The downside risk of quantitative easing is emerging asset bubbles

The downside risk of quantitative easing is emerging asset bubbles

New Delhi: As chief economic advisor, Kaushik Basu has a bird’s eye view of the Indian economy and is at the same time a key member of the A team of finance minister Pranab Mukherjee. Given his vantage position, the viewpoint of the chief economic advisor is always critical, more so now than ever when the global economy is going through a turbulent phase. Basu took some time off to speak to Mint, just ahead of a key G20 meeting in Seoul, to provide an overview of how India perceives global economic trends. Articulating his thoughts on the latest round of monetary quantitative easing, he proposed a radically different long-term fix for the global economy, held out hope that the persistent domestic inflation would ease and painted a positive economic outlook ahead of next year’s Budget. Edited excerpts:

What do you think is the outlook for the global economy?

The outlook is best described as mixed; it changes from week-to-week, month-to-month. European unemployment has deteriorated slightly, while US unemployment has held steady at a high of 9.6% for three months. So the expectations on the global front continue to be uncertain. The somewhat risky move that the US has made with the second round of quantitative easing—something that is akin to printing money—is a gamble. It is not all negative, as some make it out to be. But it is a risky move, given the changed structure of the world economy.

The relatively benign interpretation of what is happening in the world is that this is a temporary earthquake caused by the tectonic shift of economic power that is occurring beneath the surface of the world economy, marking the rise of emerging economies like India, China and Brazil. If this is indeed the case, the economic turbulence will subside and we will stabilize with an altered geography—a new mountain here and a new valley there, as happens after major earthquakes.

Two things: One, you mentioned a structural shift. Is there such a trend underway? Second, is this why conventional tools of fiscal/monetary policy are rendered relatively less effective?

I think so. But a structural shift in the case of an economy does not mean a sudden move. Small changes occurring over time reach a critical point where it suddenly precipitates a crisis, and we have to scramble to understand the new world that has emerged and craft new policies for it. To understand one such structural shift, let us go back a bit in time. Years ago it was realized that it is not viable to have a single country with multiple central banks, each with the right to issue currency, because that would lead to competitive currency wars by the multiple central banks. So, in England, starting with the creation Bank of England in 1694, and supplementary policy moves in the eighteenth and even nineteenth century, the central bank was granted an effective monopoly to issue new currency. But what is happening is that, as barriers to trade and capital flows go down, the world is becoming a single economy. But this new world has many central banks—one for each country. There should be no surprise that we are beginning to see currency wars. This is not the fault of any particular nation but the predicament of an altered world.

So how does the US move to ease quantitative restrictions play out within this new structure?

The quantitative easing by the US taking place right now would, in the older global economic structure, generate greater demand for goods in the US, create new jobs and create upward inflationary pressures in the economy. What’s happening with American quantitative easing now is that it is not creating enough demand increases and new jobs in the US economy because a part of the easy money is leaking out to other nations. In today’s world, one country’s creation of money—especially if that is a convertible one like the dollar—leaks out into other economies, something that would not have been happening earlier. So the US quantitative easing can cause inflationary pressures in China, Argentina, Turkey and India. Likewise, the recent actions by the Bank of Japan and several other nations to depreciate their currency by buying up foreign money is in part spilling over to other nations. Much more than a matter for finger pointing, this is a matter for understanding, so that we know what we can collectively do.

So is this why conventional fiscal/monetary policy is not having the desired effect?

One thing that is clear is that monetary and fiscal policies—especially the former—are not having the kind of effect that they once had. The cause may be disputed, the fact is not. I am offering a particular hypothesis about how the world economy is coming together, but having too many authorities with currency issuing rights is the source of the problem.

Is there another way to address the problem than descending into a currency war?

Let us first understand the situation. The currency war does not mean all nations are doing the same thing. And often it is not the case that nations want to harm others but they are trying to protect their own interest in an altered world. Japan buys up dollars and releases yen to boost exports, China has in the past held its currency pegged to the dollar. When India intervenes—it hasn’t done so for a while now—it does it through market operations like the Japanese one. Even though the ostensible reason for America’s quantitative easing is to lower the long run interest rate by generating more money, it does tend to lower the value of its currency. The collective impact of these varied actions is a competitive lowering of exchange rates. To manage this will require economics and politics. It is as much a matter for Ben Bernanke as for President (Barack) Obama.

This is happening because of structural change in the world. There is no way of getting away from the fact that we have some common rules of engagement for all central banks, keeping in mind that each central bank’s monetary policy has externalities of a kind that were not there earlier. Other countries have a legitimate interest in your central bank’s operation; there is no escape from this fact. The right forum for this is G20. The G20 has at times felt a bit neglected after the financial crisis abated and some questioned the rationale for its continued existence. What I am saying is that it has a great chance to do some novel thinking now, which can have a long run impact on the world we live in.

