Scott Sumner is an original economic thinker and a particular expert in monetary affairs. So I sat upright when I saw his skeptical reply to the QE2 Skeptics.
Early this week a host of high-profile economists, investors, and thinkers, under the e21 banner, issued an understated but unusually critical “open letter to Ben Bernanke.” They urged him to abandon the $600 billion QE2 strategy, warning of uncertain but possibly very large downside risks compared to little reward even in the unlikely case it works.
Sumner, who favors a concept he calls NGDP (nominal GDP) targeting, says the Fed isn’t trying to spur inflation. It’s trying to boost national income. And who could be opposed to that?
Sumner says the Fed can move the AD (aggregate demand) curve to the right. “Whether that extra spending shows up as inflation or real growth,” he acknowledges, “is of course an important issue.” A very important issue. But critics of QE2 and the broader existing Fed framework aren’t necessarily worried about short-term inflation of the CPI type. No, we are worried about sinking Fed credibility, dollar debasement, possible asset bubbles, and international turmoil. And, yes, possible inflation down the road.
I think Sumner ignores a couple important factors that argue against the simple equation that more Fed easing yields a significant and quantifiable higher level of NGDP, and more importantly RGDP.
First, the transmission mechanism whereby increased bank reserves become credit isn’t working well. A trillion dollars of excess reserves sit on U.S. bank balance sheets. Small and medium sized businesses have found access to loans difficult. Consumers, too, even with historically low mortgage and personal loan rates, have not necessarily been able to access credit because of tighter lending standards and retrenched credit cards and home equity lines. If QE2 merely increases excess reserves further, without a more effective way to boost the supply and demand of actual credit, I don’t think the Monetary Ease –> More NGDP equation is so clear. A further complication: Large companies and the federal government find credit at historically low rates abundant and accessible. But this begs the second problem with the simple Ease –> NGDP equation.
In a world of closed economies, Sumner’s view that U.S. QE would directly translate into more U.S. AD (or his preferred national income) might work, at least temporarily. But we don’t live in a closed economy. Or as Robert Mundell long ago said, “There is only one closed economy — the world economy.” Companies, hedge funds, and other global entities can borrow cheap dollars and then go find opportunities across the globe.
Southern Copper Corp., a Phoenix- based mining company that boasts some of the industry’s largest copper reserves, plans to invest $800 million this year in projects such as a new smelter and a more efficient natural-gas furnace.
Such spending sounds like just what the Federal Reserve had in mind in 2008 when it cut interest rates to near zero and started buying $1.7 trillion in securities to spur job growth. Yet Southern Copper, which raised $1.5 billion in an April debt offering, will use that money at its mines in Mexico and Peru, not the U.S., said Juan Rebolledo, spokesman for parent Grupo Mexico SAB de CV of Mexico City.
Southern Copper’s plans illustrate why the Fed’s second round of bond buying may not reduce unemployment, which has stalled near a 26-year high.
Or as Richard Fisher, CEO of the Dallas Federal Reserve Bank, said in an October 19 speech:
I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.
I’m all for companies investing in the best opportunities around the globe. And some of that investment may benefit the companies’ American assets or workforce in direct or indirect ways over time. But that kind of long-term symbiotic growth is not what the Fed is aiming for or says it’s doing with QE2. When the Fed specifically targets the short-term U.S. economy and ends up pushing money overseas, that’s a direct failure of the mission. I believe the Fed should concentrate more on the dollar’s value as the world’s key reserve currency. But here we have a case of arbitrage — getting weak dollars the heck out of the country. We can see that much of ROW is growing faster than the U.S.
Beyond these transmission and international factors, it’s clear that Fed policy — now that we are beyond the panic of 2008-09 when Bernanke and Co. rightly filled an emergency monetary hole — is fueling the growth of government and giving Washington an excuse to continue with counterproductive anti-growth fiscal and regulatory policies.
Sumner tries to addresses this criticism:
7. “Won’t monetary stimulus just paper over the failures of the Obama administration, allowing him to get re-elected?”
That’s an argument unworthy of principled conservatives. After 30 years of major neoliberal reforms all over the world (even in Sweden!) it’s time for conservatives to become less defeatist about the possibility of making positive improvements in governance. We need to do the right thing, and let the political chips fall where they may. If monetary stimulus is tried, and succeeds in boosting NGDP (which even conservatives implicitly acknowledge can happen when they worry about inflation) then it would drive a stake through the heart of the Krugmanite fiscal stimulus argument (for future recessions.)
I think Sumner misses the point. Fed critics should of course root for the success of Bernanke and our other economic policymakers. But it’s not the case that QE2 is objectively the “right thing” and all critics are opposing it for political reasons. If critics think it is the wrong monetary policy — with the additional ominous factor that it is aiding and abetting (“papering over”) a harmful fiscal and regulatory path — then they are not required to bite their lips and “let the political chips fall where they may” as the economy continues to limp along. If mere monetary policy could solve all the world’s problems, then Mao’s China could have succeeded so long as Beijing printed enough money. That’s a severe reference, an exaggeration to make a point. But Bernanke himself has stated that the Fed cannot do everything, and it’s crystal clear historically that central banks often cause more problems than they cure, often when they are trying to compensate for other poisonous policies.
