Monetary Policy And The Indian Economy With Raghuram Rajan (Former Governor Of Reserve Bank Of India)

>> Jon Hartley: This is the Capitalism and Freedom, the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I'm Jon Hartley, your host. Today my guest is Raghuram Rajan, who's a professor of finance at the University of Chicago Booth School of Business.

 

He previously served as the 23rd governor of the Reserve bank of India, is the chief economic advisor to the government of India under Manmohan Singh, and chief economist of the IMF. Raghu is also a very acclaimed academic. In 2003, he received the inaugural Fisher Black Prize, which is given every two years by the American Finance Association to the financial economist younger than 40, who has made the most significant contributions to the theory and practice of finance.

 

And also in the 2000s, he famously predicted the global financial crisis. Welcome, Raghu.

>> Raghuram Rajan: Pleased to be here.

>> Jon Hartley: I wanna first talk about your background. You grew up in India. How did you first get interested in economics? And what was your path to doing a PhD at MIT?

 

>> Raghuram Rajan: Well, I think when you're in a poor country. My father was a diplomat, so we had spent some time in Europe. And when I came back to India, the first thing that hit me was how little there was in the shops. Milk was rationed, bread was rationed.

 

You had to essentially make friends with the shop owner to get half a loaf of bread. And you wondered why this was the case. Why was it that we were poor? I mean, the people I met at school weren't any less smart than the people I had been at school with in Belgium.

 

And so the desire to know more about that, to do something about that, was ingrained from that early age. Of course, in the middle, I wanted to be a fighter pilot and all. The other fun stuff that young boys want to do. But as I graduated from school, I think what many Indians do is they sit for a very competitive exam to enter the IITs.

 

And I'd studied a lot and sunk cost fallacy. Once I'd studied, I thought I should take a degree in engineering. That seemed like a sure way to get a job. And job security is quite important. So I went to one of the IITs somewhere in the middle of my third year.

 

I said, what the hell am I doing here learning fields and waves. I just can't connect to that. And that sort of caused a slow movement away from engineering to first management degree, and then eventually the PhD, which was at Sloan. So it was a management PhD, but in finance, and I took a lot of classes in the economics department.

 

So that's how I gravitated towards economics.

>> Jon Hartley: Well, that's fascinating. And I want to drill down into some of your research. You've done a lot of really seminal work on banking, a lot of it with Doug diamond, who recently won the Nobel Prize. What have been some of the biggest findings from your research in banking and what do you think has held up best over the years?

 

>> Raghuram Rajan: Well, I think that perhaps the most important finding is the one that we're still battling people on, which is the notion that there's a purpose behind the structure whereby banks are financed with short term debt and lend long. This mismatch is not just because you want to give people access to liquidity, which is what Doug focused on in his early work, but also because it may well be a very effective form of governance.

 

Not so much that the short term deposit holders are sort of monitoring your every move and they know more than the market or they know more than the board. By the way, bank boards are typically relatively clueless about what's going on in the bank apart from what the CEOs tell them.

 

But it's really that it's a very effective punishment mechanism if the banks trace. If you go off track and you can't actually make payments, you get closed down immediately. That's the bank run. And so it's an effective punishment mechanism which doesn't really require anybody to monitor, apart from just making sure they test the bank periodically.

 

Somebody's testing it always, saying I want my money, and if as soon as the bank can't deliver it, it gets closed down. This to my mind explains the structure of banks for 5,000 years. It's not that in Babylon banks had interest tax deduction and therefore they had the structure, or in Italy, it's that it's a very effective punishment device.

 

Of course, augmented in Barcelona, if you defaulted on your debt, you were put on a diet of bread and water until you delivered to your creditors, and if you didn't past a certain time, you were executed, you had your head lopped off. I think that added to the kind of punishment mechanism.

 

But I think if you look at the free banking era, you look at every era of banking. Yes, the short term claim offers liquidity services, but it's also a punishment device. And both are critically important to how a bank works.

>> Jon Hartley: I know there's also the debtors prison era as well.

 

It's fascinating these different time periods and yet in banking, I mean, the purpose of banking serves maturity transformation. And certainly, banking I think is certainly undergo a massive rethinking since the global financial crisis. I wanna talk a little bit about the global financial crisis. Obviously there's been a lot of discussion about regulation.

