How the Tea Party is brewing up trouble for the world's currencies
When, decades in the future, historians write the definitive account of the great economic crisis of the early 21st century, the chances are they won’t waste too much ink on the G20 summit that just concluded in Seoul. Or will they? For the past few months, leaders from the world’s major economies have been sleepwalking their way towards another crisis – one that may rival or even dwarf the financial mess of 2008. In the past few weeks that sleepwalk has become a waking stampede.
The Seoul summit, with its botched compromises and unresolved differences, has only underlined the problem. It acknowledged that there is a growing tension between nations over their currency policies, but revealed that no one can agree on what to do about it. It stopped short of banning competitive devaluation, or setting limits on current account deficits or surpluses, instead retrenching to tried-and-tested phrases from previous agreements.
It isn’t merely that the summit failed to come up with any decent solutions: it failed to diagnose the problem itself properly. The fact that countries are becoming aggressive about currencies is merely a symptom of a far deeper issue: that the international monetary system has failed, and there is no one willing or able to come up with a reconstruction job.
We are in the midst of a shift in international monetary structures, such as happened in Bretton Woods in the 1940s, or in the move to floating exchange rates in the 1970s. The probability is that at least some of the characteristics of globalisation we currently take for granted – free movement of capital, the push to cut trade barriers, independent central banks and free-floating currencies – will not survive many years longer.
Epochal shifts like this happen only once every half-century or so, and usually imply a period of economic volatility, international tension and a general sense of unease over the future. Moreover, there are no silver bullets and there is rarely a clear road-map. Bretton Woods was the exception rather than the rule.
That said, the dilemma is actually pretty simple. In an ideal world, one would like to have fixed exchange rates (so that companies can trade internationally without worrying about currency movements), free movement of capital (so investors can put money where it’s most needed) and independent domestic monetary policy (so you set interest rates dependent on how fast or slow your economy is growing).
Unfortunately, one can only have two of these three at any one time. Under the 19th century Gold Standard, policy makers gave up independent domestic monetary policy in favour of a system of fixed exchange rates (tied to gold) and free-moving capital. Then, from the 1940s to 1970s, the Bretton Woods system again retained fixed currencies but gave up free capital movement in favour of independent monetary policy. From the 1970s to today Western nations swung behind floating currencies and free capital movement, while retaining independent monetary policy.
Unfortunately, this latest iteration (Globalisation III, let’s call it) is beset by the fact that many developing nations (typified by China) have chosen instead to fix their currencies (in an effort to protect their exports), and one of the upshots has been the savings glut that has contributed to the crisis of the past few years. The G20’s problem is less over specific arguments about the level of currencies and more about the fact that the world’s monetary system is being run in two incompatible ways.
What makes it worse is that there is no longer a consensus view about who is right: before the crisis Western politicians could argue confidently that China’s mercantilist policies were simply wrong. But why shouldn’t emerging nations shield their industries from international competition to allow them to develop into full-grown businesses – just as Britain and the US did in a similar stage in their development?
So not only has the international monetary structure broken down; so has the intellectual grounding that might reveal a solution. This wasn’t such an issue in the 1940s, when John Maynard Keynes and US delegate Harry Dexter White could lock themselves away in a New England ski resort; it didn’t matter in the 1870s when central bankers could safely negotiate the terms of the Gold Standard away from the prying eyes of the populace. But this time around democracy is intruding.
In the US, the White House is still reeling after the mid-term elections, in which the Democrats suffered the biggest turnover of members since 1954. It wasn’t merely the scale of the defeat – which is even more stark when you look down to state and county level – or indeed the fact that the White House will no longer be able easily to pass its laws, but that the new intake of Republican politicians (the Tea Party wing in particular) is viscerally opposed to the country’s current economic policies.
The Republicans used to be the party of the Washington Consensus, of free trade and deregulation – in short, supporting Globalisation III. No longer: a recent Pew Research Center report found that the Republican party is now more anti-free trade than the Democrats. Many of the Tea Party’s leading voices want an abolition of the Federal Reserve. The message from the mid-terms was that these voices can no longer safely be ignored. And if the US itself can’t work out a plan to overhaul the international economy, what hope is there for the rest of us?
It is not that anyone is inherently right or wrong. But the worst outcome would be to lurch from one extreme to another without a coherent plan.
Take the idea of a Gold Standard, raised by World Bank president Robert Zoellick last week. There are some instant attractions to tying one’s currency to gold, chief among them that this curtails governments’ ability to inflate their way out of their significant debt problems. But there are also serious drawbacks: referencing your currency to a commodity still leaves you vulnerable to inflation or deflation, depending on how much of that commodity is mined from the earth in any given year.
It would also mean an end to banking as we know it – the 19th century showed us that the Gold Standard malfunctions with our system of fractional reserve banking. But most catastrophically, it would mean governments could no longer adjust interest rates depending on the health or otherwise of their economy. The original system proved incompatible with widespread democracy; given the volume behind the electorate in the US, why should that be any different this time around?
Moreover, why the arbitrary obsession with gold? The chief reason Britain instituted a Gold Standard (and others followed), rather than a silver standard, goes back to a mathematical mistake by Sir Isaac Newton in 1717, then master of the Royal Mint, in overvaluing the guinea in terms of silver.
The Gold Standard is merely another set of rules which determine how countries run their economies: these rules survive only as long as people believe the government, or central banks, will follow them.
In the wake of the G20 flop, it strikes me that there are two conceivable endgames to the current stalemate on international economic reform. Neither, I should warn you, is particularly attractive.
The first is that it will only be after another crisis (perhaps sovereign debt, perhaps a fullblown currency war) that world leaders will confront the issue and try to create a coherent international monetary system.
The second is the theory of hegemonic stability: periods of chaos such as this usually come when one economic superpower gives way to another.
No matter what rules or structures policy makers try to erect, the overriding instability caused by these shifts in global economic tectonics mean that we must wait until China fully surpasses the US before we can expect a return to stability.