The Spike In German Bund Yields Will Not Last

The recent selloff in German bunds has been driven by two factors. First, Grexit risks have abated. Second, and more importantly, euro area growth continues to surprise on the upside.

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The IMF reckons that the lagged effect of a weaker euro alone should boost real GDP by a cumulative 1.7 percentage points by early next year, with lower oil prices contributing another 0.3 points. In addition, we estimate that increased government spending could boost growth by a further 0.3 points this year, while the shift from negative to modestly positive credit growth could add a full percentage point.
This is a lot of extra growth in a very short period of time, and so it is not surprising that investors have begun to reconsider their view that the ECB will keep rates on hold for many years to come. However, while the euro area economy is likely to fare well over the coming few quarters, the party will not last far into 2016. Please see the next Insight, (Part II) The Spike In German Bunds Will Not Last.

Currency-Warmongers

Currency wars. Trade wars. Beggar-thy-neighbor transgressions. Much ink is spilled talking about these supposed threats to the world economy. But these discussions are usually uninformed and filled with ominous predictions. We should call these analysts “currency-warmongers”.

Contrary to popular proclamations that the world is descending toward currency and trade wars, the current international financial architecture is the best system available to the global economy.

The international financial system always faces important fixed-constraints. In order to facilitate the smooth functioning of the world economy, the international system must resolve a trilemma – it can only have two of the following three policy characteristics, and it cannot simultaneously have all three: independent monetary policy; free flow of capital; fixed-exchange-rate regime. In economics this concept is known as the “impossible trinity”

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Today, it is difficult to imagine governments relinquishing their control over monetary policy (as they did under the gold standard, circa 1870-1914), or be willing to implement capital controls like under the Bretton Woods regime (1945-1971). The alternative that the world has begrudgingly accepted is the current one, which includes the free flow of capital and independent central banking, but with no fixed-exchange-rate regime.

Given the political and economic characteristics of today’s global economy, the current system is the best available option. For instance, the significant real economic adjustments that happened quite frequently under the gold standard would be unacceptable today. And contrary to popular belief that prices adjusted according to trade imbalances during the gold standard, empirical evidence has shown that wages and prices were rigid downward under this regime. From a political perspective that would be intolerable in today’s world.

Further, credibility was the foundation of the gold standard’s success before the First World War. Countries credibly committed that they would withstand internal devaluations and abide by the ‘rules of the game’. But would a global fixed-exchange-rate regime have credibility today? Seems unlikely. So we can say that fixed-exchange-rate regimes wouldn’t work in 2015.

In terms of the Bretton Woods alternative (i.e., fixed exchange rate, independent monetary policy, and capital controls), it is unlikely that countries would be willing to embrace capital controls. There are also many problems involved with determining the anchor for the fixed-exchange-rate system, as we witnessed with the collapse of the Bretton Woods regime under the weight of the U.S. dollar in the early 1970s.

Despite the nostalgia of earlier eras, the fact remains that the current architecture is functioning rather smoothly.

At a recent press conference, IMF chief economist Blanchard explained that the recent currency moves in the global economy reflected differences in monetary policy, which in turn reflected differences in the relative strength of the various economies. He made two important points: “monetary policies are appropriate given the state of the economies in the U.S., EMU, and Japan.” And, “the U.S. has more margin of adjustment to offset most of the effects of an appreciation [in the dollar].”

In other words, the current international system is facilitating economic adjustments among the various economies in the global system. That is a good thing. On net, the fluctuation of exchange rates is justified economically and will help the world economy in the aggregate.

In fact, although it is often alleged that changes in exchange rates simply redistribute growth, this is incorrect. A stronger dollar is clearly good for European and Japanese exporters, but it does not necessarily imply weaker U.S. growth if the Fed offsets the impact of a rising currency by not raising rates as quickly as planned. The IMF’s macro model estimates that a stronger dollar will add a cumulative half a point to the level of real global GDP by early next year.

So what are pundits talking about when they beat the currency war drums? What currency wars? What does “currency war” even mean? In general, policymakers are pursuing policies that are justifiable given their domestic economic condition relative to the global context.

The bottom line is that currency-warmongers usually add little value. First, there is no real evidence that such wars are occurring. But further than that, what logical recommendations are being made? Are these warmongers advocating for a different international financial regime?

The problem is that there is no alternative. In fact, it was the very rigidity of the gold standard era that forced policymakers in the 1930s to turn to overt tariffs and trade wars as an alternative to painful internal devaluation. Adherence to the system failed, cheating began, and trade wars followed. The landscape today is vastly different

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It might not be popular to say, but the current system has performed well since the Bretton Woods regime collapsed, and moving away from it would be folly – in addition to being very unlikely given the current economic and political constraints that exist around the world.