resilience, not stability

Raghuram Rajan on Monetary Policy and Macroeconomic Resilience

with 16 comments

Amongst economic commentators, Raghuram Rajan has stood out recently for his consistent calls to raise interest rates from “ultra-low to the merely low”. Predictably, this suggestion has been met with outright condemnation by many economists, both of Keynesian and monetarist persuasion. Rajan’s case against ultra-low rates utilises many arguments but this post will focus on just one of these arguments that is straight out of the “resilience” playbook. In 2008, Raghu Rajan and Doug Diamond co-authored a paper, the conclusion of which Rajan summarises in his FT article: “the pattern of Fed policy over time builds expectations. The market now thinks that whenever the financial sector’s actions result in unemployment, the Fed will respond with ultra-low rates and easy liquidity. So even as the Fed has maintained credibility as an inflation fighter, it has lost credibility in fighting financial adventurism. This cannot augur well for the future.”

Much like he accused the Austrians, Paul Krugman accuses Rajan of being a “liquidationist”. This is not a coincidence – Rajan and Diamond’s thesis is quite explicit about its connections to Austrian Business Cycle Theory: “a central bank that promises to cut interest rates conditional on stress, or that is biased towards low interest rates favouring entrepreneurs, will induce banks to promise higher payouts or take more illiquid projects. This in turn can make the illiquidity crisis more severe and require a greater degree of intervention, a view reminiscent of the Austrian theory of cycles.” But as the summary hints, Rajan and Diamond’s thesis is fundamentally different from ABCT. The conventional Austrian story identifies excessive credit inflation and interest rates below the “natural” rate of interest as the driver of the boom/bust cycle but Rajan and Diamond’s thesis identifies the anticipation by economic agents of low rates and “liquidity” facilities every time there is an economic downturn as the driver of systemic fragility. The adaptation of banks and other market players to this regime makes the eventual bust all the more likely. As Rajan and Diamond note: “If the authorities are expected to reduce interest rates when liquidity is at a premium, banks will take on more short-term leverage or illiquid loans, thus bringing about the very states where intervention is needed.”

Rajan and Diamond’s thesis is limited to the impact of such policies on banks but as I noted in a previous post, market players also adapt to this implicit commitment from the central bank to follow easy money policies at the first hint of economic trouble. This thesis is essentially a story of the Greenspan-Bernanke era and the damage that the Greenspan Put has caused. It also explains the dramatically diminishing returns inherent in the Greenspan Put strategy as the stabilising policies of the central bank become entrenched in the expectations of market players and crucially banks – in each subsequent cycle, the central bank has to do more and more (lower rates, larger liquidity facilities) to achieve less and less.

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Written by Ashwin Parameswaran

August 3rd, 2010 at 6:30 am

16 Responses to 'Raghuram Rajan on Monetary Policy and Macroeconomic Resilience'

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  1. I have a hard time believing anymore QE will result in anything, perhaps the biggest surprise will be the markets begin to turn against the goverment.


    3 Aug 10 at 6:50 am

  2. To take these ideas seriously, do you have to believe that bankers are consciously taking decisions in anticipation of the central bank response in the event of a crisis?

    Or can you argue that bankers may think they are doing something else, but some mechanism in the system selects behaviour doing the things this theory predicts bankers will do? If so, what’s the mechanism, and what do bankers think they are doing?

    Despite the Fed’s response, didn’t bank shareholders lose money, bankers lose jobs etc. because of the crisis. So I can’t believe they deliberately took risky positions figuring everything will be okay when things go wrong. But perhaps that’s not what you’d have me believe. Can you advise?

    Luis Enrique

    3 Aug 10 at 7:24 am

  3. shrek – I’m skeptical that conventional QE will have much impact. As I mentioned, diminishing returns mean that more and more radical policies need to be followed to extract smaller and smaller gains.


    3 Aug 10 at 7:28 am

  4. Luis – Many of the posts on this blog are focused on arguing that conscious attempts by bankers to take advantage of the central bank’s commitments are not necessary for moral hazard outcomes to come about – in fact selection mechanisms may select for bankers who genuinely believe in the risklessness of their strategies. Try for example and


    3 Aug 10 at 7:33 am

  5. ah, perfect thanks. You know, I doubtless read those first time around. Mind like a sieve.

    Luis Enrique

    3 Aug 10 at 7:54 am

  6. I met Dr. Rajan when he spoke recently at the Cato Institute (in the Hayek Auditorium). He gave a good talk on his book “Fault Lines.” Dr. Carmen Reinhart was there as well. I eventually reviewed the book here:

    I also have suggested that ultralow rates aren’t helping matters. It certainly has not helped Japan.

