Photo: AFP
Photo: AFP

The monetary policy coordination chimera

Countries with weak domestic institutions and macro-prudential policy need to be more cautious about opening up to global capital flows

Assume an economist went into a coma in 2007 and just woke up today. (S)he would be baffled by the turn monetary policy has taken since the great financial crisis in advanced economies. Interest rates have gone negative, central banks have bought assets in unprecedented quantities (quantitative easing, or QE) and we may now even see Milton Friedman’s famous helicopters raining money.

There is a lively debate on whether these unconventional monetary policies have really done anything for growth and price stability—a debate I fear will never be settled for lack of a valid counterfactual. What is generally agreed upon though is that the impact on emerging markets has been less than agreeable.

Emerging markets have suffered economic disruptions due to volatile capital flows spurred by unconventional monetary policies in the West. According to the conventional narrative, when the US Federal Reserve embarked on QE, risk aversion and yields fell, prompting search for yield in emerging markets, and a subsequent depreciation of the dollar.

When the asset purchases were halted, the reverse happened. It was amid the resulting free fall of the rupee and capital flight from India in the autumn of 2013—including from the rest of the emerging market universe—that Raghuram Rajan took over as governor of the Reserve Bank of India (RBI).

Facing the dilemma that had become all too familiar to central banks in emerging markets since 2010, the RBI had to tighten its interest rates to defend the rupee despite a relatively weak domestic economy. These central banks had to prioritize defence against spillovers from unconventional monetary policies over purely domestic concerns.

Naturally, this prompted a pushback. Brazil’s finance minister at the time, Guido Mantega—whose ability to verbally defend the fledgling Brazilian economy was second only to Saddam Hussein’s information minister “Comical Ali" during the Second Gulf War—coined the term “currency wars". The idea was that the Federal Reserve’s policies were simply intended to make the dollar competitive at the cost of the rest of the world, hence a war.

It also reinvigorated the academic literature that focused on the impact of cross-border spillovers on monetary policy. It tried to find a solution in capital controls or macro-prudential tools. Another strand of thought in policy circles and academia has focused on the room for policy coordination to avoid a repeat of adverse spillovers. In Mint on Sunday, Vivek Dehejia recently came out for a new Bretton Woods-like system for global monetary coordination, where he bats for a fixed exchange rate system tied to a nominal anchor, or a new global currency. In March, Rajan and Prachi Mishra came out with a paper setting out an argument in favour of coordination and a framework to implement it (a shorter version can be read here).

Rajan and Mishra argue that in a world of unconventional monetary policies and spillovers, countries undertake policies that are collectively suboptimal. They suggest that countries should instead “agree to guidelines for responsible behaviour that would improve collective outcomes". Under their framework, policies that have a positive or domestic effect could be rated “green", ones that must be used temporarily with care could be rated “orange" and the ones to be avoided at times could be rated “red".

Now, monetary coordination has form. The gold standard in the first half of the 20th century, the Bretton Woods system after World War II, the Plaza-Louvre Accords in the 1980s and central bank liquidity swaps at the depth of the 2008-09 financial crisis are great examples of when major central bankers got together to coordinate policy.

But colour me sceptic, there is as much chance of Rajan’s proposal seeing the light of day as of India and Pakistan finding a satisfactory settlement to Kashmir in 2016. There are reasons why and when certain types of coordination works, or doesn’t work. The problem with the Rajan-Mishra proposal is fourfold: it is institutionally untenable, strategically naive, economically dodgy and infeasible as a way of conducting policy. Let us tackle each of these one by one.

Adherence to domestic goals is at the heart of the institutional independence central banks enjoy. If they don’t, there is no obvious reason why governments should or would grant them independence.

Despite its flaws, the current global monetary set-up is a result of greater democratization. The gold standard finally collapsed during the Great Depression because democracies could no longer tolerate the high unemployment that was a direct cost of pursuing tight money policies necessitated by the gold standard—in fact, these tight money policies contributed towards precipitating the depression in the first place.

Bretton Woods collapsed at the start of the 1970s when the Nixon administration could no longer fight the Vietnam War, provide jobs to its people and still maintain the dollar value of gold. In both these set-ups, countries were often forced to prioritize global financial stability at the cost of domestic growth. Democracy made their demise inevitable.

