Beggar Thy Currency Or Thy Self?

Mohamed A. El-Erian

22 January 2013

NEWPORT BEACHNot many countries nowadays seek a strong exchange rate; a few, including systemically important ones, are already actively weakening their currencies. Yet, because an exchange rate is a relative price, all currencies cannot weaken simultaneously. How the world resolves this basic inconsistency over the next few years will have a major impact on prospects for growth, employment, income distribution, and the functioning of the global economy.

Japan is the latest country to say enough is enough. Having seen its currency appreciate dramatically in recent years, Prime Minister Shinzo Abe’s new government is taking steps to alter the country’s exchange-rate dynamic – and is succeeding. In just over two months, the yen has weakened by more than 10% against the dollar and close to 20% against the euro.

European leaders have already expressed reservations about Japan’s moves. The US auto industry is up in arms. And, a few days ago, Jens Weidmann, the president of the Bundesbank, publicly warned that the world risks a harmful and ultimately futile round of competitive exchange-rate depreciations – or, more bluntly, a “currency war” (a term used previously by Brazil to express similar concerns).

Of course, Japan is not the first country to go down this path. Several advanced and emerging economies preceded it, and I suspect that quite a few will follow it.

It is just over a year since Switzerland surprised many when it announced, and strictly implemented, a threshold beyond which its currency would not be allowed to appreciate against the euro. And, remember, the country’s operating model for centuries has been to provide a safe haven for foreign capital.

One need not be an economist to figure out that, while all currencies can (and do) depreciate against something else (like gold, land, and other real assets), by definition they cannot all weaken against each other. In order for some currencies to depreciate, others must appreciate. Here is where things get interesting, complex, and potentially dangerous.

In today’s world, no significant group of countries is looking for currency strength. Some resist appreciation actively and openly; others do so in a less visible manner. Only the eurozone seems to accept being on the receiving end of other countries’ actions.

None of this is unprecedented, and there is a lot of scholarship demonstrating why such beggar-thy-neighbor approaches result in bad collective outcomes. Indeed, multilateral agreements are in place to minimize this risk, including at the International Monetary Fund and the World Trade Organization.

Yet, when push comes to shove, country after country is being dragged into abetting a potentially harmful outcome for the global economy as a whole. Worse, this process has not yet registered seriously on the multilateral policy agenda.

There are many reasons for this, ranging from the rather debilitated state of multilateral governance to the urgency of domestic issues currently commanding national policymakers’ attention. But there is also something else at work: The causes of today’s predicament are difficult to comprehend and counter effectively.

Unlike the old days, the threat of currency wars is not directly related to trade imbalances and balance-of-payments crises. Rather, an important driver is major central banks’ pursuit of experimental measures in order to compensate for policy inadequacies and political dysfunction elsewhere.

If the world is to avoid serious harm, it is important to understand the dynamics at work. A simplified description runs as follows: Facing low growth and high unemployment, and with other policymakers stuck on the sideline, a central bank like the US Federal Reserve feels that it has no choice but to adopt a highly accommodating monetary policy. As policy interest rates are already floored at zero, it is compelled to venture ever deeper into the uncharted realm of “unconventional policies.”

The aim, as Fed Chairman Ben Bernanke said again in December, is to “pushinvestors to take more risk. Specifically, it is hoped that an artificial surge in asset prices will make people feel richer and more optimistic, thus triggeringwealth effects” and “animal spirits” that stimulate consumption and investment spending, bolster job creation, and, in the process, “validate” the artificial asset pricing.

In practice, the strategy has proved not to be so straightforward. Moreover, part of the liquidity that the Fed injects finds its way into other countries’ financial markets.

Witness the surge in capital flows to emerging markets as investors chase higher financial returns. Complicating matters even more, these inflows have become less and less connected to the recipient countries’ economic and financial fundamentals.

