This Economist Predicted the Last Crisis. What’s the Next One? (Ep. 366)
In 2005, Raghuram Rajan said the financial system was at risk “of a catastrophic meltdown.” After stints at the I.M.F. and India’s central bank, he sees another potential crisis — and he offers a solution. Is it stronger governments? Freer markets? Rajan’s answer: neither.
Listen and subscribe to our podcast at Apple Podcasts, Stitcher, or elsewhere. Below is a transcript of the episode, edited for readability. For more information on the people and ideas in the episode, see the links at the bottom of this post.
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Stephen DUBNER: In 2005, you attended the U.S. Federal Reserve’s annual symposium in Jackson Hole, Wyoming. And it was essentially a celebratory send-off for Alan Greenspan, the outgoing Fed chairman. But you, going quite against the grain, gave a talk based on a paper you’d written that was called “Has Financial Development Made the World Riskier?” And your answer was a firm “yes.” You argued that financial engineering and skewed incentives in banking and elsewhere could create “a greater, albeit still small, probability of a catastrophic meltdown.” Again, this is 2005.
Raghu RAJAN: Yeah, well let me put it this way: it was clear there was a reason for concern, but what was comforting was that we hadn’t had a crisis in major economies for 70 years.
DUBNER: What lessons are we to draw, we non-economists, from that severe miscalculation — or mischaracterization, at least — by most economists?
RAJAN: I think there was a sense of complacency. Put differently, we were living in well-run houses where the plumbing was not a problem. And the reality was the plumbing was actually getting corroded by poor incentives in that system, and we didn’t realize it until it backed up in a really big way, and we said, “What is that smell?”
I’d like you to meet today’s guest.
RAJAN: My name is Raghu Rajan. I am a professor at the University of Chicago’s Booth School.
Rajan is more than just a professor, as we’ll hear. That said, it’s likely you’ve never heard of him. You should have. And not just because he was one of the very few people who foresaw the risk of a “catastrophic meltdown” that indeed came to pass — in the form of a global financial crisis and the Great Recession that followed. You probably remember this:
CBS: Lehman Brothers, bankrupt; Merrill Lynch, sold in haste.
And then this:
CNN: Breaking news here: stocks all around the world are tanking because of the crisis on Wall Street.
And then this:
CBS: The federal government loans American International Group, AIG, $85 billion.
George W. BUSH: The house of cards was … much bigger.
CBS: The President’s plan would allow the Treasury to buy up to $700 billion worth of bad loans.
The U.S. Senate held some investigations:
Carl LEVIN: How much of that shitty deal did you sell to your clients?
Susan COLLINS: How do you account for all of these references to “the big short?”
David VINIAR: I feel — I think that’s very unfortunate to have on email.
But the damage had been done. The recession caused by the financial crisis cost the U.S. alone nearly 9 million jobs and more than $8 trillion in household wealth. But of course the recession spread around the world; it had massive economic, social, and political ramifications, many of which are still being felt today, a decade on. The crisis was all the more distressing because the political and economic elite had been so badly blind-sided; in fact, they’d been basking in what they called “the Great Moderation,” an almost magical era in which financial crises were inconceivable.
RAJAN: During the Great Moderation, there was a general sense that the system worked and that the plumbing was all fine, incentives were all fine. I remember after I gave my speech at Jackson Hole, two very senior people in the Federal Reserve System came up to me and said, “This is not a problem, because the private sector knows how to take care of itself. These are very smart people who are very well paid. They would simply not take these risks that you’re talking about.”
Raghu Rajan draws a straight line between the financial crisis and what he sees as one of the biggest dangers in the world today: the rise of populism, on both the right and left, driven by a deep distrust of those same elites who told everyone not to worry the last time around. Rajan has developed this perspective while serving as chief economist of the International Monetary Fund, as well as the head of India’s central bank.
RAJAN: If you start thinking about the responsibility, it becomes overwhelming. So you try not to think about it.
Rajan’s prescription for addressing the risks of runaway populism? That may surprise you, especially coming from an economist:
RAJAN: In this anonymous world, with anonymous markets, and anonymous bureaucracy, what allows you to have meaning in your life is really the people around you.
