Economics One

Three years ago, a study of low and declining prices on Iraq’s debt by Michael Greenstone of MIT helped paint a bleak picture of the effectiveness of the surge, as, for example, in this November 2007 New York Times op-ed by Austan Goolsbee “In the Bond Market, a Bleak Prognosis for Iraq.” But as reported in this week’s Boston Globe piece “Gambling on Iraq’s Slow Rise from Ruin,” a re-examination of Iraq’s debt now leads Greenstone to change his view. Greenstone now says “The market’s assessment is that the prospects for a functioning Iraqi state in the future have improved dramatically.’’ The good news in this recent story is tempered a bit, at least for Californians, by the comparable assessment Iraq’s debt and California’s debt.

Next Thursday March 25 the House Financial Services Committee will hold a hearing on how the Fed should exit from its quantitative easing. This past week I was in Japan discussing the Japanese experience with QE with traders and experts in the financial sector and in the Bank of Japan. A simple graphical comparison between QE at the Fed and at the BOJ puts the exit strategy in a useful perspective.

The two graphs show the monetary base—currency plus bank reserves—in the United States and Japan as reported by the Fed and the Bank of Japan. (The BOJ reports units of 100 million yen; thus the monetary base in Japan is now slightly below 1,000,000 units of 100 million yen or 100 trillion yen).

The big bulges in the monetary base are measures of quantitative easing because the monetary base would have continued to grow at relatively steady pace without QE. Japan’s experience with QE was from 2001 to 2006; during those years the monetary base increased from about 65 trillion yen to 110 trillion yen, or by about 70 percent. While QE lasted for a long time it ended very quickly, and the quick exit seemed to go smoothly without volatility in the markets. Note that the post 2008 quantitative easing in Japan is very small compared to 2001-2006; thus Japan does not have an exit problem right now though it is still struggling with a deflation problem and will likely continue with its QE. Unlike the Fed, the BOJ did not think a big quantitative easing was appropriate in the recent crisis.

Moreover, the Fed’s recent QE is quite different from the BOJ’s QE in 2001-2006:

First, the monetary base in the United States increased by twice as much in percentage terms (140 percent) compared with Japan.

Second, QE came on much quicker in the United States, with most of the increase in the base concentrated in the last few months of 2008, though increases have continued since then.

Third, the Fed entered into QE when the interest rate target was 2 percent, while the BOJ started QE when the interest rate was already essentially zero at 0.1 percent.

Fourth, the Fed’s quantitative easing has largely been caused by the need to finance its purchase of mortgage backed securities, bailouts of AIG and Bear Stearns and other loans and securities purchases.

Fifth, and most important for the exit strategy issue: the BOJ exited from QE much more quickly than the Fed is now signaling its exit will be. Japan’s experience suggests that a quicker exit for the Fed might be considered.

“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.