Banker Who Predicted 2008 Meltdown Is Worried Again

Back in 2005, Raghuram Rajan, then the economic counselor at the International Monetary Fund, stood up at the annual meeting of prominent economists and bankers at Jackson Hole, Wyo., and gave a presentation that his listeners could never have expected. The global economy was booming, but Rajan argued that increasingly complex markets, which spewed out complicated instruments like credit-default swaps and mortgage-backed securities in ever greater quantities, had made the financial system more vulnerable to collapse.

Rajan’s audience didn’t take him very seriously, but by 2008 his views had proved prophetic. He had all but predicted the sources of the worst financial catastrophe since the Great Depression.

Today Rajan is the governor of the Reserve Bank of India, that country’s central bank–and once more he’s seeing weakness in the global financial system. In an interview with Time in the bank’s Mumbai office, Rajan explained what worries him:

1. Long-term low interest rates are trouble

My sense is that monetary policy can only do so much and beyond a certain point, if you try to use monetary policy, it does more damage than good. A number of years over which we, as central bankers, have convinced markets that we will continuously come to their rescue and will keep rates really low for long–that we have all kinds of ways of infusing liquidity into the markets–has created markets that tend to push asset prices probably significantly beyond fundamentals, in some cases, and made markets much more vulnerable to adverse news. My worry is that with inflation not being strong, this can continue for some time until things are so stretched that any signs of inflation and a rise in interest rates could precipitate a fairly strong market reaction.

2. Supereasy money has led to the misallocation of capital

My greater worry is that by altering the price of capital for a substantial period of time, are we also, in a sense, distorting investment decisions and the nature of the economy we will have? Have we artificially kept the real rate of interest somehow below what should be the appropriate natural rate of interest today and created bad investment that is not the most appropriate for the economy?

3. But quickly reversing low rates could backfire

We’re in the hole we are in. To reverse it by changing abruptly would create substantial amounts of damage. So I’m with [U.S. Federal Reserve] officials in saying that as we get out of this, let’s get out of this in a predictable and careful way, rather than in one go.

4. There’s a lack of coordination in the global financial system–led by the U.S.

The U.S. should recognize that the actions [emerging economies] have to take to protect ourselves over the long run come back to affect the U.S. There is room for greater dialogue on how these policies should be conducted, not just to be nice, but because in the medium run it is in [the U.S.’s] own self-interest. If you are not careful about the volatility you create, others have to respond, and everybody is worse off.