The reform of the central bank charter was necessary for growth and stability

By Sergio Cesaratto, Marc Lavoie and John Weeks

“Give me a one-handed economist! All my economists say: on the one hand… on the other…” once famously said the U.S. President Truman. In his interview to La Nación professor Lance Taylor provides the perfect example of a two-handed economist: he supports growth, but he warns of the dangers of inflation; he approves of a central bank that cooperates with fiscal authorities, but he warns of excessive public spending; he gives his support to import controls, but he warns of their possible “micro-inefficiencies”. Professor Taylor thus plays the two-handed game of criticizing whatever the Argentineans could possibly do, even if we are not completely convinced that he actually said in the interview that he is in favor of an Independent Central Bank, as the headline would make you believe.

Of course we share, and we are sure that the Argentinean government shares, some of these preoccupations – although we are less concerned with the idea that import controls only protect domestic inefficient sectors. To begin with, comparing Argentina with Europe, where the inability of the Central Bank to cooperate with the national treasuries has created the crisis, Argentina looks pretty good, with a central bank that is mandated to cooperate with the democratically-elected government to pursue growth and employment rates that are consistent with the lowest possible inflation rate. In Europe, a non-cooperative European Central Bank has let interest rates on sovereign debt jump to unsustainable levels. In that respect the Argentinean central bank acts more like the North American Federal Reserve.

In addition, European central bankers and political leaders have advocated austerity measures that are causing a serious recession and that exacerbate the public budget problems caused by the financial crisis, very much like Argentina did during the Convertibility period, in which the former Central Bank Charter was imposed. By contrast, in Argentina now, there is a pro-growth central bank that carefully uses its foreign exchange reserves to reduce the needs of the government to borrow on international financial markets, and that wishes to sustain domestic investment through a public investment bank. This can only be good news.

Nobody would deny the importance of a competitive real exchange rate to sustain exports and favor the development of a competitive manufacturing sector. We believe that the reliance of exports on the vagaries of soya prices and harvests is a preoccupation of the Argentinean authorities too. Many Argentinean economists are however skeptical about the positive effects of currency depreciation on manufacturing exports; instead they are more concerned about the inflationary effects that exchange depreciation might have in a country like Argentina, with its strong tradition of labour militancy in defending real wages. They also warn that a policy of real wage compression through a depreciating exchange rate, if successful, would depress domestic consumption, growth and unemployment, with little compensation from an unlikely export-led boom. So, in any case, the objective of a competitive exchange rate should not be accompanied by restrictive fiscal and monetary policies, but rather should be accompanied by income policies that would preserve real wages.

Finally, the government with the support of many economists, in its attempt to diversify the export sector and reduce the import dependence, is relying on a pro-active industrial and trade policy, rather than relying on the real-exchange-rate-depreciation cum fiscal-contraction model proposed by critics. One cannot forget that Brazil has public control of long-term finance through BNDES, and that given Argentina’s higher GDP growth rate, the Argentinean government might have legitimate reasons to impose imports controls. As to the inefficiencies allegedly brought about by import substitution policies and import controls, the de-industrialization outcomes of decades of neo-liberalism are a much worse heritage. We do favor, in general, a more depreciated exchange rate to reduce the external constraint, but because devaluation is inflationary, on the cost side, and there often is wage resistance, one must be moderate. Exchange rates are only one price, and the notion that there is a perfect level that would solve everything, leading to growth, stability and sustainable current account by itself, might be a chimera.

Originally published in Página/12 (in Spanish).

The politics of the monetary policy debate

The Reserve Bank of India (RBI) has finally succumbed to the increasingly mainstream demand for lowering interest rates. In its mid-quarterly monetary policy review, it has lowered the repo rates by a substantial margin of fifty basis points.

Conventional wisdom would have it that the RBI makes its interest rate decisions on objective considerations based on clearly defined parameters. Even assuming the inevitable discretionary judgement that goes with such decisions, the broadly technocratic nature of such decisions are widely accepted. It is also assumed that these decisions stabilize the economy as a whole. The twin objective is to keep inflation anchored and boost economic growth.

However, a closer analysis of this decision reveals a deeply institutionalized political and social bias. Two observations from the debate that preceded and also followed this decision.

1. In recent months, there has been a growing belief that the RBI holds the key to restoring India's economic growth. In fact, this belief has come to dominate opinion makers across the world. The apparent simplicity of tweaking a single number, the repo rate, to alter the fortunes of the economy has obvious attractions to all parties - academicians, businesses, governments, and media. It provides an easy opportunity for all and sundry to weigh in with their two ounces of wisdom. Unfortunately, it also takes away from focussing on the real issues at hand and holding governments accountable for their role in restoring economic growth. It takes the pressure off from governments in having to deal with more fundamental structural distortions and need for more reforms.

This impression is also reinforced by a cognitive bias, the availability heuristic. The RBI's interest rate decisions are discrete and high-profile events, very frequently deployed (especially in the past few years), and is associated with clear economic growth implications. Rate hikes increase the cost of capital while reductions have the opposite effect. It therefore becomes very easy for everyone to associate a tight monetary policy stance with growth suffocation.

2. The inflation Vs growth trade-off in monetary policy management, in the Indian context, has critical political overtones. Corporate India is directly and immediately hurt by the high interest rates. It therefore becomes natural for them to lobby aggressively to lower interest rates. They argue that the downside risks to economic growth associated with higher rates are much higher than its corresponding inflation risks.

However, monetary loosening, especially when inflationary forces remain unhinged and the economy is running at its potential output frontier, poses significant inflation risks. And inflation, as the episodes of runaway spikes in food prices in recent years indicate, can very adversely affect the poor. They disproportionately bear the costs of inflation compared to the non-poor and corporates.

In simple terms, leave alone its technical merits, a rate cut now reflects a conclusive preference for one political view over another. The balance sheet squares up clearly - high interest rates increases the cost of production for corporate India, while inflation has only marginal immediate impact; inflation hurts the poor directly while the effect of high interest rates is negligible. In terms of the magnitude of short to medium-term effects, lowering of interest rates and a possible rise in inflation will impact the poor more adversely than corporates and non-poor.     

