Exchange rate regime of systemically important countries

Many people believe that the exchange rate regime (i.e. the monetary policy regime) of each country is its own sovereign choice.



In the Great Depression, we saw the harmful effects of the exchange rate mercantalism that is feasible with fiat money. This was a key motivation for Keynes and others in their design of the post-war order. The IMF was supposed to be a multilateral body that would help bring pressure on countries to move towards good sense through `ruthless truth-telling'. This didn't work out too well. The IMF got itself into a box where it would not say anything about exchange rate regimes. To some extent, by standing ready to help countries that got into a currency crisis, it has helped perpetuate exchange rate pegging.



For the present discussion, I want to emphasise the distinction between small countries who can pretty much do as they like as opposed to systemically important countries where actions have a significant impact upon the world economy at large. In this approach, the four interesting questions are:

1.  In the selfish maximisation of one country at a time, what is the optimal choice of monetary policy regime / exchange rate regime?


2. What the mechanisms and empirical magnitudes through which the exchange rate regime choice of one country imposes externalities on others? I.e. what is the consequence of the Nash equilibrium?


3. What is an ideal solution for the world, which combines optimality for the local economy with good system outcomes?


4. What international institutional arrangements can help push the system towards the right solution?

On the first question, some people believe that exchange rate mercantalism is good for the country. You don't find much of this amongst professional economists.. As Merton Miller said: If devaluations could make a country rich, Argentina would be the richest country in the world.  For a careful rebuttal of this loose thinking, done by one of the world's top economists, see these discussant comments by Michael Woodford about a paper with this view by Dani Rodrik. As Andrew Rose said in a discussant comments at the Neemrana conference about a similar paper by Surjit Bhalla: This is either a home run or it's totally wrong.



I feel that exporting is great for growth, but only when this exporting involves genuinely facing the market test of the global market. If a country exports based on subsidies of some sort - which I term `fake exports' -  then the gains in productivity and capability do not come about (link, link). My sense is that in China also, intellectuals no longer buy the `distort everything for exports' idea. Also see Lorenzo Bini Smaghi on this.



As with every other export-subsidy or protectionist scheme, this has more takers amongst non-economists than amongst economists. It's slow hard work, banging these down over and over.



On the second question, see Paul Krugman: link, link.



On the third question, I have a comment on `global imbalances'. Some people see big numbers for current account surpluses/deficits as being intrinsically flawed. I look upon them as being the success of globalisation, as a repudiation of the Feldstein/Horioka problem. It is in an autarkic world that you see Feldstein/Horioka problems, where capital flows are not large. If we are to get beyond the Lucas paradox, and get back to the massive `development' capital flows of the First Globalisation, it's going to require large sustained BOP surpluses in some countries and deficits in others.



As an example, the best deal for ageing OECD is to buy securities in young countries like India today, thus spurring their growth today. Over the next 50 years, these securities would yield a flow of widgets back and thus support consumption of their elderly.



Hence, I would say the question is: How can the world be made safe for large BOP surpluses/deficits? This is a more interesting and important problem, instead of saying to ourselves: How can the world eliminate large BOP surpluses/deficits.

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Support for free markets and globalisation in India

On 5 October 2007, I had written a blog post Does urban India favour liberal economics?, where I had used survey data released by the Pew Institute, which measures attitudes of roughly 45,000 people worldwide with roughly 2,000 in India. Their sampling mechanism has an urban bias.



Today, I saw current information, and cross-country comparisons, on their website.

Support for the free market

 

The wording of the question was: Please tell me whether you completely agree, mostly agree, mostly disagree or completely disagree with the following statements: Most people are better off in a free market economy, even though some people are rich and some are poor. `Agree' combines "completely agree" and "mostly agree" responses. `Disagree' combines "mostly disagree" and "completely disagree."



The results, showing the proportion of those polled who `Agree':

In 2002, India was halfway in the list with 62% support. In 2009, India is at the top of the list, with 81% support.

Support for international economic integration

 

The wording of the question was: What do you think about the growing trade and business ties between (survey country) and other countries - do you think it is a very good thing, somewhat good, somewhat bad or a very bad thing for our country?. `Good Thing' combines "very good thing" and "somewhat good thing" responses. `Bad Thing' combines "somewhat bad thing" and "very bad thing."



The results:

Here also, India is now at the top of the list in terms of support for plugging into globalisation.

Why is this happening?

I think there are three factors at work.



