Balancing geopolitics and monetary policy: The Fed’s interest rate dilemma

Volcker’s legacy differs: praised for restoring the US economy, blamed for causing Latin American financial disaster. History repeats?

Paul Volcker is mostly remembered fondly in the US, as the Federal Reserve chairman who restored stability to an economy gone wild. South of the border, however, he is often remembered as the man who brought the world down.

As Tyler Cowen put it in a column a few years ago, the Latin American debt crises triggered by US interest rates that Volcker hiked to nearly 20 percent in 1980 and 1981 amount, by some measure, to “the worst financial disaster the world had ever seen.” In 1980, the region’s GDP per head exceeded the world average. By the end of the decade, it amounted to only 85 percent.

The Federal Reserve is, again, chasing inflation that rose last year to its highest level since the Volcker era. As it raises interest rates at the fastest pace in over 40 years, raw memories of dashed hopes of economic prosperity are returning to the fore across Latin America and more widely throughout the developing world.

They raise a potentially urgent question: Would chairman Jerome Powell go where Volcker went before him? Could the US, today, afford to wreak such economic havoc in the developing world?

Guillermo Calvo from Columbia University, one of the world’s foremost experts on capital flows and balance of payments crises in developing countries, thinks not. “Volcker was a slap in the face for Latin America,” he said. “Today the US is more conscious of the geopolitics.”

In the tense global environment, we are living in, Calvo noted, Washington may not want to be perceived as the instigator of instability in large swathes of the Global South that its geopolitical rivals are assiduously courting.

In the 1980s, most of Latin America was locked up in the US sphere of influence, often by right-wing dictators. While the Soviet Union still supported Cuba, it was in the process of going bust itself, and in no shape to offer broad financial support across the region. Washington could afford to ignore Latin America’s plight.

This time it’s different. Washington is already struggling to convince the Global South to push back against Russia’s invasion of Ukraine. China is working to position itself as lender of last resort, offering hundreds of billions of dollars to support developing countries in financial distress. “Today the US is in a different situation,” Calvo said.

What’s more, he added, the Federal Reserve has established a track record as de-facto global lender of last resort, flooding the financial system with money each time it hits a serious bump. While the money has not been directly deployed in the service of developing countries, whether in Latin America or anywhere else, it has certainly helped keep them afloat in troubling times.

The Fed did little to help emerging economies during the Asian crisis of the late 1990s, which spread to Russia, Brazil, and even sank the US hedge fund Long Term Capital Management. And it took about four years for emerging economies to recover their pre-crisis footing.

By contrast, when the US housing market went oops a decade later, the Fed flooded the zone through what it called “quantitative easing.” It also provided hundreds of billions in swap lines, which enabled other major central banks to swap their currencies for dollars. Emerging markets were back on their feet in less than a year. “They did very well,” Calvo said.

Not everybody agrees with this reasoning. Carmen Reinhart, former chief economist at the World Bank and fellow expert on balance of payments crises, argues that the Fed only opened the liquidity hydrant when it perceived the US financial system to be in peril: during the Global Financial Crisis, COVID, and the sinking of Silicon Valley Bank. It will not pull out the stops to provide a lifeline to the developing world.

Sure, Fed policy won’t be as harsh as it was in Volcker’s day, Reinhart said. But that’s mainly because Powell is not battling 14 percent inflation, as Volcker was. If it wanted to help the White House in its standoff with Beijing, it might open swap lines to Pakistan, Turkey and Argentina, countries that are benefiting from swaps with the People’s Bank of China. But it isn’t.

The Fed is independent, not beholden to geopolitical plotting elsewhere in the administration.  For Powell voluntarily to offer financial assistance toward a strategy to stymie China’s inroads into the developing world would seem an incredibly risky bet.

In the past, in fact, the Fed has defended its policies against criticism that it fails to consider their impact on the developing world. Renihart simply can’t see evidence of it wanting to play good guy with the Global South. “When the Fed started tightening, lots of the developing world had not yet recovered from COVID,” she argued. “I don’t see a lot of synchronization.”

Brad Setser of the Council on Foreign Relations is also sceptical. “The Fed now does supply dollars globally to help G-10 central banks supply dollars to their own global banks, but those swaps are to protect global bank liquidity not to help the emerging world,” he said. For instance, he noted that the Fed didn’t adjust rates to mitigate the impact of the dollar’s strength last summer. And many countries have had trouble raising money in debt markets because of rising rates in the US.

Even if Powell were to take the fate of the developing world into account, he might conclude that it can take more punishment than in the past. “I think there is actually something to the notion that the increased resilience of many big emerging markets means that the Fed can in a sense hike more without the same kind of spill backs as in the 80s,” Setser argued.

And yet Calvo sees signs that the Fed wants to stay its hand. For instance, the monetary tightening has slowed even though real interest rates are still negative. Powell and company may fear that they already steered the economy into recession. They are undoubtedly worried about bank balance sheets. And, Calvo argues, they are worried about the world.

“They know they are going to create a serious problem. They are going to have a geopolitical problem,” he argued. “They are dead scared.”

Written by Eduardo Porter. Porter is a Bloomberg Opinion columnist covering Latin America, US economic policy and immigration. Views are personal and do not represent the stand of this publication.

This article was originally published in Bloomberg.