Open Thinking

source: Center for Responsive Politics

Senator Schumer is a longtime sponsor of legislation for sanctions against China, on the basis of “unfair” currency practice or “currency manipulation”. His latest is the Currency Exchange Rate Oversight Reform Act of 2010. According to Schumer, at least as of April, this had 16 bipartisan cosponsors “and combines several separate bills into a single, strong bill that can pass the Senate and the House.” This issue came off the boil at just about this time, as Beijing announced a currency regime reform — although June 2010 US and Chinese trade data are putting it back on the agenda.

I’m well aware of the political-economy factors impeding a re-ordering of the Chinese economy more quickly into a stance more favourable to growth of Chinese non-traded sectors. A stance which the USA, the world, and Beijing itself are keen to actualise. Pardon the jargon, but it is a victim of path-dependence. What that means is that the very sectors which have done well out of the export orientation of China’s economy are consequently those best placed to resist a re-orientation. They have the money and the guanxi (connections). That’s a very real-world problem and I think there is as much frustration in Chinese policy circles with this as there is at the US National Association of Manufacturers.

Should we not at least consider the counterpart political economy problem in the United States? Washington has its own path dependence. The sectors which have done well out of the US boom were in the non-traded parts of the economy. Which are these? Finance and real estate come to mind. Surely they support re-establishing the status quo ante. How odd, then, that these sectors are the biggest contributors to the man in Congress who carries the torch for a grand reversal in the Sino-US trade relationship. Think about it. These sectors do very well indeed from generous financing borne of Chinese (and others’) purchases of US securities. Success in Schumer’s efforts would wound the very goose whose golden eggs these USA non-traded sectors are still poaching. It doesn’t make sense.

Thoughts on what I could not say in today’s Oxford Analytica piece — this time down to lack of space and a desire to preserve a detached tone. The piece is “Euro-area report card”, on how the externally-weaker eurozone members are faring in alleviating their overvaluations. As in the blog posts of recent weeks, the overriding question is: Are these economies more like Argentina or Hong Kong?

• I just don’t see how Greece is going to make it under the status quo EMU configuration. Inflation is accelerating. The economy is just not a great candidate for deflation, at least insofar as the “Economic Freedom Index” rankings imply. Since these rankings seem a reasonable proxy for barriers to wage deflation, I think they’re useful. As I’ve said a million times, it is no accident that HK was ranked No 1 (most flexible, or most “free”) in the midst of its overvaluation episode (1998) while Argentina was ranked 32. Greece in 2010 is ranked 73.
• In light of which, we must consider the only other means of squaring the circle. This is to revisit the terms of Greece’s engagement globally and with EMU. It will need an import surchange and export bounty. I would not even be surprised to see an official seal of approval for such steps from Brussels, in the name of preserving the nominal integrity of EMU. Expect any such moves to be couched in all sorts of obfuscating language. 
• Is all this worth it? Of course not. Leaving EMU is not an existential threat to Europe. Those claiming otherwise are following the same dogged, dogmatic, line of reasoning preceding every other currency collapse ever witnessed.
• That leaves the IPSI’s. The overvaluations are not severe in Portugal and Italy; and inflation in both is very subdued; and the euro’s weakness is helpful. Spain is more overvalued; no longer deflating. Ireland though deflating smartly is still 20% overvalued. What is preventing me from declaring an “all clear” signal is the impact of Greece. When it devalues (nominally or administratively), its friends suffer another jolt of overvaluation. We’ve been here before.
• What I have in mind for Greece, normatively, is something more on the template of Brazil 1999. Man did they do a good job exiting the crawling peg! And credit where it’s due: The Fund was a key player in this episode. I mean, here is one case where the currency was eased out of a fixed arrangement with an entirely orderly devaluation. It can be done for Greece as well. We just need a pause in the dogma.

