Saturday, September 15, 2012

Why Ben Bernanke is like "Baasha"/ Rajinikanth

The Federal Reserve's move to undertake QE3 is one of the biggest intellectual and policy shifts in the field of economics.

In this post I try to explain the nature of the policy and how it will work, by using an analogy from a scene from South Indian superstar- Rajinikanth's most famous movie- "Baasha". Watch the total kvlt scene below (unfortunately could not get a clip with subtitles, but like several Rajini scenes you can figure out what's going on even if you don't speak the language)

So here's what happens in the scene: The girl (Rajinikanth's sister) goes to the owner of a medical college to seek admission. He then lewdly propositions her; she then goes crying to Rajinikanth, who joins her for the next meeting with the college owner.

When the guy still doesn't yield, Rajinikanth asks him if he can have a word with him alone. That's when he reveals himself to be "Baasha"- a renowned mafia don. Then you see the other guy abjectly surrendering, saying that Rajinikanth could not just have one seat in the college, but the entire college if he chooses to!

Notice that Rajinikanth does not actually have to do anything- he doesn't have to actually beat up the guy or even explicitly threaten him.  In fact once he knows that it is "Baasha", the rational reaction is to give him whatever he wants without putting up a fight, since resistance would be a costly exercise in futility. Hell, it's Rajinikanth, who could win a fight with him!

Ben Bernanke's strategy to solve the unemployment crisis (based on a revolutionary new policy framework in economics called "market monetarism")  is based on a similar idea.

In a recession of the kind that we see in the US now, the essential problem is a shortfall of demand- that people are not spending. This becomes a self-reinforcing cycle. As an example, if I own a cement factory, I will not produce much during a recession since people are not constructing homes; because I am not producing cement I don't employ too many people in my factory- leading to unemployment; this unemployment means people do not have enough money and hence will not construct homes, which means I will not produce cement, hence the cycle continues.

Hence we get stuck in a recession because people in the market have low expectations of demand. When people act as if there will be low demand, it becomes a self-fulfilling prophecy.

So what can we do to change people future expectations of demand?

Well the only entity that can do so is the Federal Reserve- an entity which is nearly as powerful as Rajinikanth!

Here's how it works.

Step 1: The Federal Reserve explicitly lays out its goal. Here the goal is to grow the economy by a certain rate to ensure that unemployment reduces (just as Rajinikanth makes it clear that he really really wants that medical seat)

Step 2: The Federal Reserve then hints at what it will do if the goal is not reached. In Rajinikanth's case the hint was that he would beat up the guy, in the Fed's case it is that they would 'print money' to buy mortgage backed securities to lower long term interest rates to encourage spending

Remember the Federal Reserve has unlimited power to print money, just as Rajinikanth has unlimited power to beat people up. Resistance is futile, you might as well expect that the superpower will achieve what he/it wants and behave accordingly.

Then the superpower doesn't even have to carry on it's threat! Rajinikanth does not actually have to beat up the guy...the Federal Reserve did not buy a single mortgage backed security, yet stock prices still went up!

The reason is that the cement manufacturer now knows that he may as well accept the fact that we are going to have higher demand. This is because if the Federal Reserve does not get the demand it wants in the economy, it is going to print money and buy cement itself! (albeit indirectly). The Fed can print enough money to buy over the whole world- so it's a credible promise/threat that it will increase demand

Given that there is going to cement demand in the country it's the rational thing for me to produce cement; which means I will employ people in my factory; which means they will have money to spend, which means they will construct homes, which means that I need to produce cement. The hitherto negative spiral is converted to a positive one. The market acts as if the monetary infusion has already taken place, and then the monetary infusion is hardly required! (hence the name 'market monetarism')

Never take on Rajinikanth. Never take on the Fed. Assume that they will get what they want, and change your behavior accordingly, resistance is futile.

Why I find this appealing than fiscal stimulus (i.e. the Government spending to increase demand in the economy), apart from grounds of economic ideology (which is that it involves Government interference in the economy which as a libertarian I am opposed to) , is it's beautiful aesthetic symmetry. Recessions are caused due to low expectations, hence what you need to do is to change expectations. Fiscal stimulus means you have to actually interfere, a 'market monetary' stimulus involves just credibly promising/threatening to interfere, that's enough to change expectations.

Market monetarism started as an idea proposed by a few intrepid bloggers- Scott Sumner, David Beckworth, Nick Rowe etc. and has now become Fed policy. We are witnessing one of the most consequential shifts in how we conceptualise the roles of institutions such as the Fed in the economy. These ideas require to be understood and popularised in the wider public so that we have more public discourse about these policies.

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