Aniket Baksy

It’s curious just how much intellectual capital has been invested in uncovering the “optimal” monetary policy, and exactly how powerful central bankers are, even by banking standards. This is a problem; a monetary policy has very real limits, and the Chinese collapse illustrates these vividly. It’s the excessive use of monetary policies – unconventional ones – that’s landed us in a mess we will be lucky to get out of.

Monetary policy is supposed to be complex and strange, but really, the idea is simple and threefold-

  • A low interest rate promotes investment, given the “sticky” prices of goods (and maybe some consumption as well, particularly of goods bought with EMIs – think cars, and maybe even expensive consumer goods like flat-screen TVs).
  • The more money banks have on-hand after meeting reserve requirements, the more they can meet the demand for credit.
  • The interest rate is the cost of funds available today, and also the cost of borrowing via assets, and thus, inversely related to their prices.

In practice, central banks pursue monetary policy in two ways. First, by macro-prudential policies, which ensure financial system liquidity and force banks to maintain stable balance sheets which should be able to withstand shocks and mitigate risks. These include reserve ratios, which force banks to retain some portion of their capital to maintain confidence in the system. The second way is with the central bank setting interest rates.

It’s a beautiful system – whenever in a recession, just setting a lower interest rate will generate demand. “Macro-prudential regulation” is a fancy word, but its effectiveness is doubtful. Even with several measures, the US financial system is as risky as it was in 2008, and getting worse[1]. Also, the central bank doesn’t declare the interest rates on the home loans which Citibank offers. Typically, central banks set the Overnight Call Money Market Rate, which is the Federal Funds Rate in the US, and the Repurchase (Repo) Rate in India.

How this affects the rates at which individuals, consumers, entrepreneurs, and firms borrow is based on a complex chain of assumptions. Suppose the Fed cuts “The” interest rate. This makes it cheaper for Citibank to borrow funds to meet its daily transaction requirements. The usual model would assume that Citibank, being a competitive bank, would reduce the rates it charges on loans. A fall in the cost of loans would allow more people to take loans and invest them profitably[i] – whether in a new house, in financial assets or in a new entrepreneurial venture – and this would then have a multiplier effect on the economy.

monetary(1)This chain is faulty on many counts, which theory is only beginning to understand. First, it ignores the idea that banking is anything but competitive – in all probability, the financial sectors in most advanced economies are probably in a state of advanced oligopoly, with a handful of extremely large and powerful institutions which regularly collude and consult with each other and the Central bank. If this is so, cheap capital isn’t always going to stimulate lending – it could simply drive up bank assets and be dispersed through operating costs in the form of high executive salaries, for instance. More importantly, in a recession, banks are themselves going to be indebted to each other. It’s likely that any liquidity provided to banks will be used to mitigate settlements between them, rather than be used for new loans. This, and theories of credit rationing and hoarding of bank deposits imply that the credit channel’s most important part – the part where banks reduce interest rates and stimulate investment – will be weak[2].

Further, a monetary policy has an ambiguous effect on inequality[ii]. In the US it can be shown that the economic growth, following low interest rate periods, leads to higher employment and, typically, higher wages for workers[iii]. The relative growth of wages for these groups is typically lower than the rate of growth of capital income[iv] in the presence of a loose monetary policy, which by raising asset prices enriches the owners of tangible assets[3]. However, this weakens the demand side effect of monetary policy. If the marginal propensity to consume[4] of the rich is lower than for the poor – which is highly likely, given the volumes of wealth the rich invest in capital markets via instruments like hedge funds – then excessively loose monetary policies might actually decrease the marginal propensity to consume, putting hurdles on the recovery path of an economy. Rising inequality is, in fact, probably a good explanation of continuing anaemic consumption in the US[v].

It’s likely that any liquidity provided to banks will be used to mitigate settlements between them, rather than be used for new loans.

Perhaps the biggest problem with the monetary policy is its complete ineffectiveness when there’s a liquidity trap, or when there is a supply constraint. The second problem is what probably affects the main drivers of the world economy – the emerging economies, the BRICS. All of them suffer from institutional problems which are limiting their ability to grow[vi] while stoking supply-driven inflation, limiting the space for rate cuts in economies despite high interest rates[5]. Monetary policy largely affects the demand side of the economy[6], whereas in these economies, the constraints imposed by poor governance, infrastructure and economic environments probably affect the supply side worse.

