Thoughts on 2016, Robert Brusca, “FAO Economics”

Disequilibria and risk from the international economy

In 2016 we find two conditions present that put markets at risk. One is that policymakers have the wrong model of how the world works. In plying policy under misunderstood conditions markets will be at risk.

Secondly, global and of course individual country disequilibria proliferate. Current account deficits are stuck either too high (as in the US) or surpluses are too large (as in China and Germany). And these circumstances are not changing. There is no move to take actions to change these structural imbalances. Policy will be made under the conditions of persisting disequilibria using the wrong economic model, this is a dangerous time. The probability that policy will not make a mistake is low. And globally, except for China, fiscal policy is in a strait jacket, limiting policy options.

Wrong Model – Bad Policy from the wrong model

The two operative policy models are versions of Keynesianism and Monetarism. Monetarism’s basic equation is this: MV=PQ. Here. M is money, V is its velocity, P is prices and q is real output. So PQ is nominal GDP. If Velocity is ‘stable’ in the long run changes in Money will dictate changes in PQ, Nominal GDP. The assumption on the velocity of money is questionable but, given a long enough period it can be made to ‘work’.

The real problem for monetarism is with all the things that happen in the short run that monetarism ignores. It is its sweeping view of the long run that may be irrelevant because the long term is so long. The monetarist ‘equation of exchange’ listed above has no international element in it. It presumes that changes in money supply can determine nominal GDP and nothing else matters. That is a very unrealistic view of the world. Moreover, the policy switch to regulate banks by means of capital-asset ratios has made monetarism less relevant. Banks have free reserves and are not making loans. Excess reserves in the economy can only be accessed by banks in they raise more capital. The old-dogmatic monetarist world has changed.

Keynesianism presumes that competitiveness keeps prices and costs aligned except at the extremes when bottlenecks can push inflation higher, or slack push them lower. A low unemployment rate or high factory operating rate will push prices up. These is a very old-economy views. These days, if US capacity use is high businesses can import goods. US firms’ factories can be (and are!) built abroad. We can import. If the US labor market is tight firms can mechanize. They can import labor. They can move operations overseas. And they do! The old fixed short-run economy with trade ‘around the edges’ is gone.

Observables? It is not surprising that the Phillips curve has shifted or the Beveridge curve (a relationship between the unemployment rate and the job openings rate) has shifted. It is not surprising that investment in the US is restrained as more of the investment of US firms is being made outside the US where operating costs and wages are lower. Many of the things that economists and policymakers complain about are simply understandable by a broader understanding of the world.

Outlook The Fed’s obsession with getting interest rates higher without the needed foundation will further boost the dollar, further depress prices in the US and further depress domestic economic activity. It will make things worse.

It is the wrong policy for these times. Remember that the exchange rate is a relative variable and we can’t describe its path by reference only to US variables. But, in Europe and Japan, monetary policy is being leaned on hard while the Fed is trying to reign in in past profligacy. These tensions will only push the dollar higher.

This will be a dangerous environment for markets since a stronger dollar will undercut everything we are ostensibly trying to boost back home. But economists do not treat the international sector this way. Most ignore as ‘trade is good.’ But the free trade models depend CRITICALLY on exchange rates being at their equilibrium levels and that condition is not in force. Balance of payments conditions make that abundantly clear. Asian nations are geared to boost their growth and raise employment at the cost of growth and employment in the US and no one in US policy circles even cares. Europe is doing the same thing but it is cut slack because Germany is wrapped in a Zone of Malaise and the ECB actions are not aimed at competitive devaluation but simply produces one as a side-effect.

US Elections The Democratic and Republican party candidates have no ideas that come to bear on these issues. They are focused on consequences or on old ideology. Democrats are disturbed by the income distribution aspects of the economy and want redistribution and more taxes on the ‘rich.’ Republicans want to cut taxes and deregulate, but these moves will not affect the US competitive position in the world. The dollar would still be too high and taxes could not be cut enough to offset that- nor should they.

Better policies would focus less on outcomes and more on the REASONS for those bad outcomes. But no party is doing that. This is another example of the wrong policy objective due to a bad model of how the world works. As long as the dollar is strong and the US refuses to use its vast powers to force fair trade, US wages will be too high by world standards and they will be pushed lower REGARDLESS of the labor market conditions in the US. The same is true for capital.

The bifurcated economy There are some exceptions to this since some domestic jobs are shielded. Foreigners cannot compete with US restaurants in the US nor can foreign plumbers compete with US plumbers. So we see in the Inflation data that service sector inflation is rising at about a 3% pace with goods sector prices still falling. The US economic is bifurcated and this divide reveals that the forces I speak of are truly tearing the economy apart.

We do have long run problems with our education system. But the short-run problem is competitiveness and a higher interest rate will push the dollar higher and exacerbate that problem. Until that link is acknowledged this low wage problem will persist. This monetary tact will exacerbate future growth problems since the US will get no real investment as long as it is not a competitive country. A strong dollar-now policy undermines domestic investment prospects.

The US policymakers refuse to use pressure to force its competitors to trade fair. We can already see how fair China is with its claims on the South China Sea. There should be no expectation that China will simply become a good global citizen in trade. Fair trade needs to be a global objective for trade to bring prosperity to all instead of some while spreading problems. In the US, problems will continue to spread. Robert A Brusca, PhD, Chief Economist FAO Economics, New York