'It's a very tough time to be a central banker,' says Douglas Diamond, Nobel Laureate in Economics for 2022

Douglas W. Diamond, often called the founder of modern banking theory, won the Nobel Memorial Prize in Economic Sciences in 2022 for path-breaking research aimed at enhancing the understanding of the role of banks in the economy, especially during financial crises. The 69-year-old Merton H. Miller Distinguished Service Professor of Finance at the University of Chicago,s Booth School of Business shared the prize with economists Ben Bernanke of the Brookings Institution and Philip Dybvig of Washington University in St. Louis. Over a video call with Business Today's Anand Adhikari, Diamond shares his views on the developing economic situation around the world and its implications for India. Edited excerpts:

Q: What is the long-term impact of higher inflation, higher interest rates, and the strengthening of the dollar in emerging markets, particularly India?

A: I have always thought about long periods of low interest rates in the US and other countries—as well as quantitative easing—as potentially excessive injections of liquidity, leading to expectations among financial institutions and firms that interest rates might stay close to zero forever. I thought there were some financial stability issues with that, as there was too much reliance on short-term debt. That’s the backdrop. I think that maybe they went too far in both Europe and the US by keeping interest rates where they were, and not thinking ahead enough about building up a big balance sheet and how difficult it would be to unwind that. That sets up vulnerabilities in the financial sector, including stability issues.

Now, we need to figure out how to stop the inflation and stop inflation expectations… we need to withdraw some liquidity. We need to raise interest rates. The metaphor is that we need to be pushing harder and harder on the brakes, rather than slamming on the brakes. If you slam on the brakes, then you can get two things—[one,] you can get financial instability, like we saw in the UK and their insurance sector; [and two,] if there is a large, unexpected tightening, emerging markets will suffer.

Developed markets like India that are almost ahead of everybody else and have exchange rates that float around relative to each other based on interest rate spreads… [are affected] throughout the rest of the world. And I am pretty convinced that the Federal Reserve cares about that as it reflects back on the US. Many people think that this [interest rates] should be coordinated across countries; my co-author Raghuram Rajan certainly thinks that’s something that should be coordinated. [If] we have the US stepping on the brakes too hard, it will potentially cause problems—the US hasn’t yet, but I believe it will—and that will almost certainly cause problems in the rest of the world... I couldn’t say they’re doing the wrong thing right now; they need to tighten, but they need to do it in a measured, predictable way.

Q: Global central bankers will do what is best for them. How should a country like India tackle this issue so that the gap in interest rates with the US does not widen?

A: It’s a tough time to be a central banker anywhere, but particularly if you’re not the US, and you have to respond to US policy. I would be particularly concerned about the financial stability issues in countries outside the US. If you allow the exchange rates spread, particularly the real interest rates spread between the real interest rates after inflation in India and the US, to get really big, that’s going to make the US currency go up relative to the rupee. And that’s not going to be great for anybody. So, they have to, in some sense, follow the US; they probably want to be a little more measured, but they have to follow interest rates up, which means you have to tighten your own. Your central bank basically has to tighten unless it wants a huge exchange rate change. And the exchange rate change can help your exporters, but that’s going to hurt your consumers. And you’ve got to get the right balance between those. So it’s a difficult time to be a central banker, and I believe the world will have to raise real interest rates.

Q: As far as financial stability is concerned, Indian banks have cleaned up their balance sheets. The corporate sector is also deleveraged. Banks are focussing on high rated corporate and retail borrowers. What kind of risk could the Indian markets and financial stability face in the future?

A: Let me give you the global answer. Partly because of improvements in thinking about what bank regulation is about, and thinking about systemic, macro, and macro-prudential risks, commercial banks worldwide are in a very resilient position, with higher capital buffers than in the past.

In the rest of the world, and maybe it’s true in India, the vulnerabilities are in the non-bank sector—shadow banking and the companies themselves. In 2008, all of the problems started and pretty much stayed in the financial sector… If you look at the US and Europe, you see that the financial sector is in better shape than it was [then], but the corporate sector is in worse shape. I wish I knew more about the Indian economy to give you a local answer, but the most likely place is a surprising part of the system outside of the banking sector. And that part, unsurprisingly, could be corporations. We thought corporations would be a problem in 2020 because they would have to close businesses and lay off employees. But then in the US at least, they basically threw everything in terms of liquidity, forgivable loans, and other things at companies. As a result, corporate defaults fell in 2020 and 2021. Some of that may come back now, because some of those lifelines given to the companies have been removed. And businesses that built up a lot of debt in that period, particularly short-term debt, like leveraged loans as they call them, can be particularly vulnerable.

Q: The RBI has missed the 6 per cent inflation target for three consecutive quarters. We are witnessing this for the first time, as we started the inflation targeting regime only six years ago. Are these kinds of breaches common in global markets? How should our central bank deal with this, given that the RBI’s credibility as a monetary authority with inflation targeting will be called into question?