One way I introduce the topic of the eurozone troubles is to review crises of recent decades. As is usual with currency crises, they compel some pretty heated rhetoric. It’s not surprising. When the currency is mismanaged — badly mismanaged — society suffers. Weimar Germany and Mugabe Zimbabwe are examples. So should be post-WW1 Britain, in my view. True, it suffered no hyperinflation. But the fear of it drove central bankers to the opposite extreme. How can 20% unemployment in defense of currency “stability” be good management? But I digress. The most heated — and vacuous — rhetoric comes in defense of the monetary order. Again, this is usually inspired by genuine concern over what could go wrong, a-la Zimbabwe. So let’s look at some ghosts of crises past and pick out the rhetoric.

Consider John Major, Prime Minister at the time of Britain’s fall from eurodreams grace, otherwise known as Black Wednesday.  On September 16, 1992, Britain gave up the project of monetary unification in Europe, by leaving the DM peg known as the Exchange-rate Mechanism (ERM). The cost was too high. Fifteen percent central bank interest rates for what? Currency “stability”. Days before the devaluation, Major warned darkly that “it is a cold world outside the ERM.” Priceless.

(If you thought Anatole Kaletsky is a Johnny-come-lately, the following should set you straight.)

Too much ink has been spilt on the 1997-98 East Asia crisis to warrant further mention. Except to say that this was a defining event in my education. This crisis belonged to the new generation of crises, those catalysed or at least facilitated by convertibility on the capital account — in other words, by freely tradable currencies. The Tequila crisis of 1994 kicked it all off. The Asia crisis brought down even the keenest tiger: Korea.

For my money, nothing beats Argentina. As noted, it had much at stake in the currency arrangements known as the Convertibility Plan. Bouts of hyperinflation will do that. And the IMF had a big stake in this race. Argentina was its star reformer. Make no mistake, much good came from this. The country was the first, I believe, to adopt a fully-funded public pension system. And, of course, hyperinflation was vanquished. The only trouble was the near-inevitable incompatibility of fixed currencies with financial globalization. “Near inevitable” because the only way to marry these is to surrender monetary autonomy. And the only way to do that sustainably is to have near-perfect flexibility in domestic prices (mainly wages). And the only way to do that is to be Hong Kong. But that didn’t prevent seas of rhetorical and financial ink from being spilt in avoidance of the inevitable. (Argentina gave up the peg in January 2002.)

Anne Kruger, the Fund’s policy tsar, dispensed the usual requirements dictated in the death throes of an unsustainable (overvalued) currency regime. These remarks accompanied the press release above. See if any of this sounds familiar.

At least there was no talk of an end to civilization or any other “existential threat” to the nation. At least not from the Fund. Undoubtedly there was such rhetoric from people closer to the currency regime. In any case, the currency arrangements are hard to dispose. All manner of fudge is attempted before just accepting the inevitable. I think a sampling of headlines sums up the point.

Wow. Did you catch that last headline? That one really surprised me. If you have an FT or Factiva account, do try to read that article. Keep in mind the peso collapsed just after the euro got started.

Do remember that devaluation for Argentina was bullish. Unambiguously. For Spain and its other creditors, not so much….

Argentina in the New World Order was a darling of the Fund. You can browse its archives to sample the hagiography. IMF MD Michel Camdessus in 1996 could not be more glowing about this star pupil.

This is now my fourth trip to Argentina as Managing Director of the Fund, and each time I come here, I am amazed by how much things have changed since I first took office—now nearly ten years ago. I need hardly remind you that, back then, there were still important doctrinal differences between Argentina and the IMF—about the appropriate roles of the state and the private sector, the merits of economic liberalization, the need for fiscal equilibrium, and the virtues of deregulation. More than that, I recall that the term “Fund orthodoxy” had a negative connotation in Argentina in those days and that Fund missions provoked considerable public debate.

Today, there is no longer any doctrinal divide, and the arrival of IMF missions no longer causes a stir. Personally, I am delighted by this change of events. Why is the atmosphere so different today? Clearly, because of the fundamental changes that have taken place in recent years—in Argentina, Latin America, and the world. But it goes deeper than that. There is now considerable commonality of views throughout Latin America, and in much of the rest of the world, about what constitutes effective economic policy.

