Amer­i­can-made fi­nan­cial re­pres­sion

Financial Mirror (Cyprus) - - FRONT PAGE -

A gen­er­a­tion of de­vel­op­ment econ­o­mists owe Ron­ald McKin­non, who died ear­lier this month, a huge in­tel­lec­tual debt for his in­sight – in­tro­duced in his 1973 book ‘Money and Cap­i­tal in Eco­nomic De­vel­op­ment’ – that gov­ern­ments that en­gage in fi­nan­cial re­pres­sion (chan­nel­ing funds to­ward them­selves to re­duce their debt) ham­per fi­nan­cial de­vel­op­ment. In­deed, McKin­non pro­vided the key to un­der­stand­ing why emerg­ing economies’ fi­nan­cial sec­tors were un­der­de­vel­oped.

At the end of his life, McKin­non was work­ing on a re­lated – also po­ten­tially ground­break­ing – con­cept: a dol­lar-ren­minbi stan­dard. In his view, such a sys­tem would al­le­vi­ate the fi­nan­cial re­pres­sion and frag­men­ta­tion that is un­der­min­ing global fi­nan­cial sta­bil­ity and growth. The ques­tion is whether the pow­ers that be – par­tic­u­larly in the United States, which has long ben­e­fited from the dol­lar’s global dom­i­na­tion – would ever agree to such a co­op­er­a­tive sys­tem.

The no­tion that the dol­lar’s global dom­i­nance is con­tribut­ing to fi­nan­cial re­pres­sion rep­re­sents a sig­nif­i­cant his­tor­i­cal shift. As McKin­non pointed out, the dol­lar be­came a dom­i­nant in­ter­na­tional cur­rency after World War II be­cause it helped to re­duce fi­nan­cial re­pres­sion and frag­men­ta­tion in Europe and Asia, where high in­fla­tion, neg­a­tive real in­ter­est rates, and ex­ces­sive reg­u­la­tion pre­vailed. By us­ing the dol­lar to an­chor prices and the Fed­eral Re­serve’s in­ter­est rate as the bench­mark for the cost of cap­i­tal, in­voic­ing, pay­ments, clear­ing, liq­uid­ity, and cen­tral-bank re­serves all be­came more sta­ble and re­li­able.

As long as the US re­mained com­pet­i­tive and pro­duc­tive, cur­ren­cies that were pegged to the dol­lar ben­e­fited con­sid­er­ably. For economies in tran­si­tion – such as Western Europe in the 1950s-1960s, Asia dur­ing the growth mir­a­cle of the 1970s-1990s, and China in 1996-2005 – the dol­lar pro­vided an an­chor for the macroe­co­nomic sta­bil­i­sa­tion ef­forts and fis­cal and mon­e­tary dis­ci­pline that struc­tural trans­for­ma­tion de­manded.

But two dis­rup­tions un­der­mined th­ese ben­e­fits. First, in 1971, the US ter­mi­nated the dol­lar’s con­vert­ibil­ity to gold, open­ing the way for the emer­gence of a new ex­change-rate regime, based on freely float­ing fiat cur­ren­cies.

Then came the pe­riod of “Ja­pan-bash­ing” in the 1980s-1990s, which cul­mi­nated in threats from the US to im­pose trade sanc­tions if Ja­pan’s com­pet­i­tive pres­sure on Amer­i­can in­dus­tries did not ease. With the sub­se­quent sharp ap­pre­ci­a­tion in the yen/dol­lar ex­change rate, from JPYUSD360:1 to 80:1, the world’s sec­ond-largest econ­omy has suf­fered through two decades of de­fla­tion and stag­na­tion.

Through­out this pe­riod, McKin­non ar­gued that, by forc­ing Amer­ica’s trade part­ners to bear the bur­den of adjustment, the dol­lar’s pre­dom­i­nance leads to “con­flicted virtue”: sur­plus coun­tries like Ja­pan, Ger­many, and China faced pres­sure to strengthen their cur­ren­cies, at the risk of trig­ger­ing de­fla­tion. If they failed to do so, their “un­der­val­ued” ex­change rates were crit­i­cised as un­fair.

