The US inflates the money supply leading to a trade deficit. This alone should cause the value of the dollar to depreciate relative to the currency values of its trading partners. Because the dollar flows abroad and because the dollar is the world’s reserve currency, other countries hold these extra dollars – doing so by buying dollar assets. This pressure keeps the value of the dollar stronger than it ought to be and raises the value of US bonds, stocks, and other assets. It also puts downward pressure on the currencies of US trading partners and leads to inflation in those countries. When we import goods from those countries, we also import inflation. It is a long and treacherous global circuit but it shows that what goes around comes around – that is, inflation of US money causes inflation of prices in the USA.
The above scenario was borrowed (I hope correctly) from an article in the Wall Street Journal on May 24, 2011 by Ronald McKinnon called “Return of Stagflation.” http://online.wsj.com/article/SB10001424052702304066504576341211971664684.html
I fully concur with Professor McKinnon’s assessment that inflation is around the corner if not already on our door steps. But I think that not enough responsibility or blame is assigned to US trading partners for the transmission of inflation and the occurrence of stagflation. Yes, the US is culpable but his analysis and policy advice is incomplete because it minimizes the roles played by our trading partners and especially the so-called transforming nations.
It is true that too much money creation in the US causes inflation in the US and the solution involves a reversal of US monetary policy. But while US monetary policy is not helping to control world inflation it is also true that the policies of other countries do little to deal with world inflation either. Let’s call these other countries co-conspirators or at least enablers.
What is wrong with the discussion of the first paragraph is that it treats foreign countries like robots – or like Pavlov’s famous dog that predictably salivated when a bell was rung. In fact many of the trading partners of the US are more like mean dogs that bite when the bell rings (and when it doesn’t)! A distinctive common goal among many developing countries is that they pursue economic growth through exports. Anything that might cause their currency values to appreciate could do harm to this goal and they react with policies that offset the appreciations. That means increasing their money supply – either domestically by buying domestic bonds or internationally by buying foreign currencies. If it is the US that is causing their currencies to appreciate they would buy dollars. If it was Europe causing them headaches they would buy euros. If it was Brazil leading to currency appreciation, the offended countries would buy reals.
Let’s suppose a country – let’s call it Kirstia-Allia – found its currency (ThePretty) rising and thereby threatening its exports of dancing shoes and tutus – reacted to this attack by buying euros. This market action would normally push the value of ThePretty downward and viola save the day. This action also increases the supply of The Pretty. Of course, Kirstia Allia, has other options. Each option below has its own impacts on Kirstia-Allia and the world. Which one is most desirable to a transforming nation depends on its own economic situation and goals. But clearly this list shows that Kirstia-Allia does have control over its money supply and does NOT have to transmit inflation generated by any another country:
· Recognize that exchange rates are not the only factor affecting their exports and not worry about the currency appreciation. Sales might remain strong despite the appreciating currency
· Recognize that it might be more effective to sustain exports through policies that made their products more competitive – through lower national inflation or subsidies/tax schemes designed to enhance global competitiveness
· Recognize that rising exchange rates may be beneficial in ways that might be more important than exports – making imports cheaper and inducing increased inbound foreign investment.
· Recognize that a policy to beggar-thy-neighbor through export management isn’t viable for the long-run and that it is beneficial to move towards an economy where domestic consumption and investment become more important relative to exports.
· Recognize that inflation is important and implement a two part monetary action that keeps the money supply from growing: (1) selling ThePretty for euros and (2) selling domestic bonds for ThePretty. By doing these two actions they increase and then decrease the domestic money supply. That is, they insulate or neutralize the international operation with a domestic one. In doing so, they assert control over their own money supply and price level.
Trading partners are not dogs that always react to bells with spit – they are entities with numerous goals both in the long-term and short-term. They DO NOT HAVE TO hold on to dollars and they do not have to allow an influx of dollars to cause inflation. When dollars flow in that are NOT needed to buy US goods, services, or assets – they can simply sell them – putting even more pressure on currencies. Depending on the country’s goals, this more extreme currency experience may or may not be debilitating but is the right thing to do. This is especially true with respect to the US – the reserve currency country – who is causing havoc through its own selfish and misguided monetary policies. If the US supplies too many dollars for the world to digest and countries choose to hold their reserves in non-dollar currencies, then the source of the global inflation problem will be more apparent and there will be:
· More global attention to the misguided US policy
· More US attention to the misguided US policy
· A move away from the dollar as a reserve currency
The conclusion is that while the US is now the guilty vortex, it is also true that many other countries are not innocents in the process of global inflation. These countries, through their own selfish and misguided policies abet and unwittingly support the US. The world is not automatically sentenced to global inflation because of US monetary policy – it very much depends on the goals and policies of our trading parties.
You might retort that if countries don’t use the extra dollars to buy US assets then they will have to buy assets of other countries. And this is true. So why aren’t they more willing to buy the currencies and assets of say China, Brazil, Canada, and many others? The answers are numerous and depend on the specific circumstances of each country. China’s currency is not fully convertible. Other countries may be growing rapidly but a more thorough look at these countries might uncover risk flags. Despite all the failures of US policy the big picture suggests that to date US assets offer some stability and insulation from extreme financial risk. So many countries continue to hold or buy dollars and dollar assets because they offer attractive risk adjusted real returns. This is not so much because the dollar is the world’s reserve currency. It makes sense because the US offers better/safer investment returns.
So these countries are not without some blame for current global trade problems. If China, India, Brazil, Canada and various other countries had better overall economic policies, then perhaps more nations would be more willing to buy their currencies and assets to replace dollars.
Our current global situation is a phase of a long-term economic development process wherein a couple of world wars and a cold war intervened and held back the economic progress of many countries. Since the 1950s we have witnessed a gradual if not fitful time period in which many countries experimented with and then shed some pretty awful economic policies. But the transformation is not complete and despite great economic progress in many countries, they still contain visible and troublesome weak spots. The world is investing more of its money in these places and will invest even more as time and further actions solidify a more sanguine view of their investment worthiness. As risks in these countries converge on US risk, we will enter a new time where US mistakes will lead to fewer global ramifications and where the US is no longer able to propagate world inflation.
So let’s keep pointing our boney digits at the US. But let’s also recognize that any real solution requires that US enablers have to clean-up their acts too. Yes, the US is responsible for printing too much money and leaving it out there for too long. But China needs to hasten its pace of economic development and reply less on exports. Along the way it needs to make its currency fully convertible and more open to market changes. India, Brazil, S. Korea and several other developing countries have responsibilities to find balance between exports and domestic spending. They too could hasten the pace of reforms, especially those that reduce trade barriers. So long as the world gives these countries a free pass we are stuck in second gear—a gear that guarantees that the US has a disproportionate effect on the global economy. We can make the US a smaller disturbance by making the US a more equal global trade partner. We do this not by making the US smaller – but by making her trading partners whole.