What to expect from Raghuram Rajan as RBI governor

ARTS RAJANVivek Kaul
Even the worst governments make some right decisions. The appointment of Raghuram Govind Rajan as the next governor of the Reserve Bank of India(RBI) is one of the few correct decisions that the Congress led United Progressive Alliance(UPA) government has made in the last few years. Rajan, an alumnus of IIT Delhi, IIM Ahmedabad and Massachusetts Institute of Technology, is currently the Chief Economic Advisor of the government of India.
Rajan was the Chief Economist of the International Monetary Fund(IMF) between October 2003 and December 2006. In 2003, he also won the first Fischer Black Prize, which is awarded to the most promising economist under the age of 40, by the American Finance Association. He is also a Professor of Finance at the Chicago University’s Booth School of Business.
So what can we expect from Rajan as the RBI governor? In order to understand we first need to understand what are Rajan’s views on various factors impacting the Indian economy right now, and which he will have to deal with as the governor of the RBI.
Rajan is a firm believer in the fact that high government spending in doling out various subsidies has been a major cause behind India’s high inflation. This clearly comes out in the Economic Survey for the year 2012-2013, which he was in-charge of as the Chief Economic Advisor.
A part of the summary to the first chapter 
State of the Economy and Prospects reads “With the subsidies bill, particularly that of petroleum products, increasing, the danger that fiscal targets would be breached substantially became very real in the current year. The situation warranted urgent steps to reduce government spending so as to contain inflation.”
This is something that he reiterated in a recent column as well, where he wrote “India needs less consumption and higher savings. The government has taken a first step by tightening its own budget and spending less, especially on distortionary subsidies.”
The RBI under D Subbarao has been very critical of the high government expenditure distorting the Indian economy. Rajan’s thinking on that front doesn’t seem to be much different from that of his predecessor.
Also Rajan firmly believes that Indian households need stronger incentives in the form of lower inflation to increase financial savings, which have been declining for a while. As the recent RBI
financial stability report  points out “Financial savings of households…have declined from 11.6 per cent of GDP to 8 per cent of GDP over the corresponding period (i.e. between 2007-08 to 2011-12.”
Financial savings are essentially in the form of bank deposits, life insurance, pension and provision funds, shares and debentures etc. In fact between 2010-2011 and 2011-2012, the household financial savings fell by a massive Rs 90,000 crore. This has largely been on account of high inflation. Savings have been diverted into real estate and gold in the hope of earnings returns higher than the prevailing inflation.
Also people have been saving lesser as their expenditure has gone up due to high inflation. And the financial savings will only go up, if inflation comes down, pushing up the real returns on bank fixed deposits.
“Households also need stronger incentives to increase financial savings. New fixed-income instruments, such as inflation-indexed bonds, will help. So will lower inflation, which raises real returns on bank deposits. Lower government spending, together with tight monetary policy, are contributing to greater price stability,” wrote Rajan in his column.
Given this, the focus of the RBI on controlling ‘inflation’ which continues to be close to double digits (consumer price inflation was at 9.87% in the month of June, 2013) is likely to continue under Rajan as well. Hence, the repo rate, which is the rate at which RBI lends to banks, is unlikely to come down dramatically any time soon.
Lower inflation leading to higher savings will also help in bringing down the high current account, deficit feels Rajan. During the period of twelve months ending December 31, 2012, the current account deficit of India had stood at $93 billion. In absolute terms this was only second to the United States.
The current account deficit(CAD) is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances. Since imports are higher than exports and foreign remittances, the country is spending more than saving.
As Rajan told the India Brand Equity Foundation in an interview “CAD essentially reflects the fact that you are spending more than you are saving. That’s technically the definition of the CAD, which means that you need to borrow from abroad to finance your investment. Ideally, the way you would reduce your current account deficit is by saving more, which means consuming less, buying fewer goods from abroad and importing less. Or, the other way is by investing less, because that would allow you to bridge the CAD. Now we don’t want to invest less. We have enormous investment needs. So ideally, what we want to do is save more.”
And to achieve this “the first way is for the government to cut its under-saving or its deficit and that is part of what we are doing” “The second way is when the public decides to save more rather than spend. We need to encourage financial saving,” Rajan said in the interview.
