Sunday, November 23, 2014
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Containing Competitive Monetary Easing

MUMBAI – As the world struggles to recover from the global economic crisis, the unconventional monetary policies that many advanced countries adopted in its wake seem to have gained widespread acceptance. In those economies, however, where debt overhangs, policy is uncertain, or the need for structural reform constrains domestic demand, there is a legitimate question as to whether these policies’ domestic benefits have offset their damaging spillovers to other economies.

More problematic, the disregard for spillovers could put the global economy on a dangerous path of unconventional monetary tit for tat. To ensure stable and sustainable economic growth, world leaders must re-examine the international rules of the monetary game, with advanced and emerging economies alike adopting more mutually beneficial monetary policies.

To be sure, there is a role for unconventional policies like quantitative easing (QE); when markets are broken or grossly dysfunctional, central bankers need to think innovatively. Indeed, much of what was done immediately after the collapse of US investment bank Lehman Brothers in 2008 was exactly right, though central bankers had no guidebook.

But problems arise when these policies are extended beyond repairing markets; the domestic benefits are at best unclear when economies are deeply damaged or need serious reform, while the spillovers from such policies fuel currency and asset-price volatility in both the home economy and emerging countries.

Greater coordination among central banks would contribute substantially to ensuring that monetary policy does its job at home, without excessive adverse side effects elsewhere. Of course, this does not mean that central bankers should be hosting meetings or conference calls to discuss collective strategies. Rather, the mandates of systemically influential central banks should be expanded to account for spillovers, forcing policymakers to avoid unconventional measures with substantial adverse effects on other economies, particularly if the domestic benefits are questionable.

For a long time, economists had converged on the view that if central banks optimized policies for their domestic situation, coordination could offer little benefit. But central banks today are not necessarily following optimal policies – a variety of domestic constraints, including dysfunctional domestic politics, may prompt more aggressive policies than are strictly warranted or useful.

In addition, cross-border capital flows, which increase economies’ exposure to the effects of one another’s policies much more than in the past, are not necessarily guided by economic conditions in recipient countries. Central banks, in an effort to keep capital away and hold down the exchange rate, risk becoming locked into a cycle of competitive easing aimed at maximizing their countries’ share of scarce existing world demand.

With a few rare but laudable exceptions, officials at multilateral institutions have not questioned these unconventional monetary policies, and have largely been enthusiastic about them. This approach carries two fundamental risks.

The first hazard is a breakdown of the rules of the game. Endorsing unconventional monetary policies unquestioningly is tantamount to saying that it is acceptable to distort asset prices if there are other domestic constraints on growth.

By the same token, it would become legitimate for countries to practice what they might call “quantitative external easing” (QEE), with central banks intervening to hold down their exchange rates, while building huge reserves. If net spillovers do not determine internationally acceptable policy, multilateral institutions cannot claim that QEE contravenes the rules of the game, regardless of how much instability it engenders.

In fact, this is no mere hypothetical. Quantitative easing and its cousins are implemented primarily in situations in which banks are willing to hold enormous quantities of reserves unquestioningly – typically when credit channels are blocked and other sources of interest-sensitive demand are weak. In such situations, QE “works,” if at all, primarily by altering exchange rates and shifting demand between countries. In other words, it is different from QEE in degree, not in kind.

The second danger is that source countries’ unwillingness to take spillovers into account causes unintended collateral damage in recipient countries, prompting self-interested action on their part. Even as source-country central banks have painstakingly communicated how domestic conditions will guide their exit path from unconventional policies, they have remained silent about how they would respond to foreign turmoil.

The obvious conclusion – reinforced by the recent financial-market turbulence that followed America’s move to exit from more than five years of QE – is that recipient countries are on their own. As a result, emerging economies are increasingly wary of running large deficits, and are placing a higher priority on maintaining a competitive exchange rate and accumulating large reserves to serve as insurance against shocks. At a time when aggregate demand is sorely lacking, is this the response that source countries want to provoke?

