The current monetary system threatens the open trading order
Governments of the Euro area and the ECB must not let the euro strengthen to the point where it threatens the euro area recovery. It should not rise above $1.40 – it is now at $1.31. When the euro strengthened sharply in 2009, it triggered weakness that led to the euro sovereign debt crisis. But what is the implicit exchange target of the Federal Reserve? Nobody knows, because US policy is supposed to be set by the Treasury. They say they do not have any target. Yet all the world can see the US wants to depreciate the dollar.
So why not discuss an acceptable range openly?
A good international monetary system should support a liberal, open, multilateral trading and currency order and the effective functioning of markets. During the 1980s and 1990s the current regime – run by central banks – seemed able to do. The financial crash laid bare the faults in that model.
This has left a policy vacuum. The big danger is that the vacuum will be filled by nationalistic policies. Politicians are under huge pressure to resort to such policies.
Already, practice has broken away from the model. As more countries adopt “flexible” inflation targets, we all know what this means in practice. It is the opposite of a monetary discipline or rule. It announces the removal of constraints to discretionary policies. Mark Carney was only being honest when he declared that the inflation targeting system in the UK gave him almost enough flexibility – but that perhaps he would need a little more. Anybody would imagine by the way he talked that the UK had hit its inflation targets, but was finding them unduly restrictive. In fact, it has consistently missed targets for as long as anybody can remember. It is unfair to say that inflation is out of control. Rather monetary stability is second to other objectives, notably employment and growth. But in the process central banks find themselves in an impossible position. In truth, they have no idea whether they will be able to shrink their swollen balance sheets when the time comes.
It is clear that large, long-lasting swings in major exchange rates have operated in such a way as to subject one major economy after another to unintended monetary squeezes or short-lived monetary boosts. As Willem Thorbecke has shown, the rise in the yen’s effective real exchange rate by 30% between June 2007 and March 2009 decimated the Japanese economy. Japanese real exports fell by 40%, and industrial production by 35%.
Now the strength of the euro threatens to throttle the Eurozone, just when it is starting to recover from the sovereign debt crisis.
This is the paradox facing policy makers. The more successful the ECB and national governments are in tackling their real economic problems, the beneficial effect is offset by exchange rate volatility.
This is partly in response to British and US policy makers policies of determined exchange rate depreciation, which they fondly hope will rebalance their economies. Markets and business leaders fear that the medium to long term result will merely be further inflation (viz UK’s experience after the sterling collapse, much welcomed in official circules at the time, in 2007-09) .
All the signs point to another sterling “crisis”, which will presumably be cheered on by the Financial Times.
So households and corporations sit on their cash, being too fearful to start investing and spending again.
Key problems with inflation targets
Drilling down, what are the key defects of inflation targeting? I would list four
(1) sheer incapacity to meet targets, whether inflation or NGDP, because too little is actually known about how economies function, especially about the output gap. so that the house models in use are seriously defective;
(2) predictable shying away from the slightest perceived risk of recession / falling demand, hence a chronic bias towards monetary expansion; and
(3) failure to focus on, or even to take note of, what are the real problems and the moral to be drawn for central banks’ conduct.
(4) the dysfunctional interaction between monetary policies, short-term capital flows, exchange rate movements and the real economy, as described above. This threatens progressive financial fragmentation and a retreat from globalisation.
In short, the current monetary system – independent central banks following inflation targets under flexible exchange rates – is imploding under its own contradictions. But what will replace it?
We are likely to have a drift towards managed exchange rates, capital controls, a Soviet-style system of financial regulation, growing fears of virulent inflation, volatile assets prices and long-term economic stagnation in the West accompanied by growing disaffection from open and free trade and finance in emerging markets
Given this unpalatable prospect, more radical reform ideas will increasingly be discussed.
It will be realised that much more far-reaching changes in banking and global money will be needed to support the functioning of free and effective markets. In The Money Trap I argue that these liberal purposes will be better served in the changed circumstances by a return to a system of fixed exchange rates and a new model of banking with central banks playing a much less prominent role. This approach builds on the insights of such intellectual leaders as Hayek, Keynes, Kindleberger and – among contemporary economists – Robert Mundell.