The G20’s Continuing Policy Drift

There is general agreement among the G20 countries on the basic need for economic policies to boost global demand, foster stronger job growth, and raise the prospects for sustainable, stable growth of the world economy. Unfortunately, the G20 countries have failed to agree on the policy changes required to achieve these objectives. Prospects for a significant breakthrough at the G20 finance ministers meeting to be held February 18-19 in France are virtually nil. And to make matters worse, the French chair’s proposal to add the issue of reforming the international monetary system to the meeting’s agenda is likely to bog down the G20 even more and lead it further astray.

G20 discussions have been dominated for the past year and a half by talk about processes for assessing needed changes in economic policies rather than progress in making policy changes. After the Pittsburgh G20 summit in September 2009, there was little progress made using a process where the G20 countries and the IMF would review each others’ economic policies and prospects (referred to as the mutual assessment process or MAP). In November 2010, the United States proposed using trade or current account balances as a simple indicator to highlight the need for a country to take policy actions to deal with external and internal economic imbalances. But that provoked strong objections from a number of influential countries, especially China, which continues to resist allowing its currency to appreciate more rapidly.

So it was left to the forthcoming round of G20 meetings chaired by France to reach agreement on a list of indicators of external and internal imbalances that could be used to trigger a G20 reassessment of a country’s economic policies. But don’t expect much. French Finance Minister Christine Lagarde already suggested in a February 16 interview with the Wall Street Journal that nothing concrete was likely to emerge from the meeting. So the debate on process--not policy substance--will continue.

In the meantime, France is proposing a different tack for dealing with global imbalances--reforming the international monetary system. While certain features in the system contributed to the economic and financial crisis, a discussion along the lines of a report submitted to G20 countries by the Palais-Royal Initiative (PDF) with support from the French government would tend to obfuscate the basic conflict over policies, especially that of China’s exchange rate, which has stalemated the G20. It would also raise a host of topics that are, at best, tangentially related to the G20’s primary immediate goal of trying to foster stronger, stable, and sustainable growth in the world economy.

An ineffective global adjustment process (as the Palais-Royal Initiative report characterizes it) was a significant contributor to the crisis. This is an old problem arising from the fact that large external imbalances can be maintained for extended periods by countries with surpluses who tightly manage their exchange rates and by countries with deficits whose currencies are used as reserve assets. There is an effective limit, however, to how large and how long a reserve currency country (like the United States) can run an external deficit, since this will depend on the willingness of other countries to hold the country’s currency as a reserve. There is potentially less restraint on surplus countries.

Countries like China, with large external surpluses and a policy of limiting appreciation of their currency, played a bigger role in contributing to the recent economic and financial crisis.  China, for instance, built up massive amounts of international reserves. Most of these reserves were put into U.S. dollar assets, and in turn, this inflow of capital helped to finance persistent large external deficits and contributed significantly to asset price inflation and credit excesses in the United States and elsewhere. If more flexible exchange rate policies had been followed in emerging market countries, a vital source of the excess liquidity that built up in the international monetary system would not have existed. The Palais-Royal Initiative report appears to shy away from reaching such a conclusion in the interest of avoiding confrontation.

The report goes on to suggest an expanded role for the SDR, a little-used reserve asset created by the IMF, and to propose enhancements to the governance of the international monetary system. While some elements in the latter proposal are certainly worthy of consideration, these are not issues that will be resolved easily or readily, and they could swallow up a significant amount of the G20’s time while yielding little immediate benefit.

The G20 does not need more topics for debate and discussion. While it may be useful to have a forum for major countries to exchange views on key economic topics, at this juncture it is not what the world economy needs most.

Instead, if the G20 wants to play a meaningful role, it has to step up and demonstrate that it can act. To make meaningful progress toward its stated near-term goal of promoting stronger, more stable, and sustained world growth, it is going to have to find a way to come to grips with the issue of China’s exchange rate policy. To do this, the G20 will have to confront recalcitrant members over their economic policies, especially the group’s major countries.

At present, there clearly is little political will to confront China over its exchange rate policy. In particular, emerging market countries remain reluctant to appear to support what has been portrayed as an advanced country assault on one of their peers, China. But China’s exchange rate policy is causing considerable harm to many of these countries, and this might help turn the tide and lead the G20 to act more decisively. Brazil and India have become two of the more vocal emerging market economies to criticize China’s policy.

However, the likelihood that the G20 will fail to act remains high. The consequence would be that countries will resort to bilateral actions to protect their perceived interests, and trade wars could erupt. The G20 process is still the best way to try to avoid this undesirable outcome, but relying on it becomes an increasingly risky bet for the world economy.