TH hasn’t blogged lately … but he has been reading Jim Haley’s series of posts on the burden of international economic adjustment on his New Age of Uncertainty blog. The burden of economic adjustment refers to the idea that when a country (or many for that matter) is suffering high unemployment and low growth, other countries in the global economy will inevitably bear some of the pain of adjustment to get the weaker going again. The trouble is that while getting the whole team running at full capacity is ultimately in everyone’s interests, in the near term it creates economic and political challenges.
In the series, Jim discusses how the burden of adjustment happened under the Bretton Woods system that governed the international monetary system from 1945 to 1971 and asks what the lessons are for today. After all we are living in a world in which some countries have terrible unemployment and lousy growth rates while other seem to be coping much better (though few countries are experiencing conditions better than before the 2007/2008 crisis). Jim is in his element on this stuff and his posts are good reading.
In the second post in the series, Jim reminds us that one of the most important things for us to understand about economic adjustment between countries is the degree of international capital mobility that we live with today.
To understand the this better, it helps to simplify and imagine a world working under the Bretton Woods system with just two economies (domestic and foreign), immobile capital (i.e. no international borrowing or lending) and a fixed but adjustable exchange rate between the two countries. In this situation, it is easy to show that, in the long-run, the foreign economy will be largely unaffected by a major domestic fiscal or monetary policy shock and vice-versa. The reason is simple, demand shocks are transmitted via net exports and if net exports are constrained to be zero because no one can borrow or lend internationally, then demand shocks can’t spill over. The only spillovers are in the short-run, before exchange rates and prices have fully adjusted, and even these arise because of the preference for a stable exchange rate.
For example, imagine that the domestic economy is in external balance but is suffering underemployment and, in response, engages in a substantial loosening of monetary policy. The lower interest rate and rise in income in the domestic economy had the additional consequence of an increase in import demand and, as a result, a domestic current account deficit and a corresponding foreign surplus. The increase in domestic imports spilled over to cause a temporary expansion in the foreign economy. But with capital controls in place, that was it. There was no need to worry about the fall in interest rates causing a capital out flow, because capital controls prevented this from happening. Lower interest rates served only to help the domestic economy to move towards full employment. Nor do we have to worry about increased private borrowing from abroad to pay for the domestic imports because the imports are paid for by running down the central bank’s foreign exchange reserves.
Still, a key point here is that with the exchange rate fixed, imports rose and this acted to impede the effectiveness of the expansionary monetary policy. Indeed, some of the increase in domestic demand spilled over into the foreign economy boosting demand there. At the same time the local economy was running down reserves, and was faced with the possibility of either a current account crisis if it ran out of reserves or having to abandon its expansionary policy and languish with high unemployment.
Under the Bretton Woods system, the solution was to “strike the right balance” between official lending from the Fund to cover the any short fall in reserves and adjustment to reduce the current account deficit. Adjustment came in two forms. One was to encourage wages to fall. Indeed, Australia’s current system of arbitrated and somewhat centrally fixed wages is a hangover from that by-gone era. Alternatively, exchange rates could be adjusted and the authorities could go to the Fund and announce a devaluation of their exchange rate to bring it in line with “fundamentals.” So long as the lags involved were not too great and the trade balance responded in the right way to the exchange rate adjustment, the trade deficit would soon be eliminated by the devaluation; and, in so doing, so would the export-led stimulus to the foreign economy. That stimulus, which had effectively leaked out of the domestic economy, would now be channelled back into it.
The point here is that, because there was no private net lending or borrowing under zero capital mobility, there could be no domestic trade deficit in net exports or foreign trade surplus in the long run. The exchange rate adjustment is not technically necessary since the drag from net exports in the domestic economy could have been offset by wage and price adjustments, but it helps to hasten the recovery in the domestic economy, enhance the effectiveness of the policy stimulus and reduce the potential for foreign overheating. In other words, in a system of fixed but adjustable exchange rates without capital mobility, the foreign economy was largely insulated from domestic economy efforts to maintain full employment, while the domestic economy could respond quickly to changing economic conditions.
But the outcome would have been quite different if capital mobility was permitted. In that case, domestic monetary expansion would have caused the interest rate to fall and capital flow out of the economy in search of a higher yield. This capital outflow would have resulted in a rapid erosion of foreign exchange reserves requiring either the exchange rate to be devalued or the expansionary monetary policy to be abandoned. Lending from the fund was no longer an option because that money would have leaked out in search of yield as quickly as it was lent.
If devaluation was pursued, it would have been the expansion in net exports that ultimately brought the domestic economy back to full employment, not the lower interest rate, which could not persist under perfect capital mobility because arbitrage would have eliminated it. Moreover, and importantly, the expansion in net exports, and the current account surplus would have ended up persisting as long as it was required to maintain full employment and domestic residents were willing to save the current account surplus.
What is important is that with perfect capital mobility and the adjustable exchange rate, the expansionary domestic monetary policy also resulted in a corresponding trade deficit in the foreign country and a reduction in foreign demand. So the burden of adjustment is different when capital is mobile compared to when it is not. This is not necessarily a problem, but it is a complication. And it raises many questions about what foreign policy makers can and should do about it.