ECB is back!

So, the European Central Bank made some noise about reversing its Quantitative Easing and ‘Whatever it takes’ policy decisions. After having split open the European Union countries with the consequences of its monetary policy, the ECB has now reversed its stance and has actually announced monetary stimulus today!

So, here is the gist:

Do six years of ‘whatever it takes’;

Threaten for six months to end it, without ending it;

The economy rolls over.

Then, go back to ‘whatever it takes’

That shows the efficacy (or, more precisely, the lack thereof) of their policy. Yet, there are people who do not ask those questions and advocate it (again) and the ECB obliges.

How about this for monetary policy prudence and sobriety?

Still, the ECB refrained from more extreme measures such as restarting its bond-buying program or cutting its deposit rate further from minus 0.4%. These options weren’t discussed, Mr. Draghi said. [Link]

Then, we write tomes on why ordinary folks are angry.

Rate cut dissent

If Andy Mukherjee is right that India’s financial stress is spreading, then why should one be surprised that RBI cut rates? Shouldn’t one be surprised about the dissent in the meeting? Credit Suisse research says that financial system stress is slowing the economy.

Viral Acharya’s reply at the press conference does not mirror any of the frantic distress signals that Andy is writing about:

I think this issue has come up quite a bit over the last six months I would say starting with the default of IL&FS. We have looked quite carefully at the data and our assessment is that since the peak of the stress in the short-term commercial paper markets in September and October, things have eased quite comfortably, they have eased especially for the better quality NBFCs and HFCs. So I think what is happening is that the liquidity conditions that had been extremely in surplus mode post-demonetisation have finally reached some normal level so that mutual funds and others who are providing capital to these entities are finally doing quality sorting themselves. I think that needs to be allowed to happen but nevertheless we remain watchful and if we think that there are extremely healthy borrowers who are also struggling with the funding, then we would consider that. [Link]

India should not let Finance become a Frankenstein monster

On January 20th, I read in THE HINDU that Indian stockbrokers wanted the Securities and Exchange Board of India to roll back its new risk management norms for derivatives. I was both amused and not amused. Along with Praveen Chakravarty and Ajit Ranade, I had written about the need for tightening risk management norms for derivatives exposure in Indian stock markets. Prior to these op.-eds., in our co-authored book, ‘Economics of Derivatives’, Dr. T.V. Somanathan and I had highlighted that derivatives were almost wholly used for speculation (=gambling) rather than for hedging.

That does not mean they needed to be banned but the losses from such speculative activity should be borne wholly by the participants who engage in them and that they should not have systemic consequences.

Based on the news-story, one does not get the impression that the brokers have provided any solid arguments or evidence that the proposed margining requirements would do zilch to reduce risk. In fact, their very protest is solid indication that it would. If it resulted in a lower volume or transactions in the derivatives markets, it is good for systemic stability.

This is a classic example of the case of socially useless finance. India, at this stage of development, does not need to go out of its way to facilitate such financial market activities. Instead, it should do what SEBI is trying to do now.

My co-author Gulzar Natarajan and I have finished our manuscript, ‘The Rise of Finance: causes, consequences and cures’ and we have received the first proof from the publisher. We hvae a special chapter on India. India needs to avoid repeating the mistakes that the West made with respect to Finance. The West allowed Finance to become a Frankenstein Monster and India does not have to repeat that mistake.

The myth that secondary market trading facilitates efficient capital allocation in primary markets has been persisted with, for too long, without being subject to the burden of proof. Shrinking investment horizons alone should have let that theory be put to rest permanently. It has not.