Given this, Rajan has never been a great fan of subsidies and he looks at them as a
short term necessity. In an interview I did with him after the release of his book Fault Lines – How Hidden Fractures Still Threaten the World Economy, for the Daily News and Analysis(DNA), I had asked him whether India could afford to be a welfare state, to which he had replied “Not at the level that politicians want it to. For example, the National Rural Employment Guarantee Scheme (NREGS), if appropriately done, is a short term insurance fix and reduces some of the pressure on the system, which is not a bad thing. But if it comes in the way of the creation of long term capabilities, and if we think NREGS is the answer to the problem of rural stagnation, we have a problem. It’s a short-term necessity in some areas. But the longer term fix has to be to open up the rural areas, connect them, education, capacity building, that is the key.
This commitment came out in the Economic Survey as well. “
The crucial lesson that emerges from the fiscal outcome in 2011-12 and 2012-13 is that in times of heightened uncertainties, there is need for continued risk assessment through close monitoring and for taking appropriate measures for achieving better fiscal marksmanship. Open ended commitments such as uncapped subsidies are particularly problematic for fiscal credibility because they expose fiscal marksmanship to the vagaries of prices,” the Survey authored under the guidance of Rajan pointed out.
So what this clearly tells us that Rajan is clearly not
a jhollawallah. The last thing this country needs at this point of time is an RBI governor who is a jhollawallah.
Another important issue that Rajan will have to tackle is the rapidly depreciating rupee against the dollar. RBI’s attempts to control the value of the rupee against the dollar haven’t had much of an impact in the recent past. On this Rajan has an interesting view. As he said in an interview to the television channel ET Now “When we have capital either coming in or flowing out, sometimes it is very costly standing in the way. We would rather wait till our actions have the most impact. It would wait till the moment of maximum advantage and then use all the firepower that it has to pushback.”
What this means is that under Rajan the RBI won’t try to defend the rupee all the time. Given this, the rupee might even be allowed to fall further. What Rajan does on this front will become clear in the months to come, but this will be his biggest immediate challenge.
Another factor working in Rajan’s favour is that this is clearly not Rajan’s last job. He is still not 50.
Also, he has a job at the University of Chicago, which he can always go back to.
Given this, it is unlikely that he will make any compromises to help the politicians who have appointed him and is likely to make decisions that are best suited for the Indian economy, rather than help him win brownie points with politicians.
For anyone who has any doubts on this front it is worth repeating something that happened in 2005. Every year the Federal Reserve Bank of Kansas City, one of the twelve Federal Reserve Banks in the United States, organises a symposium at Jackson Hole in the state of Wyoming.
The conference of 2005 was to be the last conference attended by Alan 
Greenspan, the then Chairman of the Federal Reserve of United States, the American central bank.
Hence, the theme for the conference was the legacy of the 
Greenspan era. Rajan was attending the conference and presenting a paper titled “Has Financial Development Made the World Riskier?
Those were the days when the United States was in the midst of a huge real estate bubble. The prevailing economic view was that the US had entered an era of unmatched economic prosperity and Alan Greenspan was largely responsible for it.
In a sense the conference was supposed to be a farewell for Greenspan and people were meant to say nice things about him. And that’s what almost every economist who attended the conference did, except for Rajan.
In his speech Rajan said that the era of easy money would get over soon and would not last forever as the conventional wisdom expected it to.
The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis,” said Rajan.
In the last paragraph of his speech Rajan said it is at such times that “excesses typically build up. One source of concern is housing prices that are at elevated levels around the globe.” 
Rajan’s speech did not go down well with people at the conference. This is not what they wanted to hear. He was essentially saying that the Greenspan era was hardly what it was being made out to be.
Given this, 
Rajan came in for heavy criticism. As he recounts in his book Fault Lines – How Hidden Fractures Still Threaten the World Economy: “Forecasting at that time did not require tremendous prescience: all I did was connect the dots… I did not, however, foresee the reaction from the normally polite conference audience. I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.” 
The criticism notwithstanding Rajan turned out right in the end. And what was interesting that he called it as he saw it. India needs the same honesty from Rajan, as and when he takes over as the next RBI governor.
The article originally appeared on www.firstpost.com on August 6, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

How Obama and Manmohan Singh will drive up the price of gold


Vivek Kaul

‘Miss deMaas,’ Van Veeteren decided, ‘if there’s anything I’ve learned in this job, it’s that there are more connections in the world than there are particles in the universe.’
