Raghuram Rajan thinks a lot about how to empower individuals, both at the community and international level. In his new book, Rajan draws upon decades of experience both as an academic and policymaker to break down how the three pillars of society — the state, markets, and communities — interact with each other, and argues that we’re currently balancing this complex relationship wrong.
How much has the U.S. actually fixed the financial system? Does India have the best food in the world? Why does China struggle to maintain a strong relationship with allies? Why are people trading close-knit communities for isolating cities? And what types of institutions are we missing in our social structure? Listen to Rajan’s thorough conversation with Tyler to dive into these questions and much more.
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TYLER COWEN: Today, we’re here with Raghuram Rajan, who is professor at University of Chicago. Raghu has a new book out: The Third Pillar: How Markets and the State Leave the Community Behind. Raghu, welcome.
RAGHURAM RAJAN: Thank you for having me.
COWEN: First question: should we really be trying to empower local communities if we think NIMBY is a big problem and strong localism just means tighter zoning regulations?
RAJAN: Well, you need a new kind of structure going forward. Certainly, you need more empowerment locally, but you have to make sure that that empowerment is not total, that it’s not about building walls around the community but making the community able to take advantage of a global economy as well as a large country. Walls prevent that.
So how do you get people to have a sense of agency, while at the same time there are flows across the borders of the community? That’s really what I’m trying to do.
COWEN: If we had stronger local communities, do you think we would have stronger restrictions on building in, say, Manhattan, San Francisco, the American suburbs?
RAJAN: I think you have to worry about that. We might, if the local communities’ abilities to enact sort of zoning laws were not tempered in some way by the other two pillars that I talk about in the book, the state and markets.
To some extent, we need to keep the borders of the community low and porous while giving the community greater decision-making power. The decision-making power is not about the borders per se, but about how it will encourage economic activity, in some sense attuned to the needs and the capabilities of the community.
COWEN: If I think, say, about China, which has done pretty well in terms of economic growth — didn’t they, in some sense, trash localism? They said, “We’re going to do the state really well. We’re going to do the market somewhat well. We’re not going to try for balance.” United States has a somewhat dysfunctional government, but we have great markets. We’re not trying for balance.
Isn’t it better to have a cultural specialization in either state or market than to try to balance all three of the things?
RAJAN: Well, first, I would disagree a little about your characterization of China. I think one of the things they’ve done very well is have pretty strong, in fact impenetrable, business regulation around — that’s not a recommended path, but what they’ve done is empowered the local government officials to essentially work with those regulations and open them up for local businesses.
So in some sense, they’ve incentivized the local officials by giving them strong rewards for growth — they get promoted faster up the Communist Party — and allowed them, in a sense, to build the local community around their abilities.
So Chinese growth — a lot of it is not because China has the best business regulation in the world, but because it has empowered Communist Party officials who know how to break the rules selectively. Now, is that a recommended mode? Certainly not, but it’s worked.
COWEN: If you were to cite a particular place in India that right now is doing community especially well, what would it be?
RAJAN: The villages, by and large, are self-governing, have been self-governing for many, many decades. But I think what you really need is, over and above that, you need the funding that accumulates at the center, or the state level, to come down to the community level, so they can decide what kinds of irrigation projects, for example, that they need.
A lot of it is local. It’s not these mega, gigantic projects which create a whole lot of problems. It’s about local tanks, local wells. And there are many areas where, once the local people take it up and have the funding associated with it, they actually do a great job of doing the right things as far as irrigation, as far as the environment, as far as everything local community needs.
COWEN: But if people are leaving villages in India or, for that matter, in America, isn’t that a sign they’re rejecting community in some sense? They find it too stifling? They prefer the anonymous, impersonal existence of the big city?
RAJAN: Well, there is some of that. There are some people who prefer the anonymous existence of the city. And there are some people who come back from the city, back to the community because they like the sense of identity that it provides. We are with people we’ve known for many years; they are who we are, in some sense. You’re defined by the people around you.
I think there’s room for both. In fact, the book is about saying, “Look, let’s create the possibility for all kinds of communities to coexist within a country.”
COWEN: How much of the decline of community do you think is actually the decline of religion? Take this country, the United States.
RAJAN: Some of it is, but you might argue that when community declines, people reach out to measures of identity that they can lock onto. And sometimes, religion is something that they grasp at because that, at least, gives them some sense of who they are. Because the local community’s collapsing, social dysfunctionality is setting in, families are breaking down, teenage pregnancies are up.
When that doesn’t satisfy you, looking for other symbols — nationalism is one, religion is another.
COWEN: It seems the secularization thesis is finally coming to this country. That is, fewer people are going to church after a long period of stability. Do you think the same is likely to happen in India as per capita income grows? Because it’s happened in just about every other country, and now finally also the US.
RAJAN: In the majority religion in India, Hinduism, you really don’t have a strong concept of church, that is, going to assemblies and so on.
COWEN: But there are festivals and deities. There are ways you participate.
RAJAN: What you see is, again, that in reaction to modernity, there is sometimes an increasing emphasis on these older symbols.
For example, the Ganesh festival — festival of the elephant god — is celebrated with full gusto in Maharashtra, and a lot of young kids are participating in that. They like the symbolism. They like the festivities. They like being with other people. But they’ve converted it into something new. They dance in the streets — a lot of Western dance as opposed to traditional Indian dance. They’ve adapted it to their needs.
COWEN: What’s your favorite Indian festival?
RAJAN: Diwali is pretty up there. It’s the most important Hindu festival. It’s, again, a time of coming together, of family, of recognizing your community.