 

Since then, there's been Dodd-Frank, Basel III capital requirements that have been imposed throughout the world. I mean, you famously predicted the buildup in mortgage credit ahead of the global financial crisis with 2005, now famous Jackson Hole speech, which I think then in 2005 was much maligned but later vindicated after the global financial crisis of 2008, 2009.

 

And what led you to that insight in 2005? And I know a lot of this is encapsulated in your book Fault Lines, but what led you to think about that maybe that there's excessive mortgage credit in the system and that that could potentially be a systemic concern?

>> Raghuram Rajan: Well, to some extent it was academic perversity.

 

I was the chief economist of the IMF at that point and I was asked to speak on this occasion. And it was Alan Greenspan's last hurrah as chairman of the Fed, and he had given some memorable speeches at Jackson Hole. Everybody was waiting to hear his last speech.

 

But also there were a parade of people sort of saying he was such a great central banker. And there was some debate as to whether he was the best US central banker in history or just a second best. And you know, in this I, I sort of thought initially of writing a piece and how, how all the developments that had happened during his time, including liberalization, et cetera.

 

But then as I started looking at the data, I said, well, wait a minute, there's all this risk in the system and there's a real question of where it's gone. Because suddenly the system doesn't seem to be that bothered about risk anymore. Where really has it gone if the banks aren't taking risk?

 

Who is taking risk? And how are the banks making money if they're not taking any risk? The conclusion I came to after thinking about it a bit was really that the banks were taking tail risk and getting paid for it without the risk showing up. What that meant was just like insurance companies, you get a premium but you know, they're taking risk and they know they have to pay out, right at some point.

 

Well, the banks were taking the risk, getting the premier looking really profitable, but when the day came to pay out, they might look really bad. That was the underlying sort of idea behind that talk. And then I documented the various ways they were taking this tail risk. And then the question was, which was the real important question at that time?

 

Why are the smartest guys on the planet doing this? And the pushback I got was precisely that, these are the smartest guys on the planet. They figured it out. They probably hedging it appropriately and you know, you're surmising that the risk is with them. They've laid it off, it turned out they hadn't.

 

It turned out, I mean, just as I conjectured that they were all taking these tail risks on their balance sheet and when push came to shove, they could not get rid of the stuff and it took the biggest amongst them down. One clear example I gave in that talk was credit default swaps, which are as close to insurance when you write them, you're insuring bonds and loans against default and saying pay me a premium and I will come in to pay it off if the bonds default.

 

AIG had written a ton of these and AIG was thought of as a really spectacularly good credit risk. And then suddenly, it blew up during the global financial crisis because it had taken these tail risks. So, I guess I was lucky because what I had conjectured actually worked out.

 

I was obviously not happy that it happened, but I was relieved that I didn't have my, you know, hang, I didn't have to hang my head in, in shame for the rest of my. I remember Leaving home at that point to go to the conference and telling my wife, this will either make me or break me.

 

Because I was the chief economist of the imf. So people did pay a little bit of attention. But of course, since what I said wasn't very popular, there's very little reporting of it in the press. After I gave that talk, despite, as I said, the position that I held, it was not popular.

 

And then things happen.

>> Jon Hartley: I think Larry Summers had, I think, famously made some comments, I think maybe calling you a Luddite or something like that. It's amazing to think how much has transpired since then and in the aftermath of the global financial crisis. I want to talk a little bit more about your amazing career in policy.

 

You had this first big policy job as a chief economist of the IMF. I'm curious, what did that teach you and how did it come about exactly in the early 2000s?

>> Raghuram Rajan: Well, I was a financial economist, as you've noted, and it turns out that the IMF was looking for a financial economist at that time.

 

After the East Asian crisis, they recognized that there are a lot of macro economists and people who knew the real sector side, but very few who were familiar with the financial sector and I had been friendly with Anne Krieger, who was the first deputy managing director at that point.

 

She called me up and said, would you like to try out for chief economist? Our current chief economist, Ken Rogoff, is leaving. And I was really surprised because I didn't think I belonged in the imf. I was not a macroeconomist, and I thought, if anything, I would be a better fit for the World bank as a financial development economist rather than a macroeconomist.

