CHANGE OF GUARDS AT CENTRAL: Banks and New Policy Thinking

The dogma of the quiet past is inadequate to the stormy present. In an interview published in one of the leading local dailies I had stated this over two years ago: while low and stable inflation rate should remain the principal objective of the BoM’s monetary policy, the MPC should take our poor growth performance on board. We have had enough of Milton Friedman’s “Fool in the Shower” play with policies in recent years. How can a former central bank Governor defy a central bank dogma and dare say that growth should have precedence over inflation? The view expressed by me was frowned at and I was seen in the wrong light of an apostate. Of course, my statement was not uttered out of malice as a few opinionated readers, not so familiar to the evolution of central banking over the years, had mistakenly taken it. Errors of opinion can be tolerated as long as reasons are allowed to correct it. And now is the time to correct it.
In some countries, including Mauritius, the public is sold to the idea that central bankers’ only policy game is inflation-targeting. Nothing else should be of policy concern to central banks. Irrespective of the prevailing economic and financial climate that sorely needs a twist in policy making, inflation-targeting is a mantra accepted unquestionably. We are part of a rapidly evolving and very rough as opposed to a static and smoothly functioning world economy. Economic conditions do change – often brutally – and with them policy emphasis should also change. No statement encapsulates this idea as tellingly as the one once quipped by J.M. Keynes: “When the facts change, I change my mind. Do you, Sir?”
A change of mind
Short of space, I had not elaborated on the reasons that had motivated me to throw the view on the table. A very brief explanation is warranted: In the last 40 years there was a belief that low inflation and prudent public finances help achieve and sustain stability of financial markets thereby enhancing the confidence of households and the business community which, in turn, contributes to the making of a robust economy over time. It was no doubt a correct belief and a correct strategy to pursue policies aimed at keeping inflation low and stable. Inflation-targeting became fashionable. The trouble is that the strategy of inflation-targeting was a direct response to the economic crises of the 1970s when financial markets, following the breakdown of the Bretton Woods System under Richard Nixon and oil price shocks, had gone through a long period of turmoil. Inflation-targeting helped restore financial stability. In sharp contrast, today’s economic crisis shares characteristics more in common with the 1930s. Whereas in the 1970s financial markets perceived inflation as the major threat to economic growth, today financial markets realize that the major threats stem not from inflation but from the absence of economic recovery. The most pressing need of the day is how to enhance confidence of households and firms in economic recovery. If they could be made to believe in economic recovery firms would invest and banks would lend. Growth would firmly resume its upward course as a result. The facts have changed. A change of mind is needed in countries with depressed growth performance. Those who do not must be either the slave of some defunct economists or are terminally ignorant.
The Bank of England threw in the towel following the issue of the latest Inflation Report. Sir Mervyn King’s admission that “the inflation target is to be quietly ignored” comes as no surprise at all. Roger Bootle, author of “The Death of Inflation”, published in 1996 toes the line of Sir Mervyn King, Mark Carney of the Bank of Canada and of Samuel Brittan, a long-time advocate of GDP (NGDP) targeting. He says the Bank could retain its inflation-targeting regime while at the same time lay policy emphasis on growth and employment. In fact, the regime could be tweaked such that inflation target could be achieved over a longer-term period than the usual time horizon. This would provide flexibility to pursue growth-promoting policies. Stanley Fischer, the former First Deputy Managing Director of the IMF and later the Governor of the Bank of Israel experimented with NGDP targeting. It has been a huge success. A view has gradually emerged that central banks cannot obsessively focus on inflation-targeting. And Central bankers have begun to redefine what their role is. They are quietly, without publicity, moving away from inflation-targeting toward sustaining financial stability to serve the wider economy.
