Beggar my neighbour - or merely browbeat him?
This week's statement by the Federal Reserve has achieved all that Ben Bernanke might have hoped it would achieve; stocks are up, the dollar is down, and so are most US bond yields. We can't say for sure that it will "work", but all of these developments ought to be net positive for the US economy. The question I raised yesterday was whether it would be expansionary for the rest of the world.
After all, the US is supposedly engaged in competitive devaluation. At the very least, it is pursuing a policy of "active dollar neglect". Talk of competitive devaluation conjures up visions of the 1930s, the iconic example of a time when countries beggared each other with depreciation and protectionism as they fought over a diminishing global pot of economic demand.
Is that what is happening today? Is the US simply exporting its demand shortage to the rest of the world?
As I said yesterday, the answer depends, in part, on how other countries respond. The big problem in the 1930s was not so much the depreciation itself, as the way it took place: through domestic price levels, rather than the exchange rate. Because most of the countries "competing" were locked into the gold standard, the only way they could make their goods cheaper overseas was by forcing down domestic prices (and demand). Once you have a lot of countries doing that, you have the ingredients for a shrinking global economy and a lot of beggaring, not just of your neighbours but of your own country as well.
To be clear: that is not the kind of competitive depreciation that the US is after. When you talk to people in the administration, they don't think they are trying to beggar anyone. Far from it. They think that they're trying to get as much growth as possible for the US economy - and if their cheap money (and currency) policies encourage others to do things which expand their own domestic demand, well, isn't that what they should be doing anyway?
Is that what's going to happen as a result of the Fed's move? That depends on whether other countries have a fixed exchange rate or a flexible one. For countries with completely fixed exchange rates, the economic would suggest that more QE by the Fed would be expansionary, because the domestic authorities have to loosen domestic monetary conditions by a similar amount to keep the currency at the same rate.
This is (sort of) what should happen in China - but not if the Chinese authorities have anything to do with it. As I discussed at length a few weeks ago, China's quasi-communist financial system means it has more ability than most both to fix its exchange rate, and to do what it wants to domestic monetary conditions.
But what about the many countries that do not fix their exchange rate? At first glance, for them the Fed's move will be clearly contractionary: their currency will go up, meaning less demand for their exports and tighter conditions at home.
However, America's economic heft makes a difference to the calculation: rising US stock prices and lower US interest rates should push global equities up and interest rates down, as they have today. That would offset the tightening effect through the currency. Also, if central banks don't want demand to go down in their economies, they can and will act to offset the Fed's move, and push their currencies back down again.
That, in a sense, is why the US sees 'competitive depreciation' of the dollar as a win-win. If other countries, with flexible countries, don't respond with QE2 of their own, then their currencies will strengthen, and demand for US goods in those economies will (theoretically) go up. If they do respond, with more easing to counteract the rise in the currency, then global demand goes up, and the US is once again better off.
Put that way, it sounds like a no-brainer. But all of this assumes that the Fed's policy is actually effective, over the medium-term, in lowering US real interest rates and raising US real demand. (It also depends, incidentally, on the policy raising inflation. Critics seem to to think it can be both ineffective and inflationary. That is simply a contradiction in terms, at least when it comes to the US.)
If the policy doesn't work, the calculation shifts: in that case, QE2 won't cause inflation in the US, but it might simply fuel asset price bubbles in emerging market economies without doing much good at home.
It's an open question whether that is contractionary or expansionary for the rest of the world in the short term. But note that it does very little to re-balance the global economy. Re-balancing is supposed to mean increasing consumer demand in the emerging economies, not increasing the amount of hot money invested in domestic real estate.
Charles Dumas, of Lombard Street Research, takes the gloomiest possible view in a paper he has just put out. He thinks the only positive effects from QE2 will come through the lower dollar. (Notably, he doesn't think it will do anything to support house prices in the US, because the Fed is not buying houses or even mortgage-backed securities, as it did in the first rounds of QE.) And that positive effect, in terms of net exports, will happen slowly, if at all.
But, in the Dumas view, the negative impact of QE2 on the US will be significant, and operate much more quickly. A weaker dollar will hit real incomes by raising the cost of food and energy; he also thinks that rising inflation expectations at the 30-year end of the US bond market could actually push mortgage rates up as a result of the Fed's move.
His bottom line? If anything, QE2 will make deflation in the US more likely over the next year or so - and raise the chance that the Chinese will slam on the brakes domestically to curb inflation there. If true, that would be well and truly the worst of all worlds: no inflationary impact in the country that wants inflation, and a deflationary impact in the country where the US most wants to see strong domestic demand.
Now you see why the Fed is playing for such high stakes. And you can see why countries resent the US putting its interests first. If QE2 does what the US central bank wants it to do, it will almost certainly do more good to the global economy than harm. But if it doesn't, some of the biggest harm might be done overseas.
Again, the US isn't trying to export its weak recovery to the rest of the world. It wants a strong recovery, for itself and everyone else.
However, it is possible - some would say likely - that a strong recovery is not available at any price in the US today, especially while the most important dollar exchange rate is set in Beijing. If that is true, the American authorities could end up simply exporting the negative side-effects of a futile expansion effort, while doing very little to raise growth at home. Let's hope it's not.