He paused and allowed her green eyes to observe him.
The hard bit is finding the right ones,’ he added. – Chief Inspector Van Veeteren in Håkan Nesser’s The Mind’s Eye
I love reading police procedurals, a genre of crime fiction in which murders are investigated by police detectives. These detectives are smart but they are nowhere as smart as Agatha Christie’s Hercule Poirot or Sir Arthur Conan Doyle’s Sherlock Holmes. They look for clues and the right connections, to link them up and figure out who the murderer is.
And unlike Poirot or Holmes they take time to come to their conclusions. Often they are wrong and take time to get back on the right track. But what they don’t stop doing is thinking of connections.
Like Chief Inspector Van Veeteren, a fictional character created by Swedish writer Håkan Nesser, says above “there are more connections in the world than there are particles in the universe… The hard bit is finding the right ones.”
The murder is caught only when the right connections are made.
The same is true about gold as well. There are several connections that are responsible for the recent rapid rise in the price of the yellow metal. And these connections need to continue if the gold rally has to continue.
As I write this, gold is quoting at $1734 per ounce (1 ounce equals 31.1 grams). Gold is traded in dollar terms internationally.
It has given a return of 8.4% since the beginning of August and 5.2% since the beginning of this month in dollar terms. In rupee terms gold has done equally well and crossed an all time high of Rs 32,500 per ten grams.
So what is driving up the price of gold?
The Federal Reserve of United States (the American central bank like the Reserve Bank of India in India) is expected to announce the third round of money printing, technically referred to as quantitative easing (QE). The idea being that with more money in the economy, banks will lend, and consumers and businesses will borrow and spend that money. And this in turn will revive the slow American economy.
Ben Bernanke, the current Chairman of the Federal Reserve, has been resorting to what investment letter writer Gary Dorsch calls “open mouth operations” i.e. dropping hints that QE III is on its way, for a while now. The earlier two rounds of money printing by the Federal Reserve were referred as QE I and QE II. Hence, the expected third round is being referred to as QE III.
At its last meeting held on July 31-August 1, the Federal Open Market Committee (FOMC) led by Bernanke said in a statement “The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” The phrase to mark here is additional accommodation which is a hint at another round of quantitative easing. Gold has rallied by more than 8% since then.
But that was more than a month back. Ben Bernanke has dropped more hints since then. In a speech titled Monetary Policy since the Onset of the Crisis made at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, on August 31, 2012, Bernanke, said: “Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
Central bank governors are known not to speak in language that everybody can understand. As Alan Greenspan, the Chairman of the Federal Reserve before Bernanke took over once famously said ““If you think you understood what I was saying, you weren’t listening.”
But the phrase to mark in Bernanke’s speech is “additional policy accommodation” which is essentially a euphemism for quantitative easing or more printing of dollars by the Federal Reserve.
The question that crops up here is that FOMC in its August 1 statement more or less said the same thing. Why didn’t that statement attract much interest? And why did Bernanke’s statement at Jackson Hole get everybody excited and has led to the yellow metal rising by more than 5% since the beginning of this month.
The answer lies in what Bernanke said in a speech at the same venue two years back. “We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial. In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly,” he said.
The two statements have an uncanny similarity to them. In 2010 the phrase used was “additional monetary accommodation”. In 2012, the phrase used became “additional policy accommodation”.
Bernanke’s August 2010 statement was followed by the second round of quantitative easing or QE II as it was better known as. The Federal Reserve pumped in $600billion of new money into the economy by printing it. Drawing from this, the market is expecting that the Federal Reserve will resort to another round of money printing by the time November is here.
Any round of quantitative easing ensures that there are more dollars in the financial system than before. To protect themselves from this debasement, people buy another asset; that is, gold in this case, something which cannot be debased. During earlier days, paper money was backed by gold or silver. When governments printed more paper money than they had precious metal backing it, people simply turned up with their paper at the central bank and demanded it be converted into gold or silver. Now, whenever people see more and more of paper money, the smarter ones simply go out there and buy that gold. Also this lot of investors doesn’t wait for the QE to start. Any hint of QE is enough for them to start buying gold.
But why is the Fed just dropping hints and not doing some real QE?
The past two QEs have had the blessings of the American President Barack Obama. But what has held back Bernanke from printing money again is some direct criticism from Mitt Romney, the Republican candidate against the current President Barack Obama, for the forthcoming Presidential elections.