So maybe, monetary policy isn’t all that it’s thought up to be. And the biggest recent failures of monetary policy are the US, 2008, and China, 2015. Everyone knows how the “Greenspan Put” effectively legalised moral hazard in the US financial sector, and propagated a bubble in poorly-understood assets, backed by a weakening real estate market. However, the case of China is truly instructive. In response to slowing global demand in the wake of 2008-2009, the Chinese state embarked on a massive stimulus package – only being in control of the majority of their economy, they coordinated monetary and fiscal policies to achieve an almost immediate investment-led boom[vii]. The policies ensured a prioritisation of investment over consumption[viii], fuelling inequality and worse, damaging the fragile financial system. While build-ups of NPAs and the emergence of a massive shadow banking system in response to an unmet demand for credit in risky sectors[ix] have threatened the economy for long, the key problem is one of debt, and this debt has been fuelled by an unnaturally loose monetary policy[x]. When these problems began to become apparent, the solution – again, an expansionary monetary policy – couldn’t calm the markets any longer. The legacy of the money supply boom is overpriced real estate, stocks which are now crashing, and vast swathes of infrastructure which are left unused.

Ultimately, monetary policy can’t do anything real – money does, eventually, become neutral. The closer the economy is to supply-side limits, the quicker monetary neutrality and its inevitable effect – inflation – whether general or in assets, kicks in. The appropriate sustainable policy response – indeed the one Keynes himself would have probably most appreciated – involves fiscal expansion financed partly by debt monetisation, and partly by selling bonds in the open market[xi].

forum_3_feb_2014-2Fiscal expansion can guide (“crowd-in”) investment in key sectors by providing an initial push in terms of publicly funded research (think of ARPANET and the Internet, or Solar Power subsidies), develop capital assets and infrastructure for the future growth of the economy (think of the New Deal[xii]) and provide for human capital formation and social justice with growth, even providing seeding grounds for innovation and entrepreneurship. There are, unfortunately, disadvantages. Friedrich Hayek pointed out in a classic piece that the State, controlled by a few, was always informationally disadvantaged in discovering what the social need was, relative to the market. Real governments fail regularly at uncovering the real needs of their people[xiii]. Worse, in “democracies”, fiscal policy has been forever subordinate to the political process of consensus building, and is hence too slow a mechanism to quell a recession, which can begin with a several percentage point fall in stock market valuation within a few hours. Also, it is unclear how in the absence of economic literacy, and the presence of extenuating biases like nationalist preferences for certain goods, distrust of foreign employers and entrepreneurs, and generic despair among the general electorate, decisions on complex macroeconomic policies[7] can be framed in a way that represents popular preferences.

Worse, in “democracies”, fiscal policy has been forever subordinate to the political process of consensus building, and is hence too slow a mechanism to quell a recession, which can begin with a several percentage point fall in stock market valuation within a few hours.

Given this complexity, political forces can typically have two effects. In the poor world, fiscal policy tends to be expansionary – government largesse is viewed as something that will help the poor, which is indeed expected. In the developed world, however, fiscal policy is strongly shaped by national ideology – thus while the state is tasked with providing social services, it is also tasked with the responsibility of fiscal prudence. Adding to the complexity of these decisions is the role of international capital flows, which force governments to adhere to their budgets.

Monetary policy has distorted asset prices, and failed to generate jobs.

The modern world is, clearly, tied up in some knots. Monetary policy has distorted asset prices, and failed to generate jobs. Fiscal policy is mired in political controversy, enforced by international capital flows into a position where it cannot produce growth. In this situation, a new consensus on development objectives for all economies will have to be backed by institutional arrangements which generate expansionary policies in specific areas – for instance, through the return of conditionalities emphasising an expansion of fiscal policy measures like the creation of employment guarantee agencies. The work of employment guarantees should be carefully examined and targeted towards infrastructure generation, human capital formation and the like. Governments must fulfil their duty to their citizens, not indulge in the fantasy that interest rate tinkering and a free reign to markets on the employment question can work.

The Author is a graduate in Economics from St. Stephen’s College, University of Delhi, and will start an MSc. in Economics at the London School of Economics in September, 2015, with an Inlaks Scholarship.

[1] See here and here.

[2] See Bernanke’s work on the same. The Credit Channel and possible pitfalls in its working were both examined in detail by Bernanke and Gertler in 1995. Current evidence of this phenomenon is available here and here.

[3] See Stiglitz’s recent four-volume work on Inequality, New Theoretical Perspectives on the Distribution of Income and Wealth among Individuals, Parts I-IV (NBER Working Papers 21189-21192). See also his analysis of Monetary Policy loosening here.

[4] The fraction of new income spent on current consumption of goods and services.

[5] In Brazil, the baseline interest rate is 13.75%, while inflation is accelerating beyond 8.47%.

[6] See The Credit Channel, quoted above.

[7] See here, here and here. Admittedly, the theory of forex value determination and international trade is complex.

