V. ANAN­THA NAGESWARAN

FI­NAN­CIAL MAR­KETS RE­DUCE MON­E­TARY POL­ICY TO A FARCE

Mint Asia ST - - Myview -

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Novem­ber, Vi­ral Acharya, one of the deputy gov­er­nors of the Re­serve Bank of In­dia, had warned the govern­ment of In­dia not to in­cur the wrath of the fi­nan­cial mar­kets. He has been proven right, but with a twist.

First, the wrath of the fi­nan­cial mar­kets has not vis­ited In­dia. It has vis­ited the United States. Even there, it has not been felt by the govern­ment but by the Fed­eral Re­serve.

Therein lies the prob­lem of in­vok­ing the fi­nan­cial mar­kets to en­force pol­icy dis­ci­pline. Fi­nan­cial mar­kets do not dis­ci­pline pol­i­cy­mak­ers, but they cap­ture them, es­pe­cially if they are cen­tral bankers.

Last week, reacting to the tantrums of the schiz­o­phrenic stock mar­ket in Amer­ica, Jerome Pow­ell, the chair­man of the Fed­eral Re­serve, said that the rate-set­ting Fed­eral Open Mar­ket Com­mit­tee was lis­ten­ing care­fully to the mes­sage from the fi­nan­cial mar­kets. Thus, the par­ent has been suitably dis­ci­plined and the cry­ing baby has got the candy.

The Fed­eral Re­serve, un­der Pow­ell, has been try­ing to break from tra­di­tion, in vogue since the mid- nineties, of set­ting mon­e­tary pol­icy in re­sponse to the preferences of the stock mar­ket. Un­for­tu­nately, it has re­ceived very lit­tle pub­lic in­tel­lec­tual sup­port in its mis­sion to re­store mean­ing and sense to mon­e­tary pol­icy.

Even sen­si­ble com­men­ta­tors, such as Stan­ley Druck­en­miller and Kevin Warsh, have ended up of­fer­ing mud­dled, con­fus­ing and con­tra­dic­tory ad­vice to the US Fed. In an op-ed, Fed Tight­en­ing? Not Now, writ­ten in The Wall Street Jour­nal on 16 De­cem­ber, the two au­thors ad­vised the Fed­eral Re­serve to cease its dou­ble-bar­relled blitz of higher in­ter­est rates and tighter liq­uid­ity.

If the Fed was shrink­ing its bal­ance sheet by not rein­vest­ing the pro­ceeds of its re­demp­tion of trea­sury se­cu­ri­ties, the re­sult should be seen in higher trea­sury yields. How­ever, that has not been the case. Trea­sury yields have de­clined in re­cent months. In­dices of fi­nan­cial con­di­tions do not sug­gest that they have tight­ened sig­nif­i­cantly enough to af­fect eco­nomic out­comes in the coun­try. Fi­nan­cial con­di­tions re­main too ac­com­moda­tive. More jobs are avail­able in Amer­ica than there are job seek­ers. The amount of debt with neg­a­tive yields has jumped 46% in the last three months. In other words, liq­uid­ity is still ex­ces­sive. It needs to be drained.

The mud­dled think­ing of the au­thors comes through in their ex­hor­ta­tion to the Fed­eral Re­serve to break from the old regime. Quite how the Fed­eral Re­serve would break from the old regime by yield­ing to fi­nan­cial mar­ket tantrums is be­yond my com­pre­hen­sion.

It is im­pos­si­ble to break from the past in a pain­less man­ner. If in­tel­lec­tu­als re­coil at the first signs of pain and urge pol­i­cy­mak­ers to stop in their tracks and if pol­i­cy­mak­ers com­ply, the old regime will be se­curely in­tact.

In a well-crafted speech de­liv­ered in 2010, D. Sub­barao, the then gov­er­nor of the Re­serve Bank of In­dia, said: “There is a joke that if some­thing works in prac­tice, econ­o­mists run to see if it works in the­ory. Ac­tu­ally, I don’t see the joke. That is in­deed the way it should be.” How­ever, econ­o­mists, pol­i­cy­mak­ers and in­vestors are not learn­ing from the prac­ti­cal world.

