Raghuram Rajan on Surging Gold and Growing Risks to Financial Stability

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1:45Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wiesenthal. And I'm Tracy Alloway. Today, listeners get a special live episode of the podcast that we recorded in Washington, D.C. at the annual meeting for the Institute for International Finance. That's right. We spoke with Raghuram Rajan. He is a professor at the University of Chicago Booth School of Business and, of course, the former head of India's Central Bank. And he is exactly the person you want to talk to when everyone seems to be talking about risks in the market. That's right. Of course. And we bring it up in the conversation.

2:19He was sort of famous for being one of the early people to warn in, I guess, 2005 about brewing risks to the financial system. So we talked about what's behind the surge in gold, what's going on with central banks and how seriously they're taking inflation, speculative fervor and frenzy in the market, all of the things that are relevant right now. So take a listen. Let's get started. Why is gold up so much? Let's start with the really important question. What is your story or theory behind this seemingly nonstop demand for gold right now? Well, there's no single story, right? It's a number of stories.

2:55First, it started taking off, what, 2023. Clearly, there is an element of geopolitical risk. Many central banks looking at the militarization or the weaponization of payments are basically saying, do I want all my reserves in developed country currencies? Do I want something which I control directly? So a movement to gold for that reason may have started initially a lot of central banks moving to more gold. But there are other reasons. I mean, what's the safe asset today? If you look around the world, certainly if you look at Japan, you know, huge amount of debt, Probably higher inflation than in the past and interest rates really low.

3:40Is that a place you want to put a lot of money in? The euro area, well, it's always been a question of whether it's a cohesive unit. Who's going to bail the system out when there's a problem? And of course, the United States running large fiscal deficits, you know, till the eye can see. So, you know, a lot more questions about safe assets today. And that's the second feature. Third, of course, interest rates coming down. Gold is easier to hold at that point. A bunch of reasons why this is happening. I would say at this point also that there is a fair amount of froth. So you can't completely discount the fact that gold prices are probably moving along with froth as everything else.

4:22Was this something that was on your radar when you were at the RBI, head of the RBI? How did you think about reserve diversification then? Well, yes, you do want to diversify your holdings. The worry about your reserve assets in developed countries being sequestered because of an angry president or prime minister wasn't as big a concern. But there was definitely a view that you needed some diversification. And, you know, once you get beyond the big reserve currencies, you know, it's harder to deal with the smaller countries. Gold is not liquid. That is a problem. It sits on your balance sheet.

5:01But if you want to transform it into something, it's sitting in your vaults. How do you convince the others that it's a lot of countries have their gold in New York or in London? There, it's a question of moving from one vault to another. But if it's in your home country, it's harder. You need to rent a 747 to take it elsewhere. Yeah, I was talking to someone last night who pointed this out. you know, there's this for a long time, the price of gold could sort of be modeled or linked to real rates in some way. And there was this sort of nice stable relationship. And they point out, you know, if you really look at when the divergence occurred, it was not long after Russia's invasion of Ukraine.

5:38And of course, the seizure of Russian assets, which fits into what you're talking about, which is that if you are, you know, a reserve manager at a bank or whatever, did that wake people up to the possibility that your fiat currency that is in some foreign central bank or some foreign entity could just disappear one day in a way that your own custodied gold cannot. I think it did. I think that's a strong reason you see the movement starting in 22, 23, it starts picking up more strongly. But it's also the willingness to weaponize a lot of stuff. As you know, a number of countries are trying to build alternatives to SWIFT, because SWIFT can be weaponized.

6:20Now, these need not be your traditional sort of, quote unquote, rogue countries, which, you know, have been on the list of sanctions for a long time. This could be any country which fears political change. I mean, if Canada can turn out to be antagonistic to a close neighbor, what about a country 5 ,000 miles away? So trust has broken down in the system. And that's part of the reason why people are trying to build alternatives which don't make them dependent. Payments are so crucial. You don't want to be dependent on any one country that can change the nature of payments. So it feels like we're at this really weird juncture where there's a lot of distrust in the system, a lot of unpredictability around the behavior of the United States in particular.

