Raghuram Rajan — Debt, Monetary Policy, and Unintended Consequences (#151)

53 min read
Raghuram Rajan — Debt, Monetary Policy, and Unintended Consequences (#151)

What were the deep causes of the global financial crisis and great recession? Has unconventional monetary policy in the wake of the crisis done more harm than good? And should monetary policy target financial stability?

I discuss these questions and more with Indian economist and Professor of Finance at the University of Chicago Raghuram Rajan.

Raghuram Rajan was chief economist at the IMF from 2003 to 2006, and from 2013 to 2016 he was Governor of the Reserve Bank of India. As RBI Governor, he notably introduced India's inflation-targeting scheme, among many other achievements.


JOSEPH WALKER: Raghuram Rajan, welcome to the podcast. 

RAGHURAM RAJAN: Thanks for having me. 

WALKER: It’s an honour and, Raghu, I have many questions for you today, but I thought we would start with the global financial crisis and Great Recession. And I want to begin there, because I think you have some views about these events that are, or at least were, very important yet underappreciated.

So, in 2005, you gave a famous speech at the Jackson Hole conference, at what was essentially intended to be a celebration of Alan Greenspan’s tenure as chairman of the Fed. And you kind of ruined the party by presenting a paper discussing how perverse incentives in deregulated financial markets encouraged tail risk in the economy, and how a low interest rate environment played a role in this. In what sense, if any, did you think of that speech as making a “prediction”? 

RAJAN: Well, I was the chief economist of the IMF at that time, and I had been asked to give a speech, one of the many that were going to talk about how wonderful Alan Greenspan’s time at the Fed had been. You know, the debate at that time was: was he the best central bank governor in history, or was he maybe not clearly the best but certainly way out there among the very best? And as I started writing my speech, I was going to write one about how all the good stuff had happened in finance. But academics – and I was still an academic at heart – academics tend to be contrarian. And so I said, “Okay, let me also think about what else I can say.” And actually, as I started thinking, it became more worrying. Where had all the risk gone? And how come it was all just profits in the financial sector? 

And as you started thinking about it, you started wondering that perhaps what we’re seeing was just the tip of the iceberg. There was a lot of risk buried. The paper that I wrote ultimately was saying that, “Look, it’s been a good ride, but it may be that we’ve taken a whole lot of tail risks and we haven’t had the incentives to avoid them. In fact, the financial sector may in some ways have loaded on it, and these will show up at some point. It’s hard to say when, but when they show up, it’s not going to be pretty.” That was the conclusion I reached by looking at various aspects of the issue. Clearly, there were people who thought I was raining on his parade, but there were also others who thought, “Well, yes, there is something to this, but what can we do about it?” 

And so there’s a mix of anger and some resignation because some of the risks had already been taken. How do you stop it at that point? 

WALKER: But in what sense, if any, was the speech a prediction rather than an explanation? Because there wasn’t really a timing attached. 

RAJAN: There was not a timing attached. It was meant to be a description of the world as I saw it, that the financial system was taking a lot of risk. I remember leaving home and telling my wife, “This speech will either make or break me,” because I had an inkling that I was saying something important. 

But I also knew that I was going out on a limb because I would look really stupid if I’d said, “Look, there are these risks building” and nothing actually happened. And, interestingly, at the end of the speech I went up to say hello to Chairman Greenspan and he was obviously not pleased. What was interesting was there were two private-sector people also there who were telling him, “Look, you’ve got to stop us from taking these risks.” And what was interesting was, that was the missing piece that somehow we had all convinced ourselves that the smartest guys in the room would have figured out how to manage the risks. 

The Goldman Sachses of the world – why would they go out on a limb? Why would they risk their firm’s capital? The missing piece, which to some extent I alluded to in the paper, was distorted incentives in the financial system – and that led to the tail risk-taking. The smartest guys were not immune to bad incentives. 

WALKER: You mentioned Greenspan not being happy with the speech. I think Larry Summers also attacked it for having a, “basic, slightly Luddite premise”. What was your model of the people who criticised the speech? 

RAJAN: I think what they had in mind was that I was standing against financial innovation. I wanted to go back to a world where there were more moderate pay packages and they thought I was trying to go back to overly regulated banking. You have to remember that pre-financial crisis, regulation was a bad word in much of the United States. The talk was all about self-regulation, about how these financial firms would be able to govern themselves completely. They didn’t need the regulators sitting on their heads. And this was the general tenor that “don’t intervene; free markets will figure it out”. And I remember – this was after the Jackson Hole speech – but we went to meet a bunch of risk management officers – this was 2007; Jackson Hole, the speech was 2005. This is as we are sort of almost at the point of the crisis, which you could date to August 2007. But this meeting was before then, and talking to a bunch of risk management officers I was just getting perturbed: “Nobody’s talking about risks here.” One of the guys from a European bank seemed to be really, really sensible and in a break I caught him and I said, “What’s going on? Why is nobody talking about the risks that have been built up?” He said, “You don’t understand. Anybody who talked about risk is no longer here.” And that was an indicator of how the system was operating. The risk management officers who cared about risks had all been fired or had been moved out. That was what was worrisome. 

I mean, there have been so many documentaries saying there are a bunch of bad apples. It’s not a bunch of bad apples. This is a system working as advertised and going completely off track in the process, which is much more worrisome, because it’s not bad people, it’s good people in a bad system. And the bad system is often much worse. 

WALKER: Yeah, in a bad Nash equilibrium. 

RAJAN: Yeah.

WALKER: So your dad was a diplomat or spy for the Indian government and so you travelled around a lot while you were growing up. Do you think your experience of the civil conflicts in Sri Lanka and Indonesia gave you a visceral sense of tail risks that maybe some others lacked? 

RAJAN: Not quite. My colleague Luigi, who’s from Italy – 

WALKER: And a former guest of the podcast

RAJAN: We often joke that, coming from more dysfunctional economies than the United States was at that time, we’re a lot more suspicious of the system. And that may have served us in good stead in the sense that we looked at some of the downsides and weren’t totally convinced that everything would work as advertised. 

I think to some extent that’s the only thing that I could attribute to my upbringing: that we were a little more convinced that systems didn’t always work. 

WALKER: After the financial crisis struck, did any of the people who had criticised the speech reach out to you and say, “Hey, you got it right”? 

RAJAN: You know, the people at conferences like Jackson Hole aren’t people who do mea culpas. I mean, they’re good people. I have been a regulator myself, and the reality is that at any point in time there are a whole bunch of people who are screaming that the sky is going to fall down soon. And the real question is, who do you pay attention to? Almost always, one of them will be right. But there are 15 of them. 

WALKER: Right. 

RAJAN: How do you pay attention? There’s always somebody writing a letter saying this firm is doing all sorts of shenanigans. And if you accumulated the letters which say that you’ve got all the banking firms in the economy who are doing something and then, when it turns out that one of them blows up, we will go back and find out that there was a letter sent on 14 March which passed by your desk, and you did nothing about it. Well, it was one of 150 letters like that and you passed it on to the right department and the right department said, “Okay, what do we do?” So warnings about crises are a dime a dozen. What do you take seriously becomes the issue for a regulator. So I am not perturbed that people ex post will say, “Well, yeah, we missed it” –  and some of them did say “We missed it and we should have paid more attention,” and some didn’t. But I’m friends with many of them. 

WALKER: By the way, Ian Macfarlane, who was governor of the Reserve Bank of Australia, told me that the RBA liked your speech at the time. 

RAJAN: Oh, that’s wonderful. 

