Capital flows and the Raghuram Rajan hypothesis
11 min read 01 Oct 2016, 11:23 PM ISTRajan opened up new frontiers of academic inquiry with his theory on the challenges of monetary policy in an emerging economy after the 2008 crisis
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Several commentators have rightly extolled the role that former Reserve Bank of India (RBI) governor Raghuram Rajan played in establishing the new inflation-targeting monetary policy regime. But amid the encomia, it was perhaps forgotten that Rajan’s contribution was as much intellectual as it was institutional. In particular, in theorizing about the challenges of conducting monetary policy in an emerging economy such as India in a post-crisis global economy, he opened up new frontiers of academic inquiry.
Without doubt, Rajan’s most important intellectual contribution to debates around the economics of monetary policy during his tenure as RBI chief was his articulation of concerns that aggressive unconventional monetary policies (UMPs) by advanced economy central banks were having a deleterious impact on emerging economies such as India. These UMPs include large-scale asset purchases (commonly known as quantitative easing), forward guidance and setting the policy interest rate at or near the zero lower bound. I have written on this at length even earlier.
In a nutshell, Rajan’s argument is that excessive monetary loosening in advanced economies via UMPs functions as a contemporary form of “beggar thy neighbour" competitive devaluation, inducing capital in search of yields to flow into emerging economies and thereby causing an appreciation of their exchange rates. This, in turn, and other things being equal, reduces their competitiveness vis-a-vis advanced economies.
In a celebrated speech given in April 2014 at the Brookings Institution, a Washington D.C. think tank, Rajan dubbed such advanced economy monetary policies as “competitive monetary easing". In the parlance of international macroeconomics, his claim is that such advanced economy monetary policies lead to negative “spillovers", which are harmful to emerging economies such as India. Let us call this the “Rajan hypothesis".
As enticing and persuasive as the Rajan hypothesis appears to be, an important unfinished task for researchers is (1) to check whether it makes sense in the context of orthodox macroeconomic theory and (2) then to check whether the data backs his claims. It turns out that task (2) is very tricky to do as, given the complexity of inflation and exchange rate determination, it is difficult or nearly impossible to validate empirically the claim that action X by advanced economy central bank Y caused impact A on emerging economy central bank B. Task (1) is more tractable, as it involves determining, at a minimum, the logical consistency of the Rajan hypothesis with the current consensus models in macroeconomics.
As it happens, a flurry of recent research papers allow us to get a handle on whether the Rajan hypothesis is consistent with the state of the art in contemporary macroeconomic science which, as noted, is an important first step towards empirical validation or refutation. A good starting point into this recent body of work is a research paper, by economists Sushant Acharya of the Federal Reserve Bank of New York and Julien Bengui of Université de Montréal, presented at a June 2015 International Monetary Fund (IMF) conference. The paper itself, updated in March, is available here.
Interestingly, the motivation for the Acharya-Bengui paper’s conference presentation is the following quote from a 2010 interview given by Rajan to German news magazine Der Spiegel: “The industrial economies are using ultra-loose monetary policy, while the emerging markets are using currency intervention and capital controls. (...) The tools they are using will create distortions—both ultra-loose monetary policy and intervention risk creating excess liquidity and asset price bubbles. If capital is too cheap, we will tend to use it too much. If the exchange rate is too low, we will focus on producing for exports. And if tempers boil over, we could get ugly protectionism".
What is striking is that in this interview, given when Rajan was at the University of Chicago’s Booth School of Business and thus in between official posts, he is critical equally of the policies of advanced economy and emerging economy policymakers and central banks. As he says specifically, the former are using loose monetary policy, while the latter are resorting to currency market intervention and capital controls.
His point here is that policies by both sets of actors induce distortions in the global monetary and financial system, even though the trigger may be actions taken by advanced economies, with emerging economy in reaction mode. These distortions, in particular, are excessive liquidity and associated asset price bubbles. This is, thus, a fuller and more balanced statement of the pathologies Rajan identified in his much more well-known 2014 speech.
Not surprisingly, perhaps, after Rajan took the helm as RBI governor in 2013, the focus in his speeches, including the 2014 speech, shifted towards the failings of advanced economy central banks rather than the failings of emerging economy responses. It will be interesting to see whether, now that he is back at the University of Chicago and no longer wearing an official hat, his commentary on problems in the global monetary system will return to his earlier line of argumentation critical of both advanced and emerging economy policies.
This would be salutary, as the phenomenon that Rajan has so importantly highlighted involves actions by both advanced economy and emerging economy central bankers. Thus, in the aftermath of the global financial crisis and an extended period of deficient aggregate demand, advanced economy central banks engaged in UMPs which drove policy interest rates close to or at the zero lower bound. In response, capital flowed into emerging economies, threatening a sharp appreciation in their exchange rates and an associated loss in export competitiveness.
In response, emerging economy central banks, to mitigate or dampen these effects, pursued a number of policy responses, such as intervening directly in foreign exchange markets to soak up some of the excess foreign exchange in the hope of attenuating currency appreciation. They also explicitly imposed regulations to curb the flows of hot money coming in, representing a form of capital control. In India, in particular, such policies were used after the 2013 “taper talk" crisis which occurred the summer before Rajan assumed office as RBI governor (for further details and analysis, see here).