3. Finally, as I have blogged earlier, RBI's recent tight monetary policy stance goes much beyond inflation control. In recent years, the Indian economy has been growing at a rate much higher than its potential GDP growth rate. In the absence of policies and investments that ease supply-side bottlenecks, this potential growth rate has remained stagnant. Therefore, it became necessary for the RBI to cool down the economy, so as to prevent the build up of inflationary pressures. However, popular debates and mainstream discussion on monetary policy have tended to gloss over this and focus on the growth inhibiting role of high interest rates.    

In the final analysis, these prejudices and biases are reflective of the dynamics that skew the priorities in the formulation of public policies and their implementation in India.

Postscript - I missed linking to this post by Daron Acemoglu and Simon Johnson which highlights how monetary policy in the US too appears to have become beholden to the interests of Wall Street. 

The fiscal and monetary "wiggle-space" - where does India stand?

Free Exchange points to the contrasting macroeconomic positions of developed and emerging economies. While the former has limited fiscal and monetary space to stimulate their economies any more, the later have adequate cushion on both fronts, if the need arises.

The average budget deficit of emerging economies last year was only 2% of GDP, against 8% in the G7 economies. And their public debt ratios were on average only 36% of GDP, compared with 119% of GDP in the rich world.

The Economist article uses a mix of fiscal and monetary policy paramters to arrive at the respective nations flexibility to manoeuvre with expansionary policies. It points to five parameters that determine the monetary policy space - inflation, credit growth, real interest rate, exchange rate movements, and current account balance. It added up the scores on these five parameters to produce an overall measure of monetary manoeuvrability. On the fiscal policy side, it constructs a fiscal-flexibility index, combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.



It ranked 27 emerging economies according to their monetary manoeuvrability and fiscal flexibility using a "wiggle-room index" constructed using the aforementioned parameters. This index is a reflection of the ability of countries to withstand a global downturn by stimulating their economies. The verdict,

The index suggests that China, Indonesia and Saudi Arabia have the greatest room to support growth. At the other extreme, Egypt, India and Poland have the least room for a stimulus, thanks to excessive government borrowing, large current-account deficits, and uncomfortably high inflation. Brazil is also in the red zone.

At first glance, on most parameters, India stands out as being among the most constrained of emerging economies. On the fiscal side, its combined government fiscal deficit of around 9% of the GDP, means that there is limited space available for any stimulus spending.

However on the monetary side, given the recent declining trend in inflation, the 13 consecutive repo rate increases by the RBI in response to rising inflation gives the central bank adequate monetary space to stimulate the economy. Further, since credit growth has been below par and exchange rate appears to have weathered its brief period of volatility, the monetary side space may not be as constrained as it appears now.

Further, while its total public debt, at about 68% of GDP, may look high by the standards of emerging economies, closer analysis reveals that it may not be as dismal as is being projected. Here are three reasons

1. The overwhelming share of this public debt is owed to domestic creditors. In fact, the total external debt (public and private) is estimated to decline to 17.4 of GDP for 2011, with government share being a mere 4.4% of GDP. As of end-September 2011, of the total external debt of $326.6 bn, with government and non-government shares in the total external debt being 24.3% and 75.7% respectively. Short-term debt accounted for 21.9% of the country's total external debt, while 78.1% was long-term. Adjusted for this, the real effective debt burden, in relation to a sovereign debt default risk, shrinks considerably. The only area of slight concern should be the 27.4% CAGR in external commercial borrowings between end-March 2006 and end-March 2011.



2. At 122% of GDP, its overall debt is the second lowest among all the major economies. Only Russia has a lower overall debt-to-GDP ratio.

3. Though its government may be profligate, the other major engines of economic growth - households, non-financial corporates, and financial institutions - have the healthiest balance sheets among all major economies, including China.





This means that all the non-government drivers of economic growth stand on very strong platforms and have enough "wiggle-room" to manoeuvre. All that is now required is for the government to get governance and policies right. Will that happen?

How Germany benefited from Eurozone

As the Eurozone tethers on the brink of collapse, questions are being raised about Germany's reluctance to play a more aggressive role in stabilizing the situation. More specifically, about its opposition to a lender of last resort role by the ECB and even some form of fiscal transfers to the peripheral economies.

Critics find this German attitude surprising since the German economy is one of the biggest beneficiaries of the monetary union. The far reaching labour market reforms and wage restraint exercised in Germany over the last decade enhanced its labour market competitiveness over the other Eurozone economies.

The tight embrace of a single currency meant that Germany's competitors did not have access to the most conventional instrument used to address trade competitiveness - exchange rate devaluation. In fact, far from exercising similar reforms and wage restraints to match Germany, the peripheral economies experienced a decade of asset bubble and/or debt driven economic boom, which drove up labour wages. The graph below shows how wages remained more or less stagnant in Germany, even as it rose elsewhere.



Labour market was not the only source of distortions. The monetary union and the attendant boost to their sovereign risk ratings meant that the peripheral economies suddenly had access to very cheap capital, a major share of which came from German and French banks. This too went towards fuelling asset bubbles (Spain and Ireland), wage price spirals (Portugal), government spending (Greece and Italy), and a consumption boom. Thanks to its increasing competitiveness, Germany provided the natural supplier for consumption booms in these countries. German exports ballooned.



So, as I have blogged earlier, among other things, the recovery path for the peripheral economies will certainly have to involve efforts to restore labour market competitiveness. This can be achieved either through internal devaluation or wage moderation in the peripheral economies or inflation in the core economies. Given the magnitude of re-balancing required, it may be necessary to have both.

But even with all this and without some form of radical debt restructuring and extendend period of monetary accommodation by the ECB, the survival of the Euro project looks increasingly in doubt.

Postscript

Paul Krugman points to the importance of export growth in Germany's economic growth of the last decade. A large share of these exports are to fellow Eurozone members, including the PIIGS. As the consumption elsewhere tanks, German exports will take a hit. It is impossible to expect consumption in these economies to regain its strength any time soon. In the circumstances, the only option left is for a massive German fiscal stimulus. This would not only keep aggregate demand in Germany up, but also provide an anchor for imports from the weak peripheral economies. In other words, German pump priming could boost growth both domestically and in the rest of Eurozone.

