The November 11-12 summit of the Group of 20 major and emerging economies originally looked like it would make progress in resolving key problems in the world economy. The leaders were expected to endorse the agreements reached at last month's finance ministers meeting that all countries would undertake structural reforms of their economies to boost global demand, foster job growth, and raise the prospects of a coordinated recovery.
As part of the deal, advanced countries would pursue credible, ambitious, and growth-friendly medium-term fiscal consolidation; and all countries would make efforts to move toward more market-determined exchange rates and refrain from competitive devaluations of their currencies. The summit was expected to carry the discussion further by reaching agreement on how reductions in external imbalance might be used to measure progress in achieving these objectives.
However, the U.S. Federal Reserve's decision on November 4 to resume quantitative easing--a program that will inject $600 billion into the economy--unfortunately appears to have shifted the focus of the G20 discussions. As a result, the leaders are likely to leave Seoul without making material progress in dealing with the key problems, especially exchange rate policies, that stand in the way of achieving a more robust and sustainable recovery of the world economy.
In the week following the Fed's decision, officials from G20 countries such as Germany, China, South Korea, and Brazil have strongly criticized this change in U.S. monetary policy. However, their concern is misplaced. A new round of quantitative easing is in the best interest of the United States to stimulate stronger growth and ensure that the United States does not slip into deflation. Moreover, a stronger U.S. economy would benefit other countries as U.S. demand for their exports would rise. Any near-term strains that U.S. quantitative easing may create for other countries reflect problems that these countries are creating for themselves, especially China, as they seek to limit appreciation of their exchange rates.
The basic criticism of U.S. quantitative easing policy is that it will force U.S. interest rates lower, resulting in further capital outflows from the United States and more downward pressure on the value of the dollar. The Europeans are concerned about the potential negative effects of additional euro appreciation on their economic recovery. Similarly, Brazil and countries in East Asia are worried about additional upward pressure on their exchange rates. But the ultimate concern of most of these countries is not so much that their currencies will rise in value, but that appreciation will have significant negative competitive effects because China will continue to heavily manage its exchange rate to limit yuan appreciation. A major concern of China is that the change in U.S. monetary policy will make its exchange rate management more difficult.
Quantitative easing is an appropriate policy for the United States and will benefit other countries. It is needed to try to strengthen U.S. growth in the near term. It will also reduce the serious risk of deflation developing in the United States. Worries that the policy might generate inflation are overblown. The potential supply of goods in the United States exceeds demand by such a large margin that inflation is not a serious worry, and with high unemployment likely to persist, inflation will not be a concern for an extended period.
Concerns that quantitative easing will generate inflation eventually are primarily based on expectations that the Fed might be tardy in the future in tightening monetary policy when it may be needed. However, the Fed's track record over the past two business cycles does not support this contention. During the latest cycle, the Fed moved decisively beginning in 2006 to tighten monetary policy and successfully contained inflationary pressures. Quantitative easing, if it succeeds in strengthening U.S. growth, will also significantly benefit the rest of the world as U.S. demand picks up more quickly than would otherwise be the case.
In contrast, China's tight management of its exchange rate is not even appropriate policy for China at this juncture. Moreover, it has substantial negative effects on the rest of the world. The policy is not in China's best interest because it slows the needed rebalancing of China's economy. For China to be able to sustain rapid growth and development over the medium term, the economy has to shift away from its dependence on investment and exports toward heavier reliance on domestic consumption to generate growth.
China's exchange rate policy creates a serious distortion in prices in China that leads to an overallocation of productive resources to the export sector and works against the rebalancing. At the same time, China's policy imposes a substantial cost on other countries because it adds significantly to China's competitive advantage. Countries competing with China feel compelled to introduce similar distortionary policies to limit their loss in competitiveness vis-à-vis China.
"[T]he leaders of the G20 countries look like they will end up lost in all of the rhetoric surrounding the U.S. decision to resume quantitative easing and lose focus on the real problem, China's exchange rate policy."
Yet China's policies no longer appear to be the foremost concern at the upcoming summit. Unfortunately, the leaders of the G20 countries look like they will end up lost in all of the rhetoric surrounding the U.S. decision to resume quantitative easing and lose focus on the real problem, China's exchange rate policy.
It is in everyone's best interest to get a meaningful change in China's policy, and pressure on China to allow its currency to significantly appreciate needs to be stepped up. Without sustained multilateral pressure, China will not move. A core group of advanced and emerging-market countries in the G20 were reaching this conclusion together before the Fed's decision. But confusion over the implications of the Fed's decision appears to have derailed the coalition, at least for the time being.
Efforts need to be directed at rebuilding this coalition to push for meaningful change in China's exchange rate policy. Otherwise, currency wars will remain a real threat, which eventually could lead to disastrous trade wars.