The Fed's key role in international economic policy coordination is a largely overlooked and ignored aspect of its work. Typically, most people think that is what the president and his economic officials do during the meetings of what American academic community derisively calls "talking shops" (G8, G20, and various U.N. agencies).
But the best kept secret is that the Fed does more for the successful operation of the global business cycle than all these "talking shops" combined. And it does that at no cost to American taxpayers. Last year, for example, the Fed transferred $76.9 billion in profits to the U.S. Treasury, while one of these summit jamborees can cost $850 million.
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How does the Fed drive the world economy?
The dollar is the channel through which the impact of the Fed's policy is transmitted to the rest of the world. Transmission mechanisms are very wide and instantaneous. About 90 percent of international trade and financial transactions are conducted in dollars; some economies are fully dollarized through currency boards or dollar pegs, the dollar accounts for 62 percent of world currency reserves, and the overwhelmingly dollar-based foreign exchange market has an estimated daily turnover of $4 trillion.
Pushing Export-Driven Free Riders
That is the framework where the Fed operates as a de facto coordinator of international economic policies. Conceptually, this policy coordination process is grounded on the idea that countries at different points in the global business cycle should conduct restrictive or expansionary economic policies depending on their fiscal and balance-of-payments positions.
For example, countries running budget and trade surpluses (or very low budget and trade deficits) should stimulate their domestic demand because they may also have sluggish growth and low inflation. Conversely, countries with high budget and trade deficits should increase taxes, cut government spending and raise interest rates because they may be experiencing an overheating economy and rising inflation.
The question is: While running the U.S. economy, how can the Fed influence that the four largest world economies – U.S., China, Japan and Germany (45 percent of global GDP) – follow these broad policy coordination criteria?
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Starting with the U.S., one can observe that its policy mix consists of a loose monetary and restrictive fiscal stance. The Fed's expansionary monetary policy is addressing problems of slow economic growth, while fiscal restraint aims at reducing budget deficits and slowing down America's rapidly rising public debt.
Germany is in a much better fiscal position to rev up its recessionary economy. With stable prices, balanced budget and a whopping 6 percent of GDP trade surplus, Germany could cut taxes and step up government spending to stimulate domestic demand. That would spur Germany's buying of foreign goods and services and help its struggling euro zone partners. But Germany does not want to do that. It is killing its domestic demand by fiscal austerity, counting on exports to ride out the cyclical downturn.
Japan is another clear case where a deflationary economy and a small trade surplus call for a properly targeted stimulus to domestic demand. Unlike Germany, Japan has come up with a stimulus package – an inauspicious action plan mainly based on repeatedly tried and failed programs of public works. And exports may not help either. Indeed, export sales are unlikely to pick up strongly enough to lead the Japanese economy out of its current recession.
China is maintaining its growth rate within the targeted policy range of 7-8 percent, but a relatively large trade surplus - nearly 3 percent of GDP – suggests that a much bigger part of its aggregate demand should be generated by private consumption and business investments. Such a compositional change of China's economic growth is an official policy objective. Some progress along these lines is being made, but there is still a long way to go.
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All this shows that – whether structurally (China) or by design (Germany and Japan) – three of the four largest world economies (which account for a quarter of global GDP) are living off the U.S. and the rest of the world. No amount of "talking shop" meetings has been able to wean these countries off their export gravy train.
The Fed, however, has been doing something about that.
Fed Deserves a Thank-You Note From France and Spain
When Germany recently complained about Japan's drive to push the yen down, it sounded like Berlin actually meant to complain about the Fed's soaring dollar liquidity and the Washington's fiscal saga pulling the euro up nearly 10 percent against the dollar since the beginning of last summer.
But if German officials appeared to have their currency wires all tangled up, the former Euro group chairman and Luxembourg's Prime Minister Jean-Claude Juncker strengthened that out last week by worrying about the euro's rising exchange rateagainst the dollar.
That is putting Germany on the spot, both because the euro's rise against the dollar is hitting the competitive standing of its exporters vis-a-vis their American, Japanese and South Korean rivals, and because downward pressures on Germany's huge export sector - nearly 50 percent of its GDP - will make it difficult to keep the economy afloat in the run-up to September elections.
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Again, Berlin is looking to exports for a way out. Here are some signs. Suddenly, Germany has gone quiet about ECB's easy money policies, no doubt because rising euro supplies could moderate competitive losses against the Fed-operated global dollar area. And, in a surprising about face, Germany is now accepting the idea that France and Spain should have more time to reduce their budget deficits in order to give some oxygen to their moribund economies. Such a pro-growth switch, however modest, will benefit Germany because these two countries take about one-third of German exports to the euro area. So, what Germany loses in the fiercely contested dollar trading area, it hopes to partly offset by exports to improving euro markets it dominates.
China and Japan Will Be Buying More Treasurys
While the ECB will not intervene to keep the euro down against the dollar, China and Japan make currency interventions part of their normal monetary management. Here is how much the Fed has pushed these two countries last year to increase their holdings of U.S. assets as they sought to keep their currencies down against the dollar.
Japan stopped its rundown of U.S. Treasurys in December of last year. Since then, the total amount of Treasury securities increased $74.4 billion to stand at $1132.8 billion in November 2012. The spikes in Japan's purchases of U.S. government bonds closely mirror the periods of yen's surges against the dollar. Quietly, the Fed was doing what was good for Japan – forcing the Bank of Japan to expand its money supply – without the threats from the Japanese government that it may review the central bank's charter if it did not print enough money to move inflation from -0.1 percent to 2 percent.
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China also continued to buy U.S. debt last year to keep its currency's virtual dollar peg. After a huge (more than $100 billion) selloff of U.S. Treasurys toward the end of 2011, Beijing changed its mind and kept increasing modestly its dollar assets to a total of $1170.1 billion at the end of last November. That is still 7 percent below its year-earlier level, but these dollar purchases, growing currency swap lines with many of its trading partners and stringent capital controls kept the stable against the dollar in 2012.
The Fed's policies are still difficult to resist. In spite of all these currency defenses, China's quest for a stable dollar-yuan exchange rate has made its trade and financial flows increasingly dollarized – a trend that will continue to strengthen for lack of any suitable alternatives. The Fed will, therefore, be able to have a direct and increasing impact on China's monetary policies as Beijing continues to open up its capital account on its long, but inevitable, road to making yuan a convertible global currency.
Apart from the euro zone, Japan and China, the Fed's monetary policy has had a large impact on Brazil, India and Russia, the countries complaining about the "currency wars." Mexico and Canada, Washington's free-trade partners, have also had to significantly step up their purchases of U.S. Treasurys to maintain their dollar pegs in response to the growing dollar-denominated money supply.
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Investment strategists would probably make better asset allocation decisions by taking into account global ramifications of Fed's policies. The dollar bears may also wish to reconsider: the greenback will have no match as the world's key transactions currency for as far as the eye can see. And while there may be some competition for the dollar as a store of value, the Fed's commitment to price stability in the United States should be taken seriously.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.