Stabilities and instabilities in the macroeconomy

Axel Leijonhufvud's latest piece in Voxeu concludes:
(I have put some sentences in bold font to emphasise the most pertinent points being made)

There are four issues to watch for:

• Twin dangers looming ahead are Japanese-style stagnation on the one hand and Latin-American-style high inflation on the other. In more normal times, we would regard these prospects as both unlikely and very far apart on a spectrum of eventualities. High levels of public debt, large unfunded liabilities, and large current deficits mean that they are not at all far apart in the current situation. The apparent political difficulties in decisively remedying the public finances are likely to mean that this is not just a temporary predicament. The navigable channel between Scylla and Charybdis has become quite narrow.
• One overwhelmingly important fact should guide policy over the near-term future – since current bailouts and stimulus policies have stretched public finances to the utmost, governments do not have the fiscal resources to handle another bubble bursting. Policy, therefore, should be conducted in a fail-safe mode. The current policies of extremely low interest rates are not fail-safe. They are aimed at reflating asset prices just enough to stave off a deeper recession. This is a delicate operation, not a robust, fail-safe move. It is creating strong incentives for the banks to return to the tables and resume the game of maturity transformation at high leverage that got us into our current troubles in the first place. It is evident that the banks are responding promptly to those incentives
• High leverage has been the big culprit in the current disaster. To reduce the risk of another crash, we must curb leverage. But governments do not want the financial sector to deleverage now because the requisite falling asset prices and curtailed credit would deepen the recession. The question, of course, is: If not now, when?
• The central banks are planning “exit strategies” by which they mean returning their balance sheets, which are presently bloated beyond recognition with a mix of strange assets, to a condition more resembling that normal to central banks. This will not be easy. If they succeed, however, they will still face the prospect of having to engage in many of the same desperate, unconventional policies in a future crisis. Under present arrangements, the responsibilities of central banks have no well-defined limits. This problem can only be solved by regulation of the financial sector. At present, it does not seem that we know how to do it.

Revisiting the orthodoxy: the experience of emerging economies

An edit in the Business Standard today highlights the changes in thinking with regard to forex reserves and cross-border flows:

This episode has clearly highlighted the need for re-assessing the benefits of accumulating large foreign exchange reserves. Once viewed as inefficient by the orthodoxy, “self-insurance” is now being seen as a legitimate crisis-management strategy.


Alongside this, the orthodoxy about the desirability of capital inflows is also being questioned. Brazil is a prominent example of having recently imposed a tax on short-term portfolio inflows, a variant of the class of instruments generally known as Tobin taxes.
Contrary to the orthodox view that Tobin taxes will queer the pitch for foreign capital, a clear delineation of the transactions on which they are to be levied may actually incentivise more desirable long-term portfolio and direct investment inflows because they promise a more stable balance-of-payments and exchange-rate environment. 

RBI Deputy Governor's speech at the FSA Turner Review Conference also deals with the space for unorthodoxy

Much of the current debate on many issues centres on the epicenter of the crisis, the developed economies with relatively advanced financial systems. The emerging markets, though, can bring a different perspective from their own past experience. Many of the emerging countries, including India, are part of the global effort in search of a harmonized framework but certain key differences in perspectives in these two sets of economies need to be appreciated. The status of the financial sector of the emerging economies is different from that of the advanced economies with different set of imperatives having different implications for the trade off between financial stability on the one hand and financial development, financial inclusion and growth, on the other. For instance, with regard to identification and mitigations of sources of systemic risk, the emerging market concerns are heightened because of the fact that many sources of systemic risk lie outside their jurisdictions. There could also be the issue of negative externality of larger than warranted capital requirements without careful calibration which could adversely impact the flow of credit to productive sectors, particularly in bank funding based financial systems. Emerging economies are faced with the challenge of managing volatile capital flows which is not a source of systemic vulnerability for developed economies,




Clearly the experience of the developing/emerging economies has much to offer in reshaping the prevalent ideology.

Financial crisis and central banking

Marc Faber in an interview recently praised the RBI for being amongst the best central banks in the world - mainly from the point of view of keeping an eye on financial stability:
The RBI has one of the best monetary policies in the world because they supervise the financial sector very closely. They have maintained relatively tight monetary policies and also they pay attention not only to core inflation which is not representative of the cost of living increases and is not representative of inflation in the system but the RBI also pays attention to rising and falling asset prices. So, I have to give them credit for being actually one of the best Central Banks in the world.


That's the view from the investment world, yet the RBI has often been criticised by economists for being ultra-conservative. Shankar Acharya talks of the good performance of the RBI in his article dealing with policy continuity at the RBI


But the conventional wisdom attributes this to an instinctively conservative and cautious approach of the RBI and its leadership, especially then governor Y V Reddy and deputy governor Rakesh Mohan. At best this is a partial truth and, at worst, it’s quite misleading. Let me explain. Reddy and Mohan should certainly get a lot of credit, but for much more than being instinctively conservative.

To begin with, maintaining a cautious stance in the boom years of 2003/4-2007/8 was itself quite a feat in those exuberant times when the financial community, the media and even the government were pressing for rapid progress on conventional, financial liberalisation. 

But the Reddy-Mohan RBI did much more than just preserve key elements of the policy/regulatory framework. Over the boom years, as the perceived scale and risks of global financial excesses mounted inexorably, the RBI evolved a diverse set of heterodox policy responses to deal with the problem. These included:

• The inclusion of “financial stability” as an explicit objective of monetary policy;
• Active management of surging and volatile capital inflows through partial “sterilisation” by market stabilisation scheme (MSS) security issues, cash reserve ratio (CRR) hikes and liquidity adjustment facility (LAF) operations, thus retaining substantial, discretionary control over monetary and exchange rate policies;
• Moderation of bank exposure to asset bubble-prone sectors such as real estate and equity markets through countercyclical provisioning requirements and differentiated risk weights for bank lending to such “sensitive” sectors;
• Extension of stronger regulation to systemically important non-bank finance companies;
• Enhanced supervision of financial conglomerates;
• Bringing bank exposure to non-banks within the prudential framework;
• Tighter guidelines for securitisation and a sceptical stance towards complex financial products.

After a challenging year of crisis management, Governor Subbarao has explicitly endorsed the key elements of the Reddy-Mohan heterodoxy. It has probably helped that mainstream, international thinking on these issues has been driven much closer to the Reddy-Mohan positions by the global financial crisis. For those, like me, who backed the Reddy-Mohan approaches to monetary and regulatory policies, the continuity shown by Subbarao’s RBI is very heartening. For earlier critics of these approaches there may be some disappointment and discomfort.

So true! For those who are looking for a short roundup of the issues plaguing EMEs today, Subbarao's latest speech on the crisis and EMEs is worth reading. His conclusion:

It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear justified. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill. This judgement skill is the one that central banks, especially in developing countries such as India, need to hone as they simultaneously pursue the objectives of growth and financial stability.