What a difference three years makes. In 2008, faced with the most dire economic outlook for the global economy since the 1930s, policymakers in the developed world, with admittedly varying degrees of enthusiasm, eventually all acted in unison, drawing on the lessons learnt from the Great Depression and Japan‘s more recent experience with stagnation. Policies were put in place to prevent financial market collapse, monetary policy was loosened aggressively, including through unconventional measures, while a textbook fiscal response was instigated, allowing the automatic stabilisers to operate fully, augmented with additional, discretionary simulative tax and spending measures. A global depression was averted.
Fast forward three years and the global economy, in the IMF’s own words, is again in a dangerous place. But the policy response could not be more different. Euro area leaders continue to prevaricate as the euro faces catastrophe barely a decade after its birth, threatening financial systems in the euro area and beyond. The ECB, unbelievably, repeated its error of July 2008, raising rates just as the economy slowed sharply and financial crisis intensified. The Fed, meanwhile, has loosened policy. But faced with intense political pressure from the right, its options have seemingly been narrowed, rejecting further QE and taking the path of least resistance in “operation twist”.
But it is fiscal policy where the differences between now and 2008 are most stark. The textbook fiscal response of 2008 has been replaced in much of the global economy by an obsession with deficit reduction. For some countries, notably in the euro area, they have little choice, as the financial crisis demonstrates that joining a single currency means not only giving up an independent monetary policy, but also constrains fiscal policy to a degree that few foresaw. But events in the euro area have led policymakers in countries with more fiscal freedom to draw the wrong lessons. There are several arguments put forward as to why further fiscal stimulus is not possible:
- First, the spectre of the experience of Greece and others in the euro area is cited as evidence that large deficits lead to rising interest rates, stymieing the recovery and risking a sovereign debt crisis.
- Coupled with this is a fear of rating downgrades, with S&P in particular circling hungrily.
- Delaying adjustment makes the eventual adjustment required larger.
- Finally, vocal policymakers and commentators argue that large deficits and fears about future government solvency are in themselves hitting confidence, hence hampering the recovery.
Given all of the above, the argument goes, more fiscal stimulus is impossible, while austerity is actually the correct policy prescription, bolstering recovery through lower interest rates and improved economic confidence. But that is to ignore the lessons of history. First, in spite of much searching by academic economists, little or no evidence that tightening fiscal policy can be expansionary has been found. Indeed, quite the opposite. And this should be no great surprise. GDP is simply an accounting identity, adding together all the economic activity in an economy. If you cut government spending, the contribution from government falls. If there is no corresponding increase in activity elsewhere (and there is no reason to expect there would be under current circumstances), of course GDP will be smaller than it otherwise would have been.
But, say the austerians (as some have dubbed them), look at Greece. If we don’t cut deficits now, that’s how we’ll end up, particularly if the rating agencies downgrade us. Ignoring the thought that democratically-elected governments should effectively have their hands tied by rating agencies that have switched from handing out AAA ratings like candy bars to assuming the role of the stern maiden aunt of fiscal austerity, Greece is not the example that is relevant for countries that are not part of a monetary union. Japan, rather than Greece, should be the historical precedent scaring politicians. Fears about sovereign debt sustainability in Japan have been around since the mid-1990s. This has led to repeated attempts to tighten fiscal policy, only for the economy to take another nose-dive, undermining tax receipts and triggering the need for more fiscal stimulus. The result is a still-moribund economy with a decimated tax base and a government debt-to-GDP ratio above 200%.
But even with this monster debt stock, 10Y JGB yields are only 1%, levels that would be unimaginable for a euro area economy with the same debt stock. So, how can Japan run a debt stock more than 50ppts above that of Greece’s but at funding costs below that of Germany? Because there are fundamental differences between Japan (and any other country with its own currency) and countries in a monetary union. First, there is a captive set of domestic investors that have a regulatory requirement to buy highly-rated debt in the same currency as their liabilities. In the euro area, funds can obviously choose between sovereign debt in a large number of countries. That is not the case in Japan, etc. Second, having an independent monetary policy, and hence the ability to print money means that there is no reason why fiscal stimulus has to lead to higher yields. If yields did begin to rise, all it needs is for the central bank to prevent that happening through purchases of government bonds, effectively moving their interest rate target further along the curve. And, ultimately, of course, there is the option of direct deficit financing by central banks – anathema to most economists, but something that is now being advocated by mainstream commentators.
Of course, none of this is to suggest that governments never need to worry about debt sustainability – in normal times running balanced budgets is sensible and central banks have no business financing government deficits either directly or indirectly. But these are not normal times. The developed economies, and in particular the US and the UK, are facing major deficits of demand. With heavily-leveraged households understandably saving hard to repair their balance sheets and firms not investing their cash piles in the face of weak demand, it is only governments, perhaps in concert with central banks, that can boost demand sufficiently to maintain growth while this rebalancing takes place. To do this, governments need to borrow and spend in large amounts to offset the saving dynamics elsewhere in the economy. In the US, the Obama Administration’s “Jobs Plan” proposal at least aims to prevent fiscal policy from tightening next year. But in the euro area the inability of policymakers to get on top of the debt crisis means that most countries have no choice but to tighten fiscal policy. And in the UK the coalition government refuses to slow the unprecedented fiscal tightening currently underway even as the economy flat-lines, arguing that there is no alternative. But there is. A time will come for governments to tighten their belts. But doing so now, particularly as the storm clouds over the euro area get ever darker, threatens to push the global economy back into recession.
Used with permission of Daiwa Capital Markets Europe Limited.
