Monetary Mystification
Joseph E. Stiglitz
04 October 2012

NEW YORKCentral banks on both sides of the Atlantic took extraordinary monetary-policy measures in September: the long awaitedQE3” (the third dose of quantitative easing by the United States Federal Reserve), and the European Central Bank’s announcement that it will purchase unlimited volumes of troubled eurozone members’ government bonds. Markets responded euphorically, with stock prices in the US, for example, reaching post-recession highs.
Others, especially on the political right, worried that the latest monetary measures would fuel future inflation and encourage unbridled government spending.
In fact, both the critics’ fears and the optimists’ euphoria are unwarranted. With so much underutilized productive capacity today, and with immediate economic prospects so dismal, the risk of serious inflation is minimal.
Nonetheless, the Fed and ECB actions sent three messages that should have given the markets pause. First, they were saying that previous actions have not worked; indeed, the major central banks deserve much of the blame for the crisis. But their ability to undo their mistakes is limited.
Second, the Fed’s announcement that it will keep interest rates at extraordinarily low levels through mid-2015 implied that it does not expect recovery anytime soon. That should be a warning for Europe, whose economy is now far weaker than America’s.
Finally, the Fed and the ECB were saying that markets will not quickly restore full employment on their own. A stimulus is needed. That should serve as a rejoinder to those in Europe and America who are calling for just the oppositefurther austerity.
But the stimulus that is needed – on both sides of the Atlantic – is a fiscal stimulus. Monetary policy has proven ineffective, and more of it is unlikely to return the economy to sustainable growth.
In traditional economic models, increased liquidity results in more lending, mostly to investors and sometimes to consumers, thereby increasing demand and employment. But consider a case like Spain, where so much money has fled the banking system – and continues to flee as Europe fiddles over the implementation of a common banking system. Just adding liquidity, while continuing current austerity policies, will not reignite the Spanish economy.
So, too, in the US, the smaller banks that largely finance small and medium-size enterprises have been all but neglected. The federal government – under both President George W. Bush and Barack Obama – allocated hundreds of billions of dollars to prop up the mega-banks, while allowing hundreds of these crucially important smaller lenders to fail.
But lending would be inhibited even if the banks were healthier. After all, small enterprises rely on collateral-based lending, and the value of real estate – the main form of collateral – is still down one-third from its pre-crisis level. Moreover, given the magnitude of excess capacity in real estate, lower interest rates will do little to revive real-estate prices, much less inflate another consumption bubble.
Of course, marginal effects cannot be ruled out: small changes in long-term interest rates from QE3 may lead to a little more investment; some of the rich will take advantage of temporarily higher stock prices to consume more; and a few homeowners will be able to refinance their mortgages, with lower payments allowing them to boost consumption as well.
But most of the wealthy know that temporary measures result only in a fleeting blip in stock priceshardly enough to support a consumption splurge. Moreover, reports suggest that few of the benefits of lower long-term interest rates are filtering through to homeowners; the major beneficiaries, it seems, are the banks. Many who want to refinance their mortgages still cannot, because they are “underwater” (owing more on their mortgages than the underlying property is worth).
In other circumstances, the US would benefit from the exchange-rate weakening that follows from lower interest rates – a kind of beggar-thy-neighbor competitive devaluation that would come at the expense of America’s trading partners. But, given lower interest rates in Europe and the global slowdown, the gains are likely to be small even here.
Some worry that the fresh liquidity will lead to worse outcomes – for example, a commodity boom, which would act much like a tax on American and European consumers. Older people, who were prudent and held their money in government bonds, will see lower returnsfurther curtailing their consumption. And low interest rates will encourage firms that do invest to spend on fixed capital like highly automated machines, thereby ensuring that, when recovery comes, it will be relatively jobless. In short, the benefits are at best small.
In Europe, monetary intervention has greater potential to help – but with a similar risk of making matters worse. To allay anxiety about government profligacy, the ECB built conditionality into its bond-purchase program. But if the conditions operate like austerity measuresimposed without significant accompanying growth measures – they will be more akin to bloodletting: the patient must risk death before receiving genuine medicine. Fear of losing economic sovereignty will make governments reluctant to ask for ECB help, and only if they ask will there be any real effect.
There is a further risk for Europe: If the ECB focuses too much on inflation, while the Fed tries to stimulate the US economy, interest-rate differentials will lead to a stronger euro (at least relative to what it otherwise would be), undermining Europe’s competitiveness and growth prospects.
For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending.
The current downturn, already a half-decade long, will not end any time soon. That, in a nutshell, is what the Fed and the ECB are saying. The sooner our leaders acknowledge it, the better.

Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia University, was Chairman of President Bill Clinton’s Council of Economic Advisers and served as Senior Vice President and Chief Economist of the World Bank. His most recent book is The Price of Inequality: How Today’s Divided Society Endangers our Future.

October 3, 2012 7:40 pm

International trade: A fragile armistice
By Alan Beattie and Alice Ross
Imbalances that sparked ‘currency wars’ have been reduced but with reforms still needed, a detente may be short-lived.
A bird flies near a ship waiting to deliver four new quayside container gantry cranes Los Angeles
   ©Bloomberg   Calm before the storm: Chinese-made gantry cranes on the way to the Port of Los Angeles. With US exports having risen sharply in the past two years, some of the political heat surrounding imbalances with China has dissipated

There was a time, between 1839 and 1842, when imperial Britain could resolve its trade imbalances by sending Royal Navy warships to the Pearl River and Shanghai to force China to accept imports of opium.

By contrast, the “currency wars” of 2010 fizzled out rather more bloodlessly. Those conflicts – whose principal combatants were the US and China, with Brazil and some other emerging markets also active – involved fierce accusations of competitive devaluations to boost exports. Two years later, current account imbalances have shrunk and tensions about exchange rates have dissipated.

Still, amid still faltering recovery in developed economies and slowing growth in emerging economies, that detente may prove an armistice rather than a permanent peace.

Rebalancing hasn’t progressed that much, and a lot of the gains are superficial,” says Steven Dunaway, an economic consultant and former senior official at the International Monetary Fund. The current account movements, particularly in China, have often not been accompanied by the kind of internal rebalancing likely to make them durable. And with the Federal Reserve recently embarking on a bout of super-loose monetary policy, with its third round of quantitative easing, accusations that the US is weakening the dollar for competitive advantage are re-emerging.

On the face of it, rebalancing is well in train, and the decade-long pattern of vendor financechronic-surplus China and other Asian economies lending money to the deficit-ridden US to buy their exports – is rapidly being broken. In September 2011 the IMF forecast a Chinese current account surplus of 5.2 per cent of gross domestic product for 2011; it came in at just 2.8 per cent.

The fund, whose views on imbalances are highly scrutinised because of its central role in attempting to mediate the currency wars, this year slashed its forecasts for Chinese surpluses in five years’ time from 7.8 per cent to 4.3 per cent of GDP. As it happens, that is only just above the 4 per cent level for which the US tried and failed to win acceptance as a global benchmark limit at a rancorous meeting of the Group of 20 leading nations in South Korea in 2010.

In their most recent (and keenly watched) regular global assessment, William Cline and John Williamson of the Peterson Institute, a Washington think-tank, say currencies are closer to fair values than at any time since they started estimates in 2008. The average global misalignment, weighted by size of economy, has dropped from 8.4 percentage points in 2009 to just 2.6 percentage points now.

With US exports having grown sharply over the past two years, comfortably outpacing the economy as a whole, even the political heat in America over the issue has dissipated somewhat. Mitt Romney, the Republican presidential candidate, has promised to name China a currency manipulator on his first day in office, but the action would be largely symbolic – and legislation to punish Beijing for exchange rate misalignments has stalled in the US Congress

Meanwhile, President Barack Obama has been touting the rebalancing already achieved – particularly inshoring”, bringing manufacturing jobs to America – as part of his campaign. Lael Brainard, the US Treasury’s most senior international economics official, said in July: “Exchange rate appreciation is starting to make a difference for our exporters and our workers.”

