The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Can today’s political classes confront the very serious problems that we face in a way that both satisfies the desire of many for a more integrated world economy, and satisfies the very legitimate concerns of people who have seen their living standards decline and feel that they have been the losers from globalization?”
– Jeffry Frieden
Kevin: We have a guest today, David, Dr. Jeffrey Frieden. But before we get to that, I just want to mention, because this ties into the nature of his area of expertise, I had a call just before we came into the studio today from a client of mine, a guy I’ve known for decades. He is an Illinois farmer and he said, “Kevin, my father told me a little bit of inflation is really a good thing.” It gave us a chance to discuss there are winners and losers for monetary policies. You have people who win, like farmers, in an inflationary policy when their grains are going up, gold owners, who win, possibly, to a degree, when inflation is going up. But you also have losers on the other side. There seems to always be a political choice for monetary policy.
David: This is one of many areas that Jeffry has focused his research on, and in a recent book, Currency Politics, which is coming out in paperback here in the month or so, he looks at the regional, the national, the global priorities which are served when you have a particular monetary system in place. So whatever your exchange rate policy is, it does help fashion the context for who will win and who will lose in a given period of time. And so that exchange rate policy, again, whether it is the gold standard or a fiat money standard like we have now in the post Bretton Woods period. There are winners and there are losers, and there is no accident in terms of the policy choices that are made and who those targets audiences are, as an expression of who is intended to drive growth in the economy.
Kevin: Let’s go ahead and go to a policy decision that we have seen in action at least for 15 or 16 years. Actually, no, I take that back, it goes back 25 or almost 30 years, the Greenspan years, moving into Bernanke, moving into Yellen. The decision has been made that a little bit of inflation is a good thing and so they have quantitatively eased, they have printed, they have lowered interest rates. They have done a number of things trying to create this regime, it’s a political decision, and yes, it has lifted asset prices, but there have been losers on the other side.
David: That’s right. And this is where I think you are beginning to see something of a populist uprising in the area of politics where people are saying enough is enough.
Kevin: And fists are flying.
David: And fists are flying. So, fisticuffs, whether it is the left side of the aisle or the right side of the aisle, there is a dissatisfaction with the status quo. And I think there is an interesting correlation between monetary policy and political temperature.
Kevin: And there is a gap that has been formed. There truly are the rich, the very rich, and the very, very rich, getting richer – and the poor not able to actually make it on a monthly basis. Look at health care costs and food.
David: It may not be immediately obvious, the connection between an exchange rate policy, or monetary policy, and political volumes and rancor, but you do find if you are looking at history, there is an interesting overlay, the conversation that is had about exchange rate policies and the priorities that individuals have, the priorities that these individuals grouped together into constituencies have. And I think it is driven by the sense of, “Something’s not right, something not fair, something’s not working for me. I want a better opportunity.” And again, it is bred out of a dissatisfaction, but you look at the history of an exchange rate policy and there is something there driving those feelings.
Kevin: And given the fact that we are in a political year, we’re in an election year, a lot of times we can be distracted thinking that we’re arguing about politics when in reality it may have origins in monetary policy.
David: And so why am I interested in the grand picture, in a conversation with Jeffry? In part, because I’m interested in what the global monetary system looks like in the 21st century. And it will change. It will change dramatically. Will it be something that embraces digital technology and moves us toward a more-or-less cashless society? Or are we talking about hatching something like the Bretton Woods agreement in 1944? Who will lead in that environment? Is it the U.S. dollar? Will we take second place, no longer playing 1st fiddle, but 2nd fiddle, on the world stage? This is very important, because there are benefits conferred, as well as costs conferred, to the person who has reserve currency status. And to lose it has implications for various constituency groups. There would be winners and losers. And to help us sort out who the winners and losers are as a consequence of a changing monetary regime, we’re having a conversation with Jeffry.
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David: Let me start with something foundational. Jeffry, thanks for being on the program. How do particular exchange rate choices, whether we are talking about the regime, itself, or the level, affect constituents, or economic agents?
Jeffry: First of all, it’s a great pleasure to talk to you, especially about my obsession, which is currencies and exchange rate policies which I think gets far too little attention from both the public in general, and people who are interested in business. Your question is absolutely central because I think that we all recognize how important exchange rates are. We recognize that a lot more now than we did 10 or 20 years ago, but in today’s world of exchanges rates, whether it is the trials and tribulations of the euro, or current concerns about the Chinese currency, or collapses of things like the Brazilian currency, they are quite central.
And I think everyone recognizes now that exchange rates are immensely sensitive to national government policy and we all know that government policy is immensely sensitive to political pressures. So your question is central to what I’m interested in, what I do, and I think it is also central to some of the most important issues in the international economy.
You ask about two dimensions. The first is the regime, and the second is the level of the exchange rate. The regime is whether the currency is more fixed, or more floating. Let’s think about it in terms of people. The people who are most likely to want a more fixed, a more stable, exchange rate, are people, not surprisingly, who trade across borders and across exchange rates, across currencies – international traders, commercial interests, financial interests, borrowers, lenders.
One of the most important people along these lines is people who have a lot of foreign currency debt. If you have borrowed a lot, if you’re sitting in Lithuania, or in Brazil, or in India, and you’ve borrowed a million dollars if you’re a firm, or $100,000 if you’re a mortgage-holder, and that debt is denominated in dollars, the last thing you want is for your currency to depreciate because that is going to dramatically increase the burden of your debt. So those are the people that want the exchange rate to be stable. Also, people who want monetary stability, low inflation, because a fixed exchange rate typically brings along with it low inflation.
