Financial, Trade, and Currency Instabilities: Rising Concerns
March 17, 2015
In l985, faced with soaring U.S. trade deficits, industrial distress, and congressional pressure, Treasury Secretary James A. Baker III negotiated an agreement among the group of five leading industrial countries, known as the Plaza Accord, which coordinated the appreciation of their currencies against the dollar.
The Plaza Accord successfully stabilized U.S. current accounts deficits at less than 2 percent of the U.S. gross national product (GNP) and held them there for more than a decade.
Subsequently, different U.S. policies after the Asian financial crisis in 1998 helped trigger renewed upward pressure on the dollar. This set the stage for a dramatic and extended collapse in the U.S. current accounts position, resulting in trillions of dollars of trade deficits related long-term net U.S. external debt and other negative consequences.
The latest global currency changes will again shift the terms of trade dramatically against us. It amounts to a Plaza Accord in reverse. The results for employment, investment patterns, and U.S. current accounts will be profound. Over the next several years, the new terms of trade will gradually impact large chunks of the global economy, including U.S. exports and investment patterns.
Since the onset of Abenomics and massive quantitative easing in Japan more than two years ago, the Japanese yen has been devalued from 85 to the dollar to 120. This has cheapened Japanese exports, served as a nontariff import barrier, flattered Japanese profits earned from overseas sales and investments, boosted the local stock market, and weakened Japan’s competitors.
The weakened yen has stimulated some of Japan’s competitors to consider ways to weaken their own currencies. Compounded by unrelated domestic economic problems, a broad on-going pattern of devaluations against the dollar has developed. The euro has fallen from 1.40 to the dollar to something now approaching parity. Since European quantitative easing has only just begun, it would be naïve to think that the euro has reached a new bottom. (The same is true of the Japanese yen.) The weakened euro will help otherwise uncompetitive Italian companies to secure additional markets abroad. But it will also turbocharge the already very competitive German export machine.
Consider for example the impact of the recent massive devaluation of the euro on Boeing’s competitive position and on Boeing’s future investment decisions. They will surely look for a more favorable currency zone for future investment in production and exports.
There is another less obvious downside to the rapid dollar appreciation. Many borrowers abroad took advantage of all those dollars in ultra-low interest rates that quantitative easing helped make available. Some, perhaps many, did not hedge the currency risk. Such borrowers will now have to repay those dollar loans by earning profits in the depreciated local currencies. The same is true of those who borrowed in Swiss francs.
Look for example at what happened to Hungary in the last large-scale currency shifts. Hungary’s economy and politics still haven’t recovered from all those foreign borrowings at once low interest rates. The subsequent defaults threatened the nation’s financial system. Borrowers in Brazil and other countries now are beginning to face similar problems in the latest currency shifts. The trillion dollars borrowed by Chinese companies and investors will not be far behind if the Chinese currency renews its softening to compete with Japan and others.
The currency issue has now been raised by some in the Congress in connection with current trade policy legislation. But the real political and economic problems for the United States will only occur when the new currency ratios fully imbed themselves into new, and for us, unfavorable trade and investment patterns and current account statistics. It will take a year or two or more for this to unfold fully. Ford Motor Company is already getting visibly upset at what they see coming. Others won’t be far behind. The U.S. economy risks becoming the classic frog in the slowly heating kettle.
Some say that if we allow currencies to become an issue in trade legislation, it will cripple the negotiations themselves. But currency shifts, not tariffs, today determine the terms of global trade.
If our current accounts deteriorate in the year or two ahead, and other related negative trends that seem utterly predictable materialize, Congress will in any case not support a new trade agreement that is negotiated without taking currency issues into consideration.
There were many well-known factors that contributed to the financial meltdown after 2008. Abnormally low and extended U.S. interest rates, which flowed in part from the massive U.S. government bond purchases by China, Japan, and other trade surplus countries, unquestionably contributed to unstable financial markets. The massive sustained currency-related U.S. trade deficits and accompanying monetary problems in the George W. Bush years also helped fuel the housing bubble, U.S. deindustrialization, the cascading disasters in Detroit, the resultant collapses, and the vast permanent increase in net external U.S. debt that will have to be serviced in the long term by interest payments.
The policy of the George W. Bush administration toward the unprecedented trade deficits was largely benign neglect, in the hope that markets themselves would eventually correct this and broader problems. Indeed they did…in 2008.
What to Do Now?
The 1985 Plaza Accord to rebalance currencies worked in part because there was supportive G5 macroeconomic policy coordination, something that seems almost unimaginable in the current circumstances.
Instead, we have today what can only be called beggar-thy-American-neighbor competitive devaluations, with a tiny rhetorical G20 fig leaf attached.
The resultant overseas currency depreciations will increasingly not only harm our employment and export-import situation, but also and importantly hit hard corporate profits from overseas earnings of U.S. multinationals. This will, over time, inevitably impact stock prices, as Hewlett-Packard’s quarterly statement recently noted.
The problem is that we ourselves started the ball rolling on quantitative easing related currency depreciations and are therefore in a weakened moral position to complain when others now do the same.
Yet, if we do not force this issue and deal with the gradually worsening currency problems, others will certainly not voluntarily accommodate our interests.