COWEN: Do you think the European Union is a substitute for community? Or an enabler of it, on net?
RAJAN: I think that, at least in the way that it has grown, it has actually created more reaction than a greater sense of community. And I’ll be very specific about that. What it’s done is, it’s taken powers up into the Union which traditionally used to belong at the country level and, within the country level, at the regional level.
And as those paths migrate up, people in the country feel disempowered. “We can’t determine everything. Everything is determined by those bureaucrats in Brussels.”
When that happens, there’s a reaction against the European Union. To some extent, the local politicians play into that. All the good stuff is because of them. All the bad stuff is because of those bureaucrats in the Union. There is no political consensus behind the Union itself, though if you ask, “What is the political consensus behind Europe?” — as a concept, I think it’s still pretty strong.
COWEN: Should the existence of the internet make us super optimistic about community? Or super pessimistic?
RAJAN: I think that it actually helps in many ways. Often, we worry about the internet — people spending so much time away — the traditional picture of a family of four eating, and each one on their cell phone, communicating with somebody outside.
But in fact, when you look at the evidence, it seems like it can also help bring together people. My kids, for example — they are so much more in touch with their college friends — through Facebook and so on — in a way that we never were.
There’s an example in the book of this community, Netville, where they actually overlay internet on half a community. This is exactly what an economist wants: a randomized experiment, half the community linked, the other half not. Which segment does better in maintaining social ties? It’s the one that’s linked. Because they can traverse locked doors, they can communicate with each other, they can do social events together, and it works a lot better.
The internet offers a lot of possibilities, not all of them good. Absolutely. But it offers a way to stay together which we didn’t have in the past. And now there’s new ways of getting together, again, which we didn’t have in the past.
COWEN: Why doesn’t online education work better, then? What’s special about face to face?
RAJAN: I think you need both. Look, face to face in my class — when I look at a student and they’re not prepared, they feel a sense of embarrassment. It’s hard to get that sense of embarrassment across the net, at least in full measure.
COWEN: You can text them an insult. [laughs]
RAJAN: You could text them an insult. It’s not as powerful, I would think.
COWEN: If you up the quality of the insult, it might be.
COWEN: Why doesn’t online education work better, then? What’s special about face to face?
RAJAN: I think you need both. Look, face to face in my class — when I look at a student and they’re not prepared, they feel a sense of embarrassment. It’s hard to get that sense of embarrassment across the net, at least in full measure.
COWEN: You can text them an insult.
RAJAN: You could text them an insult. It’s not as powerful, I would think.
COWEN: If you up the quality of the insult, it might be.
RAJAN: This goes to the point of online is less engagement. It allows you to opt in and opt out, it allows you more choice, but the depth of engagement, I would argue, is much less than when you have a local, real community.
COWEN: I’ve a few questions about India, and again, I remind our listeners this is the conversation I want to have with Raghu, not the conversation they want to have.
A lot of observers have suggested to me that the notion of a kind of Anglo-American liberalism as ascendant in India is now a dead idea, that ideologically, India has somehow shifted, and the main currents of thought, including on the so-called right, are just really not liberalism anymore. Do you have a take on that view?
RAJAN: I’m not sure I would agree. I would say that we’ve had a government over the last five years which has elements of the majoritarian, Hindu nationalist group in it. But I would argue the country, as a whole, is still firmly secular, liberal in the Nehruvian idea, which is that we need a country which is open to different religions, to different ethnicities, to different beliefs if we are to stay together.
And democracy plays an important role here because it allows some of the pressures which build up in each community to essentially get expressed and therefore diffuses some of the pressure. So I think India’s ideal is still a polyglot coming together in this country.
COWEN: But someone like Ramachandra Guha — what he symbolizes intellectually — do you think that would be a growing part of India’s future? Or that will dwindle as colonial ties become smaller, the United States less important in global affairs?
RAJAN: I think that an open, liberal, tolerant country is really what we need for the next stage of growth. We are now reaching middle income. We could go a little faster. We should go a little faster there.
Once we reach middle income, to grow further, I think we need an intellectual openness, which only the kind of democracy we have — the open dialogue, a respectful dialogue — will generate the kinds of innovative forces that will take us more to the frontier.
So I keep saying, and I say this in the book, we’re very well positioned for the next stage of growth, from middle to high income. But we first have to reach middle income.
COWEN: Do you worry much about premature industrialization for India? The percentage of jobs and manufacturing has been declining for some while, but India’s not yet quite a middle-income country.
RAJAN: It is a concern, but I would argue that there’s enough room for growth in India, doing the old traditional things. I wouldn’t worry about it right now. I think in the longer run, we have to worry.
We certainly have to upgrade the quality of education in India significantly. More people have to be better prepared for the global economy; they’re not. We have many of the same problems that we talk about in industrial countries — too few people educated at the levels that the economy needs.
But that said, I would say there are very low-hanging fruit in India, which if we pluck, we can generate 9, 10 percent growth for the next 10, 15 years that would get us firmly into middle income.
I don’t think we necessarily need to go the Chinese way of manufacturing-led growth. Maybe that option has already closed out. But just simply building out the infrastructure in India, connecting people, getting internal trade up — you don’t need to go the external manufacturing route to get strong growth for some time.
COWEN: Oil-producing countries aside, are there countries, or even regions, that have done 9 percent growth without a lot of manufacturing and exports? Isn’t there a kind of cost disease that so many of the service sectors — even in wealthier countries — they just don’t increase in productivity much?
