The Economist - USA (2020-02-08)

The EconomistFebruary 8th 2020 Finance & economics 67

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Buttonwood Two tribes

S

hove hardand any group can be

sorted into contrasting stereotypes:

larks and owls; thinkers and doers; con-

servatives and progressives. Shove again

(or simply stir), and you have the mak-

ings of a clash. There is a culture war of

this kind even in finance. The two bick-

ering tribes are economists and practi-

tioners, such as traders and fund manag-

ers. Economists use formal models based

on theory. They are rigorous, sometimes

to the point of pedantry. Practitioners’

thinking is looser and more intuitive.

The battleground, invariably, is mon-

etary policy and its effects. To outsiders

their latest spat—over whether the Feder-

al Reserve’s large-scale purchases of

Treasury bills since October counts as a

stealthy revival of quantitative easing

(qe)—seems obscure. Yet it is part of a

broader question that has important

implications. For a vocal group of pract-

itioners, central-bank policy has grossly

distorted financial markets for a decade.

For central bankers and their economist

outriders, asset prices are a sideshow.

Who is right? Everybody likes to think

they exhibit the best attributes of both

schools—the rigour of the economist and

the market-smarts of the practitioner. In

fact they may borrow the worst habits

from each. So, allow Buttonwood to walk

into the trap that has been set for him:

both camps are wrong.

There is certainly no love lost. For

economists, a lot of market talk is shal-

low and naive. A decade ago a charge

heard mainly from practitioners was that

qewould lead to hyperinflation. The

context seemed not to matter: that qe

was pushing against powerful deflation-

ary forces; that the huge increase in

central-bank reserves met a deep need in

financial markets for safe and liquid

assets. Central bankers and economists

have not been forgiven for getting that one

right. Yet it also the case that a lot of cen-

tral-bank speak is disingenuous. One of

the many talents of Mario Draghi, the

former head of the European Central Bank,

was to keep a straight face whenever he

claimed the sole aim of the ecb’s bond-

buying programme was to meet its in-

flation mandate. Why, you would be a fool

to think that capping borrowing costs for

indebted euro-zone countries, or devalu-

ing the euro, was the goal.

Mr Draghi is excused, because his

policies kept the euro zone intact. But the

slipperiness of the Fed is a harder for

practitioners to stomach. The roots of their

latest spat go back to the end of 2017, when

the Fed began to reverse qe. It was keen to

put the process on autopilot, shedding so

many bonds from its balance-sheet each

month. This would be plain sailing, it said.

Many practitioners were unconvinced.

The markets had got used to functioning

with ample central-bank liquidity. Sure

enough, last September, money markets

were suddenly short of cash. Overnight

interest rates spiked. The Fed responded

by liberally lending overnight cash. It has

since bought truckloads of t-bills. Its

balance-sheet, which had shrunk from

$4.5trn to $3.8trn, has been expanding

again ever since. Reserves are up,

shrieked the practitioners. qeis back!

Case closed? Actually, no. The Fed has

not admitted it screwed things up, which

is galling. But it is nevertheless quite

correct that the remedy it has fixed on is

not qe. When the Fed adopted the policy

after the financial crisis, it had run out of

room to cut short-term interest rates,

and so decided to drive long-term in-

terest rates down by buying longer-dated

bonds. The goal was to extend the stim-

ulative effect of monetary policy by

depressing the term premium—the

reward investors get for holding long-

term bonds instead of a series of short-

term bills. In essence, it was a swap of

cash for assets. This is very different

from what the Fed is now doing. It is

essentially swapping cash (central-bank

reserves) for its closest substitute (t-

bills) in order to keep the Fed’s key policy

instrument (short-term interest rates)

where it wants it to be. This is monetary

policy as described in textbooks. It is not

qeby the back door.

The practitioners are paying the Fed a

strange compliment. They attribute an

almost mystical quality to the size of its

balance-sheet. In fact central banks are

mostly responding to events, not shap-

ing them. Despite some extraordinary

monetary loosening, inflation has hardly

budged. In their own peculiar ways,

practitioners and economists are anx-

ious about what this long period of low

interest rates might eventually entail.

The economists deal with the uncertain-

ty by clinging to their models; the market

types by trashing the economists. qeor

not qeis not really the question.

The culture wars between economists and Wall Street

sharks, who charge at least 4% a

month—60% a year—and sluggish state

banks. Ujjivan charges 22% a year for group

microfinance, 18% for micro- and small

businesses, and 12% for housing. This, of

course, is still steep. The spread between its

lending and funding costs is 11%. For many

large banks, the figure is less than 3%.

Inevitably, that will contract, if only be-

cause Ujjivan’s success attracts competi-

tion. But for now the costs inherent in mak-

ing small loans might put rivals off. Nine of

the 11 bankers in Ujjivan’s Koramangala

branch spend their days straining to make

15-20 sales calls to customers who may not

understand banking. Better methods may,

however, be coming, particularly because

of the adoption of technology.

India’s government has created identi-

fication cards and payment networks that

make opening accounts easier. Ujjivan is in

the midst of a serious effort to make that

digitised network work for the illiterate—a

large if unquantified proportion of its cus-

tomers—in ways that both broaden the

bank’s appeal and reduce its costs. Already,

its app’s voice-recognition feature can un-

derstand and speak in nine languages,

which will soon increase to 14 and then 22.

This will work in tandem with a picture-

based interface that allows customers to

conduct electronic transactions without

needing to read.

Ujjivan’s success stands in stark con-

trast to much of the rest of India’s financial

system, which is in a slow-boil crisis, with

answers being demanded from large

banks, regulators and politicians. But the

rise of an innovative lender engaged with

poorer customers suggests there are

grounds for optimism, albeit arising from

the country’s slums, not its leaders. 7