A: In principle, inflation targets are right and quite a good idea. If you are trying to control inflation, you need something that you can hold out to say, ‘Here is my success or failure.’ In the US, the central bank has two mandates: they are supposed to keep inflation under control and keep unemployment under control. It’s hard to do both at the same time, and they were persistently below their inflation target for a long time. And then eventually, they started to believe that inflation has gone. So, they started to leave interest rates lower and real interest rates incredibly low for a long time. But I think the fact that they felt like they had to do something about their target was good. I think the inflation target in the US [2 per cent] is a bit too low—3 per cent is a better number.

Q: India is passing through a stage where the borrowings are at record levels, fiscal deficit is high and debt to GDP is also at an elevated level. How should India handle its debt management strategy?

A: It’s not just a central bank problem. It’s monetary and fiscal [problems] together; you have got to make sure that the people expect that the real value of the debt will be paid off. And that’s the way to stop fiscal inflation. You have got to make sure that they are not printing crazy amounts of money—that’s the monetary thing. And they’re not two issues attached at the hip—they’re very much the same issue. So, both fiscal and monetary credibility needs to be restored if you want to keep inflation from becoming an issue. If inflation is under control in India, they should hold on to that.

They developed this thing called the modern monetary theory that basically says that you can borrow as much as you want, and it doesn’t—as long as interest rates are zero—cause inflation. So that theory is true, as long as nobody believes it’s true. But once you start to use that [theory in practice], then it ceases to be true, because monetary and fiscal are all tied together. And they are also tied to financial stability. So, it’s a very hard time to be a central banker in the world, partly because you are into the region where financial stability is coming into question—we are not there yet—and I think central bankers understand financial stability quite well. But because the central bankers don’t control the fiscal part [that is]… too loose worldwide, it is a tough time.

Q: India recently displaced the UK as the world’s fifth-largest economy. Given our size and growth, the Indian economy will soon emerge as the third-largest one. But the big worry is per capita income. What is the right policy prescription for India to increase per capita income?

A: That is a very hard one because clearly you want to have financial stability. If you want to continue to be a growing economy, you can’t have marginal tax rates on workers to be too high. You [also] don’t want to run huge deficits. You need freer labour markets, but you need to make sure people are not being let go. Somehow, India has been doing well over the last few decades, so things are succeeding in India, [and it has] become a proud economic powerhouse. How you continue—you’re in the later stages of development [and] have a mature economy that’s rapidly growing—is the easy thing.

[These are] the early stages of development, [and] there are lots of easy things [to do, like] redeploying labour into more productive uses, having people leave agriculture—but you’re already through most of that stage. Now you’re in the middle of the development period, which is the one that’s very challenging.

Q: What are the risks in lending to retail borrowers with a new set of lending emerging—such as microfinance, consumer durables and buy now, pay later, among others?

A: Retail [lending] is difficult. It doesn’t have the big default risk of corporate loans—you get lots of little defaults. And based on data from 2008 of lots of mortgage lending in countries around the world, there is substantial risk of getting households having too much debt. And if households have too much debt and then things [in the economy go south], then households have to cut their spending, and you get waves of defaults. Household debt very much depends on economy-wide risks. If you’re going to go into a big recession, you’re going to see lots of household defaults. And then the thing we learnt—there’s lots of evidence which Professors Amir Sufi, Atif Mian and my colleagues have shown—that when you get to that stage, and households [that don’t default] start to cut back [expenses] to pay their loans, that can make the recession much worse.

In terms of thinking about macro-prudential regulation of banks, you have to make sure they are not overextending. I think the thing we’ve learnt the most from the 2008 period is that household leverage and household debt is just [as], if not more, dangerous than excessively leveraged firms.

Q: Is there risk from the higher interest rate cycle, especially for household debt?

A: People like to say that banks make floating rate loans so they’re hedged. But if you raise the interest rate above what the borrower can pay, you turn interest rate risk into default risk for household debt, [and] that’s a problem because lots of households borrow for consumption purposes. When you borrow for consumption purposes, you don’t have any collateral to sell if the interest rate goes up. So there’s a limit to how much you can raise the interest rate on household debt. I’m hoping that the supervisors and regulators in India have carefully looked at what the household debt cycle of the previous crisis in the world [was]. India was protected from that because household debt was less of a thing in the country in 2007. Now that it is a thing, too much household leverage is much more likely to cause a big recession than too much corporate leverage, particularly as long as the bankruptcy system works. You can deal with corporate leverage; [but with] household leverage, not so much because there are no assets to seize. And if people stop spending because they have to pay their debts, the economy collapses.

Q: India set up a separate institutional framework by having a bad bank to deal with stressed assets. Do you think this is the way to deal with stress in the banking system?

A: The bad bank system doesn’t really get rid of the problem; it just makes it transparent where the problem is, so it doesn’t pollute the balance sheets of the good bank. I think good bank-bad bank is an effective way to deal with the problem. It’s not really a solution… it’s more like mitigation. But the world’s experience seems to be that good bank-bad bank is much better than just bailing out the banks. If you don’t have good bank-bad bank, all your banks are bad. The good thing about good bank-bad bank is you can isolate the problem. [But] you still have to resolve the problem. It’s still going to be very difficult to recover much for the bank, but it is a step in the right direction.

@anandadhikari

This interview took place before India reported a CPI inflation print of 5.88 per cent in November 2022