The prevailing view coming out of the G-20 Summit last week is that US monetary policy is as much to blame for the precarious state of the global economy as is China’s exchange rate policy. A deluge of dollars is causing a speculative bubble in emerging markets. This analysis is wrong. U.S. monetary policy should be kept just where it is. Keep pushing on that string until the string responds. The policies that need adjusting include U.S. fiscal policy over the medium term and China’s exchange rate and structural adjustment policies.
While I recently applauded China for allowing a substantial real appreciation of the RMB, not through the nominal exchange rate, but through wage inflation, I still believe that a floating of the RMB would help reduce the world’s vulnerabilities. Likewise, a credible, medium-term plan in the U.S. to reduce government debt, not a tightening of monetary policy, would help matters.
Country risk analysts, including this writer, have often recommended to highly indebted emerging markets that they keep monetary policy loose in combination with a gradual fiscal consolidation, when there is slack in the economy. Alan Greenspan, in the aftermath of the tech bust a decade ago, used to explain to Congress that he was keeping interest rates low to offset the strong headwinds created by heavy corporate debt. The idea is that a low cost of money (the interest rate) provides the time and room for debtors to work out their problems, avoiding widespread defaults and allowing the economy to rebound. Sir Alan and Co. kept rates too low for too long, feeding the real estate bubble, but the original idea was sound.
Nowadays, rates need to stay low — and liquidity plentiful (hence, the “quantitative easing”) — in order to give highly indebted households (and sick banks) the time and room to adjust their balance sheets. This mammoth task is more difficult than the earlier corporate adjustment. What’s more, the government’s balance sheet is in bad shape. While it is too soon to pull back the fiscal stimulus for fear of tipping the country back into recession, there is much that can be done now to right the fiscal ship in the medium term. Reform of entitlements and the tax code (closing loopholes), winding down Fannie and Freddy, etc. Without withdrawing any current stimulus, fiscal reform could send a message to markets that America’s public finances will be sound and AAA for some time to come.
To improve the U.S. government’s balance sheet and underpin American power and prosperity, we don’t need more tax cuts, nor do we need an expensive health care reform. Lower taxes and fairer health care are objectives we could pursue in better times, not now. One wishes the odd country risk analyst had access to the lights leading the know-nothing party about to take over the House of Representatives or a staff position in the White House, or was there in Seoul to ply the halls of the COEX Convention Center.
The scorn I heap is not reserved for governments, but also for narrow minds in the private sector that seem not to understand the nature of the economic crisis we are in (and potentially could be in). Here, I speak of Bill Gross of PIMCO and Jeremy Grantham of the firm of his name. They are bond investors who have recently railed against the Fed’s quantitative easing, calling it inflationary. Didn’t these wealthy guys study the central policy lesson of Japan’s lost decade of the 1990s, that its central bank failed to act quickly enough with an unorthodox monetary policy to counter noxious deflationary pressures? Didn’t they study the Great Depression, as Chairman Bernanke has? Deflation is one of the worst things that can happen to an economy. Debtors owe a certain amount, but the price of their goods (or their labor) falls making it difficult for them to service their debts. Widespread defaults occur and the economy contracts. Unemployment rises (to around 25% in the Great Depression vs. under 10% today). As long as debtors pay their debts, creditors, such as Gross and Grantham, can reap real profits. Maybe that’s why they wrote their silly investment letters. Trouble is, with deflation, debtors can’t pay and ultimately, the short-sighted Gross and Grantham suffer too. Deflation is scary and preventing it well worth the risk of taking unorthodox measures, anathema to bond investors. Unorthodox because the central bank is attempting to directly influence long-term interest rates, which can backfire if inflation ticks up. But that backfiring means a little more inflation in the short run, which can be countered later on, even though it means lower real profits for PIMCO. I say, keep to investing, fellas, and let the country risk analysts of the world make policy. I wonder what Mohamed El-Erian, PIMCO’s CEO and erstwhile emerging markets chief, as well as a former IMF country risk specialist, advised his boss before he penned that irresponsible investment letter (which you can read here and Grantham’s here).
Global imbalances (featuring persistent US current account deficits and Chinese current account surpluses) should be reduced to lower the risk of financial shocks and currency instability, not to mention the diplomatic tension. Currency flexibility in China, as well as policies designed to develop domestic consumption there, should be matched by a medium-term plan to reduce government debt in the US (and elsewhere) and to enhance household savings. China’s fixed exchange rate has created a distorted economy in that country, biased toward exports and against consumption. China’s leaders did this on purpose in order to amass fx reserves. Since the Asian financial crisis in 1997-98, when its neighbors went hat in hand to the IMF, China has sought financial independence, if not the mercantilist underpinnings of power a la King Louis XIV and his finance minister Jean-Baptiste Colbert. The Brazilians on the other hand, due to their heavy debts, had to float their currency in the late 1990s to prevent a loss of fx reserves. As a result, they now suffer from waning competitiveness vis-a-vis China and should be enlisted in efforts to get the Dragon off its currency peg.
In short, the US should keep monetary policy loose and push hard for medium-term fiscal retrenchment (not likely with the current polarization in Washington). The rest of the G-20 (ex-China) should join the US in keeping pressure on China to float its currency and promote pro-consumption structural reform. And, tell the money men in Newport Beach or elsewhere to keep quiet in their corner offices.
