The Region

Raghuram Rajan

In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the 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. The careful study and willingness to challenge dogma Rajan displayed at Jackson Hole are in evidence throughout his work. As IMF chief economist, he produced controversial reports that questioned the efficacy of foreign aid and foreign investment. In 2003, he co-authored “Saving Capitalism from the Capitalists,” suggesting that government intervention is essential, not inimical, to market capitalism, but that it must be done right. These days, policymakers listen carefully to Rajan—in May he testified before the Senate Banking Committee on the too-big-to-fail problem; he serves as economic adviser to the prime minister of India (his birthplace)—and not simply because of his insight on the recent financial crisis, but based on the quality of his scholarship. Rajan is a highly respected economist, recipient of the inaugural Prize for the person under 40 who has contributed most to theory and practice in . “He has made path-breaking contributions,” noted the award committee, “to our knowledge of financial institutions, the workings of the modern corporation, and the causes and consequences of the development of the financial sector across countries.” His extensive research continues to shape academic and policy debate, and in the following interview with the Minneapolis Fed’s Ron Feldman, Rajan touches on these topics and others with eloquence and wisdom.

Photography by Michael Girard

19 DECEMBER 2009

The Region

ARE BANKS (STILL) SPECIAL? money is very fungible. If the bank manager borrows on a 10-year basis, by Ron Feldman: I had suggested that we the time the debt holders come to col - interview you, and so I get to do the lect, a lot could have happened with that interview. money. It could be away in the Bahamas, funding the bank manager’s new Raghuram Rajan: You picked the short lifestyle. And so you need something straw. [Laughter] that checks the bank manager on a more regular basis, and with short-term Feldman: Right. [Laughter] I thought deposits, which keep going in and out, that we could start with your work on there’s somebody who’s checking if the the nature of banking. Banks make banker has got the ability to pay on a loans, such as loans to small firms, and regular basis. If depositors take fright, provide other services, for example, they could run, and that’s a big source of around payments, that are not easy to discipline on the banker, so she or he replace. That is, other firms do not seem has to maintain the sense that the bank to provide the same offerings as banks. is liquid and solvent. At the same time, banks fund them - Of course, when you’re financing selves with money that depositors can Why finance yourself with demand long term, it’s hard to offer such a com - easily withdraw, and such runs can lead deposits, when on your asset side you mitment. If you [the banker] say, “Give an otherwise healthy bank to fail. That have these illiquid assets—term loans, me 30-year money to fund this complex combination of essential services and complex positions? What’s the link? ... project,” it would cost a lot for the unique vulnerability has led many investor to part with 30-year money. But Part of the answer is the Calomiris and observers and governments to consider if you say, “Give me demand deposits,” and treat banks in “special” ways—with Kahn view that when you have short-term where you can have your money back federal deposit insurance, for instance. liabilities, it puts much more discipline tomorrow if you get frightened, it’s You’ve done a lot of research on why on bank management. ... But the other much cheaper to fund the 30-year stuff. banks structure themselves in that way thing ... is that this allows the bank So the mismatch is, in a sense, deliberate in the first place. Perhaps we could start manager to some extent to pass on his rather than unfortunate. with your impressions of whether banks That was one aspect. But the other human capital skills without charging remain special today, and why that thing, which is a little more subtle, is would be. a big rent. that this allows the bank manager to some extent to pass on his human capi - Rajan: That’s a very interesting question. relatively similar across countries and tal skills without charging a big rent for The question really is, “Why the struc - over time. It’s a form that has endured, it. That’s the part that we add to tured fragility?” Why finance yourself perhaps longer than the corporation. Calomiris and Kahn. The idea is simply with demand deposits, when on your You can go back to Mesopotamia per - this: The bank manager could invest in asset side you have these illiquid haps, but certainly to , and they had long-term assets, turn around to the assets—term loans, complex positions? banks in much the form that we have short-term debt holders and say, “I’ve What’s the link? The alternative, which today. Doug Diamond [also at the made all these investments, they’re valu - surfaces every time you have a financial University of Chicago] and I have been able, but you don’t have a hope of get - crisis, is to create narrow banks—that is, puzzling over this for some time. Part of ting the money back. I know how to get have money market instruments on the answer is the Calomiris and Kahn the money back, you don’t, so pay me your asset side financed with short-term view 1 that when you have short-term extra for it.” Strategic debt renegotiation demand deposits on your liability side. liabilities, it puts much more discipline takes place all the time with long-term If you really want to hold illiquid assets, on bank management and therefore debt holders, and it would increase the finance them with long-term borrow - they have to commit to, in a sense, not amount debt holders would charge to ing, not explosive short-term debt. do anything crazy with your money. give their money to the bank. Why the private banking sector has This is where the nature of the never chosen safe narrow banking (with Feldman: Could you spell that out a bit demand deposit comes in. Because as finance companies issuing long-term more? Why do short-term debt holders soon as the depositor takes fright, the liabilities and making illiquid loans) is put more discipline on management? depositor runs, regardless of what’s on really the puzzle of the ages. It’s interest - the table in terms of offers. So the bank ing because the form of the bank seems Rajan: Banks deal with money, and manager, if he’s dealing with a sensible