Yet many economists warn that all these gains are precarious. In part, they simply reflect the fact that current account imbalances generally fall when economies are weak, as consumers and businesses cut back on imported goods and services. The US, for example, has been growing at an anaemic rate averaging just over 2 per cent over the past two years enough to stabilise employment but almost certainly leaving a big output gap between actual and potential GDP.

IMF forecasts attempt to correct for the state of the business cycle. But following a period of prolonged global economic weakness and consumer debt overhang in the US, it is difficult to work out what potential GDP is, let alone how long the US will take to regain it. “Unusually, consumer demand has not been pulling the economy out of recession, and there is a large cyclical element to the reduction in the deficit,” Mr Dunaway says.

Nor do developments in other economies, particularly China, look like a new and sustainable pattern. The broad consensus among international policy makers about what China should do – and the stated aim of Beijing in its current five-year plan – is to shift from export dependence to consumer demand.

But the fall in China’s current account surplus owes more to a surge in domestic investment following the stimulus programme of 2008-09 – in particular, stockpiling imported minerals and buying machine tools for production. Consumption remains extraordinarily low, below 40 per cent of GDP.

In April the IMF estimated that the investment surge played almost as big a role in reducing China’s current account surplus between 2007 and 2011 as did the real appreciation of the renminbi during that time. Indeed, one of the remarkable features of the past year or so is that currencies appear to have grown far less misaligned without moving much. This year’s Peterson Institute estimates show the renminbi undervalued by 7.7 per cent against the dollar, compared with 28.5 per cent a year ago. Yet the renminbi rose just 3 per cent against the US currency during that time, and by not much more in real terms.

. . .

Since China’s investment surge was funded by yet more borrowing by already indebted local governments and state-owned enterprises, it has given succour to bears who warn Beijing’s path is not sustainable. Every country with an investment-driven growth model has ended up with a debt problem,” says Michael Pettis, a professor at Peking University.

For many economists – and the US administrationChina needs more renminbi appreciation, along with financial reform, to help its consumers buy imported goods. But for now, Beijing is more worried about short-term growth than long-term balance, and if anything the pressure on the renminbi is downward. The currency has barely moved against the dollar this year but, since the rise in China’s foreign exchange reserves has also stalled, this appears to reflect market-driven capital flows rather than official manipulation.

Capital outflows from China might reflect political uncertainty ahead of the once-in-a-decade change in leadership in Beijing, scheduled for next month. More ominously, they might suggest domestic businesses are taking money elsewhere because they have a first-hand view of the economy weakening. Grant Aldonas, managing director of the Split Rock International consultancy and an adviser to Mr Romney’s campaign, says: “The irony is that we may be focusing on China’s currency while the bubble in the Chinese economy collapses.”

In fact, the worst outcome would be the reduction of deficits and surpluses through a crunching global recession, akin to cutting off someone’s nose to rebalance their face. Even short of that, any further significant weakening in the big economies is likely to raise tension over imbalances and currencies; one of the biggest risks is that weaker European demand will dent Asian exports.

The Fed’s recent move has already stimulated complaints from some of the usual suspects. Guido Mantega, the Brazilian finance minister who was the first prominent policy maker to use the expression currency war” in 2010, has again raised the spectre of competitive devaluations. Tension around exchange rates has yet to reach the heights of two years ago but some developed economies, particularly those seen as havens, are being drawn into the fray.

As well as determined action by Switzerland to hold down the franc, the Bank of Japan responded to the Fed’s action by adding to its own monetary easing programme after the dollar weakened against the yen. Investors are on alert for further action from Tokyo, including full-scale currency intervention if the yen continues to strengthen.

Similarly, central bankers in Australia and Sweden have expressed concern about appreciation. Glenn Stevens, head of Australia’s central bank, said last month that the Australian dollar was increasingly being viewed as a haven by global investors. In what some viewed as a loaded comment, he also expressed surprise that a “conservative institution” such as the Swiss National Bank would be adding Australian dollars to its reserves. Sweden’s Riksbank warned in September that the krona had appreciatedunexpectedly rapidly” in the preceding few months.