Despite the sluggish economy and these disagreements, I’m encouraged we are finally having a real, national (international!) debate over monetary policy — one I’ve urged for a long time. And I look forward to further offerings from Sumner . . . and many others.
The Federal Reserve plan to buy an additional $600 billion in longer term securities — known as QE2 — is taking flak domestically and from around the world. And rightly so, in my view. Check out e21’s understated but highly critical open letter to Ben Bernanke from a group of economists, investors, and thinkers.
But in some ways, QE2 is nothing new. Yes, it is a departure from the traditional Fed purchases of only very short-term securities. And yes, it could lead to all the problems of which its new critics warn. But this is just the latest round in a long series of mistakes. The new worries are possible currency debasement, inflation, asset bubbles, international turmoil, and avoidance of the real burdens on the U.S. economy — namely fiscal and regulatory policy. These worries are real. But this would be a replay of what already happened in the lead up to the 2008 Panic. Or the 1998 Asian Flu. Or the 2000 U.S. crash.
It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.
That was two years before a Very Big Disruption. (I followed up with another monetary critique in the WSJ here.)
But over the last few decades, there was no common critique of monetary policy among conservatives, Republicans, libertarians, supply-siders, nor among Democrats, liberals, or Keynesians, etc. (Take your pick of labels: the point is there was no effective coalition with any hope of altering the American monetary status quo. There were, for example, just as many Republican backers of Greenspan/Bernanke, and of America’s weak-dollar policy, as there were detractors.) A silver lining today is that QE2 appears to have united and galvanized a broad and thoughtful opposition to the existing monetary regime. Hopefully these events can spur deeper thinking about a new American — and international — monetary policy that can build a firmer foundation for global financial stability and economic growth.
Columbia’s Charles Calomiris discusses his opposition to the Fed’s QE2
“What’s the right policy toward China? They put a few trillion dollars worth of stuff on boats and sent it to us in exchange for U.S. government bonds. Those bonds lost a lot of value when the dollar fell relative to the euro and other currencies. Then they put more stuff on boats and took in ever more dubious debt in exchange. We’re in the process of devaluing again. The Chinese government’s accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort. The right policy is flowers and chocolates, or at least a polite thank-you note.”
“The upside of QE is limited. The money simply won’t go to where it’s needed, and the wealth effects are too small. The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export.”
“Since the financial panic began in 2008, global leaders have been at pains to stress their ‘cooperation’ on numerous issues—stimulus spending, new bank rules, trade. Yet they still insist on going their own parochial, self-interested way on monetary policy and exchange rates. It’s as if world leaders had consciously decided to deal with every economic issue except the most important one—the price of the global medium of economic exchange.”
Raghu Rajan’s Fault Lines is perhaps the most thoughtful book on the financial crisis, and now Professor Rajan is continuing his incisive analysis at a U. Chicago blog. Here, he defends his own criticism of the Fed’s ultra-easy monetary (both leading up to the crisis and again today) against Paul Krugman’s crude Keynesianism.
Some excerpts:
Before saying the real problem is we are not providing enough monetary stimulus, should we not worry about why corporations did not invest then and what other problems will emerge as we keep rates ultra-low while hoping corporations will see the light?
. . .
If the government raised taxes explicitly to provide the interest subsidy, everyone would scrutinize the use this money was being put to carefully. Because the Fed picks investors’ pockets silently and forcibly through its ability to set the short term interest rate, no one asks questions about cost.
. . .
Of course, the Fed now disingenuously claims that the worst excesses in the housing market were committed when it had already started raising rates, and therefore it is not responsible for the housing boom. But it was complicit in setting off the boom by keeping interest rates too low for too long before then!
I may disagree with Rajan’s take on “global imbalances” (as I wrote about here) but nevertheless think he has become one of the smartest academic analysts of today’s confusing economic landscape.
With the China currency question once again in the news, I’m reposting my Wall Street Journal article from early 2009. (For a much longer treatment, see this paper.)
THE WALL STREET JOURNAL / January 26, 2009
Geithner Is Exactly Wrong on China Trade
The dollar-yuan link has been a great boon to world prosperity
by BRET SWANSON
Treasury Secretary-designate Tim Geithner’s charge that China “manipulates” its currency proves only one thing. Three decades after Deng Xiaoping’s capitalist rise, America’s misunderstanding of China remains a key source of our own crisis and socialist tilt.
The new consensus is that America failed to react to the building trade deficit with China and the global “savings glut,” which fueled our housing boom. A “passive” America allowed China to steal jobs from the U.S. while Americans binged with undervalued Chinese funny money.
This diagnosis is backwards. America did not underreact to the supposed Chinese threat. It overreacted. The problem wasn’t “global imbalances” but a purposeful dollar imbalance. Our weak-dollar policy, intended to pump up U.S. manufacturing and close the trade gap, backfired. Currency chaos led to a $30 trillion global crash, an energy shock, bank and auto failures, and possibly a new big government era. For globalization and American innovation to survive, we must first understand the Chinese story and our own monetary mistakes.
