Nikkei Veritas – Market Eye column, 19th October 2010

The Japanese government’s decision to intervene again in the foreign exchange market, after a five year gap, is an important event. It was set off by the rise in the yen compared with other G5 currencies. The underlying problem is that the developed economies, in aggregate, need to improve their external current account balances and have great difficulty in doing so. As the general problem seems intractable, the major countries are in competition to devalue their currencies relative to one another. Sometimes this happens by accident rather than design. For example, the threat of default among the weaker members of the Eurozone caused that currency to weaken and has proved a great boon to Germany. But with the recent rise in the yen, the Japanese government found that the economic recovery was threatened and direct action was needed.

At the end of World War II, the countries which today constitute the G5 were responsible for at least half the world’s output and a similar amount of its growth. Now they produce less than 20% of that growth. Sixty years ago the US pursued economic policies that effectively ignored the rest of the world. This was successful in keeping the economy progressing without a major recession, but it created two large long-term problems. The first was that debts of the private sector grew by five times relative to output and the second was that the US current account moved from a surplus of 4% of GDP to a deficit of 6%.

Neither of these trends can continue and, in my view, their end was signalled by the recent financial crisis. Many of those currently concerned with managing major economies disagree with this analysis. It seems to me that they are seeking to continue the policies that caused the problem. I can illustrate this by first describing the policies which I think are needed to produce a sustainable recovery in the developed world and contrast them with those that are, for example, being pursued by the Federal Reserve.

The immediate response to the financial crisis was to cut interest rates as low as possible and increase fiscal deficits. This was in my view correct, but it was also, as I and others wrote at the time, the easy part. We are now facing the tricky part of reducing the fiscal deficits and halting the growth of debt. At the moment G5 countries are running deficits which average around 8% of GDP. As these are reduced, there must be an equal and offsetting decline in the cash surpluses of either the private sector or a reduction of their combined cash deficits with the rest of the world.

It is, I think, essential that the impact on the private sectors of G5 countries is modified by a significant improvement in their current account balances. The past build-up of debt has been so great that if the private sector is asked to take the full burden, it will be in no position to finance the rise in investment and employment which is essential for recovery.
If this view is correct, then the key to a successful and sustained recovery lies in improving the current account balances of G5 countries and this means an equal deterioration in the balances of the developing world. To do this the real exchange rates of the major currencies not only have to fall, but they have to keep falling. This is because equilibrium requires that the real exchange rates of rapidly growing countries rise steadily compared with those of slower growing ones.

There are two ways in which real exchange rates can change. It can either happen through changes in the nominal rates or by having substantial gaps between the inflation rates of the slow and rapidly growing economies. The emerging economies, led by China, are reluctant to allow their exchange rates to change and, despite the threats of the US Congress, this policy seems immovable. G5 countries must therefore adapt their policies and can no longer assume that they can run their economies as if the rest of the world doesn’t matter. They have a choice. They can either introduce protectionist policies or have inflation targets which are well below the rates of inflation found in the developing world.

I strongly favour the second of these. The Federal Reserve disagrees. Its Chairman, Dr Bernanke, has remarked that he thinks the current level of inflation in the US is too low. I hope that the Federal Reserve will not succeed in raising the inflation rate. If they do, I fear that protectionism will follow shortly and that this will quickly lead to more inflation than even the Federal Reserve desires.