Central bank independence comes with great scrutiny. The Federal Reserve chair needs to regularly explain its decisions in a testimony before the US Congress—the perfect opportunity for some Congressmen to indulge in grandstanding. Wait till you get Donald Trump in the White House.

Across the pond, whenever the Bank of England (BoE) misses the inflation target, the BoE governor writes a public letter to the chancellor of the exchequer explaining why the bank has failed and what it is going to do about it. He is not going to simply write that he cannot pursue QE to help the “working families" in Britain because India or Brazil might suffer some spillover.

The problem with playing by subjectively arrived at international rules is that it puts the democratic legitimacy and policy independence of the central banks at risk. If after that some US politician taunts the central bank board by calling it a “star chamber" or a committee of “philosopher kings"—as senator Ted Cruz often does—he or she might just be right.

Secondly, it makes no strategic sense for a major central bank to voluntarily give up any kind of control over its decision-making. Thucydides, the Athenian historian and general, said that “[r]ight, as the world goes, is only in question between equals in power, while the strong do what they can and the weak suffer what they must".

Central banks in the US, Europe or Japan can create spillovers for emerging markets, but countries on the other end of the spectrum are not big enough or systemically important enough to create spillovers for the major economies. Then, why would the major central banks want to cooperate if the emerging world can’t hurt them? What is the cost of non-cooperation? Appeals to conscience may be more palatable, but only credible threats are effective.

Central banks will only ever consider spillovers if they hurt. As anyone keeping an eye on the recent speeches of Federal Reserve chair Janet Yellen would tell you, she suddenly started referring to global conditions to justify her dovish policy stance last winter.

This is because global economic and financial conditions that are affected by Fed policy, which in turn seem to adversely affect the US economy these days. The Federal Reserve has no reason to consider spillovers as long as there is no negative feedback into the American economy, as Dehejia has noted in another column.

Coordination over the past few decades has happened when it has served everyone’s interest to coordinate. In 1985, central banks of the US, West Germany, France, the UK and Japan coordinated interest rate changes, known as the Plaza Accord, when they all wanted the exchange rates to move in a certain way. Two years later, under the Louvre Accord, they all decided to coordinate interest rate cuts to stimulate the economy while maintaining exchange rate stability.

More recently, during the most financially stressful period of 2008-09, a large number of central banks benefited from liquidity swaps from the US central bank. Behind the Federal Reserve’s generosity was not altruism, but the stability of the global financial system and concern over the galloping value of the dollar.

In March this year, all the nonsense about a so-called Shanghai Accord (a supposed secret plan by G-7 to weaken the dollar to stabilize the markets) lapped up by conspiracy theory enthusiasts was a non-starter precisely because it was irrational for struggling economies to appreciate their currencies versus the dollar.

In fact, the US treasury just released a list of countries it has on watch for currency manipulation. So much for a secret accord. Convergence of interests is a necessary condition for coordination.

Interest rate policy is not a zero-sum game. So, if all countries coordinate a rate cut, as they did at Louvre, they can be stimulative for everyone. This option is not available when rates are near zero—negative rates notwithstanding, once interest rates go below a certain point, the idea that a few basis points above or below zero makes a difference is the narcissism of small differences.

Central banks then have little option apart from directly boosting asset prices via QE or depreciating their currencies. But exchange rate policy is a zero-sum game, where you are necessarily trying to grow at the cost of others—thus beggaring thy neighbour. And so, voluntary coordination simply does not pay.

But keep that aside and suppose that the central banks voluntarily decide to coordinate. Labelling policies such a QE dangerous makes little economic sense. Opponents of QE find the benefits to be marginal at best, but costs in terms of asset inflation and capital flows to be prohibitive.

However, there is a wealth of academic literature that suggests otherwise (too large and varied to list here). Assets purchases have played a crucial role, especially in Europe, in repairing the balance sheets of the commercial banks and thus led to “credit easing" in the economy.

Some point towards the lack of inflation as a failure of QE, but there is simply no credible counterfactual to suggest that the US or Europe would not have entered a deflationary spiral without it. It is also important to keep in mind the positive spillover to emerging markets from stability in the global financial centres.

