Ending shadow banking means ending modern central banking

Ann Petitfor has a not-so-long essay in ‘Prospect’ magazine on how the world could exit QE. It is an interesting and thought-provoking essay. Some extracts:

As Claudio Borio of the Bank for International Settlements explained in 2019: “bar a few who have sailed into these waters, money has been allowed to sink by the macroeconomics profession. And with little or no regrets.”

This one is elegantly put:

… What’s forgotten is that if the world’s economic activity actually had to be calibrated to fit an arbitrarily fixed volume of circulating cryptocurrency, then—exactly as under the gold standard—the world would experience prolonged and painful depressions.

This is a good way of arguing that economic activity dictates the demand for money and that the supply of money should not dictate the level of economic activity. But, we have now swung to the other extreme: We don’t care what the economic activity is. We will provide unlimited amount of money and we believe that this should cause economic activity to pick up! In a way, the QE-adherents are presenting the other side of the coin of the Gold bugs. In doing so, they make many of us – including yours truly – crave for the discipline imposed by the Gold Standard.

But, then, this goes back to the quote attributed to Claudio Borio. We have not quite figured out the role for money.

Between 1981 and 2014, 30 countries fully or partially privatised their public mandatory pensions. Coupled with cross-border capital mobility, the move to private retirement savings steadily generated vast cash pools for institutional investors…

…Note that this whole system avoids reliance on the social construct of credit, upheld by trust and enforced by law, which traditional banks had to work within. Instead, the system is one of deregulated exchange in which cash is simply one more commodity—no more regulated than any other.

These sentences, arranged separately in the article, lay out the rationale for QE:

Today one asset management firm, BlackRock, manages in excess of $8 trillion of the world’s savings. Such companies have outgrown the capacity of “main street” banks to provide services. No traditional commercial bank could absorb these sums; few governments are willing to guarantee individual accounts of more than $100,000. ….Like pawnbrokers, who practised an earlier form of unregulated credit, shadow banks exchange the savings they hold for collateral. … Replete with cash, they can provide “liquidity” on a vast scale to businesses or investors who need it….private financiers rely heavily on government bonds as the safest collateral for their repo trades….

… It is estimated that two out of three euros borrowed through shadow banks are underpinned by the collateral of sovereign bonds issued within the Eurozone. Any decline in the value of government bonds as a consequence of shadow banking activity will influence the government’s cost of borrowing, and—ultimately—fiscal decisions….Which brings us back to quantitative easing—the remedy that central bankers reach for in the face of this recurrent threat.

It clarifies a lot of things, actually. In other words, without QE, the shadow banking system will cease to exist. If it ceases to exist, then the real economy crashes. So, central bankers can assuage themselves by saying that by providing the liquidity that the leveraged shadow banking system needs, they are indirectly supporting the real economy or preventing the real economy from collapsing.

Her conclusion is quite appropriate:

Whenever the vast shadow banks wobble, there is the threat of a disastrous contraction of the credit for the real economy, which could bring everything crashing down. As long as the system is allowed to stand, there is no alternative to taxpayer-backed central banks rescuing private markets.

The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by a responsibility not to take undue risks. And if footloose capital responds by skipping across borders and away from oversight, then we may also need to look at controls on that front too. Only then will the world stand any chance of kicking the QE habit, address those dangerous imbalances and finally escape this grim shadowland of money.

But, on their own, central banks will be afraid to do the job of deconstructing and reconstructing. It is a political project because, in reality, it would amount to cutting both shadow banking and central banking to size. That is why central bankers would resist it actually. Ending the last forty years of financialisation will also end central banking as it has evolved in the last forty years. Central bankers will go back to operating in the shadows, if shadow banking were to be ended!

Will politicians be up to the task? I doubt.

The risk is that, in doing so, the ‘House of cards’ aka ‘the real economy’ will collapse. No one wants it on their watch. If the world of shadow banking has to end, it will happen through exogenous shocks. Both QE (i.e., modern central banking) and the world of shadow banking have to collapse from being unable to bear the sheer weight that they have grown into.

A forensic farewell to Andrew Haldane

Andrew Haldane, after more than three decades at the Bank of England, is going to foray into the world of art. His ‘goodbye’ speech delivered on the 30th June is as impressive as the man’s three-decade experience has been. His career is the dream of many who aspire to be in public policy. He has played a hand in monetary policy, in regulation, in forecasting. His speeches, particularly after the 2008 financial crisis, touched upon all aspects of modern finance and banking. His speeches were the equivalent of well-researched papers with lots of references, charts and data tables.

He also covered a wide array of topics in his speeches. Also, he made it a point to speak at many forums within the UK – from professional bodies to schools to colleges to labour union forums. He supported the initiative of students at the University of Manchester to refashion the economics curriculum. It did not bear fruit. But, he saw the need for addressing the problem at its roots – namely, economics education.

My disappointment – and it is a big one – with him is with respect to his attitude towards the ultra-loose monetary policy post-2008, especially its prolonged application, unmindful of effects, costs and unintended consequences. At the minimum, these needed to be assessed, estimated, discussed, considered and then accepted as premises for policy changes or continuity. Nothing of that sort was done in the UK or in the US. Considering how thoughtful he has been in many other areas, his failure reflected a stubborn and somewhat inexplicable blindspot, as far as I am concerned. Unfortunately, that comes through in the farewell speech as well. But, there are many, many useful elements as well.

I will copy and paste the interesting and controversial portions (in my view) with my comments below them:

At the end of this exhaustive process, the forecasts were sent around the Bank, as well as to HM Treasury.

There, I have it on good authority, they quickly became landfill (as recycling wasn’t an option at the time). Like the UK’s entry at Eurovision, the Bank economists’ contribution was spirited but ultimately pointless. The Bank’s analytical brain did not connect to any hands. John Kenneth Galbraith said that economics was extremely useful as a form of employment for economists. At the time, that was the Bank’s view too.

He is describing the process and the conclusion of the exercise of forecasting M4, money supply, for the UK. This is quite realistic and down-to-earth with a good touch of humour.

With my bag of nerves now full to overflowing, I peered through the fog of Rothmans to see Eddie staring back at me. Both eyebrows were raised. This was bad news. In central bank circles at the time, the double eyebrows was career-defining for all of the wrong reasons. Most of my subsequent 25-years has been managing that decline as gracefully as possible.

That is typical classic British understatement and humour combined. He is referring to the technological glitch that greeted his first presentation to the Bank of England’s monetary policy committee – the pre-MPC presentation made by the Economics Department. Eddie George was the Governor and smoking cigars in closed rooms was then permitted. Of course, Haldane’s career was anything but managing a graceful decline over a quarter century.

On the nominal anchor for monetary policy:

It is no coincidence that durability in monetary policy processes has been accompanied by improved
macro-economic outcomes. Since 1992, inflation has averaged 2% – exactly in line with target (to one decimal place) and 6 percentage points lower than in the preceding 25 years. The volatility of output has fallen by around half over the same period.footnote[6] Contrary to everyone’s expectations, inflation-targeting has lasted and delivered a twin-win, with greater stability on both the nominal and real sides of the economy.footnote[7] Given the UK’s previously chequered monetary history, this truly is a transformation.

