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.