Home / Opinion / The peril of cheap money

When the Bretton Woods system of fixed exchange rates tied to the US dollar, which in turn fixed the price of gold, collapsed in 1971, the global economy entered a brave new world of freely floating exchange rates. Proponents of the new arrangement argued that monetary policy would now be liberated to pursue domestic policy objectives, while flexible exchange rates would ensure that the balance of payments equilibrium was automatically achieved without the need for central bank intervention. Currency and financial crises would become a thing of the past. Then, when the holy grail of inflation targeting was discovered, it was thought that optimal monetary policy could make protracted economic downturns a distant memory.

That was the conventional view on the eve of the global financial crisis in 2008. Today, that orthodoxy lies in tatters, and the global economy faces new challenges, whether in the form of the ongoing crisis in the euro zone, or the vexed question of when and how advanced economies such as the US can exit from unconventional monetary policies (UMPs) such as quantitative easing (QE) and forward guidance.

These were some of the themes avidly discussed at the most recent meeting of the Santa Colomba Conference, convened and chaired, as it has been from its inception in 1971, by the Nobel economist, and my own great guru, Robert Mundell. This year, the conference titled “Currency Disorder and Global Monetary Reform", deliberated, as ever, in the majestic setting of the Palazzo Mundell, a Renaissance villa in the rolling Tuscan hills close to the mediaeval city of Siena.

There could not have been a more appropriate forum to discuss the state of global monetary affairs, nor a more appropriate figure than Mundell to lead the discussion. Indeed, the first Santa Colomba Conference was convened mere months after the collapse of Bretton Woods, and Mundell’s was for years a lone voice decrying the non-system represented by a world operating on flexible exchange rates. As noted at the conference by economist Judy Shelton, it is surely not a coincidence that the era of fixed exchange rates under Bretton Woods represented a period of rapid growth, low and stable inflation, and falling income inequality in advanced economies, whereas the period since then has witnessed considerably greater economic instability and rising inequality.

While it lasted, Bretton Woods enforced monetary cooperation, and, by extension, macroeconomic coordination, among the world’s major economies. The absence of cooperation—one of the major ill effects of our current non-system of national economies linked by flexible exchange rates—is potentially most damaging to emerging economies such as India. A number of conference members, including myself, highlighted the perils of near-zero interest rates in the US and other advanced economies, driving flows of hot money to emerging economies in the “search for yield", which could potentially destabilize the fragile financial systems of such economies when these monies exit, as they eventually will when interest rates begin to rise in the advanced economies. Equally, there is worry that loose monetary policy in advanced economies such as the US represents a modern form of “beggar thy neighbour" competitive devaluation, widespread resort to which worsened the Great Depression of the 1930s.

These, indeed, are concerns that have been sounded loudly and clearly by Reserve Bank of India governor Raghuram Rajan in a series of speeches over the past year, including one most recently in London that was widely reported (or mis-reported) in India. Similar concerns have also found their way into the most recent annual report of the Bank of International Settlements, which were highlighted in a recent leader in this newspaper (“The danger of unending monetary stimulus", 2 July).

The chair of the US Fed, Janet Yellen, may not care about the spillovers of US monetary policy to emerging economies, and she might well discount the harmful effects of so-called “spillbacks" on the US. But she and her fellow governors ought to be mindful of the fact that QE and near-zero interest rates are feeding global asset bubbles of the sort that caused the 2008 crisis in the first place—and that, if these burst, the US will not emerge unscathed.

As investor Peter Jungen noted at the conference, in a world of asset price inflation, it is more profitable to buy an existing asset than to start a new enterprise—hence the boom worldwide in markets for property, equity, art and vintage cars—many of these being secondary markets in which the same assets turn over repeatedly. Thus, an important side effect of inflated asset prices may well be a diminution of innovation and new business formation—which, in turn, will retard job creation and future growth in productivity, the latter being the chief driver of long-run economic growth.

Thus, the liberation of monetary policy after 1971 was largely illusory; instead, in the advanced economies, it has become increasingly overburdened, performing tasks that are better accomplished through fiscal policy, prudential regulation, social policy, or structural policies, more broadly. Hopefully, it will not take another crisis for policymakers to realize that UMPs may end up being a cure worse than the disease.

Every fortnight, In the Margins explores the intersection of economics, politics and public policy to help cast light on current affairs.

Comments are welcome at To read Vivek Dehejia’s previous columns, go to

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