 

So I told Ann, let me confess, I don't know any macroeconomics. And she said, well, that makes two of us. And that sort of sealed it, if she could, she's obviously a great trade economist and knows everything there is to know about macroeconomics. But it sort of gave me the sense that she would be supportive, as I learned.

 

And, you know, I had done the regulation courses, I mean, the required courses at mit. I had done a macro class with Olivier Blanchard, one of the great teachers there but this, I said, fine. And it turns out that macro, at least as is practiced in policy circles, is not that difficult to pick up.

 

As a colleague of mine said, the only thing you have to know is which variable to pick as the exogenous variable. Everything is endogenous. So different people have forever debates on what's Exogenous. As you know, we have a debate right now as to whether the US Trade deficit is driven by everybody in the world wanting US Financial assets and therefore forcing the US to run a trade deficit or.

 

Or the US Running a large fiscal deficit and therefore overspending relative to the savings. This debate will go on forever because it's everything's endogenous in macroeconomics.

>> Jon Hartley: Yeah, everything is endogenous, that's absolutely right. Yeah. It's fascinating that you say that, I think, yeah, macro is definitely a very theoretical discipline within the academy.

 

But I think it's interesting, once you sort of get into the policy world, it ends up being a lot of empirical macro things that I think are perhaps of most interest. And I'd say that's probably true with respect to macro on Wall Street and finance as well, to some degree.

 

I want to talk just a little bit about your time as a policymaker in India. You served as chief economic adviser to the government of India under Mohan Singh, Singh just recently passed. What do you think the Singh economic policy legacy is?

>> Raghuram Rajan: I think it's actually a very important one in the sense that he came in when India was in crisis.

 

Had gone to the IMF. And he decided, I mean, he was the old traditional sort of Indian economist. He'd been to Cambridge but had studied with people like John Robinson. I think he was more of the old interventionist school, but he knew what the alternatives were. And he had spent a lot of time in India in various policy, wearing various policy hats and he knew the system wasn't working.

 

So in a sense he was an insider willing to bring outside thoughts and he really went about liberalization. He had a very supportive Prime Minister, Narasimha Rao, but as Finance Minister he really created a revolution. And you know, he was one of the, it's not clear that there were that many establishment economists in India at that point willing to take the risk and be out there.

 

And he did. We forget now, we sort of think this was easy, but it required a, a tremendous, tremendous courage and a willingness to, you know, to embrace the unknown. He did it, it worked. And now of course, everybody sort of thinks it was a piece of cake.

 

It wasn't. And you know, he was a very mild mannered man, very mild mannered. You'd walk into a room and everybody would be speaking, but the Prime Minister, when he was Prime Minister would not. He listened, and then you realize he's actually been paying attention and he knows what's what.

 

>> Jon Hartley: It's amazing. And for our listeners that aren't really familiar with Manmohan Singh and his legacy, I mean, he serves Finance Minister in the early 90s in the Rao government. And was really the central advocate for what's now referred to as the Rao reforms. And this is a period of economic liberalization that was followed by a massive surge in economic growth in India.

 

And it's a fascinating story in of itself. And we'll talk a little bit more about growth in India in a minute. But you also want to just talk about inflation for just a moment. I mean, in monetary policy, you were the 23rd governor of the Reserve bank of India.

 

I mean, what is the history of inflation and central banking in India? And how did your tenure change that?

>> Raghuram Rajan: So I, again, this is Dr. Manmohan Singh's foresight. He was very good at bringing people in from the outside. And he had brought a number of economists from the World Bank, from various Washington organizations back to India to help with reforms.

 

One of which was his strong ally, Dr. Montec Singh Alawalia. But what Dr. Manmohan Singh asked me to do was to write a plan for financial sector reforms. This was after I had served as IMF chief economist, and it was sort of a fascinating sort of task. What all would we change if we had a free hand?

 

And I wrote that report, gave it to him and it sat on a shelf. But he then invited me to be chief economic advisor. That was in a sense a trial to see that I wasn't nuts in some way. And then I was brought in as governor of the Reserve Bank.

 

India was going through the taper tantrum at that time, so a lot of turmoil. The currency had plummeted 25% and because we were subsidizing the price of oil and oil prices were denominated in dollars, that meant the fiscal deficit blew out very quickly. So everything bad was happening.

