On Friday, 4 October, the Reserve Bank of India (RBI) will release its fourth monetary policy statement for the fiscal 2019-20. There is an expectation that the RBI will match the buzz created by the Government of India with its steep cut in the tax rate for corporate income. A case could be made for restraint by the RBI or for matching aggression with a cut in the interest rate.
But, that is not the point of this piece. This piece aims to show that the prowess of central banks is vastly exaggerated, and that the world of central banking as we have come to know in the last four decades is probably in its final throes.
In India, the governor of RBI reports to the finance minister. The Government of India is the majority owner of banks that the RBI regulates. That alone is sufficient to argue that its powers of influence, both as a regulator and as a monetary policymaker, are limited. Not content with that, the government also sets interest rates on small savings schemes—directly creating competition for the banks it owns and impeding the effectiveness of the monetary policy decisions that the RBI takes.
To complicate matters further, the balance sheets of most Indian corporate borrowers are still fragile. They have high debt-equity ratios, and their debt service ratios have not come down meaningfully for them to ramp up borrowing. As a result, even if the central bank keeps lowering rates, it is resulting in higher borrowing on the part of Indian households.
According to data from the RBI, in the last four years, the annual compounded growth rate of credit card outstanding in India has been nearly 30%. Indian household debt, according to data from the Bank of International Settlements (BIS), has grown at a much faster rate than nominal gross domestic product (GDP) in the last ten years. While falling income has caused a decline in the household savings rate in India, households have sought to maintain their consumption pattern by resorting to higher borrowing than before.
The bigger picture
Central bank monetary policy decisions need a very specific set of circumstances to be of benefit to the economy in intended ways. Without that, their monetary policy decisions will have unintended and usually undesirable consequences. That is what has been happening in the West, especially post 2008.
After the crisis of 2008 struck the US and many other developed nations, central banks took unprecedented policy actions. Central banks dropped their overnight lending rates to zero in many countries, including in the US. Budget deficits of governments widened too, but they were quickly pared back.
A widely used book, Macroeconomics by Stanley Fischer, Rudiger Dornbusch and Richard Startz, shows that monetary policy stimulus is a win-win—it boosts aggregate demand and lowers interest rates, whereas fiscal policy stimulus is shown as win-lose in that it boosts aggregate demand but leads to higher interest rates.
Hence, governments in many developed countries pared back their deficits and let monetary policy guide economic activity. The underlying fear was that if long-term interest rates rose sharply due to higher government borrowing, it would impair asset prices—of bonds, property and stocks. That would hurt the economic recovery and much-needed repair of balance sheets of lenders (mainly banks).
The impression that has been created (and it has stuck) is central banks had reluctantly taken on the mantle of the saviours and guardians of economic activity in their country and globally too. That is only the partial truth, if at all. They have sought and have wielded the unelected power that came with the mandate of driving the global economic recovery post 2008.
Paul Tucker, in his book, Unelected Power, notes, “We need to be confident that central bank leaders and their staff take seriously every one of their various functions rather than prioritizing the area that is most salient with the public and politicians or that gives them the greatest personal reward in terms of professional prestige. If that risk were to crystallize, the incentives of ambitious staffers would be to get into the sexiest area...That is, plausibly, what happened at some central banks in the run up to the 2007–08 crisis, with monetary policy prioritized over regulatory responsibilities."
Actually, such behaviour continued gathering strength after the 2008 crisis. In other words, central bankers have voluntarily sought and accepted the mantle of being the only game in town, as Tucker wrote elsewhere. That is evident in the fact that they are doubling down on their failed strategies.
No lessons learnt
Post 2008, the immediate liquidity infusion, currency swap arrangements for beleaguered central banks, and a drastic cut in interest rates helped rescue the world from the potentially debilitating consequences of the crisis. But these policies vastly overstayed their welcome. Central banks kept extending and reinforcing them with additional measures despite scant evidence that they were helping the real economy.
Unemployment began to decline meaningfully in the US only five years after the crisis of 2008. In fact, despite the most unprecedented and unconventional of monetary policy actions, the American economic expansion since June 2009 has been the weakest since post-World War II. On another front, in Europe, in 2012, Mario Draghi of the European Central Bank (ECB) said he would do whatever it took to save the euro. According to conventional wisdom, he succeeded in keeping the euro intact. But, historical judgements cannot be based on journalists’ or analysts’ limited horizons.
The side effects and after-effects of unconventional monetary policy post 2008 have been several, and they vastly overshadow the feeble economic recovery. They include income inequality and wealth concentration in many countries; asset bubbles in stock markets; an unsustainable boom in private equity and valuations of technology startups with no sign of profitability over any horizon. The impact extends to companies doing balance sheet engineering through issue of debt and buying back of shares to boost earnings per share; the rise of market concentration in several industries; record rise in corporate indebtedness especially among already highly leveraged firms and so on.