Is India looking to articulate this view at the G20?

India can play a leadership role. At one level, India is not directly involved in the currency war, it is simply caught in the crossfire. This gives India a kind of neutrality in the world. The Reserve Bank of India is globally respected—as it has played by the rules of the global economy very well. This gives India some respect and we of course have the intellectual resources as much as any nation. So, despite the fact that we are not among the most powerful economies in the G20—in per capita income terms we are the poorest—we have the stature to play a leadership role in this.

Are you suggesting that the world move to one single currency like say the European Union?

The one-currency world is where, I believe, we will have to ultimately move to. But that is not happening now. The British economist Stanley Jevons suggested this 125 years or so ago. It was premature then and is premature now. Till that happens, we have to move to some form of coordination and cooperation among the various systemically important central banks.

But isn’t that already happening; meaning most global trade is in a major currency such as the dollar?

At a certain level yes and that is why we are not in even bigger trouble. But, even an oligopoly of currency issuing authorities may not be tenable in the long run. After all, it was decided that in each country you cannot have two authorities issuing money; the central bank has to be a monopoly. The world is not a single economy yet, but is heading towards that. And so we can continue for now with the occasional eruptions that we are facing. In the very long run, and this is my research economist’s view, it is not viable to have multiple currencies. But don’t worry, none of this is going to happen next week.

Are there asset bubble risks that could emerge after the latest round of quantitative easing?

The downside risk of quantitative easing is asset bubbles. What happens usually when you undertake such quantitative easing is that money goes in search of equity because interest rates get lowered and hence money gets parked in equity, property and other such assets. So pressure begins to build up there and bubbles begin to form. The plus side of QE2 is the impact on long-term employment. The main problem in the US is not high unemployment but the alarming rise in the proportion of the unemployed that has been unemployed for a long time. When this happens, there is de-skilling of labour that begins to occur, and this can have an impact on the long-run productivity of workers and do serious damage to long-term growth prospects. So the US Fed is making a move to create greater demand in the economy that will presumably quickly re-employ the unemployed. This is what the US is gambled on but there is no getting away—it is a gamble.

Some countries have responded by putting in place capital controls like say South Korea. India still hasn’t. Is it that each country is tailoring its own response?

When a couple of countries ease their currencies and the money begins to flow into emerging economies, there are a couple of options: First, you join the fray by doing similar quantitative easing. Unfortunately, India can’t afford this as it is already under inflationary pressure. The situation is very similar in most emerging nations: China’s inflation has risen sharply in recent times; Argentina’s inflation rate has crossed India’s. Second, some countries are resorting to capital controls. India already has a set of capital controls in place and hence we have not yet put in further capital controls. At some point, if this $75 billion a month of quantitative easing continues and a large part finds its way to India, we will have to look at the range of policy options open to us. My instinct is to go with market-friendly measures, (such as) the one India has used historically by buying up dollars and releasing rupees, but all options must be on the table.

Where is the tipping point?

The trouble with tipping points is that you know when they are there but not quite where. So you have to use scattershot when you try to get them. But as always with scattershot there is the risk of collateral damage. In terms of FII (foreign institutional investor) inflows, in the first six months of the current fiscal, we have had more than what we have got ever before, including in 2008. Once upon a time, that would have been large enough to causes bubbles and warrant intervention. But India is now a more robust economy, and, despite the downturn of the last two years, we are fundamentally stronger; it is not destabilizing us to the extent that it would have done three-four years ago.

Coming to the domestic economy, why is inflation not coming down?

There are two things on inflation that need to be clarified. Overall actual prices are not rising much any more. With the new index, we know that prices were rising till February. So the base effect should wear off by February. So unless there are external shocks, inflation will taper off by the end of the fiscal year. Second, it is no longer in the power of an individual government and central bank to control inflation in the way that was possible earlier. Some of the easy money policy being pursued elsewhere is probably causing some inflationary pressure here. One indicator of that is that till four-five months ago, India was the global leader in inflation, but emerging countries are now catching up and some have crossed over. India got out of recession before other countries; it now appears we got into inflation before other countries.

Given the volatility in the macro-economic outlook, your inputs ahead of the next Union Budget are going to be critical. What is your forecast?

There are different divisions in the finance ministry working on different aspects of this. My group, the economic division, is just beginning to do its projections and hence I do not have anything to share with you at the moment. Inflation is very hard to predict, but we have to make some projections, as the fiscal calculations are based on it. We are continuing to work with an inflation forecast of 6% by March 2011. As for growth this year, we are holding on to our earlier forecast of 8.5%, despite the fact that second-quarter growth this year may not be so good. On fiscal matters again we have changing scenarios—you have 3G (spectrum auctions) and revenues are buoyant; but there are new demands for expenditure as well. But I expect we would be able to meet the target fiscal deficit of 5.5%.