When Raghuram Rajan proved giant Alan Greenspan wrong

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Ten years ago, on this day, Lehman Brothers filed for bankruptcy and triggered a global financial crisis that destroyed thousands of jobs and brought down several big financial institutions. So strong was the belief in the infallibility of the market that few could see the crisis coming. One of those few was Raghuram Rajan, who later became the RBI governor. Three years before the crisis, Rajan had warned one of the men held responsible for the financial crisis, Alan Greenspan.

Greenspan, the chairman of Federal Reserve of the United States from 1987 to 2006, had built a formidable reputation as the presiding deity of a long boom the US economy had undergone. A disciple of Ayn Rand, he swore by laissez-faire policies and gave a free run to markets and unleashed growth. But his reputation lay in tatters when the financial crisis struck the US in 2008. Time magazine put him at the top of a list of “25 people to blame for the financial crisis”.

“The super-low interest rates Greenspan brought in the early 2000s and his long-standing disdain for regulation are now held up as leading causes of the mortgage crisis. The maestro admitted in an October congressional hearing that he had “made a mistake in presuming” that financial firms could regulate themselves,” wrote the magazine.

Three years before the financial crisis struck, Greenspan and his gang were dismissive of a warning sounded by a man who was then a pygmy compared to giant Greenspan. Rajan, then the chief economist at IMF, was the only party pooper at a mega event held in the honour of Greenspan in 2005 when he was about to retire as the Fed chairman. Rajan was there to present a paper ominously titled ‘Has Financial Development Made the World Riskier?’

“He says he had planned to write about how financial developments during Mr. Greenspan’s 18-year tenure made the world safer,” says a report in The Wall Street Journal. “But the more he looked, the less he believed that. In the end, with Mr. Greenspan watching from the audience, he argued that disaster might loom. 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.”

Rajan predicted a financial crisis. He argued that the financial market had developed to become more complicated and less safe. He said financial instruments such as derivatives like credit default swaps were risky. Former treasury secretary Lawrence Summers told the audience that he found “the basic, slightly lead-eyed premise of [Rajan’s] paper to be misguided”.

“Rajan has written that he left Wyoming [the venue of the Greenspan bash] with some unease—not because of the criticism, but because “the critics seemed to be ignoring what was going on before their eyes”. Several years later, his warning came true: the U.S. market for subprime mortgage securities began to implode in 2007, leading to the global financial crisis,” says an article that appeared in an IMF magazine.

Months after the collapse of the Lehman Brothers, Greenspan admitted at a Congressional hearing his policies were wrong. “For years, a Congressional hearing with Alan Greenspan was a marquee event. Lawmakers doted on him as an economic sage. Markets jumped up or down depending on what he said. Politicians in both parties wanted the maestro on their side. But on Thursday, almost three years after stepping down as chairman of the Federal Reserve, a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending,” wrote The New York Times.

That was the time when Greenspan might have remembered a certain professor of finance telling him three years ago at a bash held in his honour that the financial crisis was in the making.

Source: Economic Times