This list only covers economic and financial consequences. The political and social consequences have only partially unfolded and there is a lot more to come. From the rise of populism-nationalism on the Right to the potential return to dominance of failed redistribution policies on the Left, unconventional monetary policy can claim authorship of many momentous and destabilizing developments in the young 21st century. But critics and commentators, barring a few exceptions, have rarely faulted central bankers or demanded that they introspect on the failures of their policies to achieve the intended goals, and the success of their policies in parenting many unintended goals.
The inherent dangers
Interestingly (or, disturbingly), Graeme Wheeler, former governor of the Reserve Bank of New Zealand, had confessed to the inability of monetary policy to effect changes to real economy outcomes. In a speech delivered in October 2015, he had noted that monetary policy was relatively powerless to influence the decisions that determined long-run economic performance and distributional outcomes. Even in the shorter term, monetary policy’s influence might be low in an environment where debt levels are high, and where there is considerable uncertainty about economic prospects.
To be sure, monetary policy could influence risk-taking in asset markets, but this did not necessarily translate into risk taking in long-term real assets.
Whether it is ignorance, hubris or negligence or a combination of all three that prevents central bankers from seeing all these is hard to know from the outside. But, one former cheerleader has seen the light or at least gives the impression of having seen it. Larry Summers, former treasury secretary during the Clinton Presidency, recently admitted in an article co-written with his PhD student that there were strong reasons to believe that the capacity of lower interest rates to stimulate the economy had been attenuated or even gone into reverse, and that interest rate reductions beyond a certain point might constrain rather than increase demand.
Then, the authors go on to list some of the unintended and undesirable side effects—both macro and micro—of interest rates that are too low for too long, concluding that reducing interest rates might not only be merely insufficient but also actually be counterproductive, in an environment of “secular stagnation". Interestingly enough, as recently as in June 2019, Larry Summers had egged on the Federal Reserve to cut interest rates rapidly.
Alas, these stray instances of confessions of central bankers and intellectual redemptions have not, evidently, disturbed the conscience of central bankers, in general. They have continued to extend their experiments even more into uncharted territory such as negative rates, such as accepting private sector bonds with negative rates as collateral, etc., as the ECB has announced in its most recent monetary policy meeting in the first week of September.
Hence, it is no surprise that the ECB meeting and its decisions featured bitter divisions and doubts among the participants. Clearly, central bankers want to be the only game in town, notwithstanding protestations to the contrary. A benign explanation for their (misguided) policy activism is their mistaken interpretation of secular stagnation.
The concept of secular stagnation is widely misunderstood. In the West, it is seen as deficient aggregate demand that is persistent. In other words, actual economic growth has trailed potential economic growth for a long time, and hence, the output gap (actual economic growth minus potential economic growth) is negative. That is borne out by the fact that the inflation rate has been consistently tame, notwithstanding valiant efforts by central banks to lift it.
The problem with this formulation in advanced nations is that this calls for non-stop policy activism either of the fiscal variety or of the monetary variety.
Instead, if secular stagnation is seen as stagnation or decline in potential growth itself, then there is no negative output gap to be addressed with policy stimulus. Then, how does one explain persistently low inflation? It is easily explained by a model in which the inflation rate is a function of the pricing power of labour and that has been emaciated by political and economic changes since the advent of the (Ronald) Reagan-(Margaret) Thatcher era in the 1980s. Labour pricing power is not about to return anytime soon.
In the final analysis, as Bob Rodriguez, an experienced fund manager, said in a recent interview, “The critical lesson to learn is that you cannot dig your way out of a deepening hole of debt by taking on a growing level of debt. There is no free lunch, but central banks have effectively taught that there can be a free lunch with debt and deficits until the payment comes due. An age-old solution will likely be repudiation via inflation rather than a formal default in several cases." Perhaps, he will be right as things appear to be headed in that direction.
The response of central bankers to criticisms of the ineffectiveness of their policies is to co-opt fiscal policy in the service of monetary policy or vice versa. In other words, the new magic wand is fiscal stimulus powered directly by monetary stimulus. It is an old trick in the book that has failed to deliver the goods except inflation and yet it is called Modern Monetary Theory.
This may not achieve economic nirvana but it might end up achieving these things: return of inflation, return of labour pricing power and a swing in the balance of power between capital and labour towards the latter. Of course, there will be a realignment of the international monetary system that would inevitably follow a bout of sustained and sharply higher inflation and the return of central bankers to their limited and asymmetric role of inflation slayers rather than inflation generators.
That would be a fitting finale to a decade of failed and discredited monetary policy experiments.
V. Anantha Nageswaran is the dean of IFMR Graduate School of Business, Krea University. These are his personal views.