Many investors also feel the need to balance increasingly speculative investments (“satellite positioning”) with much safer investments (“core positioning”). To meet the latter objective, they turn to prudently managed countries, placing upward pressure on their currencies, too – and, again, beyond what would be warranted by domestic fundamentals.

It is no wonder that more and more governments are worried about exchange-rate appreciation. In addition to short-term policy headaches, stronger currencies carry potentially significant costs in terms of hollowing out industrial and service sectors.

So, after a varying mix of tolerance and “heterodoxresponses, officials are pulled into loosening their own monetary policy in order to weaken their countries’ currencies or, at a minimum, limit the pace of appreciation.

This period of expanding policy inconsistencies could prove to be temporary and reversible if central banks succeed in jolting economies out of their malaise, and if countries come to recognize that greater cross-border policy coordination is urgently needed.

The risk is that the phenomenon leads to widespread disruptions, as increasingly difficult national policy challenges stoke regional tensions and the multilateral system proves unable to reconcile imbalances safely. If policymakers are not careful – and lucky – the magnitude of this risk will increase significantly in the years ahead.

Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $1.8 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist.

Copyright Project Syndicate -

January 22, 2013 8:00 pm
America’s fiscal policy is not in crisis
The urgent challenge is to promote economic recovery
Ingram Pinn illustration

The US confronts huge challenges, at home and abroad. Its fiscal position is not one of them. This is a highly controversial statement. If one judged by the debate in Washington, one would conclude that the federal government is close to bankruptcy.

This view is false. Yes, the US does confront fiscal challenges in the long term. But these are largely caused by the soaring costs of its inefficient healthcare. Yes, the US is engaged in a fierce debate on fiscal policy. But this is due to philosophical disputes over the role of the state. Yes, the US has been running large fiscal deficits in the short run. But these are a result of the financial crisis.

Start, then, with the medium-term prospects. In a widely cited piece, published this month by the Center on Budget and Policy Priorities, Richard Kogan argues that “policymakers can stabilize the public debt over the coming decade ... with $1.4tn in additional deficit savings”. The explanation for this improved medium-term outlook is a combination of economic recovery and policy measures, particularly the Budget Control Act of August 2011 and the American Taxpayer Relief Act enacted this month.

Moreover, because of savings on interest payments, policy makers could achieve this amount of deficit reduction with just $1.2tn in further savings. That would be just 0.6 per cent of prospective gross domestic product, even on the pessimistic assumption that nominal GDP grows at an annual rate of just 4 per cent.

Click to enlarge

Under these assumptions, the ratio of debt to GDP would stabilise at about 73 per cent (see chart). Would this be unbearable? No. At current real interest rates, the cost would be zero. Even if real rates of interest were to rise to, say, 3 per cent, the fiscal cost, in real terms, would be a mere 2 per cent of GDP. That is perfectly manageable.

Now consider the long term. On this, the Congressional Budget Office notes in its 2012 Long-Term Budget Outlook that “if current laws remained in place, spending on the major federal health care programs alone would grow from more than 5 per cent of GDP today to almost 10 per cent in 2037 and would continue to increase thereafter. Spending on Social Security is projected to rise much less sharply, from 5 per cent of GDP today to more than 6 per cent in 2030 and subsequent decades ...

Absent substantial increases in federal revenues, such growth in outlays would result in greater debt burdens than the US has ever experienced.” To be precise, under the assumption that revenue is kept at 18.5 per cent of GDP, just above the average of the past 40 years, debt held by the public could reach 200 per cent of GDP by 2040.

In the long run, then, the federal government must raise receipts above historic averages; slow the rising costs of healthcare; or, more plausibly, do some of both. To non-Americans, neither should be difficult. This is because of two salient features of the contemporary US economy: extreme income inequality and health inefficiency.

First, the CBO has noted in another paper that “the share of total market income received by the top 1 per cent of the population more than doubled between 1979 and 2007, growing from about 10 per cent to more than 20 per cent.” Taxing these huge winners a bit more heavily seems a politically obvious move.

