TCA Srinivasa-Raghavan: To intervene or not

LINE & LENGTH

Macroeconomics is part of politics, not nature. It is about people, not numbers.

It could happen only in India: even with a growing trade deficit, the rupee appreciates so that the deficit can become larger. Where else would you find this?

Contrast this with the rest of the world to see how unique we are. China has the mother of all trade surpluses and its currency stays more or less constant vis-a-vis the world's reserve currency, the dollar. Japan also has a trade surplus and the yen moves in a direction that is consistent with it. The US has a massive trade deficit and lo! the dollar depreciates. You can see this sort of thing for practically every country in the world.

It is not often that this column devotes itself to something as frivolous as economics. But every once in a while something happens that escapes general attention and needs pointing out, not least to the Taliban elements""those simple minds with a single thought""that have taken to outshouting the discourse and convincing the ignorant.

But these loud chaps forget a simple truth about macroeconomics. It is about people, not numbers.

But what are our mullahs saying? Never mind the trade and current account deficits, they screech, let there be no intervention by the RBI so that the rupee can appreciate. Why? Because this is where ideology takes over: only bad guys intervene, good guys look the other way while the betting goes on.

Well, folks, I have bad news: the world is so full of bad guys that there isn't a single good guy in sight""because even that paragon of market virtue, the US, intervenes, sometimes quite massively, to keep the dollar steady. There is, in fact, a legal requirement that it does so.

Let me quote authority on this. "Several times each day, the foreign exchange trading desk of the New York Fed provides current information on market conditions to the Treasury. Whenever necessary, the trading desk buys or sells foreign currencies on behalf of the Treasury, through the ESF, for intervention purposes" (italics added). That, at any rate, is what the Federal Reserve Bank of New York says. You can check by clicking on http://www.newyorkfed.org/aboutthefed/fedpoint/fed14.html) Or see what the US Treasury has to say:

"The Secretary is responsible for the formulation and implementation of US international monetary and financial policy, including exchange market intervention policy. The ESF helps the Secretary to carry out these responsibilities. By law, the Secretary has considerable discretion in the use of ESF resources." http://www.treas.gov/offices/international-affairs/esf/And what is the ESF? It is the Exchange Stabilisation Fund.

What is special about this Fund? Though the Federal Reserve has no control over it, it serves but one purpose: to influence the external value of the dollar without adding to domestic money supply.

Its size? Around $40 billion.
Who operates it? The US Treasury.
Under whose authority? The US President's.

What does this mean? Basically, covert action when needed. You pretend to everyone that there is no intervention while you do what is necessary, which is what good practice is all about, whatever the policy may be.

Why does the Fund need to be so big? Because the bigger the stick, the harder you can hit.

And why does this need to be done? The reason is as old as the hills: the taxpayer is made to pay for the mistakes that US banks make. Sometimes they over-lend and their loans have to be protected. You can pour as much sugar over this as you want, but at the core you will find only this bitter truth.

Intervention is also necessary to discipline (which is not the same as banning) speculators. The fact that speculation is good does not make all speculators Florence Nightingales. This is the error that ideologues make.

Nations intervene in the foreign exchange market (indeed all markets) to protect what they see as their vital interests. These interests may differ for different countries but the fact of intervention is constant""from, actually, the time of Qin Shi Huangdi, the first emperor of China in 221 BC. (Qin is pronounced Chin, whence China.)

I am highly tempted to give a short lesson on the history of the subject but, relax, I won't. Instead, I will content myself with this suggestion to the mullahs of economics: Look back, and look sensibly""which means not just at post-Bretton Woods time series data. You will find that the domain of economics is not nature but politics.

For starters, you can click on this link: http://www.house.gov/jec/fed/fed/dollar.htm. It gives an excellent insight into the way the Americans think about exchange rates, price stability and the need to intervene in the markets. But what they think is not what they get their acolytes to profess. Therein lies the problem.

India is not different except perhaps in one way: Our problem""of massive capital inflow""is not because of the excellent state of the economy. It is because of lax rules.

This is not to say that all the money that is coming into India is dodgy. But a little over half of it could well be. In that sense, we are no different from other money laundering havens.

So as I see it, the policy issue is not whether the RBI should intervene but if we can afford it not to intervene.