Raghuram G. Rajan
Fix Domestic Policy, Not Exchange Rates
Last November, the U.S. 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
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 United States, this has meant an emphasis on consumption; strategies in China and other emerging markets, meanwhile, have emphasized 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 G-20 and the
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 leveled against the U.S. Federal Reserve. 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 Federal Reserve 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 U.S. 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 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 United States, lower the value of the dollar, and expand U.S. exports at the expense of other countries.
After U.S. Federal Reserve Chair
Nevertheless, the recent debates over currency valuation revealed deeper concerns. The rest of the world worries that policy in the United States, with its two-year electoral cycle, is excessively focused on short-term growth and employment. U.S. politicians neglect the damage their policies do to the rest of the world and, in the long run, to the United States itself. Unlike other countries, whose wayward policies are quickly disciplined by financial markets, the United States is given a long rope because investors value its deep and liquid financial markets -- what in the 1960s Valéry Giscard d'Estaing, then the French minister of finance, described as an "exorbitant privilege."
On the other side, the United States worries that too many countries have become dependent on it to buy their exports and have relied too much on purchasing U.S. financial assets, such as government and corporate bonds, to keep their currencies stable. Although such asset purchases provide the financing the United States needs to fund its imports, they also prevent it from exporting and reducing its trade deficit -- in other words, they encourage U.S. consumption rather than production. The exorbitant privilege may instead be an extraordinary disadvantage.
The symbiotic relationship between the United States and the rest of the world creates very real dangers. U.S. monetary policy is imitated around the world, which means that when the Federal Reserve cuts interest rates, it puts downward pressure on rates everywhere, because no country wants its currency to appreciate strongly against the dollar. Although the Federal Reserve does not recognize it, it sets monetary policy not just for the United States but also for the world. And what is appropriate for a U.S. 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 United States embraces its role as spender too readily, as it seems to have done in the recent past, it risks jeopardizing its creditworthiness -- not even the United States can borrow forever to fund spending. If the rest of the world suddenly becomes reluctant to fund U.S. spending, the adjustment will be painful, and not just in the United States.
In the years after World War II, the United States had the strongest economy in the world, deep financial markets, and immense reserves of gold. As a result, dollar assets were very liquid and the dollar was easily convertible to gold at the fixed rate of
In the early 1960s, the Belgian economist
Triffin was broadly right. the United States initially supplied dollars in the form of grants, loans, and foreign direct investment to capital-short
Much of the language of those criticizing the United States then was similar to the heated rhetoric of today. Many balked at
But unlike today, the United States was not then running a large trade deficit -- in fact, its trade balance and its current account were in surplus throughout the 1960s, albeit shrinking. The world was not dependent on U.S. spending. Also, the fixed nominal exchange rate between the dollar and other currencies was not a choice but required by the Bretton Woods system. And although cross-border private capital flows were already growing at that time, they would be dwarfed by the size of such flows today. For all but the poorest countries, the financing for a country's current account deficit now comes not from other governments or multilateral institutions, such as the IMF or the
SICK WITH CONSUMPTION
To see why the United States has come to run such a large trade deficit, it is necessary to understand why U.S. consumption increased so dramatically. In the years before the Great Recession, individual credit, especially for housing, was greatly expanded. Some of this push may have been political; politicians from both parties looked to homeownership as a palliative for people whose incomes had stagnated. Momentum also came from a financial sector running out of control. U.S. consumption increased from about 67 percent of GDP in the late 1990s to about 70 percent in 2007, financed largely with debt.
An equally important factor in increasing U.S. spending has been the tendency to implement aggressive stimulus policies in downturns. Job growth has been tepid in recent recoveries; it took 38 months, for example, to regain the jobs that were lost in the 2001 recession. Unfortunately, the United States is singularly unprepared for jobless recoveries. Unemployment benefits generally last only six months. Moreover, because health benefits are often tied to jobs, an unemployed worker also risks losing access to medical care. When recoveries are fast and jobs are plentiful, short-duration benefits provide a strong incentive to look for work. But when there are few jobs being created, a positive incentive becomes a source of great uncertainty and anxiety. The political pressure on successive presidential administrations and the Federal Reserve to bring back jobs has been enormous. And they have responded by expanding government spending and keeping interest rates ultralow, thus boosting asset prices and encouraging household spending. In other words, household spending before the Great Recession was fueled not just by expansionary credit policies but also by the aggressive stimulus implemented in response to the 2001 recession.