Buttonwood, in its penultimate column in ‘The Economist’ last year had written on the ‘Flaws in Finance’. There was a link to his earlier article published in May 2015. Both the short piece from May 2018 and the long essay he had written from May 2015 are thoughtful and make for good reading. But, his conclusions are vague. Here are two samples:

For all their criticism of mainstream economists, the challenge for the behavioural school is to come up with a coherent model that can produce testable predictions about the overall economy. [Link]

Here is the second one:

For too long economists ignored the role that debt and asset bubbles play in exacerbating economic booms and busts; it needs to be much more closely studied. Even if the market is efficient most of the time, we need to worry about the times when it is not. Academics and economists need to deal with the world as it is, not the world that is easily modelled. [Link]

In contrast, witness the most practical suggestion from Cliff Asness:

Making people understand that there is a risk (and a separate issue, making them bear that risk) is far more important, and indeed far more possible than making a riskless world. And if I may go further, trying to create and worse, giving the impression you have created, a riskless world makes things much more dangerous. [Link]

Honestly, the call for new models, etc., are either diversionary or distracting. They are not needed. One does not have to have new behavioural models that incorporate human irrationality. In fact, all that is needed is for policymakers to be reasonable.

(1) You may believe that markets are mostly or, for the most part, efficient. I do not. But, you can accept that humans can and do make mistakes. That is reasonable assumption.

(2) That one does not ignore empirical evidence is a reasonable thing to ask of policymakers

(3) That one requires policymakers to be able to see through the self-interested demands of the financial sector is not such a onerous demand either.

(4) Policymakers simply have to stop writing CALLS and PUTs for the financial sector. That is what Cliff Asness is saying in the quote above. Central banks do not have to remove risk from the lexicon for the financial sector and, in the process, encourage them to take excessive risks that put the economy and their goals for the economy in peril.

The fear of surprise, volatility and the realisation that policy will not be beholden to the financial sector even if there is short-term pain need to be inculcated in the financial sector.

What India’s brokers ask of SEBI is what the American financial sector has been asking of the Federal Reserve in the last thirty years and been getting, up to yesterday.

India does not have to walk the American way in this matter.

Finance and Federal Reserve

In my first column for MINT for 2019, I dealt with the issue of the Federal Reserve backtracking on its rate hike trajectory. Methinks it is sustained pressures from ‘financial market types’ that led the Fed chairman to cave in. I don’t buy the argument that he is tightening on two fronts: federal funds rate and quantitative tightening. So what? One acts through the banking channel (from the overnight lending rate to bank loan rates) and one acts through the capital markets channel – through the yield curve. All the rates, across the yield cuve, were depressed extraordinarily – in magnitude and for an inordinately long time. So what if all points in the yield cuve were rising? Financial conditions still remained accommodative.

This was the burden of my column. I was not impressed with the arguments of Stanley Druckenmiller and Kevin Warsh nor was I impressed with the arguments of John Mauldin. My friend Gulzar Natarajan had urged me to read his ‘Thoughts from the Frontline’. I read the last four of them last evening. You can read two of them – pertaining to the discussion of Fed monetary policy – here and here.

Nor did Gavyn Davies impress me with his arguments. So what if the Federal Reserve were triggering an economic recession? Recessions must be welcomed after excesses have built up in so many areas – from corporate debt to leveraged loans to market concentration in tech firms

‘Wrath of the financial markets’ that Viral Acharya (RBI Deputy Governor) invoked in a speech in October is felt more by central bankers than governments and that too not in public interest but in self-interest of the financial community.

Dean Baker has a list of ‘facts’ or resolutions to improve debates on economic policy in 2019. Item no. 6 is about finance. His list is about the ‘facts’ that are often obscured in economic policy debates:

6) A large financial sector is a drain on the economy
The financial sector plays an important role in a modern economy. It allocates capital from savers to those who wish to borrow. A poorly functioning financial sector is a drag on growth. The same is true of a bloated financial sector.

The financial industry is an intermediate sector, like trucking. This means that it does not directly provide benefits to households, like a housing, health care, or education. For this reason, we should want a financial sector that is as small as possible for carrying through its function, just as we would want the trucking sector to be as small as possible to deliver the goods in a timely manner.

Over the last four decades the narrow financial sector (securities and commodity trading and investment banking) has more than quadrupled as a share of the economy. It would be difficult to argue that capital is being better allocated or that savings are more secure today than 40 years ago.

This means we have little to show for this enormous expansion of the financial sector. It would be comparable to seeing the size of the trucking sector quadruple with nothing to show in the form of faster deliveries or reduced wastage. Finance is of course also the source of many of the highest incomes in the economy.

