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? 

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.

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.

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.

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.

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.

The Employment Numbers in Perspective

Friday we learned the employment conditions continue to deteriorate:

The nation lost 524,000 jobs in December, bringing the total drop for last year to 2.589 million, just shy of the 2.75 million decline at the end of World War II, the Labor Department reported yesterday in Washington. The unemployment rate climbed to 7.2 percent, the highest level in almost 16 years.

Although these numbers are bad, the widely-reported comparison to WWII is misleading. It fails to account for the fact that the U.S. labor force is now about 2.5 times larger than at the end of WWII. Consequently, a more appropriate comparison would look at the number of lost jobs relative to the labor force for these two periods, not the absolute number. Alternatively, one could simply look at the percent change in employment. As noted by The Economist magazine, this approach shows a 1.9% employment loss in 2008 versus a 2.7% 12-month loss at the dept of the 1974-75 and 1981-82 recessions. This fact is highlighted below in the figure of the year-on-year percent change in NFP employment since the late 1940s. Recessions are highlighted by the gray columns. (Click on figure to enlarge.)

To be clear, I am not saying the almost 2.6 million lost jobs are inconsequential. What I am saying is that these numbers do not yet indicate that this recession in terms of employment is the worst since the end of WWII.

Update: ECB once again provides a good response in the comments section:

[I]f we look at the fall-off in the employment/pop ratio since 2000, that is dramatic is it not? And one measure of hardship that mainstream economists ignore, is the number of people suffering from what USDA calls food insecurity. This number now stands at 12 million. That is a 40% increase from 2000. I think you may be a little blase in downplaying the recent employment fall.

See also Barry Ritholtz's post here for more sobering news coming from the labor force participation rate.

Global Liquidity Glut or Global Saving Glut?

I have argued here many times that the "liquidity glut" view of the global economic imbalances has as much merit as the "saving glut view". Many prominent observers, however, completely ignore the "liquidity glut" view and only buy into the "saving glut" view (or a variant of it--the "investment drought view"), even when it puts them in an awkward position. Fortunately, there is now a paper by Thierry Bracke and Michael Fidora of the ECB that puts these competing views to a test. Here is the abstract from their paper:

Global Liquidity Glut or Global Saving Glut? A Structural VAR Approach
Since the late-1990s, the global economy is characterised by historically low risk premia and an unprecedented widening of external imbalances. This paper explores to what extent these two global trends can be understood as a reaction to three structural shocks in different regions of the global economy: (i) monetary shocks (“excess liquidity” hypothesis), (ii) preference shocks (“savings glut” hypothesis), and (iii) investment shocks (“investment drought” hypothesis). In order to uniquely identify these shocks in an integrated framework, we estimate structural VARs for the two main regions with widening imbalances, the United States and emerging Asia, using sign restrictions that are compatible with standard New Keynesian and Real Business Cycle models. Our results show that monetary shocks potentially explain the largest part of the variation in imbalances and financial market prices. We find that savings shocks and investment shocks explain less of the variation. Hence, a “liquidity glut” may have been a more important driver of real and financial imbalances in the US and emerging Asia than a “savings glut”.

Bottome line: monetary policy via the global liquidity glut matters for global economic imbalances.

Mabye the Other Shoe is About to Drop

Yves Smith has me worried that the other shoe is about to drop:

It has been conventional wisdom that China, Japan, and other countries that run trade surpluses with the US, which means they fund our overconsumption by buying assets like US Treauries, would never restrict the flow of credit to us because it would lower their exports and hurt their growth. We've long been leery of the idea that unsustainable trends will have a life eternal, and Brad Setser has a simple reason why this process is self-limiting. Our foreign funding sources aren't just lending us money to buy their goods; they are also providing the funding for interest on the loans extended for past imports. At a certain point, the interest payments become so large relative to the value of the exports that the deal no longer makes sense.

The day of reckoning may be approaching well before Setser's tipping point. And the trigger is much simpler. We look like a lousy risk. The Freddie/Fannie conservatorship, the Lehman bankrutpcy, and the rescue of fallen Asian powerhouse AIG has, not surprisingly, lead to a reassessment of the US's creditworthiness.

