Progress requires strong political leadership

UNCONVENTIONAL MONETARY POLICY: Unconventional monetary policies (UMP) include both policies where the central bank attempts to commit to hold interest rates at near zero for long, as well as policies that affect central bank balance sheets such as buying assets in certain markets, including exchange markets, in order to affect market prices.
There clearly is a role for unconventional policies - when markets are broken or grossly dysfunctional, central bankers may step in with their balance sheets to mend markets. The key question is what happens when these policies are prolonged long beyond repairing markets to actually distorting them. The benefit to cost ratio there is less clear.
Take, for instance, the zero-lower-bound problem. Because short term policy rates cannot be pushed much below zero, and because long rates tack on a risk premium to short rates, central banks may use UMP to directly affect long rates. Direct action by a risk-tolerant central bank, such as purchasing long bonds, effectively shrinks the risk premium available on remaining long assets.
This has two effects. First, those who can rebalance between short and long assets now prefer holding short-term assets because, risk adjusted, these are a better deal. Thus as the central bank increases bond purchases under quantitative easing, the willingness of commercial banks to hold unremunerated reserves rather than long-term assets increases. Second, those institutions that cannot shift to short-term assets, such as pension funds, bond mutual funds, and insurance companies, will either continue holding their assets and suffer a relative under-compensation for risk, or turn to riskier assets. This behaviour, also termed the search for yield, will occur if the relative under-compensation for risk in more exotic assets is lower, or simply because institutions have to meet a fixed nominal rate of return constraint on their portfolios. Of course, such portfolio rebalancing will also take place because the central bank buys long duration bonds out of institutional portfolios, leaving them cash to redeploy.
None of this need be a problem if everyone knows when to stop. Unfortunately, there are few constraints on central banks undertaking these policies since they are self-financing (commercial banks become more willing to hold central bank reserves as the risk premium on long bonds shrinks). If the policy does not seem to be increasing growth, one can simply do more. All the while, the distortion in asset prices and the mis-allocation of funds can increase, which can be very costly when the central bank decides to exit.
Equally important, though, is that domestic fund managers can search for yield abroad, depreciating the sending country's currency and causing the receiving country's currency to appreciate, perhaps significantly more so than ordinary monetary policy. This may indeed cause the increase in domestic competitiveness that could energise the sending country's exports. But such increases in competitiveness and "demand shifting" can be very detrimental for global stability, especially if unaccompanied by domestic demand creation.  
SPILLOVERS TO EMERGING MARKETS AND MUSICAL CRISES: If UMP enhances financial risk taking in the originating country without enhancing domestic investment or consumption, the exchange rate impact of UMP may simply shift demand away from countries not engaging in UMP, without creating much compensating domestic demand for their goods. If so, UMP would resemble very much the exchange rate intervention policies of the emerging markets pre-global financial crisis.
Indeed, the post-global crisis capital flows into emerging markets have been huge, despite the best efforts of emerging markets to push them back by accumulating reserves (net capital flows to emerging economies reached US$550 bn in 2013 compared to US$120 bn in 2006). These flows have increased local leverage, not just due to the direct effect of cross-border banking flows but also the indirect effect, as the appreciating exchange rate and rising asset prices, especially of real estate, make it seem that emerging market borrowers have more equity than they really have. Bernanke's concerns in 2005 about mal-investment in the United States resulting from capital inflows from emerging markets have surfaced in emerging markets post-crisis as a result of capital inflows from industrial countries.
Have crises in emerging markets in the 1990s been transformed into crises in industrial countries in the 2000s and once again into vulnerabilities in emerging markets in the 2010s,as countries react to the problem of inadequate global demand by exporting their problems to other countries? The "taper tantrum" in July 2013 certainly seemed to suggest that emerging markets that ran large current account deficits were vulnerable once again. Is the world engaged in a macabre game of musical crises as each country attempts to boost growth? If possibly yes, as suggested by the previous discussion, how do we break this cycle?
GOOD POLICIES…AND GOOD BEHAVIOUR: In an ideal world, the political imperative for growth would not outstrip the economy's potential. Given that we do not live in such a world, and given that social security commitments, over-indebtedness, and poverty are not going to disappear, it is probably wiser to look for ways to enhance sustainable growth.
Clearly, the long-run response to weak global growth should be policies that promote innovation as well as structural reforms that enhance efficiency. Given that growth within countries is poorly distributed, policies that improve the domestic distribution of capabilities and opportunities without significantly dampening incentives for innovation and efficiency are also needed.