As the United States increased spending in the years before 2007, many other parts of the world reduced spending, becoming more dependent on the United States and other countries, such as the
One of the most successful growth strategies in the second half of the twentieth century was that followed by
Over time, these countries created very efficient export-oriented manufacturing sectors. The need to be competitive in foreign markets kept exporters on their toes. But although global competition limited the deleterious effects of government intervention in the export sector, there were no such restraints on the domestic-oriented production sector. In Japan, for example, banks, retailers, restaurants, and construction companies have managed to limit domestic competition in their respective sectors through their influence over government policies. As a result, these sectors are very inefficient: there are no Japanese banks that rival
This dependence has only been exacerbated by these countries' slowdowns in domestic investment in recent years. For
But perhaps the most dramatic shift in investment took place in the late 1990s among the Asian emerging markets, such as
When boom turned to bust in the late 1990s, a number of Asian governments had to go to the IMF for emergency loans. Governments bailed out foreign creditors as well as domestic banks. The local taxpayer footed the bill, while also suffering a wrenching recession and high unemployment. The lesson was well learned: rather than borrow abroad to finance investment, East Asian governments and corporations decided to abandon grand investment projects and debt-fueled expansion. Moreover, a number of them decided to boost exports by keeping their currencies undervalued, which meant buying foreign currency. In doing so, they built large foreign exchange reserves, which could serve as rainy-day funds if foreign lenders ever panicked again. Thus, in the late 1990s, developing countries cut back on investment and turned from being net importers to becoming net exporters of both goods and capital, adding to the global supply glut.
Today, developed countries, hobbled by high levels of household and government debt, are hoping that emerging markets will shoulder the burden of expanding global consumption and investment. Clearly, consumption in poorer countries, such as
Shifting future growth in spending from industrial countries to emerging markets also has a corresponding environmental benefit: since the production of physical goods, such as housing and cars, takes a toll on the environment, it is better for spending to go to moving the slum dweller in
Some change is already happening. The lesson China seems to have learned from the Great Recession is that it needs to reduce its dependence on foreign demand. The Chinese know that they cannot continue growing at double-digit rates without encountering protectionist barriers. While much of the world has fixated on
Of course, various economic sectors in China are opposed to change, from
Other emerging markets, such as
To keep the past from repeating, regulators in both emerging markets and developed economies will have to be more assertive. To ensure that foreign capital inflows do not once again support nonviable investments and irresponsible lending, foreign investors need to be exposed to the full risk of losses. At the same time, domestic financial firms should not have the incentive to expand their balance sheets rapidly when money is cheap. Regulators in a country receiving capital should discourage short-term foreign-currency-denominated loans to their banking system. Instead, they should encourage foreign investors to make long-term direct loans to domestic nonfinancial firms, denominated in the local currency. Government regulators should increase capital requirements, tighten liquidity requirements, and limit leverage for domestic financial firms when credit expands rapidly. Finally, domestic regulators should also improve their national bankruptcy systems so that investors will take a quick and relatively predictable hit when projects fail.
At the same time, regulators in countries with outward capital flows should be careful that their major financial institutions are not overly exposed to any one region, country, or sector. Irish taxpayers should not have to bail out their banks' bondholders simply because these bonds are held by British and German banks. Large cross-border banking firms currently operate with impunity, knowing they are virtually impossible to shut down and will therefore be bailed out when in danger. Reaching an international accord on how to close these banks when they get into trouble will be difficult but important. Finally, multilateral institutions, such as the IMF, should force investors in a country's debt to take a significant loss if those institutions have to step in to bail the country out -- or else taxpayers will end up having to pay both those institutions and the investors. How best to include clear and transparent triggers for write-downs in debt contracts is not an easy question -- but not an impossible one, either.