There are obviously two issues of concern. One, what magnitude of stimulus would be required to have any meaningful impact? Two, does Germany have the fiscal fire-power to sustain a big bazooka?

Update 1 (10/12/2011)

Nowhere has the benefits of euro integration more apparent than in the labour market as the graphic below shows. The German unemployment rate has steadily fallen since 2006, while that elsewhere has risen. German unemployment rate fell from 9.6% (4 million out of work) at the end of 2006 to 5.5% (just 2.3 million people out of work) today, both the figures being the lowest since the 1991 reunification.



As Floyd Norris writes, "It held down its labor costs during the boom, strengthening its competitive position relative to other members of the euro zone. The fact that those countries were in the euro zone helped to depress the currency’s value relative to other currencies, which made German exporters even more competitive."

This is a stunning statistic about the contrasting fortunes of the two parts of Europe,

"Put another way, at the end of 2006, 32 percent of the unemployed workers in the euro zone were Germans. Now the figure for Germans is 14 percent. The peripheral countries’ share went to 61 percent from 39 percent."

The focus should shift from Mumbai to New Delhi

The sources of India's most recent bout of inflation, as pointed out in a series of excellent recent speeches and papers by RBI officials (see also Amol Agarwal here), may be rooted in structural factors like demand shocks (increased protein consumption) and supply constraints. The continued fiscal accommodation, especially by way of the expansion of the mandate of policies like NREGS, may have contributed towards amplifying the upward pressures.

This means that monetary policy may have limited traction with restraining inflationary pressures, beyond cooling the economy and restraining growth in aggregate demand. Any further changes in monetary policy can only have marginal impacts, especially since the markets have already priced in the RBI's firm commitment to rein in inflation by lowering aggregate demand and thereby slowing down the economy. Blaming the RBI for taking only baby steps or being too predictable with its interest rate increases or even giving up its shock value (the recent announcement that it may not hike rates in December) looks unconvincing.

Translated into English, all this effectively means that the focus of attention on inflation fighting has to shift from RBI to the Government. It means that governments, both states and center, will have to initiate steps to ease supply-side constraints - infrastructure bottlenecks and agriculture production capacity. An aggressive program of investments in these areas is immediately required. Fiscally constrained governments need private sector assistance in many of these areas if there is to be any meaningful impact to ease supply constraints. The very nature and dynamics of their interventions also means that the expectations for immediate outcomes that we associate with RBI's monetary policy actions should be shelved.

It is interesting that during the Great Recession and the economic slowdown that followed the sub-prime crisis, governments across the world have been largely missing in action. Almost expecting this, public debates have been focussed on getting monetary authorities to pull economies out of their current mess. In the developed economies, central banks have indulged in monetary accommodation through unprecedented quantitative easing policies.

In India, the focus on its central bank has been for a different reason. Unlike the developed economies, the problem here is an overheating economy which has unleashed inflationary pressures. Accordingly, attention has been on the RBI to use monetary policy to deliver the magic bullets to lower inflation and boost growth. But, as aforementioned, this strategy has serious limitations and will not yield results. RBI can at best buy time by cooling the economy and buying time for the government to get its act in order. Only governments can fulfill the growth creation and sustaining role effectively.

The only issue at debate is whether the RBI should pause or not. The fundamental objective of the 13 consecutive rate hikes has been to rein in an over-heating economy. This growth restricting objective has to be weighed against the more important medium to long term goal of getting the economy to quickly expand its potential output and productive capacity. This requires massive investments in infrastructure and food production, both by the governments and the private sector.

Has the interest rate crossed the threshold where it has started adversely affecting these investments? This should be the critical question guiding RBI's monetary policy decisions in the months ahead. As for inflation, it is time for New Delhi to assume centerstage and take the "inflation bull" by its horns.

A graphical summary of the state of Indian Economy

Inflation has remained elevated at 8-10% range for more than 18 months since March 2010. Though the RBI and government have predicted the subsidence of headline inflation for many months now, it remains persistent at these high rates. The RBI's second quarter monetary policy review has projected baseline inflation to be 7% by end-March 2012.



Since February 2010, the RBI has increased rates 13 successive times, the largest such sequence of increases in its history. The repo and reverse repo rates have risen by 375 and 425 basis points respectively during this time.



Adding to the pressure is the steep recent depreciation in the value of rupee. While beneficial to exporters, it has the potential to add to inflationary pressures by making imports, espcially of oil, costlier.



In a reflection of the tightening monetary conditions, anchored inflation expectations, and increased government borrowings (government recently announced an increase in its 2011-12 fiscal borrowing by an additional Rs 52,872 Cr, taking it to a record Rs 4.7 trillion), long-term interest rates have been climbing. Into this milieu the announcement by the government The yields on 10 year government bonds have increased by more than 80 basis points since the beginning of the year.



As a measure of the growing global financial market instability, India VIX, the barometer of equity market volatility, has not only risen but has shown increased fluctuations over the past three months.

Impact of cash transfers in an economy with large fiscal transfers

For its extraordinary, almost global size, India's flagship National Employment Guarantee Scheme (NREGS) remains one of the least evaluated of anti-poverty programs anywhere in the world. For example, how has the massive NREGS cash transfers to rural consumers affected wages and local price levels? More generally, what is NREGS contribution to India's persistent food inflation? Or more specifically, how is the additional disposable income generated by NREGS being spent?

Unfortunately, there is no rigorus enough empirical study of the impact of world's largest cash transfer program on rural wages and resultant inflation. In a related context, Jesse M. Cunha, Giacomo De Giorgi, and Seema Jayachandran compared the relative local price effects of cash and in-kind transfers by studying a large food assistance program in Mexico that randomly assigned villages to receive boxes of food (trucked into the village), equivalently-valued cash transfers, or no transfers and found,

"Both types of transfers increase the demand for normal goods, but only in-kind transfers also increase supply. Hence, in-kind transfers should lead to lower prices than cash transfers, which helps consumers at the expense of local producers...