First, everyone in India instinctively knows that when we tried our hand at socialism, GDP growth crashed, and vice versa:

1950s	3.59
1960s	3.96
1970s	2.94
1980s	5.58
1990s	5.68
2000s	7.22

The worst of India's years -- 2.94% average GDP growth with a fast growing population -- were in the peak of Indira Gandhi's socialism of the 1970s. As India stepped away from that, things got better. This process began with the Janata Party in 1977, was carried forward by following governments, and yielded results from the early 1980s onwards.



These changes were big enough and rapid enough that they are as persuasive as a natural experiment. Comparing socialist India vs. unsocialist India is almost as persuasive as comparing East Germany vs. West Germany. So the ordinary citizen, who does not know the GDP data, knows in his bones that getting away from a big State made sense.



The second factor is that a random sample of India has a lot of young people in it, who are less influenced by our socialist baggage. When you look at the political leadership, bureaucracy, academics or media, the views of old people have a lot more importance in shaping positions and the external perception. Old people in India seem to have more socialism, autarky, and unconfidence. Opinion polls show an unfiltered picture of India as it is.



Here is some data, from the CMIE household survey database, about the age distribution of Left supporters:

The CMIE data, with a tiny share of the population which supports the Left, is consistent with data from election vote shares and the Pew data. All three information sources thus increase our confidence in the basic message.



In your mind's eye, you need to think that India is a young population, with a lot of people below 30, and declining cohort sizes beyond. So the early years in the graph are disproportionately important.



In the overall population, Left support stands at 5.36%. India's future is young and urban -- but these two regions are where the Left support is the weakest.



However, another hypothesis can be cited: Maybe it is the experiences of young people which convert some of them from being un-Left when young to being Left supporters in middle age. Maybe political attitudes are not stable through time; maybe the young of today will turn left when they reach their late 30s and early 40s. In coming years, as the data of this survey builds up, we'll be able to evaluate this hypothesis.



The third dimension is about the welfare state. India does not have a welfare state and is unlikely to build one.



Voters do not seem to want a large welfare state. Political scientists say that a homogeneous population is more likely to support population-wide welfare programs: Each voter intuitively feels that the benefits of the program go to people-like-him. In countries with heterogeneity along the lines of ethnicity, class, religion, etc., voters are less inclined to favour population-wide welfare programs, because the picture in their mind of a recipient of welfare is not a person-like-them.



The intellectuals are not pushing a welfare state. In Western Europe, in the 1930-1960 period, the best intellectuals pushed the welfare state as an antidote to the brutality of the communist or Nazi ideologies. That sort of problem has not been an issue in India, where support for communism seems to be ebbing away.



The implementation capability is weak. When politicians have tried to setup large systems -- SSA or NRHM or NREG come to mind -- the limited administrative capacity has come in the way.



The bottom line is that India has a small expenditure/GDP ratio, and there is no welfare state that is under stress. Elsewhere in the world, there is a conflict between retaining the welfare state vs. plugging into globalisation. The gains from international economic integration are weighed against the perpetuation of the welfare state. In India, that conflict of interest is absent: people only see the gains from globalisation.

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Protectionism, recession, recovery: looking back and looking forward

In thinking of protectionism, the Great Depression, the Great Recession, and what might come next, here are two interesting angles.

Governments with their backs against the wall

 

Ideally, stabilisation using monetary and fiscal policy, alongside actions by the private sector, should restrain the decline in consumption, and yield conditions which are not too harsh for households. At the time of the Great Depression, much less was known of economics. Pegging the currency to gold meant giving up monetary policy autonomy; the US Fed succumbed to contractionary monetary policy once you take into account the closure of banks; the fiscal policy response at the time was miniscule.



It has been argued that the the Smoot-Hawley Tariff Act came about in the US in June 1930, at a point in time where the politicians were coming under enormous pressure to do something. After seven months of inaction by macro policy, with mounting difficulties in the economy, the politicians succumbed to protectionism. This appears to have been of decisive importance in sending the world down the destructive path of competitive trade barriers and cometitive devaluation. In the graph made famous by Barry Eichengreen and Kevin H. O'Rourke, at month 7 there was almost no decline in world trade. Douglas A. Irwin is worth reading on this.

Protectionism adversely impacts the recovery

 

Greg Mankiw and Scott Sumner point out one more channel through which Smoot-Hawley damaged prospects for the recovery was through the impact of protectionism on confidence.