Despite the evident benefits of expanding central banks’ mandates to incorporate spillovers, such a change would be difficult to implement at a time when domestic economic worries are politically paramount. A more practicable solution, at least for now, would be for source-country central banks to reinterpret their mandates to consider the medium-term effects of recipient countries’ policy responses, such as sustained exchange-rate intervention.

Central banks could thus recognize adverse spillovers explicitly and minimize them, without overstepping their existing mandates. This weaker form of “coordination” could be supplemented by a re-examination of global safety nets.

The risks generated by the current non-system are neither an advanced-country problem nor an emerging-economy problem. The threat posed by competitive monetary easing matters to everyone. In a world with weak aggregate demand, countries are engaging in a futile competition for a greater share of it. In the process, they are creating financial-sector and cross-border risks that will become increasingly apparent as countries exit their unconventional policies.

The first step to prescribing the right medicine is to recognize the cause of the illness. And, when it comes to what is ailing the global economy, extreme monetary easing has been more cause than cure. The sooner we recognize that, the stronger and more sustainable the global economic recovery will be.

This article is based on a speech given at the Brookings Institution on April 12, 2014.

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    1. CommentedVikram Malhotra

      Mr Rajan please stop giving gyaan to foreigners and do your job at home. You missed a wonderful opportunity end of last year to clean up the banks, despite your statement that you would audit banks in Nov 2013. What ever happened to that? Thanks to your inaction and unnecessary worry over QE taper, you have neglected actions that would have meaningfully improved the financial system in India, and we would have been able to clean house and start a new growth cycle. Thanks to you, bank problems remain and are a hurdle for growth.

    2. Commentedatul baride

      Dr. Rajan seems to prescribe the medicine but want to restrict use. But, QE is addictive for the Sick and the Doctor. The Unusual Emphasize of the Market Forces on Establishing QE needs is a Poser. The economy generated through market is cursed to remain imperfect and unstable. The economic Disorder is now feeding to a New World Order in production and consumption sourced through Technology, Which is impacting Production Practises and Consumption patterns. But, this phase is also removing old produces and consumption patterns. Which ( This Pass ) is Possibly, creating bigger imbalance and uneven growth and Deficient Markets.
      But,Is the Money Supply the efficient way to balance the Gaps of economic Imbalances Within and outside..?
      It seems without sufficient know-how, economist are groping.. ? But, the longer the Rates are held by Bankers at low they are throttling the Rate of Growth..and..suppressing the natural growth Creating Bonsai than Fields.

    3. CommentedJose araujo

      I swear that I was half through the text and could see how it ended.

      I was almost sure that Mr. Rajan would prescribe accumulating large reserves, and some kind of deficit, cool down measures... Well it’s not that hard, they always end up with the same prescription.

      But why instead of blaming the FED for the QE, don't we blame other central banks for incompetency? Central bank appointments in most countries are political, and for the most they are helmed by very incompetent people (take the ECB for example).

      Yes, incompetent, the fact is that most of the central bankers were expecting QE to produce inflation, and blaming QE for the low interest rates, when a basic IS-LM keynesian approach, and why not say it, just basic logic, would point to the fact that we were/are living in a world with high risk avoidance and preference for liquidity.

      Facing this reality, what did most of the central banks do? They prescribed deficit reduction and increased savings in their own economies, failing to acknowledge the fact that we are/were living in a world with excess capital and few investment opportunities.

      Most of the central bankers act and are still acting to protect their own rentiers when they should be promoting internal demand and creating market opportunities for capital to flow to their own countries.

      Instead of searching for external competitive conditions to protect exporting industries, this countries should be taking this opportunity to increase the standards of living in their own countries, and promote sound internal markets with a development aimed at substituting Imports.

      With such a large country, why does even India care for external markets?

