Wednesday, November 26, 2014

Two Policy Prescriptions for the Global Crisis

WASHINGTON, DC – One thing that experts know, and that non-experts do not, is that they know less than non-experts think they do. This much was evident at the just-completed Spring Meetings of the International Monetary Fund and the World Bank Group – three intense days of talks that brought together finance ministers, central bankers, and other policymakers.

Our economic expertise is limited in fundamental ways. Consider monetary and fiscal policies. Despite decades of careful data collection and mathematical and statistical research, on many large questions we have little more than rules of thumb. For example, we know that we should lower interest rates and inject liquidity to fight stagnation, and that we should raise policy rates and banks’ cash-reserve ratios to stifle inflation. Sometimes we rely on our judgment in combining interest-rate action with open-market operations. But the fact remains that our understanding of these policies’ mechanics is rudimentary.

These rules of thumb work (at least tolerably so) as a result of evolution. Over time, the wrong moves are penalized, and their users either learn by watching others or disappear. We get our monetary and fiscal policies right the same way that birds build their nests right.

As with all behaviors shaped by evolution, when the environment changes, there is a risk that existing adaptations become dysfunctional. This has been the fate of some of our standard macroeconomic policies. The formation of the eurozone and a half-century of relentless globalization have altered the global economic landscape, rendering once-proven policies ineffective.

When Sweden’s Riksbank was founded in 1668, followed by the Bank of England in 1694, the motivation was that a single economy should have a single central bank. Over the next three centuries, as the benefits of instituting a monopoly over money creation became more widely recognized, a slew of central banks were established, one for each politically bounded economy.

What was not anticipated was that globalization would erode these boundaries. As a result, we have returned to a past from which we tried to escape – a single economy, in this case the world, with multiple money-creating authorities.

This is clearly maladaptive, and it explains why the massive injections of liquidity by advanced-country central banks are failing to jump-start economies and create more jobs. After all, in a globalized economy, much of this liquidity spills across political boundaries, giving rise to inflationary pressures in distant lands and precipitating the risk of currency wars, while unemployment at home remains dangerously high, threatening to erode workers’ skills. The long-run damage could be devastating.

What was evident at the World Bank/IMF Spring Meetings was that virtually all policymakers are distressed and no one has a complete answer. Neither do I. But here are two simple ideas that could help to mitigate the crisis.

First, in the absence of a single global central-banking authority, a modicum of monetary-policy coordination among major economies is required. We need a group of the major economies – call it “G Major” – that announces monetary policies in a coordinated fashion.

To see why, consider the case of Japan. Japanese policymakers have good reason to try to promote some inflation and even correct some of the yen’s secular appreciation over the last six or seven years. But, in today’s unilateral world, other central banks would soon respond by injecting liquidity, prompting the Bank of Japan to act again. These actions are usually justified as policies for boosting domestic demand, but they end up fueling a surrogate, low-grade currency war.

If, however, the G Major economies issued quarterly announcements of significant upcoming policy changes – for example, a small round of quantitative easing by country X, a larger liquidity injection by countries Y and Z, and so on – markets would be reassured that a currency war was not being fought. Exchange-rate movements would be minimal and only as intended, and volatility would be contained, because tit-for-tat injections would no longer occur and speculation would wane. Moreover, liquidity injections would be likely to have a greater impact on demand, because synchronization would reduce leakage across national boundaries.

The second recommendation pertains to the mechanics of liquidity injection, much of which takes place nowadays – in Europe, Japan, and elsewhere – through asset purchases. The US Federal Reserve, for example, is currently purchasing assets (many of them mortgage-backed) worth $85 billion each month.

Liquidity injections and low interest rates have a microeconomic effect that has received little attention: they lower the cost of capital vis-à-vis the cost of labor, which causes a relative decline in demand for labor. This is very likely exacerbating the unemployment problem; it certainly is not mitigating it.

One solution is to channel part of the liquidity injections toward countering this factor-cost asymmetry. Thus, for every $100 of new liquidity, we could use $60 to purchase assets and the remainder to give firms a marginal job-creation subsidy, which could be especially effective in economies with flexible labor markets that enable short-term hiring.

Even if the employment subsidy were offered only for, say, one year, firms would be tempted to use more labor during this time. And, because the current bout of high unemployment is self-reinforcing, once the equilibrium is broken for a while, the economy could move to a higher-employment equilibrium permanently, without the need for any further government support.