The price increase caused by cash transfers, based on the point estimates, offsets the direct transfer by 6 percent for recipients who are consumers of these goods. Meanwhile, for in-kind transfers, the price effects represent an indirect benefit to consumers equal to 5 percent of the direct benefit. Thus, choosing in-kind rather than cash transfers in this setting generates extra indirect transfers to the poor equal to 11 percent of the direct transfer. Of course, the welfare implications are reversed if transfers recipients are producers rather than consumers.

We also find that agricultural profits increase in cash villages, where food prices rose, more so than in in-kind villages where prices fell. These effects are due both to the change in the price of goods sold, but also to households responding by producing more (less) when the price of what they produce increases (decreases)."

The study also finds that price effects were particularly pronounced for very geographically isolcated villages, where the most impoverished people live. This is consistent with the fact that these villages are less open to trade and have less market competition, and are therefore more likely to be supply constrained in case of cash transfers. In these cases, the in-kind transfers actually increases supply and lowers prices.

The authors point to two issues that needs to be factored in while calculating the price benefits. One, their study does not look into what kind of effect is generated in the long-term, when the higher prices would signal to increase local production, thereby easing supply constraints. In fact, its long-term benefits are far more than that arising from external in-kind supply.

More importantly, there is the issue of how much does in-kind transfers constrain households' choices or conversely how much does cash transfers increase households' choices. As the authors point out, it is quite possible that an efficient private sector would create more surplus than if the inefficient government were the supplier. So they suggest that the best alternative would a mixture of cash transfers and policies to ease supply-side constraints.

Extending this analysis to NREGS and India will yield interesting possibilities. In India, we currently have a deeply supply constrained market where inflation expectations are on the rise. In such markets, any cash transfer would do little to increase supply. It increases the cash available with consumers, without doing much to boost supply, atleast in the short- to medium-term. Increased prices are inevitable. This increase in prices affect both the specific commodity being subsidized and the general price level.

Consider a cash transfer in place of rice supply through the Public Distribution System (PDS). Assume a family requires 60 kg of rice per month and gets cash equivalent of 35 kg of rice. Let us also assume that the subsidies are calibrated to price variability. Let us assume that there is only one variant of rice available in these remote markets and its price is Rs 15 per kg before the new cash transfer scheme is introduced. In supply-constrained markets (and remote interiors are classic examples of supply-constrained markets), which also experience government fiscal spending, prices generally increase and the following two effects are observed.

1. The beneficiary gets only a portion of his rice through the PDS. He has to purchase the rest from the market at market prices. In this case, he purchases 25 kg from the open market. After the cash transfer scheme is introduced, the price of rice increases to Rs 20 per kg (since the PDS supplies, which is not an insignficant share of total supply in such small markets, is now not available and has to come from the general market supply). He still continues to get cash equivalent to 35 kg. But now he has to shell out an extra Rs 125 per month for the same amount of rice the family was consuming before the program was introduced.

In contrast, with in-kind transfer, let us assume that the price falls (or it could remain the same) by say Rs 2 per kg after its introduction. This in turn leaves the farmer with a savings of Rs 50 per month. The difference between the two programs, with these assumptions, is therefore Rs 175.

2. There is also the likely spill-over effect on the general price level due to the increase in the price of rice. Further, the additional disposable incomes generated by way of NREGS and the resultant higher rural wages, will increase the demand for other items, mainly meat and other protein foods. Econ 101 would tells us that, when supply remains the same (which is likely to be the case with most products, atleast in the medium term), additional incomes (or higher aggregate demand) will have the effect of increasing the general price level.

All this in turn increases the burden on the family by say, Rs 100. Taken together, both these effects have the effect of reducing the real income of rural household by Rs 225 per month. The combined effect of cash transfers in an NREGS context is captured in the graph below. Note that it is possible that even the actual aggregate consumption could fall, rather than increase, especially if inflationary pressures get out of hand.



This highlights the importance of easing supply-side constraints in ensuring the effectiveness of any cash transfer scheme. In fact, taken together with NREGS, cash transfers could, without policies to increase supply, exacerbate inflationary pressures. Whatever the analysis, India's biggest obstacle to growth and successful implementation of process reforms that can increase growth, is a deeply supply-constrained economy. Its inflation problems too are just a symptom of supply bottlenecks.

The inflation monster

Kids are afraid of monsters, and so are Republican candidates apparently. The inflation monster that is. It really makes it hard to teach macro, since lots of students still think, because of the unrelenting 24 hour media coverage of GOP debates that since money supply increased (from about 7.5 to close to 9.3 trillions from Dec. 2007 until last July, using M2) we are in for a huge increase in prices. Hyperinflation should be around the corner.

It's not. As anybody with common sense knows the velocity of circulation does change (fell from slightly more than 2 to around 1.7 for M2), and the increase in money supply has no effect on spending. Banks are not lending, since demand is not growing sufficiently (if in doubt search endogenous money, now known as MMT, Modern Monetary Theory). And inflation has been subdued as the graph below shows (2011 is an IMF forecast for CPI inflation), even more after the 2007-8 crisis.

Inflation has increased a little bit in 2011, fundamentally associated to higher energy and food prices, but the pass-through to general prices in the US is relatively small (black line is a three year moving average). As noted by Adam Posen, central banks should continue to maintain low rates of interest. Unless they believe in monsters!

PS: Funny coincidence, after I posted this I saw that Krugman uploaded a graph of M2 velocity after the 1960s here.

The meaning of the gold price surge

Conventional wisdom on the surging gold prices has been that it is in indicator of inflation wary investors fleeing to a traditional safe asset. Accordingly, conservatives have invoked the recent spike in gold price in support of their advocacy for fiscal consolidation.

Paul Krugman has an interesting post, where he argues that contrary to conventional wisdom, deflationary fears may be driving gold prices. He points to the famous Hotelling Rule which says that people have an incentive to hold onto an exhaustible resource (by storing it or keeping it unextracted) because of rising prices. Economically this means that "a mineral deposit in the ground has the same significance as a bond, and is in some sense interchangeable with such a financial instrument".