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liability holder, can have this conversa - folks who suggest this separation? Five tion and extract some rent for his capa - years after we adopted that reform, what bilities. But if he’s dealing with a would we be losing? demand depositor, that conversation doesn’t take place. Practically speaking, Rajan: If you believe that banks are a demandable debt is a non-renegotiable viable entity, independent of deposit hard claim, which is why it is especially insurance, independent of too big to fail, cheap. that there’s a natural benefit to the bank So it’s the craziness of the depositor, structure we have today, that would sug - the fact that he’s going to run as soon as gest that if you then mandated separa - he suspects that he’s going to be dispos - tion, you would have much higher costs sessed in some way, which makes the of long-term intermediation. The deposit a cast-iron claim. money market fund would be reason - It works very well when banks are ably stable, presumably, and will contin - undertaking the normal course of busi - ue to invest in fairly liquid instru - ness. It works very badly when you have ments—that will not be a problem. But a systemic crisis like the one we’ve seen. it would be a problem on the other So banks in general work well when the side—the finance company funded with probability of systemic crisis is relatively I worry about breaking up banks into long-term debt: Long-term projects small. “fail-safe” parts and “failure-prone” would find finance very costly. parts. ... I think that we have to be very GOOD TRAITS, Feldman: skeptical that we will solve the problem Right. And less lending, less WITHOUT THE BAD? growth. of moral hazard, because even within Feldman: What options are available— the unregulated, risky part, we may still Rajan: Less lending, less growth. The are there options available?—to get the want to come in and provide protection other thing I think is worth thinking benefits of the structure of banks because there are some entities that about is, is it really possible to complete - regarding the loans they make and the are closely linked systemically. ly isolate a sector of the economy and other special offerings they provide make it fail-safe, and put all the risk in without getting the bad, the threats of the other sectors? Don’t the problems runs? Since these forms of banking vent bank runs when it’s truly a systemic then migrate to the area you’ve said we’ll seem to arise, as you said, spontaneous - panic, but not when it’s because of the regulate less, but which is taking all the ly over time and across countries, it fault of the bank itself. You want a bank risk? must be optimal in some sense. But to face the full costs of any stupid thing Put differently, I think only part of could you get 80 percent of the good, it does on its own. the problem in this crisis was that we without the bad? The downside to any proposal which were trying to protect depositors, and tries to deal with this is that you could limit their losses. Part of the problem Rajan: This is what people have been get a systemic breakdown when banks also was with the investment banks, trying to do for a long time, right? We also herd together in taking the same where we weren’t concerned about pro - have a “narrow banking” proposal kind of risk. They all take on mortgage- tecting the depositors. We were protect - which resurfaces every time we have a backed security risk, for instance, ing the investment banks, rightly or crisis. We heard [Bank of England because they now know that you [the wrongly, because they are so intimately Governor] Mervyn King say it yester - federal regulator] will come in and save connected with the markets. day, “Let’s break up banks into money them. So the current system where there I worry about breaking up banks into market funds and finance companies.” is some element of the Fed coming in “fail-safe” parts and “failure-prone” We’ve had that option available for so when there’s a systemic breakdown is an parts. Some of that effort might be use - many years, and it hasn’t been imple - attempt to get over some of the prob - ful in terms of cleaning up the bank mented. lems of the bank’s fragile structure itself, structure; it might be helpful to delin - Now if there is value to the way banks but it creates moral hazard, which is eate parts without actually breaking are structured today, what we would like why they all herd on the same risk. them up. You make the insured parts to do is reduce the probability of sys - less liable to some of the risk of the other temic breakdown. The truth is it’s hard Feldman: What would happen if we all parts, if you can do that. But at the same to do this without eliminating the disci - took Mervyn King seriously, or [former time, I think that we have to be very pline. What you really want to do is pre - Fed chair] Paul Volcker or the other skeptical that we will solve the problem

