The world is preparing to mark the centenary of the outbreak of World War I by starting another
The territory will be different – the sides will measure their gains and losses in terms of fractions of an exchange rate movement rather than yards of muddy land in Flanders. But the implications could be far-reaching. Nothing less than the future shape and health of the world economy is at stake. The omens are not looking good.
It will be a currency war, a war about exchange rates, about hitting targets for employment. Central bankers are reluctant warriors. But they will be in the front line. They are put there by politicians.
The present generation of central bankers worry about the huge risks they are taking. Even Ben Bernanke worries.
Central bankers see themselves as being placed in an impossible situation.
They are responding by changing their interpretations of their existing mandates. Look at how the European Central Bank has given priority to saving the euro, bending the rules against financing of government deficits. Look at how the Bank of England persists with an expansionary policy despite inflation remaining above target. When criticised, Bank spokesmen snap back: “Do you want us to raise interest rates and raise unemployment further?” Well, no, but that’s not the point; the point is that you and other central bankers are re-interpreting your mandate – using your discretion. You told us one thing and you are doing another.
In 2013 it looks likely that the political authorities will change the mandates. By acting now central banks are hoping to defend their independence. But this is at best a rearguard action.
The Federal Reserve, which through the dollar area still sets interest rates for much of the world, will be the most aggressive currency warrior. It is putting the world onto an American employment standard; not a gold standard, nor a stable money standard, nor a SDR standard, but a insular US employment standard. Its theory – what is good for us (US) is good for you. This is the message of the Judaeo-Christian intellectual tradition throughout history.
In practice, it is willing to tolerate a much higher level of inflation, if that proves to be the cost of moving to a lower level of unemployment than the current 7.6%. According to John Taylor, the implicit inflation target has already been moved up to 2.5 per cent. The NGDP crowd think it should be 5 -10%.
This may seem like a small price to pay if indeed policy can cut unemployment – but the significance lies in the message it sends. Whatever the protestations of the Fed spokesmen, it implies that price stability has been downgraded as the primary aim of the world’s most influential central bank (Yes, I am aware it has a dual mandate, but in practice, as Allan Meltzer has shown, it gives priority to one of these aims at some times, and the other at other times).
Naturally, other central bankers, subject to similar pressures, will follow the Fed’s lead. If they do not, it is likely that politicians will push them. For monetary policy remains the only game in town.
Now, I recognise that sometimes it is necessary to sacrifice a bit of price stability for a higher objective – but only if it is strictly temporary and does not loosen the anchor. Thus inside the eurozone, Germany should be willing to accept higher rate of increase in wages and prices for a temporary period to promote the painful adjustment process in the eurozone. But the eurozone itself, on average, should stick to its target.
Mr Masaaki Shirakawa, governor of the Bank of Japan, has been one of the few leading central bankers to stand against the tide. He has been sceptical of the whole doctrine of inflation targeting and is now not surprised to watch it disintegrate. But his courageous stand has not been matched by structural reforms and sufficient control of fiscal policy in Japan. Stability-oriented monetary policy cannot be pursued just in one country successfully, especially if it lacks support from other policies; in Japan, it has resulted in a sharp appreciation of the yen. Japan’s economy is therefore suffering badly, and has done for some years.
The dilemmas this situation raises for central banks around the world will be sharpened as a result of aggressive monetary crusade of the US – especially if this is accompanied by even easier monetary policies in the euro area and the UK. Mark Carney will fully support US monetary easing and make sure that the UK more than matches it.
After all, Canada and the UK have colonial mindsets, like Japan. We know a superpower when we see one.
So, Japan is often dumped on by the other G7 countries, and this looks like another “Plaza moment”. Thus Shirakawa-san faces being swept aside by events – and now confronts a new right-wing premier, Mr Abe, eager for a quick monetary fix. Given the strains with China over the Senkaku islands, Japan needs US support. Too bad about a stability-oriented monetary policy.
The whole of Asia and much of the rest of the world is likely to suffer from tidal waves of capital flows unleashed by the short-sighted monetary policies of the great powers.
The result can only be ongoing financial repression, manipulation of interest rates, postponement of adjustment in the US and UK, capital controls, and increased powers of direction over banks and other financial institutions (to ensure they invest in public debt and lend to politically favoured groups). Public distrust of money will grow. Asset and currency bubbles will recur, often in unexpected places. This distrust will do more to damage long-term growth and employment than any temporary success that printing more money will have in boosting demand.
The world financial system remains stuck in the money trap.
NB on the ECB
Kermal Dervis has this to say about the ECB’s mandate in a recent article for Project Syndicate:
‘Contrary to conventional wisdom, the ECB’s legal mandate would allow such a re-ordering of priorities, as, with reference to the ECB, the Treaty on the Functioning of the European Union states that “The primary (emphasis added) objective of the European System of Central Banks…shall be to maintain price stability,” and there is another part of the Treaty dealing with general eurozone economic policies that emphasizes employment. This would seem not to preclude a temporary complementary employment objective for the ECB at a time of exceptional challenge.’
Read more at project syndicate here.