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DUBNER: Professor Rajan, can you hear me okay? This is Stephen.
RAJAN: I can, and please do feel free to call me Raghu.
DUBNER: Very good. I will. Thank you. Let’s do a very quick biography: you were born in India but then moved about quite bit with your family, returned for university in India, got an M.B.A. in India, and then a Ph.D. in finance at M.I.T., and you ultimately took up what turned out to be a very lengthy residence at the University of Chicago, where you still are now. In 2003, after several years in academia and zero years in policy, you became chief economist of the International Monetary Fund in D.C. You were the youngest economist ever in that post, also the first non-Western economist. You also weren’t known for doing macroeconomics at all. So why did you get that job and why did you take it?
RAJAN: Well, I think the I.M.F. realized that it needed to understand finance a little better, that they were composed largely of macroeconomists. They were interested in getting somebody who knew finance, and I had met the deputy managing director Anne Krueger at a number of conferences and I’d sent her my first book, Saving Capitalism from the Capitalists. It happened to arrive at the time they were looking for a new chief economist, so she called me and she said, “Why don’t you interview for this post?” I said, “Anne, I don’t know any macroeconomics.” She said, “That makes two of us.” So, I was sold.
DUBNER: Many people who are not economists, when they hear these different sections of economic thinking and research — macroeconomics, finance, microeconomics, etc. — it’s all a little bit murky to them. What would you say that your finance background brought to an institution that did macroeconomics that maybe was missing?
RAJAN: So, the difference between these various streams is like the difference between various streams in engineering. The civil engineer knows how to build bridges, but doesn’t fully understand the motors that drive the machines he uses to build the bridges, and so on. So, the electrical engineer knows more about the motors. Similarly in economics, the macroeconomist worries about monetary policy, fiscal policy. And what the financial economists — especially somebody who has experience in banking and so on — does is brings an understanding of the financial system and how it interacts with these other pieces. To give you an example: one reason we have financial crises is because in a period of moderation, perhaps interest rates are kept really low. With plentiful liquidity around, people are willing to take on more debt, and as they take on more debt, it increases the risk that when the environment changes, when growth slows, when liquidity dries up, these companies and these banks that have taken on more debt will be left high and dry. And that’s what often happens in these crises.
Rajan here is essentially describing the risks he warned about back in 2005 at the Federal Reserve’s Jackson Hole symposium — in front of the financial system’s architects: Larry Summers, Tim Geithner, and the Fed chairman himself, Alan Greenspan. Rajan was at the I.M.F. at the time.
RAJAN: I was asked to give this talk because I was a finance guy and I would probably end up saying all these wonderful things that have happened in finance over the last 20 years in Greenspan’s time, and that was also my expectation when I agreed to give the talk. But then, as I started writing, I said, “This is standard, sort of, conventional wisdom. What is it that I’m missing? Why am I writing this?” And as I started probing, and I looked at the numbers on the risk of bank equity, for example, I started wondering whether the conventional wisdom was in fact right.
Rajan learned, for instance, that credit default swaps, a relatively new and potentially volatile financial instrument, were surging; in 2001, they made up just 5 percent of private-sector bank credit; by 2004, they made up more than 30 percent. So he told the symposium about that. He also warned that investment managers were concealing “tail risks” — that is, adverse events that had a very small probability but, if they did come to pass, would have catastrophic consequences.
RAJAN: And it was a strange paper to give in the midst of a conference where the question was whether Mr. Greenspan, a really formidable central banker, was either the best central banker in history or the second-best central banker in history. And it was, a little bit, sort of raining on a parade of compliments.
DUBNER: You were “heavily criticized.” As you recall later yourself, “I felt like an early Christian who had wandered into a convention of half-starved lions.” And yet, just a couple years later, the catastrophic meltdown that you warned could happen did happen. And it was largely caused by the very factors that you had identified. I am curious whether — over the years, as the financial meltdown happened and the recession deepened — I am curious how the academic economist community responded to you over time: did people call or write to you, or say to you, “I thought you were nuts, but you really called it, explain to me how and why.” Did that kind of thing happen?
