Raghuram Rajan: «The US housing boom was an attempt to ward off the changes caused by technological progress, global trade and the disappearance of many middle-class jobs.»
It is a pivotal moment on the eve of the financial crisis. In the late summer of 2005, the world’s most influential central bankers and economists gather in Jackson Hole at the foot of the Rocky Mountains. The atmosphere is carefree. Financial markets have nicely recovered from the bust of the dotcom bubble and the global economy is humming. Under the topic »Lessons for the Future» the presentations celebrate the era of Federal Reserve chairman Alan Greenspan, who has announced to resign in a few months. Since 1987 at the helm of the world’s most powerful central bank, he presided over a period of continuous growth and was one of the leading forces of deregulation in the financial sector.
But when Raghuram Rajan steps to the podium the mood suddenly turns icy. At that time the chief economist at the International Monetary Fund, the native Indian warns that unpredictable risks are building up in the financial system and that the banks are not prepared for an emergency. His dry analysis draws spiteful remarks. »I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions», he recollects.
Soon, however, his prediction turns out to be correct. Less than one year later, the US housing boom runs out of steam which triggers the worst recession since the Great Depression. Today, Mr. Rajan who governed the Reserve Bank of India until last fall and now teaches finance at the University of Chicago, is reputed as one of the most distinguished economic thinkers on the planet. So what prompted him to voice his concerns at that time in Jackson Hole? Where does he think the world stands in the spring of 2017? And what is his outlook for the coming years?
Dr. Rajan, in the late summer of 2005 hardly anyone noticed the bomb that was ticking in the global financial system. What made you ring the alarm?
At that time, people were aware of the exuberance in the financial markets. I don’t think I was the only one who noticed it. So I was just speaking out what other people were also seeing. But I went one step further and said that this bubble was different from the one we had seen with the dotcom bust.
How did you come to this conclusion?
Far too many people were complacent because they remembered the experience during the dotcom bust. Remember, Alan Greenspan had warned about irrational exuberance as early as 1996. So investors had seen that exuberance. But they also witnessed the run-up in stock prices and that the final results were not that serious. The losses after the dotcom bubble burst were comparably quickly recovered. The Federal Reserve cut interest rates and managed to revive the economy. Some kind of complacency set in: »We could deal with the dotcom bust which means we can deal with the next bust as well», was the general thinking. »We just have to cut interest rates and things will pick up. Let’s not worry too much.»
What was different this time?
There was a new doctrine which stated that we can’t really identify financial bubbles. Accordingly, it doesn’t make sense to try to prick them. We will just pick up the pieces after they collapse. As soon as you hear that as a financial market player you think: »Wonderful, they’ve given me a chance to make a lot of money.» But this time the difference was debt. The dotcom bust had some elements of debt too, but very localized in the telecom industry and a few related sectors. Now, there were significant levels of debt across the household sector. People were borrowing against housing with the firm belief that real estate prices never fall across the United States. But then we discovered that none of that was true. House prices did fall and debt proved to be a significant burden. The households stopped consuming and that spread quickly through the economy and we had the financial sector meltdown.
So what was the reason for the financial crisis? Just a few Wall Street bankers who once again got too greedy?
It’s all too easy to say the bankers were responsible and just put the blame on them. They were responding to an environment which essentially was telling them to go out and take risks. The same politicians who were screaming at Wall Street after the financial crisis were the ones cutting ribbons at every new development project that was financed by the banks. So the system was essentially encouraging the banks to reduce their constraints on lending. This is true not only for US, but also for Spain, Ireland and other countries which experienced a huge construction boom.
And why of all things was it housing that was in the center of the exuberance on Wall Street?
There are a bunch of nice things about housing. First, nobody feels bad when prices go up: Neither the banker nor the households nor the politician. That’s also true for a stock market boom but a housing boom is easier to engineer by expanding credit. Second, a housing boom creates a whole lot of construction activity. It creates moderately skilled jobs like work for the bricklayer or for the guy setting up the foundation. So it provides a lot of employment for people who were being laid off and that’s very good because it takes pressure off of the system. If this goes on forever it’s fantastic. But how many houses can you build in an industrial country? At some point it reaches an end and that’s the problem.
Next came the worst financial crisis since the 1930s. Where do we stand today, ten years after the first big banks had to announce severe losses in the US mortgage market?
If you talk narrowly about the financial sector we are certainly in a better place today. The capital ratios that we asked the banks to move towards have helped to bring leverage down to more reasonable levels. What’s more, we’ve tried to deal with some of the difficulties we had in resolving financial institutions, for example with respect to derivative positions. So there has been a substantial amount of progress in resolving, cleaning up and to some extent giving financial institutions incentives not to take on too much risk. However, the job is only half done.