The private sector saw protectionism as symbolising government backing away from responsible thinking in economics, and responded with a weakening of investment demand. This served to exacerbate the downturn.

Will this time be different?

 

The bulk of world GDP is now endowed with inflation targeting central banks. This ensures that monetary policy will be counter-cyclical: under bad business cycle conditions, inflation forecasts will drop below targets, and central banks will use every trick in their book to push inflation back up to target.



Fiscal policy has responded well this time around, thanks to better understanding of business cycles when compared with 1929. But there is little headroom to go further.



The world has as little ability to rein in some players engaging in competitive devaluation (e.g. China) today, as was the case in 1930. But with the bulk of world GDP being placed with inflation targeting central banks, the extent to which such tactics will be used will be relatively limited.



So far, we have had an upsurge of protectionism, but nothing on the scale of that seen from 1930 onwards. This could partly reflect the dramatic actions which governments have undertaken through monetary and fiscal policy, through which politicians have been able to reduce the domestic political difficulties that go along with business cycle downturns. But if, in coming months, the world economy remains mired in recession, then we could get fresh pressure to do something. In a recent voxEU post, Jeffrey Frieden points out that the path of adjustment of macroeconomic imbalances and currency distortions will involve political pain along the way, which could spillover into protectionism.



Some protectionist decisions could reflect bargaining tactics aimed at getting China to reduce or end their market manipulation of the currency market. But if there is an upsurge of protectionism beyond this, it will further damage the recovery by hurting investment, giving a spiral of bad economy -> protectionism -> reduced investment demand -> worse economy.

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Five questions on asset prices and monetary policy

Howard Davies was a deputy governor of the Bank of England, and the first head of the UK FSA. He is one of the world's leading thinkers on financial regulation and monetary policy, and one of the people who combines skills in both finance and monetary economics. In a recent article, he focuses on the five interesting questions about central banks and asset prices. Everyone interested in monetary policy today needs to ask themselves these five questions.

Q1: Should central banks target asset prices?

 

Davies points out that the consensus view is that central banks should remain focused on inflation targeting and not target asset prices.



However, pretty much everyone would agree that information from the world around us, about asset prices, is useful for forecasting inflation and output, and should be used in figuring out what values for output and inflation we put into our Taylor rules (whatever they might be).



So it seems that on this question, there is consensus: Asset prices are (and have always been) useful inputs in monetary policy formulation, but monetary policy should continue to do inflation targeting and not asset price targeting.

 

Q2: Should the measure of inflation targeted include an element of asset price, and particularly house price inflation?

Any reasonable CPI must have house rent in it, and through this, a boom in house prices and thus rents will get reflected in the CPI. This would give one more channel through which asset prices would directly influence a traditional inflation-targeting central bank.

 

Q3: Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers?

This is controversial territory. Some economists believe it is possible to ask central banks to make a call on when asset prices are misaligned.



I am personally skeptical about the extent to which this is possible. It is always easy to look back, ex-post, and say that it was obvious that US house prices were way off in 2006. But how many of the people who say this today were shorting US housing then?



Making a call about asset price fluctuations is hard even for a well motivated hedge fund manager. It is doubly hard in the public sector given the peculiar combination of skills and incentives that are found within central banks. The people with real skill in these things are unlikely to choose to work in a central bank; years spent in a central bank do not hone skills at market timing; the public will be very irritated if a central bank calls wrong.



So overall, I'm skeptical about the extent to which central banks (past or future) can usefully make calls about when asset prices are out of whack.

 

Q4: Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion?

Even if you knew that asset prices were grossly wrong, interest rates seem to be a very blunt tool, which inflict collateral damage all around the economy. Davies quotes Mervyn King who said two months ago: Diverting monetary policy from its goal of price stability risks making the economy less stable and the financial system no more so.

 

Q5: Should we try to find and use mechanisms other than interest rates to moderate extravagant credit expansion and associated asset price bubbles?

I think there is a good case for building some kinds of counter-cyclicality into financial regulation. But operationalising this is hard.



It should be feasible for financial regulators to have three manuals which govern boom times, normal times, and recessions. Full public disclosure of these three manuals is, of course essential, to avoid the usual issues of transparency and consistency. The question is: When would you flip from one manual to another?



Doing this based on asset prices runs into the difficulties articulated above. How is a civil servant to know when asset prices are in a boom or a bust?



