The Meltdown Continues: the Fannie and Freddie Edition

So Fannie Mae and Freddie Mac have fallen and will get a government bailout. Clive Crook has nicely summarized this latest financial domino to fall in the ongoing financial crisis:

US taxpayers are about to find out what their long-standing and (strictly speaking) non-existent guarantee of Fannie Mae and Freddie Mac will cost them. One way to think of it is this: take the US national debt of roughly $9,000bn and add $5,000bn. Not bad for an obligation still officially denied.

James Hamilton, Arnold Kling, and Mark Thoma also provide good discussions on this development. It is worth noting that Nouriel Roubini predicted Fannie and Freddie's collapse back in August 2006. If you are curious as to how the rest of this financial crisis will unfold, take a look at Nouriel's 12 steps to financial disaster. Let me add Nouriel to my list of certified economic prophets.

Dump the Dollar Peg Week

This has been the week of dump the dollar peg in the Gulf States. First, it was reported on Sunday that some officials from Abu Dhabi think the United Arab Emirates should replace its dollar peg with one tied to a basket of currencies. At the same time, Nouriel Roubini posted an article comparing the coming collapse of the Bretton Woords II system with that of Bretton Woods I where, among other things, he too called for the end of the dollar peg in the Gulf States. Then on Monday the Financial Times (FT) published its "Dollar-pegged out" editorial. Here the FT similarly argued the Gulf States needs to abandon the dollar peg and move to a basket of currencies that included the price of oil. The FT's editorial, in turn, made Brad Sester happy who followed up on Tuesday with a posting to his blog that furthered the arguments made in the FT. On Wednesday, Jeffrey Frankel, the originator of the currency-basket-including-oil idea chimed in on this debate with this piece. Then on Thursday the Wall Street Journal RTE blog posted the "Dollar Peg Gets Taken Down a Peg." And today, ordinary people like me are sifting through this debate, considering how such a change would take place and what it would mean in the near term.

But first, let's review the thinking behind the calls for the Gulf States to abandon their dollar pegs. Martin Feldstein explains it this way:

The double-digit inflation problem in Saudi Arabia and its Gulf neighbours is different from that of other emerging market economies. Although the rising price of imported food affects them all, the inflation problem in the Gulf region is exacerbated by their fixed exchange rate policy.

The peg to the dollar contributes to Saudi inflation in two ways. First, the dollar link forces the Saudi central bank to match US interest rates. As the Fed lowered its interest rate from 5.25 per cent last summer to 2 per cent now, the Saudis had to cut their interest rate. If they had not done so, investors around the world would have flooded Saudi Arabia with funds seeking the higher yield on a currency that is pegged to the dollar. While cutting rates was a good policy for the US as its economy weakened, it was a terrible policy for Saudi Arabia, which is experiencing an overheated domestic economy with rapidly rising inflation.

The dollar peg also raises Saudi inflation by increasing the cost of imports as the dollar declines relative to the euro, the yen and other currencies. The US is the source for only about 12 per cent of Saudi imports. The 15 per cent decline of the dollar relative to those currencies during the past year meant that the prices paid by the Saudis for the goods that they bought from Europe, Japan and elsewhere rose more than 15 per cent. The large US trade deficit is likely to continue to force the dollar to decline against other main currencies. The result will be a continuing source of imported inflation in Saudi Arabia and other countries that tie their currencies to the dollar.

Inflation in Saudi Arabia and the other Gulf states is depressing real incomes of millions of low-income workers. The combination of the dollar peg and the declining dollar is also reducing the value of the remittances that large numbers of foreign workers send home to their families in low-income countries such as India and Pakistan. Since these foreign workers make up more than half of the total workforce in Saudi Arabia and an even larger share in the less populous states of the region, their discontent is a significant risk to local stability.

Because of their dollar pegs, then, the Gulf States are importing the highly stimulative U.S. monetary policy at the very time their overheating economies need a tighter monetary policy. The remedy, as argued by the above individuals and media outlets, is to change the composition of their peg to a basket of other currencies and oil. Doing so, would mean that their "currencies would appreciate when oil is strong, and depreciate when it is weak" and "make for smoother adjustments than double-digit inflation" (FT).

It is clear that the dollar peg is distortionary for the Gulf States. It is also clear there is an end game in sight: either the Gulf States change their peg or continued inflation will effectively do it for them. The currency-oil basket makes sense to me as a long-term solution, but what about in the short-term when the transition between pegs would take place? What happens if in abandoning their dollar peg the Gulf States make other important dollar peggers like China nervous about capital losses on their own dollar holdings? This could start a run on the dollar and lead to more distress in our battered financial markets. So when I read these calls for dumping the dollar peg, I agree in principle but get concerned as to what would actually happen in practice.

Is there a way to guarantee the transition will be orderly? My current thinking is that part of the solution lies with the Fed: it should do more to reign in global inflation. This would remove the inflationary pressures in the Gulf States and give them more time to work on a orderly transition. It would also reduce the likelihood of a run on the dollar.

NCAA Tournament-Style Brackets: Who Killed the Economy?

