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Money matters


Published with the kind permission of the author

Loss of growth momentum and jobs, induced by demonetisation,are the reasons for government’s demands to raid RBI’s reserves 

Over the last two months, I have been forced tothink about monetary policy, first at a meetingof the Mont Pelerin Society (MPS, the academyof classical liberals set up by Friedrich Hayek) in GranCanaria in early October, then from late October backin India by the continuing disagreements between thegovernment and the Reserve Bank of India (RBI). Thefirst concerns the instruments of monetary policy. Thesecond, the role of the central bank and its relationshipwith its ‘owner’ the government.

On the first, John Taylor of Stanford presented apaper at the MPS meeting titled “Government as acause of the Financial Crisis and the Great Recession:A Reassessment after 10years”. The reassessment isof the book he published in 2009(Getting Off Track, Hoover Press),based on which he presented a paperat a special meeting of the MPS Iorganised as its President in March2009 on “The End of GlobalizingCapitalism? Classical LiberalResponses to the Global FinancialCrisis’’. Taylor presented two simpletime series charts. The first showedthat the Fed held interest rates wellbelow his well-known Taylor rulefrom 2003 to 2005. The secondshowed the actual boom and bust inthe US housing market during this period, and acounter-factual econometric estimate if the Taylorrule had been followed. The latter eliminates theboom and bust. As he concludes: “If the Fed had notheld rates unusually low, there would have been lesssearch for yield, less risk-taking and fewer problemson the bank’s balance sheets."

In his new paper, he summarises a recent researchwhich shows how as central banks across the world followedeach other, the deviation in monetary policyrates from the Taylor rule spread internationally. Heuses a chart from the Bank of International Settlementsto show that internationally interest rates were close tothe Taylor rule in the 1990s, then in the years leadingup to the crisis, particularly from 2003, there was alarge deviation, followed by a Taylor rule like reductionduring the crisis, and then a period after the crisiswhen the policy rate was ‘too low’ again. His conclusionis that "it was a mistake to deviate from policy rules forboth domestic and international reasons, and it isimportant to establish and follow a rule-based nationaland international monetary system in the future.”

But there is another element to this story which isexplained by Mervyn King (an academic who was from1991-2013 associated with UK monetary policy as chiefeconomist, deputy governor and then governor of theBankofEngland).Inhis2016book,TheEndofAlchemy,he argues that the so-called ‘savings glut’ arising fromthe trade surpluses of Germany, China and Japan ledto a fall in interest rates in an integrated world capitalmarket. In the build-up to the crisis, this did lead in theUK to steady output growth, steady inflation close tothe target of 2 per cent, and unemployment close to theestimated ‘natural rate’. But this wasnot sustainable, as the compositionof output was distorted by the largetrade deficit, which (as in the US) wasabsorbing the Chinese and Japanesestructural surpluses. The pound hadappreciated by 25 per cent with theinflow of these surpluses. Consumerdemand had risen at the expense ofexports. Investment had gone intonon-traded goods. This real exchangeappreciation needed to be reversedfor sustainable growth. But raisinginterest rates could lead to an immediateappreciation of the pound leading to a furthermisalignment of the real exchange rate. So the unpalatablechoice facing the UK’s monetary policy committeein the late 1990s was “between continuing withsteady growth and low inflation, knowing this wouldexacerbate the imbalances and risk a sharp downturnlater, and deliberately creating a slowdown [by raisinginterest rates] in order to return to a more sustainablepath for domestic demand at the cost of rising unemploymentand inflation below the mandated target inthe short run. Not surprisingly, perhaps, the committeeopted for the former” (King, ps.329-30). The USdid the same. The punch bowl which needed to betaken away when on an unsustainable path was left inplace, with the inevitable crisis following as JohnTaylor’s graphs showed.

The problem of course, as my earlier column(“Guard against neo-mercantilism”; May 30, 2018)suggested, is the real exchange rate protection in theprotracted current account surplus countries, andwithout the International Monetary Fund's (IMF’s)scarce currency clause being implemented somethinglike the threat of US President Donald Trump’strade war was probably the only way to persuade therecalcitrant surplus countries, China and Germany, tochange their policies.

On the second issue, about the recent and continuingconflict between the government and the RBI,which has abated for the time being, a number ofpoints can be made. First, three of Urjit Patel’s predecessorsas governor — Y V Reddy, D Subbarao andRaghuram Rajan—had conflicts with the central government.The current Deputy Governor Viral Acharya’sA D Shroff lecture echoed their sentiments regardingthe autonomy of the RBI.

The case for the central bank's autonomy is basedon the realisation by mainstream economists of thevalidity of public choice theories resurrecting theideas of classical economists of the ScottishEnlightenment that, far from being constituted ofplatonic guardians the State, including democraticones, are better viewed as being self-interested, evenpredatory. The self-interest of democratic incumbentcontrollers of the State is in re-election. Easing monetarypolicy before an election to generate an unsustainableboom can improve their chances. This canlead to cycles in monetary policy as after the election,the pre-election boom has to be dealt with by atightening of monetary policy. An independent monetarypolicy not influenced by these political factorscan maintain monetary stability through these politicalcycles. This is relevant to the current disputebetween the Bharatiya Janata Party and the RBI.

I have been reading S Gurumurthy’s speech at theVivekananda International Foundation (VIF) on “Stateof the Economy: India and the World”. As a memberof the RBI Board, he provides clues to the source of thisdispute, though no doubt what I have to say will be dismissedby him as the workings of a colonised mind!The most interesting point he makes, in a rambling,discursive discussion of various thinkers on the economy,and a wholly unpersuasive survey of economicpolicies and outcomes around the globe, is aboutdemonetisation and GST. Leaving aside his absurdclaims that pre-demonetisation “asset prices rosebecause of high denomination currencies” [notes],and the “Indian economy could have collapsed ifdemonetisation hadn’t happened”, he is right to saythat “the MSME sector was hit by both demonetisationas well as GST. It is the sector which was robbed ofcredit.” This of course was predictable from the mainstreamWestern economics he despises. I wrote a column“Money Mischief” (November 28, 2017), whichpredicted the fall in growth rates from the massivethree-month monetary contraction (later reversed asthe new notes filled the gap created by demonetisation),and the hit on cash-dependent MSMEs andinformal sector employment.

It is these predictable effects of demonetisationthat have led to a loss in the growth momentum andjobless growth (as the informal sector continues toprovide most additional employment), which arebehind the government’s demands to raid the RBI’sreserves and loosen monetary policy to provide a preelectionboom. They must be resisted along with anyattempt to reduce or eliminate the RBI’s autonomy.

Sourse: Business Standard