We’ve heard the refrain: China’s rapid growth was a mirage. China was stealing wealth by “manipulating” its currency. But in fact China’s rise was based on dramatic decentralization and sound money. (more…)
“I have only one project, one big idea: uncertainty. It crosses many different disciplines — math, political science, psychology, risk management — and I swing in between those, but it is always on what we call the epistemological question. There are two parts to this question: math and computation, and psychology. The second causes us to think we know more than we do. It is an endless topi. Bernanke has six problems: One, his education is in tools that aren’t helpful — and he doesn’t know it. Two, he studied the Great Depression, and he thinks he knows too much — this is nothing like the Great Depression. You can’t compare this and the Depression. Three, 99% of risk is tied to the debt/leverage and the explosion of connectivity. It’s like he did not see a truck coming right at him. Four, he has no notion of nonlinearities, and how monetary policies can be responsive in nonlinear ways. Five, he doesn’t understand fat tails. Six, he doesn’t realize that the biggest risk of failure is signified by the Federal Reserve: He thinks we need more regulation; we actually need smaller institutions. And not one person in Congress had the presence of mind to ask him these questions.”
Fed chairman Ben Bernanke over the weekend gave a big speech at the American Economic Association annual meeting in Atlanta. He defended his and and Alan Greenspan’s unprecedented easy money through the 2000’s and acknowledged no connection between monetary policy and the financial crash.
Economist David Malpass, however, had the whole thing nailed back in 2002. Here’s Malpass in a note today:
Today’s New York Times front page has a David Leonhardt article on the Fed entitled “If Fed Missed Bubble, How Will It See New One?” It criticizes Chairman Bernanke’s Atlanta speech: “This lack of self-criticism is feeding Congressional hostility toward the Fed.”
I’ve attached my 2002 WSJ article on the same topic (The Fed’s Moment of Weakness). It argued that Chairman Greenspan was “letting himself off the hook” in 2002 by saying that the Fed couldn’t anticipate asset bubbles. The 2002 article concludes that: “If the value of the dollar is allowed to fluctuate as wildly in the future, then momentum will dominate the global economy as it did in the 1990s, creating constant boom/bust cycles.”
We expect Chairman Bernanke to be reappointed and the Fed’s lagging monetary policy to continue for at least one more cycle. For now, this feels good to financial markets (everything is up today except the dollar — gold, oil, the euro, U.S. equities and especially foreign equities in dollar terms.) However, this gradually channels capital away from the U.S. and especially from the many small businesses (and yet-to-be-created businesses) left out of Washington’s aggressive credit rationing process. This undercuts U.S. growth and leaves unemployment much higher than it should be.
We often say hindsight is 20/20. Monetary policy is in a sorry state when the hindsight of the insiders lags the foresight of the outsiders. By eight years and counting.
(My own contributions to the debate here and here.)
“The irony of the zero-rate policy, coupled with Washington’s preference for a weak dollar, is a glut of American capital in Asia (as corporations and investors shun the weakening U.S. currency) and a shortage at home. For gold and oil, the low-rate policy works, weakening the dollar so commodity prices go up and providing traders with ample funds to buy into the expanding bubble. Those markets are almost daring the Fed to try to break out of its zero-rate box.
“But for small businesses and new workers, capital rationing is devastating, spelling business failures and painful layoffs. Thousands of start-ups won’t launch due to credit shortages, in part because the government and corporations took more credit than they needed (because it was so cheap).”
Zachary Karabell does a nice job explaining the “superfusion” cooperative arrangement between the U.S. and China, showing why China doesn’t want and won’t trigger a crashed dollar. They want a strong and stable dollar, which, as we have been writing for a long time, is also in our best interest. We are of course constrained by global investors, who rationally want solid real returns. But the competitive and currency positions of the U.S. are a function of our own monetary, fiscal, and regulatory policy actions, not some malign intent on the part of weaker foreign economies who in fact depend on a healthy, thriving America.
David Malpass, as usual, explains it best in this video:
Richard Fisher was the first Federal Reserve official, back in November 2006, to publicly pinpoint the easy-money mistakes that would lead to the crash.
Now, in the aftermath, as the Fed confronts a whole new set of challenges, here’s a good, long interview of Fisher by Mary Anastasia O’Grady of The Wall Street Journal.
Mr. Fisher defends the Fed’s actions that were designed to “stabilize the financial system as it literally fell apart and prevent the economy from imploding.” Yet he admits that there is unfinished work. Policy makers have to be “always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys.”
He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. “I wasn’t asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about.”
As I listen I am reminded that it’s not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue “ad nauseam” and doesn’t apologize. “Throughout history,” he says, “what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen. That’s when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can’t run away from it.”
Last night on Charlie Rose, Treasury Secretary Tim Geithner made an extraordinary admission. Here’s the exchange:
Rose: “Looking back, what are the mistakes, and what should you have done more of? Where were your instincts right but you didn’t go far enough?”
Geithner: “There were three broad types of errors in policy. One was that monetary policy here and around the world was too loose for too long. And, that created just this huge boom in asset prices; money chasing risk; people trying to get a higher return; that was just overwhelmingly powerful.”
Rose: “Money was too easy.”
Geithner: “Money was too easy, yeah . . . . Real interest rates were very low for a long period of time . . . .”
