Shock to the System

An Interview with Barry Eichengreen

Barry Eichengreen is one of the world’s most respected economists and financial historians. His insights into the strengths and weaknesses of the international monetary system are informed by a deep understanding of the crises it was built to prevent. Here, he shares his view on the future of our economic order under Trump — and why he fears we may be in for a severe systemic shock.

British PM Teresa May is riding a wave of uncertainty, much like Donald Trump.

Asian Awards. British PM Theresa May is riding a wave of uncertainty, much like Donald Trump.

Octavian Report: Barry Eichengreen, how do you see economic policy and financial policy unfolding under Donald Trump?

Barry Eichengreen: You’re definitely starting with a broad question. I think the key decisions will concern corporate taxation, individual income taxation, infrastructure spending, and trade policy. Trade policy is the one thing that the President has considerable authority to do unilaterally without agreement and cooperation from Congress. The most likely scenario is one where the President grows impatient and feels the need to do something visible. The one thing he can visibly do unilaterally — by invoking the Trading with the Enemy Act or the escape clause in NAFTA — is to do something on the trade policy front.

I think there’s a high likelihood of this happening. In addition, there is agreement, apparently, between the President and the Congress on the desirability of corporate income tax reform — although we’re receiving mixed signals about whether or not they agree on the details.

On the individual income tax front, there’s the danger of doing something that will blow a hole in the budget. We will find out in due course whether there still are deficit hawks on the Republican side of the aisle in Congress who will resist going down that path, or whether they can agree on significant spending cuts that will make those individual income tax cuts deficit-compliant.

On the infrastructure front, I’m skeptical that we will see much of anything because tax-credit-based infrastructure spending is going to be very hard to ramp up and because Congressional Republicans are skeptical about the ability of government to select and implement these kind of spending programs.

OR: Do you think that any forthcoming protectionist policies will offset any benefit that might come from tax reform?

Eichengreen: Let me step back and ask: benefit for whom? Lightening up on business regulation, environmental regulation, safety regulation, and fuel economy standards might be good for business profitability. But that doesn’t necessarily imply that it’s good for the economy overall or that it will have a positive impact on economic growth. We haven’t even gotten to the trade policy issues yet.  All this leads to the question of whether markets have overreacted.  In my view, that’s what markets do. They overreact. So it’s conceivable that second thoughts will develop over whether some of the regulatory changes will be a positive or negative for the economy.

On the trade policy front, there is no upside, it seems. My very first scholarly article in economics — published in 1981; it’s almost embarrassing to recall — was about the effects of tariffs when you have a flexible exchange rate. I wrote down that model because I was writing my dissertation on the Great Depression. The United Kingdom imposed a tariff in 1932 after it had gone off the gold standard and had a flexible exchange rate. What the model showed was that you can boost output in the short run because you’re shifting spending toward domestically produced goods, but the effects on the economy are negative in the longer run because you’re disrupting business, creating uncertainty, and disrupting global supply chains. And the situation in 1932 was one with a lot of excess capacity, where shifting spending toward locally produced goods had a positive effect in the short run.

If you believe the U.S. is close to full employment with a 4.7 percent unemployment rate and that there isn’t a lot of spare capacity at the moment, then you’re not going to get those positive short-run effects. Markets are going to look forward toward the negative, longer-term consequences.

OR: What scenarios worry you at the moment as those most likely to create a real economic crisis?

Eichengreen: Well, I am reminded of the 1930’s. Some people would say I’m always reminded of the 1930’s. I am reminded of the 1930’s not only because of the economic risks, but because of the geopolitical risks as well. If Trump were to slap a tariff on imports from China, China would not take it lying down. They would respond tit for tat, and that sounds a lot like the 1930’s, where we had the Smoot-Hawley Tariff and then retaliation by other countries. That pretty much spelled the end of the multilateral trading system.

And the economic risks would be greater now because companies in the United States and abroad are more invested in multi-national production. They source more of their components from abroad. Merchandise while in production often crosses national borders multiple times. Little, if any, of that had developed by the 1930’s. It follows that the risk of serious economic disruption is greater now. The other lesson of the 1930’s is that trade warfare can spill over into other forms of warfare and specifically diplomatic and geopolitical conflict. Countries that are at loggerheads over trade are not going to be able to partner as allies on other issues.

