The Federal Reserve’s recent announcement that it would purchase up to $600 billion in US debt in order to unfreeze credit markets has raised the hackles of most of the industrialized world. The complaints from Germany, Japan, and especially China regarding the Fed’s second go-around of “quantitative easing” (aka “QE2”) threaten the greenback’s position as the number one reserve currency for the world, and raise the possibility of counter moves from other nations’ central banks to guard against inflation and asset bubbles.
The controversy threatens to make the G-20 conference in Seoul that began Wednesday an exercise in damage control, as most of the industrialized world is nervous about the US recovery and how the devalued dollar might affect its own balance of payments with the US.
If you’re like most of us and found Econ 101 a crashing bore, you can be forgiven for being unfamiliar with quantitative easing and what it’s supposed to do. A nice, simple explanation can be found here. Basically, by way of prestidigitation, the Federal Reserve conjures up a specific amount of money out of thin air – $600 million in this case – and then purchases government and corporate bonds, thus giving banks a boost to their own reserves and, theoretically, making it easier for them to make loans and generate economic activity. Sometimes it doesn’t work at all – especially in uncertain times. Banks are perfectly free to pocket the extra cash and apply it to their reserves, hedging against another downturn. Good for the banks, bad news for the economy.
Quantitative easing is a measure of last resort because the risks of spurring inflation and creating imbalances in some assets are elevated. Other nations with strong export economies like Germany, Japan, and especially China, are worried that the addition to the money supply in the US will further erode the value of the dollar, making US exports more attractive while increasing the price of their own products. This could lead to a trade war – something that will have to be addressed in Seoul. In short, the cure may end up being worse than the disease.
As other nations see it, the dollar is more than just the US’s currency, it is also the world’s reserve currency. This benefits the US economy because the greenback is constantly being propped up by the rest of the world, which doesn’t want to see the value of other currencies plummet. When the Fed takes drastic action, like creating money and pouring it into the financial system of the US, the resulting flood of cash makes central bankers nervous about inflation and governments worried about the export sectors of their own economies.
How long will the dollar be used as the world’s backstop currency? Not very long if China has anything to say about it. Zhou Xiaochuan, head of the People’s Bank of China, set off a wave of unease last year when he almost casually suggested that the world’s financial system could do better if it wasn’t using the dollar as a reserve currency. In a speech last Friday, Zhou revisited that theme:
We can understand the Fed’s QE2 policy, from the angle that it wants to revive the U.S. economy and increase employment. But the problem is the dollar is the global reserve currency…It may not be the right choice for the global economy, though it is a good option for the U.S. economy.
China is, itself, under the gun for its own currency manipulation, but this kind of challenge coming from a nation with an economy the size of China’s will bear watching in Seoul and the months ahead.
China’s jawboning is only the tip of the iceberg. Chancellor Angela Merkel’s Germany has been even more vociferous in opposition to Fed Chairman Ben Bernanke’s QE schemes.
Merkel is worried that QE2 will negatively impact emerging economies in Asia and Latin America. “Nobody has an interest in creating new bubbles. Instead, we must see to it that growth in the global economy this year is more sustainable and enduring that we had a few years ago,” she said.
Economy Minister Rainer Brüderle was even more blunt. The Local reported:
“It would be absurd to punish those countries that are internationally competitive and are contributing to the global economy’s recovery from the crisis,” he said, adding he was “confident” Germany could fend off unreasonable US demands at the G20.
Brüderle also slammed the growing tendency for nations to keep their currencies artificially low to boost their exports. He accused China, Japan, Brazil and the United States of “indirectly manipulating” foreign exchange markets to their economic advantage.
Meanwhile, the Russians are demanding “consultations” between the Fed and other central banks before making such drastic moves, and the European Union, in the person of Luxembourg Prime Minister Jean-Claude Juncker, who is chairman of the euro-zone finance ministers, said: “I don’t think it’s a good decision. You’re fighting debt with more debt.”
While in India earlier this week, President Obama received a boost from Indian Prime Minister Manmohan Singh, who took the unusual step of publicly supporting the easing. Of course, that support came at a rather steep price, as Obama promised to work to give India a permanent seat on the UN Security Council among other goodies – including $10 billion in US contracts. But Singh was the exception to the rule.
Almost as soon as Air Force One hit the tarmac in Seoul on Wednesday, President Obama was firing back at the criticism, saying that the dollar’s strength rests on a strong economy.
The number one job for leaders at the summit will be to address the problem of trade imbalances and competitive currency devaluations. The US is pushing for a limit on trade imbalances, but that does not seem a likely outcome to the summit. The prospect of a trade war is becoming more realistic as exporting countries build up huge trade surpluses, and importing countries scramble to make their own exports more competitive. The easy way to do this is by devaluing currency – a step the US has taken, although claiming that the dollar’s fall is a consequence of QE, not an objective.
That may be true. But it doesn’t alleviate the near chaos that has roiled the international finance community as a result of the Fed’s easing policies. If anything, the controversy reveals the shocking truth that the economies of the industrialized nations are emerging from the 2008-09 crisis and have begun to grow at a healthy rate again, while the US economy is hopelessly stuck in Barack Obama’s mud.
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