7:08And yet the U.S. dollar and U.S. treasuries form the basis of the global financial system. How do you see that evolving over time, given some of these concerns, given concerted efforts to, for instance, create a new SWIFT? Well, I think part of the reason is the TINA factor. There is no alternative, right? The U.S. market is still the deepest market in the world, treasury markets and so on. It is liquid. Many institutions operate here. And yeah, people still trust the rule of law prevailing in the U.S. Potentially, the fact that there's been so much agonizing about the seizure of Russian reserves is actually a good thing, because it says that it doesn't happen on a whim, that countries actually think about it, and then are finding ways that sort of look legal to actually sequester them.

8:00And so I think that's the good. Of course, the fact that it's even questioned is what a number of other countries worry about that we may not have control of those reserves. Speaking of dollar alternatives, or there is no alternative. OK, we talk about gold. President Trump perceives the existence of this entity called the BRICS to be an assault on the U.S. dollar. You know, I always think it's pretty wild that there is this entity that exists because Jim O 'Neill thought it was a good acronym over 20 years ago, these were going to be growth markets. But like, how seriously should we take this entity?

8:34What does it represent to you? Is there a germ of something that could represent some build something that is an alternative to the dollar? So how should we think about this, this entity? Well, Jim O 'Neill thought of it initially as this fast growing group of countries. And and it has I mean, there's been differences across this group. China and India have grown much faster than the rest. And of course, China has been spectacular in the early years of the BRICS nomenclature. Is there a cohesive structure there on some issues where, for example, it's sort of the emerging market collective against the industrial country collective, issues such as green transition, who has responsibility?

9:18But again, there's a lot of divergence. China has much more of an industrial base than, say, India. If you look at who emits you know, most in the world, it's China. So even on the green issue, there is a divergence in opinion. I think with the addition to BRICS of all these countries like Iran and so on, it becomes much less cohesive and seems much more like a anti-West kind of structure, which certainly India doesn't subscribe to, which Brazil probably doesn't subscribe to, again, to the extent that some of the others. And of course, within the BRICS, there are antagonisms, right? India and China fought a border conflict in 2020.

10:00So I think the sense that it is a cohesive group, it's a talking place. The sense that they will come together with a common currency, I mean, forget about it. That's not going to happen. May they build up a payment system which is different? Yeah, I mean, I'm happy as a country to be part of five different payment systems. It gives me diversification. If somebody tries to put the squeeze on me, I move to a different payment system. But does that mean I'm going to go towards a currency? Probably not. So we started out talking about gold, which seems to reach a record high every day now. Stocks are also still pretty high.

10:38I know we had something of a correction recently. For like five minutes. Yeah, for five minutes. In general, things seem to be going relatively well for equities as well, which is a very strange situation where you have the safe haven asset going up along with stocks still quite high. I know you famously presented a paper at the 2005 Jackson Hole where you talked about financial stability and risks that you saw in the system. And I think Alan Greenspan wasn't very nice about it at the time and probably lived on to regret that. But when you look at the market landscape now, what risks do you see?

11:16Please say something equivalently historic on this stage for our podcast. That's all we're asking. Let me say something historic in the sense of talking about history. Okay. Look at every financial crisis in the last hundred years. And there are a couple of papers that have been written recently about it. If you look at the monetary policy settings before those crises. Yeah. They always have a U-shape. Easy times, that's when the risks build up. Tightening, that's when it starts crumbling and it falls apart. Okay. Whether that U-shape is policy rates or whether it's some kind of deviation from neutral, it's always accommodative followed by tightening.

12:00That's when the financial collapse occurs. And the more the credit in the easy phase, the worse it is. Okay, that's what's been established post-global financial crisis. And you can see that shape before the global financial crisis. And including in Europe, where there were countries at the periphery, where the shape was more pronounced because they had higher inflation. So the monetary policy setting was too loose for them. And countries at the core, where it was much more equal. And so Germany, France didn't have the kind of financial crisis, except through their lending to the periphery countries, as did the periphery countries.

12:37So what does that tell us? It tells us, be really careful when you have a long period of easing, followed by tightening. Now, immediate reaction, well, we had a tightening, nothing happened. Well, we had a tightening after an enormous amount of spending by governments, which essentially took the debt up from the private sector. Banks got bailed out. Remember the provision at the beginning of the pandemic? Nothing actually happened because things like the Paycheck Protection Program gave them the money back. So we had a lot of support from the public sector to the private sector. And that's why when the tightening happened, balance sheets weren't really adversely affected.

