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Business News/ Opinion / An agenda for G-20 leaders
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An agenda for G-20 leaders

The West and the rest should adopt a monetary policy regime that assigns neither disproportionate rights nor responsibilities to any one nation

A file photo of the US Federal Reserve. Photo: AFPPremium
A file photo of the US Federal Reserve. Photo: AFP

An article in the Financial Times caught my attention because it said that the famous trilemma of monetary policy—that you can achieve only two out of three objectives—has been reduced to a dilemma. The three are: independent monetary policy, free capital flows and fixed exchange rate.

At the Jackson Hole Symposium (the annual conference of the Federal Reserve Bank of Kansas City) in August, Hélène Rey, a young professor at the London Business School, told the audience of global central bankers that, for all practical purposes, central banks in developing countries have only two choices: either retain control over your capital flows or let the Federal Reserve run your monetary policy. In other words, it does not matter if the country has a floating exchange rate regime or a fixed exchange rate regime.

Considerable computational work lies behind her conclusion. She shows that domestic asset prices, credit growth, bank lending, etc., are correlated with the global financial cycle which is proxied by VIX. To put it rather simply, VIX is the index of (implied) volatility of the Standard and Poor 500 stock index. The correlations are in the range of 30-40%. According to her, “low values of the VIX, in particular for long periods of time, are associated with a build-up of the global financial cycle: more capital inflows and outflows, more credit creation, more leverage and higher asset price inflation." However, in regressions with stock market returns, bank leverage and house price inflation as dependent variables, VIX does a reasonable job of explaining stock market returns only (R2=25%).

Then, with complex econometrics (recursive Vector Auto Regression—get it?), she shows that the federal funds target rate (policy rate set by the US Federal Reserve board) influences the global financial cycle, proxied by VIX. VIX, in turn, influences the global capital flows, bank leverage and domestic credit, etc. The influences have the right sign.

Her paper highlights an important issue that developing nations are grappling with. It is the spillover effect of developed countries’ policies on developing nations. Raghuram Rajan, the incoming Reserve Bank of India governor, dealt with it at length in his Sir Andrew Crockett Memorial Lecture in July. At Jackson Hole, Federal Reserve officials said that they were only statutorily obliged to meet their full employment and price stability targets for the American economy. That is unconvincing.

A country that issues the global reserve currency has global obligations because it benefits from the global seigniorage—the difference between the value of money and the cost of producing it. It borrows in its own currency globally at much lower interest rates than if it were purely a domestic economy with a central bank focused on domestic economic goals. Of course, op-eds in Indian newspapers are not going to make the chairman of the Federal Reserve board issue a mea culpa to the developing world.

Developing countries, on their part, can ask themselves as to how far they actually deployed the tools at their disposal before they threw up their hands in helplessness at the flagrant money printing in the West. For example, the question is whether developing countries had really floated their exchange rates. They have always intervened to slow the currency appreciation and when they did, they had not fully sterilized the domestic liquidity effects of their intervention. Capital inflows seduce policymakers and elites with their (temporary but big) positive effects on asset prices and, hence, the wealth of the high and mighty. That is why counter-cyclical policies are easy to preach but hard to observe in all economies—in the West or in the East. But, at some time, we have to learn to tame the beast.

She points out that developing countries too should not blame the monetary policies of the West for capital flows and resultant dislocation in their currency and asset markets when, in the same breath, they want the West to start growing again so that they can export goods and services to them. It is a fair point but falls apart in the face of mounting evidence produced by researchers in the Federal Reserve banks that money printing has not had any meaningful impact on economic growth. So, its internal and external costs far outweigh benefits. Yet, the West insists on pursuing these policies doggedly. Therefore, it is fair to ask if these policies were for the benefit of Western financial institutions or if the West was pursuing stealth inflation.

The only answer to this asymmetric nature of the relationship between the West and the rest is to have a global monetary policy regime that assigns neither disproportionate rights nor responsibilities to any one nation. The gold standard was symmetric in imposing obligations on all member countries. No country had a special status or role to play. Hence, G-20 owes it to itself to resurrect the debate on the merits of gold standard or any alternative that captures its symmetry.

V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk-

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Published: 02 Sep 2013, 06:16 PM IST
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