Of course, there is a question about how much of this improved performance reflects good luck rather than good monetary management.

This is a huge disappointment although there is a small concession to honesty and intellectual openness in his contemplation of a possible role for good luck in ensuring ‘good macro-economic outcomes’. Second, what are good ‘macro-economic outcomes’. Is it just low and stable inflation rate? Did he not find out enough in the post-2008 research of the role played by leverage accumulated by financial institutions in precipitating and aggravating the crisis? If post-crisis efforts have attenuated the leverage in regulated entities (as he points out later), does it mean that the problem has been solved?

He, of all people, should know that if the price of debt is kept too low for too long, taking out all considerations of risk, the leverage does not vanish but goes elsewhere and possibly hidden, just as it was the case with financial institutions pre-2008 through opaque structures. Now, it must be hidden in some other crevices. Lack of acknowledgement of that possibility – a very high likelihood, in fact – is puzzling, to say the least.

In the next two pages (text of his speech), he details his concerns and reservations over the current monetary policy accommodation, post-Covid. Again, he states his concerns with inflation turning out to be higher and persistent. For a man who was the director in charge of financial stability, his apparent lack of concern over financial stability risks is remarkable. Perhaps, he knows more than I do about the state of play on financial stability in England and that he is very confident about it not being an issue. Perhaps. Nonetheless, it strikes me as odd and as a serious omission.

In any case, his inflationary concerns were well documented in his article for the ‘New Statesman’. See here.

He gets closer to the real risks in this paragraph but not quite:

A dependency culture around cheap money has emerged over the past decade. Only a minority of those with mortgages have ever experienced a rise in borrowing costs. Fewer still have significant inflation in their lived experience. Easy money is always an easier decision than tight money. But an asymmetric monetary policy reaction function is a recipe for a Minsky mistake. Having followed the right script on the way in, central banks now need to follow a different script on the way out to avoid putting 30 years of progress at risk.

The reason why he is not where he should be is because of this: what is happening now with the post-Covid response is a logical culmination of what was done post-2008. He should have seen this coming. The lesson that policymakers have drawn from the post-2008 policy response is that it was not enough. The dosage was weak, in their assessment. So, now they have upped it massively. They never have bothered to contemplate if it was the right medicine at all and if it was right to administer it for more than short-term demand management and to facilitate immediate recovery. Andy Haldane does not contemplate this question seriously either.

On financial stability:

I wrote a note and sent it to the Governors in 2005. It was titled “Public Policy in an Era of Super-Systemic Risk”. It made some bold claims about financial system resilience, most of which jarred with the prevailing orthodoxy…..I am still waiting for comments on my 2005 memo. With hindsight, one of my career regrets was not to make more of the results until it was too late. …As best I can tell, no-one got the crisis completely right, despite a number of people subsequently exhibiting supernatural powers of hindsight. Rather, the crisis illustrated the limits of our collective knowledge, our collective lack of imagination. It demonstrated that, in a world of uncertainty as distinct from risk, it is better to be super-safe ex-ante than super-sorry ex-post, better to be roughly right than precisely wrong.

Nice touch again on people with super-natural powers of hindsight. That apart, the certitude with respect to the application of post-2008 crisis monetary accommodation is at odds with the ‘limits of our collective knowledge’.

Recapitalising banks:

When UK banks were finally recapitalised that Autumn, around £65 billion was injected into them by the UK Government. Our calculations had been roughly right, good enough to save the ship. To this day, I believe that if greater amounts had been injected then – perhaps £100 billion? – UK banks would have been more willing to lend and the recovery would have been less anaemic. It would have been better to be super-safe ex-ante than super-sorry ex-post.

I wonder if this lesson has been lost on India since it continues to grapple with anaemic credit growth.

On Macro-prudential regulation:

The macro signalled two important ideological shifts from the past. First, banking needed to be managed at the level of the system as a whole, like any other eco-system. Second, as important as the resilience of the financial system was its interaction with the macro-economy to avoid adverse feedback effects between the two, such as credit crunches. Finance was to be servant of the economy, not master. This, truly, was a regulatory revolution.

He is making some important points. Finance sector interaction with the macroeconomy has been ignored for the better part of the last four decades. Before that it did not matter because finance was mostly bank-driven and banks were tightly regulated. But, once the underlying arrangement changed, regulation was far too slow to catch up. Indeed, the zeitgeist, 1980s onwards was no-or-lite regulation as the markets knew best. So, there was no question of regulation catching up at all. It was simply not in the race.

But, interaction with the macroeconomy is not just about credit crunches but also about credit excesses. Indeed, the latter has been a bigger problem leading to instability. Credit crunch is about risk aversion on the part of lenders and borrowers. Time overcomes them or higher bank capital or both. His omission of ‘credit excesses’ is conspicuous. It is very important that he mentions that finance has to be the servant of the economy and not the other way around. He deserves a shout-out for that. But, is it? To what extent post-2008 policies achieved that? Even if regulatory policy tried to establish that order, to what extent did monetary policy undermine that? Not only he does not pose those questions here but he has avoided them for the most part or, as far as I can remember, throughout the last decade.

I wonder whether central banks ignoring the quantity of money since the Eighties has also contributed to the problem of ignoring the feedback role of credit for the macroeconomy.

As you did not fight fire with fire, you did not fight financial complexity with regulatory complexity. That risked making a bad situation worse, a complexity problem squared rather than halved.

As a matter of principle, this is an important one to keep in mind. But, the devil is in the details or that the satan is in the specifics.

In the UK, the Vickers Commission reforms created a fire-break between banks’ services to the domestic economy and their other activities.

This too deserves praise. The UK might have done better than the USA in this regard.

The Global Financial Crisis had laid bare the costs of separating finance and the economy, the micro and macro – a separation that had also been a feature of the Bank in the past. Crisis needed to be the catalyst for change, forging a link between the Bank’s analytical brain and its regulatory hands.

The Financial Stability reports that many central banks are an acknowledgement of the financial and macro linkages. To the extent that central banks have dedicated brains and hands examining financial stability, it can only be a good thing. But, to what extent do they inform policy or if it is a case of form over substance, judgement has to be reserved until the blowback from the recent combined monetary and fiscal stimulus is felt and played out. In other words, the tide has to go out for us to spot those swimming naked. That might include the central banks too.

Crucial for the success of both the FPC and PRC is operational independence of decision-making, set in statute. Independence for financial regulation and supervision has received far less attention, analytically and practically, than on the monetary policy side. But, for me, the case for independence is at least as strong as for monetary policy.footnote[23] If anything, decisions on withdrawing the punchbowl are harder, and even more important, during raucous credit parties.

Andy Haldane does well to lay out the case for independence of the Financial Policy Committee and the Prudential Regulation Committee. But, withdrawing the punchbowl has to be done in a coordinated manner. It cannot be the case that the FPC and the PRC withdraw the punchbowl and the MPC puts it back. Again, strange that someone as experienced and as perceptive as Haldane is does not see the connection between the two.

Mission accomplished?