“I don’t think QE-2 was terribly effective. I think a QE-3 and other Fed stimulus is not going to help this economy…I think that is the wrong way to go. I think it also seeds the kind of potential for inflation down the road that would be harmful to the value of the dollar and harmful to the stability of our nation’s needs,” Romney told Fox News on August 23.
Paul Ryan, Romney’s running mate also echoed his views when he said “Sound money… We want to pursue a sound-money strategy so that we can get back the King Dollar.”
This has held back the Federal Reserve from resorting to QE III because come November and chances are that Bernanke will be working with Romney and Obama. Romney has made clear his views on Bernanke by saying that “I would want to select someone new and someone who shared my economic views.”
So what are the connections?
So gold is rising in dollar terms primarily because the market expects Ben Bernanke to resort to another round of money printing. But at the same time it is important that Barack Obama wins the Presidential elections scheduled on November 6, 2012.
Experts following the US elections have recently started to say that the elections are too close to call. As Minaz Merchant wrote in the Times of India “Obama’s steady 3% lead over Romney has evaporated in recent opinion polls… Ironically, one big demographic slice of America’s electorate could deny Obama a second term as president: white men. Up to an extraordinary 75% of American Caucasian males, the latest opinion polls confirm, are likely to vote against Obama… the Republican ace is the white male who makes up 35% of America’s population. If three out of four white men, cutting across Democratic and Republican party lines, vote for Mitt Romney, he starts with a huge electoral advantage, locking up over 25% of the total electorate.” (You can read the complete piece here)
If gold has to continue to go up it is important that Obama wins. And for that to happen it is important that a major portion of white American men vote for Obama. While Federal Reserve is an independent body, the Chairman is appointed by the President. Also, a combative Fed which goes against the government is rarity. So if Mitt Romney wins the elections on November 6, 2012, it is unlikely that Ben Bernanke will resort to another round of money printing unless Romney changes his mind by then. And that would mean no more rallies gold.
But even all this is not enough
All the connections explained above need to come together to ensure that gold rallies in dollar terms. But gold rallying in dollar terms doesn’t necessarily mean returns in rupee terms as well. For that to happen the Indian rupee has to continue to be weak against the dollar. As I write this one dollar is worth around Rs 55.5. At the same time an ounce of gold is worth $1734. As we know one ounce is worth 31.1grams. Hence, one ounce of gold in rupee terms costs Rs96,237 (Rs 1734 x Rs 55.5). This calculation for the ease of simplicity does not take into account the costs involved in converting currencies or taxes for that matter.
If one dollar was worth Rs 60, then one ounce of gold in rupee terms would have cost around Rs 1.04 lakh. If one dollar was worth Rs 50, then one ounce of gold in rupee terms would have been Rs 86,700. So the moral of the story is that other than the price of gold in dollar terms it is also important what the dollar rupee exchange rate is.
So the ideal situation for the Indian investor to make money by investing in gold is that the price of gold in dollar terms goes up, and at the same time the rupee either continues to be at the current levels against the dollar or depreciates further, and thus spruces up the overall return.
For this to happen Manmohan Singh has to keep screwing the Indian economy and ensure that foreign investors continue to stay away. If foreign investors decide to bring dollars into India then they will have to exchange these dollars for rupees. This will increase the demand for the rupee and ensure that it apprecaits against the dollar. This will bring down the returns that Indian investors can earn on gold. As we saw earlier at Rs60to a dollar one ounce of gold is worth Rs 1.04 lakh, but at Rs 50, it is worth Rs 86,700.
One way of keeping the foreign investors away is to ensure that the fiscal deficit of the Indian government keeps increasing. And that’s precisely what Singh and his government have been doing. At the time the budget was presented in mid March, the fiscal deficit was expected to be at 5.1% of GDP. Now it is expected to cross 6%. As the Times of India recently reported “The government is slowly reconciling to the prospect of ending the year with a fiscal deficit of over 6% of gross domestic project,higher than the 5.1% it has budgeted for, due to its inability to reduce subsidies, especially on fuel.
Sources said that internally there is acknowledgement that the fiscal deficit the difference between spending and tax and non-tax revenue and disinvestment receipts would be much higher than the calculations made by Pranab Mukherjee when he presented the Budget.” (You can read the complete story here).