On the other side, people who want a flexible exchange rate are people whose goods are very sensitive to prices that are in competition with foreign competitors, foreign producers. So American farmers, American manufacturers, and farmers and manufacturers everywhere typically want exchange rates to be able to devalue or depreciate if they’re facing competitive pressures.
That brings us to the second dimension, which is the level. The people that are the most harmed by a strong exchange rate, that is, an appreciated, or strong currency, are precisely those people who produce goods that enter into world trade. We call them tradables producers – manufacturers, farmers. If you’re competing on world markets, or on your domestic market, with foreign products, the stronger your exchange rate is, the more expensive your products are. So, if you’re an American farmer, or an American steel worker, or auto maker, the stronger the dollar is, the more expensive your products are, both to Americans and to foreigners, and that is why when the dollar is strong, the opposition, the complaints, come from the farm community, they come from the manufacturing community.
That is why, for example, I would say that one of the reasons the current presidential campaign has seen so much discontent in the industrial states, and so much concern about trade, is that the dollar is very, very strong. The strong dollar is putting a lot of pressure on American producers of goods that enter into world trade. Those are the ones who want a weak currency. Is there a trade-off? Is there something good about a strong currency? Well, yes, a strong currency gives Americans, taking the case of Americans, a lot more purchasing power.
Americans live in a pretty closed economy with the reserve currency. When Americans think about the effect of a strong currency, mostly they think, “Well, if the dollar is strong I can go to Europe a lot more cheaply, or go to Mexico a lot more cheaply, or go to Canada a lot more cheaply, all of which are true. But think of that in a broader context. A strong dollar means we can buy more of the world’s goods and services; our purchasing power is higher. So consumers benefit from a strong dollar.
If you want to put that in the starkest possible terms, the trade-off the government faces when it is faced with trying to see whether it wants a weak currency or a strong currency is that a weaker currency buys you competitiveness in world markets and allows your producers to sell a lot more, and to produce a lot more, both for domestic and foreign consumption. What could be wrong with that?
But the trade-off is, you do that and you are physically taxing your consumers. So a strong currency helps consumers, and a weak currency helps producers of created goods and services. That is a big contradiction, and it’s not a solvable one. You can’t split the difference. You have to make a choice.
David: When you look at the 19th century, we had an example where perhaps the agrarian economic bias was obvious and a great outcry against the gold standard. That deflationary period set in motion by the gold standard, to some degree favored households, and yet, household consumption was really not the driver of the economy that it is today. How is it that in the 19th century even though one of the largest segments in the economy was arguably hurt by the gold standard, why was that constituency not paid attention to?
Jeffry: First of all, let’s set the stage. I’m a professor, so you can’t take the short answer to any question, so this will be, perhaps, the longest answer, but I think it is important to set the stage. You talk about deflation and people think of the 1873-1896 period as one of generalized deflation, but it wasn’t. It was a generalized decline in farm prices because of the opening of the pampas and the prairies and the great plains in Australia, and also shipping and technology and railroads, farm prices and mining goods prices plummeted by about 50% over the course of that 25-year period. So it was the farmers who were getting hammered.
And if you were on the gold standard, that meant that other prices, like railroad transportation, or of your debt, or of housing, were pretty much stable, but farm prices were collapsing. And that’s why the farmers in the U.S. wanted us to go onto either silver or onto a paper currency. And in fact, in almost every other farming country in the world they did go onto silver or a paper currency. So that’s the stage being set.
Now, the question you might ask is, where was the support for the gold standard? The support came largely from the international financial and commercial sector. American banks were powerful then. American banks at the time, J.P. Morgan and predecessors of Chase and Citi, their principle activity was convincing foreigners to lend to the United States. These were banks that were international in the sense that they were going to Europe and convincing European investors to invest in the U.S. And you could not attract foreign capital to the U.S. if the U.S. was not on the gold standard. Foreigners, Europeans, British, French, German investors, would only lend to governments that were on the gold standard. There were some instances in which there was fear about the U.S. going off the gold standard.
And actually, Milton Friedman, right before he died, wrote a couple of articles on this. He showed that every time there was even just a hint of fear that the U.S. would go off the gold standard, the interest rates charged to the U.S., both to private borrowers and public borrowers, rose by 2-3%, that is, they almost doubled. So the principle supports of staying on gold, going onto gold and staying on gold, were those in the international financial and commercial community. You say, “Why weren’t the opponents, the farmers, listened to?”
I guess there are two answers. The first is, they were listened to. The populist movement was a huge mass movement. And in fact, throughout this entire period, Congress was always majoritarian against the gold standard. There was vote after vote after vote to stay off gold, or to go off gold. All those votes were vetoed by the president, so the executive, actually, in a sense, stood up for gold, while Congress was almost always opposed to the gold standard. I don’t want to get into the details of how this was able to be managed by the executive, but if there had been public opinion surveys in 1873 or 1896, I’m pretty sure a majority of Americans would have been opposed to the gold standard. But I think there was attention paid, it just didn’t win.
There is an analogous puzzle, if you will, in political economy, which is, why is it that poor countries almost universally tax their farmers while rich countries almost universally subsidize their farmers, even though in poor countries farmers are the majority, while in rich countries, farmers are a tiny, tiny minority. So, just because you’re a majority doesn’t mean you’re going to get your way. Politics is not always one person, one vote. That may be a surprise to some people, but I doubt it.
David: In the choice of a currency regime, are there embedded assumptions about how we should grow as an economy?