    4. CommentedEdward Ponderer

      We are avoiding a certain troubling reality of globalization. This being the domination of coupling effects. That reality means, as a first step, that the power of balanced international decision making on virtually everything must outweigh that of national governments. In short, we require a true world government--not a cultural/political weapon for strong man, cartel manipulation--like the supposed "United Nations."

      But this coupling is nonlinear--and as its strengthens, it enters into deterministic chaos. This means that a flat control of a single Internationale won't cut the mustard either eventually, but a completely fractal solution will be required--at all levels we must act as a round table.

      Two general indicators or this is that influence is beginning to disperse from the "major powers" towards a fractal distribution multiple of nations, groups, and individuals. This leads to a "fractal basin" of influence on a global scale, and inevitably in unbalanced, the onset of deterministic chaos,

      As well, large system, and certainly the globalization of Humanity is that, have failure statistics (the generalities become clearer as the control specifics turn to sand) approaching the Weibull distribution. Weibull discovered this in the 1930's, but it wouldn't be decades later that what he hid upon, independently as many other researchers early in the 20th century in different fields, was fractal geometry (his distribution is exactly the generic fractal one), which is the "phase-space orbit" of deterministic chaos. In short, to control failure without whole-scale replacement of failed units (i.e.--people, cities, provinces, countries, and whole regions! -- such module replacement cycles are how industry maintains large systems), one must establish a matching, balanced fractal sense & control system--a fractal swarm intelligence.

      In equivalent situations, in nature's subsystems and its whole, this has been the path to successful communal evolution.

      The central problem in doing what we must, is that we continue to ignore, or oversimplify our egos (just as we do with our economic problems). At grass roots, we need to work on educating ourselves--and our egos--towards the overriding necessity of integration. Then we need to move out on a deep campaign of improving basic human relations--from the personal up through the international.

      Such thoughts seem very alien to us, frightening. How can we give up simplistic approaches that we can individually grasp, play the "experts" in. How to have the courage to seek out a fundamentally new approach, one where we ourselves--our very souls--are the objects of our "equations," and ultimate control and sense is of the whole of us--not a part, or even the sum of the parts?

      Perhaps we should consider the retrospective of the Littlepeople character Haw, on p. 72 of Spencer Johnson's classic short work on dealing with necessary change, WHO MOVED MY CHEESE:

      "He had to admit that the biggest inhibitor to change lies within yourself, and that nothing gets better until YOU change.

      Perhaps most importantly, he realized that there is always New Cheese out there whether you recognize it or not. And you will be rewarded with it when you go past your fear and enjoy the adventure.

      He knew that some fear should be respected as it can keep you out of real danger. But he realized most of his fears were irrational and had kept him from changing when he needed to.

      He didn't like it at the time, but he knew that the change had turned out to be a blessing in disguise as it led him to find better Cheese.

      He had even found a better part of himself."

      --




    5. Commenteddouglas ungredda

      The article describes what is in effect a beggar thy neighbor policy of competitive devaluations, in the same fashion of the ones which eventually triggered a 1929 styled depression. The article characterizes the economies in two groups; those originating the QEE policy and those at the receiving end of it. But those of the originator type as USA and the Eurozone are characterized by the fact that their monetary liabilities are acceptable by the rest of the world as settlement payment and foreign reserve assets and the rest of the world is bound to hoard these liabilities to lend credibility to their domestic monetary policies. In this lopsided game, the winner is the generator of foreign liabilities implementing QEE. This process triggers a prisoner's dilemma monetary dynamics among competing economies who must protect their external competitiveness.
      Developing and emerging economies are bound to suffer the destabilizing capital inflows and respond by engaging in capital account inflow controls, to avert real exchange appreciations in their currencies. Competitive gains of the QEE implementing economies could be gained at the expense of those economies at the receiving end. A zero sum game? Still early to conclude in this way.

    6. CommentedGary Palmero

      Quantitative easing by central banks provides governments with the liquidity to easily finance at low nominal rates. The moral hazard is that it allows upper echelon borrowers the same opportunity often as agents or through limited liability structures where the upper echelon borrower can benefit without having to pledge personal capital to pay back the borrowing. The victim is usually the prudent saver often from the middle class. Thus the transfer of wealth...

