Recently, Larry Summers voiced a concern* that is slowly floating to the top of everyone's minds: what happens to the world economy if Americans suddenly start spending less and saving more.
"The result", he said, "would be a substantial contractionary impulse to the remainder of the global economy, an effect that would be magnified if other currencies appreciated against the dollar causing a switching of expenditure towards US goods."
That would not be all, though. The resulting decline in American interest rates would force countries that peg their currencies on US interest rates to not only increase their dollar holdings but also the rate at which they accumulated these.
Net result: many things will have to change if the world is to avoid a severe recession or even, perhaps, a deflation. How to avoid that eventuality is exercising many people, and I am happy to say that the economists don't have a clue. They are simply hoping for a miracle.
At the end of the day, of course, it will be the central banks that will have to come to the rescue. And the poor dears have only one bat to hit the ball with -- monetary policy. How effective will it be?
Michael D Bordo and Andrew Filardo** did what good economists should do, instead of playing with digits all the time. They looked at the past 200 years on a cross-country basis to see "how to conduct monetary policy in a deflationary environment".
The first thing to do, they say, is to distinguish between three types of deflation: good, the bad and the ugly. Good deflations are those that happen when there is a positive supply shock, and the aggregate supply curve shifts outwards, leading to lower prices. "Such shocks are generally accompanied by lower product prices, but higher profits, rising real wages, higher asset prices and stronger financial sector performance." In short, what we have now.
In bad deflations, on the other hand, you get a recession, that is, output contracts because the aggregate demand curve shifts to the left. "In the 1960 to mid-1990s period when the trend rate of inflation was positive, economic weakness was associated with disinflation."
Finally, we have the ugly deflations, in which everything goes wrong. Output contracts, and so do prices. Double whammy, as during the Great Depression. Fortunately, say the authors, we get ugly deflations only rarely.
So what should monetary policy do? "The appropriate monetary policy strategy depends on the inflation/deflation zone that a central bank finds itself in." In other words, the central bank has to make a judgement, which could be equi-probably right or wrong, as to where the economy is.
The authors describe four zones. In zone 1 there is high and volatile inflation. In zone 2, it is moderate. In zone 3, there is what we have in India now: low inflation and price stability. Finally there is zone 4 in which there is low-to-moderate inflation.
Bordo and Filardo say that central banks prefer zone 3, which is true. The reasons, if you ask me, have more to do with politics than economics. But be that as it may, they also say that zone 4 is where they should like to be.
Just where you end up, of course, is as much a matter of the monetary policy regime you choose as blind luck. However, in what would seem to endorse what the Reserve Bank of India (RBI) is doing, they say, "At the very least, the pathological problems with short-term interest rate instruments demand more attention."
But what happens when, for this reason or that "interest rate rules become less useful as guides for monetary policy"?
I have maintained for some time now that, thanks to the ever-increasing black economy, the RBI's writ runs over no more than half of economic activity, which partially explains the low WPI inflation but high asset-price inflation.
Bordo and Filardo's prescription that the central bank should design "a mixed policy strategy that relies on the both interest rate rules and monetary aggregate targeting" may hold for economies where the black component is small, but what of India ?
This is the nut that the RBI has to crack. For that, it needs the help of the finance ministry, which seems reluctant.
(*L K Jha Memorial Lecture, 2006, http://www.rbi.org.in/Scripts/PublicationsView.aspx?Id=8304)
(** Deflation and Monetary Policy in a Historical Perspective: Remembering the Past or Being Condemned to Repeat It? NBER Working Paper No. 10833, October 2004)