Wednesday, April 13, 2016

Central banks' push into negative territory is not working

Central banks have tried one thing after another since the 2007 financial crisis: lower interest rates, quantitative easing and, most recently, negative interest rates. They aren't getting the results they want: the IMF has recently again downgraded its growth forecast for the world. So, what next?

Well, one thing to understand, as Martin Wolf points out, is that negative interest rates are not entirely the work of the monetary authorities. Central banks are merely responding to supply-demand conditions. Where investment demand is way below savings, rates are bound to fall- and they could go into negative territory as well. Wolf writes:

Some will object that the decline in real interest rates is solely the result of monetary policy, not real forces. This is wrong. Monetary policy does indeed determine short-term nominal rates and influences longer-term ones. But the objective of price stability means that policy is aimed at balancing aggregate demand with potential supply. The central banks have merely discovered that ultra-low rates are needed to achieve this objective.

Wolf is right. He is also right in pointing out the big danger that goes with negative rates. Banks are passing on negative rates to borrowers but not depositors for fear that the latter will not park funds with them. This is bound to impact banks' bottom lines and threaten financial stability. The other concern with negative rates is that they low rates are getting consumers to save more, spend less- a point made by Larry Fink of Black Rock.

So, what do we do? The Economist has urged more unconventional measures: monetisation of the government's deficit (or helicopter money) and pushing up wages through tax incentives. Both will cause an increase in inflation and hence in aggregate nominal demand.

The Economist correctly points out that there is a more conventional tool that governments can employ: fiscal policy. It is worth pushing up public debt when the cost of it is as low as it is today. The time is ripe for a massive push to infrastructure in the advanced economies (exactly what we are attempting here in India today under different conditions).

Finally, the advanced economies of Europe need to get their banks' balance sheets into shape (again, echoing conditions in India). This means writing down bad debts and raising capital from the markets. The problem for European banks is that markets may not be in a mood to advance them funds. We are better placed here given that 70 per cent of banking assets are with public sector banks and the government can infuse funds into them instead of having them raising money from the market.

Lower interest rates, fiscal expansion and bank balance sheet repair- the ingredients of a recovery are much the same in the advanced economies as in India although the relative weights for each may vary.

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