Yu Yongding, who has advised China's central bank, urges Japan, China, and Korea to forge an agreement not to dump US bonds. Yu says in no uncertain terms that the Chinese are worried about their US holdings and see a US default as a real possibility.

We've said before that the US is in the same position as Indonesia and Thailand circa 1996, except we have the reserve currency and nukes. The precariousness of our position is now evident to all, save perhaps the average American citizen.

From Bloomberg (hat tip reader a):

Japan, China and other holders of U.S. government debt must quickly reach an agreement to prevent panic sales leading to a global financial collapse, said Yu Yongding....

[...]

An agreement is needed so that no nation rushes to sell, ``causing a collapse,'' Yu said. Japan is the biggest owner of U.S. Treasury bills, holding $593 billion, and China is second with $519 billion. Asian countries together hold half of the $2.67 trillion total held by foreign nations....

[...]

China's huge holdings of U.S. debt means it must bear a large proportion of the ``burden of sorting things out'' in the U.S., Yu said. China is not in a hurry to dump its U.S. holdings and communication between the two nations every ``couple of days'' is keeping Chinese leaders informed and helping to avoid a potential panic, he added.

``China is very worried about the safety of its assets,'' he said. ``If you want China to keep calm, you must ensure China that its assets are safe.''

Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said.

So there you have it: not only might the other shoe drop, but just the threat of it happening gives political leverage to the Asian authorities. Of course, we have no one to blame but ourselves.

Waiting for the Other Shoe to Drop

As bad as it has been in U.S. financial markets, Ken Rogoff reminds us that it could be, and may yet become, worse:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

In other words, in spite of the financial meltdown going on in the United States foreigners continue to fund the United States living beyond its means as evidenced by the strength of the dollar. (Click on graph to enlarge.)


As Brad Sester notes, though, this foreign financing as of late is (1) coming only from the public sector in foreign countries and (2) even they are running from assets other than safe U.S. treasuries. On this latter point Brad points to a disturbing development reported in the Treasury's TIC data:

[The TIC data] tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.

So even though foreign monetary authorities continue to support the dollar through purchases of U.S. securities they are doing so in a increasingly selective manner. As bad as the markets are now, it could get dramatically worse should this source of foreign financing dry up. It does not take a very imaginative mind to wonder how long before this other shoe drops too.

The End of American Hegemony?

There was an interesting issue raised in the economics blogosphere last week: the end of American hegemony. Nouriel Roubini started it off with his posting "The Decline of the American Empire" where--in addition to the much ballyhooed argument that U.S. foreign policy has been misused in recent years--he noted several economic developments that point to a loss of U.S. influence. The first is the rise of other economic powers:

[R]egardless of mistaken US policies the rise of other economic and financial powers – the rise of China, the recent resurgence of Russia, the process of economic and political integration in the European Union, the emergence of India, and the rise of other regional powers such as Brazil, South Africa and Iran – implies that the relative economic, financial and geopolitical power of the US will be reduced over time.

The second and more important development, according to Roubini, is the fact that the United States has been making poor choices in economic policy:

[T]he US squandered its economic and financial power by running reckless economic policies, especially its twin fiscal and current account deficits...

The trouble with these twin deficits is multi-fold. First, superpowers and empires - like the British Empire at its peak - tend to be net lenders – i.e run current account surpluses – and be net creditors, not net debtors; The decline of the British Empire started in World War II when the British fiscal deficits in the war and the current account deficits turned that empire into a net borrower and a net debtor both in its public debt and external debt. That financial switch into an external debtor and borrower position was also the reason for the decline of the British pound as the leading reserve currency. And the British twin deficits were being financed by a rising economic and financial power that was a net lender and a net creditor, the US.

Second, the last time the US was running large twin deficits in the 1980s the main financiers of these deficits were the friends and allies of the US, i.e Japan, Germany and Europe as the US external deficit was against these economies. Today instead the economic powers financing the US twin deficits are the strategic rivals of the US – China and Russia – and unstable petro-states, i.e Saudi Arabia, the Gulf States and other shaky petro-states. This system of vendor financing – with these US creditors providing both the goods being imported and the financing of such deficits – has led to a balance of financial terror: if these creditors were to pull the plug on the financing of the US twin deficits the dollar would collapse and US interest rates would go through the roof.

