Mr. Bernanke Goes to War

Mr. Bernanke Goes to War

Mini Teaser: Finance ministers around the world are up in arms over the Fed's latest efforts to jump-start the anemic U.S. economy. The future of globalization hangs in the balance.

by Author(s): Barry Eichengreen

By the end of the twentieth century the task had been mastered, and emerging markets settled into a position not unlike that of Europe and Japan in the 1950s and 1960s. They pegged their currencies to the dollar at low levels in order to enhance the competitiveness of their exports. They bought dollars as needed to prevent their currencies from rising. They limited domestic demand and ran external surpluses with the goal of fostering the growth of their manufacturing sectors. If this permitted the United States, the country on the other side of the transaction, to spend more than it could afford, well, then, this was just one of the costs of economic development. This system became known, for self-evident reasons, as Bretton Woods II.

By 2004, various Cassandras were warning that Bretton Woods II was riddled with inconsistencies not unlike those that brought down the original. Like its predecessor, Bretton Woods II provided the United States with cheap foreign finance. It thereby fed the inclination of American households to consume more than they produced and of the federal government to live beyond its means. Although the immediate consequences might be happy, over time financial imbalances would build up. As America became ever more indebted to the rest of the world, foreigners would grow increasingly reluctant to accumulate claims on the United States. At some point those foreign investors would pull the plug, and the dollar exchange rate would come crashing down.

These dire warnings were both right and wrong. They were right that the continued accumulation of U.S. debt obligations by foreign governments and central banks—the phenomenon known as “global imbalances”—created dangerous vulnerabilities. But they were wrong in that they foresaw those vulnerabilities as leading foreign investors to flee the United States, causing a Treasury-bond-market and dollar crash. Instead, cheap foreign finance continued to flow into the U.S. Treasury market, depressing yields there and diverting resources into U.S. securitization markets where they fueled the subprime-mortgage boom that set the stage for the subsequent bust.

Then when the financial crisis went global, international investors desperate for safety moved into the most liquid market, namely, that for U.S. Treasury bonds. It was the ultimate irony that the dollar actually strengthened as a result of the economic downturn.


WHAT WE are seeing now, under the moniker of “international currency wars,” is the last gasp of Bretton Woods II. The United States can no longer afford to be the world’s “consumer of last resort,” vacuuming up the exports of manufacturers in emerging markets.

Consumer confidence and household balance sheets in America having been damaged by the crisis, spending remains subdued and the U.S. economy’s recovery from the recession continues to disappoint. Households, having seen the value of their single most important asset, their homes, dissolve in a puff of smoke, are saving more in order to rebuild their retirement nest eggs. Firms conscious of the weakness of retail sales hesitate to invest in capacity expansion and equipment.

For the economy to start growing again and to begin bringing unemployment back down to tolerable levels, the United States will have to export more. This adjustment was postponed by the 2009 fiscal stimulus. The intention of this intervention was to prevent domestic demand from contracting too quickly while stretching out the change from a consumption-based economy back to an (at least partly) manufacturing-led system over a tolerable time period. But with the stimulus now having peaked and there being no room—or political appetite—for more, the inevitable adjustment is under way.

This means that the prices of U.S. goods will have to fall in order to encourage other countries to purchase more American products. The Fed, not without reason, has concluded that the worst way of lowering the relative price of U.S. exports is by allowing the domestic price level to fall. Deflation would further damage corporate and bank balance sheets. It would further demoralize American consumers, who would postpone spending in anticipation of ever-lower future prices. Once this process started, it would be very hard to stop. If there is one lesson of Japan’s recent history, it is: avoid this deflationary trap at all costs. With this in mind, in late 2010 Mr. Bernanke and Company opted to further ease domestic credit to prevent deflation from setting in.

