The Case for a Grand Bargain

Countries with fiscal room for maneuver should use it. Those lacking fiscal space can agree to use monetary stimulus more aggressively, while others need to implement reforms. A column by Barry Eichengreen.

Barry Eichengreen
«Supply- and demand-side support for renewed growth are in fact compatible with one another.»

The current malaise of stagnation and «lowflation» is a global phenomenon. And, unfortunately, individual efforts to defeat it, by central banks and governments proceeding on their own, are clearly not working.

Japan is relying mainly on its central bank to ramp up security purchases and push down the yen exchange rate. Europe is similarly expecting the ECB to continue quantitative easing and cut interest rates further, ideally causing the euro to weaken. The People’s Bank of China injected record amounts of liquidity into the country’s economy in January and reduced reserve requirements for Chinese banks again in February. It can be expected to do more along similar lines in coming months. Even the Federal Reserve, after raising interest rates by 25 basis points in December, is now on hold as it ponders the impact of foreign turbulence on the U.S. economy.

The one thing these policy initiatives have in common is that they are not succeeding. Despite the Bank of Japan’s aggressive balance-sheet expansion, neither Japanese financial markets nor Japanese exports show signs of picking up. To the contrary, Japan’s exports fell for a fourth straight month in January. Meanwhile, European growth remains tepid.  Indeed there is now the danger of it slowing further if the ECB’s policy of negative interest rates weakens the financial condition of the banks, given European firms’ heavy dependence on bank credit.

Everbody wants to weaken their currency

Not only is Chinese growth slowing, but the PBOC is caught in a vice. If it tries to keep the renminbi at current levels, it will experience chronic reserve losses as speculators, betting against successful maintenance of the peg, transfer money out of the country. In addition, a strong renminbi will make the going tough for Chinese exporters. But allowing the currency to depreciate sharply will only excite speculators still further and antagonize China’s foreign partners.

In effect, Japan, the Euro Area and China would all like weaker currencies to boost inflation and growth, but insofar as they are moving in the same direction they can’t all weaken their currencies against one another. In principle, they can all weaken their currencies against the dollar, but the Fed will resist further strengthening of the greenback, which has already created significant headwinds for U.S. economic growth. It will do so by delaying additional interest-rate normalization or even reversing direction and cutting rates if the U.S. economy weakens further.

This realization, that individual national initiatives have been ineffective and even counterproductive, motivated calls at the G20 summit in Shanghai at the end of February for some kind of globally coordinated initiative. Yet despite the urging, finance ministers delivered nothing of substance. Their statement that «We will use all policy tools – monetary, fiscal and structural – individually and collectively to achieve these goals» was empty. There was no change in policy, either individual or collective. Their commitment to «refrain from competitive devaluations and…not target our exchange rates for competitive purposes» held for exactly two days, until the PBOC pushed the renminbi down to its lowest level in three weeks on the first trading day following the summit.

No consensus as to the therapy

Global economic cooperation to solve global economic problems would be nice but will have to surmount formidable conceptual and practical obstacles. Take monetary policy. Those who warn of currency wars argue that, in the current environment where conventional monetary policy is exhausted, the only remaining monetary mechanism for stimulating growth and fending off deflation is by depreciating the currency. If so, global cooperation doesn’t help in a situation like today’s where every country, including the United States, fears recession and wants a weaker currency – since not every country can have a weaker currency at the same time

Alternatively, consider fiscal policy. Not every country has fiscal space; large deficits and heavy debts prevent some governments from cutting taxes and increasing spending on public infrastructure projects. Those who do so in order to act as «locomotives» for the world economy as a result bear a disproportionate share of the costs, in the form of additional domestic and foreign debt, of jumpstarting global growth.

Nor do policy makers in different countries all share a common diagnosis of the nature of the problem and its remedy. U.S.-based Keynesians would recommend fiscal stimulus where fiscal stimulus is possible. But not all Americans are Keynesian true-believers. Skeptics, and not only prominent ones like Donald Trump, openly question whether government can spend resources productively, as opposed to simply frittering them away. German Ordoliberals, for their part, see fiscal and monetary stimulus as relieving the pressure for governments to undertake the painful structural reforms needed to set economies on a sustainable path.

The dollar would strengthen

But in the underbrush of these disagreements lie the seeds of a grand bargain. Countries with fiscal room for maneuver, such as the United States and Germany, should agree to use it. Economies lacking fiscal space for their part can agree to use monetary stimulus more aggressively, not just pushing down the exchange rate but also ramping up their security purchase programs to encourage investment in risk assets and capital formation at home. And countries where structural reform is urgent, not just the Southern European countries that are Germany’s concern but also emerging markets like China and Brazil, can recommit to the reform, reassuring the skeptics that supply- and demand-side support for renewed growth are in fact compatible with one another.

This is not the perfect bargain, but then we do not live in a perfect world. In particular, the dollar would strengthen against other currencies, as it did when the U.S. pursued a similar mix of aggressive fiscal policy and cautious monetary policy under President Reagan and Fed Chair Volcker in the early 1980s. That strong dollar would cause U.S. exporters to howl, but that is the price of international cooperation to jumpstart global growth. A relatively strong dollar is appropriate, after all, given the relatively strong condition of the U.S. economy (where »relative» means compared to other national economies). A further problem or cost is that global imbalances – a growing external deficit for the U.S. and surpluses for other countries – would reemerge.

But only temporarily. Once global growth firmed, U.S. fiscal stimulus could be withdrawn. Monetary policies in other countries could be normalized.  The dollar would give back ground, and global imbalances would narrow.

Great opportunity for infrastructure spending

What would it take for all this to happen? First, there would have to be a reassertion of non-ideological economic common sense in U.S. and German policy making circles. One doesn’t have to be a Keynesian to believe that record low interest rates in both countries create a once-in-a-lifetime opportunity for infrastructure spending or to acknowledge that there are aspects of public infrastructure in both countries desperately in need of repair.

Second, central banks in countries lacking fiscal space would have to do more. This means not just talking down the exchange rate as a way of enhancing competitiveness but taking steps to encourage domestic spending, for example ramping up domestic security purchases still further, and ignoring domestic opposition.

Third, emerging markets and Southern European countries would have to make a credible commitment to structural reform. The need is there, quite independent of international coordination. But without this commitment, international coordination is off the table.

Skeptics will say that I am a dreamer for imagining this grand bargain. But the alternative to this dream is an ongoing economic nightmare.