projects. By bringing together the key ministers, the committee has coordinated and accelerated decision-making, and has already approved tens of billions of dollars in spending in its first few meetings.


In addition to more investment, India needs less consumption and higher savings. The government has taken a first step by tightening its own budget and spending less, especially on distortionary subsidies. Households also need stronger incentives to increase financial savings. New fixed-income instruments such as inflation indexed bonds will help. So will lower inflation, which raises real returns on bank deposits. Lower government spending, together with tight monetary policy, are contributing to greater price stability.


If all goes well, India’s economy should recover and return to its recent 8% average in the next couple of years. Enormous new projects are in the works to sustain this growth. For example, the planned Delhi Mumbai Industrial Corridor, a project with Japanese collaboration entailing more than $90 billion in investment, will link Delhi to Mumbai’s ports, covering an overall length of 1,483 kilometers (921 miles) and passing through six states. The project includes nine large industrial zones, high-speed freight lines, three ports, six airports, a six-lane expressway , and a 4,000-megawatt power plant.


We have already seen a significant boost to economic activity as India built its highway system, and the boost to jobs and growth from the Delhi Mumbai Industrial Corridor, linking the country’s political and financial capitals, could be significantly greater.


To the extent that democratic responses to institutional incapacity will lead to stronger and more sustainable growth, India’s current slowdown has a silver lining. But if its politicians engage in fractious point-scoring rather than in institution building, the slowdown may be a cloud that portends a storm.


Comments (4)

  • 9/5/13 - GarfieldDear Raghu Ram , Congrats on yr appointment RBI Governer. Cuming to the point , Indian economy...  Show Full Comment
  • 8/31/13 - debsI think planners have a very top down nature in identifying Indian problems. As an NRI I invested...  Show Full Comment
  • 6/8/13 - GsinghThanks for sharing.