Raghuram Rajan (University of Chicago Professor) – Fault Lines in Global Finance and Economy (May 2023)

Chapters

Abstract

Navigating the Waters of Global Economics: Insights from Raghuram Rajan

A Comprehensive Analysis of Financial Stability, Policy Challenges, and Emerging Market Dynamics

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In a world grappling with financial uncertainty and policy shifts, Raghuram Rajan’s insights provide a beacon of clarity. As the Katherine Dusack Miller Distinguished Service Professor of Finance at Chicago Booth and a voice of prescience in the field of global economics, Rajan’s perspective on the multifaceted challenges facing today’s financial systems is invaluable. This article synthesizes Rajan’s key viewpoints, exploring systemic fragilities, the role of central banks, and the intricacies of emerging market debt crises.

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Systemic Fragility and the Banking Sector

Recent collapses of medium-sized U.S. banks have cast a spotlight on the systemic vulnerabilities within the global financial framework. Rajan attributes these fragilities to factors such as increased uninsured liabilities stemming from quantitative easing, the safety of deposits, and the low profitability of mid-sized banks. The old banking model of low deposit rates and high investment returns is no longer viable, leading to profitability challenges. There has been an implicit insurance of all deposits, addressing short-term systemic problems but creating long-term profitability issues.

Rajan underscores the short-term solution of implicit deposit insurance but warns against overlooking long-term profitability issues, advocating for mergers and a reassessment of mid-sized bank viability. He suggests that authorities lack the risk tolerance to let entities fail, leading to riskless capitalism, where entities are shielded from failure through bailouts and implicit guarantees. This moral hazard, he argues, stifles the crucial dialogue on averting future bailout scenarios, thereby perpetuating a cycle of financial instability.

The first step in addressing financial instability is reassuring depositors to prevent panics and steady deposit withdrawals. A careful assessment of banks’ balance sheets is needed, including a review of the distinction between hold-to-maturity and available-for-sale assets. Mark-to-market accounting should be applied to assets that can be easily valued to ensure transparency. Banks need to address long-term asset losses, such as mortgages made at low-interest rates that now have a different value. Backup financing and consolidation with other banks may be necessary for larger banks to bolster themselves. A swift cleanup of financial issues is essential to prevent a steady flow of withdrawals.

Non-banks also pose financial stability concerns, particularly those with the potential for deposit runs, such as ETFs. Extreme duration mismatch and macro market losses due to low interest rates and the search for yield can create vulnerabilities. The question is whether such vulnerabilities can be absorbed by the institution’s equity or if they lead to runnable debt. If it’s equity and debt, resolution is possible, but if it’s runnable, quick market resolution can lead to painful fire sales.

IMF’s Role in Emerging Market Debt

The International Monetary Fund (IMF) faces pressing issues, notably emerging market country debt crises. Crucial in this context are the negotiations with China on debt relief and the need for a coherent framework for debt restructuring that considers both private and public sector creditors. Rajan emphasizes the distinction between humanitarian loans and other types of lending, highlighting the challenge of preventing countries from re-accumulating debt post-relief. Differentiating between loans made for humanitarian purposes and those made for less noble reasons remains a challenge. Preventing countries from re-entering debt distress after receiving debt relief is crucial. Ensuring that countries retain the capacity for necessary borrowing in light of ongoing crises and increasing volatility is essential. Recognizing the impact of climate change on economic volatility and its implications for debt relief strategies are also important considerations.

Differentiating between loans made for humanitarian purposes and those made for less noble reasons remains a challenge. Preventing countries from re-entering debt distress after receiving debt relief is crucial. Ensuring that countries retain the capacity for necessary borrowing in light of ongoing crises and increasing volatility is essential. Recognizing the impact of climate change on economic volatility and its implications for debt relief strategies are also important considerations.

