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

Every year, the Federal Reserve Bank of Kansas City, one of the 12 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 the 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.

Prime Minister Manmohan Singh. Image courtesy PIB

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 Chief Economist at the International Monetary Fund.

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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 percent 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 percent every year over the next 10 years.This meant that a house which cost a million dollars in 2005 would cost around $7.3 million 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 sub-prime home loan space gave out loans worth $1.7 trillion in total. Of this a massive $625 billion was lent in 2005, the year Rajan was invited to speak at Jackson Hole.

In its strictest sense, a sub-prime 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 fuelled 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 rich rewards for making money but were only penalised 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 after spending nearly 18 years as the Chairman of the Fed. 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 is 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 aone-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's. 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 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 Daily News and Analysis (DNA) after the release of his book Fault Lines I had asked him "whether India can afford a welfare state?"

His reply: "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 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 another question Rajan had said:

"The predominant 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 space, it won't take much time for the government to marginalise him. If he does not, he won't be effective anyway.

Vivek Kaul is a writer and can be reached at vivek.kaul@gmail.com