Second, behind these forecasts for government spending lies a dramatic prospect for overall private and public spending on health, which would rise “from about 17 per cent of GDP now to almost one-quarter by 2037”. Already, the US spends a far higher share of GDP on healthcare than other high-income countries.

In 2010, its total health spending was 17.6 per cent of GDP. The spending of the next highest, the Netherlands, was just 12 per cent.
Even the US public sector spent a higher share of GDP than the UK. Yet US life expectancy, to take just one indicator, was a mere 78.7, against 80.6 in the UK (see chart).

This brings us to the philosophical dispute. One side of the political debate is strongly committed to the idea that taxes should fall. Some in this camp argue that all taxation is theft.

Others believe taxes destroy incentives. Yet others argue that any state support saps self-reliance. Meanwhile, those on the other side of the debate believe, as strongly, in a safety net that covers risks related to health, ageing and unemployment. President Barack Obama defended this position, to my mind persuasively, in his inaugural speech.

In practice, political equilibrium tends to include the commitments to spending, but not the parallel commitments to revenue. In the long run, adjustments must be made. The outcome is unlikely to be exploding public debt. Far more likely are somewhat higher taxation and somewhat tighter curbs on spending, particularly on health. This is the only plausible deal. It goes without saying that defaulting now, in order to avoid hypothetical bankruptcy decades from now, would be mad.

Finally, what is to be done now? The answer starts from recognising the realities. If one looks back at the explosion in deficits in 2008 and 2009 (before Mr Obama influenced fiscal policy), one sees both dramatic cuts in real fiscal receipts and sharp rises in real spending, both of which are directly related to the financial crisis and subsequent recession (see chart). Since 2009, real federal spending has been flat.

Meanwhile, receipts have been both highly cyclical since 2000 and trend-free. The huge deficits were a result of the unexpected crisis and decisions, before that calamity, to sustain rapid rises in real spending while giving away fiscal receipts.

Yet another legacy of the crisis has been a huge rise in the consolidated financial surplus of the private sector (balance between income and spending, as shares of GDP). The fiscal deficit is the mirror image of this increased private prudence. The risk is that accelerated fiscal stringency, at a time of zero interest rates, will depress the economy more than improve the fiscal outcomes. This is because fiscal multipliers are particularly high in such circumstances, as the International Monetary Fund has argued. The time to tighten fiscal policy will be when the economy is strong.

The federal government is not on the verge of bankruptcy. If anything, the tightening has been too much and too fast. The fiscal position is also not the most urgent economic challenge. It is far more important to promote recovery. The challenges in the longer term are to raise revenue while curbing the cost of health. Meanwhile, people, just calm down.

Copyright The Financial Times Limited 2013.

A New Year of Global Conflict

Javier Solana, Ian Bremmer

22 January 2013

Illustration by Paul Lachine


DAVOS In today’s world, identifying and managing hotspots is not simply a matter of pulling out a map, spotting the wildfires, and empowering diplomats to douse the flames. To understand today’s major conflicts and confrontations, we must recognize important ways in which global political conditions enable them.
  Conflicts are much more likely to arise or persist when those with the means to prevent or end them cannot or will not do so. Unfortunately, this will be borne out in 2013.

In the United States, barring a foreign-policy crisis that directly threatens national security, President Barack Obama’s administration will focus most of its time, energy, and political capital on debt reduction and other domestic priorities. In Europe, officials will continue their struggle to restore confidence in the eurozone. And, in China, though the demands of economic growth and job creation will force the country’s new leaders to develop new ties to other regions, they are far too preoccupied with the complexities of economic reform to assume unnecessary costs and risks outside Asia. That is why the world’s fires will burn longer and hotter this year.

This does not mean that the world’s powers will not inflict damage of their own. Today, these governments are more likely to use drones and special forces to strike at their perceived enemies.

