“Lessons from the Financial Crisis for Monetary Policy in Emerging Markets” was the title for the 2010 L.K. Jha Lecture, which I gave this week at the Reserve Bank of India in Mumbai. Jha was one of the truly outstanding economists and public servants in Indian history, and the biennial lecture series in his honor was created by the RBI two decades ago. This week’s Jha Lecture was the first since the panic of fall 2008 which hit emerging markets severely. The previous lecture was given in November 2007 by Jean-Claude Trichet, President of the European Central Bank.
One cannot exaggerate the size and speed of the shock to emerging markets in the fall of 2008. International stock indexes fell in tandem with the S&P 500. Consumers and businesses pulled back, largely out of fear. Exports and imports fell sharply throughout the world, with production declines accelerating as firms cut their inventories. The drop in exports was an especially major hit to emerging market economies.
The big surprise, however, was the amazing resiliency of many emerging market countries, including India, in the face of these shocks. The contrast with the 1990s, when emerging markets were suffering their own crises, was stark. For countries such as Brazil and Turkey, which were in crisis as late as 2003, the difference was especially stark. Why were these emerging markets so resilient? In my view the most important reason is that they had moved toward better macroeconomic policies and they stuck to those policies during the crisis. They were careful not to borrow in foreign currencies, and here Indian regulatory policy deserves special credit in discouraging such borrowing by Indian banks. They built up their foreign reserves so they could intervene in the case of a big shock, like the one they received. They kept inflation relatively low and were more careful with public sector deficits. (The reason they moved in such a good direction will be the subject for a later post.)
The policy implications of the crisis are that those central banks which were following sounder policies—and here credit should be given to India and other emerging market countries—should continue to do so. There is no reason to change their reform efforts. There is no reason to raise inflation targets. There is no reason to start trying to burst bubbles. But those central banks which deviated from good policies (I discussed these in the lecture) should get back to what they were doing before the crisis. They need to earn back credibility and preserve their independence. Systematic monetary policies focusing on a credible goal for inflation worked well in the past and they will work well in the future.
But the crisis does reveal some potential new fault lines for emerging markets, largely related to the high degree of international connectedness between markets, so evident during the panic. These interconnections raise questions about the impact of central banks on each other. In the period leading up to the crisis there is evidence that some central banks held interest rates lower than they otherwise would have because the Fed set its interest rate so low. The reason, of course, is the exchange rate. A lower interest rate abroad would cause the exchange rate to appreciate with adverse consequences on exports.
Is there a better way? Making interest rates less erratic in the developed countries would help the emerging market countries. For the most part deviations from policy rules, such as the Taylor rule, have increased interest rate volatility, so keeping policy interest rates more on track will have the added advantage of reducing their erratic nature. Another possibility is a global target for the inflation rate. If such a target was considered in the deliberations of each central bank, then there would be less of a tendency to swing individual policy interest rates around by large amounts.