There you have it. Pretty simple. And yet it is the first time I can recall that any U.S. executive branch official, spanning the Bush and Obama Administrations, has admitted monetary policy was even onefactor, let alone the central factor, leading to the crash. This is very big stuff. (more…)
“Beginning in 2003, the Fed filled the liquidity punch bowl. Low rates and the weakening dollar created a monumental carry trade (borrow dollars, buy anything). This transmitted the Fed’s monetary excess abroad and into commodities. As the punch bowl overflowed, even global bonds bubbled (prices rose, yields fell), contributing to the global housing boom.”
China proposes a new world reserve currency to replace the dollar and, it hopes, launch a new era of global monetary stability. In a paper released Monday in Beijing, central bank governor Zhou Xiaochuan wrote:
Theoretically, an international reserve currency should first be anchored to a stable benchmark and issued according to a clear set of rules, therefore to ensure orderly supply; second, its supply should be flexible enough to allow timely adjustment according to the changing demand; third, such adjustments should be disconnected from economic conditions and sovereign interests of any single country. The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history. The crisis again calls for creative reform of the existing international monetary system towards an international reserve currency with a stable value, rule-based issuance and manageable supply, so as to achieve the objective of safeguarding global economic and financial stability.
It’s an interesting concept, and as I contemplate the proposal I’ll air my praise and criticisms. I’m initially skeptical of a single IMF-managed currency and of Zhou’s suggestion that this will allow nations more flexibility in their own monetary policies. Hyperflexible monetary policies, especially in the U.S., were the source of the problem. But it’s too bad we ever arrived at this point. If the U.S. had better managed the stability of the existing world reserve currency — the dollar — there would be no need for a new “super-sovereign” currency. We had a good thing going, and we blew it.
I’ve written lots about the dollar and its nexus with China (here, here, here, and here).
Nassim Taleb is moving along just fine with an elegant critique of banking’s misaligned incentives . . .
In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich. Furthermore, it is that incentive scheme that got us in the current mess.
Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses.
. . . But then, after showing how easy it is for bank management to capture short-term gains without worrying about long-term risks, Taleb concludes that
This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.
It’s a big leap from misaligned incentives to only the government can run banks. Doesn’t the expert theoretician of the highly improbable Black Swan understand that highly centralized governments are most often the cause of devastating Black Swan events? The only difference being: we shouldn’t really even call them Black Swans in the case of government failure. These events are not uncommon or unpredictable. The inherent difficulty and high-frequency failure of highly centralized bureaucracies managing dynamic systems is so common and predictable, in fact, that we might call them Black Crows.
We can do much better than nationalizing the banks. Boards should obviously reform compensation practices. Today’s shareholders have been mostly wiped out. The shareholders of the “next banks” won’t soon forget. But most crucially we should amend the wildly incoherent monetary policy regime that does more than any other private or government action to misalign incentives. During credit bubbles, dollars are easily vacuumed up by the financial industry. In a very real sense, they would be irresponsible not to exploit the Fed’s explicit free-lunch program of accommodation “for a considerable period.” Remember, Chairman Greenspan virtually ordered Wall Street to lever up.
A stable currency is the ultimate disciplinarian, the incentive aligner par excellence.
Update: See Taleb and Nobel psychologist/behavioral economist Daniel Kahneman discuss these topics at length here.
Stanford’s Ronald McKinnon, who I cited in my recent Wall Street Journalarticle on China, echoes my view:
Indeed, as the world goes into a severe economic downturn, the threat of beggar-thy-neighbor devaluations becomes acute — as in the 1930s. Stabilizing the exchange rate between the world’s two largest trading countries could be a useful fixed point for checking the devaluationist proclivities of other nations around the world.
The Dallas Fed announces a conference on the topic I’ve been writing about lately — namely, the intersection of globalization, capital flows, asset prices, China, and monetary policy.
Steve Forbes with a resounding call for stable, low-entropy money.
Greenspan truly began to think he was a monetary philosopher king who could fine-tune economic activity by manipulating short-term interest rates. Greenspan’s Louis XIV “I am the state” proclivities were intensified when he fell under the sway of a strange theory of Ben Bernanke’s. Bernanke joined the Fed as a governor in 2002 and posited that the world was plagued by “excess” savings. China, India and other countries were saving too much money. Preposterous! In a properly functioning global financial system there can be no excess savings. The whole purpose of finance is to direct savings from one party to be invested with another party. The enormous amounts of liquidity that led to the housing and commodities bubbles of recent years cannot be blamed on thrifty Chinese but on the excess money creation of Greenspan and Bernanke. If their central goal had been a steady value for the buck, those bubbles would never have reached the sizes they did, and volatility in the financial markets would have been only a fraction of what it is today.
See my latest on the nexus of China trade, monetary policy, and our current crisis in Monday’s Wall Street Journal. Contrary to the new conventional wisdom, which is gaining considerable steam, I argue that:
America did not underreact to the supposed Chinese threat. It overreacted. The problem wasn’t “global imbalances” but a purposeful dollar imbalance. Our weak-dollar policy, intended to pump up U.S. manufacturing and close the trade gap, backfired. Currency chaos led to a $30 trillion global crash, an energy shock, bank and auto failures, and possibly a new big government era. For globalization and American innovation to survive, we must first understand the Chinese story and our own monetary mistakes.
