The Global Monetary Status Quo (Part I)

The following crucial events took place the past month. First, the Capitol Hill shutdown ended in a victory for the adherents of government power. Second, the Nobel Prize for Economics was again awarded to a theory that largely shifted the pendulum of economic thought away from the Austrian School of free markets. Last but not least, the nomination of Janet Yellen as the next the Federal Reserve Chairman will  protract the use of unconventional monetary  policies (UMP).

From the global perspective it is the latter that should be the most concerning. Federal Reserve's recent decision to continue its monthly purchases of long-term securities certainly invoked different market sentiments. Even though markets were expecting the Fed to start "tapering" the quantitative easing strategy, Chairman Ben Bernanke decided to maintain the current policy. Given Yellen's theoretical proclivity to stimulus and pursuit of growth through expansionary monetary policies, Bernanke's legacy is likely to be reinvigorated. In the long-run, however, preserving accommodative monetary policies is bound to create significant negative spill-overs to other economies. As a guardian of the international monetary system (IMS), the U.S ought to enhance the external stability of the global economic structure through disciplined monetary policies. Unfortunately, following the footsteps of her predecessor will strengthen Yellen's zeal for loose monetary policies, which do not prioritize external stability of the IMS.

Why does U.S monetary policy influence the external stability of the IMS? It is widely accepted that the dollar is de facto global reserve currency, which acts as a anchoring currency -both interest and inflation rates- for several other countries. In other words, the network value of the dollar is higher than for example Euro, Yen, Franc or the Yuan. Furthermore, in order to lubricate global trade and investments -largely denominated in dollars- the Federal Reserve must provide sufficient amount of liquidity by expanding the monetary base. Naturally, therefore, the U.S must run consistent deficits, which must be balanced by surpluses somewhere else. As a result, global economic imbalances are inherently and consistently exacerbated due to global demand for dollars. Nevertheless, there are a variety of other variables, which cause further problems in the IMS. 　　 　　

To complicate the fragile system even more, historically risk-averse investors have preferred U.S Treasury bills for their safety and liquidity. Consequently, vast quantities of foreign capital is flowing back to the United States. These capital inflows are injected back to the economy, which as a result falls under the illusion of real growth and wealth. The destructive U.S housing bubble aptly epitomized such a scenario. The housing market crash initiated a larger economic downslide in the U.S with declining output and consumer confidence. As a response, the Federal Reserve engaged in quantitive easing (QE) policies designated to stimulate recovery and growth in the United States at the expense of global external stability. 　　 　　

Because of lower interest rates in the advanced economies (AE), investors searched higher yields from the emerging economies (EME), where economic growth had been robust and fairly consistent. The emerging economies, who are by large relying on the export led growth model, had learned through the 1997 Asian financial crisis that excessive capital inflows deriving from the expansionary policies of the AEs can bring about risky financial patterns. In more specific, capital inflows, or "hot money", tend to appreciate the currency and diminish the competitiveness of exports through undesirable terms of trade. The only way to preserve positive terms of trade is to intervene in the foreign exchange markets and engage in sterilization strategies. Effective sterilization, however, requires the central bank to print additional domestic currency with which to buy reserves in order to intervene in the foreign exchange markets. Not surprisingly, 61% of global reserves are denominated in dollars, which means that the dollar status quo is only reinforced. Consequently, such a vicious circle only adds more pressure to the balance of the IMS. 　　 　　

Evidently the Federal Reserve and the new Chairman Yellen can not win in any scenario. Maintaining low-interest policies pushes capital to the EMEs, which engage in above mentioned counter-policies. Withdrawing from the QE-programs, however, repatriates capital to AEs leaving emerging economies vulnerable to shocks. The only method for the EMEs to avoid balance-of-payment disequilibrium is to adopt pernicious capital controls: limit capital inflows when US interest rates are low and to block outflows when the Fed tightens monetary policy. It must be noted that capital controls are not the solution to the problem. As a matter of fact, imposing controls on international capital mobility may worsen the situation with significant dead-weight, bureaucratic and opportunity costs. Even though the IMF had a change of hearts in capital flow management, limiting global capital mobility is a wrong cure for a misdiagnosed disease. 　 　

Federal Reserve's decision to move forward with the QE policy must have a rationale behind it. Current Chairman Ben Bernanke might believe that domestic recovery is not sufficient enough to withdraw from the stimulus strategy. The Fed might suspect that the risk of tightening credit might stall the progress of domestic recovery. However, such viewpoint ignores completely the responsibility of Federal Reserve. Pursuing domestic interests at the expense of global financial stability is hardly what the world expects from its de facto international reserve currency. To make matters worse, the recent government shutdown did not create encouraging sentiments towards the dollar based IMS. Needless to say, Yellen's ideological and academic background are hardly going to change the detrimental status quo. Changes and revisions on the structure of the IMS require a more fundamental consideration for monetary discipline. One of the few credible alternatives is to reconsider the possibility of the Gold Standard.

Author: Henri Erti

The views of the author do not necessarily fully reflect the views of Ludwig von Mises Institute-Europe