Going bust for growth

By Raghuram G. Rajan     
February 26, 2016

From: Magazine

Photo by Associated Press.

There are few areas of robust growth around the world, with the IMF repeatedly reducing its growth forecasts in recent quarters. This period of slow growth is particularly dangerous because both industrial countries and emerging market economies (EMEs) need high growth to quell rising domestic political tensions. Policies that attempt to divert growth from others rather than create new growth are more likely under these circumstances. Even as we create conditions for sustainable growth, we need new rules of the game, enforced impartially by multilateral organizations, to ensure that countries adhere to international responsibilities.

The growth imperative

If indeed fundamentals are such that the industrial world has, and will, grow slowly for a while before new technologies and new markets come to the rescue, would it be politically easy to settle for slower growth? After all, per capita income is high in industrial countries, and a few years of slow growth would not be devastating at the aggregate level. Why is there so much of a political need for growth?

One reason is the need to fulfill government commitments. As the sociologist Wolfgang Streeck writes, in the strong growth years of the 1960s, when visions of a “Great Society” seemed attainable, industrial economies made enormous promises of social security to the wider public. The promises have been augmented since then in some countries by politically convenient (because hidden from budgets) but fiscally unsound increases in pension and old-age health-care commitments to public-sector workers. Without the immediate promise of growth, all these commitments could soon be seen as unsustainable.

Another reason is that growth is necessary for intergenerational equity, especially because these are the generations that will be working to pay off commitments to older generations. Insofar as these are also the cohorts that can take to the streets, growth is essential for social harmony.

Not only are the benefits of growth unequally distributed across generations, they are also very unequally distributed within generations. Because of changes in technology and the expansion of global competition, routine repetitive jobs—whether done by the skilled or the unskilled—have diminished greatly in industrial countries. With every percentage point of growth creating fewer “good” jobs for the unskilled or moderately skilled, more growth is needed to keep workers happily employed. Equally, the rapid deterioration in skills for the unemployed is an additional reason to push for growth.

Emerging markets’ response

If industrial countries are stuck in low growth, can emerging markets (I use the term broadly to also include developing or frontier markets) take up the global slack in demand? After all, EMEs have a clear need for infrastructure investment, as well as growing populations that can be a source of final demand. EMEs have no less of an imperative for growth than industrial countries. Many do not have past entitlement promises to deliver on, but some have aging populations that must be provided for, and many have young, poor populations with sky-high expectations of growth. Ideally, EMEs would invest for the future, funded by the rich world, thus bolstering aggregate world demand.

The 1990s were indeed a period when EMEs borrowed from the rest of the world in an attempt to finance infrastructure and development. It did not end well. The lesson from the 1990s crises was that EMEs’ reliance on foreign capital for growth was dangerous.

Following the 1990s crises, a number of EMEs went further to run current account surpluses after cutting investment sharply, and started accumulating foreign exchange reserves to preserve exchange competitiveness. Rather than generating excess demand for the world’s goods, they became suppliers, searching for demand elsewhere.

In 2005, Ben Bernanke, then a governor of the Federal Reserve, coined the term “global savings glut” to describe the current account surpluses, especially of EMEs, that were finding their way into the United States. Bernanke pointed to a number of adverse consequences to the US from these flows, including the misallocation of resources to nontraded goods such as housing and away from tradable manufacturing. He suggested that it would be good if the US current account deficit shrank, but this primarily required reduction by EMEs of their exchange rate intervention rather than actions on the part of the US.

Prior to the global financial crisis, then, EMEs and industrial countries were locked in a dangerous relationship of capital flows and demand that reversed the equally dangerous pattern before the emerging market (EM) crises in the late 1990s. Sustained exchange rate intervention by EM central banks, as well as an excessive tolerance for leverage in industrial countries, contributed to the eventual global disaster. But in the wake of the most recent financial crisis, the pattern is reversing once again.

Industrial countries have curtailed their investment without increasing their consumption (as a fraction of GDP), thus reducing their demand for foreign goods and their reliance on foreign finance. The counterpart of this shift of advanced economies from current account deficit (demand creating) to surplus (supply creating) has been a substantial fall in current-account surpluses in EMEs. This relative increase in demand for foreign goods from EM countries has come about through a ramp-up in investment from 2008 rather than a fall in savings. Facilitating or causing this shift has been a broad appreciation of real effective exchange rates in EMEs and a depreciation in industrial country rates between 2006 and 2014.

Have central bank policies in industrial countries, similar to the sustained exchange rate intervention by EMs’ central banks in the early 2000s, accelerated this current account adjustment? Possibly, and likely candidates would be what are broadly called unconventional monetary policies (UMPs).

Unconventional monetary policy

UMPs include both policies whereby the central bank attempts to commit to hold interest rates at near zero for long and policies that affect central bank balance sheets, such as buying assets in certain markets, including exchange markets, in order to affect market prices.