    Keep up the good work.

    David Merkel

    3 Aug 10 at 10:03 am

  7. David – Thank you! Raghu Rajan’s views are a lot more nuanced than his critics give him credit for.


    3 Aug 10 at 10:09 am

  8. Another great post. How much of a risk do you think deflation poses at present?


    3 Aug 10 at 7:35 pm

  9. John – In the short run, outright deflation is doubtful unless we have another financial crisis. In the long run, the logical conclusion of the above is that eventually the Fed will lose the war even though it may win many battles in the interim. The only way to avoid this is if it starts monetising significant new fiscal stimulus programs but even this only delays the day when the war is lost.


    4 Aug 10 at 3:21 am

  10. Thanks. Expansion to fight against structural adjustments is folly. The Fed can’t win on that front, though it might have a prolonged retreat.

    Does stabilizing the general price level during restructuring necessarily involve one in that futile conflict, or is it separable? I’m thinking of Lacker’s Jan 2009 dissent and his distinction of monetary from credit policy.


    4 Aug 10 at 9:52 am

  11. I tend to agree with Jeffrey Lacker but the option of using quasi-fiscal credit policies to shore up confidence is always the easier one than engaging in QE on a large scale. But I’m not convinced that the kind of price stabilisation commitment we’re trying is ultimately tenable in the long run – the system adapts to make the central banks’ commitment an unstable regime. ( This is very speculative though – still formulating my thoughts on this )


    4 Aug 10 at 10:49 am

  12. Very interesting. I look forward to seeing where your thoughts take you.


    4 Aug 10 at 12:25 pm

  13. Congratulations on exiting the corporate world, Ashwin, and on your new found freedom to leave anonymity behind.

    I’m a bit late to this conversation, but hopefully not fatally so.

    So, a minor query. Is Rajan and Diamond’s thesis really fundamentally different from ABCT? Couldn’t the anticipatory mechanisms they describe simply be seen as one of the drivers that allowed excessive credit creation to persist for as long as it did? Another prop to confidence, if you like.

    I don’t think such a view changes their underlying point at all but it does perhaps avoid the need for any additional conceptual framework.


    9 Aug 10 at 8:36 pm

  14. Ingolf – Thank you!

    The Rajan-Diamond argument clearly owes a debt to ABCT and they explicitly claim that their argument is a “rational” justification of ABCT. In fact, the theoretical argument in the paper uses a consumption vs investment dynamic that is very similar to ABCT.

    My point is just that the resilience, adaptive argument is broader than the specific model they run though and it is also broader than ABCT. In many cases, it can be seen as one of the drivers of excessive credit creation in a low interest rate environment. But it essentially depends not so much on the low interest rates prevailing at a point of time, but on the anticipation of low interest rates and liquidity facilities when trouble hits.

    It’s just an opinion of course, but I think this explanation was most relevant to the Greenspan-Bernanke era. So for example, such a theory could even explain a bout of misguided credit expansion even when rates are not below their “natural” rate of interest – solely driven by the anticipation of protection by the banks in case things go wrong.


    10 Aug 10 at 2:51 am

  15. Agreed. There were (indeed, still are) so many implicit and explicit backstops built into the system that perceptions of risk underwent a seachange in recent decades.

    Such elevated risk appetites can keep credit growing even when rates are very high indeed (I recall a period of near insane risk-taking and credit growth in New Zealand in the 1980s with rates at 20% plus). Of course, lunatic episodes like this tend to burn out fairly quickly whereas ones based on artificially low rates and perceived “Greenspan put” type safety nets can run on ad nauseam, as we saw.

    By the way, I came across a particularly interesting article from Roger Garrison entitled “Overconsumption and Forced Saving in the Mises-Hayek Theory of the Business Cycle”. He picks out weaknesses in Hayek’s version of ABCT, in particular his failure to allow for overconsumption as well as malinvestment during a credit boom (Mises, on the other hand, readily accepted that the two often went hand in hand and exacerbated the damage).

    Garrison thinks these “unperceived-or only dimly perceived-shortcomings in F. A. Hayek’s theorizing may help explain why Hayek was largely ineffective in responding to his critics and why he failed to produce a timely and effective critique of Keynes’s General Theory.” Kind of makes sense to me. Anyway, it’s of interest, you can find it here:


    10 Aug 10 at 5:59 am

  16. Ingolf – Thanks. I’ll take a look at it.


    11 Aug 10 at 2:52 am

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