Over at Project Syndicate: For the World's Sake, Time for a Weak Dollar Policy
July Project Syndicate: Time for the Federal Reserve to become a global central bank...
For at least a decade the United States Federal Reserve has focused almost exclusively on the domestic American economy. It has crafted its monetary policy almost exclusively in an--unsuccessful--attempt to fulfill its mandate to achieve as much as possible of effective price stability, maximum feasible employment, maximum purchasing power, and financial stability.
In so doing it has been constantly and consistently behind the curve. It failed in 2004 and 2005 to accurately assess how corrupted mortgage finance had become, how that corruption of mortgage finance was driving an unsustainable housing bubble, and to take the appropriate regulatory responses. It failed in 2006 to understand the consequences for risk and its distribution of the housing bubble coupled with innovations and housing finance. If failed in 2007 to accurately assess how the growth of derivatives had not distributed but had concentrated this risk in highly overleveraged too-big-to-fail institutions. It failed in 2008 to understand that the key task was to build a firewall between financial distress and the real economy of production and employment. It failed in 2009 to foresee the jobless recovery that required extraordinary--for then--expansions of its balance sheet to avert. It failed in 2010 to understand that there were no "green shoots" and that it was time to further reduce long-term real interest rates through the only practical tools available: open-ended quantitative easing coupled with a nominal GDP growth or a price level target. It failed in 2011 to recognize that if the FHFA was not going to use its regulatory authority to rebalance the housing market, the Federal Reserve should take regulatory steps to do so. It failed in 2012 to recognize that a genuine regime change--a la Roosevelt or Volcker--was called for. It failing in 2013 in prematurely discussing papering and future interest rate increases at a time when maximum expansionary stance was still the appropriate policy. It is failing now, in 2014, by adopting counsels of despair that what was cyclical non-employment has turned into structural non-employment, and hence tapering followed by interest-rate increases should be the forward policy path. Since at least 2004, the policies adopted by the Federal Reserve have been inappropriate. And, indeed, the Federal Reserve has failed to fulfill its policy mandate on a scale large enough that future economists will debate whether it exceeds or falls short of the policy failures in the days when the Board of Governors had members like G. William Miller, Arthur F. Burns, and Andrew Mellon.
But let all that pass.
Suppose--which is not the case--that Federal Reserve policy had been appropriate for the domestic economy since 2004, and is appropriate for the domestic economy now.
Even in that case, the Federal Reserve would be following the wrong policy because we can no longer afford to let it ignore the global dimension.
The United States is not just another large open economy in a world of flexible exchange rates capable of following its own monetary policy. The United States is a global hegemon. The Federal Reserve is thus a global central bank: the central bank for the world as well as the United States. It has a responsibility not just to stabilize output, employment, and inflation and ensure financial stability in the United States. It has a responsibility to successfully manage the world economy in its entirety: that means crafting policy in the interest of the world as a whole, and that means that its policy should take into account and compensate for market, institutional, governance, and policy failures elsewhere. One such ares of concern is the health and stability of growth in emerging markets as they attempt to (a) gain the benefits of capital inflows for development, (b) satisfy North Atlantic demands for open financial markets, and yet (c) manage the resulting instability created by "hot money", the carry trade, irrational exuberance, and overshooting.
The most extraordinary problem facing the global economy today is the crisis of Europe, and of euros. Europe cannot resolve this crisis. It lacks the institutions of global governments to do so. What needs to happen is the northern and southern Europe need to rebalance their costs this is best done through insulation in the north rather than through deflation in the south. The problem is that European institutions within the euro zone cannot at least as presently constituted, deliver that outcome.
But leave that, too, to one side. Focus on the greatest institutional vulnerability in the world today and its devastating macroeconomic consequences: the manner in which the scope and governance of the eurozone was designed. That is the principal source of microeconomic distress and risk in the world today. That is a mammoth failure--in labor market flexibility, in the construction of the institution of a single currency that far exceeds what is justifiable on optimal currency-area principles, in what groups and interests are represented to what degree in the governing councils, and in the policies adopted--that it is the Federal Reserve's duty to craft global monetary policy to attempt to offset and neutralize, to the limited degree that it can.
