Normative Narratives


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Economic Outlook: Quantitative Easing, Monetary Policy Coordination, and the IMF

I was going to write a  conflict watch about the chemical gas attack in Syria, but as different actors are aligning with their interest and using mostly circumstantial evidence (Russia / Assad Regime: rebels did it, why would we launch chem weapons while U.N inspectors here?; Opposition / Western governments: Assad did it, emboldened by lack of international intervention after previous chem attacks, Assad subsequently shelled area so time would pass, now UN inspectors cannot get reliable results), I will refrain from speculating on these troubling events until more information emerges.

Continuing the narrative that has come to the forefront since G-20 finance talks in Moscow and the focus surrounding extra-territorial consequences of loose monetary policy at the Fed’s annual Jackson Hole meeting, policy coordination between central banks and new policy responses by IMF are needed to ensure as smooth as possible a transition from Q.E. to Fed monetary policy tightening (exactly when this will occur is uncertain, I am of the mind that it will be later rather than sooner).

Original articles:

Reuters:

Central banks should coordinate to avoid unwanted side effects as they exit from ultra-easy monetary policies that have left the world awash in cheap money, top policymakers were told on Saturday.

“The main challenge will be to manage the consequences of monetary policies, and their evolutions, on cross-border liquidity movements,” Jean-Pierre Landau concluded in a paper he presented to an audience that included top central bankers from advanced as well as emerging market economies.

The Fed’s bond buying, or so-called quantitative easing, has been at the heart of its aggressive efforts to revive U.S. economic growth after it cut interest rates to nearly zero in 2008. Interest rates in Europe and Japan are also ultra-low.

However, the purchases have spurred massive capital inflows into faster growing emerging economies, which are now suffering as investors anticipate an end to the easy money.

But he lamented that the necessary coordination on monetary policy was unlikely, and warned of the potential for the “fragmentation” of global capital markets.

Stocks and currencies plunged in India, IndonesiaBrazil and Turkey this week as investors fretted over a looming reduction in the U.S. Federal Reserve’s monthly bond purchases.

Landau acknowledged that central bankers dislike the idea of coordinating monetary policy because their job is to focus on domestic goals. But they worked well together during the 2007-2009 financial crisis, when the Fed, European Central Bank, Bank of Japan and other central banks coordinated rate cuts and currency swap lines.

As cross-border liquidity pressures build, they will find it productive to do so again, although cooperation is more likely through regulatory and financial structures aimed at preventing excessive leverage or harmful asset bubbles, he said.

In an ideal world, the cooperation would extend to monetary policy because policies in major economies such as the United States can have an international impact that amplifies their magnitude with domestic implications, Landau argued.

“The system itself is producing more accommodative monetary conditions than warranted by the situation,” he said. “In a reverse environment, when monetary policies need tightening, the effects could be symmetrical and complicate the exit from non-conventional measures.”

In addition, much could be gained through an international “lender of last resort,” which would remove the motive for some nations to maintain massive foreign exchange reserves, he added.

“All countries have a common interest in finding ways to disconnect reserve accumulation from exchange-rate management,” Landau said. “The need for national reserves could be reduced if credible mechanisms exist to provide for the supply of official liquidity on a multilateral basis.”

Economix:

The stimulus campaigns of the Federal Reserve and the central banks of Europe and Japan, by depressing domestic interest rates, have helped to push trillions of dollars into developing markets in recent years.

The question of what central banks are supposed to do about it dominated the formal agenda here at the Kansas City Fed’s annual monetary policy conference.

The answers were surprisingly mellow. The rest of the world would like the Fed to explain its plans clearly, and then to travel slowly. Bankers from developing nations said they might need to impose some restrictions on the outflow of capital, but expressed little concern over the potential for serious economic disruptions.

Christine Lagarde, the managing director of the International Monetary Fund, struck the same sanguine tone in a Friday speech, declaring that “Central banks handled entry well, and we see no reason why they should not handle exit equally well.”

She added that the fund – and by extension, the major economies – accepted that some developing countries might need to impose some financial controls. “In some circumstances, capital flow management measures have been useful,” she said.

This is not the way that policymakers used to talk. The big countries and the I.M.F. spent the last few decades pushing for the liberalization of financial markets. They argued that developing nations were creating their own problems by failing to take the painful steps necessary to moderate capital inflows, notably by allowing their currencies to appreciate. And they showed no tolerance for capital controls.