More than a decade on from the crisis, the financial system is a fundamentally different animal – leverage far lower, liquidity far higher.footnote[24] The UK’s largest banks’ activities are protected, additionally, by a ring-fence and systemic surcharges. While I still doubt big banks can fail safely, they are far less likely to inflict collateral damage on depositors and the wider financial system. In all of these respects, the regulatory reform agenda of the past decade has been strikingly successful.

And the benefits of this have already been felt. During the Covid crisis, the global banking system has lived up to the expectations set for them by Mark Carney at its start: they have been part of the solution, not the problem.

These observations are striking for they confirm the failure to connect monetary policy to financial stability. Indeed, if the earlier failure was one of refusing to see the feedback from finance to economics, now it seems to be the other way around.

Lending to real businesses:

Constrained credit to companies was, in turn, a potent factor behind the UK’s anaemic subsequent recovery….

These same fault-lines were re-exposed during the Covid crisis. The good news, this time around, was that large numbers of loans – in excess of one and a half million of them – were made to UK businesses by UK banks in the space of a few months. The bad news is that the vast majority of these loans would not have been made at that speed without a 100% guarantee from Government. Only by effectively nationalising SME lending were the Macmillan gaps bridged in crisis….

To my mind, what is needed to bridge the Macmillan gaps, durably and comprehensively, is the equivalent of a UK Development Bank, operating on a decentralised basis. As other countries have found, the scale and scope created by a Development Bank is necessary to reach SME start-ups and scale-ups across all sectors and all regions. The best time to have put in place a UK Development Bank would have been 1929. The second best time is now.

Many important points are made here. There are important omissions too. We will start with the latter. What was the point of ultra-loose monetary policies including QE if lending to businesses did not pick up, post-2008 and that the recovery was anaemic subsequently? What is the policy audit here? Should it not be done?

If, post-Covid, lending picked up only because there was 100% State guarantee – effective nationalisation of SME lending as he puts it, – to what extent did low interest rates play a role and if they did so at all?

Put differently, one of the ‘excuses’ for monetary policy to have played such a big role post-2008 was that fiscal policy did not step up to the plate. But, post-Covid, with fiscal policy kicking in big time, is there a need for monetary policy to be as big as well?

If the response is that borrowing cost would have risen too much without monetary policy underwriting the fiscal expansion, then does it not confirm the failure of the monetary policy post-2008 to create a durable recovery with productive asset creation? Indeed, the above extract is the most severest indictment of the post-2008 monetary policy. It also constitutes the biggest disappointment with Haldane’s personal failure to hold the post-2008 monetary policy accountable for its failure to achieve the economic goals which were never clearly spelt out in the first place.

It appears that it has been left to the Economic Affairs Committee of the UK House of Lords to ask some of the fundamental questions that one would have expected a man of Haldane’s experience and erudition to pose, at least now. I am yet to read the report. FT reports on it here and here.

[Somewhat independently, in the Indian context, there has been a development bank to cater to small businesses. That is the Small Industries Development Bank of India (SIDBI). But, has it accomplished its mission or does it continue to accomplish its mission? How should the mission be defined in the first place? Just amount of borrowing facilitated or refinanced? In quantitative terms, as a percentage of GDP and as a percentage of overall credit? Or, should it be about the number of micro enterprises that became small, medium or large, the number of small enterprises that became medium or large and the number of medium enterprises that became large, before and after the advent of SIDBI?]

On digital currency and its benefits

On financial stability, a widely-used digital currency could change the topology of banking fundamentally. It could result in something akin to narrow banking, with safe, payments-based activities segregated from banks’ riskier credit-provision activities. In other words, the traditional model of banking familiar for over 800 years could be disrupted…. Specifically, this could lead to a closer alignment of risk for those institutions, new and old, offering these services – narrow banking for payments (money backed by safe assets) and limited purpose banking for lending (risky assets backed by risky liabilities).

While this sounds reasonable, he proceeds to (deliberately) obfuscate the issue of negative interest rates on Central Bank Digital Currencies (CBDC). Read the following:

At root, the ZLB arises from a technological constraint – the inability to pay or receive interest on physical cash. This is a technological constraint that every form of money, other than cash, has long since side-stepped…. In principle, a widely-used digital currency could mitigate, perhaps even eliminate, this technological constraint. Specifically, CBDC would enable interest to be levied on central bank issued monetary assets or digital cash. The extent to which this relaxed the ZLB constraint depends, in addition, on the elasticity with which physical cash is provided to the public alongside CBDC. Access to physical cash is an issue well above the pay grade of central bank technicians; it is a political-cum-social issue…..

Nonetheless, the potential macro-economic benefits of easing the ZLB constraint are large and have grown over time. Studies suggest the ZLB constraint can result in significant shortfalls in output relative to potential (of around 2%) and inflation relative to target (of as much as 2 percentage points).footnote[31] These are potentially enormous gains in macro-economic terms. To those benefits needs to be added the gains to digital cash users of holding a remunerated instrument, helping protect their purchasing power.

He is conflating issues. Negative interest rates are about charging the lender. In physical cash, a central bank issues a zero coupon bond. The so-called ZLB is the inability of the central bank to charge the public an interest rate for issuing them physical cash even though cash is a central bank liability! What he is hinting at and not stating openly is that with digital currencies, he thinks that the issuance of currency notes can be done at negative rates of interest. In other words, public pays interest to hold paper currency in its wallets! Otherwise, it will all be CBDC. They can choose.

This brings to my mind the comment I posted on the article by Ken Rogoff in FT on negative rates. Brilliant minds are captivated by their own intellectual acrobatics. They lose sight of the forest for the mastery of the details of growing different trees. What is the tree for? What economic purpose does it serve? That too, after acknowledging that post-2008 policies did not lead to higher lending to businesses and that it was a government guarantee – effective nationalisation – that made the difference, post-Covid. Who benefits from negative interest rates? How big is the ‘cost of capital’ constraint?

On communication and transparency, Haldane deserves much credit for taking the Bank to the public and in de-mystifying it. He also rightly takes credit for bringing people with diverse backgrounds, experiences, etc., to the bank. Those are positives. But, on the issue of transparency which he does not go into, central banks have not struck the right balance between being transparent and non-transparent to financial markets. Again, like with many things, there is no discussion and there is no accountability, hence. Why is transparency needed? What public purpose does it serve? What are the costs? Is it still worth it, after considering the costs? There has never been an open and honest discussion of these questions.

To some extent, Haldane addresses the question of ‘transparency’ with a discussion on forward guidance:

The provision of public policy signals may dampen incentives among market participants to invest themselves in understanding the economy. These risks have I think been realised in practice, with forward guidance encouraging too much poring over central banks’ words and too little poring over the data on which monetary policy decisions are based. That is the wrong way around.

I think the drawback of ‘forward guidance’ or ‘policy transparency’ is not just one of dumbing market participants down. They seem to need not much incentive to do so, these days. It is also about encouraging excessive risk-taking which is what Alan Greenspan’s gradual normalisation of monetary policy achieved between 2004 and 2006. To a considerable extent, it played a role in fomenting capital market risk.

