A fiscal policy reversal threatens global economic recovery.
A fiscal policy reversal threatens global economic recovery.
When the G20 leaders met in Washington in the depth of the financial crisis in November 2008, there was an optimistic note that such an august body of world leaders could coordinate policy to get the world economy out of the crisis. To some extent, this significant coordination in preventing the world economy from collapse took place, despite the criticism of the deficit hawks and neocons that the sky would fall as a result of the important and much needed doses of fiscal deficits at the time. However, slowly, these neocons have been gaining influence and garnering political momentum through their continued fear-mongering about the so-called unsustainably high budget deficits in most Western countries. In reaction to the political pressures and media hype, these world leaders have been changing their discourse and reshaping their policy in conformity with what their critics have been articulating. Indeed, as discussed in a previous post, we have now witnessed a complete U-turn in fiscal policy since the last summit of the G20 leaders in Toronto in June 2010.
Given the uncertainties connected with private sector spending, economists well-steeped in the Keynesian tradition would argue that this reversal in fiscal policy is probably the biggest threat to a significant recovery of the global economy today. Instead from the G20 world leaders in Seoul this week and from economists working for such important international agencies as the IMF and the WTO, we are being told that the principal threat to world prosperity are imminent currency wars which are being fueled by a declining US dollar in the international currency markets.
In a world economy in which all countries are seeking to get out of the recession via a policy of export-led growth, the fact that the US dollar is declining significantly may well trigger "beggar-thy-neighbor" currency retaliations. However, it belongs to the G20 leaders to prevent such a currency war, by addressing the actual source of the problem. But what is the source of these currency threats? The source is, of course, the lack of sufficient world demand, with each country being currently under economic pressure domestically to grab a larger share of what is essentially a shrinking world demand through near-sighted mercantilist policies of export-led growth. If the problem is a shrinking global demand, the solution would hardly be what the G20 leaders committed themselves to in June by cutting government expenditures to deal with their ballooning budget deficits. Clearly, a more enlightened policy would be to stimulate domestic demand through stronger boosts of expansionary fiscal policy that would also stimulate private domestic spending, much as it had been understood in November 2008.
In contrast, we are now being told that the culprit is the sliding US dollar. And, what is the supposed cause of the depreciating greenback in the foreign exchange markets? According to these policy leaders, the offender is the original fiscal stimulus that led to a build-up of excessive reserves that had not been sterilized by the Federal Reserve authorities, dubbed "quantitative easing" (QE). This excessive accumulation of reserves or QE, whose intent was to insure that central bank-controlled interest rates should remain at their lowest possible level to encourage private sector spending, is now also supposedly putting strong downward pressure on the US dollar.
To the ordinary reader, all of this reasoning may sound quite logical. However, the analysis rests on an outdated and pernicious theory that has been completely discredited since the early 1980s and, perhaps, even more so, during the present crisis: namely old-line "monetarism" -- a theory associated with ideas of Milton Friedman. According to the old monetarist framework, when a central bank raises the amount of reserves in the banking system (resulting, say, from federal government deficit spending), these reserves will be lent out to creditworthy borrowers who, in turn, will increase their spending. These higher expenditures will eventually trigger a higher inflation and, with it, an accompanying depreciation of the value of the currency in the foreign exchange markets. It is this monetarist model of the transmission mechanism of money to economic activity and prices which presently seems to be etched in the mind of these leaders and their economic advisors and which guides them to see the problem as one of excessive public spending and the ensuing excess reserves in the banking system.
But where is the evidence to support this view? It is true that reserves have been multiplied by many hundredfold over the last several years through the US Fed's purchases of either government or private-sector securities (in an attempt to bring down also long-term interest rates). It is also true that the Fed has not sterilized these excess reserves, although it is highly debatable that the Fed hopes that the mere existence of these excess reserves would encourage banks to lend more. However, these advocates of the supply-led view of bank lending do not seem to comprehend that US banks could be sitting on as many reserves as the Fed wants but, unless there are creditworthy borrowers out there, these reserves are irrelevant to the dynamics of credit expansion. In any case, as we all know, if the theory was correct, we should have been experiencing hyperinflation as a result of the exponential rise of these reserves because of QE in the US since 2009. But nothing is further from the truth. Moreover, the reason for the declining US dollar is simply because the US has become less attractive for footloose financial capital which goes where the returns are highest. It is certainly not because of QE but essentially because US interest returns are very low and because the US economy is in a very deep recession, which makes the latter less attractive to foreign capital.
What is hoped is that the G20 leaders will break away from a narrow focus that rests on reliance on private sector spending as the only legitimate source of economic growth and to go back to what had originally inspired them to engage in significant public sector spending at their historic meeting in November of 2008. All these G20 countries are prematurely cutting back on public spending today and, by so doing, have left themselves vulnerable to engaging in ridiculous and futile currency wars that had once plagued the world economy of the 1930s. Surely they could learn from the mistakes of the past. The biggest threat to world prosperity is not the potential for so-called currency wars, which are merely the symptom of a deeper problem -- that is, the lack of sufficient aggregate demand in a world economy that continues to generate persistent mass unemployment. This fear-mongering over currency wars and the blaming of US policy because of QE is just a diversionary tactic from the Chinese and German governments to continue with their export-led strategy à outrance and to deflect criticism of their own mercantilist policies cum domestic austerity that are endangering the stability of the world economy.
Mario Seccareccia is editor of the International Journal of Political Economy.