Third, while it is unlikely that China, Russia and other powers would suddenly pull the rug from under the US feet – as such action would lead to a sharp appreciation of their currency and negatively affect their export led growth model – relying excessively on the kindness of strangers – especially that of your strategic rivals – is extremely risky. Since almost 100 percent of all US fiscal deficits since 2001 have been financed by non-residents... by now the total stock of US Treasuries held by non-residents is getting close to 60 percent... This change makes the US vulnerable to such rivals using the financial terror weapon – dumping US assets and or reduicing their financing of the US twin deficits – in situations of geostrategic tension.

It is worth noting that some observes believe that 'geostrategic tensions' were behind the U.S. government's bail out of Fannie and Freddie. As reported by Bloomberg, Asian investors had pressured--some would say blackmailed--Treasury Secretary Hank Paulson to bolster these institutions. The key point, though, of the above paragraphs is that Americans have themselves largely to blame should this decline of American hegemony take place.

The next day Brad Sester followed up on this issue with his post "The Changing Balance of Global Financial Power." In it, Sester notes that democratic governments are increasingly receiving their funding from authoritarian governments. He provides some interesting graphs that show how the foreign assets of the authoritarian governments now exceed and are growing faster than those of the democratic governments. He concludes with the following:

One thing is clear: the world’s biggest financial powers are no longer the world’s large democracies. A gathering of the countries that matter for global economic coordination will no longer be a gathering of the leaders of the world’s big democracies. Coordination among the large democracies was never easy — and likely will only get harder as additional countries have to be brought in.

A key implication of Sester's posting is that America's influence is on the decline. Of course, these observers are not the first ones to make the case of America's decline from an economic perspective. For example, Niall Ferguson said the following in the Financial Times earlier this year:

Future historians will look back on the current decade as a turning point comparable with that of the Seventies. No, not the 1970s. This is not going to be another piece pointing out the coincidence of an unpopular Republican president, soaring oil prices, a sagging dollar and an unwinnable faraway war. I am talking about the 1870s.

[...]

This is the story of how an over-extended empire sought to cope with an external debt crisis by selling off revenue streams to foreign investors. The empire that suffered these setbacks in the 1870s was the Ottoman empire. Today it is the US.

A key story, then, that emerges from these pieces is that America's imminent decline stems in large part from its economic profligacy. These authors are spot on regarding America's spending and saving problems, but it is not clear to me that these problems imply anything more than a temporary dip in America's hegemony status. Yes, there are huge global economic imbalances that need to be worked out, but this does not mean the fundamentals that have historically made the U.S. so economically dynamic--relatively good institutions, a strong entrepreneurial spirit, and a culture of ideas and innovation--have structurally changed. If anything, the working out of the global economic imbalances should present more problems for the China and Indias of the world where institutions are less secure and the potential for social distress is greater. Moreover, the very emergence of these new economic powers is dependent on the global public goods provided by the United States. One wonders how robust their growing influence would be in the absence of such global public goods. Roubini concedes there is uncertainty on this point:

Whether the decline of an hegemonic power providing global public goods – security, free trade, freer mobility of capital and people, inducements to free markets and democracy, better environment, peace – will lead to a more stable world with many powers multilaterally cooperating on these global economic, financial and geopolitical issues; or whether the absence of such stable hegemonic power will lead to a more unstable world characterized by conflicts – economic, political and even military – among traditional nation states, great powers and non-traditional actors is an open and difficult issue.

Nothing, of course, is certain including America's hegemony status. I, however, am just not convinced that the past 7 or so years of economic profligacy is enough to undermine the United States's superpower status.

Update: Stormy comments on this issue over at Angry Bear.

Fueling Inflation, Maintaining Imbalances

Mark Gertler recently asserted the United States should "not act rashly over inflation" fears. He argued that the recent jump in U.S. inflation is the result of relative price changes in food, energy, and other commodities and not the consequence of policy-induced aggregate demand pressures. Mark Thoma concurs and notes that since relative price changes provide "important signals to the economy about where resources are needed most and about the opportunity costs of employing them...we don't want to mute those signals..." In short, negative supply shocks are the source of the recent inflationary pressures and are not the type of price shocks that should be addressed by policy (unless they add momentum to a growing inflationary spiral--something the two Marks do not see happening).

