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.

Here was my warning to the Fed in The Wall Street Journal in 2006:

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

— John H. Cochrane, October 26, 2010

— Joseph Stiglitz, October 23, 2010

“Fixed exchange rates operate between California and New York . . . .”

“These currencies should be fixed, as they were under Bretton Woods or the gold standard. All this unnecessary noise, unnecessary uncertainty; it just confuses the ability to evaluate market prices.”

— Robert Mundell, October 16, 2010

“Geithner is Exactly Wrong on China Trade” – The Wall Street Journal. January 26, 2009.

“An End to Currency Manipulation” – Far Eastern Economic Review. March 26, 2008.

“The Elephant in the Barrel” – The Wall Street Journal. August 12, 2006.

“Money and the Middle Kingdom” – September 24, 2003.

— Thomas Jefferson, 1784, as quoted by Judy Shelton

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.

After 500 years of inward looking stagnation, Deng opened 1979 with a bang. He freed 600 million peasants with history’s largest tax cut. He emulated Hong Kong and Taiwan by establishing four Special Economic Zones on the sleepy southern coast. Before Beijing hard-liners knew it, mayors across China were demanding similar low-tax, local-control freedoms. By 1993, 8,000 of these of these entrepreneurial free trade zones had swept the nation. Two hundred fifty million people migrated to this “new China,” where tax rates were low and regulations few. Capital poured in from China and the world.

Township and Village Enterprises (TVEs) were an unexpected but powerful innovation. Fiercely competitive and locally owned, these quasigovernment entities escaped Beijing taxation. Propelled by local knowledge and a zero corporate tax rate, the TVEs by 2000 accounted for half of China’s output.

China needed an anchor for its complex transformation and in 1994 linked its currency, the yuan, to the U.S. dollar. The dollar-yuan link allowed a real price system to arise in China and created a single economic fabric stretching across the Pacific. Before long, the whole region had adopted what Stanford economist Ronald McKinnon calls the East Asian Dollar Standard.

The opposite of currency “manipulation,” this dollar standard was a victory for free trade and global growth. But U.S. economists missed its portent. The Fed and Treasury of the late-1990s did not supply sufficient dollars to match rapidly growing global demand. A scarce dollar shot higher, and hard assets fell. Oil plummeted to $10 a barrel, gold fell to $250 from $400, credit shriveled, and dollar debtors across Asia went bankrupt. With an appreciating dollar and a world in turmoil, capital flooded into the U.S. and especially our soft, intellectual assets — Cisco, Microsoft and dot-coms. The technology boom and bust was not a function of easy money but a scarce dollar.

In 2003, Alan Greenspan and Ben Bernanke identified an exotic threat: deflation. The Fed was seven years late. Mr. Greenspan’s post-9/11 liquidity had already ended the 1997-2001 deflation. Yet the Fed persisted with 1% interest rates through 2003-04 and easy money thereafter. Meanwhile, Treasury Secretary John Snow targeted China and its trade surplus as a big threat. He and his successor Hank Paulson agitated for a stronger yuan and thus a weaker dollar.

Treasury’s trade-deficit mania encouraged anti-China politicians. Messrs. Snow, Greenspan, Paulson and Bernanke several times talked Sens. Chuck Schumer and Lindsay Graham off the protectionist precipice. But the administration did not realize that the weak-dollar policy was itself protectionism.

China was imparting deep changes on the world economy. Yet in 2003 U.S. manufacturing was 50% larger than in 1994. U.S. knowledge industries were generating most of the world’s profits and wealth. American consumers were benefiting from low-cost imports. Meanwhile, many Asian goods were rerouted through China for final assembly. The U.S.-China trade deficit thus grew even as the total portion of U.S. imports from East Asia fell below 35% from 40% in 1990.

The real threat was a devalued dollar. In mid-2005, we finally forced China to delink from the dollar and mildly appreciate the yuan. Nevertheless, the trade deficit accelerated. Robert Mundell — Nobel laureate, China expert, father of the euro and supply-side economics — continued to warn that the trade deficit was perfectly natural. Worry about currency instability instead.

But other eminent economists urged a “more competitive dollar.” On May 13, 2006, this newspaper headlined: “U.S. Goes Along With Dollar’s Fall to Ease Trade Gap.” All these “more competitive” dollars had to go somewhere, and with amazing efficiency found their way into oil and subprime mortgages.

The weak dollar had the opposite of its intended effect. Cheap-dollar commodities exploded the trade gap. Conceived to make the U.S. “more competitive,” the policy channeled money away from technology innovators and into home-building and home-equity consumption. Inflation for a time does pump up demand, and so U.S. consumers bought, and Chinese growth shot even higher. Chinese, Russian and Middle Eastern foreign reserves grew, further depressing the yields of U.S. Treasurys.

Some credit indicators are now improving, but the Fed’s past destabilization policy will reverberate. The weak-dollar blunder helped scuttle the Doha Round of trade talks and will make the successful Bush tax cuts difficult to preserve. American interventionism could absolve Europe’s anti-innovation “antitrust” policy and excuse China’s worst intellectual property violations and “national champion” subsidies.

And yet, with sound-money advocate Paul Volcker in the Obama White House and Mr. Mundell plugged into Beijing, the monetary mayhem of the last decade could give way to a worldwide, sound-money revival in 2009 and beyond.

Mr. Swanson is a senior fellow and director of the Center for Global Innovation at the Progress & Freedom Foundation.

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.)

– David Malpass, March 27, 2009

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).