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Business News/ Opinion / Is controlled disintegration of the world economy on its way again?
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Is controlled disintegration of the world economy on its way again?

The US does not escape unhurt when it tightens policy but it inflicts greater damage upon others, thus strengthening its relative position

Photo: Hemant Mishra/Mint Premium
Photo: Hemant Mishra/Mint

In a speech delivered at the University of Warwick in November 1978, Paul Volcker, the then president of the Federal Reserve Bank of New York, considered the prospect of a controlled disintegration of the world economy, found it uneasy and declared that he preferred managed integration. But, the interesting question is if he opted for it once he became the chairman of the US Federal Reserve. This is important because, 36 years later, the US finds itself in a similar situation as it did towards the end of the 70s.

“The United States no longer stands astride the world as a kind of economic colossus as it did in the 1940s, not, quite obviously, is its currency any longer unchallenged," Volcker had said. “Now, other centres of strength and power have arisen in the industrialized world, and they will need to share in the leadership. Developing countries have a new economic importance and political consciousness of their own." He noted that while it was intellectually easy to recognize interdependence, the practical instinct was to assert independence. It was true of him too, perhaps.

From the time he became chairman of the Fed in 1979 and until he relinquished the post in 1987, he sought to establish the primacy of the dollar as a global reserve and transaction currency because, as the dollar strengthened, concerns about diversification dwindled. If in the process collateral damage was inflicted on other nations, all the better.

As the US monetary policy tightened and the dollar strengthened in the early to mid-eighties, it imparted a deflationary bias to the whole world. High US interest rates helped finance president Ronald Reagan’s budget deficits. It helped draw the Soviet Union into a financially disastrous and unsustainable arms race. At the same time, the deflationary policy bias reinforced the tendency of the price of oil—main source of dollars for the Soviet Union—to decline. It declined from nearly $40 per barrel in April 1980 to around $11.6 by July 1986.

Earlier in the monetary tightening process, the Latin American debt crisis erupted which, in the end, helped cement the region’s dependency on the US and nipped any anti-American tendency to grow roots. It also created a mini shakeout in the US financial industry consequent upon the restructuring of the Latin American debt. It set the stage for the spectacular collapse of the Japanese economic miracle later that decade.

Due to space constraints, I shall refrain from discussing the mostly adverse international consequences of monetary tightening that the US undertook in the last 25 years (1988-89, 1994, 1997, 1999-2000 and 2004-06). It might be true that the US does not escape unhurt when it proceeds to tighten policy unilaterally but it inflicts a far higher damage upon others, thus strengthening its relative position.

Its ability to do so stems from its role as the provider of the global reserve and transaction currency and the outcomes that it achieves from its unilateral actions strengthen and extend the dollar’s status. It is hard to imagine that these considerations did not play a role in the timing, duration and extent of past monetary tightening episodes.

In my recent comments, I have expressed scepticism about the timing and extent of the US’s eventual monetary tightening since the US economy is still saturated with high debt and its financial markets are inebriated with low interest rates. Yet, I am tempted to argue that the situation is ripe for an encore by the US.

The price of crude oil has begun to decline. Tighter monetary policy might help to push it sharply lower, twisting the knife on the back of the Russian economy. It might also come in handy in reining in the funding abilities and the nuisance value of those pesky West Asian oil and gas producers—both official and unofficial. Tight monetary policy and the resulting strong dollar will, as before, put an end to all the loose talk of diversifying global reserves away from the US dollar.

Managers of wannabe reserve currencies such as the Chinese renminbi will be in a quandary as to whether to let their currency appreciate with the dollar imparting a further deflationary bias on a structurally slowing economy or to weaken it and end all talk of being a dollar alternative for the foreseeable future. Further, the rising yield on US treasuries will drill a nice hole in the value of Chinese official foreign exchange reserves and hurt its external debt servicing abilities.

After Japan in the late 80s, it might be the turn of China. Finally, some shakeout in the US financial industry might not be a bad thing after all.

V. Anantha Nageswaran is co-founder of Aavishkaar Venture Fund and Takshashila Institution.

Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk

Follow Mint Opinion on Twitter at https://twitter.com/Mint_Opinion

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Published: 22 Sep 2014, 07:14 PM IST
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