RAJAN: Well, we have to think more cleverly about doing that. But it’s not primarily going to be the financial services, or consulting and so on. It’s actually construction. If India can construct what it needs in terms of housing, in terms of infrastructure, in terms of boats, railroads, et cetera, for the next 15 years, that’s where a lot of the jobs will be, not just around the roads we build, but the restaurants, the motels, the service sector which builds around those roads.
And of course there will be some manufacturing. India still has very cheap labor, so manufacturing will increase. What Vietnam is doing now, India will also do. But we need to build out that infrastructure. So I would say construction, then manufacturing, and around all this, a significant increase in services.
COWEN: One Belt, One Road emanating from China — is it even a real thing? Is it just public relations? What’s your prediction? What’s your take?
RAJAN: It is a real thing. But like any country doing something so gigantic, I think they’re learning that there are lots of unintended consequences. Some of the debt traps that countries have gotten into as they’ve built out some of the infrastructures associated with the One Belt, One Road — I don’t think that was necessarily intentional on the part of the Chinese.
But they do realize that it creates a tremendous amount of resentment. You think people are happy because you’ve essentially financed this infrastructure for them? But nobody’s using it, and the people on the other side say, “Look, why did we build this? This is a white elephant.”
So I think there are aspects of One Belt, One Road which are going that way. There are also successes. Longer run, I think, as an important thrust, an important international responsibility of the Chinese, this is an important step forward. The Chinese have grown internally and now are saying “What do we do for the world?” We should look at what they’re doing and see how it can be pushed in the right direction.
COWEN: Why does China have such a bad record at cultivating allies? Maybe Cambodia, maybe North Korea, Pakistan perhaps. But China has remarkably few allies relative to its GDP.
RAJAN: Some of that may have to do with the nature of the government, that it is a one-party system. There isn’t an enormous scope for internal dialogue and debate.
I would suspect that one of the reasons people felt more comfortable with the United States’ postwar hegemony was the internal debate in the United States. Not so much that everybody trusted the US government, but they realized that there were checks and balances internally, and that every once in a while — especially in the ’70s and the ’80s and the ’90s — the public would start pointing at some of the actions of the US government and restrain some of the worst actions.
So I think there was greater confidence, I would say right from Jimmy Carter. Carter’s not a popular president in the United States, but the kind of introspection that he did in public, I think, was useful for the rest of the world to know that the United States was actually morally on the right path.
COWEN: If we look at Spain today, many Catalonians wish to leave. To outsiders, the difference between a Spaniard and a Catalonian appears relatively small compared to, say, the differences in India. I see no serious signs of India breaking up whatsoever. What is it that accounts for this extreme stability of India that maybe is not so visible to outsiders?
RAJAN: I would say that to some extent, the structure we created has stood us well. And this is where I go back to the democracy. Yes, people question how illiterate people can have a sensible vote. But again and again, you see that our voters make what seem like sensible decisions.
COWEN: But Spain has democracy, Belgium has democracy. They might be splitting apart.
RAJAN: I think there is a reasonable . . . We found a balance. Every country has to find that balance between regional power and central power. And it goes back and forth. Increasingly what we find is, in India, the states are demanding more power, and more is being decentralized to them.
This is something that every country has to work out. How much do you allow a state like Catalonia the freedom to express itself within the larger nation? And sometimes repression has the wrong consequences. We in India know that. We have had a number of states where there has been repression, and there has been pushback.
COWEN: Jeff Sachs wrote a famous review of Acemoglu and Robinson, and he pointed out that if you go back in time and try to predict which countries will do well on the basis of their institutions, it’s very hard to predict, using institutions, which countries will be the high-growth winners.
To most economists that sounds counterintuitive. We feel in our bones institutions have to matter. Are we mismeasuring institutions? Are we not looking at the right ones? How do you account for this paradox?
RAJAN: I think what happens is, more than institutions is the political environment in which these institutions are created that matters. The political dispensation. That’s a lot of what the book is trying to say — that you need the right political structures to emerge.
Take, for example, the US Constitution, which Liberia adopted. But you would not say that the checks and balances we have in the US, the distribution of power in the US transferred to Liberia. So the institution, that is, the constitution being imposed in Liberia didn’t necessarily mean that they inherited the same sort of structure.
And I would say that’s true of country after country. The same institution can function very differently if the distribution of power is different, which is why in this book, I emphasize it’s that distribution in which markets play a very important role that we need to think about to have stable, functioning democracies.
COWEN: What do you think will prove enduring from Indian fiction?
RAJAN: From Indian fiction? Well, Arundhati Roy wrote a stellar book, The God of Small Things. She hasn’t followed it up, unfortunately, thus far. But every once in a while, we have a great author who comes out like that.
Is there anything that I particularly like nowadays? Amitav Ghosh has written a nice trilogy on immigration, which I think is very sensible and very interesting.
One of the problems — this goes to your earlier question — is we don’t see much of the vernacular literature coming out in English. And there are depths there which are very, very interesting, and they deserve more airing.
COWEN: Jhumpa Lahiri has argued that when you read her books about a kind of Indian American experience, does that relate to your personal life? Do you feel at home in those books? Or do you feel your experience is so different from hers?
RAJAN: No, I think we all have some commonalities in that experience. For example, she writes in her books about parents coming from India and wondering why this is an entirely different world — the temptation to hang your washing outside and the knowledge that that’s a no-no in some communities here. Some of those experiences translate very well to what each one of us experiences.
COWEN: What’s something, say, from Indian culture — music or Bollywood — that maybe our listeners, who are mostly Western I think, wouldn’t know about, that they should appreciate better than they do?
RAJAN: Hmm, that’s a tough one.