Defying dogmas…
Mark Carney, Governor of the Bank of Canada, is the first foreigner to have been appointed, by the Queen, Governor of the Bank of England in its 300 years’ history. Surprisingly, with London as the capital of global finance, the UK Government did not find any of its citizens suitable for the job. He has been praised, in worshipful terms, in the House of Commons as the Governor who will bring a fresh perspective to monetary policy thinking in the City. A couple of weeks after the announcement of his appointment for the Bank of England job with effect from June 2013, Mark Carney, defying dogmas, made an arresting statement in Toronto in December last challenging the prevailing school of thought. He signaled that central banking objectives could include targeting of NGDP particularly at a time when GDP growth rates are miserably low. Carney seems to have served an advance notice of changes likely to come. A 13-member Treasury Committee of the House of Commons queried Mr Carney for more than 3 hours last month. He is open to debate about moving the Bank of England away from its current mandate of targeting inflation at 2 per cent. While he is not sold on the idea of a more flexible approach including a measure of NGDP as a target, Mr Carney described his role as a kind of “managing partner, not an emperor” in the City and said, “I see value in having a debate.”
As always there are arguments for and against the use of NGDP targeting. Advocates of NGDP are confident it would work. The policy shift would push up growth expectation thus persuading businesses to start spending and kick-starting the UK economy. Some observers in the City cling to the belief that if Mr Carney wants to change the mandate he may be pushing an open door. Consciously or not, a nominal GDP is in fact what the Bank of England has been pursuing (by way of Quantitative Easing) over the past few years.
Smaller economies are like kayaks
Advanced economies are growing at half the rate they did in the past. Governments are turning to a new set of monetary-policy makers. New policy makers may bring in new tools. Mr Carney’s view must be looking attractive to politicians in afflicted economies. No wonder the revolving doors of central banks are rotating worldwide. A revolution that began with the arrival of Mario Draghi in November 2011 at the European Central Bank is now gathering momentum as Mark Carney is about to join the Bank of England. Carney’s move to the Bank of England has created a vacancy in Ottawa. Bank of Japan is awaiting a new Governor. Glen Steven’s tenure of office at the Reserve Bank of Australia is expiring in September. Sergey Ignatiev, Chairman of Russia’s central bank, retires in June. Duvvuri Subbarao’s term at the Reserve Bank of India ends in September. China has already signaled the replacement of Zhou Xiaochuan this month. Orally and verbally, the new monetary-policy makers are more aggressive than their predecessors. It’s however a tough job to turn around the seriously afflicted economies. Time will tell if they succeed in steering their respective economies into a stronger growth path.
Smaller economies are like kayaks, far easier to turn around than huge battleships. The BoM had gone for its own variant of quantitative easing in the early years of the new millennium. For the Illovo deal, banks had found it too risky to finance the re-structuring of the sugar industry. Although flushed with liquidity, they were very unwilling to lend. As is currently happening in advanced countries banks, though flushed with liquidity, are unwilling to lend because of perceived risks. The BoM had dished out Rs2.0 billion in the early years of the new millennium through banks to the sugar industry. Without this variant of quantitative easing by the Bank, landed property would not have been released on the market. Prices of landed property would have shot up. Ebene and the massive construction projects would not have seen daylight. Cost of office space in Port Louis would have skyrocketed to prohibitive levels. Quite some offshore companies would have moved to other jurisdictions. The construction sector would obviously not have boomed. Banks that had shied away from the financing of the restructuring of the sugar industry later rushed to locate their headquarters, branches and offices in Ebene. What would have been our economic growth rates today without that variant of quantitative easing by the BoM in 2002? We definitely got the bang for the buck. It certainly does not go to say that I am advocating quantitative easing in the present context. It’s not warranted.
Growth performance in the present context is too important a consideration to be left out of the policy picture. Just like war is said to be too important to be left to Generals, this issue of NGDP targeting is too important to be left to the central bank alone. It needs to be fully debated (backed by published scientific studies) within and outside Government. Like anywhere else, the Government, and not the central bank, sets the monetary policy framework. The central bank is at the receiving end; it has the tools and the power to support growth. That I had said economic growth should be taken on board by our MPC over two years ago did not justifiably make me an apostate. It was clairvoyance.