The Fed and Its Impact on the Global Economy

Paul Krugman writes about a two-speed global economy where the emerging economies are experiencing rapid economic growth and rising inflation while the advanced economies remain in a slump. A key point he makes is that the countries still in a slump should focus on their own economic problems, not those of other countries. This especially applies to concerns about the Fed's monetary policy being exported across the globe:

What about complaints from other countries that they’re suffering inflation because we’re printing too much money? (Vladimir Putin has gone so far as to accuse America of “hooliganism.”) The flip answer is, Not our problem, fellas. The more serious answer is that Russia, Brazil and China don’t have to have inflation if they don’t want it, since they always have the option of letting their currencies rise against the dollar. True, that would hurt their export interests — but economics is about hard choices, and America is under no obligation to strangle its own fragile recovery to help other nations avoid making such choices.

He makes a fair point here in that the reason the Fed's policies are being felt overseas is because those affected countries have chosen to link their currency to the dollar.  By linking to the dollar these emerging economies have made a decision to allow their monetary policy to be set in Washington, D.C.  That is a choice outside the Fed's control. 

Here is where I wish Krugman would go with his argument.  Because these dollar block countries--all those emerging economies that either explicitly or implicitly peg to the dollar--are a significant share of the global economy, the BoJ and the ECB have to be mindful of what the Fed does too.  If the BoJ and the ECB try to ignore the Fed's easing of monetary policy in the United States and in the dollar block countries, then they risk having their currency appreciate too much against a large portion of the global economy.  That is why, as I noted earlier, the ECB could not possibly maintain its plans to steadily raise its targeted policy interest rate throughout the rest of the year.  For better or for worse, then, the Fed is a monetary superpower.

Now if you buy this reasoning so far, think about this question: could the Fed's monetary superpower status have played a role in the global credit and housing boom in the early-to-mid 2000s? I say yes and explain why in this working paper.

Another Nail in the Global Saving Glut Coffin

David Laibson and Johanna Mollerstrom have a new paper--see here for a shorter version--that further undermines the popular global saving glut theory (GSG). According to the GSG theory there was an increase in global savings beginning in the mid-to-late 1990s that originated in Asia and to a lesser extent in the oil-exporting countries. This surge in global savings found its way into the United States via large current account deficits that, in turn, created the asset bubbles of the past decade. Laibson and Mollerstrom argue the GSG theory has the causality backwards: the asset bubbles in the advanced economies came first and spurred consumers to go on a consumption binge. That consumption binge, in turn, was financed by savings from abroad. The smoking gun in their story is that had the foreign funding been truly exogenous then there would have been a far larger investment boom given the amount of foreign lending. Instead, there was a consumption boom which is more consistent with causality starting from an asset bubble. Their paper adds to their growing chorus of SGT skeptics including Menzie Chinn, Maurice Obstfeldt andKenneth Rogoff, Guillermo Calvo, and myself.

Interestingly, Laibson and Mollerstrom note that their story fails to answer two important issues:

There are many open questions that we have failed to address, but two stand out in our minds. First, our model takes the existence of the asset bubbles as given and does not explain their origins.

[...]

Second, our model does not explain why global interest rates fell between 2000 and 2003, and thereafter stayed at a relatively low level.

Well let me help Laibson and Mollertrom here. The actions of U.S. monetary policy can answer the first question and at least the first part of the second question for this period. As I have written before, this is easy to see given the Fed's monetary superpower status:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

In short, the Fed set global monetary conditions at the time and pushed global short-term rates below their neutral level which, in turn, started the asset booms. Of course, financial innovations and credit abuses also played a role and may explain the persistence of the low global interest rates. I think my monetary superpower hypothesis fits nicely with the Laibson and Mollertrom story. One more nail in the saving glut coffin.

P.S. In case you are wondering, here is evidence the Fed kept the federal funds rate below the neutral rate during the early-to-mid 2000s (source). Here is more formal evidence from the ECB.

Janet Yellen: the Fed is a Monetary Superpower

Federal Reserve Bank of San Francisco President Janet Yellen makes the case for the Fed as a monetary superpower, at least in Asia:

For all practical purposes, Hong Kong delegated the determination of its monetary policy to the Federal Reserve through its unilateral decision in 1983 to peg the Hong Kong dollar to the U.S. dollar in an arrangement known as a currency board. As the economist Robert Mundell showed, this delegation arises because it is impossible for any country to simultaneously have a fixed exchange rate, completely open capital markets, and an independent monetary policy. One of these must go. In Hong Kong, the choice was to forgo an independent monetary policy.

[...]

As in Hong Kong, Chinese officials are concerned about unwanted stimulus from excessively expansionary policies of the Fed and in other developed economies. Like Hong Kong, China pegs its currency to the U.S. dollar, but the peg is far less rigid.

[...]

Overall, we encountered concerns about U.S. monetary policy, and considerable interest in understanding the Federal Reserve's exit strategy for removing monetary stimulus. Because both the Chinese and Hong Kong economies are further along in their recovery phases than the U.S. economy, current U.S. monetary policy is likely to be excessively stimulatory for them. However, as both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent stuck with the policy the Federal Reserve has chosen to promote recovery.

I am glad to see such a high-ranking Fed official agrees with me that the Fed is a monetary superpower. Now that we have this common understanding let us explore its implications for the saving glut theory. Let us do so by referencing an older post of mine:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

I wonder what Yellen would say to the above paragraphs. More pointedly, I would love to ask her the following question: If the Fed can influence global liquidity conditions now why not in the early-to-mid 2000s? (I would also enjoy hearing Ben Benanke's answer to this question.) If so, then surely the Fed had some role in the global housing boom. Chris Crowe of the IMF and I are working on a paper that documents this superpower status of the Fed and will be sure to send Janet a copy when it is done.

