Trouble can be worse than bubble
The Financial Express, November 3, 2009, Page 8
Short-term interest rate as anti-speculation measure has high collateral costs
Dhiraj Nayyar
Almost all economic indicators from everywhere in the world suggest that we have exited the worst period of the crisis that began with the collapse of Lehman in 2008. This relatively quick comeback by historical standards—the Great Depression lasted nearly a decade—is in no small part the result of some very aggressive fiscal and monetary stimulus action taken by the governments of all leading economies. Keynes, it seems, was right after all.
But, and here's a word of caution for diehard Keynesians, like many other powerful medicines, fiscal and monetary stimuli have important, visible and perhaps harmful side effects. Cheap and abundant money, made available by close to zero interest rates in the leading developed economies, has played a crucial role in revitalising the financial sector and sections of the real sector. However, because finance picks up faster than the real economy, there will be a period when there is more liquidity floating around than the real economy can productively absorb. That's when it goes into creating bubbles in stock markets and real estate.
There is some evidence of this already with major stock markets recovering to near pre-crisis levels without the fundamentals in the real economy warranting such a comeback. In India, the Sensex has risen some 100% over the last eight months even while the real economy continues to stutter—few firms are reporting significant improvements in their topline (improved profits are largely the result of cost-cut bottomlines)—which would be the true indicator of a recovery in demand. Similarly, real estate, particularly in emerging markets like China and India, is witnessing a sharp revival, again to near pre-crisis levels, even though the underlying demand conditions don't justify this upward correction.
Ironically enough, just as the US Fed's cheap money policy, in a highly deregulated financial sector framework, over the 'golden' Greenspan years led to the subprime bubble and the crisis thereafter, the medicine for correcting the worst effects of that very crisis may be now fuelling another tricky bubble.
One part of the solution to the problem of bubbles is unfortunately still in the making and not ready for use. The G-20 may have started the process of devising new regulations, including newer capital adequacy norms for financial institutions, but the work is far from complete. Remember Basel II took some 12 years to negotiate. Even if the new regulations (call them Basel III) are agreed on quickly, an agreement will take longer than a year, largely because there are so many differences of opinion. In the interim, however, financial institutions are back to playing the old high leverage-high risk-high returns model slush as they are with what is money for free. Surely, if there is one lesson from the crisis that we have just about seen away, it is that finance could not possibly be allowed to continue with business as usual.
The other part of the solution, which is readily available, is the option of withdrawing the plentiful and cheap money floating around in the system. This would require central banks to begin hiking interest rates. Unfortunately, any exit strategy cannot be based simply on asset price inflation—growth must be factored in as well. And at the moment, it is far from obvious that growth anywhere in the world is robust enough to sustain itself if there is a tightening of interest rates. Sure, a significant tightening will eventually bust the stock market and real estate bubble but it will choke the real economy with it, too. It's like using a powerful bomb to kill three terrorists in a heavily populated area. It will meet the stated objective, but at what cost?
It is admittedly a difficult situation for policy makers, globally. There is a problem building up—bubbles in stock markets and real estate—and the world cannot afford another spectacular bust—we know how grave the consequences can be. The appropriate medicine is coordinated global regulation (Basel III)—get those who peddle the cheap money to adhere to strict risk-reducing norms on their capital adequacy, and on their trading books. But the medicine is still in preparation. Hiking interest rates—the other rather old fashioned medicine—so soon will extract a heavy price. In any case the US Fed, the most important player in the global policy game, seems determined to keep money cheap in the near future.
RBI must think about all of this as it gets ready to harden monetary policy perhaps as soon as in January. We may indeed have a stock market and real estate bubble in India already. And food price inflation is very high. But none of these is the result of excess demand in the local economy. Credit offtake, the real indicator of underlying demand conditions, is still sluggish.
Stock markets are being pumped with abundant dollar liquidity from abroad and the massive returns are then going to real estate. Food price inflation, at this moment, is a supply side phenomenon. That will be reinforced by a rise in global commodity prices because excess dollar liquidity is being used to buy into the commodities market, too. However, tightening monetary policy will not solve the problem of food inflation, or real estate prices or inflated stock markets. It will simply choke the real economy. The Reddy experiment in the summer of 2008 proved that beyond doubt.
In fact, as long as asset price or commodity inflation is driven by the abundance of cheap dollars in the global economy, RBI's monetary policy stance can't control it—the rupee was never cheap enough to fuel significant speculation in the local economy. Ironically, hiking rates will attract even more dollars, fuelling the bubbles, and complicate RBI's exchange rate management. If RBI really wants to prevent a dollar fuelled party in India, it must be bold enough to start thinking about forms of capital controls—like Brazil has. At least until appropriate global regulation is agreed upon. Any other action is a red herringthat will bite.
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