Many kudos to Raghu Rajan who, already in 2005 even before I expressed my deep concerns in 2006 about the excesses of credit and mortgages leading to a financial crisis and recession, had pointed out in his excellent paper about the market failures and agency problems that were leading to excessive risk taking in financial markets. His 2005 paper is the best introduction to the distortions and market failures in financial markets that led to the worst financial crisis since the Great Depression.

From the Wall Street Journal Blogs:

Wall Street Journal Blogs January 1, 2009, 10:20 pm

Ignoring the Oracles: You Are With the Free Markets, or Against Them

It’s hard to tell what’s more striking about Raghuram Rajan’s 2005 presentation at the Kansas City Fed’s Jackson Hole symposium — the way many of the dangers he laid out came to pass, or the way he was attacked, and then discounted. (Read the full story.).

Mr. Rajan came to the conference, dedicated to soon-to-retire Fed Chairman Alan Greenspan, with strong bona fides as a pro market advocate. He and University Chicago colleague Luigi Zingales wrote a 2003 book, “Saving Capitalism from the Capitalists,” that argued at length that free-market capitalism is the best way to organize an economy, and that free financial markets – through their ability to direct funds to where the economy needs them most – are crucial to the system’s success. But when he suggested at Jackson Hole that markets could get it badly wrong sometimes, and that central banks should consider responding to that, he was lambasted as nostalgic for the old days of highly regulated banking.

Fed Governor Donald Kohn – who for years has played the role of providing intellectual ballast to the central bank’s decisions and now serves as its Vice Chairman – said that for central bankers to enact policy’s aimed at stemming risk-taking would “be at odds with the tradition of policy excellence of the person whose era we are examining at this conference.” Former Treasury Secretary Lawrence Summers said the premise of Mr. Rajan’s paper was “misguided.”

“This is a common feature of people when they come across dissent – they want to put you in a box and label you and dismiss you,” says Mr. Zingales. “He is definitely not anti-market. That’s the most mistaken characterization of Raghu.”

The episode suggests one reason that the crisis went unchecked: A dangerous all-or-nothing orthodoxy had come to dominate the policy debate, where one was either for free markets or against them.

Another reason that many policymakers may have missed the risks is that macroeconomists didn’t have a good understanding of the changes that were occurring within financial markets and the banking system.

There has long been a marked distinction between economists who study finance and economists who study the broader economy, with limited communication between the groups. As a young Harvard University economist, Mr. Summers argued this was a dangerous shortcoming in a now famous screed, where he unfavorably compared finance specialists to “ketchup economists” who are too narrowly focused on their field of study, while also complaining about general economists tendency to continually rediscover conclusions that the finance specialists had come to long ago.

Finally, many academic economists privately worried that a housing bubble was building, and that it’s bursting would cause severe problems, but didn’t publicize their concerns. An exception is New York University’s Nouriel Roubini, who in 2006 said that the U.S. was almost certainly heading into a recession. Mr. Roubini is often characterized as a grand stander, but Mr. Rajan says that he deserves credit for acting on his convictions.

“Most academics are really reluctant to take part in the public dialog, because the public dialog requires you to have an opinion about things you can’t really be sure about,” says Mr. Rajan. “They fear talking about things where everything is not neatly nailed in a model. They stay away and let the charlatans occupy the high ground.” – Justin Lahart