Monetary easing: Is it yesterday once more?

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As the world seems to be struggling back to its feet after the great financial crisis, I want to draw attention to an area we need to be concerned about: the conduct of monetary policy in this integrated world.

A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, as I will argue, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. To ensure stable and sustainable growth, the international rules of the game need to be revisited.

Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle. Central bankers are usually reluctant to air their concerns in public. But because the needed change has political elements to it, I take my cue from speeches by two central bankers whom I respect greatly, Ben Bernanke in his 2005 "Global Savings Glut" speech, and Jaime Caruana in his 2012 speech at Jackson Hole, both of whom have raised similar concerns to mine, although from different perspectives.

Before starting, I should disclose my interests in this era of transparency. For the last few months India has experienced large inflows of capital, not outflows, and is seen by the markets as an emerging economy that has made some of the necessary policy adjustments.

We are well-buffered with substantial reserves, though no country can be de-coupled from the international system. My remarks are motivated by the desire for a more stable international system, a system that works equally for rich and poor, large and small, and not the specifics of our situation.

I want to focus on unconventional monetary policies (UMP), by which I mean both policies that hold interest rates at near zero for long, as well as balance sheet policies such as quantitative easing or exchange intervention, that involve altering central bank balance sheets in order to affect certain market prices.

The key point that I will emphasise throughout this talk is that quantitative easing and sustained exchange intervention are in an economic equivalence class, though the channels they work through may be somewhat different. Our attitudes towards them should be conditioned by the size of their spillover effects rather than by any innate legitimacy of either form of intervention. Let me also add there is a role for unconventional policies - when markets are broken or grossly dysfunctional, central bankers do have to think innovatively. Fortunately for the world, much of what they did immediately after the fall of Lehman was exactly right, though they were making it up as they went in the face of extreme uncertainty. They eased access to liquidity through innovative programmes such as TALF, TAF, TARP, SMP, and LTRO. By lending long term without asking too many questions of the collateral they received, by buying assets beyond usual limits, and by focusing on repairing markets, they restored liquidity to a world financial system that would otherwise have been insolvent based on prevailing market asset prices. In this matter, central bankers are deservedly heroes.

The key question is what happens when these policies are prolonged long beyond repairing markets - and there the benefits are much less clear. Let me list four concerns:

* Is unconventional monetary policy the right tool once the immediate crisis is over? Does it distort behaviour and activity so as to stand in the way of recovery? Is accommodative monetary policy the way to fix a crisis that was partly caused by excessively lax policy?

* Do such policies buy time or does the belief that the central bank is taking responsibility prevent other, more appropriate, policies from being implemented? Put differently, when central bankers say, however reluctantly, that they are the only game in town, do they become the only game in town?

* Will exit from unconventional policies be easy?

* What are the spillovers from such policies to other countries?

The current non-system in international monetary policy is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing.

If I use terminology reminiscent of the Depression era non-system, it is because I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it. In the process, unlike Depression-era policies, we are also creating financial sector and cross-border risks that exhibit themselves when unconventional policies come to an end.

There is no use saying that everyone should have anticipated the consequences. As the former BIS General Manager Andrew Crockett put it, "financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle."

A first step to prescribing the right medicine is to recognise the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognise that, the more sustainable world growth we will have.

Edited excerpts from remarks by Reserve Bank of India Governor Raghuram Rajan at the Brookings Institution in Washington, April 10