Capital Flight is Good

Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.

In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:

1. Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
   
   
2. Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
   
   
3. Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
   
   
4. (in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.

For the US today, the real problem would be if foreigners insisted on continuing to purchase US assets. That would support the dollar, making it that much harder to sell US goods and services and contributing to the weakening of the economy, thereby exacerbating the positive feedback between a weak economy and a weak financial system.

As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.

If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)

If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).

There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.

TSLF: Is the government taking a risk?

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

This inflaiton report scares me.

Quoting myself from the comments section of my last post:

...Japan had plenty of missed opportunities in the early to mid 90s to prevent the depression from getting out of hand. It was only when the inflation rate went to zero...that it really became intractable.

Speak of the devil, and he shall arrive appear. I'm pretty sure we'll get positive core inflation in March (and there's no question that we'll get positive headline inflation), but seeing zero even in one month (as in today's February CPI report), while commodity prices are rising at unprecedented rates, is pretty disturbing. Both the 12-month CPI inflation rate and the 3-month annualized rate are 2.3%, which is right in the middle of the normal range. This is disturbing because it seems to indicate that business don't even have enough pricing power to pass on part of the huge cost increases they are facing in energy and materials. What happens when commodity prices stop rising? I don't think I want to find out.

Not a Bubble

Alex Tabarrok of Marginal Revolution has gotten a lot of (mostly dissenting) attention for his argument that there was no housing bubble (hat tip: hmm, I don't even remember, but I'll cite Paul Krugman, Jane Galt Megan McArdle, and Battlepanda, among the many who have pointed to the post). Alex Tabarrok reproduces Shiller's now-famous chart of housing prices over the past 100 years and comments:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 [culminating at an index value around 200] was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average. Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007). Prices have fallen more in the hottest markets but the run-up was much larger in those markets as well.

Prices will probably drop some more but personally I don't expect to ever again see index values around 110. Do you?

As Battlepanda points out, "Do you?" is not a very convincing argument unless you already agree with him. But I think I can make it a little bit more convincing:

Prices will probably drop some more, but personally, given the likely effect that an additional 40% drop in home prices would have on the already weak economy, I don't expect that the Fed will allow index values to fall to anywhere near 110 in the foreseeable future. Do you?

Some people will respond with something like, "OK, I don't either, but that doesn't mean it wasn't a bubble; that just means there's a Bernanke put on home prices: there was a bubble, and the Fed is now going to ratify the results of the bubble." But that's not right. The Fed is not actively causing inflation in order to bail out homeowners and their creditors. The vast majority of professional forecasts call for the inflation rate to fall over the next few years. The Fed is just doing its job -- trying to keep inflation at a low but positive rate while maximizing employment subject to that constraint. The ultimate concern of the Fed is to avoid deflation, which becomes a serious risk if the US housing market has a total meltdown. It's very much as if the Fed were passively defending a commodity standard, with the core CPI basket as the commodity.

The ultimate source of the housing boom is the global surplus of savings over investment. That surplus is what pushed global interest rates down and thereby made buying a house more attractive than renting. And that surplus is still with us. If anything, it appears to be getting worse, as US households begin to reject the role of "borrower of last resort." And it is that now aggravated surplus that threatens us with weak aggregate demand and the risk of economic depression in the immediate future -- a risk to which the Fed and other central banks will respond appropriately. Until the world finds something else in which to invest besides American houses, the fundamentals for house prices are strong -- not strong enough, probably, to keep house prices from falling further, but strong enough to keep them well above historically typical levels.

What is the core for?

Suddenly I have so much to say about the core CPI, in response to the latest attacks by Barry Ritholtz and Daniel Gross. I've already said most of it in comments to a post by Brad DeLong (also note kharris' insightful comments) and one to the original Barry Ritholtz post. I may reproduce some of them in future posts here, but my last (thus far) comment (from the DeLong post) is probably what needs to be said first:

There are really 3 separate questions here:

(1) What is the best measure of retrospective changes in purchasing power?

(2) What is the best indicator of the general trend in prices (with respect to what can expected in the immediate future)?

(3) What is the best target for monetary policy?

For the first question, obviously the full index is better than the core, and nobody denies that.

For the second question, there is room for debate, but if the only choices are the core and the full index (to measure inflation for a specific period of a year or less), I would still choose the core. (If you let me smooth the inflation rate with, say, an exponential smoother, I might prefer the full index.)

For the third question, I think there is little room for reasonable debate: the core is better. When food and energy prices go up relative to other prices, the optimal policy rule would accommodate those increases so as to allow other prices to remain stable. The increase in the general inflation rate does little harm; the alternative of deflation in the non-core component would do considerable harm.

Messrs. Ritholtz and Gross, and their supporters in this commentary, are finessing the issue by not distinguishing among these three purposes.

The answer to the third question only works if people know roughly what to expect in advance. If people expect the Fed to control the overall inflation rate but the Fed only attempts to control the core, the outcome will not be good when the two start to diverge. People who attack the core index are contributing to the likelihood of such a bad outcome, as well as to the likelihood of the other bad outcome in which the Fed actually does control the full inflation rate even in situations where it shouldn't.

