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International Monetary Fund former chief economist Raghuram Rajan (TIM CHONG)
International Monetary Fund former chief economist Raghuram Rajan (TIM CHONG)

Taking Stock

Why we should avoid extremes in uncertain times Add to ...

Raghuram Rajan must have winced when his latest pronouncement made headlines and raised the ire of New York Times columnist Paul Krugman in the bargain. Although the former IMF chief economist warned any central banker who would listen as early as 2005 that a global financial crisis was brewing, Professor Rajan dislikes the economist-as-celebrity syndrome that seems to have infected his profession.

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But that didn't stop him from publicly calling on Federal Reserve chief Ben Bernanke to hike interest rates "sooner rather than later" -- by as much as two percentage points, at a time when the U.S. economy is noticeably faltering and unemployment continues to hover near 10 per cent.

Professor Krugman, on the other hand, and some other leading economists and policy makers, are urging Washington to keep a tight lid on rates indefinitely and to pump out a good deal more stimulus cash to keep an obviously fragile recovery from collapsing.

Both the deficit spending and the continued pegging of interest rates below zero in real terms send the wrong signal to the financial community and could do more harm than good to the economy as a whole, insists Prof. Rajan, who teaches finance at the University of Chicago Booth School of Business.

"I think we should recognize there are dangers in keeping negative real short-term rates for a sustained period of time," he told me in a recent interview. "It creates undesirable kinds of activities. It creates problems for certain segments of society. It creates certain patterns of behaviour that could be problematic."

Interest rates, he points out, are a price like anything else. "They are the price of capital. When you keep rates really low, you're saying: What we want to do is encourage the capital-intensive segments of the economy. The question you have to ask is: We've just been through a bout where we encouraged certain capital-intensive segments such as housing and we built too much of it. So are we misallocating again?"

Krugman's View

Not surprisingly, Prof. Krugman, a Nobel laureate and the most prominent of those riding the keep-the-spigots-open-at-all-costs bus, immediately waded into the fray.

"Let me try to explain what bothers me about this sort of thing, aside from the fact that it would be an utter disaster for the economy," Prof. Krugman, who teaches economics at Princeton University, remarked on his Web blog. "It's the way Rajan - and many other economists - seem to be making up new doctrines on the fly to justify their policy prejudices."

What, he asks, is Prof. Rajan's model? "What's the justification for raising real rates in the face of high unemployment? How would that model work in normal times?"

Prof. Krugman says: "My sense, obviously, is that a lot of the people who want monetary tightening start from a prejudice - they just dislike the idea of easy money - and then look for some arguments to back up that prejudice. And that's no way to do economics."

Prof. Rajan counters: "I am not advocating that the Fed raise rates to 2 per cent overnight. That would be irresponsible. I am saying that as worries [largely about financial turmoil emanating from Europe]settle down and we return to expecting steady but slow growth, we should not wait for employment to come back substantially before we start the process of raising rates to a low normal."

Prof. Rajan freely acknowledges that aggressive fiscal and monetary measures were needed at the height of the panic. But he decries the notion that the Fed should keep on using the same blunt tools and questions whether government has "the capacity to spend effectively in a sustained way."

He also gets suspicious when anyone claims further radical action is essential, without knowing the possible outcomes or delving into the root causes of the problem.

"I agree with Bernanke that we are in a period of unusual uncertainty," Prof. Rajan says. "But it seems to me that in these periods, you have to be a little careful about moving policy to the extreme. We can't tell fully the consequences of what might emerge from these policies."

The Issues

He goes on to ask whether policy makers are focusing on the right issues.

That's what Prof. Rajan, 47, attempts to do, with some success, in his latest book, Fault Lines: How Hidden Fractures Still Threaten the World Economy. Among other things, he argues provocatively that cheap consumer credit became official U.S. government policy as a means of compensating for worsening income inequalities that have yet to be addressed. Before the meltdown, people didn't feel they were overspending, because of the low cost of borrowing and the rising value of their homes. And they could ignore the fact incomes were largely static, because they were consuming more.

Prof. Rajan would like to see fellow economists acknowledge that they don't really know the eventual outcomes of their policy prescriptions.

"I think we should be relatively humble and accept that what we're putting forward is an argument which others should take or leave. I have been making some arguments about interest rates, but I hope that I've been making them in the spirit that I worry about these things and here are reasons why. But I'm not saying you [those who disagree]are dead wrong."

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