Thursday, March 26, 2009

China Wants a New Reserve Currency

Here is why:

From the WSJ:
BEIJING -- China called for the creation of a new currency to eventually replace the dollar as the world's standard, proposing a sweeping overhaul of global finance that reflects developing nations' growing unhappiness with the U.S. role in the world economy.


Mr. Zhou's idea is to expand the use of "special drawing rights," or SDRs -- a kind of synthetic currency created by the IMF in the 1960s. Its value is determined by a basket of major currencies. Originally, the SDR was intended to serve as a shared currency for international reserves, though that aspect never really got off the ground.

These days, the SDR is mainly used in the IMF's accounting for its transactions with member nations. Mr. Zhou suggested countries could increase their contributions to the IMF in exchange for greater access to a pool of reserves in SDRs.

Holding more international reserves in SDRs would increase the role and powers of the IMF. That indicates China and other developing nations aren't hostile to international financial institutions -- they just want to have more say in running them.
See Brad Sester's discussion on this proposal as well.

There is Hope for Zimbabwe

Time to find a new poster child for hyperfinflation. Zimbabwe's economy seems to have turned the corner by (1) allowing foreign currency to be used in transactions and (2) abandoning any further production of Zimbabwe dollars. Here is one news report:
HARARE (AFP) — A man whistles as he picks groceries from the shelves of a supermarket in Zimbabwe's capital. Another shopper, spoilt for choice, compares cooking oil bottles while queues form at the tills.

In Zimbabwe, these were simple and almost forgotten luxuries.

For more than a year, supermarket shelves were bare and shops resembled empty warehouses as the country reeled under an economic crisis that turned sugar and the staple corn meal into rare commodities.

Now shops are stocking up again, after the government in January agreed to allow retailers to conduct business in foreign currency.

The government has even stopped printing Zimbabwe dollars, which it once churned out in trillion-dollar denominations that quickly became worthless under inflation that independent economists estimated in the quadrillions.

The switch to foreign currency has already started bringing prices down in US dollar terms, according to official statistics which are being borne out at the till.

The BBC also notes that prices are now falling in Zimbabwe and further claims the following:
The US dollar was adopted by Zimbabwe's government following the inauguration of the unity government between the MDC and President Mugabe's Zanu-PF.
So Zimbabwe has dollarized. This is certainly an improvement in policy, but why not adopt the South African Rand? The economies of South Africa and Zimbabwe surely are closely to an optimal currency area than the U.S. and Zimbabwe. Does Zimbabwe really want to import U.S. monetary policy? With all that said, this is good start for Zimbabwe.

Tuesday, March 24, 2009

Risks from the New Fed Policy

As I mentioned in my last post, the Fed's announcement that it will more aggressively expand the monetary base is a much needed development. Without it the dramatic collapse of U.S. nominal spending will only get worse and further destabilize the U.S. economy. This move can be viewed as an attempt to prevent the U.S. economy from overshooting on the downside, a policy objective that even Frederick Hayek supported. With all that said, there are risks associated with this policy move. First, Caroline Baum reports this new policy, which purposefully targets long-term Treasuries, may create big distortions in the market for Treasuries. Second, this aggressive monetary expansion will eventually have to be reversed to avoid a repeat of the 1970s-type inflation. This reversal, however, may not be politically popular if it involves some pain as noted by John Taylor:
Will the Fed be able to change course in time? To do so, it will have to undertake the politically difficult task of getting more than $3,000bn of government securities, private securities and loans off its balance sheet.
Given the short-run real effects of monetary policy, a reduction of the money supply of this size could be very disruptive. The reversal also may involve some quasi-fiscal costs as noted by Paul Krugman:
But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.In short, unwinding this aggressive expansion of the money supply may not be easy.
Given the possibility of these politically sensitive developments, one could question whether the Fed will actually be able to reverse itself in the future. This is a real concern, but as pointed out by Tim Duy the Fed and U.S. Treasury released a statement yesterday reconfirming the Fed's independence. Hopefully, this statement gives the Fed the freedom to take do what is needed to stabilize nominal spending presently without jeopardizing its independence in the future.

