I came across this news item from CNBC about Bernanke and Rajan face-off and that was enough to break the long blogging hiatus! Rajan raises an important question that should be addressed given today’s closely connected economic systems. In the context of unconventional monetary policies, he asks “If the policy hurts the rest of the world more than it helps the United States, should this policy be pursued?” This question is important because there has been a lot of debate about the domestic impact of Fed’s QE policies , but not much has been said about the effects of such policies on emerging market economies. In fact, Rajan puts it quite bluntly when he criticizes “the Fed for failing to mention turmoil in emerging economies in its January 2014 policy statement, sending “the probably unintended message that those markets were on their own,” a sentiment reinforced by public comments by regional Fed bank presidents.” (Source)
While some macroeconomists and even the new Fed Chairman continue to argue about the favorable effects of QE and the eventual low interest rate regime, there has been a convincing argument against it made by New Monetarists like Stephen Williamson here and more informally here. The infromal argument in short goes somewhat like this: if money competes as means of payments with other assets playing similar role (shadow banking) and if QE is increasing their prices, then the only way money can retain value is if inflation goes down. So we have an imminent danger of Japaneese style stagnation as the lowering of interest rates and increase in value of money creates a liquidity trap. This is quite apparent in the data and hence quite surprising that Fed continues to neglect it when it comes to policy making. Thus, given that the benefits of QE for the US itself are circumspect or unclear at best, Rajan’s criticism seems valid and timely. Of course, Bernanke did not take it well- he does not want any blemish on his legacy! Not sure what to think of his argument about QE being demand augmenting as suggested by required exchange rate intervention.
Notwithstanding this face-off between two first rate scholar central bankers, something definitely needs to be thought about policy making in an interconnected world economy-especially in case of the US who supplies the world’s most prominent reserve currency and the general shortage of safe assets as argued by Caballero. It looks like there was some talk about this in Kansas City Fed in 2012, the Jackson Hole symposium in 2013, and very recently at the IMF. Rajan’s proposal in this regard seems interesting and worth researching. He sees “merit in assigning the International Monetary Fund or a similar institution the responsibility of assessing the spillover effects of major central banks policies – much as the World Trade Organization does with trade rules – but acknowledged this isn’t politically viable.”
Whether, such a solution is possible or not, the argument against activist monetary policy favoring low interest rates has never been stronger than now. As James Bullard suggests here, there is a strong evidence that low interest rates may have prolonged the recession that started in August 2007, when firms speculated in the international oil markets using the abundantly available cheap funds and literally engineered an oil price shock! Of course, real data available to Fed at that time did not reflect this and significantly understated the extent of actual recession. Talk about lags in policy making eh!
Recently, the Governor of the Reserve Bank of India (RBI), Dr. Subbarao emphasized the need to move to electronic payments system in India from its current primarily cash based one. It seems to be a reasonable proposition coming from a central banker especially such transition might mean a better control over an economy with a large informal sector. However, is it economically feasible to have such a transition in India right now? Dr. Subbaroa’s answer is yes and he cites other emerging economies like Brazil that use way less cash than a typical Indian does. But I believe that the nature of payment systems practiced only partly depends on deliberate policies and a whole lot on the economics involved. This is especially true for the retail transactions which was the focus of Subbarao’s statement.
Cash is preferred in many transactions in India as a significant number of people lack access to banking facilities. The RBI has time again pursued various initiatives to spread the banking access, but such efforts have not meant much in terms of transforming retail payments. The way commerce is organized in India (a large number of small sellers- large scale retailing is a new and urban phenomenon) make electronic payment systems prohibitively expensive. Further, use of electronic platforms like Visa or Mastercard for payments subjects the economy to economics of two sided markets. There are many issues involved, and most resolutions suggest a preferred cash used in equilibrium for a country like India (For a review of economics of two sided markets see Rysman 2009. For a non-technical discussion of payment systems in India see Waknis (2010)).
A large informal as well as black economy adds to the necessity of cash use in transactions. Lastly but not the least, the level of economic growth itself is a good determinant of the payment system used. While one could argue that Brazil uses less cash than India and hence the later should follow suit, these countries are not exactly in the same league. To further shed light on such cross country comparisons, one probably needs a careful analysis controlling for country specific characteristics to understand the factors that determine the use of electronic payment systems. In addition, questions like do the existing payments systems evolve to address the frictions in payment system and how do they affect economic efficiency also need to be given thought (See Kahn and Rehbords 2009 for a survey of empirical and theoretical literature on payment economics.).
