Interest rates and growth

This article by Rohan Chinchwadkar of IIM Tiruchi made me happy for more than one reason:

  • It is from a faculty member from one of the newer IIMs
  • It is well and simply written. It does not try to overdo its point
  • It sources a recent piece of international research
  • It shows a faculty member who is in touch with contemporary reserach. Good for students
  • It was well timed – on the eve of the RBI Monetary policy meeting
  • It presented a paper that had turned conventional wisdom on its head

Not much can be asked of an op.-ed.

Kudos to MINT for publishing it.

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The Thiruvadanthai trilemma

Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:

Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).

I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!

The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.

Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.

Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.

That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.

Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.

Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.

So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.

Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.

In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.

In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.

If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.

If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.

Powell’s seminal debut

After easing substantially during 2017, financial conditions in the United States have reversed some of that easing. At this point, we do not see these developments as weighing heavily on the outlook for economic activity, the labor market, and inflation.

The FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis. [Link]

Powell’s prepared remarks were rather brief but telling. He does not think that financial market volatility will have a big bearing on  economic activity.  We agree. One hopes that it is not just about current level of volatility but also reflects a structural attitude that assigns a lower weight to the goings-on in financial markets in terms of their impact on the real economy. Anna Cieslak and Annette-Vissing Jorgensen have documented this rather well. The Fed is more concerned about declines in financial asset prices than they ought to be. In reality, the impact is far lower than what Fed models assume.

His second statement is even more interesting. He is no longer talking about striking a balance between employment and inflation but between avoiding overheating and bringing inflation to 2% (from below). He is not going to be fixated on bringing inflation up to 2% from below. He will also keep an eye on overheating. Good for him!

Interesting times ahead.

Nearly three months ago, Gavyn Davies wrote a blog post for FT that Trump has the opportunity to shape the Federal Reserve Board this year in an unprecedented manner:

Including the promotion of Jerome Powell to Chair, six of the seven board members will have been nominated by the current administration when the process is completed next year. In addition, the President of the New York Fed will have been replaced by its own board. Such a root-and-branch upheaval in the Fed’s key personnel is unprecedented in its history.  [Link]

He predicted that the new Federal Reserve Board would likely display the following tendencies:

There may be more enthusiasm for expansionary fiscal policy, and greater belief in beneficial supply side effects from cuts in marginal tax rates;

There may be greater concern about possible instability from rising asset prices;

There may be greater willingness to reverse some of the regulatory restrictions in the Dodd Frank legislation;

There may be less emphasis on gradualism when it comes to raising interest rates;

There may be a greater eagerness to run down the balance sheet, especially in non-treasury assets;

There may be more emphasis on rules-based policy decisions, notably on the use of the Taylor Rule.

I like most of the above. In fact, I think Jerome Powell alluded to the second item in the above list when he spoke of balancing between overheating considerations and bringing inflation up to 2%.

I was surprised that many have not observed his comment about balancing between avoiding an overheating economy and bringing inflation to 2.0%. John Authers, here, notes that his message was not too different than that of Ms. Yellen but that he delivered the message in a business-like fashion. I disagree. The message too was different.

It is the first time in a long time that a Fed chair mentions overheating risks while trying to bring inflation back up to 2%!

In November 2017, Stephen King (formerly with HSBC) wrote a nice piece in FT suggesting that “central banks that focus on price stability alone may only be stoking the next financial bubble”.

We may have found a central banker who wants to put an end to that practice.

What is RBI’s role in PNB?

Someone who read my blog post called me and told me to consider the following:

If a fraud in any company occurs, it is the problem for the management, the Board and the owner, in that order.

In this instance, can the regulator change the owner? No. The Board? – No. The owner appoints them. Can the regulator order the CEO replaced? No! The owner does not need the regulator’s approval for public sector banks to appoint CEOs whereas private sector banks do need the regulator’s approval.

The regulator is responsible for financial stability and consumer protection.

Now, Tamal Bandyopadhyay in his piece for MINT says that RBI insists on reconciliation of Nostro accounts:

Finally, RBI is very particular in keeping a tab on all transactions in banks’ Nostro accounts and it always insists on timely reconciliation of such accounts. How could the rapid rise in transactions in PNB’s Nostro account escape the regulator’s eye?

I understand RBI sent a note to all banks in the first week of February, asking them to reconcile all Nostro accounts.

What if banks tell the RBI they have done so, without doing so? What can the regulator do, in such situations? Have the bank’s internal auditors and statutory auditors failed here?

From Tamal:

Concurrent auditors in bank branches are assigned the job of transaction verification. There could be delay, but I wonder how the concurrent auditors failed in tracing out the full chain. Ditto about the statutory auditors. They are supposed to check customer-wise transaction register, along with sanctions /approvals for authenticating the true state of the books of accounts and establish the amount of bank’s contingent liabilities on the date of book closure. Similarly, the internal auditors are expected to verify client files, outstanding transactions, approvals and transaction registers. Besides, RBI auditors conduct the annual financial review.

But, Tamal also added this:

Besides, RBI auditors conduct the annual financial review.

What is the depth and breadth of this review? So, is the regulator really free of lapses here?

A much scarier thought

On this Punjab National Bank scandal, it does seem simple enough to understand what happened. But, that is worrying. If it was reasonably simple, why did it go undetected? It is not unreasonable to assume that several could be on the take – cutting across banks, auditors, the regulator, governments, etc. We live in a cynical world.

