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?