Has Financial Development Made the World Riskier?

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That’s the title of a paper presented in 2005 by Raghuram Rajan, who was then Economic Counselor and Director of Research (Chief Economist) at the International Monetary Fund. Incidentally Rajannow serves as the Chief Economic Advisor to the Government of India.The paper warned that disaster might be looming large on the US horizon on account of the unbridled permissiveness of the financial sector.

raghuram rajan
Img-credit:wikipedia.org

When the paper was first presented at a celebration honoring Alan Greenspan, who was about to retire as chairman of the US Federal Reserve, it received a rather hostile response; former U.S. Treasury Secretary and former Harvard President Lawrence Summers, for instance, called the warnings “misguided” and Rajan himself a “luddite”. The rest is history.

The crux of the paper lay in a simple observation :the changes in the financial sector have altered managerial incentives, which in turn have altered the nature of risks undertaken by them, with some potential for distortions. And that is what exactly happened, beautifully described in documentaries like Too Big To Fail(2011), Inside Job(2010), Capitalism: A Love Story (2009) and The Last Days Of Lehman Brothers(2009).

It is important to understand that at the heart of the big catastrophe lay small human foibles. It is for Rajan now to look for them in the Indian system. They are not likely to show on the public radar; but that does not mean they do not exist. Those of us who have been part of the incentives game in the financial sector cannot miss them; but we pass them by as private sins. Someone out there, up there, needs to take a more holistic picture, a systemic perspective; who can be better than Rajan ?