A consequence of this Rule is that, assuming negligible storage costs and the major part of the stock has already been extracted (so the choice is between storing it for the future or selling it now), the "real price must rise at a rate equal to the real rate of interest". If the real rate of interest is lower, as is the case now, people have an incentive to "hoard gold now and push its actual use further into the future" because the lower rates reduces the return on investment of the sale proceeds. This translates to higher prices in the short run and the near future. Krugman writes about its implications,

"(T)his... 'real' story about gold, in which the price has risen because expected returns on other investments have fallen; it is not, repeat not, a story about inflation expectations. Not only are surging gold prices not a sign of severe inflation just around the corner, they’re actually the result of a persistently depressed economy stuck in a liquidity trap — an economy that basically faces the threat of Japanese-style deflation, not Weimar-style inflation... And if you view the gold story as being basically about real interest rates, something else follows — namely, that having a gold standard right now would be deeply deflationary. The real price of gold 'wants' to rise; if you try to peg the nominal price level to gold, that can only happen through severe deflation."

In other words, since interest rates are low and rational expectations are for an extended period of low rates (and therefore low inflation), people prefer to hoard or store gold, thereby boosting gold prices in the short-run. This analysis would see the increase in gold price as a signature of deflation.

In another post Krugman also makes the distinction between gold and other commodities, in so far as their applicability to this hypothesis. Unlike gold, most other natural resources, including oil, does no conform to atleast one or both of the assumptions - negligible storage costs and most stock has been extracted out.

Changing Inflation dynamics in India

An excellent recent speech (via Mostly Economics) by the Executive Director of RBI, Deepak Mohanty, reveals certain interesting trends in India's inflation dynamics. A few points from the speech



1. The role of food inflation



He finds a structural break in the mid-2000s in India's WPI-based inflation, which is the measure of the policy headline inflation. The historical average long-term inflation rate of around 7.5%, which moderated in the first half of 2000s to about 5.2%, started rising in the second half to touch an average of 5.5%. More worryingly, the volatility in WPI inflation increased sharply.







The driving force behind this rise was primary food inflation, in particular protein items. He says,

"Protein inflation has assumed a structural character and is partly driven by demand factors. Within the protein group, persistence was lower for pulses as well as 'egg, meat and fish', but it was markedly higher for milk... Increase in demand for protein appears to be an inevitable consequence of rising affluence. This process was further accentuated by renewed global food price shock during 2010-11. Among the processed food items, the persistence of inflation for edible oils was high."

2. Core inflation



The inflation in non-food manufactured products, which represents the core-inflation, and which has a weight of 55% in the WPI, too has inched upwards since 2009-10. It averaged 4% in the 2000s, and even moderated in the second half of the decade, only to start rising from 2009-10. Deepak Mohanty claims that "the non-food manufactured products inflation shows a major structural break towards the middle of 2009-10 around the time the global commodity prices rebounded".







In fact, he even finds that industrial raw material prices also showed a structural break in early 2009 and the average price increase has been high and volatile.







The coincidence of the recent rise in core-inflation and the similar rise in industrial raw material costs, with the global commodities price increases, lends credence to the view that both are interconnected. He writes that the "pass-through from non-food international commodity prices to domestic raw material prices has increased particularly in the recent years reflecting growing interconnectedness of domestic and global commodity markets".



3. Demand side factors



The less discussed side of our inflation story is the rise in the purchasing power and resultant demand-side pressures, an inevitable consequence of the last decade of high growth. In fact, the the NSSO surveys (61st round and 66th round) shows that the nominal wage rates of skilled workers in both rural and urban areas increased much faster in the second half of the 2000s than in the first half. While the real wage rates declined in the first half, it increased significantly in the second half of 2000s. The wages of the rural unskilled labour has increased sharply, both in nominal and real terms, since the beginning of 2010.







As indicated earlier, a clear manifestation of this trend is the sharp spike in the consumption share of protein items in the rural and urban consumption baskets. The increase in wage rates of the unskilled rural labourers has certainly played a role in contributing to this spike in protein consumption.







In the formal sector, company finance data suggest that the wage bill has risen at a faster rate since the middle of 2009-10.

More on FT's negative propaganda on Argentina

I had promised to return to the issue of inflation in Argentina, in my previous post about the Financial Times' biased coverage of the Argentine boom post-default and devaluation in 2001-02.  The important question, and not only in the Argentine  case, is whether inflation is somehow associated to excess demand,  which would justify the conservative calls to cool down the economy and promote tighter monetary and fiscal policies.  The graph below shows average capacity utilization in the Argentine economy, and it clearly shows that since 2006 the levels have reached the normal position close to 80% of utilization.

The same can be seen in the measure of the output-to-capital ratio presented below.  In other words, investment has allowed capacity to adjust to demand, and the level of the Y-K ratio to return to its normal level.  In other words, the boom has allowed the economy to recover normal levels of capacity utilization, and if the economy grew at a faster pace, capacity would have most likely adjusted.  The only way that the economy would reach full capacity would be if the rate of growth of demand was considerably faster than the ability of capacity to adjust.  From 2003 to 2010 GDP (proxy for demand) grew around 60%, while investment did 147% (the adjustment of capacity), on a cumulative basis.  Also, even though unemployment fell from close to 25% to around 7.5%, there is space for lower levels of unemployment, something that is particularly in an economy with significant numbers of employees underemployed, or employed in low productivity activities.

The real danger, as always for developing and peripheral countries, comes from the balance of payments.   The graph below shows the current account to export ratio.  Clearly the space to grow without reaching the external restriction has shrunk during the boom, approaching zero in 2011, but the limit has still not been reached.  This would be a limit, but not a capacity limit.

In sum, inflation cannot be associated with excess demand, since the evidence does not support that the economy is above maximum capacity.  Further, well understood what I'm suggesting is that capacity does adjust to demand, so inflation in normal times (exclude wars and other catastrophic events) is related to cost pressures. I'll deal with the evidence for commodity prices, and distributive conflict in another post.

