The stability of the international monetary and financial system is a global public good and, as is well known, the provision of public goods gives rise to collective-action problems: countries may be tempted to free ride on each others’ efforts to preserve international stability. One of the most challenging manifestations of the collective-action problems that the global community is currently facing is the threat of currency wars. If key global players were to manipulate the exchange rate seeking to steal each other’s aggregate demand and net exports, the economic outcome would undoubtedly be suboptimal from the point of view of the global system, as past experiences with beggar-thy-neighbor policies have indicated.
A central mission of the G20 is to address global collective-action problems. According to its mandate, it must “promote constructive discussion between systematically important industrial and emerging economies on key issues related to global economic stability”. It is not surprising, then, that the recent meeting of G-20 leaders in November attracted so much attention.
The Communiqué issued at the end of the meeting addressed the issue of currency wars; it says that the G-20 members will “refrain from competitive undervaluation” of their currencies and “move toward a more market-oriented exchange-rate system”. This declaration, nonetheless, looks rather timid in light of the international situation and reflects a structural weakness of the G-20: its mandate does not contemplate specific mechanisms to enforce international cooperation. Although “constructive discussions” could eventually result in the implementation of mechanisms to enforce a particular agreement, the G-20’s main contribution to solving collective-action issues is to provide a framework for consensus-building and to nurture mutual confidence. This means that the central task of the G-20 should be to identify common interests, as well as potential areas of conflict between the members and design policies to secure international stability.
In light of recent G-20 activities concerning the most pressing collective-action challenge –the threat of currency wars– the following points are worth highlighting.
(1) The US agenda has led the discussion in Korea to the detriment of a proper assessment of the spillover effects associated with advanced countries’ policies. Prior to the meeting, Treasury Secretary Timothy Geithner sent a letter to other G-20 participants saying that countries should reduce current-account imbalances to “below a specified share of GDP over the next few years.” Reflecting this, the Communiqué said that “persistently large imbalances will be assessed against indicative guidelines to be agreed” (the US proposed establishing a 4-percent limit on current account surpluses and deficits). Likewise, the FED anticipated that quantitative easing will be more aggressive if the threat of deflation and high unemployment persists, which means that the dollar is likely to continue to weaken.
Of course, it can be argued that a weaker dollar does not represent an attempt to free ride because some currencies (notably the renminbi) are undervalued. However, a weaker dollar would also affect other emerging countries that have not implemented “mercantilist” policies. This is particularly the case in the Latin American region. For example, the Brazilian real has appreciated substantially and persistently in recent years; the country is running a current account deficit and the export basket is “deindustrializing”. Having to deal with both strong Chinese competition and a weak dollar is far from growth-friendly for semi-industrialized emerging countries.
(2) The policy exercises do not properly reflect the emerging world’s vulnerabilities and policy constraints. In order to assess the global consistency of policies, the G-20 has called on the IMF to conduct a Mutual Assessment Process (MAP). The MAP makes a grouping of countries that is functional to the analysis of global imbalances from the point of view of advanced countries –the basic distinction is between surplus and deficit countries. But it is central to include other asymmetries in the exercise.
First, in a globalized world national policies are interconnected, hence, the MAP exercise should distinguish between the G-20 countries that are policy shapers and those that are policy takers. Most emerging countries (with the notable exception of China) fall into this latter category. For example, concerning monetary policy, the US has the option to move first; if the FED adopted a more expansionary monetary policy, the emerging countries would have no option but to adapt their domestic policies accordingly. Brazil and other emerging G-20 members are facing difficult-to-manage capital inflows, which increase the likelihood that a bubble or a significant misalignment in the real exchange rate could occur. Brazil and other countries have been implementing corrective policies, such as higher taxes on capital movements and reserve accumulation. Although emerging countries are policy-takers, when taken together, their policy responses do have important effects on the global economy and the result may be sub-optimal.
Second, the available policy space differs between countries. In effect, those countries that have a stricter control over capital movements and are prepared to actively manage the nominal exchange rate are in a better position to deal with policy-induced externalities. This is the case of China. Those countries in which the obstacles to capital movements are softer and have a flexible exchange rate regime, in turn, are in the worst position. This is the case of many Latin American countries. The differential ability to deal with shocks originating in the global economy should be incorporated into the consistency exercises.
(3)The increasing vulnerability of the emerging world may jeopardize global recovery. The nature of global collective-action problems has changed substantially since the creation of the G-20 in 1999. The main sources of potential instability are now located in the advanced rather than the emerging world. Indeed, to the extent that the growth prospects are much stronger in the emerging world, emerging economies are now perceived to be part of the solution: higher emerging growth is expected to strengthen aggregate demand in advanced economies. Furthermore, if growth were accompanied with currency appreciation in the emerging world –especially in surplus countries– it would be easier for developed countries to increase domestic savings and to increase net exports in deficit countries. It is precisely the latter that creates the incentives for free riding (i.e. currency wars).
In a currency war context, policy-taker countries with reduced policy space will bear the bulk of the costs and this may result in the collapse of growth in the emerging world. The attempt to free ride will be self-defeating in a world in which “the global economic recovery continues to advance, albeit in a fragile and uneven way”, as the Communiqué states.
In sum, if the G-20 is going to contribute to solving global collective-action problems, more emphasis should be placed on the discussion of the following points:
a. The expansive monetary policy in the US and other advanced countries increases the likelihood of bubbles in the emerging world. If these countries implement tighter self-insurance policies in response, such as reserve accumulation and tighter control on capital flows, global imbalances will worsen.
b. The experience of the most successful countries indicates that export-led growth strategies work. It is unreasonable to expect the emerging countries to be eager to explore new “unproven” strategies in a highly uncertain international context. The policies aimed at increasing domestic demand in surplus countries should not crowd out emerging exports.
c. Natural resource-rich countries face the continuous threat of Dutch Disease and excessive capital inflows. It is only natural that they resist excessive currency appreciation and this is good for the global stability to the extent that it contributes to reducing macro vulnerability.
d. Emerging countries are basically policy-takers and have reduced policy space to operate. The advanced world should not overestimate the capability of these countries to manage stressful macroeconomic situations. The G-20 should incorporate a better assessment of the externalities associated with the policy decisions that developed countries make.