Punch at Caesar's Funeral

Contrarian that I am, Daniel Gross’ latest Moneybox commentary in Slate (hat tip: Mark Thoma) has all but convinced me that a drastic easing of Fed policy will be necessary to avoid a major recession. The main thrust of his commentary seems to be that, because a lot of rich people and conservatives want the Fed to cut interest rates, therefore anyone who is not rich or conservative should regard such a cut as a bad idea. (He doesn’t make that logic explicit, but since the commentary contains little explicit logic, I feel entitled to read between the lines.) To me, as a non-conservative* who is not (yet) rich (certainly not in the same league as Mr. Gross’ “motley collection of gazillionaires”), the observation that such people are “begging the Fed to cut interest rates” tends to reflect well on them rather than reflecting badly on the possibility of interest rate cuts.

At the end of the commentary, Mr. Gross does attempt to make an actual argument against interest rate cuts, but I fear he has confused metaphor with reality:

College students don't alleviate the after-effects of an evening spent at the punch bowl by returning to lap up the dregs. Just so, finance types should know that cheap money, credit on demand, and endless leverage aren't the cure for a hangover caused by too much cheap money, leverage, and credit on demand.

Or perhaps he has merely forgotten some relevant history. Unlike me, Mr. Gross does have a degree in history, so perhaps he will be able to find historical examples to buttress his case. (There were none in this particular commentary.) But to my own sparsely tutored ear, his analogy bears an unpleasant resemblance to the type of argument that was often heard in policy circles during the period 1929-1932.

As a matter of macroeconomics, I would say that “cheap money, leverage, and credit on demand” are precisely the cure “for a hangover caused by too much cheap money, leverage, and credit on demand” – at least to the extent that said hangover carries a risk of recession or deflation. If only the Fed had provided cheap money and credit on demand in late 1929 and 1930 (or, for that matter, 1931 and 1932), history might have turned out quite differently (and, I dare say, better). Perhaps Mr. Gross can cite some recent history – the 1998 experience – as an example of what’s wrong with easing monetary policy in response to a mass deleveraging. I have to ask, though: If the choice is between risking another 1999 and risking another 1931, which one should we be more concerned about? I pause for reply....


Not that we really have to worry about a repeat of the 1930s. Ben Bernanke is an economic historian – and an expert on the Great Depression, at that. As soon as he gets a strong whiff of recession, he will do anything but repeat the mistakes of the early 1930s. But it’s also clear that Chairman Bernanke is bending over backward to avoid repeating 1998. The last three weeks have been a case study in how to loosen monetary policy without loosening monetary policy. And it’s worth noting that the US economy was a lot stronger going into 1998 than it was going into 2007.

The classic “punch bowl” metaphor adopted by Mr. Gross has (at least) one major limitation: unlike alcohol, money is pretty much essential to the functioning of a modern economy. Certainly the Fed should take away the ice cream before our waistlines start to inflate. But when our bulimic economy realizes it has eaten too much, there are healthier approaches than encouraging vomiting and fasting.


* I hesitate to use the word “conservative” in any substantive context, however. The fact that “conservatives” are calling for easy money is yet one more small contribution to the mounting evidence that such words have little left in the way of meaning.

To Put or Not To Put

Pardon my language, but enough with the God damn Greenspan put! There never was a Greenspan put!

Let me be more precise. There was, and is (and ever more shall be, if the Fed does its job well), a put on the general price level. So if you’re speculating directly on the general price level, you can expect some degree of protection from the Fed. For example, if you buy TIPS and short nominal Treasury notes, and if you maintain enough capital to meet a reasonable range of margin calls, Ben Bernanke will make sure you don’t go broke. (He will also try his damnedest to make sure you don’t make any money out of the deal either, but that’s another story.) If you are following this strategy, consider yourself protected. If your enemies are following this strategy, and it pisses you off that they are being protected by the Fed, go ahead and send hate mail to Ben Bernanke. He welcomes your hatred. (Not that I have inside information on this point; it’s just that any reasonable central banker should welcome the hatred of those who think deflation is acceptable.)

The impression that there is a put on certain other assets arises from the fact that various assets are correlated with the general price level in complicated ways. So if you bought stock during 1998, when the general price level in the US was fairly stable and there were deflationary forces afoot in the world, you could be confident that Greenspan would bale you out. You have to recognize, though, that when he bails you out, it doesn’t mean he likes you. It just means he dislikes deflation. On the other hand, if you bought stock during early 2000, when the inflation rate was showing signs of acceleration, you couldn’t count on Greenspan to protect you. Those who did somehow found themselves unable to exercise that protective put that they thought they owned.

