Central Banks - The Only Game In Town?

Post the 2008 financial crisis, central banks have reacted with extraordinary monetary policy while politicians are still lagging behind in fiscal policy and structural reforms. Does this leave the central bankers, the only game in town? A book written by an expert on the matter gives some hope.

Author: Mohamed El-Erian, Book: The Only Game in Town, Central Banks, Instability and Avoiding Next Collapse, Year: 2016, Publisher: Random House,

The markets have been in turmoil for the past two quarters fueled by a dip in commodity prices, dramatic dips in oil prices, currency market volatility, and geo political tensions.

While market pundits continue to speculate probability of a recession or deflation to be highly unlikely, due to strong fundamentals and corporate profits – the bear markets reflect a contrasting story.

Are the Central Banks to be blamed for this emerging T Junction inflection point? Many in the markets think so.

Some blame the US Fed rate hike in the last quarter to be a case in point. Compounding the issue is the Fed’s Balance Sheet, which rakes up 16% of the assets of the US Banking System depriving much needed capital for Commercial Banking.

Chinese Debt perceptions, Japan’s inability to drive growth leveraging its three arrow principle, Germany locked up in the European moribund of migrant crisis and lack of resurgent EU economy has effectively grid locked three largest Economic Systems in asymmetry.

It is in this context, the most recently published book by the very distinguished Mohamed El-Erian, a former IMF official, “The Only Game in Town, Central Banks, Instability and Avoiding Next Collapse“ must be read.

As a foreword to his book El-Erian in his Bloomberg View Column, has this to say:

“The global economy is not just unusually fluid, it also is being jolted: from above, by economic uncertainties, domestic political polarization and geopolitical threats; and from below by disruptive technologies in an ever-expanding number of industries.” assesses, from the perspective of central banks, where we are and where we are going, as well as the outlook for the global economy and markets.

The book assesses, from the perspective of central banks, where we are and where we are going, as well as the outlook for the global economy and markets. El-Erian adds.

“These unusual bottom-up and top-down forces, some quite controversial, also have been explored in several works that captured my interest in 2015.”

Role back the clock, taking us back to 2013

Giving the first Andrew Crockett memorial lecture in June 2013, Dr Raghuram Rajan concluded: “Central banks are now the only game in town”. He had predicted the 2008 crisis and been pleading for an organised role back of extraordinary monetary policies.

But Mervyn King got close to the feelings of the assembled company of central bankers when he responded, “If central bankers are the only game in town, I’m getting out of town!”

The central Banks have maintained price stability, and money supply with the much criticised Quantitative Easing (QE) programs, often controlling the abyss of deflation, while waiting for more structural and macro-economic reforms to flow through, which in any case are finally left with the governments.

The first striking message in “The Only Game in Town” will, therefore, cause some alarm. It is that the new normal is soon to be no more.

El-Erian believes it is a mistake to see the current state of the global economy as a modestly disappointing equilibrium — “sluggish, but relatively stable”, in the version he quotes from the Economist.

In reality, we have been incubating an ugly brood of existential challenges: high unemployment and rising inequality; the decay of the system of global economic governance bequeathed by Bretton Woods; the disintegration of trust in national institutions and the growth of political insurgency; and a financial system that is more prone to liquidity illusion and less well anchored to economic reality than ever.

Forget the new normal; the correct metaphor for our immediate future, El-Erian warns, is a “T-junction”. The road we are on is about to come to an abrupt end. Take the right turn, and the world can be on the way to inclusive growth and peace. Take the wrong one, and things will get considerably worse.

Having held out this stark prospect, El-Erian moves on to the first of his two main themes: the appropriate future role of central banks. The response to the crash of 2008, he argues, has relied disproportionately on monetary policy. Emergency lending, zero interest rates and QE have done the heavy lifting while fiscal policy and structural reform have passively stood idly by.

The trouble is that monetary policy alone cannot solve the kinds of challenges haunting the new normal. It has bought time but cannot buy reform. It is now for politicians to take the lead; the central bankers have done all they can.

Few would dispute that central bankers cannot cure the world’s problems on their own. But opinions differ widely — and the recent market action shows that the differences are becoming fraught — over what they should do from now on, and whether we are going to reap a harvest or a whirlwind from what they have done so far. Clearly there is no whirl-wind in sight.

His second central theme: how to make policy of any sort in an unprecedentedly complex world. Today’s policymakers, he explains, are buffeted by a bewildering maelstrom of interacting forces: the decoupling of the developed and the emerging markets, divergent monetary policy, unpredictable politics, disruptive technological innovation, and more. How to predict their effects, and strategise accordingly? It seems an impossible task.

We must jettison, he says, conventional modes of analysis that focus on unique central predictions and accept instead that today’s unusually uncertain world follows no single likeliest path.

The book itself is very well constructed with six sections making up 35 chapters and it’s a fairly easy read. From setting the context to summing it up. Often you wonder as you read through the book you can also observe the predicament of the author as a central banker and as a market player.

The imminent approach of the T-junction calls for new tools and techniques: above all, the cardinal virtues of “optionality, resilience, and agility”.

Flexibility, liquidity, free hands — these are indeed the master-virtues of the financial markets. Policy, and political leadership more generally, has a rather different logic.

While prescribing the perils of the T Junction encounter – his observation or remedial measure leaves us in more consternation than a ray of hope.

“One road out of T Junction ahead, involves a restoration of highly-inclusive growth that creates jobs, reduces the risks of financial stability, and counters excessive inequality. It is a path that also lowers political tensions, eases governance dysfunction, and holds the hope of defusing some of the world’s geopolitical threats.”

Sounds like hope, rather than solution, true words of an economist and not one of free market reformer. One would conclude so.

This is where much of the criticisms would emerge from – more so from US Markets. The rates have been held low for too long making capital allocation a hazardous journey, and when the rates do eventually raise, beyond the first one of 25 basis points – how do you allocate capital against risk.

Does this sound like India, possibly yes, when we look at it in our context. Much of the work has come from the RBI Governor – be it managing the rates, liquidity, NPAs, currency support etc.

Where is the economic policy that Modi has promised. Not dilution of holdings but privatization of the PSU and his three arrows – GST, labour and land reforms.

It’s under siege on many fronts and most notably political, to the extent – most of the policy is being managed either by the prime minister’s office or through monetary policy with lack of political will.

For the Nation to avoid its “T Junction“, India must show courage, should its socialistic policies and further evolve into a market-based economic model. Sustained growth will emerge when capital is freed from the Government balance sheet and shifted to the private sector.

Dr El-Erian book is a worthy read and some great lessons to learn from.