A “more competitive currency” and monetary “stimulus” cannot create new wealth. Only technology and entrepreneurship can do that. The “China currency” issue distracts America from all the important things that could actually make us more competitive –e.g., better K-12 education, much lower corporate tax rates, cutting-edge broadband networks, less (not more) centralization and power in Washington, and, of course, a stable dollar.
Excellent summary on the euro currency’s first decade of life:
As important, the creation of a single European Central Bank (ECB) has better insulated monetary policy from political manipulation. Politicians could no longer attempt to inflate their way out of their employment or fiscal problems. National central banks could no longer finance fiscal deficits, removing a source of economic instability.
The single economic space anchored by the euro has also forced European policy makers to compete for people, goods and capital with improved policies. While we had hoped to see more reform by now, the pan-European reduction in corporate tax rates is one fiscal benefit of the euro. Even Germany has cut corporate taxes, after its efforts to harmonize rates across the European Union failed.
The New York Times, in its series on the origins of the financial crisis it calls “The Reckoning,” pins our housing and credit bubbles on Chinese savings and the U.S.-China trade gap. This is basically the view of Alan Greenspan and Ben Bernanke. We were helpless. Monetary policy had become ineffective. The New York Times also says the U.S. failed to react to the China-U.S. “imbalances” soon enough, that we took a “passive” approach.
In fact, most of this is backward. We did not under-react to China. We overreacted. The U.S. weak-dollar policy — a combination of historically low Fed interest rates and a Treasury calling for a cheaper currency — was a direct and violent reaction to the trade gap. A series of Treasury secretaries and top U.S. economists, from John Snow and Hank Paulson to John Taylor and Martin Feldstein, explicitly backed this policy as a way to “correct” these “imbalances.” This weak-dollar policy was designed to reduce the trade gap but in fact boosted it by pushing oil and other commodity prices through the roof. It also created and pushed excess dollars into other hard assets like real estate, resulting in the housing boom and then bust.
America’s overreaction to China’s rise in particular and our misunderstanding of global trade and finance in general was thus, I believe, the chief source of our current predicament. The Fed and Treasury failed to grasp the truly global nature of the economy and the centrality of the dollar around the world. I tell the story of Chinese-U.S. interaction in this long paper, “Entrepreneurship and Innovation in China: 1978-2008.”
I’ve been a harsh critic of the Greenspan-Bernanke monetary policy that was the chief cause of our current economic mess. But it’s also true that, once the financial firestorm hit, Ben Bernanke, perhaps the world’s leading student of financial crises, has taken bold and creative action to douse it. Nobel laureate Bob Lucas thinks Bernanke is on the right track:
monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues.
Gold’s on the move again, up to $867 an ounce this afternoon. It still does its job exposing the crucial monetary mistakes that drive our dramatic booms and busts.
Treasury Secretary Hank Paulson is back at it. Having presided over the debasement of the U.S. dollar, he is once again cajoling the Chinese over the value of its currency, the renminbi (or yuan). Paulson earns a few points for his semiannual Special Economic Dialogue that has facilitated U.S.-Chinese cooperation on some fronts and helped defuse some of the worst protectionist policy on both sides. But the Greenspan-Snow-Bernanke-Paulson weak dollar policy — which was in itself deeply protectionist, and ultimately highly self-destructive — utterly swamped any of Paulson’s good intentions vis-à-vis China.
Digging through some old files, I found a May 13, 2006, e-mail I wrote to a senior White House economic official, warning of the certain harmful effects of its weak-dollar policy. (I had, six months prior, met with the official in the West Wing to discuss the matter.) The morning of my e-mail, The Wall Street Journal, citing top Administration officials making clear their weak-dollar preference, had published a major story: “U.S. Goes Along With Dollar’s Fall to Ease Trade Gap,” with the subhed, “Quiet Acquiescence Holds Possible Risks for Economy; Surge in Exports in March.”
The previous week economist John Taylor, just off his post as Treasury Undersecretary, had, in another Wall Street Journal article, dismissed the views of Nobel laureate Robert Mundell and Stanford economist Ronald McKinnon. Mundell and McKinnon had been arguing against dollar weakness and urging dollar-yuan stability. Taylor’s offensive, moreover, had been previewed by yet another two articles, one from Martin Feldstein and another from Lawrence Lindsey, arguing for a “more competitive” dollar. That’s a euphemism for weak, as in competitive devaluation. (See, not supposed to happen in America).
Written in the heat of battle, I think my e-mail memo holds up pretty well:
From: Bret Swanson <bret.swanson@********.com>
Date: Sat, May 13, 2006 at 1:38 PM
Subject: stunning protectionist mercantilism
To: [senior White House official]
*** Warning: Blunt Statements to Follow ***
[senior White House official],
Even considering Treasury’s misguided currency stance these past few years, today’s news in the Journal that the White House approves of the further weakening of an already too-weak dollar is stunning and alarming.
Using monetary policy to target the trade deficit instead of using monetary policy for its only legitimate purpose of price stability and currency stability, is massively irresponsible. The trade deficit is a mostly meaningless accounting number that if anything demonstrates the strength of the American economy, not its weakness. “Competitive devaluation” is what Third World nations did for decades. It’s what helped keep them poor. It’s what we did in the 1970s, a lost decade of malaise. In an era of globalization, currency devaluation is more damaging than ever when there is more cross-border trade and investment and a larger proportion of inputs into our final products and services come from abroad.
