New rules for the monetary game

Raghuram Rajan NEW DELHI – Our world is facing an increasingly dangerous situation. Both advanced and emerging economies need to grow in order to ease domestic political tensions. And yet few are. If governments respond by enacting policies that divert growth from other countries, this “beggar my neighbor” tactic will simply foster instability elsewhere. What we need, therefore, are new rules of the game. Why is it proving to be so hard to restore pre-Great Recession growth rates? The immediate answer is that the boom preceding the global financial crisis of 2008 left advanced economies with an overhang of growth-inhibiting debt. While the remedy may be to write down debt to revive demand, it is uncertain whether write-downs are politically feasible or the resulting demand sustainable. Moreover, structural factors like population aging and low productivity growth – which were previously masked by debt-fueled demand – may be hampering the recovery. Politicians know that structural reforms – to increase competition, foster innovation, and drive institutional change – are the way to tackle structural impediments to growth. But they know that, while the pain from reform is immediate, gains are typically delayed and their beneficiaries uncertain. As Jean-Claude Juncker, then Luxembourg’s prime minister, said at the height of the euro crisis, “We all know what to do; we just don’t know how to get re-elected after we’ve done it!” Central bankers face a different problem: inflation that is flirting with the lower bound of their mandate. With interest rates already very low, advanced economies’ central bankers know that they must go beyond ordinary monetary policy – or lose credibility on inflation. They feel that they cannot claim to be out of tools. If all else fails, there is always the “helicopter drop,” whereby the central bank prints money and sprays it on the streets to create inflation (more prosaically, it sends a check to every citizen, perhaps more to the poor, who are likelier to spend it). But they can also employ a range of other unconventional tools more aggressively, from asset purchases (so-called quantitative easing) to negative interest rates. But do such policies achieve their goal of strengthening demand and growth? Monetary policy works by influencing public expectations. If an ever more aggressive policy convinces the public that calamity is around the corner, households may save rather than spend. That tendency will be even greater if the public senses that the consequences (distorted asset prices, high government debt, etc.) eventually must be reversed. Conversely, if people were convinced that policies would never change, they might splurge again on assets and take on excessive debt, helping the central bank achieve its objectives in the short run. But policy inevitably changes, and the shifts in asset prices would create enormous dislocation when it does. Beyond the domestic impacts, all monetary policies have external “spillover” effects. In normal circumstances, if a country reduces domestic interest rates to boost domestic consumption and investment, its exchange rate depreciates, too, helping exports. Today’s circumstances, however, are not normal. Domestic demand may not respond to unconventional policy. Moreover, facing distorted domestic bond prices stemming from unconventional policy, pension funds and insurance companies may look to buy them in less distorted markets abroad. Such a search for yield will depreciate the exchange rate further – and increase the risk of competitive devaluations that leave no country better off. As matters stand, central banks in developed countries find all sorts of ways to justify their policies, without acknowledging the unmentionable – that the exchange rate may be the primary channel of transmission. If so, what we need are monetary rules that prevent a central bank’s domestic mandate from trumping a country’s international responsibility. To use a traffic analogy, policies with few adverse spillovers should be rated “green”; those that should be used temporarily could be rated “orange”; and policies that should be avoided at all times would be “red.” If a policy has positive effects on both home and foreign countries, it would definitely be green. A policy could also be green if it jump-starts the home economy with only temporary negative spillovers for the foreign economy (the policy will still be good for the foreign economy by eventually boosting the home economy’s demand for imports). An example of a red policy would be when unconventional monetary policies do little to boost a country’s domestic demand – but lead to large capital outflows that provoke asset-price bubbles in emerging markets. There will be plenty of gray areas (or orange, to stick to the analogy). A policy that has large positive effects for a big economy might have small negative effects for the rest of the world and yet still be positive overall for global welfare. Such a policy would be permissible for some time, but not on a sustained basis. We are far from having clear agreement on the color of policies today, even with the best data, models, and empirical work. So we must begin a discussion. We could start with background papers from eminent academics and move on to multilateral institutions such as the International Monetary Fund and the G-20. There will be a lot of fuzziness initially, but discussion will lead in time to better models and data – and will push policymakers to stay out of the clearly red. Arguably, what I have in mind will eventually require a new international agreement along the lines of Bretton Woods, and some reinterpretation of the mandates of internationally influential central banks. But we already have a basis for discussion. The IMF’s Article IV states: “In particular, each member shall … avoid manipulating exchange rates or the international monetary system in order to prevent effective balance-of-payments adjustment or to gain unfair competitive advantage over other members…” Setting the rules will take time. But the international community has a choice. We can pretend all is well with the global monetary non-system and hope that nothing goes spectacularly wrong. Or we can start building a system fit for the integrated world of the twenty-first century. This article is based on work with Dr. Prachi Mishra at the Reserve Bank of India. Raghuram Rajan is Governor of the Reserve Bank of India. Copyright: Project Syndicate.

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New rules for the monetary game