He now can solve he puzzle them.

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Speech

Welcome Remarks by Dr. DeLisle Worrell, Governor, Central Bank of Barbados at the Monetary Policy in Small Very Open Economies Seminar

Welcome Remarks by Dr. DeLisle Worrell, Governor, Central Bank of Barbados

Monetary Policy in Small Very Open Economies Seminar
December 15, 2014

I became aware of Tarron's work in 2008 when I was appointed Executive Director of CCMF. We were looking to fill a vacancy for a Research Fellow, and Professor Ramesh Maharaj, the previous Executive Director, suggested Tarron as an excellent potential candidate. In the event, we were unable to attract him to the Centre, but I have been excited by Tarron's work ever since that first acquaintance.

Tarron does economics the way that the masters of our craft has always done it. They were always motivated by a puzzle arising from their observation or experience. They struggled to resolve that puzzle, and in the process uncovered genuine insight, novel perspectives that provided a solution to the puzzle, and new guidance for the way forward. There is a fascinating book you should all read by Sylvia Nasar, the celebrated author of A Beautiful Mind. The book I refer to is called Grand Pursuit: The Story of Economic Genius. It contains chapters on Karl Marx and Frederick Engels, Alfred Marshall, Stanley and Beatrice Webb, Irving Fisher, Joseph Schumpeter, John Maynard Keynes, Frederick Hayek, Joan Robinson, Milton Friedman, Paul Samuelson, and Amartya Sen. The thing that remains with me from reading this book is the extent to which the insights of these great economists were derived from their lived  experiences, not from theoretical speculation. The theory they developed was in the service of unravelling the puzzles they encountered in real life. Alfred Marshall regarded economics as an engine of analysis useful for discovering truths; for Keynes it was an apparatus of the mind for better understanding reality.

To draw an example from the book, Marshall's works were set against the background of the sensation created by Henry Mayhew, correspondent of the London Morning Chronicle, in articles which provided a picture of the city dwellers' wretched lives in 1849.

Life expectancy was only 31/32 in Manchester and Liverpool, compared to about 45 in rural England in the early 1800s.Marshall’s lectures on the paradox of poverty amid plenty are seen in this context. The cause, Marshall argues, is low productivity. Careful planning, and winning over hearts and minds, are needed for change. Marshall studied the particulars of every major industry, but found the constant efforts at improvement that make for improved productivity were hard to model. He contended that the economic function of the firm is to produce better living standards for consumers and workers, and that it should do so through raising levels of productivity.

It is the motivation, to solve an observed economic puzzle, which makes Tarron's work of a piece with the masters of our discipline. In finding solutions to contemporary puzzles in banking and finance he offers intriguing insights for the content of policy. That is what I find particularly exciting about Tarron's new book, Money, banking and the foreign exchange market in emerging economies.  It address a puzzle that faces every small open economy, with respect to exchange rate and interest rate policy. The standard prescription of flexible exchange rates and interest rate policy geared to control inflation is problematic for the small open economy. If the local currency depreciates it triggers inflation, irrespective of interest rate policy. What should the central bank do? Clearly, pursue policies to protect the value of the domestic currency.

Tarron's book provides the theoretical rationale: “Central banks in emerging market economies have to hold foreign exchange reserves, irrespective of the exchange rate regime, in order to guard against instability and so that the public has confidence in the economic policy. In the short term foreign reserve accumulation drains funds from the domestic banking system; in the longer term, inflows of foreign currency which are bought by the central bank will add to the pool of domestic liquidity. Domestic interest rates are determined by how large this domestic liquidity pool is, relative to the local currency demand for credit by credit‑worthy borrowers. Mopping up this excess by open market operations is best regarded as compensating banks for holding excess cash in domestic currency, to avoid a depreciation of the local currency.  Excess reserves do not cause banks to lend more in local currency. Instead they seek investments in foreign currency, if the domestic interest premium is thought to be insufficient. This action has the potential to trigger an exchange rate depreciation, which has inflationary consequences. Monetary policy affects inflation through the exchange rate channel: if domestic interest rates are set at a level which offers banks adequate compensation on their excess liquidity, the exchange rate is unchanged and inflation remains at the international rate. However, if domestic interest does not adequately compensate local currency holdings, the exchange rate depreciates, aggravating the impact of international inflation on the domestic economy.”

Here we have a novel theoretical perspective which gives policy guidance that makes sense for small open economies, as opposed to what remains the conventional notion, that the exchange rate should not be an objective of policy. In putting forward this alternative interpretation, Tarron has solved a puzzle that has been admitted by no less a person than Olivier Blanchard, the top economist at the IMF and the joint author of a standard economics text book. In a joint paper on "Rethinking macroeconomic policy", published in 2010, Blanchard and his co-authors stated: “For smaller countries, however, the evidence suggests that, in fact, many of them paid close attention to the exchange rate and also intervened on foreign exchange markets to smooth volatility and, often, even to influence the level of the exchange rate.
“Their actions were more sensible than their rhetoric. Large fluctuations in exchange rates, due to sharp shifts in capital flows (as we saw during this crisis) or other factors, can create large disruptions in activity. A large appreciation may squeeze the tradable sector and make it difficult for it to grow back if and when the exchange rate decreases. Also, when a significant portion of domestic contracts is denominated in foreign currency (or is somehow linked to its movements), sharp fluctuations in the exchange rate (especially depreciations) can cause severe balance sheet effects with negative consequences for financial stability, and thus, output.
“In that context, the discrepancy between rhetoric and practice is confusing and undermines the transparency and credibility of the monetary policy action. Central banks in small open economies should openly recognize that exchange rate stability is part of their objective function.”

I am bound to add that Tarron's book complements my own research, represented most recently in my monograph "Policies for stabilization and growth in small very open economies.". Tarron provides the rationale for an exchange rate anchor. My paper explains how the exchange rate may be stabilized, via the management of the demand for foreign exchange, using fiscal policy as the tool of aggregate demand management.

Let me welcome you all to what promises be an exciting seminar, not only because of the novelty and practicality of the insights Tarron offers, but also because he has thoughts on extensions, developments and related puzzles that we should tackle next. I urge you all to think of taking Tarron's challenge to join him in further research studies which may be in your field of interest. Also, I highly recommend his approach to economic research. Let us start with observations, puzzles, paradoxes and received notions that do not square with reality, and let us bust our brains trying to figure out what is really driving the observed behaviour. It is hard work, but genuinely worthwhile.

This seminar is path-breaking for Central Bank of Barbados. I do not recall that we have ever organised a policy related event of this kind, and certainly nothing as innovative as this. We will also stream the final session live, for the global audience, something that has become an integral part of how we conduct seminars and other public outreach.