A Keynesian solution to monetary madness

Lowy Interpreter

The major advanced economies have had very accommodative monetary policies since the 2008 global financial crisis. These 'flat to the floor' expansionary settings are likely to remain in place for some years to come, and there are positive and negative implications not only for their domestic economies but for other countries as well. Some bold policy thinking is required if these policies are not to be seen as 'currency wars', but rather as an opportunity for beneficial international interaction.

Interest rates in the US, Europe, the UK and Japan have been close to zero for five years. The US Fed overnight promised to keep the policy rate low as long as unemployment remains above 6.5 per cent and inflation below 2.5 per cent, and it has worked hard to get longer-term interest rates down as well. Economic prospects are so bleak in Europe, the UK and Japan that higher interest rates are beyond the forecast horizon.

In addition, each of these countries has implemented some form of 'quantitative easing', expansion of the central bank's balance sheet in an attempt to further stimulate economic activity. These dramatic measures have taken central banks into unexplored policy territory, to the edge of a central bank's proper remit.

Lower interest rates boost demand and weaken the exchange rate, encouraging more exports. The boost to activity is not, however, without downside. Low interest rates artificially encourage borrowing and potential over-leverage; they promote investment which may not be viable at normal interest rates; they squeeze the interest income of pensioners and pension funds; and there will be capital losses for bond-holders later, when interest rates rise. The QE component of monetary policy is of uncertain effectiveness and loads banks with excessive reserves which distort balance sheets.

So much for the domestic effects. Are these extreme settings of monetary policy harmful for other countries? Brazil's finance minister certainly think so, describing this as a 'currency war' because low interest rates cause excessive capital flows to emerging countries, pushing their exchange rates to uncompetitive levels. This grievance can be seen as analogous to America's complaint that China's exchange rate policies have given its exporters an unfair advantage, thus boosting domestic demand. Is Brazil entitled to feel aggrieved, and if so what might be done?

Until recently, conventional wisdom judged countries to be free to set their monetary policies without regard for knock-on effects on other countries. But opinion is shifting. The International Monetary Fund's U-turn on capital flows seems to include this issue as well, putting focus on countries whose macro policy settings cause excessive capital flows to countries with more normal policy settings.

If that seems to be an advance in policy thinking, then (as usual) there is an offset: the Fund has no suggested policy action for the capital-exporting country. But at least the issue is on the table for discussion.

How might that discussion go? The main argument in defence of these extreme policy settings is that, if the advanced countries succeed in stimulating their economies, global growth will resume at a more normal pace. But of course this same argument could be made in defence of China's policy: what's good for China will spill over into some benefit for the world.

In the end, the argument is about the mix of policy. If a country has tight fiscal policy combined with loose monetary policy, it will get the unfair advantage of a lower exchange rate, just as surely as China benefits from its exchange rate policies.

But it is harder to establish that advanced countries have the wrong policy mix. The IMF explored this issue in its latest World Economic Outlook, but as usual the discussion was so perfectly balanced that it is hard to draw policy implications. Box 1.1 of the WEO noted that fiscal multipliers might have been understated, giving an unintended boost to fiscal restraint. But this message was immediately followed by Box 1.2, showing that official debt levels in a number of advanced countries were dangerously high, so fiscal restraint should not be relaxed.

In short, the world has got itself into a macro policy bind. The accommodative monetary policies in advanced countries are accumulating serious problems at home and gathering ill will overseas. But it looks like the emerging countries will just have to take their own policy actions, as best they can, if they find themselves with excessive capital inflows.

The boldest of the policy makers might see this as a once-in-a-lifetime opportunity to make use of these low-cost funds to build infrastructure. Not every emerging country will want to seize this opportunity: China needs no foreign funding for its massive infrastructure spending. But the Philippines and Indonesia, both seriously constrained by inadequate infrastructure, can borrow dollars at less than 4 per cent and local currency for only a little more. The World Bank and its regional counterparts can borrow for 2 per cent and could act as intermediaries for countries unable to borrow in their own name.

This might be seen as 'global Keynesianism', where demand deficiency in advanced countries is countered not by make-work programs at home but by expansionary policies in countries which have the fiscal capacity and a multitude of high-social-return projects.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.