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IMF Paper counters Rajan on easy policy being crisis-recipe

Raghuram-RajanWith RBI’s Raghuram Rajan ringing alarm bells about the world economy facing the Great Depression-like problems, an IMF research paper has countered his views and says monetary policy easing alone can’t be blamed for triggering a financial crisis.

Rajan, who himself has been IMF’s Chief Economist and is among the few to have rightly predicted the financial crisis of 2007, has triggered a debate among policymakers and economists with his warning against central banks globally being pushed into “competitive monetary policy easing”.

In an address at the London Business School, Rajan went even further and warned that the global economy was “slowly slipping” into the Great Depression-like problems of the 1930s and the central banks need to sit together and define new “rules of the game” to find a better solution to deal with it.

Rajan also said it’s a problem of collective action and not a problem of industrial nations or emerging markets.

Countering his views, the IMF Working Paper now says the monetary policy easing alone cannot be blamed for the financial instability and the bigger cause for the global recession in the past, including in 2007-09, has been the “absence of an effective regulatory framework aimed at preserving financial stability”.

The IMF Working Paper, authored by Bank of England Economist Ambrogio Cesa-Bianchi and Alessandro Rebucci of John Hopkins University, has made this conclusion after studying the global financial crisis of 2007-09 and the role of policies for stability of the financial system or the economy as a whole at that time.

“In advanced economies, this debate is revolving around the role of monetary and regulatory policies in causing the global crisis and how the conduct of monetary policy and the supervision of financial intermediaries should be altered in future to avoid the recurrence of such a catastrophic event,” the two authors wrote in the paper authorised by the IMF’s Research Department.

The two economists agreed that the monetary policy can affect financial stability, for which they have cited a research paper authored by Rajan in 2005, but argued that an effective regulatory mechanism can counter-balance this.

Incidentally, it was this Working Paper on ‘Has financial development made the world riskier’, wherein Rajan had warned against an impending financial crisis and had said that “economies may be more exposed to financial sector-induced turmoil than in the past”.

“One last ingredient can make the cocktail particularly volatile, and that is, low interest rates after a period of high rates ? either because of financial liberalisation or because of extremely accommodative monetary policy,” Rajan had said at that time, but his warnings were dismissed by the most and some even called him “Luddite” for airing such views.

Luddites were 19th Century English textile workers who destroyed labour-saving machines to protest against job cuts. Since then, the term ‘Luddite’ is used for a person who is opposed to new technology or greater industrialisation.

In their latest IMF Paper, the two economists said some observers have assigned to monetary policy a key role in exacerbating the severity of the global financial crisis of 2007-09.

“Despite a somewhat widely shared common sentiment that the Federal Reserve is partly to blame for the housing bubble, the issue is highly controversial in academia and the policy community,” they said.

While some observers support the idea that monetary policy contributed significantly to the boom that preceded the global financial crisis, others argue against this thesis.

“To address some of these issues, we developed a simple model of consumption-based asset pricing with collateralised borrowing, monopolistic banking, real interest rates rigidities and pecuniary externalities,” they said.

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