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Alok Sheel: Sub-prime and monetary policy

Alok Sheel  |  New Delhi 

The central bank, as we know it, evolved in the wake of the financial panic of 1907 in the US when a private banker, J P Morgan, was called upon to bale out the financial system by injecting liquidity in financial markets. The was consequently established to maintain orderly conditions in financial markets.
Central banks subsequently acquired a second objective, namely, to ensure macro-economic stability across business cycles. They lowered benchmark short-term rates and injected liquidity when the economy was expanding, and sucked out liquidity through monetary tightening and higher reserve requirements when demand surged ahead of supply, leading to inflation ('overheating').
More recently, the resurgence of mercantilist beliefs has added a third objective, namely a competitive exchange rate. Central banks in developing countries now mostly juggle the twin objectives of inflation control and exchange rate management on a regular basis. Since globalisation makes it virtually impossible to control cross border capital flows "" even where the capital account is regulated "" central banks have struggled unsuccessfully to tame the legendary triple-headed monster called the 'impossible trinity' "" none more than the RBI!
But there are other conflicting objectives as well. Central banks are every now and then rudely reminded of their raison d'etre when a crisis of epic proportions, such as the Great Depression over a quarter century ago, or the sub-prime threat today, presage financial Armageddon.
The legendary Milton Friedman's explanation of the Great Depression, reiterated not too long ago by the current Fed Chairman Benjamin Bernanke, was that it was mostly a monetary phenomenon. The Fed apparently did not heed the sage advice of Walter Bagehot, the founding father of central banking theory, to lend freely in a liquidity crisis.
The ghosts of 1907 and 1929 have haunted the boardrooms of central banks ever since. Benjamin Bernanke's predecessor, Alan Greenspan, pumped liquidity into markets during the stock market crash of 1987, during the banking crisis associated with the collapse of the Long Term Capital Management Hedge Fund in 1998, and again during the dot-com bust of 2001-03. The Fed and ECB also moved quickly to pump liquidity to stabilise financial markets in the wake of the current sub-prime mortgage crisis. Indeed, the central bank's propensity to cut rates when bubbles burst has now come to be known as the "Greenspan put!"
The irony this time around is that central banks have been constrained to pump liquidity into markets that they have put on inflation watch for possible benchmark short-term rate increases. While central banks may dither between the conflicting objectives of demand and exchange rate management, the trade off between demand management and financial apocalypse is a no brainer, the attendant moral hazard of encouraging future risky behaviour notwithstanding. And rightly so, for protracted turmoil in financial markets will sooner or later spill over into the real economy.
The danger lies in the liquidity overhang once the crisis is past, which can either lead to a liquidity trap (what happened in Japan in the nineties following repeated rate cuts by the Bank of Japan in response to the collapse of the real estate bubble) or a build up of the same exuberance that creates financial bubbles in the first place. The Great Depression, it may be recalled, was preceded by an easy money policy. Greenspan has been faulted not for his 'put', but for the excessively slow monetary tightening after the dot-com crisis, and which may well be the long-term cause of the current sub-prime imbroglio. According to some observers, the tightening was more measured that what the Taylor Rule for monetary policy predicated.
The real problem, however, is that monetary rules currently followed by central banks are too narrowly focused on consumer prices as benchmarks for inflation targeting. In view of rapid globalisation and trade liberalisation, consumer price indices "" based primarily on baskets of internationally traded commodities "" are arguably becoming a less reliable measure of domestic overheating than asset prices. The has remained low and stable between 2-3 per cent since 2000. However, the US Real Home Value Index that fluctuated within a relatively narrow range of 90-120 over the last century from 1890 (=100) to 2000, except during the Great Depression, rose sharply over the last four-five years to touch 200 in 2006. This unprecedented real estate bubble does not seem to have majorly shaped the Fed's monetary policy, Greenspan's occasional references to "irrational exuberance" in asset prices notwithstanding.
Perhaps the most enduring lesson of the sub-prime financial crisis may well be the need to revisit the rules informing monetary policy.
The writer is a civil servant. The views are personal

First Published: Fri, September 14 2007. 00:00 IST