In the short run, though, the need for sensible investment is paramount. In industrial countries, green energy initiatives such as carbon taxes or emission limits, while giving industry clear signals on where to invest, also have the ability to move the needle on aggregate investment and help long-run goals on environment protection.
Most emerging markets have large infrastructure investment needs. We still need to understand how to improve project selection and finance - too much public sector involvement results in sloth and rent-seeking, too much private sector involvement leads to risk intolerance and profiteering.  Going forward, well-designed public-private partnerships (PPPs), drawing on successful experiences elsewhere, should complement private initiative.
The Australian Presidency of the G 20 created a welcome mechanism to share best investment practices across countries. At the same time, we must recognise that large-scale investment projects need patient risk capital, which is in short supply in emerging markets. Private investors rarely have the risk tolerance that governments or multilateral institutions have. So, in addition to knowledge sharing, global growth would benefit from an augmentation of the capital base of multilateral institutions like the World Bank, the African Development Bank, and the Asian Development Bank, so that they can provide part of the patient risk-tolerant capital the emerging world needs. Despite competing domestic demands, industrial countries should recognise the important catalytic role that the development banks can play and help bolster their capital. At the very least, they should not stand in the way of others augmenting capital and taking more ownership.
Clearly, sensible investment has a much better chance of paying dividends when macroeconomic policies are sound. And such policies are easier when the adverse spillovers from cross-border capital flows are limited. This may require new rules of the game for policy making.
NEW RULES OF THE GAME? How do we focus on domestic demand creation and avoid this game of musical crises with countries trying to depreciate their exchange rate through sustained direct exchange rate intervention or through unconventional monetary policies (where demand creating transmission channels are blocked)? It might be useful to examine and challenge the rationales used to justify such actions.
Rationale 1: Would the world not be better off if we grew strongly?
Undoubtedly, if there were no negative spillovers from a country's actions, the world would indeed be better off if the country grew. But the whole point about policies that primarily affect domestic growth by depreciating the domestic exchange rate is that they work by pulling growth from others, not creating growth for others.
Rationale 2: We are in a deep recession. We need to use any means available to jumpstart growth. Once we get out of recession, the payoff for other countries from our growth will be considerable.
This may be a legitimate rationale if the policy is a "one-off" and once the country gets out of its growth funk, it is willing to let its currency appreciate so that it absorbs imports, thus pulling other countries with it. But if the strengthening currency leads to a continuation of the unconventional policies as the country's authorities become unwilling to give back the growth they obtained by undervaluing their currency, or if the strengthening currency leads to greater domestic political clamour about foreign countries undervaluing their currencies, this rationale is suspect. Moreover, policies that encourage sustained unidirectional capital outflows to other countries can be very debilitating for the recipient's financial stability, over and above any effects on their competitiveness. Thus any "one-off" has to be limited in duration.
Rationale 3: Our domestic mandate requires us to do what it takes to fulfil our inflation objective, and unconventional monetary policy is indeed necessary when we hit against the zero lower bound.
This rationale has two weaknesses. First, it places a domestic mandate above an international responsibility. If this were seen to be legitimate, then no country would ever respect international responsibilities when inconvenient. Second, it implicitly assumes that the only way to achieve the inflation mandate is through unconventional monetary policy (even assuming UMPs are successful in elevating inflation on a sustained basis, for which there is little evidence).
Rationale 4: We take into account the feedback effects to our economy from the rest of the world while setting policy. Therefore, we are not oblivious to the consequences of unconventional monetary policies on other countries.
Ideally, responsible global citizenship would require a country to act as it would act in a world without boundaries. In such a world, a policy maker should judge whether the overall positive domestic and international benefits of a policy, discounted over time, outweigh its costs. Some policies may have largely domestic benefits and foreign costs, but they may be reasonable in a world without boundaries because more people are benefited than are hurt.
By this definition, Rationale 4 does not necessarily amount to responsible global citizenship because a country only takes into account the global "spillbacks" to itself from any policies it undertakes, instead of the spillovers also. So, for example, Country A may destroy industry I in country B through its policies, but will only take into account the spillback from industry I purchasing less of country A's exports.   
Rationale 5: Monetary policy with a domestic focus is already very complicated and hard to communicate. It would be impossibly complex if we were additionally burdened with having to think about the effects of (unconventional) monetary policies on other countries.
