More on the Dollar

From Barry Eichengreen:

[T]he dollar isn’t going anywhere. It is not about to be replaced by the euro or the yen, given that both Europe and Japan have serious economic problems of their own. The renminbi is coming, but not before 2020, by which time Shanghai will have become a first-class international financial centre. And, even then, the renminbi will presumably share the international stage with the dollar, not replace it.

From David Lynch:

In the short run, the only currency that could challenge the dollar is the euro... But for all its attractions, the euro lacks some essential attributes. Although the European Union has a central bank, comparable to the Federal Reserve, there is no European treasury. Instead, there are 27 European treasuries. Investors can't easily track or influence fiscal policy on the continent.

The dollar is also buoyed by the existence of a massive government bond market. There's roughly $4 trillion worth of U.S. Treasuries floating around, and almost $100 billion changes hands each day, according to investment management firm Pimco. Trading that's carried on almost 24 hours a day, rolling east to west from Tokyo to London to New York, makes it easy to move into and out of dollar positions in a hurry.

Europe, by contrast, has no analogue to the U.S. Treasury market. Instead there is a fragmented scene with individual sovereign debt from Germany, Italy, France and other EU members. No individual market enjoys anything like Treasuries' liquidity and size.

[...]

There's another potential dollar rival on the horizon, though its day likely lies a decade or more in the future... But before it does, China will have to thoroughly overhaul its existing financial system. Today, the yuan isn't freely convertible into other currencies, and there are strict limits on the cross-border movement of the Chinese currency. Chinese officials publicly have committed themselves to freeing the yuan to float alongside the dollar, euro, yen and other major currencies. That change, however, won't happen overnight.

Much Ado About Nothing: the Dollar's Decline

There has been much angst by observers over the dollar's decline from the conspiracy laden to the serious and somber. Other observers say this discussion is pointless; the weakened U.S. economy needs some dollar depreciation so get over it. A quick look at the dollar's value in the figure below shows the dollar's decline is (1) only returning it to where it was 2007 and (2) pales in comparison to its slide between 2002-2007. (Click on figure to enlarge.)



Daniel Drezner provides great perspective on this development:

OK, let's be as plain as possible about this - as a reserve currency, the dollar is not going anywhere. Really.

The dollar's slide in value has been predictable, as the need for a financial safe haven has abated. By and large, a depreciating dollar helps the U.S. trade balance (though it would help much more if the Chinese renminbi got in on the appreciation).

Even the Chinese, who have spoken like they want an alternative to the dollar as a reserve currency, are in point of fact not doing much to alter the status quo. Why? To paraphrase Winston Churchill, the dollar is a lousy, rotten reserve currency - until one contemplates the alternatives.

Because all of the alternatives have serious problems. The euro, the only truly viable substitute for the dollar, is not located in the region responsible for the largest surge of growth. It would be unlikely for the ASEAN +3 countries to agree to switch from the dollar to a new currency over which regional actors have no influence (the Europeans wouldn't be thrilled either, as it would lead to an even greater appreciation of the currency). Oh, and the European Union has no consolidated sovereign debt market. The euro is worth watching, but it's not going to replace the dollar anytime soon.

The other alternatives are even less attractive. Most other national currencies beyond the euro - the yen, pound, Swiss franc, Australian dollar - are based in markets too small to sustain the inflows that would come from reserve currency status. The renminbi remains inconvertible. A return to the gold standard in this day and age would be infeasible - the liquidity constraints and vagaries of supply would be too powerful. There's the using-the-Special-Drawing-Right-as-a-template-for-a-super-sovereign currency idea, but this is an implausible solution. As it currently stands, the SDR is not a currency so much as a unit of account. Even after the recent IMF authorizations, there are less than $400 billion SDR-denominated assets in the world, which is far too small for a proper reserve currency.

So, what's really going on here with the dollar obsession? I suspect that with the Dow Jones going back over 10,000, Republicans are looking for some other Very Simple Metric that shows Obama Stinks. The dollar looks like it's going to be declining for a while, so why not that? Never mind that the dollar was even weaker during the George W. Bush era -- they want people to focus on the here and now.

The thing is, I'm not sure this gambit is going to work. People who already think Obama is a socialist will go for it, sure, but that's only rallying the base. I'm not sure how much fence-sitters care about a strong dollar, however. If anything, populist movements tend to favor a debasing of the currency rather than a strengthening of it.

