Greg Ip

Articles by The Economist’s U.S. Economics Editor

For once, a positive parallel to the 1930s

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The original blog post is linked here.
IN THE prelude to the G20 meeting, many commenters, including this newspaper, worried of a repeat of the London Conference of 1933. Franklin Roosevelt is often accused of wrecking it with his refusal to return to the gold standard. The resulting disarray, it is said, deepened the Depression.

Yet one could argue that in its failure to return the world to gold, the 1933 conference was a success. Markets greeted Roosevelt’s July bombshell “enthusiastically”, notes economic historian Allan Meltzer. They correctly anticipated “reflation, rising output, and a vigorous policy of domestic expansion.” As Barry Eichengreen has demonstrated, the gold standard was a monetary straitjacket that transmitted deflation between countries; each country’s recovery is highly correlated with when it abandoned gold.

On this front, I see a parallel (though perhaps a tortured one) with the G20’s decision to boost the IMF’s lending resources from $250 billion to $1 trillion. Of the increase, $500 billion will come through an expanded line of credit with its major members, and $250 billion through the creation of new special drawing rights, or SDRs, the IMF’s unique currency. This latter is essentially the printing of new money. As Dominique Strauss-Kahn, the IMF’s managing director, says, “it’s the beginning of increasing the role of the IMF, not only as a lender of last resort, not only as a forecaster, not only as an advisor in economic policy and its old traditional role, but also in providing liquidity to the world, which is the role finally and in the end, of a financial institution like ours.”

In other words, it is a step closer to turning the IMF into a world central bank.

The analogy to the 1930s is imperfect, of course. We are not on the gold standard today and global liquidity is not limited by how much of the metal central banks have in their vaults, but how much currency they choose to print. Still, I would argue there is a parallel. Instead of gold as the international monetary base, we have the US dollar. While any country (or the ECB in the case of the euro zone) can produce as much domestic currency as it wishes, only the Federal Reserve can create more dollars. That removes monetary flexibility from any country that has large liabilities in dollars, or transacts heavily in dollars. This is a source of vulnerability to the world monetary system, as Zhou Xiaochuan, China’s central bank governor, highlighted when he called for a more prominent role for the SDR.

This seems an odd concern given that since the Fed promised to purchase or “monetise” $300 billion of Treasury bonds, people seem more worried it will supply too many dollars, not too few. But it was not so long ago that a shortage of dollars was exacerbating the crisis. Last year, many foreign banks and institutions found themselves unable to roll over maturing dollar-denominated borrowing that financed everything from commercial loans to off-balance sheet conduits. The resulting scramble for dollars drove up its value and interbank dollar interest rates.

The Fed responded by creating swap lines that in effect gave key foreign central banks temporary capacity to print dollars. Since then, an easing of global panic and the Fed’s decision to purchase Treasuries has reversed some, but not most, of the dollar’s appreciation and brought down interbank rates.

In this instance the Fed discharged its responsibility as global lender of last resort with aplomb. But it cannot do so indefinitely. No central bank can properly fulfill a mandate for domestic price stability and economic growth while acting as a global liquidity provider; the two roles will inevitably conflict.

A lot of people worry the Fed’s aggressive action against the crisis will create inflation. (I’m not one of them, but then I’m a bit of a deflation nutter.) The Fed will feel more free to confront inflation if it doesn’t have to worry that doing so will suck precious liquidity out of the global monetary system.

I do not know whether creating new SDRs will do the trick. Since they are distributed according to member countries’ quota, the largest countries like America will get the most, not the countries that need them. It will be a long time before the IMF can act with the speed and scale that the Fed can. But it’s a start.

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Written by gregip

April 6, 2009 at 8:45 pm

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