Jeffry: Yes, I think very much so, and we can see this both in the gold standard area, and I think today, in Europe and elsewhere, a fixed exchange rate, in addition to the generalized stability that it brings, is a tremendous incentive to, or assistance to, cross-border economic exchange. There have been studies done on this, and the smallest estimate we have is that having a fixed exchange rate increases trade between two countries by 30%. Now, 30% is a lot. We couldn’t increase trade if we signed all the free trade agreements in the world today, trade between the U.S. and the rest of the world would not increase 30%. So fixing the exchange rate has a big impact on increasing trade. It also probably has a bigger impact in increasing cross-border investment, cross-border finance. So, if you’re someone who believes that globalization, to use the current buzz word, is a good thing, then a fixed exchange rate, or a common currency, is a good way of encouraging global economic integration, and we see that in Europe. The Europeans, really since the 1960s, have believed that to have a truly integrated single common market, they also had to have a common currency. So, if you want to associate a fixed rate with a particular attitude toward the world economy, I would say people with a strong supportive belief in the value of global economic or regional economic integration are more likely to support a fixed exchange rate.
David: You argue that currency policy is about as powerful as any single economic policy can be, and you frame that by saying that currency values have a powerful impact on the wellbeing of important economic actors, and indeed, the fate of national economies, more broadly. From a political perspective, isn’t the choice of currency system an expression of preference for one constituency over another?
Jeffry: You’re absolutely right. Life is full of trade-offs and politics and economic policy is no exception. When you choose to fix the exchange rate, you are giving up a very, very powerful tool of macro-economic policy. When you think of the 2008-2009 crisis, the principle response of all of the major economies to that crisis was in monetary policy. Now, we could argue about whether the response was correct or not, but I don’t think anyone would disagree that if countries had not had some ability to respond to the crisis with monetary policy flexibility they would have been in big trouble.
And in fact, we have an indication of that. There were countries in the eurozone that didn’t have a monetary policy of their own, that is, they were either in the euro or they had fixed their exchange rate to the euro, and they had a terrible, terrible time. The Baltic states that were fixed to the euro because they wanted to join the eurozone and eventually did joint the eurozone, they saw their GDPs drop by 20-25% in a year. They saw their unemployment rates go from 4 to almost 30% in a year, because they didn’t have monetary policy as a tool. So, yes, there are great values to having a fixed rate, but there are great costs, as well.
How does a government choose between the benefits and the cost? Well, I think, being a political economist, they choose on the basis of the kinds of political pressures that they are responsive to. Sometimes governments are more responsive to the broad electorate, like when an election is coming, and sometimes governments are more responsive to powerful concentrated special interests, like maybe in normal times. There is a very common observation, for example, in Latin America, that no government will devalue the currency in the run-up to an election because what that is doing is impoverishing the mass electorate. But at other times maybe they are less concerned about the electorate.
The specific answer to your question is, governments face very difficult political trade-offs, and how they make choices based on those trade-offs is largely something that is played out in the cauldron of domestic politics. It is not really a technical economic issue. There are good economic arguments for virtually any exchange rate regime or virtually any level of the exchange rate. It is really a political question.
David: I can hear one of our previous guests almost jumping in halfway into your answer there and saying, “Yes, the macro-economic policy interventions were very effective.” This is Jim Grant that comes to mind.
Jeffry: (laughs) Okay.
David: And he would say that being on the Ph.D. standard, as opposed to the gold standard, meant that it was monetary policy that probably got you into that mess that you were hoping that monetary policy was going to clean up anyway. You were supposed to be leaning into the wind, not operating in a procyclical [going up and down in concert with the economy] manner. Is there a fair assessment to this idea that, yes, macro-economic policy, using monetary policy to drive the economy forward, in an intervention mode, can be very helpful. But you also have to apply some disciplines and organize yourself according to some rules so that you cannot just have a procyclical bent.
Jeffry: Absolutely. I can’t say that I agree with everything that Jim Grant says, but he certainly has a very good point on this, as you mention, in the run-up to the 2007-2008 collapse. Both in Europe and in North America you had extremely low real interest rates. There was some justification for that after 9/11 and after the recession of 2000-2001, but I think John Taylor has made a very convincing argument that those real interest rates in the U.S. were kept way too low for way too long. Whether that was done, as you say, on the Ph.D. standard or for political reasons, because Alan Greenspan wanted to get reappointed or he wanted to help George Bush get re-elected, or whatever the reason might have been, is something we could argue about.
I think a related point, which I think Jim Grant probably wouldn’t agree with, is, sure, monetary policy was probably too loose in both instances, but we have another tool of macro-economic policy which not only was not used between 2000 and 2008, but inasmuch as it was used, it reinforced the procyclicality of monetary policy, not fiscal policy. So what happened in that period was that in the U.S. we had a very expansionary fiscal policy because of the tax cuts of 2001 and 2003 that really put the monetary policy stimulus on steroids, and some would argue that it was fiscal policy stimulus, procyclicality and fiscal policy, that really contributed to the bubble as much as monetary policy, or at least, the two of them played a major role.
And the same thing in Europe, so you had these bubbles developing – Spain, Portugal, Ireland. Forget about Greece, it was a special case. Spain, Portugal and Ireland were experiencing the kind of housing bubbles that we had, entirely private, private lending to private borrowers – this was not the government borrowing. So you had these bubbles developing. The government could have responded with fiscal policies designed to try to slow down these overheated economies, but it didn’t. Nor did the Germans respond to stagnation in Germany with countercyclical [moving up when the economy goes down, and vice versa] fiscal policy.
