Friday, November 28, 2014

The World’s Central Banker

BERKELEY – The US Federal Reserve these days is broadly happy with its monetary policy. But, since mid-2007, its policy has been insufficiently expansionary. The policy most likely to succeed right now would be analogous to that implemented by the Fed in 1979 and 1933, Great Britain in 1931, and Shinzo Abe today.

Those of us who fear that the Fed’s approach has greatly deepened the US economy’s malaise and is turning America’s cyclical unemployment into permanent long-term structural non-employment have lost the domestic monetary-policy argument. But there is another policy argument that needs to be joined. The Fed is not just the US central bank; it is the world’s central bank.

America’s current exchange-rate regime is one of floating rates – or at least of rates that can float. Back in the 1950s and 1960s, economists like Milton Friedman assumed that a global regime of floating exchange rates would be one in which currency values moved slowly and gradually alongside differences in the economy’s inflation and productivity-growth rates.

In the 1970s, the economist Rudi Dornbusch (and reality) taught us that that was wrong: a floating-rate regime capitalizes expected future differences in nominal interest rates minus inflation rates into today’s exchange rate. A country that changes its monetary policy vis-à-vis the US changes its current exchange rate by a lot; and, in today’s highly globalized world, that means that it deranges its import and export sectors substantially. Because no government wants to do that, nearly all governments today follow the US in setting monetary policy, diverging from it only tentatively and cautiously.

So the US is not just one economy in a world of economies following their own monetary policies under a flexible exchange-rate regime. The US is, rather, a global hegemon: the central bank for the world, with a responsibility not just to stabilize output, employment, and inflation and ensure financial stability in the US, but also to manage the world economy in its entirety.

One area of concern is the health and stability of growth in emerging markets as they attempt to benefit from capital inflows; satisfy North Atlantic demands for open financial markets; and manage the resulting instability created by speculative “hot money,” the carry trade, irrational exuberance, and overshooting. Emerging-market central-bank governors fear a US that alternates between expansionary policy that fuels huge hot-money inflows and a domestic inflationary spiral, and rapid tightening that chokes off credit and causes a domestic recession.

Then there is the main problem facing the global economy today: the crisis of Europe and the eurozone. The creation of the euro without an appropriate fiscal union meant that transfers from surplus to deficit regions would not eliminate or even cushion demand imbalances. The fact that the eurozone lacked the labor-market flexibility needed to make it an optimal currency area meant that adjustment via regional reallocation of economic activity would be glacial, while its members’ loss of control over monetary policy ruled out adjustment via nominal depreciation.

Moreover, Europe lacks the governance institutions needed to choose the easiest path to manage economic rebalancing: moderate inflation in the north, rather than grinding deflation and universal bankruptcy in the south. The European Union’s institutional design amplifies the voices of those interests pushing for policies that have now set Europe on the deflationary road, thus all but guaranteeing lost decades during which the EU will fail to deliver growth and prosperity.

We have an example from the early twentieth century of the political consequences of such a period of economic depression and stagnation. The reaction to what Karl Marx called “parliamentary cretinism” is the rise of movements that seek, instead, a decisive leader – someone to tell people what to do. Such leaders soon learn that their solutions are no better than anybody else’s and decide that the best way to remain in power is by blaming all problems on foreigners. Thus they exalt the “nation” and focus their policies on zero-sum quarrels with other countries and on scapegoating deviant “aliens” at home.

This is not in Europe’s interest, and it is not in America’s interest to have to deal with such a Europe. A democratic, prosperous, and stable Europe implies a much better and safer world for the US.

Here is where the Fed comes in. By shifting its monetary-policy regime to target 4% annual inflation – or 6% annual nominal GDP growth – the US would set in motion rapid rebalancing in the eurozone. Rather than see the 30% euro appreciation that would follow from the ECB’s current monetary policy, German exporters would scream for measures to prevent America’s “competitive devaluation,” finally bringing about moderate inflation in the north rather than the current grinding depression in the south.

A world in which the US has a proven record of honoring the trust that is required of it to play the role of global economic hegemon is a much better world for the US than one in which it is not trusted. Simply put, the US must manage the global economy for the collective common good, or else confront a world in which global macroeconomic management results from race-to-the-bottom national policy struggles.

America’s medium- and long-term political, security, and, yes, economic interests require the Fed to recognize that its policy mission is not to focus narrowly on attempting to achieve and maintain internal balance. Rather, it is to embrace and fulfill its role as the world’s central bank, by balancing aggregate demand and potential supply for the global economy as a whole.

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    1. CommentedNichol Brummer

      What is the responsibility of Europe and the Eurozone? Should the ECB not shoulder part of this responsibility? How far has easing in the US and UK also worked for the Eurozone? Does FED QE flow across swaplines into Europe and the world?

      In the end, the only way to 'manage the world economy for the common good' would be to involve all the (main) players, so they can have an input in the matter of defining what the common good would be. You can know what is necessary, you can be right, but one central central bank cannot be effective, it is impossible to impose trust in your actions. The only way to get trust is through some cooperative process, that is reasonably transparent, in which some unanimity is reached on how to define the common good. Maybe Keynes was right, with the Bancor idea?

    2. CommentedAlasdair MacLean

      The responsibility, identified in paragraph 5, is too heavy to bear and cannot be coordinated amongst nations, however desirable the outcomes are.

    3. CommentedMargaret Bowker

      Extremely interesting article by J. Bradford Delong, which probably will not be heeded. The Federal Reserve seems inward-looking at present and 'The World's Central Banker' premise has been around for some time without any noticeable effect. Not convinced on the 4% inflation concept, although it could go pass the limit of 2.5%, if some of this idea does take off. 6% growth? What would you have to do to achieve that? UK is motoring and it's looking at four. Shinzo Abe's economic stimulus is working, but the politics doesn't seem right in the US to try to emulate it. All of which supports Robert Skidelsky's argument that economics should be taught not so much from a classical viewpoint, as a multi-faceted one.

    4. CommentedDanny Quah

      Persuasively argued, as always. Yes, under hegemonic stability theory, Kindleberger wrote convincingly how in the 1930s the world needed the US to be global hegemon but that the US was reluctant to serve. And, yes, the world today again needs benevolent global leadership. But perhaps now it is US incapacity rather than reluctance that keeps it from global hegemony.

    5. CommentedG. A. Pakela

      If the Fed could target 4% inflation and 6% nominal GDP growth, we would have grown like it was 1999 again. It is hard to see how sparking inflation in the U.S., which will hurt the bottom 50% than the top 50% will do anything for Europe other than as you describe, force the euro even higher. Perhaps the ECB should target the exchange rate of the euro and bring it back to unity with the dollar or lower, as it was in your heyday during the Clinton administration.

    6. Commentedslightly optimistic

      "The Fed is not just the US central bank; it is the world’s central bank."
      Following the international financial collapse the G20 had to intervene and urged the US among other things to give a bigger say to rising nations in the UN's global financial institutions. Little response, so China is planning its own version of the World Bank, starting with $100 billion in capital. Incidentally this is the same amount that the US has fined international banks [largely European] in recent years for breaking its unilateral sanctions.