COWEN: What’s your favorite Bollywood movie?
RAJAN: If you want the standard Bollywood movie, Sholay is the all-time favorite, right?
RAJAN: It’s a story about dacoits and revenge, love, et cetera, et cetera. It has the whole song and dance sequence, and it goes on forever. It’s the Bollywood movie we all grew up with.
COWEN: Let’s say I’m an educated person, I’ve been to maybe 20 countries, but I’ve never been to India, and I’m going for two weeks, and you’re designing a trip for me. Where should I go?
RAJAN: I certainly think you should see some of the traditional sites that every tourist goes and sees: the palaces in Rajasthan, the Taj Mahal, et cetera. But there are lots of interesting parts of India which tourists don’t go to. The wildlife parks, the bird sanctuaries, a tremendous variety of animals and birds.
And there are really very interesting places in India that nobody really knows of or goes to. Certainly the temples in South India are very worth visiting. Some of the towns in Kerala are very quaint, very interesting. India is many countries in one. If you go to the south in one trip, you go to the north in another trip, you’re in a different country.
COWEN: Why does India have the best food in the world? It’s not obvious that it should.
RAJAN: [laughs] Far be it for me to say it has the best food, but I like Indian food.
COWEN: But it’s much better in India than in the United States. Is it the lower wage rate? Vegetables are so fresh, but so much food rots on the way to market. That to me seems counterintuitive, that the country with the freshest vegetables would have one of the highest rates of rotting on the highway.
RAJAN: Well, there’s less use of fertilizer, and the highest rate of rotting is because we don’t have that infrastructure we talked about earlier. We need to build that infrastructure to take those vegetables to market because cities want those vegetables. They’d fetch a much higher price — that’s development for you. Based on services.
COWEN: And make the food worse.
RAJAN: It would make the food better because it would get faster to the city where it’s not rotting on the way.
COWEN: But you’d rely more on refrigeration, right? So it’s a double-edged sword.
RAJAN: Some on refrigeration, absolutely. So you wouldn’t grow your own food, but I’m sure, over time, you’d have these urban farmers setting up little farms outside the city to produce exactly what they produce here.
COWEN: I have a few questions on monetary economics, and again, feel free to pass on these.
How is it even that money matters at all? And is that different in the United States versus India?
RAJAN: Well, we have learned it does matter in India.
RAJAN: Because we just had a massive experiment where 87 and a half percent of the currency was taken out. And it turns out that actually, people use the money for transactions, and not everybody had a credit card. Not everybody could use a check.
So overnight you found activity in these areas dropping significantly, even though much of that activity, we don’t measure because it’s informal activity. So people have used fancy ways of getting at that activity by looking at, for example, the intensity of lights in that area at night to see if activity went down, and they conclude that yes, money matters in India.
COWEN: But will that show up in per capita income levels 10 years from now? So there’s a one-time shock. It’s like an investment — you move to a higher technology, you adjust. There’s catch-up growth, and maybe 13 years from now, you’re glad you have the new technology.
RAJAN: Maybe. I think there are less harsh ways of creating that new technology. A number of people died standing in lines. A number of people — their firms closed down, their livelihoods went away. I think we can find smoother ways of actually getting people to use new payment systems than just eliminating the money overnight.
COWEN: But take, say, the US — money mattering. How much do you think is sticky nominal prices? And how much is credit channel, or how much is something else?
RAJAN: We’re going to be debating this thing for years to come, right? How much is each one of these? And of course, we have now new theories which say nothing matters. You can print all the money you want.
COWEN: But we know those are wrong, right?
RAJAN: I hope they’re wrong! Because otherwise we have to throw all our knowledge out of the window.
COWEN: Well, it would make life easier if they were right.
RAJAN: It would make life very easy, yes. Money is debt. Let’s print as much as we want, and nothing actually happens.
COWEN: What’s the most underrated idea in monetary theory?
RAJAN: Let me tell you what is the most difficult concept. So, I’ll answer a different question. It is how people’s expectations form. See, modern textbooks are full of “you said this” and “people will think that” and “therefore we will have an effect.” But how many people actually think about inflation? How many people actually know what inflation is out there?
In India, we found that in our surveys, the median inflation rate that people said was going on was about 10 percentage points higher than the highest rate had been for the last 10 years. So people don’t really have a good sense of what those numbers are. Yet we focus on them because, ultimately, we think changing those expectations matters.
And by the way, this is true even of industrial countries. The expectation of inflation is typically higher than what it actually is measured to be.
So why is there this very strong link to expectations that we have in our theories, but in practice how they formed is really a mystery? How do people on the street actually gauge inflation? Because they don’t read the financial papers. They don’t pay attention to the inflation numbers that appear on Bloomberg or whatever. How do they actually react?
COWEN: If people don’t know what inflation means, should we then move to NGDP targeting?
RAJAN: Well, that’s precisely the point. We’re getting more and more esoteric in how we implement inflation targeting, now price-level targeting, nominal GDP targeting. The poor guy on the street doesn’t even understand what inflation is. So why are we getting more and more esoteric here? Let’s first figure out how we communicate what inflation is.
We’re getting more and more esoteric in how we implement inflation targeting, now price-level targeting, nominal GDP targeting. The poor guy on the street doesn’t even understand what inflation is. So why are we getting more and more esoteric here? Let’s first figure out how we communicate what inflation is.
COWEN: But if we think sticky nominal wages are a problem, and we then want the flow of nominal payments to grow at some preordained rate each year so that stickiness doesn’t cause output losses, why isn’t nominal GDP targeting necessarily better than, say, inflation targeting?