So, there are two big tools in the arsenal of macroeconomic policy-makers. There is monetary [central bank control of the money supply] and fiscal [government spending] policy. One of the great mysteries of the last 15-20 years is why it is that policymakers have relied so heavily on monetary policy while fiscal policy has, with some minor exception, been more or less absent, or when used, has been used in ways that most macroeconomists would say were foolish. And easy answer would be, “Well, the voters don’t like taxes to be raised, or don’t like governments to run budget deficits, but that is too easy an answer. The last 15 years look very different from the previous 20 years, so I think there is a puzzle as to why governments have not been more active on the fiscal side given that there have been some serious problems that have had to be addressed.
Another way of approaching it, David, would be to say – again, let me put my political economy hat on and say, procyclical policies are politically very attractive. Remember what William Chesney Martin once said about the job of the central banker? The job of the central banker is to take away the punchbowl just when the party gets started. No one likes that. No politician wants to have to put on the brakes when the economy is growing. So procyclical policies are politically attractive, countercyclical policies, not so much.
David: And that does raise the question of how much of a gap there is between the political class and the Federal Reserve. There is supposed to be political independence, and yet procyclical policies on the monetary policy side would seem to still have some influence. Maybe that is in specific administrations, Arthur Burns might have been more susceptible to that than others (laughs).
Jeffry: He was the poster child, yes.
David: Coming back to this issue of globalization, does the preference for a particular currency system change as you go through distinctive phases of globalization? For example, when growth slows and the political conversation turns inward to more domestic versus global issues, is there then, all of a sudden, the change of preference in terms of monetary flexibility?
Jeffry: Yes. Well, if you don’t mind, I would like to say something about your first question, because I think it is a very important one, and one that is really misunderstood. People talk a lot about central bank independence and most people are in favor of it, at least in principle. The reality is, there is no central bank in the world that isn’t sensitive to politics because central banks are creatures of governments. The Federal Reserve could be closed down tomorrow if Congress wanted to close them down, so it has to be sensitive to the political environment. Now, they will never say that publicly, but it is the reality.
And there used to be – I can’t remember who it was, but I think the chairman of one of the House banking committees that said that whenever the chairman of the Fed would come testify he, the congressman, would make sure that there were at least half a dozen bills in the hopper reducing the independence of the Fed. So central banks everywhere are navigating some difficult political shoals, and they have to. Listen, they are creatures of government. They weren’t created by Martians, they didn’t drop from the sky, they are creatures of government. And they are political, they have to be politically sensitive, and that is probably a good thing, but you want it to be in moderation. Where that moderation stands is a matter of debate, I suppose.
On your point about globalization, yes, I think that if I were to identify the stages, if you want to use those terms, of the kind of exchange rate policies that countries pursue, I would first set to one side a country like Britain during the gold standard era, or the United States today, which are reserve currency countries. They’re different. They’re the sun around which the solar system of the world monetary system revolves. So let’s set them to one side and think of countries that are growing rapidly.
Countries that go through a cycle of growth, countries that are growing rapidly, typically should have flexible exchange rates and relatively weak exchange rates, like the East Asians. The East Asian model, although it comes into criticism and complaint because it leads to lots of exports, or imports from our standpoint – what they are doing is trying to encourage their producers, with a weak flexible exchange rate, to produce more and more goods that are of world class quality, that are of world class technology, that are able to be sold on world markets. They are sort of forcing their producers into world markets.
The counter-example is the Latin American countries, or many African countries, that for years had very inflexible and very over-valued exchange rates. And what happened there was they got industrial structures that were incapable of competing on world markets. When they opened their borders they found that there wasn’t much they were producing in their factories that anyone wanted to buy. So as countries develop, they typically would want to have more flexible and weaker exchange rates. But as they become more developed and their industries are more mature, if you will, and they are more competitive on world markets, then the stability of the foreign exchanges becomes quite a bit more important.
There is another aspect of this, which is, the more sophisticated your manufactured products are, the less sensitive they are to price movement, so the less you care about how strong the exchange rate is. Boeing sells commercial aircraft. They don’t really care about the exchange rate. They are selling on 10- or 15-year contracts. What they care about is stability and predictability. So as a country becomes more and more developed, its industry becomes more and more sophisticated, it becomes richer and richer, then typically the exchange rate strengthens and is more likely to be fixed.
That is why in the gold standard era, all the developed countries, pretty much, were on the gold standard with a fixed exchange rate, and all the developing countries, pretty much, were on a flexible, either paper or silver currency and a weak exchange rate. And that is the kind of stage that we see, even today, the developing countries, on average – not all, but on average – have relatively weak, relatively flexible exchange rates, and the developed countries, like the Europeans, can have much stronger exchange rates, and they tend to be more interested in maintaining stability.
David: You mentioned the East Asian model, encouraging producers, and China might be an example of that transition from one mode to another, as, at least if they are trying to pursue and implement the changes they suggested in the last five-year plan, move toward empowering the household, and the household sector. Do they do that by increasing the value of their exchange rate, encouraging an increase in compensation in the workplace, and how do they move away from encouraging producers to encouraging household consumption? Doesn’t this come back to a very important issue? This is tied to an exchange rate policy.
