The US Federal Reserve recently announced its third round of quantitative easing – i.e. loosening monetary policy by increasing the supply of money. It got Torrens Hume thinking about whether monetary policy was really the right tool and whether US monetary policy might be too loose. There are many ways of thinking about the problem, but TH was reminded of one of the most important classes he had in his undergrad international economics course on the assignment problem. We talked about it once before (here).
In its simplest form, the assignment problem says that if you have two policy objectives you need two policy instruments. Understanding this simple bit of Dutch inspiration was pretty important when the global economy was on a system of fixed exchange rates. This was because it meant that if you were trying to maintain external balance (i.e. balance in the balance of payments – basically net exports – to avoid a crisis that required a visit from the men in black at the IMF) and internal balance (full employment) then you needed two policy tools – monetary and fiscal policy. Monetary policy was best suited to fixing the exchange rate, leaving fiscal policy to maintain full employment.
All that came to an end about 30 (well actually 29) years ago when Nixon nixed the Bretton Woods system, and, in doing so, drove the world towards a system of mostly floating exchange rates. Countries like Australia, which finally adopted a floating exchange rate in the 1980s and Canada, which pretty much had one from day one, found that now the market automatically adjusted the exchange rate to maintain full employment, leaving policy makers free to choose whether to assign fiscal or monetary policy to the maintenance of internal balance.
Fast forward to today. Pretty much every advanced economy has decided to assign the job of maintaining full employment solely to monetary policy – thus leaving fiscal policy to achieve other objectives: mostly social objectives such as income redistribution, education, health and so on. And to ensure that they did their job free of political influence, governments went further made their central banks independent and gave them explicit targets (such as inflation targets) to pursue. With the exchange rate free to adjust monetary policy no longer had to be coordinated with fiscal policy, it just had to respond to it – if the government deemed it fit to spend more on schools, roads and so forth, the central bank could simply offset the expansionary effect with a tighter monetary policy. Likewise fiscal contraction could be offset with monetary expansion.
The trouble is that the US doesn’t have a fully flexible exchange rate. It has some hangers on, most notably China. This means that to a certain extent its exchange rate is effectively fixed. But the US behaves like it has a flexible exchange rate: its central bank is mandated to maintain full employment not external balance. As a consequence, it is setting a loose monetary policy. Because the exchange rate can’t respond vis-a vis the China’s of the world the adjustment tends to fall on other economies, the US dollar tends to depreciate against those that it can (e.g. the Aussie and Canadian or Brazilian) currencies, but not against the fixers (e.g. China). This means that the monetary policy tend to help US exports to the former group of countries, but encourage imports from the latter. Since monetary policy is targeted at internal balance the effect on external balances is not clear.
That leaves the US with a problem. It has a partially fixed exchange rate and the monetary policy tool is being assigned to internal balance. But no policy tool has been assigned to maintain external balance. It’s just flapping in the wind, determined partly by monetary policy, partly by the whims of policy makers in the rest of the word that tinker with capital controls, fix exchange rates and just generally intervene with the global economy, and partly by some troublesome market distortions too.
Perhaps the US needs to assign a policy tool to maintain external balance. US Fiscal policy is “stranded” at the moment – caught between the need to control the growth of the US government debt and do so without causing another recession. Arguably, the US could use fiscal policy tools to encourage a “fiscal devaluation” – changes in taxes and subsidies that raise the prices received by producers and paid by consumers of goods relative to services to bring about a structural transformation of the economy. This would tend to reduce the trade deficit and encourage investment in manufacturing, which could help boost growth. But this sounds a bit like central planning and it’s not obvious that it will work in practice.
And speaking of Europe …, OK we weren’t, but now that we are, the assignment problem is even more relevant for them. Nearly all the Europeans governments external and internal balance problems of some sort. The periphery have exceptionally high unemployment and are mired in recession as well as having current account deficit problems. But policy tools that they have at their disposal are limited. They all have high debt levels and many (especially in the periphery) can’t use fiscal policy. None of them have monetary policy instruments (because the ECB only sets a euro-wide monetary policy) nor a flexible exchange rate. So how will they achieve internal and external balance? What two instruments do they have at their disposal? TH reckons this problem explains why the regulators are going so easy on periphery banks, which are able to create credit and support the local economies. But then what policy instrument do you assign to financial stability? TH has a head ache now. He’s going to bed.