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How the international monetary system holds back recovery

Failure of G20 leadership

 

Ever since the end of Bretton Woods, exchange rate volatility driven by diverse monetary policies and diverse expectations about future exchange rates have been frequent sources of shocks to the world economy and national economies. The very existence of independent central banks with independent monetary policies is the common origin of shocks. The more proudly independent they are, the worse it gets. The latest source of instability is the promise by Mr Kuroda, new governor of the Bank of Japan, to double the monetary base. Much of this will flow out to the rest of the world, powering asset and currency bubbles and destabilising local economies.

Wasted stimulus

Every time the USA, Japan or the eurozone adopt expansionary monetary policies funds tend to flow out around the world. This has two effects. First, the economies at which the stimulus is directed fail to benefit as it spills overseas. Second, the flows from the centre overwhelm local defences against financial instability and inflation. The answer given by the major central banks – that countries at the receiving end should let their currencies appreciate – is highly damaging, especially when the flood of liquidity could be turned off at any moment.

That is why the world lurches from one crisis to the next – five major crises in the 30 years 1980-2010 and another one building in 2013. by contrast, there were no systemic crises under Bretton Woods or the gold standard (plenty of banking collapses, panics and runs, but none that threatened the system as a whole).

Exploitation of the periphery

Floating has created an asymmetrical system which benefits powerful countries or currency areas at the centre but penalises other countries. No wonder China and Russia as well as smaller countries push for a more symmetrical system. They are on the receiving end of the system and they don’t like it. On the other hand, the system does not serve the real needs of the countries at the centre of the system either. For example, the US suffers from the over-extension of the role of dollar as a reserve currency. And its monetary policy is cramped.

Meanwhile, peripheral countries, including China, suffer. As Frederic Neumann, head of Asian economics at HSBC,put it in the FT on April 24 :

“The region, including China, is already drowning is liquidity and the BOJ’s action means that another powerful wave will crash onto its shores.”

All this will, he says, ultimately merely “drive up inflation, and asset prices, to dizzying heights.”

Obsolete policy frameworks

Simple inflation targeting, embraced by many leading central banks, has proved to be a superficial and naive approach to monetary policy. Prices should go down as well as up from time to time to preserve the value of money. Targets are easily manipulated and vulnerable to political machinations.

No adjustment, no discipline

Flexible exchange rates contain no mechanism by which to bring external balances into equilibrium. The surplus of Asian countries, for example, can seemingly continue indefinitely. But this will not bring financial stability.

As the late Tommaso Padoa-Schioppa put it:

“It is an illusion to think that a flexible exchange rate would effectively enforce discipline on national economic policies and ensure the rapid correction of imbalances, both because the market is not always ‘right’, and because its signals are in any case insufficient to trigger ‘good responses’ from economic policy.” 1

Irrational piling up of reserves

Every succeeding crisis causes a further increase in appetite for reserves as a cushion against future shocks. Everybody agrees this is unstable and irrational yet we are unable to get out of it under the present dispensation.

Risk of a flight from dollar

Floating exchange rates obviously pander to the forces of economic nationalism. They beguile politicians into catering to the satisfaction of national demands, at the cost of international cooperation, agreed rules of good behaviour – and their countries’ own longer-term interests.

Conclusion

The system is inherently unstable. It offers no way for major countries to reach their objectives without taking actions that destabilise their neighbours. Capital flows will always be destabilising while there is no stable international standard around which expectations of yield and purchasing power can cluster.

The G20 response

What have the G20 and IMF to offer? Nothing that treats the underlying systemic faults – see their latest pathetic communique here. Contrast it with what they should have said here.