We all know what happened: The creation of the euro without an appropriate banking union or sufficient coordination between national-level banking regulators encouraged massive capital flows to southern Europe without proper risk calibration. Once the risks became clear, the money dried up, imposing an enormous deflationary shock on the south. The creation of the euro without an appropriate fiscal union meant that transfers from surplus to deficit regions would not rebalance or even cushion the maladjustments in demand. The fact that the eurozone lacked the labor market flexibility that would make it an optimal currency area meant that adjustment via the regional reallocation of economic activity would be glacial. The fact that the eurozone was a fixed currency zone ruled out adjustment via nominal depreciation. There were only two roads to recovery: reflation in northern Europe to push up relative costs and boost the north's demand for exports from the south to allow it to pay off its debts and deleverage, or deflation in southern Europe to push down its relative costs--at the price of deep depression and lost decades. And the way the institutions had been built, the voices of the interests in the governing councils pushed for the destructive policies that set Europe on the deflationary road, thus all but guaranteeing a failure of the European Union to deliver prosperity and growth for a period that will exceed a decade.
We have an example from the early twentieth century of what such a period of economic depression and stagnation does in politics, in Europe at least. The lesson from eighty years ago is that if parliamentary democracy does not deliver prosperity and growth, voters turn away from parliamentary democracy and toward nationalism, authoritarianism, and fascism. The interest group corruption, the corrupt corruption, and the near-gridlock of incremental parliamentary politics turns people off if the parliamentary régime does not deliver rough justice, prosperity, and growth. The reaction to what used to be called the cretinism of parliaments is the rise of movements that seek, instead, a leader: someone to tell people what to do. Such leaders soon learn that they have little better real solutions than anybody else. They decide that the best way to remain in the seats of power--because --is distraction. Identify the leaders with the group and the group with the leaders and so define critics of the leaders' as deviant aliens outside the group who are not to be listened to. silence outsiders and dissenters as deviant from the group. They decide that the best people to blame for the defects of the situation are those who cannot vote in national-level plebiscites: foreigners. Thus they turn to busying giddy minds with foreign quarrels, and making exaltation of the nation in what is at best a series of zero-sum nation-vs.-nation contests the focus of politics--one of the standard tools of power since the Lancastrian Dynasty.
It is in the strong medium- and long-run interest of United States not to have to deal with a Europe swirling with political currents that at the least flirt with nationalism, authoritarianism, and fascism. A prosperous parliamentary-democratic world is a much better and safer world for the United States to be in. And a world in which the United States has a proven record of fulfilling the trust it has taken on by assuming the role of global economic hegemon--and thus in which the United States is trusted to manage the global economy for the collective common good--is a much better world for the United States then one in which it is not trusted, and in which global macroeconomic management becomes the emergent result of nation-level race to the bottom policy struggles that at best zero-sum.
Right now is thus one of those moments in which the medium- and long-run national interest of the United States--political, security, and, yes, economic--requires the Federal Reserve to note that its proper policy mission is not to focus narrowly on attempting to achieve and maintain internal balance but rather to actively take on and successfully achieve its mandate as global central bank of balancing aggregate demand to potential supply for the world as a whole.
What is the politically-feasible way to deliver the needed policy outcome? It is obvious. For the United States Federal Reserve to partner with the U.S. Treasury and to adopt a weak dollar policy, of course.
And:
Paul Krugman: European Green Lanterns: "Sitting in a room listening to EU officials...
...reacting to the European Parliament elections--and it seems to me that they’re deep in denial. Barroso just declared that the euro had nothing to do with the crisis, that it was all failed policies at the national level; a few minutes ago he said that Europe’s real problem is a lack of political will.
This is quite amazing, in a really bad way....
We know very well what happened... the creation of the euro encouraged massive capital flows to southern Europe... the money dried up... the absence of national currencies meant that the debtor countries had to go through an extremely painful process of deflation. How anyone could deny any role for the currency... And if there’s one thing Europe has, it’s political will. All across the southern tier, governments have dutifully imposed incredibly harsh austerity in the name of being good Europeans. What should they have done that they haven’t? I guess the notion is that if the Greeks, or the Portuguese, or the Spaniards really, truly committed their all-powerful wills to reform and adjustment, their economies would boom despite deflation and austerity. The possibility that things are so bad--and radicals have been empowered--because the policies are fundamentally misguided just doesn’t seem to be considered...
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