 

Inflation was double digits, the currency was going through the floor and the fiscal deficit was not good and didn't look good. And I came in and my thought was we need to chalk out an agenda which builds some confidence in markets. So on the first day after I took over, I gave a speech to TV which basically said here are the steps we're going to take.

 

Many of them from that report I had done, which included liberalizing bank branching, etc., etc. But also importantly saying we're gonna move towards inflation targeting. I've asked the deputy governor to chalk out the steps we need to do to move towards that. A whole bunch of steps in terms of reforms were announced on that first day.

 

I think that helped build some confidence that we were back on a reform path. And over time the exchange rate came back to something like normalcy. But importantly, and this is what my Latin American Central bank governor friends had told me, forget about the exchange rate, worry about inflation and say you're worried about inflation and that's going to be key to stabilizing everything.

 

And that's what we said. We said we're on an inflation glide path. We are going down to this level in the space of two years. Here are the intermediate targets. Once we get there, we'll move into full fledged inflation targeting. I don't know how it worked, but it worked.

 

By the time I left, we were in the middle of the band, which was 2 to 6%, which is around 4. We'd started at double digits. And we had signed the pact with the government for inflation targeting.. And the committee was met just after I left for the first time, so that was some success.

 

And it stayed largely within the band over the last few years, including in difficult times like the post Covid inflation around the world. And right now it's again trending towards the midpoint of 4. So I think it's been very. People have done studies on it, it's been very successful in bringing inflation down to approximately where it should be.

 

What was important is that we established credibility by not being overly ambitious. So we had this glide path to get into the band, and I didn't want to announce inflation targeting until we were in the ban and were confident we could remain there. And that was what was important to establish credibility.

 

If we had announced inflation targeting and found we had no way of being in the band, then we'd have diminished credibility totally. So it was a process, but I think it'll serve India well.

>> Jon Hartley: It's fascinating, bringing inflation targeting into India is a huge accomplishment. And interesting that at some level, how you needed to have a sort of a glide path and that it needed to be something of a gentle evolution rather than a swift revolution.

 

And that is interesting to think about, I guess these sorts of, you know, political economy sort of constraints even when we sort of may have the right idea of what the optimal policy thing to do might be from an economic policy standpoint. I want to talk just a little bit about growth.

 

India is still a poor country, GDP per capita in India today is around $2500 U.S, this is about 5x of what it was in 2000, about eight times what it was in 1991 when the RAO reforms began. What do you think about say the Modi BJP government's attempts to further say, a pro business agenda that perhaps began with the Congress rousing reforms in the early 1990s.

 

What do you think right now needs to be top of mind as it relates to pro growth India economic policy?

>> Raghuram Rajan: I think what we need to do is try and figure out what makes sense in an environment where automation is making it very difficult to create a lot of manufacturing jobs, where there is potential impending automation also in services through AI and so on, which is coming down the line.

 

Where most of the big markets are turning protectionist in some way, especially for manufactured goods. Everybody has some sort of manufacturing fetishism, sort of embedded we need to produce stuff because all the other things that we do are sort of ephemeral, not real production. You know, it's the old, what was it, the scholastic view that's come back.

 

>> Jon Hartley: Or something, the mercantilist view or, I don't know.

>> Raghuram Rajan: Well, mercantilist on the protectionist side, but on the notion that the only real sort of activities or venerable activities are making things or growing things, agriculture and manufacturing and everything else is a scam, especially finance. Trading also is a semi scam, but finance is the biggest scam of all.

 

Those used to be notions way back but I think that in an environment where it's getting more protectionist and of course in an environment where China is still finds it very hard to get away from manufacturing and has a huge presence there in that environment, where is the space for India to grow?

 

And what I have been arguing is trying the old export led manufacturing growth path is going to be much more difficult and it's not going to create the kinds of jobs that India needs and we need a different growth path. And what I've been advocating in my recent book Breaking the Mold is a focus on service, high Skilled services for the export sector, generating the kinds of foreign exchange revenues you need, but also moderate skilled services focused at the domestic market, which India has a big, big one.

 

In order to create more jobs, obviously you take what manufacturing you can get and you do whatever value added agriculture you can get. Agriculture still accounts for a significant portion of Indian jobs, but for the modern sector it may have to be more of an emphasis on services, both high skilled and moderately skilled, rather than on manufacturing.

