Saturday, April 02, 2016

The gains from sound macro and finance policy

by Ajay Shah.

Israel went through a complete transformation of macro and finance policy. They started out pretty bad, and put in all the key machinery : inflation targeting, floating exchange rate, open capital account, modern financial regulation, public debt management, etc.

A graph of the nominal yield curve for government borrowing is quite revealing [source]. It superposes the yield curve prevalent at many dates:

The curve at the top is the yield curve in October 1996: it goes out to only 3 years, and features nominal rates of 16 to 17%.

Through the years, as the macro and finance reforms fell into place, nominal interest rates for borrowing went down, and the maturity went up. By January 2012, inflation had stabilised at the target of 2%, the short rate was 1.5%, and the 30 year rate was 5.51%.

Note that the 2012 situation is without financial repression and without capital controls. Private persons voluntarily choose to lend to the government, for a 30 year horizon, at 5.51%. There are no other distortions in the picture. This is the `fair and square' cost of borrowing for the government.

This shows the the direct gains to the fiscal authority from doing the orthodox approach to macro and finance policy. Similar large gains became available to the private sector, as corporate bonds and bank loans are expressed as credit spreads off the government bond interest rates. We in India will get these gains by enacting and enforcing the Indian Financial Code.

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