Jeffry: Absolutely. You are absolutely right. This is, I think, the overriding, overwhelmingly central issue in current Chinese politics and policy. They have done very well for the last 35 years with a very weak currency and throwing all their resources to the export sector. And what that has meant, effectively, as you say, is that they have transferred resources away from households, away from consumers, into the export sector. Now, China has grown so fast that even with this, consumers and households have done well. But you have to recognize, just look at the numbers, consumption just keeps declining as a share of GDP. They need to stop. They need to change this. The leadership, I believe, understands it. They need to change it for a variety of reasons. First of all, the world is not willing to accept unlimited quantities of Chinese goods. Secondly, their rapid growth has led to big increases in wages so that they are losing competitiveness in a lot of these sectors. A lot of the things that they used to be able to produce competitively are now being made in Vietnam or Bangladesh or other places And third, it is leading to social unrest. People are unhappy. They see the booming cities of export areas like Guangzhou and Shanghai, and that prosperity is not reaching the interior. So I think the Chinese leadership is well aware that they need to turn things around and try to direct many more of the resources toward the household sector, toward the domestic economy.
But a national economy, especially a national economy of 1.3 billion people, is not a car. You can’t turn it around on a dime. And it’s not really a technical issue, either. It’s an issue of re-orienting, or re-balancing, the entire social, political and economic order away from these coastal manufacturing, exporting regions, and toward the vast majority of Chinese people who live in the interior. And most political power in China resides in the export regions, resides in the coastal regions. To change that around will be very, very difficult, and probably the single biggest marker is the exchange rate. If the Chinese government is able to manage a substantial appreciation, upward movement, strengthening, of the renminbi over the next five years, that will be an indication that they have been successful at trying to reorient the economy away from the export sector and toward domestic production for domestic consumption.
So far, I would say, the jury is still very much out. When the crisis hit in 2008, what did they do first? They depreciated the currency. They have allowed it to float upward since then. Their surpluses have declined. I’m not going to say anything could happen, but I don’t know what is most likely to happen in China. I think it is one of the great questions we currently face. Are they going to be able to deal with all the macro-economic and micro-economic problems they have with failing companies, with nonperforming loans, and re-orient their economy toward domestic production for domestic consumption, toward the household sector? I sure hope so, because if they’re not, it’s going to have a big negative impact on the rest of the world economy, but it will not be an easy task.
David: You mentioned Britain and the United States as reserve currency systems, kind of different than other kinds of exchange rate policies and exchange rate systems, the sun around which others are oriented. The last time an international monetary regime was constructed, it centered on the U.S. dollar, in large part due to the championship of Harry Dexter White. Who would the U.S. dollar champion be today in a Bretton Woods style negotiation, or has there been so much that has changed since 1944 that you would be talking about a fundamentally altered construction?
Jeffry: I think it would be a fundamentally altered construction. You’re right, that was the last time a world monetary system was constructed. It was also the first time. It was the only time that countries, governments, sat around a table and said, “This is how we want the international monetary system to be constructed.” All the other international monetary orders just happened. And I have a feeling that that is probably what is going to happen over the future. At best, what we will see is some increased cooperation among the major governments, the G7 perhaps, or G7 plus a few more, among the major governments of the world, to try to feel our way toward a new international monetary order.
There will be people in the U.S. who would like that monetary order to be explicitly organized around the U.S. dollar. I don’t know what names I would attach to those, but certainly they would be people in the financial community, I suppose. They would benefit from having the dollar as the world’s reserve currency. And maybe people who feel that the U.S. deserves a greater place in the sun. But I don’t think that’s likely to happen. Although the U.S. dollar is crucially important, and is the world’s principle reserve currency, I don’t think that the eurozone, the European Union, the ECB – I don’t think that the Chinese are likely to agree to a system in which the dollar has the kind of privileges that it did during the Bretton Woods system.
Now, we had responsibilities as well, but we had a lot of privileges. So I don’t see a lot of prospects for an explicitly dollar-centered international order. What I think we are more likely to see is two or three main currencies, the dollar, the euro, maybe eventually the renminbi, all of which will be important, and among which I hope there will be cooperation among their monetary authorities to avoid competition, to avoid competitive devaluations, to avoid crises, and to deal with crises if they arise, but I think we are much more likely to move toward a bipolar or tripolar monetary world than to go back to something like the Bretton Woods system.
David: Barry Eichengreen points out that by the 19th century about 60% of world trade was invoiced in pounds sterling, and, not surprisingly, we find the pound sterling and its gold backing as the basis for the global monetary system, with Britain as the nexus of that particular episode of globalization. And then you fast forward to another period of globalization and it’s based on a currency related to gold, this time the U.S. dollar, and the nexus is the United States, this nexus of the next leap forward in terms of global growth. Are we talking about something that relates to trade? Are we talking about growth that was allowed on the basis of the stability enabled by the gold standard in both cases of major globalization?
Jeffry: A very interesting question, and let me make a couple of points. The first is, the gold standard era was one in which both trade and finance and investment were central to rapid economic growth. It wasn’t just that Argentina or the U.S or Canada could zoom forward economically by exporting to Europe. It was also that they could borrow huge amounts of money by the standards of the day, huge amounts of money in order to build the railroads, the canals, the factories, the ports necessary to jump into that global economy. So the gold standard era was one in which both trade and finance were crucially important.
The Bretton Woods period from 1945 until 1971 or 1973 is a period in which it is mostly trade. Most countries had capital controls and international finance was dead for a large part of that period, only gradually reviving toward the end. So international finance and international investment were not central to the growth of the world economy between 1945 and 1973. After the Bretton Woods period ends, starting in the 1980s and 1990s, then you get this huge upsurge in globalization via international investment and international finance.
And I would argue that today, in some ways, the leading edge of globalization is on the investment and financial side. Trade is important, of course, but international investment and international finance has really been leading the way. So there are different periods. Bretton Woods was a trade-based growth period. The current era of globalization in some ways is a sort of finance/investment/technology/R&D/knowledge economy-based globalization period. So there is a big difference there, I think.
