Complex and lengthy international adjustment

The world economy is at a difficult crossroads, since several factors have come together: first, the most serious, the inflationary process since March 2021; then the inescapable cycle of interest rate hikes, which is putting financial stability at risk; the inevitable consequence of a recession; the strength of the dollar; a business trend toward deglobalization; and fiscal accommodations to mitigate the problems brought by the pandemic and now the permanence of growing social spending. The latter is leading to public indebtedness beyond what is healthily responsible.

Already in the past, the global economy had faced critical situations, making the necessary adjustments to overcome the problems. Just remember the financial crisis of 2008-09. Another complex episode was that of the strong appreciation of the dollar that led in 1985 to the historic exchange coordination agreement between the then G5, known as the Plaza Hotel Agreement, to orderly depreciate the dollar and make the world economy adjust. But on that occasion inflation was the lowest in 20 years with low interest rates. The United States, unlike its European peers and Japan, was growing and running current account deficits. The weight of the adjustment fell mainly on the United States. In that country, growth slowed, trade flows contributed to the adjustment, the current account turned into a surplus, and moderate inflationary pressures arose. It was an unprecedented cooperative agreement to revalue the dollar over two years through concerted currency interventions among central banks.

Given the current complexity, the adjustment towards equilibrium will have to take place in three stages: the first, to control inflation through restrictive policy with the unavoidable costs of a recession and an appreciation of the dollar; the second, once said objective has been achieved, to initiate a gradual cycle of decreasing interest rates with an economic reactivation, with an orderly depreciation of the dollar and the transition to current account deficits. It is very important that at this stage foreign exchange interventions are not abused; depreciation is never a good substitute for the required macroeconomic adjustments, mainly that of public finances. The third stage is the consolidation of the balance.

However, the first stage may take a considerable time, not only because of the lag with which monetary policy acts, but also because to the extent that the energy crisis and the disruptions to value chains subside, inflation is likely to underlying increase, mainly due to expansionary fiscal policy, a common denominator throughout the world. This could de-anchor inflation expectations and we could enter a process of self-fulfilling expectations.

Central banks cannot do all the work; fiscal policy is required to be aligned with monetary policy. Not in vain there is a saying in the IMF that its acronym IMF stands for “it’s mostly fiscal”. Here is an important lesson for Mexico.

Twitter: @frubli