Rajan’s pie in the sky

This from Rajan, Governor of India’s Reserve Bank is worth a read.

It opines on the need for more monetary policy coordination, something I think is pure pie-in-the-sky, and so much so that I presume the words are there just to explain how difficult a place the world can be in which to set monetary policy, and not that he really expects anything to come of it.

Rajan is clearly not a fan of the Fed’s program of quantitative easing.  He would classify this as a ‘red’ policy.  Something which has only marginal benefits for those that undertake it, and malign side effects – particularly capital inflows that produce asset price bubbles – for emerging economies.

A project syndicate op-ed may not be the place to do this, but he doesn’t address the voluminous event study literature showing how QE reduced yields.  I’m no fan of QE either, but there is a lot of work now that cannot simply be dismissed out of hand.

The way the Fed and other central banks would see it is that the counterfactual is for the US/UK/Eurozone to be stuck with very low growth and deflation for decades.  A circumstance that could hardly benefit emerging markets.  Indeed, there is emerging evidence that the liquidity trap can be contagious.

QE may well have generated capital inflows to the EM countries.  But three points to note here.

First, this offsets only some of the dominant force of this capital being exported ‘uphill’ to richer countries, to realise returns that are higher only net of risks due to politics and expropriation of one form or another.

Second, if QE instills confidence by reducing the risk of being caught forever in the liquidity trap, it may well encourage capital out of EM countries, not push capital into them.

Third, the precautionary response of EM countries should be to adopt tight prudential standards – how EM banks fund themselves, and their lending practices – which will have the same effect as capital controls, without many of the attendant costs.

The uphill countries would presumably welcome this.  Although it would diminish the exchange rate effect of QE for them, it would amplify the effect of compressing yields on uphill, private sector assets.

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