"What Raghuram Rajan did not say", 'Business Line', July 17, 2015
Dr. Rajan on the world economy
By Pulapre Balakrishnan
It is difficult to heap scorn on the idea of karma once you see India’s exceptional good fortune in having as the head of its central bank a Governor who must be the envy of the global financial world! At least as accomplished as his peers, Dr. Raghuram Rajan has a demonstrated advantage over them in that he is also fearless. He is unafraid to speak his mind, as the Union Minister for Finance may have discovered to his discomfiture along with much of India’s political class. The latter, after all, is used to professionals appointed by it to remain always seen but never heard. Actually, the present governor of the RBI has raised the bar for his successors twice over as he has not only expressed his views openly, but he has also chosen to not confine himself to matters of monetary policy, extending his views to those of governance. Most recently he has pushed the envelope by reflecting upon how to govern a world economy deficient in demand. You can hardly blame him for this as it is far more exciting a terrain than the tenuous relationship between inflation and growth, the staple of most central bank chiefs. Thus, recently he has spoken of the state of the world economy at the London Business School, to which talk the media has given wide coverage. In particular, it was reported that Dr. Rajan had likened the present global economic situation to that prevailing at the time of the Great Depression of the nineteen thirties. He had, it was reported, cautioned against beggar-thy-neighbour policies adopted by embattled governments of that time, policies that are supposed to have heightened the depression. Coming from an economist who has a deep understanding of the workings of the world economy, we should be taking what he says seriously. But need we agree with all his assumptions and prescriptions? I would think not.
It is evident from the text of his speech that Dr. Rajan has a problem with unconventional monetary policy the main attributes of which are unusually low interest rates and asset purchases by the central bank. This combination has been in place in the United States since the global financial crisis that had peaked in 2008. The fear is that this will cause financial instability by encouraging excessive risk-taking. But this is not inevitable. It is true that a lender-of-last-resort opens up the possibility of moral hazard, short-form for unethical behaviour. However, if the loan-of-last-resort is made conditional upon a turnaround, failing which the assets of the firm would be taken into public ownership, the borrower may for sure be expected not to breach the acceptable line of conduct. Nationalisation is not a desirable outcome for the lords of finance, and the threat of it is likely to spur rectitude on their part. Secondly, at the ground level, it is not as if risky behaviour has increased along with quantitative easing in the United States. On the contrary, the problem is that private investors are being skittish, with America’s private banks in particular preferring to keep their money with the Federal Reserve rather than lend it out to the public. (In fact, this episode also demonstrates that self-interested behaviour, this time round by banks, is not necessarily enhancing of the social good.) Altogether there can be no doubt whatsoever that the US economy has benefited from the unconventional monetary policy pursued as its growth rate now exceeds the immediate pre-crisis rates after having turned negative in 2008.
Dr. Rajan has in mind, however, a specific form of instability the source of which he traces to unconventional monetary policy. It is this that leads him to see pursuit of the latter as akin to the beggar-thy-neighbour policy that is devaluation. He reasons that a low interest-rate policy leads large investors, such as pension funds, to seek higher returns elsewhere. Such capital flight can lead to depreciation of the currency which only succeeds in redistributing demand globally. This is indeed a possibility, but the reduction of the interest rate also increases aggregate demand in the country initiating the policy, which acts as an attractor to the exports of others. So it is not as if unconventional monetary policy only re-distributes demand, it also creates it. Moreover, aware of the possibility of infinite capital flight, countries are unlikely to indulge in a race-to-the-bottom in terms of interest-rate reductions. And even as this keeps capital flight in check it also checks the depreciation that follows. So somehow it is difficult to imagine “competitive” monetary easing of the kind Dr. Rajan alludes to.
But there is a different message that we can draw from the very situation that Dr. Rajan has presented. He places the blame for beggar-thy-neighbour outcomes on unconventional monetary policy while, arguably, the outcome is due to capital flight. Economists have long-ago established that that capital mobility makes it difficult for a country to have an independent monetary policy under certain circumstances. However, this had been based upon the premise that capital flight is a given. But must we accede to this? This is the issue, as in the absence of unlimited cross-border financial flows, and the exchange-rate fluctuation they bring about, monetary easing will not re-distribute global demand.
While the governor of the RBI has weighed in with his views on the prospects for the global economy he has refrained from querying its current architecture. Decades ago James Tobin had already identified the weakness of the claim that untrammelled finance was so essential for the efficient functioning of a capitalist economy. Internal to its economy, he had pointed out that in the United States at least the greater part of capital formation was financed via the retained profits of firms and not via external finance. As for the international economy, he had been sceptical enough of its role to call for a tax on non-asset-creating cross-border capital flows. The proposed ‘Tobin Tax’ was hardly extortionary but capable of throwing sand in the works of a destabilising machine. Unfortunately, no serious chance has been given to the implementation of such a tax as an instrument of global economic governance. This of course represents the power of the industrialised countries in the multi-lateral institutions that govern the world economy and the power of their financial-sector barons vis-à-vis the governments of these countries. After all, it is only a revolving door that stands between the government of the United States and its financial sector housed on Wall Street.
The special role granted to capital in the current state of affairs is in stark contrast to that given to labour. Quite simply, not only is there no free movement allowed to labour but also no recognition has been granted to its potential beneficial role in ameliorating labour imbalances across the globe. While the political leadership of the G-7 argues for free capital-mobility it is perfectly at ease with immigration controls. So, when Dr. Rajan brings his considerable prestige to bear upon the debate on the global economy he should be querying the usefulness of much of the capital flow that we observe rather than see unconventional monetary policy as useless in the context.
Pulapre Balakrishnan is Professor of Economics, Ashoka University.