This prescription has one problem. Asset purchases have no balance-sheet effect, because assets replace money. Subsidizing labor, by contrast, is a pure injection of liquidity. However, for precisely that reason, an employment subsidy is likely to be more effective in boosting demand, which implies that a smaller injection of this kind is likely to boost demand as much as a larger asset purchase would.

Among the few certainties in crafting economic policy is the need to adapt to external change. Our challenge is like that of Industrial Revolution-era moths, which adapted to their new soot-laden environment by becoming darker (and thus better able to hide from predators). In a globalized economy, national policymakers should not be left circling light bulbs.

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    1. CommentedJonathan Lam

      Gamesmith94134: Two Policy Prescriptions for the Global Crisis
      In prescribing the employment subsidy, I think it would require great disciplinary act on the politicians since redistribution of wealth was the causation of the inequality, and dependency on the liquidity or inflationary. Of cause, when we looked back at the sustainability and the balance of trade. It became rudimentary especially in the developed nations where workers are more protected with unemployment benefits or subsidies.
      I suppose Mr. Kaushik Basu can give a better description of them.
      “Exchange-rate movements would be minimal and only as intended, and volatility would be contained, because tit-for-tat injections would no longer occur and speculation would wane. Moreover, liquidity injections would be likely to have a greater impact on demand, because synchronization would reduce leakage across national boundaries.”
      It was a sound statement on globalized finance, if we can provide a system of control that each nation can participate. If it were inference to the trading partners like OCED, OAS or AU; then I would say the world would be better off. If everyone can have a handle of it, then it is not just a few with its unilateral world of unemployment or inflationary problems. We need alignment on solving all problems with a unilateral solution.
      However, I agree on the G Major economies in the open-market operation with lesser asset buying programs; in addition, we must establish a better anti-trust global legal system to void enumerator in taking advantages on the interest rates or currency rate changes since we all vary. In compliance to the interest rate and currency exchange, I would expect the World Bank and IMF could contribute more like a transfer system similar to the FDIC for all currency accounts and the Development Bank and WTO can take on the roll of the globalized Central Bank to the world that each can marginalize the long-term interest rate and scale it growth and developments; after we can agree to open a global system that we all contribute. By then, most central banks can follow with its nations can shift to its system for all that fits individually and adequately.
      “The ECB was also "technically ready" to cut its deposit rate from the current zero percent into negative territory, meaning it would start charging banks for holding their money overnight.” By Reuter.
      I alert me on the coming month that the probability of moving out off EU or just closing the European banks. I repeatedly emphasized the inequality and sustainability that are holding our pace to growth; perhaps, it is how we can witness another disaster is being unfolded like the imbalance of the currency exchange rate or interest rate can make revolution-era moth circle the light bulbs.
      Do the hedge fund managers turn themselves into CO of those Banks? Or why do we need banking? I am just kidding.
      May the Buddha bless you?

    2. CommentedKanav Sharma

      Mr. Basu is only talking about policy prescriptions in terms of injecting liquidity into the system. The real problem is not liquidity but fall in innovation rates. The world needs to rather define the major problems being faced and then build solutions to these problems by taking a system view rather than only a econimic view.

    3. CommentedC. Jayant Praharaj

      Given how capital, labor and production are intertwined, Mr. Basu needs to explain better his comment about the cost of capital versus labor and unemployment. Perhaps, a reference to research papers will be useful. Mr. Basu needs to explain how the microeconomics of his employment subsidy will work, and how it will add up at the macroeconomic scale given other mechanisms in the labor market, the framework of wage adjustments and labor hour adjustments etc. He needs to show us that this method will help and not hurt the unemployment scenario at the macroeconomic scale. This article does not give the arguments about how his microeconomic prescription about the employment subsidy will add up on the macroeconomic scale and what possible cancellation effects they might create. Will these cancellation effects be even stronger than the effects of the employment subsidy ? Also, he needs to explain how this employment subsidy and any "incentive" provided to capital may be interlinked. Again, both the microeconomic justification and the macroeconomic results must be explained, and the article doesn't really do that.

    4. CommentedBurak M

      Very interesting article indeed.

      Your second point sir, is undoubtedly quite spot on and would be a refreshing approach as opposed to the current wave off liquidity injection.

      With regards to your first point, it is equally refreshing and may be a wholly or semi solution for the currency wars light phenomena. Hence with that, it may also accommodate against the undesirable leakage of ofshore liquidity.
      However, with regards to this approach, I cannot help but ask in my humble curiosity, as to how such a united approach would be met by developed or significant economies whom are on the opposite side of the easing spectrum. Countries such as New Zealand, Canada and so on whom have a hawkish bias in their monetary approach pending no drastic deverlopments.