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of moral hazard, because even within second strand was to think about the the unregulated, risky part, we may still incentive structure of the financial sys - want to come in and provide protection tem and say that while we have moved because there are some entities that are to a compensation structure that penal - closely linked systemically. ized obvious risk, risk that you could see and measure, that may have made Feldman: So if those proposals worked, employees focus on risks that could not there’d be less growth, of some magni - be measured. An example of that is “tail tude. But it’s not clear they will work. risk,” because you can’t measure it until it shows up, and it shows up very infre - Rajan: Exactly. quently. So part of the reason I was wor - ried was that people were taking more DOUBTS ABOUT tail risk; an insurance company writing DIMINISHING RISK credit default swaps was just one exam - ple of that. Feldman: In a prominent Jackson Hole It didn’t require genius at that point paper, 2 you talked about some of the to look around and say the insurance technologies of banking that people companies were writing these credit thought were going to distribute risk It didn’t require genius ... to look around default swaps as if there was no chance widely and therefore diversify it, making and say the insurance companies were on earth that they would ever be asked the financial system and financial insti - writing these credit default swaps as if to pay up, so they were really taking on tutions less risky. It was less clear to you there was no chance on earth that they tail risk without any thought for the that risk reduction was actually occur - would ever be asked to pay up, so they future. AIG should not have been such a ring. Could you talk about how you surprise to the Fed. were really taking on tail risk without came to that view and how important you think that was in the current crisis? any thought for the future. AIG should WHY WAS THIS CRISIS not have been such a surprise to the Fe d. SO SEVERE? Rajan: One of the things I was asked to do was to look at the development of the tance-to-default measures didn’t look Feldman: Why do you think this finan - financial sector, and I have great admi - like they were coming down despite all cial crisis was more severe? There are ration for some of the things that have this talk about securitization and shift - lots of potential explanations. Some happened. There have been good things ing risk off bank books. That struck me observers point to the failure of credit in the financial sector which have as consistent with my view that maybe rating agencies; others point to flawed helped us. But to some extent there was the risks that banks were taking on were incentives in compensation and to the a feeling that when you distribute risk, more complicated. Whether they were creation of new financial products as you’ve reduced the risk of the banking excessive or not, I couldn’t tell. examples. If you had to list the two or system. Also, as I saw the mood, I became three things that you think really under - My thought was, what business are worried. Having studied past financial lie why there was so much risk-taking, the banks in? They’re not in the business crises, I knew that it’s at the point when why more risk-taking than people of being plain-vanilla entities, because people say, “There’s no problem,” that in thought, what’s the deep answer for they can’t make any money that way. fact all the problems are building up. So that? They are in the business of managing that was just another indicator that we and warehousing risk. So if it becomes should be worried. Rajan: You can go right to the meta- easier to lay off a certain kind of risk, the I should add that while I thought we political level, but let me leave that aside bank better be taking other kinds of risk could have a crisis, I never thought that for now. If you hone down on the bank - if it wants to be profitable. And if the we’d come to the current pass. However, ing sector itself, I think it was a situation vanilla risk is going off your books, pre - I did argue that it could be a liquidity where it was extremely competitive. sumably the risks that you’re taking on crisis, it could well be centered on the Every bank was looking for the edge. are a little more complex, a little harder banks because banks were taking more And the typical place to find the edge is to manage. of these risks, and even though banks in in places where there are implicit guar - That was the logic which led me to the past had been the safe haven, they antees. argue based on distance-to-default could be at the center of this problem. measures for banks that they were not So, one strand of my argument was Feldman: So you think moral hazard had becoming less risky—I saw that dis - based on the business of banks, but the an important role?

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be plentiful all the time. And my sense al structure. In this regard, requiring of what the Fed does, in part, by reduc - them to create “living wills” that indi - ing interest rates considerably is help cate how they could be resolved could liquidity, and so there was a sense that, be an important incentive for them to well, we can take all the liquidity risk we collect information on their assets and want, and it won’t be a problem. Of liabilities, and simplify their organiza - course, it turned out that not just inter - tional structures. est rates mattered; the quantity of avail - able liquidity or credit also mattered at CORRUPTION, IDEOLOGY, this point. And that was the danger. HUBRIS OR INCOMPETENCE?