On ‘Forward Guidance’, Haldane concludes with the right advice:

My takeaway for forward guidance from this experience echoes my takeaway for the Bank’s approach to communications generally. Where possible, keep it short and simple. And focus the message on the needs of those shaping our economy, companies and households, not those trading financial instruments. [Emphasis mine].

He is heading over to head the Royal Society of Arts. As I stated at the beginning, there is much to envy in the career trajectory of Andrew Haldane. He steered clear of politics and did not conflate his policy competence with political ambitions. By all accounts, he has achieved a lot. There is much to admire and much to applaud. But, equally, there is much to criticise too for a fair and objective assessment of a man’s contribution to public policy has to encompass a much longer time line since policy itself makes its presence felt with a long and variable lag.

Do the rich finance unproductive household debt?

A Chicago Booth school research review note (or article or brief) published in May talks of the research by Sufi, Mian and Straub on how the top 1% investment in Treasury bills, notes and bonds and deposits in financial institutions end up as household debt for the bottom 99% which is relatively and mostly unproductive. The paper is problematic because it is looking at at the wrong place for the causes. Both the phenomenon they describe – the wealthy ending up with too much wealth and hence cash to invest and the lower-income households taking on more debt – are traceable to a common factor. That is monetary policy of the Federal Reserve.

By training their guns on the top 1% – not that I have a particular problem with it – they are not holding the Federal Reserve accountable for perpetrating huge wealth and income inequality. 

Ultra-loose monetary policy through a combination of low interest rates and liquidity provision fuel asset markets. Rich hold assets and they are able to enhance the return on such asset holdings through leverage as well that low interest rates amply facilitate and amplify as well.

To the extent that extraordinarily loose monetary policies fuel a much greater rise in equity prices than in real estate prices, then monetary policy can boost the wealth of the top 1% or 10% compared to the rest of the 99% or 90% and that is what has been happening.

In fact, this was pointed out in a brief but useful essay in the BIS Quarterly Review of March 2016. The essay is titled, ‘Wealth inequality and monetary policy’. Some extracts:

While low interest rates and rising bond prices have had a negligible impact on wealth inequality, rising equity prices have been a key driver of inequality. A recovery in house prices has only partly offset this effect. Abstracting from general equilibrium effects on savings, borrowing and human wealth, this suggests that monetary policy may have added to inequality to the extent that it has boosted equity prices.

Considering the tails of the wealth distribution – not shown here – generally reinforces this picture. The share of securities holdings, equity in particular, tends to be even higher at the top 5% or 1% of the distribution. Conversely, housing accounts for a higher share in the lowest net wealth quintile, for which low net wealth is in many cases a reflection of high levels of mortgage debt. In a number of cases, net wealth is negative, suggesting that liabilities, in the form of mortgage, consumer and other debt, exceed assets.

Since 2010, high equity returns have been the main driver of faster growth of net wealth at the top of the distribution.

What is interesting is that this essay points out that even in Japan, which is one of the least unequal among advanced nations, ultra-loose monetary policy has played a part in fomenting a rise in equity prices and hence a rise in inequality. This is what footnote no. 16 of the essay says:

Frost and Saiki (2014) study the impact of unconventional monetary policy on income inequality in Japan in a vector autoregression (VAR) framework. Using household survey data, they find that quantitative easing widened income inequality, especially after 2008 when policy became more aggressive. They identify capital gains resulting from higher asset prices as the main driver.

Corporate businesses do not invest in productive assets in America. They used to do that a lot in other countries to save on costs. They engaged in share buyback and the managers paid themselves very well. Workers were laid off as production went offshore. Worker insecurity restrained wage growth. Workers made up for it through borrowings and mortgage debt thinking that the rising value of their homes would keep them safe and offset weak income growth.

Loans are fixed and legal obligations. Real estate prices can go up and down and hence low income households bore the brunt of the real estate crash of 2008. The cycle repeats.

To say that banks recycle the excess savings of the top 1% into unproductive debt for low-income households is to misunderstand how banks create assets. The authors have not taken into consideration BoE research published in 2014 and which is borne out by empirical research (Richard Werner) as well that banks do not wait for deposits to create assets. They create money and THEN create deposits, in its wake.

Banks engaging in real estate lending (what the authors call unproductive debt) is partly lazy banking. Real estate loans carry lower risk weight because they are collateralised (Alan Taylor, et al) and mortgage loans are easier to securitise and get off the books as well. Third and a weaker consideration is that real estate loans to lower income households also gets a relatively freer pass on politically correct considerations.

So, the paper rests on flimsy foundations or is empirically unfounded. The common problem is the excessive and prolonged reliance on monetary policy to drive long-run economic performance as opposed to using them as short-run business-cycle management (or, aggregate demand management) tools.

Second, the review states:

Mian, Straub, and Sufi lean toward the global savings glut theory. Mian and Sufi argue in 2018 research that a rapid flow of foreign funds into the US triggered a credit-supply expansion that boosted household debt, which they say was a major factor in igniting the financial crisis.

This too is problematic and faulty. There are proximate and seemingly logical causes and there are longer-term considerations. Foreign funds flowed to America because extremely low US interest rates caused a surge in the value of other currencies against the US dollar. The ‘too-much-too-quick’ appreciation met with natural and unsurprising resistance from other countries. They accumulated foreign exchange reserves and those reserves were deployed in US Treasury and agency debt, etc. Even in stocks. Again, the underlying cause and the proximate cause are different.

Third, the authors appear to have recycled stale and impractical solutions to the problems that they had identified. Given that the problem identification was wrong, naturally the solutions were superficial too:

Their proposed solutions involve taxation—either a more progressive tax system or a wealth tax—through which the government can finance spending and investment, or redistribution programs that benefit lower-income households. 

The review does well to point out, citing other researchers, the practical difficulties of implementing a wealth tax:

As of 1990, there were 12 countries in Europe taxing net wealth, but now that is down to Norway, Spain, and Switzerland. When France did away with its version in 2018, the prime minister said it had caused many millionaires to flee. 

That is why any proposal to tax the wealth of the rich has to come from the rich themselves as part of a broader social compact. But, that is the stuff of fantasy and dreams these days, for the most part.

The practical suggestion:

Research by Booth’s Eric Zwick and Princeton’s Owen Zidar suggests that reforms such as rolling back special deductions for pass-through businesses, which they say collectively generate more taxable income for the top 1 percent than do big C corporations, could be a key part of a tax plan that raises up to $5 trillion over the first decade of implementation. Pass-through businesses typically include medical and law practices and other types of consultancies.

This makes sense. I do remember reading about the magnitudes of these pass-through in ‘The Captured Economy’ by Brink Lindsey and Steven M. Teles. Perhaps, it is a relatively unheralded book. It offers specific solutions and backs up its assertions with data and evidence. In a way, it provides the all-important evidential backing for the assertion that capitalism needs to be saved from capitalists.

In conclusion, one can speculate on why academics, in general and for the most part, tend to give a free-pass to central bankers. But, it is, well, speculative. Further, to be fair, it is not just academics who give a freer pass to fellow academics. This piece by Daniel Moss in Bloomberg on the (subtle or not) policy shift by the European Central Bank is proof that the cosy network is bigger and wider.

