David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 29 Exchange rate regimes
It is the massive size of this imbalance that prompts Western governments to press for a change of exchange
rate policy, particularly by China. The counterpart to Chinese trade surpluses is trade deficits in the US
and Europe, whose domestic trade unions protest that jobs are being exported to Asia. Comparative
advantage implies that many manufacturing jobs are bound to disappear from the US and Europe, but the
current exchange rate configuration is artificially accelerating the process. If hysteresis matters, jobs that
go now may never return, even if there is a subsequent exchange rate correction.
World economy in a cul de sac?
After the slump of2008/09, the world economy recovered in 2009/10 after the largest monetary
and fiscal expansion in peacetime. Fiscal stimulus cannot be sustained at this level. What
happens when fiscal policy has to tighten again?
While governments were spending so much, the private sector had been taking the opportunity to save like
crazy to rebuild its balance sheet. The OECD forecast a private sector surplus of around 7 per cent of GDP,
both for the eurozone and for the OECD as a whole. Given that private saving had previously fallen to tiny
levels during the borrow-to-spend boom, by both firms and households, this represented a significant rise in
the private sector saving rate. Equivalently, it represented a dramatic fall in private sector spending, which
lowered aggregate demand. Without the aggregate demand rescue by governments across the world, output
and employment would have fallen much more dramatically still. And without the simultaneous and drastic
easing of monetary policy, private spending would also have fallen further.
If governments are to tighten fiscal policy, as they must, without causing the very collapse of aggregate demand
that fiscal expansion was originally designed to prevent, private spending must somehow be jump-started
again. This cannot be achieved by further monetary loosening since interest rates are already near zero.
In the optimistic scenario, credit growth is somehow restored in the rich countries: both firms and households,
anticipating future economic growth, are prepared to start borrowing and spending again. In the pessimistic
scenario, the private sector and its potential creditors remain scared of the economic future once fiscal policy
cuts back. Private saving remains high, consumption and investment demand remain low, and the paradox of
thrift (see Chapter 16) stifles economic recovery.
The rich but now highly indebted OECD countries can 'solve' their debt problem either by reducing their debt
or by increasing their income. The latter is much less painful if it can be achieved. One possible source of
higher aggregate demand is export demand from emerging markets such as China; since emerging markets
have recovered much more quickly, they have not accumulated nearly so much government debt during the
crash. This is why OECD politicians are so concerned about the undervaluation of the exchange rates of
emerging market economies - and corresponding overvaluation of exchange rates of OECD countries. This
reduces the scope for the US, Europe and Japan to enjoy substantial export booms to emerging markets as
these latter economies resume rapid growth.
If the mature economies do not experience this export-led growth, the next-best bet is probably a resurgence
of private and public investment. Although this would require further borrowing today, it would not only add
to aggregate demand in the short run but also boost aggregate supply in the longer run as this new capital
stock became available for production.
Such thinking underlay the New Deal pursued by the US in the 1930s, with extensive government support.
Whether national economies in a globalized economy can credibly co-ordinate and sustain the financing
required must be an open question. For example, if competitive emerging markets are continuing to peg
exchange rates and run trade surpluses, it might require a mechanism, such as the IMF, to channel surplus
funds from emerging markets to the US, Europe and Japan.
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