RAJAN: No, I think you see more of the, “I also thought it wasn’t working and agree that we could have done more.” I mean, the reality is that in a period of fairly peaceful growth, there are a lot of people who warn about problems. Today, there are people who are warning about problems, say, with leveraged loans, which I am worried about also. But for a policy maker who’s at the receiving end of all this advice, you have to ask, “What do I really want to pay attention to and what do I want to dismiss?” If you take all the warnings to heart, you will never ever let the system grow. You will never ever let the system take risks, because everything could actually implode. So, it is a tough act for regulators to figure out what they should pay attention to and what they should not.
In 2010, Rajan published a book, called Fault Lines, about what he saw as the underlying causes of the financial crisis. One big factor was a rise in income inequality, coupled with weaker social-safety nets. Rajan paid particular attention to what he called the “college premium” for workers — or, really, the “non-college penalty”: that is, the median high-school graduate was earning 72 percent less than the median college graduate. He also identified the many components of the housing bubble — financial profiteering, consumer overreach, and a federal government that pushed home ownership too far, in both Democratic and Republican administrations. All this led to too much credit that was too easy to get, which led to too many bad loans that were too aggressively commodified and ultimately blew up like — well…
RAJAN: We said, “What is that smell?”
Rajan also warned that these underlying problems — societal, financial, and political problems — would need to be addressed to prevent a recurrence.
DUBNER: Here we are roughly 10 years out from the crisis. Talk to me about the degree to which you believe these underlying factors have or have not been addressed.
RAJAN: Well, I think I was talking at two levels. One was the deeper underlying societal problems. And I thought that that was an important factor in why credit was emphasized so much in Western economies as the answer. Because once you can see your house as an A.T.M. from which you can take out the home equity and spend, you’re much less worried about your stagnant income, and consumption inequality went up much less than income inequality.
DUBNER: The easy credit was kind of a compensation for the lack of wage growth, then, yes?
RAJAN: Absolutely. And far too many politicians ran away from the problem, saying they were nowhere near it when, in fact, the whole political system was pushing for easier credit in the years preceding the crisis. Now, that said, I think there was a second level which was — given these broader incentives I think the financial system also went haywire. It’s very easy to look for scapegoats, for a few bad apples. Much more worrisome is when the whole system is part of the problem, and then you have to do much more careful work. I think we’ve done some of that. I think mandating banks to carry more capital was part of the answer. But we mustn’t become complacent and think that solved everything, because even as you ask banks to carry more capital, they still have to make profits, and they have to find new ways of making profits, because the old ways don’t work. But my sense is also that risks in the system don’t necessarily go down. They get shifted. So even as we’ve made the banks safer, there are parts of the system which may in fact have taken on some of those risks.
DUBNER: Can you give some details? What do you mean — where do those risks lie now, or where do you suspect they may lie now?
RAJAN: Okay, let me give you an example. The problem before the financial crisis in the United States was: households levered up too much with this home equity line of credit and on. Right? I think households have become more, sort of, careful given their experience during that crisis. But corporations, which didn’t lever up that much before the crisis, have levered up more. In private equity, the kind of leverage ratios you see today for transactions that are done are approaching the ones that were done before the crisis. Also, loans without covenants, loans without controls for the lender. And who’s holding these loans? Well, it turns out the pension funds, insurance companies. All those entities.
Here’s some data to consider: U.S. corporate debt grew from around $5 trillion in 2007 to more than $9 trillion in 2018. At the same time, about 60 percent of the activity in the leveraged-loan market now falls under what’s called “covenant-lite” terms — that is, with fewer restrictions on collateral, payment terms, and income levels, and fewer protections for the lender. Given Rajan’s history of correctly identifying risks in the past, it’s probably worth hearing him out today. That said, it’s one thing for an academic or an I.M.F. economist to point out risks in the system and quite another for a policymaker to strike the proper balance. As it happened, Rajan soon got his turn in the policymaker role too, back in India. He was an economic consultant to the federal government — and then, in 2013, he was installed as Governor of the Reserve Bank of India, the R.B.I.; his job was the equivalent of Chairman of the Federal Reserve in the U.S.
