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. 

Fiscal Policy in Depressions

Lawrence Summers and Brad DeLong have this paper which argues that in severely depressed economies, which are also constrained by the zero-interest rate bound, discretionary fiscal policy can be a powerful instrument to revive growth. They write,

In normal times central banks offset the effects of fiscal policy. This keeps the policy-relevant multiplier near zero. It leaves no space for expansionary fiscal policy as a stabilization policy tool. But when interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilization policy tool. Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios. While our analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution re-garding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound.

Following the apparent triumph of monetarism in the seventies, Keynesianism had been upstaged as the dominant macroeconomic stabilization ideology for nearly three decades till the Great Recession took hold. It was believed that front-loaded fiscal consolidation for deficit-reduction coupled with accommodatory monetary policy would help achieve price stability, positively shape expectations and restore market confidence, encourage investment and consumption, and thereby boost aggregate demand. It would help successfully combat short-term business cycle problems and address medium-term growth dimensions.

It was also believed that the multiplier of discretionary fiscal policy was small. When the economy is close to its productive level, fiscal policy induced rise in demand will run up against supply constraints, thereby fuelling inflation, and rise in interest rates. This tightening of monetary policy, at a time when the economy needs accommodatory monetary policy, will end up crowding out private investments and off-setting the aggregate demand gains due to higher government spending. In contrast, monetary policy packs a much greater punch as an economic stabilization policy instrument. However, when there is a deep economic downturn coupled with interest rates touching the zero-bound, fiscal policy assumes a different character.

As Summers and DeLong write, there are atleast three distinguishing features of the current economic situation in many developed countries that leaves monetary policy without much traction and makes discretionary fiscal policy critical.

1. The absence of supply constraints and interest behavior associated with an economy constrained by the zero-bound means that the multiplier associated with fiscal expansion is likely to be substantially greater and longer lasting. The expectations of growth returning and raising inflation, and thereby lowering real interest rates, magnifies the multiplier.

2. Even very modest hysteresis effects through which output shortfalls affect the economy's future potential have a substantial effect on estimates of the impact of expansionary fiscal policies on future debt burdens. They find evidence that mitigating protracted output losses like those suffered by the United States in recent years raises potential future output. In other words, downturns have the potential to permanently lower the potential output and the trend rate of growth - "Large recessions may create labor-market as well as capital-stock hysteresis".

For example, the longer the economy stays depressed, the more likely that workers will quit the labour force altogether. Therefore, by putting these people back to work today, stimulus generates higher taxes not just this year but for years to come, lowering the long-term debt burden.

3. Extraordinarily low levels of real interest rates raise questions about the efficacy of monetary policy as a source of stimulus, and reduce the cost of fiscal stimulus.

In this context, Paul Krugman has this nice scatterplot of the changes in GDP growth rates against the change in government consumption among Eurozone economies. The correlation is unmistakably salient.

Europe's Big Bazooka - Round Two

As part of Europe's efforts to unfreeze the credit markets and kick-start economic growth, the ECB conducted its second round of lending to Euro zone banks on 29th February under its longer-term refinancing operation (LTRO). More than 800 banks borrowed €529.5 billion, or $713 billion, in three-year loans at the benchmark interest rate of 1% by pledging collateral, typically bonds or other liquid securities. The ECB does not disclose which banks take out loans or where the banks are based for fear of stigmatizing those banks.

In the first round in December, 523 banks borrowed €489 billion at the same terms. The increased demand in this round is a reflection of the gravity of the credit squeeze being felt by Eurozone banks. Further, relaxations in collateral requirements aimed at helping the several smaller and community banks take advantage of this credit window may also have added to the loan off-take. These banks are more likely to lend to businesses and consumers.

It is hoped that this credit infusion will help ease fears of a banking meltdown and restore market confidence. The longer tenor of the loans was intended to provide the banks with the breathing space to get things right even if the credit markets take some time to get back to normal. The challenge now will be to get these banks to start lending to businesses and consumers so that the stalled economies in many Eurozone countries can be revived. In fact, though given to banks, these liquidity infusions serve as a backdoor support to distressed sovereign bond markets. Evidence from the first round show that many banks have used atleast a part of this money to buy sovereign bonds and thereby keep borrowing costs lower for the peripheral economies.

However, though the ECB has lend more than a trillion euros over the two rounds, the actual amount of new money flowing to banks is closer to €520 billion, because many banks shifted money from shorter-term ECB loans into the three-year loans. Further, though the money injections have been substantial, it has not led to the revival of the interbank market, in which banks lend excess cash to each other for short periods. Banks have preferred to keep their excess cash in the safety of the ECB, despite the 0.25% interest rates paid by it.

Finally, there is the danger that this easy credit will only postpone the inevitable and prevent banks from taking the tough decisions required to put their house back in order. Critics argue that it will take the pressure off banks and governments to reform by providing easy credit and by also keeping down sovereign borrowing costs.

The real test of whether these policies are succeeding will be the emergence of signals that banks have started lending again to businesses and consumers. In particular, any signs of revival in the corporate bond market will be closely watched. Ultimately, given the depth of the slowdown, as reflected in the rising unemployment rates, these measures will need to restore economic growth. Robust economic growth is the only way in which these economies can pull themselves out of this crisis.

Update 1 (10/3/2012)
Greece finally managed to arm-twist its private creditors into accepting a 75% haircut on Greek government bonds. Nearly 86% of creditors accepted the deal, and the final figure is expected to be more than 95%. It had warned that without such a deal, Greece might be forced to default altogether, with no one getting paid. The outcome has enabled Greece to reduce its debt load by just over 100 billion euros, or about $132 billion. This makes it the largest private debt write-down in history.



The International Swaps and Derivatives Association ruled that the agreement was a technical default by Greece. This will enable payouts on CDS contracts that various investors had taken out on the privately held Greek debt. Around $70 billion in default swaps on that debt are outstanding, although analysts expect the net payout to end up at only $3.2 billion or so.

