Monday, September 28, 2009

Global structural imbalances and monetary policy autonomy

In earlier posts here, here, here, and here, I have blogged extensively about the importance of rectifying the global macroeconomic imbalances, if we are to avoid the recurrance of the sub-prime mortgage crisis and the recession that followed.

An excellent guest post in Baseline Scenario adds more to the list of reasons to remedy these imbalances. It argues that "structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar". This leads to situations like the present one, when pressure mounts on the Fed to raise rates to quell inflationary fears even when unemployment is rising, capacity utilization is declining, and potential output gap is widening.

Baseline Scenario points to unaccounted for (in conventional macroeconomic models) leakages in the monetary stimulus - "to large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit" (and blowing up newer bubbles) and outflow of capital from the country "through dollar hedging mechanisms (into commodities, foreign assets, and an anti-dollar carry trade)" - that takes away from the expansionary impact of a cheap money policy. And there is also the leakage due to the liquidity depressing effect arising from decreased money velocity of circulation due to the reluctance of businesses and households to invest and spend.

In the circumstances, the Fed's monetary policy can be effective only if complemented with "financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up)".

In the absence of these set of policies and effective regulation ("due to regulatory capture or because financial innovation has outpaced the political system's willingness to extend regulators' reach"), the Fed will be forced into taking away the punchbowl during booms and giving it back during busts, with the attendant risk of getting the timing wrong - "taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility". And recent history shows that the timing is most often likely to be wrong and rarely right! Brad DeLong's blog describes this as "second-best punchbowlism"!

In this context, it is important that we revisit the conditions of the Mundell-Fleming Impossibility Theorem. In an earlier post, I had blogged about the challenge of the Impossible Trinity - it is impossible for a Central Bank to simultaneously achieve capital mobility coupled with stable (fixed or an adjustable peg) exchange rates and interest rate autonomy. Under any macroeconomic circumstances, only two of these objectives could be simultaneously met.

In view of the aforementioned reasoning, to the list of conditions under which Central Banks can maintain interest rate autonomy, we must now add effective financial market regulation (of which higher capital asset ratios are just one of the desirables). In its absence, even with floating exchange rates and free capital mobility, Central Banks will be unable to respond to a downturn with the necessary loose monetary policy.

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