All of which is a typically long winded way of saying I get scared when I hear dogmatic talk about defense of the monetary order. Here’s German Chancellor Angela Merkel, on May 16, 2010:

“If the euro fails, not only the currency fails. Europe fails too, and the idea of European unification.”

In a speech broadcast live on WDR television, Merkel said the crisis over the euro’s future was “not just any crisis, it is the strongest test Europe has faced since 1990, if not in the 53 years since the treaties of Rome.”

“This test is existential — it must be passed. If it does not manage to (do that), the consequences for Europe and beyond are unforeseeable,” the conservative Christian Democrat said.

Italy source: open-thinking.com

Portugal source: open-thinking.com

Spain source: open-thinking.com

Italy and Portugal do not appear massively overvalued on these measures, about eight percent above where they started in 2000. This should not be hard to remedy. Spain has a further road to travel, about 16% overvalued on the BIS measure of real-effective exchange rates.

Ireland source: open-thinking.com

Ireland is worse off. Notwithstanding some robust deflation, the real exchange rate was still 21% over-valued as of June 2010.

Greece source: open-thinking.com

Greece is like Ireland — about 20% overvalued. The difference: Ireland is able to deflate. By contrast, Greece exhibits the opposite. Consumer price growth has accelerated in Greece. This is no salve for the real exchange rate. What’s going on? For one thing, taxes. In order to close the fiscal deficit, the authorities have slapped on large valued-added taxes. Is Greece more Argentina or more Hong Kong? You be the judge.

Fragrant Harbor

I gave a lecture to Georgetown MBA and public policy students here this morning, on the travails of the eurozone. Preparing this presentation forced me to collect the data and assess how “adjustment” is going so far in the Club Med economies. When I say adjustment, I mean getting prices in line with some notion of a fundamental equilibrium with the rest of the world. If prices are too high, the economy is uncompetitive. (If prices are too low … that’s another story, which belongs to East Asia. For better or worse, the strains from being too expensive are not symmetric with the strains of being too cheap, and this has been a source of difficulty for the international monetary system throughout history.)

Obviously in the case of Club Med, prices are too high. How’d they get there? Well, these economies grew on the basis of non-traded sectors, so being competitive didn’t matter. What did matter was steady inflows of credit, and of course this was plentiful because these economies for the first time enjoyed the same interest rates as does Germany, thanks to the common euro currency. As I’ve explained before on this site, the seeming absence of exchange-rate risk misled market participants into under-pricing credit. Where’s the exchange-rate risk if there’s no country-specific (nominal) exchange rate? Well, it’s there. You just have to recognise a shadow exchange rate. Also missing was one of the key measures markets use to sniff trouble in the currency: foreign reserves. With no visibly shrinking stockpile of foreign reserves to focus on, markets lost sight of the shadow exchange rate. Sheer unfamiliarity with currency unions explains a large part of this. (1/)

The measure of an economy’s price position internationally, and thus its need or otherwise for adjustment, is the real-effective exchange rate, or reer. “Effective” and trade-weighted are synonyms. The reer is simply a composite index of the exchange rates between the local economy and all of its key trade partners, weighted by trade share and adjusted for differentials in inflation between the home economy and that of the trade partner. If you didn’t look at the effective index, you’d be misled by a currency peg into thinking nothing was happening to the currency. If you didn’t adjust for inflation differentials, you’d miss the price divergence between the home and abroad countries, and thus their relative divergence in competitiveness. 

Before jumping straight to the reer indices for the Club Med, it’s worth considering how these dynamics played out in previous strains of fixed-currency systems, in crises as well as non-crises. A key non-crisis was Hong Kong. Although this economy was surrounded by devaluations in the midst of the 1997-98 East Asia financial crisis, it did not break the US dollar peg. In fact, it was almost totally unique in hanging on. You should already know that by definition it must have accomplished this through “internal devaluation”, otherwise known as deflation. (If you can’t devalue, and everyone else around you devalues, then the only way to get the reer back into alignment is to deflate.) And indeed that’s what it did. Hong Kong experienced a prolonged and deep episode of deflation, which suceeded in eliminating the local currency’s overvaluation, at least as measured here by the reer index (souce: BIS). The vertical line is June 1997, the month in which the Thai baht fell, which was the proximate start of the crisis.