Bernanke Goes for the KO and Misses

Ben Bernanke came out swinging today throwing some hard punches at those critics who say the Fed's monetary policy was too accommodative in the early-to-mid 2000s. He does so by throwing the following four-punch combination of arguments: (1) economic conditions justified the low-interest rate policy at the time; (2) a forward looking Taylor Rule actually shows the stance of monetary policy was appropriate then; (3) there is little empirical evidence linking monetary policy and the housing boom; and (4) cross country evidence indicates the global saving glut, not monetary policy was more important to the housing boom. Though Bernanke rejects the view that interest rates were too low for too long in this speech, he does acknowledge the Fed could have been more vigilant in regulatory oversight of lending standards. By far this is one of the better defenses of the Fed's low-interest rate policy of the early-to-mid 2000s that I have seen. Arnold Kling seems convinced by this rebuttal while Mark Thoma appears more agnostic about it. While Bernanke's case seems reasonable for the 2001-2002 period, I find his arguments far from convincing on all four points for the period 2003-2005 and here is why:

(1) By 2003 economic conditions did not justify the low-interest rate policy. Aggregate demand (AD) growth was robust, productivity growth was accelerating, and the ouput gap was near zero by mid 2003. The following figure shows the robust AD growth rate--measured by final sales of domestic product--and how the federal funds rate markedly diverged from it in 2003 and 2004 (marked off by the lines):


Note this rapid growth in AD indicates there was no threat of a deflationary collapse. Then what about the low inflation? That came from the robust productivity gains, not weak AD growth. The following figures shows the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed:


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. It is also worth pointing out that this surge in productivity growth was both widely known and expected to persist. Productivity gains, then, were the reason for the lower actual and expected inflation. [It is also worth noting that productivity growth typically means a higher real interest rate which serves to offset the downward pull of the expected inflation component on the nominal interest rate. In other words, deflationary pressures associated with rapid productivity gains do not necessarily lead to the zero lower bond problem for the policy interest rate (Bordo and Filardo, 2004).] The big policy mistake here, then, is that the Fed saw deflationary pressures and thought weak aggregate demand when, in fact, the deflationary pressures were being driven by positive aggregate supply shocks. The output gap as measured by Laubach and Williams also shows a near zero value in 2003 that later becomes a large positive value. As Bernanke notes, though, there was a jobless recovery up through the middle of 2003. This can, however, be traced in part to the rapid productivity gains. The rapid productivity gains created structural unemployment that took time to sort out, something low interest rates would not fix. In short, it is hard to argue economic conditions justified the low interest rate by 2003.

(2) A forward looking Taylor Rule does not close the case that the stance of monetary policy during 2003-2005 was appropriate. Bernanke cleverly constructs an "improved" Taylor rule that has a forward looking inflation component to it and finds monetary policy was actually appropriate during this time. Now a forward looking rule does make sense but invoking it now appears as an exercise in ex-post data mining to justify past policy choices. Regardless of this Taylor Rule's merits, there is still reason to believe Fed policy was too accommodative during this time. As mentioned above, productivity growth accelerated and it is a key determinant of the natural or equilibrium real interest rate. Typically, higher productivity growth means a higher equilibrium real interest rate. The Fed however, was pushing real short-term interest rates down--a sure recipe for some economic imbalance to develop. Below is a figure that highlights this development. It shows the difference between the year-on-year growth rate of labor productivity and the ex-post real federal funds rate with a black line. A large positive gap--i.e. productivity growth greatly exceeds the real interest rate--emerges during the 2003-2005 period. This gap is also seen using the difference between an estimated natural real interest rate (from Fed economists John C. Williams and Thomas Laubach) and an estimated ex-ante real federal funds rate (constructed using the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters):



This figure indicates the real federal funds rate was far below the neutral interest rate level during this time. These ECB economists agree. Further evidence that Fed policy was not neutral can be found in the work of Tobias Adrian and Hyun Song Shin who show that via the "risk-taking" channel the Fed's low interest rate help caused the balance sheets of financial institutions to explode.

(3) There is evidence (not mentioned by Bernanke) that points to a link between the Fed's low interest rate policy and the housing boom. For starters, here is a figure from a paper that I am working on with George Selgin. It shows the gap discussed above between TFP growth and the real federal funds rate and the growth rate of housing starts 3 quarters later:

Also, below is a figure plotting he federal funds rate against the effective interest rates on adjustable rate mortgages, an important mortgage during the housing boom:


They track each other very closely. Bernanke, however, argues it was not so much the interest rates as it was the types of mortgages available that fueled the housing boom. My reply to this response is why then were these creative mortgages made so readily available in the first place? Could it be that investors were more willing to finance such exotic mortgages in part because of the "search for yield" created by the Fed's low interest policy?

(4) While there is some truth to saving glut view, the Fed itself is a monetary superpower and capable of influencing global monetary conditions and to some extent the global saving glut itself. As I have said before on this issue:

The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

With that background I turn to Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary (and fiscal) policy and was more the cause rather than the consequence of the funding coming from Asia.

Conclusion: Bernanke fails to make a KO of Fed critics with this speech.

