The four key aspects of the crisis articulated by the RBI Governor are macro imbalances, conflicts between monetary and fiscal policies, inflation targeting and the interplay of the real and financial sectors.
The global economic crisis, the deepest of our generation, is often compared to the Great Depression of the 1930s. Both were global in scope. Both were centred in the U.S. and, more important, were preceded by mounting global imbalances, loose monetary policies and high leverage.
But there are major differences between the crisis of today and the Depression of the 1930s and the several intervening crises affecting individual countries. The last mentioned were essentially traditional retail banking crises. Richer countries bailed out the crisis-hit countries and regions. In contrast, the current crisis has hit at the very heart of global finance with no buffer to fall back upon.
The other distinguishing feature of the current crisis is that no country has been spared. The U.S. and the EU have been at the epicentre of the crisis.
Discussing four aspects of the crisis, Reserve Bank of India Governor D. Subbarao has said (in his JRD Tata memorial lecture, “Questioning the questions” on July 31, 2009 — RBI website) that global imbalances along with developments in the financial markets were the two root causes of the crisis. There were large and persistent current account surpluses in Asian economies and corresponding current account deficits in advanced economies.
Central banks in Asian countries invested their large reserves in government bonds of the advanced countries. That in turn drove down risk free interest rates to historically low levels, caused an unprecedented credit expansion, lowered credit standards, eroded credit quality and encouraged the search for yield at all costs. All these have been the factors responsible for the crisis, Dr. Subbarao added.
Although India did not contribute to the global imbalance, it remained affected by the crisis, principally because of its integration — through trade and financial markets — with the rest of the world over the last two decades has been rapid. Global imbalances can never be eliminated but they have to be managed in such a way that they do not reach destabilising levels.
Unnerved by its complexity and size of the crisis, governments and central banks have responded with an unprecedented “show of force”, according to Dr. Subbarao. However, even as banks and governments co-operated and collaborated many of the familiar conflicts came to the fore.
Central banks brought down their policy interest rates to record lows: in many advanced countries they are near zero. However, even in normal times monetary transmission has lagged behind policy. In a crisis situation, there is fear and uncertainty which further impede transmission. Central banks responded through a slew of measures variously described as quantitative and credit easing. Despite all this, governments had to revive their credit markets with huge fiscal packages to stimulate demand. They had to recapitalise their banks.
Consequently fiscal deficits have ballooned around the world. Financing these deficits has not been a problem so far. However, there are reasons to think that the present tensions between monetary and fiscal policies will remain. Monetary policy will therefore have to be conducted in a regime of large and continuing fiscal deficits.
In India too, there have been tensions between monetary and fiscal policies even though the government and the RBI have co-ordinated their crisis management efforts. Such coordination was necessary to cushion the economy. However, the large government borrowing has impeded monetary transmission and militated against the objective of ensuring low interest rates. Going forward, the government and the RBI will need to strike a balance between short-term compulsions and medium-term sustainability with great care and judgment. High fiscal deficits can sow the seeds of the next inflationary cycle.
The RBI needs to roll back the special monetary accommodation provided (a) the government shows a firm and credible commitment to fiscal responsibility and (b) there are more definite signs of recovery.
In the years leading to the crisis, inflation targeting — rather than targeting monetary aggregates — was the accepted policy of central banks in the developed world: it seemed to promise stable growth, low inflation and low unemployment.
The crisis changed all that. Two important lessons have been: (a) the policy of benign neglect of asset price build up has failed and (b) price stability does not guarantee financial stability.
In India there are a number of reasons why inflation targeting is neither desirable nor practicable.
(1) The central bank of a large economy will have to be guided by a number of objectives at the same time — price stability, financial stability and growth.
(2) Food items have a large weight in the various consumer price indices. They are susceptible to supply side shocks especially because of the vagaries of the monsoon.
(3) There are several inflation indices.
(4) Monetary transmission in India is impeded by large fiscal deficits.
(5) In the context of volatile capital flow, a single point monetary policy loses much of its appeal.
Turning to the interplay between the real and financial sectors, Dr. Subbarao said that the financial sector had no standing of its own; it derived its strength and resilience from the real economy. It was the real sector that should drive the financial sector, not the other way around.