Hong Kong.   source: Open-thinking.com

If Hong Kong was the most noteworthy success, then Argentina was the the most noteworthy failure. Argentina had a lot at stake in this struggle. For whatever reason, monetary management has never been a strong suit in Argentina. After many failed currencies (failed in the sense of hyperinflationary), the central bank by the early 1990s had seemingly exhausted its credibility. And yet the new age of financial globalization, in the wake of the collapse of the Soviet Union and the triumph of the Washington Consensus, demanded a wholehearted international engagement, meaning open trade and financial accounts. Yet a fixed currency was also desirable, lest a floating one become a source of continuing depreciation-induced inflationary pressure. The only way to ‘square’ this circle, seemingly, was to adopt a particularly rigorous form of currency arrangement, known as a ‘currency board’. The point of the currency board is to eliminate the central bank: control of the domestic money supply is not possible under a currency board (it becomes ‘endogenous’). The currency board’s defining feature is a legally mandated fixed relationship between domestic money and foreign money. In other words, the currency board must allow outflows of capital to shrink the money supply (whereas normally a central bank is free to replace these outflows with new money, thereby preventing the monetary contraction — a technique known as ‘sterilization’). It must not emit new money except in proportion to new money entering via the foreign-exchange market. And the fact that it holds these monies in fixed relationship means that there should never be a panicked flight from the currency: there’s always enough reserves to cover capital flight because the quantities are mandated by law.

Argentina source: Open-thinking.com

No doubt the sucess of Hong Kong’s currency board, even before the 1997-98 crisis, was an inspiration for Argentina. We can learn a lot from the failure in the one and success in the other. Foremost, it is not the trappings of monetary arrangement but the idiosyncracies of the economy and political-economy that sustain it. This is crucial. It is not merely because it had a currency board that Hong Kong sustained a fixed exchange rate through periodic crises. It has sustained the fixed exchange rate because it is Hong Kong. What do I mean by that? Probably there’s no better summary than the consistent declaration by the Heritage Foundation that Hong Kong’s economy is the “most free”. This economy is uniquely able to absorb international pressures on the back of domestic prices — for goods, wages, capital and land. Crucially, that means the ability for these to deflate in instances of severe and chronic over-valuation, such as befell the currency in 1997. (Deft monetary management and, yes, the currency board were certainly helpful. The monetary authority, for example, jettisoned the laissez-faire playbook at the height of the crisis to commit public money to the stock market, thereby severely burning speculators and chastening them.)

Put briefly: Argentina ain’t Hong Kong. Currency board notwithstanding.

So how are our Club Med countries faring? I’ve got the analogous charts for them and will put them up soon. There are some surprises — good and bad. The main thing I wanted to impart in this post is to understand their burden(s) of adjustment in light of the successes and failures of recent memory. Remember, to succeed in this mission, Greece et al need to be more Hong Kong, less Argentina.

notes

1/ Which is one reason why the gold-standard incarnations of international monetary system (or regional) are useful templates for analysing what’s happening in the eurozone. As in the eurozone, countries’ entry into the international gold standard implied an “irrevocable” system of fixed exchange rates. Until they weren’t. Also like the eurozone, the dogmatic defence of the monetary order under a gold standard was breathtaking. The first few posts in this blog (from 2010) go into this a bit. I’ll re-post on this as well.

The conclusion to Alarming errors in “Lessons” from the 1930s had a glaring error — now fixed! Perhaps it’s Freudian. It should read:

More broadly, the threat to global prosperity is not the use of too much stimulus but too little. If we one day find ourselves in a more protectionist world, it won’t be a result of ignoring Gurría’s warning. It will be because we forgot our own history.

Partly for reasons of space, but more because I am cautions of repetition. My sense is the consumers of these analytical papers remain to be convinced how much relevance prior downturns, the Great Depression, and history in general have for today. That’s OK with me; I used to be of a similar view.