The world has grown used to US drone strikes in Afghanistan, Pakistan, and Yemen, but recent news reports suggest that China and Japan are also investing in unmanned aircraftin part to enhance their leverage in disputes over islands in the East China Sea. By lowering the costs and risks of attack, these technological innovations make military action more likely.

Perhaps the lowest-cost way to undermine rivals and attack enemies is to launch attacks in cyberspace. That is why so many deep-pocketed governments – and some that are not so rich – are investing heavily in the technology and skills needed to enhance this capability.

This form of warfare is especially worrisome for two reasons. First, unlike the structure of Cold War-eramutually assured destruction,” cyber weapons offer those who use them an opportunity to strike anonymously. Second, constant changes in technology ensure that no government can know how much damage its cyber-weapons can do or how well its deterrence will work until they use them.

As a result, governments now probe one another’s defenses every day, increasing the risk of accidental hostilities. If John Kerry and Chuck Hagel are confirmed as US secretaries of state and defense, respectively, the Obama administration will feature two prominent skeptics of military intervention. But high levels of US investment in drones, cyber-tools, and other unconventional weaponry will most likely be maintained.

These technological advances create the backdrop for the competition and rivalries roiling the two most important geopolitical hotspots. In the Middle East, US and European officials will continue to resist deeper involvement in regional turmoil this year, leaving local powersTurkey, Iran, and Saudi Arabia – to vie for influence. Confrontations between moderates and militants, and between Sunni and Shia factions, are playing out in several North African and Middle Eastern countries.

US officials have reason to believe that, over time, they will be able to worry less about the region and its problems. According to current projections, technological innovations in unconventional energy will allow the US to meet more than 80% of its oil demand from sources in North and South America by 2020. China, on the other hand, is set to become more dependent on Middle Eastern output.

Meanwhile, East Asia will remain a potential trouble spot in 2013. Many of China’s neighbors fear that its ongoing economic and military expansion poses a growing threat to their interests and independence, and are reaching out to the US to diversify their security partnerships and hedge their bets on China’s benign intentions. The US, eager to boost its economy’s longer-term prospects by engaging new trade partners in the world’s fastest-growing region, is shifting resources to Asiathough US (and European) policymakers would be wise to move forward with a transatlantic free-trade agreement as well.

There is a growing risk that the new Chinese leadership will interpret a heavier US presence in the region as an attempt to contain China’s rise and stunt its growth. We have already seen a series of worrisome confrontations in the region, pitting China against Vietnam and the Philippines in the South China Sea, and against Japan in the East China Sea. While these disputes are unlikely to provoke military hostilities this year, the use of drones and cyber weapons remains a real threat.

The greatest risk for 2013 is large-scale economic conflict in Asia, which would not only harm the countries directly involved, but would also undermine global recovery. The first shots in this battle have already been fired.

Last summer, disputes over a string of contested islands in the East China Sea led to a furious exchange of charges between China and Japan, the world’s second- and third-largest economies, respectively. The two sides were never in danger of going to war, but Chinese officials allowed nationalist protests to develop into boycotts of Japanese products and acts of vandalism against Japanese companies. Japan’s automobile exports to China fell 44.5%, and China’s imports from Japan fell nearly 10%all in just one month.

That was a tough hit for a struggling Japanese economy. It is also a clear warning to the rest of us that a fight need not involve troops, tanks, and rockets to exact a heavy price.

Javier Solana was Foreign Minister of Spain, Secretary-General of NATO, and EU High Representative for Foreign and Security Policy. He is currently President of the ESADE Center for Global Economy and Geopolitics and Distinguished Fellow at the Brookings Institution.

Ian Bremmer is President of Eurasia Group and the author of Every Nation for Itself: Winners and Losers in a G-Zero World.

Why Stimulus Has Failed

Raghuram Rajan

22 January 2013


NEW DELHITwo fundamental beliefs have driven economic policy around the world in recent years. The first is that the world suffers from a shortage of aggregate demand relative to supply; the second is that monetary and fiscal stimulus will close the gap.