David: I apologize, this is kind of a long question, but from an essay that Michael Bordo and Barry Eichengreen contributed to – this was a volume in honor of Charles Goodhart, where they were discussing financial crises of the past and present. They looked at industrial countries and there seemed to be less of a connection between banking crises and currency crises during the 1880 to 1913 period, again, sort of the gold standard era period. And there was a sharp rise in currency crises following on the heels of banking crises from the 1919 to the present period. That is one thing that I thought was interesting.
Then they also highlighted that there have been more currency crises since 1973 – this is post Bretton Woods – than any other period. So on the one hand there appears to be a containment or limitation with the crisis, simply to the banking sector as long as gold is in the monetary backdrop, but then absent gold and absent the Bretton Woods system, which still had something of a gold basis, post 1973, there seems to be – (laughs) I don’t even know how to say this – a crisis conveyance, or a continuance, into the entire currency system. What are your thoughts?
Jeffry: What your question reminds me of is the old canard that the one way to make sure that you don’t have any banking crises is not to have any banks. And that’s guaranteed. And so when you move from a specie-backed currency, that is, from the gold standard, or the modified gold standard of the Bretton Woods era, the financial system becomes much more important, because we know banks and the financial system create money in the ways that we understand. And so, critics have then talked about this as being the financialization of the economy, the overly great importance of the financial sector.
And that may be true, I don’t have a position on that, it is a difficult issue. But what is certainly true is that as we have moved away from a specie-backed currency, the role of banks in the economy has grown dramatically. The financial sector now plays a much more central role in the financing of investment, the financing of consumption, the financing of both household and industrial and government activities, than it did in Bretton Woods, or in the gold standard era.
Now, again, there are trade-offs. Yes, we have an incredibly efficient financial system that can move money, billions of dollars, around the world in a matter of seconds in response to very, very small movements in macro-economic conditions or interest rates. And that is tremendous inasmuch as what it leads to is moving money from where it is less needed to where it is more needed, moving money from where it can’t be used or is not being used productively to where it can be used productively.
But it also means that when there are problems, they get transmitted around the world with incredible efficiency, with great speed, and can cause the kinds of earth-shattering crises that we entered into in September and October of 2008. So yes, we are much more susceptible now in a fiat currency based system to financial crises and currency crises. But we also have the extraordinary benefit of the world’s most efficient and largest international financial system, the greatest ability to move money around the world that the world has ever known.
And I just want to say something about that, bracket that for a moment, because I know a lot of people say, “Well, that’s not a good thing. I saw the big short, that’s not a good thing.” You know, thinking about this in a global perspective, the greatest possibilities for increasing equality around the world, that is, for bringing the 5-6 billion people who live in poverty up toward middle class standards, is development. The real source of inequality in the world is inequality between rich countries and poor countries. And poor countries’ opportunities depend fundamentally on their access to capital. They don’t lack people, they don’t lack ingenuity, they don’t lack entrepreneurial sentiment, they don’t lack the desire to grow. They lack capital.
And so, if we’re going to see more Koreas and Taiwans and Chinas, more countries work their way out of poverty and into the middle class of the world, it’s going to be because they have access to this international financial system. So from a global development standpoint, the existence of this globe-straddling, very efficient international financial system is a great thing, but it brings with it lots of risks. I think the way to deal with that is to recognize the benefits of international finance, but to also recognize that governments need to do more to manage, control and regulate the riskiness of international financial transactions.
David: We heard rumblings a few years ago of a currency war. I think it started, perhaps, with the Brazilian finance minister, and there were others, of course, but I take that to mean a competitive currency devaluation. And they were particularly boisterous when we started our first and second rounds of quantitative easing, which they viewed as means of competitive currency devaluation. When you have a floating exchange rate system, what prevents a country from prioritizing their domestic political concerns via devaluation over maybe longer-term goals that relate to healthy international relations?
Jeffry: The only thing that prevents a country from acting unilaterally without concern for the rest of the world is that the fate of the rest of the world might have an impact on it. So that means that if you’re Costa Rica or Uruguay, you can do whatever you want because you know it’s not going to have any effect on the rest of the world economy. But if you’re the U.S. or China or the eurozone, then your policies are going to have big spillover effects on the rest of the world economy, and eventually on you.
So let’s go back to your question. When Guido Mantega – it’s ironic, because the complaints about currency wars, the Brazilians first complained that the U.S. was artificially weakening the U.S. dollar, which was hurting Brazil’s competitiveness.
David: As if they’ve never done that themselves.
Jeffry: That’s right, of course, the pot calling the kettle and all that. In the summer of 2013 rumors began circulating that the Fed was going to start tapering off quantitative easing and interest rates were going to rise. Those rumors led to a big increase in the dollar and a flood of capital out of Brazil into the U.S., and then Guido Mantega started complaining about the opposite. So for five years he complained that the dollar was too weak and then for the next three years he complained that the dollar was too strong. So, you know, some people just like to complain.
I mean, he had legitimate concerns and Raghuram Rajan in India had legitimate concerns, and their main concerns were that the U.S. was acting in such a way as to impose costs on the rest of the world economy and not paying enough attention to what their policies meant for the rest of the world. I think there is a germ of truth in that, but there is also the reality that, although she would never say it, Janet Yellen, when she and her colleagues make policy at the Fed, do worry about its effect on the rest of the world economy, because they know that if their policies cause a deep recession, let’s say, in Europe, or a financial crisis in China, it will come back to bite the United States. So since the constituency for the Fed is the U.S. and the U.S. Congress, she’s not going to go to the Congress and say, “We needed that policy, we implemented that policy because we were worried about its effect on China, or Europe.” But they’re thinking that.
