Return of the "real" economic anchors in monetary policy

As a recent Mint op-ed pointed out, the Friedmanite consensus on monetary policy may be another casualty of the global financial crisis. In his famous 1968 lecture at the American Economic Association, Milton Friedman had debunked the effectiveness of the Keynesian Phillips Curve relationship between inflation and unemployment. He questioned the belief that monetary policy could be used to stabilize the business cycle and lower unemployment arguing that it would only stoke inflation without any corresponding gains in reduction of unemployment rate. Agents (laborers bargaining for wage rise) would quickly factor in this expectation and thereby drive up inflationary pressures.

It also meant that governments and central banks could no longer target real variables to stabilize the output. Only a nominal anchor could achieve this purpose. Since then monetary policy has sought to  target a nominal anchor - initially money supply level, then exchange rate, and finally either price level or some measure of inflation. Inflation targeting was borne out of the last set of trends and have been underpinned by the New Keynesian theories about "sticky" prices. For nearly two decades, nominal inflation targeting has been the name of the game in monetary policy. 

However, in December, the FOMC announced a landmark decision to keep interest rates low till unemployment falls below 6.5%, so long as its inflation forecast remains below 2.5%. This effectively brings back "real" anchors back into monetary policy making. Fed Governor Ben Bernanke has argued that numerical thresholds for low rates would help “support household and business confidence and spending” and that this would make monetary policy “more transparent and predictable” to the public. 

But it is in Japan that nominal anchors are making the biggest splash. The new Shinzo Abe government looks set to make nominal anchors the basis of its macroeconomic policy making. After calling on the central bank to revise upwards its long-held inflation target to 2%, it has moved on to target other indicators. A recent Telegraph article wrote,

Mr Abe's Liberal Democrats have already lambasted the central bank, threatening a new bank law unless it adopts radical measures to pull Japan out of deflation – including a growth target of 3% for nominal GDP, implying massive monetary stimulus. He has set an implicit exchange range target of 90 yen to the dollar, instructing the Bank of Japan to drive down the yen with mass purchases of foreign bonds along lines pioneered by the Swiss.

The new Bank of England (BoE) Governor, Mark Carney recently suggested abandoning the nominal inflation targeting policy in favor of nominal GDP (NGDP) targeting. He said, "adopting a nominal GDP-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting". He argues that such a regime shift may be useful in times as now when the interest rate is touching zero-bound. Robin Harding wrote in the FT recently about NGDP,

The Fed’s new 6.5 per cent unemployment condition is a way to tell everybody that rates will stay low until the economy gets better. The nominal GDP target is a more drastic version of the same thing. In essence it combines growth and inflation into one number. Targeting this not only puts more weight on growth, it means promising to make up for low inflation now with more in the future – another way of saying the central bank will keep interest rates low.

In other words, inflation, nominal GDP, and even exchange rate have all become "real" economic anchors for a government looking to throw the kitchen sink in a desperate attempt to recover from its current deep slump. At a time when the economy is stuck in a protracted deflationary trap, interest rates are at zero bound, and excess capacity is widespread, nominal anchors may not be a bad strategy to shape expectations and get the economy's animal spirits active.

But in any case, it decisively marks the end of the Friedmanite consensus on nominal anchors in monetary policy making.

Performance-based payments to doctors

Just as achievement of student learning outcomes has become the holy grail of education, alignment of incentives among doctors, patients, and insurers is arguably the most challenging problem in healthcare.  In particular, how do we ensure that doctors deliver the most cost-effective treatments - most effective treatment at the lowest cost?

In an interesting experiment, New York city public hospitals have initiated a project to reward doctors for their performance based on a set of parameters related to better patient outcomes, instead of the prevailing volumes or procedures-based remuneration of doctors. Doctors attached to hospitals are generally remunerated based on the income they generate for the hospital. The latter has been found responsible for generating several incentive distortions, primarily in promoting over-treatment.

