Debt relief for US is the answer, not FX war

I would suggest a debt-relief program for U.S. households in which the U.S. government issues bonds for the program and G20 countries purchase a significant portion of it.

National University of Singapore professor Shin Jang-sup

By Shin Jang-sup
Professor at National University of Singapore

Singapore does not normally use monetary and fiscal policies to boost its economy. This is because if liquidity is disbursed through those policies in the small open economy, their effects mostly spill out abroad with little help to its own economy. The Singapore government therefore relies on the exchange rate policy to counter business cycles.

It seems the U.S. economy is currently showing a “small country syndrome” as if it was a Singapore. “Quantitative easing,” an unheralded monetary policy of the Federal Reserve, hardly produces multiplier effects for the domestic economy.

This is mainly due to the fact that American households are struggling with debt burdens and are unable to increase spending. U.S. banks, sitting on three trillion dollars of excess reserves, are hard to find good borrowers and they are even calling on loans from existing ones to shore up their own balance sheets. Companies also find it hard to sell their products in the domestic market and cannot increase employment.

Meanwhile, liquidity released by the Fed are leaking outside and creating huge volatilities around the world. Financial institutions and investors are anxious to find lending and investment opportunities abroad especially in emerging markets, prompting upward pressure on their currencies. The Australian dollar is now trading at near par value with the U.S. dollar. Brazil has increased its financial transaction tax rate to 4 percent in an effort to stem sudden inflows of foreign money. China is resisting a sharp adjustment of the yuan but is pressured hard by the U.S. and Eurozone countries to drop its ‘currency manipulations.’

If the current “currency war” intensifies, there are more things to lose than to gain. The perceived gains by the U.S. may not be that great. Exports only account for about 7.5 percent of its gross domestic products and it is a long way to go before a depreciation of U.S. dollars will boost its export competitiveness and therefore increase domestic employment. In the short run, it is instead possible that a cheaper U.S. dollar would increase import prices and further constrain domestic consumption. Moreover, if long-term interest rates rise due to a weak dollar, the whole financing scheme for economic recovery would become very difficult to function.

On the other hand, countries on the receiving end of the pressure are unwilling or unable to adjust their currencies as demanded. China may be amassing large current account surpluses but it has concerns with the health of its exporting firms. The Chinese premier Wen Jiabao thus emphasized that if the yuan appreciates as demanded by its Western partners, “a large number of factories will go bankrupt.”

Chinese leaders also consider demands for a sharp appreciation of the yuan as a Western conspiracy to derail the country’s economic ascent. China looks determined to stick to its original position of gradual adjustment of the yuan. This would be why Premier Wen said, without elaborating on what would be China’s responses to the pressure, a sharp appreciation of the yuan “will be disastrous for the world”. Japan is already suffering from a high yen and does not seem to have the capability to accommodate an even higher yen.

The likely outcome of this standoff is a continued disagreement on foreign exchange rate levels and an escalation of the currency war. How can we avoid this war? We need to tackle directly the key factor that delays the economic recovery of the USA. To my view, which I guess is shared by most policy-makers and economists, is lackluster consumption, not the current account deficit of the country.

The global imbalance has been a structural problem of the world economy and by its nature cannot be fixed quickly. We should recall the historical experience that the sharp appreciation of the yen in the late 1980s did not really help resolve the problem and instead drove the Japanese economy to a spiral of bubble, bust, and subsequent stagnation. In the short run, the most urgent task for the US recovery is the revival of domestic consumption. It may not need to return to the level before the global financial crisis but it should return to a level that can stop the current vicious circle of deleveraging, lessening consumption, and lessening employment.

To this end, I would suggest a debt-relief program for U.S. households in which the U.S. government issues bonds for the program and G20 countries purchase a significant portion of it. It would really be a disaster for the world economy if the proposed $1 trillion of quantitative easing, on top of $780 billion already disbursed from last year, produces no effect for the recovery.

The liquidity should be directed to increasing consumption of the U.S. than simply floating around the world generating various adverse effects. If the U.S. government directly injects them, by sharing the burden with U.S. financial institutions, into reducing debt burdens of households, it will increase consumption and improve investor confidence in the U.S. economy, halting capital outflows from the USA.

China and Japan are likely to support this program if the U.S. can make a credible promise to stabilize the U.S. dollar. China is the largest holder of treasury bills (TBs). As a country whose per capita income is still about $3,700, less than one twelfth of that of the U.S., it does not have an incentive to challenge the U.S. dollar hegemony as far as the current pace of economic growth maintains.
Recent measures to internationalize RMB should be understood as ones to protect itself from pressure from the U.S. or possible sudden collapse of the U.S. dollar rather than a challenge against the dollar hegemony. Japan is a world number two TB holder and suffering from the strong yen. It would love to see a stable US dollar.

It might be an affront to the national dignity of the U.S. to accept this program of borrowing money abroad to pay down its household debts. However, ordinary Americans are likely to support such a program. They are discontented with the fact that they are suffering from debt burdens and unemployment while financial institutions whose greed brought about the financial crisis were rescued by taxpayers’ money.

On second thoughts, it is also not really a matter of lowering national dignity. It would be really hurting if one has to keep borrowing money without having any prospect to improve his/her current situation. However, the U.S. is relatively young and is still a land of opportunity. It is legitimate to try to find a ‘win-win’ solution to the current predicament by mortgaging on its own future. This kind of practical solution would be a lot better for keeping its dignity as a great nation than seeking a small country solution by blaming others.

Historically, heavy debt burdens have been resolved by some kind of relief. It looks better for the world economy as well as for the U.S. economy to adopt a debt relief program early rather than saving it as a last resort after going through currency wars, trade retaliations, inflation, financial crises and so on. G20 political leaders and finance ministers will surely discuss ways to avoid currency wars before the G20 summit in Seoul in coming November. The summit would be a success if it is able to draw a ‘G20 Plan’ that can reverse capital outflows from the U.S. as the ‘Brady Plan’ did for Latin America in the late 1980s.