Raghuram G. Rajan

Raghuram Govind Rajan is one of the few economists who correctly warned about the 2008 financial crisis. He was the Chief Economist for the International Monetary Fund from 2003 to 2006. He is now the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business. Rajan is also an economic adviser to the Prime Minister of India.

In 2005, Dr. Rajan correctly pointed out how structural flaws in the economy would lead to financial crisis. He presented a paper entitled "Has Financial Development Made the World Riskier?" at the annual Economic Policy Symposium of central bankers. This was at the height of the housing market bubble, when then-Federal Reserve Chairman Alan Greenspan's expansive monetary policies could do no wrong. Rajan confronted the wisdom of the times and predicted crisis when no one wanted to hear it.

Now, Rajan warns these imbalances have not been addressed, despite new regulations such as Dodd-Frank Wall Street Reform Act, and fiscal policies to reduce sovereign debt, and that they could cause the next financial crisis.

Rajan had planned to present at the Symposium an analysis of how derivatives and other financial innovations lowered risk. Like everyone else, he thought that banks shed risk by selling their mortgage-backed securities and collateralized debt obligations to investors on the secondary market.

Instead, he found that banks were holding onto these derivatives to boost their own profit margins. He warned that, if an unexpected "black swan" event occurred, banks' exposure to these derivatives could cause a crisis similar to the LTCM hedge fund crisis, and for similar reasons. Rajan pointed out, "The inter-bank market could freeze up, and one could well have a full-blown financial crisis."

The audience scoffed at his warnings, and then-Harvard University President and economist Lawrence Summers called Rajan a Luddite. However, Rajan's prediction is exactly what happened two years later. (Source: Economic Times Economist Raghuram Rajan Risked Reputation to Predict Credit Crisis, June 9, 2010)

Dr. Rajan points out in that the economic fault lines that created the financial crisis still threaten the world economy. He warns, "We risk going from bubble to bubble." These fault lines are :

1. Political response to income inequality in the U.S. - Many politicians continue to push easy credit so Americans can buy a better standard of living. Instead, they should focus on educating those without college degrees, who suffer more from unemployment. These now include the structurally unemployed and older workers.
2. Trade imbalances - China and other emerging markets rely on U.S. demand to fuel export-driven growth. They buy U.S. Treasuries, keeping interest rates low and protecting Americans from the consequences of too much debt.
3. Financial reward systems - Banks still pay and promote managers for generating above-average returns, which can only gotten by taking on additional risks. The costs of those risks are spread throughout the economic system, and are ultimately born by taxpayers through government bailouts.

Rajan became the IMF Chief Economist at 40. At the time, it was seen as a big gamble for the IMF, since Rajan was a finance expert, not a classically trained economist. The Fund had been highly criticized for its role in the 1997 Asian currency crisis, the Russian default which helped cause the LTCM hedge fund crisis, and the sovereign debt crises in Brazil and Argentina.

Economist Joseph Stiglitz, then chief economist of the World Bank, criticized the IMF for stifling the economic growth of the countries it was trying to help by enforcing strict measures designed to cut back their debt burden. Unfortunately, these measures -— raising interest rates, removing controls on capital and cutting deficits -- impeded the very growth needed to fund debt repayment. This argument is relevant today, since that's exactly what the EU is trying to do to solve the eurozone debt crisis.

Rajan's earlier book, Saving Capitalism from the Capitalists analyzed how free-market capitalism is subverted by lobbyists. They influence the government to deregulate so they can take on excessive risk in the name of global competitiveness. Or, they go the other way, and establish laws to protect their industries. Two examples of this are US tariffs on imported steel, and subsidies to U.S. agribusiness that blocked the Doha free trade agreement.

Dr. Rajan received an electrical engineering degree from the Indian Institute of Technology in Delhi, an M.B.A. from the Indian Institute of Management in 1987, and a Ph.D in economics from MIT. He taught at Chicago's Booth School prior to, and following, his work at the IMF. A few of Rajan's students nicknames him "Frontier Function," which is an economic term that means the cutting edge of maximum value.

Rajan is a senior advisor to BDT Capital, Booz and Co, on the advisory board of Bank Itau-Unibanco's advisory board, and a director of the Chicago Council on Global Affairs. He is on the advisory councils for the Comptroller General of the United States and the FDIC

In 2003, Rajan received the American Finance Association's first Fischer Black Prize for contributions to finance by an economist under 40. He is currently President of the Finance Association, as well as a member of the American Academy of Arts and Sciences. Rajan has been on the editorial boards of the American Economic Review and the Journal of Finance. His book, Fault Lines: How Hidden Cracks Still Threaten the World Economy, won the Financial Times/Goldman Sachs Business Book of the Year award in 2010. He also received the Infosys Prize for Social Science - Economics in 2011.(Article updated January 18, 2012)