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Remarkable prescience of Raghuram Rajan

Remarkable prescience of Raghuram Rajan
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First Published: Sat, Feb 02 2008. 12 24 AM IST
Updated: Sat, Feb 02 2008. 12 24 AM IST
In the good old days before the global credit crisis, a number of very plausible theories had attempted to explain why we had entered a brave new world, a world of low volatility and high asset prices.
One argument was that with countries such as China, India, Russia and the ex-communist states of eastern Europe rejoining the world economy, the stage had been set for a long period of rapid expansion. Low-wage labour from these countries would ensure that prices of goods and services were bid down and the result was that inflation would remain firmly under control. That allowed central banks in the developed world to pursue an easy money policy. Naturally, this also meant a higher level of asset prices.
A variant of this theory was that of the Great Moderation. This hypothesis pointed to the substantial fall in macroeconomic volatility in the developed countries from the late 1980s. There were several branches of this theory. One argued that financial innovation, by which they meant the widespread use of derivatives and practices such as securitization, had increased the ability of households to borrow more, mitigating the rigours of the business cycle. Another was that structural changes in macroeconomy, such as globalization, had led to the low volatility. Another group propounded that technology was the chief reason for the change. As Citigroup Inc. ex-CEO Walter Wriston said long ago, globalization was “…a galloping new system of international finance (which)…differs radically from its precursors in that it was not built by politicians, economists, central bankers or finance ministers, nor did high-level international conferences produce a master plan. It was built by technology…by men and women who interconnected the planet with telecommunications and computers.” It allowed global production chains, just-in-time manufacturing and globalization of services. A third group advocated that improvements in monetary policymaking had led to shallower business cycles. It was also easy to make the assertion that the lack of volatility at the macroeconomic level was responsible for the very low levels of volatility in stock prices. If stock prices were less volatile, that meant they were less risky and, therefore, could have higher values. Others pointed to the steep fall in interest rates in the US and the UK in the 1980s and asserted that was the reason stock prices soared in the 1990s. To cut a long story short, there was no shortage of theories that put a positive spin on the bull run in stocks.
Of course, there were also several warning voices. Many of them were based on tried and tested valuation models. Others, such as Stephen Roach, warned of global asset bubbles being blown by central banks. Studies established the link between low interest rates and risk taking. To take one example, a paper on “The impact of short-term interest rates on risk-taking: hard evidence” by Vasso P. Ioannidou, Steven Ongena and Jose Luis Peydro in October arrived at the following conclusion: “We find that short-term interest rates affect risk taking and credit risk. In particular, low interest rates encourage ex-ante risk taking. Prior to loan origination, low interest rates imply that banks soften their lending standards for new loans—banks give more loans to borrowers with lower credit score and/or with bad credit history.”
But it was Raghuram Rajan, former chief economist of the International Monetary Fund, who sounded a very different warning. The crux of his thesis was that the reason for higher risk tolerance was the skewed incentive structure for financial market participants. Rajan pointed out that investment managers, particularly hedge fund managers, are compensated on the basis of the extra returns—alpha—they generate. The trouble is that the ability to generate alpha is rare, so how does the run-of-the-mill fund justify its existence? In an extremely prescient speech given in June 2006, Rajan said, “One option is to hide risk—that is, pass off returns generated through taking on beta risk as alpha by hiding the extent of beta risk. Since additional risks will generally imply higher returns, managers may take risks that are typically not in their comparison benchmark so as to generate the higher returns to distinguish themselves. For example, a number of insurance companies and pension funds have entered the credit derivative market to sell guarantees against a company defaulting. Essentially, these investment managers collect premiums in ordinary times from people buying the guarantees. With very small probability, however, the company will default, forcing the guarantor to pay out a large amount. The investment managers are thus selling disaster insurance or, equivalently, taking on “peso” or “tail” risks, which produce a positive return most of the time as compensation for a rare very negative return. These strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them, especially when times are good and disaster looks remote. Every once in a while, however, they will blow up.” Unfortunately, we know that we’re now going through one of those “tail risk” events.
But won’t reducing interest rates merely add to the risks? In a speech in 2004, current Federal Reserve chief Ben Bernanke said: “My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation.” The 125 basis point US rate cut is probably part of that improvement.
(Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at capitalaccount@livemint.com)
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First Published: Sat, Feb 02 2008. 12 24 AM IST