Author: David Vines, Oxford University and ANU
After the Great Depression, US policymakers lost their nerve, and embarked upon fiscal consolidation.
They tipped the US, and the world, back into recession in 1937-38. The resulting problem was only resolved by the onset of World War II. Now, without serious cooperation on global macroeconomic policy, we run the risk of similarly derailing the recovery from the global financial crisis (GFC).
From the collapse of the Bretton Woods system in 1971, until the GFC, the global macro-economy was managed without cooperation. This held true even following the East Asian Crisis of 1997. In that period, the global policy system pursued (and achieved) two targets – output growth in East Asia and output growth in the rest of the world, using two instruments; real exchange rates (effectively set in East Asia) and world real interest rates (effectively set in New York).
What happened was that East Asian countries utilised their depreciated currencies to achieve export growth (with the exception of China, which relied on domestic deflation and importation of technical skills), and the US set low interest rates (the Greenspan ‘put’) – which led to low world interest rates – to achieve a continued high growth rate. It is true that this system led to global imbalances, and that it created the financial fragility which led to the GFC. But it delivered growth.
Now the international system is different. It has three objectives, a raft of challenges, and only one and a half instruments to deal with them. Sorting out the resulting policy conflict requires real cooperation.
As a result of the EMU crisis in Europe, achieving growth in Europe has now become a third global objective, in addition to growth in East Asia and the US. Achieving this objective may conflict with the requirements for high growth in the US.
Furthermore, new risks to global growth are threatening the three global objectives. The ‘old’ OECD countries are deleveraging, with corresponding declines in private spending. Political instability in the Middle East led to an oil price hike to over $100 a barrel. In Europe the EMU crisis has led to urgent fiscal cuts in the GIPS (Greece, Ireland, Portugal and Spain) and beyond (in Italy and Belgium) but no compensating rise of spending in Germany. In many of the other ‘old’ OECD countries, including the US and Japan, financial markets and policymakers are focused on reducing public deficits and debt. Finally, and crucially, in East Asia, an adjustment is happening only gradually, due to the slow rise of consumer spending in China.
In addition there is an ‘instrument problem’: global short-term real interest rates reached their zero bound two years ago. Central banks are now relying on a new half-tried half-instrument: quantitative easing (QE). This involves a central bank buying government and corporate bonds with newly created money, so as to lower the long term interest rate and depreciate the exchange rate of the country. But so far this policy instrument is of uncertain strength.
With three objectives, and only one-and-a half instruments, the world’s key regions are in danger of not being able to achieve what they desire. This is a global prisoner’s dilemma.
The responses to this prisoner’s dilemma have not been encouraging. Many countries, including China, various East Asian countries, the UK, and Germany are pursuing export-led growth. And the US will soon need to follow, to rectify its huge current account deficit.
But not all countries can have export-led growth. Policymakers and financial markets are refusing to realise this. Each country – properly – thinks of its own interests, rather than thinking of the world as a system. But this is in danger of producing a world that does not add up. That is why global macroeconomic cooperation is now so necessary.
The US will help to ameliorate the prisoner’s dilemma problem if Obama fails to raise US taxes, and if the US government continues overspending. In these circumstances the global growth trajectory will be sustained, albeit by a continuation of global imbalances.
This resolution of the prisoner’s dilemma will look good for a while. But the resulting global growth trajectory will bring the prospect of a delayed global adjustment. After another few years there will need to be a further significant fall of the dollar. But, once the dollar begins to fall, holders of dollar assets will have to sell en masse, because the carry trade is so highly leveraged. This will probably lead to a full-blown dollar crisis. The medium-term implications of this approach are therefore grim.
In addition, the US Federal Reserve is likely to respond to the prisoner’s dilemma problem with further, aggressive, quantitative easing, to keep long-term US interest rates low, and push the dollar down sooner rather than later. But if the dollar falls soon against the Euro, European nations will ensure that the ECB also resorts to QE, to push the Euro down and safeguard European growth, leading to the prospect of a global currency war. These QE strategies will together therefore push us into another low-interest-rate bubble, globally. That will be bad for China, and for East Asia generally, for whom the current level of interest rates is already too low.
What is at the heart of this problem? As long as China continues with its own slow speed of adjustment, the US is likely to maintain a fiscally lax stance, and proceed with QE, provoking QE in Europe. This bad global outcome must therefore be seen as a necessary consequence of the deliberate slow-adjustment choices being made by the Chinese authorities. Such a strategy is not only not in the global interest, it is also not in China’s interest. It will push China into a bubble-world which the Chinese authorities will find extremely difficult to manage.
A similar argument can be made about Germany. Germany is forcing a speedy and unprecedented degree of austerity adjustment on the GIPS. But Germany is not ensuring a correspondingly rapid expansion of demand at home. Instead Germany is using its competitive position to ensure that it grows rapidly by means of an export surplus. This explains why the rest of Europe is so keen to see the Euro fall against the dollar. This is Europe’s version of the China problem, with very similar global consequences.
The G20 and IMF do not have the instruments needed to ensure a global coordination of macroeconomic policies. This is why previous systems of multilateral surveillance – attempted by the IMF between 2004 and 2007 – were such a dismal failure. But a new process, the G20 Mutual Assessment Process, or ‘G20-MAP’, offers significant opportunities.
In this G20-MAP process, the IMF is taking the policies which countries propose, and integrating them into global scenarios. It is doing this to find out whether:
(i) adjustment happens – because China and East Asia adjust, and Europe and the US adjust as well, and growth is maintained; or
(ii) adjustment does not happen and there is inadequate global growth; or
(iii) adjustment does not happen but growth remains adequate, sustained by global imbalances.
The G20-MAP gives officials at the IMF the additional task of pointing G20 Heads of State towards policy adjustments of the kind which will lead to the first sort of outcomes. This process will – it is hoped – lock officials of the IMF and policymakers of the G20 countries into a situation in which they together seek adjustment-with-growth. Gordon Brown, in his important new book called ‘Beyond the Crash: Overcoming the First Crisis of Globalisation’, has described this outcome as a ‘global deal’.
What is happening might turn out to be very important for global institution-design. We may end up with an international community of policymakers and officials – both in the G20 nations and at the IMF – who are committed to resolving global macroeconomic problems and to sustaining global growth. If this works, the G20-MAP will institutionalise a new shared responsibility for managing the global macroeconomy.
David Vines is Professor in the Department of Economics and a Fellow of Balliol College at Oxford University, and an Adjunct Professor in the Centre for Applied Macroeconomic Analysis in the Research School of Economics at the Australian National University.