The Hindu Business Line : Bernanke’s bold initiatives

Overall, the Federal Reserve’s moves have had a beneficial impact, which is reflected in corresponding improvement in stock market prices around the world and the hope that the US economy will revive faster.

S. Venkitaramanan

The US Federal Reserve has administered a pleasant shock to the markets by intervening in the market for Treasuries and buying long-term bonds with maturities of more than 10 years. This is a bold step aimed at reducing the interest costs for Government borrowing.

It is pertinent to recall that the Fed Reserve Chairman, Mr Ben Bernanke, is a dedicated student of the developments in the years of Great Depression, during which the relative inaction of the Federal Reserve was much criticised, and he has realised that the present problem is not one of fighting inflation but preventing deflation.

In a statement issued last Wednesday, the Fed Reserve warned of increasing economic slack in the US and abroad. The statement pointed out that unemployment rate had increased to 8.1 per cent in February 2009 and is moving faster than expected.

The US factories, it stated, are operating currently at extremely low capacity utilisation. Both these developments mean the economy is not putting its workers and resources to use. This is a recipe for deflation!

Preventing deflation

The Federal Reserve by deciding on the purchase of long-term Treasury bonds is, in effect, “printing” money and using it to reduce the rates of interest at which the Federal Government borrows in the market.

Considering the high level of federal deficits, announced by President Obama, this move of the US central bank is obviously part of a co-ordinated strategy and it will help the US Government to finance its deficits at a lower cost than others.

The Federal Reserve has also simultaneously proposed to buy securities of the distressed mortgage giants, Fannie and Freddie. These moves have already brought down the current rates of mortgage lending, which will have favourable impact on the off-take of housing loans in the US market.

BENEFICIAL IMPACT

Overall, these moves have had a beneficial impact on economic activity in the country. It is reflected in a corresponding improvement in stock market prices around the world, and the hope that the US economy will revive faster.

The Federal Reserve’s action has to be accompanied by more concerted and bold steps by the US Congress in supporting President Obama’s moves for fiscal stimuli.

There are obvious political brownie points to be gained by various leaders of different political parties, who want to have their pet projects approved in the process of implementation of fiscal stimulus packages. The Federal Reserve’s action, however, is a starting point in the journey towards the US’, and hence global economic recovery.

It goes without saying that Bernanke’s move has to be seen in the context of the US plan to consolidate the banks that have large toxic assets on their books. The US Administration is busy at work putting through such a plan. On its success, together with the impact of Bernanke’s initiative, will depend the overall outcome of Obama’s efforts to revive the economy.

It is obvious that the US’ attempts to prevent deflation, if successful, will have a beneficial impact on the rest of the world. There are, of course, inflation hawks who are afraid that the return of low interest policies, which Bernanke’s move induced, on the part of the Federal Reserve may stoke developments similar to Greenspan’s era.

It is obvious that the Federal Reserve would have learnt at the school of the Greenspan experience and would not permit the excesses of leveraging effects, which led to disastrous consequences in the Greenspan era.

The Bernanke initiative requires to be managed in a way that the financial system returns to sanity in respect of regulation so that those entities that misuse freedom to the detriment of society, with disastrous consequences for US and global financial order, are brought to discipline well ahead.

Bernanke’s bold initiative has had one effect — the fall of the dollar, which has had repercussions in the shape of the return of rising oil prices. It is to be hoped that an effort such as Bernanke’s at stemming deflation does not contribute indirectly to inflationary consequences.

Bernanke’s bold steps have excited interest on the question whether other central bankers would follow that initiative. It is obvious that different countries suffer from different economic problems. India, in particular, does not face the risk of deflation at present, although there is news that inflation has declined substantially in recent weeks.

We do not have data on the comparative levels of unemployment in our economy. But it is a fact that large sectors or enterprises have recorded under-utilisation of their capacity, which brings risks associated with it.

Need to review ban

There is obviously need to re-examine whether there is scope for rescinding the ban on the RBI financing Central deficit directly, which is incorporated in the FRBM Act. Articles have recently appeared pointing out that the RBI is, in fact, financing the Central deficit to some extent when it intervened in respect of oil bonds and so on. There is need to examine and consider on a well-structured basis whether the ban in the FRBM Act on RBI’s lending to Government is worth a re-look.

Mr A. Seshan, who worked with me in the RBI in the 1990s, has written an article in favour of monetising the deficit. He points out that the present provision in the FRBM Act prohibiting such borrowing is a fig-leaf. His is a powerful plea, which deserves to be looked into.

There may be arguments in favour of continuing such a ban as a resort to printing money may lead to higher deficits. On the contrary, if the economy is faced with the need for fiscal stimuli to alleviate unemployment and under-utilisation of capacity, there is scope for a limited resort to the RBI’s direct financing of the deficit.

It is possible to reformulate the FRBM Act in respect of its ban on RBI’s lending to Government except with regard to the Ways and Means Advances.

Some contra-cyclicality can be introduced to take care of the problem. In my view, the RBI’s direct financing of the fiscal deficit is to be contemplated only when the economy is assessed to be declining beyond a certain predetermined level.

It is hoped that the experts at the Centre and the RBI will study this aspect and decide how to modulate the probability of limited monetisation of fiscal deficit to help reduce borrowing costs for the Government. This will lead to correspondingly lower rates for corporates and individuals and thus spur economic growth.

blfeedback@thehindu.co.in

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