Rising economic star warns of risks ahead

WASHINGTON — These are quiet times in the global economy, just the sort of lull that worries Raghu Rajan, one of the University of Chicago's leading stars.

On loan to the International Monetary Fund, where he became the youngest-ever chief economist and the first from a developing country, the 42-year-old native of India sees risks on the rise in housing markets, hedge funds, pensions — all across the seemingly tame landscape of world finance.

Difficult to track and often disguised, the steady accumulation of risks has increased the odds of what Rajan cautiously terms "a greater [albeit still small] probability of a catastrophic meltdown."

A sharp decline in home prices, for instance, could cripple the job market, trigger loan defaults, hurt anyone invested in mortgage securities and eventually undermine every moving part of the interconnected financial system.

"When you've let down your defenses, things can come and smack you," Rajan said.

Rajan is no Dr. Doom. His sophisticated ideas have won him the respect of the world's financial experts. Yet he is convinced that years of easy credit and the rapid expansion of financial markets have left little cushion if things go wrong.

"We haven't had a real storm in the financial markets since 1987," he said. "The cost of this thing could be tremendous if it turned out the wrong way."

What to do? Surprisingly for a dedicated advocate of free markets in the University of Chicago tradition, Rajan believes more government regulation is needed. After decades of deregulation and laissez-faire policies, "We are in danger of the pendulum swinging too far," he said. "The times have changed."

The same applies to the University of Chicago, which has warmly embraced what might have sounded like heretical sentiments not long ago.

Rajan has enjoyed about as fast a rise as any academic at the renowned shrine to financial thought.

Colleagues at the Graduate School of Business say Rajan's smarts and people skills have brought him influence normally associated with the grand old-timers of his profession, and he is just starting to use it. "He's going to go down in history as one of the most influential people at the IMF,'" Dean Edward Snyder predicted. "Raghu is out there trying to change the world."

Foreign assignments

Rajan's family hails from the southern Indian state of Tamil Nadu. His father climbed the ranks of a central government police force similar to the American FBI, eventually becoming its chairman. Foreign assignments took the Rajans across the globe.

At age 3 Rajan moved to Indonesia. He arrived in Sri Lanka at age 7 not long before a 1971 insurrection. "No school for a year. Great fun,"' he recalled. Next, his family relocated to Belgium, where Rajan roller-skated to his French-speaking school down traffic-free streets during the Arab oil embargo.

The family returned to India soon after, and Rajan, who grew up speaking English and Tamil at home, had to learn Hindi for his new school in Delhi. He went on to obtain electrical-engineering and management degrees in India before traveling to the States for his Ph.D. at the Massachusetts Institute of Technology.

Maybe because of his cosmopolitan upbringing, or maybe because his dad was a cop, Rajan developed discipline. "He wakes up very early and starts working, and continues working through the night," said Luigi Zingales, a close University of Chicago colleague. Asked if Rajan does anything for fun outside the office, Zingales paused, then replied, "I don't think so."

Rajan laughs off the comment but allows that he has little time for anything besides his job, his wife, their two young children, weekly squash matches and the stack of books on his nightstand.

Rajan's schedule has been picking up speed since he arrived in Chicago from MIT.

In less than four years he became a full professor — a rapid and unusual leap over the intermediate post of associate professor. He won a slew of awards, including an inaugural prize named after the late Fischer Black for the thinker under 40 who contributes the most to finance. In recent years the university awarded him an endowed chair and the "distinguished service" title it reserves for academic heavyweights.

Free-market research

In the 2003 book that Rajan and Zingales co-authored, "Saving Capitalism from the Capitalists," the pair described how economic elites use their power to restrict competition, limit access to capital and promote their vested interests over those less fortunate — undermining the potential of free markets to spread wealth and opportunity.

Governments must be powerful enough to thwart those intent on rigging the marketplace, but the balance between too much regulation and not enough is tougher to achieve than previously supposed, the pair concluded. Only the right balance of rules and incentives can prevent capitalists from becoming capitalism's worst enemies.

His recognition of the difficulty of bringing about free markets led Rajan to the IMF, which has struggled with its stated goal of making "the global economy work for all."

Rajan has continued his research, and in August at a Fed-sponsored symposium spoke about how today's seemingly quiet times could end with a bang.

The popularity of derivatives such as swaps, for instance, has enabled big banks and other regulated institutions to offload their risks. Spreading the exposure among more players might be a plus, since it reduces the concentration held by any given institution.

But as it is dispersed, that exposure becomes harder to follow. The players involved become more mutually dependent. Money managers take on more risk than they should.

"Even though there are far more participants who are able to absorb risk today, the financial risks that are being created by the system are indeed greater," Rajan told the Fed group.

So given soaring U.S. debt levels, rising interest rates and the economy's reliance on a housing sector that is slowing, what should happen next?

Greater transparency and disclosure could help, but it's not enough, Rajan said. He urges stricter lending requirements to target excesses such as interest-only mortgages. Continuing to do nothing "has its own costs," Rajan warned. "You have to be vigilant and it's harder in this environment. Don't wait for the pieces to fall and pick them up afterwards."