Month: June 2014 | Page 2

23 June, 2014

Monsoon starts weak: What will be its impact on agriculture?

It has been widely reported that there is a possibility of a bad monsoon this year. Data released by the India Meteorological Department (IMD) suggests that “the rainfall activity was deficient/scanty over the country”. In fact, “for the country as a whole, cumulative rainfall during this year’s monsoon has so far upto 18 June been 45% below the Long Period Average (LPA)”, the IMD data suggests.
This has had an impact on the sowing of summer crops. Data released by the ministry of agriculture shows that the sowing of kharif crops,which are typically sown around this time of the year for harvesting after the rains (ie, September-October), has come down majorly in comparison to last year.
Last year the farmers had sowed rice over an area of 16.4 lakh hectares by June 21, 2013. This year it has dropped by more than half to 7.59 lakh hectares. The planting of oil seeds has dropped by a whopping 84.9% to 1.23 lakh hectares. Pulses have also fallen from 3.74 lakh hectares to 2.6 lakh hectares this year. The planting of sugarcane continues to remain more or less stable at 43.92 lakh hectares. Nearly 55% of the cropped area in India is dependant on rains.
It is still early days for the monsoon and the situation might improve in the days to come and that will lead to more sowing. A bad monsoon doesn’t necessarily mean that agricultural productivity will fall and will lead to a lower production of kharif crops. Why is that the case? As Chetan Ahya and Upasana Chachra of Morgan Stanley write in a recent report titled El Nino Impact on India’s Farm Output “In 2009, even with a 22% deficient rainfall trend, agriculture output did not decline on a year on year basis then.”
This means the agricultural output in 2009 was not lower than that in 2008, even though the monsoon was 22% lower than normal. The IMD expects the monsoon this year to be 7% lower than normal. Given this, the agricultural productivity should not be impacted much.
As Ahya and Chachra explain “while North Western India is likely to face the largest shortfall, it is also the most irrigated region and currently has full reservoir levels. Even in 2009, the impact on the region’s food production was minimal. Hence, North West India (comprising Punjab, Haryana and Western UP), which produces most of the Kharif season (summer crop) rice, should see a near normal crop.”
What this means is that rice production is unlikely to drop. What also helps is the fact that the Food Corporation of India(FCI) as on June 1, 2014,had a rice stock of 20.6 million tonnes. The government recently decided to unload around 5 million tonnes of this stock on to the open market in order to control inflation. Even after that a stock of 15.6 million tonnes of rice still remains.
Over and above this, the FCI will buy more rice in the coming months. Hence, unless the government ends up buying much more rice than it needs (as it has in the past) to run its various programmes, the price of rice should remain stable. By buying much more rice than it needs the government in the past ensured that a lesser amount of rice landed up in the open market and that led to a rapid rise in its price.
Further, the Modi government also needs to ensure that it does not raise the minimum support price of rice at the same rate as the Congress led UPA government had done in the past.Every year the government of India sets a minimum support price for rice and wheat. At this price, it buys rice and wheat from farmers, through the FCI and other state government agencies.
In 2005-2006, the MSP for common paddy(rice) was Rs 570 per quintal. By 2013-2014 this had shot up to Rs 1310 per quintal, an increase in price of around 11% per year. In comparison, between 1998-1999 and 2005-2006, the MSP of rice had increased at the rate of 3.8% per year.
If these steps are taken the price of rice will remain stable.
But what about the other kharif crops? Oil seeds and pulses are largely grown in south and central India. The irrigation facilities in this region are no so well developed as Punjab and Haryana. Also, the reservoir levels in these areas are a concern. “Consequently, price pressures for these items [i.e. pulses and oil seeds] may build up. India may potentially need to import pulses to meet the shortfall in production,” write Ahya and Chachra. The scenario on the oil seeds front is looking particularly weak given that sowing has fallen by 84.9% in comparison to last year. This after central India has received 52% lower rainfall than normal until now. The number in case of south India stands at 27%.
“The overall farm output growth is unlikely to contract”, feel the Morgan Stanley analysts, even though things could get difficult on the pulses and the oil seeds front. But the real worry is the drought psychology setting in. As T N Ninan writesin a column in the Business Standard “A drought does not reduce agricultural output with the frequency of an earlier age. In fact, the agricultural sector managed to show marginal growth in both the last two difficult years – helped by the spread of irrigation and other drought-proofing measures.”
Hence even with a bad monsoon, a water shortage is unlikely. “For all one knows, cereal production may increase yet again. The real danger is of drought psychology setting in and sending prices skyward, as has already happened with onions and potatoes,” writes Ninan.
And that is something that Modi government will have to tackle through better communication.