WALKER: Moving to the deep causes of the financial crisis, the idea of yours that has most influenced my thinking on the global financial crisis and Great Recession is the ‘let them eat credit’ narrative which you introduced in your book Fault Lines, which was published in 2010. I think it has very deep implications and I’d like to kick the tyres of this story with you as well as discuss how your thinking might have evolved since the book was first published. So, firstly, could you just please briefly outline the ‘let them eat credit’ view? 

RAJAN: Well, there was a sense – which, again, like all ideas, there’s an element of good intent and truth to it – the sense that if we make credit easier, if we allow people to buy houses, for example, and they can ride the house appreciation, that’s good for their wealth, that’s good for their portfolios, but it also can take some of their worries away, including worries that they don’t have good jobs, they don’t have adequate human capital, et cetera. It may also make them property owners, which the [political] right thought was a good thing to have, a lot more property owners in the system. The left wanted workers to own their houses and become wealthier. So both sides sort of converged on this thing that we have to expand housing credit. I think that’s a good idea but within limits, right? 

The problem was that it became too much of a movement in its own right, and too much credit pushed too easily can actually do harm and even the people who get the credit can be harmed because they can get it at the wrong time. As prices are really going up they may not be able to afford the houses, they may not be able to afford the consumption that it made possible, they drew down on their home equity lines, and then found that house prices collapsed and there’s no equity anymore, in fact they were deeply in debt. 

So, like all good ideas, there’s probably a reasonable amount to which it should be pushed, and I think both the Republicans and the Democrats pushed it more than it should have been pushed. And, of course, as credit became easier, a whole bunch of lenders got in and some of those lenders weren’t particularly scrupulous, and this thing became a credit boom with perverse sort of outcomes like my colleagues Amir Sufi and Atif Mian have pointed out, that some of the poorest neighbourhoods got more credit than some of the richer neighbourhoods. 

WALKER: Yes, the number of mortgages was inversely correlated to income. 

RAJAN: Exactly. That kind of environment eventually contributed to the depth of the crisis. 

WALKER: Was the proximate cause of the expansion of credit politicians making cynical calculations or was it politicians just rationally responding to the demands of constituents? 

RAJAN: I think it was a little bit of responding to constituents who wanted greater access to credit to be able to buy homes. But I think it was also a calculation – I don’t know if cynical – but certainly a calculation that happy home owners made happier by house price increases are home owners who don’t have to worry so much about their income growth. And incomes weren’t growing particularly strongly for the lower middle to middle class at that time. 

WALKER: So the ‘let them eat credit’ view says that credit was extended almost as compensation for stagnant incomes. 

RAJAN: I think there was more pressure on politicians to do something if incomes weren’t growing and this was something which kept people happy. And why not? 

WALKER: Yeah. Because if incomes aren’t growing, then the only way you can consume more is through debt or equity. 

RAJAN: Right. And this gave people the illusion that they weren’t borrowing, because their home prices were increasing and so they were just drawing down on the equity they already had, rather than actually taking loans. Drawdown sounds better than borrowing. The truth of the matter is, they were borrowing against appreciation, which was getting more and more fragile because it was based on a bubble. 

WALKER: So there’s an even more pessimistic interpretation of what happened, which was that it wasn’t so much that credit was being extended as a palliative for inequality and stagnant wages, but it was actually a mechanism of upward redistribution, because once people took on these enormous debts, then they were, I guess, transferring permanent income to the rich through banks and the shareholders of banks. Although, I guess that sounds a bit too sinister to be true. 

RAJAN: I think that what was true is that the mechanisms that allowed these home lenders, for example, to make some of these mortgage loans and take in the fees and then pay themselves big bonuses based on the fees that they got from these loans, was there. Whether the entire system was sort of rigged to give them more bonuses or whether it was an outcome of a system which was at least publicly intended to give more credit to people… I’m happy to stay with the good intent gone bad, rather than saying the intent was bad in the first place to give the plutocrats yet more money. And, typically, I would say if you search the souls of the politicians, if we had access to it, I think many get into the business because they want to do good. What outcomes emerge from that may not be the right ones, but I think that they would start with the intent of lining the pockets of the rich at the expense of the poor, I think that’s a little further than I want to go. 

WALKER: Yeah, I agree. So as intuitively compelling as I find the ‘let them eat credit’ narrative, there still feels like a paucity of empirical evidence for the causal link between inequality and the expansion of credit. Have you found any, or what’s the closest to a smoking gun that you have found?

RAJAN: What is clear, from the work of people like Mian and Sufi, is that there was a perversity in the credit that was offered, and that this flowed much more than in the past to low-rated borrowers, to poorer neighbourhoods, as you said, inversely proportional to income. So there was an attempt to reverse the traditional flow and, again, that could have been completely driven by wanting to expand access to credit. What is the missing piece to some extent is what was the intent? Was it intended as a palliative? And that you can only gauge by going into the minds of the politicians. Why did they do this. But what was clear was it was from both sides: the easing of credit standards, the attempt to expand access, was both Republican and Democrat. 

WALKER: Yeah, you’re right that even that Mian and Sufi paper – that looked at the ZIP codes and found that between 2002 and 2005 the number of mortgages was inversely correlated to incomes – even that feels quite circumstantial [on the question of political intent]. A couple of years ago I had a look around on Google Scholar for whether there were any papers that got at that question of intent that you raised, and I could only find two, but neither of them was particularly conclusive. One of them was actually another Mian and Sufi (and Trebbi) paper, which was called ‘The political economy of the subprime mortgage credit expansion’; and then there was another one by Bertrand and Morse called ‘Trickle-down consumption’. 

RAJAN: That’s the one I had in mind. 

WALKER: Okay, yeah. They look at a particular bill... 

RAJAN: Yeah, yeah.

WALKER: Is there international evidence for the ‘let them eat credit’ view? How universal is it as a phenomenon? 

RAJAN: Well, look, I think the idea that credit can be a palliative is something that is seen in – I mean, look at Indian farm credit. 

We keep extending loans to farmers. The idea is this is really a transfer because we also waive the loans every few elections once they become really burdensome. It becomes a system of transfer which doesn’t have to be budgeted for at the time that you are initiating it, because it seems like what you’re doing is really expanding credit and that’s not a gift. But then, when you write it off, it does become explicitly a transfer. That’s one example where you are using credit for this objective of really softening people’s hardship. I think there are better ways of doing it than through credit. Credit allows you to mask the budgetary impact. 

WALKER: Yeah. I was trying to work out the intellectual history of ‘let them eat credit’, and I was curious how it originated in your thinking and whether you can take me through the chronology of that. You mentioned the 2009 Shawn Cole paper on Indian agricultural credit. Was it that, or was it a conversation with Amir Sufi, or Joseph Mason at LSU who alerted you to that 1995 National Homeownership Strategy document? 

RAJAN: No, I’m going to reflect my age, but there’s a guy who wrote paper after paper saying credit was misdirected

This is a guy who’s from the right. His was more a conspiracy theory; he was trying to put the blame of the entire subprime episode on government. 

I thought half the blame should belong to the government, but half should belong to the private sector also. Post-crisis, before the work of [Amit] Seru or Mian and Sufi, I think there was increasing discussion of the fact that government policies before on housing were partly to blame. That, I think, was a spur for my thinking about this in this particular way. 

During the crisis, I’d written about the kind of odd incentive structures in the private sector – “Let me take the bonus today and let the downside risk come tomorrow. So long as I take tail risk, that’s fine. I get the money up front and somebody else bears the losses down the line.” That was part of what was going on, but part was, why did it get focused initially on subprime housing? And that was the government piece, and there, tracing back the policies of both sides… You know, Barney Frank was at every opening of housing projects in Massachusetts, but he also eventually wrote the DoD Frank bill. So I think it was a bipartisan effort at pushing housing. 

