The currency policy that dares not speak its name

President Obama is at the G-20, defending the US against an international uproar caused by the Fed's latest round of quantitative easing. Here's what's going on:

The unemployment rate in the US is 9.6% and recovery has been sluggish. With fiscal policy off the table because of the Republican victory in the midterm elections, the Federal Reserve has decided to use one of the few remaining tools it has: purchases of $600 billion worth of long-term government bonds over the next eight months in an effort to lower long-term bond rates. Some economists think this program would have little effect and we'd be better off if the Fed did nothing, but one can also argue (and I would) that the program is in fact too modest: the Fed would do more good if it announced that it intends to keep buying bonds until inflation rises somewhat above the usual 2 percent comfort range for awhile. Creating expectations of higher inflation would give an additional boost to spending beyond the effect of lower nominal bond rates.

Germany, China and Brazil have voiced strong opposition to the Fed's move. What these countries have in common is that all of them are enjoying a strong recovery without the kind of extraordinary measures that the US is undertaking. They are worried that the Fed's policy will force them to import higher US inflation or cause the dollar to depreciate against their currencies. I've got some sympathy for Brazil here, but none at all for China and Germany.

China, as we all know, is pegging its currency at an undervalued rate relative to the dollar, resulting in huge trade surpluses for China and deficits for the US. The normal route to correcting imbalances like this is a real depreciation in the deficit country (the US) and a real appreciation in the surplus country (China). There are two ways for a real appreciation to occur in China: its inflation rate could rise or its currency could appreciate, either of which makes its goods more expensive relative to US goods and reduces its surplus. Monetary expansion in the US will force China to allow higher inflation, revalue its currency, or expand an already cumbersome and costly system of capital controls that requires it to buy enormous amounts of US Treasury securities (which, thanks to the Fed, will be offering either lower yields in the future than they currently do). If quantitative easing forces China to back off from its destructive currency policies, it will be a force for stability in the world economy.

While Germany is enjoying a strong recovery the rest of Europe is teetering toward another recession. Germany, which has an outsized influence over the European Central Bank, is reluctant to help its fellow European countries out by further expanding monetary policy because of its historic hangups over inflation. The Fed's quantitative easing may force Germany to do the right thing here as well: if the ECB wants to resist an appreciation of the euro it will have to match the Fed's monetary expansion, easing economic conditions in the rest of Europe.

I'm not as familiar with Brazil's objections to the Fed's policy. I suspect that the root of their objection is that Brazil's major competitors in trade, Argentina and some other Latin American countries, peg their currencies to the dollar, so that a depreciation of the dollar hurts Brazil's trade position. My understanding may be dated however. At any rate, this is a problem that I think could be easily cured if Brazil allowed its currency to track the dollar downward.

There are surely some complications I haven't accounted for, for example the fear that monetary expansion will feed world-wide speculation in commodities. But it seems to me that half a century ago the world economy agreed on an international monetary system where each country has autonomy over its monetary and fiscal policies, exchange rates can adjust to insulate one country from the policy choices of another, and a web of national and international regulatory agencies can keep financial markets in line (ok, that one doesn't always work perfectly). The world economy needs monetary expansion in the US and countries have the tools to adjust to the US policy.

Ultimately we are going to have to see a depreciation of the dollar because of the large US trade deficits and our weak economy, and quantitative easing is going to push us in this direction. It would be nice if Obama could come right out and say this, but it would violate a taboo in the world of international finance which is that the US government must always and everywhere declare its support for a "strong dollar." The currency policy that dares not speak its name.