Monetary Illness

As the world struggles to recover from the global economic crisis, the unconventional monetary policies that many advanced countries adopted in its wake seem to have gained widespread acceptance. In those economies, however, where debt overhangs, policy is uncertain or the need for structural reform constrains domestic demand, there is a legitimate question as to whether the domestic benefits of these policies have offset their damaging spillovers to other economies.

More problematic, the disregard for spillovers could put the global economy on a dangerous path of unconventional monetary tit-for-tat. To ensure stable and sustainable economic growth, world leaders must re-examine the international rules of the monetary game, with advanced and emerging economies alike adopting more mutually beneficial monetary policies.

Greater coordination among central banks would contribute substantially to ensuring that monetary policy does its job at home, without excessive adverse side effects elsewhere. Of course, this does not mean that central bankers should be hosting meetings or conference calls to discuss collective strategies. Rather, the mandates of central banks should be expanded to account for spillovers, forcing policymakers to avoid unconventional measures with substantial adverse effects on other economies, particularly if the domestic benefits are questionable.

For a long time, economists had converged on the view that if central banks optimised policies for their domestic situation, coordination could offer little benefit. But central banks today are not necessarily following optimal policies – a variety of domestic constraints, including dysfunctional domestic politics, may prompt more aggressive policies than are strictly warranted or useful.

In addition, cross-border capital flows, which increase exposure to policies from outside more than in the past, are not necessarily guided by economic conditions. Central banks, in an effort to keep capital away and hold down the exchange rate, risk becoming locked into a cycle of competitive easing aimed at maximising their countries’ share of scarce existing world demand.

Endorsing unconventional monetary policies unquestioningly is tantamount to saying that it is acceptable to distort asset prices if there are other domestic constraints on growth. In fact, this is no mere hypothetical.

Quantitative easing and its cousins are implemented primarily in situations in which banks are willing to hold enormous quantities of reserves unquestioningly – typically when credit channels are blocked and other sources of interest-sensitive demand are weak. In such situations, the policy works, if at all, primarily by altering exchange rates and shifting demand between countries.

Unwillingness to take spillovers into account causes unintended collateral damage in recipient countries, prompting self-interested action on their part. Even as source-country central banks have painstakingly communicated how domestic conditions will guide their exit path from unconventional policies, they have remained silent about how they would respond to foreign turmoil.

The obvious conclusion is that recipient countries are on their own. As a result, emerging economies are increasingly wary of running large deficits, and are placing a higher priority on maintaining a competitive exchange rate and accumulating large reserves to serve as insurance against shocks.

At a time when aggregate demand is sorely lacking, is this the response that source countries want to provoke?

Despite the evident benefits of expanding central banks’ mandates to incorporate spillovers, such a change would be difficult to implement at a time when domestic economic worries are politically paramount. A more practicable solution, at least for now, would be for source-country central banks to reinterpret their mandates to consider the medium-term effects of recipient countries’ policy responses, such as sustained exchange-rate intervention.

Central banks could thus recognise adverse spillovers explicitly and minimise them, without overstepping their existing mandates. This weaker form of coordination could be supplemented by a re-examination of global safety nets.

The risks generated by the current non-system are neither an advanced-country problem nor an emerging-economy problem. The threat posed by competitive monetary easing matters to everyone.

In a world with weak aggregate demand, countries are engaging in a futile competition for a greater share of it. In the process, they are creating financial-sector and cross-border risks that will become increasingly apparent as countries exit their unconventional policies.

The first step to prescribing the right medicine is to recognise the cause of the illness. And, when it comes to what is ailing the global economy, extreme monetary easing has been more of a cause than a cure. The sooner we recognise that, the stronger and more sustainable the global economic recovery will be.

By Raghuram Rajan
Raghuram Rajan is governor of the Reserve Bank of India.

Published on July 27, 2014 [ Vol 15 ,No 743 ]



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