      Dr. Rajan's view is well founded. India is a complex country with great opportunity, and is tied to the British system of finance. It cannot afford to be the beneficiary/victim of "hot" money. Since QE is now in its sixth year in the US, there are those who believe they have discovered El Dorado and this will go on forever. What happens if it doesn,t? We will see. Suffice to say, the longer it takes to unwind QE, the riskier the likely outcome.

    7. Commentedotto ruthenberg

      dont buy the logic that QE today is still driven by the economy or jobs. asset owners have grown addicted to it and have the clout to make central banks play their inflating tune. central banks are fearful of crashes once they change the outlook for real. anticipative investor crowd action would cumulate to a crash blamed on central banks not greed - the real culprit.

    8. Commentedslightly optimistic

      "world leaders must re-examine the international rules of the monetary game"

      The incentive for change? The monetary game is of course the world's political economy. The largely unenforceable rules were drawn up after WW2, but adherence by nations is on the slide - as we see in so many areas. Global monetary discipline, for instance, was effectively destroyed over 40 years ago [Nixon shock] and the United Nations system [mainly the IMF] was found to be impotent.
      The political incentive for change?

    9. Commentedsai sumanth

      Just one doubt, What and Who exactly need CENTRAL BANKS for?

      Well, from a common man's perspective as much as this is clear, Central Banks are a failure in their stated Vision and Mission statements. The only purpose they successfully accomplished was, is and will be to Legally Exploit the common man and transfer wealth to the Elite , in the form of interest rate policy, exchange rate stabilizing mechanism, Fractional Reserve Banking, the list goes on and this is INSANITY. This have to stop. CENTRAL BANKS should be shut down for good.

      People inside the banking vouch for the absolute necessity and essential institution as a Lender of Last Resort but typing currency into an account number will not create or stabilize the economy. Printing money is history now.. all we have is just an electronic number inside a number and that numbers being created out of nowhere by central banks and the burden is born by every individual. Central banks have corrupted the holy subject of Economics beyond recognition and the solution is to get rid of them. The sooner the better.

      I don't want to raise my kids in bondage.

    10. CommentedTomas Kurian

      The solution is obvious:
      Recycling the unmoving capital by regular taxing of savings.
      ( to print always more and more of new money, which are ending at the same accounts has no point at all and at certain time will lead to massive inflation)

      To be able to do this, we first need fully digital financial system.

      16. Periodic taxation of accumulated capital
      http://www.genomofcapitalism.com/index.php/16-periodic-taxation-of-accumulated-capital-2

      16.5 Evolution of monetary systems
      http://www.genomofcapitalism.com/index.php/16-5-evolution-of-monetary-systems

      With extra taxes coming from this source, we can get rid of unemplyment, outsourcing needs by subvencing productivity.

      17.1. Primary & subvenced productivity
      http://www.genomofcapitalism.com/index.php/17-1-primary-subvenced-productivity

    11. Commentedroberto martorana

      I wrote about this on "riodialogues "during RIO20:I suppose a new rule for central bank: a model that integrates the concepts between von Hayek and J.M. Keynes,because it keeps the economic freedom of enterprise and market , creating resources that can be used by the government but to the extent that they are created and without increasing the tax burden... when one of the central bank(respectively of each country or through international agreements) have a new emission of money whith each rate the same bank print corrispective quantity of money of the rate ,off C.B. budget,and give this quantity ( to compense the monetary mass to solve the lack natural compensation previously provided by 'gold mining ..) at a pubblic commission that use for pubblic necessity etc etc...we resolve three problem :pubblic necessity,pubblic balance,and market crisis,;for example : the B.C. have a emission of hundred billion unit and fix a rate of 3% and give this money to commercial bank,at the same moment print 3 billion and give these to pubblic commission that spend for pubblic problem....
      (More on:Teoria della compensazione della massa monetaria https://www.facebook.com/notes/teoria-della-compensazione-della-massa-monetaria/bozza-espositiva-/228248770537241 this is my page about a new theory macroeconomic conception monetary system ,and any contribute are well accepted )

    12. CommentedAriel Tejera

      Also, “coordinated global monetary policy” as suggested by Governor Rajan, would draw away even more macro economical responsibility from political governments, and into the hands of central bankers. Big time.

