It's 2012, Not 2002

Back in the early 2000s, the world economy was buffeted with a series of positive aggregate supply shocks: the opening up of Asia, rapid technological gains, and the ongoing liberalization of the real economy in many countries.  These shocks expanded global economic capacity and implied higher future economic growth.  In turn, there should have been a higher global natural real rate of interest given the higher expected economic growth. These shocks also should have resulted in more benign deflationary pressures that would have kept real wages up in advanced economies.

The Fed, however, did not allow this to happen because it feared the deflationary pressures. It loosened U.S. monetary policy and through the many countries that link their currency to the dollar, it also loosened global monetary policy. Even the ECB and Bank of Japan followed suit to some degree since they were mindful of letting their currencies become too expensive relative to dollar and the all the currencies pegged to it. In short, the Fed's monetary superpower status allowed it to lower global real interest rates below the global natural real interest rate level during this time.¹  This was an important part of the global housing boom story and the Bank for International Settlements (BIS) was all over it. It repeatedly told the Fed that its misguided fears of deflation were causing it to create a global liquidity glut.  The BIS was spot on during this time.

But that was then and this is now.  The global economy is now being hit with negative aggregate demand shocks in Europe, Asia, and the United States.  The economic outlook is dim and consequently the global natural real interest rate is depressed and is most likely negative.  This time around the Fed, with help from the ECB, is keeping global real interest rates above the natural real interest rate level.  In other words, global monetary policy is too tight now. This is evident in the figure below which shows that total current dollar spending for the OECD region is depressed.

The only way for such a drop in aggregate nominal spending to occur is for either the stock of money asset to decline or the velocity of money to decline.  Central banks can meaningfully reverse both through better expectation management (e.g.. by raising the expected path of aggregate nominal income and spending).  The fact that this has not happened and that OECD nominal GDP remains depressed is thus prima facie evidence that global monetary policy has been too tight.  

The BIS, however, seems to be operating from the same manual it used in the early 2000s.  It tries to argue   that global monetary policy is actually accommodative.  From its 2012 annual report:

In the major advanced economies, policy rates remain very low and central bank balance sheets continue to expand in the wake of new rounds of balance sheet policy measures. These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies in the form of undesirable exchange rate and capital flow volatility. As a consequence, the stance of monetary policy is accommodative globally.  

How could central bank policy be "extraordinarily accommodative" if measures of the money supply in both the Eurozone and the United States are declining?  The BIS is falling for the interest rate fallacy here that Milton Friedman warned us about. Low interest rates only indicate loose monetary policy when they are low relative to the natural interest rate, as in the early 2000s. As noted above, this is note the case now.  

Put it this way: does the BIS really think that fall in yields on 10-year treasuries from about 5.25% before the crisis to a low of 1.50% recently has been due to the Fed?  It is more likely that global slump can explain most of the drop in yields.  The fact that yields have remained so low is, if anything, an indication that monetary policy has been too tight.  For were the Fed and ECB to raise expected nominal growth, yields would start rising again.

The BIS calls for monetary restraint are therefore way off.  It needs to quit thinking like this is 2002 when global monetary policy was too loose and realize that it is 2012, the fourth year of tight monetary policy.  The global economy is a far different beast today and policy makers need to respond appropriately. 

P.S. Paul Krugman, Scott Sumner, [update: Ryan Avent,] and Isabella Kaminsky also raise questions about the BIS report.  Kaminsky notes that what is really needed are more safe assets, something that U.S. Treasury could provide.  I agree with her, but would note that if the Fed were to return nominal GDP to trend then it is likely that there would be far more privately-produced safe assets and thus less need for government securities. See here for more on this point.

¹ The "global saving glut" can be understood in part as the global economy simply recycling the Fed's loose monetary policy back to the United States.  For all those dollar-pegging countries that were forced to buy more dollars when the Fed eased monetary policy used those dollars to buy up U.S. debt.  And they did not want just any U.S. debt, but safe U.S. debt.  This increased the demand for safe assets.  Since there was a limited amount of  public safe debt, the private sector responded by converting risky assets into safe assets (e.g. AAA-rated CDOs).  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.  

Monetary Policy and the Saving Glut Both Mattered for the Boom

That is what Filipa Sá, Pascal Towbin, and Tomasz Wieladek find in their new paper. Moreover, they find that the effects of monetary policy and the saving glut were more pronounced in those economies with more developed and securitized mortgage markets.  On this latter point, Roger Ahrend similarly finds that easy monetary policy had its biggest effect on housing in periods of financial deregulation and innovation.  The Sá et al. paper also is consistent with the findings of Thierry Bracke and Michael Fidora who show that monetary policy shocks and global saving glut shocks contributed to the buildup of global economic imbalances.  These nuanced studies that take a global perspective and find both monetary policy and global savings to have mattered are far more satisfying than the "Not us!" research being pushed by former and current Fed officials lately.  

It would be nice, however, if these nuanced studies did more to tease out (1) how much of the saving glut was due to truly exogenous developments in the emerging economies versus (2) how much was due to endogenous responses by these economies to the Fed's loose monetary policy.  In other words, how much of the saving glut was simply recycled U.S. monetary policy? 