DUBNER: Your appointment was met with devout enthusiasm, I guess I’d call it. The rupee immediately rose 2 percent against the dollar, there was a big rally in the Sensex, the stock market. One commentator said that you “put the sex back into the limp Sensex.” You were cast as a sort of economic superhero. And, additionally, a homecoming hero. Can you — before we get into the policy and the things that you actually did — tell me a bit about the state of the Indian economy when you first began consulting. Because, as I understand it, there was a rather deep crisis, multi-level crisis. I’m very curious to see what you saw and what you thought policy should do to help correct that.
RAJAN: Well, we were one of the countries that essentially was growing quite strongly before the global financial crisis, and then growth started dropping off very sharply post-crisis. So, as growth started dropping off, the government did what governments naturally do, which is expand spending so that growth would keep up. And the central bank essentially was more easy on policy. And before we knew it, first, growth had picked up after the recovery in Western economies and growth was actually very strong. But we had all the sort of problems of an overheating economy. We were running large fiscal deficits. We had very high inflation. We had the classic symptoms of a country which was going towards financial difficulty. As we went into 2013 with all these numbers really large and alarming, when Ben Bernanke speculated about ending the era of easy money, money started leaving the Indian economy, and our exchange rate started plummeting. So that was a really difficult period, because we had elections coming in 2014, and usually the uncertainty created by elections creates more anxiety amongst investors. And that, coupled with our bad numbers, meant we really had to do something to build confidence.
DUBNER: Had you had Ben Bernanke’s job at that moment and India said to you, “Listen, if you do this the wrong way, it’s going to punish us unduly,” what would you have done? Would you have changed the method or rate at which you pulled the money back?
RAJAN: No. Look, I think every central bank has a mandate of its own, and it has to respect that mandate. I think given the mandate of the Federal Reserve, I think you really don’t have the ability to take significant cognizance of the effects of your policies on other countries — except to the extent it feeds back onto your own country.
DUBNER: You once said in an interview, during the time that you were governor of the R.B.I., you said, “Central bankers have had enormous responsibilities thrust on them to compensate essentially for the failings of the political system, and my worry is we don’t have sufficient tools to do that but we’re not willing to say it. And as a result we push as hard as we can on the existing tools and they may create more risk in the system.” Can you talk about that for a moment: what do you mean by central bankers compensating for the failings of the political system?
RAJAN: I think the problem was that governments weren’t even doing some of the basic stuff that governments do in recovery. And as a result, monetary policy was — as Ben Bernanke once said — the only game in town. Moving interest rates up and down is not going to improve the quality of education or the ability of the fired worker to essentially retrain himself or herself. Yes, you can recreate some of the old jobs, but they may not be what the worker needs or wants. So that’s the sense in which — what, really, industrial countries need is structural change.
DUBNER: So, in retrospect, what would you say were some of your best decisions?
RAJAN: Well, I think to stabilize the currency. We needed to bring inflation down.
DUBNER: Which you did.
RAJAN: We moved to creating a structure which would create credibility that we would do it, and that structure’s in place today. We have an inflation-targeting framework, we have a monetary policy committee, and inflation is still low — in fact, it’s probably where we wanted it be: 4 percent. This is a problem India has grappled with for decades. To my mind, the fact we could bring it down is very important. But, of course, this was not all that we needed to do — liberalizing the markets; we licensed 23 new banks in an environment where there was enormous worry that this process would be corrupt. The Economist ran a feature saying people were selling these licenses for $75 million apiece. I said, “Where’s that money. I don’t see any of it.” No, we created a really transparent process with three layers of committees to ensure that no single person controlled the process and gave away licenses, and nobody has raised a peep about how those licenses were granted.
So, on the payments system, we transformed the payment system from — especially on the retail level. Now in India you can send money from my bank account to your bank account without knowing anything else. You just tell me where your bank is and I can zap it across. And I’m not locked into a monopoly provider, one of the big tech companies. It’s done over public bridge.
