Lajos Bokros: Gyorgy Matolcsy is a political appointee who understands nothing of monetary economics

May 1, 2014

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In an exclusive interview given to the Budapest Beacon Lajos Bokros talks about recent developments at the Hungarian Central Bank under Gyorgy Matolcsy.

The Hungarian Central Bank recently announced that it will transform its main policy facility to encourage banks to shift funds into short and long term government bonds in order to reduce the country’s external debt.

It’s important for us to understand some of the basic proposals underlying this seemingly complex and sophisticated monetary policy change. This is not rocket science, but I can explain it in a very simple way.

You know, Matolcsy has a very specific world view. His world view is that if the Federal Reserve can get away with extreme monetary quantitative easing, why not the Hungarian Central Bank? He feels that monetary policy is the right tool to restore growth and monetary policy alone is capable of stimulating domestic demand so that you end up with a higher level of growth, investment, and employment.

Now, the problem is that monetary policy is not capable of stimulating growth in all circumstances. Sometimes yes, sometimes no. Stimulating growth is much more complex, especially if you take into consideration several other factors outside monetary policy, such as fiscal policy, income policy, structural reforms, overall business environment, taxation, et cetera.

Even in the best case scenario, you may have a good monetary stimulus, but its impact could be completely eliminated by all other factors because the impact or power of monetary policy is never exercised in a vacuum. It’s part of an unorthodox policy mix. Having said that, let’s narrow down the focus and concentrate our attention on monetary policy.

It isn’t so easy for monetary policy here in Hungary to restart growth. Especially not when it comes to the behavior of the central bank because the central bank can only increase the central bank’s money supply, but not the overall money supply, and least can it increase the demand for money. If people do not want to take a loan, they will not. If people do not want to invest, they will not, no matter how much more money you create and print. It does not work that way, not even in the United States.

The Federal Reserve has basically quadrupled its balance sheet by printing a huge amount of money, but the intermediation mechanism together with the commercial banks has slowed down to such a great extent that there is no additional lending in the economy.

So, what happens when there is no additional lending in the economy?

What happens when there is no additional lending in the economy is that the commercial banks will deposit the extra money created by the central bank back into the central bank. Now this is what Matolcsy recognized.

Matolcsy thinks, “Ahhhh. Okay, we have to create disincentives for the commercial banks to channel this newly created money back to the central bank. We will no longer accept this two-week long central bank bond, but only some of the eligible banks will be able to put a deposit in the central bank without this deposit being able to be used for interbank liquidity management.”

Moreover, he wants to kill two birds with one stone by saying, “Okay, if we make it so that they cannot put that money in the central bank bond, they should buy government securities”.

According to Matolcsy’s logic this will change the financing mix of Hungarian sovereign debt: more domestic financing and less external financing.

But here at least two points need to be emphasized: First, even if banks would buy more Hungarian government bonds denominated in Hungarian Forints here in the domestic interbank market, it doesn’t necessarily lead to a reduction of external borrowing because the banks themselves can borrow from abroad, exchange that into Hungarian Forint, and as a consequence use those funds to buy domestic public debt. It’s an absolutely open economy. Matolcsy doesn’t understand that.

Secondly, if banks don’t need central bank liquidity anymore, they can choose to buy foreign exchange. They can even take the money out of the country instead of buying Hungarian government paper. Why? How? Because it’s an absolutely open economy, whereby the Hungarian Forint is 100 percent convertible for all capital account transactions, not just for current account transactions in the balance of payments.

The banking sector is completely open and they always have an alternative. If they do want to buy Hungarian paper, they can buy German bonds, or they can even choose to buy Portuguese newly-issued, 5 percent yielding government securities. Why should they finance the Hungarian state if it is not a competitive option? Why should they have to finance the Hungarian state if it is not attractive enough for Matolcsy?

So Matolcsy does not like that foreign investors are holding Hungarian government debt? Why is that a problem for the Hungarian people? Why is that a problem for Matolcsy?

Yes. Because there is an exchange rate risk. It seems to me that the implicit – although it’s not explicitly stated – but at least the implicit objective of the Hungarian central bank is to weaken the Hungarian currency. They openly say that they don’t have a target for the exchange rate. When Orban was asked about it he responded that it’s up to the central bank. The central bank says nothing about this, but every step they are taking creates the impression that at least implicitly they have a target, which involves a step-by-step further weakening of the Hungarian currency.

Why would they do that?

Because in a low inflation environment further devaluation of the currency will help (although only very little) in increasing inflation, which will help the further redistribution of funds within the economy for the state. So it’s an implicit, quasi-fiscal policy.

Is this healthy policy?