. . .

Meanwhile, if emerging markets are dragged in en masse, they could be even more resistant than in 2010 to pressure from developed economies to allow ex­change rate appreciation and greater trade deficits. David Lubin, of Citigroup, says the 24 largest emerging market economies outside China ran a net $134bn trade deficit in the first six months of 2012, as against just $38bn in the first half of 2010.

“The last time around, some emerging markets were relatively content to see their currencies strengthen to help them deal with inflationary pressure and because exports were healthy,” he says. Now, many have an external problem and are concerned about worsening it by letting private credit growth increase. This will limit the ability of developed economies to export their way into a more rebalanced state by selling to emerging markets.”

The fundamental problem is still that there are many more countries keener on exporting than on consuming, and not much export demand to go around. The US has no desire to return to being the consumer of last resort. In the eurozone, though the external position as a whole has been largely balanced, the troubled economies of Ireland, Spain, Greece and Portugal desperately need to increase exports. Yet core countries – particularly Germany, which has benefited from Chinese purchases of machine tools in recent years – are unlikely to want to go into deficit to buy them all, suggesting the eurozone as a whole will try to be a net exporter.

Meanwhile the volume of global trade, having recovered smartly from its collapse in the aftermath of the fall of Lehman Brothers in 2008, has slowed sharply. The World Trade Organisation recently cut its forecast for world goods trade to a 2.5 per cent increase this year, as against 5 per cent last year and 13.9 per cent in 2010. Trade generally moves with – though is more volatile thanglobal GDP, so this is neither a good signal for short-term growth nor helpful for medium-term rebalancing.

The reduction in global current account surpluses and deficits in the past few years has been striking, and the period of calm it has delivered in economic diplomacy welcome. But it would be premature to conclude that the underlying problems have been solved and that a sustainable period of peace and prosperity has begun.


October 3, 2012 7:40 pm
Switzerland leads charge in forex fight
The country is now the fifth-largest holder of forex reserves
Switzerland is giving financial markets a lesson in the ramifications of trying to manipulate a currency, writes Alice Ross. The Swiss National Bank has been keeping the franc weak since September 2011. This came after foreign investors, nervous about the euro crisis, had snapped up francs to the dismay of Swiss exporters.

The SNB now regularly buys euros to prevent the franc growing stronger than SFr1.20 against the single currency. Switzerland has built up a stockpile of hundreds of billions in its foreign exchange reserves as a result. It is now the fifth-largest holder of forex reserves, with SFr418bn, of which 60 per cent is held in euros.

This has proved politically awkward for the SNB. Last month a report by credit rating agency Standard & Poor’s said Switzerland had become one of the main drivers of the market in the bonds of core eurozone economies because of its preference for highly rated government bonds. That provoked a rare response from the SNB, which argued that S&P’s calculations were incorrect.

Still, analysts agree that Switzerland now holds tens of billions of euros worth of eurozone debt and has been at least partly responsible for some of the moves in French and German borrowing costs this year. Credit Suisse calculates that the SNB was responsible for $102bn of the $142bn rise in global forex reserves held by central banks in the second quarter of this year.

The SNB has also become a driver of global currency markets as it tries to recycle some euros into what it sees as safer assets. Anticipating moves by the SNB has become a popular pastime among forex traders and investors, who have helped drive up the value of the smaller currencies, such as the Australian dollar and the Swedish krona, that the SNB is known to be fond of.

With tensions over the eurozone cooling in recent weeks, Switzerland has had to buy fewer euros, adding just SFr10bn to its reserves in August compared with SFr60bn in May.

But the SNB is not planning to end its policy any time soon, arguing that its currency is still overvalued.

Others disagree. This week, Switzerland revealed that its current account surplus in the second quarter of the year was the second-largest on record, with net inflows from foreign direct investment and long-term equity.

John Normand, head of global forex strategy at JPMorgan, says: “Such data in our view fatally undermines the SNB’s contention that franc appreciation is largely the work of unsustainable speculative flow. The SNB is rowing against a fundamental tide.”

Copyright The Financial Times Limited 2012.