Now, the bulk of Athens’s 260.2 billion euros ($341 billion) in remaining government debt will now be held by the IMF, ECB and the individual European nations that have lent Greece money through the EFSF and contributed to the region’s bailout fund. This means that any further haircuts will hurt the sovereign lenders to Greece. Further, since the IMF will balk at haircuts, the bulk of any future haircuts will have to be borne by Europeans themselves. The Times writes,

As recently as 2008, virtually all of Greece’s government, or sovereign, debt was held by private sector bondholders, chiefly banks and investment funds. But as a result of Greece’s escalating debt crisis and intervention by public institutions, private creditors now hold only 27 percent of Greece’s debt.

And even after the write-down, Greece is estimated to be saddled with a debt-to-GDP ratio of 151 percent in 2012, and 149 percent in 2013. The Greek economy shrank by 7.5 percent in the fourth quarter, and its youth unemployment is at a staggering 51 percent.

Central Bank Communication and Financial Stability

Central Banks across the world are racing to go transparent. In United States, the Federal Reserve has raised transparency to new levels by publishing the long-term policy rate forecast and the next rate hike expectations of the individual members of the Federal Open Market Committee (FOMC). The Reserve Bank of India too has not remained unaffected by this trend as its minutes now reveal the individual opinions of its Monetary Policy Committee members.

The argument behind this transparency is that it minimizes information asymmetry and helps shape policy expectations among all market participants more effectively. However, it is far from certain that such transparency is beneficial in the long-term or any more efficient than the current strategy of relative opacity.

For example, in the instant case of the Fed, the longer-term forecasts of the individual members, albeit appropriately qualified, helps bake in expectations of longer-term policy direction among market participants. Though qualified with assumptions and conditions, this fine print is most likely to be overlooked, especially when there is a sustained period of upswing in various growth indicators. As the actions of Alan Greenspan and Co. over the first half of the past decade shows, the members are themselves likely to be blinded to the various cognitive biases that influence their decisions when the economy is either doing well or badly.

The resultant "irrational exuberance" is certain to bias the decisions of a large number of market participants. In these circumstances, the longer-term forecasts act as pro-cyclical amplifiers. In the absence of such forecasts, the market participants would atleast have been that less certain about the economic trends. And given the formidable reputation that central banks have assiduously built-up over the past few years, these forecasts are likely to carry much greater punch than other sources of information.

Therefore, such transparency enhancing forecast publications, tend to make the market participants lean more towards the wind than would have been the case in their absence. Perversely enough, a dose of uncertainty may have diminished the "irrational exuberance" and herd mentality and made market participants more guarded in their economic decisions. In simple terms, instead of improving market efficiency, the reduction of information asymmetry has the potential to lower market stability.

Update 1 (24/2/2012)

It appears that the Fed's push to reduce frictions in one area is complemented by increased frictions in other areas. Simon Johnson detects a very clear bias in the meetings held by the Fed officials on the Dodd Frank legislation,

Just on the Volcker Rule — the provision in Dodd-Frank to limit proprietary trading and other high-risk activities by megabanks — Fed board members and staff members apparently met with JPMorgan Chase 16 times, Bank of America 10 times, Goldman Sachs nine times, Barclays seven times and Morgan Stanley seven times...

Based on what is in the public domain on the Fed’s Web site, my assessment is that people opposed to sensible financial reform — including but not limited to the Volcker Rule — have had much more access to top Federal Reserve officials than people who support such reforms. More generally, it looks to me as though, even by the most generous (to the Fed) account, meetings with opponents of reform outnumber meetings with supporters of reform about 10 to 1.

Heterodox central bankers II

"At the present time we are still in the depths of a depression and, beyond creating an easy money situation, there is very little, if anything, that the Reserve organization can do toward bringing about recovery. One cannot push a string. I believe, however, that if a condition of great business activity were developing to a point of credit inflation, monetary action could be very effective in curbing undue expansion. That would be pulling a string."

Marriner S. Eccles

Chairman, Federal Reserve Board

March 4-20, 1935.

"The factor of unutilized capacity appears to furnish the decisive answer to the argument that if the budget had been balanced the resulting restoration of confidence would in itself have led to recovery. There is nothing in balancing the budget that would lead to an absorption of excess capacity and hence make it profitable for business to increase its disbursements for plant and equipment. On the contrary, balancing the budget, by curtailing the incomes of people receiving money from the Government and by reducing buying power through increased taxes, would heve been expected to decrease demand and hence increase excess capacity."

Marriner S. Eccles

Chairman, Federal Reserve Board

June 8, 1936

Central Banks hold sway, where are the governments?

There is a common feature in the respective policy responses to the current domestic economic situations in United States and India. In both countries Central Banks are at the frontline fighting the battle, while governments appear missing in action. In many respects, both the Fed and the RBI are, in different ways and degrees, fighting not only the monetary policy but also the fiscal policy battles. This over-reach in both areas is unsustainable and is generating distortions that could set the stage for even bigger crises.

More worryingly, not only do the central banks themselves appear convinced of their leadership role, but everyone else too believes that they should keep doing more. In the process, governments are getting away lightly. Nothing can take away from the fundamental fact that only governments can sustainably bring a closure to the ongoing economic crisis and set the stage for a more sustained economic recovery.

In the US, since late 2008, the Fed has unveiled a series of policies, ranging from classic monetary policy to outright fiscal policy, to not only keep the credit market open but also to backstop aggregate demand from falling and stimulate economic growth itself. It has lowered rates to near zero and has committed to keep there till end-2014 (a period of over 6 years of extraordinary monetary accommodation), multiplied its balance sheet many-fold to over $3 trillion by purchasing a large category of assets and injecting massive quantities of liquidity, and is now experimenting with greater transparency in communicating the Fed's monetary policy processes so as to mould market expectations.

In contrast, apart from the initial stimulus plan, ARRA, the US government has largely remained at the sidelines. All this, while averting a financial meltdown and deep deflationary economic recession, has created several incentive distortions, besides postponing important adjustments. Mohamed El-Erian summed it up nicely in a recent FT op-ed,

"Despite its repeated pleas for fiscal and housing engagement, the Fed has inadvertently provided cover for other government agencies to continue avoiding difficult, but necessary, decisions. Notwithstanding these shortfalls, the Fed still feels compelled to do even more. For both moral and political reasons, it believes that it cannot be seen to stand on the sideline as the economy struggles with a deeply-entrenched unemployment crisis and political dysfunctionality – even if this means having to use even more imperfect, indirect and, increasingly, unpredictable policy measures."

