Currencies are not the problem

Published March 11, 2011 on The Business Times

By RAGHURAM GRAJAN

Professor of finance at the Booth School of Business at the University of Chicago and the author of 'Fault Lines: How Hidden Fractures Still Threaten the World Economy'. 

LAST November, the US Federal Reserve embarked on a second round of a type of monetary stimulus known as quantitative easing. The central bank declared that it would buy US$600 billion in long-term Treasury bonds in an attempt to push down long-term interest rates. Immediately after the move, the rest of the world accused the United States of deliberately attempting to depreciate the US dollar.

However, Washington was not alone in apparently trying to influence its currency's value. China has continued to hold the yuan relatively stable against the US dollar, even though many economists believe that the fair value of the Chinese currency is considerably higher.

Last September, Japan intervened in the exchange markets to prevent the yen from rising too quickly, and many emerging-market countries have used a mix of similar interventions and capital controls to keep their own currencies from appreciating. 

Intervention is a zero-sum game: For one country's currency to depreciate, some other countries' currencies must appreciate. Are the same type of senseless beggar-thy-neighbour currency depreciations as those of the 1930s, when many countries tried to depreciate in a race to the bottom, just around the corner?

Thankfully, probably not. Today's jockeying over exchange rates has several important differences from that of the Great Depression years. Most countries today are not trying to gain a short-term advantage through currency actions; instead, they are following domestic economic policy strategies that have allowed them to grow easily in the past. For developed countries such as the US, this has meant an emphasis on consumption; strategies in China and other emerging markets, meanwhile, have emphasised exports.

Taken together, these strategies have led to significant trade imbalances around the world, even before the recent crisis. Sustained trade imbalances, in turn, seem to lead to financial and political instability, making them quite dangerous in the long run. However, unless the domestic policy strategies change dramatically, these imbalances will likely persist.

Global economic stability, therefore, is not dependent on some grand agreement among countries - if you allow your currency to appreciate, I will rein in my fiscal deficit - which unfortunately seems to be the focus of recent economic summits. Instead, stability will emerge when governments move to more sustainable domestic policy agendas, which are typically in their long-term interest.

The role of multilateral bodies, such as the Group of 20 and the International Monetary Fund, should therefore be not to coordinate policies among countries but to insert the international dimension into each country's domestic policy debate on reforms. It should also be to set reasonable rules of the game on financial regulation, cross-border capital flows, and international bailouts.

Multilateral bodies conduct neither of these functions adequately today. But the silver lining in an otherwise dark cloud is that the rethinking prompted by the Great Recession is already altering policy agendas in some key countries. Given all this, with more effort and some luck, the global economy will not repeat the tragic history of the early 20th century.

Easing ain't easy

A country's exchange rate affects the international price of its goods. By keeping its currency undervalued (economists debate how easy, in fact, this is to do), a country can expand its market share and production by essentially stealing demand from other states. Exchange-rate manipulation can be particularly attractive in a recession, when preserving jobs is politically important. Governments often view this sort of direct manipulation as a particularly unfair form of competition.

Accusations of such unfairness are now being levelled against the Fed. Usually, when a central bank cuts interest rates, the country's currency weakens as capital leaves for more attractive shores. However, lower interest rates also tend to increase domestic demand, as households and firms spend more. In the end, monetary easing does not simply take demand from other countries; it also creates demand overall. 

Monetary easing, of which quantitative easing is just an extreme form, is therefore typically viewed as a perfectly legitimate economic policy. But the circumstances under which the Fed embarked on the second round of quantitative easing (the first round was the buying of long-term Treasury bonds and asset-backed securities starting in late 2008) made the move questionable. 

With short-term US interest rates already near zero, and with large firms able to borrow at very low rates, it was unlikely that corporate investment was being held back because firms thought interest rates were too high. Similarly, households were cautious about spending not because they thought interest rates were too high but because their balance sheets were in disarray.

Quantitative easing, other countries alleged, would make US dollar bonds unattractive, because long-term bond yields would fall below what investors wanted given their expectations of higher inflation. This, in turn, would cause capital to flee the US, lower the value of the dollar and expand US exports at the expense of other countries.

After Fed chairman Ben Bernanke announced that he would undertake quantitative easing, US long-term interest rates dropped and the dollar weakened. But worries about sovereign debt in the eurozone economies soon led the dollar to rebound. And better news about the US economy, as well as worries about the US' long-term fiscal health, led to a sharp increase in US interest rates. 

In the end, quantitative easing may have had neither the effect the Fed predicted nor the one its critics feared.

Nevertheless, the recent debates over currency valuation revealed deeper concerns. The rest of the world worries that policy in the US, with its two-year electoral cycle, is excessively focused on short-term growth and employment. US politicians neglect the damage their policies do to the rest of the world and, in the long run, to the US itself.

US holds a long rope

Unlike other countries, whose wayward policies are quickly disciplined by financial markets, the US is given a long rope because investors value its deep and liquid financial markets - what in the 1960s Valery Giscard d'Estaing, then the French minister of finance, described as an 'exorbitant privilege'.

On the other side, the US worries that too many countries have become dependent on it to buy their exports and have relied too much on purchasing US financial assets, such as government and corporate bonds, to keep their currencies stable. Although such asset purchases provide the financing the US needs to fund its imports, they also prevent it from exporting and reducing its trade deficit - in other words, they encourage US consumption rather than production.

The exorbitant privilege may instead be an extraordinary disadvantage.

The symbiotic relationship between the US and the rest of the world creates very real dangers. US monetary policy is imitated around the world, which means that when the Fed cuts interest rates, it puts downward pressure on rates everywhere, because no country wants its currency to appreciate strongly against the US dollar. Although the Fed does not recognise it, it sets monetary policy not just for the US but also for the world. And what is appropriate for a US economy that is recovering slowly from a recession may be overly aggressive for emerging markets that are near full employment, creating inflation and asset bubbles in those economies. 

Over the medium term, if the US embraces its role as spender too readily, as it seems to have done in the recent past, it risks jeopardising its creditworthiness - not even the US can borrow forever to fund spending. If the rest of the world suddenly becomes reluctant to fund US spending, the adjustment will be painful, and not just in the US.

This article is sourced from Foreign Affairs, a publication of the US Council of Foreign Affairs. This is the first in a series drawn from a longer article in the March/April edition