Cash allows anonymity in transactions and in itself can be looked upon as a solution to anonymity of buyers and sellers. This implies that there will be always some transactions that will use cash. The money search literature pioneered by Lagos and Wright (2005) makes this point very well where money as a store of value gets valued in the centralized Walrasian market because the participants are anonymous. This literature is rich and has handled many issues related to payment systems. For an introduction see Williamson and Wright (2010).
So what could Dr. Subbarao do to make it economically attractive for market participants to use electronic payment systems instead of a cash one? Now that is a question worthwhile some thought!
What would Keynes say about the way his ideas are being used and abused to figure out what should policy makers do in the wake of recent financial crisis? I would like to believe he would not repeat his general theory. But leaving the speculation on this question for some other time, I would like to focus on Krugman and Layard’s manifesto for economic sense in today’s Financial Times. Interestingly, while arguing for differences in the European and US financial crisis, Krugman and Layard seem to have a single policy response as a panacea. This according to me actually seems to be a first step towards economic nonsense.
My reasoning is as follows: Among many other things related to how the ECB should function and whether Greece should stay or go, the European crisis is indeed a crisis of excessive public borrowing in countries like Greece, Ireland, Portugal, Italy and Spain. Contrary to this, K and L suggest that excessive public borrowing is a problem only in the case of Greece. To refresh on the EU situation, both of them might do good by reading or watching the work by Fernando Martin and Chris Waller of the St. Louis Fed. Fortunately, K and L get at least part of the US crisis right. They say it was caused by “excessive private borrowing” but leave out the counterpart that this appetite was whetted by the financial system’s need for collateral to settle debts between themselves. While K and L somewhat agree with these differences, their blanket prescription for government spending in both the cases makes little sense. Looking at the level of public debt that the above mentioned countries have, austerity does seem like the only way to go! On the other hand, considering the ‘paucity of good collateral argument’, at least in the long run US government should borrow and spend more.
Now as K and L suggest, is there no evidence for deleterious effects of government deficits and the resulting borrowing on interest rates? The rising yield curves on government debt for countries in EU, (See this interesting chart on Andolfatto’s blog), seem to suggest otherwise. It is probably only US that can still borrow at a lower interest rate without risking an immediate rise in the future interest rate. This is primarily because the US dollar still remains a strong international currency and the ability of the US government to honor its debt is not yet in doubt. So as much one could argue for government spending in the US, especially on retraining programs or on Universities where the unemployed tend to flock, not all countries have the capacity to roll over their debt indefinitely and sustain such expenditure.
So what should be the manifesto for economic sense? Thinking carefully about the nature of the two crises and suggesting policy prescriptions based on such analysis or lumping both these crises together and somehow arguing that government spending is a panacea in both the cases? I pick the former while practical men seem to gobbling down the later keeping with the Keynesian adage of falling for a defunct economist!
I have been thinking about monetary policy for a while now- primarily as a part of my dissertation research and also because that is one of the things that interest me about macroeconomics. What should central banks do as a part of their regular functioning? Maintaining low inflation seems like a good task at hand. Of course, central banks like the Reserve bank of India (RBI), have a little more than that on their plate as managing the forex markets gets added to their usual functions. In addition to this there is also managing a substantial government borrowing program, making inflation targeting a bit more ominous of a job.
James Bullard convincingly argues here for inflation targeting by proposing to interpret the recent financial crisis as primarily a persistent wealth shock. I think Federal Reserve will do good to abide by it and be flexible on its current stance of maintaining a near zero interest rate. How does his advice bear on the RBI? If RBI decides to target inflation with managing the exchange rate and government borrowing along with it, the only thing it can actually do is to just keep on playing with the interest rate. This may or may not have the desired effect given a significant informal economy outside the purview of the formal banking sector. This is because the informal sector makes the transmission mechanism for monetary policy changes significantly complex than in an economy dominated by formal banking and financial sector. To figure out the transmission mechanism in presence of a informal sector, one has to have a model in mind of how the formal and informal sector interact in reaction to the given policy changes. Also, most of the inflation in the Indian economy is caused by persistent food price inflation which, seems to be not under the direct influence of RBI and may require some fundamental changes in the way the Government of India manages the food procurement and distribution system. For more on this check this post.
Good food for thought-any suggestions!