Doing it based on business cycle conditions is more objective and feasible. It should be possible to setup indicators like Eurocoin which give low latency information about a coincident indicator. This could be used to drive rules about when we go into each of the three manuals. I personally think this would be useful.



Such efforts can be rationalised on the narrow ground that we seek to reduce the extent to which finance is a source of pro-cyclicality in the economy. If this is done right, it would reduce the amount of heavy lifting that monetary and fiscal policy have to do by way of stabilisation.



You don't have to have a `financial markets are irrational' view to support this. All you have to believe is that the existing structures of financial regulation are a source of pro-cyclicality. If that much is agreed, then there is a case for changing the framework of financial regulation so as to reduce the extent to which this is the case.

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Interesting readings

• Tim Harford in the Financial Times on the skepticism about the extent to which microfinance matters.


• London's attempts at turning away international finance: from the Economist, and Mint. Also see this piece from the Economist.


• M. R. Madhavan in Financial Express on the ineffectiveness of the UPA in translating Parliament time into economic reform.


• Michael Pomerleano on financial stability reform proposals.


• An idea from Ila Patnaik has popped up again.


• Sabrina Tavernise in the New York Times, on Syed Babar Ali, who started LUMS. Here's a comparison, of the footprint of the name of the institution upon google scholar, of LUMS as compared with India's ISB. LUMS was founded in 1986, and is well ahead of ISB in the extent to which they have evolved away from being a pure MBA program [undergraduate] [graduate].


• Ila Patnaik on the questions that RBI now faces on monetary policy.


• An eBook on financial reform, released by the Stern School of Business. A quick read of their chapter summaries gives you a sense of what they have done, and the questions faced in financial reform today on an international scale.


• In continuation of my recent article on the Bombay Club, do look at this view of Bajaj Auto by Swaminathan S. Anklesaria Aiyar.


• In Businessworld, Ashok Desai discusses a recent speech by Dr. Subbarao, and worries about competition amongst Indian banks.


• Ramachandra Guha in The Telegraph on India's nuclear energy program. Also see these two old pieces (from 2005) by Ila Patnaik: one, two.


• Protectionism alert.


• Deborah Solomon interviews Jeff Bezos, CEO of Amazon, in the New York Times. More CEOs in India should learn to speak like this.


• The meaning of open, a beautiful essay by Jonathan Rosenberg, Senior Vice President, Product Management, Google. More SVPs in India should learn to think like this.

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Building the perfect GST

The 13th finance commission has released the report of the task force on the GST. Here are some responses:

• Let's design a good GST, an editorial in the Economic Times.


• The Economist.


• M. K. Venu in Indian Express.


• Satya Poddar and Sukumar Mukhopadhyay in Business Standard.


• Anil Padmanabhan and S. Narayan in Mint.


• Editorial in Financial Express.


• Tina Edwin and Gautam Ray in the Economic Times.

There are three huge and complex projects which are afoot in India today, each of which is of critical importance in transforming the landscape. They are: the Goods and Services Tax (GST), the New Pension System (NPS) and the Unique Identification (UID).



A lot of what I know about pension economics comes from David Lindeman, and he often quoted Larry Thompson in saying that such reforms involve three dimensions of effort : policy, politics and administration. Each of the three has to work out right in order to obtain success. If any one of the three goes wrong, then the overall outcome is attenuated.



With the NPS, we have made enormous progress on the politics and policy, but are weak on implementation. The GST faces political difficulties and it is not clear that the policy thinking will be done right. But the moment these early stages are crossed, the brunt of the problem will become administration. With the UID, there seems to be political support (so far), and the challenges are of making the right moves on policy and administration.



Bringing Nandan Nilekani to run UIDAI is an important step forward because it shows a recognition that the administrative challenges of these systems are unlike business-as-usual in government. These are complex IT systems, and require a new kind of execution punch in terms of rolling out complex nationwide IT systems. Similar thinking needs to be brought to bear for NPS and GST also.



Till date, the best success of a large complex system of this nature is the TIN. That was a problem which was all administration - it did not involve complex problems of politics and policy. However, it has proved a certain model of how to get this done (by contracting-out to NSDL using a certain kind of contract structure).



On large complex IT systems and their impact on India, you might like to see: Improving governance using IT systems, page 122-148 in Documenting reforms: Case studies from India, edited by S. Narayan, Macmillan India, 2006.



Update (February 2011): IT strategy for GST.

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