13:16But credit keeps growing, not in the households, but in the corporate sector. So we haven't had a really strong tightening, except remember in the tightening phase, we had Silicon Valley Bank, which was, people forget, the largest crisis in terms of nominal losses in the U.S. banking system. And you had 22 bank runs at the same time as Silicon Valley Bank happened, enormous intervention by the Fed to support the banking system, including by pushing out reserves and backing to the system and giving people an easy way to borrow against the full nominal value of the liabilities. We forget that that was a big crisis, which we avoided because of intervention.

13:59Going forward, you have a lot of froth in the system. And now we're talking about cutting rates. But we're talking about cutting rates when inflation has been high for a reasonable amount of time. It's plateaued at three. It's still nowhere near two. People are saying, is there a new sort of target, three, not two? And you're seeing that demand is still strong, whether it comes from resilient households, whether it comes from the AI boom, whether it comes from government spending, even while supply in the U.S. is more constrained because of the immigration constraint that is being put. So strong demand, weaker supply.

14:36Is that really conducive to disinflation? Maybe not. And so what's the bottom line? You have a lot of froth in anticipation of further cuts. And you have some risks that, in fact, it may go the other way. And the system, in many ways, whether it's stocks, whether it's leverage in some parts of the system, as we've seen, is priced for perfection.

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17:26But as you just described, inflation is not close to 2 percent. It's closer to 3 percent. Obviously, risky assets are surging, even with some of the little like credit cockroaches. I think Jimmy Diamond used that term, like actually spreads have totally been fine. Do you think that term restrictive, is it all appropriate to describe the current stance of monetary policy in the US? So restrictive is always in famous central bank speak relative to an R star. And nobody knows what R star is, what the equilibrium rate is. But if you think there's strong demand and somewhat more constrained supply, R star is higher than it was historically.

18:04But look at another indicator. And I know people sort of complain about financial conditions indices and say, well, what does it really mean? But look at the Chicago Financial Conditions Index. You know, almost right from the time of the Fed raising interest rates, it has actually been coming down, becoming more supportive rather than less. So whatever the Fed is saying about restrictive, yes, there's one part where it's really restrictive. Nobody's getting a mortgage today at these rates. That's an exaggeration. But you're seeing the mortgage market is tight. So household borrowing against houses is dead in the water.

18:42But everywhere else, look at credit spreads. They're really at historic lows. And that's suggesting that we have a funny financial market, which is actually quite frothy in many places. So I worry about that. And I worry because central banks sort of seem to say somebody else is going to take care of financial stability. We're about inflation versus growth. And, you know, when you talk about all the discussion about Fed policy, there's not a lot of talk about where the financial markets are. And what I told you about the U-shape suggests we should be paying more attention because this is the time the kind of vulnerabilities get created in the frenzy.

19:21Maybe it is AI investment moving from being financed internally to being financed by credit. Maybe it is some of the weak credit standards that are billing first brands as an example. Froth is when the problems are built, and we should keep that in mind. You know, you mentioned the investment boom that we're seeing, and it does feel like AI-related companies are spending enormous amounts of money arranging some very interesting, somewhat circular financing. deals to each other. With your central banker hat on, how should a central bank deal with inflationary pressures that come from an investment boom versus, for instance, some other type of boom in the system?

20:07Well, this is the great Austrian dilemma, right? What the Austrian economists used to call malinvestment. Is this malinvestment or is this good investment? Almost surely, if you draw the parallel with, say, the telecom investment during the dot-com boom, some of this infrastructure will be used. Eventually, the AI will get good enough for many companies to use it and improve productivity. I mean, we all know spectacular examples of AI in our work. And Bloomberg sort of summarizes a whole lot of stuff using AI. My turgid writing becomes much more accessible when I say, you know, make this engaging, I tell chat GPT.