Read the rest of Drezner's article here.

Update: Martin Wolf has a great column on this issue titled "the rumours of the dollar's death are much exagerated."

Speaking of Taylor Rules...

See this recent blog post on Taylor Rules by John Taylor himself and this discussion of Taylor Rules by Paul McCulley of PIMCO.

Interesting Interviews

I found these two interviews interesting. First, Zanny Minton Beddoes, the economics editor at The Economist, joins Aaron Task of Tech Ticker for a conversation on the global economy.



Second, Niall Ferguson, an economic historian from Harvard University, talks with Aaron Task about the decline of the U.S. empire relative to the ascent of the Chinese empire.

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.

More Fed Cheerleading

The battle for the narrative of the Fed actions in the early-to-mid 2000s continues. The latest salvo comes from a blog post by David Altig of the Atlanta Fed and a Cato Policy Analysis piece by Jagadeesh Gokhale and Peter Van Doren. In both cases the authors absolve the Fed of any wronging doing during the housing boom period. I am not surprised to see Fed cheerleading coming from a Fed insider, but from the CATO institute? These are strange times.

In the first article, Altig conveniently finds a modified form of the Taylor Rule that shows the Fed acted no differently than it had in past 20+ years when monetary policy seemingly worked fine. The first problem with this piece is the obvious problem of data-mining a modified Taylor Rule that justifies ex-post his employers actions. If Altig really wants to be convincing, he needs to explain why the original Taylor Rule, which does show the Fed being unusually accommodative during the housing boom, is suspect and why his modified Taylor Rule is better. As John Taylor has shown, the original Taylor rule goes a long way in explaining this crisis. For example, Taylor shows in the figure below that deviations from the Taylor rule in Europe were closely associated with changes in residential investments during the housing boom there (click on figure to enlarge):


Even if Altig could show that his modified Taylor rule makes more sense, there is still the question of whether monetary policy was truly optimal during the previous 20+ years to the housing boom. This was the period of the Great Moderation--a time of reduced macroeconomic volatility--whose appearance has been attributed, in part, to improved monetary policy. As many observers have noted, though, this also was a period of the Fed asymmetrically responding to swings in asset prices. Asset prices were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. This behavior by the Fed appears in retrospect to have caused observers to underestimate aggregate risk and become complacent. It also probably contributed to the increased appetite for the debt during this time. To the extent these developments were part of the reason for the decline in macroeconomic volatility, the Great Moderation and the monetary policy behind it becomes less of a success story.

In the second article Gokhale and Van Doren make the following arguments: (1) detecting asset bubbles is a difficult thing to do; (2) even if the Fed could have detected and popped the asset bubble in the housing market in the early-to-mid 2000s it would have done so at the expense of a painful deflation; and (3) the Fed's ability to reign in home prices was limited. On (1) I agree that responding to an asset bubble after it has formed is challenging. But that is not the the point of most observers who find fault with the Fed during this time. They would say the Fed could have prevented the housing boom from emerging in the first place had monetary policy started tightening before June 2004. On (2) the authors still think the deflationary pressures of that time were the result of a weakened economy. This is simply not the case. As I just recently noted on this blog (here and here), rapid productivity gains were the source of the deflationary pressures, not declining aggregate demand. In fact, by 2003 nominal spending was soaring at a rapid pace. In other words, the deflationary pressures of 2003 were vastly different than the deflationary pressures of 2009. On (3) the authors claim that there was simply no way for the Fed to reign in home prices since the influence of its target federal funds rate on other interest rates declined during the time of the housing boom. While it is true the link between monetary policy and long-term interest rates is more tenuous, the authors argue that even interest rates on ARMs and other subprime-type mortgages were beyond the Fed's influence. A CATO Policy Briefing by Lawrence H. White, however, provides evidence that the supbrime market was in fact very sensitive to the Fed's action during this time. Below is figure that corroborates White's work by showing the effective interest rates on ARM mortgages along with the federal funds rate. Is there any doubt? (Click on figure to enlarge):

Update: To support my claim that nominal spending was soaring by 2003 I have posted a figure below that shows the growth rate of domestic demand relative to the federal funds rate since 2002. The years 2003 to 2004 are marked off by the dashed lines. Note that the growth rate of nominal spending is increasing during the 2003-2004 period while interest rates are kept low for most of the period (click on figure to enlarge):

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.