The Guardian Unlimited, November 15, 2010
See article on original website
It would be great if the leaders of the G-20 countries knew a little economics. It might make their meetings more productive and less confrontational.
The central area of dispute at the recently concluded meeting was the decision by the Federal Reserve Board to engage in another round of quantitative easing (QE2). This is intended to boost growth by pushing down long-term interest rates.
Lower interest rates will boost consumption by allowing people to refinance their mortgage and will also induce additional investment. QE2 will also likely have the effect of lowering the value of the dollar as investors sell dollars in search of higher returns in euros, yuan and other currencies. This fact seemed to unite the rest of the G-20 in their anger at the United States.
There were numerous lectures coming from various countries that the United States was taking the easy way out. The argument was that the United States should be correcting its over-spending by reducing its budget deficit. The G-19 argued that this was better than trying to increase growth by using a lower-valued currency to reduce its trade deficit.
Suppose the U.S. did what the G-19 urged and quickly reduced its budget deficit. Suppose that it immediately closed its budget deficit by raising taxes by 5 percentage points of GDP and cutting spending by 5 percentage points of GDP. (We’ll ignore for now the fact that the plunge in GDP would add to the deficit.) Would the G-19 then be happy?
If we saw rapid reductions in the U.S. budget deficit then we would expect to see a substantial drop in U.S. GDP. If GDP falls, then U.S. imports will fall. This means that exports from China, Brazil and other countries will drop and workers in these countries will lose jobs. This is the primary effect that would be expected from a sharp decline in the U.S. budget deficit.
But, this is only the first part of the story. The second part of the story is the part that the advocates of fiscal austerity emphasize. A lower budget deficit should lead to lower interest rates, even if the impact will be small in the current environment. Lower interest rates will in turn spur growth in the United States by allowing people to refinance their mortgages, inducing more investment, and causing the dollar to drop and thereby improving the trade balance.
What do you know? We’re back at a lower valued dollar leading to an improvement in the U.S. trade balance.
It is difficult to imagine what economic theory the QE2 critics in the G-19 could possibly have in their heads. The United States was running large trade deficits in the years following the East Asian financial crisis in 1997. These deficits were caused by a large real appreciation in the value of the dollar against the currencies of the region and most other world currencies.
This should not have happened. In the textbook theory, rich countries like the United States and Germany are supposed to be exporters of capital. On this point it is worth distinguishing the trade surplus of Germany from the trade surplus of China. Germany is a rich country with a stagnant or shrinking labor force. We would expect Germany to be an exporter of capital. China on the other hand is a very rapidly growing developing country in which capital gets a very high rate of return. The textbook economics says that China should be an importer of capital, not a huge exporter.
The blame for this anomaly goes beyond China. The punitive measures that the IMF imposed on the East Asian countries during their financial crisis, under the direction of the Rubin-Summers Treasury, made developing countries fearful of accumulating debt.
The response of the East Asian countries and the developing world in general was to shift to a pattern of trade in which they build up huge surpluses so that they need never worry about being forced to beg the IMF for a bailout. This meant deliberately keeping currencies under-valued so that their exports would enjoy a competitive advantage.
This pattern of trade created in the wake of the East Asian financial crisis should be reversed, but there is no plausible way to get from here to there that does not involve a decline in the value of the dollar. In the system of floating exchange rates that is how trade adjusts. If the G-19 are unhappy about the necessary decline in the dollar then they are not upset with the United States, the Fed and QE2, there are upset with the logic of economics. There is not much that President Obama or anyone else can do to help them on that score.