Jeffrey Frankel Says More...

Project Syndicate: The recent US decision to label China a “currency manipulator” has been roundly criticized. The People’s Bank of China (PBOC), you wrote last month, merely “gave in to market pressure – the immediate source of which was none other than President Donald Trump’s announcement” of new tariffs on Chinese goods. But with Trump announcing yet another escalation in tariffs and pressuring the Federal Reserve to cut interest rates and weaken the dollar, could the label become a self-fulfilling prophecy, with both sides engaging in competitive depreciation?

Jeffrey Frankel: The US finding of manipulation was absurd. China has been intervening to resist renminbi depreciation since 2014. It is Trump who seems eager to engage in competitive devaluation, despite a February 2013 G7 agreement not to do so: he has been strongly urging the Fed to cut interest rates, with the explicit motive of pushing down the value of the dollar.

If the dollar does depreciate in the future, other monetary authorities, such as the European Central Bank, might respond by renewing their own monetary expansion, with an eye toward exchange-rate competitiveness. That scenario would have some characteristics of the type of “currency war” that is so often discussed, but direct intervention in the foreign-exchange markets still seems to me unlikely.

The Chinese, in any case, won’t fit the pattern. They are unlikely to take active steps to depreciate their currency in the foreseeable future. I do not think they want their currency to weaken substantially from where it is now.

PS: You argued last November that the Fed cannot take responsibility for offsetting the supply shock created by Trump’s trade war. If, however, that trade war – which has already hurt almost every segment of the US economy – undermines price stability and employment, the Fed would presumably have to take action to fulfill its mandate. Is the Fed fated to become a mere tool for offsetting the administration’s policies, independent in name only?

JF: I don’t see it that way. The Fed has a dual mandate: to sustain employment and to maintain price stability. (Its original mission was to safeguard financial stability.) As a result, it is not as clear as many seem to think how the Fed should respond to a trade war.

On one hand, a trade war hurts output and employment. Indeed, most observers attribute the slowdown in global growth over the last year partly to unfortunate protectionist trade policies. That would seem to suggest that the Fed should cut interest rates, to forestall a recession.

On the other hand, tariffs raise prices. That would suggest that the Fed should not cut interest rates, because inflation may already be headed higher.

This dilemma, intrinsic to a supply shock, means that the central bank could not offset foolish trade policies, even if it wanted to.

PS: Fed Chair Jerome Powell has acknowledged as much. And lack of monetary-policy space doesn’t bode well for responding to a recession, which increased stock-market volatility and an inverted bond-yield curve suggests is increasingly likely. What could be done, both in the US and by policymakers elsewhere, to counter the next downturn?

JF: When Powell, in his recent Jackson Hole speech, diplomatically hinted that the Fed can’t fix bad trade policies, he wasn’t making the point that with interest rates at barely 2%, it lacks monetary-policy space. Even if they had lots of room to cut interest rates, a central bank couldn’t fix bad trade policies any more than it could fix bad health or security policies.

Nonetheless, it is true – as a separate matter – that the Fed has much less monetary-policy space now than it has had at similar points in past business cycles. If a new recession does come, interest rates can’t be cut five percentage points as in the past.

I believe that policy ought to be generally counter-cyclical, to moderate swings in the business cycle. Admittedly, it is hard to get the timing right; but that is no excuse for pro-cyclical policies, which intensify the swings.

And yet too many politicians have effectively been pursuing pro-cyclical policies. When unemployment is near or below 4% – as it has been in the United States for more than a year – it is not the time for trillion-dollar fiscal deficits, ultra-low interest rates, and financial deregulation. Yet that is what we have gotten, meaning that we have little ammunition for responding to a recession. We should have spent the last three years keeping our powder dry – ready to be used when a recession does hit.

Trump and his supporters are not the only ones who act as if they believe in pro-cyclical policy. In the eurozone, fiscal and monetary policy has at times been pro-cyclical. German-driven austerity in times of recession is a notable example. And most developing countries have long followed a pattern of raising spending during booms, only to be forced into austerity when the downturn comes.

PS: Many view the emerging trade dispute between South Korea and Japan as inspired by – and patterned after – Trump’s trade policies. What might be the consequences of this new trade disruption? Could it be a harbinger of a broader global shift toward protectionism?

JF: I also put some of the blame on Trump for the tit-for-tat trade dispute that broke out between Japan and Korea in early August. Trump not only set a bad example with his aggressive trade policies, but has also abdicated the leadership that previously held the three-country alliance together.

The prospect of a Korea-Japan trade war is alarming. It would be one of the first signs that a breakdown in the rules-based global trading system may extend beyond the manic flailing that is now US trade policy. (Admittedly, the Brexit vote predates Trump.) The national-security implications are even more serious than the economic ones.

The Asia-Pacific region is beset by risks, including the US-China rift, a nuclear North Korea, and Russian troublemaking. In this context, it is especially necessary that South Korea and Japan get along.

It was not pure luck that the second half of the twentieth century was a time of unprecedented global peace and prosperity. Though US leadership after World War II was frequently flawed, it was, overall, integral to establishing the international rules and institutions that promoted not just free trade, but also economic growth, democracy, and human rights. It is a tragedy that the US under Trump has been acting to reverse those historic accomplishments.