WALKER: Right. When you wrote Fault Lines, the ‘let them eat credit’ view was underrated. Has this changed? 

RAJAN: Look, I think when people now are looking at some of the consequences of what happened – so, for example, I had a student who was looking at how credit affected minorities, and one of the worries is that minorities – who find access to credit harder – found it easier in the run-up to the crisis and were well positioned to bear the brunt of the losses during the crisis, and so it really hurt them. So that’s an example of places where people are sort of looking at this and saying what might have been well intentioned up-front eventually can be quite harmful to the people it was meant to serve. Some of the people looking at historically disadvantaged communities and how they got drawn into the crisis and were spit out, suffered badly during the crisis, I think there’s more work coming out on that. 

WALKER: So that work indicates that the economics profession is not underrating the ‘let them eat credit’ view as much anymore? 

RAJAN: I don’t think so. I think if you look at microfinance, for example, people are increasingly, certainly in practice, but also in some of the work, worrying about excessive lending. So earlier it was, “Oh, this is an underserved community, we have to get money to them.” But there have been a number of episodes now, certainly in India, where people overborrow and then are being hounded by the lenders to repay when they simply don’t have the capacity, given how much they’ve borrowed. And so, there is more of a sense now that public policy plus the private sector may make it too easy to access for the disadvantaged to access credit, and they themselves may not have the capacity to understand what is reasonable. In fact, they’ll take whatever comes because their discounting of the future is much higher – “Sick child today. Let me try and get the child to a hospital. What if I have to borrow.” But then the loan has to be paid tomorrow. That’s when the lenders start hounding this person. I myself, while I was in India, was much more focused on pushing payments and other services as the lead into inclusion, rather than pushing credit as the first thing. Because it struck me that the problem with pushing credit was that before people know how to manage their finances, if they get easy credit, there’s a likelihood they will overborrow and then face problems down the line. Why doesn’t the private sector understand how much people can borrow? That’s the same question that you want to ask of the subprime lenders in the US. There’s a sense, where there’s collective euphoria, they’ll find some way to repay. And when the euphoria dies down, there is no way to yeah. 

WALKER: And the lenders are subject to the same euphoria. 

RAJAN: Exactly. 

WALKER: Apart from inequality in the US, one of the other fault lines you wrote about in Fault Lines was that between developing countries (and Japan), whose economies had been shaped by export-led growth and who were looking to offload their surpluses, and then, on the other hand, developed countries looking to spend. On reflection, to what extent does the problem just collapse back into inequality again, because those surpluses could be the result of inequality within developing countries? 

RAJAN: Perhaps. What I was trying to talk about was the fact that we had a period of global imbalances. Some of it was driven by the US consumer being the consumer of first and last resort for the world and essentially driving large current account deficits in the US. But it was also true of Spain, of Portugal, countries in Europe, of Greece, that basically now had access to easier credit within the euro system, and who had become part of the euro system – the euro was their currency. And essentially they suddenly found borrowing constraints were much more relaxed, both on the private side as well as the sovereign side. And so they went on a spending spree. Even though they had to have pretty severe constraints while getting into the euro, once they were in the euro, it liberated spending. So, at a national level, you had the phenomenon of relatively poor countries within the euro area going out more on a limb and taking on big debts. 

But within the emerging markets, I think it was more a question of being a little more cautious about generating those spending sprees, especially in some of the Asian economies, where you remembered what happened during the Asian financial crisis. Instead of running a deficit, you tended to focus on running a surplus and let somebody else spend. You try and, in a sense, accommodate that spending through your exports. You let demand happen elsewhere. 

Domestic demand, getting your own people to spend by giving them easy money, we had discovered, was a problem and would end up creating banking problems and other problems. I think a bunch of emerging markets discovered that in the 1990s. So they had flipped over and moved to running more surpluses, and the industrial countries were quite happy to run the deficits. So it was a marriage made in heaven till it stopped being a marriage. 

WALKER: I want to move to central banking, but before I do that, a brief interlude on the IMF. I mentioned to a former very senior Australian economic policymaker that we were going to be speaking, and this person said to me: “One topic I would want to discuss with him is how frustrating it must have been to have had the US preaching about the importance of a rules-based international order from which it saw itself as exempt – the so-called American exceptionalism. In my view, the inability of the IMF to deal with this, especially in the years following the Asian financial crisis, when the US lectured the rest of the world about the need to reform the global financial architecture but rejected all commentary about its own policy failures, explains much of what precipitated the GFC.” To what extent do you or did you share this policymaker’s frustration? 

RAJAN: What was true at the IMF was the big countries had a bigger say in what you could say about them, in the sense that we recognise the large US current account deficit and also the fiscal deficit, the twin deficit problem at that time. I would say that, officially, the view at the fund was this was the central problem, and this would eventually lead to a collapse, a kind of macro-crisis of some kind, typically a currency crisis. I think while I was at the fund I started talking about the financial sector and the problems, but I don’t think the official view of the fund was that the collapse would come from the financial sector. The sense was always that the collapse would come from some kind of collapse in the dollar or something like that. Right? And it turned out that wasn’t right. But I think the sense in the fund that there were these global imbalances and they were weakening the system was indeed there. 

In fact, we put together, somewhat bravely, what was called a multilateral consultation, which was really an attempt to get the big players in these deficits and surpluses to talk to each other and find ways to bring it down. My sense is we persuaded the US that this was a good thing for the US to participate in. We went to a bunch of capitals to talk about how it was important to make changes. And then there was a change in the US Treasury. The secretary who was supporting this left and a new secretary came in, and he had no sort of desire to participate in this anymore, and the whole initiative just collapsed – reflecting to some extent what your interlocutor said, which is that the participation of big countries matters, them having the right attitude matters. But it’s not always that they want to push back on what the IMF does. 

Sometimes they are supportive. In this case they were initially. 

WALKER: Okay, to central banking; we’ll come to monetary policy and financial stability, but first some other questions. When you look around the world, which central bank or banks have the best-adapted governance structure for their circumstances? 

RAJAN: That’s a tough question. I think that a whole bunch of countries have the governance structure that they need. I think the Fed is reasonably well governed. I think the Reserve Bank of India has a reasonable governance structure for the country it is in and for the circumstances that it faces. I don’t think the issue is as much the governance structure as it is the kind of beliefs that sort of permeate a central bank at different points in time. 

WALKER: The culture? 

RAJAN: I would say more the economic ideology. It’s not so much a political ideology, but the economic ideology. 

WALKER: Interesting. Well, we will implicitly come to that question of economic ideology. But some more questions on central banking generally. So it’s interesting to me that central banks often draw their leaders from abroad. Examples include Mark Carney at the Bank of England, Stanley Fischer at the Bank of Israel, Gabriel Makhlouf at the Bank of Ireland. Why are central bank chiefs more like national football coaches than, say, heads of intelligence agencies in that they can be recruited from overseas? And what is it about the nature of the role that makes this plausible? RAJAN: Actually, I’ll push back on that a little bit because I think Mark Carney has some British roots, right? He’s not entirely – 

WALKER: Canadian. 

RAJAN: Well, he’s part of the Commonwealth, broadly speaking, but also he has some British roots. Stanley Fischer was always in the US and Israel, where he was governor. I don’t know if he has Israeli citizenship. 

WALKER: I think he has dual citizenship. 

RAJAN: Yeah, he must have. He’s also Rhodesian, by the way. 

WALKER: Oh, wow. 

RAJAN: But I think neither of those guys – I don’t know the third person you mentioned, but neither of those guys would have stood out from the banks. 

WALKER: The third person is a Brit in Ireland. 

