TOKYO – The US Federal Reserve’s gradual exit from so-called quantitative easing (QE) – open-ended purchases of long-term assets – has financial markets and policymakers worried, with warnings of capital flight from developing economies and collapsing asset prices dominating policy discussions worldwide. But, given that most major economies operate under a flexible exchange-rate regime, these concerns are largely unwarranted.
The logic behind the fear of the Fed’s “tapering” of QE is straightforward. Unconventional monetary policy in the United States – and in other advanced countries, particularly the United Kingdom and Japan – drove down domestic interest rates, while flooding international financial markets with liquidity. In search of higher yields, investors took that liquidity – largely in the form of short-term speculative capital (“hot” money) – to emerging markets, putting upward pressure on their exchange rates and fueling the risk of asset bubbles. Thus, the Fed’s withdrawal from QE would be accompanied by a capital-flow reversal, increasing borrowing costs and hampering GDP growth.
Of course, not all emerging markets, according to this logic, are equally exposed. Among the most vulnerable countries are Turkey, South Africa, Brazil, India, and Indonesia – the so-called “Fragile Five” – all of which are characterized by twin fiscal and current-account deficits, high inflation, in addition to faltering GDP growth.
This logic would be correct if the world were operating under a fixed exchange-rate regime, with governments tying official exchange rates to another country’s currency or the price of gold. Under these conditions, monetary contraction (or slowing expansion) would have a recessionary (or a less stimulative) impact on other economies.
With flexible exchange rates, however, monetary-policy contraction in a major economy would stimulate other economies in the short run, while monetary expansion would damage their performance. (To be sure, in the medium or long run, monetary expansion can facilitate increased domestic production and trade, thereby generating positive spillover effects.)
After the collapse of Lehman Brothers in 2008, the rapid expansion of the money supply in the US and the UK triggered a sharp appreciation of the Japanese yen, as well as of some emerging-market currencies. In short, QE is what merits concern – not its termination.
Of course, the Fed’s policy reversal could hurt countries that maintain fixed – or, like China, “managed floating” – exchange rates. Likewise, weaker eurozone economies like Greece and Spain, which would prefer stronger monetary stimulus than their more competitive counterparts in Europe are willing to accept, may suffer. But, given that these economies have chosen to adhere to a fixed exchange rate, the Fed cannot really be blamed for the fallout.
In fact, the Fed – and other advanced-country central banks – should not be blamed for the negative effects of monetary expansion, either. Japan’s bold monetary easing, for example, was a critical element of Prime Minister Shinzo Abe’s strategy for lifting the Japanese economy out of more than a decade of recession – and it has led to a remarkable recovery.
The problem is that the policy has also caused the yen to depreciate, leading nearby countries to accuse Japan of adopting “beggar-thy-neighbor” policies. Similarly, emerging-market officials warned that monetary expansion in the US and the UK would trigger a wave of competitive currency devaluations, with Brazilian Finance Minister Guido Mantega going so far as to accuse the Fed and the Bank of England of waging a full-blown “currency war.”
But, while it is true that such expansionary policies can have a recessionary impact on other economies, modern international-finance theory shows that the concept of a “currency war” is a myth. The reality is that, under a flexible exchange-rate regime, competitive devaluations do not produce undesirable imbalances. On the contrary, they can bolster recovery in participating economies.
In fact, currency devaluations were critical to ending the Great Depression. As Barry Eichengreen and Jeffrey Sachs demonstrated in 1984, while abandoning the gold standard had an immediate negative impact, it quickly spurred recovery, with the first countries to devalue their currencies escaping depression earlier than others.
The fact is that, with a flexible exchange rate, a country can offset the recessionary impact of a neighboring country’s monetary easing using its own independent monetary policy, guided by carefully chosen inflation targets. If all countries adopt this approach, the entire global economy benefits.
By working to revive the domestic economy, the Fed, like other advanced-country central banks, is simply fulfilling its mandate. Instead of complaining about its actions, emerging-country policymakers should be devising strategies for offsetting the spillover effects on their own economies. After all, they have the tools to do so.