Tuesday, 2 November 2010

Apropos Quantitative Easing

What passes these days as monetary policy in the US and in the Eurozone is going to be a complete disaster for developing countries. Just think for a second what the taboos are is that emerging markets politicians cannot touch when it comes to monetary policy. Surely, the independence of the central bank is going to be top of anyone's list.

How do you build an efficient central bank in a developing country? First you push through some laws that make sure that a legal framework is in place that ensures–at least in principle–the institutional independence of the central bank. Then you select a few, talented, young local economists, and ferry them away to good university somewhere in the West and teach them macro, monetary theory. (I was probably one of these guys.) Then you lure them home, and they start filling in the institutional space you created at the beginning. If at the same time the country is going through a development phase, then probably the banking sector is growing up, the financial markets are emerging. Thus you not only have a central bank, with some people who know what monetary policy means, but you also have a monetary transmission mechanism of sorts. If you throw in and able IMF rep, then probably the country is on the right track.

The point here is that at the heart of this process is the taboo that stops politicians meddling with the centre bank. Developing country politicians will always want to meddle with the central bank. In fact every politician will always want to meddle with the central bank. But in developing countries the checks and balances that would stop them from doing so are not there. Hence the taboo.

It will be very difficult to convince governments facing elections in difficult economic circumstances that they should respect the independence of the centre bank, and not expect monetary policy to find its raison d'être in financing pre-election fiscal expansion, while at the same time the Fed and the ECB store up on government bonds.

A whole decade of capacity buildup in developing countries is being thrown into the rubbish bin these days.


  1. Oh, from the first sentence I thought you were going to elaborate on the QE -> carry trade -> risk of sudden stops / capital flights issue.

    On your point: in theory this seems correct but I doubt there are many voters, or indeed polititians in emerging markets that care about the relationships of western governments and CBs.

    In fact Hungary's recent experience shows only a tiny minority of voters have ever heard of CB independence at all.

  2. You are right: the EM policy debate (let alone a budget fight) does not usually include lengthy arguments about the relationship between western governments and central banks...

    But, I am not sure if this invalidates the point of the post. EM central banks tend to copy policies from the west, and from the US, in particular. The Fed has been more than just another central bank: it is the only global opinion leader in monetary matters, and that includes the policy toolbox. If you are a research director of an EM central bank, and you feel that you should provide arguments against QE, it is tough to do so if all your opponents have to do is to point at the US (and the ECB). Look they are doing QE, and say it works (ha!), we should do the same! In EM terms, that's bankrolling the government.