The New York public hospitals, the largest public health system in the US with 11 large public hospitals and more than a million emergency room visits a year, proposes to link doctors pay increases to performance on bench-marked indicators. The Times, which runs the story, writes,

Under the proposal, bonuses of up to $59 million over the next three years would be distributed to about 3,300 doctors, and would be given to physicians as a group at each hospital, rather than as individuals, so that even the worst doctor would benefit. They would amount to up to 2.5 percent of salaries, which range from about $140,000 for entry-level primary-care physicians to $400,000 for experienced specialists... The public hospital system has come up with 13 performance indicators. Among them are how well patients say their doctors communicate with them, how many patients with heart failure and pneumonia are readmitted within 30 days, how quickly emergency room patients go from triage to beds, whether doctors get to the operating room on time and how quickly patients are discharged. 

However much I am enthused by such initiatives, I am not too optimistic about its success. Already the union of doctors have disputed the set of parameters being used for bench-marking. The selection of parameters will be critical. What constitutes patient outcomes will vary, often widely, based on the category of medical conditions being treated. It will also vary based on the nature of patients, and their expectations. Arriving at a set of parameters that accurately reflect all these and other variations and will be more or less universally accepted may be easier said than done.

Is QE turning into "stealth nationalization"?

I am surprised this has not generated the level of discussion it merits. The Telegraph (via FT) reports of the new Shinzo Abe government's plan to lift the Japanese economy out of its long-slump,

Premier Shenzo Abe is to spend up to one trillion yen (£7.1bn) buying plant in the electronics, equipment, and carbon fibre industries to force the pace of investment... The plan to buy plant involves leasing back the assets to firms in trouble. Analysts say it is a means of funnelling industrial aid, a move sure to raise the hackles of global rivals. It may violate World Trade Organisation rules on subsidies.

As FT writes, this is a "stealth nationalization" of the economy. And it argues that this is a logical culmination of quantitative easing itself,

Whether it’s QE or government-debt funded stimulus, the two amount to the same thing. Both offer support to industries, companies and banks which might otherwise collapse. QE is simply a more generic funnel. Stimulus, on the other hand, involves strategic government choices with respect to which industries, companies and banks to invest in and support. Take this trend along its natural course, however, and you only get to one result. The nationalisation of almost everything.

Amazingly, for the last two years, in a last gasp attempt to revive the economy, the Japanese Central Bank has been priming the equity markets by purchasing exchange traded funds (ETFs), so much so that it is now "en route to becoming a majority holder in the country's primary equity ETF". 

This transformation of monetary policy has been stunning. A simple credit infusion program by opening a liquidity injection window, shifted gears to different versions of quantitative easing by initially purchasing government securities and then private bonds with increasing dilution of credit standards. The credit expansionary interventions moved into a different plane by then purchasing ETFs in the equity markets and is now echoing nationalization by proposing to directly take stakes in private firms.  

With governments reluctant or paralyzed from taking the strong steps required to reverse the course and preferring to take the easy route by passing on the buck to central banks, there will be increasing pressure on them to incessantly keep printing money so long as inflationary pressures remain invisible. If the economy does not recover with conventional QE, as looks increasingly likely in most parts of developed world, then the pressure on central banks to indulge in, apparently "costless", Japanese style "nationalization" will rise. Is the Fed and ECB going to follow the Bank of Japan?

Negative Externalities of Central Bank Actions

The fundamental macroeconomic challenge facing large parts of the world economy today is how to manage a sustainable recovery from the depths of the global financial market crises and the Great Recession. Any such recovery has to be a twin recovery - repairing financial market balance sheets and restoring growth and lowering unemployment rates in the real economy.

In his Stamp Memorial Lecture (pdf here) at the LSE, Mervyn King, the Governor of Bank of England, had this to say about the challenge with using expansionary policies to mitigate the economic impact of financial market crises,

Misperceptions mean that unsustainable levels of spending, and associated levels of debt, can build up over many years. When those misperceptions are eventually corrected, they lead to sudden large changes in asset values, a synchronised de-leveraging of balance sheets, a large downward correction to spending and output, and defaults. Keynesian policies to smooth the path of adjustment by supporting aggregate demand can help in the short run, but their effectiveness is limited by the fact that a significant adjustment to spending – from consumption to investment – is required.

