Non-economists at central banks

I am not sure whether my friend Amol Agrawal’s piece in Business Standard is a lament or praise for the fading of economists from high seats in the world of central banking. It seems to be a factual article leaving much unsaid. Perhaps, he is training to become a central banker!

I do feel, for the record, that governments should allow independent institutions to exist within the government framework. But, they cannot become alternative power centres and be vocal about their differences with the government. But, they should be voices of conscience and they should focus on the long-term objectives of governance which can be different from the short-run goals of those who govern. Therein lies the tension. On those occasions, they must speak out with restraint, firmness, confidence and politeness but must avoid grandstanding. If they fail, they should leave, rather than make the situation worse for the country with a messy fight.

Paul Volcker had his run-ins with James Baker, Treasury Secretary under Ronald Reagan in his second term. He mentions the post-Plaza Hotel Accord incidents. The communication committing the G-5 (Canada and Italy were added later to become G-7) to monetary easing was opposed by Volcker. Soon, he faced an insurrection inside the Federal Reserve Board. He did not resign nor did he do grandstanding then. He left at the end of his second term although originally he had planned to serve only two years of his second term. That seems like a better way of handling differences. (Source: ‘Keeping at it’ by Paul Volcker)

Ninan’s missed opportunity

Last weekend (June 29, 2019), T.N. Ninan wrote an article on the departure of Viral Acharya from RBI. He is the Deputy Governor. His first term ends in January. He is leaving six months ahead in July.

Viral Acharya has been personally courteous to me. In fact, when I pointed out that RBI surveys (quarterly surveys) should be captured in Excel for download and analysis, he quickly set the ball in motion and it became a reality. Now, we can download the survey results and do analytical stuff with it.

That is not the point. His departure is neither the end-of-the-road for RBI independence nor is it an embarrassment for the Indian government.

Ninan writes:

Similarly, those within the Indian government system do not speak out publicly against the government they serve. When you are the governor or deputy governor, you do not have the freedom of speech that an ordinary citizen enjoys. Differences are aired only internally. On the occasions when someone feels the need to start a public debate, it is not done in apocalyptic terms. Naturally, when Dr Rajan and Dr Acharya spoke out bluntly (in the case of the former, on issues with which he was not officially concerned), it did not go down well.

No employer will allow their employees to speak out against them publicly when you are still working for them. No private sector enterprise would allow that. Nor, for that matter, do foreign governments – even those in developed countries – allow that.

Independence of the central bank does not mean that they cannot be questioned. It does not mean that they are not accountable to anyone. If they are forced to overturn a decision taken in public interest by the sheer weight and force of authority without logic, that is an assault on institutional independence.

Indeed, those who brandish independence as the first line of defence against and all criticisms are the ones who are shutting out debate.

I was happy to see the header in a MINT report on RBI’s revised circular on the recognition of non-performing assets after the Supreme Court struck it down. The report said that the new circular was an exercise in humility. Well said. I found the new circular pragmatic and it did not sacrifice credit discipline.

Mr. Ninan concludes his article thus:

Today, with growth having slowed and macroeconomic challenges in every direction, would the government have benefited from the advice of “Harvard” economists? Perhaps, but judging by past record it probably would not have paid much heed.

Is that so? But, Andres Velasco provides a counter perspective. India, probably, does not miss much or would not miss much.

Mr. Ninan has missed an opportunity to write a more useful piece. That is a pity because he is one of the more perceptive, experienced and balanced commentators in the country.

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