Monetary sovereignty

Lessons from Ben Bernanke's exchange with Raghuram Rajan

Ben Bernanke, who recently stepped down after an eventful eight-year term as chairperson of the US Federal Reserve Board, was in Mumbai last Tuesday. Among other things, he spoke about the impact that US monetary actions might have had on the rest of the world and, in this context, indicated that there was ongoing dialogue between central bankers from around the world in multiple fora. The views of others about the consequences of US actions, he said, were always given due consideration. This was significant as, just last week, Reserve Bank of India (RBI) Governor Raghuram Rajan made an apparently provocative speech in the Brookings Institution in Washington, DC, with which Dr Bernanke is now associated. The crux of Dr Rajan's argument was that the US Fed's unconventional monetary policy, popularly referred to as quantitative easing (QE), whatever its consequences for the US economy, had not been particularly good for other, particularly emerging market, economies. The large infusion of liquidity by the US Fed flooded capital markets elsewhere, raising asset prices to levels unjustified by fundamentals and causing currencies to appreciate. By the same token, when the Fed announced that liquidity would be rolled back, it led to enormous turbulence in global markets, especially in India. Dr Rajan's recommendations for an avoidance of repetition of this unfortunate series of events are twofold: one, that central banks need to co-ordinate more effectively; and two, that multilateral safety nets, such as those provided by the International Monetary Fund (IMF), ought to be much more accessible and flexible in their terms and conditions.

Dr Rajan's critique was, not surprisingly, rejected by other panelists from central banks of advanced economies, including Dr Bernanke, who was in the audience. The standard response is that monetary policy operates in a sovereign context and each central bank must primarily respond to macroeconomic conditions in its country. Building global consequences into a policy rule is both complex and politically indefensible at home. Exchanging thoughts and concerns during global meetings hardly qualifies as effective co-ordination. However, Dr Bernanke's other riposte has significant merit. Domestic macroeconomic vulnerability clearly exacerbates the impact of external shocks, including US monetary actions. Put your own house in order, he has implied, before pointing fingers at others. India's experience during 2013 underscores the validity of this argument. It is certainly true that the challenges arising out of global capital flows have also to be faced through better preparation at home. And the efforts, however minimal, made so far by the RBI in accumulating reserves need to be expanded to include other measures as well.

What else should countries vulnerable to such shocks do? Dr Rajan's emphasis on more accessible multilateral financial safety nets is certainly acceptable in theory, but IMF governance reforms - which are necessary for this to happen - are effectively stuck; no country can afford to rely on this framework to the total exclusion of self-insurance. In effect, the message from the Rajan-Bernanke exchange seems to be that the more risky a country's macroeconomic situation, the better off it will be building up its own protective barriers. Of course, its first priority should be to improve macroeconomic conditions, but a little more insurance while this is being done is not a bad idea. Large capital inflows do offer an opportunity to build up reserves and the RBI should think seriously about taking advantage of it.