There clearly is a role for UMPs: when markets are broken or grossly dysfunctional, central bankers may step in with their balance sheets to mend things. The key question is what happens when these policies are prolonged well beyond repairing markets to actually distorting them. Take, for instance, the zero-lower-bound problem. Because short-term policy rates cannot be pushed much below zero, and because long rates tack on a risk premium to short rates, central banks may use UMPs to directly affect long rates. Direct action by a risk-tolerant central bank, such as purchasing long bonds, effectively shrinks the risk premium available on remaining long assets.

This has two effects. First, those who can rebalance between short and long assets now prefer holding short-term assets because, risk adjusted, these are a better deal. Thus, as the central bank increases bond purchases under quantitative easing, the willingness of commercial banks to hold unremunerated reserves increases. Second, those institutions that cannot shift to short-term assets, such as pension funds, bond mutual funds, and insurance companies, will either continue holding their assets and suffer a relative undercompensation for risk or turn to riskier assets. This “search for yield” will occur if the relative undercompensation for risk in more exotic assets is lower, or simply because institutions have to meet a fixed nominal rate of return.

None of this need be a problem if everyone knows when to stop. Unfortunately, there are few constraints on central banks undertaking these policies. If the policy does not seem to be increasing growth, one can simply do more. All the while, the distortion in asset prices and the misallocation of funds can increase, which can be very costly when the central bank decides to exit.

Equally important, though, is that domestic fund managers can search for yield abroad, depreciating the sending country’s currency, perhaps significantly more so than ordinary monetary policy. This may indeed cause the increase in domestic competitiveness that could energize the sending country’s exports. But such increases in competitiveness and “demand shifting” can be very detrimental for global stability, especially if unaccompanied by domestic demand creation.

Spillovers to emerging markets and rotating crises

If UMP enhances financial risk taking in the originating country without enhancing domestic investment or consumption, the exchange rate impact of UMP may simply shift demand away from countries not engaging in UMP, without creating much compensating domestic demand for their goods. If so, UMP would resemble very much the exchange rate intervention policies of the EMEs before the global financial crisis of 2007–09.

Indeed, the postglobal-crisis capital flows into EMEs have been huge, despite the best efforts of EMEs to push them back by accumulating reserves. These flows have increased local leverage, not just through the direct effect of cross-border banking flows but also through an indirect effect, as the appreciating exchange rate and rising asset prices make it seem that EM borrowers have more equity than they really have. Bernanke’s concerns in 2005 about malinvestment in the US resulting from capital inflows have surfaced in EMEs postcrisis as a result of capital inflows from industrial countries.

Have crises in EMEs in the 1990s been transformed into crises in industrial countries in the 2000s, and once again into vulnerabilities in EM countries in the 2010s, as countries react to the problem of inadequate global demand by exporting their problems to other countries? The “taper tantrum” in July 2013 certainly seemed to suggest that EM countries that ran large current account deficits were vulnerable once again. Is the world engaged in a macabre game of hot potato as each country attempts to boost growth? If possibly yes, how do we break this cycle?

Good policies . . . and good behavior

In an ideal world, the political imperative for growth would not outstrip the economy’s potential. But as we do not live in such a world, and because social-security commitments, overindebtedness, and poverty are not going to disappear, it is probably wiser to look for ways to enhance sustainable growth.

Clearly, the long-run response to weak global growth should be policies that promote innovation, as well as structural reforms that enhance efficiency. Policies that improve the domestic distribution of capabilities and opportunities without significantly dampening incentives for innovation and efficiency are also needed.

In the short run, though, the need for sensible investment is paramount. In industrial countries, green-energy initiatives such as carbon taxes or emission limits, while giving industry clear signals on where to invest, also have the ability to move the needle on aggregate investment and help long-term goals on environment protection.

Most EM countries have large infrastructure investment needs. We still need to understand how to improve project selection and finance, for too much public-sector involvement results in sloth and rent seeking and too much private-sector involvement leads to risk intolerance and profiteering. Going forward, well-designed public-private partnerships, drawing on successful experiences elsewhere, should complement private initiatives.

Clearly, sensible investment has a much better chance of paying dividends when macroeconomic policies are sound. And such policies are easier when the adverse spillovers from cross-border capital flows are limited. This may require new rules of the game for policy making.

New rules of the game?

How do we focus on domestic demand creation and avoid this game of hot potato, with countries trying to depreciate their exchange rate through sustained direct exchange rate intervention or through UMPs (where demand-creating transmission channels are blocked)? It might be useful to examine and challenge the rationales used to justify such actions.

Rationale 1: Would the world not be better off if we grew strongly? Undoubtedly, if there were no negative spillovers from a country’s actions, the world would indeed be better off if the country grew. But the whole point about policies that primarily affect domestic growth by depreciating the domestic exchange rate is that they work by pulling growth from others.