    13. CommentedT Selvakumaran

      Raghuram Rajan gave a talk at the Brookings Institute three weeks ago on this same article. At that talk, Bernanke essentially told Rajan that he (Rajan) has been opposed to unconventional monetary policy as a rule, because he had been behind the curve in appreciating the innovative aspects of the unconventional monetary policies that Bernanke-Krugman were pursuing. Moreover, Bernanke said that the empirical models available at that time guided him towards the decisions he made as the Chairman of the Fed. If theempirical evidence that Rajan has now is directing him towards a different direction, then obviously he would differ with Bernanke, or so said uncle Ben. Added to this, Eshwara Prasad, one of the panelists, announced that he is going to speak bluntly, and then blamed it all on the politicians for not taking fiscal measures to address the economic crisis, leaving all the work to the central banks. Bernanke also made another important point about the difference between central bank interventions in currency markets and unconventional monetary policy. The first is only demand diverting while the second is demand creating, like for example happened when the US went off the gold standard during the depression.

      Essentially, the technical toolkit that Raghuram Rajan, Anil Kashyap and Eshwara Prasad are employing is too light-weight, to convince the economics profession that the unconventional monetary policies promoted by Ben Bernanke, Janet Yellen and Paul Krugman should be revised. They need to consider historical patterns of global migration -- a point I had raised with Lawrence Summers during the Phelps conference in 2012.

    14. CommentedDonald Lee

      Aside from the impracticality of his suggested “coordinated global monetary policy,” Governor Rajan’s take on monetary easing is in my view a little bit overdone, by stating the omnipotence of what central banking can do to the real economy, perhaps something what we should be expecting from a central banker.

      While the scale of money printed by central banks around the world is enormous, the actual money that is circulating in the real economy is way short of it. As a result, most of the money that is created is sitting on banks’ accounts today, failing to spur consumer demand. It only created false recovery mood by merely extending the asset price reflation period that we are seeing now, which probably would sustain the wealth effect people are enjoying now for some time.

      For example, the U.S. is enjoying one of the longest streak of stock market rally, and real estate prices in some states surpassed the pre-crisis level, even though there are still buttload of underwater houses. Furthermore, corporate profits as a proportion of the GDP are reaching a historic high. Meanwhile, peripheral European countries’ governments bonds that were once trading at precarious levels are now experiencing oversubscription, causing many European critics’ jaw to drop.

      Turning our attention to Asia, we have seen the Chinese government effectively replicating the size of the U.S. banking system, which took the U.S. 100 years to build, within just over the past five years, by inundating the financial system awash with credit according to the former Fitch analyst Charlene Chu. Its close neighbor Japan, which is struggling to escape from decades-long deflationary spiral, has engaged in massive bond-buying scheme starting from 2013 in order to ignite growth and inflation. Yet, most of the Japanese people are only seeing their energy and tax bills creeping up without any increases in disposable income.

      This global glut cannot last forever, and once it ceases, “source” countries and “recipient” countries will all experience serious problems, not because for the stated underlying reason in this commentary. In fact, if we think about it, aside from active central banking, there were no commensurate amounts of fiscal policies taking place during the last few years, and this very fact will pivot our position back to the origin. That is, a state where countries are laden with debt, but even more this time, and with a global financial system looking more weaker than before due to lack of central bank-led liquidity. It was the central bankers’ successful ingenuity and activeness that led many governments to sit idly by, enabling them to put off many needed reforms and adjustments that should have been implemented in the real sector over the past years.

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