GLOBAL FINANCIAL CRISIS: Prescient Pundits Deconstruct Forces, Actors Shaping Crisis


The global financial crisis has been analyzed, scrutinized, and deconstructed from almost every angle since it erupted in 2007, both within the IMF and elsewhere.

But two books published in 2010 by eminent authors Raghuram Rajan and Sebastian Mallaby show that there are still fresh areas to explore.

At a September 2 IMF book discussion, Special Advisor to the IMF Managing Director Min Zhu joined authors Raghuram Rajan and Sebastian Mallaby to discuss their books on the deeper forces at work during the financial crisis.

Rajan, formerly the IMF’s chief economist and now Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago, offers in his book Fault Lines: How Hidden Fractures Still Threaten the World Economy a new perspective on factors that led to the financial collapse.

In his book More Money Than God: Hedge Funds and the Making of a New Elite Mallaby, Senior Fellow for International Economics at the Council on Foreign Relations, provides an authoritative history of hedge funds.

The two authors shared the podium at a special discussion of their works. Introducing them, Min Zhu praised the authors as “outstanding scholars” who have opened up new dimensions on the financial crisis.

Remarkable prescience

Both writers had shown remarkable prescience about the current financial crisis, Min Zhu pointed out. Rajan, the IMF’s former Director of Research immediately before the crisis, presented a paper at the 2005 Jackson Hole Conference that questioned the financial system at a time when the market was somewhat rosy. Mallaby, meanwhile, through his Washington Post column early in the crisis, had recognized that market volatility and fragility required a stronger IMF, making a case for this in an article headlined “Supersize the IMF.”

“These are not just two great authors, but these are two great, great scholars,” Min Zhu said. “They stand, although from different angles, to lead the current debate about the financial market, how to define the market, how to fix the market, how to reform the regulatory framework, and how to change the whole financial system.”

Rajan said that his book grew out of reflections on the crisis and whether the commonly blamed culprits—the “greedy bankers”—were the real ones. “I think if you just focus on the banking sector, you miss the political force that allows you to overcome the traditional checks and balances in the system” he told the audience.

Forces at play

Rajan focused his remarks mainly on the United States, while stressing that his points are applicable more generally.

Chief among the political forces at play was rising inequality in the United States, Rajan said. Too much of the U.S. workforce is now not qualified for the kinds of jobs that are being created. Instead of tackling this education gap, politicians went for a quick fix of extending credit for housing, which could push up home prices and consumption.

“Credit was the palliative that allowed many people to ignore stagnant incomes,” he said.

Other important factors, he argued, were the relatively shallow social safety nets in the country. Yet the last three recessions have been followed by increasingly jobless recoveries. In 1991, it took 23 months for the jobs that were lost in the recession to come back; in 2001, it took 38 months; in the current recession the count is about 60 months.

“It puts tremendous pressure on the politicians to do something,” he said. “The U.S. is a stimulator of first and last resort in the world simply because political pressure on both the Fed and the Treasury is just enormous to create the jobs.”

A third factor Rajan pointed out was that the United States is both structurally prone to consumption, but also prone to stimulate more than other economies in downturns. “So these create the kind of imbalances which, I argue in the book, create the financial sector response which helps create fragilities,” he said.

Rajan added that these points are indicative that the United States has a structural problem. “And if it doesn’t deal with that problem … if the U.S. backs away and looks inward, it is going to be devastating for the world,” he said.

Mystery and intrigue

Whereas Rajan’s book was a response to the crisis, Mallaby’s motivation in writing his account of hedge funds was researching a subject that had previously not been tackled in any comprehensive way.

“These guys appear to be the last bastion of mystery and intrigue and, for an investigative journalist like me, that was simply irresistible,” Mallaby said. Yet, in delving into the colorful history of the personalities behind the hedge funds, Mallaby found lessons that are pertinent to the current financial crisis.

In 2007, the first year of the crisis, hedge funds were actually up 10 percent on average when everybody else was losing money, Mallaby pointed out. The next year, they were down 19 percent, which was about half of the loss seen on the S&P index, and in 2009 recovered to be 20 percent up.

Hedge funds not only weathered the crisis well but were also sound from a systemic point of view, since their failures carried no systemic risk at all, he said.

“So I end up with the view that, systemically speaking, it would be better to have more financial risk, more trading risk housed in hedge funds than in other types of institutions,” Mallaby said.

Part of the reason, he found, was that the incentives within hedge funds were healthier than in other parts of the financial system, since the hedge fund managers were risking their own money.

Profiting from incentives

“It’s better to have money being managed—and risk being managed by these guys who have good incentives— than it is by mutual funds, who tend to herd and tend not to do much research,” Mallaby said. “They’re not incentivized to do research, to be contrarian.”

Mallaby added that it was also healthier to have money housed in hedge funds, which are free standing, than inside proprietary trading desks of investment banks, which are too big to fail, and where traders’ options and distorted incentives encourage too much risk taking.

“My basic view is that regulators should be encouraging more hedge funds, particularly smaller hedge funds,” he said. “The general response in Congress [to the crisis] and in the debate, I think, has been to focus on what went wrong. I would like to urge people to focus also on what went right. We have an experiment of a piece of the financial sector that actually worked.”

In the subsequent audience discussion, Mallaby admitted that hedge funds were not an all-embracing answer, or “silver bullet,” to the challenges posed by the crisis since, for example, the sector is too small to correct more sizable problems such as asset bubbles.

“I’m not proposing a silver bullet … it’s really a copper bullet,” he said. “But I think it’s a bullet worth having. Bit by bit, this sector can get bigger, and that will be a healthier outcome than the opposite.”

In the floor discussion, Rajan also defended his views on inequality while admitting this can also have positive benefits. “When you find that people who have a lot of entrepreneurial spirit—who work very hard—make a lot of income, that’s a good thing,” he said. “My focus is not so much on curbing the opportunity of people to make money or to innovate … but to create the opportunities for the rest.”