The column originally appeared on www.firstbiz.com on June 23, 2014

(Vivek Kaul is a writer. He can be reached at [email protected])

23 June, 2014

The costly ticket to achche din

A few days back a friend complained on Facebook that since the Narendra Modi government had come to power, power cuts in his city had gone up dramatically, and he had not been able to sleep at all during the night. “So where are the acche din that had been promised?” he asked. To this someone cheekily replied that the promise was of acche din and not acchi raatein.
Narendra Modi and the Bhartiya Janata Party fought the Lok Sabha election on the plank of “acche din aane waale hain”. The slogan offered “hope” to the people of this country, in an environment where economic growth had been falling and inflation had been rising. It was for the first time that a political party was not treating the voter as a “victim”. The slogan struck a real chord with the Indian voter.
The success of the slogan has now led to a scenario where every tough economic decision that the Modi government makes is and will be viewed through the lens of the “acche din aane waale hain” slogan. Take the recent case of the decision to increase the railway passenger fares by 14.2 per cent and freight fares by 6.5 per cent.
The hike in railway passenger fares has been the steepest in 15 years and has been long overdue. Between 1999 and 2014, the passenger fares were increased only thrice, of which one hike was reversed. This has left very little money with the railways for any sort of modernisation and the upkeep of railway tracks. It has also led to a scenario were traveling has become increasingly unsafe, as can be made out from the spate of railway accidents over the last few years.
The trouble is that for too long Indian Railways has been used as a political tool and not a service which is economically viable on its own. One way to correct this is to index fares to the prevailing rate of inflation and increase prices on a regular basis, every year. So, if the inflation is 8 per cent during the course of the year, then fares can go up by 8 per cent at the beginning of the financial year, on April 1. If this practice were to be followed, the chances of railways being economically viable and safer are likely to go up. Also, it would rule out the chances of one-off increases in fares, which upset the monthly budget of people who use the railways to travel regularly.
In the short-term, this increase in fares is expected to add to inflation. There are other decisions that the government will have to make over the next few months which will add to inflation. Take the case of oil. The price of the Indian basket of crude oil stood at $111.94 per barrel on June 19, 2014. It averaged at $106.72 per barrel between May 29 and June 11, 2014.
The price of oil has gone up by close to 5 per cent in such a short period of time primarily because of a threat of war in Iraq. India imports 80 per cent of the oil it consumes. The government will have to pass on this increase in the price of oil to the end consumer. If it does not do that it will have to compensate the oil marketing companies for the “extra” under-recoveries they are likely to face on the sale of diesel, cooking gas and kerosene. This would lead to an increase in government expenditure and, hence, the fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
The government is already very stretched on the fiscal deficit front with the last government leaving unpaid bills of more than Rs 1,00,000 crore. Hence, it will have to pass on the increase in the international price of oil to the end consumers. This will mean higher inflation and another jolt to the promise of acche din.
What makes the situation even more difficult is the fact that the monsoon is expected to be much lower than average this year. In fact, data from the India Meteorological Department shows that rainfall upto June 18 has been 45 per cent lower than normal. This number may improve in the days to come, given that it is still early days for the monsoon. It needs to be pointed out that a bad monsoon does not necessarily lead to a lower production of food. In 2009, even with a 22 per cent deficient rainfall, the agriculture production did not go down. The real problem is once the psychology of drought sets in, the prices of food products start to go up, even though their production may not be impacted.
One thing that the government can do to prevent inflation is to procure a lower amount of rice and wheat from farmers this year. As on June 1, 2014, the Food Corporation of India (FCI) had food grain stocks of 74.8 million tonnes, when it does not require more than 41-47 million tonnes. By buying less from the farmers, the government can ensure that more rice and wheat lands up in the open market, and helps prevent a price rise. The government also needs to ensure that it does not raise the minimum support price of rice and wheat at the rate that the Congress-led UPA government had done in the past. These moves are unlikely to go down well with the farmers, who have also been promised acche din.
It is important that Mr Modi borrows a leaf from Franklin Roosevelt, the President of the United States between 1933 and 1945. This was a difficult time for the US — the Great Depression was on. Between 1933 and 1944, Roosevelt made 30 fireside chats through the radio, explaining to Americans the tough decisions he was taking to get the economy back on track. Mr Modi and his government need to keep talking to the people and explain why they need to take some tough decisions over the next few months.

