02 April 2013

ECB/Cœuré: Currency fluctuations - The limits to benign neglect

Large policy spillovers in an increasingly integrated world economy naturally raise the possibility of inefficiencies. National policy-makers, who pursue a domestic objective and ignore the externalities they impose on other countries, may find themselves in equilibria that entail collective welfare losses. Policies that are efficient for the global economy are not necessarily optimal from the national vantage point, and there is a temptation to shift the burden and costs of adjustment abroad, and maximise the net gains accruing to national residents.

Some central banks in major industrialised countries are currently pursuing, or have announced policy measures to stem entrenched deflationary pressures and bring down unemployment levels. Because policy interest rates are at or close to their lower bound in these economies, monetary easing has taken the form of non-standard measures, such as forward guidance concerning the path of future policy rates, and/or quantitative easing. These measures have had domestic effects (e.g. raising inflation expectations); but as it is a standard outcome of monetary policy easing, have also exerted some depreciation pressures on the currency of the respective country. The question I want to address is the following: should policy-makers, especially those in large countries whose currency is appreciating, be concerned by these developments? Do the latter pose a challenge to the G20 international cooperation policy agenda?

Taking mainly the perspective of a large currency area, he first outlines the conditions under which the answer to the above question is “No”. In the process, he also argues that there is a misleading “Panglossian” view that is emerging, namely that competitive devaluations are an efficient way to coordinate national policies on the global task of taking the world economy out of a deflationary trap. He then contends that competitive devaluations, if aggressively pursued, would be quite harmful, due to the constraints faced by policy-makers in most countries in today's environment.

As much as exchange rate movements are the natural result of policies aimed at achieving sound and legitimate domestic targets, such as price stability, and as long as other central banks are not constrained in their ability to take offsetting actions, there is no reason for concern. Keeping one’s own house in order, however, is quite different from sticking one’s head in the sand. Especially in the current conjuncture, the room for policy actions might be reduced, or countervailing interventions might have become more costly. Then, large and sustained currency swings might hinder the achievement of domestic targets.

I am inclined to believe that global economic circumstances are currently far from the ideal case of “divine coincidence” where one policy instrument would suffice to achieve all targets. Although they are on a clear path to recovery, financial markets in advanced economies are still fragile and the real economy is at best giving timid signs of improvement. There are some concerns that non-standard policies would not gain enough traction on domestic aggregate demand because of deleveraging by domestic agents, including banks. This would leave the exchange rate as the residual macro-policy instrument, with forward guidance but especially quantitative easing mainly operating via external channels. Under these circumstances, the temptation to divert global demand and foreign capital towards the domestic economy at the expense of other ailing countries could be dangerously alluring. It is during times like these that the international community has to display an ability to reach mutually beneficial agreements, while recognising the legitimate ambition of each country to solve its domestic problems.

The economic literature highlights the dangers of individual countries pursuing “beggar they neighbour” or “burden-shifting” policies. He believes this message is well understood by central bankers. This kind of cooperation seems different from the way it is treated in theoretical models, where cooperation takes the form of policy-makers agreeing on a configuration of policies to maximise global welfare. He does not think this difference matters. For him, the main value added coming from the economic literature consists in identifying and quantifying the implications for welfare of spillovers across economies and policies. Cooperation between the ECB and other major central banks is and will remain extensive and effective, building on a common ground of shared experience and mutual trust.

Full speech

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