Friday, April 23, 2010

Monetization challenges in India -- leading indicator for the rest of us?

Monetization is playing itself out in India this week. One of my previous posts (In The Black Trunks…, Monday, April 12) I discussed monetization in the context of the USA. Monetization is a very specific term meant to describe how (even independent) central banks act as if they are “printing money” to help governments finance their deficits. Since US deficits are VERY large, the worry is the monetization could lead to a very large wave of money growth and future inflation. But since inflation in the USA is low and stable right now, this future tsunami is not taken very seriously….

But India is in the eye of the storm right now. A report out this week portrays the Reserve Bank of India as in quite a pickle. India’s robust recovery from the recession is already generating double-digit inflation and the RBI has already begun draining reserves from the system and raising key policy interest rates. But whoa Silver (the Lone Ranger’s horse was named Silver) – it turns out that the RBI is concerned that the government of India has a lot of bonds to sell to cover large government deficits. As the government sells these bonds this adds even more pressure for interest rates to rise. So what – isn’t that what they want? Yes, the RBI wants to cool off the economy with higher interest rates, but India is just like Little Red Riding Hood who wanted her porridge warm but not too hot. The RBI wants a cooler economy but considering that the economy is not quite out of the recession woods yet, if interest rates rise too much and too soon, the RBI could find itself with a double dip.

The astute reader at this point might recognize that the RBI might solve this dilemma easily -- just suspend its open market bond sales and let the government suck the money out of the system with its bond financing activities. But that would not work. The government of India is raising funds so they can spend them! The result is that any money they collect through bond sales gets injected back into the economy as more spending. So if the RBI stands back and does nothing – the money or liquidity problem remains and they have put off or stalled a policy designed to reduce future inflation.

So there is the pickle or the rock and hard place thing. What’s a good central bank to do? The RBI wants to stop the inflation rate from rising through higher interest rates. The government is sending rates even higher than desirable so the RBI responds by buying government bonds to try to bring the rates back down. If they tighten too much they risk a recession. If they monetize too much they threaten inflation. It just doesn’t seem fair! But, of course, India is just a little ahead of the inflation curve and most nations could be in the same situation later this year.

Geez, how did we all get in this jam? The answer is that the recession scared the wee wee out of us and we asked our policymakers to inject historical amounts of stimulus. There we are – lots of juice running through our veins and it needs to come out. The most intuitive approach is to begin removing the stimulus before it creates devastating inflation. It would help if at the same time we come up with appropriate reforms that effectively address the causes of the recession. Finally, I will say the S-word and note that an aggressive supply-side policy which focuses on raising national productivity relative to business costs is known to have the desirable impact of reducing inflation and unemployment at the same time. Now where is that cake that I want to have and eat it too?


  1. Larry,

    As usual, you are right on point. I wish more of our representatives in Congress and the Administration would use (and understand) the S word. For many of them the S word means socialism. I am also afraid that whatever comes out of this reform frenzy that we are in will not fundamentaly address the root of what caused our financial problems of the past 2-3 years. I am normally an optimistic individual, but listening to the dialog of the past month or so on this issue, I am concerned. Can we use our primary vote next month to vote for a slow but steady rise to a more normal borrowing rate level and less spending? Got a few more wishes but if we could vote those two ideas in, I would be happy. Have a good one.

  2. Dear LSD. Me thinks India is doing the U.S. a favor by previewing what will happen here before it happens here. Sort of like paying it forward and also seeing the future from the present – or like having your cake and eating it at the same time, too.

    I have no confidence that the current administration (‘bama the Hate Capitalism Socialist Rookie and Mr. No Personal Income Taxes Here Geithner) can/will take steps that support free enterprise (e.g. your supply-side stuff) sufficient to really create jobs. I recall that ‘bama the Hate Capitalism Socialist Rookie held a brainstorming session at the WH to generate ideas to create jobs and haven’t heard more about that circle jerk. So much for hope and change – fuhghetaboutit. Considering that he and de boyz are floating the VAT idea (and many think it’s gonna be a done deal), we gonna find it imposiblĂ© to create jobs (and wealth) cause we gonna be paying mucho taxes via fat VAT and indirect taxes (e.g. higher premiums and actual out-of-pocket costs) for the “cost-reducing” Obamacare. Fuhghetaboutit.

    Poor Bernanke will be in a Chinese fire drill . . . running to and from extinguishing the flames of inflation and simultaneously drawing down excessive (unused and inefficient) stimulus cash on the Bank’s balance sheet. He obviously won’t be able to have his cake and eat it at the same time, too. Maybe we’ll see him throw his cake at ‘bama the Hate Capitalism Socialist Rookie and Mr. No Personal Income Taxes Here Geithner.

    I think psychiatrists would characterize this administration’s economic situation schizophrenic – delusional, hallucinogenic, incoherent, and physically/mentally agitating the masses – those that wanted hope and change and don’t see it happening and those that knew it was smoke and mirrors and can’t find the water bucket as the embers of impending inflation flicker.

  3. Who'da thunk that a post on monetization would have brought out such angst? Thanks Bob and Charlie for your contributions. Our liberal friends might be thinking differently -- "geez for the first time we have a president who will go after those mean, greedy, selfish folks on main/wall street!" :-)

  4. While the CPI and PPI are not monsters yet, we may see a quasi-inflationary monster feasting on the very strong performance in equity markets. While the Fed was injecting lots of liquidity to the money supply, investors were cashing in their equity bets and then sitting on these hoards of cash. As corporate profits have continued to gradually improve over the last year, all that cash that was sitting idle is coming back into play. So is another bubble forming?

    If Democrats don't do anything about the expiration of the Bush tax cuts at the end of this year, I'm expecting a sell off in the 4Q. Which might well tip us back into recession. Sigh.

  5. Hi Larry,

    Part of the problem with posting on any economic topic is that it is hard to deal with that topic in isolation. Whatever ones ideas about monetization (like why does the spell check not like it) things like politics which to me seem rather off topic and things like inflation and interest rates which can interact strongly with monetization and seem to be more on topic always seem to creep in.

    In keeping with this spirit I will post this link

    and a short blurb from the article concerning the something we have touched on before; how to determine bank reserve levels

    "Officials in the US and Europe are now starting to discuss the quantity of an increase in ratios among themselves. Some want a dramatic increase in the minimum level of capital over risk-weighted assets – perhaps to as much as 25 per cent from 8 per cent today – to be on the table while others want a more modest revision of capital rules."

    If banks are required to maintain 25% reserves (or even 8%) should govts be required to maintain the same gold reserves for it's currency? What's good for the goose is good for the gander.

  6. John,

    I think we may have a little bit of "bubble-mania" these days. It is well earned. After a flu epidemic everyone with sniffles thinks they have the flu. It is legitimate to worry about bubbles at any time, but bubbles are highly infrequent phenomena. A lot of water will have to pass under the bridge before we have the real bubble. But as my post warns and you seem to confirm it is not too early to think about the coming of inflation given the liquidity that remains in the system and the looming large government deficits.

    Mike, I think you are confusing capital requirements and reserve requirements. These are two different things. Reserve requirements are levied on a bank's deposits. Capital requirements have more to do with an institution's loans. Much of what we are reading about today relates to capital requirements. Of course, a higher reserve requirement could imply that a bank is holding more capital. But a higher capital requirement might not require more reserves...