Liquidity — The Plasma For An Ailing Economy
Netflix’s Money Heist (La Casa De Papel) gave us all a lesson on money– central banks across the world are pulling off the biggest heist and that too in broad daylight! The Professor managed to justify the robbery of the Royal Mint of Spain and turned the cop into an alias, just with the elucidation that the so called ‘liquidity injections’ by the European Central Bank are nothing but creation of money out of nowhere, that goes right into the pockets of the rich.
So how is it that printing money right under our noses is considered legal? The term is ‘Quantitative Easing’. Besides the fact that the increasingly cashless economy we are in does not require central banks to ‘run a printing press’ per se; quantitative easing has been used as a monetary tool to boost the economy during recession and create liquidity; by not just the European Central Bank but also the Federal Reserve, Bank of England, Bank of Japan and more.
Earliest in history, the Great Depression of the 1930s gave rise to Quantitative Easing. In 2006 when the housing bubble in the United States popped, began the Great Recession where we saw a rerun of this unconventional monetary policy. Citizens across the globe ended up as mere ‘collateral damage’ for the banking system. But this policy isn’t ill-founded, it is in fact based on the Quantity Theory of Money by John Maynard Keynes which states that prices depend on the supply of money which is relative to the quantity of goods and services sold. However, the theory fails to address the role of ‘expectations’ by people in modern economies. People’s guesses regarding the situation in the future influence every aspect of the economy. Given the severity of the 2008 crisis, central banks concluded that conventional monetary policies would not suffice and greater stimulus was needed and went ahead with injecting money into the economy. Wishful thinking by countries that a dose of inflation will lead to economic growth instead of long-term stagnation is still highly disputed by economists globally.
The Covid-19 pandemic has tipped the world economy into a recession. But is this crisis the same as The Great Recession? The last time a non-financial crisis caused a severe global economic contraction was the Oil Embargo in the 1970s. Do non-financial crises like the Oil Embargo and now the Covid-19 pandemic require the same measures as a financial one? In the current situation, the usual financial solutions by policy makers alone are not enough, but instead they also need to be supplemented by effective policies that address the healthcare issue directly. While stringent austerity measures seem plausible on the government’s end, doing so has disrupted economic activities across most industries at various levels. Financial institutions are facing a credit crunch and liquidity issues. The breakdown of the supply chain has led to a visible contraction in the demand side which eventually functions as a catalyst for a vicious cycle of further reduction in supply until the government intervenes to get the demand flowing.
Prime Minister Narendra Modi mentioned 4Ls in his recent speech — Land, Labour, Law & Liquidity. Although the first three are long term measures, liquidity perhaps is the one which is pertinent to reviving the economy. But the only solution to extricating the economy of an impending liquidity trap instantly is demand, demand and more demand! As part of the Rs 20 lakh crore economic package by the Modi government, Finance Minister Nirmala Sitharaman introduced various liquidity boosting measures for MSMEs, NBFCs & DISCOMs including collateral free loans, equity infusion, subordinate debt etc. as a strong push for achieving self-reliance as a nation. Survival of MSMEs is critical to the economic growth as they employ over 110 million people and contribute to 1/3rd of the economy. Although these measures played a big role in providing relief and kickstarting business operations, they do not result in immediate fiscal effects for the government.
During Raghuram Rajan’s tenure, RBIs liquidity revamp was perceived by some as the ‘Indian Style Quantitative Easing’. This is because the relationship between Central Bank and Liquidity Management is often interpreted as some form of quantitative easing. The explanation to this puzzle is the distinction between short-term and durable liquidity. The liquidity injection strategy ensured that the Weighted Average Call Rate (WACR) was close to the policy repo-rate, which in turn increased dependency on injecting short-term liquidity, even though a more durable liquidity was called for. Although currently the bank liquidity is in a surplus position; to mitigate the impact of Covid-19 and revive growth on a sustainable basis, RBI needs to ensure durable liquidity in the banking systems.
“But the resource of these borrowings which gives a present ease comes to a bad end and is a fire of straw. To revive a State, it is needful to have a care to bring about the influx of an annual, a constant and a real balance of Trade.”
— Richard Cantillon
Richard Cantillon, an 18th century economist warned that there are greater consequences to increasing liquidity, those which reach far beyond the realms of financial systems. In Cantillon’s times money was gold and the closer you were to the king, the more you benefited; coined as the Cantillon Effect in 1700s, it simply meant money is not neutral. Translated to the modern economies, this basic theory remains. The rich become richer and the poor become poorer. Jeff Bezos’s wealth soared by $20 billion so far this year, Elon Musk got $50 billion richer but the bottom half of our global population lost their jobs and is struggling to survive. This is a testament to how increasing liquidity has redistributive impacts on income, consumption and wealth.
Boosting liquidity is required but it isn’t enough. The government’s measures towards MSMEs & NBFCs are welcome, but there is a need to distinguish between illiquidity and insolvency. To increase consumption the government needs to put money in the hands of the people. Aggregate demand has taken a fall and the need of the hour is to increase the purchasing power of the people. The migrant workers who have been the worst affected by the pandemic need immediate attention. Although the PM Cares Fund is meant to be allocated to these workers, it is imperative to ensure that this money reaches the intended beneficiaries. The informal economy needs to be the addressed — the lowest economic strata across India must be enabled to initiate spending and set the ball rolling. The huge hit from the pandemic this year was cushioned by the agricultural sector, the only sector to have shown a positive trajectory. As an agricultural economy, a greater number of reforms focusing on the agricultural and allied sectors are crucial and need to be implemented on priority.
The dichotomy between monetary and fiscal policy is a hassle. Monetary policies impact demand whereas fiscal policies impact supply. In the Indian economy where output is determined primarily by demand, this would ideally lead to inflation. Hence a cooperative strategy is required to strike a balance between these two to create an effective policy which lifts an ailing economy. The extreme shocks due to Covid have given rise to coordination between these two policies, as the focus of financial institutions around the world is on growth which has now proved to be a common ground for both fiscal and monetary policies to work on.
Covid-19 brings to question if globalization has gone too far. It has pushed the economy into a tailspin, exposed the weak infrastructure and enfeebled our existing vulnerabilities. This has brought to light the need for resilient supply chains which could have sustained the blow to aggregate demand. What this crisis also points to is the need for universal basic income to prevent a major chunk of this section being pushed into poverty traps every time a crisis ensues. A creative policy which aligns demand with supply will mitigate the chances of inflation and aid in recovery of the economy. But in the long term, new institutional arrangements are critical to balance between economic and social systems to act as shock absorbers and not amplify the gap between various strata of an ailing economy.
