Raghuram Rajan, an Indian born professor at the University of Chicago’s Booth Graduate School of Business, predicted the crisis in 2005. He was the “Economic Counsellor and Director of Research” (Chief Economist) at the International Monetary Fund from September 2003 until January 2007. In 2003, he was also the inaugural recipient of the Fischer Black Prize awarded by the American Finance Association for contributions to the theory and practice of finance by an economist under age 40.
It was August 2005, at an annual gathering of high-powered economists at Jackson Hole, Wyo. – and that year they were honouring 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 chose that moment to deliver a paper called “Has Financial Development Made the World Riskier?” His answer was – Yes. Mr. Rajan quickly came under attack as an anti-market Luddite, wistful for old days of regulation. 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.” Today, however, few are dismissing his ideas.
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.
The problem is that in a boom everybody thinks they’re brilliant. Central bankers think they have skilfully delivered inflation-free growth; the finance sector thinks it is brilliantly making profits; home-owners think they have shrewdly timed the market; politicians don’t like to rock the boat. Naysayers are ignored and history is repeated!