Unlike in the US where economic growth and financial market stability have been the central themes, inflation and burgeoning public deficits have been the biggest concerns. RBI has been pitchforked into the frontline of the inflation battle. In turn, since the onset of the initial signs of economic strains and inflationary pressures in early 2010, the RBI has increased interest rates 13 consecutive times. In the process, it has tempered the over-heating economy and appears to have brought inflation down to more tolerable limits.

It was evident to anyone who cared to go beyong stage one that India's inflation problem was fundamentally a supply side problem and could be sustainably managed only by easing supply constraints, especially by removing infrastructure bottlenecks and increasing foodgrain production. RBI's inflation fighting policies only managed to cool the over-heating economy and bring it down to its constrained production possibility frontier.

This long-period of inflation-fighting by monetary tightening was an ideal opportunity for the government to undertake policy measures and reforms that would initiate the process of declogging the supply-side and pushing up the production possibility frontier. But nothing of that sort was forthcoming. Worse still, the government added to the problem with a series of fiscal largesse, unconcerned about the severe fiscal strains that were clearly evident.

This in turn increased government borrowings and boosted aggregate demand at a time when supply was severely constrained, therefore adding to the inflationary pressures. With interest rates rising, inflationary expectations anchored upwards and policy parlysis gripping government, investment climate weakened. Instead of expanding aggressively in a growing economy, cash rich businesses turned off their investment taps and have preferred to wait and watch.

Now, with the inflationary pressures easing, the onus is again back on the RBI to take the centerstage. Everyone calls on the RBI to lower interest rates to encourage investment. Critics accuse it of being "behind the curve" in lowering rates, just as it was accused of being similarly slow to raise rates in the first place as the recession struck.

For sure, in the coming months, the RBI will lower rates and cost of capital will come down. Businesses will start investing and economic growth will recover somewhat. But all that will be pyrrhic victories if interest rate cuts are not accompanied with policy reforms to ease supply constraints. In its absence, we will witness another short-cycle of boom followed by over-heating and slowdown. The RBI will again be forced to step in an re-enact its current role.

Markets and central banks alone cannot set the foundations for economic growth. Governments have a critical role to play in laying the policy framework for expanding the economy's production possibility frontier. Markets thrive on the enabling policy environment established by public policy actions. Paralysed governments, which cede responsibility to technocratic institutions like central banks, are merely kicking the can down the road.

Satyajit das has an excellent article in FT which outlines the distortions caused by a prolonged period of ultra-low interest rates.

Update 1 (30/4/2012)

An excellent FT op-ed on how leveraging central bank balance sheet has come to be seen as the least costless route out of a financial crisis induced recession. The unprecedented liquidity injections have undoubtedly helped backstop the lurch into full-blow depressions. By early 2009, the Fed, the ECB and the BoE had all cut their main policy rates to all-time lows, and it has remained there since. However, the challenge for central banks is not to manage the retreat from these accommodatory policies before stoking inflationary pressures and without suffering massive losses.

The use of the balance sheet as a policy tool is no longer likely to be considered unconventional. The crisis has moved it to the centre.

 

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?

Monetary accommodation in a graphic

As historians look back on the sub-prime mortgage meltdown and the Great Recession, one of the things sure to receive considerable attention is the dramatic expansion of central bank balance sheets in their aftermath. As the credit markets froze, central banks emerged as lenders, insurers, and even buyers of last resort in an effort to backstop the slide and maintain financial market stability.

The graphic below captures the true magnitude of the balance sheet expansion by central banks acros developed economies. It is four years old and there are no signs of any exit.



Fortunately, fears of inflationary expectations being unhinged and bond-market vigilantes wreaking havoc have so far proven unfounded.

Update 1 (16/1/2012)

Economist has an excellent graphic and article on the extraordinary monetary accommodation being carried out by central banks across advanced economies.


Update 2 (2/5/2012)

Martin Wolf has this graphic that highlights the dramatic changes that have swept central banking in recent past.

Update 3 (8/5/2012)

Gavyn Davies on the difference between monetary base and monetary aggregates and why the expansion in monetary base does not always lead to inflation,

These are very different types of “money”. The monetary base is mostly the reserves of the commercial banks held at the central bank. M1-M4 are mainly deposits of varying maturity held by the public at the commercial banks. The monetary base can behave very differently from the wider aggregates, and with very different consequences for the economy at large.
 
The recent rise in the monetary base has occurred because the central banks have purchased sovereign debt from the commercial banks, and have credited the banks with reserve balances at the central banks to settle these transactions. Since the commercial banks have simultaneously wanted to increase their holdings of liquid balances in the safest possible form, in order to secure their future funding requirements, these balances have simply remained at the central bank doing nothing...

Monetarist models of the economy generally assume that there is a fixed ratio between the monetary base and M1-M4...The fixed relationship between base money and M1-M4 applies when bank lending is constrained by reserve requirements and banks are eager to increase their lending. In those circumstances, a rise in the monetary base or banks’ reserve assets leads to an automatic “multiplier” rise in bank lending, and then in the bank deposits which comprise the M1-M4 monetary aggregates. None of this is happening now, since bank lending is not constrained by reserve requirements and banks do not want to lend.

Martingale strategy - the folly of excessive monetary loosening

John Kay describes the European response to the sovereign debt crisis as a Martingale betting strategy - increase your stake everytime you lose, in the expectation that a win on the next game would recoup all your losses and leave you ahead. I feel that this description is also appropriate for much of what passes as unconventional monetary accommodation being pursued by central banks on both sides of the Atlantic.

Lower rates, print money, inject liquidity, buy assets, do maturity transformation, and so on, all in the expectation that the "animal spirits" will be revived and market valuations will return to its bubble-era days (given the magnitude of losses suffered, only such recovery can restore them). This would make the Greenspan put look a small-time bet. The recovery martingale bet through extraordinary monetary accommodation is arguably the mother of all bets.

