Developing a Theory of Risk and Reward

Rajan on poverty, options pricing, and predicting the crash of 2008.

As a young MBA student, Raghuram Rajan spent a summer interning at a prestigious foreign bank. “This was before quotes were online, and there was something called ‘cholesterol pricing,’” he said. “A colleague would offer to take a call from your client, who wanted a foreign exchange rate, and the colleague would offer ridiculous pricing,” Rajan recalled. “If the client didn’t immediately have a heart attack, that was the rate he got. But if he objected, the colleague would say, ‘Let me have your banker get back to you. He might be able to get you a better rate.’ It wasn’t the norm, but there was a sense that this was acceptable.”

Not to Rajan. “Who would I be making money for, and who would I be squeezing?” he recalls thinking. “Growing up in India, I had seen poverty all around me. I had read about John Maynard Keynes and thought, wow, here’s a guy who managed to have an enormous influence on the world. Economics must be very important.”

That summer, Rajan also worked on a project about options. He ran across Robert Merton’s paper on rational option pricing, and something clicked that set him on his own intellectual path. “It all came together. You didn’t have these touchy-feely ways of describing human behavior; there were neat arbitrage ways of pricing things. It just seemed so clever and sophisticated,” he said. “And I could use the math skills that I fancied I had, so I decided to get my PhD.”

Rajan, now Eric J. Gleacher Distinguished Service Professor of Finance, has made a successful career in researching banking, corporate finance, and economic development, especially the role finance plays in it. His approach, shaped by his conviction that the free market needs rules to make it fair, has won him esteem at Chicago, a place known for its distrust of regulation.

Rajan was among economists invited in 2005 to celebrate the legacy of the Greenspan era. On leave from Chicago Booth and serving as economic counselor of the International Monetary Fund when the invitation came, he asked his staff to gather data, and the results took him by surprise: The new financial instruments had stayed on bank balance sheets, so banks had become riskier, not safer, over the past decade. The paper he delivered questioned whether the expansion of financial markets had made the world safer and warned of a “catastrophic meltdown,” drawing a storm of criticism.

Three years later, it became clear that Rajan had been right; the market collapsed. Heralded by the media as “the one who saw it coming,” he has been repeatedly sought out for his new book, Fault Lines: How Hidden Fractures Still Threaten the World Economy, which won the Financial Times and Goldman Sachs Business Book of the Year award for 2010.

“Competition is central to the free enterprise system, but getting access to things like education, health care, and finance is also critical,” Rajan said. “We take for granted that everybody has the same opportunities, but they don’t.

And when people start out at very different levels and don’t have the same ability to take advantage of opportunities, they could turn against opportunity and try to shut things down for others.”

In fact, widening income inequality in the United States is the one of three causes behind the crash, he wrote in Fault Lines. With middle-class earnings stagnating, politicians who wanted to lessen the pain helped make borrowing easier—particularly for low-income households—so that people could afford to keep shopping.

Emerging markets like China readily supplied the goods, exacerbating already high trade imbalances, the second cause Rajan cites. The third is that the U.S. financial sector, with its skewed incentives, is the critical but unstable link between an over­stimulated America and an underconsuming world.

The book has grabbed the attention not only of the business press but also the mainstream media. Esquire called it “especially fascinating because it mixes free-market Chicago School econom­ics with good-government ideas straight out of Obamaland.”

In Chicago, Rajan’s success is welcomed by his colleagues. Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance, who coauthored an earlier book, Saving Capitalism from the Capitalists, with Rajan called him “the best financial economist of our generation.”

In reviewing the book, U.S. Court of Appeals Judge Richard Posner, senior lecturer at the Law School, said, “Rajan’s book stands out for several reasons: the author’s intellectual distinction, his academic and real-world involvement in the problems of finance and the macroeconomy, his global perspective, his search for the roots of the financial crisis in America’s growing economic inequality, and also his prescience.”

Rajan, modestly, says others also saw it coming. His concern now is “over the next 10, 15, 20 years, what do we do to make the economy more stable? That’s what we should be thinking about,” he said, “because we can’t afford another collapse.”—P.H.

Read more about Fault Lines and Rajan’s work.

Last Updated 3/4/11