Taking it back

Can transition economies handle inflation?

 

Around the world, governments balk at spending more for fear of racking up debts that they cannot easily repay.  They leave it up to the central bank – which manages the nation’s money supply -- to stimulate the economy, effectively by printing money.  The Federal Reserve in the United States and the European Central Bank have pledged to provide enough dollars and euros to keep low the interest rate, which is the price of holding money (since this is what you forego by holding rather than lending).  The Bank of Japan is doubling the supply of yen -- although, unusually for a central bank these days, especially for Japan’s, this is to accommodate the government’s largesse.  In Kazakhstan, M2 money -- which includes cash, checking accounts and small savings accounts -- has tripled since the beginning of the banking crisis in 2007.

As a rule, new money eventually raises prices, since people use it to bid more for products.  When the economy operates at full capacity, it cannot create more goods and services, so increased demand for them merely drives up their prices.  At the moment, the world economy is well below capacity, so inflation is not a problem.  But the day will come when that may change.  Are central bankers ready?

They usually argue that they can easily soak up excess money, by exchanging securities for them.  By selling a public bond (basically an IOU issued by the government) for $50,000, the bank can withdraw that many dollars from the economy.

This may work in Western countries, which have well-developed financial markets.  In the U.S., the market for overnight loans, called “repos”, has run into trillions of dollars and is quite sensitive to changes in demand and supply.  The Federal Reserve can quickly withdraw from it a precise amount of money by selling loans.

But in transition economies, financial markets are embryonic.  Their central banks cannot rely on exchanges of securities for money (“open market operations”) to manage the money supply.  They must fall back upon cruder tools.

The folly of ’37

One is to raise the interest rate that the central bank charges on loans to commercial banks.  (In Kazakhstan, this is the “refinancing rate”).  These banks will respond by borrowing less money, which reduces the amount that they can provide to people to spend.  Unfortunately, bank demand for loans depends not only on the interest rate but also on such factors as the banks’ expectations of economic growth, since they will re-lend the money only if they expect to get paid back.  In a recession, impoverished borrowers may default rather than pay interest.  Since expectations are hard to measure in times of uncertainty, the central bank may misjudge the response to a given increase in interest rates.

Another tool for central banks in transitional economies is to reduce the share of deposits that commercial banks can legally lend out.  (This is the “required reserve ratio”).  Again, it’s hard to anticipate precisely how this tool will affect the money supply; it depends on the behavior of banks, depositors and borrowers – behavior that we don’t understand well.  When the Fed doubled the ratio in 1937, the U.S. economy plunged back into depression, recovering only when World War II boosted government spending.

Even central banks in transitional economies that use open market operations may face hurdles.  In some countries of the Commonwealth of Independent States, the central bank has sought (or was required) to discourage the government from borrowing, by refusing to buy many of its securities.  When the day comes, those banks may not have enough securities on hand to sell in order to reduce the money supply sharply.

Most central banks today probably should not withdraw much money from circulation.  Unemployment still matters more than inflation.  But accommodation has long-run consequences.  Central banks in the CIS may prepare by developing securities markets; ensuring that they have enough securities to buy back lots of money;  and by researching effects of monetary policy.  Central banks can take the money back – without taking it on the chin. –Leon Taylor, tayloralmaty@gmail.com   


Good reading


Cole, Harold L., and Lee E. Ohanian. The Great Depression in the United States from a neoclassical perspective. Federal Reserve Bank of Minneapolis Quarterly Review. Winter 1999. The source of the story about Fed policy in 1937.

Friedman, Milton, and Anna Schwartz. A monetary history of the United States, 1867-1960. Princeton. 1963.

References

Ewing, Jack.  A rate cut in Europe, and a hint of limits.  The New York Times.  May 2, 2013.

National Bank of Kazakhstan.  Monetary aggregates.  www.nationalbank.kz

Tabuchi, Hiroko. Japan initiates bold bid to end years of tumbling prices.  The New York Times.  April 4, 2013.