Imagine if the United States and China engaged in what we could call politely a trade dispute or label more alarmingly as a trade war. Imagine them then cooperating to deal with North Korea. It’s hard to see.

OR: How do you see the future of the dollar playing out against that backdrop?

Eichengreen: There are a number of different avenues from which one could approach that question. Number one, U.S. policies will clearly make for an even stronger dollar. There’s going to be a move toward looser fiscal and tighter monetary policies. That’s the Reagan policy mix of the first half of the 1980’s. That looser fiscal policy will weaken the current account of the balance of payments, while the tighter monetary policy — by attracting capital inflows — will strengthen the capital account. That made for a dramatically stronger dollar in the 1980’s.

And that mechanism will operate more powerfully now: in the 1980’s, there was spare capacity in the U.S. economy. You could stimulate domestic spending because you could elicit more supply. Now that we’re at full employment, you’ve got to do something to shift that additional spending back toward foreign sources of supply — and that happens through a still stronger dollar.

Then there’s the proposal for a destination-based corporate tax, which would tax goods according to where they’re consumed and not where they’re produced. It would tax imports. That would shift Americans’ spending toward domestically produced goods. If you think we’re close to full employment, that requires something else to shift that spending back to foreign sources. That’s a second, entirely separate, independent, reinforcing factor making for a still stronger dollar.

Then you’ve got tariffs. If Trump imposes tariffs on imports from Mexico or China (or both), that will shift spending toward domestic goods. If you think we’re close to full employment, more domestic supply will not be forthcoming. Something else has to happen to shift spending back toward foreign sources of supply.  Tariffs are thus a third, separate, independent, reinforcing factor making for a stronger dollar.

How much stronger are we talking about? To make a 20 percent destination-based corporate tax rate trade-neutral, you need 25 percent appreciation of the dollar. And that’s only one of the three effects that I’ve been describing.

Policy will make for a significantly stronger dollar, something that the President would not like, since it will make life harder for U.S. exporters and make imports cheaper. That’s a recipe for a trade war, if there is a continued failure to recognize the tension between the policy proposals of the new administration and Congress and the implications for the dollar.

A second avenue from which one could approach your question is whether the dollar will remain the world’s safe-haven currency. Whenever there has been a period of uncertainty and volatility, the dollar has benefited because the dollar is the only true safe haven when things go wrong. Even when the United States causes the bad thing, as on September 15th, 2008, people rush into dollars because the dollar is liquid, because it has a long history of stability, and because the full faith and credit of the U.S. government stands behind it.

Now we have a president who, while a candidate, mooted the possibility of “renegotiating” the federal debt. If those kinds of ideas were to resurface, investors would have reason to rethink whether or not the dollar is a safe haven currency. This is not something that we should take for granted.

OR: If the dollar disappeared as a reserve currency, what do you see as replacing it?

Eichengreen: There isn’t a good substitute out there. There is a limited amount of gold above ground. If everyone looking for a safe haven all shifted into gold, that would imply an immensely higher price of gold. Other commodities, too: commodity prices tend to move together. The only other economies with the scale to supply a safe haven currency are the euro area and China. And we know that, for the moment, neither of them is up to the task. Europe is troubled; there are existential questions about the future of the euro with elections coming up in France and Germany and anti-Europe, anti-euro parties making gains at the polls.

China, for its part, is regressing rather than progressing on internationalizing the renminbi: in response to the weakness of the currency and the desire of people to there to diversify their currency holdings, Chinese policy makers have been tightening capital controls.

OR: Do you see gold going up?

Eichengreen: I have a long history of reminding people of Keynes’s phrase about how gold is a barbarous relic, and how in a modern financial system there are better ways of hedging inflation risks. I’ve been predicting lower gold prices for many years — and I’ll keep predicting them until I’m right!

OR: Do you think central banks have painted themselves into a corner?