DUBNER: Now, shortly after your departure as governor of the R.B.I., Prime Minister Modi executed a sudden, controversial plan to abolish 500- and 1,000-rupee banknotes, hoping to crack down on the shadow economy and tax evasion. I understand you had not been in favor of that idea, correct?
RAJAN: Absolutely. It didn’t make sense. I was asked for my opinion, and I said, “Look, it is taking away money that people use in transactions. It’s going to create enormous disruption unless we replace it overnight with freshly printed money.” And it’s very important that we have all that in place, difficult to maintain secrecy, and then the fundamental sort of objective of this, which was to get people to bring out the money that they hoarded in their basements and pay taxes on them — I said, “That’s probably not going to work out, because they’re going to find ways to infuse the money back into the system without paying those taxes.”
DUBNER: It’s been roughly two years now. What have been the effects of this demonetization?
RAJAN: Well, I think more than the numbers suggest, because India was growing at that time. And we had numbers which were in the 7.5 percent growth range at that point, at a time, in 2016, when the world was actually growing quite slowly. When growth picked up in 2017, instead of going along with the world, which we typically do and we exceed world growth significantly, we went down. That suggests it had a tremendous effect on growth, but that, the numbers don’t capture it all, because what actually got killed was the informal sector — the people who were doing work with notes rather than with checks, who didn’t have formal bank accounts. And when you look at the job numbers that some private-sector people estimate 10, 12 million jobs were lost in that episode. And, of course, we haven’t recovered them yet. It was one of those places where more economic thinking would have helped.
DUBNER: Was it a coincidence that Prime Minister Modi went ahead with the plan only after you’d left?
RAJAN: Well, I can’t speak on that. I can only say that I made my objections very, very clear.
DUBNER: Some of your comments as governor were not well received by some members of the political class, and you did not seek a second term as governor of the R.B.I. Could you just describe that decision for us, please?
RAJAN: Well, I think that was relatively straightforward. I had a three-year term that came to an end. I think we — the government and I — talked about whether I could be useful for a little more while. And I think we really didn’t agree on an extension. I mean, they didn’t want to extend it, and I didn’t, at that point, on those terms, want an extension.
DUBNER: Your name has been mentioned as a potential Prime Minister of India. What sort of probability would you assign to that?
RAJAN: Pretty close to zero. Look, I’m not a politician. That requires enormous capabilities in a very different direction, which I don’t have. I certainly will stick to what I know, which is advice and policy. If I can have some influence on public policy in the future, I certainly would think about it, but I’m perfectly happy where I am.
For what it’s worth: the man who succeeded Rajan at the Indian central bank didn’t even last his full three-year term, resigning over frustration with the government. And the Modi government, heading into a reelection campaign, was recently accused of having suppressed troublingly high unemployment numbers. It’s really too soon to judge Rajan’s term as India’s central banker. It is worth noting he did help stabilize a fragile economy; it was also an economy that, over the past decade or so, had gravely disappointed a lot of global investors. India had been one of the fastest-growing economies in the world, but as India faltered, China started running away with the race. Over the past few years, that dynamic has been reversed; the Indian stock market has absolutely crushed the Chinese markets, and it’s outperformed the U.S. markets by a good bit too.
If your job was to look around the world and hire a central banker with crisis experience, a good track record, and the sort of equanimity that is rare among the political and economic elite, you’d almost inevitably cast your eye on Raghu Rajan. So what’s he worried about now?
RAJAN: The kind of disruption we are seeing, the rise of strong authoritarian regimes across the world — too many strong leaders around, if you will, for a peaceful world.
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Raghuram Rajan is a professor of finance at the University of Chicago; he’s also been chief economist for the International Monetary Fund and head of India’s central bank. His first book, Saving Capitalism from the Capitalists, helped get him his I.M.F. job. His second book, Fault Lines, performed a post-mortem on the Great Recession and the underlying financial crisis — a crisis that Rajan was nearly alone in warning about. This month, he’s publishing a new book, called The Third Pillar: How Markets and the State Leave the Community Behind. It’s a fairly radical argument for an economist. To understand where Rajan is coming from, and where his economic and political views developed, it’s maybe best to go back to his beginnings.