[i] Keynes argued in The General Theory (1936) that whether an investment project would be undertaken depends on the project’s internal rate of return (IRR), the discount rate which would make the present value of the project just equal to the present value of cost of the project. If the IRR exceeds the Interest Rate, the project is profitable in nominal terms. Thus, when the interest rate falls, projects with IRR above the new rate but below the old one are now profitable and are undertaken; this is the micro-foundation of the idea that investment is inversely related to the interest rate.

[ii] On Monetary Policy and Inequality, the Economist observes that among the many channels by which inequality is propagated, one is via inflation. Typically, the poor tend to own nominal assets, such as bank deposits, which inflation erodes. The rich usually own real assets, such as property. The rich are also better placed to handle risk, and thus diversify into riskier assets with higher returns. While inflation theoretically reduces the real value of debt, unless households have experienced significant nominal income increases, nominal debt contracts won’t fall in value by enough to induce shifts in household behaviour.

[iii] Theoretically, this occurs since monetary loosening produces growth, which raises labour demand and thus “tightens” the labour market, pushing real wages up. There are issues in the empirical measurement of these metrics. For instance, typically wage series are deflated by a chained index of consumer prices, which cannot entirely capture rising costs of basic goods and services such as education. This theoretical model also ignores factors like technical progress, which makes the demand for highly educated labour rise and the demand for low-skilled labour fall, thus exacerbating inequality.

[iv] Measuring the returns to capital is difficult and controversial, ranging from the Capital-Wealth distinction to whether real estate is capital or not. For the purposes of this discussion, I’ve adopted Piketty’s idea that it consists of all forms of non-labour incomes including capital gains on assets and rents on owned property.

[v] Monetary policy could theoretically help the poor by inducing inflation, which would reduce the real value of their debts. However, unless households have experienced significant nominal income increases, nominal debt contracts won’t fall in value by enough to induce shifts in household behaviour. Further, this relies on a recovery of nominal wages, which hasn’t occurred robustly yet. Also see here and here.

[vi] These range from political indecision in India to corruption in Brazil. The problem across the BRICS economies appears to be institutional weakness and over-powerful governments lacking stability and reliability. See here.

[vii] Being in control of Banks, the Chinese could order an immediate expansion of credit creation financed by their stimulus worth USD 586 Billion. They could then order the firms and institutions they controlled to actually borrow and invest these sums as well. It is estimated that the incremental expansion in the net valuation of the financial sector was USD 14-15 Trillion, the size of the US Commercial Banking system, which took over a century to build.

[viii] Gross Capital Formation in China reached 48% of GDP in 2013. Chinese local governments undertook massive infrastructure projects, building 25 metro rails, 30 airports, 6,000 km of high-speed railways and the world’s three longest bridges (How China Fooled the World, BBC Two, 2014). In 2013, four of the 10 fastest growing urban areas in the World were in China.

[ix] The Chinese Financial system is a classic example of the East Asian relationship-based financial system, whose interactions with transparency-seeking western investors is identified as a weakness in the World Economy in Fault Lines (2010). Moral Hazard problems are everywhere – for instance, Banks in China are guaranteed profits due to state-administered interest rates which pay savers less than interest rates charged from borrowers, and thus have no incentive to curtail risky lending. A number of debt-saddled local Governments were thus rendered incapable of repaying a financial sector suddenly in a crisis of fund availability. See here and here.

[x] This has been exacerbated by China’s relentless drive to maintain the Yuan’s value, through purchases of foreign debt (see here).

[xi] In a demand-constrained economy with perfectly competitive financial intermediation and perfect economic equality of participants, the monetary expansion mechanism itself, whether it be through bond sales or through quantitative easing or similar, wouldn’t matter. In the more realistic economy, it does – bond sales transfer purchasing power generated through seignorage to the State, whereas QE transfers it to Bank Stockholders, who may not lend it out for employment-generation activities, instead preferring to drive up the asset value of their holdings.

[xii] The New Deal Programmes of 1933-38 were probably some of the most Keynesian measures ever tried, and evidently, they were at least partially successful. As a part of the initial relief package, USD 500 million was sanctioned for the creation of “Make-Work” Jobs, a scheme which provided immediate relief to the unemployed and, curiously, was supported by Milton Friedman himself. This was augmented by the Public Works Administration’s USD 3.3 billion, spent on bridges, airports and public infrastructure. The Hoover Dam is among the legacies of this era, while the San Francisco-Oakland Bay Bridge was a legacy of the “second” new deal.

[xiii] Fiscal Policy measures in India, for instance, have focussed on augmenting consumption at the expense of investment through employment generation schemes which don’t focus on capital formation and subsidies on a gamut of consumption goods, ignoring the imperative of creating an environment to generate growth, necessary for sustaining these transfers and the nation’s prosperity.

Posted by The Indian Economist