Guide to central banks

Bloomberg has a very useful compendium of the state of play in central banks. What comes through clearly is the ‘talk the talk’ but not ‘walk the talk’ or ‘walk the talk’ and not ‘walk the walk’ attitude of Developed Market (DM) central banks.

(1) Nouriel Roubini in ‘Project Syndicate’:

“central banks have effectively lost their independence, because they have been given little choice but to monetize massive fiscal deficits to forestall a debt crisis. With both public and private debts having soared, they are in a debt trap.” [Link]

(2) John Taylor in ‘Project Syndicate’: 

“The Burns memo is a perfect example of how bad ideas lead to bad policies, which in turn lead to bad economic outcomes. Despite Burns’s extraordinary reputation, his memo conveyed a set of terrible policy recommendations. By blaming everything on putative structural defects supposedly afflicting the entire economy, the memo’s worst effect was to shun the Fed’s responsibility for controlling inflation, even though it was clearly responsible for the rising price level.”  [Link]

This has relevance to India. Monetary policy is largely ineffective with respect to inflation. That is my view. That is also the empirical evidence. However, it is relatively more effective when it is trying to tame inflation rather than when it is trying to stoke it. Put differently, the effort needed to achieve the latter is far, far more and has quite a fair bit of unintended consequences. We are witnessing that. The reason is that sky’s the limit for rates, to tame inflation. Not so for lower rates. AT least until now, with paper currencies.

In other words, too-loose monetary policy for too long could become problematic. The excuse of structural rigidities that Arthur Burns came up with in his memo to Nixon must resonate in India.

This is not to argue for rate increases right away in India. But, with every passing day, the cost-benefit ratio keeps shifting. Moreover, we cannot have the cake and eat it too. The recovery from the first wave was better and faster before the second wave struck. Recovery from the second wave also seems to be happening faster and better than expected. RBI talks of banks’ balance sheets being in a healthier state than anticipated or feared. If these factors are taken into consideration, then it also makes the case for re-visiting the accommodative stance.

Structural supply-side inefficiencies, loose monetary policy, natural economic recovery and asset price bubbles can be a pretty lousy combination for many things.

(3) Interesting chart from Liz Ann Sonders:


Text explanation by her:

Given ISM Mfg Prices Index hit 92.1 (highest since 1979), it’s in its highest historical decile … interesting that going back to 1948, avg return for S&P 500 in next 6m was -1.5% (lowest in decile range); avg CPI y/y in next 6m was +7.6% (highest in decile range)” [Link]

(4) She also tweeted this:


Text explanation:

Of 24 historical occasions that DJIA gained between 10% & 20% in first half of year, only once did it fail to finish full year positively (CAVEAT: that was 1929: worst-ever entry point for U.S. equities in history) ⁦@SPDJIndices [Link]

You can decide which of the two tweets you would pay attention to!!

Have a good week.

Powell warned

The FT carried a story on a Democrat politician warning the Federal Reserve against raising interest rates. I am not even going into the question of Fed independence and the reappointment of Powell that is coming up. She is a member of the House Financial Services Committee! But, this is the comment I left on the article:

Few hours after this report was published, the FT also published a story on the increase in home prices. Citing a report from the National Association of Realtors in the US, FT reported that the median price of an existing home went up by 23% in the last one year. Separately, a visit to the NAR website would show us that their Housing Affordability Index witnessed a stunning 20 point drop in one month in April 2021 from March (175.0 to 155.8). The lower the index, the lower the income available to buy a median home.

A simple search on the internet on whether easy monetary policy helps or hurts the poor through inequality results in plenty of hits that show that easy monetary policy has aggravated income and wealth inequality around the world.

So, to suggest that the Fed should persist with low interest rates is to make the argument for further aggravation of income and wealth inequality in the United States, not to mention further expansion of asset price bubbles. As and when they burst, it will result in large and persistent unemployment and misery, further necessitating fiscal and monetary policy interventions. In turn, they would go to work, recreating inequality…

Unless America stomachs the short-term (could last longer than the double-dip recession of 81-82) pain of reversing the course on easy-monetary-policy-led-asset-price-led-economic growth, things will get from bad to worse and not improve. The eventual risk is the loss of reserve currency status of the US dollar.

Therefore, the Democrat politician must be careful what she wishes for.  Maybe, I am wrong here.

Some interesting references I came across as I searched for some credible research on monetary policy and inequality:

(1) This group analyses Denmark and their conclusions were quite unambiguous:

a decrease in the policy rate of one percentage point raises disposable income by less than 0.5% at the bottom of the income distribution, by around 1.5% at the median income level, and by more than 5% for the top 1% over a two-year horizon….a decrease in the policy rate of one percentage point increases asset values by around 20% of disposable income at the bottom of the income distribution and by around 75% of disposable income at the top over a two-year horizon (implying asset returns on housing and stocks of 6-8%). This suggests that the effects of softer monetary policy through appreciation of assets are generally much larger than the effects through higher disposable income. The income gradient largely reflects that households at higher income levels hold more assets relative to their disposable income, and, to a lesser extent, that the asset returns created by monetary policy are higher….accounting for direct as well as indirect channels, reducing the policy rate by one percentage point raises the share of aggregate disposable income for the top-1% by around 3.5% over a two-year horizon and lowers it by almost 2% for the bottom income group. [Link]

(2) This is from the abstract of a BIS research note published in its Quarterly Review in March 2016:

While low interest rates and rising bond prices have had a negligible impact on wealth inequality, rising equity prices have been a key driver of inequality. A recovery in house prices has only partly offset this effect. Abstracting from general equilibrium effects on savings, borrowing and human wealth, this suggests that monetary policy may have added to inequality to the extent that it has boosted equity prices. [Link]

Further thoughts on inflation targeting

I am creating a post out of two email replies I had sent to a friend who wrote to me after reading my column in Mint yesterday.

I would like to start off by placing these four quotes here first:

(1) “He was pondering why the price of provisions should have risen by so much more than could be accounted for by any deficiency in the harvest. He did not, like Ricardo a few years later, invoke the quantity of money. He found the cause in the increase in working-class incomes as a consequence of parish allowances being raised in proportion to the cost of living. …”

Original source: ‘Essays in biography’ by John Maynard Keynes on Malthus cited by Andrew Batson in his blog https://andrewbatson.com/2021/04/05/malthus-reconsidered/ (5th April, 2021)

(2) I don’t know, since I don’t understand the relationship between monetary policy, fiscal policy, and inflation, and I don’t think anyone yet does.

Source: Noah Smith, https://noahpinion.substack.com/p/bidenomics-explained (4th April 2021). This long article by Noah Smith is a very good read, even if one does not agree with it in entirety. It is a great learning material.

(3) Central banks misinterpreted these global, demographic trends for the success of their inflation targeting regimes which were introduced from 1990. The over-confidence of central banks in their ability to control inflation, volatility and financial stability contributed to the under-regulated rise of house prices. The rest, as they say, is history.