Global Nominal Spending History

As someone who believes that stabilizing nominal spending rather than inflation is key to macroeconomic stability, I have taken the liberty in the past to reframe U.S. macroeconomic history according to this perspective. Thus, I renamed (1) the "Great Inflation" that started in the mid-1960s and ended in the early-1980s as the "Great Nominal Spending Spree" and (2) the "Great Moderation" of 25 years or so preceding the current crisis the "Great Moderation in Nominal Spending." I also labeled the late-2008, early 2009 period as the "Great Nominal Spending Crash". Below was the figure I used to summarize this reframing of U.S. macroeconomic history (Click on figure to enlarge):


Recently, I learned the OECD has a quarterly nominal GDP measure (PPP-adjusted basis) aggregated across 25 of its member countries going back to 1960:Q1. The countries are as follows: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States. The combined economies of these counties make up over half the world economy and thus, provide some sense of global nominal spending. So in the spirit of reframing global macroeconomic history according to a nominal spending perspective I created the following figure (click on figure to enlarge):



I suspect the similarities between these two figures speak to the size and influence of the U.S. economy. I think it also speaks to the influence of U.S. monetary policy on global liquidity conditions and, thus, it influence on global nominal spending.

Pick Your Poison

After reading Nouriel Roubini's latest article in the FT I feel less certain about what the Fed should be doing going forward. On one hand I see figures like the one below from the IMF's World Economic Outlook (p. 32) that point to excess global capacity and the ongoing threat of global deflation (the bad kind) and come to same conclusion as Scott Sumner:

If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.

In short, the Fed should use its monetary superpower status to ensure there is ample global liquidity and in so doing stabilize global nominal spending.


On the other hand, Nouriel Roubini claims the current Fed policies in conjunction with a large dollar carry trade is creating a new set of asset bubbles:

Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals... So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fueling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time.Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

Roubini is not optimistic about what this means for the future:

[O]ne day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

So what is the bigger threat: global deflation or asset bubbles driven by Fed policy and "the mother of all carry trades"? Tim Lee via Buttonwood also sees potential problems to the unwinding of this dollar carry trade. I hope there is another way out for the Fed.

More Takes on the Fed's Monetary Superpower Status

As a follow up to my previous post, here are some more articles that point to the Federal Reserve (Fed) as a monetary superpower. Before I get to them I want to be clear why this discussion is important: if the Fed is a monetary superpower then it was more than a passive player during the global liquidity glut of the early-to-mid 2000s--it was an enabler. Moreover, the monetary superpower status means the Fed will continue to shape global liquidity conditions for some time to come. Until the Fed takes this role and the responsibilities that come with it seriously, it is likely to create more distortions in the global economy.

Now on to the articles. First up is Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary policy and was more the cause rather than the consequence of the funding coming from Asia.

Along these same lines Sebastian Becker of Deutsche Banks makes the following case:

[I]t might well be the case that excess savings in emerging markets and the resulting re-investment pressure on developed economies’ asset markets contributed to the pronounced fall in US long-term interest rates between 2000 and 2004. Nevertheless, a simple graphical depiction of the US Fed funds rate and selected US long-term market interest rates (as e.g. 15-year and 30-year fixed mortgage rates) rather suggests that the Federal Reserve’s monetary policy stance was the major driver behind low US market interest rates. [See the figure below-DB] Correlation analysis confirms that US mortgage rates and US Treasury yields have both been strongly positively correlated with the official policy rate since the early 1990s. Although global imbalances and the corresponding rise in world FX reserves are likely to have contributed to very favourable liquidity conditions prior to the crisis, the savings-glut hypothesis does not seem to tell the full story. Instead, what really caused global excess liquidity might have been the combination of very accommodative monetary policies in advanced economies between 2002-2005 coupled with fixed or managed floating exchange rate regimes in major emerging market economies such as China or Russia. Consequently, emerging markets implicitly imported at that time the very accommodative MP stance of the advanced economies. (Click on Figure to Enlarge):

The entire Becker piece is worth reading and is a follow-up to another interesting article he did on global liquidity in 2007.

Finally, let's turn to Scott Sumner for how the Fed could use its monetary superpower status in a productive manner going forward:

If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.

The Fed abused its monetary superpower status in the past by creating a global liquidity glut that in turn fueled a global nominal spending spree. Now the Fed has a chance to redeem itself by stabilizing global nominal spending and preventing the emergence of global deflationary forces.

More Evidence the Fed is a Monetary Superpower

I have the made the case many times that the Fed is a monetary superpower. Recent developments seem to confirm this view: the Fed's low interest rate policy is making it difficult for other countries to raise their interest rates lest their currencies strengthen and they lose external competitiveness to the United States. Here is Vincent Fernando:

There's a huge problem with the entire world trying to have weaker currencies relative to the dollar right now.

It's that they've all become slaves to U.S. interest rate policy, even more so than they already may have been.

Right now, raising interest rates in any country before the U.S. does so is likely to strengthen that country's currency against the dollar, all else being equal.

[...]

For countries with a strong desire to keep exports competitive, that's a big problem.

Thus the Eurozone, the U.K., and most international countries have to decide whether their own fear of currency strength is worth the collateral damage it causes at home.

And you thought the ECB was a truly independent central bank? The Economist also has an article that touches on this issue:

The ECB will eventually face a problem that some central banks are already encountering. As long as America keeps its interest rates low, attempts by others to tighten policy (even stealthy ones that leave benchmark rates unchanged) are likely to mean a stronger currency. That is a price that Australia’s central bank seems prepared to pay. The minutes of its policy meeting on October 6th, at which it raised its main interest rate, revealed the exchange rate was not a consideration. The bank’s rate-setters ascribed the Australian dollar’s rise to the economy’s resilience and strong commodity prices. In New Zealand, similarly, the central-bank governor, Alan Bollard, told politicians that the kiwi dollar’s strength would not stand in the way of higher rates.

