Was the Fed to blame? Rebalancing and an exit from economic stagnation and crisis

599px-The_Blue_MarbleWas one of the causes of the Great Recession excessively low interest rates in the US? And if so, was the Federal Reserve to blame? I would argue that both questions can be answered the same way: partly. I say this because in some ways the mandate of the Fed left it with no choice but to leave interest rates in the early 2000s at very low levels, contributing to a house price boom and excessive growth in private debt which, when the bubble burst, led to a deep recession. This sequence of events happened in many rich countries.

The legal mandate of the Fed is to operate monetary policy so as to achieve ‘internal balance’: the highest possible level of growth and employment compatible with low inflation. However there is no mandate to achieve ‘external balance’: a more or less balanced current account of international trade and payments. There is a powerful argument, made especially by Michael Pettis, that substantial current account imbalances across the world were a key cause of the Great Recession and the economic difficulties experienced by many countries since.

Under its mandate, the Fed had little choice over monetary policy due to a variety of deflationary forces operating in the world economy at the time, which could be grouped under the term ‘savings glut’. Others have termed it ‘investment dearth’. These reduced external sources of demand in the US, and the central bank reacted by keeping interest rates relatively low in order to boost domestic demand. It cut rates dramatically in the aftermath of 9/11 in order to restore confidence in both the financial markets and the wider economy; it then kept them low for several years, helping to boost house prices and the accumulation of private debt. While the US moved back towards internal balance, its current account remained in substantial deficit.

Although aggregate investment is always equal to aggregate savings for the world economy as a whole, the two can diverge for individual countries. In China during the early 2000s, overall saving exceeded investment, and this was reflected in a substantial current account surplus and a rapid accumulation of foreign exchange reserves. The excess savings were lent abroad and ultimately fuelled credit and housing bubbles in rich countries rather than productive investment.

A number of countries in East and South East Asia also ran current account surpluses over the same period, a consequence of keeping relatively competitive currencies vis-a-vis the US dollar. This was in turn part of a deliberate policy to avoid a repeat of the damaging and sometimes humiliating international bailouts in the wake of the ‘Asian crisis‘ of the late 1990s.

The major oil-producing nations ran current account surpluses in the 2000s as well, due to high oil prices, which boosted their exports.

In the Eurozone, Germany was the major current account surplus country, partly reflecting a policy of stagnant wage growth among exporting firms which made them more competitive in foreign markets.

To repeat, these current account surpluses among the aforementioned countries, other things being equal, inevitably exerted deflationary forces on the world economy. For the latter, international trade and investment flows necessarily balance. For every surplus there must be a deficit. But for the surpluses to be realised, the exported goods and services (ignoring investment flows) must be purchased abroad. If the deficit countries do not import these goods and services, or deflate domestic demand to restore external balance by reducing imports relative to exports, this will slow growth and lead to rising unemployment, both at home and in the surplus countries. Without rebalancing in a way that restores a sustainable growth path, this can only be overcome in the short term through unsustainable debt-fuelled growth in the deficit countries.

To simplify dramatically: if the world economy consisted of the US, running a current account deficit, and China, running a matching surplus, external balance for each of them could be achieved in two ways. Both involve a fall in Chinese domestic savings relative to domestic investment and the reverse process in the US. One leads to stagnation or recession and higher unemployment, the other to more rapid output and employment growth

In China, what is currently needed is a rise in the share of consumption in national income, and a fall in the shares of savings and investment, with savings falling more than investment, so that the two move towards balance. This is what the Chinese government is attempting at the moment. It would reduce the current account surplus, and raise demand for US exports, stimulating growth there and reducing the need for it to be driven by debt-fuelled bubbles.

In our two-country world economy, balance could also be achieved through deflation in the US, so that the import share falls relative to exports. Of course, this will lead to rising unemployment in the US and among Chinese exporters, as US demand for Chinese exports falls. If Chinese domestic demand does not rise to compensate for the slowdown in exports, then growth would slow there too, and overall unemployment in China would rise. The US would move closer to balancing its current account. Investment would fall relative to savings, again towards balance. Both countries would move towards external balance, but with negative consequences, namely rising unemployment and slower growth. Internal balance would not be achieved.

I have ignored exchange rate changes in this simple example. A fall in the US dollar against the Chinese yuan could also help the rebalancing process. This would tend to raise US savings relative to investment and boost net exports, reducing the current account deficit, with the reverse happening in China as the current account surplus falls.

This discussion of the evolving economic relationship between China and the US shows that the more desirable path is somewhat out of the hands of the US government and depends on changes in those countries running current account surpluses. The US could regain some influence by imposing tariffs on imports from China, which would create static inefficiencies but help to boost domestic demand by reducing spending on imports.

The optimal outcome economically requires either international coordination in economic policy or, at the very least, enlightened thinking on all sides to pursue sustainable national prosperity.

Coordination between the two countries would ideally result in a realignment of the exchange rate, and appropriate domestic policies. Together these should aim to move domestic savings and investment closer to balance. This combination of policies would necessarily move the current accounts towards balance, promoting maximum growth and employment. Both internal and external balance could potentially be achieved.

In the aftermath of World War II, at the Bretton Woods conference in New Hampshire, which aimed to establish a new international monetary order to promote prosperity among the capitalist nations, Keynes pushed for the adoption of rules which would have shared the burden of current account adjustment equally between countries running surpluses and deficits. His ideas were not adopted, and in the post-war period the burden of adjustment has been forced onto deficit countries alone. This policy tends to promote deflationary forces and higher unemployment internationally and still operates today.

International coordination in economic policy-making tends only to happen in the midst of exceptional crises. The usual place for economic policy is at the national level, as this is where democratic legitimacy tends to lie. An enlightened, dominant economic power, such as the US in the post-war period, may be required to push for international cooperation in policy-making to restore global prosperity. But with the global balance of power shifting increasingly to emerging Asia, the US now seems less comfortable taking the lead. As a consequence, the global economy may struggle to move beyond its current sluggish performance.

Of course, recessions and crises have proved to be an inevitable aspect of capitalist development. But without the kind of favourable internal and external economic rebalancing outlined above, we may be headed for another major crisis far too soon after the last one, devastating livelihoods across the world once again. Maybe that would be enough to focus minds, but don’t hold your breath.


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