Goodhart, C. A. E.. The Great Demographic Reversal (p. 55). Springer International Publishing. Kindle Edition. 

(4) Normally inflation is treated as a monetary phenomenon. Given the expansionary monetary policies in recent decades, trying to explain current disinflationary pressures in this way would be a struggle.

Goodhart, C. A. E.. The Great Demographic Reversal (p. 102). Springer International Publishing. Kindle Edition.

Charles Goodhart and Manoj Pradhan refer to the paper ‘The Primary Cause of European Inflation in 1500-1700: Precious Metals or Population?- The English Evidence’ by Anthony Edo and Jacques Melitz (Oct. 2019). The paper assigns equal weight to monetary and real factors in explaining the ‘Great Inflation’ of that period. You can access the paper here.

It is true that interest rates have to impact both output (growth) and inflation both being nominal variables. It does not preclude the possibility that real economy variables affect inflation outcomes more than what the central bank does. That may well be the case in both the developed world and in the developing world. Those real economy variables may differ between developed and developing nations.

The original economic logic or premise of inflation targeting is that central banks print money (they are not the only ones who create money  ) and therefore they should be responsible for protecting and defending its value is logical. But, the reality of influence need not follow from the aspiration or desire to influence. Of course, we know that inflation targeting was as much a political project as it was an economic project. Second, we now that central banks do not create money as much as commercial banks do. If anything, central banks adjust bank reserves to the amount of money that commercial banks create.

There are other nominal variables over which central banks may have better control than they have on inflation. For example, credit growth. So, if they wish to, central banks can control credit growth by raising the cost of credit creation by commercial banks in a few ways. They influence that both with the price of credit (interest rates) and with their role as a regulator of the credit system. 

The problem with inflation targeting in the developed world is that central banks neglect other indicators of overheating. That happened pre-2008, post-2009 and is happening post-2020. IN the developing world, given structural rigidities, the central bank may commit the opposite mistake: tighten on signs of inflation when other signatures of overheating are absent. Both are two sides of the same coin and are the consequences of slavishly adhering to an inflation regime.

In India, in the first decade of the new millennium, the Indian Rupee gained against the US dollar 7 out of the 10 years. In the second decade, it gained in only one year. That was 2018. It happened because the Reserve Bank of India tightened monetary policy. If the rupee strengthened in a year when the Federal Reserve was raising its policy rate, then one can imagine how excessively high India’s real policy rate was. The inflation rate came down from a peak of around 5.2% (below the upper end of the range) in Dec. 2017 to a low of 2.0% in January 2019. That was at the lowest end of the band. After demonetisation happened – which sucked out liquidity – the central bank cut the policy rate by 25 basis points in August 2017 (just once and ten months later!) and raised the policy rate twice in the course of 2018 based on its wrong (as it turned out) inflation forecasts. It squeezed the economy in the face of an ongoing NPA crisis and in the face of the emerging NBFC Funding crisis in the wake of the collapse of IL&FS.

Such an obsessive monetary policy regime was due to a slavish and rote obsession with Flexible Inflation Targeting (FIT). That obsession sacrificed economic growth in 2018 for sure. Residual effects must have been felt in 2019 as well, at least partially. Unwinding that took time. There were time lags and then Covid happened.

In sum, I do believe that central banks are far more able to control inflation when it is high because there is no ceiling on the interest rate. They are far less successful in stimulating it. In trying to do that, they are creating unacceptably high costs. This is happening in the developed world.

In countries like India, inflation is far more of a real phenomenon than a monetary phenomenon. It should be noted that it is a relative statement and not an absolute statement that rules out any role for monetary (or nominal) influences. Certainly not.

This statement applies for developed countries too except that the real factors can be different between developed and developing nations.

For India, in particular, I do feel that the Government of India has abdicated its responsibility for inflation by making RBI responsible for it. In doing so, it has failed to recognise or avoided recognising that India’s inflation problem is its creation due to the high costs and supply inefficiencies it imposes on the economy with its LIC Raj.

Since the central bank has been mandated to keep inflation within a range when its monetary policy actions are not the key driver of it, its actions can only have unintended side effects.

For central banks, overheating and financial & economic stability should matter. Inflation is only at best a partial and at worst, an imperfect indicator of both overheating and financial & economic stability.

Inflation targeting is neo-classical

What RBI policymakers should be mindful of this fiscal

4 min read . Updated: 05 Apr 2021, 10:44 PM IST

V. Anantha Nageswaran

Recently, I read a paper, titled ‘Overcoming the Tragedy of Super Wicked Problems: Constraining our Future Selves to Ameliorate Global Climate Change’ (May 2012), that presented a framework for tackling climate change. The paper was about how to win public support and participation and sustain it in the efforts to address carbon emissions, etc. It recognized climate change as a ‘super wicked problem’, as per the definition of Ritter and Webber in their paper, ‘Dilemmas in a General Theory of Planning’, published in 1973. Wicked problems defy neat solutions and linear approaches that are technocratic in nature. The paper acknowledges that path-dependent processes tend to happen by accident, and that they can even exacerbate super-wicked problems, rather than resolve them.

The paper contained references to two classic papers, ‘God Gave Physics the Easy Problems’, published in 2000, and the 1985 classic by Paul David, ‘Clio and the Economics of QWERTY’. Paul David’s paper on Qwerty Economics points to the influence of ‘software’ on hardware. Investment in skills required to type using the Qwerty keyboard created scale economies for it and entrenched it as the global standard, even though it did not optimize the efficiency of using both hands for typing. Neither did it keep widely-used letters of the alphabet apart to prevent manual-typewriter keys from jamming. Yet, it survived.

Separately, the authors of the first paper referred to here note that big questions in social science involve contingent and complex causality, and that the search for ‘laws’ and invariant causal relationships can be frustrating. It called for constructive humility in the current context of our attraction to deductive logic and falsifiable hypotheses. The advice is rather timely, given the deterministic statements that are frequently made about the path of institutional autonomy, the cause of liberty, and the role of businesses in influencing the two, etc. The advice is equally relevant to questions that financial investors and policymakers confront.

Two recent crises in financial markets illustrate the mistakes that continue to blight the policy approaches followed by central banks in developed nations for well over a decade (or three, depending on which one you look at). First came Greensill. A firm that offered supply-chain finance went broke. It brought back memories of 2008. Then, last week, a family business named Archegos fell victim to the debt and derivatives it had accumulated. More interesting than its failure was the evaporation on Friday morning of the cooperative arrangement that banks had agreed upon just the night earlier. It was the Prisoner’s Dilemma at work. So much for Homo Economicus.

We have just entered a new financial year. The Reserve Bank of India (RBI) will hold its first monetary-policy panel meeting this week. In the spirit of the above discussion, it is appropriate to recall what Willem Buiter wrote in ‘The Unfortunate Uselessness of Most ‘State of the Art’ Academic Monetary Economics’ (6 March 2009). He was one of the ‘founding’ members of the monetary policy committee of the Bank of England after it was given an inflation mandate by the UK Treasury. Given the extreme monetary and fiscal stimuli that pass for economic policy in the developed world, his observations will be useful for RBI policymakers as they look ahead to a new financial year.

