RWER issue 55: Arista, Erturk
The case for international monetary reform
Jane D’Arista and Korkut Alp Ertürk [Financial Markets Center and University of Utah, USA]
The conventional view on global imbalances is based on a few basic propositions: that (i) they are the ultimate cause of the financial crisis, and (ii) mainly the result of overspending in the US and currency manipulation in China; (iii) the overall policy objective should be to rebalance which requires that deficit countries should save more and surplus countries less, and (iv) that exchange rate flexibility should be enhanced. Traditionally, overspending used to be blamed on government budget deficits, so the policy prescription would call for reduced government spending. But since the crisis, regulatory failure appears to have emerged as a new culprit. Financial regulation failed to detect and stop excessive credit growth which in turn made it possible for US households to over-consume. Now that financial reform legislation has supposedly fixed that problem in the US, attention appears to have shifted onto global imbalances and exchange rate flexibility.
However, what is not discussed as much is the downside of raising savings to rebalance in the midst of an anemic recovery. Economists often talk from both sides of their mouths to deal with the problem: Spending should be raised in the short run to revive growth when in a slump, but needs to be curtailed in the long run when the economy recovers. But, the short run fix takes us further away from the long run objective and it is never clearly spelled out how one goes from the former to the latter without tripping along the way.
It is possible that the conventional view suffers from an even deeper problem, for it assumes a world that no longer exists. It implicitly presupposes an international economy consisting of distinct national economies with their own separate systems of financial intermediation tied to one another mainly through trade. But, in a world of free capital flows why should the net demand for national currencies and thus the market determination of exchange rates depend solely on trade balances? The conventional view would only make sense in a world where financial assets are traded mainly to move goods; where central banks control credit growth and where the current account rules the roost. Of course, none of this is consistent anymore with the increasingly transnational world we inhabit, a world that is interconnected through financial flows and global production networks; one where the notion of global financial intermediation is no longer an empty supposition.
You may read the whole paper at: http://www.paecon.net/PAEReview/issue55/AristaErturk55.pdf