Note that this means the Fed is setting global liquidity conditions, just as it did during the early-to-mid 2000s. The Fed's official mandate is the U.S. economy, but its reach is global.

Ben Bernanke vs. Edwin Truman on U.S. Domestic Demand

Ben Bernanke is back at it. In a speech before the Federal Reserve Bank of San Francisco, he noted that Asia continues to save too much and the United States too little. As a result, global economic imbalances may once again grow. Here is what he had to say about Asia:

For their part, to achieve balanced and sustainable growth, the authorities in surplus countries, including most Asian economies, must act to narrow the gap between saving and investment and to raise domestic demand. In large part, such actions should focus on boosting consumption.

Bernanke is saying Asian economies must increase their domestic demand going forward to help reign in global economic imbalances. He also acknowledges that U.S. domestic demand will have to come down via less fiscal stimulus for this endeavor to work. So, in short, the key to a rebalanced world economy is better management of domestic demand. Fine, but where was the Federal Reserve with managing U.S. domestic demand back in 2003-2005? If better management of domestic demand is key to removing global imbalances now, surely it would have helped in the early-to-mid 2000s. The Federal Reserve could have done a lot on this front. Had it reigned in U.S. domestic demand back then it seems likely Asia would have been more likely to switch to its own domestic demand sooner. As Mark Thoma notes, though, Bernanke fails to mention this point in his talk.

The Federal Reserve cannot claim ignorance on this point. Edwin Truman, one of its long-time former employees, argued forcefully for the Federal Reserve to take seriously the growth in U.S. domestic demand and its implications for the build up of global economic imbalances back in 2005:

What the Federal Reserve has not acknowledged is that monetary policy has a role to play in slowing the growth of total domestic demand relative to the growth of total domestic supply or domestic output. The issue of concern is not just the effects of external adjustment on financial markets, but also on the real economy. It is one thing for politicians to be reluctant to acknowledge the real economic costs of external adjustment. The Federal Reserve does not have that excuse.

The majority of the members of the FOMC apparently do not embrace the view that they should pay more attention to total domestic demand. They are mistaken. Monetary policy is not just about managing domestic output and employment; it is also about managing total domestic demand, and most importantly managing the balance between demand and output. The view that net exports are a “drag” on GDP rests on knee-jerk arithmetic analysis. Exports and imports of goods and services are jointly determined with consumption, investment, and many other macroeconomic variables. Moreover, policy should focus significant attention on total domestic demand. In particular, the Federal Reserve should ponder whether it is not unnatural to continue to stoke the furnace of domestic demand three years after the dollar has begun to weaken, the US economy has moved into an expansion phase, and the US external deficit has widened. It was wrong for Mexico to ignore the message for monetary policy from the foreign exchange markets in 1994 and for Thailand to do so in 1996. Is it wise for the Federal Reserve to do so in 2005?

Too bad his views were not embraced by the FOMC. Let's hope he gets more of hearing going forward.

Obstfeld and Rogoff's New Paper

Mark Thoma directs us to a new paper by Maurice Obstfeld and Kenneth Rogoff titled Global Imbalances and the Financial Crisis: Products of Common Causes. In this paper the authors acknowledge that highly accommodative U.S. monetary policy in the early-to-mid 2000s in conjunction with other developments played an important role in the build up of global economic imbalances. In their discussion of U.S monetary policy, interest rates, and global liquidity conditions they miss, however, some important points on the issues of (1) productivity growth and (2) the monetary superpower status of the Federal Reserve. Let me take each point in turn.

The first point comes up when Obstfeld and Rogoff criticize the saving glut explanation for the decline in long-term interest rates that began in the early 2000s. They rightly expose the holes in the saving glut story but then turn to a less-than-convincing explanation for the decline in the long-term interest rates. Here are the key excerpts:

[T]he data do not support a claim that the proximate cause of the fall in global real interest rates starting in 2000 was a contemporaneous increase in desired global saving (an outward shift of the world saving schedule)... according to IMF data, global saving (like global investment, of course), fell between 2000 and 2002 by about 1.8 percent of world GDP... [A]n end to the sharp productivity boom of the 1990s, rather than the global saving glut of the 2000s, is a much more likely explanation of the general level of low [long-term] real interest rates.

So their story is that the productivity surge of the 1990s ended and pulled down long-term interest rates. This is a plausible story since productivity growth is a key determinant of interest rates, but the data does not fit the story. Below is a figure showing the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed (Click on figure to enlarge):


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. Rather than pushing interest rates down this indicates they should have gone up. That still leaves the question of why long-term interest rates declined during this time. My tentative answer is that it was some combination of (1) a drop in the term premium that itself was the result of a false sense of security created by the Great Moderation and (2) and expectations of future short-term interest rates being low because of accommodative monetary policy.

The productivity point, however, does not end there. It becomes important in understanding why the Fed continued to keep interest rates so low for so long. As the authors note in the paper:

In early 2003 concern over economic uncertainties related to the Iraq war played a dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first time that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Deflation was viewed as a real threat, especially in view of Japan’s concurrent struggle with actual deflation, and the Fed intended to fight it by promising to maintain interest rates at low levels over a long period. The Fed did not increase its target rate until nearly a year later.