Eichengreen: I’d draw a strong contrast between the Fed and other advanced countries’ central banks. The Fed was on its way toward normalizing the level of interest rates before the election. To the extent that we’ll now see more expansionary fiscal policies and more inflation pressure, it will be likely to move more quickly than otherwise. That’s in contrast to the situation in Europe, where the ECB is undershooting its inflation target. It’s in contrast to the situation in Japan, where defeating inflation requires not only negative short-term interest rates but also taking the 10-year bond yield to low levels.

The thing that has been driving the dollar up until now has been policy divergence between central banks: the difference in interest rate policy, actual and expected, between the central bank here and central banks there. Now we will have those three additional, powerful tailwinds for the dollar reinforcing that divergence.

The problem for central banks has been created by the fact that they were the only game in town, and that they were forced to shoulder a disproportionate share of the burden of supporting the economy when the economy needed support. People now recognize that it would’ve been better to rely a bit more on fiscal policy and not to rely all but exclusively on monetary policy for economic support in the U.S. and Europe starting in 2010. Our political leaders, in their wisdom, opted for what they in Europe call austerity and what here we call fiscal consolidation. Its common implication was that somebody had to fend off deflation — something which remains a risk in Europe and was a risk in the United States until recently. And that somebody was the central bank.

Central banks had to take interest rates down to historically unprecedented levels and expand their balance sheets to unprecedented extents. Reversing that out now is difficult. Getting interest rates up to normal levels when you start from zero is harder than getting them up to normal levels when you start from two percent, or wherever interest rates are in the typical downturn. So central banks are between a rock and a hard place, yes, but it’s the politicians and fiscal policymakers who put them there.

OR: Even though our debt has almost doubled over the last eight to 10 years?

Eichengreen: Debt goes up when you have a financial crisis. That doesn’t mean that the economy has all the support that it needs. The visible indication that it lacked the necessary policy support was that inflation was significantly below target, and we’ve remained dangerously close to outright deflation for a period of years. Deflation is a condition that, once you get into it, is difficult to get out of. Ask our Japanese friends.

That the debt went up is unfortunate. But it was an unavoidable consequence of the financial crisis. It was the fault of the inadequate supervision and regulation of financial institutions in the period before 2007-2008. The debt went up because we passed the TARP to prevent the banking and financial system from collapsing as it did in 1933. The debt went up because unemployment was rising toward 10 percent and would’ve risen very much higher without Obama’s stimulus.

Does that imply that the economy had the support it needed? Absolutely not.

OR: Do you think that we’re going into an era of more inflationary pressures?

Eichengreen: We in the United States are exiting from a period of dangerously low inflation, where the risk of collapsing into outright deflation was significant. Do I expect this to be followed by a surge of inflation like in the 1970’s? No, I think the Fed is committed to keeping inflation close to its two-percent target. If it retains its independence, and if the intellectual composition of the Federal Reserve Board is not significantly different in the future, then I would expect the Fed to succeed in keeping inflation close to two percent, regardless of what happens with other policies.

But if you imagine that very different people are appointed to the Federal Reserve Board, people who think that much lower interest rates are needed to enable the President to hit his four-percent growth target, then all bets are off.

OR: You’re suggesting somebody even more dovish would come in under political pressure?

Eichengreen: I don’t think “doves” versus “hawks” would any longer be the right labels. When we think about President Trump, is he conservative or liberal? Answer: He’s a different kind of politician. It’s possible that we would have different kinds of monetary policy makers on the Federal Reserve Board. But anything we say along those lines is in the realm of speculation at this point.

One could speculate that Mister Trump is a businessman, that he has a preference for low interest rates, and that he would be able to draw a link between low interest rates and more corporate borrowing, more corporate investment, and faster growth. One could speculate that he will appoint people to the board who prioritize low interest rates and want the two percent inflation target. Would I call such a person a dove or a hawk? I’m not sure.  It simply is not the appropriate set of labels.

OR: Speaking of uncertainty, what is your view of Brexit? Do you see any way that the euro survives?

Eichengreen: Many people have been surprised that the British economy hasn’t suffered more from the fallout from the referendum, that there hasn’t been an outright recession yet, and that spending has held up relatively well. To which I would continue to respond:  “Be patient.” What we’ve seen so far has been largely British households front-loading their spending. They see a significantly weaker pound. They know import prices are going up. They have been told that Brexit is raising the price of marmite and want to get their marmite (and their big-screen televisions) before prices go up more.