While undoubtedly, there is the hope that low interest rates will provide the time and conditions for all agents to repair their balance sheets and for recovery to take hold, it also runs the risk of aggravating the problem. Gangrene cannot be treated with a sustained high dose of steroids. Fundamental adjustments, with short to medium-term pain, may be necessary to sustainably address this problem. There are two related risks

1. There is the risk that the monetary accommodation may not be able to solve the fundamental problems that caused the crisis and it may only be delaying the inevitable adjustments. If that is the case, then it also carries the risk that by kicking the can down the road, we may be actually aggravating the crisis by making the necessary adjustments larger than would have been the case if it were done now. By the time the inevitable amputation happens, the gangrene infected patient would also have undergone untold suffering. 

2. The other risk is more political. It cannot be denied that central banks across the world have come to assume the center-stage in national economic policy making. But unfortunately their rise has mirrored the reluctance of governments to bite the bullet when faced with severe economic and financial crises. In fact, the aggressive monetary accommodation may have contributed to this trend. As Martin Feldstein wrote recently in the context of the US, "By keeping the long-term interest rate low, the Fed has removed pressure on the president and Congress to deal with deficits". Much the same motivations are evident elsewhere as governments sit back paralyzed goading central banks to cover for their own inaction.

There is the danger that ultra-low rates will come in the way of decisions that are necessary to wring out the excesses built-up during the boom times. For example, the assumption that all major asset categories will recover close to its pre-crisis valuations and thereby eliminate the balance sheet problems of financial institutions is questionable. In the circumstances, central banks provide the alibi for governments to abdicate on their fundamental responsibilities.

The junk bond bubble

The extraordinary monetary accommodation by central banks across developed economies has been criticized for laying the seeds for another round of resource mis-allocation in the financial markets. It has been blamed for inflating speculative bubble in commodities markets. The latest signal of market distortions comes from junk bond yields which have fallen to its lowest rate ever, declining below the 6% mark.

This has forced the FT to question the wisdom of even calling them "junk" bonds. It writes,

To put this in perspective, junk yields peaked at almost 23 per cent during the financial crisis and have traded at a median of 8.2 per cent over the last decade. Current junk yields are closer to investment grade bonds’ 10-year median of 4.7 per cent... The yield on the 10-year Treasury... remains below 2 per cent. Investment grade bonds yield 2.8 per cent, on average. Top-rated 10-year municipal bonds are paying 1.8 per cent. All three are near historic lows. So bond investors fleeing the craziness of junk bonds will not find much sanity elsewhere, and junk, at least, tends to be less vulnerable than other bonds to losses when rates rise.

The ultra-low interest rates have driven down returns on all but the high risk securities. Investors in fixed income securities have responded by driving up the prices on these high risk junk bonds. According to The Bank of America Merrill Lynch High-Yield Master II Index, junk yields have fallen to 5.975% from 8.24% at the beginning of 2012 on the back of a 15.58% increase in their values this year. Junk bond issuance too has been rising in recent years. A record $79 billion in high-yield corporate bonds were sold in the United States in the third quarter. 

As yields fell, prices climbed, from 98.1 cents on the dollar at the start of 2012 to 104.75 now, near the all-time high of 104.99 recorded in January 2004, and above the key call-constrained 103% level that once served as a reliable upper boundary. Corporates too have been using the low rates to raise capital for retiring off their older, higher interest rate capital. Junk bonds have been on a rising path over the past four years, increasing by 4.4%, 15.2%, and 57.5% respectively in 2009, 2010, and 211 respectively. 

However, fortunately, there is a limit to how much junk bonds may rise. They can be redeemed early, from halfway through their life and starting at par plus half of the coupon. With average coupon of 8%, the redemption price comes to about $104, lower than the current pricing of $105. 

But for now, investors and financial institutions are piling on the risk as they see junk bonds as the only fixed income instrument offering attractive enough returns. Its immediate beneficiaries are the weaker companies, whose debt generally would have had to be priced at high premiums, who now are able to raise capital at much lower rates. 