In other words, the fear of deflation is what motivated Fed officials to keep interest rate low for so long. As I have noted many times before, though, the Fed's fear of deflation at this time was misplaced. Deflationary pressures emerged not because the economy was weak, but because TFP growth was surging as shown above. The Fed saw deflationary pressures and thought weak aggregate demand when in it fact it meant surging aggregate supply. Making this distinction is important if monetary policy wishes to fulfill its mandate of maintaining full employment. Not making this distinction in 2003-2004 meant an economy already buffeted by positive aggregate supply shocks (i.e. productivity surge) got simultaneously juiced-up with positive aggregate demand shocks (i.e. historically low interest rate policy). This was a sure recipe for economic imbalances to emerge somewhere.

The second point with the Obsteld and Rogoff's paper is that it fails to appreciate how important is the Fed's monetary superpower status. As I have explained before

the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Obstfeld and Rogoff actually hint at this possibility briefly when they say the following:

the dollar’s vehicle-currency role in the world economy makes it plausible that U.S. monetary ease had an effect on global credit conditions more than proportionate to the U.S. economy’s size.

But then they go on to say

While we do not disagree entirely with Taylor [who believes the Fed was too accommodative in the early 2000s], we argue below that it was the interaction among the Fed’s monetary stance, global real interest rates, credit market distortions, and financial innovation that created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis.

I agree that there were many factors at work, but if you accept that the Fed is a monetary super power and therefore helped generate the global liquidity glut then it could have also tightened global liquidity conditions and helped pushed the global interest rates toward a more neutral stance. And without the global liquidity glut it seems that many of the other credit market distortions that arose at the time would have been far less pronounced.

Follow the Leader

Take a look at this figure from the OECD's September 2009 Economic Outlook. It shows the policy rates for the three biggest central banks in the world since 2000. I find it interesting that the ECB and the BoJ appear to follow the Fed's policy rate moves. (Click on figure to enlarge.)


This figure is consistent with the view that the Federal Reserve is a monetary superpower. As I noted before on this issue:

The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Put differently, the Fed's monetary superpower status meant it was able to stimulate global nominal spending in the early-t0-mid 2000s. Given there exist nominal rigidities in the global economy, this development meant the Fed temporarily pushed the global economy beyond its natural rate level.

Is Another Global Liqudity Glut Forming?

Yes is the answer from Joachim Fels & Manoj Pradhan of Morgan Stanley. From a global perspective they note the amount of money creation is staggering but accomplishing what central bankers hoped it would: (1) support global asset prices, (2) help end the global recession, and (3) remove the global deflation threat. However, they note the creation of this new global liquidity glut may set the stage for some uncomfortable global inflation once the recovery starts. This is an interesting article, but I wish the authors would have provided some numbers on the size of the global liquidity glut. Here it is:

Excess liquidity surges to a new record-high... Back in January, the available data indicated that the new liquidity cycle was only in its infancy. Our favourite metric for excess liquidity - the ratio of money supply M1 to nominal GDP (a.k.a. the ‘Marshallian K') - had only started to tick up slightly for the G5 advanced economies (the US, euro area, Japan, Canada and UK) and was still declining for the BRICs aggregate. Now, our updated metrics, which include data up to March 2009, confirm that a powerful liquidity cycle is underway, with excess liquidity surging to a new record-high both in the advanced and the emerging economies. Thus, the jump in excess liquidity over the past two quarters has more than fully reversed the preceding decline in excess liquidity, which had foreshadowed the credit crisis.

...and further increases are likely in the coming quarters: The surge in excess liquidity reflects both rapid M1 growth in response to monetary easing, and the outsized declines in GDP in most economies over the past couple of quarters (recall that the growth rate of excess liquidity equals the growth rate of M1 minus the growth rate of nominal GDP). Looking ahead, further growth in excess liquidity appears likely, though probably at a slower pace. We expect M1 growth to remain strong or even accelerate further, reflecting the active quantitative easing in the US, UK, Japan and euro area that is underway and still has further to go. At the same time, we expect global GDP to bottom out soon, so that the real economy will start to ‘absorb' some of the additional money that central banks are printing. Yet, further growth in excess liquidity appears likely in the foreseeable future as central banks are far from done with quantitative easing, and we deem a V-shaped economic recovery to be unlikely.

Asset markets supported: We have argued repeatedly over the years that the ups and downs in excess liquidity have been key drivers of past asset booms and busts... The mother of all credit and housing bubbles was also fuelled by the surge in excess liquidity that started in 2002, just as the downturn in excess liquidity in the G5 from 2006 onwards and in the BRICs from mid-2007 foreshadowed the crisis of 2007/08.

This time around, it doesn't seem to be any different. Risky assets such as equities, credit and commodities have rallied over the past few months as excess liquidity has surged. The ‘wall of money' has dominated the (justified) concerns about the outlook for corporate earnings and the implications of deleveraging in the financial sector and the private household sector. Whether the rally in risky assets can continue remains to be seen... our analysis suggests that there is plenty of liquidity around - and more coming - to support asset prices.

Global bottoming is near: Also, our view expressed in January that the massive liquidity injections by central banks would find traction and help to end the recession in the course of this year appears to be on track... While the bank lending channel remains impaired, easy monetary policy has been affecting the global economy through several other channels, including asset markets, inflation expectations and cross-border money flows into countries pegging to the dollar, such as China...

Deflation fears dispelled: Finally, decisive monetary action has in fact helped to dispel the fears of lasting deflation that were so widespread around the turn of the year. Market-based measures of inflation expectations have increased significantly from very low levels back to more normal levels over the past several months. In our view, however, inflation expectations still look too low and could move substantially higher once markets start to focus more on the potential implications of the monetisation of government debt that is currently underway...