But, that is low probability because it is risky to involve too many stakeholders. Someone could spill the beans, if not out of altruism and morality but out of pique, let us say, because the spoils were not shared ‘fairly’. Yes, there could be moral considerations in immorality!

A scarier thought – scarier than the possibility of multiple layers and cross-sections of involvement – is that simply no one bothered to notice or do their job. The mind-numbing possibility is one of pervasive and deeply ingrained indifference and sloppiness. In other words, no one cared or cares any more!

Hence, it was scary to read that someone actually mentioned this as the possible reason for the scandal remaining undetected:

The accounts given by current and former executives who spoke to Reuters suggest an answer as simple as it is alarming: no one was paying attention. [Link]

This does not augur well for the integrity and unity of the country at all because it could be pervasive – yes, not within the banking system alone. Why should other sectors be different?

[Postscript: If the bank issued LoU to foreign banks (or, foreign branches of Indian banks, I presume that they would credit PNB’s Nostro account held with them before PNB credits the account of the borrower with the money. If I am right, why did the audit of PNB’s Nostro Accounts not spot the ‘unusual’ transactions? Why did anyone not raise a flag? Are these stupid questions? Perhaps.]

Problem disguised as solution!

A very ‘clever’ piece of writing by Ajay Shah on the Punjab National Bank scandal and the need for strengthening capabilities of the regulator, the Reserve Bank of India. Nothing wrong with the principle. But, really the devil is in the details.

In a country that does not know how to regulate banks, we should systematically reduce the size of banking relative to GDP. We should foster non-bank financing, and block the nominal growth of banking until we get to a minimum level of capabilities at the RBI.

That is the ‘clever’ bit, kept for the last.

What is the logic behind the assumption that non-banking sources of finance – i.e., capital markets – are exempt from scams, scandals and frauds? What about the capital market regulator, SEBI? Has India done enough to strengthen it with capabilities? Has India’s stock market been free of scandals and scams? Three, what about mis-selling of capital market products to retail investors if capital market financing becomes the route for Indian businesses? Yes, the Indian Financial Code (IFC) might have consumer protection clauses. But, they too require a regulator to implement. What is the guarantee that they will be born with those capabilities straightaway, in the Indian context? Four, reliance on capital markets means that savings are not pre-empted by a large State through the banking system. That is not the case in India, yet.

If we do not grow the banking system, will the public save more through small savings schemes? That carries a much higher interest burden and with tax exemptions, the effective cost to the borrower (the State) is even higher. The government will rely on it even more for covering its spending, if the banking system is ‘not allowed to grow’ until the regulator is strengthened, as the author says.

That will effectively raise the government’s interest burden and hence the deficit. Higher benchmark bond yields will follow and higher cost of capital for corporate borrowers. They will not want to tap capital markets and if, in the meantime, banks are not allowed to grow, what happens to capital formation in the economy?

If more domestic savings are either pre-empted by the government or is directed towards small savings, then for capital market, it means greater reliance on foreign savings for non-bank sources of financing to become more dominant. Is that desirable? Will that not have other consequences? Or, is there any basis to believe that foreign sources of savings are untainted and exempt from bad behaviour?

It does not make much sense to propose solutions that open a new can of worms and which, arguably or potentially, could be more destabilising.

Weekend snippets

On the other hand, regulation remains a concern for many, with 75 percent of members continuing to feel foreign companies are less welcome in China than they have been in the past. Although down from 55 percent last year, some 46 percent feel foreign companies are treated unfairly compared to local companies and, for the third year running, respondents cited inconsistent regulatory interpretation/unclear laws and enforcement as the top challenge to doing business in China. For the first time, compliance and enforcement made the list of the top challenges companies expect to face in 2018. [Link]

(2) US Non-Farm payroll data for Jan. 2018 [Link]

(a) ​from Jan. 2017, unemployment rate for Whites has declined the most among races.

(b) In terms of education, unemployment rates for

high school or below and

high school but no college have declined the most.

Put (a) and (b) together, ​Trump has delivered for his constituency, I suppose.

(3) This Matthew Klein post in FT Alphaville might be from December 2014 but well worth a read on how Japan is far better placed than most think.

(4) A Chinese company lets go off the option of paying off a perpetual bond and has to raise the coupon by 3 percentage points. [Link]

(5) Dr. Manmohan Singh’s master class in fiscal indiscipline. Indeed! Who is better qualified than him to offer a master class in fiscal indiscipline?

(6) Academic economists close ranks on Janet Yellen as she departs but the last line attributed to Shiller restores a bit of a faith in their judgement [Link]

(7) An important read for financial market participants (aka investors) [Link]

(8) FT records the slump in U.S. stocks on Friday as the worst in the Trump era, leaving not much to the imagination of readers as to what message it wants them to take away.

Curious to know if the FT credited Trump when the stock market kept breaking records on the way up. It takes two to tango – the President would not take the blame for the fall even as he took credit for the ascent (both wrong). Similarly, the media would associate the decline in the stock market with him but not credit him for its ascent for one full year.  Both wrong, again. But, what gives the media folks the right to think that they are morally superior to the man that they love to hate?

(9) Vivek Kaul writes one of the most relevant comments on the Indian budget for 2018-19 [Link]

(10) A good piece on the challenges facing Jerome Powell as he takes office on Monday as the Chairman of the Federal Reserve.