Amidst all this, it cannot be denied that riskier bonds cannot become any less risky just because the market thinks that the cost of carrying it can be lower. 

India's Jobs Crisis

Amidst all talk of the need for second generation of reforms in India, we should not overlook the fundamental reality that the sustainability of India's economic growth, indeed its democratic polity itself, would depend on how it is able to manage the transition from agriculture to manufacturing and services for the majority of the 60% of population currently working in the former. This boils down to job creation, especially in manufacturing. And it is here that the alarm bells are ringing the loudest.

The most alarming signal is this graphic taken from a CRISIL report which shows that job creation slowed down even as growth rate increased. In the five years from 1999-00 the economy grew at 6% and created a net 92.7 million wage and self-employment jobs, whereas in the next five years from 2004-05 the net job creation declined to just 2.2 million even as the economy grew at an average rate of 8.6%. The biggest problem was the decline in the numbers joining the self-employed category by 25.5 million in the later period. The report finds that the majority of this fall in self-employed jobs was in agriculture. The role of NREGA in this shift is undeniable.

Even within the regular jobs, job creation fell dramatically in that engine of formal economic growth, urban areas. The number of urban regular jobs created fell sharply from 13.7 million in the 1999-2005 period to just 5.5 million in the 2004-10 period.

The biggest concern was the performance of the creating sectors like manufacturing, which were supposed to create the jobs required to help the country make the transition from a predominantly primary to a secondary and tertiary sectors. In many of these sectors, even as sectoral growth rate rose, the employment growth rate actually declined.

The report also contains another graphic that highlights how employment intensity, or the number of people employed for every Rs 100000 of real output, has been falling. It has been falling steadily in all sectors except construction. In fact, for the economy as a whole, it has fallen from 1.71 in 1999-2000 to 1.05 in 2009-10. While on the one hand, it is a reflection of productivity improvements, it also underscores the magnitude of the job creation challenge, even when growth is robust.

In this context, Livemint draws attention to a Planning Commission report which points to an alarming decline in employment elasticity in recent years. The Mint report writes,

The Planning Commission says that employment elasticity has come down “from 0.44 in the first half of the decade 1999–2000 to 2004–05, to as low as 0.01 during the second half of the decade 2004–05 to 2009–10.” An employment elasticity of 0.01 implies that with every 1 percentage point growth in GDP, employment increases by just one basis point. (One basis point is one-hundredth of a percentage point.) It’s as good as saying that the extraordinary growth during those years didn’t lead to any employment growth at all. What is worse is that employment elasticity of growth was much higher during the pre-reform period. The 10th Plan document has a table that shows employment elasticity for the economy as a whole was 0.68 during the period 1983 to 1987-88; this fell to 0.52 if we consider the period 1983 to 1993-94, implying a slowing down during the later years; and it went down to a mere 0.16 during 1993-94 to 1999-2000, which led to much worrying about jobless growth at that time. But employment elasticity during 2004-05 to 2009-10 is even lower than during the late 1990s. The bang we used to get for the buck is now an almost inaudible whisper.

Historical growth trajectories of countries show that as the economy grows and diversifies, the non-formal sector would shrink. But in India's case, exactly the opposite appears to be happening,

The total net increase in employment between 2004-05 and 2009-10 was 2.72 million. But the increase in informal employment during the period was 4.62 million. That means not only were the new jobs all created in the informal sector, but there was some shrinkage in formal sector employment as well, with jobs shifting to the informal sector. Indeed, in the decade 1999-2000 to 2009-10, formal sector jobs shrunk by two million and the entire job growth was in the informal sector. Nearly 93% of the workforce in 2009–10 was in informal employment, compared with 91% in 1999–2000. Not only are jobs hard to get, their quality too has worsened. 

Construction sector, where employment is predominantly non-formal

Many of the new jobs in the informal sector were in the construction industry. Between 2004-05 and 2009-10, there was a reduction of 14 million jobs in agriculture and five million in manufacturing. Most of the persons displaced found jobs in construction, where employment went up by 18 million. And since most of the construction industry is in the informal sector, the trend explains the growing share of informal employment.