Today’s brief is an “In-Depth Analysis”, which is Oxford Analytica’s term for a survey-style piece. It is double the length of a normal article (2400 words instead of 1200). The title is G7 forced to confront the reality of a rising ‘periphery’  and the remit was to look ahead to the response of the developed world to unprecedented growth in the developing. In short, this is a bullish story. It is no less than the redress of centuries of divergence in development between the global core and ‘periphery’, what used to be called the “third world”. What’s not to celebrate?

What I left out today is the parallel between China’s global role today and that of the USA between the wars. It’s something I raised in a footnote to this post, which footnote I’ve copied below:

1/ There is no solace in examining the outcome when the US was the premier global exporter, akin to China today. This was the interwar period. What the world needed desperately was a US economy as capable and willing to run an occasional trade deficit as it was a surplus. But the US economy wasn’t that way inclined and neither were its managers. A trade-surplus mindset was firmly implanted and nothing shifted it. Nothing, that is, except world war. It was only amidst that conflagration that the US policy establishment took a hard look in the mirror and asked, What happened? The answer is a 1943 publication commissioned and published by the US Department of Commerce, written by a private economics consulting firm called Hal B. Lary and Associates. (The citation is Lary, H.B., The United States in the World Economy: The International Transactions of the United States in the Interwar Period.)  You won’t find a drier piece of reading nor one as illuminating in this respect. It is one giant mea culpa for the US role in the interwar depression. I gave a talk here recently to a delegation of banking executives from Shanghai, on the prospects and requirements of a ‘global currency’, which the renminbi is certainly destined to become (look out for the blog posting). I mentioned the Lary publication and urged them to consider their own views about China’s role today and whether it might be repeating the US’ own policy experience. Which of course is its right. The US currency was no less pegged between the wars as China’s is today, and that was seen very much as the sovereign’s prerogative. Which it was and is.

Whether you’re from a left or right perspective, you can probably agree that policymaking played some role in the Great Depression. If you’re of a right/libertarian view you might see policymakers as having lacked the mettle to force the economy into a deflated-price equilibrium (or, more accurately, to force the factors of production (pdf) to accept new equilibria) or simply to adhere to the agreed-upon principles of global economy (free markets, fixed exchange rates, a currency basis in gold, independent central banking …). And in fact this view was predominant in the post-war academic treatment of the Depression.

Then came the 1980s literature linking recovery to currency devaluation (pdf) (i.e. leaving the gold standard). This is the currently predominate view. The cornerstones are Lessons from the Great Depression (Temin 1989) and Golden Fetters (Eichengreen 1992). The latter in particular is an exhaustive treatment of the dynamics leading up to, and then transmitting globally, the 1929-33 depression. Temin and Eichengreen co-wrote a 2000 paper on the policymaking mentality sustaining poor choices (pdf). That article came to mind as I read Paul Krugman’s recent post about the Fed not doing enough to sustain the recovery. He used the frog-in-boiling-water analogy: if policymakers aren’t careful, they will wind up inadvertently presiding over a decade of stagnation. Temin and Eichengreen write that

The world economy did not begin to recover when [governing elites] changed their minds; rather, recovery began when mass politics in its various guises removed them from office.

How should we read that in today’s environment? The party in the White House is the party of the left. Will “mass politics” replace it with something further left? Unlikely (for now). What kind of policy “ethos” would mass politics produce from the party of the right? I think that’s a fascinating question. One way I like to frame policy choices is in the lens of the macroeconomic “trilemma”. This is the name for the inability simultaneously to choose your exchange rate and your monetary (and fiscal) policy amid free cross-border financial flows. Think of a few examples and you’ll quickly grasp it. If a country fixes the exchange rate but tolerates a little bit too much inflation (perhaps unemployment is high, so the central bank doesn’t want to raise interest rates, which it would otherwise need to do in order to kill off that inflation), then pressure will build on the currency peg: the rise in prices makes domestic output less competitive, so the trade balance starts to slip, which one day will break the peg, since you have to finance that trade deficit out of reserves. (I’m abstracting a lot here.) With free flows of capital, “one day” happens well in advance of the natural rate of attrition of central bank reserves. People see the writing on the wall and anticipate the collapse, thereby bringing it forward. (It was Krugman who formalised this.)