An already inflationary dollar will become more inflationary. Oil prices will rise further. Recession in 2007 now becomes a real possibility because the Fed will likely now overshoot on interest rates to combat inflation that they and Treasury created but which they never see until it’s too late. Why are we risking ruin of a robust economy?
The best economists I know are alarmed at the Fed’s lack of vigilance and the deepening of Treasury’s weak-dollar policy. Having now lost faith in the Fed and Treasury, these economists have changed their outlooks for the U.S. economy from positive to negative.
Lindsey and Feldstein are 180-degrees wrong on monetary/currency/trade policy. Clearly their recent Journal articles were a set-up for this potentially disastrous currency move. John Taylor’s statements last week pooh-poohing Mundell and McKinnon — who are absolutely right on China — were equally discouraging. Not since Richard Nixon have Republicans stood for debasing the currency. It’s painful to agree with those who say this may be the most protectionist Administration since Herbert Hoover.
The U.S. Auto Companies and manufacturers want a weaker dollar — manufacturers always do — but the dominance of the Japanese auto makers is not a currency issue. Japan has just come out of a decade of deflation – the yen was way too strong, not artificially weak – exactly the opposite of what the auto makers say. Manufacturers in general face a huge challenge from China, but not because of the yuan, which is exactly in line with the dollar. The China challenge is real, not monetary. The U.S. must become more competitive via lower tax rates and less regulation. Currency is nothing but a scapegoat, and focusing on it reduces the chances we can solve our real competitive disadvantages on taxes and regulations. Because changing the unit of account cannot change the terms of trade, debasing the dollar does not make us more competitive; it makes us less competitive because it fosters inflation and possibly recession.
Furthermore, autos and manufacturing are a shrinking portion of our economy, and this misguided protectionist policy at their behest is highly damaging to the real, growing, leading edge sources of American wealth and power: our prowess in technology, finance, and entrepreneurship.
Please forgive my blunt statements. I make them with respect and concern for the success of this White House. I know you can’t comment on currency matters, but if I am overreacting or wrong on my interpretation of what appears to be happening, please let me know.
Very best,
Bret
I then sent the following warning to a number of friends at the U.S. Chamber of Commerce, who had been seeking my views:
From: Bret Swanson <bret.swanson@*******.com>
Date: Sat, May 13, 2006 at 2:26 PM
Subject: ALERT: stunning protectionist mercantilism
To: [U.S. Chamber officials]
ALERT
I believe the outlook for the U.S. economy could be shifting. An article in this morning’s Wall Street Journal makes clear that instead of reversing the dollar’s decline and inflationary pressures, the White House and the Fed are actually encouraging a further fall of the dollar. Amazing. This means more inflation, a potential Fed overshoot on interest rates, and a slow-down and possible recession in 2007. None of this was necessary. We’ve had a very robust economy since mid-2003, and it could have easily continued. Debasing the dollar in a misguided protectionist attempt to reduce the trade deficit is hugely counterproductive. I warned of this possibility in my February memo but held out hope that the Fed and Treasury would reverse its inflationary/weak-dollar course in time to blunt these effects. No such luck.
What this means: The Chamber should prepare for a slow-down/recession in 2007-08. We should prepare for an inflationary environment. This policy means gas prices will probably stay high or go HIGHER. Some auto and manufacturing companies could benefit in the very short term, but overall this is bad for the larger economy, especially for technology and financial firms and for entrepreneurs. When the Fed figures out what’s going on, it will have to raise interest rates more than if it had gotten ahead of the curve in 2004-05. Commodity based businesses will continue to do well for a while, with intellectual property based businesses being hit the hardest. Eventually a recession would hurt everyone.
Currency volatility will also discourage international trade and investment, which could lead to slower global growth.
I’ll continue to think about what this means and how the Chamber should prepare.
Best,
Bret
Most of this scenario came to pass. Oil and commodity prices rocketed. Subprime loans, fueled by easy weak-dollar credit, kept flowing through 2006 and 2007. And the U.S., we now know, hit recession in “2007-08.”
Only the mechanism was a bit off. With elevated inflation, real interest rates never got very high — certainly not to the point that normally causes recessions. But the bursting of the adjustable-rate housing bubble, enabled by weak-dollar easy money, and the ensuing credit crisis had the same effect as a high real Fed Funds rate.
Many of the easy money mistakes had already been made by the Fed in 2003-2005. But this crucial period in 2006, when the U.S. government doubled down on a misguided weak-dollar strategy, told foreign capital to stay away, directly devalued all dollar assets, accelerated the financial collapse, and destabilized the globe.
Please, Mr. Paulson, enough with the currency lectures.
Robert Rubin famously was part of the “Committee to Save the World,” so dubbed by Time magazine, as he, Alan Greenspan, and Larry Summers supposedly prevented the Asian flu of 1997-98 from spreading around the globe.
But finally — finally — the mainstream press is wondering whether Rubin’s reputation over the years was justified. From today’sWall Street Journal:
Mr. Rubin’s salary made him one of Wall Street’s highest-paid officials — and a controversial figure among Citigroup shareholders and some executives, who questioned whether his limited duties justified the big paydays.