But McKin­non dis­agreed with the con­ven­tional wis­dom that the best way to re­solve this con­flict would be to shift to flex­i­ble ex­change rates. In­stead, he rec­om­mended that Asian coun­tries de­velop a re­gional cur­rency that would pro­vide macroe­co­nomic sta­bil­ity in the face of dol­lar vo­latil­ity. Long be­fore the Bret­ton Wood in­sti­tu­tions con­ceded that cap­i­tal con­trols could be use­ful, McKin­non was as­sert­ing that, un­der cer­tain cir­cum­stances, such con­trols might be nec­es­sary to sup­ple­ment pru­den­tial bank­ing reg­u­la­tion.

McKin­non has a par­tic­u­larly strong fol­low­ing among Chi­nese econ­o­mists. China achieved its strong­est growth when the ren­minbi was pegged to the dol­lar – a sys­tem that re­quired stead­fast re­forms and strict fis­cal dis­ci­pline.

The ren­minbi’s steady ap­pre­ci­a­tion against the dol­lar – at an an­nual rate of about 3%, on av­er­age, since 2005 – shrank China’s cur­rentac­count sur­plus. In a weak global eco­nomic en­vi­ron­ment, China’s progress in ad­dress­ing macroe­co­nomic im­bal­ances, while main­tain­ing an an­nual growth rate of about 7%, was no small feat.

But the ren­minbi’s ap­pre­ci­a­tion also at­tracted carry-trade spec­u­la­tors, who pur­chased ren­minbi as­sets in or­der to ben­e­fit from high in­ter­est rates (par­tic­u­larly after 2008) and ex­change-rate gains. This is partly why China’s for­eign-ex­change re­serves have swelled so rapidly, from $250 bln in 2000 to $4 trln this year.

The prob­lem, as McKin­non recog­nised, is that th­ese spec­u­la­tive in­flows of “hot” money have weak­ened China’s macroe­co­nomic tools and fu­eled ever more fi­nan­cial re­pres­sion. For starters, China’s lead­ers, recog­nis­ing that higher in­ter­est rates would draw even greater in­flows, are in­creas­ingly wary of in­ter­est-rate – and even cap­i­tal-ac­count – lib­er­al­i­sa­tion.

Mak­ing mat­ters worse, the Chi­nese au­thor­i­ties are tight­en­ing credit and reg­u­lat­ing the money sup­ply through ster­il­i­sa­tion and high re­serve re­quire­ments for bank de­posits – an ap­proach that un­der­mines real eco­nomic growth con­sid­er­ably. In or­der to stem this de­cline with­out rais­ing in­ter­est rates too much, they have re­sorted to ad­min­is­tra­tively tar­geted credit loos­en­ing.

More “China-bash­ing,” with the US de­mand­ing that the ren­minbi be al­lowed to ap­pre­ci­ate fur­ther, is clearly not the an­swer. In­stead, the US should fo­cus on re­duc­ing its own fis­cal deficit, thereby fa­cil­i­tat­ing Chi­nese ef­forts to boost do­mes­tic con­sump­tion. If the Fed’s bench­mark in­ter­est rate can be re­stored to his­tor­i­cal trend lev­els, China would have more pol­icy space to ad­just in­ter­est rates in align­ment with its growth pat­tern and pur­sue an or­derly open­ing of its cap­i­tal ac­count.

Sim­ply put, the world needs its two largest economies to work to­gether to bol­ster global mon­e­tary sta­bil­ity. To­gether, China and the US can al­le­vi­ate fi­nan­cial re­pres­sion, avert pro­tec­tion­ist ten­den­cies, and help main­tain a strong foun­da­tion for global sta­bil­ity. Un­for­tu­nately, McKin­non’s pol­icy ad­vice has not been popular among main­stream Amer­i­can econ­o­mists and pol­i­cy­mak­ers, who pre­fer the short-term po­lit­i­cal ad­van­tages af­forded to them by free-mar­ket rhetoric.

It is time for US lead­ers to recog­nise that what for­mer French Fi­nance Min­is­ter Valéry Gis­card d’Es­taing called the “ex­or­bi­tant priv­i­lege” that the dol­lar’s global dom­i­nance af­fords Amer­ica also en­tails con­sid­er­able re­spon­si­bil­ity. Global mon­e­tary sta­bil­ity is, after all, a pub­lic good.

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