 

And it's not just a problem for India. You see, Indonesia also struggling to create middle class jobs. You see, China now struggling to create jobs for youth. That manufacturing led growth path is showing its age in a world where so many other things have changed. And I think we need a growth path for this new world.

 

And that's what I've been trying to push. The government is entirely focused on building a manufacturing sector in India and they also suffer a little from manufacturing fetishism. If we're not manufacturing anything, what are we really doing? And so they're plying the sector with subsidies and so on.

 

But I worry that this is not effective job creation. And if you look at the numbers over the last 10 years, in fact, look at the last five years, writing off the first five years as a learning phase. In the last five years, manufacturing has actually created fewer jobs than its share of the economy.

 

Services also hasn't done that well, because what really has picked up is agriculture, which is extremely worrisome in a country which is developing. The Arthur Lewis kind of model would say, you first drain the agricultural sector of workers. And in many modern economies it's 5%. In India, it's still a significant number.

 

53% of jobs in the last five years were in agriculture. And that's not.

>> Jon Hartley: There's been that big of a pickup in agriculture.

>> Raghuram Rajan: Not so much a pickup in agriculture as a lack of jobs in the other sectors. So people stay at home in their villages or have gone back to their villages into, you know, overcrowded farms.

 

It's not that the farm sizes are that big to afford everyone a livelihood. And so it's actually a sign that we're not producing enough good jobs.

>> Jon Hartley: Interesting. That's fascinating. And for our viewers here, definitely recommend checking out Rajan's book, Breaking the More India's Untraveled Path to Prosperity.

 

It's fascinating just to think about economic growth in India and elsewhere and all these market reforms that transpired over the late 20th century and there's a paper by Andre Schleifer that sort of describes this period as the age of Milton Friedman. And it's interesting to think about the legacy of many of these market reforms now, many years later, and some of the effects of of these things.

 

It's a research interest of mine that I think is very interesting and some of these microforms, obviously, are somewhat more controversial than others. But it's something that I think began in the 70s and 80s and really touched many, many countries. And now we're in a world where growth looks very different than it once was.

 

But there's still even though there has been a considerable amount of convergence in maybe the past, in the couple decades leading up to Covid, I think it's not totally clear that we're still on a path to convergence in the post Covid years here. I want to talk just a little bit about an old book, actually, that you wrote a book in 2003.

 

Titled Saving Capitalism from the Capitalists you wrote with Luigi Zingales. I'm curious, 20 years later, how do you think it's held up? And you've written quite a bit recently on this topic of riskless capitalism. I'm curious what you mean by that.

>> Raghuram Rajan: So we wrote that book worried about cronyism and saying that both George Stigler and Karl Marx were worried about the same thing, business being in bed with the government.

 

And if there was a problem with capitalism, it was primarily that working to both stifle competition but also promoting authoritarianism. When they were in bed together, of course they had very different solutions. Stigler's solution can be caricatured as get rid of the government. And Karl Marx was get rid of the business and let government run everything.

 

They're caricatures, but I think that the problem still remains. And we're seeing it in the United States today, that big business being very, very closely in bed with government on so many dimensions. We're also seeing the revival of industrial policy where government decides it has all the foresight needed to pick winners.

 

And you know, coming from a country, Luigi coming from Italy, I coming from India, where we saw the dangers of these kinds of policies, we were trying to argue in that book that that one, it was very problematic when that happened. And second, that the only surefire way of creating a pro-competitive environment was openness, including trade openness.

 

It was competition from the people you don't control that keeps cronyism under check because you know so long as you're open or forced to be open, your people have to compete with the rest of the world. Of course we were aware, but we didn't anticipate the extent to which there would be a movement to closing down the borders and to protect.

 

Given how we had seen how bad that could be in our economies, we thought the US would not move in that direction. We certainly there have been other forces which have moved us in that direction. I think primarily the force of technology. Technological change, as always, has been huge.

 

And people blame the loss of middle-income jobs to globalization. But as you know, most economists would say the bigger factor is technological change and that's killed a lot of middle income jobs, creating the reaction. And that reaction to some extent has been deflected towards globalization. I think globalization bears only part of the blame.