John Kay writes,

"Whenever European institutions have failed to end the current crisis, they have returned with a new, larger, commitment. “We will do what it takes”, “we will see it through”, is the strategy, if it can be called that. “Just in time, just enough”, is how my colleague Martin Wolf last week described the tactics. These are the key components of the martingale system. But debt markets illustrate a malevolent game. A player on the other side of the table – global financial markets – has very large resources, and can ensure that each round of the game can be played for very large stakes.

The wise person’s reaction to the casino is not to go there. The next best course is to plan an early night. Leave while you are ahead, and if you cannot do so, accept a small loss. If the eurozone had quickly recognised defeat in Greece, it would have suffered a manageable failure and learnt an important lesson for the future. Instead it has followed the martingale. As the size of the bet grows after a run of losses, the commitment to do what it takes becomes steadily less credible.

The gambler who is confident his system will work looks to rich friends. When the indulgence of Berlin was exhausted, a banker was dispatched to Beijing. Now the players look to the only remaining credible supporter. Surely the European Central Bank can enable them to see the night through. The ECB really does have infinite resources: if it runs out of money, it can print more."

The fundamental urge behind the martingale strategy is the desire to restore the economy back to its pre-crisis normalcy. It is widely believed that this process of restoration can be achieved only through extraordinary monetary accommodation.

This strategy overlooks the possibility that a restoration of the pre-crisis normalcy may not only be not desirable but also unsustainable. It overlooks the severe excesses and inefficiencies that had got built-up in the boom years and the need to wring them out. It also glosses over the fortunate confluence of favorable factors that contributed to the long period of sustained low inflation, low unemployment and high economic growth rates. Now many of these factors have subsided or disappeared and the sins of the excesses have to be reaped.

The Martingale strategy is a classic case of kicking the can down the road and ignoring a continuous build-up of systemic risk. The perils of such a strategy are only too well known to be ignored.

Counter-cyclical Fed communication strategy

When the history of central banking is written, historians will surely devote a substantial part of the book to the aftermath of the bursting of the sub-prime mortgage bubble. As financial markets veered at the edge of precipice and the Great Recession took hold, and fiscally constrained and politically paralyzed governments largely abdicated the policy making space, central banks were left with the onerous task of stabilizing financial markets and restoring economic growth.

Central banks, led by the American Federal Reserve and the Bank of England, have deployed a wide range of monetary policy tools to stabilize markets and boost aggregate demand. These unconventional monetary easing approaches like quantitative easing policies have contributed to a dramatic ballooning of the balance sheets of central banks across the developed world.

In keeping with such changes, central banks have also sought to make more effective use of their communication strategies to anchor market expectations. One of the most important instruments of central bank communication has been the publicly announced commitment to keep interest rates low for extended periods of time. The Federal Reserve in the US had very early in the crisis announced its commitment to keep interest rates low for "and extended period of time". Subsequently, it went further in providing greater clarity to this phrase by announcing in August that it planned to keep rates near the zero bound till atleast the summer of 2013. The objective is to firm expectations among various market participants and reduce uncertainties about consumption and investment decisions.

Now, the NYT reports that the Fed is planning to make publication of interest rate forecasts a permanent feature of its monetary policy communication strategy. The Times writes,

"Forecasting policy is part of a broader set of changes that the Fed is considering to improve public understanding of its methods and goals. The Fed’s chairman, Ben S. Bernanke, and other officials say that improved communications could deliver a modest boost to the economy with relatively little risk. None of their other options for additional action are nearly so appealing...

Such a forecast likely would cover the expected path of policy over the next three years, including information about the range of predictions. The Fed already publishes similar predictions about economic growth, inflation and unemployment four times a year."

While the attempt to shape longer-term expectations to revive the "animal spirits" is understandable during such recessionary times, there will be questions raised about the wisdom of such upfront commitment during upturns in the business cycle. For example, during an economic recovery when financial markets are booming and inflationary pressures are rising, such upfront commitment to keep interest rates low would, instead of leaning against the wind, be amplifying the market exuberance. It would run contrary to the conventional wisdom on central banking - "take the punch bowl away when the party gets going".

Such upfront commitment could also restrict the central banks' freedom to manoeuvre. Economic headwinds can change unexpectedly. A commitment to follow a particular policy stance would limit the central bank's ability to change track in response to emergent trends. Any such abrupt deviation from its pre-announced policy stance would erode the credibility of future announcements by the central bank.

In other words, while anchoring expectations by announcing a commitment to maintaining interest rates during recessionary and uncertain times may be desirable, it may not be wise to institutionalize such medium to long-term commitments into the monetary policy framework of central banks.

It's the ECB stupid!

So the Fed announced yesterday that they will inject money into European banks if needed. Mark Thoma and Paul Krugman posted about it (here and here). This is not new, since the Fed did lend to European banks after the Lehman collapse. The reason is simple, US banks would be also affected by a collapse of the European banking sector. The point is that this not sufficient to end the euro crisis, for that the ECB must act buying European bonds. No substitute for that. So Bernanke is still asking: what are these guys doing over there?

Is monetary accommodation becoming a dogma?

When history of the tumultous period of the Great Recession will be written, central bankers will be among its dominant characters. All along the crisis, across the world, monetary policy has been the predominant and preferred choice to fight both financial market instability and boost aggregate demand.

In a recent blog post, Brad DeLong echoed this view when he advocated further massive expansion of the Fed's balance sheet and committing to a target nominal GDP growth. He writes,

"The Federal Reserve might be able to spark a real economic recovery by... announcing that it is going to keep short-term Treasury interest rates low not just as long as the economy is depressed but even afterwards when the economy has recovered and when it would normally be raising interest rates: that it is going to keep short-term Treasury interest rates low until it generates an inflationary boom, and that you had better start building capacity now to serve your customers during that inflationary boom or your competitors will do so and take your profits...

If I were in the hot seat, I would follow the Jan Hatzius plan: (a) take the Fed's balance sheet up to $5T over the next two months, and (b) say that if that turned out not to be enough to get nominal GDP growth to a path that will return it to its pre-2007 trend within three years, that I would then keep interest rates low and take the Fed's balance sheet even higher until it did."

