By Hema Senanayake –

Hema Senanayake

This article is not directly related to matters of Sri Lanka but it addresses a question that is grappled by all nations – developing and developed.  It is about the weakness of macroeconomics.

On August 31, 2013 Reuters reported that India wants to make a joint intervention in off-shore Foreign Exchange market (FX market). The proposal came from Dipak Dasgupta, the Indian finance ministry’s principal economic adviser. Recently India appointed Dr. Raghuram Rajan to be the next Governor of Reserve Bank of India (RBI) with effect from September 04th. Dr. Rajan who was formally the chief economist of IMF, is hailed as a star-economist who perhaps can save dwindling Indian economy and its currency. India’s GDP has now shrank to 4.4% and its currency depreciated by 20% against U.S. dollar. I do not think that Dasgupta wanted to outperform Rajan by making this announcement of intervening in off-shore FX markets jointly with other developing nations especially with the participation of other BRIC countries. The proposal is the silliest one and already Brazil had rejected it. Hence there is nothing important to write an article on the proposal itself but it is important to understand the underlying reasons for making such a proposal.

Indian rupee slides its value against U.S. dollar. Foreign investors sold part of their investments and took the money out in order to invest elsewhere in dollar-denominated assets. This resulted to further depreciate the Indian rupee. Dasgupta observed this as “short-seller attack” originated due to fact that U.S. Federal Reserve ending its quantitative easing. He observed that the end of cheap dollars from the U.S. Federal Reserve’s stimulus programme has prompted a massive capital flight toward dollar-denominated assets and he wants to stop such capital flights. He said “now it is time to stop it.” His observation has some merit but the proposed solution is very naïve. Let us look at his proposal.

He proposes to set up a Reserve Fund mainly by BRIC countries to intervene in FX market. According to him short-seller attack originated due to fact that the U.S. dollar getting stronger. Therefore any solution must have a mechanism to keep the dollar stable or prevent appreciating. This objective he thinks can be achieved by setting up a reserve fund and making necessary intervention when dollar is appreciating. Dasgupta has observed that BRIC countries except China have reserve of USD 1.2 trillion and with China total reserves amount to USD 6 trillion – And such reserve levels facilitate in setting up a so called reserve fund if they decided to.

The world’s most sought reserve currency is U.S. dollar. Europe wanted to challenge the position of U.S. dollar and they came up with a new money call euro with the establishment of European Union. Even though the EU is considered as the largest economy of having GDP over 16 trillion USD, still U.S. dollar dominates its number one position. Due to an unsolvable structural weakness of European Central Bank, euro will never overtake U.S. dollar. However euro is the second reserve currency in the world as at now. Even with having a second reserve currency the dollar fluctuates within a limited range; some time it shows weakness and some time it gets stronger. Canada likes if US dollar get stronger, so is China. One time China warned the U.S. against weakening dollar and requested to ensure its dollar-denominated assets by preventing the depreciation of dollar.  This is true for euro zone which favors for stronger U.S. dollar so as to increase exports to the U.S. Yet, Indian Finance Ministry wants the exact opposite. Therefore, it is clear that Indian proposal does not get the support it seeks from BRIC country partners. Even if they set up a reserve fund using all reserves of 6 trillion dollars, sooner they will see that pumping of more dollars actually strengthen dollar rather than weakening it because money does not behave the way that usual commodity behaves in a demand-and-supply situation. This is the reason that Iceland’s five largest banks held assets in their balance sheets, over 1200% of the country’s GDP, before the economic crash of 2008.

In fact India is proposing a microeconomic solution to a macroeconomic problem. The problem is not the strengthening dollar but the weakness in macroeconomics and monetary theory which are used in economic management today.

Just two decades ago, in the decade of 1990s, the world saw two major currency (monetary) experiments. One experiment was carried out in 1991 in the then seventh largest economy namely in Argentina under the law of “currency convertibility law”. This experiment was at least greatly hailed by Nobel laureate Professor Robert Mundell of Columbia University in New York, if the convertibility law was not his brain child. Within a decade this experiment failed big time creating an earthquake in the economy in the year 2000.

The second experiment was carried out in Europe by the European Union forming a common currency called euro which came into existence in January 1999; with this EU became the world’s largest economy. Within a period of 10 years’ time that is in 2008, the euro system or the Growth and Stability Pact based on which euro was established, virtually failed.

