Duvvuri Subbarao: Quantitative easing - unconventional policy response
to the financial crisis
Remarks by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, while welcoming
Mr Ben Bernanke, Chairman of the Board of Governors of the US Federal Reserve System,
at the Reserve Bank of India, Mumbai, 10 October 2012.
* * *
I am delighted to welcome Chairman Ben Bernanke to the Reserve Bank and to this meeting
with the Top Management Group of RBI.
It would be presumptuous on my part to introduce a legendary personality like
Ben Bernanke, especially to a gathering of central bank staff. I will do so nevertheless, if only
to pay homage to a tradition.
Crisis - an intellectual challenge
As we all know, the crisis was an intellectual challenge as it called into question many of our
beliefs and theories, and reopened issues that we thought had been settled. Clearly, it
demanded a policy response that went beyond conventional economics. As central bankers
started battling the crisis, ferociously easing monetary policy, leading the intellectual charge
from the front was Chairman Bernanke.
Unconventional policies
Through his resort to unconventional policies, Ben Bernanke demonstrated the enormous
range, depth and power of the central bank policy arsenal. In doing so, he drew not only from
his impressive scholarship of the Great Depression, but also from the lessons of several
post-war crises, including the long slow down in Japan. This is a rare instance of academic
economics being tested in real time.
As an academic and as a policy maker, Chairman Bernanke was ahead of others in
recognizing the limits of conventional monetary policy. As someone quipped, he believed
strongly that it is better to succeed through unconventional policies than to fail through
conventional policies! In a scenario where the policy interest rate was already at the zero
lower bound, he had advocated a money-financed tax cut, essentially equivalent to a
"helicopter drop" of money (earning him the sobriquet "Helicopter Ben"). Unlike a
bondfinanced tax-cut, which leads to tax increases down the line, a tax cut financed by money
creation should, in theory, not emasculate fiscal expansion through the Ricardian
Equivalence.
Quantitative Easing (QE)
The Federal Reserve under Bernanke was not, of course, the first central bank to deploy
quantitative easing (QE). The Bank of Japan (BoJ) is considered to be the pioneer in this
regard. However, where Chairman Bernanke stood out was that he used QE far more
aggressively than the BoJ ever did, introducing innovations as he went along. QE became
"credit easing" when private assets were bought to stabilize financial markets, followed by
another unconventional move - "operation twist" - to intervene directly at the long end of the
yield curve with offsetting interventions at the short-end. The latest version of QE, as we all
know, is an open ended commitment to purchase mortgage backed securities at the rate of
$40 billion per month for as long as the "labour market does not improve substantially".
QE, in all its variations, was able to halt the downward deflationary spiral by making up for
the declining velocity of money caused by deleveraging. It kept sovereign borrowing rates
low in the face of a market revolt. It helped clean up the balance sheets of stressed financial
institutions through cheap funding.
The recovery from the Great Recession was relatively quick; at least that was how it seemed
through the "green shoots" of 2010. Now, of course, we are no longer so sure. The limitations
of macroeconomic techniques honed through deconstructing the Great Depression, the
inflationary seventies and the Great Moderation are there for all to see. Quite
understandably, therefore, QE has its critics. It may be relevant to recall some of the
criticism.
Criticism of QE
The main criticism has been that QE is being continued beyond its usefulness. What the US
economy requires now is a fiscal stimulus, and further QE is no substitute for a fiscal
stimulus. It would only stoke inflationary pressures down the line.
A second criticism, in fact a corollary to the first one, has been the argument that stretching
monetary policy to unconventional levels has obliterated the firewall between fiscal and
monetary policies, with monetary policy increasingly becoming an extension of fiscal policy,
thereby renewing concerns about the fiscal dominance of monetary policy.
Third, whereas fiscal stimulus leads to higher taxes down the line, the combination of
zerobound interest rates and QE is an immediate tax on savers, who in effect finance the
stimulus. This tax on savings should induce people to consume and invest more, and save
less. But with impaired balance sheets, they are possibly saving even more. Given this
outcome, some have questioned the circumstances under which and the extent to which QE
can trigger a virtuous cycle of demand for and supply of credit to the real economy.
Fourth, there has been criticism from some emerging markets alleging that the excess
liquidity unleashed by QE is fuelling volatile capital flows, asset bubbles and inflation and
also spiking up commodity prices.
Finally, the Fed is being challenged on the risks in the process of unwinding QE, in particular
of how this could be managed consistent with price stability and financial stability.
Chairman Bernanke has responded to the above criticism on several occasions from various
platforms. He has also found an innovative answer for each new problem thrown at him so
far. This is all the more remarkable given that there is no recent real life experience to draw
from.
Central banks and the new trilemma
As a central bank, we empathize with the Fed's concerns. The crisis has pushed central
bank policy making into uncharted territory. We will not know for many years whether the
policy mix we have followed to manage the crisis is right. Even so, in real time, all of us have
to struggle with the challenge of managing the new trilemma - of balancing fiscal
sustainability, price stability and financial stability.
Communication policies
Chairman Bernanke's unconventional policies have extended beyond the content of policy to
its communication. Hard as it might be to imagine from today's perspective, prior to 1994, the
Federal Reserve was not actually announcing the target Fed Funds Rate; the market was
expected to infer the rate from the timing, sequencing and magnitude of its open market
operations. In sharp contrast, today the Fed not only explicitly announces the rate but also
gives a clear indication of the future policy trajectory. Like Chairman Bernanke has carried
his policies to an unconventional level, he has carried their communication also to an
unconventional level by shaping and managing expectations through post-policy press
conferences and town hall meetings.
Bernanke's legacy
All in all, because of what he did, what he said, and above all because he stuck to his
convictions honed through deep scholarship, Chairman Bernanke will have a profound and
lasting influence on the theory and practice of central banking. In the world of policy, he
might be remembered for fashioning the monetary policy of the 21st century. In the world of
academia, he will probably earn the ultimate honour an academic craves if his real world
practice of economics becomes the stuff of text books.
Once again, I have great pleasure in welcoming Chairman Bernanke to the Reserve Bank.
Ben, we are truly delighted to have you with us and look forward to hearing you.