G20: Words and Walls

Germany's finance minister calls the US economic model "in deep crisis" and describes the country's policy response as "clueless".

Germany regards the Federal Reserve's quantitative easing programme as a dangerous dance with inflation; the US sees it as a legitimate attempt to generate demand for the benefit of all.

"The issue of the Renminbi is one that is an irritant not just to the United States, but is an irritant to a lot of China's trading partners..." - Barack Obama

China says it risks social unrest if it allows the yuan to appreciate rapidly against the dollar.

 4% cap on current account surpluses - says Tim Geithner, U.S Treasury Secretary  - Germany slams this down.

"Smiling family photographs marking the attendance at international gatherings are no substitute for specific actions" (January) - Mervy King, Governor Bank of England

"The fear we should all have is a return to what happened in the 30s: protectionism, trade barriers, currency wars, countries pursuing beggar my neighbour policies – trying to do well for themselves but not caring about the rest of the world. That is the danger..."
"Now on the big battle, the biggest issue of all is the cause of the last crisis – a wall of money in the east, a wall of debt in the west. We've got to deal with that imbalance and I think it's a real test for this summit and one that Britain will play a very positive part in trying to make sure we really look at these imbalances and deal with them." - David Cameron

Just for some perspective, it's important to see who is a surplus country and who is a deficit country.

"Recycling surplus savings into investment in developing countries will not only address the immediate demand imbalance, it will also help to address developmental imbalances. In other words, we should leverage imbalances of one kind to redress imbalances of the other kind." - says Dr. Manmohan Singh


Our PM also says we must avoid competitive devaluation and protectionism. He said advanced deficit countries should move towards fiscal consolidation and sustainable borrowing. For rebalancing of global demand he suggests the advanced deficit countries should work on their competitiveness and efficiency. And the surplus countries should increase domestic demand. And finally he added that countries must not manipulate their exchange rates.

Current Account Deficit and Capital Inflow

What does it mean when Kaushik Basu says we don't need capital controls yet, even while the rupee appreciates and imports grow at a much faster rate than exports. In my attempt to understand why and how experts say that our current account deficit (above 3% GDP) is alright, I found an article written in 1998 at the Federal Reserve Bank of New York website - Viewing the Current Account Deficit as a Capital Inflow. This article explains the scenario when U.S was witnessing huge capital inflows while it had a considerably large current account deficit. It talks about some people claiming that the unemployment they had at that time was because they were allowing the current account deficit to rise. The authors argue that looking at the situation from a micro angle of imports exceeding exports does not entirely justify the claim that there is unemployment. They in turn make us look at the economy wide perspective where these inflows financing the deficit were actually employment generating foreign investment capital. The reason for decline in  U.S. exports at that time was the recession in Asia. It also gives an example of recession in Japan which brought investment in Japan down, shifting all their excess savings to U.S. and other parts of the world.

"Given the low level of domestic private saving in recent years, U.S. economic growth would likely be choked off by higher interest rates and reduced investment spending if the nation had no access to this capital."

It gives some insight into the current situation of both U.S. and India. Indeed the situation today is different. U.S. faces high unemployment and huge trade deficit. India faces a considerable current account deficit as well while we also have huge capital inflows. One of the aims of QE2 is to encourage investment spending and notwithstanding the claims made by Germany and China that QE2 aims at manipulating the exchange rate, the indirect impact of a weaker dollar is also a positive thing. And what about India? We have to note that unlike Brazil we are not an export dependent economy. India would have faced tight liquidity conditions if not for the inflows, given the persistent inflation RBI would have anyway raised rates. But how does the government make sure that the inflows coming in will definitely lead to employment and high growth?

QE2 : Quick Analysis

All eyes are going to be on whether QE2 will do what it sets out to do. Especially emerging economies like India. If QE2 doesn't achieve it's goals to discourage saving by raising inflationary expectations, then what?  If this doesn't encourage enough spending to bring back unemployment to full employment levels, hence increase income and aggregate demand (AD), then what?

Here's my attempt at trying to answer this question with the little I know about applying Economic theory I learn in the classroom. If QE2 doesn't work in effectively raising prices, the economy will be stuck on the keynesian side of the short run aggregate supply curve (SRAS) (from AD to AD') where prices don't really change, and equilibrium output is way below the full employment level of ouput indicated by the long run aggregate supply curve (LRAS), which is what implies the so called recessionary gap (AE). This is where there is high unemployment, prices refuse to really decline (prices are sticky or inflexible downward on this side of SRAS, i.e. even though demand is low prices don't drop) and so there is no reason why demand and spending should ever go up from here and that just keeps going on and we reach e'. But if fiscal policy or monetary policy is aggressive enough things are different and the economy will be able to move the AD curve outwards to the desired extent.
(really sketchy graph, done on paint ;-) )

So what the fed essentially is trying to do is this: Usually when AD curve moves outward (from AD to AD''), equilibrium is at a higher output and clearly higher price level(inflation). On this part of the SRAS, no matter how the prices move, demand grows until we reach e''. So if it's hard to stimulate spending in times when nearly zero percent interest rate becomes ineffective in doing the same, we do the opposite, i.e. we try to shift the AD curve outwards by raisng infaltionary expectation first and then that should induce spending now (rather than later; basic aim of inflationary expectation). And this point is reached through the inlfationary gap (EB).

If QE2 doesn't achieve its objectives, then will it push up inflows into emerging economies like India? it's hard to tell. In the second quarter review RBI mentioned a very important point that factors apart from the interest rate differential are driving the current FII surge in our capital markets. We'll just have to wait and watch.

Can this be one of fed's last few chances to prove those people wrong, the ones who krugman claims use "shibboleths" to oppose fed's attempts to use inflation to bring about negative interest rates? Obama's streak of bad times just got worse, would this further reduce support for Bernanke's policies and give room for his opposers to make more noise?