All these measures will raise the direct costs to emerging markets of borrowing and will make foreign investors more careful about lending. Higher direct costs will be more than offset by the benefits of more productive and sensible investments, not to mention the decreased likelihood of future busts.
A TRIPLE MANDATE?
The slowdown in spending by the industrial world will give emerging markets strong incentives to shift their growth strategies away from exports -- stronger, in fact, than might emerge from any agreement produced by international summitry.
But will "the Great Spender," the United States, cooperate and avoid yet again pumping up demand excessively? U.S. households have certainly increased their savings rates in response to the recession and are trying to pay down their debt. But what is worrying is that many of the efforts of the Federal Reserve and the Obama administration -- whether to keep interest rates very low or offer new tax benefits and government-supported credit for home purchases -- have been meant to encourage household spending. In the meantime, reduced government revenues and increased spending -- the usual effects of a recession -- have been coupled with repeated stimulus packages, which has led to a ballooning of public debt.
As in past recessions,
Finally, a more stable and less aggressive U.S. monetary policy will not only lead to more sustainable U.S. growth; it will also reduce the volatility of capital flows coming into and out of emerging markets. Given the thin safety net, the political pressure on the Federal Reserve to be adventurous with monetary policy when unemployment is high is enormous. But such pressure can be counterproductive if the Fed's aggressive policies have little direct effect on employment but instead generate asset price bubbles and risky lending, which eventually impose high costs on the economy, including greater unemployment.
It is debatable whether
A CHANGE IS GONNA COME?
In sum, governments know what they need to do. Change, however, will not be easy because it involves short-term pain that is likely to be politically difficult. So what role should multilateral bodies, such as the G-20 and the IMF, play in all this? Thus far, they have been trying to broker grand agreements among countries, guided by the assumption that world growth will be more stable if, for example, the United States cuts its spending in exchange for
There are two problems with this assumption. First, even if a grand agreement could be reached and each country carried out its side of the bargain, there is no guarantee that the timing of the reforms and their effects on global demand could be synchronized. Most policy changes have consequences that kick in with variable and uncertain lags, making it a miracle if their effects actually offset one another and smooth growth. Second, it is not clear that policymakers, even heads of state, have the ability to commit their countries to any kind of economic agreement. For instance, the president of the United States can propose adhering to a path of fiscal contraction, but
Moreover, it can be counterproductive to raise hopes before every international meeting that there is an agreement that could magically bring down trade imbalances quickly. Publics are disappointed with the same vague communiqués that end nearly all such summits. Politicians, meanwhile, blame other countries for failures. In trying circumstances, such finger-pointing can degenerate into protectionism. Of course, each country knows what actions are necessary. The key will be to give politicians incentives to take those actions despite domestic pressure to maintain the status quo and despite the short-term pain that invariably accompanies reform.
Multilateral organizations, such as the IMF, can help by communicating the international consequences of a country's policies to that country's elite. These organizations have to become more media savvy and should use the Internet, as well as social networking tools, to encourage countries to add their international responsibilities to their domestic policy agendas. Although multilateral organizations rightfully have no domestic vote, an agreement among countries to allow these institutions to speak freely within each country on the international ramifications of its domestic policies may help nudge these policies in the right direction.
The current tension over currencies reflects the unsustainable trade imbalances that developed thanks to long-standing domestic economic strategies. Many economists would place part of the blame for the Great Recession on these imbalances. Interestingly, the consequences of the Great Recession -- the slow growth of industrial economies relative to emerging markets -- may offer a strong impetus for countries to change those strategies.
For the developing countries, the imperative is to become less dependent on industrial-country spending and to spend more themselves; industrial countries such as the United States must start producing and exporting more, even while consuming less. To help these changes along, international capital flows must become less volatile and more risk sensitive. the United States, in particular, can play an important role in the transition, by focusing more on medium-term reforms that will preserve its competitiveness and less on short-term stimulus, which tends to delay change. There is no guarantee that governments will overcome the political pressure to be myopic, but if they do, the collective rewards will be considerable.
RAGHURAM RAJAN is 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.
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