Buiter wrote that the conventional economics training of academic and other professional economists at the Bank of England proved to be a handicap when the crisis of 2008 struck. They had to switch from targeting inflation under orderly financial conditions to dealing with conditions of widespread market and funding illiquidity. Such exigencies may not arise in India this year. But, it is possible that global financial markets would face such situations with spillover effects on India. In such a situation, will India’s inflation-targeting framework be an inconvenient shackle on policymakers? We should not forget that inflation targeting is a product of neo-classical economics that ignores the path-dependency of economic outcomes.

A recent paper, ‘Inflation Targeting: Much Ado about Nothing? Examining the Evidence’ (March 2021) by a group of distinguished policy economists had established that India’s inflation rate was coming down even before flexible inflation targeting (FIT) was introduced. Second, this was the case with other countries, too, that really had no FIT target. Third, they show that given the lopsided weight for food and related components in the Indian Consumer Price Index (CPI), the index was prone to overstating inflation when food prices were elevated, resulting in a more restrictive monetary policy than necessary. Fourth, this was one of the reasons for India’s growth underperformance in recent years.

India recently affirmed that it is sticking to its FIT framework for another five years with the very same parameters. The good news is that RBI is blessed with a leadership that interpreted the framework so flexibly in 2020 as to handle the risks of instability competently in the course of the year. [Link]

Supply chain disruptions and the threat of inflation

I have long held the view – and am still holding on to it – that a sustained pickup in general price levels (familiarly known as a higher inflation rate) requires acceleration in wage growth. Post-1980 policy framework basically embraced the Phillips curve and suppressed wage growth in order to suppress the inflation rate. It served a dual purpose. It held down the inflation rate and hence the cost of capital. It also meant holding back the power of labour vs. capital. To put it somewhat provocatively and more colourfully, it was about defeating Marx in the name of markets. That framework has remained in place for four decades.

Now, central banks are only trying to loosen a small plank of it. They want to let inflation rise without letting the cost of capital rise and they are confident that wage growth is not accelerating anytime soon.

Robin Wigglesworth in this long article for the FT on the ‘inflation bogeyman’ comes up with a good description of the forces that held the inflation rate down in the advanced world in the last four decades:

Inflation will mechanically accelerate in the coming months, simply given the base effects from last year’s coronavirus-blasted data. A spurt of post-lockdown spending could give it some extra juice in places. But labour markets are not exactly screaming that wage growth is going to be an issue, and the longer-term inflation outlook remains clouded by the same secular, powerful forces that have kept it contained for decades…..

… It was only the “heady cocktail” of post-second world war rebuilding, the birth of welfare states, the collapse of the Bretton Woods exchange rate system, trade unionisation, and an oil crisis that helped send inflation spiking in the 1970s, he said. It might re-emerge as a genuine, long-term threat, but that is likely to take decades to manifest itself, not months. 

[Parenthetically, I want to mention a couple of things:

(i) Robin Wigglesworth’s article has a nice graphic on ‘the largest market tail risk’ as perceived by market participants over the last ten years (2012-21). Check it out. My guess is that all the five tail risks identified between 2012 and 2017 are likely to come back this decade.

(ii) I must note here that you are better off saving time by not reading this article by Martin Wolf which had appeared a day before Robin Wigglesworth’s article. It is too long for too little insight.]

While that is a good stylistic description, are there signs that things are beginning to shift? Well, the evidence is in favour of this balance of power not shifting anytime soon. This short news-story in FT on the wage negotiations between IG Metall – the labour union that represents all manufacturing sector workers in Germany – proves that central bankers are right to be sanguine about the rate of inflation ‘not getting out of hand’ any time soon.

So, central banks are right about the latter – wages. Further, they will mostly succeed in holding back the cost of capital with their tsunami of bond purchases because they may not succeed in stoking inflation higher, much as they want to.

Regular visitors to the blog will be familiar with these arguments of mine. Pl. bear with me. But, what if I am wrong and the central banks succeed in stoking inflation, without wages accelerating and therefore, what if they fail in holding the cost of capital down?

Evidence contrary to the IG Metall story from Europe is emerging from the United States of America despite a record number of people still remaining unemployed. It is partly because of the unemployment cheques are generous. Hence, there are job openings and no takers. Ed Yardeni points out that the ratio of unemployed to job openings dropped to 0.81 in January. It jumped to 4.63 in April 2020. Hence, wage growth is somewhat on the brisker side. Into this milieu has come the new USD1.9 trillion stimulus package that has been passed. Its effect will be unfolding in the coming months.

So, could this combination of wage growth due to unexpected reasons, over-generous and superfluous fiscal stimulus supported by an ultra-accommodative monetary policy be a sure-fire recipe for inflation resurgence? The Federal Reserve might then experience the old Chinese proverb: “Be sure of what you want; you may get it.”

If they succeed in letting inflation rise and if they fail in holding down the cost of capital, then mayhem will follow in financial markets because too much of debt has been added to many balance sheets in the last fifteen years. Further, wage growth may follow as the higher cost of living will force workers to wake up from their slumber and start demanding their pound of flesh.

So, it is a high-risk, high-wire game for central banks. But, it may be a familiar world for commercial banks. They may like it as interest margins rise but before that, the pain of bad loans might strike first. Eventually for central banks since taming inflation does not impose any upper bound on interest rates as the lower bound does, when trying to generate inflation. But, none of this will be smooth. In fact, more likely tumultuous, painful and long drawn out.

How can this situation emerge? This is where we have to pay attention to climate risks. In fact, that might be the reason why central banks are beginning to keep an eye on climate change. Some are going a step further and are wanting to incorporate it into their policy framework. Climate change impact can be stagflationary. That is my first guess. So, how to react to it is a challenge for central banks.

Climate change has caused quite a few disruptions in short time. One was the Texas freeze that gutted chip production. Then, the drought in Taiwan. Third, the desert winds that caused a big container ship to run aground. It has since been freed. Clearly, climate change is emerging as a significant ‘facilitator’ of higher inflation. That is what I am now beginning to be alive to, notwithstanding the long-held view that a sustained acceleration in wages is a pre-condition for an equally sustained pick-up in inflation.

This long article in Wall Street Journal captures the chaos or mess in supply chain everywhere. The evidence assembled is compelling and persuasive. Of course, many of these might be ephemeral and may disappear. But, one does not get that impression. It depends on the investments made already. Not sure if the western business world did really invest in capacity building. Not much in America, for sure. The chart below captures the ‘non-residential fixed investment in equipment and software’ as a share of GDP. This is long-form for what is more commonly known as capital expenditure by businesses or, simply, capex.

I have taken the nominal quantities rather than real since they are subject to somewhat subjective quality adjustments. Since the 1980s, the ratio has been declining. The striking thing is the failure of the ratio to rise in the new millennium. The internet boom had bust and many an investment had gone sour. There was a recession that lasted about 3 to 4 quarters. Then, there was the Bush tax cuts. The Federal Reserve dropped the Federal funds rate to 1.0% by 2003 and held it there for a year. There was ample reason and avenue to invest afresh in ‘capex’. But, instead, we got a real estate investment boom that eventually went bust in 2007-08.

