In light of the Fed’s decision to pump an extra $600bn into the US economy, US Treasury Secretary Geithner has had a difficult balancing act. On the one hand, no amount of monetary stimulus can change the changes that need to be seen to rebalance the global economy in real terms, meaning he is right to highlight the issues around countries’ persistent trade surpluses and deficits. But, on the other hand, he is sensitive to accusations from Asia and elsewhere that the US is pursuing a weak dollar strategy. Both of these stories have at least a degree of truth – but we also hear an awful lot of nonsense on them from politicians as well. So what’s the real story?
First, consider the supposed weak dollar strategy. The accusations here are levelled against the Federal Reserve, which is busy furiously printing money at the moment. The reason for this, of course, is not that the Fed wants to cause problems abroad, but to shore up US domestic demand and spending. The cyclical response of the labour market, in particular, has been shocking – we just aren’t seeing the normal, or required, pace of job creation. In light of the Fed’s primary remit to focus on maximum employment (among other things), and signs that the recovery is faltering, another shot in the arm from monetary policy was sensible, especially given that fiscal policy is likely to go nowhere fast after the mid-terms.
But is the Fed actively seeking to devalue the dollar? Only in a highly specific and technical sense. Inflation, by definition, is the decrease in the value of money. The Fed thinks inflation is too low – after all, core inflation was just 1.2%Y/Y in September, as measured by the consumer expenditure deflator. So, in trying to get inflation a bit higher – even if only back to a 2-3% level – the Fed is implicitly seeking to erode the value of the dollar a bit faster. And rightly so.
That, however, is as far as it goes. Complaints, particularly from Asia, that the US is exporting inflation are political nonsense. In a world with flexible exchange rates, the slightly faster devaluation of the dollar (as measured in terms of slightly higher inflation) would be offset by movements in nominal exchange rates, such that real exchange rates – the relative purchasing power of different currencies, adjusting for inflation – would be broadly unchanged. The problem for Asia is not that the Fed is printing money, and trying to raise inflation. The problem for Asia is that, because they are wedded to fixed (or at least managed) exchange rates against the dollar, in order to maintain their currency pegs they are setting domestic monetary policy too loose, and there are concerns about bubbles and overheating. China’s concerns about US monetary policy are of its own making.
There is, of course, a link here with the whole issue of trade surpluses and deficits. The whole reason Asian economies – not just China – have been fixing their exchange rates against the greenback is because many still remember the trauma of the late 1990s, when they were hit hard by the regional crisis. After that period, many took the deliberate decision to build up foreign exchange reserves in order to provide a buffer against future crises. Those inflows of foreign capital, driven by the public sector – often, but not always, governments buying US Treasuries – had to be funded by running trade surpluses, which meant keeping the exchange rate ‘competitive’ against the US dollar. And with trade such a critical engine of growth for most Asian economies, they are loath to let their currencies float, see the US dollar adjust to a sensible level, and watch their trade surpluses decline.
But this is, ultimately, the outcome that the world needs to see – a weaker greenback, and smaller trade surpluses throughout the rest of the world as the US deficit shrinks. I can understand why Asian economies are complaining, as this change may well be painful. But currency pegs are an anachronism in a globalised economy where prices and wages don’t adjust flexibly. Indeed, I have more sympathy with Germany, which has maintained an export-led growth model despite seeing a strong euro (although Merkel is now trying to shaft her fellow euro area members). But, fundamentally, one person’s deficit is another person’s surplus – trade is a zero sum game, barring statistical errors. If Asian economies are really worried about importing inflation and asset bubbles from the US, they need to manage their exchange rates differently.