A similar debate is being played out across the Atlantic in Europe. With the Eurozone economies grappling an existential crisis, there have been calls for the ECB to emulate the Federal Reserve and indulge in aggressive monetary policy to stabilize financial markets. A leading advocate of such measures, Wolfgang Munchau wrote,

"The European Central Bank must agree a backstop of some kind, either an unlimited guarantee of a maximum bond spread, a backstop to the EFSF, in addition to dramatic measures to increase short-term liquidity for the banking sector. That would take care of the immediate bankruptcy threat."

More specifically, in addition to advocating a fiscal union, he favors unconventional quantitative easing and issuance of large enough joint-and-several liability eurozone bonds. On same lines, James Surowiecki has called for the ECB becoming the lender of last resort for the embattled European economies,

"If the European Central Bank were to commit publicly to backstopping Italian and Spanish debt, by buying as many of their bonds as needed, the worries about default would recede and interest rates would fall. This wouldn’t cure the weakness of the Italian economy or eliminate the hangover from the housing bubble in Spain, but it would avert a Lehman-style meltdown, buy time for economic reforms to work, and let these countries avoid the kind of over-the-top austerity measures that will worsen the debt crisis by killing any prospect of economic growth."

The suggestions of DeLong, Munchau, and Surowiecki are representative of policy prescriptions on both sides of the Atlantic calling for aggressive measures to restore economies to their pre-crisis normal. The monetary policy bias is very distinct.

As I have blogged earlier, advocates of such policies suggest them more out of desperation than from any strong conviction. There is a strong urge to throw everything and the kitchen sink at the intractable problem and hope that something will click. Brad DeLong himself writes,

"How well would it work? We don't know. Are they worth trying? I certainly think so..."

While all such accommodatory policies will surely contribute towards backstopping losses and stabilizing the markets, there are two important questions. One, given the circumstances, how effective will be such policies? Two, what are the costs - direct and secondary market distortions - associated with this?

A honest assessment of both these questions will raise disconcerting answers. The severity of the crisis, on both sides of the Atlantic, means that the magnitude of monetary accommodation - liquidity injections and indirect debt guarantees - required to meaningfully and sustainably stabilize the financial markets is beyond the abilities of most central banks and governments.

Further, the secondary market distortions that are certain to be set off by such sustained and extra-ordinarily large monetary accommodation will certainly challenge global financial market stability. It will perpetuate many of the bad practices that contributed towards the sub-prime era financial market excesses - regulatory arbitrage, TBTF, mis-pricing of risk etc. This monetary accommodation and flood of liquidity has the strong likelihood of generating another round of resource misallocation in the financial markets. It will also expose the emerging economies to the vagaries of massive cross-border capital flows, with all its attendant adverse consequences.

Much of the academic debate that feeds into policy making has been on exploring alternatives to get the economy back to its pre-crisis normality at any cost. This line of thinking glosses over questions about whether the old normal is itself desirable. There is a strong case that the quarter century of Great Moderation, with its low unemployment rate and inflation coupled with high growth rates, was the result of a fortunate confluence of favorable factors. The dynamics generated by China and the emerging economies, a big wave of trade and financial market liberalization, and dramatic productivity improvements generated by advances in information technology contributed to the Great Moderation.

The past 15 years, atleast since the late nineties, has been an era of unprecedented complementarities. The emerging economies saved to cheaply finance consumption and deficits in many parts of the developed world. Cheap exports of consumer durables and non-durables served to keep inflation low across the world. The consumption boom in developed economies also kept up the demand for commodities from many developing countries. It was over-optimistic to imagine that these forces would maintain their momentum forever.

In the process of this era of extraordinary stability and growth, several distortions and imbalances had become institutionalized into the world economy. The monetary-pump-prime-your-way-out of recession fails to acknowledge that the efforts to restore normalcy would serve to perpetuate many of the same distortionary trends and policies that fuelled the crisis. For example, there is enough evidence that the ultra-low rates have benefitted the remaining big financial institutions, who have used the opportunity to grow even bigger and pose even greater systemic risks.

Apart from resolving the extant problem, every crisis is also an important opportunity to wring out the excesses of the bygone era that was in the first place responsible for the crisis. In this case, the later can be done both by letting those responsible pay for their recklessness and greed (after all this is the primary incentive formation and disciplining mechanism of capitalism) and by refining regulatory policies to pre-empt such future failures. Unfortunately, influential opinion makers across the world have been focussed more on exploring options to get the economy back to its pre-crisis normal instead of doing the hard problem solving to get things back to a more efficient and desirable "new normal".

Update 1 (3/12/2011)

In a move to ease Eurozone's debt squeeze, the Federal Reserve, ECB, BoE, BoJ, SNB, and Bank of Canada announced that they would reduce by about half the cost of a program under which banks in foreign countries could borrow dollars from their own central banks, which in turn get those dollars from the Fed. The banks also said that loans would be available until February 2013, extending a previous deadline of August 2012. This move effectively makes the Fed emerge as the global lender of last resort, lending dollars to foreign central banks so as to ease credit markets there. The move is intended to free up liquidity and ensure that European banks have funds during the sovereign debt crisis and keep borrowing costs down for consumers and firms.

These are loans between central banks rather than loans to individual foreign banks, there is very little risk to US taxpayers. However, in the face of ECB's reluctance to buy debt of the most beleaguered Eurozone economies and work as the risk absorber of last resort, this is the closest that the Fed can get to effectively doing ECB's job and purchasing foreign government debt itself.

The Italian mess in a graph

The Eurozone authorities, both governments and the European Central Bank (ECB), have to bear a great deal of the responsibility for worsening the impact of the American sub-prime crisis and the Great Recession and taking the region to the brink of a potential collapse of the Euro project.

The graphic below captures the magnitude of ECB's failure. Even as the Italian economy lurched into crisis, ECB's tight monetary policy squeezed the Italian credit markets. All the three major credit growth indicators plunged steeply.