Take a look at this Portfolio.com NCAA tournament-style bracket where you pick who killed the economy. I might have added some brackets for certain mortgage lenders, the debt-addicted American consumer, and those prominent academic economists who gave credence to the Fed's low interest rate policy back in 2003. Still, it is a fun distraction to check out.

Double Trouble

History is Repeating Itself

In thinking about today's global inflation problem and the role U.S. monetary policy is playing in it, it struck me that we have seen this story before. The collapse of Bretton Woods system--the global monetary system from the end of WWII through the early 1970s-- was due to the United States abusing it role as the anchor currency. During this time, many countries outside the communist block pegged their currencies to the dollar, which was ostensibly backed by gold. Consequently, these countries were willing, initially, to take dollar and dollar-denominated assets for international payments. The United States, however, had pressing domestic spending objectives--the Vietnam War and the Great Society--that required foreign financing. This meant foreign countries took increasingly more dollar and dollar-denominated assets as payment. After some time, these countries began to question whether the U.S. really could back up all of these dollars it was exporting with gold. The answer, of course, was that it could not and eventually the system collapsed. Along with the collapse came a surge in global inflation--the delayed consequence of the U.S. exporting its loose monetary policy to the rest of the world for so many years.

Today, we see the same thing happening. Nouriel Roubini has a post yesterday that makes this very point:

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Suffice to say history seems to be repeating itself. Maybe this time around the world will become once bitten twice shy about the dollar.

A Good Hyperinflation?

I see Bryan Caplan is questioning again the necessity of the American Revolution. His views on the American Revolution reminded me of an experience I had in grad school with one of my monetary economics professors.

Somehow, I had picked up J.K. Galbraith's Money: Whence It Came, Where It Went and read his account of how fiat money was used by the Continental Congress to finance the Revolutionary War. The excessive creation and uncertainty surrounding the Continentals, as the fiat currency was known, created an hyperinflation-like environment. Galbraith, unlike Caplan, valued the American Revolution and concluded that "the U.S. rode the wave of hyperinflation into existence." The implication was clear: hyperinflation was needed to win U.S. independence. Feeling all smug about having in hand what seemed to be a hard-to-refute example of high inflation actually being a good thing, I visited my monetary economics professor. Now I am not an advocate for hyperinflation--far from it--but I could not resist the chance to throw a monetary curve ball at my professor. So I did and expected him to strike out. Instead, he hit took my pitch and hit a home run off of it with these sharp words:"David, history is written by the victors!" I left his office humbled once again.

The Economist Magazine Forgot This Global Institution in Its Leader

The Economist has an interesting leader on the future of global institutions such as the G8, the IMF, and the UN Security Council. The article, however, makes a glaring omission when it comes to its list of important global institutions. This oversight, though, may be a good thing since there is no point in reminding the world about a highly influential global institution that is largely indifferent to the needs of the world yet highly concerned about the one country that runs it.

So what is this global institution? Let us turn to the Financial Times for the answer:

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed sets interest rates for Asian [and many Middle Eastern] countries because, explicitly or not, they manage their exchange rates against the dollar. If US interest rates are low, countries targeting the dollar are obliged to follow, because otherwise investors will sell dollars to buy their currency.

So the Fed is a monetary hegemon and its current accommodative stance, while arguably appropriate for the United States, is way too stimulative for the dollar block, those countries whose currencies are tied to the dollar. This is creating some geopolitical angst and is why the Fed should be added to the list of important global institutions.* The global reach of the Fed is something I have discussed before, but recent commentary on this issue by Brad Sester started me thinking more about the fundamental problem with this arrangement. Here is Brad Sester's take on these developments:

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

...Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US — and the world — would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Brad's point is that this arrangement is the one of the main reasons for the global economic imbalances--the large, ongoing U.S. current account deficits and the financing for them from Asia and the Gulf region--and is therefore unsustainable. I agree with Brad's conclusions, but have started thinking about this problem from a different perspective: the dollar bloc an optimum currency area (OCA). Consider the standard criteria of an OCA: similar business cycles, mobile labor, flexible prices/wages, fiscal transfers, diversified economy. The main regions of the dollar block--U.S., Asia, and the Gulf region--fail to meet the OCA criteria on most counts. For example, the U.S. economy is slowing down while the rest of the dollar block is overheating. Or, when was the last time you saw a mass exodus of former Rustbelt workers moving to China or heard of a fiscal transfer from the Gulf region to the Rustbelt? By my reckoning, then, the OCA criteria also indicates the dollar block countries should abandon their pegs and take on more monetary policy autonomy.

With that said, I am fearful of what would happen to the U.S. economy if the dollar block countries abandoned their dollar pegs anytime soon. The Fed's job would certainly be made more challenging and potentially there could be a run on the dollar. In the near term, then, it may be more sensible for the Fed to acknowledge its role as a monetary hegemon and take the lead in fighting global inflation. (Actually, I would have the Fed stabilize global nominal spending, but I digress). This may have some domestic economic consequences, but it would (1) help reign in global inflation and (2) give more time to dollar block to hammer out a coordinated plan of separation.

*According to Ken Rogoff, these countries make up about 60% of the global economy so the Fed's influence is significant.