Ten years ago, the fi­nan­cial cri­sis of 2008 was, in part, a con­se­quence of cen­tral banks ig­nor­ing, wil­fully or oth­er­wise, ex­cesses in fi­nan­cial mar­kets, while train­ing their my­opic gaze on con­ven­tional met­rics of over­heat­ing and eco­nomic sta­bil­ity. It is déjà vu 10 years later. Those who won their No­bel prizes for ra­tio­nal ex­pec­ta­tions (no sys­tem­atic er­rors) must do “award wapsi”.

Sim­i­larly, based on em­pir­i­cal ev­i­dence from re­peated episodes, it is is premised on pil­grims sub­scrib­ing to the crowd man­age­ment rules— im­ple­mented by vol­un­teers. Those who have wit­nessed this are struck by the abil­ity of the pop­u­lace to ac­cept the rule of law—a very im­por­tant take­away for a coun­try seek­ing to get be­yond its seven-decade legacy of a dis­cre­tions-based regime.

Third, flow­ing from the above, the big take­away is that the suc­cess­ful or­ga­ni­za­tion of the Kumbh Mela proves that as a coun­try “Yes, We Can”. It is very sim­i­lar to the suc­cess­ful im­ple­men­ta­tion of the goods and ser­vices tax (GST), which ush­ered in the era of “one com­mod­ity, one tax” regime, re­plac­ing 17 taxes and mul­ti­ple cesses, and the trans­for­ma­tion of the coun­try into an eco­nomic unity for the first time. Es­sen­tially, it shows us that In­dia can suc­cess­fully im­ple­ment com­plex projects of scale by us­ing the very same bro­ken pub­lic de­liv­ery sys­tem.

Fi­nally, the con­gre­ga­tion is a ter­rific repos­i­tory of big data. Var­i­ous arms of the govern­ment can pig­gy­back on the in­fra­struc­ture, in­clud­ing the cell­phone foot­print of vis­it­ing pil­grims, to re­search is­sues like health, de­mog­ra­phy, com­mu­ni­ca­tion and mi­gra­tion pat­terns.

Clearly, the lessons from the geog­ra­phy of faith are promis­ing. Mint clear that the fi­nan­cial mar­kets are nei­ther in­for­ma­tion­ally ef­fi­cient nor are they use­ful price dis­cov­ery mech­a­nisms.

Ac­tion in stock mar­kets in Amer­ica since the third week of De­cem­ber have only con­firmed their schiz­o­phrenic na­ture. Ef­fi­ciency is the last thing that comes to mind when one thinks of stock mar­ket move­ments. Daily re­turns of more than 3% are not a fea­ture of mar­kets with nor­mally dis­trib­uted re­turns, the as­sump­tion that un­der­pins many mod­els of fi­nan­cial as­set pric­ing.

Sec­ond, if stock mar­kets were in­deed sig­nalling to the Fed­eral Re­serve that the econ­omy was slow­ing, where is the ev­i­dence that the mar­ket is pric­ing in lower earn­ings from a slow­ing econ­omy?

On the other hand, stock prices jump or swoon in re­sponse to shifts in liq­uid­ity. In other words, in the stan­dard equa­tion for the price of a stock, the nu­mer­a­tor fig­ures, but rarely in the cal­cu­la­tion. It is all about the de­nom­i­na­tor—in­ter­est rates and liq­uid­ity. That is a sign of a casino that is happy with the free flow of money and not an ef­fi­cient price dis­cov­ery mech­a­nism.

Clearly, the Fed­eral Re­serve did not have to be apolo­getic about drain­ing the punch­bowl. That it has been forced to do so sug­gests that an hon­est in­tel­lec­tual de­bate on mon­e­tary pol­icy in­de­pen­dence is over­due.

V. Anan­tha Nageswaran is the dean of IFMR Grad­u­ate School of Busi­ness (KREA Univer­sity). These are his per­sonal views

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