"Growing" out of debt

Debt is central to any discussion about the US economy nowadays. How to reduce the massive $14.3 trillion public debt and the $1.6 trillion (11% of GDP) fiscal deficit?

Conventional solutions include cutting expenditures, raising taxes, inflating away debts with higher inflation, and the final resort partial and selective sovereign default. However, as I have blogged earlier, all of them are fraught with dangers. As Lane Kenworthy pointed out in a recent post, any government's debt levels "are a function of government expenditures and revenues and economic growth".

In the current macroeconomic circumstances, Catherine Rampell hits the nail on the head by describing "economic growth" as the secret weapon to bring the debt back to sustainable levels. Growth creates its own set of dynamics, the most important of which is to boost revenues and bring down the real debt burden. It is therefore no surprise that the largest contributor to America's massive public debt stock, other than Bush era tax cuts, has been the decline in revenues caused by the recession. In fact, of the $12.7 trillion in additional federal debt that was accumulated over the last decade, about a third came from the souring economy.

However, the traditional sources of economic growth remain depressed. Household consumption which forms more than 70% of US GDP remains weak as households grapple with debt-ridden balance sheets. Weak consumption means that businesses have little incentive to invest. Trade, the other traditional engine of growth, too is depressed on the face of weak economic prospects among the major US trading partners in the developed world.

This leaves the government with the responsibility of shouldering the major share of the recovery burden. But government spending comes with a fiscal cost, which adds to the already high debt stocks. It will succeed if the rate of GDP growth caused by the stimulus exceeds the rate of growth in debt stock due to the additional fiscal demands. Fortunately, given the specific conditions, all evidence and macroeconomic theories points to this being the most possible outcomes.

Expansionary policies, fiscal and monetary, have traditionally been the engines thaht put recession-hit economies on the path of recovery. In contrast, austerity has most often had the effect of deepening the recession. The fiscal and monetary stimulus spending, while substantial, is not that large when seen as a share of the total debt stock. As mentioned earlier, if the multiplier due to growth (in the prevailing macroeconomic conditions) is taken into consideration, a net cash inflow is the result.

However, even if short and even medium-term debt reduction objectives are achieved, as they look very much possible, the long-term debt reduction prospects for the US economy looks bleaker. There are important structural factors, mainly related to demography. The aging population means ballooning health care costs. It is therefore critical that these longer term factors are effectively addressed for America to make any meaningful dent on its long-term fiscal balances.

It is not just the US that is suffering a debt overhang. It is as big a problem on the other side of the Atlantic and in some developing countries.



The agreement reached between President Obama and Congressional leaders of both parties on Sunday to raise the debt ceiling (by $1.6 to 1.9 trillion) has firmly embraced the fiscal consolidation route to debt reduction. The agreement calls for at least $2.4 trillion in spending cuts over 10 years, including on Medicare, Medicaid and Social Security, with a new Congressional committee to recommend deficit-reduction proposals. It does not contain any proposal to increase taxes. It has been criticised by economists as making a weak economy weaker, a catastrophe on multiple levels, and even plain extortion.

China's Local Government Debts

One of the most intriguing questions for Indians marvelling at China's spectacular economic growth is about how its government manages to finance a never-ending shelf of mega infrastructure projects entailing extraordinary investments. For all its governance failures, corruption, resistance to reforms and recent political paralysis, the fundamental problem for a chronically infrastructure deficient India remains paucity of resources to finance its massive infrastructure requirements.

The contrast with a flush-with-funds China is stark. However, as the Times points out in an excellent article chronicling the challenges facing China's increasingly infrastructure investment dominated economic growth push, things may not be as rosy as it appears across our northern borders.

As the Great Recession took hold, the Chinese government stepped in with a mssive $580 bn stimulus package. Local governments across China borrowed heavily from state-owned banks and pumped money into infrastructure. Infrastructure replaced exports as the engine of economic growth.

The Times reports that spending on so-called fixed-asset investment (infrastructure and real estate projects) is now equal to nearly 70% of the nation’s GDP, a sign of dangerous over-dependence on infrastructure spending. It is a ratio unheard of in modern times for any nation, with the ratio being just 35% for Japan during its 1980s building boom and 20% for US for decades now.



Now this model is becoming unsustainable as local government debts, cleverly hidden from the local government balance sheet through accounting tricks, mount and repayment strains start appearing. The National Audit Office recently released figures showing that the local governments had amassed 10.7 trillion yuan ($1.65 trillion) in debt as of the end of December, amounting to 26.9% of GDP in 2010. Of this debt, local governments are explicitly responsible for repaying 62.6%, have guaranteed 21.8%, and are required to partially repay 15.6%. Worryingly, the report writes that nearly half the debt was accumulated in just two years by way of the loan-powered fiscal stimulus of 2009-10. This debt, mainly owed to state-run banks, poses serious risks for the Chinese financial system.

Most local governments borrow through special investment corporations set up by them and their debt shows up nowhere on its official balance sheet. Such local government financing vehicles (LGFV) were set up to get around rules forbidding them from borrowing directly from banks and raising funds through municipal bonds and also conceal the true extent of local government debts. These LGFVs were set up to finance light rail projects, bridges etc. It is estimated that there are more than 10,000 of these local government financing entities in China.

In fact, the audit office said 46.4% of the debt is held by such intermediary vehicles. Another recent report from the People's Bank of China had said that local government financing vehicles had taken out loans worth up to 30% of total outstanding bank loans or 14 trillion yuan. The collateral for many loans is local land valued at lofty prices that could collapse if China’s real estate bubble burst.

An earlier estimate by the Northwestern University Prof. Victor Shih found that the total local government financing platform debt was around 11.4 trillion yuan ($1.75 trillion) at the end of 2009. His latest estimate of total local governmental debt ranges between 15.4 trillion yuan and 20.1 trillion yuan, or 40% to 50% of China's 2010 GDP. He also estimates that LGFV interest payments are at least 1 trillion yuan a year, and realistically more than 2 trillion yuan.