The argument for global monetary policy coordination– mainly that in today’s globalized world, where unfathomable amounts of money can and do flow at the click of a mouse, that a large countries monetary policy choices have a direct impact on other countries–has already been explored in depth.One of the most important developments in monetary policy over the last generation is the conclusion that central banks can increase the power of their actions by talking about their goals, thereby shaping the expectations of investors.” Managing expectations and policy coordination are logically related and present a synergy point for global monetary policy coherence. 

Central banks historically have served a dual mandate, to manage unemployment and inflation. A 3rd (secondary) mandate has emerged since the Great Recession; to manage the extra-territorial effects of monetary policy decisions.

Two other interesting points are raised in these articles; the issue of capital controls and flexible credit lines.

Capital Controls:

International  capital investments are necessary for helping least developed countries (LDCs) escape poverty traps / expedite their development process. However, the mobility and liquidity of capital in today’s digital and globalized age make capital flows intrinsically volatile–capital controls help temper this volatility. IMF managing director Christie Lagarde has endorsed the use of capital controls in certain instances, which represents a complete 180 from the IMFs “Washington Consensus” policies of the 1980s and 90s. When money is “cheap” (as it is now), it flows to places that offer a higher rate of return (i.e. developing countries). Capital controls provide a buffer from capital flight when monetary policy tightens (which is inevitably as the global economy recovers), which can otherwise have devastating standard of living / human rights implications.

Capital flight may lead to less investment / higher “risk premium” (investors will not like the idea of not having complete control over their investment), but it is surely should be a countries own decision what investments it allows in its country and under what conditions, considering the destabilizing nature of unchecked financial inflows. If speculative money does not wish to come into a country, that may be in that countries best long term interests anyways. The failure of “Washington Consensus” policies, culminating in global financial contagion during the Great Recession, has led the international financial community (headed by the IMF) to reverse it’s previous stance on capital controls.

Flexible Credit Lines:

Jean Pierre-Landau alluded to flexible credit lines with this comment;

In addition, much could be gained through an international “lender of last resort,” which would remove the motive for some nations to maintain massive foreign exchange reserves, he added.

“All countries have a common interest in finding ways to disconnect reserve accumulation from exchange-rate management,” Landau said. “The need for national reserves could be reduced if credible mechanisms exist to provide for the supply of official liquidity on a multilateral basis.”

Flexible Credit Lines are available to countries through the IMF if they meet certain preconditions (a shift by the IMF from imposing constitutionality on loans to having countries reach certain thresholds for eligibility, but after that providing assistance without conditions that can sometimes undermine development (see “Washington Consensus”). Countries gain access to funding by the IMF at an agreed upon rate (which is fairly low). By having this IMF insurance policies, countries are able to pursue policies in their best long-term interests (for example capital controls, or fiscal investments in public goods), as opposed to the short-term interests of speculative investors.

The existence of a FCL eases concerns of financial actors. The overall experience with FCL countries (to date Mexico, Columbia, and Poland, evidence suggests that Ireland will be next) has been overwhelmingly positive. These countries have been able to borrow at a lower risk premium without ever having to access FCL money–no FCL country has ever had to draw on FCL funds. The efficacy of FCLs is only amplified against the backdrop of the European Debt Crisis.

I am a strong advocate of both FCLs and capital controls for developing countries. Both policies are fully consistent with a human rights based approach to sustainable human development. Both policies can temper the destabilizing effects of capital inflows, giving governments the capital, policy, and fiscal space needed to respond to crisis situations. It is encouraging to see high level policy makers are of the same mind when it comes to monetary policy coordination, FCLs, and capital controls.

I invite my readers to view a PPT presentation (FCL Final) I did last year on FCLs. The study shows graphically the experiences of Mexico, Columbia and Poland before, during, and after the Great Recession (these three countries all performed very well compared to comparable countries). It concludes by arguing for “scaling-up” of FCLs by offering them to more countries as a potential development tool.

 

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Economic Outlook: Fiscal Policy, Monetary Policy, and the Zero Bound

Paul Krugman does a nice job of explaining why unprecedented monetary expansion (“quantitative easing”) has not really moved the needle in terms of reducing unemployment and increasing aggregate demand.

It would be prudent to remind the reader that there has been very little counterfactual analysis of the Feds policies since the Great Recession began (that I am aware of). The situation would almost certainly be worse, higher unemployment and deflation, had the Fed failed to act in the way it is. If you would like to read further on the downward spiral of debt, austerity and deflation in a depressed economy, Irving Fischer wrote on the subject following the Great Depression in a way that is both easy to understand and still as relevant today (perhaps even more-so given how much less politically charged expansionary monetary policy is post-gold standard).

A liquidity trap is a situation when slashing interest rates on government bonds to near zero percent is insufficient to provide enough credit to allow the economy to produce at full productive capacity. Investors would rather invest in safe government assets with almost no yield then invest in private markets.

