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

“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.

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.

“One request: This time around, could he make the mess and clean-up a little less bloody?

“A striking fact of the last two years of financial trouble is how accountability has differed in the public and private spheres. On Wall Street and across the country, decades-old firms have failed, fortunes have vanished, and some former captains of finance face jail or fines. In Washington, meanwhile, most regulators and Members of Congress remain on the job, often with enhanced power.”

— The Wall Street Journal, August 26, 2009

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 one factor, let alone the central factor, leading to the crash. This is very big stuff.

Some of us have been saying this for years, and even warned of the potentially severe consequences as the monetary errors were building. Few predicted the exact course of extraordinary events over the last 18 months, but it was clear to me in August 2006 the size of the monetary mistakes would have big repercussions:

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.

So Geithner, who’s had some rocky moments, gets real credit for admitting a crucial and central truth of this historic economic event, heretofore banished from polite conversation by an omertà of the economic brethren.

Yet why, among the endless lending, spending, and Tarping (unending?), does monetary policy not even get a mention when we talk about building a more robust economic system for the future? Obviously the Fed and Treasury are taking unprecedented and, I would even say, bold and creative actions to relieve the immediate crisis.

But when we contemplate a new financial order, when the the G20 meets in London to supposedly consider a Bretton Woods II, when economists begin revising their models of risk and politicians fantasize of new regulatory strictures on banks, hedge funds, investors, and lenders — when we gab about full-proof prevention of such trauma in the future — why do the key players neglect to even gently raise the “overwhelmingly powerful” central error of the whole episode?

New computer models. International super-regulators to spy and pierce bubbles. A rich new slush fund for IMF bureaucrats. Austere new pay limits for private finance. Cramming down mortgages. Propping up banks. All talk of money. Yet no mention of . . . the dollar.

Credit’s fiercest disciplinarian is sound money. The best regulator of risk is a stable currency. Far more than the new policy contraptions proposed by Davos dreamers and Gaussian copula critics, it is the elemental simplicity of a low-entropy dollar that can once again be the steadfast foundation for dynamic creativity and the measuring stick and promoter of real economic value.

(Hat tip: Social Security Institute)

UPDATE: See The Wall Street Journal’s excellent editorial on this important concession. 

– David Malpass, March 27, 2009

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.

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.

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.