This interpretation, however, begs the question of why these commodity are soaring in the first place? Could it be that in addition to the usual suspects--increased Asian demand, biofuel distortions, speculators--that loose U.S. monetary policy is playing a part? Given the monetary hegemon role played by the Federal Reserve--its monetary policy gets exported to all those countries pegged to the dollar--it seems reasonable to conclude that some of the increase in commodity prices are more than relative price changes; they are in part the result of policy-induced aggregated demand pressures. That is what I was thinking, anyhow, when reading Gertler's article. I was not alone in my thinking. Ken Rogoff makes a similar case in the FT:

As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

[...]

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation (expressed mainly through a temporary acceleration in renminbi appreciation), has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach.

Dollar bloc countries have slavishly mimicked expansionary US monetary policy, even in regions such as the Middle East, where rapid growth is putting huge upward pressure on inflation. Of the major regions, only Europe, led by the European Central Bank, has resisted joining the stimulus party so far. But even the ECB is coming under increasing domestic and international political pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus, albeit at the expense of loosening inflation expectations and possibly paying a steep price to re-anchor them later on. But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Rogoff goes on to address Gertler's claim that the Fed should more concerned about the financial crisis than the inflationary pressures:

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? It is hard to see the argument in emerging markets where inflation is raging, but even in epicentre countries it is becoming increasingly dubious. Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to have several years of elevated inflation to help bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on.

Another consequence of this pump-priming aggregate demand was recently mentioned by Brad Sester:

The [U.S.] policy response to the subprime crisis has avoided the sharp adjustment that many feared. But it also meant that many of the underlying imbalances haven’t really corrected. The composition of the US current account deficit has changed – the oil deficit is bigger, the non-oil deficit is smaller; the fiscal deficit is bigger and aggregate deficit of households is smaller - but the aggregate deficit remains large. And the rest of the world’s imbalances haven’t corrected either. China’s economy remains unbalanced. The oil surplus has gotten bigger.

Hence it is possible to argue — see Yves Smith — that risks are still increasing.

So in addition to potentially unanchoring inflationary expectations, U.S. policy--with help from foreign governments--has put off for another day the inevitable correction of economic imbalances.

Not Following the Pattern

Brad Sester had an interesting post that looks at how U.S. economic imbalances have been affected by the subprime crisis. First, he notes what typically happens to countries running huge current account deficits like the United States when hit with a economic crisis like the subprime one:

Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.

He then examines the U.S. experience since the subprime crisis erupted. Has it followed the typical currency crisis pattern?

A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets...

So no, the United States has not followed the pattern. And no matter how bad you think the U.S. economy has been hit, it could be far worse had external financing dried up.

Brad's point that the typical currency crisis pattern has not held up with the United States reminded me of something I heard about the Early Warning Systems (EWS) that were so popular a few yeas back. Before I mention what it was, let me review the purpose of the EWS by way of the IMF:

The IMF uses econometric models known as early warning system (EWS) models in its efforts to predict currency crises—defined as a sharp currency depreciation or loss of foreign exchange reserves or both—before they occur. These EWS models focus on external volatility and exploit systematic relationships apparent in historical data between variables associated with the buildup to crises and the actual incidence of crises. The variables include the ratio of short-term debt to foreign exchange reserves, the extent of real exchange rate appreciation relative to trend, and the external current account deficit. Both theory and evidence suggest that the higher the value of each of these variables, the greater the probability of a crisis. Extensive tests have been performed to determine which of these empirically based models best fits the data and is the most robust.

The IMF's EWS models focus on a relatively long prediction horizon of 12-24 months to provide countries with enough lead time to adopt corrective policies. The focus is, after all, on prevention. The IMF also keeps an eye on alternative EWS models developed by the private sector and explores variations on the central IMF model. The private sector models, produced chiefly by investment banks, have shorter time horizons because the aim is to guide short-term investment decisions. Among the IMF's alternative models, one focuses on balance sheet variables, notably for the financial and nonfinancial corporate sectors, and another (estimated with annual data) focuses on fiscal variables.

