Tuesday, June 29, 2010

Ambrose Evans-Pritchard Unloads Both Barrels at the Fed

Ambrose Evans-Pritchard always has something interesting to say about economic policy. Some observers have called him sensational, but he often is spot on in his analysis of U.S. monetary policy. His latest piece doesn't disappoint. It is a reply to Kartik Athreya's now infamous essay that tells readers to ignore economic commentators on matters of monetary policy and only listen to the high priests of the Federal Reserve System. What is really great about this reply is that it summarizes many of my own views on the evolution of U.S. monetary policy over the last 10 years: monetary policy was too loose in the first half of the decade and has been effectively too tight in the latter half. It also does a good job highlighting how the Fed's inordinate focus on stabilizing credit markets has come out the expense of stabilizing aggregate demand. Here is Evans-Pritchard:

Dr Athreya’s assertions cannot be allowed to pass...

Central banks were the ultimate authors of the credit crisis since it is they who set the price of credit too low, throwing the whole incentive structure of the capitalist system out of kilter, and more or less forcing banks to chase yield and engage in destructive behaviour.

They ran ever-lower real interests with each cycle, allowed asset bubbles to run unchecked (Ben Bernanke was the cheerleader of that particular folly), blamed Anglo-Saxon over-consumption on excess Asian savings (half true, but still the silliest cop-out of all time), and believed in the neanderthal doctrine of “inflation targeting”. Have they all forgotten Keynes’s cautionary words on the “tyranny of the general price level” in the early 1930s? Yes they have.

They allowed the M3 money supply to surge at double-digit rates (16pc in the US and 11pc in euroland), and are now allowing it to collapse (minus 5.5pc in the US over the last year). Have they all forgotten the Friedman-Schwartz lessons on the quantity theory of money? Yes, they have. Have they forgotten Irving Fisher’s “Debt Deflation causes of Great Depressions”? Yes, most of them have. And of course, they completely failed to see the 2007-2009 crisis coming, or to respond to it fast enough when it occurred.

The Fed has since made a hash of quantitative easing, largely due to Bernanke’s ideological infatuation with “creditism”. QE has been large enough to horrify everybody (especially the Chinese) by its sheer size – lifting the balance sheet to $2.4 trillion – but it has been carried out in such a way that it does not gain full traction. This is the worst of both worlds. So much geo-political capital wasted to such modest and distorting effect.

The error was for the Fed to buy the bonds from the banking system (and we all hate the banks, don’t we) rather than going straight to the non-bank private sector. How about purchasing a herd of Texas Longhorn cattle? That would do it. The inevitable result of this is a collapse of money velocity as banks allow their useless reserves to swell.

And now the Fed tells us all to shut up. Fie to you sir.

Read the entire piece here.


  1. Needless to say Athreya's essay has been well and justly thrashed, but Evans-Pritchard's account does raise a couple of questions for me.

    The first is on the savings glut side of the story, which AEP admits is at least half true. You've written before that you believe the Fed should have allowed some deflation in the face of a 'supply shock' out of China, which would have likely prolonged the 2001 recession.

    But it is fairly clearly the case that Chinese policy amounts to financial repression in order to boost savings and restrain demand. So what looks like a supply shock in the US is a negative demand shock in China. Do we know what the policy responses from China would have been to a US tightening, and could that change one's presciptions? We are, it seems, in a rather non-optimal currency union and I am not sure how that would/should affect Fed decisions.

    Also, I am not clear AEP's take on the shape of US QE, is refering to the interest on reserves here?

  2. Anonymous:

    My current thinking is that the Fed should have started raising rates in late 2002. Domestic demand was growing by the second half of 2002 and at a minimum there was no need of further rate cuts. I don't think this would have prolonged the 2001 recession, but even if had surely that would have been far better than this recession.

    One could point to the negative output gap that persisted well beyond the 2001 recession to argue in favor of the Fed's decisions, but even here I am not convinced. This is because a good part of the negative output gap at this time came from the productivity gains increasing the economy's capacity. This is far different than a negative output gap emerging from a collapse in demand.

    I can't know for sure how China would have responded had the Fed acted differently in the first half of the 2000s, but one thing is clear: the Fed's expansionary policy was exported to China via China's peg to the dollar. China had to suck up dollars and increase it forex holdings in order to maintain the yuan-dollar link. Had the Fed tightened sooner China would have had fewer dollars to buy up. So some of excess savings (though not all) from Asia was simply recycled loose U.S. monetary policy.

    And yes, it takes two to tango. The Chinese weren't forced to pegged. But given that they and many other emerging market countries did peg to the dollar, this effectively made the Fed a monetary superpower. Consequently, its loose monetary policy got exported to a large part of the world. (See here for more on the implications of the Fed's monetary superpower status). And this speaks to your point that in effect we have a non-optimal currency union across much of the globe.

    I believe AEP's point on QE is that it helped credit conditions but failed to do much else. Thus, much of the new monetary base is sitting idly in the banking system. (Of course we wouldn't want all of it coming out, but some would be nice.)

    Maybe I am too tucked away in my 'ivory tower', but I really believe that had the Fed simply been (1)stabilizing nominal spending and (2) implementing some macroprudentail policies then many of the problems would have been avoided.

  3. Thanks for the reply.

    I have the impression that a currency area that large and that non-optimal is pretty well doomed to end in tears one way or another.

    Has anyone done any research on the implied quantitative difference in monetary policy between the US and the Dollar Zone as a whole over the last ten years as well as going forward?

    Also, given that the Chinese government was not saving and acquiring dollars as a reserve or in order just to acheive a nominal rate of exchange, but rather as a part of a development strategy to maintain an 8% rate of real growth, it makes sense to try to understand what policy response they may have made. For example, they did allow some nominal appreciation in 2005-2008, with tighter Fed policy that likely would not have happened. Though conversely, they may have loosened domestic demand more with less US demand.

    At any rate, my view is that US Monetary super power status is a net negative for most of economy. The exhorbitant privilege is a an exhorbitant distortion, and should be transitioned away from as quickly as possible.