Thursday, March 19, 2009

The Fed Finally Swings for the Fences

The Fed has finally decided to swing for the fences with monetary policy. It announced yesterday that moving forward it will purchase another $700 billion of agency mortgage-backed securities, $100 billion of agency debt, and $300 billion of long-term Treasury securities. Add this move to the already $1 trillion-plus expansion of the Fed's balance sheet since the beginning of the crisis and the almost 0% federal funds rate and we have a Fed that is finally pulling out the big guns. This latest action, however, is the Fed's boldest move yet and sends a clear message that we have only begun to see what unleashed unconventional monetary policy looks like in practice. So much for the view spouted by many observers that monetary policy is all tapped out.

Like Tyler Cowen, I wish that such a bold policy move would have been done from the start instead of the piecemeal approach the Fed has tried to date. It would have reduced the need for a large fiscal policy stimulus. I also wished the Fed would have unleashed unconventional monetary policy in a more explicit manner by stating some target for nominal GDP growth or inflation (with the first of the two choices being my preferred option). Still, this change in policy is a huge improvement and should make a difference.

While the Fed's new policies do raise the possibility of inflationary problems down the road, let us not forget why this move is needed: (1) nominal spending is crashing in the United States and (2) only unconventional monetary policy has been shown to fix such problems. For those who are highly concerned about the inflationary implication of the Fed's expanding balance sheet I would refer you to Nick Rowe's thoughts on the matter.

Update: See The Economist's discussion of this policy move.

Tuesday, March 17, 2009

Why Are Bank Creditors Being Protected?

Justin Fox questions why bank creditors, other than depositors, are getting a pass in the current crisis? Bank shareholders and taxpayers are taking a hit so why not the creditors, particularly those bank bondholders? Here is Fox:
These bank bonds are mostly in the hands of large, sophisticated institutional investors — pension funds, insurance companies, mutual funds. It may be too much to ask small depositors to monitor the risks at the banks where they put their money and pay for getting it wrong. But these bond buyers are pros. If there is to be any market discipline of risk-taking by banks, bond investors ought to be the ones who enforce it by withholding their cash from the bad apples — and paying the price for misjudgments. Plus, a few concessions from creditors could ease the burden on taxpayers dramatically. If Citi's $486 billion in wholesale debt were converted into common shares — admittedly a pretty extreme solution — the company's balance-sheet woes would evaporate. Which is why these arguments have been gaining in popularity.
Fox calls this protection of bank bondholders the "great bond bailout." So why have the bondholders not taken a hit along with shareholders and taxpayers? The answer is that it would bring about another global credit crisis on the scale of what happened late last year. Here is how James Kwak describes such a scenario:
Let’s say that Citigroup were restructured - via bankruptcy, or via government conservatorship - in such a way that creditors did not get all their money back. (None of this applies to FDIC-insured deposits or to recently-issued senior debt that is explicitly guaranteed by the government.) They might be forced to convert debt for equity, or they might be stiffed altogether. The first-order concern is that this would have ripple effects that could take down other financial institutions. According to Martin Wolf, bank bonds comprise one quarter of all U.S. investment-grade corporate bonds; losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If Citigroup did not support its derivatives positions, then institutions that bought credit default swap protection from Citi would face further losses. (I believe that most U.S. banks were net buyers of CDS protection, however.) The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.

The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again.
Kwak notes that this fear of another systemic failure of the financial system is why the U.S. government is bending over backward to protect bank creditors without actually saying so. I suspect the U.S. government is also trying to placate the concerns of certain foreign governments whose holdings of U.S. debt securities could be impaired if bond markets collapsed. Note that without this government protection many of the big banks are effectively insolvent. Unless the economy suddenly recovers and asset prices rebound, this insolvency will have to be meaningfully addressed at some point. When this restructuring takes place it could get ugly.

Monday, March 16, 2009

Greenspan's Failed Attempt to Exonerate the Fed

Alan Greenspan is again defending U.S. monetary policy under his watch. Writing in the Wall Street Journal last week he acknowledges interest rates were too low in the past decade, but not the short-term interest rate targeted by the Federal Reserve (Fed). Rather, it was those stubborn long-term mortgage rates that failed to go up when the Fed started its tightening cycle in 2004. So do not blame the Fed, blame those folks overseas whose excess savings were funneled into the United States and, in turn, pushed down long-term interest rates. These are the real culprits according to Greenspan.

Greenspan's defense is wrong on several counts.