This comes from a 1999 paper, so the EWS models have evolved. Still, the basic premise behind the EWS remains: forecast currency crisis. So here is what I heard about these models. If you plug the United States into these models you find a major dollar crisis happened years ago. That has not happened though the dollar has already depreciated just over 25% over the last 3 years. Still, there are huge economic imbalances that will require further depreciation of the dollar. A sudden collapse of the Bretton Woods II system could turn this need for further dollar depreciation into a dollar crisis. I hope for a different outcome.

Could This Be The Tipping Point?

Amidst the headline news of failing financial institutions and stagflationary conditions in the United States, there has been one U.S. story that so far has been good news: central banks in Asia and oil-exporting countries continue to support the financing needs of the United States. According to Brad Sester, this foreign financing was $283.5 billion during the first half of 2008 and continues unabated. As is well known, this support one day will end--the United States cannot forever live beyond its means--but now would not be a good time. Most Americans do not recognize their dependence on this foreign financing nor the added stress the U.S. economy would be under in its absence. The sustained nature of this quiet bailout, as Brad Sester calls it, has been good news for the weakened U.S. economy.

Some observers, however, are now warning this financial lifeline may be in jeopardy given recent events. Ambrose Evans-Pritchard reporting on a Merrill Lynch paper writes the "US faces global funding crisis." From his article:

Merrill Lynch has warned that the United States could face a foreign "financing crisis" within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst.

The main point of the Merrill Lynch report is that the recent spate of bad economic news may be the tipping point for the end of this global financing arrangement, popularly known as Bretton Woods II (BWII). Nouriel Roubini makes similar points here. So what do you think? Is this really the end of BWII?

Dump the Dollar Peg Week

This has been the week of dump the dollar peg in the Gulf States. First, it was reported on Sunday that some officials from Abu Dhabi think the United Arab Emirates should replace its dollar peg with one tied to a basket of currencies. At the same time, Nouriel Roubini posted an article comparing the coming collapse of the Bretton Woords II system with that of Bretton Woods I where, among other things, he too called for the end of the dollar peg in the Gulf States. Then on Monday the Financial Times (FT) published its "Dollar-pegged out" editorial. Here the FT similarly argued the Gulf States needs to abandon the dollar peg and move to a basket of currencies that included the price of oil. The FT's editorial, in turn, made Brad Sester happy who followed up on Tuesday with a posting to his blog that furthered the arguments made in the FT. On Wednesday, Jeffrey Frankel, the originator of the currency-basket-including-oil idea chimed in on this debate with this piece. Then on Thursday the Wall Street Journal RTE blog posted the "Dollar Peg Gets Taken Down a Peg." And today, ordinary people like me are sifting through this debate, considering how such a change would take place and what it would mean in the near term.

But first, let's review the thinking behind the calls for the Gulf States to abandon their dollar pegs. Martin Feldstein explains it this way:

The double-digit inflation problem in Saudi Arabia and its Gulf neighbours is different from that of other emerging market economies. Although the rising price of imported food affects them all, the inflation problem in the Gulf region is exacerbated by their fixed exchange rate policy.

The peg to the dollar contributes to Saudi inflation in two ways. First, the dollar link forces the Saudi central bank to match US interest rates. As the Fed lowered its interest rate from 5.25 per cent last summer to 2 per cent now, the Saudis had to cut their interest rate. If they had not done so, investors around the world would have flooded Saudi Arabia with funds seeking the higher yield on a currency that is pegged to the dollar. While cutting rates was a good policy for the US as its economy weakened, it was a terrible policy for Saudi Arabia, which is experiencing an overheated domestic economy with rapidly rising inflation.

The dollar peg also raises Saudi inflation by increasing the cost of imports as the dollar declines relative to the euro, the yen and other currencies. The US is the source for only about 12 per cent of Saudi imports. The 15 per cent decline of the dollar relative to those currencies during the past year meant that the prices paid by the Saudis for the goods that they bought from Europe, Japan and elsewhere rose more than 15 per cent. The large US trade deficit is likely to continue to force the dollar to decline against other main currencies. The result will be a continuing source of imported inflation in Saudi Arabia and other countries that tie their currencies to the dollar.

