Underwhelming and porous

Summers and his co-author present a summary of their thesis on addressing secular stagnation in a VoxEU article. My final opinion on the article is summed up in the title of this post.

Summers + 1 seem to be more concerned about the spillover of capital inflows into developed countries already at ZLB by competitive exchange rate policies followed by developing countries more than about the other type of spillover from the developed to emerging that Raghuram Rajan was concerned about!

In a sense, they are somewhat stealthily arguing for vigilance on the exchange rate policies of the developing world! That is protectionism.

Their main plank is that monetary stimulus has negative externalities for both the developed world and the developing world and that fiscal stimulus is better. I agree with the former and have questions about the latter.

But, the negative externalities of monetary policy that they talk about are not the ones we are worried about. They are missing how the real world works.

It is not in spite of cutting rates that the developed world attracts capital inward. Theory would argue that it should send capital out seeking higher returns. That too happens. But, because they cut interest rates they attract capital for a different reason. That happens because zero or negative rates tend to cause currencies of the emerging world to appreciate leading those central banks to resist it. That causes reserve accumulation and capital inflows. So, stimulative policies attract capital flows through a different mechanism.

Therefore, one can agree with their observation that stimulative policies in the presence of financial integration leads to unpredictable and unpleasant consequences for both the countries pursuing such policies and others. That is true. That means that the world has to rethink on financial integration, especially of the short-term variety. That inference is not stressed by the authors. But, it should be.

[Blanchard and co-authors argued that bond inflows are contractionary and that non-bond inflows (think FDI) are not contractionary and even positive. See here and here. Theoretically correct and countries, they concluded, can choose policies to attract the latter and repel the former. How convenient in theory and how hard in practice! They had conveniently ignored the political economy dynamics and the power of international portfolio investors to keep markets open, especially now that their opportunities and avenues to make returns have shrunk dramatically].

Back to Summers and his co-author.

But, at the same time, they argue that the Federal Reserve should not normalise monetary policy because it would attract capital inflows and ‘amplify the contractionary effect of tighter monetary policy’. The theoretical case for it is weak. Usually and under normal circumstances, capital inflows are stimulative. They can, under some circumstances, be contractionary. But, those are quite rare.

What Summer and his co-author seem to argue for is no action from the Federal Reserve. So, no monetary tightening but fiscal stimulus too!

They  argue that fiscal policies ‘leak’ their benefits to other countries and hence countries followed monetary stimulus. That is flawed. In fact, monetary stimulus, in the presence of open capital account, leaks as capital flows out to overseas assets and that is the spillover that RR was talking about. Eventually, it is not beneficial for either the country that sends capital out and those that receive them. Monetary policy stimulus, in the presence of open capital account, is arguably more porous.

Their emphasis is on coordinated fiscal policies as policy responses to address secular stagnation. As for coordinated fiscal policies, when saving rates are not rising in the world and, in fact, demographic developments are bringing them down, who will finance them? If it is helicopter money, then the risk of the public losing confidence in fiat money is real. That actually amounts to co-ordinated debasement of fiat currency and co-ordinated ‘competitive’ devaluation.

Further, the politics of fiscal policy would lead to pork-barrel spending and all kinds of wasteful spending. Japan has engaged in fiscal stimulus with little effect. Will it boost public confidence or undermine it, even if financed by central banks, so that the fear of future taxation is supposedly removed? Public may fear simply that it will have unknown consequences down the road.

Now, that even long-term bond yields are negative, what if the bond yields back up by 40-50 basis points or more as they did in 2013? It will cause havoc to mutual funds and ETFs which have loaded up big time in recent years on corporate bonds.

Overall, theoretically porous. Fits arguments to support preconceived conclusions. Ignores market reality. That is why I found the paper underwhelming.


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