Where is more work to do?
There are two questions which emerge for the financial sector. First, have we gone overboard in some areas? For instance, the amount of compliance some banks have to undertake has increased significantly. Also (ALSN 131 -0.91%), have we put too much of a penalty on natural risk-taking? We don’t want banks to take huge amounts of engineered financial risks. But somebody has to take the real risks. You have to lend to firms otherwise you don’t get good investments. Furthermore, a lot of the growth opportunities are now in the risky parts of the world, the emerging markets.
And what’s the second question?
We know quite well how to regulate the banks because they are familiar creatures. But the question is have we left other entities too uncovered? For example, it’s well known among regulators that we need to do something with respect to the shadow banking system. The problem is we don’t know quite what. If you have a highly regulated structure on one side and a poorly regulated structure on the other side, how much activity migrates from one side to the other? And it’s not just activity. If the banks are unattractive employers some of the smartest guys will go to the unregulated sector – and we know now that it can be a toxic combination if you have smart guys who are unregulated.
Since the financial crisis, the United States have taken the lead in financial regulation. What does it mean if the new US government wants to dismantle Dodd-Frank and other banking regulations?
I don’t think anybody would say that Dodd-Frank is an ideal regulation. Having been on the other side as a former emerging market financial regulator I have seen the consequences for us from the implications of regulations elsewhere. So I would suggest that there is certainly some overreach. That’s why I keep saying that we should rather have lighter but more uniform regulation across the financial system. Also, in the past, financial regulation has always been pro-cyclical: we have a crisis, we regulate, we go too far. Then we deregulate, we go too far and have another crisis. That’s why I wrote an article in «The Economist» as early as in 2009 and said that we are setting ourselves up for doing it all over again: We will overregulate and then we will cut back once again. So I fear today’s discussion in Washington is now along those lines.
And how does it look outside of the financial sector? Since the financial crisis, the economy never really gathered steam again.
The most important question is what made us push credit so much in the years leading to the financial crisis? In my book, Fault Lines, I described the reason as inequality stemming from technological change and the lack of education.
What have those things to do with the financial crisis?
The United States was falling behind on education. That meant people who were losing their jobs weren’t being retrained to the jobs that were available. Also, the US doesn’t have a strong safety net. So when people lose their job they can fall quite far. That’s why America is much more focused on strong growth than other countries. Since the safety net is so weak it needs strong growth in order to avoid public anger.
So what changed?
Since the 1990s the recessions in the US have been much longer. The Great Recession has been particularly difficult and a lot of workers have left the labor force because they haven’t found jobs. And what are they doing, once they leave the labor force? Most of them are too young for Social Security and they can’t get unemployment insurance. So they go on disability to collect money from the government at a younger age. That’s unfortunate but that’s what happens.
What are the consequences of that?
We are experiencing a technological revolution and our society hasn’t responded fully to it, except in some smaller countries which historically have responded quickly to change. For example, the Scandinavian countries have always been subject to huge fluctuations in trade and therefore have responded quickly to external factors and changed the skill base of their economy. I assume that’s also true for Switzerland. But large economies tend to be much slower in adapting to change.
They often try to mute the effects of change as long as they can. In the US, the construction boom was an attempt to ward off the changes caused by technological progress, global trade and the disappearance of many middle-class jobs. The adaptation would have to been to improve skills and education. But that takes time. So the short sighted answer was to let the housing sector boom. That makes everyone feel happy and it creates construction jobs for the people who were being laid off from the factories. So you didn’t have to worry a lot about those fundamental changes until everything exploded. Now, we have to worry once again and I think that’s directly responsible for the populist movements we are seeing today.
In the US as well as in Europe, the populist movements feed off of anger against the establishment. Where does this fury come from?
Our leadership has been continuously saying that the solutions to our problems are easy and that it’s just a matter of stimulus: Some more fiscal stimulus and some more monetary stimulus and the economy will get going again. But our problems go much deeper and can’t get solved just with stimulus. How does it help the guy who left the labor force if the economy revives moderately? He’s not going to come back to work because he can’t really fit into the jobs that he needs. He wants to get a good job and the only jobs that are available to him are basically of very low quality. So he’s going to remain dissatisfied and becomes prey to the anger that radical politicians are sowing.
Since the financial crisis, it was mainly the central banks that took the lead and deployed new policy instruments like quantitative easing and negative interest rates. Have we seen the most extreme measures yet or is there more to come?
