BackThe only game left to play
Direct monetization of government debt is perhaps the last nostrum that central banks in the world are yet to try
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The latest general election in Japan has brought the Liberal Democrats back in power with Shinzo Abe as the party leader and Prime Minister. As part of the party agenda, Abe has already announced that he would ask the Bank of Japan (BoJ) to weaken the yen, if necessary by increasing its holdings of foreign bonds (in other words, active intervention in the market). The yen has weakened sharply in the last couple of weeks even before any central bank action. He’s also asked BoJ to underwrite government bonds issued to finance construction projects and increase its inflation target from 1% to 2%, adopting unlimited monetary easing until the target is achieved. The Prime Minister has also threatened that, if necessary, he would enact a law allowing the government to issue directives to the central bank on these issues.
Across the Pacific, the US Federal Reserve formally announced that it would continue the low interest rate policy until unemployment falls below 6.5%, the first time such an explicit target has been announced. (This is quite a change from the good old NAIRU—the non-accelerating inflation rate of unemployment. At one time, Fed used to be worried about unemployment falling below NAIRU.) In the euro zone, the European Central Bank (ECB) has undertaken a programme to buy government bonds of member countries. In India, there is considerable pressure from New Delhi and business lobbies on the Reserve Bank of India (RBI) to reduce interest rates to help economic growth despite the fact that real (i.e. inflation adjusted) rates cannot be considered high.
The reality in today’s world is that whatever their formal mandates, monetary policymakers need to balance two objectives—inflation and output/employment creation. Fed has an explicit dual mandate—price stability and employment. ECB is supposed to have a single-point agenda, namely price stability. In practice, through its outright monetary transactions (OMT) it is clearly helping weaker governments keep their cost of borrowing low.
Another myth that has been exposed is the ban on monetization of fiscal deficits. This disallows central banks to buy government paper in the primary market. But in reality, this is being circumvented through operations in the secondary market as these central banks, as also RBI, are doing this. RBI’s own holdings of government securities have gone up from 60,000 crore in 2006 to 6.5 trillion currently. The Japanese Prime Minister is going one step ahead, asking BoJ to buy construction bonds in primary issues.
This monetization of public debt is fine so long as it has been incurred for investment and not to finance revenue deficits. All major central banks have sharply increased their assets in the last five years: Fed by more than three times; Bank of England by four times, ECB by 2.5 times. BoJ has been in the game now for more than two decades.
There are many other areas in which accepted relationships between different variables are proving to be empirical busts. Take the relationship between fiscal deficits and interest rates. In the US, the fiscal deficit is very high but benchmark 10-year bond yields are at an all-time low—as low as in parts of Europe despite the fact that the latter countries are following fiscal austerity. Then, consider the accepted relationship between money supply, inflation and interest rates. To be sure, that arch-monetarist of the Chicago school, Milton Friedman, had debunked the relationship between money supply and interest rates as far back as his 1968 presidential address to the American Economic Association. Despite extremely loose fiscal and monetary policies in the US and Japan, there are few signs of inflation taking off. In fact, after 15 years of fiscal and monetary easing, the Japanese economy is experiencing deflation, i.e., prices are falling. The low rates hurt savers, benefit hedge funds and banks indulging in carry trades. Monetary transmission to the real economy is weak at best. Overall, low interest rates have benefited the middlemen far more than the end-users of the monetary system. In our case, of course, quite apart from the unreliability of the macroeconomic statistics, we have different measures of inflation, often moving in opposite directions. Most central banks have abandoned the good old Taylor rule (1993) linking short-term interest rates to deviations from the target inflation rate and output gap.
The fact is that the conclusions derived from econometric models depend on the assumptions made. These are often unrealistic, and too many times, leave out many material variables. In the real economy, the most important variable is, of course, the “animal spirits" of investors and consumers (both of whom often have less than rational expectations), which cannot be quantified in any case. Perhaps the reliability of the dynamic stochastic general equilibrium model and other econometric models used by policymakers needs a review in the light of empirical evidence.
A.V. Rajwade is a risk management consultant, columnist and author.
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