I believe a liquidity trap is in itself justification for expansionary fiscal policy. It is basically investors saying to the government, “here, we don’t want to invest our money, so do it for us and just promise to pay us back in the future, don’t even worry about the interest”. But fiscal policy, which originates in the House of Representatives, is politically charged (especially when a government is already highly indebted, then every spending program comes under close scrutiny).

Monetary policy, on the other hand, is much more politically isolated. It originates within the Federal Reserve, which is staffed with economists who understand economics better than politicians. The Fed began by cutting rates, hoping to stimulate aggregate demand.

Once this conventional monetary policy failed, unconventional means were taken; the Fed is buying assets on a large scale, expanding the monetary base. The Fed has pledged to continue to pursue expansionary monetary policy by buying assets on a monthly basis until either the unemployment rate falls below a certain level (I believe 6.5%) or inflation rises above a certain level (I believe 2%).

The Fed made this announcement to try to change people’s expectations. Since you cannot cut nominal interest rates below zero percent (the “Zero Lower Bound”), the Fed hopes to stimulate demand by making people think that in the future inflation will be higher than it is now. If money is worth less in the future, then people will want to spend it now while it is worth more. More spending stimulates the economy and reduces unemployment.

So why has this policy been ineffective? Well, as I said before, I am not so sure it has been—certainly the situation would be worse right now, not only for America but for the rest of the world which overwhelmingly relies on dollars for international transactions.

But as to why expansionary fiscal policy would be unquestionably more effective, Professor Krugman hits the nail on the head:

“I’m not claiming that there is nothing the central bank can do; but as I’ve tried to explain before, monetary policy can, for the most part, gain traction under current circumstances only by changing expectations about future actions (and changing them a lot). Meanwhile, fiscal policy has a direct, current effect on the economy, which easily trumps attempts to move the economy by changing the Fed’s messaging.

Sorry, guys, but as a practical matter the Fed – while it should be doing more – can’t make up for contractionary fiscal policy in the face of a depressed economy.”

Think of beginners national income accounting, where aggregate demand (Y) = C (consumption) + I (investment) + G (government spending).

Fiscal policy can stimulate AD directly by increasing either G, C, or I depending on how the program is designed.  Monetary Policy, on the other hand, has a much less direct effect. It tries to incentivize people to act a certain way (increase C or I), but people do not always act “rationally” in the economic sense. Sometimes people are so risk averse that even reducing the yield on an investment does not reduce the demand for this investment (particularly in times of economic uncertainty, when I would argue investors tend to become more risk averse).

Also, there is inherently less scrutiny in exactly how monetary policy works. While it is true that some portion of fiscal expansion may be used inefficiently, it is much more tractable than monetary policy.

Monetary policy stimulates AD, but it can also feed into financial bubbles. By providing low interest loans to banks, the Fed is making a leap of faith that the money will be spent wisely. The money should be going to helping people restructure underwater mortgages, or generally providing low cost financing, freeing money for people to spend and stimulate demand. And to a certain extent it is does, but it can just as easily be spent in other less egalitarian ways. If this money goes to Wall St.  investments, the gains will be realized almost entirely by the wealthy.

Evidence exists that this is happening—unemployment remains stuck while financial markets have reached record highs. Securitization, which became taboo after the financial crisis hit, has began to become common practice again. Without meaningful financial reform, the Feds policies could be fueling the next asset bubble.

The Fed has maintained it is keeping a close watch on how its money is being spent, and given the suffering caused by the Great Recession I’m sure it is, but there is only so much it can do. The Fed cannot possibly micromanage how all of its “cheap money” is being spent. The Fed could try to only lend to more people-friendly institutions, such as “credit unions”, or establish mechanisms to lend directly to people and small businesses, but up until this point has either has not or cannot do so (either due to its mandate or due to insufficient manpower for such oversight).

So expansionary monetary policy has kept the recovery from not being worse than it is (or not being a recovery at all), but it has predictably fallen short of its intended goal. It needs to be complimented by expansionary fiscal policy. That’s not to say that there are no inefficient programs that can be made to more efficient–there almost assuredly are. The stimulus-advocate policymaker should have concrete examples of how resources can be used more effectively, if he has any hopes of convincing his austerity minded counterpart of coming to an agreement. Policy, like markets, requires both competition and coordination to be made as efficient as possible.

The Fed should not reverse course now, but should ensure proper oversight for its policies. The Federal government, on the other hand, seems to be slowly moving from austerity to stimulus. Will common sense and text-book macroeconomics prevail, or will business as usual continue? Only time will tell.

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