Stephen King: Political blame prevents policy co-operation

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The Independent Online

There was a period in the mid-1980s when international economic policy co-operation among the world's major industrialised nations suddenly became a big thing. Primarily, this was because the world economy had started to look rather fragile.

Reaganomics had led to the twin deficit problem in the US. The mixture of loose US fiscal policy and tight monetary policy - designed to kill off inflation once and for all - kept US real (inflation-adjusted) interest rates firm, driving the dollar up to ever higher levels. High real interest rates in the US were penalising growth not just there, but also in the other major industrialised countries. Europe was weak for other reasons too, notably through the inflexibility of its labour markets and because of its continued devotion to capital controls. (Politically, the other countries had been prepared to step back for a bit because at least the US was standing up to the Soviet bloc. Although it was never clear at the time, the US government borrowing that funded mounting defence expenditures undoubtedly contributed to the collapse of the Berlin Wall and all the good things that have happened in Europe since then.)

If things were starting to go wrong economically, all of the major industrialised countries stood to lose out in one way or another. The spirit of co-operation that emerged in the mid-1980s was, therefore, a reflection of mutual self-interest. Every country recognised its dependence on every other country and it seemed easy to come up with a strategy that might work. The Plaza Agreement arrived in September 1985, followed by the Louvre Accord in February 1987.

These agreements tried to foster greater economic co-operation, in part designed to stop markets heading off in the wrong direction. One obvious concern was the performance of the dollar - too strong in 1985, too weak in 1987. Another, related, concern was the loose nature of US fiscal policy - too much US government borrowing meant too high a level of real interest rates which, in turn, meant too strong a dollar. So the Gramm-Rudman Act was put in place, designed to achieve a multi-year reduction in US government borrowing.

Fearing that this fiscal contraction could damage growth prospects in all industrialised countries, the quid pro quo was a significant loosening of policies elsewhere - mostly monetary policy. The best example, perhaps, was Japan, which (reluctantly) attempted to switch the source of its growth away from exports towards domestic demand. The policy worked, but the longer-term costs - bubble followed by deflation - were bigger than Japan deserved.

Japan's experience suggests that the longer-term consequences that stem from joining a co-operative venture are less than clear. Some might argue that the policy co-operation of the mid- to late-1980s did more harm than good - the stock market crash in 1987, the inflationary boom of 1988 and 1989 and then the descent into recession at the beginning of the 1990s. Nevertheless, there are times when co-operation seems like a sensible bet, even if the eventual outcome is less than clear.

Arguably, we're in one of those periods today. The dollar has fallen a long way but the US current account deficit has got bigger, not smaller. The US budget deficit has also become rather large, generating a second "twin deficit" problem. Demand growth in both Europe and Japan is disappointingly weak. And, although the dollar has fallen a long way against the euro and sterling, it's made a lot less progress against the Asian currencies whose exports to the US continue to boom. So, is there a policy agreement in the pipeline? Are we about to see a Plaza II or a Louvre revisited?

Although there is a case for policy co-operation, the biggest obstacle that lies in its way is a lack of agreement on what the problems are, and where the responsibility lies. Everyone agrees that the US current account deficit is too large. No one can agree on why it's too large. Is it because of excess demand and too low a level of savings in the US? Or because of weak demand and too much savings in Europe or Asia? Or is it because the dollar hasn't been allowed to fall far enough?

From a US perspective, the tendency is to blame everyone else. John Snow, the US Treasury Secretary, never loses an opportunity to berate those countries that don't allow their currencies to adjust (China). And US Congress is always keen to "account for" the US trade imbalance by drawing attention to those countries that have "unfair" bilateral trade surpluses with the US (again, China).

In both cases, though, the arguments are hardly watertight. China accounts for about 10 per cent of US trade so a 10 per cent rise in the renminbi, let's say, would only lower America's exchange rate against a basket of currencies of its main trading partners by 1 per cent. Even if all other Asian currencies followed an initial Chinese move, the fall in the dollar would only amount to around 3.5 per cent. Yet the dollar has already fallen by around 20 per cent on a trade-weighted basis and the US current account deficit continues, inexorably, to climb.

Then take the arguments that focus on bilateral trade imbalances. Lots of people believe that bilateral trade positions should determine bilateral currency levels. It follows, therefore, that any country that has a large and growing trade surplus with the US should see an appreciation of its exchange rate. Again, China fits this model. Yet the connection between bilateral trade positions and currency levels is, at best, tenuous and, at worst, illogical.

To see why, think about the trade position between Malaysia and the US. Let's say that Malaysia successfully exports saucepans to the US. One day, its businessmen discover a new non-stick technology that allows Malaysia to export even more saucepans to the US. Malaysia's exports to the US therefore rise, leading to a larger bilateral trade surplus and, according to the argument, a higher level for the ringgit against the dollar.

Then suppose that Malaysia discovers that it is cheaper to sell its saucepans to the US via China - perhaps because China has better packaging facilities. Malaysia's bilateral trade position with the US now deteriorates, so the ringgit falls against the dollar. Malaysia's bilateral position with China improves so the ringgit should rise against the renminbi. Meanwhile, China's bilateral position with the US improves, implying a rise in the renminbi against the dollar. These currency movements simply cannot happen: according to the bilateral argument, the ringgit has to fall against the dollar but rise against the renminbi, but the renminbi has to rise against the dollar, which implies that the ringgit must also rise against the dollar.

These sorts of misunderstandings suggest we are still a long way from any co-operative venture. Europe provides another example. Ideally, the eurozone should deliver faster domestic demand growth but it's difficult to see how this could be achieved easily. Demographics argue against a sustained European pick-up, the macroeconomic policy levers can't move very far (short-term interest rates are very low and most countries have poor fiscal positions) and any structural reforms to labour and product markets would probably weaken growth in the short term, even if there might be longer-term benefits.

The truth of the matter is that, while everyone recognises that global imbalances exist, the discussions to date have revolved around political blame and counter-blame, not on the real economic issues. The absence of savings in the US is probably the most important driver of the global imbalances but, until the US Administration admits this, policy co-operation will have a tough time getting on to the international agenda.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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