Challenges and Opportunities in Debt Restructuring

Rajan notes the subjectivity in debt sustainability assessments and calls for a more explicit framework for debt reduction. This framework should address both humanitarian considerations and the interests of various creditors, balancing immediate relief with long-term economic stability. A more explicit framework for debt reduction is needed, considering private sector needs and public sector lending. Engaging China and prominent emerging markets in discussions on debt relief and multilateral system reform is necessary to ensure a holistic and equitable approach. Avoiding the perception that the current framework benefits only Western creditors is crucial. Promoting a comprehensive dialogue on reforming the multilateral system is long overdue.

Preventing countries from re-entering debt distress after receiving debt relief is crucial. Ensuring that countries retain the capacity for necessary borrowing in light of ongoing crises and increasing volatility is essential. Recognizing the impact of climate change on economic volatility and its implications for debt relief strategies are also important considerations.

The Dilemma of Deposit Flight and Bank Balance Sheets

Regulators face complex choices in addressing deposit flight and assessing bank balance sheets. Rajan points out the fictional distinction between “hold to maturity” and “available for sale” assets, advocating for a clear assessment of assets and liabilities. He suggests that some banks may require backup financing or consolidation to address these issues effectively. The issue of deposit flight has resurfaced, as evidenced by the First Republic Bank situation. Regulators face difficult choices in addressing this issue, as there are no easy solutions.

Non-Bank Financial Institutions and Market Stability

Non-banks, such as ETFs and asset managers, face risks associated with duration mismatch and macro market losses. Rajan warns of potential “slow burning runs” and fire sales in certain market areas, exacerbated by extreme duration mismatch created by low interest rates and the search for yield.

Extreme duration mismatch and macro market losses due to low interest rates and the search for yield can create vulnerabilities. The question is whether such vulnerabilities can be absorbed by the institution’s equity or if they lead to runnable debt. If it’s equity and debt, resolution is possible, but if it’s runnable, quick market resolution can lead to painful fire sales.

Quantitative Easing and Tightening: A Double-Edged Sword

Rajan and Viral Acharya have highlighted the destabilizing effects of both quantitative easing (QE) and quantitative tightening (QT). While QE aimed to stimulate the economy, it also led to a search for yield, repricing of financial assets, and increased duration risk for banks. Conversely, QT, intended as a reduction of the central bank’s balance sheet, poses risks of asset price declines, credit tightening, and financial instability. Rajan emphasizes the need for careful management of QT to minimize adverse outcomes. Rajan discusses the impact of quantitative easing, noting that it has been successful in achieving its objectives in the short term. He cautions that quantitative easing can have unintended consequences in the long term, such as asset bubbles and financial instability. Rajan emphasizes the need for central banks to be mindful of these risks and to carefully manage their balance sheets.

Quantitative easing (QE) programs led to increased leverage and risk-taking in the financial system. The sudden reversal of QE can cause asset values to decline and lead to financial distress. We need to examine the long-term consequences of aggressive monetary policy to avoid future financial crises.

The Central Role of Central Banks

Central banks, according to Rajan, should not be absolved of responsibility for financial sector troubles. Their decisions have significant implications for financial stability, often overlooked in the separation between monetary policy and financial stability. He advocates for a recognition of the intertwined nature of these areas and the careful use of instruments at their disposal.

The separation of monetary policy and financial stability is artificial and ineffective. Monetary policy actions have significant financial stability effects that cannot be ignored. Central banks should recognize the interconnectedness of monetary and financial stability and use their instruments carefully.

Addressing Spillbacks and Spillforwards in Monetary Policy

Rajan draws attention to the spillbacks and spillforwards of monetary policy actions. While spillbacks, such as capital outflows from recipient countries, are often considered, spillforwards, including political change, are equally significant. He calls for improved dialogue between central banks and recipient countries to address these effects.

The US monetary policy can have significant spillback effects on the global economy. Central banks should consider spillforwards, which are the immediate effects of their actions on recipient countries. Ignoring spillforwards can lead to financial sector problems, demand drop-offs, and political changes in recipient countries.