Feldman: I think that’s right. We have Feldman: One thing you haven’t men - not heard that much discussion of that, tioned as a proximate cause is issues but that’s my inclination as well, that around “crony capitalism.” Some seem moral hazard played a role. I don’t know to argue that banks were allowed to how big it was, but it certainly wasn’t grow large and complex because they zero. were run by friends or colleagues of people who were in power. And for sim - My sense of what the Fed does, in part, Rajan: Right. Absolutely, absolutely. ilar reasons, these firms got bailed out— by reducing interest rates considerably is because they had colleagues and friends help liquidity, and so there was a sense PUTTING CREDITORS AT RISK in “high places.” Given that you’ve that, well, we can take all the liquidity risk thought a lot about that in your own we want, and it won’t be a problem. Of Feldman: If you agree that moral hazard writing, given that you were at the IMF contributed to the current financial cri - [International Monetary Fund] where course, it turned out that not just interest sis, what can we do today to put credi - you had the ability to look across coun - rates mattered; the quantity of available tors at risk of loss? tries where it is an issue, how important liquidity or credit also mattered at this would you say crony capitalism is in the point. And that was the danger. Rajan: I think one option is to write it U.S. context in the current crisis? into the contract—the contingent capi - Rajan: I suspect it was not irrelevant. tal bonds that Mark Flannery and the Rajan: Let me put it this way. There is This is where I think the most damaging Squam Lake Group have been advocat - always some amount of regulatory cap - statement the Fed could have made was ing would make creditors bear losses ture. The people the regulators interact the famous Greenspan doctrine: “We almost automatically, but in the process with are people they get to know. They can’t stop the bubble on the way up, but stabilize the bank. see the world from their perspective, we can pick up the pieces on the way A second option is to strengthen res - and, you know, they want to make sure down.” That to my mind made the situ - olution authority in as transparent a way they’re in their good books. And so it’s ation completely asymmetric. It said: as possible. The point is that creditors not surprising that across the world, you “Nobody is going to stop you as asset should have a very good sense of the have a certain amount of the regulators prices are being inflated. But a crash is kind of losses they will have to bear, but acting in the interest of, and fighting for, going to affect all of you, so we’ll be in those losses can and should be imposed. the regulated. there. By no means go and do some - There is, of course, a possibility that this Beyond that: Is there naked corrup - thing foolish on your own, because will make banks more fragile, because tion, or less naked corruption? “If you we’re not going to help you then. But if short-term debt, anticipating losses, will do my work for me as a regulator, then you do something foolish collectively, run. But banks then will choose the Fed will bail you out.” whether to continue financing them - selves this way or alter their capital The people the regulators interact with Feldman: And people read that to be structure. are people they get to know. They see broader than monetary policy? A key part of making banks more the world from their perspective, and, you “resolvable” is first, for the relevant reg - know, they want to make sure they’re in ulator to have the legal authority to con - Rajan: It could mean many things. Even their good books. And so it’s not surprising if it was just monetary policy, my sense tinue or abrogate contracts that might that across the world, you have a certain is one of the tail risks that was promi - impose significant costs on the taxpayer nent in this cycle was liquidity risk. and, second, for the bank to have a amount of the regulators acting in the People were acting as if liquidity would much simpler capital and organization - interest of, and fighting for, the regulated.

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you can come and join me as a senior if not less. So they’re not extraordinarily official in my firm, and I’ll pay you back big in terms of equity capital. Now, you at that point.” I’m sure there were stray may argue leverage today is higher. I instances of that, but that to my mind, think there is some question about how wouldn’t be the number one reason for you measure that leverage. this crisis. But if U.S. corporations are bigger, the risks that U.S. banks have to take in RESPONSES TO THE CRISIS lending to a U.S. corporation are also bigger. So we should make sure that Feldman: So we’ve talked about the crisis we’re comparing apples and apples when itself and some causes. Can we talk a lit - we look over time. Have the U.S. banks tle bit about the responses? One propos - become unconscionably big relative to al that wouldn’t seem to flow from what what they were? One way to look at that you’ve said is the idea of not just split - is concentration ratios. In the U.S., ting commercial banking from the secu - they’re not particularly high. Another rities and trading, the Mervyn King way is to look at asset size relative to cor - kind of idea. But another is the idea that porations. Again, they do not seem too somehow we should just make the firms big. themselves smaller—literally smaller— I would also look at mergers with a very So, the problem may be that these and that will prevent this from happen - jaundiced eye going forward—I would ask, banks are really, really difficult to man - ing again. Perhaps it will make the firms “What’s the benefit of having a trillion- age once they get to some size like this. I less influential, if you think there are dollar company merge with another think what we’ve seen in terms of pat - some cronyism problems. What do you terns—and there’s some research emerg - trillion-dollar company?” ... I think so long make of that argument? ing on this—is some banks have a histo - as you discourage mergers of megabanks, ry of messing up time and again, a DNA Rajan: You know, it’s a nice argument to you can get half the way to the goal of of bad management, or excessively risky put forward. I’m much less clear about getting banks of manageable size. management. These are also banks that how it would work practically. I’m also a make a ton of money in good times, but little worried whether this is a knee-jerk we’re seeing more small banks go under, lose it all in bad times—so, highly reaction to what we’ve seen this time so maybe in a few months, we will volatile earnings profiles. I think there’s around. So let me start with the second absolve the large banks of blame. More more value to looking closely at them to point first. sensibly, what we really need to argue see if there are ways these “bad” banks One of the U.S. responses to the about is why size may have mattered. can be discouraged from increasing Great Depression, or at least the Clearly part of the problem is the their size and maybe even encouraged to response of U.S. academics, was to point too-big-to-fail (TBTF) issue that you shed some assets. to Canada and say, no banks failed worked on and pointed out in the past. there. So at that time, the problem was And here the idea is that one way to pre - Feldman: You would do something tar - there were too many small U.S. banks, vent TBTF is to have small banks. But geted, based on past performance? they were undiversified, they all took are they any safer than big banks? the same risk in terms of credit risk, real Having a hundred small banks exposed Rajan: I would target based on past per - estate risk, farm risk, and they collapsed. to the same risk may actually be riskier formance, rather than make it a blanket The argument then was that Canada than having one large bank exposed to “you can’t grow beyond this size”— didn’t collapse because they had these that risk. But the other problem is, when though there are obvious dangers to giv - large banks that were big enough to be you look at the size of U.S. banks relative ing regulators carte blanche to subject diversified and they had no problems. to U.S. corporations—when you look at banks to differential treatment. I would But, of course, now we’re saying, we capitalization, for example, the equity also look at mergers with a very jaun - have these large banks, and if we break capital of U.S. banks has actually come diced eye going forward—I would ask, them up, we will solve the problem—of down relative to U.S. firms, compared to “What’s the benefit of having a trillion- course, Canada still has big banks that what it was in the past. dollar company merge with another tril - did not fail, but now they are an inap - U.S. firms have also grown big over lion-dollar company?” If you want to propriate benchmark. It seems to me this time. You have $400-500 billion grow organically, by all means do so, that according to this line of reasoning, capital companies, and the largest U.S. and as a supervisor I’ll pay attention if any structure that didn’t exist in the bank is in the region right now, with you grow too fast, but micromanaging most recent crisis is the right one. Now shrunken capital, of about $200 billion, what size you should be seems to me is a