      Just to clarify, I am in no way being crritical, but just curious as to how modifications depending on each country would be handled with respect to a united central bank approach.

      In conclusion, your first comment in the article, with a blend of humour and modesty is definitely against the grain of most highly recognised intellectuals or corporate figures whom feel that their word should be taken on board as the gospel. Your modesty is even more to be respected when one considers your past incredibly important roles sir.

    5. Commentedsrinivasan gopalan

      With due deference to the intellectual credentials of Dr Basu who was the Chief Economic Advisor in the Ministry of Finance in India before joining the World Bank, one must laud his impish modesty for having prefaced his prescriptions that experts know that they know less than non-experts think they do! As long as economists are not hubris tic enough to claim patent rights to their failed policies or proverbial failings, Dr Basu is welcome to proffer two or multiple prescriptions to the maladies plaguing the global economy today. To say that globalization has eroded boundaries and simultaneously seek coordination among at least major countries is ironical in that it penalizes the forced participants in globalization while investing a few countries with the power to call the shots or determine how others , particularly those out of the G-Major camp, should conduct themselves. The post-war global economy witnessed golden growth spell for more than three decades till Washington Consensus wreaked havoc across continents, bringing once puissant socialist USSR to its knees or much later the capitalist citadel US on a crumbling point by the financial meltdown of its own making! So any advocacy of fanciful ideologies either by the right or the left is no panacea for the ills bedeviling the world today. The only sane course is to let each nation fashion its own economic policy as was the case immediately after the post-war instead of prescribing one-size fits all strategy that is still being purveyed by the so-called professional economists who are bankrupt of fresh ideas or have their own personal axe to grind. No doubt, return to the sanest past is difficult as the world has advanced from the early 1970s but then all the strategies that the economists of repute prescribed or persist in prescribing in the name of saving the global economy are nothing short of chimerical proposals that have no solid base to unleash the growth impulses that lay dormant for far too long. Ideas like employment subsidies would only allow indolence and slovenliness to get embedded in the economy instead of contributing anything substantive for progress. G.Srinivasan, Journalist, New Delhi, Inde

    6. CommentedTomas Kurian

      I am happy to see that ideas of employment subsidies are getting considered by more and more people.

      The current problems are stemming from ever increasing productivity, which we somehow failed to pass to the people in the form of less working time.

      The problem of liquidity injections are not working ( or working with huge expense/benefit proportion) because the economy has( at given epoch) reached full potential and we are simply not capable to produce more (in any MEANINGFUL way). It is like pushing the gas pedal on a car in zero gear - lots of noise, gas consumption and no movement at all.

      By decreasing the productivity by lowering the working time with help of employment subsidies, we will gain huge increases in jobs and also missing buying power able to realize itself in traditional and also new industries and we could move to new, qualitatively higher level of society based on travel, tourism, services, education,...

      But this shift towards lower productivity (more jobs with less working time) really needs the upgrade of existing financial framework. Those subsidies need to be permanent and from that reason there must be a way how to reclaim them from the system, otherwise sources for these subsidies would have to be infinite as well.

      I am addressing these issues in my work Genom of Capitalism ( ), where I am explaining reasons why such changes are absolutely necessary (see chapters 16-18) and also how to implement such passing of productivity gains toward free time.

    7. CommentedEdward Ponderer

      The key point is why rules of thumb are becoming evermore worse as globalization interdependence increases in both complexity of connection and coupling strength.

      Such rules of thumb are analogous to Newton's Theory of Universal Gravitation. It worked quite accurately in explaining the dynamics of our solar system, except for one deviation -- the slow, but definite rotation of Mercury's elliptical orbit about the orbital plane. Now all planets have elliptical orbits, but per Newton, there was no direct reason for any rotation of the ellipse itself. Scientists had struggled to try to explain it as the net influence of the other planets causing a "wobble" in the first-order isolated Sun-Mercury dyadic system. However, the net effect proved clearly too insignificant to cause this.

      The matter only became understood with Einstein's theory, where the vector forces of gravity are revealed as a curvature tensor for space-time. [In the tensor, a gravitation from any source has components in all 4 dimensions of space and time.] The slight deviation of Mercury was readily measurable because of the higher intensity of gravity that close to the sun. This was a storm warning of the radical breakdown of the Newtonian "rule of thumb" near such items as black holes. This, as well as the universe as a global whole -- and very noticeably locally if and when the final "Big Crunch" occurs.

