The US cannot expect China and other emerging economies to shoulder the entire burden of adjustment. It needs to realise that for now, fiscal and monetary stimulus must go hand in hand.
In the wake of the subprime crisis, the G20 coordinated its fiscal and monetary actions to avoid an economic catastrophe.
It succeeded in averting a possible repeat of the Great Depression.
In recent months, as most people have come to believe that the worst is over, the sense of emergency is gone.
Cooperation has given way to bickering.
Quarrels have erupted amongst the G20 as to how best to sustain the ongoing recovery.
As a result, growth in the advanced economies remains sluggish and is acting as a drag on the global economy.
The US blames emerging markets, mainly China, for not doing enough to foster recovery.
The US itself faces criticism from some of its own economists, not just from emerging markets.
The meeting of finance ministers in Seoul last week failed to resolve the quarrels in the G20 although it may have succeeded in averting a trade war for now.
‘Global imbalances’ are widely believed to have been an important factor underlying the subprime crisis.
Everybody knows what is to be done. The US and other advanced economies need to export more and consume less.
China and other emerging markets with large current account surpluses need to consume more and export less.
Neither has happened, at least not to the extent required.
The US believes this is because China and other emerging markets refuse to allow exchange rates to rise to reflect market forces.
The emerging markets say keeping the dollar weak by relying entirely on loose monetary policy is a form of exchange rate manipulation.
They cannot afford to allow the dollars flooding into their economies to dictate their exchange rates as any sharp reversal of inflows could prove destabilising.
At the recent Seoul summit of G20 finance ministers, the US changed tack in order to secure agreement on policy coordination.
US treasury secretary Tim Geithner dropped the American insistence on exchange rate alignment and instead sought agreement on keeping current account imbalances within an agreed limit — say, 4% of GDP.
This would allow emerging markets to contain their surpluses in ways other than appreciation in their nominal exchange rates.
Emerging markets could achieve an adjustment in the real exchange rate through a rise in inflation.
Or they could simply try to reduce the surplus of savings over investment which is mirrored in a current account surplus.
The proposal has a serious catch to it. As Gavyn Davies points out in the Financial Times, only four economies would be breaching the 4% current account surplus target: Saudi Arabia, Germany, China and Russia.
Of these, Saudi Arabia and Russia would be excluded because the Geithner proposal allows exceptions to be made for countries with large commodity-producing sectors.
Germany is not intervening in the markets to keep its currency undervalued and the IMF projects that its current account surplus would fall below 4% by 2015.
So, the latest US proposal can easily be construed as targeting a familiar villain, China.
Davies also notes that there are only two countries with a current account deficit of over 4%, Turkey and South Africa.
The US itself runs a current deficit of 3.2% and would be conveniently excluded from making any adjustment!
Not surprisingly, the US proposal failed to win approval in Seoul.
The G20 merely agreed to “move towards more market-determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies”. That statement fails to tell us exactly who should be doing what.
Where do we go from here? The US must recognise that it cannot shift the burden of adjustment entirely onto emerging markets.
This, in turn, means it has to revisit its current approach of relying wholly on monetary policy to revive the US economy.
Fiscal policy will have to play the role Keynes had famously assigned to it in a recession.
An impressive array of US economists — Paul Krugman, Christana Romer, Bradford de Long, Joseph Stiglitz, to name a few — happens to think so.
It is becoming clear that monetary policy by itself cannot do the trick.
Since interest rates are close to zero, the Fed has resorted to a second round of ‘quantitative easing’ — the infusion of money into the system through the purchase of longterm government bonds.
But this is just not stimulating private demand.
Private consumption has fallen sharply in order to correct the excesses of the subprime crisis.
Private investment is being held back by what Greenspan believes to be the lack of investor confidence.
It is also possible that private investment is being constrained by banks’ unwillingness to lend.
When banks can borrow at virtually zero interest, they can make easy money in the markets.
They do not have trouble themselves with risky loans.
In such a situation, government spending alone can pick up the slack in demand.
Unfortunately, the Greek debt crisis earlier in the year seems to have coloured the perceptions of policymakers.
They were quick to conclude that any further fiscal stimulus was unsustainable. But there are economies and economies.
The US is not Greece. Greece had to correct its course because the market rates on Greek government bonds soared.
As Christina Romer points out, even today the markets are willing to lend to the American government at the lowest 20-year interest rate since 1958.
American government spending will not only revive the US economy, it will strengthen the world economy and restore the financial markets to health.
The IMF’s latest World Economic Outlook carries the results of an internal study.
The study scotches the notion that fiscal consolidation can stimulate growth even in the short-run by boosting household and business confidence.
It corroborates the Keynesian view that fiscal consolidation in the short-run typically results in contraction of output.
The lesson for the US is clear: for now, fiscal and monetary stimulus must go hand in hand.
At the same time, Congress can reassure the markets by approving plans for long-term consolidation.
The US cannot expect China and other emerging economies to shoulder the entire burden of adjustment.
Adjustment, like charity, must begin at home.
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