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Thoughts out of a hat – Reserve Bank, Rajan and Greece

, June 18, 2015, 0 Comments

Thoughts out of a hatThe Reserve Bank thinks conventionally of itself as a central bank and refuses to stray beyond its role; so most of its publications are deadly boring. Its internal proceedings must be even more so. How does an intelligent man like Raghuram Rajan endure the boredom? How does he resist the temptation of jumping out of his window on the 18th floor? One of the things he does to stay sane is do economics – read it, think it, and even utter it sometimes. He was a good macroeconomist before he stumbled into babudom; he stretches and exercises his intellectual muscles once in a while.

He did so recently in New York, where he spoke to the Economic Club. He was moved to do so after reading Martin Wolf’s recent book on the 2008 financial crisis, and another book I had not heard of – House of Debt by Atif Mian and Amir Sufi. Their message is that the growth of industrial countries has not returned to the rates before 2008 because they are burdened with high levels of debt; their governments could spend more by borrowing and running up debt, but they have borrowed too much to do that.

Greece is an extreme case: it has borrowed so much that no one would lend to it any more; and it cannot print and spend money because it ceded its power to do so to the European Union. If Greece cannot repay its debt, it has to declare bankruptcy. That would be easy. Everyone can see that it may do so one day; so no one wants to lend to it. Some people argue that governments that are so badly off can spend on infrastructure that would give high returns. But infrastructure projects that would have given high returns once – for instance, high-speed trains – are much less promising in current circumstances, when aggregate demand is not growing.

Government spending is not the only way to revive stagnant economies; they can also expand if consumers begin to spend more. The way to persuade them to do so is to reduce interest rates. But consumers of many industrial countries have also borrowed too much – usually to finance property purchases – and lenders would think twice before lending to them. So interest reduction would not raise spending. In some countries, consumers are unlikely to spend more even if they were given loans. In the US for example, the rich are so rich that they cannot think of anything more to spend on. And in all industrial countries, the number of old people has gone up, and they do not have many years left to enjoy spending.

But the rich countries are rich enough; their people are living comfortably. Could they not bear it if their standards of living did not go up for a while? No,  because they face problems of income distribution. They have a growing number of old people who have been pensioned off and who consume without producing anything; they can afford these old people only if they have young people who produce without consuming all they earn. They have arranged for this: to finance the pensions, they have levied heavy taxes – euphemistically called social contributions – on the young. But they have reached the limits of such taxation as well; they cannot afford more social transfers unless their youth produce and earn more. Since their populations are not growing, neither is the number of their young; their neither-young-nor-old people enjoy their pleasures in or out of marriage, but do not want the trouble of having to change nappies, so they do not have children. The few young people they have need education and training to become more productive; both are expensive, and wasted unless the young get jobs.

If industrial countries cannot produce more for themselves, why can they not export to underdeveloped countries? That too has been tried out.  Developing countries financed investment booms by running payments deficits and borrowing from developed countries; when the time came to repay the debts, they went bankrupt instead: for instance, Mexico in 1994, East Asian countries in 1997-98 and Argentina in 2001. That looked like a nice trick, but industrial countries made things pretty unpleasant for them; it taught them to avoid borrowing. If they limit themselves to investment they can finance from their own savings, they cannot have big enough booms to help out industrial countries. Some of them – China, for example – saved and depreciated their own currencies until they themselves became exporters.

So industrial countries grew wary of exporting to or investing in developing countries to stimulate their own economies, and looked for a domestic instrument. Starting with the US, they found it in what came to be known as unconventional monetary policy. It involved purchase by central banks of financial instruments, usually long- and short-term debt of their governments, until the interest rate on them turned zero – even negative in the case of Japan. When interest rates fell, banks and investors in countries where that happened went in search of higher yields – to other countries. Such investment outflows would depreciate the currency of the country that is exporting funds, and stimulate its economy. Its central bank would see that as additional stimulus, and would welcome it. This is a new variant of the policy countries once followed of accumulating foreign exchange reserves and depreciating their own currency – what Joan Robinson called “beggar-my-neighbour” policy in the 1930s. And now as then, the neighbours did not wait patiently to be turned into beggars. Some accumulated reserves but neutralized their impact on currency supply, while others introduced exchange controls. Rajan calls these ritual dances of industrial and developing countries “a macabre game of musical crises”, and wonders if the world could not do better than that.

The swirling capital flows from industrial to developing countries are inherently unstable. At the same time, developing countries do need investment, and could absorb more. Rajan suggests that their needs should be met by international institutions – International Monetary Fund, World Bank, and the sundry development banks that developing countries are setting up. Being owned by governments, these institutions can bear the risk that private funds cannot. But they do not work in the interest of the world economy and have no incentive to act in time. So Rajan proposes a new international monetary architecture.

In his view, the International Monetary Fund should act as the international bank of last resort, as it was intended to do from the outset, but with two changes. First, it and the sundry development banks should come to an agreement whereby it can borrow from or swap currencies with them whenever necessary. And second, it should determine a safe borrowing limit for each country, and give it credit whenever it needs it without any visits, negotiations, rituals or rigmarole.

This is an idea the government in Delhi should pick up and pursue in international fora. Starting with the chronic American payments deficits, international liquidity improved in the past two decades, and developing countries stopped borrowing from international institutions. Now the latter should turn into banks, and give developing countries unconditional, unasked-for credit whenever they have payments problems.