A Grand bargain

Mar 23, 2009 Editorial

The Africans have a well known saying that whether elephants make love or war, the grass will suffer. Today in the financial crisis that suffuses the world, the two largest elephants are the US and China. Earlier this year, Timothy Geithner, the new US Treasury Secretary nearly precipitated a public spat between the two behemoths when he asserted that the Chinese were engaged in currency manipulation.

By keeping their currency (the yuan) undervalued, Geitner claimed that China was giving itself an unfair advantage to keep its prices low – and thus its exports (and the US deficit) high.

To everyone’s surprise the usually circumspect Chinese did not take this accusation lying down and while denying it categorically, bluntly told the US that they should fix its own affairs before deigning to lecture others.

Now for sure, the last thing the world needs is an escalation of tensions between these two economies that the rest of the world, including us, depend on to pull us out of the present meltdown. We need them to cooperate. The Obama administration evidently recognises this need and quickly dispatched Secretary of State Hillary Clinton to smooth over the ruffled feathers.

Their interests, however, dictate relations between states, and we believe that it is incumbent for policy makers in both states to work out a common approach that addresses their major interests at this juncture. Professor Eswar Prasad of Cornell University recently proposed that they strike what he called “A Grand bargain” in macroeconomic policies and international economic affairs. We concur and offer the main points of his model.

First, the two countries commit to using fiscal and monetary policy to the best extent possible to stimulate domestic demand in their economies in the short run. This step has already been accepted and is being implemented

Second, the Chinese allow their currency to become more flexible and responsive to market forces while the US articulates a plan that commits it to taming its budget deficit once the economy begins to recover. This is an opportune time for China to allow more flexibility in its currency. Now that capital is flowing out of China, it could be the case that the currency depreciates slightly in the short run.

In any event, it is world demand rather than modest exchange rate changes that will affect China’s exports in the short run, so the currency issue is more symbolic than substantive. But greater currency flexibility could have long-term benefits for China by reducing its dependence on exports and re-balancing its economy towards domestic consumption.

The US will need to tackle its mammoth budget deficit and rising public debt, which have contributed to its current account deficit and dependence on funds flowing in from the rest of the world.

A clearer commitment to lower the deficit over a reasonable period after the economy recovers would reassure financial markets that US government borrowing will not be allowed to get out of control and exacerbate global macroeconomic imbalances. President Obama has already made this commitment.

Third, the US supports an expanded role for China in multilateral financial institutions, including significantly greater voting rights at the International Monetary Fund and membership in the Financial Stability Forum.

These steps would make these institutions more inclusive and effective in dealing with global challenges. They are also strongly desired by China, which feels that its role in such institutions is well beneath its economic stature. It appears that this will be satisfied on April 2nd at the G-20 meeting in London.

While greater Chinese influence in international economic affairs is inevitable, the US has some leverage as it can throw a spoke in the wheels if it so chooses – at least in terms of delaying changes – given its prominent role in multilateral institutions. Tying this issue into the grand bargain would allow China to assume its rightful place on the world stage soon.

The political leadership on both sides has to move beyond nationalistic sentiments and convince their people that, in this interconnected world, China and the US will sink or swim together. There is a way. Is there the will?

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A Grand bargain

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A Grand bargain

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