Prosperity has dulled the appetite for the heavy-lifting and pain-bearing required to restore sustainable economic growth in the world.
It was an eventful week for the world economy. First, OECD slashed its global growth forecast for 2015 from 3.7 percent to 3.1 percent but kept its forecast for 2016 at 3.8 percent. Everything will always be alright later. OPEC kept output unchanged despite the OECD growth forecast revision. Other things being equal, that argues for lower oil demand. But, OPEC cannot agree on a quota; not when OPEC is riven by so many divisions. The ‘hero’ of the week on macro policy was, of course, the International Monetary Fund which announced on Thursday (June 4) that the Federal Reserve Board would be better off postponing any rate increase to the first half of 2016. That must have come as a shock to the Federal Reserve Board.
On Friday, it took a seemingly solid employment report for American policymakers to recover some lost ground. William Dudley of the Federal Reserve Bank of New York made a speech on Friday, June 5, reiterating that the first rate hike could come in the later part of the year, even though he sounded more uncertain about economic growth, and less uncertain about inflation hitting 2 percent in the medium-term. At the same time, he was clear that the financial market’s reaction to the rate increase would dictate the speed and depth of the rate increase. For instance, volatility and turbulence in financial markets would make the Federal Reserve rate increases shallow and slow.
One thing is clear. Notwithstanding the lack of firm conviction among policymakers in the United States about the health of the US economy, they seem keener to raise the Federal funds rate off the zero base, for various reasons. Chief among them is to get some firepower to address the next downturn when it comes. If the Federal funds rate is at 1.0 percent by the middle of next year and if a recession strikes, they will have 100 basis points to work with. Further, finally, they are becoming uncomfortable with exuberance in different parts of financial markets. With liquidity in bond markets gone, central banks in the West are flying in the dark as to the driver behind recent volatility in bond markets.
Jeremy Warner, writing for The Telegraph observed that the notion that governments had somehow gotten on top of the forces of financial stability was for the birds. Aggressive monetary intervention might have been needed to restore liquidity and confidence in the early stages of the economic recovery, but sustaining them beyond a reasonable length of time had sown the seeds of the next crisis. Central banks have no tools left to respond to it. This is where the inevitably (or, incredibly) Myopic Fund (IMF) lived up to its reputation. It blithely noted, in paragraph 10 of its report on the conclusion of the Article IV consultation with the United States government that, at this stage, policy rates should not be used in an effort to reduce leverage and dampen financial stability risks. The Fund falls back on the ill-defined macroprudential framework.
About two months ago, when the Fund hosted a conference on “re-thinking macropolicy” which was co-organised by two former Research Directors of the International Monetary Fund, including the current governor of the RBI, not much light was shed on what macroprudential regulation meant in practice. Olivier Blanchard, the current (and departing) research Director of the Fund, noted that there were many questions that involved political economy dimensions in determining the specific form and duration of macroprudential regulation. More than two years ago, Jeremy Stein, then in the Federal Reserve Board, had pointed out that macroprudential tools worked best in conjunction with conventional monetary policy tools. He said that they were a complement and not a substitute for conventional monetary policy. Among other things, he noted that interest rates got in through all the cracks because it is common for a commercial bank, a hedge fund, a broker-dealer and a special purpose vehicle. To the extent that interest rates influence risk appetite and the incentives to engage in maturity transformation (simply put, borrow short and lend long); interest rates have the ability to reach into the corners of the market that regulation and supervision would not.
While all economic policy decisions – including monetary policy decisions on interest rates – have distributional consequences, macroprudential controls have more direct and possibly, greater distributional consequences because of their more discretionary nature than interest rate decisions. Hence, the question of whether central banks are the right and sole authority to impose macroeconomic regulation on the economy remains unsettled.
As Gavyn Davies wrote in his insightful blog on the IMF conference on Rethinking macropolicy, not much rethinking appears to have happened during the conference or afterwards. In fact, the only place where such rethinking is happening is the ‘Institute for New Economic Thinking’.
Finally, while Lars Svensson, a former member of the monetary policy committee of the Swedish Riksbank, sounded enthusiastic about macroprudential tools, it is important for all interested policymakers to read the speech delivered by Per Jansson, deputy governor of the Swedish Riksbank on December 3, 2014 on the myths and facts relating to the Swedish monetary policy after the financial crisis. A brief history is that Riksbank’s policy came under criticism from people like Paul Krugman for having aggravated an economic downturn because, according to them, it raised interest rates to address a bubble in the housing market.
The speech by Per Jansson dispelled many such myths. It is important to note that he had posted the link to his speech as a comment on the blog post of Ben Bernanke on whether monetary policy should take into account risks to financial stability published two months ago. Per Jansson posed several questions for advocates of macroprudential policy. He wanted to know the specific macroprudential measures that should be taken, their dosage and their duration and whether other measures were needed. They do not have answers. For many, ‘macroprudential’ may not roll off their tongue easily but it sure does make them sound intellectually sophisticated.
Lars Svensson resigned from the Swedish Riksbank in April 2013 because his call for further monetary easing went unheeded in the Executive Committee. However, he has continued to argue his case and has promptly put up blog posts whenever Per Jansson had made the official case for Riksbank’s monetary policy. The fact that inflation had gone down everywhere in the western world, irrespective of whether central banks kept up with their loose monetary policies or loosened them further, considerably dilutes whatever strength there was in his arguments. Of course, it is quite possible that measured inflation declined because consumer prices indices are now subject to hedonic calculations whereas actual inflation is hitting households badly. If so, it is a not-so-delightful irony that governments have become victims of their own success in wringing inflation out of all statistics – an effort that was first made in the United States in the late 1990s and quickly adopted elsewhere in the western world. Of course, yours truly is not aware if Sweden too was guilty of adopting hedonic pricing.
Further, it is always amusing to note the confusion among Western trained economists and central bankers with regard to the efficacy of interest rate increases when it comes to containing bubbles and their conviction as to the efficacy of interest rate cuts in fomenting one. If, six years after the crisis officially ended and rates had remained at zero, an international institution that also monitors the emergence of macroeconomic and financial imbalances cautions against a quarter percentage point rate increase, what exactly has it learnt from the crisis of 2007-2008? The answer is clear.
They have learnt nothing. Too much of prosperity has dulled the appetite in all of us for the heavy-lifting and pain-bearing required to restore sustainable economic growth in the world. We are condemned to quick-fixes and the dreadful consequences that ensue in its wake. In fact, they are round the corner.
(This is an expanded version of the article that appeared in MINT on June 9, 2015)
Photo: Ken Teegardin