Perplexity, Skepticism, Desperation

Perplexity: After more than two years of double-digit deficits, near-zero interest rates and large purchases of public and private financial assets by central banks, the developed world (United States, Europe and Japan) continues to have an anemic economic performance: low growth, high unemployment rates and the risk of deflation. These policies did manage to reverse the collapse of the credit market, but they are not succeeding in reactivating the economy.

Skepticism: Faced with the realization that double-digit fiscal deficits are unsustainable, increasing liquidity became the only available instrument for trying to reactivate economies in the short run. As a result, the Federal Reserve (Fed), the U.S. central bank, signaled at its most recent meeting that it was going to increase liquidity by means of new purchases of government debt. But, with interest rates near zero, families indebted, wealth decreased due to the crisis and a high level of uncertainty, the general assessment is that this policy will have little or no effect on the real variables of the economy.

Desperation: Nonetheless, with a high rate of unemployment and a non-negligible risk of deflation, the Fed feels itself obliged to do something, even if “something” may result in negative collateral effects for the global economy. The additional liquidity will take the form of purchases of financial assets (stocks and bonds) in the U.S., and financial and real assets in developing countries (stocks, bonds, real estate, commodities, etc.). This will generate inflationary pressures, bubbles in the prices of real (developing countries) and financial (world as a whole) assets, and increasing commodity prices and rates of exchange of other currencies with respect to the dollar.

To avoid the revaluation of its currency, China adopted a strategy of maintaining the value of its currency (the renminbi) stable in terms of the dollar, by accumulating reserves, since the onset of the financial crisis in 2008. This policy also raises the pressure on the currencies of other countries which, squeezed between China and the United States, have chosen to intervene in foreign exchange markets and introduce capital controls, a situation that has already been characterized as an “exchange rate war.”

This scenario presents two risks for the global economy. First, the only instrument available to the United States to try and force China to allow a more rapid increase in its exchange rate is the introduction of trade restrictions, which would very likely lead to a retaliation on the part of China. On the other hand, since interventions in exchange markets have high costs and only temporary effects, the incentive for introducing trade restrictions is increasing over time. In this context, transforming an “exchange rate war” into a “trade war” would only be a matter of time, which would inevitably lead to a return of recession.

Second, as a significant part of the demand for goods produced in China comes from abroad (internal consumption represents only 40 percent of GDP), a very rapid rise in the exchange rate is likely to greatly reduce external demand, economic growth and employment. The example of Japan in the 1990s shows that one should not minimize the probability of this occurring. Inasmuch as China today is the sole autonomous motor of world economic growth, the risk of a new recession is not to be dismissed. This explains the reluctance of Europe and developing countries to ally themselves with the United States in putting pressure for a rapid revaluation of the renminbi.

The U.S. central bank is planning to double the dose of the remedy — increasing liquidity — based on its diagnosis that the results up to now have been weak because the dose was small. As this diagnosis is faulty, doubling the bet will only lead to an increase in negative collateral effects of the remedy. The problem of the U.S. economy (as for that of Europe, apart from Germany, and Japan) is structural: deficits and excessively high public debts; a system of generous pensions that are potentially underfunded; very low savings rates; labor skills not matched to the realities of the labor market, due to the changed structure of production that has resulted from the movement of a large part of the industrial base to developing countries; and regulatory uncertainty and instability. These are just some of the problems that need to be resolved in order for these economies to return to a path of healthy growth. And these problems call for structural reforms that will require time and patience (who remembers the Washington Consensus?). Doubling the dose of the remedy, apart from generating additional asset bubbles, brings with it the risk of destroying the two principal sources of world economic recovery: renewed growth in international trade and Chinese economic growth.