Somewhere in the halls of George Washington University, after Bernanke's last lecture, a conversation between the Fed Chairman and a student was overhead. This is the first part of that conversation.1
Student: Oh hi, Chairman Bernanke. I have enjoyed your lectures. Thanks so much for making time for us.
Bernanke: You are more than welcome. You know, it has been a real treat for me to get away from the Fed and back into the classroom. Sometimes the stress of dealing with hard-money congressmen, rogue regional Fed presidents, and bloggers who cite my Japanese work can be overwhelming. So it really is nice to escape into the classroom. Now tell me, is there anything in particular we have talked about that struck your fancy?
Student: Actually, yes. When you explained that China's currency peg to the dollar means China effectively has it monetary policy set by the Fed I was shocked--1.3 billion Chinese have their monetary conditions set by a few Americans holed up in a secretive, old building on the other side of the world. Wow, talk about fodder for conspiracy theories! Anyhow, this got me thinking: are there other countries that have their monetary policy determined by the Fed too? So I did some research and learned that almost half of the world's currencies are tied in some way to the dollar. This translates into about a third of world GDP. That means you guys at the Fed are like a monetary mafia, right?
Bernanke: Well, uhm, I would not phrase it that way but...
Student: But you do influence monetary conditions for about a third of the global economy, right?
Student: Okay, let's say the Fed eased monetary policy for a third of the world economy. That would imply that the currencies of these dollar-pegging countries would depreciate relative to the rest of the world. And that, in turn, would make the ECB and the Bank of Japan mindful of U.S. monetary policy lest their currencies becomes too expensive, right?
Bernanke: Probably, but...
Student: So the Fed, then, is also shaping monetary policy to some extent at the ECB and the Bank of Japan. That explains figures like this one and this one that until now I did not understand. Wow, you guys really are the monetary mafia. So does this mean the monetary mafia thinks about the implication of the FOMC's actions for these other economies when doing monetary policy?
Bernanke: Actually no, we have a domestic mandate so we don't really worry too much about them unless they create problems for the U.S. economy. And besides, they don't have to peg to our currency. No one is forcing them to do so. We may exert a lot of influence on global monetary conditions, but we are not a monetary mafia! Please quit using that name!
Student: Okay, no more monetary mafia references. But, if you do exert a lot of influence on global monetary conditions, then can't it explain, at least in part, why there was a global housing boom? The Fed lowered global interest rates and sparked off a global housing boom, right?
Bernanke: You need to read my papers on the saving glut. They show that it wasn't U.S. monetary policy, but excess savings from rest of the world that created the demand for safe assets that in turn drove down global interest rates. This development combined with the securitization of finance, poor internal governance, misaligned creditor incentives, and other private sector failings is what caused the global housing boom.
Student: Doesn't that sound a bit self-serving, blaming only foreigners and private sector failings for the housing boom?
Bernanke: Look, as I said, read my papers on the saving glut. The answers are all there.
Student: Well, I have read your saving glut papers, but I still have questions. It seems to me that in those papers you are focusing on the structural component driving the global demand for safe assets, but ignore the cyclical ones.
Bernanke: What do you mean?
Student: The structural component is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets. The cyclical component, on the other hand, is that because of the Fed's monetary superpower status, U.S. monetary policy accentuated the demand for safe assets during the housing boom.
Bernanke: Oh really?
Student: Really. Here is why. First, in the early-to-mid 2000s, those dollar-pegging countries were forced to buy more dollars when the Fed loosened monetary policy with its low interest rate policies. These economies then used the dollars to buy up U.S. debt. This increased the demand for safe assets. To the extent the ECB and the Bank of Japan also responded to U.S. monetary policy, they too were acquiring foreign reserves and channeling credit back to the U.S. economy. Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.
Second, when the Fed pushed interest rates low, held them there, and promised to keep them there for a "considerable period" in 2003 it created new incentives for the financial system. First, via the expectations hypothesis (which says long-term interest rates are simply an average of short-term interest rates over the same period plus a term premium) these developments pushed down medium to longer yields as well, as seen in this figure. This drop in yields caused big problems for fixed income fund managers who were expected to deliver a certain return. Consequently, there was a "search for yield" or as Barry Ritholtz says the managers of pension funds, large trusts, and foundations had to "scramble for yield." They needed a higher but relatively safe yield in order to meet their expected return. The U.S. financial system meet this rise in demand by transforming risky assets into safe, AAA-rated assets. The Fed's low interest rate policies also increased the demand for safe assets for hedge fund managers. For them the promise of low short-term interest rates for a "considerable period" screamed opportunity. These investors saw a predictable spread between low funding costs created by the Fed and the return on higher yielding but safe assets. They too wanted more AAA-rated assets to invest in so that they could take advantage of this spread that would be around for a "considerable period." Here too, the U.S. financial system responded by transforming risky assets into safe assets. So what do you think Mr. Chairman?
Bernanke: Well, what do you know, I am out of time. We will have to continue this conversation next time after my next lecture on the financial crisis.
Student: Speaking of the financial crisis, I also think that since late 2008 the Fed has erred the other way. By failing to first prevent and then restore aggregate nominal income to its expected path, the Fed allowed the large scale destruction of many privately-produced safe assets far beyond that needed to correct for the housing boom.....
Bernanke: I am outta here!1Okay, this conversation did not really happen, but I wish it had.