“Even though he has no ‘operating’ responsibilities, he still has a fiduciary responsibility as a board member,” said William Smith, a New York money manager and frequent critic of Citigroup’s current management and board. “He has overseen the entire meltdown, yet been compensated as an operating employee while bragging about having no operating responsibility.” Mr. Rubin can’t “have it both ways,” Mr. Smith added.
Somehow, the most central factor — the fundamental cause — of both the late-90s Asian meltdown and our current crisis — namely monetary and dollar policy — has escaped much criticism. Yes, the argument that Alan Greenspan and Ben Bernanke held interest rates too low for too long in the 2003-06 period can now be discussed in polite company. But it often is thought to be peripheral, or more often it just gets lost in all the chaos.
The late-90s mistake was just the opposite of this decade’s easy-credit mistake, with predictable mirror image effects. Back then, Greenspan and Rubin held a super-tight squeeze on dollars, pushing the dollar ever higher versus foreign currencies and commodities, crushing all dollar-debtors across the globe, from Thailand, Indonesia, and Korea, to Turkey, Russia, and Argentina. The world’s capital abandoned hard assets and flooded into the U.S. in general and into our soft, intellectual assets like Microsoft, Cisco, and dot-coms in particular. Eventually, after the “Committee to Save the World” had worked its magic and basked in its cover-boy status, the deflationary Greenspan/Rubin policy in 2000 toppled the U.S. markets, too.
Mr. Rubin likes to offer his wisdom “in an uncertain world” — the title of his memoir. But the world would be much less uncertain if the Rubin-Greenspan-Bernanke-Snow-Paulson monetary/dollar policy weren’t so manic.
P.S. Yes, to reiterate, these are supreme cases of the arsonist posing as heroic fireman.
“It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.”
Zachary Karabell writes about China’s ever growing importance, especially now, with our stumbles and its $2 trillion in reserves.
China’s actions could also have direct — and positive — effects on the U.S. economy. An investment arm of the Chinese government is now deep in talks to buy up parts of AIG. China is already the primary source of growth for many U.S. companies, including ones like Caterpillar that make things in the U.S. and export them to China. As the developed world sags, China is becoming even more important to the global system.
China also needs a vibrant U.S. (and Europe). Beijing will likely take action to prevent a collapse by continuing to purchase U.S. Treasuries. We may not like the fact that China is our creditor, but having no creditor would be a good deal worse.
Update: In his final international address, President Bush pushed continued free trade with China. Good for him. But if only his administration had realized that its weak-dollar policy was effective protectionism, which boomeranged — as it always does. The policy inflated the home, oil, and credit bubbles, which of course led to our present crash.
Really? That seems like an odd thing to advise at a time like this. But read David Dreman’s argument:
One last investment that should work out well over time: Buy property, if you live in a place with a forest of for-sale signs. The housing crisis is terrible, but it won’t last forever. If you can get a mortgage, and if I’m right about inflation, you will eventually be paying it back with 50- or 60-cent dollars. Pay 20% down on a house that rises 40% in five years and you’ll triple your investment, assuming you can cover the interest and maintenance with rental income. If prices rise above the rate of inflation, a reasonable possibility given how depressed they are now, your return will be still higher, possibly significantly so.
Shrewd advice from an accomplished money man. But, at the same time, it’s dispiriting that he’s right. The way to make money is not by financing progress but by speculating against the ability of the Federal Reserve to do its job.
Gambling by investors is a good thing, if by that we mean gambling on the next Orville Wright or Steve Jobs. But the gamble against the dollar is something different. It’s one in which your windfall profit is matched by a windfall loss for the fellow on the other side of the table–the unfortunate saver who lent you the money for the house.
Whether the topic is football or finance, Michael Lewis is maybe the best non-fiction story teller of our times. Now this author of Liar’s Poker, the smart-ass inside tale of Eighties Wall Street excess, finds the man who helped expose today’s housing charade and learns about real excess — the ’80s, how quaint — as he chronicles the 2008 crash.
More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens. “The price was absurd, and they were giving her a low-down-payment option-ARM,” says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he’d hired back in 1997 to take care of his newborn twin daughters phoned him. “She was this lovely woman from Jamaica,” he says. “One day she calls me and says she and her sister own five townhouses in Queens. I said, ‘How did that happen?’ ” It happened because after they bought the first one and its value rose, the lenders came and suggested they refinance and take out $250,000, which they used to buy another one. Then the price of that one rose too, and they repeated the experiment. “By the time they were done,” Eisman says, “they owned five of them, the market was falling, and they couldn’t make any of the payments.”
But the sub-prime detective Eisman still had not fully grasped the enormity and breadth of the problem.
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower.
Finally, Lewis lunches with his long-ago boss John Gutfreund, the Salomon Brothers CEO who he skewered almost 30 years ago.
[Gutfreund] thought the cause of the financial crisis was “simple. Greed on both sides—greed of investors and the greed of the bankers.” I thought it was more complicated. Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed.