RAJAN: Yeah. That’s also not too far away. I do think that central banking is a very political job. It may seem technocratic and, yeah, you think about what R-star is and you set interest rates with that in mind. 

Where you think R-star is completely political. I shouldn’t say completely political; it cannot be devoid of politics. But your language, your persuasion, the extent of hostility that you face – all that is political. You have to make the case that you’re doing something which is in the interest of a country at all times, and the less suspicion there is that you’re not against the country in some way, the better it is. Now, it may be that as a neutral technocrat you can convince. But it’s, in my view, better that there be no doubt about your allegiance and your sense that you want to do the best you can for the country. 

WALKER: To what extent are central banks truly independent? 

RAJAN: I don’t think they are. Technically, as a central bank chief, some countries will make it very hard to fire you. Does that mean that you can do what you want? No. You may have to go back to parliament for funding for this or that. You may need the support of parliament for certain actions that you need to take under certain circumstances. And parliament can, if it’s really angry with you, impose rules on you which would constrain your activities. I mean, you can feel happy that you can’t be fired. 

You may still worry about reappointment. I don’t know how many people worry about reappointment, but even if you don’t worry about reappointment, there’s still the issue of “Will my capacity to run this institution towards the aims that I have been given be compromised if I do something here or there?” In some sense, you’re always thinking, “Okay, what’s the political cost of taking this action versus the economic benefit?” 

For most actions, the political cost may be small, but there are some actions for which the political cost may be really big. And then you want to think twice, thrice, “Do I want to devote the political capital I have to that particular cause?” 

WALKER: You alluded to the fact that parliaments, ironically, try to influence central banks by threatening to undermine their independence. Would it be optimal or best practice for central bank independence to be enshrined in constitutions so that parliaments can’t make those threats? 

RAJAN: I don’t think it’s wise to completely put the central bank outside of any kind of control. I think unelected officials should have some oversight by the elected representatives of the people. I think there’s an optimal point where you respect them and you try not go too far away from what is politically acceptable. But there are times when there is something you need to do which will cause pain, which somebody who wanted to be elected in the next election would perhaps not espouse, but which you think is needed not just for the next election cycle, but for many election cycles down the line. 

That’s when, if you have enough independence as a central bank, you can make the tough choice. But to completely ignore the elected representatives of the people all the time? Well, sometimes they actually have sensible ideas which you should be paying more attention to. 

WALKER: They can be an input? 

RAJAN: I think having a dialogue with them is not a bad thing and having respect for them, respect for their views, and not being able to dismiss them out of hand is important. At the same time, being under their thumb is not where you want to be. So, all I’m saying is there are trade-offs here. I think complete independence is probably not warranted; complete dominance is not warranted. There’s an intermediate place where I think societies achieve a reasonable outcome. 

WALKER: Some questions about the history of inflation-targeting. As you know, the Reserve Bank of New Zealand was the first central bank to adopt an explicit inflation target, in 1990. It picked 2%, and then soon after, all the major central banks followed suit. Why have all the major central banks coalesced around this 2% number? How was it derived? 

RAJAN: I think just like the Basel capital requirements initially – which was set at, if I recall, 8% – out of thin air. It seemed like a reasonable thing; not too close to zero, and not too high up that at some point inflation becomes noticeable. Two per cent is a level where you get some inflation, but nobody really cares about it. Studies of where inflation becomes a problem typically would say somewhere in the double digits. So there’s a lot of room between 2[%] and double digits. And the reality is, the worry is, when inflation is higher, it can start getting a life of its own. And so what you want is a level of inflation which is low enough that nobody really cares too much about it. Then what that does is it means that things get anchored around that. And there are relative price movements, but not an absolute price movement. 

WALKER: Right. 

RAJAN: It’s at the higher levels that the relative price movements become more absolute price movements and you get more generalised inflation from, say, the oil price going up, stuff like that. 

WALKER: And I suppose there may also be some kind of psychological effect of double digits. 

RAJAN: I’d say high 8, 9% is also a reasonably high level of inflation. And remember, it’s an average. So things could be going up 15, 20[%]and say, “Oh my God, my shoes have gone up so much!” As you know, people’s thinking about inflation is never driven by the CPI; it’s driven by the salient stuff that you see, right? “What do I think is most important,” and that’s going to drive your perceptions. 

WALKER: Yeah, well, I have a question on that. It’s a small question: what’s your best explanation for how inflation expectations are actually formed? 

RAJAN: It’s a great question, because I always wondered how, certainly in India, because our whole edifice of inflation control is built on discussions of bringing inflation expectations under control, bringing them down. And to some extent, what was absolutely clear was that what we said we intended to do – and I think we had got credibility – was exactly what the analysts and the monetary journalists thought would happen. So we were very good at getting their expectations more focused on what we intended. What I couldn’t fathom was how this got into the public’s expectations because, unlike industrial countries, we didn’t have strong wage-setting bodies, unions and so on, where you would think the second round of expectations would sort of flow; the unions would maybe read what the analysts are saying and say, “Okay, maybe we should shoot for 3% or 4% inflation in our wage”. We didn’t have a whole lot of that in India. So how did it get from there down to the public’s expectations? If you looked at surveys, they were so far from the actual inflation numbers. I mean, historically they’d always been much higher than the actual inflation numbers, but also how they’ve moved down over time. Yet we brought inflation down from double digits to within our inflation band. I still am not fully sure of how that mechanism worked. 

WALKER: Any hunches? 

RAJAN: I think things percolate and I think they feed on themselves. And lastly, luck helps if some of the salient aspects of inflation get taken care of – food prices, fuel prices – and they slow down, then people’s expectations become more moderate. But can you target food and fuel?  Well, some government management can target food; fuel is much harder, that’s more an international price. 

WALKER: Yeah, for India particularly. 

RAJAN: For India particularly. But I think things percolate, but it’s not as… Sometimes when you read these papers in journals: “the central bank sets a particular inflation objective and it somehow gets internalised by the system.” That step, there’s a lot of hocus pocus in how that happens. 

WALKER: A bit of magic. So you oversaw the introduction of India’s inflation-targeting scheme, and India’s inflation target obviously is 4% plus or minus 2%. How was that target derived? 

RAJAN: Well that’s much simpler, right? I started with this notion that, look, a salient price is the rupee–dollar exchange rate. That’s what a lot of people focus on and seem to think that that’s an important indicator of the strength of the economy but also what’s going on and inflation et cetera. So, let’s try to have an inflation target which would keep that nominal exchange rate reasonably stable. If we have around 2% real productivity growth, maybe with a 4% inflation, our nominal exchange rate would be relatively stable against the dollar. So it was as simple as that. 

WALKER: I mean, not to belabour this point but just generally, doesn’t it strike you as odd how arbitrarily these numbers can be picked? 

RAJAN: Yeah. 

WALKER: Given they’re so important. 

RAJAN: I don’t think it matters that much. 

WALKER: It’s more that they’re low and you just hit them consistently? 

RAJAN: Yeah, I think that’s what’s more important. And this is where I think people say, “Oh, 2% is too low; let’s go to 4”. Well, there’s never a good time to do that. If you are way above 2[%] and you say, let’s go to 4[%], it sounds like you’re admitting defeat. I can’t get back to 2[%]. 

WALKER: “Let’s change the goalpost.” 

RAJAN: Therefore let’s change the goalpost. And, of course, if you are at 2[%] or below 2[%] and you say 4[%], sometimes the problem when you’re below two is really getting inflation up. That was the whole problem before the pandemic, right? The Fed had too low inflation. I think it was 1.2% or something over the previous decade before it changed its framework and said, look, we really need to get it up. But it ignored people who were saying, “Say, 4[%],” because it seemed a little ridiculous: you can’t reach 2[%], so you say 4[%] instead. What it did was, it changed the framework to be a little more accommodating of inflation. 

