Central banks are not — and never should be — the fixers of last resort

  • Americans are not trade warriors. They are the victims of decades-old unabashed mercantilism that Washington continues to tolerate.
  • Asking the Federal Reserve to make up for the damage done by rising trade deficits and an unaffordable fiscal policy, is unmistakably a quick road to recession.
  • Let the Fed focus on price stability to maintain the economy within its noninflationary physical limits to growth.
A television broadcasts Jerome Powell, chairman of the U.S. Federal Reserve, announcing an increase in the Federal Reserve interest rate on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Wednesday, Dec. 19, 2018.
Michael Nagle | Bloomberg | Getty Images
A television broadcasts Jerome Powell, chairman of the U.S. Federal Reserve, announcing an increase in the Federal Reserve interest rate on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Wednesday, Dec. 19, 2018.

America's economic and financial disaster scenarios are increasingly popular trades in spite of an economy growing at twice the rate of its noninflationary potential, with a 3.9 percent unemployment at one of its lowest readings and nearly a million confident job-hoppers maximizing their earnings and career prospects.

Still, "run for the hills" sounds like the order of the day.

Perversely, Wall Street sees salvation in signals that China might concede to kick its door ajar, with promises to protect American intellectual property and to put an end to forcible technology transfers.

But the U.S. financial community is unmoved by the country's calamitous trade imbalance with China, and the fact that Beijing's talk about opening up and meeting, on its own terms, some of Washington's demands for regulatory changes will do nothing to stop China's soaring trade surpluses with America.

Defend US trade and let the Fed focus on price stability

That is unfortunate because, with monetary and fiscal policies having no room for active support to economic activity, U.S. net exports should be the only sustainable source of stimulus to demand, output and employment creation.

Wall Street should know that better than anyone else.

The easy monetary policy — or, more precisely, the 10 years of monetary crisis management — has run its course. Excesses exemplified by the banks' loanable funds of $1.5 trillion (as of Jan. 2) and the Fed's monetary base (M0) of $3.4 trillion are huge structural aberrations. They are sequels to desperate measures of keeping afloat a profoundly destabilized U.S. economy. During the pre-crisis times in 2007, banks' excess reserves fluctuated around monthly averages of $1.5 billion to $2 billion, while the monetary base remained at relatively stable levels around $800 billion.

Fiscal policy is an even more impaired instrument of demand management. The public sector deficit of 6 percent of GDP, and the gross public debt of $22 trillion (108 percent of GDP), are showing that the U.S. is in an acute phase of a worsening fiscal crisis.

With the primary budget deficits (budget balances before interest charges on public debt) of 2.5 percent, the U.S. public debt is on an unstoppable upward trend. Just to stop the spiraling debt, the primary budget must shift to steady and sustainable surpluses of 3 percent to 4 percent of GDP. A far cry indeed.

So, a rapidly improving trade balance is the only thing that could serve as a strong prop to U.S. economy.

That's what Wall Street should be rooting for, instead of carping about Washington's trade wars. Losing half-a-trillion dollar of purchasing power on an annual basis, America has been a victim — a trade war victim — of Chinese, European and Japanese mercantilist policies. Remember, those trade deficits are subtractions from the U.S. GDP. Over only the last five years, trade deficits have reduced the U.S. economic growth by a total of about 2 percentage points.

And the U.S. stands accused of waging a trade war!? So far, the rising U.S. trade deficits show that President Donald Trump's administration has offered no defense to stop the huge erosion of America's external accounts.

But there is one thing you can count on: With no progress at all on balancing the U.S. trade, and no room for additional fiscal stimuli, the markets, Congress and the White House will all gang up on the Federal Reserve to do the heavy lifting — put more money in to keep things going.

The Fed's best line of defense is to stick to its mandate of price stability. To those arguing that there should be a flexible pursuit of that mandate, the Fed can easily explain that accelerating inflation is incompatible with high employment and faster economic growth.

The ECB sets sound foundations to EU economy

The mechanism is simple: Rising inflation expectations lead to increasing bond yields, and the ensuing arbitrage along the yield curve forces the Fed to respond with increasing money market rates. All that inevitably leads to weakening demand in labor and product markets, growth recessions or worse.

The European Central Bank does not need that pedagogy. Arguably, the ECB is Germany's greatest contribution to the project of the European economic and political union. (That contribution was forced by the French, but that's another story.)

In exchange for giving up their Deutsche Mark, Germans demanded, and got, two fundamental concessions from their euro partners. First, price stability, defined as an inflation rate in the range of zero percent to 2 percent, is the ECB's main policy mandate. Second, by design, the ECB has been set up as a genuinely independent supranational institution.

And so it is. The ECB withstood Berlin's legal assaults at Germany's Constitutional Court in Karlsruhe and at the European Court of Justice in Luxembourg.

Undeterred, the German plaintiffs argue that the justices did not understand their brief, and they keep accusing the ECB of conducting loose monetary policies that are killing the incentive of fiscal miscreants to tighten their belts. In other words, Germans would like to throw back into a recession countries like France, Italy, Spain, Greece, etc.

The ECB ignores all that noise and continues to act in accordance with its mandate: The euro area's headline inflation rate in December was down to 1.6 percent from 1.9 percent in the preceding month, and the core rate of inflation (CPI less food and energy) remained stable at 1.1 percent.

In that remarkable environment of price stability, the euro area has roughly balanced its public sector accounts, the gross public debt has declined toward 100 percent of GDP, and a surplus on goods and service trades now amounts to a whopping $560 billion, or 4 percent of GDP.

The only question — which is outside the ECB's remit — is whether Germany will lead the euro area surplus countries to expand their domestic spending in order to facilitate the adjustment of deficit countries in a general framework of growing demand and employment.

Investment thoughts

Wall Street has to understand, and support, U.S. attempts to stop, and reverse, the country's growth-killing, excessive trade deficits with China, Europe and Japan.

It also has to be understood that the Fed's focus on price stability is the best policy to maintain and enhance sustainable growth of demand, output and employment.

The ECB's institutional and functional independence is the example of a successful pursuit of price stability — even in an environment that lacks the unmatched flexibility of American labor and product markets.

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He 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 Business School.