 

And what we've done as a result is created the environment where everything closes down. And that I think will serve us very, very poorly.

>> Jon Hartley: When you write about riskless capitalism, I'm curious, what do you think about bailouts? And not just bailouts per se, but I think thinking back to 2008 and sort of the pre 2008 era versus the post, I think there is a greater reflexivity on the part of policymakers to intervene, whether it's more quantitative easing or whether it's some sort of like, you know, say, dovish monetary policy signal, if there's some sort of disruption in financial markets.

 

>> Raghuram Rajan: Yeah, I mean-

>> Jon Hartley: Right, say the put, the Powell put, you name it, or even when you think the 2020, 2021 response. It seems to me like it's trying to not only put out all fires, but prevent any fires from possibly ever coming up again. And I don't know if that's something that I think sort of at some level there has to be some fires, there has to be some risk taking.

 

That's just part of the nature of capitalism, part of the economy. I'm curious, do you think there is a moral hazard risk there?

>> Raghuram Rajan: So there are two kinds of riskless capitalism, right? One is where you take out the capital upfront, which is practiced by a number of entrepreneurs across the world, and you run the enterprise on somebody else's money, right?

 

A second related, you run it on a very thin layer of equity. But you also depend a lot on public intervention to bail you out when things go wrong. I think that the west suffers more from the latter right now that risk taking. And I would say, when I say the West, I think Europe is much more concerned about the downside risks and tends to regulate in such a way that you really also eliminate the upside.

 

But it's perfectly willing to intervene when, despite all the regulation, bad things still happen. I think in the US there's more of a tolerance for downside risk in the hope that it will create some upside. So for example, the willingness to let crypto currencies run wild without regulating them, hoping that maybe there's some technological development there which makes us all better off.

 

But I think the flip side of this is that the US has become much more willing to intervene in order to protect the broader mass of people against the downside. And some of this may have to do with also the fractures in society that we see that people are angry as it is and you don't want them to get much angrier.

 

So we saw the repeated sort of transfers to households, but also to small firms during the pandemic. And some of those transfers to small firms went straight back to their banks. And so the banks which should have taken a hit because of, you know, bad stuff happens occasionally.

 

Actually saw their loan losses go down during the pandemic. And we also saw 2023, March 2023, perhaps the most expensive bank crisis in terms of assets that failed over 900 billion. But also hugely important in the extent of intervention. Effectively, the Fed and the treasury combined to say all uninsured deposits are now insured.

 

And when that happens, as you correctly put does suggest to people who signed up to a contract that they would take the risk of putting their money in an uninsured way, that if they did it in sufficient mass, they would all be bailed out. I don't think we've seen the last consequence of all this.

 

The one immediate consequence was the public thought it wasn't a big deal. Nobody is paying attention to the big crisis of 2023. They call it a mini crisis because of the massive intervention that took place. Now what that means is that a bunch of players in the market know that when liquidity gets tight, the Fed will come in with all guns blazing and may alter contracts also in a way as to protect the system.

 

Will Lehman ever happen again? Not if the Fed can help it. Because the lesson from Lehman is never again and not so much. Okay, we need the regulations to make sure that Lehman doesn't really happen. I'm not saying we need a whole lot of new regulations. I'm saying that we need to make sure that we are regulating reasonably given the kinds of interventions that the system has come to expect.

 

Otherwise, this is a one-way street, heads I win, tails the public loses. And that is another version of riskless capitalism that I think we've engendered. Especially for the people taking big bets in the system. Big financial bets in the system.

>> Jon Hartley: Absolutely, yeah, 2023, I think we still don't fully understand what the consequences of it really are in terms of if de facto all deposits are really actually insured versus not.

 

There's still, I think, quite a bit to be figured out in terms of what deposit insurance is and what its limits are in the US. Very fascinating hearing about your thinking around riskless capitalism. And a real honor to have you on Raghu and hear about your career and ideas.

 

Thank you so much for joining us.

>> Raghuram Rajan: Thank you, Jon, it's a pleasure being with you.

>> Jon Hartley: This is the Capitalism and Freedom in the Twenty-First Century podcast, an official podcast of the Hoover Economic Policy Working Group, where we talk about economics, markets, and public policy. I'm Jon Hartley, your host, thanks so much for joining us.