To conclude
So for gold to continue to rise there are several connections that need to come together. Let me summarise them here:
1. Ben Bernanke needs to keep hinting at QE till November
2. Obama needs to win the American Presidential elections in November
3. For Obama to win the white American male needs to vote for him
4. If Obama wins,Bernanke has to announce and carry out QE III
5. With all this, the rupee needs to maintain its current level against the dollar or depreciate further.
6. And above all this, Manmohan Singh needs to keep thinking of newer ways of pulling the Indian economy down
(The article originally appeared on www.firstpost.com on September 11,2012. http://www.firstpost.com/economy/how-obama-and-manmohan-will-drive-up-the-price-of-gold-450440.html)
(Vivek Kaul is a writer and can be reached at [email protected])

Why gold is not running up as fast as it can…


Vivek Kaul

Gold is on a roll. Again!
The price of the yellow metal has risen 8.5% since August 1 and is currently quoting at $1,735 per ounce (one ounce equals 31.1gram). In fact, just since August 31, the price of gold has risen by around $87, or 5.2%.
Still, the price is nowhere near how high it could go. All thanks to the US Presidential elections, as we will see here.
Today, it is widely expected that the US Federal Reserve (Fed), the American central bank, will soon carry out another round of quantitative easing (QE) — that’s the big reason for the spurt.
QE is a technical term that refers to the Fed printing dollars and pumping them into the American economy.
“Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labour market conditions in a context of price stability,” Ben Bernanke, the current Fed chairman, said in a speech titled Monetary Policy since the Onset of the Crisis at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, on August 31.
Fed chairmen are not known to speak in simple English. What Bernanke said is, therefore, being seen as Fedspeak for another round of easing.
Interestingly, in a speech he made at the same venue two years earlier, on August 27, 2010, Bernanke had said, “We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial. In particular, the committee (Federal Open Market Committee, or FOMC) is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly.”
The two statements bear an uncanny similarity to each other. Bernanke’s August 2010 statement was followed by the second round of quantitative easing, in which the Federal Reserve pumped in $600 billion of new money into the economy.
QE2, as it came to be known as, started in November 2010.
Between August 2010 and beginning of November 2010, gold prices went up by around 9% to around $1,350 per ounce. QE2 went on till June 2011, and by then gold had touched $1,530 an ounce.
No wonder the market is now expecting another round of easing — QE3 if you please.
To be sure, the Fed has been hinting at another round of QE for a while now. At its last meeting, held on July 31 and August 1, the FOMC said in a statement, “The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labour market conditions in a context of price stability.”
Mark the phrase “additional accommodation”, which is a hint at another round of easing.
Gold has rallied 8.5% since then.
But these hints haven’t been followed by any concrete action, primarily on account of the fact Mitt Romney, the Republican candidate against the current US President, Barack Obama, has been highly critical of the Fed’s quantitative easing policies.
“I don’t think QE2 was terribly effective. I think a QE3 and other Fed stimulus is not going to help this economy… I think that is the wrong way to go. I think it also seeds the kind of potential for inflation down the road that would be harmful to the value of the dollar and harmful to the stability of our nation’s needs,” Romney told Fox News on August 23.
Paul Ryan, Romney’s running mate, echoed his views, when he said, “Sound money… We want to pursue a sound-money strategy so that we can get back the King Dollar.”
The theory behind quantitative easing is that with more money in the economy, banks and financial institutions will lend that money and businesses and consumers will borrow. But both American businesses and consumers have been shying away from borrowing. Hence, all this money floating around has found its way into stock markets around the world.
As more money enters the stock market, stock prices go up and this creates the “wealth effect”. People who invest money in the market feel richer and then they tend to spend part of the accumulated wealth. This, in turn, helps economic growth.
As Gary Dorsch, an investment newsletter writer, said in a recent column, “Historical observation reveals that the direction of the stock market has a notable influence over consumer confidence and spending levels. In particular, the top 20% of wealthiest Americans account for 40% of the spending in the US economy, so the Fed hopes that by inflating the value of the stock market, wealthier Americans would decide to spend more. It’s the Fed’s version of “trickle down” economics, otherwise known as the “wealth effect.””
That suggests the economy is likely to grow faster and hence, people aremore likely to vote for the incumbent President.
Given this, Romney has been a vocal critic of quantitative easing, knowing that another round of money printing will clearly benefit Obama.