      But our little Earth is a socio-economic and bio-ecologic whole, and its "Big Crunch" is well under way. And unfortunately the mathematics of nonlinear complexity here points to the same direction -- an ever-growing entropy leading to complete heat death. However

      So what to do? Well, in the universal case, while this Crunch is unstoppable -- there is some critical manipulation of its detail possible.

      In a fascinating theory proposed by Professor of Mathematical Physics, Frank J. Tipler, in 1994, in the far future (many billions of years) -- humanity (assuming we survive the short term) would spread out in some form among the galaxies. The descendants of today's humanity will -- for the sake of ultimate survival, take mutual responsibility without any hope for actual communications over the vast distances, much less mutual coercion, to manipulate the location of large quantities of matter locally. The global result will be a shaping of the unstoppable contraction - changing the spherical into the ellipsoid. This will establish a gradient. While the rise of heat and gravity will proceed ad infinitum, there will also be a lesser, but nonetheless infinite rise in usable energy. From this, rather than civilization dying, it would evermore evolve into an ultimate unity of infinite intelligence -- the "Omega Point" (supposedly, God).

      Whatever the merits or demerits of this rather abstract theory and its line of assumptions, nonetheless, a scale model of this on Earth at this time would be a very good idea. Let us work in mutual responsibility to turn our globalizing world into a higher Humanity rather than letting it fall to an exponentially accelerating Murphy's law. While we haven't the wherewithal to reshape galactic clusters, at least we can be connected consciously enough to realize realistic production and planetary homeostasis. Perhaps we won't become God, but maybe we all, together, can become a singular Humanity.

    8. CommentedZsolt Hermann

      I would combine the two sentences from the article that I thought very very important:
      "...One thing that experts know, and that non-experts do not, is that they know less than non-experts think they do..."
      "...As with all behaviors shaped by evolution, when the environment changes, there is a risk that existing adaptations become dysfunctional..."
      But we still do not grasp how deeply this is true and how much we do not know where we are, and how much all our present framework, our present tools and methods are dysfunctional.
      Evolution is not quantitative. We still think the evolutionary changes effect us in a quantitative way and greater, faster, more is always better and our whole development should be based on quantitative growth.
      But evolution is qualitative, when the vegetative evolved from the still, the animate from the vegetative, these were revolutionary changes, the whole system was elevated into a different dimension.
      So far human evolution from the animate has not passed this threshold, we are not qualitatively different from other animals, neither in our biological makeup, nor in our behavior.
      Humans today behave in the same instinctive, automatic way as any other animals, based on the pleasure/pain principle, except we refined what pleasure and pain is.
      There is one huge difference which separates humans from animals, and this is the human ego, consciousness, which gradually, and lately exponentially separated humans from the natural system.
      It is as if we received a virus in our original, natural operating software, and instead of being automatically balanced with nature as any other living organism, we have become more and more opposite.
      This is still instinctive but with a twist, we have become "anti-animals" living by basic instincts but opposite to the natural system.
      This behavior brought us to the dead end of today, where our present socio-economic system has finally become self-destructive as our ego reached its maximum potential placing us in total opposition with the system we exist in.
      Although the "crisis" feels bad, and it is perceived negatively, it is actually our jumping board to the next stage of our evolution, to become truly human, for the first time giving us a true free choice.
      The human is a creature that can go above its ego, its inherent operating software and return to the natural system against its ego, feeling, controlling, using the tension in between the inherent and the acquired.
      The human is the creature that acquires the capability to ride over its own beast and start truly controlling the whole system by becoming partners with it.

    9. CommentedEdward Lambert

      Actually it has become quite clear that experts don't have good models. In my own research, I have improved the AS-AD model by incorporating Effective demand. The model works much better now. And the AS-AD model is very basic to economics. It wasn't a perfect model.
      Another aspect of my research shows that labor share of income is at the heart of the problems in the advanced countries.
      Let me know if I can provide my research...

    10. CommentedProcyon Mukherjee

      An excellent piece with some brilliant prescriptions, or should we call it a movement towards a 'gradual increase of assurance', as Hume would have said. But the central idea regarding a border-less world where one central bank cannot ensure the steadfastness around an anchor is well taken. Out of the prescriptions, the one worth trying out is to offer not a short term but rather a long term subsidy on labor, that would act just not to make a short term switch from capital to labor, but rather a sustained one that allows a flow of labor, which through a mix of innovation could actually prove more collectively beneficial than the injection of dry liquidity month after month that simply gets converted into certain classes of assets and inflates them in the short term.