Inflation Targeting Amidst Changing Economic Conditions

Inflation targeting remains relevant, Rajan argues, especially for emerging markets with histories of high inflation. He suggests that central banks may need to adjust their inflation targets and policies in response to evolving economic conditions, cautioning against overly ambitious targets that may lead to aggressive and ineffective policies. Rajan’s overarching theme is a call for prudence in monetary policy, emphasizing the need for central banks to focus on their core mandate and avoid overreach. He highlights the unique challenges faced by emerging markets in controlling inflation and the necessity for tailored policies. Rajan’s insights offer a roadmap for navigating the complexities of the global financial landscape, underscoring the importance of a balanced, thoughtful approach to policy making in an increasingly interconnected world.

The recent inflationary developments have challenged the effectiveness of 2% inflation targeting and R-Star monetary policy.

Monetary Policy in Developed and Emerging Markets: Focusing on Inflation Control and Avoiding Excessive Intervention

Overview:

Raghuram Rajan’s insights on the role of central banks in monetary policy, with a focus on the developed and emerging markets, emphasizing the importance of inflation control while avoiding excessive intervention.

Key Points:

1. Monetary Policy in the 1990s and Early 2000s:

– Central banks’ focus on inflation control during this period contributed to relative economic stability and growth.

2. Importance of Financial Stability:

– Rajan advocates for considering both financial stability and inflation when setting monetary policy.

3. Overemphasis on Low Inflation Rates:

– Excessive concern about low inflation led to aggressive policies like quantitative easing.

4. Central Banks’ Limited Capacity:

– Rajan cautions against central banks engaging in activities beyond their effective capacity.

5. “Less is More” Approach:

– Central banks should prioritize their core mandate of inflation control and avoid excessive intervention.

6. Inflation Targeting in Emerging Markets:

– Rajan acknowledges the different challenges faced by emerging markets, where high inflation remains a concern.

7. Effectiveness of Inflation Targeting:

– Inflation targeting has been a successful tool for communicating with the public and controlling inflation in emerging markets.

8. Financial and Economic Risk Factors in 2023:

– Credit and the potential for a financial crisis are key risk factors to monitor in the coming year.



Raghuram Rajan emphasizes the need for central banks to strike a balance between inflation control and financial stability, while avoiding overly ambitious policies. He suggests a “Less is More” approach, focusing on core mandates and avoiding excessive intervention. For emerging markets, inflation targeting remains a valuable tool, but the focus should be on controlling high inflation rather than elevating low inflation. Rajan also highlights the importance of monitoring financial and economic risk factors, particularly credit, as the economic cycle progresses in 2023.

Raghuram Rajan on Credit Tightening, Stock Prices, Inflation, and Commercial Real Estate

Credit Tightening and Consequences:

– Raghuram Rajan cautions that credit tightening could lead to consequences, including potential losses and bankruptcies that have been temporarily suppressed during COVID-19.

– The effects of credit tightening should be monitored through credit spreads and stock prices of banks, which serve as timely indicators of their health.

Inflation and Wage Demands:

– Rajan emphasizes the ongoing challenge of inflation and the potential for a worst-case scenario where credit tightening slows the economy but inflation persists in certain sectors.

– He empathizes with workers’ demands for higher wages to cope with rising inflation and maintain their livelihoods.

US-China Rift and Ongoing Wars:

– Rajan acknowledges the significant geopolitical rift between the United States and China and the importance of dialogue to prevent further adverse measures.

– He also highlights the impact of ongoing wars and the need to monitor their developments.

Commercial Real Estate in the US:

– Rajan anticipates adjustments in office property prices and rents as companies navigate hybrid work arrangements and reduced in-person workforces.

– The demand for office space may decrease, particularly for older-style offices, leading to potential losses for banks with exposure to this sector.



Raghuram Rajan offers insights into various economic and geopolitical issues, emphasizing the need to monitor credit markets, stock prices, and inflation, while also considering the impact of the US-China rift, ongoing wars, and the evolving commercial real estate landscape.

Notes by: Alkaid