Is it possible that the diagnosis is right, but that the remedy is wrong? That would explain why we have made little headway so far in restoring growth to pre-crisis levels. And it would also indicate that we must rethink our remedies.

High levels of involuntary unemployment throughout the advanced economies suggest that demand lags behind potential supply. While unemployment is significantly higher in sectors that were booming before the crisis, such as construction in the United States, it is more widespread, underpinning the view that greater demand is necessary to restore full employment.

Policymakers initially resorted to government spending and low interest rates to boost demand. As government debt has ballooned and policy interest rates have hit rock bottom, central banks have focused on increasingly innovative policy to boost demand. Yet growth continues to be painfully slow. Why?

What if the problem is the assumption that all demand is created equal? We know that pre-crisis demand was boosted by massive amounts of borrowing. When borrowing becomes easier, it is not the well-to-do, whose spending is not constrained by their incomes, who increase their consumption; rather, the increase comes from poorer and younger families whose needs and dreams far outpace their incomes. Their needs can be different from those of the rich.

Moreover, the goods that are easiest to buy are those that are easy to post as collateralhouses and cars, rather than perishables. And rising house prices in some regions make it easier to borrow even more to spend on other daily needs such as diapers and baby food.

The point is that debt-fueled demand emanates from particular households in particular regions for particular goods. While it catalyzes a more generalized demand – the elderly plumber who works longer hours in the boom spends more on his stamp collection – it is not unreasonable to believe that much of debt-fueled demand is more focused. So, as lending dries up, borrowing households can no longer spend, and demand for certain goods changes disproportionately, especially in areas that boomed earlier.

Of course, the effects spread through the economy – as demand for cars falls, demand for steel also falls, and steel workers are laid off. But unemployment is most pronounced in the construction and automobile sectors, or in regions where house prices rose particularly rapidly.

It is easy to see why a general stimulus to demand, such as a cut in payroll taxes, may be ineffective in restoring the economy to full employment. The general stimulus goes to everyone, not just the former borrowers. And everyone’s spending patterns differ – the older, wealthier household buys jewelry from Tiffany, rather than a car from General Motors. And even the former borrowers are unlikely to use their stimulus money to pay for more housing – they have soured on the dreams that housing held out.

Indeed, because the pattern of demand that is expressible has shifted with the change in access to borrowing, the pace at which the economy can grow without inflation may also fall. With too many construction workers and too few jewelers, greater demand may result in higher jewelry prices rather than more output.

Put differently, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.

There is thus a subtle but important difference between my debt-driven demand view and the neo-Keynesian explanation that deleveraging (saving by chastened borrowers) or debt overhang (the inability of debt-laden borrowers to spend) is responsible for slow post-crisis growth. Both views accept that the central source of weak aggregate demand is the disappearance of demand from former borrowers. But they differ on solutions.

The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative. Writing down former borrowers’ debt may be slightly more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level. In any case, do we really want the former borrowers to borrow themselves into trouble again?

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand – to ease the way for construction workers and autoworkers to retrain for faster-growing industries. The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.

Supply-side adjustments take time, and, after five years of recession, economies have made some headway. But continued misdiagnosis will have lasting effects. The advanced countries will spend decades working off high public-debt loads, while their central banks will have to unwind bloated balance sheets and back off from promises of support that markets have come to rely on.

Frighteningly, the new Japanese government is still trying to deal with the aftermath of the country’s two-decade-old property bust. One can only hope that it will not indulge in more of the kind of spending that already has proven so ineffective – and that has left Japan with the highest debt burden (around 230% of GDP) in the OECD. Unfortunately, history provides little cause for optimism.

Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the chief economic adviser in India's finance ministry, served as the International Monetary Fund’s youngest-ever chief economist and was Chairman of India’s Committee on Financial Sector Reforms. He is the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.