Opinion


Monetary management




Introspective
By Raul V. Fabella


Posted on November 07, 2011


The last five years have provided economists with ample occasions for great humility. Just when things were getting simpler and prosperity becoming our birthright, the Great Recession -- starting in 2008 and lingering to the present -- forced a deep reexamination of accepted certainties on how real economies work and how the monetary authorities should respond. Real economies are much more complex and unpredictable than even the most powerful models will have us believe.

First, there is the realization that very low inflation is not synonymous with economic stability and the low inflation targets (say, 2%) adopted by many central banks muzzled monetary policy response to unforeseen downturns because of the increased possibility of deflation. The low associated policy rate meant that downward adjustment is limited by the zero bound. Thus, Blanchard, et al. (2010) of the IMF have advocated higher inflation targets (say, 4% versus 2%) to give central banks more policy space.

Second, it became clear that central banks should pay attention to, and influence the behavior of, other critical variables such as asset prices, excessive leverage and risk taking, the exchange rate, and the composition of output. This means the use of more than one (the interest rate) policy instrument, such as money aggregates and macro-prudential regulations to keep the economy at an even keel.

Third, there is a better appreciation for the use of fiscal response, which was put out of pasture by such esoterics as the Ricardian equivalence. The emerging consensus favors greater eclecticism and an expanded policy space, which the old consensus has stripped bare.

As regards the composition of output, the Swiss National Bank’s (SNB) response on Sept. 6, 2011 -- pegging the Swiss franc to the euro after 30 years of floating and promptly devaluing it by 10% -- was very instructive, apart from being a big surprise. The SNB was responding to the squeeze the Swiss traded goods sector suffered from the rapid appreciation of the Swiss franc, resulting from rapid capital inflows. The old consensus considers this move unwarranted since the trigger is one-off and temporary, and bridge financing can always be found. The reality is that one-offs can kill otherwise healthy firms and, once dead, return to normality will not bring them back. The devaluation is precisely the proper lifeline. This episode shows that the Swiss monetary authorities pay attention to output composition and disregard such neoclassical niceties as perfect capital markets that can provide any bridge financing required. It then drew from a richer (non-neoclassical) toolbox to respond. The Swiss are not alone. The 1st of November 2011 saw the Japanese authorities force the depreciation of the yen from 75 to 80 to a US dollar. The pressure on Japanese exports had become unbearable, resulting in closures and/or flight overseas. Of course, China does not face the dilemma only because the Chinese exchange rate is fixed.

There is a new idea aborning: the idea that an exchange rate float can nevertheless result in a currency overvaluation. The Swiss authorities used the phrase “massive overvaluation” to describe the pre-peg situation. “Hollowing out” of the manufacturing sector is the description favored in Japan. Both Switzerland and Japan had set their interest rate to zero to discourage safe haven inflows. The interest rate option just ran out of space. So to an option less traveled by: a devaluation or forced depreciation which, by the way, acts like a negative interest rate! Perhaps other countries can learn from the actions of these two manufacturing behemoths and not just from the high theories of Neo-classical economics. While the Swiss response is a big bang and may be too shrill, the recognition by monetary authorities of a larger set of targets and of an expanded policy space is healthy. If so, there is no need for unquiet heraldry to press home the point. There is no need to budge from inflation targeting; only to budge from narrow interpretations to greater inclusiveness, both in the policy and outcome space. This constitutes a new paradigm in monetary and exchange rate management.

Is our monetary authority up to this challenge? The good tiding is that the Bangko Sentral ng Pilipinas (BSP), under Governor Tetangco, is actually ahead of the curve. It has exhibited a healthy eclecticism unfazed by dogma. The BSP has acted to limit the damage of forex inflows on the composition of output and the welfare of millions of OFW families by vigorous purchase of dollars. This has managed to keep the exchange rate on or around P43/$. Proof of this is the burgeoning of our international reserves which, if we have our fiscal wits about us, we should render even more propitious by employing it to bankroll an ambitious domestic infrastructure investment where returns are much higher. Our monetary authority recognizes the strategic importance of our most dynamic forex earning sectors, viz., BPO, OFW, and Tourism. These forex champions backstop the strong Service sector growth in recent years and the economy’s own. Absent the BSP’s leaning against the wind, we could see these sectors and a brighter economic future go the way of sports shoes and dinosaurs.

Raul V. Fabella is the vice-chairman of the Institute for Development and Econometric Analysis, a professor at the UP School of Economics, and a member of the National Academy of Science and Technology.

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