I would say it doesn’t really matter what number you pick, so long as it is below the radar screen of people. But what is important, I think what I would say as far as the inflation target goes, is we have much better tools, we have much better understanding how to bring inflation down. We are much less capable of pushing inflation up when it is low. At the same time, it’s probably not that problematic if it’s 1% and your inflation target is 2[%]. The world doesn’t come to an end because of that. It’s just that people still don’t pay attention to inflation. It’s when it’s galloping deflation that it becomes a problem. 

And yet we haven’t seen galloping deflation anywhere since perhaps the Great Depression. And so, I would say be a little more relaxed on the downside. Don’t say that I’m underperforming my inflation target, I have to pull out all stops and find some new monetary tool to expand the economy; instead, say, okay, what I’ll do is when it exceeds the target, I will bring it back to the target. When it is below the target, I’ll be a little more relaxed. It may be a sign that I can be a little more accommodative, but I’m not going to get aggressive on it. Because if I start getting aggressive and trying to push inflation up, bad things can happen. 

WALKER: That asymmetry is relevant to this broader conversation around unconventional monetary policy, which I want to come to now. Firstly, after the GFC, why didn’t the Keynesian approach to restoring aggregate demand work? 

RAJAN: It’s a great question. My colleagues have talked about excess debt. You know, Larry Summers uses the term ‘secular stagnation’, though it’s a little fast and loose about where the stagnation comes from. I think the reality is that post-global financial crisis, there certainly was still a worry about too much fiscal stimulus. And there are those who say that perhaps the fiscal stimulus, post-global financial crisis was a little too little. It was only a trillion relative to the $6 trillion that happened during the pandemic. Be that as it may, my own sense, which is what I wrote about in my book The Third Pillar, was that the reality was developed countries had a development problem. It demonstrated itself inequality, and so on. But the real problem was that you had a whole bunch of people who didn’t have the skills that would get them good jobs. And to some extent, until you focused on that, I think it was going to be harder to get the kind of growth that you needed. 

In other words, you had to do structural reforms. And this sounds like the annoying sort of old geezer who says whenever things are slowing down, “All you young pups, you always want to stimulate. You actually need to fix the underlying problems. Structural reforms.” But I do think, as a number of people have suggested, one of the problems with the low demand in industrial countries stems from inequality that the lower end could consume more, would consume more, but doesn’t have the incomes. But how do you generate more incomes at the lower end? You have to make them more capable of getting good jobs, which means focus on capabilities, skill building et cetera. And for all the talk about the China effect on the US, I think the reality is the US has a lousy system of training people in response to trade shocks. The trade adjustment mechanisms simply don’t work. 

On the other hand, small economies like Sweden or Denmark have very active processes by which workers are constantly being trained for potential new jobs if they lose their old jobs. And I think that kind of more active labour market policy would have been more effective for the kinds of shocks that the US faced. But more broadly, I think the point is, while the US doesn’t have that active training process, it has a wonderful higher education system and to the extent that can be purposed towards providing a broader set of skills… Now, again, that system did go into overdrive, sometimes provided the wrong kind of skills to the wrong kind of people at high debt. The student loan problem is another problem related to the ‘let them eat credit’ problem that we saw with housing. I think, again, this is a problem with no easy solution, but it is one that I don’t think the answer is more stimulus; the answer is more reform, which creates more capabilities. It’s a development problem rather than a stimulus problem. 

WALKER: To the extent that quantitative easing is effective, is your guess that the dominant mechanism is signalling or that it’s portfolio rebalancing? 

RAJAN: I think the jury is still out. So the portfolio rebalancing idea for quantitative easing is, “Look, we’re going to take long-term assets out of your portfolio.” I’m going to say it as simply as I can. We’re going to take long-term assets out of the private portfolio. That gives the private sector an incentive to rebalance towards the longer term. And that’s going to be really good for the economy because rebalancing towards longer term means making longer-term loans, getting new projects financed, and that’s going to be a driver. So, effectively, we’re going to take out term premium and as it gets re-established, you get the kind of lending and activity that you desire. By the way, when you think about it in the detail, it doesn’t happen that way because what happens is you’re buying these long-term assets from the private sector, but they don’t immediately rebalance into new long-term assets. 

Instead, what happens is, because some of the financing of these reserves that are issued by the central bank take place in the banking sector, the banking sector actually goes the other way. It shrinks the maturity of its liabilities towards more demandable claims and away from time deposits, and so offsetting the fact that the private sector as a whole may want more longer-term assets. The commercial banking sector actually produces more short-term liabilities and inhibits its own ability to finance longer-term. So it’s not as simple as portfolio rebalancing. 

The other point you talked about was signalling, and this is the idea that so long as I’m doing quantitative easing, I’m not going to raise interest rates. That’s most associated with Arvind Krishnamurthy and Annette Vissing-Jørgensen. I think it’s a good point and to some extent both the Fed and the ECP stayed on hold longer in order to finish quantitative easing, perhaps to verify this instrument for the future, to strengthen the quality of this idea for the future. 

But, broadly, I think it’s really hard to find serious positive effects on activity from QE. Going back to our previous discussion, it may be that really the need of the hour in the period between the end of the panic in the global financial crisis and the beginning of the pandemic, what you needed in the in-between period was really structural reforms  – and I’m going to be a little bit of a broken record on that. 

WALKER: No, by all means! A brief digression just on this point about signalling: it got me wondering, what proportion of central banking is just mere signalling as opposed to more object-level effects? 

RAJAN: It’s hard to say. I mean, look, I think central bankers worry a lot about portraying a reasonable degree of confidence that they know what they’re doing, and that even if there is short-term pain, there is much longer-term gain. We talked earlier about political signalling. That’s part of the political signalling also. You have to convince the representatives of the people that you’re not masochistic, you’re not just inflicting pain for the sake of pain, and you’re not completely some nutcase who’s going to just focus on inflation and forget what the pain to the real economy is. You’re basically saying, “I understand, and even taking into account all the pain that I’m going to inflict, trust me, we have thought about this a long time. We have a lot of evidence and it would suggest better take some pain now than have a long, drawn-out, painful process and much greater pain down the line.” 

That’s the argument that central bankers have to make again and again. 

WALKER: Would all aspiring central bankers benefit from studying signalling theory? 

RAJAN: I don’t think it’s so much signalling theory as they need to show a degree of confidence about what they’re about. I mean, the classic example was Mario Draghi with his “We’ll do what it takes and trust me, it’ll be enough”; he’s, one, signalling what he intends, which is to not allow the fragmentation of the euro area; and, second, that he’s confident he has the ammunition. And I’m sure years from now, we will still be talking about that as an example of a central banker essentially portraying confidence about what he was about and that he could do it. Whether he really believed he had all the tools and whether he could do it, you’d have to ask him. But I think it is exactly what a central banker is supposed to do. 

WALKER: My favourite kind of formulation of this was a blog post written by my friend and a former podcast guest, John Hempton, in 2011. He’s a famous short seller and hedge fund manager in Australia. This was when people were arguing that Ben Benanke needed to be irresponsible and commit to encouraging higher than normal inflation to try and raise expectations. Hempton’s blog post was that Bernanke should go on CNBC, announce that he’s buying Italian government bonds, wearing a Hawaiian shirt, and then light up a marijuana pipe and start smoking. 

RAJAN: Yeah, absolutely. I do think that a less effusive way of doing it was the new framework that the Fed adopted in 2020. Unfortunately, it was adopted at just the wrong time. 