Update 1 (26/11/2011)

The Times likens the ECB to "a fire department that is letting the house burn down to teach the children not to play with matches". It writes that though the ECB "has a fire hose — its ability to print money... the bank is refusing to train it on the euro zone’s debt crisis". Influential ECB members and Germany believe that ECB cannot be a lender of last resort to backstop falling bond prices and its charter forbids them from using bank resources to finance governments.

The dismal European landscape

One of the most contentious debates surrounding the sovereign debt crisis in Europe is that about the institutional mechanism to provide the necessary liquidity support to the embattled economies.

The European Central Bank (ECB) is not empowered to provide the unconventional monetary policy actions that the Fed did in the US and thereby backstop losses and unfreeze credit markets as a lender of last resort. Further, there is strong ideological and political opposition to printing money to buy the debts of individual members for fear of stoking inflation.

Therefore, as a compromise, the Eurozone leaders had established the European Financial Stability Fund (EFSF) to provide financial assistance to these governments. The IMF joined hands with the EFSF in structuring a first round of Eurozone financial stabilization fund of 440 m Euros.

Its mandate and firepower was designed with the objective of rescuing Greece, Ireland and Portugal. However, now with the turmoil spreading to Italy, Italian bond yields crossing the seven percent mark, and the country facing the danger of losing market access, the stabilization fund clearly looks under capitalized. A "big bazooka" appears necessary.



There is also a growing realization, given the magnitude of market uncertainty surrounding the Eurozone, that the current liquidity crunch being faced by otherwise sound economies like Italy (and maybe France later) could turn into a solvency crisis. And if this happens to the country with the fourth largest public debt, it will be the final nail in the Euro project and have devastating consequences for the world economy itself. The frantic search for possible solutions to provide adequate liquidity cover for Italy is understandable. Nouriel Roubini writes,

"Once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable. So Italy and other illiquid, but solvent, sovereigns need a 'big bazooka' to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone."

One option which has found favor with a number of opinion makers but has been rejected by Germany and the ECB is to issue Eurobonds. It is argued that such bonds, issued initially through the EFSF, could simultaneously solve two problems. One, it would help raise the cash required to refinance the debts of countries finding it difficult to access the debt market. Second, it could complement the German bund and provide an alternative risk-free investment avenue. Such assets can help stabilize the financial markets by providing investment avenues for institutional investors to rebalance their portfolios as they exit the struggling peripheral economy bonds.

In an FT article, Wolfgang Münchau has rejected the notion of leveraging the EFSF to purchase Italian and other PIIGS debt. He describes his Eurobond proposal,

"The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds. The European Central Bank would refinance the EFSF for as long as it takes. Once the Eurobonds are in place, EFSF liabilities would simply be transformed into Eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible."

But there are strong reasons to cast doubts on success with the Eurobond plan. For a start, the issuance of Eurobonds would require changes to the Treaty itself. Before that could happen, it would have to overcome entrenched opposition in Germany. Further, it will consume valuable time. After this even if it arrives, it may be too late to save the monetary union.

In any case, monetary policy support is only one side of the policy requirement spectrum. Another formidable challenge facing the new Italian government involves the fundamental restructuring of the economy, especially its labor market. The country has lost labor cost competitiveness against Germany by more than 50% since the mid-nineties. The reforms required include dismantling the two-tier jobs market, which protects the jobs of older workers in dying industries but traps youngsters in temporary work; and the industry-wide wage bargains that mean businesses cannot match wages to productivity. The closed-shop professions and trades, and the mircro-sized family businesses, are a barrier to innovation and efficiency. The business landscape which is dominated by small firms should accommodate more bigger sized firms. The pension system should be further reformed and a clampdown on tax evasion enforced.

However, as Nouriel Roubini writes, structural reforms like raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable. He feels that there can be only one denouement,

"Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness. That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labour costs.

So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts...

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster."

Even without going into any of these, the details of sustainably financing and paring down its massive public debt of €1,900bn (120% of GDP) is frightening. This problem, difficult in normal times, is amplifed by a weak economy (it is the only major economy where per-capita GDP declined annually in the 2001-10 period) and severe austerity measures. Though much of its debt is short-term, as much as €350 bn of debt comes due next year. An FT article argues that any increase in bond yields (and therefore cost of capital) will weaken the economy and deepen the debt crisis,

"The impact of crisis interest rates is likely to increase the annual debt burden by less than 1 per cent of GDP next year, compared to what would happen with 'normal' interest rates... With medium term nominal GDP growth likely to be in the doldrums at 2 per cent per annum, interest rates at 6.5 per cent would mean that Italy needs to run a primary surplus of 5.5 per cent of GDP indefinitely in order to stabilise its debt/GDP ratio at 120 per cent."

In simple terms, if Italy is to make a significant dent on its public debt problem, it will have to pull off reforms that ease the economy into a growth path that can create a primary budget surplus of over 5% of GDP for several successive years. And all this with a depressed economy, weakness among major trading partners, and a severe bout of austerity. As the FT writes, "If such a large fiscal consolidation can be achieved in the teeth of a recession, it will be very impressive, to say the least".

Update 1 (28/11/2011)

Wolfgang Munchau offers a three pronged approach to resolving the Eurozone crisis. First, aggressive intervention by ECB to provide massive temporary short-term liquidity and unlimited guarantee of a maximum bond spread or a backstop to the EFSF. Second, end the current process of cross-broder national guarantees and float joint-and-several liability eurozone bonds of credible size. Third, a fiscal union.

The Eurozone crisis in perspective

The crisis facing the Eurozone today is in someways inevitable given the impossibility of managing a monetary union without some form of fiscal union and a fully committed central bank.

To put the folly in its true perspective, let's compare the different Indian states to Eurozone members. Imagine 28 independent countries federate into a single country with a single monetary policy. All the countries embrace a single currency, rupee, and all monetary aggregates, including the interest rates, are harmonized across all states. Trade barriers have been brought down and there is unrestricted cross-border trade across states.

However, both the central bank, the Reserve Bank of India (RBI) and the central government at New Delhi will not make monetary and fiscal transfers to help any state if it runs into economic problems. All taxes are levied by the states and they refuse to allocate a share of their tax revenues to the central government. Driven by moral hazard concerns, the RBI is traditionally averse to monetary accommodation and banking bailouts.