The Great Depression was an incredible laboratory of policy choices from among the trilemma. Policymakers had to run every which way to escape the vortex. So you had Germany and some of central-east Europe adopting stringent capital controls to keep up the façade of a pegged currency whilst pursuing strongly expansionary macro policy. You had another group of countries which stayed with the old-time religion of (mostly) open markets and fixed exchange rates. They didn’t need an independent macro policy because their one-off devaluation whilst crashing out of the gold standard left their economies quite competitive, meaning they spent the 1930s accumulating rather than spending reserves, which accumulations they could use to inflate the domestic money supply and therefore support recovery. (Global liquidity was boosted too by the USA revaluation of the gold stock in 1934.) Much less chosen were open capital flows, independent policy, and floating exchange rates — what we see among the rich countries today, mostly.

The United States issues the world’s numeraire currency. To an extent, that gives it a ‘free pass’ from the trilemma.The US can expand (or not) as much as it wants, while also having free capital flows and a fixed currency. “Hold it right there“, you say. “The US has a floating currency.” That’s actually not correct. The US may have a floating exchange-rate regime (i.e. the manner in which it manages the exchange market), but it does not have a floating exchange rate. A floating currency adjusts to the conditions prevailing in the economy, mostly. It’s a shock-absorber but also an enforcer. For example, if there’s a recession and growth is miserable, capital flows out to seek better returns elsewhere, and the currency slumps (and this slump makes the economy more competitive and possibly triggers recovery). By the same token, if you pursue reckless policy, the currency sells off and you pay the price in higher inflation.

Because the dollar is the global numeraire, a whole lot of people around the world buy and sell it for reasons that have nothing to do with USA domestic economic conditions. In addition to the mundane factors contributing to overall demand for the dollar in the global foreign-exchange market is one particularly pernicious if not outright capricious factor: liquidity flight. A.k.a. flight to safety or “running toward the fire when the alarm goes off” if you are looking at it from Peter Schiff’s viewpoint. Whatever you want to call it, the dollar surges when panic strikes.

One can appeal to more direct grounds when claiming that the US dollar ain’t “floating”. Some of the US’s largest trade partners peg to it. Does anyone consider the USD/RMB exchange rate “floating”? No. Ditto the USD/riyal, the USD/TWD, the USD/KRW and so on. According to the Federal Reserve’s compilation of trade weights, these partners alone make up 30% of US trade. Bear in mind that trade weights, like much else in the world of economic analysis, are an artefact of a time when trade made up the majority of demand for the currency. We don’t live in that world. In our world, the foreign exchange market turns over a multiple of annual trade every few days. (Hence the influence of flight-to-liquidity when you’re the numeraire.) Bear in mind too that the current developing-world policy convention (the ‘Beijing consensus’) prescribes intervention in the fx market. When you read about accumulations of official reserves in Argentina, Brazil, Russia etc, keep in mind those reserves are predominately denominated in dollars. That’s not “floating”.

If you’ve any doubt that this is the inevitable price of being the numeraire, consider that this path has been trod before. The British pound sterling held that mantle in the 1930s. The parallel with today is striking. If you can get your hands on International Currency Experience (1944), the League of Nations’ autopsy of the global economy between the wars, have a look at Chapter 3, Section 4, “The Position of the Centre.”

When a great proportion of the available supply of Treasury bills in London was taken up by sterling-area central banks, less was left over for the clearing banks. The shortage of bills, if not actually deflationary, acted at any rate as a check on the expansion of credit. The effect was somewhat analogous to what would have happened under the orthodox gold standard, though obviously much weaker. 

The operation of an exchange-reserve system such as the sterling area involves no doubt certain inconveniences to the reserve centre [the numeraire]. It has often been argued that, while the United Kingdom could not “go off sterling”, the member countries could obtain competitive advantages at the expense of the United Kingdom by pegging their currencies to the pound at an unduly low level. 

