Long Live the Queen

Last week, Janet Yellen was sworn into one of the most important offices in the land, becoming the new chair of the Federal Reserve.

Her first challenge may not be at home but abroad. Around the world, from India to Turkey, currency values have fallen and inflation has skyrocketed. The weak currencies, coupled with lukewarm global recovery, could send the “Fragile Five,” five developing nations with high short term instability (South Africa, Turkey, India, Indonesia, and Brazil), into a death spiral. Yellen will have the power and responsibility to stop that from happening.

Indeed, Yellen has the ability to strengthen the outlook of multiple currencies at the same time; after all it was her predecessor, Ben S. Bernanke ’75, whose action catalyzed the turmoil in the first place. When Bernanke announced plans to cut the Fed’s bond-buying program last year, the yield on dollar-denominated assets rose. Capital, in search of higher yields, abandoned the emerging market currencies and fled back to the United States. The exodus of capital put a downward pressure on these currencies, and sent inflation higher.

This is not merely a global financial crisis, but also a global political and humanitarian catastrophe. In Turkey, the prime minister accused the “interest rate lobby” of causing civil unrest and lack of growth, but the central bank had no choice but to raise the interest rate to defend the value of the lira. This political concession may lead to more political fragmentation in the fragile democracy. In India, the rupee’s fall contributed to 10 percent inflation last year, mainly in food and energy prices. As the impoverished nation has not yet achieved energy and food security, this crisis could cause millions to lose access to basic food and commodities. Such economic woes would have unthinkable consequences for some of the world’s poorest.

To avert these outcomes, Yellen can do much more than merely continue the bond-buying program. This global crisis requires global cooperation among central banks. The crucial position of the Fed in international finance gives Yellen the resources to orchestrate a global defense of weak currencies. After years of running current account deficits, these nations do not have the currency reserves to keep their currency value high. A union of these nations, supported by the Federal Reserve, however, has a much better shot of doing so. The Federal Reserve would emerge as a natural leader in this monetary consortium, replacing the International Monetary Fund as a guardian of global financial stability. As the IMF turns increasingly Euro-centric, this could be a golden opportunity for the Fed to improve its already formidable global standing.

The Fed’s involvement is likely to have long term impact on the emerging market. In the decade before the financial crisis of 2008, the developing world was on the course of five percent annualized growth, surpassing the developed world’s two percent. The higher growth was accomplished mainly by embracing foreign capital. The newly-arrived foreign capital provided stimulus for local governments to liberalize stagnant sectors and adopt more business- and capital- friendly policies. These policies paid off as long as the capital stayed. As a financial crisis looms for emerging markets, however, this process is currently in danger of rewinding. Many governments have imposed capital control to save their currencies, which will only make matters worse in the long term as investors worry about policy turnaround in the future. If not managed well, this crisis may lead to the withdrawal of multiple emerging markets from the international finance community. It is possible that countries like India and Brazil might look more like China, with strong international commerce but severe capital controls, after the panic. This will be a short-sighted development that makes future international cooperation nearly impossible. As the strong advocate for financial internationalization, the Federal Reserve should assure currency stability in these nations, so that they will focus on the long-run benefits of free capital movement when they make policy decisions.

Providing short-term support for the most vulnerable foreign currencies will not necessarily go against the Fed’s official mandate of curbing inflation and steering unemployment. Nations with high current account deficits tend to have large demand for international goods. Helping such demand may be a creative way to increase demand for American goods. Supporting foreign markets will also allow speculative capital to find havens of high return elsewhere, rather than creating another asset price bubble in the United States’ low interest rate environment.

Since Indian central bank governor Raghuram G. Rajan made a case for greater cooperation between policy makers around the world, skeptics have criticized his allegation of victimhood of developing nations at the hands of developed nations. The developing world has embraced global financialization out of self-interest, they say, and their economic policies, not the foreigners, were to blame for the recent crisis. The developed world, therefore, in the words of Dani Rodrik and Arvind Subramanian, has no “obligation to charity."

The Federal Reserve, obviously, is not an organization for charity. However, as the leading central bank, its policy goals may be more aligned to those of the rest of the world than the “self-interest” mantra suggests. It is in the Fed’s interest and responsibility to create and lead a cooperative environment for international finance. The Federal Reserve should intervene in foreign currency markets not because it is obliged to, but because it—and only it—can.

Jonathan Z. Zhou ’14 is an applied mathematics concentrator in Eliot House. His column appears on alternate Mondays.