Inflation in Saudi Arabia and the other Gulf states is depressing real incomes of millions of low-income workers. The combination of the dollar peg and the declining dollar is also reducing the value of the remittances that large numbers of foreign workers send home to their families in low-income countries such as India and Pakistan. Since these foreign workers make up more than half of the total workforce in Saudi Arabia and an even larger share in the less populous states of the region, their discontent is a significant risk to local stability.

Because of their dollar pegs, then, the Gulf States are importing the highly stimulative U.S. monetary policy at the very time their overheating economies need a tighter monetary policy. The remedy, as argued by the above individuals and media outlets, is to change the composition of their peg to a basket of other currencies and oil. Doing so, would mean that their "currencies would appreciate when oil is strong, and depreciate when it is weak" and "make for smoother adjustments than double-digit inflation" (FT).

It is clear that the dollar peg is distortionary for the Gulf States. It is also clear there is an end game in sight: either the Gulf States change their peg or continued inflation will effectively do it for them. The currency-oil basket makes sense to me as a long-term solution, but what about in the short-term when the transition between pegs would take place? What happens if in abandoning their dollar peg the Gulf States make other important dollar peggers like China nervous about capital losses on their own dollar holdings? This could start a run on the dollar and lead to more distress in our battered financial markets. So when I read these calls for dumping the dollar peg, I agree in principle but get concerned as to what would actually happen in practice.

Is there a way to guarantee the transition will be orderly? My current thinking is that part of the solution lies with the Fed: it should do more to reign in global inflation. This would remove the inflationary pressures in the Gulf States and give them more time to work on a orderly transition. It would also reduce the likelihood of a run on the dollar.

History is Repeating Itself

In thinking about today's global inflation problem and the role U.S. monetary policy is playing in it, it struck me that we have seen this story before. The collapse of Bretton Woods system--the global monetary system from the end of WWII through the early 1970s-- was due to the United States abusing it role as the anchor currency. During this time, many countries outside the communist block pegged their currencies to the dollar, which was ostensibly backed by gold. Consequently, these countries were willing, initially, to take dollar and dollar-denominated assets for international payments. The United States, however, had pressing domestic spending objectives--the Vietnam War and the Great Society--that required foreign financing. This meant foreign countries took increasingly more dollar and dollar-denominated assets as payment. After some time, these countries began to question whether the U.S. really could back up all of these dollars it was exporting with gold. The answer, of course, was that it could not and eventually the system collapsed. Along with the collapse came a surge in global inflation--the delayed consequence of the U.S. exporting its loose monetary policy to the rest of the world for so many years.

Today, we see the same thing happening. Nouriel Roubini has a post yesterday that makes this very point:

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Suffice to say history seems to be repeating itself. Maybe this time around the world will become once bitten twice shy about the dollar.

The Economist Magazine Forgot This Global Institution in Its Leader

The Economist has an interesting leader on the future of global institutions such as the G8, the IMF, and the UN Security Council. The article, however, makes a glaring omission when it comes to its list of important global institutions. This oversight, though, may be a good thing since there is no point in reminding the world about a highly influential global institution that is largely indifferent to the needs of the world yet highly concerned about the one country that runs it.

So what is this global institution? Let us turn to the Financial Times for the answer:

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed sets interest rates for Asian [and many Middle Eastern] countries because, explicitly or not, they manage their exchange rates against the dollar. If US interest rates are low, countries targeting the dollar are obliged to follow, because otherwise investors will sell dollars to buy their currency.

So the Fed is a monetary hegemon and its current accommodative stance, while arguably appropriate for the United States, is way too stimulative for the dollar block, those countries whose currencies are tied to the dollar. This is creating some geopolitical angst and is why the Fed should be added to the list of important global institutions.* The global reach of the Fed is something I have discussed before, but recent commentary on this issue by Brad Sester started me thinking more about the fundamental problem with this arrangement. Here is Brad Sester's take on these developments:

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

...Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US — and the world — would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Brad's point is that this arrangement is the one of the main reasons for the global economic imbalances--the large, ongoing U.S. current account deficits and the financing for them from Asia and the Gulf region--and is therefore unsustainable. I agree with Brad's conclusions, but have started thinking about this problem from a different perspective: the dollar bloc an optimum currency area (OCA). Consider the standard criteria of an OCA: similar business cycles, mobile labor, flexible prices/wages, fiscal transfers, diversified economy. The main regions of the dollar block--U.S., Asia, and the Gulf region--fail to meet the OCA criteria on most counts. For example, the U.S. economy is slowing down while the rest of the dollar block is overheating. Or, when was the last time you saw a mass exodus of former Rustbelt workers moving to China or heard of a fiscal transfer from the Gulf region to the Rustbelt? By my reckoning, then, the OCA criteria also indicates the dollar block countries should abandon their pegs and take on more monetary policy autonomy.