There’s been quite a consumer spending spree in the U.K., but business investment in the most recent quarter was down and disappointed expectations. Uncertainty around Brexit is rising rather than falling due to unresolved legal issues and the incompatibility of Prime Minister May’s various proposals to retain single market membership but restrain immigration. That will be an impressive needle to thread.  As this uncertainty rises, investment will fall farther and the British economy will suffer.

That will be something of a deterrent to other countries contemplating going down the same road. In addition, I think that getting out of the European Union when you’re not a member of the euro is easier than extracting yourself when you’re in the euro. Way back in 2007, I was commissioned to write an article for a conference. The volume was called Europe and the Euro. My commission was to write a chapter titled “The Breakup Of The Eurozone.”

My conclusion was that holding the euro together would be immensely difficult and costly, but breaking it up would be even more difficult and costly. As soon as there was serious talk about a country withdrawing from the euro, that country would experience a bank run and a bond-market collapse — the mother of all financial crises — as everyone shifted their money to Frankfurt on the first day.

I have grey hair because I’m on record with that forecast. But so far, 10 years later, I’ve been right. That’s not a guarantee that I will still be right a year from now, of course.  But talking about getting out of the euro is easy. Actually getting out without suffering immensely large economic and financial costs is hard. It’s appealing to pundits and intellectuals to think about separate Northern European and Southern European euros, but I regard that as equivalent to standing on one rim of the Grand Canyon and imagining that the view is better on the other rim: take a step forward to get from here to there, and where do you end up?

OR: Given Europe’s climate of political insurgency, do you see a scenario where a country in the euro decides to leave it despite the risks?

Eichengreen: Absolutely. The story I just told you was one where not only experts but also politicians weighed the economic costs and benefits of alternative courses of action. That’s what Tsipras did when he took office in Greece. He realized that what he had said about the euro while he was campaigning was not economically rational to implement once he was in power.

But we know that politicians, in the heat of the moment, can take decisions based on pride, self-image, and other considerations that trump — if you allow me to use that word — purely economic calculus. Yes, it can happen and you don’t have to go very far back in history to see it happen. But a majority of voters in the euro area still support the single currency. It’s not simply an elite project. In countries where people do not entirely trust their own government, whether because of corruption or for other reasons, they’re more inclined to support European government which, in this context, means the euro. I think even the young people who have suffered from 30, 40, or 50 percent levels of youth unemployment, depending on country, are often committed Europeans.

In my view, the single most powerful force making for European integration has been Ryanair: these young people flying for low-cost weekends between secondary airports in one country and another.  They have grown up together with their friends in other European countries in a way that their parents never could.

OR: What do you see as the biggest risk to the monetary system? What do you see as the most likely potential cause of a problem?

Eichengreen: If we get a further, strong rise in the dollar, that will cause serious financial problems for emerging markets with dollar-funding needs — for emerging markets that borrow from international banks and international financial markets. These countries fund themselves with dollars, which will become more expensive. I don’t think it’s a coincidence that Turkey is now in the sights of international investors as a country with a very large external funding need — a country whose troubles are going to be compounded by the rise of the dollar.

The other thing we know is that there are big financial institutions out there — we don’t know who they are; I certainly don’t know who they are — that could be wrong-footed by a further, sudden rise in the dollar. Institutions that are short dollars and long something else. That’s what worries me first and foremost: the dollar strengthening due to U.S. policies and the certain negative impact on emerging markets and the possible negative impact on global financial stability.

OR: Do you think that would ironically give a boost to the economy in Europe, or do you think with tariffs that scenario is going to be more problematic?

Eichengreen: Europe needs a weaker euro because inflation is still well below two percent. Economic growth is subdued. The same is true of Japan, but President Trump will see a weaker euro and weaker yen as evidence of currency manipulation, as frustrating his efforts to bring manufacturing jobs back to the United States. What the U.S. gives with one hand — i.e., more competitive euro and yen exchange rates — it takes away with the other — i.e., trade restrictions. There’s no way you get one without the other.