In this context, consider this scenario. Maharashtra and Tamil Nadu are booming. In contrast, Uttar Pradesh and Rajasthan are experiencing a deep recession. The later two have a serious competitiveness problem, since their wages have been driven up by a positive economic shock. In this period, both state governments have indulged in populist fiscal profligacy and run up massive debts, including from neighbouring states and their banks. Both now stand at the verge of sovereign defaults.

Further, when the the states form the monetary union, the initial conditions of the different states vary widely. The economies of Uttar Pradesh and Rajasthan are uncompetitive in relation with Tamil Nadu and Maharashtra. The former have much lower labor productivity, though wages and prices remain more or less the same. There are also critical structural imbalances in these two states and they also suffer from high fiscal deficits.

There is more. Even as Rajasthan and UP struggle, the increasingly competitive states of Maharashtra and Tamil Nadu prosper, partly by increasing their exports to Rajasthan and UP, and in the process, atleast partially, displacing local production and driving out local jobs. Clearly, Maharashtra and Tamil Nadu are, atleast partially, prospering at the expense of Rajasthan and UP. So what is the way out for these two struggling states?

If Uttar Pradesh and Rajasthan were independent countries with their own currencies and interest rates, they would have responded to such a supply shock by either devaluing their currencies or lowering interest rates or both. They may even have welcomed a bout of moderate inflation to reduce the real debt burden and narrow the gap in labor costs. The objective in all these cases would have been to lower real wages and costs and thereby increase competitiveness and investments. Now that these states are part of a monetary union, they do not have access to these traditional options.

In the real world, India is a monetary and fiscal union. Faced with such a situation, the central government will invariably step in with fiscal transfers (packages, as they call it politically!) and restructure their loan books with help of the RBI. The central government will be committed to ensuring that even a solvency crisis will be averted. Sure, tough conditions will be imposed and the state will be forced to implement reforms that will help improve its competitiveness.

The only strategy to restore economic strength in these two states without compromising on the monetary union is for the central government to step in and provide fiscal transfers to these states and the RBI to open liquidity windows and ensure that the credit tap is kept open. Simulataneously, the two states will have to undertake structural reforms to increase their medium and longer term competitiveness. It has to be hoped that these measures will buy adequate time to restore the health of both the state economies.

Replace Rajasthan and UP with Greece and Italy, Maharashtra and Tamil Nadu with Germany and France. The problems facing Eurozone economies today are not much different. In this context, in an FT op-ed, the former British Prime Minister, John Major had this observation of Eurozone economies locked in Germany's embrace,

The powerful German economy is still locked within the same currency as weaker economies. She racks up huge trade surpluses within the eurozone while others have comparable deficits. Since Germany has an estimated 30 per cent currency advantage within the euro, this seems likely to continue. It is undesirable and unsettling.

In a sensible world, the southern states would devalue to become competitive – but they cannot. They are locked in a single currency. And because they cannot devalue their currency, they must devalue their living standards and promote reforms to enhance efficiency. This will take years. Meanwhile, wages must fall, unemployment will rise and social unrest will increase. The severity of this medicine may not be bearable in a liberal democracy.

His solution is similar to what India is today,

It must become a fiscal union; a union of transfer payments to off-set regional disparities; or it must shrink. The latter option – essentially expelling Greece – has political consequences. There is no mechanism to do it. What would Greece’s future be? Would she remain democratic in the chaos that might follow? Pushing Greece out is not a risk-free option.

Nor is a transfer union. Germany would hate it and transfer payments would institutionalise inefficiencies. That leaves fiscal union as the most likely destination. But it has huge political consequences. It implies a far greater level of integration, and is an escalator to a federal eurozone. This may be sensible economically, but it is profoundly undemocratic. It would drive voters and decision-makers dangerously far apart. More top-down Europe imposed by a remote elite could provoke a powerful antipathy.

Mario Draghing the feet on monetary policy

Central Banks have been at the epicenter of the current crisis, and have been, for good and for bad, fundamental for the policy response mounted to avoid a new Great Depression. Recently Christina Romer argued that the Fed should start targeting nominal Gross Domestic Product (GDP) instead of inflation. As I noted previously (see here), this is strange since it is far from clear that the Fed actually targets just inflation, or that targeting nominal output would make any significant difference.

Further, the idea that a central bank has the ability to actually hit a targeted level of output, or inflation for that matter, under the current circumstances in particular, is wishful thinking. Central banks can ease the credit conditions by reducing interest rates, a range of rates from the short to the long, to stimulate spending, and pump money into the system, fundamentally to avoid systemic crisis caused by bankruptcies. The ability of Ben Bernanke or Mario Draghi, the newly appointed head of the European Central Bank (ECB) that reduced the rate of interest in Europe as his first measure (see here), to further reduce interest rates and with that help the staggering recovery in the US or the free fall in the periphery of Europe is very limited.

Read the rest here.

Neo-Wicksellian macroeconomics

Modern macro has more to do with Wicksell's Interest and Prices than with Keynes' General Theory. For one, the idea of a natural rate of unemployment derives directly from Wicksell's natural rate of interest, as Friedman noted. So here is a brief explanation of Wicksell's main argument in that book.

Wicksell distinguished between the natural rate of interest (R*) and the monetary or bank rate of interest (R). The former was determined by the marginal productivity of capital (I) and the intertemporal decisions of consumption (leading to savings S), along the lines of what became known as the loanable funds theory. The monetary rate was determined by bank decisions. That is, banks supplied credit (Ms) at the chosen rate of interest (R), according to money demand (Md). Monetary equilibrium occurred when the two rates coincided (see figure below). The natural rate is the gravitational center around which the bank rate fluctuates. Real and monetary shocks could cause deviations of the bank rate from equilibrium.

Wicksell assumes that a positive productivity shock raises the natural rate of interest, and that banks maintain the initial monetary rate. Thus, with a low bank rate, investment exceeds savings and once the system reaches full employment prices would go up. However, continuous lending would reduce bank reserves, and as a result banks would be forced to increase the monetary bank until a new equilibrium was reached. Inflation resulted from a bank rate that was too low, as much as deflation (and temporary unemployment) from a bank rate that was too high.