First, as noted by observers such as Barry Ritholtz and Larry White much of the problematic mortgage lending took place under adjustable rate mortgages, interest-only mortgages, and other non-traditional mortgages whose interest rates were tied to short-term interest rates. Thus, the Fed's super low interest rate policy in the early-to-mid-2000s was highly consequential to these types of loans.

Second, Greenspan's invoking of the interest rate "conundrum"--the Fed pushing up short term rates in the mid-2000s but long-term rates not following--and explaining it away by the foreign saving glut makes it appear that the Fed was helpless at that time. As Greg Ip shows this was not the case. The Fed could have tightened monetary policy or tightened the lending standards in the mortgage industry. While Greg is technically correct, I will go one further and say the saving glut story is at best a partial explanation for the conundrum. Another more compelling story is that there was no conundrum, but rather the bond market was expecting a recession in the near future and pricing it into long-term interest rates. In short, the conundrum was simply the case of a yield curve inverting and pointing to a recession. Moreover, this explanation makes sense in light of the fact that yield curves across the globe were flattening or inverting and thus indicating a global recession was in store. (See here and here for more).

Third, Greenspan overlooks the fact that Fed is a monetary superpower whose loose monetary policy got exported to the rest of the world in the early-to-mid 2000s. As I wrote earlier:
One important factor was the emergence of an unexpected global liquidity glut created by the Federal Reserve (Fed) in the early-to-mid 2000s. The Fed is a is a 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. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's 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). Thus, its highly accommodative monetary policy during this time was exported to the world.
This global liquidity glut served to facilitate a global credit expansion and as a result, a global housing boom. Yes, there was also a saving glut coming out of Asia and oil-exporting countries but it was more important to the story beginning about 2005 after the Fed's tightening cycle had begun to be take hold.

Finally, the original motivation for Greenspan's easing in the early-to-mid 2000s was a case of misreading the deflationary pressures. As documented in this post, nominal spending was not collapsing at the time. Also, the lack of robust employment gains coming out of the 2001 recession were not alarming given the robust productivity growth and the (policy-induced) low interest rates that encourage inordinate substitution of capital for labor.

To be clear, there were other developments such as the the securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agency failures, etc. that contributed to the current economic crisis. The Fed's role in this crisis, though, is unmistakable and clear. Consequently, no matter how many editorials Greenspan writes he will never be able to exonerate the Fed from the responsibility it bears for this crisis.

Thursday, March 12, 2009

Great Posts on Monetary Policy

Scott Sumner discusses George Selgin's ideas, questions the Goldman Sach's report, and mulls over Nick Rowe's thoughts on Monetarism. Nick Rowe, meanwhile, discusses temporary versus permanent quantitative easing and liquidity and aggregate demand. There is much to chew on here, but the common theme across these posts is that monetary policy is not tapped out.

Tuesday, March 10, 2009

Christina Romer: More Unconventional Monetary Policy Now!

Christina Romer, President Obama's chair of the CEA, gave a talk on "Lessons from the Great Depression for Economic Recovery in 2009" yesterday at the Brookings Institution. Drawing upon research on that period, she makes the case that both fiscal policy and monetary policy can be used to help stabilize the current economy. What I found most interesting were her comments on monetary policy:
A second key lesson from the 1930s is that monetary expansion can help to heal an economy even when interest rates are near zero...A key rule of my current job is that I do not comment on Federal Reserve policy. So, let me be very clear – I am not advocating... Tim Geithner should start conducting rogue monetary policy. But the experience of the 1930s does suggest that monetary policy can continue to have an important role to play even when interest rates are low by affecting expectations, and in particular, by preventing expectations of deflation.
The message seems very clear to me: the Fed can and should do more. How about it Ben Bernanke?

Monday, March 9, 2009

History Lesson: Use More Unconventional Monetary Policy

Tyler Cowen takes note of Harold Vatter's work that shows monetary policy was a key part of the World War II economic expansion. These results are consistent with Christina Romer's study that shows monetary policy rather than fiscal policy ended the Great Depression. Now these were unconventional monetary policies--FDR choosing not to sterilize gold inflows in the 1930s--but they worked and should help shape the current debate over how best to stabilize the economy. It seems odd that those observers who like to invoke the Great Depression when thinking about macroeconomic problems today often seem to overlook this successful use of unconventional monetary policy. Fortunately, other observers like Tyler Cowen, Nick Rowe, and Scott Sumner do believe monetary policy still packs a punch and have been making the case in the blogosphere. I hope policymakers and other influential observers are listening.