RAJAN: No, I’m not saying that it’s better or worse. I’m just saying that, for me, it’s a mystery how these concepts translate to the common person, whose expectations we care about, unless you think they don’t matter, and who we are communicating to are largely the union bosses, are largely the analysts on the street. These are the people who determine how the economy moves and shakes, not the ordinary person who’s making consumption decisions.
But some of our theories require that person to also internalize our model of whether it’s inflation targeting or nominal GDP targeting. And my sense is, it would be very useful for us to know how that transmission takes place.
COWEN: If citizens don’t understand what the rate of price inflation is, am I wrong to think that the American public has become much more inflation averse compared to, say, the 1980s?
In the Reagan recovery, you have rates of price inflation, 5 percent. I’m not sure people like it, but it’s not a big issue. Whereas today, you creep a bit over 2 percent, people flip out and go crazy. Why has that change happened?
RAJAN: Let me throw that back to you. Who’s flipping out on 2 percent? I think this smaller crowd is flipping out, so people get very angry when the Fed says, “We’re going to run a little hot.” But I’m not sure it’s the common man who’s saying, “I hate 2.25 percent.” I don’t think they’re the guys who’re flipping out.
And that also leads to the question of whether we’re getting a disconnect within the broader population and some of the ways policies are set. One of the bastions of elite policy making in any economy is a central bank. Increasingly, I think, the public is basically asking, “What on earth are you doing? And is what you’re doing in my benefit?”
COWEN: But say you have a lot of bureaucratically set wages, which is the case in most countries. So there’s real stickiness in wages. When the rate of price inflation is higher, a lot of people are taking real wage cuts, and at least some of them notice.
So my theory is Congress flips out — not that they think people understand what’s happening, but people will understand they have less to spend in some way, and they’ll take it out on Congress. So Congress pressures the central bank, and we’re maybe today way too inflation averse, and we’d be better off if we could tolerate 4.63 inflation rates during a recovery.
RAJAN: It may well be. The difficulty, Tyler, as you know, is moving away from whatever the central bank has been saying — 2 percent is our target.
RAJAN: And if you hit 4 and a half percent, people start worrying that if you’re tolerating 4 and a half, well, why not 6 and a half? You become a prisoner of the target that you’ve set.
And so the flexibility that you have been moving away, or even moving the target, which Oliver Blanchard, as you know, has suggested, becomes much more difficult.
On corporate America
COWEN: A lot of your early research is on business firms, corporations. A few questions there. What’s the biggest crisis today in American corporate governance?
RAJAN: I would say that there are two big issues. One, of course, is the domination of industry after industry by a few firms. Many of these firms are well managed. Many of these firms provide efficient services, provide a service that people want.
But it does raise the question going forward, how are they maintaining their dominance? And is it possible that they might chill innovation and competition going forward? That certainly is a concern. I don’t think we know the answer, but it is a concern which America’s addressed time and again in the past.
COWEN: What’s a sector where you have that worry?
RAJAN: Certainly right now, the focus is on big tech, so Facebook, Google, et cetera. What do they know? How do they know it? And are they able to maintain a hold over their clientele because of that?
How do you make the area more competitive? One of the worries is, we don’t fully understand the extent to which the possession of a network can keep out the competition and how long it can do that. Our theories are, well, you will find this wonderful innovative company. We should demolish the opposition by producing such a baited mouse trap that everybody will migrate to that.
But with the kinds of structures we have today, it’s theory still. We don’t know if that will work. Yes, people say before Facebook, there was . . . What was that? Make My Space?
RAJAN: Myspace, and so on. And Facebook came in. But yeah, Facebook came in, and it’s gobbled up everybody else who was anywhere near a threat. So, will Facebook face the appropriate amount of competition? Remains to be seen.
COWEN: But if there’s a lot of innovation, and there’s zero price, and obviously no coercion, I can network with people by texting. I can use email, I can use Twitter, I can use my blog. I can still use the telephone, believe it or not, though I don’t. Why isn’t that actually a pretty contestable market?
RAJAN: It’s unclear. The question is whether the network itself — let’s take Facebook for the sake of discussion — whether that network itself is strong enough, and their ability to acquire anybody who poses anything of a threat is strong enough, to keep out competition.
As you know, many venture capitalists now talk about a kill zone. If we finance somebody within this zone, they will not grow to be full adults. They will be bought out early or forced out of business. And that’s not going to make enough returns for us.
Now, there’s stuff here which needs to be unpacked. What I’m saying is, we need to watch this in a careful way because this is the future, and we have to be careful that it doesn’t become an uncompetitive future.
COWEN: Are you worried that there are so few public corporations in America these days compared to the past?
RAJAN: Well, so long as the private corporations are reasonably well governed and that there is . . . you know, many of these private corporations have public funds as investors, so that the returns for investment are also broadly distributed. I don’t think whether it’s public or private is a big issue. I’m more worried about excessive corporate market power.
COWEN: Are CEOs paid too much?
RAJAN: That’s the question of the ages, right? I’d say there are examples of CEOs that are paid too much.
COWEN: Oh, of course, but on average? Is it just that they’re managing larger firms with global reach, and the job is harder to do, and in essence, they deserve the money?
RAJAN: My colleague, Steve Kaplan, would say that. I think he has some arguments in his favor. At the same time, you can point to corporations in other countries where the disparity in income — the guy at the bottom and the guy at the top — is not so great. Are they doing as well? I think that’s what we have a big debate about — whether US corporations are, in fact, managed better than corporations in other countries.