No, it’s not. Monetary policy cannot calibrate the exact rate of inflation. There are instances where huge quantitative easing can result in no inflationary impact, and there are times where with a very small amount of additional liquidity you can get a huge inflationary impact. There’s no one-on-one determination between the money supply and deflation. Sometimes the money supply can be increased tremendously without inflation, sometimes it is only just the announcement of increasing the money supply which creates inflation because expectations on the part of the people is what matters ultimately. The central bank is always there to regulate the money supply, never to determine the money supply. Moreover, it is about the demand for money that matters, not just the supply. It’s a very fragile, very delicate, very indirect mechanism. Central banks typically cannot create growth. Monetary policy is ineffective for creating growth. You can see that in the Eurozone and you can see that in the United States. Why would Hungary be any different?

Moreover, Matolcsy doesn’t understand any of this. Matolcsy doesn’t even know the difference between central bank money and deposit money created by the commercial banks. He doesn’t understand anything about monetary economics, which is a problem because in the United States monetary easing can work better simply because the dollar is a world market reserve currency and, unlike the US dollar, the Hungarian forint is not. If they have an implicit target for the Hungarian currency to weaken that will kill some other parts of the economy. For example, those who are holding foreign exchange denominated mortgage loans.

Like Antal Rogan?

Yes, for example.  So, there’s an internal conflict, if you will, within the government, just as there is a conflict between fiscal policy and monetary policy, because the monetary policy may be geared more toward quantitative easing and, as a consequence, a further weakening of the exchange rate. Matolcsy’s thinking is that rooted in some kind of a hope that this will lead to more economic growth, higher demand, more investment, more jobs, and things like that.

In the meantime, because Matolcsy’s actions work on a time lag, you kill many other sectors in the economy, including for example the domestic consumption by those who have a huge amount of debt and are already underwater. Those people will never increase their consumption because they can’t even service their debt.

Conversely, wouldn’t this be incredibly beneficial for export-oriented Hungarian companies?

All things considered and being equal, devaluation would help exporters because their revenue stream in the Hungarian Forint would grow. The problem for most of the export-oriented companies is that they work with a huge import content. The Hungarian value-added is not that much. Even among the shining stars of Hungary’s manufacturing companies, like Audi and Mercedes, 60 percent of the total value of the car is imported. It’s not local value-added. Engine, transmission, gearbox, and many other things are imported. Even the steel plates are imported because there is no good Hungarian stainless steel production anymore.

So yes, if taken alone, devaluation does help exporters. Furthermore, this help may be overcompensated by the negative impact of uncertainty because you don’t actually know to what extent, how much, within which period of time, the currency will depreciate. There are wide fluctuations and volatility in the meantime. If you cannot adjust your sales profile to those low points of the exchange rate when you can gain more, then you can just as easily lose as much.

What’s the worst possible scenario that can result from such measures to weaken the currency?

For me, the worst possible scenario would be an even more brutal devaluation. If business confidence doesn’t improve., if these ineffective tricks of pushing up the domestic portion of public debt finance don’t work, then you may end up having a very large free-fall of the Hungarian Forint. In relation to the Euro, it can go through 320 and 330. There’s no limit, basically, and that’s a problem. If a weakening of the Forint gathers pace, continues speeding up, and eventually accelerates to such a great extent that the government is no longer able to break this vicious circle, then what happens is that any remaining confidence in Hungary for all investors is destroyed, domestic and foreign investors alike.

Frankly, if I can comment further on this, as an economist I never understood this sharp distinction which nationalist governments want to make between foreign investors and domestic investors. Typically, they basically behave the same way. If the domestic investors see that all foreign investors are flying away and trying to escape because they fear the uncertainty of the future, then the domestic investors will do the same.

There may be a run on the banks, and people will just take their deposits out. And why not? Their Hungarian Forints are perfectly convertible and the people can just buy the Euro at any moment, in any amount.

But that’s why I’ll also use this as an opportunity to say something positive: foreign investment doesn’t come at the detriment of domestic investment. The two can mutually reinforce the positive spillover impact and benefit the economy to such a great extent that everybody benefits.

The economy is not a zero-sum game. That’s my ultimate even philosophical point. Matolcsy feels that the economy is a zero-sum game in which either you gain and I lose, or vice versa. No, the economy is not a zero-sum game. The economy can be a positive sum game, or a negative sum game. What we’re seeing today is that it is managed in such an unprofessional way that it has become a negative sum game for Hungary.

Unprofessional? But we’re talking about Gyorgy Matolcsy, Governor of the Central Bank!

And the whole government! You can extend that to them too because the even the Governor of the Central Bank used to be Minister of Economics and he’s a very faithful and loyal disciple of the Prime Minister. He’s a political appointee. As I said, he understands nothing of monetary economics.