WALKER: So, has unconventional monetary policy been good or bad on net? 

RAJAN: I think history and the jury is still out, so I think we’ll need a lot of analysis. I would say it was very good early on. If we’re talking about quantitative easing, it was good early on when it was about repairing markets. It’s much harder to find evidence that it was hugely positive after that. And because there’s so many other things happening in financial markets as well as in the real economy, it’s very hard to tell the signal from the noise later. Did, for example, QE work in bringing down the term premium? Depending on which study you see, you can get different answers. And especially when you ask the question, “Did it have positive effects on real activity?”, it’s easy to see where Draghi says “We’re going to buy bonds” and then suddenly bond prices of European sovereigns go up. Banks which are holding a lot of this see their equity prices go up and then they effectively have more capital. They can go out and lend and there’s some of that that happens. Well, that seems like a natural mechanism, you can understand that. Whether the broader mechanism, the portfolio rebalancing, the signalling, any of that helped elevate activity, is much harder to tell. And, as you know, my colleague, along with a bunch of co-authors, has written a paper, Ľuboš Pástor, basically saying it depends on the eye of the beholder. If you look at studies by central banks – 

WALKER: Is this the ‘50 Shades of QE’? And they look at those 54 papers?

RAJAN: Yeah, and basically there’s a lot of noise. And I don’t think the authors of the studies are falsifying data in any way; I just think it depends on what period you look at, what variables you look at, what you put on the right-hand side in the regression. It does suggest that the results are tenuous enough that you can have different interpretations. That to me suggests that it’s not clear that it had a lot of positive effect. I do think getting out of these enormous balance sheets is going to be a huge problem. And we’ve already seen one of the downsides, which is that I would suggest the ease with which we have seen fiscal expansion in the last few years, which is now starting to seem problematic, is in part because central banks were big buyers. I’m not saying it’s the only reason, but I think the fact that long-term rates were anaesthetised during the period of enormous fiscal expansion helped. And indeed there are some economists who said, “Go out and spend. Long-term rates are really low, this is a good time to spend”, without thinking about the fact that spending takes a life of its own.

WALKER: On that ‘50 Shades of QE’ paper, just for people wondering, I think they find that papers written by central banks are broadly positive about the effects of QE. Papers written by academic economists are ambivalent, and then the Bundesbank is like moderately negative. 

RAJAN: Exactly, and it’s the Bundesbank which is the most interesting. Here’s a central bank, except that the official view in that central bank is generally negative on aggressive monetary policy and – surprise – it doesn’t find a positive result. 

WALKER: And what’s the path dependence or history of that institution that makes it negative about QE? 

RAJAN: Look, I think that it has historically been conservative. Of course, the German experience with hyperinflation in the ’20s, and at least the hint that it might have led to the rise of Hitler because it wiped out the middle class, is something that they are acutely aware of. The flipside, of course, is, from the American perspective, that the deflation of the ’30s is something that seems to be very strongly embedded in the psyche of American central bankers. If you recall Bernanke’s famous statement to Friedman, you know, “We know the mistake we made then, and we won’t do it again.”

WALKER: Yeah, “You were right”. 

RAJAN: Yeah. So in that sense, I think these episodes… And that’s where I came to economic ideology I said earlier in the podcast, right? That’s to some extent what I mean. There is a national ethos that gets embedded into central bank thinking also: “This is what we need to guard against.” So the US is very much guarding against a deflationary episode. Not that we’ve actually seen one in the recent past, but of course the argument could be we haven’t seen one because we’ve been guarding against it. While the Bundesbank is much more worried about inflationary episodes and wants to jump at the first sign that it sees any. 

WALKER: So, thinking about problems like liquidity dependence, to what extent did central banks, in your opinion, have a clear exit plan when they embarked on unconventional monetary policy and QE? 

RAJAN: I don’t think they felt there was a need for one. If you recall when the Fed embarked on QE the first time, I think it was one of the Fed presidents, later echoed by Janet Yellen, one of the Fed presidents said basically it’s going to be as boring as watching paint dry. There was a sense that you had built up so much in terms of assets, all you had to do was sell it back to the market. At worst, what would happen would be you’d see a re-emergence of the term premium which you had extinguished by buying those long-term assets. But what goes down must come up – that’s all there is to it. I don’t think that anybody thought about the consequence of this kind of central bank balance sheet expansion that it could have led to an expansion in the commercial bank balance sheets, which is what we – my co-authors, Viral Acharya, Sascha Steffen and Rahul Chauhan and I – showed that expansion in the commercial bank balance sheet is something to worry about because it doesn’t come down at the same pace as the central bank balance sheet expansion. What you get is a more and more fractional reserve banking system as the central bank withdraws reserves. Now, of course, we now have a second episode of quantitative tightening, and this one early on precipitated a mini crisis with the banking crisis in March of 2023. And since then, you do see commercial banks also shrinking their balance sheets, but for a different reason, which is that they now have to pay high interest rates and they simply don’t want to pay those high interest rates anymore. 

WALKER: To what extent should we view QE as being motivated by political considerations? Namely, say, take the Fed, for example, it had done a lot in bailing out Wall Street, and then it felt that it needed to be seen to be doing something for Main Street. 

RAJAN: I don’t think, as with any question of intent, it’s possible to draw a straight line and be sure of it. I do think that there’s a lot of pressure on central banks when inflation didn’t come up to the target and they were undershooting the target. There must be some monetary expansion that you can still do, and you’re not doing it. If you’re not doing it, that must mean that you really don’t care as much for the people. I’m sure that kind of argument could have been playing, but it’s also an argument that is consistent with their mandate, right? Their mandate is maximum employment within price stability. So if you’re not achieving price stability, it means that you can do some more to try and achieve maximum employment. Again, I don’t think anybody saw the possibility of any downside to balance sheet expansion. It was a free tool which hadn’t been exploited before. 

Why not do it now? And so long as we don’t look like we’re financing the government, we’re just buying assets from the market – let’s do it. So I don’t think people looked at the downsides and nobody worried about whether there’d be costs getting out. 

WALKER: Okay, monetary policy and financial stability – we’ve saved the most controversial to last. It’s obviously not terribly controversial to say that financial stability should be part of a central bank’s mandate broadly. But should financial stability be a goal of monetary policy specifically? 

RAJAN: Here’s the way many central bankers deal with this, right? “Oh, absolutely, we do care about financial stability and obviously we have a whole rationale built up for how we determine monetary policy. But the twain never need meet because we have this fantastic separator called supervision, including prudential macro-supervision, which will somehow make it so that easy money never creates financial instability.” So that’s the separation principle, and central bankers have convinced themselves: once we have the separation principle, we have a monetary policy side that looks at monetary policy. We have a financial stability board, which looks at financial stability. They don’t need to talk to each other. And I think this is rubbish. 

WALKER: Can you say more? 

RAJAN: I think there’s a very nice paper by José-Luis Peydró and a bunch of co-authors which shows that before every serious financial crisis, you have a period of expansionary monetary policy, interest rates coming down, and then monetary tightening, interest rates going up, and then, boom, it explodes. I think this is basically that the problems are built in a period of easy money – the perverse lending. I mean, no matter how well run the system, easy money makes it possible to make the kinds of loans against booming asset prices, which essentially become problematic down the line. And of course the period of tightening is when the easy money disappears. That’s when – the famous Warren Buffett quote, “you see who’s swimming naked because the tide has gone out”. I think to the extent that central banks are really aggressive in the period of easy money in trying to elevate activity and constrained by their mandates to be aggressive in withdrawing that accommodation in bad times, they put all the adjustment on the financial sector. The financial sector is simply not able to adjust in such a smooth way, and so that’s when things go boom, because leverage builds up in the period of easy money and withdrawing the liquidity, raising interest rates, makes that leverage toxic in the period of tightening money, and that’s when you realise that there are problems. 