LA Daily News on the Business Cycle and Religiosity

The LA Daily News has an interesting article on the "spiritual tidal wave" being created by this recession. It is a nice complement to the earlier New York Times article on this topic and makes an even stronger case for the link between the business cycle and religiosity.
In Time of Economic Hardship, Houses of Worship Experience 'Spiritual Tidal Wave'

Throughout Los Angeles County and the nation, ministers and rabbis say they've seen dramatic increases in attendance in recent months as people worried about the worsening economy and turmoil in the world turn to religion.

Some houses of worship are using overflow rooms, hosting presentations to help people with their finances and giving sermons on the economic downturn, world events and Bible prophecy.

"There is a spiritual hunger and openness for God that I have not seen since 9-11," said Kirby, who estimates that his congregation has swelled from 550 to 750 worshippers in just the last four months.

"But this is a bigger and more sustained wave. The increase in church attendance after 9-11 only lasted a short time. But we have seen this now for four months and it's pretty much every Sunday. It's a spiritual tidal wave that is sustaining."

As attendance at churches in South America, Africa, China, Russia and other parts of the world is "exploding in growth," Jim Tolle, pastor of 25,000-member The Church On The Way in Van Nuys, said "pockets of revival or awakening" are also occurring in the United States.


In America, we used to feel like we were safe and secure as a nation," Durham said. "I think 9-11 took away safe and the recession has taken away secure. And so ... people are looking to faith and looking to God for reassurance and security."


At Shepherd of the Hills church in Porter Ranch, Senior Pastor Dudley C. Rutherford said he spent the fall preaching about Bible prophecy and has seen attendance grow from an average of 8,030 last year to 9,673 this year, a 17 percent increase. Rutherford attributes the increase to concerns about the economy and curiosity about world events...

Sunday, March 8, 2009

What Happened to the Debate over the Dollar's Reserve Currency Status?

The New York Times has an article today on the rise of the U.S. dollar during the current economic crisis. The article is interesting throughout, but I found this excerpt particularly poignant:
As the dominant flavor of money used in business worldwide, the dollar has once again been affirmed as the global reserve currency.

Only last year, some analysts said that as the American economy sagged, foreign central banks would be reluctant to sink national savings into the dollar. That has been soundly debunked.
Yes, the debate on whether the dollar would maintain its status as the main reserve currency (see here, here, and here) seems so dated now as does this picture:

As noted on this blog, the real debate now is whether the Euro can survive this economic crisis.

Recession-Proof Industries

See if you can find in the figure below--which plots the cumulative % change in employment since the start of the recession--those industries where this recession has had little or no effect on employment (click on figure to enlarge):

Yes, employment in the education and health services sector and the government sector appear impervious to the recession. Interestingly, employment in the natural resource and mining sector is also growing, but the rate of growth started slowing down in September 2008. Unsurprisingly, employment in the construction sector and durable goods manufacturing sector have been hit the hardest. Below are the absolute numbers for the various sectors (click on figure to enlarge):

No matter how you slice the data, these numbers are ugly. And as noted by Justin Fox, William Polley, Barry Ritholtz and others, these employment numbers in percentage form are now worse than the 1981-1982 recession.

Friday, March 6, 2009

Conditional Monetarism

Nick Rowe notes that many economists have a hard time thinking about "unorthodox" monetary policies since the dominant Neo-Wicksellian (i.e. New Keynesian) view focuses only on output gaps, inflation, and short-term interest rates as the sole problem facing central bankers. He explains that this paradigm has no meaningful role for money and it provides useless guidance--create inflationary expectations but wait, the the short term interest rate is already at 0%!-- for the current economic crisis. Nick, therefore, concludes we need to "revert to an older, earlier way of thinking" where monetary and credit aggregates were taken seriously. He suggests taking another look at Monetarism, or at least part of it. After all, if monetary policy cannot adjust prices (i.e. interest rates) anymore it has to start looking at adjusting quantities (i.e. monetary and credit aggregates). It is interesting that Nick's case for conditional monetarism finds merit in the work of Michael Bordo and Andrew Filardo. They have a paper where they argue for a "zonal view" which says monetary and credit aggregates can be meaningful for monetary policy depending on the state of the economy. Here are some key excerpts from the paper:
Money Still Makes the World Go Round: The Zonal View (non-gated version)