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little limiting. I think so long as you dis - their firms, they become big firms and courage mergers of megabanks, you can the United States becomes the strongest get half the way to the goal of getting economy in the world. banks of manageable size, because Emerging markets in developing banks at least for a while will be shrink - countries don’t seem to have that time. ing. They want to grow like Korea and Japan. And it seems to me that in that acceler - WHY SOME COUNTRIES GROW ated growth path, there’s more manage - ment by the government than in the Feldman: We’ve talked about the role of more organic growth path. There was financial systems in economic growth, still some amount of management, noting that fundamental changes to the some amount of protectionism in the structure of banks could reduce growth. U.S. and the U.K. when they grew, but You have done much work on the fac - there’s a lot more intervention in these tors that are important to country newer, rapidly growing countries. growth, particularly for developing I think the difficulty for these coun - countries. What are the key factors that tries is they have to perform an act lead some countries to grow and others which no other developed country has not? In developing countries, the financial had to do, apart from and system is very reluctant to finance small- Japan, which is to have the government Rajan: One of the potential dangers of to medium-size firms. It’s too risky. They manage the process up to a certain point this crisis is essentially that we might just don’t touch it. So if you say organic and then back off totally and let the throw out everything good that we market forces take over. That switch, it growth, let them grow naturally, let the know markets do and say they do only seems to me, is extremely difficult. And bad. good ones come out of the primordial it’s also a problem for the financial sys - ferment—nothing happens! Imposing tem because in that early phase, the gov - Feldman: That “capitalism has failed.” the free market, it seems to me, in the ernment is doing a lot of directed lend - first few years on those countries, doesn’t ing—you’re telling the banks whom to Rajan: Right. Capitalism hasn’t failed. I work, which is why there’s so much support; you’re giving them subsidies to think capitalism has always been subject support the right guys. There’s a lot of impetus for intervention. The question is, to a certain amount of boom and bust, intervention in this process. And then and every time we have a bust, we try to when do you stop? suddenly, you tell the banks they are on figure out what went wrong and try to their own and have to find profits fix it—this is a natural process of devel - power structures, viewpoints and cul - through competitive lending. Few sys - opment. But the broader principle is ture they had, were different from the tems survive the shock. that free-enterprise capitalism, despite people in the United States. its flaws, is a reasonable system, and it So you need support for the kinds of Feldman: Are you saying that significant does create the greatest good for the institutional structures you’re putting government intervention into the econ - greatest number of people. That, I think, down on the ground, and often, it’s omy is going to happen anyway, so we is beyond doubt. So then the question is, growth that produces that support. That should recognize that, or are you saying how do we get the right capitalism in support doesn’t come independent of that such intervention is constructive these countries? the growth process itself. because it helps economies to grow? As we learn more, I think the view of A second point is that the institutions growth for these countries is becoming by themselves are not enough. Rajan: I think it may well be construc - more nuanced. There’s a view held just a Sometimes we say, “Create a market tive, at least in the initial phases, short time back of “build the institu - structure, and then the firms will because it creates the organizational tions and then everything will take off.” emerge and so on.” I think there is capabilities. In developing countries, the Well, you know, you can’t build the something to be said for the fact that financial system is very reluctant to institutions in a vacuum. We need pub - firms don’t emerge spontaneously, at finance small- to medium-size firms. It’s lic support for these institutions. least of reasonable size, except over a too risky. They just don’t touch it. So if Imposing the U.S. Constitution on long period. So let the market flourish you say organic growth, let them grow Liberia didn’t make Liberia the United for years and years, as it has in the naturally, let the good ones come out of States. It made Liberia Liberia, because United States, and over time you get the the primordial ferment—nothing hap - the people in Liberia, and the kind of Rockefellers, the Carnegies. They set up pens! Imposing the free market, it seems

