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Asian investment in plant has run ahead of Western ability to consume. The debt-strapped households of Middle America, or Britain and Spain, can no longer hold up the dysfunctional edifice. Asians must take over, or it will come down on their own heads.
The countries actively intervening in exchange markets to suppress their currencies— China, Japan, Korea, Thailand, even Switzerland, to name a few— are all too often the same ones that have the biggest trade surpluses with the US. They are taking active steps to prevent America extricating itself from the worst unemployment since the Great Depression, now 17.1% on the latest U6 index and rising again. Each country is doing so for understandable reasons: Japan to avoid a deflationary crisis, China to hold together a political order that is more fragile than it looks. In both these cases they are trapped because they clung too long to a 'mercantilist' export strategy, failing to wean themselves off American demand when the going was good.
Yet this is an intolerable situation for the US. It should be no surprise that Washington has begun to retaliate in earnest, and not just by passing the Reform for Fair Trade Act in the House (not yet the Senate), clearing the way for punitive tariffs against currency manipulators. The atomic bomb, of course, is 'quantitative easing' by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 'a l'outrance' to flood your economies with excess liquidity.
We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison. This is what QE2 means, though Fed officials prefer to talk of their "mandate" of supporting employment. It is nothing like QE1, which was emergency action to halt the economic free-fall of late 2008 and early 2009.
This time the Fed is using QE as a long-term tool to manage America's chronic ailments.
Uber-dovish Fed comments over recent days have been enough to send the dollar crashing to a 15-year low of 82 against the Japanese yen, to below parity against Swiss franc, and back to the EMU pain barrier of $1.40 against the euro. There was much tut-tutting about currency warfare at the IMF meeting over the weekend. "If one lets this slide into protectionism, we run the risk of the mistakes of the 1930," said World Bank chief Robert Zoellick.
You have to say this kind of thing if you run a Bretton Woods institution, but in real life wars occur because somebody finds the status quo unacceptable, perhaps justifiably so. As Nobel economist Paul Krugman puts it: "people are looking for innocuous ways to deal with this problem, and there just aren't any". Devaluation was not the mistake of the 1930s: it was the cure, albeit a bad one.
The Gold Standard broke down during the inter-war years because the US and France had structurally undervalued exchange rates (like China/Asia today) and ceased recycling their trade surpluses (like China/Asia today). This caused a deflationary downward spiral for everybody. Escaping from such a deformed system was a path to recovery.
The parallel with modern globalization— though not exact— is obvious. So is the 1930s lesson that currency and trade clashes are asymmetric: they are calamitous for surplus countries, but not always for deficit countries. Britain enjoyed a five-year mini-boom after retreating into an Empire trade bloc in 1932.
Fed chair Ben Bernanke knows his history. In a speech as a junior Fed governor he described Roosevelt's 40% devaluation against gold as "an effective weapon" against deflation and slump, adding "1934 was one of the best years of the century for the stock market". I suspect that the Bernanke Fed is working with the Treasury to steer the dollar lower, and above all to stop it rising again, since the global dollar index looks poised for a powerful rebound.
There is certainly something odd about the latest Fed rhetoric. New York chief William Dudley said inflation had fallen to "unacceptable" levels. Has it really? The Dallas Fed's 'trimmed-mean' CPE inflation index has been creeping up over the last three months.
His Chicago colleague Charles Evans has called for "much more accommodation". Why now? Bank credit has stopped contracting. The M2 money supply growth has accelerated sharply to a 7.4% rate over the last month of published data. The St Louis Fed's monetary multiplier has edged up at last. By the Fed's own account, the double-dip scare of the early summer has abated.
I happen to think that the Fed will need to launch QE2 on a big scale as US fiscal tightening bites, the inventory spike fades, and the housing foreclosure crisis gathers pace. But we are not there yet. Fresh QE cannot be justified at this juncture under any normal understanding of central bank policy.
Is the Fed in reality trying to shore up consumption by juicing asset prices, and trying to ensure that the effect boosts jobs at home rather than in China, Germany, or Japan by holding down the dollar? This is a dangerous moment for the world, and may backfire against the US itself. We are already starting to see the same sort of rush into oil and resources that played such havoc in mid-2008, and may have been a key trigger for the Great Recession. There is a risk that this commodity shock will hit before QE stimulus filters through.
And while the French deny that they are in talks with China over the creation of a "new currency regime", I heard French finance minister Christine Lagarde say in person at a meeting in Italy that France would use its G20 presidency to push for an alternative to the dollar. She specifically cited the "Bancor", the idea floated by Keynes in the 1940s for a commodity currency priced off a basket of metals. The US risks gambling away the "exorbitant privilege" it has enjoyed for two thirds of a century as currency hegemon.
Yet the surplus states have most to lose if this brinkmanship tips into commercial war. They must know this, but what we are witnessing may run deeper than a calculus of advantage. Was it naïve to think that Confucian Asia and the old democracies of the Atlantic seaboard can share an open global trading system?
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