Interview of Raghuram Rajan

I have often pointed to interviews conducted by Region Magazine, a publication from Minneapolis Fed.

• Paul Volcker
• Ken Rogoff
• The Romers

And so on. The interviews are an excellent place to understand the various econ’s research. All Region issues are here

The recent edition has an interview of Raghuram Rajan. As usual very insightful on Rajan’s research and thinking on crisis. For a  clearer picture on the crisis, one should read his literature survey as well

You’ve done a lot of research on why banks structure themselves in that way in the first place. Perhaps we could start with your impressions of whether banks remain special today, and why that would be?

Rajan: That’s a very interesting question. The question really is, “Why the structured fragility?” Why finance yourself with demand deposits, when on your asset side you have these illiquid assets—term loans, complex positions? What’s the link? The alternative, which surfaces every time you have a financial crisis, is to create narrow banks—that is, have money market instruments on your asset side financed with short-term demand deposits on your liability side. If you really want to hold illiquid assets, finance them with long-term borrowing, not explosive short-term debt.

Why the private banking sector has never chosen safe narrow banking (with finance companies issuing long-term liabilities and making illiquid loans) is really the puzzle of the ages. It’s interesting because the form of the bank seems relatively similar across countries and over time. It’s a form that has endured, perhaps longer than the corporation. You can go back to Mesopotamia perhaps, but certainly to Italy, and they had banks in much the form that we have today. Doug Diamond [also at the University of Chicago] and I have been puzzling over this for some time. Part of the answer is the Calomiris and Kahn view that when you have short-term liabilities, it puts much more discipline on bank management and therefore they have to commit to, in a sense, not do anything crazy with your money.

Apart from crisis, he speaks on Indian economy and how financial sector reforms could push India into a high growth path.

On his next research agenda:

Feldman: You talked about the research agenda for macro: figuring out some of the financial details and putting that in models. What’s your research agenda now, given the crisis? Is it changing what you were working on?

Rajan: One thing that I certainly have rethought a lot is, I had the view that countries got into trouble because they didn’t have the right institutional structures. I was of the view that if you transformed the institutional structures, you could become fairly immune to problems. I’m less persuaded of that now.

I think there might be some inherent volatility in financial markets that you really can’t eliminate by creating more transparency, by creating the right structures and so on. These things will take on a life of their own. So you have to focus on creating more resilience in the economies. You can’t eliminate the financial markets; you need them, especially as you get more sophisticated. But you need to create more resilience.

Feldman: So, things like a resolution regime, contingent capital …

Rajan: And a variety of markets and institutions so there’s more buffering. You can’t ward off these problems. You can’t anticipate them. I’ve been reading [UC Berkeley political scientist Aaron] Wildavsky recently. The guy wrote about it in the 1980s: How do you deal with these kinds of risks? A lot of what he said makes sense, which is if you try to protect the system too much, then you make it incapable of dealing with risk. One example of this is the rating system, right? The financial system became excessively reliant on something it thought was failure-proof, which was the rating system. By the time we found out that it wasn’t failure-proof, so many people were relying on it, it became a systemic risk.

So there is a problem where the system becomes less varied and overly confident about safety and in the process creates tremendous risk of its own. This crisis is—pardon me for saying so—sort of a full employment act for economists [laughter], and we will keep working on these things for a long time to come.

I have no doubt that our research agendas will change. Personally, apart from the stuff on banking, I am working on trying to think about the metapicture. Why did the system go wrong? Not just thinking about the financial system, but what were the political forces, what were the structural forces creating this? That’s a book project which comes out, hopefully, this spring—but I’ve got to work on it. The title is Fault Lines: The Hidden Cracks that Still Threaten the World Economy.

Feldman: And it’s around these issues of diversity, the things you’ve just talked about?

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 example, 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.

The crisis is posing basic questions and most economists are just taken aback. Rajan has a great research agenda. Apply for a Phd under Rajan. If he takes you, it could be very exciting.