The article originally appeared in The Asian Age/Deccan Chronicle on June 23, 2014
Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]

20 June, 2014

The difficulty of doing good

V Kasturi Rangan is the Malcolm P McNair Professor of Marketing at the Harvard Business School. He is also the co-chairman of the school’s Social Enterprise Initiative. In this interview with Vivek Kaul, Rangan talks about why it is important for companies to have a corporate social responsibility (CSR) strategy and how can they go about creating it. Kaul is the author of the Easy Money trilogy, which deals with the evolution of money and the financial system and how that led to the current financial crisis.
Does every company needs a CSR strategy?
Absolutely. Any business in the world operates in the context of a community. Not all members of the community are investors in the company or are its customers. But they are impacted by what the company does. Businesses operate in a social, cultural and regulatory context, a lot of which is not directly in the value chain. If that is the context in which a business operates it is absolutely important for business to have a CSR strategy.
Does every company have a CSR strategy?
They don’t, including the big companies. A lot of big companies have CSR programmes, but that is different from having a CSR strategy. They always do something useful. Take for example a textile mill sets up a school feeding programme and decides to feed ten schools by providing them a mid day meal. Someone else says that I am going to provide education. Or I am going to provide free food in the canteen for all my workers. So they have programmes. I am not faulting them for not having programmes. Just having programmes is not equal to having a CSR strategy. The CSR strategy requires the company to think very carefully about its business purpose.
Could you substantiate that through an example?
There is a terrific water utility in Philippines called the Manila Water Company. They have got the concession to run the water utility in Eastern Manila. Eastern Manila has some 5-6 million people. As a part of the water franchise, other than providing water, the company needed to ensure that within 10 years they provided water connections to 95% of the households. Of the five million, around 2.5 million people did not have a water connection. These were people who lived in the slums. The company looked at them as an opportunity because ultimately they got water from somewhere, which was typically poor quality water, which had been stolen from the main pipe anyway.
What happened next?
The company said these poor people are paying more for poor quality water. So they came up with a brilliant idea making sure that they gave a connection to everybody, but the water bill was collected through a community leader. If they went to collect the water bill from every hut it would be very expensive. So the community leader collected the bill. This lowered their cost. But the community leader also ensured that when the water mafia came to steal water illegally, the community acted as a self policing force. Its also worked like a self help group. If one member of the community could not pay the water bill, other people pitched in for one or two months. Also, it was an incremental revenue for the company because water pipes are a fixed cost.
Anything else that they did?
The government gave them the permission to dump the sewage in the sea. But they processed it and made it into sewage cakes which went to regenerate areas which had seen a volcanic eruption in the Philippines. The took the grey water for city boulevards. So it is a very profitable company and is directly linked to the business, where the poor people are seen as an opportunity. And it is a completely integrated company where you will not be able to separate their CSR from their business strategy. It is all integrated. And when the company so profitable the consumers are not saying that they are making too much money like has been the case with micro-finance in Andhra Pradesh.
Any other example that you can share?