In this paper, we describe a hypothesis we call the zonal view of monetary policy and offer empirical evidence in support of it. Broadly speaking, the zones of interest span a range from high inflation (zone 1) to deep deflation (zone 5), with intermediate zones of moderate inflation (zone 2), low inflation (zone 3) and low deflation (zone 4). The implications of the zonal view go straight to the heart of the current monetary policy debate. Under the zonal view, the information content of quantitative measures of monetary policy such as the monetary aggregates (and credit aggregates in more financially advanced economies) versus, say, short-term real interest rates, depends on the inflation zone in which a central bank finds itself. Naturally, the inflation dependence of the zones should not be construed to represent a structural relationship, owing to the endogenous nature of inflation. But these zones might be best thought of as shorthand used to broadly characterize the policy environment, not least being the conservatism of the central bankers and the way in which economic agents update their inflation expectations. We will argue that these zones provide a simple but useful taxonomy to reflect historical regularities between the level (and variability) of inflation and the relative usefulness of the monetary aggregates and real interest rates as measures of the stance of policy.


In sum, monetary policy can eliminate deflation of any magnitude just as it can eliminate inflation. However, the appropriate monetary policy strategy depends on the inflation/deflation zone in which a central bank finds itself. Emphasizing the monetary aggregates appears, from a historical perspective, to be rather important during periods of high inflation and deep deflation. During periods of low inflation, velocity over short periods of time has shown a tendency to be more volatile and unpredictable than variation in the natural interest rate, thereby tilting the balance of the arguments toward the reliance on interest rate instruments in the conduct of monetary policy. However, in the zone of low inflation/price stability and low-to-moderate deflation, the influence of the zero lower bound for short-term nominal interest rates makes reliance on short-term interest rates more problematic; hence, the balance tilts toward the monetary aggregates playing a dominant role as the guide of choice. Finally, even though monetary policy has the ability to generate inflation, it cannot necessarily eliminate stagnation arising from deep-seated structural problems, especially a dysfunctional financial intermediation system. All of this points to a U-shaped pattern in the relationship between the zones and the usefulness of the monetary aggregates relative to real short-term interest rates as measures on the stance of monetary policy.
Below is a figure from the paper that nicely summarizes their view. (Click on figure to enlarge.)

I heard Andrew Filardo gives this paper at a national meeting. As I recall, the discussant of the paper more or less dismissed it by invoking the New Keynesian view of the world. I wonder what that discussant thinks now.

Monday, March 2, 2009

A Note to Paul Krugman: There is More to the Story than Just a Saving Glut

In his column today, Paul Krugman pushes the saving glut theory as the reason for the current global economic crisis. At the expense of sounding like a broken record, let me remake the case that the saving glut alone does not explain the entire crisis. Rather, it was number of factors (including the saving glut) that came together to create a perfect financial storm.

One important factor was the emergence of an unexpected global liquidity glut created by the Federal Reserve (Fed) in the early-to-mid 2000s. The Fed is a is a 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. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's 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). Thus, its monetary policy was highly accomodative during this time and was exported to the world.

While the global liquidity glut was important early on in the decade, the saving glut became more important starting in 2005--a view shared by Brad Sester (See also his comments in this Econbrowser post). However, other factors throughout the entire 2000s were important to this process as well : the securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agency failures, etc. All of these developments in conjunction with the global liquidity glut early on and later the saving glut came together to create the witches brew of excessive credit, asset bubbles, and unsustainable aggregate demand across the globe. That, in short, is my view of how this once-in-a-lifetime perfect financial storm was created.

Sunday, March 1, 2009

If Only He Had Been Blogging Sooner...

I am talking about Scott Sumner. It is thrilling for me to find someone who (1) believes monetary policy still packs a punch and can reverse the collapse in domestic demand and (2) believes nominal income targeting is the way to do it. He makes a convincing case for both points over at his new blog The Money Illusion--see his posts here and here in particular--which hopefully is broadening the debate on policy options. I too am a big fan of nominal income targeting (here and here) and believe that monetary policy is not tapped out. Those with similar views should be glad to have someone as articulate and influential as Sumner now making the case.