What Giscard d’Estaing described as America’s “exorbitant privilege” in the 1960s was Britain’s too, before the war:

The other distinctive element in such a system … has this consequence that any deficit in the centre country’s balance of payments with the member countries, reflecting an overvaluation of the centre currency in relation to the members, tends to be covered by an “equilibrating” inflow of funds into the centre in the form of an increase in the member countries’ exchange reserves. … It is clear, however, that a persistent and excessive undervaluation of member currencies must after a point become objectionable to the centre country. 

Moreover,

… the fluctuating balance of payments of the member countries (was) capable of rendering the centre vulnerable to international disequilibria in which it was not otherwise concerned. 

The USA doesn’t have a currency policy because it can’t have a currency policy. This tedious exposition may in fact reveal something about the policy options for the next occupant of the White House, or of the party next to control the House of Representatives. Perhaps he/she/they will consider changing the rules. It’s akin to the Temin/Eichengreen quote: if the incumbents are passive, the insurgents get a look-in. Passivity in the US economy’s relations with the global economy might not be tolerable much longer. What does that mean? Probably the ‘un-thinkable’: a US tariff. It’s no novelty. It’s as American as apple pie. It was used to great effect the last time the US decided forcibly to wean the overdependent suckling economies off of its economic tit. Nixon in 1971 imposed a unilateral 10% import surcharge in tandem with taking the US dollar off gold, to shake off the stubborn pegs of countries which by all rights had otherwise outgrown such a developmental stage of policy. (Think of it as a political-economy problem. Particular domestic constituencies in the pegging country benefit from the peg. By definition, they are prevailing. Changing that political/policy equilibrium is very difficult from within (1/). The US tariff in 1971 was a nudge, a shove.) Nixon was following a distinguished tradition. FDR’s dollar shock in 1933/34 had a similarly rejuvenating influence on the populace and the economy, albeit for differing reasons.

The trilemma gets interesting when the US economy loses numeraire-currency status. For one thing, domestic US politics has never had to deal with this. The trade-offs imposed by the trilemma are real and, by definition, some constituencies and ideologies will be aggrieved. I am not a zero-sum thinker but the trilemma is something you cannot escape (unless you’re the numeraire).

Notes

1/ There is no solace in examining the outcome when the US was the premier global exporter, akin to China today. This was the interwar period. What the world needed desperately was a US economy as capable and willing to run an occasional trade deficit as it was a surplus. But the US economy wasn’t that way inclined and neither were its managers. A trade-surplus mindset was firmly implanted and nothing shifted it. Nothing, that is, except world war. It was only amidst that conflagration that the US policy establishment took a hard look in the mirror and asked, What happened? The answer is a 1943 publication commissioned and published by the US Department of Commerce, written by a private economics consulting firm called Hal B. Lary and Associates. (The citation is Lary, H.B., The United States in the World Economy: The International Transactions of the United States in the Interwar Period.)  You won’t find a drier piece of reading nor one as illuminating in this respect. It is a mea culpa for the US role in the interwar depression. I gave a talk here recently to a delegation of banking executives from Shanghai, on the prospects and requirements of a ‘global currency’, which the renminbi will become. I mentioned the Lary publication and urged them to consider their own views about China’s role today and whether it might be repeating the US’ own policy experience. Which of course is its right. The US currency was no less pegged between the wars as China’s is today, and that was seen very much as the sovereign’s prerogative. Which it was and is.

Angel Gurría explained this morning that protectionism is the real and present danger facing the world economy, citing the 1930s as an object lesson. This view no doubt enjoys considerable support. It is practically a ‘stylised fact’ in our historiography of the Great Depression (was the Smoot-Hawley tariff not in your high school textbook?). It is presumably uncontroversial among policymakers, since Gurría heads the official talking-shop of the world’s advanced economies. That makes it all the more alarming, because it profoundly misunderstands the dynamics of global depression.

Here is an authoritative contemporary review of the interwar problem (Lary 1943). On page 182 begins the subsection, “Summary of Experience, 1930-33”:

The principal conclusion that may be drawn from the foregoing survey of the international transactions of the United States during the great depression is simple and obvious: Whatever may have been the other factors contributing to the breakdown of the world economy, an orderly and integrated international society could not be expected to survive a contraction [in US GDP] on the scale that occurred after 1929.

