Author: shyam

In my recent post Game Theory: Rajan vs. Government, we saw how the ideal relationship between the central bank and the government is one where neither party gets what it wants, but there’s a stable outcome. Here are a bunch of articles that expands on the conundrum faced by a central bank.

Interest rate policy is a poor substitute for good regulation

“Monetary policy faces significant limitations as a tool to promote financial stability,” Ms. Yellen said in an event at the International Monetary Fund in Washington. “Its effects on financial vulnerabilities … are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment.”

Source: Janet Yellen Signals She Won’t Raise Rates to Fight Bubbles

Andy Haldane: Financial markets are nuts

Andy Haldane, the Bank of England’s chief economist, explains that central banks have “grown a new arm, macro-prudential regulation” to prevent the markets becoming over-egged with risk.

He cites the BoE announcing measures to prevent the housing market overheating, last week.

The financial markets today are nutty, but they’d be nuttier if central bankers hadn’t acted in the way they did since the collapse of Lehman Brothers.

Source: Andy Haldane agrees markets are ‘nuts’

Trilemmas breed instability

• A country can have a fixed exchange rate, free movement of capital or independent monetary policy, but not all three.
• Countries cannot simultaneously pursue democracy, national self-determination and economic globalisation.
• It is impossible to combine financial stability, internationalised finance and national sovereignty.
• Health systems have to choose among the “three Cs” — cost, coverage and choice.

There are very few “right” answers. All policy decisions involve trade-offs. Different generations of politicians (and voters) will favour different solutions.

Source: Three’s a crowd

Came across this incredible paper by Alan S. Binder, Issues in the Coordination of Monetary and Fiscal Policy, 1982 that uses game theory to explain the relationship between a country’s central bank and the government. It seemed appropriate, given that Raghuram Rajan, the RBI governor, is the same for both the UPA-2 and NDA governments, to study the options before both Rajan and the NDA in framing their relationship.

The paper was written when Regan was the President and Volcker was the chairman of the Federal Reserve. Inflation in 1980 had soared to 13.5% and Volcker had raised the federal funds rate to 20% by June 1981.

The feeling that Rajan and the government are at cross-purposes are echoed in the paper’s introduction:

But how is this game played?

The game being played

The players in this game is Rajan, who sets interest rates, and the politicians, who determine the mix between government spending and tax revenues. Rajan thinks that the control of inflation is his primary responsibility and he’s anyway appointed for a fixed tenure. The politicians, on the other hand, have elections to win, which leads them to favor economic expansion over economic contraction.

The object of the game is for one player to force the other to make the unpleasant decisions. Rajan would prefer to have tax revenues exceed spending rather than to have the government suffer a budget deficit. The politicians, who worry about being elected, would prefer Rajan to keep interest rates low and the money supply ample. That policy would stimulate business activity and employment.

The preferences matrix

There are 3 decisions in front of each player: contract, do nothing, or expand. The numbers above the diagonal in each square represent the order of preference of Rajan; the numbers below the diagonals represent the order of preference of the politicians.

The highest-ranked preferences of Rajan (A, B, and D) appear in the upper left-hand corner of the matrix, where at least one side is contractionary while the other is either supportive or does nothing to rock the boat. The three highest-ranked preferences of the politicians appear in the lower right-hand corner (F, H and I).

End game

Assuming that the relationship between Rajan and the politicians is such that collaboration and coordination are impossible, the game will end in the lower left-hand corner where monetary policy is contractionary and fiscal policy is expansionary. If Rajan cannot persuade the politicians to run a budget surplus and that the politicians cannot persuade Rajan to lower interest rates, neither side has any desire to alter its preferences nor can either dare to be simply neutral. As long as Rajan is contractionary and the politicians are expansionary, both sides are making the best of a bad bargain. And this is where we were under UPA-2.

The challenge, is to shift the play to the upper right hand corner. Here, neither side is “happy”, but this is the best case scenario – things are stable. This outcome is known as a Nash Equilibrium.

The Nash Equilibrium

Under the Nash Equilibrium the outcome, though stable, is less than optimal. Both sides would obviously prefer almost anything to this one. Yet they cannot reach a better bargain unless they drop their adversarial positions and work together on a common policy that would give each a supportive, or at least a neutral, role that would keep them from getting into each other’s way.

Will the budget provide the push to get us to the upper right hand corner? Only time will tell.

Sources:

• Issues in the Coordination of Monetary and Fiscal Policy (pdf)
• Early 1980s recession (Wikipedia)
• Against the Gods: The Remarkable Story of Risk (Amazon)