There is a bank called the Pittsburgh National Bank(PNC), which operates in mid-west United States, in places like Pittsburgh, Cleveland. The parts that they operate in used to be an industrial area, where the factories have left and so there is a lot of unemployment. The area also has families with a lot of single mothers. They decided to put all their effort into early childhood education.
So how is that a strategy?
Earlier they were doing philanthropy. Some sections were giving to art and culture organizations. Some other directors were supporting their local sports team. They said, let’s aggregate and put it behind one initiative—early childhood education. They got $100 million in early childhood education. So when a company puts in $100 million, then the CEO of the company sits on the national board of education. This $100 million leverages the state budget. They can move the needle. What I am saying is that if you do CSR and if you can focus only one or two things which can move the needle, then it has an impact. The point about CSR is that just like you measure business impact you also have to measure social impact.
How does a company go about having a CSR strategy?
Here is my view. If you go in and take the helicopter view of some of the better companies. You will find that they have their CSR programmes which falls into three theatres. Theatres one is by and large like philanthropy. Theatre two CSR is more like shared value. I am going to be environmentally responsible by using alternate fuels rather than fossil fuels. That sort of thing. The third theatre is transforming the business. It is like Manila Water. It is like saying I am going to do a completely different business formula.
Could you elaborate on that?
When you go in, the company will have all the three theatres operating at the same time. What you have to do is two things. First, you have to look at each of these silos, whatever programme is their in the silo has got some kind of a connection to the business purpose. The second thing which is the biggest drawback of companies whether international or Indian, the philanthropic CSR programmes are usually run by their community affairs director or the CSR manager or the foundation head. The operation stuff is usually run by the line managers, the factory head, the functional manager etc. And “change the business” is run by the executive committee of the CEO. These three rarely talk to each other on CSR. When the three talk to each other, a CSR strategy emerges.
Any examples?
That is what Ambuja Cement has done. They have the Ambuja foundation that does very good community development work. The mining managers work with local managers. They think in terms of water usage because they produce cement which needs water. They are thinking in terms of how can we give water back to the farms. And then the CEO is thinking in terms of how can we sustain the mining activity etc. They put together a process where the CEO, the operational manager and the foundation started talking to each other. The CSR strategy emerged from that. Now the company has a CSR strategy where they are saying that we have to be a sustainable business where we should put in more into the environment than we take from it. So they are not only water positive they are 3x water positive i.e. they put three times the water back than the water they consume. They want to be plastic positive. They are not yet.
What does that mean?
They sell cement in plastic bags. So the plastic goes into a landfill somewhere and that is not good for the environment. What they have thought of doing is collecting the plastic bags and burning it as alternate fuel in the kiln. If they do that they don’t have to use so much of fossil fuel. So, the strategy is that this whole process of becoming plastic positive. Also, now that they are 3x water positive the farm yields have improved in and around them. The profits of farmers has gone up. So, what I am saying is that a CSR strategy emerges when you link the three theatres and that changes the way the business operates.
The interview originally appeared in The Corporate Dossier, The Economic Times on June 20, 2014