20:51So there are ways that we all think the promise of AI will eventually show up. But it's that transition from when the infrastructure is created to when people use it and pay for it, which is the big issue, right? Because these are investments which are large, which have high depreciation rates at this point. And so they need the revenues in order to make them justify the investment costs. And there, I worry a lot more. We've seen all these surveys saying companies, yeah, they have their toe in the water, but are they rolling out in a big way? Yeah, Goldman Sachs will because it has really smart programmers and people capable of doing that.

21:33The average company on the street is probably not that advanced. And maybe it's not as much into services, etc., that it can employ it in such a big way. It will come. But the pace is really important. And the Austrians always talked about the fact that the pace is critical. If the pace is much longer down the line, at some point, the markets realize that the net present value of these investments are not that high, especially if you add in that little piece about interest rates being higher than being lower, R star being higher, long rates therefore being higher. And that would make the present value of the revenues lower than we anticipate.

22:15So I do worry that this investment is something that may prove a little more elusive, the returns. What does the central bank do about it. I think it cautions. I think it tells the supervisors, look for this kind of lending, make sure that it is reasonable. But it has to have an eye on the credit expansion that is taking place and say, well, that's part of my calculation as to whether we're really in a boom time and whether I need to cut rates further. So I would factor that into my rate decision. And I presume me. That's part of what they're looking at. You know, we started this conversation, talk a little bit about geopolitics, the seizure of Russian gold and other sort of big, deep issues related to trust.

23:03Something I'm very interested is not geopolitics, but politics. I mean, we're in D.C. right now where the government is currently shut down with no imminent prospect, as far as anyone knows, of reopening. There are similar evident dysfunctions elsewhere in the rich world. The complete collapse of the two-party system in the UK, for example, seems to be getting a lot of attention. When you think about, you know, this sort of ability of central banks to do their job, to address concerns, how worried are you about the political environment that buttresses the independence of the autonomy of these institutions?

23:40It's a great question. You know, the view about what distinguished developed countries from emerging markets and developing countries was always, it's the institutions. And Trio won the Nobel Prize for it last year. The developed countries have strong institutions. The developing and emerging markets don't have strong institutions. So what's the prescription for development? Build the institutions. It's that simple. Just build good institutions was the challenge. It didn't work. You put in inflation targeting regimes in other countries, maybe politicians got into the act, pushed the central bank, didn't work as well.

24:23What worked was getting the politics right. Consensus amongst the parties in a country that this was the way to develop. Let's not go to the extremes on spending. Let us have a much more modest spending program. Let's bring inflation in check. Let's give the central bank its independence. OK. When the politics became more conducive to macroeconomic stability, the institutions naturally developed. I would argue that that in Brazil, it was a combination of the parties deciding that we don't want to go the old way. So Cardozo is the guy who brought in inflation targeting, but it was Lula who appointed governors who would continue that rather than reversing it as soon as he came into power.

25:11That combination, right-left combination, which built into the consensus gave Brazil a strong institution, the central bank, which actually carries it through and has carried it through. We're not seeing the kind of inflation in Brazil that we're seeing in Argentina. Brazil broke from the back. And I think you can see this again and again in many emerging markets. Why am I telling the story? Because our confidence in industrial country institutions should be directly proportional to our confidence in the politics being consensual. And that consensus, as you say, has broken down in part because parties of the extreme left and the extreme right are looking more appealing than parties at the center because they offer unorthodox solutions.

25:55Solutions we've tried before in history often and not work, but it's time to try them again, because we haven't seen them not work recently. Let's try the old experiment again, shut down the economy and see what happens. So my sense is that we blame it on the institutions not being strong enough. These institutions are as strong as we can make them, but it's the politics that has to support them. When the central bank is assaulted at every corner by the administration, there is no set of structures which can protect it. And almost surely, it will bend. It is natural. You know, you protect the tenure of the central bank governor or the chairman, that's not going to help if you can affect its finances, you can affect who's appointed next.

26:47There's so many levers the government has. So institutions cannot be made fully independent. They will always bend. And that's what we're seeing. It's the politics that has changed, not so much the institution. Is there anything a central bank can do to, if not be fully independent, at least protect its ability to say no? Well, I think ultimately it comes down to the integrity and the backbone of the people there. They can try and be as persuasive as they can, but there's some battles they really have to fight and say, look, you know, I've tried. You've said no, no, no. It's my turn to say no.