COWEN: Many years ago, you wrote an article with your colleague, Luigi Zingales, on the concept of power in industrial organization. Do you feel that piece explains anything worth seeing in the world today? Or what has come of that in your mind?
RAJAN: I do think that increasing the notion of corporations as being a variety of fixed-claim holders and the shareholders of the residual claimants, which is what led Friedman to propose shareholder value maximization as a principle — I think that’s being challenged. Increasingly, corporations, agglomerations of a variety of entities that essentially benefit from the corporation and share in the corporation’s rent, so to speak.
So essentially, the nature of the corporation is moving more towards partnerships rather than manager-worker. The nature of the corporation has to actually reflect that, and more and more corporations are doing that. What that means is that, increasingly, long-term workers are part of the stakeholders of the corporation. And seeing them as part of the value-maximization process, I think, is both politically reasonable, but also economically the right thing to do.
The nature of the corporation is moving more towards partnerships rather than manager-worker. The nature of the corporation has to actually reflect that, and more and more corporations are doing that. What that means is that, increasingly, long-term workers are part of the stakeholders of the corporation. And seeing them as part of the value-maximization process, I think, is both politically reasonable, but also economically the right thing to do.
COWEN: How fragile is a free society with respect to the behavior of its own corporations? Can crony capitalism bring the system down? Or is it just a deadweight loss we’d like to minimize, and as long as we have some economic growth, we can pay off the interest groups and get on with our business and live to fight another day?
RAJAN: No, I believe very much that crony capitalism is really the danger for any economy because it not only constrains economic growth, but I also think it limits political freedom. That, to some extent, a comparative independent private sector is extremely important to keep government in check.
That when the private sector gets compromised and depends on tariffs to protect itself or depends on cartels — government-sanctioned cartels as we had post-depression — I think that’s when we find that the private sector’s no longer independent. When it is no longer independent, it becomes a pawn of the government, and that’s when we get authoritarianism.
So to some extent, Hayek’s The Road to Serfdom — I think essentially one way of looking at that in the current context is, it’s when the private sector is co-opted by the government that we get both political unfreedom as well as a noncompetitive economy.
On finances and budgets
COWEN: If I look at the federal budget, don’t I see a problem being that too much of it is controlled by voters, not that too much is controlled by corporations? And tariffs — even under Trump, they’re still quite low.
RAJAN: When you say they’re controlled by voters, certainly the representatives of the people have an ability to opine on it. And certainly, over time, certain kinds of spending have picked up. Now, I’m not saying that, necessarily, what we need is more redistribution of spending. I think we have a constant interplay between the two.
But I would argue that it’s not so much how the budget is controlled, but how profits are allocated in the economy. What kinds of special dispensations do you have? What kinds of tariff protections do you have? Those are the kinds of things that limit the competitiveness of the economy.
COWEN: As you know, you’re quite well known for, among other things, having predicted the financial crisis that started in 2008. We’ve all been updating our views ever since then, but if you were to say, just in the last three or four years, how have you even further revised your view of what happened during the financial crisis?
RAJAN: I would say that this 30-year process of technological change that we’ve been talking about — increasing automation, the disappearance of the middle-income jobs that you’ve talked about in your books — that stagnation, for at least certain groups inside these certain communities, we tried to remedy through making credit easy.
Didn’t work. We ended up with a whole lot of people with underwater houses and even angrier because for a while they enjoyed home equity loans which allowed them to consume, but now they were deeply under water.
I think that we’re getting into that trap once again, where easy money is the answer when, in fact, we need structural change in the economy. We need to find ways for people to get the skills that they need for sustainable employment.
If you look around, one of the problems during the run-up to the Great Recession was the enormous increase in construction jobs, which pulled people out of high school into a well-paying construction job, only for that job to disappear and to leave this person with a family and a kid but no real skills.
We are seeing some of that again in, for example, the enormous increase in Uber drivers — the great way to make a little bit of money, but in terms of sustainability, you have to ask yourself, how long is this going to be sustainable?
COWEN: And this all relates to your new book on community. Going back to some of your earliest research, what’s your opinion now? How well does financial development predict economic growth rates?
RAJAN: I think it’s sort of associated with it. It’s one of those institutions you talked about. When everything is going well, a good financial market also helps. It’s a lubricant to growth. Is it the underpinning of growth? I don’t think so.
COWEN: But some people argue that, past a certain level of per capita income, there’s no relationship between financial deepening and economic growth rates. Do you agree?
RAJAN: No, I think that beyond a certain level, once you have adequate access to finance and the ability to channel it into savings, the real problem is to prevent the other side, the adverse side of the financial sector, of it going haywire and taking your GDP down by 10, 20 percent, which really sets you back for a decade or two.
So to my mind, beyond a certain level, it’s managing certain risks while ensuring that the financial sector allocates resources appropriately.
COWEN: In a world with so much information technology, do you think there’s still a synergy between loan making and deposits? Can you borrow from a bank more cheaply if you have an account there?
RAJAN: Well, banks have been resilient for the last, what, 3,000 years?
COWEN: But why? What’s the nature of their informational advantage? How do we model it? How do we think about it?
RAJAN: I think it’s not so much on the lending side. They have some ability there. But it’s just the fact on the depositors’ side that it doesn’t require a genius to keep testing the bank. If you want your money, you go in and say, “I want it back today.” That is a disciplinary mechanism on the bank which has stood the test of time.
Is it still necessary today? Even today, when you see what forces the bank into distress, it’s the run on the banks by the large depositors. That’s an enormous disciplinary device on the banks, keeps them from going off the straight and narrow.
