The G20 Summit earlier this month took place against the background of major domestic economic problems in G3 – the US, the European Union (EU) and Japan – with slowing economies and huge fiscal deficits. US President Barack Obama had been weakened politically, since the mid-term elections, held just a few days before the Summit had led to major gains for the Republicans, who now have a majority in the lower house of the US Congress. At least in theory, the Republicans are committed to simultaneously pursuing lower taxes and a balanced budget — which, prima facie, seems contradictory. In fact, the last 30 years’ history (Presidents Reagan and two Bushes) suggests that, when in power, they manage to achieve the former but end up substantially increasing the fiscal deficits. The October 2010 Global Economic Outlook report of the International Monetary Fund (IMF) has argued “fiscal consolidation needs to start in earnest in 2011”. The advice is perhaps more relevant to the US than to Europe. In the latter, fiscal consolidation has already begun in many countries. And, among the G3, the Japanese economy seems immune, in terms of both growth and inflation, to both fiscal and monetary stimuli.
With little room for fiscal stimulation, the US Federal Reserve announced, in mid-October, another major programme of Quantitative Easing (QE2): since interest rates are as low as they can be, pumping money by buying government paper in the market is the only weapon left with the monetary authorities. The idea is to pump $600 billion in the market. Many analysts felt that QE2 may lead to a fall in the external value of the dollar; the Chinese authorities criticised the US policy as being a pre-Summit tactic to pressure China to allow its currency to appreciate more rapidly. Ironically, since the announcement of the QE2 programme, the dollar has appreciated against both the euro and the yen. And, the 10-year treasury security, which yielded just 2.5 per cent a month back, is now yielding 2.9 per cent. Both these developments could (more than?) take away whatever positive impact QE2 was expected to have on growth and output.
Indeed, this strongly manifests the limitations of monetary policy in impacting macro-economic variables in the desired direction. To be sure, most modern central bankers acknowledge the limitations, and claim that they aim at shaping “expectations”; at dousing or rousing the “animal spirits” of the economic agents. It is obviously not easy. The fact is that monetary policy can be far more effective in bringing inflation down by pulling the monetary string hard (as Paul Volcker demonstrated in the late 1970s and early 1980s), if only at the cost of recession. Pushing the string to achieve the opposite is far less effective. The Federal Reserve’s problems have been compounded after the Republican victory: they are opposed to QE2 since they believe it will ignite inflation — if only the cause and effect relationships were so consistent and predictable. One basic assumption underlying monetary theory, namely the constancy of the velocity of money, is certainly weak.
Meanwhile, the last few years have witnessed a sharp rise in the size of the balance sheets of central banks in the US, the eurozone, Japan and England. Much of the increase has come through buying of assets in the market in support of the banking system (and/or to expand money supply). Surely, the quality of some of these assets – mortgage bonds, for instance – is highly questionable, even as the gearing of central bank balance sheets has gone up sharply. Some day, will the Fed and the European Central Bank need a bailout?
In the pre-Summit weeks, the president of the World Bank brought back the question of using the old price as an indicator of inflation. (One had thought that the ghost had come back to haunt policy makers for the last time during the Reagan era, only to be reburied forever — but no.) It is strange that the issue has been brought up now — when gold prices have gone up so high even as, in the rich countries, there are far greater worries about deflation than inflation. And, what happens to demand in the rich economies would also affect the prospects of the developing countries, whatever the “de-coupling” thesis may say.
The major pre-Summit US proposal was to limit external imbalances. The earlier meeting of G20 finance ministers could not reach any specific agreement on the issue. The proposal did not find much support – even India opposed it – and seems, for all practical purposes, dead. But its fate is a manifestation of the much lower prestige and weight the US now enjoys in global fora.
More From This Section
To come back to the exchange rates, the recent rise of the dollar is yet another example of the inability of analysts to predict market movements, and the lack of correlation between domestic monetary policy and the external value of a currency, a point I will come back to while discussing global imbalances and the now off-the-table US proposal to limit them.