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to me, in the first few years on those other hand, if you started off with free countries, doesn’t work, which is why markets, which is what a number of there’s so much impetus for interven - economists have been advocating, tion. The question is, when do you stop? maybe you don’t get any organizational If you don’t stop at some point, then capabilities. Maybe you need a little bit it becomes the crony capitalism that you of protectionism initially; maybe you referred to earlier. It’s the friends and need to create organizations. But you relatives of those in power who benefit need to break off from that at some from growth, and then growth tends to point because markets and competition peter out because the inefficient are have tremendous virtue. propped up. BACK TO REGULATION Feldman: So how do countries figure out how and when to … ? Feldman: Let’s get back to the financial crisis just for a minute, if we could, to Rajan: It’s extremely difficult. And this is discuss the proper role of government in why I think a lot of growth success is that context. Some observers harken serendipitous. For example, in India, the back to the 1960s and 1970s, at least in reason we broke away from that crony the U.S., when there was more regula - So I think the strength of the United capitalist model where licenses were tion, and banks were more protected. States’ economy is based on its dynamism. given away to the favored families and They seem to connect that type of regu - Going back would make us lose that the favored families got cheap credit lation to the few bank failures of that dynamism. What I think we need is to from the state-owned financial institu - period, and so they suggest we would be tions is we had a crisis, a huge crisis, in better off if we were to return to more get the dynamism with a little less risk. 1990. India had to open up. It was open - significant regulation. It strikes me that That means let’s avoid bringing back all ing up slightly before, but this was when this view misses the costs of such a these old solutions. I don’t think the the rubber hit the road. heavily regulated banking system, but banking system can be made more boring. Mind you, if India had opened up in what is your view? Is there any merit to Anyone who advocates that doesn’t 1960, we would not be talking about consider going back to a regulatory sys - understand banking today. China as much now. We’d be talking of tem that looks like the ’60s and ’70s in India because it would have grown so the U.S.? much more over that period. On the had dissipated. That means you needed other hand, if India had opened up in Rajan: I don’t think so. The reason that a financial system to restructure, to send 1947 when it got independence, it may worked so well was that there were huge flows from one place to another. And still have been a basket case. There was rents built into the banking system. one of the advantages of the system of a right time, after you’d built some insti - Remember when we got toasters instead the kind that the United States has is tutions—maybe ’65, maybe ’70. But of interest rates? Clearly, you shovel that the restructuring happens more India actually opened up in 1985. enough profits into a system and it will effectively—and there’s some evidence be stable, because the system doesn’t for this—that the sunrise industries Feldman: So you’re skeptical of a com - want to lose that money. The reason the tend to get more funding than in a rela - mon playbook that’s going to work banking system is less stable now is that tionship or old-style financial system. across many countries. There’s some it’s far more competitive. I think that’s So I think the strength of the United point at which countries need govern - one effect. States’ economy is based on its ment intervention and other points at The other is, the United States (and dynamism. Going back would make us which countries need free markets, and the rest of the world) has a far more lose that dynamism. What I think we that transition has a lot of luck associat - dynamic and competitive economy than need is to get the dynamism with a little ed with it. it used to have. The United States in the less risk. That means let’s avoid bringing ’60s benefited from the tremendous back all these old solutions. I don’t think Rajan: Absolutely. Because that transi - advantage it still had over many of the the banking system can be made more tion doesn’t come naturally. In fact, the countries in Europe, and Japan, which boring. Anyone who advocates that forces are all against that transition, were still recovering from the war. They doesn’t understand banking today. Now, because the vested interests that have had almost reached the point where I think it can be made less risky, but that built up in the period of managed they had fully recovered, but not quite. requires a lot of thought, and these very growth don’t want it to open up. On the That advantage, by the ’70s and ’80s, Draconian solutions, it seems to me,

