The RBI governor was right to question the benefits of the US Federal Reserve continuing with quantitative easing now that the financial system is back to a modicum of health.
A few days ago, at a Brookings Institution event, a tiff of sorts broke out between Raghuram Rajan, governor of the Reserve Bank of India and Ben Bernanke, former chairman of the US Federal Reserve Board (FRB).
In his speech, Rajan questioned the continued benefits of sustained quantitative easing (QE) beyond the time required to repair an ailing financial sector.
He also justified exchange rate intervention (ERI) as a similarly unconventional measure undertaken by developing nations to manage their own economies.
In addition, he made a strong case for more collaboration between central banks to manage the ill effects of both, entering into unconventional policies and exiting them.
Bernanke, who was in the audience, took exception to a couple of points. Apart from disagreeing with Rajan on the reducing benefits of continued QE, he tried to differentiate between the policies of developed nations as being “demand enhancing” and beneficial, and those of developing nations as being “demand diverting” and hence, non–beneficial.
He argued that Rajan’s fault lay in ignoring the “money” effects of these measures. He also claimed that central banks do collaborate and that he did not see much benefit from further collaboration.
On a visit to India for a privately organised event a week later, he chose to devote his entire address to rebutting Rajan by expanding on these arguments.
When two renowned experts take opposing positions on a subject as inherently mysterious as monetary policy, it leaves observers confounded.
We can choose to back Rajan’s position based on his prescience in predicting the financial crisis alone, but that would leave one with a seed of doubt. Is it possible for Rajan to take on Bernanke and still be right? Doesn’t that mean that the mighty Ben Bernanke may be wrong?
After the global financial crisis, financial systems in developed markets were in utter disarray.
One of its consequences was a drop in developed market demand that led to widespread domestic recessions, lower import demand and, therefore, deficient growth in the developing world.
The US saw QE as a panacea since it promised both support for a teetering financial system and enhanced demand. After successfully restoring the financial system to a modicum of health, it tried to end QE, only to be faced with falling demand and the threat of recession once again. As a result, QE continues till date.
One may be forgiven for thinking that the measures taken by the US were aimed at enhancing domestic demand alone, as Bernanke claims.
This would be wrong. Increased money supply increases the demand for both consumption goods and capital assets.
It was also fairly obvious from experience in the pre–crisis years that some of this additional demand for capital assets would flow to the developing world.
In the absence of ERI by the recipient nations, their currencies would appreciate, diverting goods demand from domestic suppliers to the external market, primarily to the source nation.
As a result, not only would the source nation benefit from enhanced domestic demand but also from potentially higher exports.
Clearly, gaining external demand through a weaker dollar was an unspoken, but much-desired outcome of QE.
For developing nations, in addition to export demand for goods and services suffering greatly due to the slowdown in developed markets, these nations also stood to lose a portion of their domestic demand to cheaper imports due to the unconventional policies undertaken by the US.
Central banks in developing nations intervened to ensure their currencies did not appreciate in response to capital flows.
However, since domestic demand in these nations hadn’t suffered much to begin with, this intervention threatened to overheat their respective economies.
The decision to sterilise it was only logical since it rendered the intervention domestically neutral.
With this understanding, it is clear that Bernanke’s assertion that QE is demand enhancing is, at best, a half truth.
With capital flows and in the absence of ERI by recipient nations, it is demand diverting as well, with the recipient nation losing consumption goods demand to the source nation.
Expecting developing nations to stand by and sacrifice demand to accommodate the US is not only unrealistic, but also arrogant.
For recipient nations, whether to intervene or not was never really a choice.
Their options were limited to either merely negating the diversion through sterilised intervention or also adding to domestic demand by allowing the intervention to remain unsterilised.
It isn’t Rajan ignoring money as much as it is Bernanke ignoring capital and exchange rates.
But more importantly, this arrogance also calls into doubt the authenticity of the collaborative efforts undertaken by the US Federal Reserve with other central banks.
A collaboration essentially implies giving participants the ability to influence the outcome of a discussion. In the absence of such ability, it is merely information sharing.
In the current context, collaboration does not necessarily imply sacrificing national goals. In fact, the longer-term outcomes of a collaborative effort are bound to be incrementally beneficial to all concerned, if simply by avoiding the volatility associated with confrontation.
It would be invaluable in charting a stable long-term global monetary policy path with participants fully aware of their respective responsibilities. The only sacrifice this requires from the US is that of its arrogance.
It isn’t often that central bankers break rank and express concerns with peer behaviour publicly. For Rajan to have done so, displays angst deeper than that visible in his speech.
For Bernanke to confront him with a contrived rebuttal, only highlights the reasons for Rajan’s angst to begin with. While the US may believe that it can have its way with the rest of the world today, it must realise that changes in the global financial order will ensure this doesn’t last forever.
More importantly, its arrogance may well hasten the process. With every confrontation, the desire to look for an alternative to the US consumer market and its currency acquires greater urgency.
The choice facing the US is a simple one. It can either lose its arrogance or lose its leadership. It can’t have both.