Q & A with Raghuram Rajan

Photo of Raghuram G. Rajan
Raghuram G. Rajan
Photo Credit
Photo by Dan Dry. © University of Chicago Booth School of Business

An interview with Raghuram Rajan, author of Fault Lines: How Hidden Fractures Still Threaten the World Economy

What inspired you to write this book/what are you trying to accomplish in writing this book?
This crisis is a wake-up call, telling us something in the global economy is terribly broken. It is more than a problem of a few greedy bankers (and there were plenty of those) or spineless regulators. The financial sector does need serious reform but if we focus only on fixing it, we miss the point that this was a systemic crisis, where the usual checks and balances broke down.

I highlight concerns at three levels. My first concern is about the United States, where because of a thin and inadequate safety net, the government responds to global downturns with excessive stimulus so as to avoid job losses. This is not the first jobless recovery we have had, it is the third in a row. Yet we respond with the same failed policies. This sets the stage for subsequent financial excess. Politicians have made thing worse by trying to use easy credit to households as a palliative to paper over other deeper problems the middle class and the poor face, including lack of access to education and stagnant incomes. My second concern is at the global level, where the strategy of export-led growth in a number of recent fast-growing countries, including Germany, Japan, and China, has made the world too dependent on a few countries like the United States to be the "demanders of first resort". And last but not least, I am concerned about the U.S. financial sector, which is the critical but unstable link between an over-stimulating America and an under-consuming rest of world. We have plenty of work to do, and the more we delay, the harder these problems will be to fix.

In your book, you link the financial crisis of 2008 in part to the lack of a strong safety net in the United States. Can you briefly explain how something like the lack of affordable health care in America precipitated a worldwide economic meltdown?
The link is as follows. If you lose your job in the United States, you typically lose access to healthcare for yourself and your family. Your unemployment benefits run out soon, and given most middle class households have meager savings, your home soon follows. A loss of a job is therefore a fearsome event, and the level of public anxiety increases quickly as job losses mount. Politicians respond through both fiscal and monetary stimulus--technically the Fed is in charge of monetary policy, but it is not politically tone-deaf. The problem is therefore that the lack of a reasonable safety net makes the United States the "stimulater" of first resort whenever there is a potential downturn. But stimulus is costly and weakens the system, especially because the financial sector takes more risks in anticipation. The current financial crisis can be tied, in some ways, to the extremely loose monetary policy that was adopted in the U.S. in 2003-2005, which in turn was a response to the job losses and the jobless recovery following the 2001 recession. And we are in danger of repeating the mistakes we made then.

What needs to be reformed?
The needed reforms are not easy. But they are not impossible either.

At the global level, countries need to become less addicted to exports, so that they can pull along with the United States in getting the global economy out of the periodic ruts it gets into. The countries best placed to make the change are the rich exporters like Germany and Japan. But poorer developing countries like China should also move towards a more balanced growth path over time. Unfortunately, countries are unlikely to reform on their own, they will have to be persuaded. We need to revamp our global organizations completely so that they can help countries accept their international economic responsibilities, and I lay out an agenda for possible changes, drawing on my experience as chief economist of the International Monetary Fund.

In the United States, we have to work on creating a better safety net. We should recognize there is a lot of flexibility built into the US system, and what is good for Europe need not be good for the United States. However, there are clear improvements we must make, one of which is moving to an affordable universal healthcare system. The current healthcare package is near universal, but it has to be made affordable.

We also need to work on improving access to quality education in the United States, especially at the K to12 level, for inequality in education sets the stage for a lifetime of continued inequality. The growing levels of inequality then tend to increase levels of conflict, and people’s anxiety about the rest of the world. Politicians respond with bad policies such as easy credit which encourages consumption and papers over the lack of income growth, leaving people even less prepared to face global competition. We should tackle the problem at the source.

Lastly, the financial sector needs reform, but reform should not simply amount to yesterday’s answers such as increasing capital requirements for sub-prime mortgage backed securities, for that will only push the excess somewhere else next time. Moreover, such stable-door closing will not address the creativity with which some large financial firms get into trouble repeatedly--Citibank has been near death’s door three times in the last three decades, each time for a different reason. Also, any reforms we undertake should recognize the natural limitations of regulators, and their susceptibility to the same influences that infect the private sector. We should reform while recognizing that key to a vibrant innovative real economy is a well-functioning competitive financial sector. I propose a set of reforms that will seek to retain the vibrancy of the financial sector and its support of entrepreneurship, competition, and real innovation, while dealing with its tendency to take too much risk.

Do you think it is possible to have a financial system that is crash-proof?
No, the only way to ensure that is to keep it from taking any risk. But sensible risk-taking is key to the value a good financial system provides--the risk it takes in financing an unknown entrepreneur or in helping a household meet a medical emergency. North Korea has a crash-proof financial system, but I am not sure we would wish that system on our worst enemy. We have to recognize that crashes can happen. We have to reduce their likelihood, but also work to ensure that bankers and their investors absorb the costs of their risk taking so that their adverse effect on Main Street and the tax payer is minimized.

What is at stake here?
In some ways, the stability of the global free enterprise system is at stake. The global economy has been stress-tested, and has been found wanting. We can heave a sigh of relief that the damage, though deep, has not devastated the system, and then go about business as usual because the cost of reform is high. Or we can pay serious attention to what went wrong. I hope it is the latter, for the trends are such that the problems can only get worse. And even a mild repeat will make people lose faith, and blame the free enterprise system itself rather than the enormous but fixable problems I have identified. We do not want the world to go back to the ideological wars that proved so costly in the last century. We need to act now.