More Takes on the Fed's Monetary Superpower Status

As a follow up to my previous post, here are some more articles that point to the Federal Reserve (Fed) as a monetary superpower. Before I get to them I want to be clear why this discussion is important: if the Fed is a monetary superpower then it was more than a passive player during the global liquidity glut of the early-to-mid 2000s--it was an enabler. Moreover, the monetary superpower status means the Fed will continue to shape global liquidity conditions for some time to come. Until the Fed takes this role and the responsibilities that come with it seriously, it is likely to create more distortions in the global economy.

Now on to the articles. First up is Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary policy and was more the cause rather than the consequence of the funding coming from Asia.

Along these same lines Sebastian Becker of Deutsche Banks makes the following case:

[I]t might well be the case that excess savings in emerging markets and the resulting re-investment pressure on developed economies’ asset markets contributed to the pronounced fall in US long-term interest rates between 2000 and 2004. Nevertheless, a simple graphical depiction of the US Fed funds rate and selected US long-term market interest rates (as e.g. 15-year and 30-year fixed mortgage rates) rather suggests that the Federal Reserve’s monetary policy stance was the major driver behind low US market interest rates. [See the figure below-DB] Correlation analysis confirms that US mortgage rates and US Treasury yields have both been strongly positively correlated with the official policy rate since the early 1990s. Although global imbalances and the corresponding rise in world FX reserves are likely to have contributed to very favourable liquidity conditions prior to the crisis, the savings-glut hypothesis does not seem to tell the full story. Instead, what really caused global excess liquidity might have been the combination of very accommodative monetary policies in advanced economies between 2002-2005 coupled with fixed or managed floating exchange rate regimes in major emerging market economies such as China or Russia. Consequently, emerging markets implicitly imported at that time the very accommodative MP stance of the advanced economies. (Click on Figure to Enlarge):

The entire Becker piece is worth reading and is a follow-up to another interesting article he did on global liquidity in 2007.

Finally, let's turn to Scott Sumner for how the Fed could use its monetary superpower status in a productive manner going forward:

If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.

The Fed abused its monetary superpower status in the past by creating a global liquidity glut that in turn fueled a global nominal spending spree. Now the Fed has a chance to redeem itself by stabilizing global nominal spending and preventing the emergence of global deflationary forces.

More Evidence the Fed is a Monetary Superpower

I have the made the case many times that the Fed is a monetary superpower. Recent developments seem to confirm this view: the Fed's low interest rate policy is making it difficult for other countries to raise their interest rates lest their currencies strengthen and they lose external competitiveness to the United States. Here is Vincent Fernando:

There's a huge problem with the entire world trying to have weaker currencies relative to the dollar right now.

It's that they've all become slaves to U.S. interest rate policy, even more so than they already may have been.

Right now, raising interest rates in any country before the U.S. does so is likely to strengthen that country's currency against the dollar, all else being equal.

[...]

For countries with a strong desire to keep exports competitive, that's a big problem.

Thus the Eurozone, the U.K., and most international countries have to decide whether their own fear of currency strength is worth the collateral damage it causes at home.

And you thought the ECB was a truly independent central bank? The Economist also has an article that touches on this issue:

The ECB will eventually face a problem that some central banks are already encountering. As long as America keeps its interest rates low, attempts by others to tighten policy (even stealthy ones that leave benchmark rates unchanged) are likely to mean a stronger currency. That is a price that Australia’s central bank seems prepared to pay. The minutes of its policy meeting on October 6th, at which it raised its main interest rate, revealed the exchange rate was not a consideration. The bank’s rate-setters ascribed the Australian dollar’s rise to the economy’s resilience and strong commodity prices. In New Zealand, similarly, the central-bank governor, Alan Bollard, told politicians that the kiwi dollar’s strength would not stand in the way of higher rates.

Note that this means the Fed is setting global liquidity conditions, just as it did during the early-to-mid 2000s. The Fed's official mandate is the U.S. economy, but its reach is global.

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.