We prevented the small depositors from earning through deposit insurance. But even today, what closes a bank down is when the large guys say, “These guys are not good for our money. We’re going to take it out.” And that’s when it closes. I think that basically forces a bank to stay on the straight and narrow to the extent possible.
Of course it creates the downside of financial-sector risk, but it is a fairly strong governance mechanism, much better than the equity holders in the bank who have no clue as to what it’s doing.
COWEN: But say if there’s deposit insurance, especially in the US, where resolution occurs quite quickly, why should that discipline be much of a force? If I have a hundred thousand dollars in a bank and they screw up, I still have my money. I don’t really have to wait. Why should the bank have some kind of comparative advantage?
RAJAN: Well, you will not do anything because you’re insured, and deposit insurance has been very successful in putting the small depositor to rest, their anxieties to rest.
What closes the bank is when the large guys — the guys who have 5, 10 million in the bank, who are monitoring the bank on a daily basis because they operate in the commercial paper markets, the hedge funds, the big mutual funds — they’re the guys who start taking the money out quickly, as soon as there is a whiff of trouble about the bank.
I think they perform an enormously important role, which is why, as you said, the bank gets shut down in a day or two, but that preserves the money. Lehman, when it shut down, was essentially — when you looked at the overall value — it was pretty close to the value owed to the depositors. It was shut down before it lost even that money.
COWEN: In the United States, are current financial and lending connections too relationship based? Again, going back to your earlier work.
RAJAN: My coauthor, Luigi Zingales, would say there’s a lot more connections that work today than is healthy. I would say that modern business operates in a mix of both arm’s-length contracts, as well as relationships that fill the gaps in these contracts. I don’t think relationships are necessarily bad if they are a way of enforcing trust, of adhering to terms that are not precisely written in the contract.
You do business with somebody else because, broadly, you think they will do the right thing. They won’t haul you to court anytime there’s any sense of discrepancy. I think that’s how business works. And that’s usually a good thing. It’s when those relationships become the only way of actually functioning that you restrict access to a narrow circle of friends and relatives. That’s when it becomes problematic.
COWEN: Can narrow banking proposals work?
RAJAN: Not really, for the reasons we just discussed. Narrow banking basically requires all the deposits to be invested essentially in safe treasuries, and no lending.
COWEN: But you’re lending to the government, and then other private capital can do the private lending.
RAJAN: Well, that’s the part, right? All the deposits first go to the government, and if the government has an excess of funding, it has to find a way of recycling it back to the private sector. It’s that part that people don’t talk about.
What is the way the government is going to recycle it back? Is it going to start buying corporate bonds? Which bonds is it going to buy? What’s the kind of worry about cronyism that takes place at that point? Those are the kinds of issues we don’t talk about in narrow banking, and I think they deserve to be opened up.
The other point is, of course, is there virtue for banks to be financed with shorter-term debt while lending longer term? And that’s part of what I’ve been trying to talk about.
COWEN: Will current payments companies end up as competitors to banks or complements to the banking system? Or are they free riders on the banking system?
RAJAN: I think they’re trying to figure out their space. As of now, sometimes they’re substituting for . . . Certainly, my daughter uses her payment system completely separate from her bank account. But longer term, we’ll find ways of meshing these in and reduce the costs of making payments. Those costs are really too high at this point, and reducing those costs makes a lot of sense.
COWEN: Will banks ever be truly excellent at doing software?
RAJAN: I think we will have a combination of the guys who are truly good at software — the fintech companies — merging with banks who know how to do the financial side. They’ll bring each of their talents together. I’ve seen a lot of fintech people who have no clue as to what finance is really about. And I’ve seen a lot of banks who have no clue as to what tech is about. I think some merger will happen over time.
COWEN: How much has the US actually fixed its financial system? Post 2008.
RAJAN: Some. I think the recapitalization of the banks and increasing the capital requirements was generally a good thing. However, the banks have reduced the risks that they take. A lot of the risks have migrated into what we call the shadow financial system. And the worry is, we don’t fully understand that. Are they managing their risks appropriately?
We have the same questions we had before the global financial crisis when everybody said, “Don’t worry, these are the smartest guys in the universe. They know how to manage their risks.” Well, there’s a lot of trust that the shadow financial system knows how to manage its risks, and I’m not sure we can be confident.
COWEN: So what do we need to do to address that?
RAJAN: I think we need to keep exploring what’s really going on and trying to understand. For example, we’ve seen a big explosion in leveraged loans in recent years. Are they being placed in the right places? When they dry up, will the entities that borrowed that way have enough liquidity? Those are the kinds of questions we’ve got to keep asking. Increasingly, liquidity becomes a source of both leverage and, eventually, credit risk.
And that’s, unfortunately, the problem. When liquidity dries up, a lot of people — both the lenders as well as borrowers — are left high and dry, which is why you get pressure on the central banks to come in to the rescue of the system: Infuse the system with liquidity. Start lending to anybody who needs it. And that becomes a problem. You become too reliant on public liquidity.
COWEN: Say I’m just a naïve citizen, maybe even with a left-wing bent, and I say, “Look, why should banks even have off–balance-sheet risk to begin with? Why shouldn’t we force almost everything on the balance sheet? There’s otherwise no way of handling this. We’re completely on the wrong track in terms of bank regulations.” Do you agree or disagree?
RAJAN: I think you have to be a little careful. Every time you stop something, it’ll show up somewhere else if there’s a need for it. And is it better that it be in an entity that you regulate and you monitor reasonably closely? Or in an entity that you don’t regulate?