20 June, 2014

Why the Modi govt finances won’t see acche din any time soon

In a report titled How Will the New Government Cut the Fiscal Deficit dated June 16, 2014, Chetan Ahya and Upasana Chachra of Morgan Stanley write that “a national fiscal deficit below 5% of GDP would allow real borrowing costs for the private sector to decline meaningfully and encourage private investment.”
Fiscal deficit is the difference between what a government earns and what it spends. The national fiscal deficit includes the deficit run by the central as well as the state governments. In the financial year 2013-2014 (April 1, 2013 to March 31, 2014) this number stood at 7.6% of the GDP.
This number the Morgan Stanley analysts believe should be less than 5% of the GDP. Governments make up for their fiscal deficit through borrowing. A lower fiscal deficit means lower borrowing by the government (s) leaving more money on the table for everyone else to borrow.
Also, with the government borrowing less, the interest rates are likely to come down. Further, businesses are more likely to borrow at lower interest rates and this will encourage investment. Or so goes the story.
If the national fiscal deficit has to come down the onus lies primarily on the central government to cut down on its fiscal deficit. As Ahya and Chachra point out “The state governments’ deficit is closer to the trend line…Hence…the bulk of the reduction in the fiscal deficit needs to be at the central government level.”
The question is how well placed is the central government to cut down on its fiscal deficit? Cutting down on subsidies is one option that is suggested by the analysts. Subsidies stood at 1% of the GDP in mid 1990s and since then have ballooned to 2.3% of the GDP.
The trouble with this argument is that a lot of subsidies are offered by the government under programmes which have been cleared by the Parliament. So these subsidies cannot be suddenly done away with.
What can be cut are the so called “oil subsidies”. The central government taxes oil products and earns revenue in the process. Over the years, a major portion of this revenue has been used to pay oil marketing companies for the “under-recoveries” they suffer on selling diesel, cooking gas and kerosene.
For the year 2012-2013 the central government earned Rs 1,17,422 crore by taxing oil products and oil companies. It paid out Rs 1,00,000 crore in the form of cash assistance to oil marketing companies for their “under-recoveries”. What this basically tells us is that unlike earlier, the government did not gain much from taxing oil. In 2012-2013, the gain was only Rs 17,422 crore.
If the fiscal deficit has to come down, this gain has to go up. This can only happen if oil marketing companies are allowed to increase the price of oil products. The trouble is that given the amount of central and state taxes built into the price of oil, Indians are already paying one of the highest prices in the world for these products.
Also, an increase in the price of these products will add to inflation. For a party whose main election plank was “acche din aane waale hain” this can’t be a good sign. What makes the situation even more difficult is the war in Iraq which has led to a spike in the price of oil. The price for the Indian basket of crude oil stood at $111.25 per barrel on June 18, 2014. It had averaged at $106.72 per barrel for the period between May 29 and June 11, 2014. Hence, in a matter of days, the price has gone up by more than 4% in a matter of days.
If oil marketing companies are allowed to pass on this increase to the end consumer it would lead to higher inflation (including higher food inflation). If they are not it would mean increasing “under-recoveries” for these companies. The government will have to compensate the oil marketing companies for these “under-recoveries” and this in turn would lead to a higher fiscal deficit. Also, it is worth remembering that the war in Iraq might continue and lead to the price of oil shooting up further.
What does not help the cause of the government is the fact that the Congress led UPA government had postponed expenses of greater than Rs 1,00,000 crore to this financial year (this includes food, fertizlier and oil subsidies). This money will have to come from somewhere. Ideally, the government should settle this expenditure during the course of this year and try and start on a clean slate from the next financial year, even if it leads to a higher fiscal deficit.
Another major factor that not many people seem to be talking about is the fact that the recapitalization of public sector banks will need a lot of money in the years to come. The Report of The Committee to Review Governance of Boards of Banks in India (better known as the PJ Nayak committee) released in May 2014, estimates that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.”
The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.” That clearly is a lot of money. If the government spreads it over a period four years, it would mean an expense of around Rs 90,000 crore (Rs 3,50,000 crore/4) per year. Where is this money going to come from?
The situation becomes even more difficult given that the situation on the tax revenue front has been very weak. As Ahya and Chachra of Morgan Stanley point out “gross tax revenue has declined from the peak of 11.9% of GDP in F2008 to 10% of GDP in F2014.” The analysts go on to suggest that the government should look to “roll back the excise duty cuts for the automobile industry that were introduced in the interim budget.” But that would mean hitting the automobile industry, which in the recent past has looked like coming out of the doldrums that it has been in for a while. Car sales grew by 3.08% in May 2014.
One way out for the government is to start to look at disinvesting its stake in public sector companies in a very serious way, through the next few years. The disinvestment target in the interim budget presented by P Chidambaram had been set at Rs 56,925 crore. This is clearly not enough. The government needs to aim at much more than this. One way of doing this is to cede managerial control and sell out lock, stock and barrel to the private sector. In that scenario the government is even likely to get a premium above the current market price of the company’s stock. But that is not going to go down well with the employee unions. Further in a lot of companies the government will need a new legislation which will allow it to drop its stake below 50%. This includes nationalized banks as well as Coal India.
Having said that it is not a good practice to finance current expenditure by selling things that one owns. But in the short run that is the only way out for the government.
(Vivek Kaul is a writer. He can be reached at [email protected])

