Dr. Ronald I. McKinnon
|As part of its special lecture series, ICRIER organised a lecture on “The Role of Central Banks in Fostering Economic Growth” by Dr. Ronald I. McKinnon, William D. Eberle Professor of International Economics, Stanford University on February 15, 2006.
In the last few decades, there have been major changes in the way people view the Central Bank. In the current situation, when the developing countries are living in a state of conflicted virtue, it is very important to understand the role of Central Banks in fostering growth. But this task will be very difficult unless we take a historical perspective of this issue.
Before 1930, under the Gold Standard, the role of the Central Banks was set out very clearly. They were the guardians of the economy. Constrained by gold convertibility, it was a time, when economies had fixed exchange rates and endogenous money supply. At that time, though they didn’t have any direct regulatory function, Central Banks worked as the lender of last resort in case of liquidity crises to retain external convertibility.
After the First World War, gold standard suffered a major setback. In 1930s, inflation started to increase; there was shrinkage in the supply of gold, hence deflationary pressure started to build up. At the beginning of the great depression, in 1931, interest rate started to rise in US. Reacting to this calamity, we had Keynes to write his famous book .The General Theory of Employment, Interest and Money in 1936. His idea was to provide national autonomy to ensure full employment. His plan was very liberal in allowing countries to inflate. But it made almost no mention of Balance of Payment or Trade Policies. Influenced by his work, the Central Banks became agents for promoting employment nationally. They were no longer bound by BOP constraints. This is when the trade off between employment and inflation was established by the use of Phillips Curve. The concept became influential in determining the thought process of the regulators at that time.
In the 1940s, different countries worked for reestablishment of fixed exchange rate regime. The main reason behind this was the inflation which they experienced in the post World War II period. In Europe, 15-16 countries started paying in dollar, stabilizing the exchange rate volatility. In Japan, they followed a different path of fiscal consolidation, which is also known as the Dodge plan. In both the cases, these measures were successful. Western EU recovery and the Japan Plan brought back those economies in proper track. In the post war period, there was pressure on Britain from US to dismantle all the regional currency boards. But UK treasury, which wanted to keep starling area, resisted this move. However, most of the ex-British colonies later chose their own currencies.
In the 1950s and 60s, the Central Banks worked as agents to the governments to allocate credit to direct commercial bank loans, maintain high reserve requirements and capital controls on international payments. This resulted to the financial repression during that period.
In the late 60s, USD started to inflate because of the poor financing of the Vietnam War. The Latin American and African countries also experienced high inflation rates at that time. During this period, the Central banks used to mobilize resources. There was a major push on industrialization at that time. The central banks also used to take part in long term capital lending. The other role which the Central Banks played at that time was the role of the regulator. The interest rate structure became very pragmatic. In real term, the interest rate became negative. There was shrinkage of banking resources also.
In the 70s, there was a huge growth of the unregulated euro currency markets, which started during the 60s. It was a regime of deposit insurance. The managers could gamble, since they were insured by the government. This led to the problem of moral hazard. This problem was aggravated by international competition. Since the international players didn’t have any capital requirement, it led to reduction in the capital requirements of the local banks also. This made them vulnerable to banking crises. And as a result, US faced a banking crisis in 1980s; Western Europe faced it in the late 1980s. As an answer to these crises, the first Basel Accord came out in 1989. The biggest risk for the developing countries is the exchange rate risk. Basel Accord tries to address that issue. But inter bank lending was completely kept out of this accord, which in turn led to the South Asian crises later.
The 90s saw a number of banking crises followed by currency crises. During this period, private capital flows to developing countries largely displaced the official development assistance. This period saw a spread of official deposit insurance to more than 70 countries. Except in China and South Asia, most of the other countries loosened the capital control. The interest ceiling was lifted. The Central Banks are not activist intermediaries any more. Phillips Curve is no more accepted. There has been recognition for the fact that using the Central Bank as a direct agent in capital market runs risk of financial repression and a loss of monetary control with inflation. There are no private or official direct borrowings from Central Banks. But regulatory oversight and crisis management role of the Central Banks still remain intact.
This has led to the problem of non-availability of long term finances for the developing countries. Apart from few countries like India, the bond market is not very effective in the Developing Countries. An answer to this problem can be setting up of local development banks. China has successfully developed China Development Bank to cater to the needs of the long term finances. Similar measures can be taken by other countries also.
In conclusion, the speaker asked the important question should the Central Banks target the exchange rate? His answer was exchange rate should be given more weight. Most of the East Asian countries have tried to fix a soft peg to Exchange rate. And they have been successful so far by doing so. Independent Central Banks should also think of stabilizing the exchange rate.
The speaker started with the concept of conflicted virtue. He explained it at the end of his speech. The Asian countries are good savers, so they are virtuous by the Victorian concept. This huge saving has made them run in foreign exchange surplus. US, being a deficit economy for long, put pressure on these economies to appreciate their currency. So these countries are always under the pressure from US. So, these developing countries are actually living in a state of conflicted Virtue.
After the lecture, Prof. McKinnon took few questions from the audience. Answering to a question on if the sterilization policy taken by China has any deep impact in the economy, he said that though China is buying a lot of USD for the last few years, and they are running in Foreign Exchange surplus, due to high growth rate and raise in GNP, there is a huge increase in the demand for this increasing money base.. Furthermore, for China, sterilization policies are almost painless. The domestic inter bank interest rate in China is 1.37%, whereas it is 4.5% in US. So, they buy US treasury bonds at a much higher interest rate and sell Central Bank bonds at their domestic interest rate. Answering a question about the increasing imbalance in the world economy, he agreed that the economic imbalance is creating a kind of trap. US is running a deficit economy, on the other hand, the Asian countries are saving a lot. But there is no exchange rate solution to this. To solve this, US government has to save more. But the current administration is not following that path. He opined however, that the world economy is doing well under these circumstances. In the concluding question, Prof. Shankar Acharya, Chair of the session, asked if there is any chance of any swing in the trap. Prof McKinnon answered that it is almost impossible to attack the USD, since it is the only debtor country in the world which can debt in its own currency. So in his opinion, there is no such indication of the trap being reversed.
In the end, Prof. Rajiv Kumar, director, ICRIER, delivered his vote of thanks.
15 Feb, 2023