Dollarization in Zimbabwe

Having lived in Southern African for a number of years when I was younger, I have more than a passing interest in the economic crisis that is Zimbabwe. As I noted early last year, there were two policy moves there last year that were very promising: (1) Zimbabwe was abandoning the production of its own currency and (2) it was allowing foreign currencies to be used as legal tender. The hope at the time was that these developments would make life more bearable there, as it would bring an end to the hyperinflation and start allowing a functioning medium of exchange to emerge. Here is a video clip that shows how life has improved since these changes took place:



Here is a link to another video clip that shows how hard life was right about the time these changes took place. In case you missed it, here is my post on the extent of the Zimbabwe hyperinflation and here is my post on the $100 trillion bill in Zimbabwe.

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.

A Positive Global AS Shock + Loose U.S. Monetary Policy = Trouble

Menzie Chinn is not pleased with the new paper by Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg. In this paper the authors argue the underlying cause of the current crisis was a large positive labor supply shock to the global economy that originated in Asia:

Labor in developing countries – countries with vast pools of grossly underemployed people – can now augment labor in the developed world, without having to relocate, in ways not thought possible only a few decades ago. We argue that this large shock to the developed world’s labor supply, triggered by geo-political events and technological innovations is the major underlying cause of the global macro economic imbalances that led to the great recession. The inability of existing institutions in the US and the rest of the world to cope with this shock set the stage for the great recession[.]

Menzie notes there is (1) no discussion in the paper on the role U.S. economic policies played in contributing to the financial crisis and (2) it implies that forces outside the U.S. are the sole driver of U.S. macroeconomic activity. I too am skeptical of studies that suggest developments elsewhere alone are the source of our current problems. However, this study does make a good point in that there was a large positive labor supply shock to the global economy with the opening up of China and India over the past decade. This development created a large positive global aggregate supply shock (AS) that--in addition to positive AS shocks coming from ongoing IT gains--had implications for the global economic policy. The primary implication is that global interest rates should have gone up since the return to the global capital stock increased as a result of this shock (i.e. the marginal product of the global capital stock increased as the global labor supply increased). Instead, the global monetary superpower, the Federal Reserve, pushed global short-term interest rates down and created a global liquidity glut. Throw in some financial innovation, credit market distortions, complacency created by the Great Moderation and the stage is set the greatest financial crisis in the world since the 1930s Great Depression. This point was made by The Economist magazine back in July 2005 in an article titled "From T-Shirts to T-Bonds." Here is a key excerpt:

The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a is allocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.

So, contrary to the paper's assertions, the U.S. could have handled this global AS shock better had its monetary policy been more appropriate. Until we began to take seriously the role U.S. economic policy played in the buildup of global imbalances that ultimately led to this global crisis we are bound to repeat history.

How Bad Was Hyperinflation in Zimbabwe?

There is an interesting article in the latest issue of the Cato Journal by Steve Hanke and Alex Kwok. In this article, the authors estimate the amount of hyperinflation in Zimbabwe in 2008. This may seem like a trivial task, but no so for Zimbabwe:

Even though the Reserve Bank of Zimbabwe produced an ever increasing torrent of money, and with it ever more inflation, it was unable, or unwilling, to report any meaningful economic data during most of 2008. Indeed, the last Reserve Bank balance sheet and money supply data produced in 2008 were for March. As for the 2008 inflation data, the last available figures were for July, and these were not released until October. This data void hid Zimbabwe’s hyperinflation experience under a shroud of secrecy.

Hanke and Kwok fills this data void with their hyperinflation estimates. Here is their summary table from the article (click on figure to enlarge):


In plain English, the monthly rate of hyperinflation was 79.6 billion % in November 2008. That is an astonishing figure. Fortunately, the hyperinflation ended earlier this year when the government shut down its currency-printing presses and allowed foreign exchange to legally circulate. There was, however, a high price to pay for this hyperinflation and there is still much reform needed in Zimbabwe. Here is an excerpt from the IMF's 2009 Article IV for Zimbabwe:

Background. The economic and humanitarian situation worsened dramatically in 2008. Hyperinflation, fueled by the RBZ’s quasi-fiscal activities, and a further significant deterioration in the business climate contributed to an estimated 14 percent fall in real GDP in 2008, on top of a 40 percent cumulative decline during the period of 2000–07. Unemployment, poverty, malnutrition, and incidence of infectious diseases have risen sharply.

The official adoption of hard currencies for transactions in early 2009 recognized the de facto virtually complete dollarization of Zimbabwe’s economy. The government also recently announced that the rand would be the reference currency. Dollarization has helped stabilize prices, improve revenue performance, and impose fiscal discipline, including on the RBZ.

Outlook. Reversing output decline and improving social conditions would require determined efforts to maintain sound macroeconomic policies, and to attract domestic and foreign investors and significant donor support. In the absence of cash budget support, higher humanitarian assistance, and wage restraint, the economic and social situation could deteriorate significantly in 2009. Zimbabwe’s external debt burden is unsustainable even if policies are improved and medium-term financing gaps are filled by concessional financing.

I hope this is truly a new beginning for Zimbabwe.