The Hindu Business Line : Create confidence by fiat?

The massive amounts of money which global central banks are creating by fiat, or quantitative easing, are not getting transmitted to the broader economy. They are largely getting deposited back at the central banks.

T. B. Kapali

Can the confidence to borrow and lend be created by fiat? If yes, central banks across the world now would want to know how and, more importantly, may even put that knowledge into practice in quick time. For, it is that spark or animal spirit (in Keynesian terminology) which drives economic agents to borrow, invest and lend with confidence generally (and with over-confidence or irrational exuberance at times), which is missing in the overall environment now.

The absence or weakness of that animal spirit has meant that the massive amounts of money which global central banks are creating by fiat (called quantitative easing) are not getting transmitted to the broader economy (and the broader money supply) — through the process of financial intermediation. They are largely getting deposited back at the central banks.

Consumer sentiment and confidence is yet to recover convincingly from the blows it has received in the past 18 months — on the back of sharp job losses, weak incomes and substantially eroded (stock market and real estate) wealth. That weakness, in turn, is reflected in the business sector’s muted investment intentions. Bank loan growth is consequently anaemic or even negative in the key western economies.

The Fed, of course, has identified some “green shoots” of late — key among them being some recovery in consumer sentiment from its late 2008 lows and the pick up in re-financings in the housing mortgage market on the back of soft interest rates.

Consumer sentiment has historically been a leading indicator of the turn in the economic cycle. It, nevertheless, promises to stay the course (on fiat money creation) to cement the very incipient recovery. Ditto for the Bank of England and the European Central Bank. What else can be done — in the absence of any technique to stoke confidence by fiat?

That inability to inspire confidence by fiat, could, in fact, be disappointing and even somewhat of an awakening for the major G-7 central banks. For, systematic, rule-based and a targeted monetary policy and the confidence this inspired was identified as one of the key contributors to the “great moderation” in the G-7 economies in the 2-½ decades since the early 1980s.

The “great moderation” was a period marked by significantly reduced variability in output growth and inflation in relation to earlier periods.

The fairly pronounced deceleration in output growth (even absolute contraction) and the fall in price levels which have occurred in the past year even as they (central banks) have systematically added another dimension to their monetary policy tool kit viz. fiat money creation, sure will tarnish that long-term record.

Fiat money by RBI too

Nearer home, much the same predicament has confronted the Reserve Bank of India also in recent times in its endeavour to re-kindle higher levels of borrowing, lending and investment in the Indian economy. Like in the G-7, much of the lendable resources being created (primary money) are not getting translated into higher broad money growth. They are either simply getting deposited back or remaining deposited at the RBI as the appetite for both loan demand and loan supply seems to be weak.

But the important difference between the RBI and the G-7 central banks (barring Japan) is that fiat money creation has a long history in India.

The RBI has been aggressive in fiat money creation — not only in the very recent past. It has been doing that right through this decade — courtesy its foreign exchange market intervention policy.

That policy has meant that the Indian financial markets (the money markets to be precise) have broadly been in surplus mode — with enough and more for those financial institutions which seek to borrow in that market for funding their lending operations.

Average money market interest rates (and their variability) in India have progressively declined in the past many years. There have been periods of tightness, shortages and high volatility in these markets, but these were driven by idiosyncratic features in the financial system.

The money market surpluses have at times been heavy. But in the overall environment of a higher level of economic activity in the period up to (mid) 2008, they were broadly absorbed in higher credit growth in the financial system — with, of course, its unfavourable consequences for general price levels in the economy as well as in specific asset markets such as real estate, stocks and commodities.

Will RBI stay the course?

So, it is with a certain mixed background that the latest phase of fiat money creation has been undertaken in India. This background would seem to call for some caution if there is wholesale adoption of (exogenous) money creation policies in India.

(This phase of money creation is also technically different in that the central bank has broadly been buying domestic rupee-denominated assets and creating money as well as releasing impounded bank reserves as against the expansion of its balance-sheet through purchases of FX assets in the earlier period. In a sense, we can say that the RBI has gone back to the practice which was followed till the mid-1990s.

In that period, the RBI’s balance-sheet expansion was primarily through purchase of domestic assets viz. government securities. The qualitative and quantitative impact of money creation, though, would be the same whatever the method).

Therefore, even as the RBI possibly contemplates a further fine-tuning of its money and liquidity creation/management operations (the latest act of fine-tuning being the decision to conduct only one LAF auction in the mornings; a further move here would mean closing the reverse repo window altogether or placing a ceiling on the surplus absorption under the window like in March 2007), economic agents may well bear that background in mind and position themselves accordingly.

The strong rise in global commodities prices in the last quarter (despite it being from a low base) is a leading indicator of the overall price pressures that are possibly developing.

This shows that the Fed’s assessment of “green shoots” is probably on the dot and not restricted to the US domestic economy alone.

Fiat money may well be doing the trick, even without the explicit aid of confidence by fiat. And given the historical background in India, it may well be appropriate that the monetary policy arsenal does not include the ability to create confidence by fiat!

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. The views are personal.)

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