GLOBAL MONETARY AND FINANCIAL DISORDER:

tauringhuang.

My difference with Ronald McKinnon are fundamentally two.

First, he believes that the real exchange rate is determined by the savings surplus, while I argue that the causality for the countries targeting the real exchange rate (and that is what they are, without doubt, doing) is the other way round. In other words, countries target a nominal exchange rate and try to keep inflation down. They do so by pursuing monetary, fiscal and regulatory policies intended to curb domestic demand and so make room for the surplus on net exports. I am not suggesting they can do this forever. But they can do it for a very long time.

The current account tail wags the economic dog – this being a mirror image of what I think has happened in the US over the past decade. It is, after all, US assets that the intervening countries have been targeting and so the US exchange rate that they have been holding up, the US current account deficit they have been financing and US longer-term interest rates that they have been keeping down. A trade deficit is contractionary: for any given level of domestic demand, it lowers domestic output. Thus, the US needed to expand domestic demand, in order to offset the contractionary effect of the external deficits. Some groups within the economy needed to spend more than their incomes.

The most important such group turned out to be households. Thus the growth in US household indebtedness that led to today's “credit crunch” is a direct result not just of the global imbalances, in general, but of the exchange-rate targeting policies of a large number of emerging economies.

Second, I believe the principal motivations for the real exchange rate targeting are not to provide a monetary anchor, but to pursue export-led growth, accumulate reserves and, above all, minimise the risks historically associated with running sizeable current account deficits: this, in other words, is not so much “fear of floating” as “fear of deficits” and the financial crises they almost unfailingly brought.

What are the consequences of these policies? In a word, they are expansionary. The results normally include rapid rises in net exports, low interest rates, aimed at curbing the capital inflow, and expansion in the monetary base, despite attempts at sterilisation. The Chinese economy has been overheating as a direct result of this trio of effects.

Today's inflationary predicament

Today, the Federal Reserve is trying to re-expand demand in a post-bubble US economy. The principal impact of its monetary policy comes, however, via a weakening of the US dollar and an expansion of those overheating economies linked to it. To simplify, Ben Bernanke is running the monetary policy of the People's Bank of China. But the policy that is at least arguably appropriate to the US (I am not going into that debate before this audience) is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further. The result is strongly negative real interest rates in countries where they should clearly be positive.

What we see then is an incipient global inflation. Yet the central bank with the greatest influence on global monetary policy is the one confronting the post-bubble credit crunch. Its post-bubble predicament is made worse by the soaring energy prices that result from the strong growth of the world economy.

This then is a global challenge. The advanced countries are no longer the global driving force: they are importing inflation. If the world had a single central bank and a single currency, the former would surely tighten its monetary policy, in light of the evidence on the constraints on the rate of growth of potential global supply.

We do not have such a global central bank. The central bank that is closest to playing that role – the Federal Reserve – is responsible for about a quarter of the world economy. Its region is, of course, also the most economically depressed large one. It is as if the ECB were setting its monetary policy to meet the conditions of Spain alone. The results are likely to be highly inflationary.

tauringhuang.

My difference with Ronald McKinnon are fundamentally two.

First, he believes that the real exchange rate is determined by the savings surplus, while I argue that the causality for the countries targeting the real exchange rate (and that is what they are, without doubt, doing) is the other way round. In other words, countries target a nominal exchange rate and try to keep inflation down. They do so by pursuing monetary, fiscal and regulatory policies intended to curb domestic demand and so make room for the surplus on net exports. I am not suggesting they can do this forever. But they can do it for a very long time.

The current account tail wags the economic dog – this being a mirror image of what I think has happened in the US over the past decade. It is, after all, US assets that the intervening countries have been targeting and so the US exchange rate that they have been holding up, the US current account deficit they have been financing and US longer-term interest rates that they have been keeping down. A trade deficit is contractionary: for any given level of domestic demand, it lowers domestic output. Thus, the US needed to expand domestic demand, in order to offset the contractionary effect of the external deficits. Some groups within the economy needed to spend more than their incomes.

The most important such group turned out to be households. Thus the growth in US household indebtedness that led to today's “credit crunch” is a direct result not just of the global imbalances, in general, but of the exchange-rate targeting policies of a large number of emerging economies.

Second, I believe the principal motivations for the real exchange rate targeting are not to provide a monetary anchor, but to pursue export-led growth, accumulate reserves and, above all, minimise the risks historically associated with running sizeable current account deficits: this, in other words, is not so much “fear of floating” as “fear of deficits” and the financial crises they almost unfailingly brought.

What are the consequences of these policies? In a word, they are expansionary. The results normally include rapid rises in net exports, low interest rates, aimed at curbing the capital inflow, and expansion in the monetary base, despite attempts at sterilisation. The Chinese economy has been overheating as a direct result of this trio of effects.

Today's inflationary predicament

Today, the Federal Reserve is trying to re-expand demand in a post-bubble US economy. The principal impact of its monetary policy comes, however, via a weakening of the US dollar and an expansion of those overheating economies linked to it. To simplify, Ben Bernanke is running the monetary policy of the People's Bank of China. But the policy that is at least arguably appropriate to the US (I am not going into that debate before this audience) is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further. The result is strongly negative real interest rates in countries where they should clearly be positive.

What we see then is an incipient global inflation. Yet the central bank with the greatest influence on global monetary policy is the one confronting the post-bubble credit crunch. Its post-bubble predicament is made worse by the soaring energy prices that result from the strong growth of the world economy.

This then is a global challenge. The advanced countries are no longer the global driving force: they are importing inflation. If the world had a single central bank and a single currency, the former would surely tighten its monetary policy, in light of the evidence on the constraints on the rate of growth of potential global supply.


First, the world as a whole cannot import inflation: if every central bank assumes that the rise in commodity prices is the product of policies made elsewhere, general overheating is likely to be the result. Worse, if that feeds into expectations the world will be depressingly similar to the 1970s. We are not there. Policymakers must ensure we never do get there.

Second, global monetary policy is too loose, despite the adverse impact of the credit crisis on high-income countries. In many emerging countries output is growing quickly, with inflation rising strongly. If, as seems likely, the world economy cannot grow as fast as people hoped only a year or two ago, emerging economies have to be part of the adjustment. This will become still more obvious when, at last, the high-income countries recover fully.

Third, the biggest monetary policy requirement is a tightening in emerging economies, many of which now have strongly negative real interest rates. A precondition for such a tightening is a relaxation of exchange rate targeting.

Fourth, if such relaxation of exchange-rate targeting is not going to happen, then the Federal Reserve has to take account of the global impact of its monetary policies, working, as they do, on the policies of the rest of the world's central banks. For this reason, at least, it is likely that Federal Reserve has already cut too far.

Conclusion

We have an incoherent global monetary system, with a quasi-global central bank concerned about just one region of the world economy and the monetary and financial consequences of current account imbalances created by exchange-rate targeting. I have argued here that both the financial crisis of today and the inflation are, at least in part, the consequence of this dysfunctional system. Change will, and must come. Let us hope it happens before we relive anything similar to the 1970s.