Sovereign risk = inflation risk: Indeed, there are some signs that, over the past week or so, investors have started to worry about inflation risks. While the headlines have been dominated by concerns about sovereign risk and potential sovereign downgrades, we find it interesting that the accompanying rise in nominal bond yields has been almost entirely due to a rise in breakeven inflation rates, rather than real yields. This makes sense as the risk of a sovereign default for countries such as the US, where government debt is denominated in the domestic currency, is virtually zero. If needed, the central bank will simply be instructed to print more money to service the debt. Thus, sovereign risk in these cases is really inflation risk, and should be reflected in rising breakeven inflation rates.

Bottom line: Reviewing the evidence to date, we conclude that the new global liquidity cycle, which started late last year, is alive and kicking. Excess liquidity has surged, asset markets have rallied, the global economy looks set to bottom out, fears of lasting deflation have been dispelled, and inflation risks are on the rise. With quantitative easing still in full swing and the economic recovery in 2H09 expected to be rather anaemic, we believe that there is no early end in sight for this liquidity cycle.

It Was the Saving Glut?

An increasing number of observers are placing the origins of the current economic crisis with the saving glut explanation of global economic imbalances. This trend was noted (and more-or-less endorsed) by The Economist this week and mentioned by Menzie Chinn in this post. It is worth noting some prominent observers such as John Taylor and Stephen Roach dismiss the notion of a saving glut entirely and instead pin the blame on bad policies. My own view is that both bad policies--specifically loose monetary policy--and a saving glut played a part. Here is what I said over at Econbrowser on the role played by policy:

What the about Fed's low interest rates in early-to-mid 200s? Surely there was something exogenous here in that no one expected the interest rates to drop as low and long as they did during this time. Not only did the Fed's unexpected loose monetary policy affect domestic consumption/savings, but it got exported to the dollar block countries and to some extent to non-dollar block countries (e.g. ECB had to keep watchful eye on dollar lest the Euro got too expensive). I am not saying it was the only enabler, but it certainly seems important...

I further develop this point--and provide some evidence--in this article (see page 374). However, as noted by Brad Sester, the expansionary policy story for the rising current account deficit best fits the data for the period 2002-2004 while the traditional saving glut story does a better job thereafter. Of course there were other factors at work during this time--the securitization of finance, underestimating aggregate risk, the lowering of lending standards--but the low interest rate environment generated by these two forces was a key contributor to the current economic crisis.

Willem the Bold

That is my new name for Willem Buiter who boldly challenged the Federal Reserve and its policies at one of its own meetings. Buiter presented a paper that was very critical of the Fed's actions leading up to, during, and after the housing boom-bust cycle at the Fed's annual Jackson Hole, Wyoming retreat. The Wall Street Journal and Bloomberg both report his paper generated a heated debate at the meeting. Coming to Buiter's rescue in the blogosphere is Yves Smith while Mark Thoma sides with the Fed. I have only scanned his paper (144 pages!) , but here is a section from it that summarizes his critique of the Fed:

I argue that three factors contribute to Fed’s underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.

The second is a sextet of technical and analytical errors: (1) misapplication of the
‘Precautionary Principle’; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on ‘core’ inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.

[...]

The third cause of the Fed’s macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.

Yves Smith says points 1 and 3 are valid, but 2 is debatable. It will be interesting to see what other observers say on these points. On a different note, I found interesting his suggesting for addressing asset bubbles:

Therefore, while I agree with the traditional Greenspan-Bernanke view that the official policy rate not be used to target asset market bubbles, or even to lean against the wind of asset booms, I do not agree that the best that can be done is for the authorities to clean up the mess after the bubble bursts...[Rather,] [c]ountercyclical variations in capital and liquidity requirements [or] an automatic financial stabiliser [is needed.]

This is something to consider, but I submit that a nominal income targeting rule would go far in avoiding the formation of asset bubbles in the first place. But I digress. This is a provocative paper that should fuel debate for some time to come.

A Question For Martin Wolf, Brad Sester, and Other Advocates of the 'Saving Glut' View

There has been a lot of talk about how current U.S. monetary policy, which has been highly accommodative for domestic reasons, is pushing up demand and thus inflationary pressures in those Asian and Gulf region countries whose currencies are pegged to the dollar. A big concern is that since these countries in the 'dollar block' make up a significant portion of the world economy, loose U.S. monetary policy is effectively creating a global monetary stimulus that may create undesired outcomes for the world economy. Nouriel Roubini describes it this way:

Easy US monetary policy, followed by monetary easing in countries that formally pegged their exchange rates to the US dollar (as in the Gulf) or that maintain undervalued currencies to achieve export-led growth (China and other informal members of the so-called Bretton Woods 2 dollar zone) has fueled a new asset bubble in commodities and overheating of their economies... [this and other] factors are akin to positive global aggregate demand shocks, which should lead to economic overheating and a rise in global inflation.

Ken Rogoff similarly notes:

[M]any countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements. As a result, whenever the Fed cuts interest rates, it puts pressure on the whole ''dollar bloc" to follow suit, lest their currencies appreciate...

Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ― perhaps as much as 60 percent ― of the global economy.

But, with most economies in the Middle East and Asia in much stronger shape than the U.S. and inflation already climbing sharply..., aggressive monetary stimulus is the last thing they need right now...

Finally, Martin Wolf's says it most succinctly with the following:

To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China. But the policy appropriate to the US is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further.