19 June, 2014

'The Federal Reserve Learnt the Lessons Of The Great Depression'

R Jagannathan and Vivek Kaul

Randall S Kroszner served as a Governor of the Federal Reserve System from March 2006 until January 2009. During his time as a member of the Federal Reserve Board, he chaired the committee on Supervision and Regulation of Banking Institutions and the committee on Consumer and Community Affairs. Kroszner was a member of the President’s Council of Economic Advisers (CEA) from 2001 to 2003. Currently he is the Norman R Bobins Professor of Economics at the University of Chicago Booth School of Business. He is an expert on international financial crises and the Great Depression. He was recently in India for the opening of The University of Chicago Center in Delhi. In this interview Kroszner tells Forbes India on how the Federal Reserve managed to avoid another Great Depression in 2008 and why it had to let the investment bank Lehman Brothers go bankrupt.

You were a governor at the Federal Reserve between 2006 and early 2009. That must have been a very tough and an exciting time…
Three easy years…(laughs). I am joking.
Can you give us some flavour of how those years were?
It was an incredibly challenging time because the markets were moving so rapidly. The economy was also moving rapidly downward. So we had to take important decisions in real time. We would often get into situations where we would try to survive until Friday and then try to do the resolution by Sunday, before the Asian markets opened. So we had a lot of board meetings late on Fridays, Saturdays and Sundays. And it was a time where having an economic framework was very useful because when you have to make decisions in real time, you need to have a framework to understand what the priorities are.
You and Ben Bernanke are scholars of the Great Depression. How did that help?
A number of us were quite familiar with the economic history. Three out of the five of us on the board had written papers on the Great Depression. And we were all pretty much influenced by Milton Friedman and Anna Scwartz’s magisterial A Monetary History of the United States. Their study squarely put the blame on the inaction of the Federal Reserve, turning a depression into the Great Depression. Those were very important lessons for us and gave us both an economic and historical framework for looking into the kind of price distress we were having at that point of time, so that we could act quickly and boldly to prevent a repeat of the Great Depression.
Did you all really believe that if the fiscal side and the monetary hadn’t acted as they did in 2008, you were really seeing a repeat of the Great Depression?
There was a certainly a risk of that because clearly there was a lot of turmoil in the financial markets. There was a potential for failure of many financial institutions, if the Fed did nothing and did not provide liquidity to the market and some institutions. It was by no means a certainty. Even if the probability was low, it’s a risk that I and other members of the Federal Reserve board were reluctant to take.
In the meetings at the Fed before September 2008 what was the atmosphere like? Did Chairman Bernanke and other governors have a clue of what was to come?
If you see the verbatim transcripts of 2008 many of us including myself were very concerned about the fragility of the market and the economy. We undertook some very bold action in terms of a very rapid interest rate cut. This was at a time when the European central banks were raising interest rates because oil prices were rising throughout 2008. But our forecast was that demand was likely to go down significantly and that the rise in oil prices was just a temporary price shift not suggesting an underlying increase in inflation. And that is why we had interest rates very low during that time period while other central banks were raising interest rates.
Being the Chair of the committee on Supervision and Regulation of Banking Institutionsyou must have been in the room when a decision to let Lehman Brothers go bust would have been made. What was the atmosphere like?
So, there was no meeting where a go/no go was made. It was a series of processes. Remember we were dealing with independent investment banks having significant funding troubles and having great concerns about their ability to survive. And so we were exploring whether there could be merger partners for organisations like Merrill Lynch and Lehman Brothers. Bank of America decided to buy Merrill Lynch. There were others who were looking at Lehman Brothers and we thought that we would be finding a merger partner. But it then emerged over that weekend[the weekend of September 13-14, 2008] that a merger partner was not available for Lehman Brothers. The market had known that they were in trouble for a while. And Lehman Brothers had not been willing to merge with a number of other institutions that had proposed merger over the summer. Hence, it was in an effectively weak capital position. Its business model was imploding and so, the Fed was not able to do a capital infusion.