So is this a law of history? I think it’s sufficiently sort of… you see the pattern time and again before every crisis. If you think about these famous macroprudential tools, the Bank of Spain had macroprudential tools before the global financial crisis and Spain had a rip-roaring banking crisis. So I think when you’re pushing on the monetary accelerator, there’s very little that the supervisory side can do to sort offset that. I mean, we saw it in 2023, right, with Silicon Valley Bank. I mean, what were they thinking? But more, what were the supervisors thinking? And these guys basically loaded up on longer-term debt so that they were effectively decapitalised as interest rates went up. Why didn’t they do basic risk management 101? And you have to believe that, “let me make a small spread, let me pick up pennies before the road roller,” and they got into trouble doing that. 

We make the same mistakes again and again. We don’t have to make new ones, but of course we figure out new ways of making mistakes also. 

WALKER: Great. Okay, so I want to push back on your argument, but actually just quickly before I do that, as a side note, I was wondering, there was this 2012 Financial Sector Legislative Reforms Commission that presented the Reserve Bank of India with a report that recommended that the supervisory function should be split out from the RBI, I think maybe because of conflicts of interest and the RBI already had a lot on its plate. But then this didn’t happen under your governorship. Was that because you thought that financial stability should mostly be the role of the central bank? 

RAJAN: Look, I thought we had more important things to do. 

WALKER: Okay, fair enough. 

RAJAN: I think financial stability is important, but it wasn’t so much that I didn’t think that the problem was serious conflicts of interest as not doing what a sensible supervisor should do. Which means figure out where the excessive lending is happening… Now, when I was at the RBI, it wasn’t so much excessive lending as forbearance – not taking account of the mistakes that had already been made which had to be reversed. And so my focus was on that, including tallying up the actual bad loans that had been made and how much evergreening that was going on. We started the process of cleaning up then and it took five years, but by about 2019, under my successors, finally we had a clean banking system. But the problem was the referees not calling the penalties. That we had to change. 

WALKER: Yeah, that airing of the non-performing loans, that was a massive achievement. So some reasons against targeting financial stability with monetary policy. I’m sure you’re aware of the cost-benefit analysis by Lars Svensson in 2017 that found that there’s not necessarily a problem in principle with leaning against the wind, but in reality he finds that the costs were more than cleaning up after. What about that analysis didn’t persuade you? 

RAJAN: I would be really surprised if any analysis of the global financial crisis and the subsequent political changes which, leading up today, would suggest the costs of that crisis were less than the costs of somewhat more reasonable monetary policy before. 

WALKER: Properly accounted for. 

RAJAN: Yeah. I just think crises are so dramatic, including in changing your views of the system itself, that I think they’re best avoided. And if it means that you don’t become so aggressive on monetary policy that you have more moderate changes in interest rates, I think almost surely that beats having a crisis. Yeah, you sacrifice some activity. We still sort of have no idea how this is going to play out in the next year or two, whether we’re going to have more turmoil. We still have weak banks in the US, especially the small and medium-sized banks because they’ve gone out on a limb in terms of lending, et cetera. 

But this is the cost-benefit analysis we have to ask at some point, right: would easier monetary policy over the last ten years – again, you have to say, relative to what – but if we hadn’t done all the QE, would it have made that much difference? Set aside the risks of higher financial instability. We’ve already had massive Fed intervention by insuring all uninsured deposits in March of this year. What that sets in place for the future, we don’t know. But I think more moderate… I’m not saying you have to be really crazy on monetary policy. I’m saying be a little less aggressive on either side. More moderation. Maybe there’s Friedmanian in it – don’t go chasing after every goal with absolute press the accelerator – press the brake. 

WALKER: Another pushback: doesn’t a financial stability goal for monetary policy require a central bank to have a rigorous test for identifying asset price bubbles? And is it even possible to identify bubbles ex ante? And if we can’t even get prudential regulation right, why should we expect to get something like that right? 

RAJAN: So, look, I think it is possible to argue yourself into a corner here, right? We cannot identify every bubble. Are there places where we start seeing the combination of credit growth as well as asset prices moving together? This is the famous paper that Philip Lowe wrote with Claudio Borio – 

WALKER: for the Bank of International Settlements – 

RAJAN: Yeah. Which I think suggested that was when you had more danger. And again, I would say the point is not so much stopping it in its tracks, but being more wary at that point and throwing more sand in the wheels at that point, certainly slowing accommodation if you already have accommodation somewhat. Again, we’re not talking about monetary policy as the way to stop every bubble, but we’re saying lean against the wind a little bit. It’s not a bad idea. 

WALKER: Okay, next pushback. A financial stability objective affords too much discretion – that’s the claim that I’ll put out there. And too much discretion, as you know, can actually undermine a central bank’s independence, because when bankers are bound to strict rules they are less likely to be influenced by politicians. 

RAJAN: Yeah, again, this is one of those things in practice that’s different from what it looks like in theory, right? In theory, it looks like, oh, with the monetary policy rule, it’s so clear. Well, we’ve seen big deviations from Taylor rules, right? So it’s not as if because you’re focusing only on activity, not on financial stability, that what you do is predictable and very clear and communicable. There’s lots of variables which go into your decision on what monetary policy you set, when and how. To the extent that’s already a really complicated thing, and it’s hard for outsiders to discern that carefully, one way of looking at it is, why add more complications? The other is it’s already complicated, so adding more complications doesn’t make it that much harder to do. The reality is, we never set monetary policy, any sensible central bank never sets monetary policy, based on models alone. Sometimes the models even are back-fitted to substantiate the position of the central bank. “Why am I not doing this? Because my model says I can be a little more comfortable.” 

But really, a lot of it is looking at really a complex set of variables and trying to decide, given this complex set of variables, where is the most cost-effective path of getting to my objective? It’s not something that you can tie to one model. In that sense, I think it is a complicated task. I think, keeping in mind, how would you bring financial stability in? This is the way many people already talk about how they would bring it in. Oh, yes, we’re looking at activity over the medium term and inflation over the medium term. And, of course, if we have a deep crisis over the medium term, there will be very little activity to speak of and then we’ll be undershooting our inflation targets. That means it comes in through the inflation targeting framework itself that we need to be aware of financial stability risks building up. 

Now, what you do in terms of monetary policy and how you communicate it, of course we will have to make changes from where we are now, because we completely ignore that while talking about this. I think, again, it’s the combination of credit liquidity and asset prices that you would start trying to say more about than just about asset prices. And I agree with you: that alone would be something that would be very difficult to communicate and you may be wrong a lot of the time. 

WALKER: Reading your work, I get the sense that you appreciate the parsimony in John Geanakoplos’s view of leverage cycles. He has this model where an extension of credit availability basically empowers the optimists in a population to set the marginal prices for an asset. Do you think that is like a sufficient explanation of how bubbles begin? Or do we need some kind of deeper theory of where the demand shift happens? 

RAJAN: I think bubbles always have… I mean, this is the Schillerian view, right? There’s a narrative behind the bubble: how this thing is going to be the answer to all our dreams. And you can’t quite pinpoint how it’ll be the answer, but it will. AI for now is an example, right? It’s going to change the world, it’s going to change everything and how everything is done. It’s going to be the solution. Precisely how? Well, look at ChatGPT-plus and, somehow, wave hands and it’s going to make a huge difference. So I think there is usually a narrative behind financing the optimists. Narrative plus money creates the self-reinforcing view: oh, yes, this is the new, new thing that is going to happen. But, obviously, different bubbles have different aspects also that combine with these. 