In September 2010, Brazilian Finance Minister Guido Mantega shocked the world by launching the opening salvo in what he called a “currency war”. Mantega claimed that emerging markets were being squeezed by a combination of a depreciating US dollar and an undervalued Chinese renminbi.
Only weeks later, French President Nicolas Sarkozy placed reform of the international monetary system atop the G20 agenda under France’s chairmanship, prompting the IMF and other organisations to launch a host of events and studies on the issue. Meanwhile, Congress renewed its bid for legislation to brand China as a currency manipulator, while China, Brazil, and other countries condemned the US for its quantitative easing policies, claiming that their real purpose was to devalue the dollar (see for instance, Evenett 2010 ).
In our recent report (Dadush and Eidelman 2011) we argue that the international monetary system has performed well during an extraordinarily tumultuous time and does not need a major overhaul. The real cause of currency tensions lies in misguided domestic policies and the disequilibrium caused by the crisis in the reserve currency countries. One very important contributing factor is Chinese exceptionalism. China, the world’s largest exporter, is the only major trading nation to maintain a pegged and nonconvertible currency, and also remains almost entirely insulated from global financial markets. This situation requires reforms in China.
The implication is that reformers should focus on putting the reserve currency countries back on an even keel and on making China less exceptional. But, in fact, only incremental changes are needed in the international monetary system. In short, the rules of the game do not need a big change; rather, the big players need to raise their game. Until they do, no conceivable reform of the rules can provide stability.
In contrast to its predecessors – the gold and dollar standards – the current international monetary system has served the global economy well, even in the most difficult of times. During the Great Recession – the worst downturn in seventy years – the system exhibited great flexibility and resilience. Countries with flexible exchange rates, which account for 80% of global GDP, used them to good effect as shock absorbers. Several countries with pegged rates switched to more flexible regimes during the crisis and some switched back again when confidence returned. These changes were nearly always orderly, with most currencies following a common path against the dollar, which retained its safe-haven status despite the fact that the US was at the epicentre of the crisis: Currencies depreciated against the dollar during the worst of the crisis and then appreciated again once it ended. Though some currencies saw large real appreciation, most remained in line with fundamentals; misalignments occurred in only a few instances, usually related to the dysfunctional institutional set-up of the Eurozone monetary union. Overall, the global economy avoided the balance of payments crises and protectionist responses that characterised previous episodes of acute economic turmoil.
For these reasons, it is difficult to conclude that today’s exchange-rate system is fundamentally flawed. At the same time, a number of undesirable developments and responses have occurred in the aftermath of the Great Recession:
- Some developing countries have excessive reserves;
- Several countries have reluctantly resorted to capital controls;
- A few countries, including Brazil, Switzerland, and Japan, have seen very large exchange-rate appreciations;
- The Eurozone is in deep crisis; and
- Fear persists that global imbalances may widen again.
The roots of these problems, however, lie not in inadequate international exchange-rate arrangements, but in the fact that countries and regions holding the main reserve currencies – the US, the Eurozone, Japan, and the United Kingdom – are severely off balance. Their output gap (actual versus potential GDP) is large, unemployment is high, public debt is soaring, monetary policy remains extremely loose, and divergences in economic performance and fiscal management within Europe have placed the survival of the euro itself in question. Not surprisingly, doubts about the soundness of these economies have big repercussions. No one welcomes currency appreciation when demand is weak and uncertainty reigns; nervousness about exchange-rate levels and competitiveness, and hot money flowing into emerging markets, are two of the most severe manifestations of the turmoil. At the same time, China’s extraordinary advances in world markets have compounded these fears, as perceptions that the renminbi is undervalued are widespread, and China’s capital controls have kept out inflows that are flooding other, much smaller developing economies.
In response to the sharp domestic imbalances that were the main cause and are now also the effect of the financial crisis that engulfed them, the reserve currency economies – beginning with the US and the Eurozone – are scrambling to find an international fix to their problems. It is often easier to place the focus on reducing ‘global’ imbalances or on reform of the international monetary system than to recognise that the politically thorny solutions to their problems lie at home.
The US’ fundamental problem is not a loss of competitiveness, and it will not be corrected by dollar devaluation – nor, as is more politically correct in Washington these days, by demands that China and other countries allow their currencies to appreciate. Instead, the US must find ways to durably raise its household savings rate and reduce its budget deficit.
The Eurozone must move faster toward fiscal and labour market integration in support of its single currency, while the countries in its periphery must accelerate their structural reforms and budget consolidation if they are to regain access to the government debt markets.
China cannot aspire to be both the world’s largest trading nation and largest economy while conducting itself as if it were an outsider to the international monetary system. It must move faster on the far-reaching reforms required to internationalise its currency, open its capital markets, and make the renminbi more flexible.
All of these moves are necessary not only to ease currency tensions – which may be alleviated naturally as the reserve currency economies regain their footing and as the renminbi plays an increasingly important role in international transactions – but also, and more importantly, to restore the health of the advanced economies and to make China’s growth more balanced and sustainable.
Meanwhile, any efforts to reform the international monetary system should recognise the resilience that the system has shown during the crisis, and that the changes needed are incremental rather than revolutionary. These changes include encouraging more exchange-rate flexibility where appropriate, increasing the diversity of reserve holdings, and further expanding IMF resources and the organisation’s surveillance role. While these improvements will make the international exchange-rate system work more smoothly and help alleviate currency tensions, they are of secondary importance to the reforms needed in the major countries.
Dadush, Uri and Vera Eidelman (eds.) (2011), “Currency Wars”, Carnegie Endowment for International Peace.
Evenett, Simon (ed.) (2011), The US-Sino Currency dispute: New insights from Economics, Politics, and Law,
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