The low bank rate implies overinvestment, and the need for additional savings. The inflationary process by reducing the ability of consumers to spend provides the additional 'forced savings.' Inflation acts as a tax that provides the additional resources needed to finance investment. The business cycle can be explained by exogenous shocks to productivity (the I curve), changes in consumers preferences (shocks to S), or by the misconduct of the banking sector (shocks to Ms). Wicksell, as much as the modern Real Business Cycle (RBC) School, favored the former.

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.

Nominal output targeting

Christina Romer wrote this Sunday about the necessity for the Fed to target nominal output. The implication seems to be that so far the Fed had been targeting inflation, which is obviously incorrect. That would be the ECB. Krugman (here) for some reason liked it. By the way the idea is not new, Samuel Brittan had argued for that not long ago (here), and as noted by David Beckworth so have two other prominent FT columnists (Clive Crook and Martin Wolf).

First of all, Romer calls this a Volcker moment, which is from a historical point of view (and she is a macroeconomic historian) preposterous. Volcker is the guy that tried to use nominal monetary targets, as in Milton Friedman's monetary growth rule (now he is much better and is against de-regulation and too big too fail among other things).

Further, it's not clear how a nominal GDP target would be different from what the Fed is already doing, namely acting as a lender of last resort, and keeping interest rates (short and long, the latter through QE) low. Worse, her argument smells to the confidence fairy stuff you hear from the crazies serious people, and that correctly Krugman deplores. She says:

"By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth."

Sure as objective targets come, nominal GDP is better than inflation,  but since the Fed does not target inflation what is she fighting? Ben Bernanke is fine, Super Mario (Mario Draghi), the new president of the ECB needs whatever is the reverse of a Volcker moment. The US (and Europe) need more fiscal expansion.

Debt restructuring or default - Is it enough?

Call it whatever you like, Greece has effectively defaulted on its sovereign debt, atleast half of its private external debt. The agreement that private investors will take a 50% haircut on their bonds constitutes a virtual default. The agreement reached to resolve Eurozone crisis contains this restructuring of Greek debt, a bank recapitalization plan, and an expansion of Eurozone bailout fund.

The agreement to restructure Greek debt also includes a new €130 bn bail-out of Greece by the European Union and the International Monetary Fund and is estimated to reduce Greek debt levels to 120% of GDP by end of the decade. The deal includes a decision to force the continental banks to raise new capital amounting to a total of €106 bn ($150 bn) by June 2012 to raise their Tier I capital ratio to 9% of total capital so as to provide them with greater cushion against potential losses on loans to the PIIGS.

They also agreed to increase the firepower of the remaining amount in the €440 bn ($610 bn) European Financial Stability Fund (EFSF) (estimated to be about €250bn after the proposed new Greece debt deal) by providing "risk insurance" to new bonds issued by struggling eurozone countries, especially Italy. This would limit bondholder losses by guaranteeing a portion of potential losses - EFSF effectively offers credit protection on Greek debt. It is hoped that this would increase the size of the EFSF by 4-5 times to about €1,000bn. Efforts are also on to get outside investors like sovereign welath funds from China, Russia and others.

Though any agreement is welcome, there are several doubts about whether this is a case of too little too late. Critically, even after the haircuts and bailout, Greece will still have a debt-to-GDP ratio of 120% even in 2020. This raises questions about its effectiveness and increases the possibility of more write-downs and bailouts. This would mean complete wiping out of private bondholders and even write-downs by official lenders (who will be the last to suffer any haircuts). Of the 340 billion euros in Greek government debt, only about 200 billion euros is owed to private creditors and therefore covered by the restructuring plan. The rest of the debt is controlled by the European Central Bank, the International Monetary Fund and other institutions that have said they would not participate in a debt restructuring. FT Alphaville has several interesting questions here about the details of the three-pronged bailout plan.

In addition there are more fundamental issues. Eurozone countries' economic stagnation which is driven by a combination of declining economic competitiveness, huge sovereign debts, and difficulty in financing government deficits. The beleaguered peripheral Eurozone economies are handicapped by the unavailability of all the remedies traditionally used by countries facing recession and sovereign debt crisis - inability to indulge in fiscal and monetary expansion, reflate their economies, or devalue their currencies. Though notionally a currency union with a harmonized monetary policy, it does not have any central fiscal authority nor does it have a monetary authority willing to assume its traditional role. In simple terms, Eurozone is a monetary union without a fiscal federation or a full-fledged central bank.

The better placed economies like Germany are strongly opposed to fiscal transfers to bail out their reckless peripheral partners. The European Central Bank (ECB) has refused to lend to its struggling member states. It has preferred to let the newly created and limited European Financial Stability Fund (EFSF) assume the responsibility of lending to those countries and stabilizing the financial markets.

This is in sharp contrast to the policy followed by the US Treasury and the Federal Reserve when faced with similar (some would say, less severe) crisis in late 2008. The Government announced a massive stimulus package to stabilize the economy, while the Fed deployed extraordinary measures to emerge as the lender, buyer and insurer of last resort.

In fact, unlike the US and British bank recapitalization plans in which the respective central banks injected funds directly, the ECB has refused to do so. The banks are therefore relying on private investors to raise their capital so as to reach the 9% level. However, raising money from private investors will be difficult especially given the conditions.

The current conditions call out for proactive central bank leadership. No one seriously disputes that Spain and Italy, currently the biggest concerns, are solvent and are only experiencing a liquidity crisis. Such crises are best averted when central banks step in and open liquidity windows and function as lender of last resort. As Martin Wolf wrote recently, if sovereign default risk is addressed, it will "also automatically stabilise the banks, since it is fears of sovereign defaults that are driving worries over banking insolvency". See also this excellent paper by Paul De Grauwe. In light of all this, it remains to be seen whether the latest bailout will be effective.

Times, as always, has this nice graphic that captures the three prongs of the bailout plan.



The market reaction has be positive, with Greek CDS spreads nearly halving from 6000 to 3500.