A book that creates fresh awareness on challenges to monetary and fiscal policies, especially in emerging economies

Hard core monetarists had a Talmudic attachment to the model developed by Robert Mundell and Marcus Fleming seven decades ago. It posited that out of three objectives underpinning macroeconomic policy — price stability, fixed exchange rate and independent monetary policy — countries can hope to achieve only two. The incompatibility of the trio led to its being named “The impossible Trinity.” For decades it seemed inviolable.

The model was based on unrealistic assumptions and did not provide for changes in international trade and financial structures. In an illuminating lecture delivered at an Annual Research Conference of the IMF held in November 2000, Prof. Maurice Obstfeld narrated other alternative modelling approaches emerging in academies. (International Macroeconomics: Beyond the Mundell-Fleming Model, IMFF Staff Papers, Vol. 47, Special Issue, 2001.) These models tried to reckon with rigidities, intertemporal approaches to open-economy dynamics and the effects of market structure on international trade.

Even when the Holy Trinity held sway, it was not the case that all countries abided by its tenets. Financial globalisation exposed developing countries to capital flights. Concerns over financial stability assumed importance. Each country had to devise its own policies and instruments to manage the flows and bring about financial stability. Perhaps, India set a good model in this. The Reserve Bank was able to maintain financial stability even as the global economic scenario was marred by recurring crises. The Bank pursued a multiple objective approach in a calibrated manner. Dr. Y.V. Reddy, former Governor, won global plaudits for this approach. Dr. Rakesh Mohan, his deputy, captures it thus: “The impossible trinity was managed preferring middle solutions of open but managed capital account and flexible exchange rate but with management of volatility. Rather than relying on a single instrument, many instruments have been used in coordination.” (Managing the Impossible Trinity: Volatile Capital Flows and Indian Monetary Policy, Stanford Center for International Development, Working Paper No.401, November 2009.)

The crisis of 2008 legitimised the pursuit of independent national policies and also threw up newer issues for coverage. This provides the background to the birth of the New Trilemma, the theme of this book. It is a compilation of papers submitted at the Second International Research Conference held by the Reserve Bank of India in February 2012. The participants are leading lights in central banks or academies. Naturally, there is a lot of ‘bankspeak’ and group-think running through the papers.

Only one paper (Chapter 1) by Dr. Subbarao, former Governor, examines lucidly, and at length, the concept of the New Trilemma. There are four papers (Chapters 3, 6, 7 and 9) covering new challenges to monetary policy in the wake of the crisis. Three chapters (5, 8 and 10) handle issues governing debt overhang. Thus, except for the paper by Subbarao, all others handle various aspects of monetary policy tangentially related to the New Trilemma.

As Subbaro explains, the New Trilemma is not a new impossible trinity. It refers to the need for simultaneous pursuit of price stability, financial stability and sovereign debt sustainability. He compares them to the three legs of a tripod which need to be balanced. He traces the interlocking relationship between the legs and how, when properly balanced, they mutually reinforce each other. As he says, “Under the new trilemma — the holy trinity — no country can afford to sacrifice any of the objectives as the feedback loops can quickly shift the economy from equilibrium to disequilibrium.” The issue of is one managing the inter se priorities and the role of the central bank. This harks back to the fears of central banks losing independence as a result of fiscal dominance.

Yung Chul Park analyses (Chapter 3) the “macro-prudential approach to financial supervision and monetary policy”. His thrust is over the relationship between macro-prudential framework for regulation and interactions between monetary and macro policies. While the earlier supervisory aim was to save individual institution from bankruptcy, the macro policy deals with systems and the approach has to be different. Newer limits such as capital/risk ratios, restrictions on group lending, etc. have to be set. There is yet no agreement on these. He narrates the Korean experience. On supervisory roles, he visualises that the responsibility has to be shared jointly by all the agencies, viz. the central bank, the regulatory agency and the central government’s fiscal authority.

The paper by Stephen Cecchetti and Enisse Kharoubi (Chapter 3) is not directly related to the main theme. It deals with the impact of finance on growth and is indeed a brilliant analysis and should warn policymakers about the risks of courting too much capital. The argument is that there are limits to growth resulting from finance (capital) and too much finance is bad for the economy. They refer to several country studies which establish the fall in productivity level associated with higher capital. They also draw attention to the adverse impact created on the employment market. It drives too many into the high paying financial sector (The City or Wall Street!) and hollows out employment in other sectors.

The chapter (6) by Benjamin Friedman is an odd item in the pack. Friedman does not share the concerns expressed by a horde of economists on the crisis resulting from the low interest (zero bound!) policies of the Fed. He blames it on other factors like excessive leverage, trading in securities, derivatives, etc. He suggests that the easy money policy pursued over thirty years has brought about all the growth and development and should not be destroyed unless we work out alternative structures.

The papers on debt overhang carry the usual lament about excessive growth in public debt and high debt debasing growth. Much reliance is placed on some of the studies by Rogoff and Reinhart which suggested that when the debt/GDP ratio crosses 90 per cent, relative growth goes down. This thesis was the mainstay of austerity measures put through in the wake of the crisis. Unfortunately, later research by a junior researcher exposed the flaws in their computer programmes and explained how it had led to wrong conclusions. Indeed, these findings came later and we should not blame the authors for group think!

Partha Shome (Chapter 8) overreaches himself. His attachment to the IMF and its approach are rather known. He develops the theme that global crisis had its origin in excessive spending by households and governments. Corporates also joined the fray. Banks joined the party. The boom was encouraged by governments since there was expansion in revenue. The cozy relation between government and private sector was self-perpetuating and bred excesses. Governments are unable to take corrective action when a crisis erupts.

Sadly, the author’s explanation of the origins of the crisis makes all other explanations thus far stand on their head. Truly, it was the banks which took the lead under the benign neglect of the FED and governments were dragged in when the crisis broke out. Much of the debt hang is the result of bailouts which drained public resources to buy toxic assets. Again, Shome argues that the IMF can clean up the mess if it is provided with adequate resources. Its record in handling the euro crisis is rather known. Further, it is not clear who foot the bill. China? It is also unclear how the IMF with its current undemocratic management structure can play an even handed role.

Perhaps, the paper on Rethinking Central Banking (Chapter 9) is the icing on the cake. It is by three authors and one of them is Raghuram Rajan who was an academic at that time and presently the Governor, RBI. It elaborates how the conventional approach has to be rethought taking into account its inadequacies in the changed context. Central banks should go beyond their emphasis on low inflation and adopt an explicit goal of financial stability. Macro-prudential tools need to be used alongside monetary policy.

The paper goes on to delve into issues like handling emerging bubbles and recalls older debate on it. It covers several aspects of macro-prudential policy tools. Institutional responsibilities are gone into.. The intractable problem of separation of functions is another area covered. It studies the problems relating to spill-overs and the cracks in the management of flexible exchange rates. All the issues have been examined at a high level of scholarship expected from these authors. To achieve those objectives, they lay down a roadmap. The authors take a dim view of the role played by the existing forums like the BIS or G-20 in global cooperation. They feel that a separate forum is needed. Indeed it is laudable. But how will it come about without US/EU cooperation?

The book succeeds in creating new awareness on the challenges to monetary and fiscal policies, especially in emerging economies. Only one chapter handles the concept of the New Trilemma and all the others relate to it tangentially. It is a rewarding contribution to monetary economics.

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