This widely-heard rationale is really an abandonment of responsibility. It amounts to asserting that the monetary authority only has a domestic mandate, which is Rationale 3 above. In an interconnected globalised world, "complexity" cannot be a defence.
Rationale 6: We will do what we must, you can adjust.
Adjustments are never easy, and sometimes very costly - one reason why Ben Bernanke placed the burden of change in his "Savings Glut" speech outside the United States. Emerging markets may not have the institutions that can weather the exchange rate volatility and credit growth associated with large capital flows - for instance, sharp exchange rate depreciations can translate quickly into inflation if the emerging market central bank does not have credibility, while exchange rate depreciations may be more easily endured by an industrial country.
The bottom line is that multilateral institutions like the IMF should re-examine the "rules of the game" for responsible policy, and develop a consensus around new ones. No matter what a central bank's domestic mandate, international responsibilities should not be ignored. The IMF should analyse each new unconventional monetary policy (including sustained unidirectional exchange rate intervention), and based on their effects and the agreed rules of the game, declare them in- or out-of-bounds. By halting policies that primarily work through the exchange rate, it will also contribute to solving a classic Prisoner's Dilemma problem associated with policies that depreciate the exchange rate -- once some countries undertake these policies, staying out is difficult (the country that eschews these policies sees its currency appreciate and demand fall). Exit is also difficult (the exiting country faces sharp appreciation). Therefore, in the absence of collective action, these policies will be undertaken even when sub-optimal, and will carry on too long.   
Of course, with country authorities in almost every industrial country focused on appeasing populist anti-trade anti-finance (and anti-central bank) political movements, there is little appetite for taking on further international commitments. We clearly need further dialogue and public debate on the issues that have been raised, while recognising that progress will require strong political leadership.
INTERNATIONAL SAFETY NETS: Emerging economies have to work to reduce vulnerabilities in their economies, to get to the point where, like Australia or Canada, they can allow exchange rate flexibility to do much of the adjustment for them to capital inflows. But the needed institutions take time to develop. In the meantime, the difficulty for emerging markets in absorbing large amounts of capital quickly and in a stable way should be seen as a constraint, much like the zero lower bound, rather than something that can be altered quickly. Even while resisting the temptation of absorbing flows, emerging markets will look to safety nets.
So another way to prevent a repeat of substantial emerging market reserve accumulation, this time for precautionary rather than competitive purposes, is to build stronger international safety nets. For instance, one possibility is an unsolicited liquidity line from the IMF, where countries are pre-qualified by the IMF and told (perhaps privately) how much of a line they would qualify for under current policy - with access limits revised in the annual dialogue the Fund has with a country, and any curtailment becoming effective six months later. Access to the line would get activated by the IMF Board in a situation of generalised liquidity shortage (as, for example, when policy tightening in source countries after an extended period of low rates causes investment managers to become risk averse).  
In turn, the Fund could finance this liquidity by intermediating swaps with central banks (and thus guaranteeing central banks against default). Such proposals allow countries access to liquidity without the stigma of approaching the Fund, and without the conditionality that accompanies most Fund arrangements, and thus are more likely to be acceptable as precautionary measures.  It would also be a useful exercise for the Fund, in a period of growing vulnerability to capital flow reversals, to determine those countries that do not have own, bilateral, regional, or multilateral liquidity arrangements to fall back on, and to work to improve their access to some safety net.
CONCLUSION: The current non-system in international monetary policy is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing and musical crises.
I use Depression era terminology because I fear that in a world with weak aggregate demand, we may be engaged in a risky competition for a greater share of it. We are thereby also creating financial sector risks for when unconventional policies end.
We need stronger well-capitalised multilateral institutions with widespread legitimacy, some of which can provide patient capital and others that can monitor new rules of the game. We also need better international safety nets. And each one of us has to work hard in our own countries to develop a consensus for free trade, open markets, and responsible global citizenry. If we can achieve all this even as recent economic events make us more parochial and inward-looking, we will truly have set the stage for the strong sustainable growth we all desperately need.
A presentation by Dr. Raghuram Rajan, Governor, Reserve Bank of India, at a  Public Lecture on 'Going bust for growth: Policies after the global financial crisis' held on June 11, 2015 in Dhaka and organised by the Bangladesh Bank. Dr. Rajan thanks Dr. Prachi Mishra of the Reserve Bank for very useful
comments and research support.