WALKER: Okay, here’s a question I’ve been wondering about. So, if central banks are to lean against the wind, should they distinguish between debt bubbles, like real estate booms, and equity bubbles, like the dot com bubble, and then not lean against or lean more lightly against the equity bubbles? Because there’s some interesting evidence that some bubbles, usually the equity bubbles, actually help to kind of lay the infrastructure for new technology revolutions. There’s a good book on this by Carlota Perez

RAJAN: The Perez book is a very interesting one. Look, I think when we talked about this earlier, I said where we can be more worried is where there’s a combination of leverage, liquidity and asset prices coming together. And that would suggest what you just said, which is focus more on debt bubbles, debt-fuelled bubbles, than equity. Because equity at one level, as you said, the risk-taking, risk tolerance of equity investors may actually fuel certain kinds of investments which wouldn’t be otherwise done, and which may take us over a certain hump in terms of innovation and growth. But the other is – typically, not always – you might think these are the people with more money and therefore they can afford to lose it more than perhaps people who’ve just got into their first home and find that they’re in deep distress. I think from an equity perspective and from the growth perspective you’re talking about, perhaps one might want to worry less about equity bubbles. 

And it may also be hard for monetary policy, unless it has reasonable foresight, to do much about that. But that said, I would say, certainly when there’s a combination of debt and asset prices as well as liquidity, it’s important to look at it.

WALKER: The Reserve Bank of India, alongside the European Central Bank, is one of the few central banks in the world to continue to pay attention to credit growth in determining its monetary policy. What is it about the institutional history of the RBI that makes it special in this regard? 

RAJAN: I don’t want to comment on the current sort of policies of the Reserve Bank. When I was governor, it was one of the things we looked at, but it was just a measure of activity amongst others, and I wasn’t going to target credit growth. We were focused on inflation. I think the Reserve Bank [of India] in the past used to have five or six indicators it used to look at and it wanted a reasonable balance between all indicators; it thought that if it did a good job on all of them, that was sufficient. When we moved towards the inflation-targeting regime, I was much more concerned that when we said five or six, people never knew what we were doing and as a result we could claim success because we achieved three out of five and might still be failing tremendously on inflation. So I said, let’s give ourselves no room and we are going to bring down inflation. That was not wholesale price inflation, which was the convenient focus of the Reserve Bank. A lot of wholesale prices were determined by imported goods, and so we could bask in low-imported inflation while, in fact, CPI inflation, which is what the common person faced, was through the roof. 

So we said we’re going to bring down CPI inflation, and that was not some sort of core CPI. We’re going to focus on headline, because food is a big part of people’s basket and even though it’s volatile, that’s what they consume. So yeah, we can look through the volatility, but we need to keep people’s sort of inflation under control. That was why we focused on CPI inflation. I don’t know if the RBI has gone back to adding more stuff in that, but the inflation targeting mandate is CPI. 

WALKER: Got it. Okay, so one last pushback on targeting financial stability with monetary policy. As you pointed out, Raghu, historically, prudential regulation has been inadequate. But why isn’t this just an argument for better prudential regulation? I guess you could make Crockett’s argument, which is that the effectiveness of prudential regulation is inherently countercyclical. But then, isn’t that in turn just an argument for non-cyclical prudential rules? 

RAJAN: There’s a practical aspect to what I’m trying to say, right? Which is that it’s convenient to say, “Let those guys take care of it,” but they’ve never taken care of it, maybe for the Crockett reason that in good times it’s hard to stand in the way of the herd. You know the famous William McChesney Martin (I think it was William McChesney Martin) – “Take away the punch bowl when the party gets going.” Even for monetary policy it is difficult, but at least there you’re controlling a tool which is a little distant from the politicians. If on the other hand, you put in borrowing controls or leverage requirements which hit the average borrower just as the economy is rollicking, I think the kind of political pushback you get is tremendous. So maybe it’s for that reason we haven’t seen macroprudential tools used really effectively, but it’s also that macroprudential tools are typically only operative on the banking sector. 

In today’s economy, we have a huge area of financial sector players. As Jeremy Stein once put it, the good thing about interest rates is it gets into every crack, while all this other stuff is very narrowly focused and may not get into every crack. So, to that extent, I’m saying the practical reality is, you can’t sort of completely ignore it and leave it to others. Do you abandon it? No. You try and do the best job you can on macroprudential supervision, on supervision itself, et cetera. But you also recognise that monetary policy cannot be jamming on the accelerator when you have a deep macroprudential problem building up and you have to say, “Look, maybe I need to give those guys some help.” And one way is to take your foot off the accelerator a little bit. 

WALKER: To respond to Jeremy Stein’s point, is the kind of stuff that lives in the cracks the same stuff that we really care about anyway? 

RAJAN: Absolutely. Because what we have done, the other thing we have done, is push the risks increasingly out of the big banks into the smaller banks, into the shadow financial system, right? I mean, why are we so happy that the big banks were safe this time? Well, because they’re the big banks. But let’s not be totally confident that the risks have disappeared. They’ve moved elsewhere within the system. And we need to see at the end of it, when we tally the risks and the losses, whether in fact the system is safer. Now, having an island which is totally safe, and a surrounding ocean full of sharks, may not necessarily be the safest, especially if people decide to take a swim. Mixing too many metaphors here. 

WALKER: I follow you! Okay, three final questions. If a central bank is to target financial stability with monetary policy, how should it choose between price stability and financial stability when these objectives are in tension (and assuming here that macroprudential regulation will be ineffective)? 

RAJAN: Yeah. This is the old ‘one tool, two objectives’ business, right? You always have to give a sense of the trade-offs. And as I said, one way of talking about the trade-offs as being compatible is to say, look, we don’t want to kill the financial system, because that would imply much lower growth and much lower inflation than we want. And so, as we’re going forward, we see some risk building up in the financial system. Let’s be a little careful about that. And one of the ways we are careful is that we don’t lower interest rates much more, we sort of stop here at a reasonable level. 

I don’t think this completely is going to lead to incoherent statements. You can very well make a statement. Chairman Powell makes a statement after every monetary policy meeting. He can perfectly well articulate monetary policy that is taking into account rising risks in some part of the system, which suggests that perhaps some amount of accommodation – even while inflation is still a little too low. Remember, this is where it’s more likely to hit rather than when inflation is really high. But when inflation is really low, we say, okay, we’ll live with the low inflation without further accommodation. 

WALKER: Yeah. Australia recently completed a review of our Reserve Bank. Did you hear about this? 

RAJAN: No, I haven’t. 

WALKER: Okay. Between 2016 and 2019 the RBA’s concern about high household debt levels and financial instability led it to not cut rates more aggressively. This review, among many other things, effectively concluded or responded with disapproval to that approach. It recommended that the RBA should have a dual monetary policy objective of price stability and full employment, with equal consideration to each, thereby omitting financial stability, although financial stability is to be given a legislative basis in the RBA’s mandate more broadly. But monetary policy should, according to this new review, only focus on price stability and full employment. So given everything we’ve discussed, I presume you would say that is a step in the wrong direction? 

RAJAN: Yeah, I think ignoring financial stability is a mistake. I think financial instability is society-changing. If you put some probability on financial instability, I think it’s reasonable to think that you would sacrifice some monetary room for that. So completely ignoring it, I think, is a mistake. 

WALKER: Raghu, I could actually talk to you for hours. I have many more questions, but I do want to be respectful of your time. So let’s wrap there. But this has been an absolute privilege. Thank you so much. 

RAJAN: Well, thank you for your questions. It’s always good to be pushed, and you have to rack your mind for a response, so it’s been a good couple of hours.