Inflation fears threaten US creditworthiness
By Korkut Erturk
The exceptional advantage the United States has in being able to issue its
liabilities in its own currency has shielded it from the worst ravages of the
financial crisis any other country would have experienced in its position. But
fears that the United States might be forsaking this advantage are mounting.
The issue isn't the imminent collapse of the dollar, but that the United States
will be increasingly constrained in its fight against the economic downturn by
concern over the sagging value of the dollar.
In his visit to Beijing this past summer, US Treasury Secretary Timothy
Geithner looked like a wastrel trying to appease his creditors, giving
assurances to skeptical Chinese audiences. Increasingly, the Federal Reserve
finds it has to assure investors of its "exit strategy" from extreme monetary
easing. Yet, the only thing that can sustain aggregate demand, and thus income
and
employment, in the period to come is to keep up the fiscal stimulus. Anything
that poses a threat to the large budget deficits the Barack Obama
administration is running, and will continue to in the coming years, is liable
to worsen the economic slump. Whether warranted, inflation fears pose a threat.
Two valid points are often made by those who argue that inflation fears are not
warranted in the current period. First, substantial slack in both the labor
market and in industrial capacity militate against any wage increases or
pricing power on the part of businesses, which is definitely true. Second, the
liquidity the Fed has been injecting into banks cannot cause inflation unless
it first leads to a lending spree. This is again not something to worry about,
given the continuing anemic state of bank credit today.
Banks have had to shrink their balance sheets drastically and the public sector
had to expand its own to check the free fall in asset prices. If the Fed can
rapidly reduce its own balance sheet when banks begin expanding their balance
sheets again, the argument goes, inflation will not or need not be a problem.
While both points are valid it does not follow that inflation is not a concern.
The fear of inflation itself poses a threat for the creditworthiness of the
United States as an international net borrower.
It is a bad omen that with the slightest sign of improvement in the world
economy demand for the dollar began to sag. The rise of oil and commodities in
the last few years as an asset class in which to invest is emblematic of the
ebbing confidence in the dollar, of the fact that US financial liabilities can
no longer mop up the excess liquidity the country is creating in the world
economy.
If the economy continues to show signs of improvement, the recent upward trend
in oil and commodity prices will only gain momentum, causing inflation fears to
intensify. We glimpsed the vicious cycle to which this can give rise last
summer, when investors' efforts to hedge against the dollar caused a
speculative bubble in oil and commodity prices, raising inflationary
expectations, which further undermined the dollar. The same is likely to happen
again.
A safer way to inflate the US economy would have been to couple that policy
with international currency reform. Much has been written on this issue here
and elsewhere. But there is no sign of any inclination on the part of the Obama
administration to move in that direction, and, clearly, the Chinese and Russian
rumblings about the dollar have had little effect on making global monetary
reform imminent. The trouble is that output and employment will have to stay
depressed to keep US inflation fears from threatening to turn the slide of the
dollar, so far orderly, into a rout. Economic malaise will keep concerns about
both in check and may be the best we can hope for.
The irony is that US financial markets and neo-liberal global order were
perversely functional in recycling other countries' trade surpluses to the
United States and through it to the rest of the world. The problem was how they
were recycled. Consumption booms on borrowed money caused insolvency in the
emerging economies. The same thing happened in the US when recycled global
surpluses became fodder for excessive credit growth here as well, bankrupting
its households and banks.
Now, the difficulty in recycling these imbalances is causing them to shrink,
and that is in a nutshell the driving force behind the global slump. Oddly,
current US policy amounts to fighting the slump by trying to return to business
as usual even though it is recognized that US private consumption can no longer
be the engine of growth and rising fiscal deficits pose a problem.
Exports will have to rise to counter the downward slide, for they are the only
way to bolster aggregate demand without adding on debt. That in turn requires
more than a weak dollar. The level of income has to rise in the rest of the
world, and that is why many commentators have recently been calling for surplus
countries to increase spending in their respective economies and be the new
engine of world growth. But, even if surplus countries recognize that that is
in their enlightened self-interest, they face a classic collective action
problem.
Whichever country fails to reflate its economy can gain by bolstering its
exports at the expense of those who do. In the absence of some global
coordination mechanism it is unrealistic to expect surplus countries to
overcome their fear of losing their competitiveness through reflation.
Secondly, the onus of adjustment is never on them. Unsurprisingly, US efforts
to push reflation in surplus countries onto the agenda in the recent Group of
20 did not go anywhere as both Germany and China were cool to the idea.
If collective action problems or even mere shortsightedness prevent surplus
countries from acting on their enlightened self interest, where does that leave
us? An alternative approach could be to aim at recycling global surpluses to
fund development in developing countries. Provided there is sufficient
political will, bonds issued by poor countries can be funded by an
international financial institution, which can in turn issue its own
liabilities that can function as reserve assets alternative to the US
Treasuries, which the surplus countries can invest in.
This would not only relieve the tension on the dollar but also help revive the
recycling of global imbalances on sound footing. Moreover, it would also save
the world the political tensions that would inevitably rise when China sooner
or later stumbles on its own Marshall Plan in the developing world.
Korkut Erturk is Chair, Associate Professor, University of Utah
Department of Economics.
(Published with permission of the Global Policy Innovations program at the
Carnegie Council for Ethics in International Affairs.
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