Now, the way to square the circle in some sense is if the big countries really should worry and have to worry about the impact of their policies on the rest of the world, then what we need to do is recognize that explicitly, and set up some mechanism that allows for the cooperation or coordination of monetary and macro-economic policy among the big centers of international economic activity. That doesn’t exist today. They did this on paper with the G7 and the G20. But really, global macro-economic policy coordination or cooperation is a phrase, it is a wish list, it is not a reality.
I believe, and this is not saying that I believe in this normatively or ethically or morally, but I believe that because of today’s international economic realities, because the world is so financially integrated, because of the experience of the great financial crisis that began in 2008, the major powers will be driven toward more cooperation on monetary and macro-economic policy. They will find themselves under pressure from their own constituents, and from their position in the world economy, to work more closely together.
I think both that that is a good thing and that it will happen. And we see glimmerings of it going on, but it will be a slow process. It is very difficult for a national government, or a national central bank, to say, “We are going to make some sacrifices on our domestic policy front in order to contribute to a broader cooperative effort at the international level. Very difficult, but we do live in a very integrated world economy, and I think that the major powers are going to find themselves forced to do more of that in the future.
David: I’m not meaning to disagree with you at all here, it’s a question relating to Europe and what we see in terms of a greater huddling in Brussels, and yet also, a greater polarization in terms of an electorate, and to some degree, we have the same sort of populist polarization here in the United States between extreme right and extreme left. And let me bring this back to a specific question. You look at the European monetary system. You have member countries – will they continue a currency union bearing many of the pressures of a quasi-fixed exchange rate. They have the opportunity more than anyone to demonstrate what you just described as greater degrees of cooperation, and they have a framework in place that took them 30-40 years to put together, and yet it may not hold together.
Jeffry: Yes, you have identified what I think is the crucial nexus in everything that we’ve been talking about, which is, can today’s existing political elites, the political classes, and let’s just focus on the U.S. and Western Europe, and we could add Canada, Japan, if you want, but can today’s political classes confront the very serious problems that we face in a way that both satisfies the desire of many for a more integrated world economy, and satisfies the very legitimate concerns of people who have seen their living standards decline, and feel that they have been the losers from globalization?
There is a longstanding view in the literature in economics and political economy that says, if you have a policy like liberalizing trade, opening borders, that makes the country better off, but hurts some people, what you should do is undertake that policy, and then compensate the losers out of taxing the winners. It’s a Pareto improvement, to use the term of art, and it makes perfect technical economic sense. It is politically extremely difficult to do.
We can think about it in the American context. The recovery, which has been a substantial recovery since 2009, the benefits of the recovery have gone almost entirely to the top 25% of the American income distribution. Median household income today is substantially below where it was before the crisis, and that’s why people are so angry. They say, “What are you talking about recovery? I’ve had four spells of unemployment in the last five years. I can’t afford to make my car loans. I can’t afford to send my kids to college.” This is not a recovery that is affecting the average American. And there are ways of confronting that. They are not politically popular.
But I think that the reason that so many voters are so dissatisfied with political systems in Europe and in North America is that they feel that our political leaders have not adequately addressed the real problems that we face. That’s true in spades in Europe, and what you say about Europe is so depressing for someone like me who has followed European policy and politics for a long time. European gridlock makes ours look like child’s play. They have been stuck in a stagnant economy with, depending on how you count it, three recessions, for eight years now, and there doesn’t seem to be any forward motion.
And that is why you are getting extremists of the left and the right everywhere, all over Europe, because the political classes have completely lost the faith of their people. And this is the great crisis that I think we face politically. Politicians, political classes, governments, have to figure out how to take advantage of the benefits of globalization, take advantage of the world economy that we live in, with all the wonderful technologies and research and development and globalizations we have at our fingertips, take advantage of these things, and at the same time make sure that the impact of globalization on the average person is not as negative as they have been feeling it to be, whether that is because of integration or trade or finance, I think, in some sense, that is the crucial problem of the hour.
How do we realize the benefits of globalization and spread them widely enough that political and public opinion remains favorable to us? We’re not doing a very good job now. I’m optimistic because I’m an optimistic kind of guy, but I’m only guardedly optimistic. You look at some of the trends in Europe, you look at some of the trends in the U.S., and it is easy to see how things could spiral out of control if the prospects for global economic integration are not handled carefully.
David: Coming back to your book, you are exploring how closely monetary politics is to interest group politics and you test how, with past regimes, you demonstrate how there has been an intended distribution of benefits via the exchange rate policies. First of all, will we continue with the status quo? And tying onto what we were just talking about, what factors would shift the distribution a different direction? Is a radically conservative or a radically liberal president a sufficient catalyst?
Jeffry: First of all, the American system, due to the genius of the founding fathers, is one that is not very easy to turn in radical or extreme directions. We have a separation of powers that sort of voids that. But I do think that, however you want to think about it, I don’t care whether you want to think about it from the standpoint of Donald Trump or from the standpoint of Bernie Sanders, I think we have to accept that both of them are identifying a great source of discontent in the U.S., which is that, as I said before, the average household has not done well.
And when you look at a country that has grown tremendously since the early 1990s, and you see that median household income hasn’t changed in those 20-25 years, there is something wrong. And I don’t know if the solution is on a fiscal policy front. An easy answer that everybody always gives is that we need to improve our educational system. That’s easy for an educator to say (laughs) – we need to improve our educational system, we need to improve our infrastructure. There are lots of things we could do.