DUBNER: You were born in India. I understand your father worked in intelligence for the Indian government. He was a spy, although you didn’t know it at the time, and that you moved around a lot: India, Indonesia, Sri Lanka, Belgium, back to India. Talk about what that experience and what your family was like.
RAJAN: Well, it was a very warm childhood. We were four siblings, and our parents tried to give us the best education they could. Part of that education was moving to really interesting places. We were in Indonesia during The Year of Living Dangerously, when there was a coup. And I remember gunfire in the evenings as the army executed — some people say — over 250,000 communist sympathizers. And we were at home worrying about what was happening, but it was still a very warm and loving environment. We went to Sri Lanka. There was an insurgency there. We had a year off because the rebels were on the streets.
DUBNER: A year off from school, yes?
RAJAN: Yeah, a year off from school, and my parents were really worried that we weren’t really getting any education. The next place we moved to was really staid and boring Belgium.
DUBNER: You got back to India in time for what’s referred to as “The Emergency.” For those who don’t know about it, just describe what the Emergency was, and I’m particularly interested to hear how it affected you and your family.
RAJAN: Well, India is a democracy, and Indira Gandhi, who was the Prime Minister at that time, in 1975, the courts ruled against her and said that she had won her seat illegally. Instead of accepting the ruling of the court, Indira Gandhi declared an emergency where she basically shut down all questioning of her authority. And this was a two-year period where she attempted to run India on authoritarian lines. And as with such regimes, initially people were very happy. The trains ran more on time. But then some of the excesses started showing up. For example, to control population, there were camps where people were forcibly sterilized. There was heavy censorship of the press, and there’s, of course, the jailing of the opposition. She eventually, two years later decided to go for elections. There’s a lot of controversy about why she did that. Some people say it was because she was going back to a democratic instinct; some people say it was just that in that authoritarian regime, the domestic intelligence agencies basically told her, “You’re going to win for sure,” and they were being sycophantic and she actually believed them.
RAJAN: It was an interesting time, because that is when India realized how fragile its democracy was.
The fragility of democracy is essentially the theme of Rajan’s new book, The Third Pillar.
RAJAN: The book emphasizes a society held up by three pillars.
The first pillar is:
RAJAN: Markets, which ensure that society is productive and efficient by allocating resources to the right place, and taking them away from places where their resources aren’t being used well.
The second pillar is:
RAJAN: The state, which is the composite of the executive, the judiciary, the legislature, and its role, really, is security.
And the third pillar?
RAJAN: It’s the third pillar which has been underemphasized; that is, the social aspects. We’ve talked about economic. We’ve talked about political. The social aspects; that is, the community, which ultimately offers meaning in our lives.
The Third Pillar is an interesting book, and an odd book. It’s largely a work of economic history, even though Rajan isn’t an economic historian. It covers a lot of politics and sociology even though he’s not a political scientist or sociologist either. More than anything, it’s a plea to reset society — a cri de coeur, really, although given Rajan’s rather moderate bearing, it’s a somewhat moderate cri de coeur. His main argument is that the markets and the state have grown so big and powerful and institutional that they’re choking off the lifeblood of actual communities. That we’ve gotten so good at scaling up that it’s time for a concerted effort to scale down. Because when communities erode, when people feel the state and the markets are running their lives, the result is often an angry populism.
BBC: A four-point lead for leaving the EU, and that’s the result.
Channel 4 News: The shock result was the AfD, which became the third-largest party.
AUDIENCE: USA! USA! USA!
Donald J. TRUMP: Thank you. Thank you very much everyone. Sorry to keep you waiting. Complicated business.
RAJAN: Most people actually are quite frightened. We see strong political movements around the world which are looking to disrupt the kind of system we’ve had for the last 70 years. And people are asking, “Why now? What’s going on?” and “What’s the future hold for me?” At the same time, they see technological disruption create threats to the jobs they have, and they worry whether their children will have as good a life as they’ve had, let alone a better life.
The populism Rajan’s talking about exists on both the left and right wings of the political spectrum. In each case, there’s deep dissatisfaction and distrust of political institutions. It wasn’t always thus.