… It was inevitable that many foreign countries should have ceased to depend on internal contraction as a means of adjustment to external pressure … and embarked on programs of domestic expansion.  And it was also inevitable that most of them should have resorted to additional and more direct measures of curtailing imports and that these measures should have fallen with particular severity on imports from the United States in order to redress the balance. Under these conditions many approaches to the problem aimed at immediate restoration of the international gold standard and removal of trade restrictions and discrimination were more concerned with the outward manifestations than with the basic causes of disorder. (emphasis added)

For “international gold standard” substitute “Economic and Monetary Union” i.e. the euro-area. For “trade restrictions” substitute “the danger of trade restrictions” — viz the Gurría warning.

Were France and Germany’s illiberal trade policies a cause of the Great Depression or a consequence? Nurkse (1944), writing the League of Nations’ post-mortem on the interwar economy, is unequivocal:

In practice, apart from its inherent disadvantages, income deflation and unemployment as a means of adjusting the balances of payments is liable to encounter insuperable social resistances. in these circumstances the only remaining alternative to exchange adjustment in cases of chronic overvaluation is a policy of import restrictions. Here the interest of outside countries in a revision of exchange rates is equally plain; thus in 1935, for example, the outside world would have generally welcomed a certain measure of devaluation in France and Germany in preference to the alternative policies of deflation and import quotas in France and drastic exchange controls in Germany.

We actually don’t need to cite contemporary sources. The modern literature is equally clear on the underlying dynamics of the Great Depression. Illiberal trade policies were a refuge from the Depression, not a cause. It was the dogged pursuit of fundamentally flawed policy which fomented and transmitted that depression. Here’s Eichengreen (1992, 290):

The failure of economic activity to stabilize reflected not the rise of trade barriers but the tendency of supplies of money and credit to fall more rapidly in gold standard countries than they rose in countries with depreciated currencies.

The proximate cause of the Great Depression’s policy flaw is so unfamiliar today that its relationship with current events is veiled to too many, not least to some of the principal authors of the modern literature. The ‘proximate cause’ was the gold standard. The fundamental cause can be seen on at least two levels, both with parallels today. To do so, one needs to appreciate that the “gold standard” was both a national currency regime and, when practiced widely, an international monetary system. The significance will become clearer as we go along.

As a national currency regime the gold standard necessitated fidelity to monetary and fiscal austerity. These were necessary to keep the currency’s link to gold and this link was seen as the only defence against an inevitable outbreak of inflation. The widespread fear of inflation in the depth of the Great Depression occurred even as deflation was both a reality and a threat to these economies. There is no gold linkage to defend today, but the champions of austerity point to this same inevitability of inflation as a consequence of fiscal and monetary stimuli. As then, the reality is quite different.

As an international monetary system, the gold standard dictated the exchange-rate relationships between countries. Whatever else its importance, a country’s exchange rate determines how its economy will adjust to crises, whether of foreign or domestic origin. The EU’s decision to view euro-area integrity as a Maginot Line dictates that Greece’s exchange rate will play no role in its adjustment to the present crisis. (“But Greece has no exchange rate”, you reply. Well, yes it does. It’s just harder to recognise because it shares a common currency with a group of otherwise heterogeneous and equally sovereign neighbours. That exchange rate is classified by the International Monetary Fund as “no separate legal tender”.)  As in the Great Depression, this means that the burden of adjustment for Greece falls on domestic prices and incomes, meaning both deflation and unemployment.

The alarming thing about Gurría’s comment is that by fighting the wrong wars we are making refuge in illiberal policy all the more likely. The true “existential threat” to Europe is not disintegration of the euro-area; it is the advocacy of policies which not only can’t succeed but will push domestic political strains to breaking point. More broadly, the threat to global prosperity is not the use of too much stimulus but too little. If we one day find ourselves in a more protectionist world, it won’t be a result of ignoring Gurría’s warning. It will be because we forgot our own history.