It was during this period that China had a massive investment boom and export-led growth. Post-2008, China continued in that vein. Even now, China’s investment share of GDP is quite high. So, excess capacity in productive sectors, if any, is to be found in China. But, with China adopting ‘dual circulation’, how much of this excess capacity will be available to the rest of the world and at what price is a different question to answer than it was in the heydays of globalisation before the global financial crisis of 2008.

Indeed, the freak weather related disruptions or accidents, apart from the pandemic-induced shutdowns and lockdowns, what has come into sharp focus in recent months or a year is the fragility of just-in-time inventory systems. Read this well-researched (good graphics, again) article in FT on the chip shortages faced by car-makers. They are not the biggest customers of the chipmakers. The first two spots belong to smartphone and PC (incl. laptop) makers. Work-from-home has caused a spurt in PC demand. Along with that, came the disruptions in Texas and Taiwan.

An interesting quote from the article is this:

“It’s unheard of for such incidents to happen all at the same time. The impact will be considerable,” said Akira Minamikawa, analyst at research firm Omdia. 

Three things came to my mind. One is my blog post few days ago on the brilliant or wicked scriptwriter from the heavens. The second is that such statements are more likely to occur than not going forward. Third, I wonder if such accidents are more likely harbingers of a pickup in inflation even before wage pressures kick in.

I shall end this article with the time-worn expression of op.-ed. writers: “Only time will tell.”

What should RBI do and why?

I just chose this title because I was reminded of the way we used to get case studies in the classrooms some 37 years back at IIM-A (PGP-85). Almost all the cases would either come with a similar title or end on that note: ‘What should XYZ do and why?’.

So, the point is that the title may be so grand but don’t be fooled by it. It is just a collection of thoughts triggered by reading two articles sent by two friends – articles that they wrote. One is by Sajjid Chinoy and the other is by Ananth Narayan at SP Jain. I would like to stress that my thoughts are triggered by their articles but they do not necessarily constitute a response or rejoinder to their views. That said, they both are in disagreement with or, at best, only in partial agreement with my views on what RBI should be doing with respect to the currency.

Sajjid’s article is here. Ananth Narayan’s article is here. If anything, much of what follows below relates more to Sajjid’s article than to Ananth’s. I am inclined to agree with Ananth’s suggestion that, under the current circumstances, RBI should not move short-term rates higher.

I am not convinced that (a) there will be a strong American recovery; (b) that it would be sustainable; (c) that it would be a repeat of 2018 if not 2013 (headache and not migraine) and (d) that monetary policy in the West would be forced to move in the direction of normalisation. The recovery, if any, in the USA will be shortlived. That monetary policy is in no position to even move towards 30% to 40% of the peak FF rate (2.5%) reached in 2018 and that the EM countries face 2018. We face neither 2018 nor 2013. We will continue to face 2003-2007. So, the sins, if anything, will be committed at home. The danger is to avoid irrational domestic exuberance again.

Therefore, with respect to America, perhaps, one could say that I am more in the no-reflation camp if not in the ‘deflation’ camp. Put differently, I align more with Albert Edwards and David Rosenberg than with the so-called optimists on reflation. Regardless of whether you agree, this interview of David Rosenberg from February 2021 is well worth a read.

Also, I am not convinced that, for an emerging economy, it better to have the problem of managing currency depreciation than to manage currency appreciation – which is RBI’s problem. I am not convinced of it. To let the rupee appreciate rather than intervene and add to domestic liquidity is the lesser of the two difficult choices, in my view.

The notion of competitiveness being threatened with currency appreciation is theoretical. For exports, income and price effects both matter with the former more important than the latter. Exchange rate acts predominantly through the price effect. Second, if the American economy is the only one that is going to recover – and that too through non-tradables – then any threat to export competitiveness is mostly theoretical and overstated.

If I were RBI, I would opt for currency appreciation and coordinate with the Union Government and State governments to offset the so-called loss of competitiveness through regulatory easing to boost productivity and competitiveness. That is, as I had written in Mint, the route to competitiveness lies in ‘divesting from LIC’ – I mean, the License, Inspection and Compliance at all levels of the government – Union, States and Local.

I am more concerned about the ill-effects of continued intervention and the surge in domestic liquidity, having endured a near ‘lost decade’ (or half decade) in economic growth due to de-leveraging and banks’ reluctance to lend, caused by surge in domestic liquidity, credit and asset prices pre-2008 and post-2008. Given the current global growth backdrop and given India’s context, the downside of currency strength is vastly overstated by macroeconomists and is mostly theoretical.

None of the above is to suggest that this is THE only possible view or path for the economy. I could be totally wrong. It is not a faux statutory disclaimer. The reality is so hazy that the range of possible outcomes is rather wide. Hence, the disclaimer. Much as I believe that the world is not facing an inflationary spiral yet – and recent data from the US and elsewhere bear this out – and, therefore, the surge in the bond yield would be shortlived, I must concede that Edward Chancellor makes a good bearish case for bonds here. This is just one illustration of how reasonable people can make a credible case for entirely different outcomes.

Bitcoin untethered – links

Andy Kessler tracks the rise of Bitcoin to Tether:

Tether’s creators might have manipulated bitcoin, a University of Texas paper suggests, by issuing tokens willy-nilly unbacked by real dollars and then buying bitcoin to jack up its price. (The company claims the research is flawed.) [Link]

This is the link to the original Univ. of Texas paper published first in 2018. The link did not open for me, however. I will be trying again. Having problems with SSRN tonight.

(2) Edward Chancellor appears to have thrown in the towel on Bitcoin, having called its top in 2017 correctly. [Link]

(3) This article in ‘Research Affiliates’, published barely two months ago, echoes the point made by Andy Kessler on the how Bitcoin was ‘tethered’:

Tether is currently being sued by some investors who allege that no one is actually buying USDT from Tether Limited, but are minting USDT out of thin air, bypassing the supposed one-to-one (USDT/USD) backing (Mizrahi, 2019). They further allege that agents for Tether then use USDT to buy Bitcoin (and select other cryptocurrencies in favor with Tether) on exchanges, such as Bitfinex and Binance, that offer trading on the BTC/USDT pair. This action pushes up the price of the BTC/USDT pair. Because USD/USDT trades at dollar parity, the price is arbitraged on exchanges that trade the BTC/USD pair. Tether’s agents can then sell the BTC for USD and deposit them into the Tether bank account in case of audit and Tether could claim the USD were always there. …

If the market manipulation story is true, then BTC is not in a bubble in the traditional sense (Arnott, Cornell, and Shepherd, 2018), but is in the midst of something that could be much worse. If Tether were to be shut down, and if, in fact, artificial demand from Tether was supporting the price, the losses from a BTC crash may not be recoverable. [Link]

(4) Jim O’ Neill writes for ‘Project Syndicate’:

The rising popularity of SPACs and cryptocurrencies seems to reflect not their own strengths but rather the excesses of the current moment, with its raging bull market in equities, ultra-low interest rates, and policy-driven rallies after a year of COVID-19 lockdowns. [Link]