RAJAN: The balance before was what one might call liberal market democracies, which essentially created the prosperity that we’ve seen post-World War Two. Now, that is under threat, and part of the reason for that threat is because the community in many parts of the developed world is imploding under the pressure of both global markets, as well as technological change, as well as a government which isn’t doing the right things to support both the opportunities that people should have as well as the safety nets that they should have.
DUBNER: What you’re describing sounds foreboding to the point of dangerous. How much danger do you think we’re in?
RAJAN: Well, I think there is a danger for sure and I think we’ve seen these kinds of environments before. It’s all too easy to point to the 1930’s and say it looks like that. Nothing really looks like the past in exact detail, but the kind of disruption we are seeing, the rise of strong authoritarian regimes across the world, too many strong leaders around, if you will, for a peaceful world. I think all this makes you wonder if the risks have gone up. And I think they have.
DUBNER: In the book you write that “a populist movement believes that ruling elite are corrupt and undemocratic, that the masses have been treated poorly, and that the system ought to be changed because the general will of the people demands it.” That sentence to my ear doesn’t sound nonsensical, especially given the fact that governments and markets can both be fairly punishing to the median person. So why does populism — or maybe it’s Populism — have such a terrible reputation at the moment?
RAJAN: I don’t think the problem is identifying what’s going wrong. I absolutely think populists are necessary to jolt the establishment, to say, “Look, this is not reaching so many people.” It’s the answers they provide which often are too easy and wrong at the same time.
So, let’s take a standard answer which has appealed to both sides, the left and the right. Let’s close down trade. Free trade is very problematic, right? Or let’s put constraints on it. So what do we do? We raise steel tariffs, right? The economist would tell you, “Okay, but be aware of the unintended consequences.” As you raise steel tariffs, the price of steel domestically goes up. As the price of steel goes up, car companies find it harder to compete because they buy a lot of steel. Now, remember, they are competing with car companies abroad, who don’t have the tariffs that you just put on your steel. They are buying steel cheap, in fact even cheaper, because steel that used to come to the States now is going elsewhere. Their prices actually are much more competitive than car companies in this country. So G.M. announces it’s going to close down a bunch of plants. That is the consequence of the easy solution. The cost of saving a steel job could be jobs lost in other industries, and typically, economists say, more than the jobs that you save in steel — and you’re increasing costs overall for the consumer, also, to boot.
DUBNER: You argue that communities have been left behind, often, by technological change and globalization, and that the solution lies in restoring power to communities. Now, what do you mean by that, restoring power to communities?
RAJAN: One of the tendencies with the growth of markets is for government to also grow, and then in order to maintain uniformity across which markets can operate, there’s a tendency to take more decisions into the government. There’s also the problem when markets implode — again, government grows to bail out individual communities, right? And what I’m arguing is: this essentially leaves people in the community frustrated. There’s much less to engage on when, for example, your school is being paid for largely out of state or federal grants, and the state or federal bureaucracy is what decides what will be taught and how it’ll be taught and how teachers will be compensated. The school no longer pays attention to the local community. Similarly, if regulations on how you can produce locally are determined elsewhere, then, I think, you have a sense of disempowerment. Why bother about the local ward elections when the ward does pretty much nothing?
DUBNER: So, when community is successful — and it’s not always — but when it is, how important is simply the fact that it operates in much smaller units than the typical government or market? You write about a poverty-relief program in Germany called the Elberfeld system. Talk about how that worked and why you think it worked.
RAJAN: This was in the first flush of industrialization in Germany. Germany was one of the first countries to put together some kind of social support in an explicit way, as in the town of Elberfeld. And there what they did was: they got volunteers from each ward who would come together under an overall structure run by the city. They would go into the homes of people who were not doing well and ask them what their needs were, and essentially approve very quickly some kind of financial support for those families, but also give them contacts, give them opportunities: here is where there might be jobs — they were essentially acting as voluntary counselors, and a lot of people volunteered.