Since early on, I’ve kept saying that we shouldn’t push too much on these new aggressive instruments. At some point, people start to point fingers at monetary policy saying that these measures are not driven by concerns about domestic demand but by concerns about international competitiveness and that they are just put in place to devalue the currency. That leaves central banks exposed to accusations that they are just trying to push the exchange rate channel. That’s exactly the kind of criticism that’s now increasingly being articulated.
Fed chief Janet Yellen has taken an important step to normalize monetary policy. What’s the impact on the global financial markets if interest rates in the United States start rising meaningfully?
The exiting process of the Federal Reserve gives other central banks essentially a more accommodative monetary policy. Their currencies are depreciating vis-à-vis the dollar which loosens their monetary policy without them taking any additional measures. At this point, most central banks would be happy to allow the United States to exit and then follow slowly. In the meantime, they will enjoy more accommodative monetary policies because their currency is depreciating.
What are your thoughts on the Swiss central bank against this backdrop?
As a former central banker, I can’t really comment on the activities of other central banks. All I can say is that SNB (SNBN 5680 0.35%) president Thomas Jordan is doing a fine job as a central banker. But he has an incredibly challenging task with Switzerland sitting just next to the Eurozone, one of the biggest economic areas in the world.
At least, there is rising hope that the outlook is lightening up. What’s your take on the global economy?
The fundamental problems that led to the financial crisis are still with us. The economic forces that have been playing out over the last couple of decades are probably going to get worse. So unless we change the structure of our economy and society, we’ll probably risk significantly greater turmoil.
How can we tackle those problems?
Across the industrial world there is fear of the future. In the 1960s with some distance to World War II and then again in the 1990s after the victory over Communism, people had confidence that the future will be bright and that the free market economy was here to stay. That certainty and that confidence has disappeared. An important part of the reason for this is the rising inequality before the financial crisis and the slow recovery after the recession. To some extent, our leaders are succumbing to this anxiety rather than standing up and saying: »Let us not shut ourselves up back into a box. It took us long enough to open up this box. Let us not go back into it. Let us adapt rather than shut down.»
Then again, it looks like we are going backwards. Just a couple of weeks ago, the finance ministers from the world’s biggest economies dropped pledges to renounce protectionism amid tensions over global trade.
There is a deep problem of adaptation to the significant forces which are hitting us: Technological change and global integration. Adaptation is not easy. These are forces that make us much better off but they hit certain segments of our society very hard. There is a lot of fear that immigration and trade will take jobs. But interestingly, the places that have been the least affected by immigration are often the ones that are most worried about it. When surveys ask in California or in New York about immigration the response is quite positive. But in places where they haven’t really seen an immigrant for many years the answers are very negative. For people who don’t have the confidence that they can adapt to those changes it can be very difficult. So they’re looking for solutions from politicians who promise to shut the borders and make sure to keep them closed. But that can’t be a solution because it involves taking the country back in time. It’s not going to work. History proves it’s not going to be ineffective.
Nevertheless, investors don’t seem to be bothered at all. Since Donald Trump won the election on promises to build a wall and rip trade agreements apart Wall Street is celebrating and US stocks have rallied nearly 10%.
The financial markets are celebrating something different. We have a dual economy: There are the ones who are angry and are falling behind and there are the ones who are doing very well. The financial markets are largely about those who are doing very well. So what we are seeing now are the consequences of an administration which is largely pro-business. There’s a sense that some of the regulations that were put into place by the Obama administration will be withdrawn or less vigorously enforced. There is a hope for tax cuts and a general sense that Mr. Trump as a businessman will push business quite strongly. That’s what the markets are celebrating. Also, they hope that none of all the talk about trade barriers and tariffs comes true. So it’s quite a one-sided hope and we will see how it plays out.
So what’s the real answer to our fundamental challenges?
There are already places where we are finding solutions. But they are piecemeal. There are towns and cities that are reinventing themselves and becoming vibrant hubs. In the US, places like New York and San Francisco are really flourishing. But you can also find smaller communities reinventing themselves and doing well, building knowledge based industries. In Europe, you are seeing it in places like Eindhoven in the Netherlands and flourishing areas like Switzerland. So it’s not that there are no answers. But the answers are slowly emerging while the anxiety about change is much more widespread and big.
How can we overcome this anxiety?
We need to understand how these places reinvented themselves. I don’t want to state this as a theorem but typically the process starts around institutions that already exist, typically a university. There is some firm that sets up nearby and starts to build links to the university. That creates opportunities in R&D and small firms start up close by, a lot of them cutting-edge. Attracted by those job opportunities, new people come in and that creates more service jobs in the locality. So the economy is really reviving and it can take place in a distressed community as well. But you need to seed, you need a process of revival and that takes time. That’s why it’s important not to say it’s going to be easy and not to preach gloom and doom.