The U.S. Treasury Department had to use threats in the back room to force the Plaza Accord on our unwilling trade partners. Secretary Baker played the “good cop” and let Congress be the bad cop. In the Nixon administration, Treasury Secretary John Connally hit our trading partners with a tariff sledge hammer to develop an action-forcing mechanism to achieve a badly needed currency adjustment.
But that’s all history. The point now is that if we don’t start planning to deal with these destabilizing competitive devaluations, the problems they create will imbed themselves structurally into the U.S. economy and take years to unwind. In the meantime, we face a presidential election and trade legislation.
In today’s environment, there will also be no voluntary easing of the currency situation by trade partners concerned by their own slow growth and politically difficult structural problems. From the overseas perspective, these politically sensitive structural problems (e.g., rigid labor markets in Italy and Shinzo Abe’s “third arrow” structural reforms in Japan) can be most easily sidestepped by competitive devaluations and a ramping up of exports and export profits at our expense.
The long-term negative consequences of global quantitative easing and unsustainably low interest rates have resulted in bonds where obvious risk is not priced in. Pension funds and insurance companies desperate for short-term yield hold these junk bonds and hope to be able to exit the market in time when conditions deteriorate. Recent history richly demonstrates, however, that exits in panic-stricken financial markets can suddenly become very crowded.
The global economy has other vulnerabilities that make some of the most sophisticated financial policymakers deeply troubled. But short-term pressures are now driving policy, and there is a risk that even the United States may face renewed employment problems by the time U.S. presidential election occurs. The nervousness in financial markets is palpable. The need to stabilize and revive the U.S. economy may become a major theme of the 2016 election.
Major and needed postelection regulatory reform could help the U.S. economy, especially with flagging small business formation, but the currency issues will also need to be faced front and center.
It will take tactics similar to the Plaza era to make this happen in the face of resistance and economic problems abroad. We will also have to anticipate sophisticated lobbying operations in Washington and in parts of the media, by our trade partners and those who have bought in to a benign neglect policy, to keep the lid on. Such lobbying efforts are already clearly beginning.
Without a lot of public fanfare, the Treasury Department needs to set up an internal task force to plan contingent measures to achieve greater international macroeconomic policy coordination and ultimately a new Plaza agreement. This will necessarily involve encouraging our trading partners to deploy structural reforms and more sustainable economic policies instead of depending chiefly on currency devaluations and money printing to achieve more growth, exports, employment, and profits at other’s expense.
Quiet consultations with Congress should also be part of the contingency planning. Without the totally credible threat of U.S. unilateral action, and an action-forcing mechanism, it is extremely unlikely that sufficient reforms abroad will be adopted to prevent a meltdown of our current accounts and all that goes with it in the years immediately ahead.
A Final Word
Quantitative easing, which remains one of the main drivers of currency instabilities, arguably performed a useful role during the early desperate days of the financial crisis. It became addictive, however, and many believe, overstayed its welcome. In the of case Japan, money printed by the central bank is now being used for direct large-scale purchases of stocks, and virtually the entire vast annual emission of Japanese government bonds.
This is the state creating, allocating, and managing capital on a very large scale, which was one of the hallmarks of the Soviet centrally planned economy.
One of the many problems of such ambitious and pervasive central bank activity is that the market is no longer operating normally, constantly sending useful signals to policymakers, investors, and the public that imbalances and unsustainable trends are evolving. Thus, on the surface, all appears well. Confidence is maintained. But policies that should be changed, do not get changed. Wasteful or misdirected investments continue. Risk is no longer priced into bonds and other financial markets.
Lacking clear warning signals from markets, potential corrective mechanisms remain frozen on automatic pilot. This is what happened to the Soviet Union and a number of other states with central planning and government-directed finance.
Many of Japan’s current monetary and finance policies in many ways resemble closely those deployed by the government of Japan in the peak war year of l944. As in 1944, Japan’s once independent central bank has, de facto, become an arm of the Ministry of Finance. Japan’s bond market has become circular. The Finance Ministry issues the bonds. The Bank of Japan buys them. The interest payments revert to the Finance Ministry. Today’s parallel to Japan’s l944 policies is not an original observation by me, but rather comes from some of Japan’s ablest, deepest thinking, and highly concerned private economists.
The danger of unprecedented global quantitative easing and lavish central bank money printing is that capital is misallocated on a very large scale. Risks are not priced into investments. Currencies become unstable. Excess capacity is indirectly financed by government, which ultimately proves to be deflationary, as is the case of China. Public accumulation by governments and the mechanisms for managing this debt, including Japan’s, are becoming ever more problematic.
In the case of the Soviet Union, where many similar problems existed, when the music stopped, both the currency and the country itself fell apart, almost without warning. Savings and pensions vanished in a puff of inflationary smoke.
Despite major and increasing debt problems, no major part of the global economy is yet facing such dire circumstances. We would be wise, however, not to forget what happened to the former super power, and why.
Ambassador Richard McCormack was undersecretary of state for economic affairs and G7 Economic Summit sherpa for President George H.W. Bush. From 2006 to 2012, McCormack was vice chairman of Bank of America. He is currently a senior adviser at the Center for Strategic and International Studies in Washington, D.C.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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