These facts make for a strong case for measures that reduce the size of the sector, like financial transactions taxes, reduced opportunities for tax gaming, and increased openness in pension fund and endowment contracts. In any case, it is important to recognize that a big financial sector (as in Wall Street) is bad for the economy, not the sort of thing that we should be proud of.

Reducing the size of the financial sector will also mean that its influence on monetary policy will come down. About time.

Lord Skidelsky on central bank independence

An important letter by Lord Skidelsky:

Chris Giles and Sam Fleming rightly note the growing conflict between central bankers and elected politicians (December 10), but fail to explain how this has come about and how it should be resolved. They note that before 2008 central bank policy limited the “volatility of inflation”, though it then “signally failed to prevent the financial crisis”. There is surely more to be said. Limiting the volatility of inflation was an important achievement, but it is far from clear that central banks had any control over the inflation rate itself.

As Mervyn King has said, they had a “nice environment for monetary policy” because of the downward pressure on world prices from the entry of millions of low-paid east Asian workers into the labour market. The failure of central banks to prevent — or even foresee — the 2008 financial crash stems directly from their acceptance of Eugene Fama’s efficient market theory, which implied that commercial banks needed only light regulation. Central banks have played a crucial but hardly stellar role in the recovery from the crash.

Most of the money pumped into the economy by quantitative easing leaked out into the financial and real estate sectors rather than stimulating the real economy. As your columnist John Kay pointed out ( July 9, 2013), “the one certain consequence of boosting asset prices is that those with assets benefit relative to those without”. Monetary policy is neither particularly effective nor politically neutral. Since governments, not central banks, are accountable for the results of policy, macroeconomic management cannot be outsourced to central banks. The two arms of policy, fiscal and monetary, need to be integrated. The experiment of independent central banks has to be brought to an end.

Lord Skidelsky FBA

London, SW1, UK

Retreat of liberal economics

My topic for the MINT column coming Tuesday was partly inspired/provoked by this piece by Vivek Dehejia in the Nikkei Asia Review. He laments the retreat of liberal economics. He should not. Western economies did not become prosperous by following liberal trade or with independent central banks or by encouraging free capital flows. 

Even if one were to vote for free trade, it has to come with caveats on compensating losers. That never happened in many countries in the world. Winners – capitalists – became richer. Losers faced job insecurity and diminished incomes. But, to lump capital flows with trade flows is flawed and dangerous:

The acolytes of Indic economics espouse an end to free trade and free movement of capital.

Dehejia’s mentor – Jagadish Bhagwati – distinguished between trade liberalisation and capital account liberalisation. 

Dehejia has harsh words to say on demonetisation:

His best-known achievement so far has been to oversee demonetization — the botched 2016 cancellation of high-value currency notes in a futile bid to fight corruption, that Prime Minister Narendra Modi insisted was necessary even though most economists said in advance it would be a disaster.

‘His’ in the first line in the above quote refers to Shaktikanta Das.

and this one:

The protectionist swing follows the earlier demonetization fiasco and the mismanaged introduction of a new national sales tax. Ironically, it was Das, the newly appointed central bank chief, who supervised not only demonetization but also the tax reform.

You must read the earlier pieces of Vivek Dehijia on demonetisation. You can find them here, here and here. The tone and the tune are very different now. I doubt if any new evidence has emerged since the last link above (September 2017) that justifies the about-face on demonetisation.

If anything, recent data from the Central Board of Direct Taxes vindicate the header of the last linked article that it was too soon to assess the success or failure of demonetisation. 

Clearly, the Goods and Services Tax (GST), in theory, could have been done better. The peak rate need not have been set at 28%, for example. Exempted goods could have been included. But, this is a continental size economy. Only Singapore has a single GST rate. Other countries have multiple rates. In short, India has not done too badly with the GST introduction and the subsequent course corrections. For another perspective, readers should read the book, ‘Of Counsel’ by Arvind Subramanian.

For some of the newspapers and columnists, Mr. Gurumurthy has become a lightning rod. My views do not correspond with his on all matters and he has acknowledged that we differ, in one of his tweets. That said, I find it hard to accept the argument that he has precipitated the departure of Mr. Urjit Patel from RBI.  Just to be clear, Patel is the fifth RBI Governor to resign.

