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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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January 25

Some thoughtful criticism and a response

Rising middle-class inequality

Daron Acemoglu from MIT, Ed Glaeser of Harvard University , both economists of the highest caliber, and I were on a panel at the American Economic Association meetings, where I presented the arguments on inequality in my book Fault Lines, and Daron and Ed critiqued them. I take their arguments seriously because I truly respect their opinion. However, the Economist recently aired their criticisms without presenting the rebuttal I gave  at the panel discussion.

Let me therefore present my response.

First, to recapitulate,  the income of the median worker in the United States has been stagnating since the early 1980s relative to the incomes of workers at the 90th percentile of the income distribution. I argue in the book that with middle class incomes stagnant, pressure built on the politicians to do something. They responded with a raft of government initiatives to expand home ownership through the 1990s and early 2000s, including lower down payments for government loans and guarantees, and more mandates to Fannie and Freddie for affordable housing. Expanded credit, especially housing credit, helped maintain household consumption even though household incomes were not keeping pace, and was a contributory factor to the financial crisis. 


The data I relied on in my book and in all my presentations is from Golden and Katz, which suggests that the 90-50 income differential (the differential between those with incomes at the 9oth percentile of the distribution and those with incomes at the 50th percentile) increased throughout the 1980s and 1990s. Interestingly, the 50-10 income differential first increased in the 1980s and came down in the 1990s (see chart).


Daron has two points. First, he latches on to the lower graphed line (or rather his version of it), the 50-10 income differential, and says this came down in the 1990s. Why should politicians work hard for the poor when inequality for the poorest is actually decreasing? There are two important problems with this argument. First, people at the 10th percentile of the income distribution (e.g., temporary farm workers), were not the population targeted by the affordable housing initiatives. The home ownership rate in the United States is about 65 percent.  If we assume owenership rates correspond roughly to income (admittedly, some people at the very top of the income distribution might want to rent, but most people will own, while some people at the very bottom might own, but most will rent), then the farm worker  is simply not in the population targeted by expanded housing lending. In fact, in California, the sub-prime population could be upper middle class households, who simply could not afford high Californian prices without stretching. Put more cynically, the poorest of the poor that Daron focused on, do not matter that much to politicians but the vocal middle class does.  And it is the rising inequality of the middle class they were responding to. That inequality expanded steadily over the last 25 years.


Of course, there is no reason for politicians to respond immediately to any pattern;  Even discerning a pattern takes time, it takes more time for constituents to complain, and it takes even more time for the system to respond. So even if inequality in the target population was going down in the 1990s, there is no reason to believe politicians did not respond with a lag, a point that Daron admits. But there is a more interesting possibility. Recall that the 1980s were the era of strong, anti-redistribution, Republican administrations. The Clinton administration was perhaps the first after a long time that was pre-disposed towards responding to the growing inequality. It may well be that the fall in inequality of the lowest decile was driven by policies (such as changes in minimum wages and transfers) enacted by the same administration that also pushed the expansion in home ownership.  It may have been much easier to raise the incomes of the lowest decile through administrative measures than to raise the income of the middle class. It need not be surprising, therefore, that measures to expand home ownership were enacted long after inequality started rising, and coincided with a relative rise in incomes of the poorest of the poor. All this is, of course, conjecture.


Daron’s second point is that elite politics, specifically the willingness of the financial elite to push for liberalization of financial markets, was the more important factor in the financial collapse. I do not disagree that it might have been a factor, though I think excessive blame is placed on deregulation, and too little on how regulation (and monetary policy) was implemented. More generally, his point that U.S. policy is driven by and for the elites is overstated – the primary factor in much of the economic policy calculation today is unemployment, which is much more of a problem for the uneducated poor than the educated elite (the unemployment rate today for those without a high school degree is approximately three times the rate for those with a college degree).  If the poor had no voice, we would not see repeated extensions of unemployment benefits, or a Fed on hold for the foreseeable future.


Ed Glaeser made two points in his presentation. First, he argued that he did not see big legislative changes during the 1990s, which might indicare Congress pushed affordable housing finance. I am surprised he says this.  In 1992, Congress passed the Federal Housing Enterprise Safety and Soundness Act, which brought Fannie and Freddie under a new regulator and asked the Department of Housing and Urban Development (HUD) to set affordable housing goals for these agencies. Following that, the government (including the Bush administration) intervened more and more to push affordable housing.  My book offers details.


 Second, Ed argues that the supply of credit can account for only about 4.6 percentage points of the run-up in house prices. I think we could have a long and interminable debate about the role of credit supply and how much effect it had on house prices, but the key issue was not its effect on house prices but on the quality of credit. As I argued in my presentation, the government certainly took credit for the housing boom before it collapsed. In 2004, when HUD announced yet higher affordable housing goals for Fannie and Freddie, it boasted:


“Over the past ten years, there has been a ‘revolution in affordable lending’ that has extended homeownership opportunities to historically underserved households. Fannie Mae and Freddie Mac have been a substantial part of this ‘revolution in affordable lending’. During the mid-to-late 1990s, they added flexibility to their underwriting guidelines, introduced new low-down-payment products, and worked to expand the use of automated underwriting in evaluating the creditworthiness of loan applicants. HMDA data suggest that the industry and GSE initiatives are increasing the flow of credit to underserved borrowers. Between 1993 and 2003, conventional loans to low income and minority families increased at much faster rates than loans to upper-income and nonminority families.”


Interestingly the aspects in red that HUD extolled are precisely what we think were responsible for the deterioration in credit quality. Bottom line: Daron Acemoglu and Ed Glaeser have useful questions, but I don’t think they controvert the fundamental point of the book.



Comments (7)

  • 11/30/11 - yogeshshardaHere is my hypothesis to my comment yesterday. The moderate social security net actually makes...  Show Full Comment
  • 11/30/11 - yogeshshardaI just finished reading this book and I have one comment to offer about your observation on the...  Show Full Comment
  • 2/28/11 - DuboisYour response for argument that the credit expansion to be responsible for only 4,6 is rather...  Show Full Comment