The Fed's key role in international economic policy coordination is a largely overlooked and ignored aspect of its work. Typically, most people think that is what the president and his economic officials do during the meetings of what American academic community derisively calls "talking shops" (G8, G20, and various U.N. agencies).
But the best kept secret is that the Fed does more for the successful operation of the global business cycle than all these "talking shops" combined. And it does that at no cost to American taxpayers. Last year, for example, the Fed transferred $76.9 billion in profits to the U.S. Treasury, while one of these summit jamborees can cost $850 million. How does the Fed drive the world economy?
The dollar is the channel through which the impact of the Fed's policy is transmitted to the rest of the world. Transmission mechanisms are very wide and instantaneous. About 90 percent of international trade and financial transactions are conducted in dollars; some economies are fully dollarized through currency boards or dollar pegs, the dollar accounts for 62 percent of world currency reserves, and the overwhelmingly dollar-based foreign exchange market has an estimated daily turnover of $4 trillion.
Pushing Export-Driven Free Riders
That is the framework where the Fed operates as a de facto coordinator of international economic policies. Conceptually, this policy coordination process is grounded on the idea that countries at different points in the global business cycle should conduct restrictive or expansionary economic policies depending on their fiscal and balance-of-payments positions.
For example, countries running budget and trade surpluses (or very low budget and trade deficits) should stimulate their domestic demand because they may also have sluggish growth and low inflation. Conversely, countries with high budget and trade deficits should increase taxes, cut government spending and raise interest rates because they may be experiencing an overheating economy and rising inflation.