The Pain We Are In, Part Deux

Rupert's newspaper details the predictions of an economic prophet:

It was August 2005, at an annual gathering of high-powered economists at Jackson Hole, Wyo. -- and that year they were honoring Alan Greenspan. Mr. Greenspan, a giant of 20th-century economic policy, was about to retire as Federal Reserve chairman after presiding over a historic period of economic growth.

Mr. Rajan, a professor at the University of Chicago's Booth Graduate School of Business, chose that moment to deliver a paper called "Has Financial Development Made the World Riskier?"

His answer: Yes ...

Mr. R's gloomy analysis went as follows.

Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly.

He pointed to "credit-default swaps," which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred.

Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said: "The interbank market could freeze up, and one could well have a full-blown financial crisis."

Strangely, Mr. Rajan didn't dwell on the problems of Fannie and Freddie, since he was looking at the big picture, not the micro. And the evils of the wretched Barney Frank were not brought up.

Nevertheless, his predictions turned out to be dead on, as the Wall Street Journal attests.