Political interventions, especially cheap housing credit, were as much responsible for the economic crises in the US as the unbridled financial capitalism, argues Raghuram G Rajan, noted economist and honorary adviser to Prime Minister Manmohan Singh in his latest book Fault Lines. Low-cost credit was a political reaction to contain the adverse effects of income inequality in the US. In a candid interview with Sunny Verma of FE, Rajan discusses critical issues crippling the financial world as well as emerging regulations such as entry of fresh private banks in India. Excerpts:

What is the motivation behind the new book?

I felt that we were focusing on too narrow a view of the problems that led to the global economic crisis. I saw that this crisis is really reflecting a deeper malaise in specific countries, which is seen as a more general problem. This book is to detect the problems and to find the solutions.

It appears that to an extent, you have turned your first book ? Saving Capitalism from the Capitalists ? on its head. Now we are finding faults with the financial system that produced somebody from nobody.

That might not be the correct reading. In a sense the underlying premise of both books is the political fragility of free enterprise capitalism. It is saying that you need to get the political forces on board to get the right structures for free enterprise capitalism to flourish. That is the kind of capitalism that gives greatest opportunity to greatest number of people. Now the treatment in this book is in a sense quite similar. But it is saying that capitalism doesn?t seem to be working for people is because they don?t have capability to compete in a market system. So they will put enormous political pressure on the system to subvert the process of capitalism. And I argue this crisis was in some ways because of the good intentions of politicians who saw people falling behind, who saw that they didn?t have sufficient jobs that were being produced by the economy and they decided that the one way to keep them happy was to give them cheap credit, especially housing credit. That process eventually attracted the private sector in a big way and the private sector went over board. So in some sense even the commonalities are this extremely important interaction between the political forces and the market economy.

Low cost credit may have its motivation in the political sector. But what about the financial innovation engineered primarily by the financial sector?

Absolutely. I am not saying that the financial sector is blameless. I am saying that it is the interaction. Were the mortgage backed securities created independently of the tremendous amount of the money that was put into buy these? Similarly there was a lot of foreign money looking to MBS for an extra yield. What the financial sector did was to respond in some ways to the demand for these securities that was there.

In the same breath, one can argue the global stimulus has been engineered by political motivations.

Yes. It is political push-work. Look at what is driving the stimulus today: the unemployment numbers, thin social safety nets in the US.

So we have wasted the crisis?

We are trying to bring in the status quo ante. There have been some changes that the financial sector reform bill is carrying out in the US. I think we have to recognise the deeper forces and address those.

Is there any central fault line?

I think the deep problem is that the market never thought that any of these entities would ever suffer failure. So they never priced the credit/default risk. I think ultimately the solution will have to be that risk has to be priced in.

Another running theme in your book is inequality.

I think inequality is not always a bad thing. In fact, it can be seen as a fair system. For instance, if a guy gets the highest marks in a class he is rewarded, and the worst performer has the motivation to work harder. So inequality of money, things and grades can be positive force.

But not inequality of opportunity.

We need a level-playing field. Sometimes, opportunities are what you make of it. But some people do not have capabilities because they grew up in poor households and didn?t have education. That kind of inequality stemming from very different access to opportunity can be detrimental to the capitalist system. Also, people having access to power, appropriate natural resources and government contracts, and are able to get rich. We have both kinds of inequalities. This tends to create a despair about the system. That can actually turn out to be a strong reaction against growth. To sustain growth, capabilities of people need to be improved. Initiatives such as the rural employment guarantee programme and providing health insurance to poor are stopgap measures.

Can financial inclusion be the answer, that is now been planned at a giant scale with IT, mobile banking and UID?

It could be. The technological measures will help us bypass the entrenched interests and reach poor people directly. But we also need to build infrastructure. A major problem in that is land acquisition, which has to be made more transparent and effective. That means recognising the rights of not only people who have own the property but those having customary rights over them such as tribals. We need to find the way to compensate them effectively.

You have been quoted saying infra bottlenecks will restrict India?s growth to 8-8.5%. Is it your futuristic view too?

Nothing is static. But if you see power shortages, pricing power in corporations, governance problems and increasing wages it shows there is a limit to the rate at which we can grow. There is a danger in rapid increase of interest rates. But there is also a danger in staying behind the curve, because inflation becomes entrenched. Expectations become entrenched because of the things that people see everyday such as food prices going up everyday.

So you don?t think double-digit growth rate is advisable.

I don?t think yet.

RBI is preparing norms for bank licences. What safeguards do you suggest?

In the report that my committee put together, we were very much for more entry into banking. I am not sure large size is a necessary criterion on which entry should be based. Because I think it is hard to find large companies that can switch to a banking licence immediately without potentially creating problems down the line. In many ways, I would be more favourable towards allowing a few smaller entities to get licences. These can be monitored effectively and closed if the need arises. The fixation with size as the necessary criteria that you have to be above a certain size, typically again limits the possibilities to a few. It also implies the central bank is taking more risk because this can be a disaster.