© Hendrik van den Berg
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Three of the world's largest central banks, namely the U.S. Federal Reserve, the European Central Bank and the Bank of Japan, have launched unconventional monetary easing by pumping a large amount of money into economy. To your mind, what impact it might have on the International Monetary System in the future?
Monetary easing reflects the fact that the US, EU, and Japanese economies in recession, or in danger of falling into recession. Governments and their central banks are looking at ways to reduce unemployment, stimulate economic activity, and shore up the weaknesses of their financial sectors. Traditionally, macroeconomic policy involves some combination of monetary and fiscal expansion. But fiscal policy is today ruled out for a variety of reasons. In the US, the Republican Party that controls the House of Representatives simply will not authorize increases in government expenditures. This political posture seems to reflect ideology more than economics. In the EU, high levels of debt in many countries plus the rules that the Euro countries agreed to make fiscal expansion difficult. In any case, most governments in the EU have embraced austerity programs. Japanese government debt is well over 200% of GDP. These high levels of government debt are in part the result of the recent financial crisis and economic recessions, but they are also in part the result of annual budget deficits before the 2007-2009 crisis. In short, economic policy thus falls largely into the hands of the central banks. So we have monetary policy without fiscal expansion, central bank purchases of assets from the financial and private sectors while governments cut expenditures.
Under quantitative easing (QE), the central bank acquires large amounts of assets, such as government bonds but also many types of private bonds and other assets, from the private financial system and private investors. It is hoped that by replacing financial assets with actual Dollars, Euros, or Yen, interest rates will remain low and the financial system will increase lending for investment and job creation. Note that QE is "unconventional" because it is carried out throughout the broader financial system rather than only within the traditional banking sector. Modern finance is no longer restricted to traditional banking, of course. But, otherwise, quantitative easing is simply monetary expansion.
Unfortunately, we know that monetary expansion does not work as well as fiscal expansion when an economic contraction is caused by a financial crisis. Indeed, the unprecedented levels of quantitative easing in the US have stopped the economy's downward slide, but it has not been able to stimulate a real recovery. Some EU economies are still in downward spirals, with austerity causing further erosion of government budgets rather than closing budget deficits. I believe it would be much better if central bank money creation was directly coupled with increased government spending, even direct employment by governments.
With inflation not an immediate threat, as evidenced by the very low interest rates demanded in the financial markets, government borrowing costs are very low. Perhaps it is time to seek more traditional Keynesian solutions, but the combination of government expenditures and money creation to pay for the expenditures clash with the dominant austerity mentality.
Of course, the long-run impact of quantitative easing is a concern. If economies recover, then inflation could become a problem. Central banks would then have to raise interest rates by means of massive sales of assets to the banks and the public. Interest rates would rise sharply if inflationary expectations change, and it will be a challenge for central banks to manage such a policy reversal without killing the economic recovery.
A former French President Nicolas Sarkozy once said: "We must rethink the financial system from scratch, as at Bretton Woods," while in December 2011, the Bank of England published a paper arguing for reform, saying that the current International monetary system has performed poorly compared to the Bretton Woods system. Do you think that international financial architecture should be rebuilt? And if so, what would be its new structure?
In the last chapter of my International Finance textbook I ask whether we need a new Bretton Woods conference to agree on a new international financial system. Among economists and policy makers, opinions shift with economic conditions. To seriously answer this question, we first need to ask some critical questions about the current system. What is wrong with the current system? Does the system permit national governments to maintain full employment and economic growth? Does the system support an orderly growth of international trade and investment? Do all countries enjoy good economic outcomes under the system? Is the system easy to sustain or does it require constant emergency responses? Then, we need to serious question whether some other system would actually bring better results. What would indeed happen if we shifted back to a fixed exchange rate system such as Bretton Woods 1950-1971? Should we replace the dollar as reserve currency? Should we move to a single world currency? Do we need stronger international institutions?
Each alternative has disadvantages as well as advantages. Every international financial arrangement is a compromise between various economic goals. Also, we should remember that the current system evolved gradually from the original Bretton Woods system. This latter revolutionary system was imposed when one country, the United States, dominated the Western world economically and politically. Since then, as other economies grew and gained importance, the system has changed. The changes were often erratic, often occurring when individual countries changed policy in reaction to some emergency. Everyone then reacted as best as they could. Large economies like the US and the EU have had a disproportionate influence, but no one country has been able to control the process of change.
One reason there may not be any change soon is that the US likes the status quo over other suggested reforms. Because so any countries would have to agree, it is easier to maintain the status quo than to change the system! In fact, I have no idea how the world would go about reaching a consensus on a completely new financial system. National interests simply differ too much across the world's countries to be able to agree on any major changes in the system. Just look at how difficult it is to make modest banking and financial reforms to address the most serious causes of the 2007-2009 crisis. Unlike the Bretton Woods period, we now also have a powerful global financial industry that works hard to push national policies in its favour across all countries. Having studied the political economy of international economic policy for years, I am not optimistic about being able to change the system. We are more likely to see national political forces push governments to selectively cut some of the links between global system and national economies and financial systems.