Central Banking Wisdom

Y.V. Reddy, the author of this book, was governor of the Reserve Bank of India from September 2003 till September 2008 (Lehman Brothers collapsed on September 15 that year). No less a publication than The New York Times credits him with being one of the architects of the policies that cushioned the Indian economy from being hit hard by the global financial crisis. In this book, a compilation of Reddy’s essays on a range of banking-related subjects, the chapter on the global financial crisis offers insights into how Western central banks — chiefly the US Fed (though Reddy abstains from naming it) — failed to discharge their regulatory duties properly. Reddy’s points about the Indian central bank’s policies that enabled the country to emerge relatively unscathed should be read closely by all who want to gain an insight into the arcane world of central bank policy-making.

Proud boast
In the early years of the first decade of this century, it was the proud boast of the US Treasury and central bank that they had learnt to tame the boom-and-bust cyclicality of the economy. In reality, what the Fed was doing was that to keep the economic expansion going it kept interest rates at very low levels for a prolonged period. Sceptics like Raghuram Rajan who warned that such policies would create asset bubbles, whose bursting would cause grievous damage to the economy, were scoffed at. Retribution finally arrived in 2008. The Fed’s accommodative policy had created a surfeit of liquidity which, in the pursuit of high returns, was invested in high-risk instruments, including mortgage-backed securities.
During the years leading to the crisis, between the market and the government, the balance of power had clearly shifted in favour of the former. The prevailing wisdom then was that the markets knew best. And even if they were sometimes prone to excesses, they had the capacity for self-correction. Regulators allowed themselves to be persuaded (by vested interests within the financial sector) that they had no business intervening in the markets.

Played the fiddle
rices in asset markets soared, like Nero the US central bank played the fiddle while the economy burnt. For its inaction it offered the excuse that spotting a bubble in advance was difficult, and in any case, spotting bubbles was not part of its mandate. So it did not tighten regulation when the economy displayed excessive exuberance. It allowed itself to be lulled into complacency by a viewpoint widely prevalent then that even if there was excessive risk in the system, new derivative instruments and new entities like hedge funds would help disperse it widely.
Reddy asserts that the central bank’s failure lay in the fact that it did not take the countercyclical measures so necessary for moderating boom-and-bust cycles. Instead its policies first fuelled the boom, and in the later stages, it stood by and watched the bubble grow. He further adds that many central banks in the developed world focused only on containing inflation. Since their mandate did not explicitly say so, they were not vigilant about maintaining the stability of the financial system.
Reddy criticises Western central banks’ practice of providing forward guidance about monetary policy to the markets. Assured that rates would not be raised anytime soon, speculators speculated freely with borrowed money. It is understandable why such a practice is anathema to an ex-RBI governor like Reddy. In India the central bank tries to achieve its policy goals more through shock measures and by doing the very thing that the market doesn’t expect.

Regulatory capture
Regulatory capture in the US also contributed to the crisis, says Reddy. The fast-growing financial sector had come to wield inordinate influence over the political economy, and by extension, over the regulators. Former Goldman Sachs employees holding heavyweight positions within the government is a case in point. With such people in charge, a laissez faire policy vis-à-vis the markets was the natural outcome.

Crystal gazing
Reddy’s foresight is apparent from his comment that the steps taken by the US to revive its economy would have consequences for developing economies. This has indeed come about. The quantitative easing programmes led to escalation in commodity prices and import-dependent nations like India paid the price in the form of high inflation.
Reddy’s prescient warning that the fiscal stimulus measures undertaken by developed countries would increase their debt levels, and that these nations should constantly assess the fiscal sustainability of their actions, has also turned out right. Three years after the crisis, high sovereign debt in much of the developed world has taken away governments’ ability to take counter-measures as growth stalls and the danger of a double-dip recession looms large.

India: relatively unscathed
To readers one of the key points of interest in this book would be the policies that helped the Indian economy escape the crisis with only a marginal slowdown in its growth rate. Reddy explains that in India monetary policy always tended to be countercyclical: in other words, policymaking here did not encourage the build-up of asset bubbles. Moreover, the RBI conscientiously discharged its duty of maintaining financial stability. And it did not encourage speculation by providing forward guidance on policy.
Also, during the boom years India and many other Asian nations wisely built up their forex reserves. This served as a kind of insurance in case there was a sudden outflow of portfolio flows (which dominated the strong foreign capital inflows of the boom years). During the East Asian crisis of the late nineties, such outflows had wreaked havoc on the currencies and economies of many East Asian nations, and they were keen to avoid a repeat.

Lessons learnt
Has the world drawn any lessons from the economic havoc — massive destruction of wealth, years of slow growth, and unemployment of millions — that the crisis has wrought? Yes, to some extent. In the developed world, it is now recognised that the deregulation of the financial sector needs to be reviewed and redesigned. Policymakers there now admit that the financial sector, though critical, is only a means to an end, and that while it may enable growth, it does not create or sustain it. Its unbridled growth may not be permitted in future.
On financial innovation, it is recognised that all innovation may not be good for the system: a balance has to be struck between efficiency and the larger social good.
The crisis has also had the salutary impact of restoring the balance of power in favour of the government. It is no longer presumed that the markets are always right and that they do not need the government’s regulatory hand to guide them. In future, says Reddy, central banks of advanced nations will also have to focus more on financial stability, besides discharging their basic duty of inflation targeting.
In fact, central banks of the advanced world would do well to take a leaf from the Indian central bank’s manual of policymaking (to which the author has contributed richly). After all, it is among the few central banks that have emerged from the crisis with their reputation enhanced.