Demonetisation and monetary policy 

India’s currency swap is yet another example of how the powerful monetary policy tool is a victim of its own success

The original objective of central banking was monetary and financial stability. Photo: AFP
The original objective of central banking was monetary and financial stability. Photo: AFP

Although the underlying motive may be non-economic, from the economic perspective, the recent demonetisation in India can be viewed as part of ongoing experimentation with monetary policy around the world. An eminently powerful and successful policy tool, it has become the victim of its own success—with attempts to expand its scope, objectives and toolkit to a point that is undermining its efficacy, tarnishing the halo deservedly acquired by central bankers and hobbling their putative independence. We have moved from a point where Alan Greenspan, the chairman of the US Federal Reserve, was acknowledged as the master of the universe, to calls for the abolition of the Federal Reserve. How has this come about? 

Let us start from the beginning. Global growth before the Industrial Revolution was not only extremely uneven but, in the absence of continuous technological and productivity improvements, averaged well under 1% per annum. With the Industrial Revolution, it rose to 1% between 1700 and 1900, and to 1.3% in the first half of the 20th century. Periods of growth, however, continued to be punctuated with sharp declines. Global growth rose dramatically to average 3.8% between 1950 and 2014. While the stimulus provided by the war economy is credited for pulling the US out of the Great Depression, and the initial momentum of the postwar boom was provided by the reconstruction of Europe and Japan, later sustained by the development of East Asia, and more recently of China and India, this spurt in growth was only partly fortuitous. Much of the credit goes to sound structural policies and reform. The remarkable fact that the global economy has not seen a single year of negative growth after 1950 can be ascribed to advances in macroeconomic, and particularly monetary, policy. 

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The original objective of central banking was monetary and financial stability. Its origin lay in the response to freebooters, bank runs, financial bubbles, and dislocation caused by war. Following the Great Depression and the postwar Keynesian revolution, macroeconomic stability became a second objective, soon overriding the original. The macroeconomic policy toolbox was initially limited by the gold standard. Beginning with the US in 1970, the world went off the gold standard, adding fiat currency as a powerful new tool for expanding and contracting money supply at will. 

Like a baby getting a new toy, this tool was flogged to excess. Hyperinflation followed. Fiscal policy was too political, making for easy entry and difficult exit. Originally inclined to be accommodative of lax fiscal policy, monetary policy run by independent central banks now became the policy tool of first resort, with fiscal policy being largely relegated to automatic stabilizers. Beginning with Milton Friedman’s monetarism, it became rule-bound, culminating with the Taylor rule. The underlying rules depended on central bank targets, which were prices and employment in the US, price stability as primary and growth as subsidiary target in the European Union, and inflation targeting in the UK and Japan. India’s revamped monetary policy objectives are like those of the European Central Bank. 

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As financial markets developed, advanced economies moved away from monetary aggregates to the overnight policy interest rate as the chief instrument to modulate the demand for and supply of money, defending this rate through market intervention. The overnight rate was transmitted along the entire yield curve by financial markets. Monetary policy attained its high watermark under chairman Paul Volcker of the Federal Reserve, who used the policy rate to telling effect to tame hyperinflation.

Unbeknown to central bankers, even as their reputation was becoming formidable, their eminently successful framework was unravelling on account of three separate developments. First, globalization blunted macroeconomic policy tools as they could leak abroad: Fiscal expansion fuelled competitive external economies, monetary easing sent capital abroad instead of increasing investment. Second, as headwinds to growth in advanced economies increased on account of ageing and declining productivity growth, they became reliant on financial markets as the engine of growth, losing sight of financial stability. Symptomatic of this was the “Greenspan put” of reducing rates to fight market falls. Third, monetary policy overreach expanded the objectives beyond short-term stabilization to addressing structural problems such as rising public deficits and debt, and more recently, illicit wealth. 

Additional objectives led to expansion of central bank toolkits far beyond the conventional overnight policy rate. The Bank of Japan deployed quantitative easing (QE) to stimulate growth when policy interest rates hit the zero bound to fall into a liquidity trap in the 1990s. Extending its market intervention to the purchase of long-term bonds to directly influence long-term rates did not work, however, as the headwinds to growth were not cyclical. QE helped stabilize financial markets in 2008-09, but successive rounds were less effective, despite the increase in scale, bond maturities, and credit easing that targeted specific segments of the yield curve by churning, instead of simply expanding, the balance sheet. The objective changed, more aligned to those of the Bank of Japan. 

Also read: Bank of Japan keeps monetary policy steady

New objectives were added with public debt spinning out of control. The zero-bound policy rate was protracted to support these additional objectives. The latest addition is targeting illicit wealth through the demonetisation of high-value currency notes, recommended by Harvard economist Kenneth Rogoff—when India demonetized its high-value currency, it burdened the tool with the additional objective of reducing cash transactions. 

The experience with unconventional monetary policy has been arguable at best, and has at worst generated unintended negative externalities, such as new asset bubbles (QE), damaged savings (protracted zero-bound rates) and damaged growth (demonetisation). Macroeconomic policies are designed to address short-term perturbations around structural trends, not to modify underlying structures such as trend growth, public debt or illicit wealth. These are best addressed through structural policy and reform. Central bankers must return to a time when monetary policy did not attempt to do too much and was focused on stabilizing financial markets and growth.

Alok Sheel is a retired civil servant.

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