OR: How do you see China fitting into all this?

Eichengreen: China has been doing its best to be a positive moderating influence at Davos and elsewhere. But China is also a proud country and would not take U.S. sanctions or trade restrictions lying down. It would respond tit for tat and try to occupy whatever space the U.S. vacated in Asia and elsewhere with preferential trade deals with its neighbors and with foreign investment through the Asia Infrastructure Investment Bank.

Another implication of the new administration in the United States will be less support for the IMF and World Bank. That will open up space for the Asia Infrastructure Investment Bank and the Chiang Mai Initiative — technically the Chiang Mai Initiative Multi-lateralization — in which China is a leading player. It’s not incidental that an additional couple of dozen countries have just applied for membership in the Asia Infrastructure Investment Bank.

OR: Do you think that this is the end of the liberal postwar order, of the IMF and the World Bank serving as anchor institutions and the U.S. leading the world? Do you think that the ramifications will lead to a snapback?

Eichengreen: I think this President and this Congress are on the same page in that they do not see the advantages for the United States of — number one — international entanglements  and — number two — a rules-based international system where they see the rules or their application as biased against the United States. They see these institutions and organizations as limiting U.S. autonomy and room for maneuver.

Normally, a President can think what he wants, but there are checks and balances coming from the Congress, public opinion, and the corporate sector. Here, however, there is an apparent alignment of views hostile toward what we call the post-war international economic order between Congress and the administration.  And we will see if public opinion is still an effective countervailing force.

Again, to invoke what happened in Greece after Syriza took power, it typically requires a major crisis for people with these strongly held views to pause and rethink. Obviously that would be a high price to pay in order to save the global order.

OR: What would you do if you had unlimited powers and scope to fix the system?

Eichengreen: We got into this mess partly because we experienced a major financial crisis, one of the two gravest financial crises of the last century. So I would be sure that the United States and other countries had measures in place to limit the likelihood of another. I’m deeply worried, therefore, that the mania for deregulation that we now see in the United States will include financial deregulation and that will set the stage for more financial instability.

I also worry that some of the international institutions that have been positive forces in recent years — the Basel Committee on Banking Supervision, the Bank for International Settlements and the Financial Stability Forum — are at risk because U.S. participation in those fora and willingness to conform to their standards for financial regulation, capital adequacy, and liquidity will no longer exist.

The danger is that we will not subject ourselves to those same high standards. So I would start there. Beyond that, the global trading system is worth preserving. If there are things about the World Trade Organization that the President or the Congress doesn’t like, they should be negotiated rather than throwing the baby out with the bathwater.

At the same time, I would avoid trying to replicate the other things that were achieved at Bretton Woods, like a system of pegged exchange rates, because the world has moved on. The world in the 21st century is very different from the world in 1944.  I don’t think that’s something that can be replicated.

OR: Going back to where you started on infrastructure: are you skeptical Trump will be able to do it at scale?

Eichengreen: It’s clear that the United States has significant infrastructure needs, and you can make a plausible case that repairing roads and bridges will reduce wear and tear on cars and trucks and increase the efficiency of commerce and production. It’s not always the case that infrastructure investment translates into faster growth, but I don’t think it would be hard to identify some key infrastructure projects that would be good for growth.

I would add two caveats. Number one, I don’t think this can be efficiently done by providing tax credits for private investment alone because those private investors are don’t have an incentive to start with the infrastructure projects that matter most for growth. Number two, the construction companies that build infrastructure projects don’t have cash flow for several years, so they have to sell the tax credits to someone else. That market, which is called the tax equity market, is small. It exists for solar farms and solar panels but doesn’t appear to work very efficiently, and it’s not clear how quickly it can be scaled up. I think doing something significant on infrastructure requires the Congress to acknowledge that the government is the agency that has to do it — an acknowledgment that sits uneasily with contemporary Republican ideology.

A second point I would make is that we should be talking here not only about investing in physical capital but also in human capital. President Trump wants to increase the growth rate from two to four percent. In the long run, the only way that can be achieved is through faster productivity growth, which means a more productive labor force, which in turn means more investment in early childhood education and vocational training. That doesn’t appear to be part of the discussion at the moment.