Further, RBI has made many mistakes in recent years. It was late to wake up to the problem of non-performing assets. It ordered Asset Quality Review of banks only in 2015. It has not undertaken an honest review of its own shortcomings and failures in banking regulation.  The fraud in Punjab National Bank was going on for seven years. IL&FS was regulated by the Reserve Bank of India. On monetary policy, it had stuck to a version of doctrinaire monetarism.  The Government has not interfered with monetary policymaking, even if it has not been happy about it.

The accusation that India is returning to failed autarkic policies of the past appears too extreme. At best, it is a risk that needs watching. But, before that, the world has to avoid returning to the failed liberal economic policies of the last four decades.  For that to happen, so-called ‘liberal economists’ have to admit first that many tenets of ‘liberal economics’ were flawed and they were the fountainhead of many insurmountable problems that the world faces today.

In this regard, the rating agency Moody’s threat that any threat to RBI independence could be construed as needless interference. As I wrote in my earlier post, the Reserve Bank of India is not an independent body, created under the Constitution. It was created by an Act of Parliament. The Ministry of Finance is accountable to the Parliament for the functioning and performance of the Reserve Bank of India. RBI is now independent for the conduct of monetary policy. That has not been jeopardised and it has actually not covered itself with glory on that, with its excessive monetarism.  See Sanjaya Baru’s piece here for a different perspective.

A lumpy error by Tim Harford

By lumping Fed, BoE and RBI in one article, Tim Harford missed out the nuances. Trump’s sniping at the Federal Reserve is unfortunate. America needs a return to normal monetary policy because ultra-accommodative policies have created a lot of imbalances – social and economic. Asset price bubbles are back in many asset classes if not in real estate. Excessive leverage caused the problems in 2008 and leverage ratios are higher now. Eight years of near-zero interest rates and bond buying might have hidden risks in places that would be revealed only later. Therefore, normalisation of monetary policy in America is long overdue. Trump is wrong.

The Bank of England (BoE) inserting itself into the debate on Brexit has been ‘condemned‘ by Mervyn King himself, a long-standing former BoE Governor. Well, he was ‘saddened’. BoE eased pre-emptively in 2016 but the worst macro-economic consequences of Brexit have not materialised.

In India, the story is different. The Reserve Bank of India (RBI) is a creation of Parliament. It is not an independent organ of governance established by the Constitution of India. In the Westminster system of governance India has adopted, institutions created by Acts of Parliament are answerable to the Parliament through the Executive. The Ministry of Finance is answerable and accountable to the Parliament for RBI’s performance. Therefore, the MoF must have authority too, over RBI.

It had ceded the monetary policy function to a committee constituted by RBI and the Government together. The Government has signed an agreement with RBI for inflation targeting and hence the committee is responsible for setting the interest rate. The Government is not commanding the RBI to cut interest rates or intervening in this function. The previous Finance Minister in the previous government did so. He once directed the government-owned banks not to raise their interest rates when the central bank raised rates. That is blatant interference with the transmission mechanism of monetary policy.

The present Government had not acted to curb any institution that has been set up independent of the Executive, by the Constitution. Hence, the question of eorsion of institutional independence does not arise. Nor has it interfered with the monetary policy mandate of RBI which it has ceded to the central bank. One can argue on whether the central bank has excessive capital and whether there is a macroeconomic need for additional liquidity support by the central bank, etc. but the charge of ‘sniping’ is weakly founded.

Further, those who bat for central bank autonomy (independence is illusory except in the case of the Bundesbank and now the European Central Bank) should also bat for central bank accountability. In the West, central banks must be held accountable for their role in the rise of political and economic polarisation (wealth and income inequality and concentration of market power). Arguably, the former is the consequence of the latter.

In India, RBI must be held accountable for its failure to detect and take timely action on the rise of bad debts, on its monitoring of banks’ risk and compliance management systems with respect to frauds and on its regulation of non-banking finance corporations. With respect to monetary policy too, there is a reasonable case that it has been guilty of a doctrinaire approach to inflation-targeting. So, there is really no need to shed too much tears for the exit of the previous RBI Governor.