In the meantime what I call the “orthodox-monetary-system” failed in the second largest economy after EU, namely the United States in 2008 and in Japan in 1990s and the crises are still continuing. Even though both countries managed to contain (not solve) the problems with a newer monetary approach call “quantitative easing”, the excessive “quantitative easing” shows the weakness of the orthodox monetary theory rather than the strength of it.

What does this mean? This means that the orthodox monetary theory is bad, the monetary experiment of common currency for a particular economic region is worse and the experiment carried out in Argentina under “convertibility law” was the worst.

One year ago a Minister of Government of Sri Lanka wanted to know how BRIC countries were performing better. I wrote to him in June 2012 and I quote “Do Brazil, Russia, India and China which are known as BRIC countries have different monetary theory? The answer is big “NO”. When the time comes, those economies are bound to fail. You might now ask me, when is the time. My answer is brief and precise. In the contemporary monetary economics, including all experiments that took place in Argentina, under euro and under quantitative easing there are two major characteristics that ensure the demand-and-supply equilibrium at existing output level or increasing output level, which is a necessary condition to have a stable, non-crashing economy.

The first characteristic is that the most money is created as debt in the process of lending under the current practice of Fractional Reserve Banking system. The second is that continuous investment is a must and in regard to investment, a good part of investment must not produce products for immediate consumption, instead should be made available in the future.

So, the time for the economic crash for BRIC countries would come either (1) when lending freezes domestically or in importing countries due to inevitable debt bubbles, or (2) when investments slow down or when investments do not increase consumption year after year. Both these eventualities are inevitable in a system where the money is created through lending. BRIC countries and their importing partners are currently run on this monetary system. In this system lending is not purely arising from savings but by creating what is known as credit money through the process of lending itself.

What does this mean?  This means the contemporary monetary theory is not supportive to create and sustain (1) a debt free but growing economy and (2) a virtually self-sufficient economy but none indulgent with extreme consumerism.

In other words, when the society including the government, tries to be debt free the economy crashes or when the society including the government tries to lead a frugal life (a life abstaining from extreme consumerism) the economy crashes.” (End of the quote).

Do you think that with such kind of monetary theory we can face the challenges of twenty first century? Intuitively you may know the correct answer.

The faultiness of monetary theory does not arise by itself. It should arise from the weaknesses of macroeconomic theory because it is the subject of macroeconomic theory that deals with the equilibriums at total output levels. For an example, if the economy crashes when the society including the government, tries to be debt free then this problem must be investigated first by macroeconomists. Similarly, if the economy crashes, when the society including the government, decides to live a life abstaining from extreme consumerism or live a life within the society’s monetary means, then this problem too must be investigated by macroeconomists. It is after the macroeconomic analysis the monetary theory can do what it is supposed to do, not the other way. So, I strongly argue that if anybody wants to be a good monetary theorist then, he or she first must be a good macroeconomist.

The present paradigm of macroeconomic theory as well as monetary economics is a big illusion. This illusion cannot be rectified by infinite number of BASEL conventions which set guide lines to Central Banks and commercial banks or by modern algorithmic models such as Dynamic Stochastic General Economic Equilibrium (DSGEE). We need a real paradigm shift here in the fields of macro and monetary economics in order to ensure the well-being of humanity in the 21st century and beyond.

A learned observer of this issue is Prof. Kumar David. One time he opined “In the old days a PhD was awarded for an original contribution to knowledge, but gradually the purpose changed. With the increasing demand for PhD programs the purpose now is training in research, that is giving candidates a sound grounding in research methodology. That is O.K. And also this is positive only if the expanded army of PhDs kept the purpose unchanged collectively in their post-doctoral career that is to make an original contribution to fundamental knowledge of the humanity. If not much touted DSGEE programs and algorithmically manufactured risk models and the resultant computer print-outs would not relate to the real world.”

India’s proud of high economic performance and its monetary management skill have eroded. Its current GDP is 4.4% by the end of June 2013 and the rupee has devalued over 20% this year. Dr. Rajan’s most favored supply-side solutions are no solutions for India because in the final analysis the monetary infrastructure is not supportive for such solutions. The real solution must come by placing a monetary system that solves the systemic contradiction in the macroeconomic system. India, with a population of 1.24 billion cannot avoid this need.