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would throw out much of the baby with out in the Wall Street Journa l3 yesterday the bathwater. —whole new ways that firms are trying to reach that population, which is creat - INDIA’S FUTURE ing a whole new range of innovation, some of which to my mind will feed Feldman: We know you’re closely back to the West. involved in India as an adviser and in a I was in a meeting just before this at variety of different roles. What does the the University, where a doctor was future look like for India? What kind of speaking about what he was doing in advice are you providing regarding India. One of the things he was saying is India’s financial sector? that the way Indian hospitals do opera - tions, and the way they treat the very Rajan: Well, I chaired a committee poor, is actually a blueprint for how we which wrote a report for the Indian gov - can treat the very poor in this country. ernment for financial sector reforms, It’s not that the poor in India settle and slowly elements of that are being for lower value. It’s that they settle for no implemented. The vision we had was for frills while getting value that they need. a system which is innovative and inclu - Cataract operations, for example, are sive, but also we focused a lot on trying India has done some of the harder things. immensely important in India. Tons of to reduce risk in the system. So it was, to For example, it has created a knowledge people with cataracts in their eyes; they some extent, learning from this crisis as sector, a pharmaceutical sector, IT sector, can’t see. It’s a very simple operation. it was developing. And in India, they’ve actually mass-pro - while not having done the more basic Some of the things that have been duced the operation now and can do it suggested here in the United States, I stuff—that is, building the big roads and for a fraction of the cost it used to cost think, we made those suggestions earli - the bridges, which don’t take rocket in India, let alone what it costs here. It’s er in that report. But it wasn’t rocket sci - science, which just take execution, the down to its basics: How many things do ence. You need more coordination right amount of capital and so on. we need to do? It’s back to the mass pro - amongst the regulators. You need to duction revolution that we had here, have various forms of resolution for except it’s now done in other arenas. these entities. ly—then there is a fair amount of I can’t resist this. I was at a meeting There are also very low-hanging fruit growth ahead for India. India has done the other day with the head of an inter - in India. An effective bankruptcy court some of the harder things. For example, national auto company. We were talking for corporations, for example, would be it has created a knowledge sector, a about design, and he said when he useful. The current bankruptcy court pharmaceutical sector, IT sector, while wants something designed for a low- doesn’t work. So, how to strengthen the not having done the more basic stuff— income population, no-frills, he can’t bankruptcy court so that then you can that is, building the big roads and the send it to his industrial country design - have corporate bond markets, which bridges, which don’t take rocket science, ers. Their immediate instinct is to add then can serve as a buffer between vari - which just take execution, the right on all the frills. He sends it to the low- ous financial institutions. Right now amount of capital and so on. income country designers because those you are ostensibly borrowing from If India focuses on doing that and guys have a mentality of saying, “Do I finance companies, but the finance moves more of its population out from really need this or not?” companies borrow from banks, so agriculture into industry, rural industry essentially you are borrowing at one or services, I think that in itself will create CURRENT RESEARCH AGENDA step removed from the banks them - a tremendous amount of productivity selves. My sense is that improving the growth which can take India forward for Feldman: You talked about the research financial infrastructure in India could the next 10 or 15 years. If India is growing agenda for macro: figuring out some of do wonders for creating some of the at 7 or 8 percent without all that happen - the financial details and putting that in buffers and improving the resilience of ing, add a few percentage points with that models. What’s your research agenda the financial system. happening, and you’ve got pretty solid now, given the crisis? Is it changing Because there are lots of low-hanging growth for a long time. what you were working on? fruit for India to pick, I have confidence The other thing that I think is that unless there’s a huge political prob - extremely interesting is, because much Rajan: One thing that I certainly have lem or there’s a totally incompetent gov - of the population is poor, there are rethought a lot is, I had the view that ernment—which seems to me unlike - whole new ways—this certainly came countries got into trouble because they

