What does Raghuram Rajan think of Ben Bernanke’s quantitative easing programme?
How does Raghuram Rajan, the governor of the RBI, view the experiment of fiscal stimulus that the US Federal Reserve, under Ben Bernanke, has been pursuing? Remember, Rajan had correctly warned in 2005 that a combination of low interest rates, financial innovation, rising asset prices, and behavioural biases was a matter of great concern. The 2008 crisis proved him right. He has similar warning for Fed’s current policies
Since 2008, the US Federal Reserve under Ben Bernanke has been using an unconventional monetary policy tool known as quantitative easing (QE). It includes massive bond-buying programme that frees up capital for the banks, making it easy for banks to lend, which it is hoped would create economic growth and jobs. The programme is controversial, with some saying that is what is helping the US and world economy grow while others criticise it has adding to exactly the kind of instability we saw in 2007-08. Some of this money eventually found its way to emerging markets, including India. Is this a good thing? Not quite, according to Dr Rajan.
Remember in 2005, Raghuram Rajan gave a similar speech at Jackson Hole, Wyoming, to a conclave of the best and brightest financiers and bankers. He had warned that the risks in the system due to low interest rates, rising asset prices and perverse incentives for banks and investors were not be calculated accurately and that there was a small chance of a catastrophic meltdown. A meltdown did happen in 2008, as he had feared and it put Dr Rajan on world stage as a thinker to be reckoned with.
So it is worth paying attention to what he thinks of the US Fed Reserve’s current policy is. A brilliant speech given at the Bank of International Settlements (BIS), on 23 June 2013, underscores what Raghuram Rajan views are about QE.
“The Fed, led by perhaps the foremost monetary economist in the world, proposed creative solutions that few in policy circles, including the usually conservative multilateral institutions, questioned.” Though he doesn’t name him explicitly, Dr Rajan feels that Bernanke, among many other central bankers, have turned into technocrats humbled by his inability to control economic narrative. He goes on to say, “If there is one myth that recent developments have exploded it is probably the one that sees central bankers as technocrats, hovering cleanly over the politics and ideologies of their time. Their feet too have touched the ground.”
Dr Rajan’s speech has raised the dangers of adopting QE. He says, “The bottom line is that unconventional monetary policies that move away from repairing markets or institutions to changing prices and inflationary expectations seem to be a step into the dark.” In other words, it has unintended, dangerous consequences.
The whole purpose of central bankers is to put the economy back on track and create employment, or in Keynesian jargon – full employment equilibrium. Yet, this has not happened. Instead, according to Rajan, businesses and citizens were actually retaining their savings, postponing purchases and not reinvesting back into the economy. The dollars printed are not circulating back into the American economy in form of real investments viz jobs creation, businesses, etc. In fact, it caused businesses to cut back on jobs! After all, Ben Bernanke’s premise for QE was precisely that: job creation. Dr Rajan explains, “...accommodative policies may reduce the cost of capital for firms so much that they prefer labour-saving capital investment to hiring labour...excessive labour-saving capital investment may defeat the very purpose of unconventional policies, that is, greater employment.”
The reason the Federal Reserve resorted to so called “creative solution” of QE is because the interest rates could not go below zero and therefore the Fed has resorted to alternative or “creative” solutions.
Dr Rajan is critical of this approach. He says, “That the equilibrium or neutral real interest rate is ultra-low—has become the justification for more and more innovation.....the view that the full employment equilibrium real interest rate is strongly negative can be questioned. Once that is in doubt, the whole program of pushing rates lower as a way of moving the economy back to full employment is also questionable.”
Dr Rajan says, “By changing asset prices and distorting price signals, unconventional monetary policy may cause overinvestment in areas where asset prices or credit are particularly sensitive to low interest rates and unanchored by factors such as international competition.”
In other words, money has gone to riskier areas, including emerging markets. Moreover, central bankers in emerging markets are confused as whether to contain incoming flows or revel in greater infusion of foreign capital. The Federal Reserve’s experimentation in the dark, has stumped them. This has put the spotlight on emerging market central bankers who weren’t trained properly. He says, “Few had the training and confidence to question the orthodoxy, and the ones that nevertheless did were considered misguided cranks. Multilateral institutions, empowered by their control over funding, dictated policy from the economic scriptures.” It is pertinent to note the last part of the sentence in the Indian context: Indian bankers and politicians still believed in India’s growth story and ignored the consequences of relying too much on foreign inflows instead of taking difficult decisions to fix the economy and bridge the deficit.
“The dilemma for central bankers is particularly acute when the immediate prospect of a terrible economic crisis is necessary for politicians to obtain the room to do the unpleasant but right thing,” quips Dr Rajan. This is particularly relevant in the Indian context. He says, “For the receiving country, it is unclear whether monetary policy should tighten and attract more inflows, or be accommodative and fuel the credit boom. Tighter fiscal policy is a textbook solution to contain aggregate demand, but it is politically difficult to tighten when revenues are booming, for the boom masks weakness, and the lack of obvious problems makes countermeasures politically difficult.” Simply put: the foreign capital inflows created economic growth which camouflaged the real problems India has. Nobody did anything.
Towards the end of his speech, he fears that such “creative” tools like QE are increasingly becoming a norm rather than an exception. With the global financial world in crossroads, central bankers have been given a free hand to do what they want as they run out of options. Dr Rajan says, “The central banker has to be confidant, and will constantly refer to the many bullets he still has even if he has very few... Perhaps it was the political difficulty of doing nothing after spending billions rescuing the private bankers that encouraged central bankers to act creatively. .. Was it that once central bankers undertook the necessary rescues of banks, they were irremediably entangled in politics, and quantitative easing was an inevitable outcome?”
The speech transcript is a must read for anyone who wants to know more about central banking and economics, and what the future holds for the financial world.