So the Federal Reserve is now being called to task for not being more careful with its monetary hegemon status and thus its ability to create real economic distortions in the global economy. Note, though, that the countries on the receiving end of the Fed's global monetary stimulus are the same ones that a few years ago were being blamed for creating global economic distortions via a 'saving glut'. This 'saving glut', it was argued, was so economically powerful that even the Fed's monetary policy was held hostage to it. Martin Wolf, for example, argued the following:

Prof Taylor dismisses the “savings-glut” explanation for the low US interest rates, with the observation that global savings rates are lower than three decades ago. But the world, without the US, had a rapidly rising excess of savings over investment in the early 2000s, much of it directed to the US. Given the huge capital inflow, the Fed’s monetary policy had to generate a level of demand well above potential output.

So Martin Wolf is telling us the poor Fed had no choice, it was victimized by the global saving glut and forced to lower interest rates to historically low levels. But wait, this is the same Martin Wolf we just saw above who stated that the Fed is determining monetary policy for these regions and has done it in a destabilizing fashion. Martin Wolf is not alone in this change of heart. Most observers who sang the 'saving glut' tune over the past few years are now singing--sometimes unknowingly--a global liquidity glut tune. These observers have somehow gone from a world where the Fed is a slave to the dollar block to world where the dollar block is a slave to the Fed. For these folks, then, I pose the following questions:

(1) If the Fed is a monetary hegemon and has the ability to create a global monetary stimulus with real economic effects today, is it not possible that had a similar ability to do so back in the early 2000s?

(2) If the answer is yes to (1), then is it not possible that some of global economic imbalances developed during that time were the result of the Fed's monetary policy?

Here and here are my answers to the questions.

Why I like Stephen Roach

I used to look forward to reading Stephen Roach's commentaries every Monday and Friday at the Morgan Stanley Global Economic Forum. He had much to say about global economic imbalances and was one of the few thoughtful observes who took the 'liquidity glut' view seriously. (See his critique of the 'saving glut' view here.) Some of his classics form the Global Economic Forum include "Original Sin" and "The Great Unraveling." Unfortunately, he stopped writing for this outlet when he took on new responsibilities with Morgan Stanley. His commentaries have been missed. I was delighted, therefore, to run across this Op-Ed of his in the Financial Times yesterday.

America’s inflated asset prices must fall
By Stephen Roach

The US has been the main culprit behind the destabilising global imbalances of recent years. America’s massive current account deficit absorbs about 75 per cent of the world’s surplus saving. Most believe that a weaker US dollar is the best cure for these imbalances. Yet a broad measure of the US dollar has dropped 23 per cent since February 2002 in real terms, with only minimal impact on America’s gaping external imbalance. Dollar bears argue that more currency depreciation is needed. Protectionists insist that China – which has the largest bilateral trade imbalance with the US – should bear a disproportionate share of the next downleg in the US dollar.

There is good reason to doubt this view. America’s current account deficit is due more to bubbles in asset prices than to a misaligned dollar. A resolution will require more of a correction in asset prices than a further depreciation of the dollar. At the core of the problem is one of the most insidious characteristics of an asset-dependent economy – a chronic shortfall in domestic saving. With America’s net national saving averaging a mere 1.4 per cent of national income over the past five years, the US has had to import surplus saving from abroad to keep growing. That means it must run massive current account and trade deficits to attract the foreign capital.

America’s aversion toward saving did not appear out of thin air. Waves of asset appreciation – first equities and, more recently, residential property – convinced citizens that a new era was at hand. Reinforced by a monstrous bubble of cheap credit, there was little perceived need to save the old-fashioned way – out of income. Assets became the preferred vehicle of choice.

With one bubble begetting another, America’s imbalances rose to epic proportions. Despite generally subpar income generation, private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.

None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.

Read the Rest

Why the U.S. Needs A Recession to Correct Global Imbalances

I have argued in previous postings that past monetary policy profligacy in the United States has contributed to the global imbalances (here, here, here, and here). Here is an article by Gilles Saint‑Paul that takes a similar view and follows this line of reasoning to its logical conclusion: the current easing by the Federal Reserve puts off the correction of these imbalances--and allows them to continue to build--until a later time when correcting them will be more painful.

It is refreshing to see a thoughtful article on global imbalances that does not bow at the altar of the 'saving glut' goddess. This article takes seriously the 'liquidity glut' view of global imbalances and shows why the conduct of monetary policy for the world's reserve currency can be distortionary for the global economy.

Update: Saint-Paul mentions Volker's recessions in the early 1980s. See here for comments on this experience

Update II: Bill C at Twenty-Cent Paradigms cautions us not to put too much faith in the ability of monetary policy to correct the global imbalances.

How the US imbalances can be corrected
Gilles Saint‑Paul

There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.

This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences. In 2001, the Fed engaged in a policy of drastic reduction of interest rates, for fear that the conjunction between the end of the so-called “Internet bubble” and the attacks of September 11 would drive the US economy into a recession. These considerations were compounded by the increasingly popular view that inflation was no longer a problem. The strong expansion of the late 1990s had been accompanied with little inflationary pressures and there were fears that the deflationary experience of Japan might hit the United States.

The result of these policies is that the US was in a regime of very low real interest rates. From 2002 to 2004, the federal funds rate did not exceed some 1.5 %, while inflation moved from 1.6 % to 2.7 % during that period. Thus short-term real interest rates were clearly negative. As for longer maturities, some real rates fell to 1.5 %. Many would argue that this was the right thing to do; GDP stayed at its potential level, or below it, and the incipient increase in unemployment was reversed.

The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.

One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.

