Cracks in the consensus

Central bankers are in deep disagreement about what to do next. They are not following the Americans

Cafe Economics | Niranjan Rajadhyaksha

A sharp slowdown in the US economy could have three effects on India—the good, the bad and the ugly.

Financier Mike Milken hosts an annual conference on the global economy at his eponymous institute in California. This year’s conference was held in April and featured four Nobel economists—Gary Becker, Myron Scholes, Michael Spence and Edward Phelps. One of the issues they discussed is how a US slowdown could affect economies such as India’s.

“When the US goes into a slump, that is tough for exporters in the rest of the world. So, production of goods for export tends to fall. At the same time, when the US goes into a slump, that tends to reduce real interest rates in the US—which to some extent pushed down real rates around the world. That can send up asset prices globally and actually stimulate investment because investors are looking for higher returns. So there are these two opposite effects, one through trade and one through asset prices,” said Phelps.

He believes that the effects on asset prices were more important till the 1980s. The high US fiscal deficits in that decade pushed up real interest rates, lowered asset prices and dampened investment. That negative effect was more powerful than the positive effects that came from the demand generated by extra government spending in the US. “Because trade has become a much larger proportion of economic activity in the last 20 years, I now think it is a horse race between the two,” says Phelps

A lot of the decoupling debate that raged a few months ago could be re-examined in the light of what Phelps is saying. On the one hand, the slowdown in the US is likely to lower exports from Asia. Global economies continue to be coupled. And on the other, the steep reductions in US interest rates to fight the financial meltdown there sent a lot of money to this part of the world, sending asset prices sky-high and firing up corporate investments. That underlines the case for decoupling.

That is the good and the bad. And what about the ugly?

The ugly possibility arises when there is a US slowdown and yet interest rates go up. Unlikely? Take a look at the state of the world right now. There is both a slowdown in growth as well as a rise in inflation. We have a mild version of the 1970s’ style stagflation. It could get worse. The growth slowdown—and perhaps outright recession in some parts of the world— will push central banks towards cutting interest rates. But higher inflation will send them scurrying in the opposite direction. In this case, there are few easy exits.

A lot will then depend on what central banks believe to be the bigger threat: an economic slowdown (mixed with a financial crisis in the West) or higher inflation.

That’s where the story gets interesting. The men in the central banking citadels are in deep disagreement on what to do next. The rule till now was simple: Follow the US Federal Reserve as far as possible. The Americans can run global monetary policy, especially in countries that have a fixed exchange rate against the dollar and where monetary policy has essentially been outsourced to Washington.

The consensus is now cracking. The biggest disagreement seems to be across the Atlantic. The Europeans have refused to follow the US and cut interest rates. Columnist Wolfgang Munchau wrote in the Financial Times earlier this month about another type of decoupling—monetary policy decoupling. “In the past, European central bankers tended to follow the US Federal Reserve, often with delay, never perfectly, but generally in the same direction,” he wrote. “The policy response to our most recent financial crisis has been different. While the Fed cut by an accumulated 325 basis points, the Europeans first refused to follow, and they are now moving in the opposite direction.”

Much the same is happening in Asia. Central banks across the region—including the Reserve Bank of India— are busy tightening the monetary screws, a sign that they are more worried by the threat of double-digit inflation than with modestly lower economic growth. Australian central bank governor Glenn Stevens has been blunt. He said last week that the biggest problem for emerging markets is not “the credit crunch about which we hear so much…but inflation”.

There are now signs that even Ben Bernanke is increasingly worried about the jump in inflation. If the US Fed begins to increase interest rates later this year, we will have a mirror image of the monetary policy scene since the mid-1990s. The Americans are following the rest. It is too early to say this will happen.

All those bothered about the effects of the US slowdown on the Indian economy should keep a close watch on what central bankers are saying and doing. A fall in US demand for exports and a rise in global interest rates could lead to far more damage to Asian economies than assumed.

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