It is a no-brainer to realize that job creation is India's biggest challenge in the years ahead. It is at the same time a massive economic, social, and political problem. Failure here will have consequences for the social and political order in the country.

Update 1 (24/1/2013)

Mint reports of an alternative explanation for the fall in jobs created during the 2004-09 period. It points to research which shows that the main reason for this decline was an improvement in the rural economy, which led many women to quit agricultural work. It writes,

Of the 59.5 million jobs created during the first half of the previous decade, nearly a third was in agriculture, at a time when the sector was in distress and agricultural growth was near-zero. Most of the new farm jobs in that period went to “self-employed females”. The majority of such workers were “unpaid”, which means they worked mostly for their relatives or husbands, without compensation. The rise in such low-quality jobs was a reflection of rural stagnation. As the rural economy improved in the second half of the decade and wages shot up, especially for males, women quit distress jobs. The fact that these women could afford not to work even in the drought year of 2009 suggests a rapid reversal of rural fortunes in the last decade. Thus, despite an increase in 22.3 million jobs in the non-agricultural sector, the overall increase in employment in 2004-09 appears poor because of the withdrawal of 21.1 million agricultural workers. The spread of education is also partly responsible for the declining LPR (the sum of employment and unemployment rates): most young males and nearly a third of women missing from the workforce chose to study rather than work. 

Update 2 (1/12/2013)
Mint has an excellent series on structural changes in India's labor market, based on the latest NSSO survey findings. This graphic has the changes in sectoral composition of jobs in India.

This graphic shows the changes in urban wages over the 2004-05 to 2011-12 period...

... and this in the rural areas...

... and this the female labour force participation trends. In the period, female labor force participation rate has declined by seven percentage points to 22.5%, one of the lowest in the world.

Mr Bernanke, put back that wall!

The quantitative easing and unconventional monetary accommodation policies followed by central banks in developed countries has undoubtedly shifted monetary policy into a largely unknown terrain. Though supporters assure that central banks have adequate instruments at their disposal to roll back when need arises, given the sheer size of expansion of central bank balance sheets and the massive quantities of liquidity being created, the concerns are well-founded.

The conventional wisdom on the issue of central bank independence has revolved around governments trying to keep a leash over their activities to maintain their freedom to indulge in seignorage (or printing money) to finance public spending. In this context, Alan Blinder points to an alternative reason why central bank independence may be in danger - the increased co-ordination between monetary and fiscal policy authorities. He says,

The question is whether there has been too much coordination between monetary and fiscal policy, not too little; whether the close cooperation between central banks and Treasuries has compromised central bank independence; and whether, therefore, this close cooperation should end promptly. If I may paraphrase Ronald Reagan, it’s: Mr. Bernanke, put back that wall.

He argues that the recent crisis forced central banks and governments across much of developed world to co-ordinate very closely to stabilize the financial markets and also to prevent economies from slipping deeper into recession. Central banks on both sides of the Atlantic deployed all the monetary policy instruments at their disposal in this endeavor. In fact, popular and large sections of professional opinion has been socialized into believing that central banks, more than even governments, hold the dominant policy cards for stimulating economic growth.

This is dangerous either way. If all these fail and the economy falls into a long-drawn recessionary trap, it will seriously erode the functional credibility of central banks themselves. This will have very adverse long-term consequences. After all, a large part of the effectiveness of monetary policy actions stems from rational expectations about the central banks' inflation targeting commitment.

And if the policies succeed and the economy recovers, then the central bank will be pushed even more into the center-stage of the larger economic policy making domain. Such an expanded role invariably comes with more political compulsions that may often conflict with its primary responsibility of maintaining price stability. For example, it may constrain central banks from leaning against the wind and pursuing counter-cyclical policies.

Furthermore, it could also aggravate the current disconcerting trend of national governments passing the buck on to central banks and refraining from taking the hard long-term structural reforms required for sustainable long-term growth.

In the circumstances, a careful re-examination of the role of central bank may be necessary for the long-term institutional health of central banks themselves as well as the effectiveness of larger economic policy making itself.