The mechanics of spillovers are also more complex than commonly recognized. Change in risk appetite in response to policy changes in the US or Europe is the primary driver of cross-border flows and spillovers, not unconventional monetary policies per se. It is not obvious that risk appetite would not have reacted in the same way to a rate cut—had rates not reached zero already—as it did to QE.

That the global financial markets have recently been hanging on to every indication of future US interest rate path (QE was over in 2014) only underlines that this dichotomy between conventional and unconventional policy measures is false. And I would hasten to add that it is not like central banks have artificially lowered rates to below what free market forces would determine. In a country going through a deep prolonged slowdown, the so-called “Wicksellian" interest rate, or the natural interest rate of the economy, would be close to zero anyways.

Furthermore, the extent to which countries have suffered from spillovers is also a function of domestic imbalances. Emerging markets with high external debt, especially short-term foreign currency debt, wide current account deficits, loose fiscal policies and an inadequate macro-prudential set-up suffered much more than others. They had become dependent on global capital. Thus, a lot of the hand-wringing over spillovers from the advanced economies is simply a diversion from bad domestic policymaking.

Finally, the rule-based approach as suggested in the Rajan-Mishra paper ignores the way monetary policy is conducted. The paper suggests that, initially, a globally representative committee of eminent academics can be appointed to assess the spillovers and grade policies.

Thereafter, policymakers will be invited to defend the particular policies and persuade the international community whether a policy must be graded green or orange. Mind you, if labelled red, the policy is off the table.

In the 1980s, targeting money supply was in vogue, while after the 1990s, most countries started targeting inflation—now, we may go to nominal GDP targets. It is simply a response to learning by doing. Monetary policy works with long and variable lags, and it is difficult to gauge its impact, more so for unconventional measures.

When first announced in 2010, QE was supposed to unleash nothing short of hyperinflation of Weimar Republic proportions. In reality, the US Federal Reserve, the European Central Bank and the Bank of Japan have struggled to meet their inflation targets. Thus the idea that a committee of eminent economists can somehow ex-ante forecast the impact of UMPs accurately, grade them, and then perhaps prohibit them is a non-starter.

Heck, the profession is yet to decide on the meaning of money.

In the current political context in the Western world, where fiscal policy is missing in action, central banks are sometimes left to just take the “everything but the kitchen sink" approach to revive their economies. They are not going to sit on their hands waiting for a global certification authority to green-light their policy innovations.

Dehejia has a more traditional kind of coordination in mind—a Bretton Woods 2.0 with fixed exchange rates at its heart. The political and strategic difficulties with voluntary coordination as discussed above are valid here as well.

But even if we assume that advanced economies do come to the discussion table, fixed exchange rates pegged to dollar, gold or a basket of these is not at all desirable. As Maurice Obstfeld and Michael Klein and Jay Shambaugh have argued, flexible exchange rates provide much greater flexibility for conducting monetary policy.

The regime of open capital markets and fixed exchange rates as suggested by Dehejia, deals only with a part of the spillover, while completely surrendering monetary autonomy. Asset prices or capital markets will still continue to experience spillovers from capital flows.

Moreover, as economic performance in terms of prices and productivity between countries inevitably diverges overtime, countries also lose or gain competitiveness. Now, you can always go for corrective internal devaluation (austerity, deflation, wage reduction, etc.) but then they tend to be economically, politically and socially painful—think of Greece.

Of course, fixed exchange rates can be re-pegged at new levels. But devaluations are destabilizing and in most cases precipitated by crises often caused by a build-up of imbalances. This is precisely why Bretton Woods, or the gold standard before that, collapsed—something fixed exchange rate nostalgists forget. A floating exchange rate, while volatile, protects against the build-up of price and productivity divergences for very long periods.

This does leave us with the problem of what to do about spillovers? As mentioned above, the pain from spillovers is found to be strongly linked with bad domestic policies. So, perhaps countries with weak domestic institutions and inadequate macro-prudential policy set-ups need to be more cautious about opening up to global capital flows.

Even the International Monetary Fund has now got around to countenancing limited capital account controls. Why expose yourself to spillovers if your institutions are too weak to withstand them?

Ankit Mital is an economist and a lapsed academic. He is currently writing a book on the 1991 economic crisis and liberalization.

His Twitter handle is @Molto_Vivace_88

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