To outline his fears about the U.S. economy, Raghuram Rajan picked a tough crowd.It was August 2005, at an annual gathering of high-powered economists at Jackson Hole, Wyo. -- and that year they were honoring Alan Greenspan. Mr. Greenspan, a giant of 20th-century economic policy, was about to retire as Federal Reserve chairman after presiding over a historic period of economic growth.
Mr. Rajan, a professor at the University of Chicago's Booth Graduate School of Business, chose that moment to deliver a paper called "Has Financial Development Made the World Riskier?"
His answer: Yes.
Mr. Rajan quickly came under attack as an antimarket Luddite, wistful for old days of regulation. Today, however, few are dismissing his ideas. The financial crisis has savaged the reputation of Mr. Greenspan and others now seen as having turned a blind eye toward excessive risk-taking.
He says he had planned to write about how financial developments during Mr. Greenspan's 18-year tenure made the world safer. But the more he looked, the less he believed that. In the end, with Mr. Greenspan watching from the audience, he argued that disaster might loom.
Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly.
He pointed to "credit-default swaps," which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred.
Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said: "The interbank market could freeze up, and one could well have a full-blown financial crisis."
Two years later, that's essentially what happened.
Many of the big names in Jackson Hole weren't ready to hear the warning. Former Treasury Secretary Lawrence Summers, famous among economists for his blistering attacks, told the audience he found "the basic, slightly lead-eyed premise of [Mr. Rajan's] paper to be misguided."
You know Larry Summers, the widely-hailed economic wise guy who is helping to lead Obama's economic team. Because the Democrats are going to be so very different at managing the economy than the Wall Street-worshiping Republicans (he said, sarcastically).
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I agree that there is too much vulgarity out there, but, if used sparingly, it can be an effective way to get a point across. (The problem is that too few people understand the concept of "sparingly".)
I'm reminded of an article I read once on slate.com, in which the writer was suggesting -- seriously -- that the two greatest contributions of the British Empire to global civilization were the game of soccer (or "football, if you prefer), and the word "f*ck".
Add one more feather of failure to Mr. Greenspan's hat: too easy credit. The price of credit, from 2003 or 2004 forward, should have been much higher than it actually was. When you add a regulatory environment that overregulated in a few areas, while ignoring the creation and trading of ridiculously-conjured derivative securities, the circle is complete.
Great article. There were others that warned about the need to regulate credit default swaps (CDS). In the mid to late 90s, Ms Born, Chairman, CFTC wanted to regulate CDSs, but Summers, Rubin, and Greenspan ruined her reputation with harsh attacks.
Law Professor Michael Greenberger, former CFTC Director has been quoted in a large number of articles about the need to regulate. An interesting statement, "Do we want the US economy based on gambling or producing something of value." He predicted the bank failures since at least last spring. He also told Congress that the price of gas would go dowm about $40 to $60 a gallon if the speculators were controlled. He under estimated the amount gas would go down.
Greenspan told Congress he was wrong. I would like to hear Summers say the same.
Part of the issue was lack of proper regulation and way too much risk ( I see this crisis as being multifactorial). Part of the problem was also the lack of enforcement of existing standards and laws. Suppose Moody's and the other ratings agencies had done their job properly. Would we still be here?
Steve
steve
Part of the issue was lack of proper regulation and way too much risk ( I see this crisis as being multifactorial). Part of the problem was also the lack of enforcement of existing standards and laws. Suppose Moody's and the other ratings agencies had done their job properly. Would we still be here?
What are you talking about, 'do their job properly'?
They were paid to rate bonds, in exchange for money. They did so, they got paid, case closed.
I always get confused when people imply that other people, who got paid for their work, didn't do their job properly. I'm pretty certain that what those people considered their job was 'produce something, doesn't matter what, as long as they can get paid for it'. As they did get paid for it, obviously they are, in fact, doing their job, by definition.
This is what happens when employment is not actually based on results.
Of course, the actual solution to this is some very quick and very hard lawsuits, like the ones the Teamsters have going. I'd actually like to see the corporate death penalty for said companies.
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