Rationale 2: We are in a deep recession. We need to use any means available to jump-start growth. The payoff for other countries from our growth will be considerable. This may be a legitimate rationale if the policy is a “one-off” and if, once the country gets out of its growth funk, it is willing to let its currency appreciate. But if the strengthening currency leads to a continuation of the UMPs as the country’s authorities become unwilling to give back the growth they obtained by undervaluing their currency, this rationale is suspect. Moreover, policies that encourage sustained unidirectional capital outflows to other countries can be very debilitating for the recipient’s financial stability, over and above any effects on their competitiveness. Thus, any one-off has to be limited in duration.

Rationale 3: Our domestic mandate requires us to do what it takes to fulfill our inflation objective, and UMP is indeed necessary when we hit the zero lower bound. This rationale has two weaknesses. First, it places a domestic mandate above an international responsibility. If this were seen to be legitimate, no country would ever respect international responsibilities when it was inconvenient to do so. Second, it implicitly assumes that the only way to achieve the inflation mandate is through UMP (even assuming UMPs are successful in elevating inflation on a sustained basis, for which there is little evidence).

Rationale 4: We take into account the feedback effects on our economy from the rest of the world while setting policy. Therefore, we are not oblivious to the consequences of UMPs on other countries. Ideally, responsible global citizenship would require a country to act as it would in a world without boundaries. In such a world, a policy maker should judge whether the overall positive domestic and international benefits of a policy, discounted over time, outweigh its costs. Some policies may have largely domestic benefits and foreign costs, but they may be reasonable in a world without boundaries because more people are benefited than are hurt.

By this definition, Rationale 4 does not necessarily amount to responsible global citizenship because a country takes into account only the global “spillbacks” for itself from any policies it undertakes, instead of the spillovers also. So, for example, Country A may destroy Industry I in Country B through its policies, but it will take into account only the spillback from Industry I purchasing less of Country A’s exports, not the destruction of Industry I itself.

Rationale 5: Monetary policy with a domestic focus is already very complicated and hard to communicate. It would be impossibly complex if we were additionally burdened with having to think about the effects of (unconventional) monetary policies on other countries.
This widely heard rationale is really an abandonment of responsibility. It amounts to asserting that the monetary authority has only a domestic mandate, which is Rationale 3. In an interconnected globalized world, “complexity” cannot be a defense.

Rationale 6: We will do what we must; you can adjust. Adjustments are never easy, and sometimes they are very costly—one reason Ben Bernanke placed the burden of change in his “savings glut” speech outside the US. EM countries may not have the institutions that can weather the exchange rate volatility and credit growth associated with large capital flows; for instance, sharp exchange rate depreciations can translate quickly into inflation if the EM country’s central bank does not have credibility, while exchange rate depreciations may be more easily endured by an industrial country.

The bottom line is that multilateral institutions such as the IMF should reexamine the “rules of the game” for responsible policy and develop a consensus around new ones. No matter what a central bank’s domestic mandate may be, international responsibilities should not be ignored. The IMF should analyze each new UMP (including sustained unidirectional exchange rate intervention) and, on the basis of its likely effects and the agreed-on rules of the game, declare it in or out of bounds. By halting policies that primarily work through the exchange rate, it will also contribute to solving a classic prisoner’s-dilemma problem associated with policies that depreciate the exchange rate: once some countries undertake these policies, staying out is difficult (the country that eschews these policies sees its currency appreciate and demand fall). Exit is also difficult (the exiting country faces sharp appreciation). Therefore, in the absence of collective action, these policies will be undertaken even when they are suboptimal, and will be carried on too long.

Of course, we clearly need further dialogue and public debate on the issues that have been raised, while recognizing that progress will require strong political leadership.

Global oversight and domestic diligence

The current nonsystem in international monetary policy is, in my view, a source of substantial risk, both to sustainable growth and to the financial sector. It is not an industrial-country problem or an EM-country problem; it is a problem of collective action. We are being pushed toward competitive monetary easing and rotating crises.

I use Depression-era terminology because I fear that in a world with weak aggregate demand, we may be engaged in a risky competition for a greater share of it. We are thereby also creating financial sector risks for when unconventional policies end.

We need multilateral institutions with widespread legitimacy to monitor new rules of the game. And each one of us has to work hard in our own country to develop a consensus for free trade, open markets, and responsible global citizenry. If we can achieve all this even as recent economic events make us more parochial and inward looking, we will truly have set the stage for the strong sustainable growth we all desperately need.

Raghuram G. Rajan is distinguished service professor of finance at Chicago Booth and the 23rd governor of the Reserve Bank of India.

©MIT Press, excerpted from Progress and Confusion, edited by Olivier J. Blanchard, Raghuram G. Rajan, Kenneth S. Rogoff, and Lawrence H. Summers, forthcoming from the MIT Press.