Ok, so, here is the problem worrying some: Behind the encouraging headlines of somewhat stronger growth in the advanced economies, Larry Summers worries that the North Atlantic economy — think: old Europe and the New World of Canada and the U.S., with Japan thrown in for good measure — is at risk of secular stagnation, perpetually trapped in a low-growth environment; meanwhile, the IMF frets that Europe is flirting with deflation, China is slowing as conditional convergence suggests it eventually must, and the emerging markets that powered global growth in 2009-2011 are fearful of more “taper tantrums” as the Fed begins to slow the pace of quantitative easing.
What is to be done?
If you are Paul Krugman, you pull out your model of the liquidity trap and say that central bankers need to commit to higher inflation. The reason higher inflation is needed is that, in a liquidity trap, interest rates are too high to move the economy to full employment. What matters here is the real, or inflation-adjusted, interest rate. And, with advanced countries' central banks having already reduced nominal interest rates to, effectively, zero, the only way to reduce real interest rates is to raise inflation. Krugman worries, however, that central bankers may be ensnared in a timidity trap. That is to say, central bankers to whom society delegates enormous responsibilities are reluctant to act in a manner that might be viewed as irresponsible or worse, “unsound,” after the fact.
Or, perhaps, there is a problem of how to credibly commit to higher inflation in a way that contains the risk of overshooting and creating a hyperinflation that does more harm than good. An earlier post, here, noted three possible ways in which a central bank could potentially commit to higher inflation: through political commitment in which a higher political authority directs the central bank to generate higher inflation (Abenomics); targeting monetary aggregates at rates of growth consistent with higher inflation, with monthly targets allowing for frequent Bayesian updating to convince the public that you mean what you say; and, finally, targeting the exchange rate.
Jeff Frankel has proposed that the ECB adopt the third option (details here). Well, not exactly. Frankel has suggested that the ECB follow the Fed's example and undertake Quantitative Easting. In contrast to the Fed, however, which purchases U.S. domestic bonds (Treasuries), Frankel suggests that rather than purchase Eurozone domestic sovereign bonds, which could create legal and constitutional “difficulties” with the Germans, the ECB buy U.S. Treasuries. Frankel notes that this measure would depreciate the exchange rate and (helpfully) raise expectations of inflation.
As I noted earlier, an exchange-rate-based reflation strategy might work for a small economy on the periphery of the global economy that could target a depreciated exchange rate without inviting a reaction. I’m not sure, however, that the U.S. Treasury would take so benign a view if, say, the largest single economic block in the global economy were to try it. And I suspect Congress would take a rather dim view of such a policy should a sudden, sharp appreciation of the dollar derail a U.S. economy that is finally gaining strength. The cries of righteous indignation would ring out, followed shortly thereafter by legislation.
Such was the reaction 80 years ago when perceived beggar-thy-neighbour exchange rate depreciations led to trade barriers designed to preserve domestic employment. The tit-for-tat retaliation that followed resulted in a collapse of world trade; currency inconvertibility followed. Soon an increasing share of global resources was being allocated through opaque state-to-state agreements.
Thankfully, we haven’t passed through a decade of global stagnation followed by global war and we don't face the same challenges today. The global trade system remains remarkably resilient, perhaps because of the remarkable degree to which supply chains have become truly global. And emerging market economies have the potential to be engines of global growth. There are, however, some worrying similarities in some countries (unacceptably high unemployment and the risk of deflation) and new challenges (demographics). And, if exchange rates become policy instruments, resurgent protectionism could once again undermine global prosperity.
Fortunately, the international community is better prepared to deal with these threats to our common prosperity than were our grandfathers.
The IMF was created 70 years ago to assist the global economy in dealing with the adjustment challenges in the post-war global economy. Ask most economists today what the purpose of the Bretton Woods system was, however, and they will likely respond: “fixed exchange rates.” Yes and no. That response is akin to saying that the purpose of JFK’s vow to land a man on the moon (and bring him back) “by the end of the decade” (1960s) was to go to the moon. Technically correct, but somewhat lacking in perspective — surely Kennedy’s objective was to meet the geopolitical challenge posed by the Soviet Union. It is important not to confound objective and instrument. Bretton Woods was a cooperative solution to the problem of how to sustain full employment; restore global trade and payments; and promote economic, political and social development in the nascent democracies that would follow from the retreat of European colonial regimes. Exchange rate flexibility was contained — to finesse the international trilemma — to facilitate the achievement of these goals and the IMF established to support cooperation. But the goal of Bretton Woods was not fixed exchange rates for the sake of fixed exchange rates.
Given the challenges in the global economy today, it would be comforting to know that the IMF enjoys the confidence and support of the international community. That scenario requires the international community to agree on the responsibilities and obligations that each member has to the system and on the role of the IMF in supporting that consensus. Such an outcome would reduce the risks associated with the formidable adjustment challenges that we face in the new age of uncertainty.