The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high. In fact, when interest rates fall below the growth rate, assets become impossible to price. Consider, for example, a share that pays a dividend which grows at 5 % a year. With a 2% interest rate, it is profitable to buy that asset regardless of its price, because I only need to hold it for a sufficiently long time for the dividends to eventually exceed the interest payments. So the price of the asset is in principle infinite. In fact, people do not live forever, so they will have to sell the asset back at some point; but one can show that any change in markets' expectations about that future price can be validated by a corresponding change in the current price—so, the current price can be anything.

In particular, low interest rates may start asset bubbles. One mechanism is as follows. As the price starts rising due to lower interest rates, irrational speculators start buying the asset on the grounds that the price increases are going to continue. That fuels the price increase which may eventually develop into a bubble where all speculators, including the rational ones, pay a high price for the asset because they expect the price to be even higher in the future. So one by-product of the fall in interest rates is that real house prices started to go up very quickly.
To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.

These imbalances have to be corrected. In principle, consumer spending can be brought down without the economy having to go through a recession, provided there is a sharp real depreciation of the US dollar, which would shift the structure of demand away from domestic spending and in favour of exports. On the other hand, the correction in house prices is likely to be contractionary. Some consumers have borrowed against the capital gains they made on their house, to purchase, for example, a second house or consumer durables. They are going to cut their consumption since they are more likely to become insolvent. As the collateral value of their houses falls, consumers will get less credit; hence a further drop in consumption. Furthermore, the securities backed by mortgages, subprime or otherwise, have been used as collateral by financial institutions; that collateral is worth less, thus reducing credit between those institutions. As a consequence, they will have more trouble lending to firms, so that investment will also be hit. The housing bubble has jeopardised the financial sector both because people have borrowed to hold it and because institutions have used the corresponding securities as collateral.

Because of this gloomy scenario, the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market. The signal sent by the Fed is that it is sound to join any market fad or bubble provided enough people do so, because one will be rescued by low interest rates once things turn sour. Worse, the more people join, the greater the lobby in favour of an eventual bail-out.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

Is History Repeating Itself?

As we watch the dollar continue to free fall, one thing that really strikes me is how similar these recent developments are to those taking place before the break up of the Bretton Woods System in the early 1970s. Back then, the periphery countries were importing a loose, inflationary monetary policy from the dominant anchor economy, the U.S. The periphery countries also had piled up large amount of dollar reserves that eventually lost value when the system cracked in 1971-1973. Today, the dominant anchor country once again is the U.S. and is exporting a loose, inflationary policy to the periphery countries (i.e. Asia and the Gulf States) who have acquired vast dollar reserves. These countries too are now taking a huge capital loss as the dollar falls. Will this system, called by some the Bretton Wood II System, also crack like the original? Are we living through a time where economic history is repeating itself?

Part of what got me thinking about these historical patterns was the lead article and a subsequent longer piece in the Economist on the dollar's fall. These articles do a nice job explaining the structural reasons--the pressures from the huge U.S. current account deficits are finally being felt--the and cyclical reasons--the increasingly probability of U.S. recession and further rate cuts--for the falling dollar. The Economist also provides an interesting discussion of whether this decline means the U.S. dollar will lose its reserve currency status (answer: not necessarily) and what it means for the global economy. I then followed up by reading Brad Sester's discussion on these same Economist articles. He especially makes a good case that contrary to conventional wisdom, central banks can have a meaningful influence in foreign exchange markets--just look at the influence of the BRICs and the Gulf States.

What a fascinating time to be alive... as long as I keep my job!

The Forex Market

Menzie Chinn at Econbrowser points us to the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. Among other things, this report shows the amount of forex transactions as well as the currency distribution of forex transactions. The table below shows on average $3.2 trillion of forex traded per day!




This next table shows the currency distribution of forex transactions. The dollar makes up 86.3% in 2007.




Very interesting reading...

Central Bankers Who Appreciate the Distortions They Can Make

Central bankers in the U.K. and Canada are being thoughtful. They are thinking through the implications of trying to stem the current credit squeeze. Too bad there is not more of this discussion occuring at the Fed and ECB. The Financial Times reports:

A clear divide between the world’s leading central banks emerged on Wednesday over how best to respond to the credit squeeze and the abnormally high interest rates for lending between banks for periods of more than a month.

The European Central Bank pumped an extra €75bn ($103bn) into the financial system for a fixed period of three months in a bid to cut the interest rate gap between overnight funding and lending over longer maturities.

In contrast, the governors of the Bank of England and the Bank of Canada publicly doubted whether such action would work. Mervyn King, the Bank of England governor, also warned in a written submission to the UK parliament that this approach risked encouraging “excessive risk-taking and sows the seeds of a future financial crisis."

The ECB said last Thursday that it would pump three-month money into the system to “support a normalisation of the functioning of the euro money market”. Both Mr King and David Dodge, the Canadian central bank governor, said commercial banks were well capitalised and strong enough to absorb the assets of troubled off-balance sheet investment vehicles that need to be brought on to their books.

Speaking in London, Mr Dodge said he thought investors would be more careful to understand what is contained in complex products in future. “The responsibility does rest on the investor to make sure he or she understands the risk in the product they are buying,” he insisted.

The Federal Reserve, meanwhile, appears to occupy the middle ground. It has not extended the duration of its money market operations, but it has made 30-day money, renewable at the borrower’s request, available through its discount window.

Policymakers are expected to step up calls for more transparency in structured finance when European finance ministers meet in Portugal on Friday. Discussions also continue over possible responses, such as a review of bank capital standards or efforts to pool distressed assets.