Thus, the policy-relevant questions are,
1. Was it appropriate for advanced economies to use UMPs in the wake of the global financial crisis?
2. Did emerging economies react correctly by resorting to currency market intervention and capital controls?
As it happens, the second question relates to another unsettled debate in international macroeconomics, as to whether capital controls have any place in a world of flexible exchange rates and inflation-targeting central banks. This, in turn, relates to the so-called “impossible trinity" or “trilemma" attributed to the Nobel-winning economist, Robert Mundell.
The Acharya-Bengui paper studies these questions by deploying a variation of a canonical macroeconomic model in the New Keynesian tradition. These new breed of models marry the assumption of rational, forward-looking actors from neoclassical theory with the assumption of nominal price rigidities, in line with the ideas of John Maynard Keynes and his disciples.
The paper’s first main finding is that, when faced with a large, negative aggregate demand shock, in a world in which the zero lower bound is a binding constraint (in other words, nominal interest rates cannot be driven below zero), it is optimal for advanced economies to keep interest rates at the zero lower bound for a prolonged period. This has the effect of minimizing the initial output drop and thus making the recession caused by the negative shock less severe.
At least within the limited context of the model, therefore, the answer to question (1) above is, yes, it is appropriate for advanced economies to drive interest rates to zero in the face of a large negative shock.
It follows that, in response to the advanced economies hitting the zero lower bound while there are still positive interest rates in the emerging economies, capital will flow from the former to the latter. This is beneficial for advanced economies as it reallocates spending power to the emerging economies, who will spend at least part of their extra income on purchasing goods from the advanced economies. This has the effect of cushioning the recession in the advanced economies.
The paper’s second main finding is that a regime of free capital mobility actually leads to an inefficiently low (from the perspective of world welfare) level of capital flows from the advanced to the emerging economies in a situation in which the former are stuck in a recession and at the zero lower bound. In other words, aggregate global welfare would be enhanced if capital flows from advanced economies to emerging economies were actually enhanced compared with what would prevail in a world of laissez-faire free capital mobility.
(Without getting into too much technical detail, the reason is that, under laissez faire, no account is taken by policymakers that capital flows in this context lead to a boost in aggregate demand in the advanced economies, which amounts to an externality. A fictitious global central planner would “internalize" this externality.)
The third main finding is that if, instead, we look at what would be individually optimal for policymakers in the advanced and emerging economies, rather than consider global welfare, it turns out that, as intuition suggests, the former would like to subsidize outward capital flows while the latter would like to tax them. In other words, advanced economies would like to help speed up capital on its way out the door while emerging economies would like to slam the door on excessive capital flowing in.
The mechanism here is that capital flows affect the terms of trade, so policymakers in each region are attempting to turn the terms of trade in their favour. In the aggregate, with policymakers in the two regions pushing in opposite directions, the end result is not that different from the laissez-faire situation of free capital mobility.
Taken together, these results provide support for the spirit of the Rajan hypothesis, but with a twist. It is true that in a non-cooperative world, in which advanced and emerging economy policymakers act independently, there is indeed an incentive for policymakers to exploit the terms of trade advantage to be gained by manipulating capital flows. But the crux is that both are playing this game—not just policymakers in the advanced economies.
Thus, on the flip side of Rajan’s “competitive monetary easing" in the advanced economies, there is what one might term “competitive monetary tightening" in the emerging economies. This is, indeed, closer to the spirit of the 2010 pre-RBI quotation from Rajan than from his more recent utterances.
The authors’ conclusion is that the discrepancy between what is globally optimal and what is individually optimal for the advanced economies and the emerging economies suggests a case for global policy coordination—of monetary and financial market policy, in general, and of capital flow management, in particular, in the context of their model. They do not, however, spell out the nature of such coordination (or cooperation, more broadly), nor do they suggest an institutional mechanism which would make coordination binding or at the very least credible.
(In other words, there must be some mechanism which constrains each party to keep its side of the bargain, or alternatively to strike a bargain so that each side has a built-in incentive to play by the rules.)
This brings us to the main lacuna in Rajan’s argument. As I argued in a recent Mint column: “It is one thing to decry the absence of a system and to point out the failings of the current non-system, and it is quite another to propose a realistic alternative. The outgoing governor of the Reserve Bank of India, Raghuram Rajan, has excelled at the former but not the latter".
Indeed, as I noted, Harvard economics professor Richard Cooper has described Rajan’s complaints against advanced economy policymakers as amounting to little more than “grumbling" in the absence of a better alternative. This brings us to the crux of the problem, the absence of a global monetary order following the collapse of the Bretton Woods system in 1971, an argument made by Mundell, among others.
In a world of flexible exchange rates in which every central bank sets its own monetary policy, one is bound to get repeated episodes of beggar thy neighbour approaches such as we have witnessed in recent years. The problem is exacerbated by the fact that the US dollar, even post-Bretton Woods, remains the de facto global reserve currency, even though the US Federal Reserve, correctly, is mandated only to be concerned about the US national economic interest and not internalize the impacts of any spillovers it creates for other economies.
This is a vast topic deserving separate treatment, but one interesting proposal for a new global monetary order suggests that we start by phasing out the dollar as a reserve currency and replacing it with a modified version of IMF’s Special Drawing Rights. This proposal has been championed by former IMF economist Warren Coats. See, for instance, a 2015 research paper, Why the World needs a Reserve Asset with a Hard Anchor, by Coats, Dongsheng Di and Yuxuan Zhao.
In sum, the problems with the current global non-system that Rajan has aptly identified and brought attention to are very real. The much more difficult task ahead of us is to reform this non-system and create a new global monetary system which is of benefit to advanced and emerging economies alike.
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