Another report by Moody's says that the audit office's data fails to account for about 3.5 trillion yuan, or about $540 billion, of loans to local governments. It also estimates that the Chinese banking system's nonperforming loans could reach between 8% and 12% of total loans. This is in stark contrast to the official ratio of non-performing loans of 1.14% at the end of 2010.‬

The biggest concern is a possible rise in inflation, which would force the central bank into raising interest rates. In fact, yesterday the People's Bank raised interest rates for the third time this year in order to cool the sizzling pace of economic growth, estimated to touch 11.9% in the seond quarter. Inflation is up 4.4% for June, the highest rate in more than two years and above the 3% target set by central bank.

In fact, the threat of the whole pack of cards collapsing when faced with higher interest rates is also behind the reluctance of authorities to rein in the bubble. As Prof Shih argues, the only way to cool down the continuously inflating debt bubble and credit flows is by engineering a credit crunch. Unfortunately, this would entail raising interest rates, with all its possible adverse consequences.

There have been rumors that the government is considering write-off about 2-3 trillion ($300-470 bn) in debts owed by local governments to the country's China's top banks. Though this would force losses on banks, local and central governments, it should reduce the risks that cloud the Chinese economy. Fortunately, a banking crisis would not have the sort direct impact on consumers as witnessed in the US since the Chinese citizens save heavily and have limited exposure to mortgages and other financial investments.

The debt build-up also amplified the already frothy real estate market, which was pushed up further by the stimulus spending in 2010 and 2011. A large share of this spending was routed into real-estate related infrastructure. Chinese state-owned banks, on government orders, lent about $3 trillion mostly to giant state-owned enterprises and local governments to fight the effects of the downturn. Though intended at infrastructure, a substantial share of these loans wound up financing real-estate purchases by government agencies.

Further, in the absence of financial alternatives to beat inflation, Chinese savers piled into real estate and drove residential property prices up by half to about 9% of GDP between 2006 and 2010. In that period, real-estate prices in major cities in China roughly doubled.

The continuing paucity of investment avenues coupled with exceptionally high savings rates and the reliance of local governments on land sales for revenue means that property prices could go higher before the bubble bursts. The Standard Chartered estimates that about 50% of China's GDP is linked to the fate of its real-estate market (it affects construction, steel, concrete, power and appliance industries), making a potential bust extremely damaging. A banking crisis would be inevitable.

See also this Times Room for Debate on China's local government debt.

Lindsay Lohan is a monetarist



Via Jason Linkins; the joke of the day.  So Lohan twitted the following:

"Have you guys seen food and gas prices lately? U.S. $ will soon be worthless if the Fed keeps printing money!"

Apparently she was paid by a group called the National Inflation Association (with that name I'm sure they are in favor of inflation).  Forget that the causes of inflation had nothing to do with the Fed printing money, what is really hilarious is that conservative/monetarists chose Lohan as the speaker of their cause.  It must be a question of credibility!

The Great Indian Inflation Challenge

The great Indian inflation debate shows no signs of abating and if the prevailing trends are any indication, it may continue well into the foreseeable future. The RBI recently enacted its 13th continuous repo rate increase in an attempt to bring inflationary pressures under control. But monetary policy may be on its last legs as the negative impact of high interest rates on economic growth already appears to have become predominant.

In the circumstances, it is not surprising that inflation has become a political football. Opposition parties, civil society organizations, and opinion makers in the media cry hoarse at the government's inability to bring down food prices. They blame everything from bad policies to corruption to inefficient bureaucracy to hoarding for the persistence of inflation. Why is the inflation monster becoming so intractable?

Econ 101 teaches us that economies are at their most efficient when they grow at their production possibility frontier, which is a function of the basic resources - manpower, capital, and infrastructure - available in the economy. Any economic growth is under-pinned by these available resources. As economies expand at their natural pace, it accumulates these resources, and a positive virtuous spiral of growth is generated - growth brings in tax revenues, which are funneled into capital investments, which in turn creates the platform for further growth.

However, when the economy experience a sudden growth spurt, wherein the trend rate of growth is suddenly lifted up, the available resources often get depleted quickly and its growth may fail to keep pace with the needs of economic expansion. In simple terms, the economy grows much faster than the supply of resources required to sustain the expansion. More factory capacity is built up than electricity supply can support; manufacturing production exceeds the ability of transportation facilities to move them by road, water and air; cities grow much faster than local governments can provide civic infrastructure facilities and so on. The economy is "over-heating".

Amplifying all this is the impact of growing incomes generated by the booming economy, which changes people's living habits and expenditure patterns. If coincidentally the government is indulging in some direct fiscal spending to boost incomes across the board, then the demand pressures burst open. In such circumstances, where aggregate demand is on the up and the supply infrastructure and other basic resources not keeping pace with the requirements, inflationary pressures are inevitable.

India is experiencing something similar to that described above. A decades long trend annual growth rate of around 5% suddenly gave way to near double-digit rates since the turn of the century. Once the initial slack and spurt of government investments had run its course, the supply constraints started showing up. The supply of capital resources stagnated and failed to keep pace with galloping demand.

Targets in critical infrastructure areas like provision of civic utilities, roads, power generation, port capacity addition, agriculture storage etc were repeatedly missed. A severe shortage of skilled factory and construction manpower and qualified engineering personnel has very badly affected businesses. The high interest rates are only exacerbating this trend by creating constraints on the supply of capital.

The well-intentioned NREGS has had the direct impact of giving thousands of crores of additional cash in the hands of rural poor, besides boosting labour wages across the board. The income effect created by all this has increased disposable incomes and boosted aggregate demand across the economy. The supply-side has badly lagged behind this huge spurt in demand. Inflation was almost inevitable and will persist till these conditions change.

It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones. The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production and over-stretched infrastructure, especially power and transport logistics.

Assuming that the lions share of infrastructure investments should have come from governments, it would be reasonable to expect government investments to have increased atleast as spectacularly as the recent spike in GDP growth rates. However, even as gross fixed capital formation as a share of GDP has increased impressively since about 2003, government consumption as a share of GDP has remained stagnant. This is despite the considerable increases in government consumption by way of petroleum and other subsidies in recent years. It can be safely presumed that government capital investments, especially in infrastructure, lags badly and remains woefully inadequate.



