By Patricia Houlihan

We take for granted that everybody has the same opportunities, but they haven’t.”
—Raghuram Rajan
Eric J. Gleacher Distinguished Service Professor of Finance

Figuring out how to make financial systems work better has become a research mission for Rajan, now the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. He is widely regarded as one of the few economists who foresaw the financial crisis of 2008, identifying as early as 2005 the unsustainable banking practices that led to economic collapse. His latest book, Fault Lines: How Hidden Fractures Still Threaten the World Economy, warns that reforms have not addressed the underlying income inequality that helped cause the meltdown.

Rajan’s approach, shaped by his conviction that markets need oversight to make them fair, might seem at odds with a purely free-market outlook. Yet he says preserving the unique virtues of free markets is his true goal; an earlier book that Rajan co-authored with Chicago Booth professor Luigi Zingales was titled Saving Capitalism from the Capitalists.

“Competition is central to the free enterprise system, but getting access to things like education, health care, and finance is also critical,” Rajan says. “We take for granted that everybody has the same opportunities, but they haven’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.”

Forecasting the Crash

Many economists did not react warmly when Rajan first predicted that the financial system could be headed for a massive crisis.

In 2005 Rajan was on leave from Chicago Booth, when as chief economist of the International Monetary Fund, he was among those invited to celebrate the legacy of the Alan Greenspan era. For his presentation, he asked his staff to gather data on the widespread use of new financial instruments, and the results took him by surprise: The new tools meant that banks had become riskier, not safer, over the past decade. The paper he delivered questioned the expansion of financial markets and warned of a “catastrophic meltdown,” drawing a storm of criticism.

When the market collapsed three years later, dragged down by some of those same risky financial instruments, it became clear that Rajan had been right. He says the real source of the problem went beyond reckless bankers and lax regulators—though those factors also played a role. Rather, the entire financial sector had come to rely on skewed incentives, without proper concern over pervasive risk-taking.

As Rajan told The New York Times in an interview earlier this year, “The signals were stuck on green when they should have been red, and the Ferrari of a financial system accelerated rapidly in the wrong direction.”

The Three Causes

Widening income inequality in the United States is one of three root causes behind the crash, Rajan writes in Fault Lines. With middle-class earnings stagnating, politicians who wanted to lessen the pain helped make borrowing and buying homes easier— particularly for low-income households—so people could afford to keep shopping. In addition, the fears engendered by the thin U.S. unemployment safety net ensure that job creation becomes priority one in downturns. But when private firms have other constraints holding them back, government and Federal Reserve stimulus can be excessive, as was the case from 2001 to 2004, Rajan contends.

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 over-stimulated America and an under-consuming world.

Economists and political analysts alike have praised Rajan’s book. In October it won the Financial Times and Goldman Sachs Business Book of the Year award for 2010. Esquire called the book “especially fascinating because it mixes free-market Chicago School economics with good-government ideas straight out of Obamaland.”

In Chicago, Rajan’s colleagues welcome his success. Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at Chicago Booth, calls him “the best financial economist of our generation.”

In reviewing the book, U.S. Court of Appeals Judge Richard Posner, senior lecturer in 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 how to make society more equitable and sustainable over the long term. “That’s what we should be thinking about,” he says, “because we can’t afford another collapse.”