The engagement helped, in a sense, tie people back into the community, and helped them stand on their feet. And these were people volunteering to do this, rather than part of a bureaucracy. This was what they did in their spare time. And therefore, you got engagement and enthusiasm and people doing this got local, social prestige. As we go forward into a more technologically enhanced world, it’s the people around us who are going to be much more important. In this anonymous world, with anonymous markets, and anonymous bureaucracy, what allows you to have meaning in your life, is really the people around you.
DUBNER: I have to say, some of these words that you’re using now, Raghu, “community” and “meaning,” if I did not know better, I would not think that you were an economist at all. I’m curious whether this represents an evolution for you as a human and an economist, or was this always who you were and economics was just a route that helped you further your thinking.
RAJAN: I think, as you sort of progress in life more, you understand a little more, and to some extent, I think, as you read outside your field, you learn what’s been done elsewhere. You realize there are many parts which are missing. I mean, look: to be fair to economists, they’ve expanded what they focus on so much.
DUBNER: You do argue in the book that community has long been undervalued as the third pillar of a society, and especially undervalued by economists. I’m curious why you think that is?
RAJAN: Well, I think it’s harder to analyze. I think that we are very comfortable with explicit contracts. We understand prices. But in a community, many of these transactions are not priced. You may do more favors than you get. You may not even get greater status as a result of something you do. But sometimes you do it because it’s ingrained in your sense of who you are, that you have to help the community. And I mean, think of it as almost seared in your utility function. I think some of these features are hard for economists to analyze. For example, we don’t have a good theory of what sometimes is called “the norm of reciprocity,” that when people get a favor, they feel almost compelled to return it at some point. And why do we feel that that norm so strongly? Unclear.
DUBNER: Have you lost some faith in the markets, or would you not put it that way?
RAJAN: I would say the capacity of markets to take care of themselves — which I was much more convinced about — I’ve lost some faith. Now, the automatic answer doesn’t mean that you replace them with governments. It’s all about balance.
DUBNER: In some ways your book is frightening, and it describes the potential for — really — disaster. You, however, sound in this conversation, and in some moments in the book, to be quite hopeful. Can you just distill your, kind of, over/under for the hope factor, in terms of the global economy and society continuing to enjoy prosperity and progress versus potentially backsliding?
RAJAN: Look, I think the potential for progress is certainly there. I mean, if you look at what’s happening across the world — certainly in many of the emerging markets — how tremendous changes have happened in the last few decades. You have to be really happy that a country like Vietnam, which was enmeshed in war 50 years ago, is now where it is.
The dangers, well, we see them when we read the papers every day. I mean, this fight between China and the United States just now on trade — but there are geopolitical concerns. If we have another Cold War, or potentially, even places of hot war — here are two enormously rich countries. If they go at each other and use all the capabilities that they have for new technologies in fighting each other, rather than building a common sort of world, I think the path down could be very, very steep. We need to engage with each other for the good. And we need to figure out ways to do that. So I am worried, but what gives you some confidence is: we’ve always figured it out.
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Freakonomics Radio is produced by Stitcher and Dubner Productions. This episode was produced by Zack Lapinski. Our staff also includes Alison Craiglow, Greg Rippin, and Harry Huggins. Our theme song is “Mr. Fortune,” by the Hitchhikers; all the other music was composed by Luis Guerra. You can subscribe to Freakonomics Radio on Apple Podcasts, Stitcher, or wherever you get your podcasts.
Here’s where you can learn more about the people and ideas in this episode:
- Raghuram Rajan, economist at the University of Chicago’s Booth School.
- Saving Capitalism from the Capitalists by Raghuram Rajan and Luigi Zingales (Crown Business 2003).
- Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan (Princeton University Press 2010).
- The Third Pillar: How Markets and the State Leave the Community Behind by Raghuram Rajan (Penguin Press 2019)).
- “Has Financial Development Made the World Riskier?” Raghuram Rajan (2005).
- “Cash and the Economy: Evidence from India’s Demonetization,” Gabriel Chodorow-Reich, Gita Gopinath, Prachi Mishra, and Abhinav Narayanan (2019).
- “Why Larry Summers Is the Economist Everyone Hates to Love,” Freakonomics Radio (2017).