To the extent the entity you don’t regulate can absorb those loses, that’s not a bad thing. But to the extent that it cannot, and it all comes back into the system via these interconnected markets, you’re no better off. In fact, you’re worse off because you’re blindsided by the risks migrating to places you don’t look at.
COWEN: Given China’s own lending initiatives, and also fissures in the international order, is there now a coherent way of integrating China into the IMF and World Bank the way we used to talk about five years ago?
RAJAN: I think we have to figure out not just how to integrate them, but how these organizations have to change for a multi-puller world. When the US was determining the shots, which it still does, there was a sense that there was one entity, and it had pull position in many of these organizations.
Increasingly China is becoming bigger in certain markets than the United States, and probably, in the next five to ten years, will become bigger in terms of overall GDP. Would the US still have that pull position? And if not, what kind of structure do we have in which there’s not one single sort of equity holder, but there are multiple equity holders, some of whom have very different incentives?
The structure of the organization has to change to accommodate these different interests to make sure they work together. So I think this change — especially given that China doesn’t have that liberal market democracy structure that the US has — will be painful, but it’s something we need to do if we are to essentially get better multilateral institutions for this more integrated world.
COWEN: Have we actually learned the proper lessons from the East Asian financial crisis of the late ’90s? Or has that just fallen down a memory hole?
RAJAN: I think we learned some. We learned, for example, that the international merger fund — that it’s not primarily or always a fiscal problem. That sometimes the financial sector’s the problem, and mandating significant austerity at that point sometimes can backfire. I think that lesson has been used in the global financial crisis also.
However, I do think there is a very real ongoing problem, which is how to deal with capital flows — abundant capital flows — because when they come in, it’s hard to say no to them, but they don’t stay that long, and they can leave on a whim. And again and again, countries like, now, Argentina, Turkey, get into trouble because they borrow in the good times and don’t know how to deal with the bad times.
On the Raghuram Rajan production function
COWEN: Our final section of this chat, of course, is about you. I call this the Raghu Rajan production function — just a few questions about your life. Your parents were diplomats. You lived all over. Is it good for kids to live abroad? And where did you go?
RAJAN: Well, yeah, we had a fantastic time. I grew up initially in Indonesia.
COWEN: In Jakarta?
RAJAN: In Jakarta in the year of living dangerously — we were there. I remember — and my father corroborates this because I was really very young — gunfire in the streets as the Suharto coup was getting rid of the communist sympathizers of the previous government. Two hundred fifty thousand people, at a low estimate, died in that. I remember some of that. I don’t know if it’s a figment of my imagination.
We went to Sri Lanka when, again, they had an insurgency. We had student terrorists who used to blow up government vehicles by embracing people, human bombs. We had a year with no school. We loved it! My parents didn’t like it so much.
We then went to Belgium, which was appropriately sober and boring. It was a fun place in the early ’70s. And then back to India, which was enormously interesting. India was still very poor.
COWEN: And where in India?
RAJAN: Delhi. New Delhi.
COWEN: And you had early training in engineering — is that correct?
RAJAN: I am an electrical engineer, certified.
COWEN: How did you become an economist?
RAJAN: At some point in my 30s, I had enough of fields and waves.
COWEN: We do fields and waves in economics.
RAJAN: Yeah. Well, I could touch and feel fields and waves, and I wanted to do something where I felt more connected. And I’ve always been a fan of — believe it or not — John Maynard Keynes. Not in terms of . . . I didn’t know anything about his work, but I did know that he was such a renaissance figure.
And I said, “That’s the kind of guy who’s really impressive.” You need these sort of superstars in a profession to attract people in. Not that anybody in there ever has a chance of getting there, but it’s a way of bringing people into the profession. So I owe my economics to Keynes.
COWEN: In one interview, I think you mentioned Marx as one of your favorite economists, though of course you’re not a Marxist, but what aspect of Marx do you find important or interesting for today?
RAJAN: I think he was deeply sensitive of the importance of technology. And I am more and more convinced that it’s these technological revolutions which create the impetus for society to change. And this book is really about how this technological revolution has created the disruption, but we still haven’t seen the societal change, and I think we will need to see that in order to adapt to it.
COWEN: You and Luigi Zingales — you’ve written so many pieces together, dozens I think. Why has that particular partnership been so productive? How does that work?
RAJAN: Luigi comes from Italy. I come from India. We both have maybe some cultural sympathy? But we’re also to some extent . . . we started with a very healthy skepticism of how industrial countries function, I mean, him from his view from Italy, and I from India. And I think, over time, our skepticism has been borne out, unfortunately, more than we would like it to be.
COWEN: And to close, last question: what general message would you like to leave us with concerning your new book, The Third Pillar: How Markets and the State Leave the Community Behind?
RAJAN: In many ways, this book is my view of why capitalism worked and why it’s not working as much anymore. Central to this view is how important democracy is — democracy working through the community, the community pushing its ideas up. And to some extent, that we need to regain that ability for capitalism to work for all.
That’s the effective capitalism that took us in the West over the last 70 years to where we are. It’s where I think we could go in the East, but we need that spreading of capitalism’s benefits. And there I think democracy, in opening up capitalism and keeping it open, is extremely important. That’s why I focus in this book on the community, because it seems to me that the community is a basic building block of democracy.
It’s the guy at the bottom, who has no influence, who is essentially saying, “I want capitalism to work for me” — that’s when capitalism actually works. It’s when everything is determined at the top that it stops working and we get the crony states. Whether they be socialist crony states, or fascist crony states, or even some versions of capitalist crony states.
COWEN: Raghu, thank you very much.