In retrospect, it seems clear that the Fed reacted too quickly and too aggressively in 1998, and not quickly enough in 2000-2001. Ben Bernanke has the benefit of hindsight on both of those episodes, and he will presumably try to steer and intermediate path. A lot of people (more than in 1998, one might imagine) will end up bankrupt, and certain pundits will watch them and curse the Fed for risking a meltdown. A lot of people (more than in 2001-2002, one might hope) will find that their perhaps ill-advised investments recover enough to avoid bankruptcy, and certain pundits will watch them and curse the Fed for encouraging inappropriate risk-taking. And those who make their living by writing straddles on general price indexes (if there are any such people) will, in all likelihood, keep on happily collecting premiums as if nothing were happening.

Don’t Just Float the Yuan

My earliest posts in this blog (see the archives from April and early May 2006) dealt largely with the subject of China’s artificially weak currency. The general thrust was that the weak-RMB policy was inefficient from a global point of view, contrary to China’s interest, and probably contrary to US interest as well despite the benefit to US consumers. Upon further thought, it seems to me that those posts stand in a somewhat ironic relation to my KNZN screen name. From a Keynesian point of view, if we take China’s other policies as given, allowing the yuan to appreciate seems like a distinctly bad idea for China and not necessarily a good one for the US.

By most accounts, the pace of capital investment in China is already so rapid as to be unhealthy. Meanwhile, despite some concerns about overheating, the inflation rate remains tame. So what would happen if China were to allow the yuan to appreciate? In terms of the components of national output, net exports would fall. There is no reason to expect a change in either consumption or government purchases. This means that China’s monetary authorities would face a choice: either push easy money to encourage increased private investment, or let national income fall (relative to its path under the current regime). If national income were to fall, standard Phillips curve theory suggests that the inflation rate would fall as well, possibly pushing China into an unpleasant deflation. Those possibilities don’t sound particularly pleasant.

There is also the possibility that “standard” Phillips curve theory doesn’t apply in this case. That is, China’s Phillips curve may be flat in its current range, so the result of an appreciation would be lower output at the same inflation rate. A flat Phillips curve is essentially a free lunch, so by advising China to allow appreciation without encouraging more rapid investment, we would be advising them to pass up the free lunch. Alternatively, maybe the Phillips curve is vertical, in which case deflation becomes the only alternative to more rapid investment in the case of an appreciation.

The US, on the other hand, is by most accounts (though not by mine) already near (if not at or above) full employment. By increasing net exports (which is to say, decreasing net imports), a stronger yuan would force the Fed to raise interest rates to discourage private investment, which is already not as strong as one might hope. (I’m assuming that the Fed agrees with the consensus and not with me, and since the US Phillips curve seems to be fairly flat right now, it will be a long time before the Fed – and the consensus – realizes its error. Alternatively, you can just assume that the consensus is right.)

So a good Keynesian ought not to advocate a mere floating of the yuan (unless of course that good Keynesian disagrees with the consensus that investment in China is currently too rapid). For China, a good Keynesian ought primarily to advocate a fiscal stimulus – lower taxes or more government spending, perhaps a publicly financed health insurance system that would reduce the need for precautionary saving by individuals. Once the fiscal stimulus is a done deal, it will hopefully be obvious to the Chinese that the currency needs to appreciate.

Hawk Helicopter

Fed Chairman Bernake is famous for once having given a speech in which he trumpeted the Fed’s ability to combat deflation by creating money – if necessary, by dropping it from a helicopter. The image of Old Ben piloting a chopper, raining dollars on a world fertile for price growth, has stuck in the minds of many inflation hawks and left them with the impression that the Chairman is likely to be relatively soft on inflation. But when we look at his famous statement in context and apply the logic of central banking, it becomes clear that this conventional interpretation is not just incorrect but diametrically opposite to the statement’s true implication.

First we have to recognize that there is a consensus that deflation is bad. It is a matter of dispute just how bad deflation is. But it is fair to say that those who regard deflation as a potentially healthy process are a small minority. To many, deflation conjures up images of the early 1930s, probably the most unpleasant period in the history of capitalism. There is also dispute – and this is where Bernanke’s speech weighs in – about how hard it would be to end a deflation if such a thing were to materialize. The example of Japan suggests a rather pessimistic prognosis, but Bernanke’s speech makes clear that he thinks more effective anti-deflation policies would have succeeded much sooner in Japan.

As a central banker, one is faced constantly with the problem of balancing risks. The biggest risks, I think most would agree, are, on the one side, deflation, and, on the other side, excessive inflation. The problems associated with high inflation are well known. From a central banker’s point of view, it isn’t really the end of the world, because it is generally acknowledged to be curable. The cure, however, is painful and politically difficult, so most central bankers make diligent efforts to provide more than an ounce of prevention. Deflation, on the other hand, is not generally acknowledged to be curable, so some central bankers might regard it as the end of the world. Anyone who does regard deflation as the end of the world is likely to tilt the balance of risks toward inflation.

Bernanke, it should be abundantly clear, is not such a central banker. Bernanke thinks deflation is a solvable problem, just like inflation, and the solution to the deflation problem is a lot less painful than the solution to the inflation problem. Accordingly, Bernanke is not likely to be overly concerned with the risks of pursuing a tight money policy. With his helicopter fueled and ready in case it should be needed, Bernanke’s inclination will be to tilt the balance of risks toward deflation rather than inflation.