Why was that the case?
The Fed can only lend against good collateral to a solvent organisation. It was very difficult to make an assessment at that time. There was a merger partner avaialble for Merrill Lynch and Bank of America could provide capital infusion and support. Morgan Stanley and Goldman Sachs had sufficient capital and sufficiently functional business models, that we felt comfortable granting them bank charters on an emergency basis. But Lehman Brothers did not have that wherewithal.
But two days later Federal Reserve stepped into rescue AIG. How do you explain that?
Well remember that the Fed could lend against good collateral. The problematic part of AIG was the financial products subsidiary of the holding company. But AIG had other operations in many states and in many countries that were not associated with the challenges that were there in the financial products division. And also AIG had sufficient collateral to be able to post against the loan.
You are also a scholar of the Great Depression. What were the mistakes made during the Great Depression that haven’t been made during the period of what is now called the Great Recession?
As you know a number of us including Bernanke, myself and one of the other governors, were students of the Great Depression and had done work on it. Milton Friedman and Anna Scwartz’s in their magisterial book on the monetary history of the United States had said that depression of the late twenties and early thirties was turned into the Great Depression precisely because the Fed did not act. The Fed stood by as the money supply collapsed, and as deflation came in. The prices fell by a third, GDP fell by 30%, and unemployment went up to 20%, and there was no action.
And that was the lesson?
Yes. That was a very important lesson for those of us who had studied the Great Depression, to make sure that we did not make that mistake of inaction because the central bank can prevent deflation. Broadly, we certainly learned the lessons of the Great Depression at the Fed, to make sure that we didn’t make the same mistakes. We didn’t just sit ideally and allow the price level to fall significantly and allow the GDP to contract. Honestly, we were able to avoid a significant to recession. It is really something very different from what happened in the 1930s.
You also managed to avoid a deflation…
Deflation can be very destructive as we saw in the thirties. Even a mild deflation can be very problematic as we have seen over the last fifteen years in Japan. It was the strong commitment on the part those of us who studied the 1930s as supposed to the others, to make sure to not allow a state of inaction, where a central bank did not act as the lender of the last resort, which is actually what it was created to do. Further, central banks around the world have to be vigilant against the threat of deflation.
International financial crises is an area of your expertise. Why are economists unable to spot bubbles. Your colleague and Nobel laureate Eugene Fama has even gone to the extent of saying that “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
It is easy ex-post to say that aha that price did not make any sense or it was clear that price would be coming down. But when in you are real time it is very difficult to be able to tell whether there is some sort of dislocation of the market or a fundamental change. We had the same challenge after the Asian, Russian and the Latin American crisis in the 1990s. The World Bank, IMF and many economists looked for indicators, so called red flags, which you could look at and tell when the economy is is getting overheated. They tried to figure out which are the indicators that can tell us that credit growth is too fast, or that there is a “bubble” in a particular sector. Despite a lot of work by a lot of very smart people on the policy side and the academic side, we really haven’t come up with a simple set of indicators or any indicator where you can have confidence and say just look at x, y and z, and you know that there is some sort of dislocation here, that is going to be reversed.
In a recent interview you said that the Fed’s approach to communication has changed through the years. Could you elaborate on that?