With that said, I am fearful of what would happen to the U.S. economy if the dollar block countries abandoned their dollar pegs anytime soon. The Fed's job would certainly be made more challenging and potentially there could be a run on the dollar. In the near term, then, it may be more sensible for the Fed to acknowledge its role as a monetary hegemon and take the lead in fighting global inflation. (Actually, I would have the Fed stabilize global nominal spending, but I digress). This may have some domestic economic consequences, but it would (1) help reign in global inflation and (2) give more time to dollar block to hammer out a coordinated plan of separation.

*According to Ken Rogoff, these countries make up about 60% of the global economy so the Fed's influence is significant.

Fed to World: "We Want the Exorbitant Privilege, But Not the Responsibility"

Okay, the Fed did not exactly say that, but I suspect that is how the world, particularly the dollar block, is interpreting Donald Kohn's speech this week. While much was said about globalization and the issue of decoupling in the speech, the controversial part was as follows:

Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

As reported over at Real Time Economics, this amounts to the Fed outsourcing the global inflation fight. The Fed, whose monetary policy applies to all those countries who peg their currencies to the dollar, is unwilling to sacrifice domestic economic goals in order to stabilize global inflationary pressures. While this stance makes domestic political sense, it ignores the monetary hegemon status of the Fed and its role in creating the global inflationary pressures in the first place. It also ignores the potential damage to the dollar as a reserve currency--a development that would have domestic economic implications for the Fed. As Tim Duy notes,

[T]he US has benefited by the foreign willingness to accumulate Dollar assets; it allows the US to consume well beyond productive capacities without, until recently, inflationary consequences. If the rest of the world is implored to tighten policy and weaken the Dollar, then I suspect those positive inflation dynamics will be reversed. The Fed effectively replaces one inflation concern with another by advocating what amounts to a Dollar drop.

In short, the Fed's job is made easier because it manages the main reserve currency, but it is not willing to take on the responsibilities associated with this exorbitant privilege. This complacency could be costly for the U.S. economy.

Update: The Financial Times makes a similar case in this editorial.

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.

The Long Journey Ahead

Wolfgang Munchau tells us that the unwinding of global economic imbalances may take many years.

Global Adjustment Will be Long and Painful
...It is no accident that our multiple crises – property, credit, banking, food and commodities – have been happening at the same time. The simple reason is that they are all part of same overriding narrative. The mother of all these crises is global macroeconomic adjustment – a rare case, incidentally, where the word “crisis” can be used in its Greek meaning of “turning point”.

It is a huge global macroeconomic shock. How long the financial part of the crisis will go on will depend to a large extent on how bad the economic part of the crisis gets.

The economic part of the story started more than a decade ago with a liquidity-driven global boom. Property, credit and equity bubbles were all part of this.

So was a Ponzi scheme that later became known as Bretton Woods II, a gravity-defying design that allowed the US to run persistent current account deficits. The dollar surplus in the newly industrialised countries was recycled back to the US and European markets, where various categories of asset prices were driven up and banks lured into excessive risk-taking. It could not last, and did not.

If excess liquidity was the ultimate cause of this crisis, the real estate sector was its most important driver. Experience shows that housing cycles are long and symmetrical: downturns last as long as upturns. We also know from the past that house prices undershoot the long-term trend on the way down, just as they overshoot it on the way up. You can see this quite easily when you look at long-run time series of inflation-adjusted house prices for several countries.

The last property downturn in the US and the UK lasted some six years. This is not a prediction of what will happen this time, more like a best-case scenario – because this bubble has not only been more intense than previous ones; it has also bubbled on for longer. But even if we take six years as an estimate of the peak-to-trough period, that means the housing downturn will last until 2012 in the US and a couple of years longer in the UK...

Read the rest here.