China Wants a New Reserve Currency

Here is why:



From the WSJ:

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

[...]

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

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

Holding more international reserves in SDRs would increase the role and powers of the IMF. That indicates China and other developing nations aren't hostile to international financial institutions -- they just want to have more say in running them.

See Brad Sester's discussion on this proposal as well.

There is Hope for Zimbabwe

Time to find a new poster child for hyperfinflation. Zimbabwe's economy seems to have turned the corner by (1) allowing foreign currency to be used in transactions and (2) abandoning any further production of Zimbabwe dollars. Here is one news report:

HARARE (AFP) — A man whistles as he picks groceries from the shelves of a supermarket in Zimbabwe's capital. Another shopper, spoilt for choice, compares cooking oil bottles while queues form at the tills.

In Zimbabwe, these were simple and almost forgotten luxuries.

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

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

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

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

The BBC also notes that prices are now falling in Zimbabwe and further claims the following:

The US dollar was adopted by Zimbabwe's government following the inauguration of the unity government between the MDC and President Mugabe's Zanu-PF.

So Zimbabwe has dollarized. This is certainly an improvement in policy, but why not adopt the South African Rand? The economies of South Africa and Zimbabwe surely are closely to an optimal currency area than the U.S. and Zimbabwe. Does Zimbabwe really want to import U.S. monetary policy? With all that said, this is good start for Zimbabwe.

Risks from the New Fed Policy

As I mentioned in my last post, the Fed's announcement that it will more aggressively expand the monetary base is a much needed development. Without it the dramatic collapse of U.S. nominal spending will only get worse and further destabilize the U.S. economy. This move can be viewed as an attempt to prevent the U.S. economy from overshooting on the downside, a policy objective that even Frederick Hayek supported. With all that said, there are risks associated with this policy move. First, Caroline Baum reports this new policy, which purposefully targets long-term Treasuries, may create big distortions in the market for Treasuries. Second, this aggressive monetary expansion will eventually have to be reversed to avoid a repeat of the 1970s-type inflation. This reversal, however, may not be politically popular if it involves some pain as noted by John Taylor:

Will the Fed be able to change course in time? To do so, it will have to undertake the politically difficult task of getting more than $3,000bn of government securities, private securities and loans off its balance sheet.

Given the short-run real effects of monetary policy, a reduction of the money supply of this size could be very disruptive. The reversal also may involve some quasi-fiscal costs as noted by Paul Krugman:

But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.In short, unwinding this aggressive expansion of the money supply may not be easy.

Given the possibility of these politically sensitive developments, one could question whether the Fed will actually be able to reverse itself in the future. This is a real concern, but as pointed out by Tim Duy the Fed and U.S. Treasury released a statement yesterday reconfirming the Fed's independence. Hopefully, this statement gives the Fed the freedom to take do what is needed to stabilize nominal spending presently without jeopardizing its independence in the future.

The Fed Finally Swings for the Fences

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

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

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

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

Why Are Bank Creditors Being Protected?

Justin Fox questions why bank creditors, other than depositors, are getting a pass in the current crisis? Bank shareholders and taxpayers are taking a hit so why not the creditors, particularly those bank bondholders? Here is Fox:

These bank bonds are mostly in the hands of large, sophisticated institutional investors — pension funds, insurance companies, mutual funds. It may be too much to ask small depositors to monitor the risks at the banks where they put their money and pay for getting it wrong. But these bond buyers are pros. If there is to be any market discipline of risk-taking by banks, bond investors ought to be the ones who enforce it by withholding their cash from the bad apples — and paying the price for misjudgments. Plus, a few concessions from creditors could ease the burden on taxpayers dramatically. If Citi's $486 billion in wholesale debt were converted into common shares — admittedly a pretty extreme solution — the company's balance-sheet woes would evaporate. Which is why these arguments have been gaining in popularity.

Fox calls this protection of bank bondholders the "great bond bailout." So why have the bondholders not taken a hit along with shareholders and taxpayers? The answer is that it would bring about another global credit crisis on the scale of what happened late last year. Here is how James Kwak describes such a scenario:

Let’s say that Citigroup were restructured - via bankruptcy, or via government conservatorship - in such a way that creditors did not get all their money back. (None of this applies to FDIC-insured deposits or to recently-issued senior debt that is explicitly guaranteed by the government.) They might be forced to convert debt for equity, or they might be stiffed altogether. The first-order concern is that this would have ripple effects that could take down other financial institutions. According to Martin Wolf, bank bonds comprise one quarter of all U.S. investment-grade corporate bonds; losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If Citigroup did not support its derivatives positions, then institutions that bought credit default swap protection from Citi would face further losses. (I believe that most U.S. banks were net buyers of CDS protection, however.) The fear is that it will be impossible to predict how these losses will be distributed and who else might go down.

The second-order concern is bigger. After all, Lehman did not seem to force any major financial institution into bankruptcy, although it may have twisted the knife that AIG had already stuck in itself. Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again.

Kwak notes that this fear of another systemic failure of the financial system is why the U.S. government is bending over backward to protect bank creditors without actually saying so. I suspect the U.S. government is also trying to placate the concerns of certain foreign governments whose holdings of U.S. debt securities could be impaired if bond markets collapsed. Note that without this government protection many of the big banks are effectively insolvent. Unless the economy suddenly recovers and asset prices rebound, this insolvency will have to be meaningfully addressed at some point. When this restructuring takes place it could get ugly.

Greenspan's Failed Attempt to Exonerate the Fed

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

Greenspan's defense is wrong on several counts.

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

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

Third, Greenspan overlooks the fact that Fed is a monetary superpower whose loose monetary policy got exported to the rest of the world in the early-to-mid 2000s. As I wrote earlier:

One important factor was the emergence of an unexpected global liquidity glut created by the Federal Reserve (Fed) in the early-to-mid 2000s. The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.

This global liquidity glut served to facilitate a global credit expansion and as a result, a global housing boom. Yes, there was also a saving glut coming out of Asia and oil-exporting countries but it was more important to the story beginning about 2005 after the Fed's tightening cycle had begun to be take hold.

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

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

Great Posts on Monetary Policy

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