The communication has become more complete and more transparent and also the words have changed over time. They are sometimes called forward guidance. They are sometimes called open mouth operations because its talking about what kind of purchases and sales that the open market operations are going to do. In my last meeting at the Federal Open Market Committee(FOMC) we brought interest rates to approximately zero and said that we would keep them there for an extended period of time. That gradually changed into a particular date, and Fed would describe dates like 2014/2015. That changed to a description of 6.5% unemployment threshold. And most recently the Fed has said that it would not be focusing on a particular unemployment threshold.
What is the aim here?
I think all of the statements are trying to get at the same thing. It’s different words in different circumstances, around the same idea about the desire of the Fed to provide liquidity support to monetary accommodation to make sure that the economy fully recovers before it decides to take the punchbowl away. In these uncharted waters, giving a little bit more guidance about what the Federal Reserve thinks about policy making and how is it going to react to data is helpful because the past behaviour may not be that useful because we haven’t had these kinds of circumstances before.
In a recent interview when you were asked that when do you think the time will come when the Federal Reserve will start to raise interest rates, you had replied “I do think it will come sometime in my lifetime”. Does that mean the era of low interest rates in the US is here to stay? That was a bit of flip comment. I hope you understand that it was not meant seriously. We have had low interest rates for five to six years now. There is a hope that the economy will be strong enough sometime in 2015, and rates will be able to go up. You can see from most recent FOMC documents all of the FOMC members believe that the interest rates will be higher by the end of 2015 than they are now. And that sounds to me as reasonable.
A lot of gold bulls have been thinking that some point gold should have some role in money making. Do you see gold ever having any kind of role in monetary policy in future?
It’s narrow to pull this in any particular commodity because then the value of the currency will rise and fall depending on the vagaries of the particular market. So, like a flood in a mine in South Africa will have a big impact. And that is like putting too many eggs into one basket. The least you would want is a broader commodity based basket that would be well diversified and would be able to withstand these kind of shocks. So certainly thinking about alternative benchmarks for units of account are worthwhile to do. But I wouldn’t want to put all of my eggs in one particular commodity basket, particularly a market like gold which is a very small one. Small shocks like a flood in a mine in South Africa could have a big impact on money supply. Hence, it doesn’t seem like a very stable system.
The near zero interest rates and the QEs have had a bigger impact on the assets markets than the credit markets and the real economy. Would you say it is building up some problem?
It is important that the Fed is aware about this and is looking into this. Jeremy Stein one of the governors of the Fed has been at the forefront trying to think about what indicators to look at, indicators that might raise red flags. Jeremy as well as his staff are thinking very carefully about that. Monitoring this very very closely is very important and I know that the Fed is. To be able to predict which markets will have a dislocation, it is impossible to do that. No one has that kind of foresight. But I do think there is much more focus on that today than there was in the past.
In another five six months it will be six years since the Lehman Brothers went bust. How long do you think the easy money policies will continue?
As Chairman of the Federal Reserve, Ben Bernanke had said, whatever it takes, a corollary of that is as long as it takes. We have had a slow recovery than anyone had hoped for and that has been true not only in the US but many other countries as well. Some countries like India and some emerging markets that had done very well in the late 2000s have seen a significant fall in growth more recently. As the FOMC and Janet Yellen have said they are now on a path of tapering. It is very important to draw the distinction between tapering and tightening. The Fed had made a commitment to buy $85 billion worth of additional assets every month and that added nearly $1 trillion to the balance sheet every year. And with tapering now it is going to reduce the pace of that increase. So, it is not a tightening it just reducing the pace of additional accommodation. The additional accommodation is likely to wind down by the fourth quarter of this year and then depending on economic conditions, around six to nine months after that, the Fed might actually begin the process of tightening. But this is sort of a very gentle lengthy process. This is not a sudden shift of policy.

The interview originally appeared in the Forbes India magazine dated Jun 27, 2014