On a historic perspective, India's economy has, atleast since about 2003, reached a new and higher growth phase. However, this (involving the near doubling of the average growth rates from about 5% annually to about 10%) has not been accompanied by any commensurate increase in government consumption (the spurt in 2008 can be attributed to the different kinds of stimulus spending).



The choices facing the Indian economy are stark. If it has to rein in inflation in the foreseeable future, capital investments in physical infrastructure and human resources will have to increase exponentially. Or else, faced with chronic supply constraints, inflation will persist, and ultimately growth itself will get compressed. Either are not easily resolved and will take considerable time.

The most plausible scenario appears to be a slip back into an intermediate trend growth trajectory, where moderation of growth stabilizes inflationary pressures. Hopefully, this time, the government gets its act together and channels massive investments into basic physical and human infrastructure, so as to set the stage for recovering back into the current high trend growth stage quickly.

PS: Once the over-heating economy line of reasoning is accepted, the central bank faces no trade-off between inflation targeting and economic growth. The objective then is to do monetary tightening so as to cool down economic growth to a level where the supply-side growth is in sync with the aggregate demand growth. The danger of course is that no-one knows how much tightening or cooling is optimal!

Update 1 (4/7/2011)

Evidence of overheating economy comes from this graphical survey by The Economist. Using inflation, current GDP and employment growth rates over the average of the past decade, credit growth rate, and current account deficits, it finds that India is among those handful of emerging economies which are clearly overheating.

More on macroeconomic policy arguments during the Great Recession

The Great Recession has become a fertile ground for considerable analysis of the prevailing conventional wisdom macroeconomic policies. The relative merits of contractionary and expansionary monetary and fiscal policies are at the heart of all ideological battles.

Conservatives fret at the inflationary effects of expansionary conventional (zero-bound interest rates) and unconventional (quantitative easing) monetary policies and call for tightening monetary policy or atleast oppose any further monetary expansion. They also point to the unsustainable public debt and fiscal deficit and argue any fiscal expansion. Some even argue that all this is crowding out private spending, despite the overwhelming evidence of massive idling resources and capacity in the US economy. Their general belief is that hard money and sound government finances are necessary for a robust recovery to take hold.

Paul Krugman has been the strongest proponent of the view that when faced with a liquidity trap, increases in the monetary base (which includes bank reserves as well as currency) doesn’t cause inflation, or even a rise in broader definitions of the money supply. Faced with a recession and the zero-bound, businesses postpone investments and consumers their spending, thereby forcing banks to hold on to their reserves. This propensity to hold on to reserves is amplified by the fact that under such conditions, cash and T-Bills become near perfect substitutes, and the Fed cannot therefore expand M2.

Krugman points to the evidence from old and recent history to highlight this. At the onset of the Great Depression, though the Fed expanded the monetary base considerably (admittedly this may have been smaller than was required), it did not result in the expected increase in money supply and inflation remained muted.



Much the same happened in Japan. Despite a dramatic expansion in the monetary base by the Bank of Japan, prices kept falling.



Since the beginning of the Great Recession, the US Federal Reserve has been quick in dramatically expanding its balance sheet and increasing the monetary base. The result - M2 money supply and consumer prices have hardly budged.



However, even among those who favor monetary expansion, there is one group who argue that the Federal Reserve could have done more to avert a deep recession in 2008 and 2009 if it had indulged in much more aggressive monetary expansion. Scott Sumner, David Beckworth and others argue that the central bank using monetary policy tools can do more, even when faced with a zero-bound in interest rates, to stimulate aggregate demand and expand the economy.

They advocate setting an explicit nominal GDP target (or nominal GDP growth path) to shape future market expectations about current and future nominal spending and thereby boost economic growth or prevent aggregate demand crashes. This, they argue, can be done by purchasing assets other than Treasury Bills, like longer-term securities, to lower long-term rates and thereby incentivize investment and consumption spending so as to reach the nominal GDP target. David Beckworth writes,

"Set an explicit nominal GDP level target so that expectations are appropriately shaped. If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target... Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment...

if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange... The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument."

As David Beckworth acknowledges, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds.

Paul Krugman points to evidence from Japan to question the quasi monetarist position on the utility of monetary policy during such liquidity trap crises. In this context, he also draws attention to the views of the late Milton Friedman who had advocated that the central banks push more reserves into the banking system through monetary expansion. In fact, Friedman had famously blamed the Fed's unwillingness to indulge in sufficient monetary expansion as the major contributor towards the Great Depression.

However, unlike the Fed in the 1930s, the Bank of Japan indluged in massive monetary expansion. However, this did not result in the expected rapid growth in the money supply or monetary base.



Paul Krugman concludes that "in the face of a really big shock, which pushes the economy into a liquidity trap, the central bank can’t prevent a depression". In the circumstances, the only option left is fiscal policy. Here Krugman points to the critical role that the government borrowing and spending played in making up for the steep decline in private consumption.



Update 1 (28/10/2011)

FT Aplhaville points to a Goldman report which advocates nominal GDP targeting for the US.

"For the US, we advocated a shift to nominal GDP targeting, backed up with asset purchases, as the best of these options if further easing is needed. We think nominal GDP targeting probably provides the best way of communicating a credible intention to deliver a more aggressive easing without taking risks on long-term inflation. First, the framework is simple and transparent and avoids the complications of choosing a particular price index. Second, it deals directly with the problem of large excess capacity in the economy and focuses on a variable that is more directly linked to the ability to cope with debt contracts that were mostly made on the assumption that nominal income would be much higher than it currently is. Extending the price level trend for the US or UK would not deliver as strong a case for easing (and in the UK may argue for tighter policy). Third, it does not focus directly on generating inflation, which may make it more palatable to the public, or on the exchange rate, which could raise international tension. Fourth, it defines a clear exit strategy for policy and so minimises the risk of runaway inflation. Other policy options meet some of these criteria, but we think overall score less well."