The monetary masquerade
Since the great global recession, all major advanced economies have resorted to series of liquidity injections to alleviate fiscal challenges.
The unintended consequence is that the resulting massive monetary expansion defers vital structural reforms in the advanced world, while posing huge downside risks to the emerging and developing countries.
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Last Tuesday French President François Hollande complained that the euro should not be left fluctuating at the mercy of the “mood of markets.” As far as the Élysée Palace is concerned, the eurozone is asking some countries for competitiveness efforts, even as it is making their exports more expensive.
The European Central Bank (ECB) should have a foreign exchange policy, Hollande argued. "Otherwise we are asking countries to make efforts on competitiveness that are annihilated by the value of the euro."
When Spain and Italy were swept by market turmoil more than a year ago, the euro plunged to $1.20. Since then, the eurozone currency has appreciated steadily and sharply, peaking at $1.36 recently. In fact, the rise of the euro could continue for some time to come. Analysts believe the currency could soar to $1.45 against the dollar and stay there for a while.
Of course, President Hollande’s real target was not the ECB, but Berlin. "There are countries that have surpluses and high levels of competitiveness and others with deficits that have efforts to make,” he said. “Countries in the first situation should boost domestic demand to allow others to one day see a return to activity."
While the concern for the fluctuations of the euro may be valid, the proposed medication – mandating the ECB to run a foreign-exchange policy – is only politically unviable and could prove economically counter-productive. It would reinforce competitive devaluations rather than show a way out.
The current European currency debate is not exactly a new one, however.
From liquidity traps to economic stagnation
“We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.”
This warning was made almost two and a half years ago by Brazil’s finance minister Guido Mantega. At the time, interest rates remained close to 11 percent in Brazil, in the aftermath of the quantitative easing by the Federal Reserve. “It’s no use throwing dollars out of a helicopter,” Mantega lamented.
Soon afterward, China’s vice foreign minister Cui Tiankai noted that “international confidence in the recovery” might be hurt.
In turn, Germany’s finance minister Wolfgang Schäuble called US policy “clueless,” while his South African counterpart Pravin Gordhan thought that the Fed´s move undermined the G-20 leaders’ “spirit of multilateral cooperation.”
While the debates center on “currency wars,” the underlying forces reflect a massive monetary expansion that serves to defer desperately needed structural reforms in the advanced world, while posing huge downside risks to the emerging and developing countries.
As the global crisis has exhausted the traditional instruments of monetary policy, central banks have been opting for new rounds of quantitative easing (QE). And, with investors seeking higher returns, more QE has been driving ‘hot money’ (short-term portfolio flows) into high-yield emerging-market economies.
Further, as the current monetary policies remain in place, they are growing less effective, but continue to inflate potentially dangerous asset bubbles in Asia, Latin America, and elsewhere.
The G-7 liquidity gamble
In September 2012, the Fed expanded its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month. It seeks to hold the federal funds rate near zero until 2015. The goal was to boost growth and reduce unemployment. The net effect is the huge acceleration of quantitative easing.
In late summer 2012, the ECB chief Mario Draghi pledged to do “whatever it takes” to preserve the euro. The pledge was followed by the Open Monetary Transactions (OMT) program, to provide liquidity to sovereign debt markets. The goal was to reduce tensions and boost market recovery in the eurozone.
Recently, the Bank of England's incoming Governor, Mark Carney, said that he would tolerate inflation above the BoE's 2 percent target rate to achieve stronger growth.
The Bank of Japan has raised its inflation target and pledged limitless stimulus. Meanwhile, the stimulus package of Shinzo Abe’s new government, coupled with the anticipation of aggressive monetary easing and reforms, has driven Japanese stocks sharply higher and the yen significantly lower – which could unleash a series of new currency rivalries.
During the past four years, the bloated balance sheets of these major central banks have doubled and then almost tripled to almost $10 trillion. What about the payoffs?
In the United States, stagnation has replaced sustained growth and unemployment remains nearly 8 percent. Labor force participation has plunged and monthly job creation is significantly below what is needed for a solid recovery.
In the eurozone, unemployment has soared from 7 percent to 12 percent and the area is in recession, again. In the ailing Southern periphery, the rate is twice as high and youth unemployment more than 50 percent. In Japan, the third lost decade has begun.
While monetary policies create a perception of stability, they also provide a pretext to defer structural reforms, which, in turn, creates a moral hazard.
In Washington, this status quo has resulted in a prolonged fiscal cliff. In Brussels, muddling through has postponed change. In Tokyo, the standoff has discredited a generation of political leaders.
In their zeal for competitive devaluations, advanced economies are competing against each other to achieve a relatively low exchange rate for their own currency. Unfortunately, such policies unleash retaliatory actions by other countries.
Moreover, the perception of stability could prove elusive if the US fiscal cliff fails to lead to a credible, bipartisan medium-term adjustment plan, if the eurozone is swept by new turmoil, or if markets would lose faith in Japan’s huge debt.
The bloated central bank balance sheets in the advanced world are no longer a means to an end, but a part of the problem.
The writer is research director of international business at India China and America Institute (USA) and visiting fellow at Shanghai Institutes for International Studies (China) and EU Center (Singapore).