I think what we really need is – and this is going to sound very wimpy, but what I really think we need is a broad public debate or discussion over what we, as a people, are willing to pay for to try to make the country work better for the majority of its citizens. We have had national discussions over lots of issues in the last decades, over race, over gay marriage, over social issues. We have not had sensible discussions over how we try to ensure that we can both realize the benefits of economic growth and distribute them somewhat more equitably so we don’t get the kind of right wing or left wing populist pressures that we are now seeing.
That may seem like pie in the sky, but great political leaders are able to get people to focus on important issues, and I’m hopeful, again, optimistic, that at some point we will have the political leadership and the leadership from public intellectuals and others to allow us to try to think about these issues in a broader way, in a way that might help us think about resolutions to, or ways of addressing these problems, rather than coming at them with bumper stickers. The bumper sticker solutions are always wrong. All these problems are complicated. If they were simple, they would have been solved, right? So we need to talk about the complications, we need to talk about the problems, and we need to try to devise strategies to move forward that will include more people rather than excluding them. And as I say, it is a hope.
David: This next question kind of bridges between political economy and perhaps something that is more purely economic in nature. In the U.S. we have had our fiat currency. We have had a bimetallist system, the gold-silver standard. We had the gold standard, kind of a change on that theme as we had the gold exchange standard for a period, although not a currency exchange system per se, the Bretton Woods systems, post Bretton Woods floating fiat. You now have economists, and I’m thinking specifically of Michael Woodford and Ken Rogoff, who are championing the idea of moving and forcing an increase of aggregate demand by bringing the money system into an entirely digital world, allowing for greater ease of financial repression by running negative rates.
And it seems to me that some of the macroeconomic flexibility that we have via monetary policy continues to put households in an awkward position, and it may, in fact, do more harm than good. As we have been talking about this divide between the wealthy and those who have not come along, households were still struggling with income that doesn’t match what it was ten years ago. How does financial repression solve a problem? These are monetary policy tools, but they do tie into our existing currency system. I guess the real question is, what is next in terms of our monetary system? What is the way forward?
Jeffry: Oh boy (laughs). Well, both the great appeal of, and the great shortcoming of macroeconomics is that it focuses on macroeconomics. And the economy is made up of both macro and micro circumstances. When people like Ken Rogoff, who I have tremendous respect for, say, “These are policies that we need to undertake because the crisis-ridden nature of contemporary monetary and financial systems has imposed too great a cost,” I nod my head and say, yes, we need to do something to try to limit the damage that financial crises can cause. But every measure along those lines, as you indicate, has substantial costs. And so financial repression is going to hurt a lot of people.
I give talks publicly, and who goes to those talks? A lot of retirees, because who else has time to go to listen to someone talk? And the most common comment that I get is how do they expect us to live with these low interest rates? These are people who for a long period of time were used to 4%, 5%, 6% returns on their retirement savings, and now they’re lucky to get 1-2%, if they’re not losing. So there are winners and losers to every policy. Yes, financial repression of one form or another would limit the potential damage of a financial crisis, but it will create hardship for many others. And so I don’t think that’s a panacea.
I don’t think there are panaceas to any of these problems. As I said, if they had simple solutions they would have been adopted. I think that some combination of structural policies, what sometimes are called supply-side policies, like about education and the infrastructure, and incentives to entrepreneurship and things like that, R&D, are crucially important. I think that, certainly, fiscal policies that are more sensible, both from a tax side and on the spending side, would be a tremendous assistance.
We do need more spending on things like infrastructure, education, and macro-economic policies like some of the ones that Ken Rogoff and Carmen Reinhart and Larry Summers and others have talked about to limit the negative effects of financial crises, are also possible. I don’t think any one of those buckets of policies will solve the problem. I think some combination of them will help. They are all politically incredibly difficult to achieve, and that is the frustration. Political economy, in some sense, is the dismal science, because what political economy tells us is, whatever policies are currently in place, those are the ones that are going to always be in place because that is the political equilibrium that we have.
I don’t think that. I think that there is room for political leaders, for thought leaders, for political entrepreneurs, for interest groups to say, “We’re in a mess. We have to get out of it, we can’t keep doing what we’ve been doing. We can’t just pretend that we will circle the wagons and keep things going as they have been going.” I hope this is one of those moments in which we will start to get the political leadership and the intellectual leadership to try to find the combinations of policies – macroeconomic, microeconomic, fiscal, monetary – to get us out of our current bind.
David: Clearly, the conversation we’re having needs to continue, but we’re out of time. I want to encourage listeners to look for your paperback. The hardback has been out now for a little while, but the paperback of Currency Politics: The Political Economy of Exchange Rate Policy will be out shortly. And of course, if they want to google Jeffry Frieden, they will find your home page there on Harvard, and it will link to every bit of research you’ve done, papers you’ve written, contributions and reports co-authored, etc., etc.
I just want to thank you for your time, and your careful thought. As I look through the list of books that you’ve written in your tenure as an academic, I’m glad you’re writing. It would take me a lifetime to write one. I glad I stand in the privileged position of being able to read and simply ask a few questions because you’ve done some heavy lifting and I’m appreciative of it.
Jeffry: Thank you very much, David. This has been a pleasure, and I hope we get a chance to talk again sometime.
David: I look forward to it.
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Kevin: David, for the person who has listened to this interview and wants to dig deeper, how will they get more information on Dr. Frieden?
David: First, I would look at his paperback book coming out here in the next month or so, but if you want a general overview of the things that he has done research on, including Latin American debt and various currency and debt crises through the centuries, then I would google his name, Jeffry Frieden, and you will find his Harvard home page, and there you can access countless articles, for those who are interested and want to take it one step further.
