The economist who predicted the financial crisis just sounded another alarm—it would be wise to listen this time

In his first official act as the new governor of the Reserve Bank of India (RBI), Raghuram Rajan raised the benchmark interest rate from 7.25 to 7.5%, causing a ripple of surprise in financial circles and eliciting protests from various business representatives. But for people who know the current condition of emerging markets and Rajan’s professional trajectory, this was not surprising, at all.

Rajan has no qualms about staging such challenges. In 2005, Rajan was chief economist of the International Monetary Fund and attended the top central bankers’ get together in Jackson Hole, Wyoming, to present a paper on how the financial sector had evolved during Alan Greenspan’s era.  As Rajan later described the meeting, which was to be Greenspan’s last, in his book Fault Lines: “Some of the papers in the conference, in keeping with the Greenspan-era theme, focused on whether Alan Greenspan was the best central banker in history, or just among the best.”

Not Rajan. He argued that under Greenspan, incentives had been artificially skewed in favor of the managers of the financial system, which reaped millenary rewards if things went fine but paid very little, if at all, when things turned sour. And he added that things were likely to turn sour because the skewed incentives were offering incentive to those managers to take excessive risks. He then focused on the “credit default swaps” which promised to repay delinquent loans in exchange for moderate insurance premiums. Noting that nobody really knew how realistically these swaps were priced, Rajan said that the banks were probably taking excessive risks because they trusted that the insurer would repay them. In these circumstances, a sudden increase in defaulting loans could exceed the reserves of the insurer, leading to a financial crisis. This is exactly what happened two years later, leading to the 2008 financial crisis.

His warning was not well received.  Many people thought that Rajan didn’t understand modern finance. As it turned out, he understood it all too well—and it was those who looked down on him who did not.

Now Rajan has issued another warning by increasing the benchmark rate in India, shortly after the US Federal Reserve decided to keep on buying $85 billion of securities per month under its quantitative easing 3 program, to the general happiness of financial sector managers and traders. The Fed’s announcement spurred an immediate mini-boom in all financial instruments. The day after the announcement, I published an article in Quartz in which I argued that the current high rate of monetary creation and the extremely low interest rates caused by QE3 are unsustainable and that, sooner than later, interest rates are bound to increase. I argued further that the long prevalence of extremely low interest rates is likely to be creating the conditions for a serious financial crisis; all the economic activities that are profitable due to low rates will become unprofitable and will not be able to repay their obligations.

For this reason, it is necessary to prepare for such eventuality. This is what Rajan is doing by increasing interest rates in India, by easing the appetite for unsustainable activities that can survive only with low rates. The Financial Times quotes his rationale: “Let us remember that postponement of tapering is only that—a postponement…Let’s not lose the chance, the warning that we have been given, because this is going to come back and what we need to do is put our house in order before.”

This is a warning that the entire global economy should take seriously.  Not just other emerging markets.

What can be done in this situation? In emerging markets, central banks should start increasing interest rates now that it can be done very gradually. Higher interest rates would deter investment in unsustainable activities and attract funds to more solid ventures. Moreover, they would help in stopping capital outflows that are seeking higher rates in the United States, and alleviating the trend toward currency devaluations, which are only accelerating those outflows. The postponement of the interest rates increases in the United States will allow these countries to go through the adjustment process in a gradual way. In a crisis, interest rates are raised in leaps, which causes considerable more damage to the economy.

Individual investors should see ahead of the curve, noticing that a world of higher interest rates looms. People now holding the kind of assets that would experience a sharp fall if interest rates go up should get out of them, particularly if these investments are burdened with fixed obligations that will not be reduced as interest rates go up. Of course, this is the kind of advice that cannot be useful for everybody at the same time. Aggregate losses cannot be avoided. Someone will have to absorb them because, as interest rates go up, the prices of the assets will go down. If you sell your assets before prices fall, for example, it is the buyer who will have to take the loss. This is the price that society has to pay for having unsustainably low interest rates for a long time.

Rajan’s warning is just one of the many that point to higher interest rates in the near future.

We welcome your comments at ideas@qz.com.

To read more, visit: http://qz.com/126875/the-economist-who-predicted-the-financial-crisis-just-sounded-another-alarm-it-would-be-wise-to-listen-this-time/