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Economy Jul 6, 2012

Is RBI the one-eyed hawk in a world of blind bankers?

By R Jagannathan

On Thursday, the European Central Bank (ECB), the Bank of China and the Bank of England (BoE) sent a clear signal that their medicines are not working. And so they prescribed more of the same - interest rate cuts and monetary easing - to see if it will work at least now.

While the ECB cut its main interest rate to 0.75 percent, the Bank of China cut its one-year lending rate by 0.31 percent and deposit rate by 0.25 percent. The Bank of England, which actually had no room to cut rates (at 0.5 percent, it is at rock-bottom), instead decided to work its note printing presses harder to generate money worth 50 billion. (Officially, it is called "asset purchases" of 50 billion, meaning BoE will buy outstanding bank loans by paying them cash. The idea is it will increase liquidity and enable banks to lend more to enable an economic recovery.)

Last month, the US Fed tried more of its snake-oil remedies. It announced a further expansion of its Operation Twist by $267 billion - which means it will sell short-term bonds and buy long-term ones to reduce long-term interest rates and aid an economic recovery. That the previous Operation Twist - a $400 billion indulgence announced exactly one year ago - has not quite achieved its objective of reviving growth does not seem to have mattered to the Fed.

Interestingly, since the world is giving away money for free, the pressure will be on the Reserve Bank of India (RBI) to follow suit and cut rates. With a repo rate at 8 percent, the RBI now has probably the highest rate in the world. The question is: is it just a obstinate hawk that refuses to see reason, or it is the one-eyed man in a world led by the blind?

The Keynesians have more or less lost the argument on this one. It is time for the supply-siders to try their remedies and see if it works better. Reuters

The world's motto now seems to be: if nothing works, try harder and more of the same. Will pumping in more money and asking people to borrow for free help the world rediscover its growth spark?

The Keynesians argue yes. For them, when growth is flagging, it means there is too little demand, and hence government and the monetary authorities must keep throwing in cash till the economy revives. Paul Krugman, Nobel prize winner in economics and New York Times columnist, is one of them. His remedy for the economic crisis is spend, spend, spend till the recovery begins (or the patient dies, whichever comes first), never mind if inflation is the short-term result.

The Austrian school of economists, the so-called supply-siders, say no. They believe that the solution to a recession does not lie in busting government budgets, but in stoking entrepreneurship and creating incentives for job-creation, which could come through tax-cuts or reducing regulations that block the supply side of the economy. It is the supply side (new factories, etc) which creates jobs and growth, not demand.

So who is right? The right answer could be both and neither. But since the Keynesians have been doing their bit for the last four years and still have nothing to show for it means the intellectual argument will shift in the direction of the supply-siders sooner than later.

At a more fundamental level, the argument between stoking demand with cheap money, and stoking supply with incentives for saving and investment is like debating the merits of allopathy and antibiotics versus ayurveda combined with good diets and exercise. Nobody can say the choice is between one or the other. You may need both, but at different times.

If you are in the operating theatre, you need life-support, allopathic medicine and antibiotics to keep you alive; if you are back home for the recovery, you need to wean yourself away from strong medicine and shift to sensible diets and exercise to build back your strength. An over-reliance on antibiotics can only make the medicine less and less effective, leaving you back where you began - in the operation theatre (OT).

The world economic situation is something like this: the heart attack that came in 2008 with the Lehman crisis has been dealt with by wheeling the patient into the OT and administering a heavy dose of allopathic medicine, but as the whole world overloads itself with antibiotics (monetary easing and almost free money) the medicine has stopped working. It is time to try something else.

Consider what all the governments have done: the US, Europe and Japan have practically zero interest rates, and their central banks have been spending trillions of dollars and euros trying to revive growth. But growth has actually slowed and we are now entering a recessionary down-spiral.

The reason why the medicine is not working is simple: the world is trying to solve its debt problem with even more debt. Whether it is the US, Europe or Japan, all the economies are overleveraged (read a Firstpost article on the US here) - and so both companies and individuals are reducing debts. There is no demand because people are trying to pay off accumulated debt. This will not change till the debts come down.

As Kenneth Rogoff, professor of economics and public policy at Harvard, points out in an article for Project Syndicate: "The real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation."

Since China is not going to write off its US credits, or Germany its loans to the more profligate members of the eurozone, we are now staring at a Greek default, followed by that of Spain and Italy, or a strong effort to print money - which is what the ECB rate cut is now signalling. Printing money means debts will be reduced by making its value less through inflation.

The US has tried endless monetary easing to achieve higher inflation, but that hasn't quite happened. The only result has been an ever-increasing debt burden on the US government, which now tops 100 percent of GDP. Growth continues to slow.

Europe, under the tutelage of Germany's Angela Merkel, has prescribed both financial repression (for Greece and the PIIGs), and easy money (the so-called long-term refinancing operation of the ECB), but neither idea has been implemented rigorously. The eurozone is still sinking and the smart money is on an ultimate euro breakup or at least a Greek exit from it.

When the monetary authorities of the world's biggest economies are just asking people to borrow for free, and are themselves doing the same, and their economies still fail to recover for four years, surely it means the remedies aren't working.

Everything has been tried and nothing has worked. It leaves us with the only sensible option: remove the unnecessary medication, shift to healthy diets and exercise to incentivise recovery through the body's inherent capacity to regenerate good health. The world economy needs to move away from permanent dependence on life-support and debts to steady debt-reduction, sharp cutbacks in unproductive government spending, and a gradual, but more credible recovery, once that happens.

The Keynesians have more or less lost the argument on this one. It is time for the supply-siders to try their remedies and see if it works better.

My money is on the supply-siders. And RBI's Duvvuri Subbarao is probably the best central banker in a world of bankers gone bonkers.

by R Jagannathan

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