But Bernanke is unlikely to start another round of quantitative easing before November 6, the day the Presidential elections are scheduled, because he might end up with Romney as his boss.
Currently, most opinion polls put Obama ahead in the race. But the election is still two months away, a long time in politics.
Romney has made clear his views on Bernanke by saying, “I would want to select someone new and someone who shared my economic views.”
This has held back the price of gold from rising any faster.
As such, any round of quantitative easing ensures that there are more dollars in the financial system than before. And to protect themselves from this debasement, people buy another asset — gold — something that cannot be debased.
During earlier days, paper money was backed by gold or silver. When governments printed more paper money than they had precious metal backing it, people simply turned up with their paper at the central bank and demanded it be converted into gold or silver.
Now, whenever people see more and more of paper money, the smarter ones simply go out there and buy that gold.
So, all eyes will now be on Bernanke and what he does in the days to come. From the way he has been going, there will surely be some hints towards QE3 in the next FOMC meeting, scheduled for September 12-13.
(The article originally appeared in the Daily News and Analysis on September 8,2012. http://www.dnaindia.com/money/column_why-golds-not-running-up-as-fast-as-it-can_1738192))
Vivek Kaul is a writer and can be reached at [email protected]

Raghuram Rajan’s advice isn’t what UPA may want to hear


Vivek Kaul

Every year the Federal Reserve Bank of Kansas City, one of the twelve Federal Reserve Banks in the United States, organizes a symposium at Jackson Hole in the state of Wyoming. The conference of 2005 was to be the last conference attended by Alan Greenspan, the then Chairman of the Federal Reserve of United States, the American central bank.
Hence, the theme for the conference was the legacy of the Greenspan era. One of the economists who had been invited to present a paper at the symposium was the 40 year old Raghuram Govind Rajan, the man who is likely to be the government’s next Chief Economic Advisor.
Rajan is an alumnus of IIT Delhi, IIM Ahmedabad and the Massachusetts Institute of Technology (MIT). After doing his PhD at MIT, he had joined the Graduate School of Business at the University of Chicago (now known as the Booth School of Business). At that point of time Rajan was on leave from the business school and was working as the Chief Economist at the International Monetary Fund.
The United States had seen an era of unmatched economic prosperity under Greenspan. Even, the dotcom bust in 2000-2001 hadn’t held America back. Greenspan had managed to get the economy back on track by cutting the Federal Funds Rate to as low as 1% by mid 2003. The low interest rate scenario along with a lot of financial innovation had created a financial system which was slush with money. American banks were falling over one another to lend money. And borrowers were borrowing as much as they could to buy homes, property and real estate. The dotcom bubble of the late 1990s had given away to the real estate bubble.
In a survey of home buyers carried out in Los Angeles in 2005, the prevailing belief was that prices will keep growing at the rate of 22% every year over the next 10 years. This meant that a house which cost a million dollars in 2005 would cost around $7.3million by 2015. Such was the belief in the bubble.
And the belief was not limited to only the people of United States. Banks were equally optimistic that real estate prices will continue to go up. Between 2004 and 2006, banks and other financial institutions playing in the subprime home loan space gave out loans worth $1.7trillion in total. Of this a massive $625billion was lent in 2005, the year Rajan was invited to speak at Jackson Hole.
In its strictest sense a subprime loan was defined as a loan given to an individual with a credit score below 620, who had no assets and was thus unlikely to qualify for a traditional home loan. A credit score is a number calculated on the basis of the borrower’s past record at paying bills and loans of all kinds, the length of his credit history, the kind of loans taken etc. On the basis of the number the lender can get some sort of an idea of what sort of a risk he is taking on by lending to the borrower.
That was the purported idea behind the credit score. In the normal scheme of things, a borrower categorized as “sub-prime” should not have been touched with a bargepole. But those were days when everybody and anybody got a loan.
It was an era of optimism which had been fueled by easy money that was going around in the financial system. The conventional wisdom of the day was that the bull run in property prices would continue forever. The American economy would continue to prosper.
In this environment Raghuram Rajan presented a paper titled “Has Financial Development Made the World Riskier?” In his speech Rajan harped on the fact that the era of easy money would get over soon and would not last forever as the conventional wisdom expected it to.
