Monetary policy now needs global teamwork
Globalisation is negating the effect of huge liquidity injections, writes Kaushik Basu.
One thing that experts know, and non-experts do not, is that they know less than non-experts think they do. This much was evident at the recent meetings of the International Monetary Fund and the World Bank - three intense days of talks that brought together finance ministers, central bankers, and other policymakers.
Our economic expertise is limited in fundamental ways. Despite decades of data collection and mathematical and statistical research, on many big questions we have little more than rules of thumb.
Sometimes we rely on our judgment in combining interest-rate action with open-market operations. But our understanding of these policies' mechanics is rudimentary.
These rules of thumb work (at least tolerably so) as a result of evolution. Over time, the wrong moves are penalised, and their users either learn by watching others or disappear. We get our monetary and fiscal policies right the same way that birds build their nests right.
As with all behaviours shaped by evolution, when the environment changes, there is a risk that existing adaptations become dysfunctional. This has been the fate of some of our standard macro-economic policies. The formation of the eurozone and a half-century of relentless globalisation have altered the global landscape, rendering once-proven policies ineffective.
When Sweden's Riksbank was founded in 1668, followed by the Bank of England in 1694, the motivation was that a single economy should have a single central bank. Over the next three centuries, as the benefits of instituting a monopoly over money creation became widely recognised, a many central banks were established, one for each politically bounded economy.
What was not anticipated was globalisation would erode these boundaries. As a result, we have returned to a past from which we tried to escape - a single economy, in this case the world, with multiple money-creating authorities.
This is clearly maladaptive, and it explains why big injections of liquidity by central banks are failing to restart economies and create jobs. In a globalised economy, much of this spills across boundaries, giving rise to inflationary pressures in distant lands and precipitating the risk of currency wars, while unemployment at home remains dangerously high, threatening to erode workers' skills. The long-term damage could be devastating.
What was evident at the World Bank/IMF meetings was that virtually all policymakers are distressed and no one has a complete answer. Neither do I. But here are two simple ideas that could help to mitigate the crisis.
First, in the absence of a single global central-banking authority, a modicum of monetary policy co-ordination among big economies is required. We need a group of the major economies - call it "G Major" - that announces monetary policies in a co-ordinated fashion.
To see why, consider the case of Japan. Japanese policymakers have good reason to try to promote some inflation and even correct some of the yen's appreciation over the past six or seven years. But, in today's unilateral world, other central banks would soon respond by injecting liquidity, prompting the Bank of Japan to act again. These actions end up fuelling a surrogate, low-grade currency war.
But if the G Major economies issued quarterly announcements of significant coming policy changes - for example, a small round of quantitative easing by country X, a larger liquidity injection by Y and Z, and so on - markets would be reassured that a currency war was not being fought.
The second recommendation pertains to the mechanics of liquidity injection, much of which takes place through asset purchases. Liquidity injections and low interest rates have a micro-economic effect that has received little attention: they lower the cost of capital vis-a-vis the cost of labour, which causes a relative decline in demand for labour. This is likely exacerbating the unemployment problem.
One solution is to channel part of the liquidity injections towards countering this factor-cost asymmetry.
Thus, for every $100 of new liquidity, we could use $60 to buy assets and the rest to give companies a job-creation subsidy, which could be especially effective in economies with flexible labour markets that enable short-term hiring.
Even if the employment subsidy were offered for, say, only one year, companies would be tempted to use more labour during this time. And, because the current bout of high unemployment is self-reinforcing, once the equilibrium is broken for a while, the economy could move to a higher-employment equilibrium permanently, without the need for further government support.
Kaushik Basu is senior vice-president and chief economist of the World Bank and professor of economics at Cornell University.
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