The Global Monetary Non-System, RAGHURAM RAJAN

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Raghuram Rajan

Raghuram Rajan is Governor of the Reserve Bank of India.

• NEW DELHI – As 2015 ended, the world boasted few areas of robust growth. At a time when both developed and emerging-market countries need rapid growth to maintain domestic stability, this is a dangerous situation. It reflects a variety of factors, including low productivity growth in industrial countries, the debt overhang from the Great Recession, and the need to rework emerging markets’ export-led growth model.
  So how does one offset weak demand? In theory, low interest rates should boost investment and create jobs. In practice, if the debt overhang means continuing weak consumer demand, the real return on new investment may collapse. The neutral real rate identified by Knut Wicksell a century ago – loosely speaking, the interest rate required to bring the economy back to full employment with stable inflation – may even be negative. This explains central banks’ attraction to unconventional monetary policy, such as quantitative easing. The evidence that these policies boost domestic investment and consumption is mixed, at best.

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  Another tempting way to stimulate demand is to increase government infrastructure spending. In developed countries, however, most of the obvious investments have already been made. And while everyone can see the need to repair or replace existing infrastructure (bridges in the United States are a good example), badly allocated spending would heighten public anxiety about the prospect of tax hikes, possibly increase household savings, and reduce corporate investment.
  Arguably, industrial countries’ growth potential had fallen even before the Great Recession. Former US Treasury Secretary Larry Summers popularized the phrase “secular stagnation” to describe weak aggregate demand caused by aging populations that want to consume less and the increasing income share of the very rich, who are unlikely to increase their already-large consumption.
  Such structural reasons for slow growth suggest the need for structural reforms: measures that would increase growth potential by spurring greater competition, participation, and innovation. But structural reforms run up against vested interests. As Jean-Claude Juncker, then Luxembourg’s prime minister, said at the height of the euro crisis, “We all know what to do; we just don’t know how to get re-elected after we’ve done it!”
  If growth is so hard to achieve in developed countries, why not settle for lower growth? After all, per capita income already is high.
  One reason to press on is to fulfill past commitments. In the 1960s, industrial economies made enormous promises of social security to the wider public, later augmented by fiscally unsound commitments to public-sector workers. Moreover, growth is necessary for social harmony, because the young – who can always take to the streets in protest – have to work to pay for those commitments to older generations. And if technological change and globalization mean fewer good middle-class jobs for a certain level of growth, more growth is needed to keep inequality from widening.
  Finally, there is the fear of deflation, the canonical example being Japan, where policymakers supposedly allowed a vicious cycle of falling prices, depressed demand, and stagnant growth to take hold.
  In fact, this conventional wisdom may be mistaken. After Japan’s asset bubble burst in the early 1990s, the authorities prolonged the slowdown by not cleaning up the banking system or restructuring over-indebted corporations. But once Japan took decisive action in the late 1990s and early 2000s, per capita growth was comparable to that in other industrial countries. Moreover, the unemployment rate averaged 4.5% from 2000 to 2014, compared with 6.4% in the US and 9.4% in the eurozone.
  True, deflation does increase the real burden of existing debt. But if debt is excessive, a targeted restructuring is better than inflating it away across the board.
  Regardless of these arguments, the specter of deflation haunts governments and central bankers. Hence the dilemma in industrial economies: how to reconcile the political imperative for growth with the reality that stimulus measures have proved ineffective, debt write-offs are politically unacceptable, and structural reforms frontload too much pain for governments to adopt them easily.
  Developed countries have just one other channel for growth: boosting exports by depreciating the exchange rate through aggressive monetary policy. Ideally, emerging-market countries, funded by the developed economies, would absorb these exports while investing for their future, thereby bolstering global aggregate demand. But these countries’ lesson from the emerging-market crises of the 1990s was that reliance on foreign capital to fund the imports needed for investment is dangerous. In response, several of them cut investment in the late 1990s and began running current-account surpluses, preferring to accumulate foreign-exchange reserves to preserve their exchange-rate competitiveness.
  By 2005, Ben Bernanke, then a governor at the Federal Reserve, coined the term “global savings glut” to describe the external surpluses, especially in emerging markets, that were finding their way into the US. Bernanke pointed to their adverse consequences, notably the misallocation of resources that led to the US housing bubble.
  In other words, before the 2008 global financial crisis, emerging and developed countries were locked in a dangerous symbiosis of capital flows and demand that reversed the equally dangerous pattern set before the emerging-market crises of the late 1990s. In the aftermath of the 2008 crisis, the pattern reversed itself once again, as capital flowed to emerging markets from developed countries, setting up fragilities that will come fully to light as developed-country monetary policy tightens.
  In an ideal world, the political imperative for growth would not outstrip an economy’s potential. In the real world, where social-security commitments, over-indebtedness, and poverty will not disappear, we need ways to achieve sustainable growth. Above all, we need to avoid beggar-thy-neighbor policies, such as unconventional monetary policy or sustained exchange-rate intervention, that primarily induce capital outflows and competitive currency devaluations.
  The bottom line is that multilateral institutions like the International Monetary Fund should exercise their responsibility for maintaining the stability of the global system by analyzing and passing careful judgment on each unconventional monetary policy (including sustained exchange-rate intervention). The current non-system is pushing the world toward competitive monetary easing, to no one’s ultimate benefit. Developing a consensus for free trade and responsible global citizenship – and thus resisting parochial pressures – would set the stage for the sustainable growth the world desperately needs.