Indeed, greed is ever-present. And not just on Wall Street. It is the incentives and discipline — the structure — of the market that keeps greed from pushing us over the cliff. It is this discipline of the market that makes service to others, in the words of George Gilder, more valuable than self-centered avarice. Had he taken it one step further, Lewis might have said that the ultimate disciplinarian — the taskmaster that demands real value instead of greed, froth, and fraud — is a rock-solid dollar.
The prolific Niall Ferguson with a long narrative of the financial crash in Vanity Fair:
The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.
On the eve of the G20 global financial summit, Judy Shelton weighs in with yet another brilliant exposition on stable money:
At the bottom of the world financial crisis is international monetary disorder. Ever since the post-World War II Bretton Woods system — anchored by a gold-convertible dollar — ended in August 1971, the cause of free trade has been compromised by sovereign monetary-policy indulgence.
Today, a soupy mix of currencies sloshes investment capital around the world, channeling it into stagnant pools while productive endeavor is left high and dry. Entrepreneurs in countries with overvalued currencies are unable to attract the foreign investment that should logically flow in their direction, while scam artists in countries with undervalued currencies lure global financial resources into brackish puddles.
Steve Pearlstein of the Washington Post is on Charlie Rose right now saying the U.S. trade deficit was a chief cause of the present financial crisis. He’s got it just backwards. It was our overreaction to the innocuous trade deficit — namely, inflationary weak-dollar easy credit, designed in part to close the trade gap — that brought us here. The weak-dollar Fed juiced oil and home prices. High oil prices boosted the trade deficit — just the opposite of the weak-dollar advocates‘ intent. Skyrocketing home prices required, and were fueled by, hyper-aggressive and unsustainable mortgage lending.
Pearlstein then said we needed an international regulator to stop this from happening. This entity should have stopped the U.S. from buying so much from China. Wrong again. We needed the Fed and Treasury to maintain a stable dollar. A stable currency is the ultimate financial regulator and disciplinarian. If we had ignored the trade deficit and focused on stable money, there would be no financial crisis.
The U.S. will experience its most severe recession since World War II, much worse and longer and deeper than even the 1974-1975 and 1980-1982 recessions.
There’s no hope of a V-shaped recovery:
a U-shaped 18- to 24-month recession is now a certainty, and the probability of a worse, multi-year L-shaped recession (as in Japan in the 1990s) is still small but rising.
And there’s a real
risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed funds rate
leading to global
stag-deflation
When a permabear like Roubini has been right so often for the past year (lo for the wrong reasons) it may seem a tall order to refute him. But John Tamny does an admirable job:
just as housing was the hot asset class in the early and late ‘70s, so was it this decade not due to economic growth per se, but thanks to currency debasement that always leads to a flight to the real. In short, the subsequent moderation of home prices has not been an economic retardant so much as it’s been the result of economic sluggishness that always reveals itself when currencies are allowed to weaken.
Roubini holds the reputation of soothsayer at present, but the very analysis that has made him all-seeing was faulty on its face. Lower home prices are an undeniable good for less capital going into the ground, as opposed to the entrepreneurial economy. What led to housing’s moderation of late was paradoxically what caused its boom. When currencies decline, hard assets do well, and investment in real economic activity withers. . . .
In short, Roubini made the correct call a few years ago about looming economic difficulty, but the call ignored the real cause which decidedly was the weak dollar. Happily for Washington’s political class, Roubini’s suggestions for “stimulating” the economy absolve it of its own mistakes, all the while allowing it to do what it does best: spend the money of others.
After two straight electoral defeats, it is time for a substantial party shake-up. We don’t need a feather duster; we need a fire hose.
We need to be honest about the root causes of our current financial crisis: loose money, crony capitalism and a lack of market transparency and information.
If Barack Obama ran for president by calling for a heavier hand of government, he also won by running one of the most entrepreneurial campaigns in history.
Will he now grasp the lesson his campaign offers as he crafts policies aimed at reigniting the national economy? Amid a recession, two wars, and a global financial crisis, will he come to see that unleashing the entrepreneur is the best way to raise the revenue he needs for his lofty priorities?
Read the whole op-ed here, and listen to a brief radio interview here.
In his Tract on Monetary Reform, John Maynard Keynes made the essential point that when money is debased, enterprise is discredited, and trade barriers soon reveal themselves. Having witnessed the worldwide monetary errors of the ‘20s that led to economic isolationism in the ‘30s, Keynes knew well the importance of the 1944 Bretton Woods monetary standard, of which he was a chief architect. . . .
Unfortunately, we’ve regressed. The chaotic monetary and currency policy of the present Administration has given rise to the trade skeptics of the next.
Tuesday’s “election could put trade-liberalization on ice for a while.”
There’s nothing like a credit crisis to stop inflation in its tracks.
Headline inflation will fall markedly over the coming year as energy and food prices fall from the previous spike. But inflation could later resume when the panic-induced plunge in velocity picks up. The Fed more than doubled its balance sheet to more than $2 trillion in the last two months, and it will have to be vigilant to pare liquidity as panic hoarding goes away. An inflationary weak-dollar Fed caused most of the credit crisis in the first place as it juiced the oil, housing, credit, and foreign reserve markets. Today’s crisis, which happens to be temporarily disinflationary, is not an especially pleasant trade-off to bring down the price index. Better just to keep the dollar sound in the first place.