And the lower the Fed pushed yields on U.S. Treasuries, the more it motivated investors to search for higher yields abroad. In practice, those investors didn’t have to look far. Stronger growth in emerging markets meant that interest rates there were higher. Investors therefore borrowed at rock-bottom rates in the United States in order to buy higher-yielding securities in emerging markets.

But here was where the strategy came into conflict with Bretton Woods II and raised the specter of a currency war. As international investors pulled their money out of dollars in order to invest in stocks and bonds denominated in Brazilian reals, Thai baht and Indonesian rupiah, there was a tendency for the dollar to fall and these other currencies to rise. Exporting is the bread and butter of manufacturing enterprises in developing countries—necessarily so, given the limited size of their domestic markets. Stronger currencies threatened the profitability and, indeed, the very survival of those export industries.

In China—and in emerging markets generally—export-oriented manufacturing is integral to the government’s development strategy. Labor productivity is higher in manufacturing than in agriculture. The most straightforward way of boosting incomes is therefore by shifting workers from the farm, where their productivity is low, to the factory, where it is higher. Learning by doing and productivity spillovers are also more prevalent in manufacturing than in agriculture and services. In developing countries, workers and managers in export-oriented industries acquire technological know-how and skills on the job that they are then able to apply elsewhere in the economy. Where assemblers rely initially on imported parts and components, for example, over time local suppliers, who learn how to produce parts and components to international standards, spring up to meet their needs.

This is the model of export-led, manufacturing-based economic growth that has served China and other East Asian countries well. And the operation of that model in turn requires keeping the local currency at competitive levels against the dollar, the currency of the main market in which their exports are sold.


AT THIS point the irresistible force meets the immovable object. Rock-bottom yields in the United States mean that emerging markets find themselves on the receiving end of a flood tide of capital flows. Their currencies strengthen against the dollar, which in turn threatens their manufacturing base and puts economic growth and development at risk.

Desperate measures are then deployed to repel the influx of capital, or at least to slow it down. China intervenes in the foreign-exchange market to mop up the additional dollars. It instructs its banks to limit their lending in order to prevent the influx of capital from fueling inflation and eroding export competitiveness. Brazil triples an existing 2 percent tax on money entering the country meant for investments in fixed-income instruments like bonds. Taiwan bars foreigners from investing in interest-bearing, set-term savings accounts. Indonesia imposes a one-month holding period for foreign investments in its debt market. Thailand introduces a 15 percent withholding tax on interest and capital gains on bonds held by foreign investors.

Those foreign investors, for their part, are more than a bit perturbed by these new financial measures. But receptive as ever to the siren song of high interest rates in emerging markets, they devise ways around the authorities’ locks and levies. The new measures therefore work imperfectly. While the flood of capital into bubbly emerging markets abates, it does not subside entirely.

U.S. policy makers, for their part, are equally displeased. Quantitative easing does less to boost U.S. economic growth insofar as it does not also produce a weaker dollar that encourages the demand overseas for U.S. exports. And this is how we come to find ourselves in the world of tariff threats. American politicians, fearing anti-incumbent sentiment as a result of continued high unemployment, look for someone to blame other than themselves. The obvious targets are China and other emerging markets that have shown themselves reluctant to let their currencies strengthen against the dollar. Congress therefore reacts by threatening to slap a punitive tariff on Chinese exports.

Whether this would do much to improve the U.S. employment situation is of course dubious. All that the imposition of such a tariff would mean is that what we now import from China we would just import from other East Asian countries. But whatever the argument for slapping a tariff on Chinese exports may lack in economic logic, its political rationale, in the eyes of your typical congressman, is impeccable.


SO THERE you have it: international disputes over exchange rates, the imposition of barriers to cross-border investment and serious disruptions to international trade, all putting globalization at risk. Leaving the question of what to do.

We can start with what not to do. From Brazil to China we hear officials arguing that the Fed’s lax credit policies are the source of the problem. The United States should raise interest rates, they contend, to avoid destabilizing the international system.

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