New rules for the mone­tary game

The Pak Banker - - OPINION - Raghu­ram Ra­jan

OUR world is fac­ing an in­creas­ingly dan­ger­ous situation. Both ad­vanced and emerg­ing economies need to grow in or­der to ease do­mes­tic po­lit­i­cal ten­sions. And yet few are. If gov­ern­ments re­spond by en­act­ing poli­cies that di­vert growth from other coun­tries, this "beg­gar-my-neigh­bor" tac­tic will sim­ply fos­ter in­sta­bil­ity else­where. What we need, there­fore, are new rules of the game.

Why is it prov­ing to be so hard to re­store pre-Great Re­ces­sion growth rates? The im­me­di­ate an­swer is that the boom pre­ced­ing the global fi­nan­cial cri­sis of 2008 left ad­vanced economies with an over­hang of growthin­hibit­ing debt. While the rem­edy may be to write down debt to re­vive de­mand, it is un­cer­tain whether write-downs are po­lit­i­cally fea­si­ble or the re­sult­ing de­mand sus­tain­able. More­over, struc­tural fac­tors like pop­u­la­tion ag­ing and low pro­duc­tiv­ity growth - which were pre­vi­ously masked by debt-fu­eled de­mand - may be ham­per­ing the re­cov­ery.

Politi­cians know that struc­tural re­forms are the way to tackle struc­tural im­ped­i­ments to growth. But they know that, while the pain from re­form is im­me­di­ate, gains are typ­i­cally de­layed and their ben­e­fi­cia­ries un­cer­tain. As Jean-Claude Juncker, then Lux­em­bourg's prime min­is­ter, said at the height of the euro cri­sis, "We all know what to do; we just don't know how to get re-elected af­ter we've done it!"

Cen­tral bankers face a dif­fer­ent prob­lem: In­fla­tion that is flirt­ing with the lower bound of their man­date. With in­ter­est rates al­ready very low, ad­vanced economies' cen­tral bankers know that they must go be­yond or­di­nary mone­tary pol­icy - or lose cred­i­bil­ity on in­fla­tion. They feel that they can­not claim to be out of tools. If all else fails, there is al­ways the "he­li­copter drop," whereby the cen­tral bank prints money and sprays it on the streets to cre­ate in­fla­tion. But they can also em­ploy a range of other un­con­ven­tional tools more ag­gres­sively, from as­set pur­chases (so-called quan­ti­ta­tive eas­ing) to neg­a­tive in­ter­est rates.

But do such poli­cies achieve their goal of strength­en­ing de­mand and growth? Mone­tary pol­icy works by in­flu­enc­ing pub­lic ex­pec­ta­tions. If an ever more ag­gres­sive pol­icy con­vinces the pub­lic that calamity is around the cor­ner, house­holds may save rather than spend. That ten­dency will be even greater if the pub­lic senses that the con­se­quences even­tu­ally must be re­versed.

Con­versely, if peo­ple were con­vinced that poli­cies would never change, they might splurge again on as­sets and take on ex­ces­sive debt, help­ing the cen­tral bank achieve its ob­jec­tives in the short run. But pol­icy in­evitably changes, and the shifts in as­set prices would cre­ate enor­mous dis­lo­ca­tion when it does. Be­yond the do­mes­tic im­pacts, all mone­tary poli­cies have ex­ter­nal "spillover" ef­fects. In nor­mal cir­cum­stances, if a coun­try re­duces do­mes­tic in­ter­est rates to boost do­mes­tic con­sump­tion and in­vest­ment, its ex­change rate de­pre­ci­ates, too, help­ing ex­ports.

Today's cir­cum­stances, how­ever, are not nor­mal. Do­mes­tic de­mand may not re­spond to un­con­ven­tional pol­icy. More­over, fac­ing dis­torted do­mes­tic bond prices stem­ming from un­con­ven­tional pol­icy, pen­sion funds and in­surance com­pa­nies may look to buy them in less dis­torted mar­kets abroad. Such a search for yield will de­pre­ci­ate the ex­change rate fur­ther - and in­crease the risk of com­pet­i­tive de­val­u­a­tions that leave no coun­try bet­ter off.

As mat­ters stand, cen­tral banks in de­vel­oped coun­tries find all sorts of ways to jus­tify their poli­cies, with­out ac­knowl­edg­ing the un­men­tion­able - that the ex­change rate may be the pri­mary chan­nel of trans­mis­sion. If so, what we need are mone­tary rules that pre­vent a cen­tral bank's do­mes­tic man­date from trump­ing a coun­try's in­ter­na­tional re­spon­si­bil­ity. To use a traf­fic anal­ogy, poli­cies with few ad­verse spillovers should be rated "green;" those that should be used tem­po­rar­ily could be rated "or­ange;" and poli­cies that should be avoided at all times would be "red."

If a pol­icy has pos­i­tive ef­fects on both home and for­eign coun­tries, it would def­i­nitely be green. A pol­icy could also be green if it jump-starts the home econ­omy with only tem­po­rary neg­a­tive spillovers for the for­eign econ­omy.

An ex­am­ple of a red pol­icy would be when un­con­ven­tional mone­tary poli­cies do lit­tle to boost a coun­try's do­mes­tic de­mand - but lead to large cap­i­tal out­flows that pro­voke as­set-price bub­bles in emerg­ing mar­kets.

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