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didn’t have the right institutional struc - about it in the 1980s: How do you deal tures. I was of the view that if you trans - with these kinds of risks? A lot of what formed the institutional structures, you he said makes sense, which is if you try could become fairly immune to prob - to protect the system too much, then lems. I’m less persuaded of that now. you make it incapable of dealing with I think there might be some inherent risk. One example of this is the rating volatility in financial markets that you system, right? The financial system really can’t eliminate by creating more became excessively reliant on something transparency, by creating the right it thought was failure-proof, which was structures and so on. These things will the rating system. By the time we found take on a life of their own. So you have out that it wasn’t failure-proof, so many to focus on creating more resilience in people were relying on it, it became a the economies. You can’t eliminate the systemic risk. financial markets; you need them, espe - So there is a problem where the sys - cially as you get more sophisticated. But tem becomes less varied and overly con - you need to create more resilience. fident about safety and in the process creates tremendous risk of its own. This Feldman: So, things like a resolution crisis is—pardon me for saying so—sort regime, contingent capital … Apart from the stuff on banking, I am of a full employment act for economists working on trying to think about the [laughter], and we will keep working on Rajan: And a variety of markets and metapicture. Why did the system go these things for a long time to come. institutions so there’s more buffering. I have no doubt that our research wrong? Not just thinking about the You can’t ward off these problems. You agendas will change. Personally, apart can’t anticipate them. I’ve been reading financial system, but what were from the stuff on banking, I am working [UC Berkeley political scientist Aaron] the political forces, what were the on trying to think about the metapic - Wildavsky recently. The guy wrote structural forces creating this? ture. Why did the system go wrong? Not

More About Raghuram Rajan

Current Positions Member, International Advisory Board, Indian Institute of Management Eric J. Gleacher Distinguished Service Professor of Finance, Booth School Member, Advisory Board of the Comptroller General of the United States of Business, University of Chicago, since 2006; on faculty since 1991 Consultant: Finance Ministry, Government of India; World Bank; Economic Adviser to the Prime Minister of India, since 2008 International Monetary Fund; Federal Reserve Board; Swedish Parliamentary Commission; various financial institutions Previous Positions Honors and Awards Chair, High Level Committee on Financial Sector Reforms, India, 2007–08 Inaugural Fischer Black Prize (for the person under 40 who has Economic Counselor and Director of Research, International Monetary contributed the most to the theory and practice of finance), Fund, 2003–06 American Finance Association, 2003 Fischer Black Visiting Professor, Sloan School of Management, Numerous awards for best paper from the Journal of Finance, Journal Massachusetts Institute of Technology, 2000–01 of Financial and Review of Financial Studies, 1992–2006 Visiting Professor of Finance, Kellogg School, Northwestern University, 1996–97 Publications Bertil Danielsson Visiting Professor of Banking, Stockholm School of Co-author (with Luigi Zingales) of Saving Capitalism from the Capitalists, Economics, 1996–97 2003; author of over 60 research papers on banking, financial develop - ment, economic growth, firm structure and corporate governance Professional Activities Education Program Director (Corporate Finance), National Bureau of Economic Research, since 1998 Massachusetts Institute of Technology, Ph.D., 1991 Director, American Finance Association, 2001–04 Indian Institute of Management (Ahmedabad), M.B.A., 1987 Founding Member, Academic Council, Indian School of Business Indian Institute of Technology (Delhi), B.Tech. (Electrical), 1985

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just thinking about the financial system, Endnotes but what were the political forces, what were the structural forces creating this? 1Calomiris, Charles W., and Kahn, Charles M. That’s a book project which comes out, “The Role of Demandable Debt in Structuring hopefully, this spring—but I’ve got to Optimal Banking Arrangements.” American work on it. The title is Fault Lines: The Economic Review, June 1991, 497–513. Hidden Cracks that Still Threaten the 2 “Has Financial Development Made the World Economy . World Riskier?” Proceedings of the Jackson Hole Conference organized by the Kansas City Fed, 2005. Feldman: And it’s around these issues of diversity, the things you’ve just talked 3 Bellman, Eric. “Indian Firms Shift Focus to about? the Poor.” Wall Street Journal, print version, Oct. 20, 2009. Online version, Oct. 21, 2009, at wsj.com. Rajan: No, those are the details. I want to go back to how the macroeconomy runs. Why is it that the U.S. is focused so much on consumption? Why have our policies pushed credit? Why, for exam - ple, has the U.S. safety net not worked as well as it did in the past? Why is it that stimulus, both monetary and fiscal, is so much stronger in the U.S. than in other countries? And then how does this relate to what the rest of the world is doing? So, link it back together to, “Here is the gap, the fault line. How do we bridge that?”

Feldman: That is an ambitious project. You’re not resting on your laurels.

Rajan: No, no. The financial sector is somewhere in there, but it’s more about the big picture.

Feldman: Is there anything else that you’d like to add right now?

Rajan: No, no, this has been very good. We’ve covered a lot.

Feldman: Thank you very much. R

—Oct. 21, 2009

For the full interview, including Rajan’s thoughts on sources of the crisis, the state of economics and government’s role in housing, visit minneapolisfed.org.

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