What happened to the global economy and what we can do about it
with 128 comments
This guest post was submitted by Joe Gagnon, a senior fellow at the Peterson Institute for International Economics. Joe is an expert on international economics has spent a great deal of time studying the effects of exchange rate depreciation. Even if the dollar depreciates sharply in the near term, he argues that is unlikely to have adverse effects – primarily because inflation will stay low.
Pundits and policymakers around the world are wringing their hands over the possibility of further declines in the foreign exchange value of the dollar. Predicting exchange rates is notoriously difficult; there is almost as much chance of the dollar rising next year as of it declining. But if the dollar were to fall further, should we be concerned?
A lower dollar is good news for US exporters and foreign importers and bad news for foreign exporters and US importers. However, if policymakers respond appropriately, there is no reason to fear overall harm either to the US economy or to foreign economies. Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the global economy away from excessive US trade deficits and foreign reliance on export-led growth, putting the world on track for a more sustainable expansion.
The fear in economies that are appreciating against the United States is that a falling dollar will choke off exports and hobble economic recoveries. The correct response is to ease monetary policy and temporarily delay fiscal contraction. As I explain here, even in economies with short-term interest rates near zero, there is plenty of scope for central banks to stimulate aggregate demand, and doing so will help to limit the extent to which the dollar falls.
For the United States, the benefits of a falling dollar are obvious: stronger exports and a faster recovery. The fear is that a falling dollar would be inflationary. However, as I have shown in two recent papers, even very large currency depreciations in developed economies have no effect on inflation unless they are caused by policies that attempt to hold an economy's unemployment rate below its equilibrium level. With US unemployment currently at 10 percent, there is no chance that inflation will rise in the near term. Whether inflation rises in the longer run will depend on whether US monetary and fiscal policy stimulus is withdrawn appropriately as the economy recovers (and tighter macroeconomic policies would tend to support the dollar). Many believe that US policymakers erred in not withdrawing stimulus soon enough in 2003-05, but policymakers now seem to be keenly aware of this mistake and have expressed their determination not to repeat it. Only time will tell, but my own view is that the Federal Reserve, at least, will not allow runaway inflation.
For economies that peg their currencies to the dollar (notably China) the costs and benefits of a falling dollar are the same as those facing the United States and so is the policy dilemma: how fast to tighten macroeconomic policy as the economy recovers? These economies differ on several dimensions, including financial market development and capital controls, strength of economic ties to the United States, and prospects for economic slack and inflation. These differences will determine the appropriate policy stance. To some extent these economies have forfeited the freedom to adjust monetary policy, but they retain the option of adjusting the levels of their dollar pegs. In some cases, a further decline in the dollar may represent an opportune moment to move to a floating exchange rate.
By Joseph E. Gagnon
Written by Simon Johnson
November 14, 2009 at 6:05 am
Posted in Commentary
I note the careful restriction of the universe of discourse to “developed economies” here. Otherwise one of the usual suspects like Zimbabwe would provide an immediate refutation since policies there (insofar as they exist) clearly don’t even pay lip service to holding unemployment below any sanely defined equilibrium. This restriction implies there must be some fundamental characteristic of developed economies that differentiate them from the rest.
It would also be useful if the article gave an estimate of the equilibrium unemployment level in the US. Given the emphasis on the need to avoid keeping the stimulus going too long, I have an uneasy feeling the author may consider it to be pretty close to the current level. It is quite possible that a few million unemployed might disagree.
ozajh
November 14, 2009 at 6:35 am
Dear ozajh,
Thanks for your insightful comments.
1. The track record of central banks and governments is critical in determining how the economy evolves. All the developed economies (with the possible exception of Iceland) and many emerging economies have demonstrated a history of relatively sound monetary and fiscal policies, with low and stable inflation. (By “relatively” I mean in comparison with the disastrous policies seen in Zimbabwe now and Argentina and other places not too long ago.) This track record means that inflation in the US is very stable, responding mainly to unemployment and then only slowly.
2. I think unemployment is the #1, #2, and #3 economic problem in the US today. I am certain that the equilibrium level is less than 7% and fairly sure that it is less than 6%.
Joe Gagnon
November 14, 2009 at 10:24 am
Unemployment is NOT the #1,#2 and #3 economic problem in the United States Gagnon.
DEBT and a de-valued dollar and a massive deficit are. Reality check: The US is insolvent.
DavosSherman
November 14, 2009 at 11:37 am
For about the millionth time, devaluation is how economies repair bad debt structures. It is the natural mechanism for restoring trade balance – advocating a strong dollar policy and debt reduction simultaneously is like economic psychosis.
It is unfortunate that the US is suffering from such deep structural problems that the dollar needs to decline in order to achieve equillibrium. But the answer is not to artificially prop up a weak dollar. The answer is to let the dollar devalue as needed, and fix the structural problems.
StatsGuy
November 14, 2009 at 11:57 am
I agree that the only way out is to devalue and then re-denominate the dollar.
Advocating a weaker dollar and saying all will be super is not the same as the solution.
DavosSherman
November 14, 2009 at 12:09 pm
It may or may not be morally right to encourage DEBT. It is more than likely that you believe the kind of debt you call DEBT is unconscionably WRONG. I may or may not agree with you (as it happens I disagree, but that is irrelevant). But one should not confuse a moral imperative with the way the world works. The fact that a solution is, by your values, immoral, does not mean that it won’t work.
I think liberals have an unfortunate tendency to assume that strident conservatives are knaves or fools. More than likely, most are neither: they are just incapable of perceiving something that ’shouldn’t be’. It’s a fundamental psychological process we all have, which is, in this case, running riot.
David
November 14, 2009 at 12:44 pm
“It may or may not be morally right to encourage DEBT. It is more than likely that you believe the kind of debt you call DEBT is unconscionably WRONG. I may or may not agree with you (as it happens I disagree, but that is irrelevant). But one should not confuse a moral imperative with the way the world works. The fact that a solution is, by your values, immoral, does not mean that it won't work.
I think liberals have an unfortunate tendency to assume that strident conservatives are knaves or fools.”
I am not a liberal.
Putting our children and our children’s children into the slavery of debt is, by any definition immoral.
Debt to make money or buy a home I do, for the record agree with. Debt for a bread and circus empire that calls itself a democracy I can’t agree with.
DavosSherman
November 14, 2009 at 6:37 pm
I don’t know if you saw Bob Herbert’s column today, but it seems we have two economies now: (1) the “elite” and (2) everyone else. The low unemployment rate in economy “1″ is pushing at least some prices higher (and it seems like we do have overall inflation of about 2%). Further, many firms that service economy “2″ are failing and causing production and supply to be impacted. I see a lot of empty stores fronts around.
In addition, as you mention, a much weaker dollar impacts domestic commodity prices because of foreign demand pushing prices higher, and imported commodities are re-prices. Similarly, goods used in manufacturing are likewise effected also causing upward price pressure. I guess my question is could these issues drive inflation independent of weak US demand and employment.
Clifford Nelson
November 14, 2009 at 9:38 pm
If the dollar continues to fall, is there a point where people who own our debt start to feel that their investment is declining and they will no longer invest and start redeaming their bonds.
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