ANJUM HODA, who has been a fixed-income portfolio manager for around two decades now, has come up with this book called Bluff. The book, meant for central bankers and their critics, exposes the games central banks play in the garb of stabilising the economy with undesirable results. That’s the gist of Bluff.
Today, there is a constant—and animated—discussion on why central banks should keep lowering interest rates. There is a clarion call for such moves throughout the year everywhere in the world, including India, with one central bank’s action being used as justification for others to follow suit. When economic conditions are downbeat, this action looks logical and feasible, and hence acceptable. And this is where Hoda has a problem. She feels that lowering rates is not a solution to the problem of recession and, by doing so, we could be paradoxically sowing the seeds of something worse in the form of a future bubble.
Hoda says something that will make central bankers sit up. She argues cogently that while the Federal Reserve, European Central Bank and Bank of England did their jobs and addressed the issues from 2008 onwards, they have also been instrumental in creating a similar crisis in the future by sowing the seeds for it. Let us see how her argument goes.
Central banks lower rates significantly to kickstart their economies with the hope that spending, especially investment, will increase. Now, if this does not lead to the creation of jobs and an increase in productive activity, we have a problem. In fact, if people earn more and spend more, it creates a virtuous chain. In turn, this will create business for companies.
But in these recessionary times, perceptions have changed. Companies feel that if they expand and others don’t, they will be left in the dark and so don’t spend on investment until they are sure. Consumers, on the other hand, are not certain of jobs and income, and hold back from spending. Hence, this leads automatically to a sub-optimal solution.
Theoretically, low rates help increase credit growth, but if funds are not borrowed for production, the money flows to the real estate sector and equity markets. This is because individuals and companies take their chances while increasing their leverage, which is available at a low cost. Such funds can also flow to other countries as speculative investment, thus making the scale global.
Now, with excess liquidity and a thrust by central banks to keep inflation at a certain level, the purchasing power of households comes down even as their leverage increases, as they enter the markets to borrow more (the infamous NINJA loans). After all, everyone wants to make a quick buck and low interest rates work against financial savings in conventional instruments. The preference is for riskier and higher-yielding ones like stocks or real estate. This is a strong foundation laid for a future crisis, which Hoda calls “bubbles waiting to burst”.
The author argues that we need to have a new social contract between the people and the central bank. One must realise that when such crises are addressed—just like the way the Federal Reserve rescued several financial entities (barring Lehman)—the resuscitation packages come from the tax-payers’ money, which is not fair, especially since the general public has no say in the way central banks behave.
Here, the author takes us through what the Federal Reserve and Bank of England did in the period starting 2007-08: they alleviated the situation with cheap money and injection of zero-cost money. But ironically, these measures, which have been used as a solution to a problem, were themselves problems created by central banks. This is contrary to literature, which actually blames the Federal Reserve for not lowering rates and injecting money during the Great Depression of the 1930s. By turning the argument around, the author does provide a fresh perspective on the role of central banks.
This book and the arguments put forward are essential reading not just for the RBI, but also for businesses and analysts in India. The constant call for lower rates should make one stop and think. When we have a situation where income is not increasing and businesses not investing because of excess capacity, lowering rates may not help and, on the contrary, can fuel a potential crisis.
The two issues in our context are relevant. One, the RBI has very good regulation in place to ensure that funds do not move to any speculative activity. Second, lending to high-risk projects is fraught with the danger of creating fresh NPAs. An increase in retail credit is good, but we need to ensure that the system does not go overboard—if employment and income do not increase commensurately, there can be a problem going ahead.
The crux, as per Hoda, is in analysing the movements in interest rates, productivity, employment, wages, inflation and assets prices. If all of these do not move the way they should, central banks will, at some stage, have to start increasing interest rates to check inflation. In that case, the economy will slip into a recession and markets will go under. This is a problem for all central banks, which are committed to an inflation rate. Lowering rates is good, but excessive leverage, as happened earlier, hit the companies and bank balance sheets hard. One has to think hard about this process. But we can say with confidence that the RBI has so far acted prudently and not given in to apparent pressures from the outside.
Madan Sabnavis is chief economist, CARE Ratings