He said:
The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis
He also suggested in his speech that the incentives of the financial sector were skewed and employees were reaping in rich rewards for making money but were only penalized lightly for losses. In the last paragraph of his speech Rajan said it is at such times that “excesses typically build up. One source of concern is housing prices that are at elevated levels around the globe.
Rajan’s speech did not go down well with people at the conference. This is not what they wanted to hear. Also in a way Rajan was questioning the credentials of Alan Greenspan who would soon retire spending nearly 18 years as the Chairman of the Federal Reserve of United States. He was essentially saying that the Greenspan era was hardly what it was being made out to be.
Given this, Rajan came in for heavy criticism. As he recounts in his book Fault Lines – How Hidden Fractures Still Threaten the World Economy:
Forecasting at that time did not require tremendous prescience: all I did was connect the dots… I did not, however, foresee the reaction from the normally polite conference audience. I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.
The criticism notwithstanding Rajan turned out right in the end. And what was interesting that he called it as he saw it. He called spade a spade despite the aura of Alan Greenspan that prevailed.
What this story clearly tells us is that Rajan is not an “on-the-other-hand” economist. There are too many “on-the-other-hand” economists going around, who do not like to take a stand on an issue. As Harry Truman, an American President once famously said “All my economists say, ‘on the one hand… and on the other hand…Someone give me a one-handed economist!
If news-reports in the media are to be believed the government is in the process of appointing Rajan as the Chief Economic Advisor to replace Kaushik Basu. As far as academic credentials and experience go they don’t come much better than Rajan. Other than having been the Chief Economist of the IMF between September 2003 and January 2007, he is also currently an honorary economic adviser to the Prime Minister Manmohan Singh.
The question though is will the plain-speaking Rajan who seems to like to call a spade a space, fit into a government which believes in the idea of a welfare state? In an interview I did for the Daily News and Analysis (DNA) after the release of his book Fault Lines I had asked him “whether India can afford a welfare state?” “Not at the level that politicians want it to. For example, the National Rural Employment Guarantee Scheme (NREGS), if appropriately done it is a short term insurance fix and reduces some of the pressure on the system, which is not a bad thing. But if it comes in the way of the creation of long term capabilities, and if we think NREGS is the answer to the problem of rural stagnation, we have a problem. It’s a short term necessity in some areas. But the longer term fix has to be to open up the rural areas, connect them, education, capacity building, that is the key,” Rajan had replied.
This is a view that is not held by many in the present United Progressive Alliance (UPA) government. They politicians who run this country have great faith in the NREGS.
Rajan had also written in Fault Lines that “the license permit raj has given away to the raj of the land mafia.” I had asked him to explain this in detail and he had said:
Earlier…you had to navigate the government for permissions and this was license permit. You needed permission to produce. Now you have to navigate the government for land because in many situations land titles are murky, acquiring the land is difficult, and even after you acquire protecting that land is difficult. So there are entrepreneurs who have access to the power of the government, who basically can do it. And then there are others who can’t. So you have made it a test of who can acquire the land in certain kind of functions than who is the best developer than who is the best manufacturer. Put differently what used to surround the license permit has moved to corruption surrounding land. The central source of wealth today in the whole economy is land and we need to make the land acquisition process transparent.
In answer to another question Rajan had said:
The predominant of the sources of mega wealth in India today are not the software billionaires who have made money the hard way by being competitive in a global economy. It is the guys who have access to natural resources or to land or to particular infrastructure permits or licenses. In other words proximity to the government seems to be a big source of wealth. And that is worrisome because it means that those who can access the government who can manage it are in a sense far more powerful than ordinary businessmen. In the long run this leads to decay in the image of businessmen and the whole free enterprise system. It doesn’t show us in good light if we become a country of oligopolies and oligarchs and eventually this could even impinge on democratic right.”
What these answers tell us is that Rajan has clear views on issues that plague India and he is not afraid of putting them forward. But these are things that the current government would not like to hear. Given this, it remains to be seen how effective Rajan’s tenure in the government will turn out to be. The trouble is if he calls a spade a spade, it won’t take much time for the government to marginalize him. If he does not, he won’t be effective anyway.
(The interview originally appeared on www.firstpost.com on August 8,2012. http://www.firstpost.com/economy/raghuram-rajans-advice-isnt-what-upa-may-want-to-hear-410694.html/)
(Vivek Kaul is a writer and can be reached at [email protected] )