The Downside of a Currency War

Matt Yglesias has suggested, many times, that there are no downsides to a “currency war”. Here is the most recent example. Now Paul Krugman and Greg Ip are on board. The basic argument is as follows: much of the world needs more monetary stimulus, and currency wars are a form of quasi-coordinated monetary stimulus. Hence, if we start a currency war we’ll all get monetary stimulus and a bunch of national economies will improve simultaneously. According to this view, currency wars not only are not negative-sum (the Barry Eichengreen finding concerning the 1930s devaluations), they aren't even neutral; they're positive-sum.

The problem with this way of thinking is common in a lot of commentary about economics: it refers to global dynamics purely in terms of local effects (if it refers to global dynamics at all). But global dynamics have global effects.

That is, this is a conceptual problem. If we think of the global economy as a single system comprised of many different interdependent units, then we would ask what the effect of a currency war would be on the system. There is no reason to think it would be the same everywhere. At the very least, we should think that parts of the system which control systemically important currencies would react different than parts of the system which do not. If we conceptualize the global economy in terms of the units, and not the interdependencies between them, then we end up only caring about what happens in the U.S. and EU.

Thinking in terms of systemic, rather than just local effects, leads us to the conclusion that there may some significant downsides to a currency war, although they are likely not to be primarily in the U.S. There is mounting evidence suggesting that the several food crises since 2007 have been a result of ever-expansionary Federal Reserve policy. For example, a 2009 paper suggested:

While the market dynamics during this period are still not well understood, a combination of macroeconomic factors such as the depreciation of the dollar and lower interest rates in the United States...

Krugman considered this view in 2011, and rejected it. He blamed the food crises on climate change. While that may be a contributing factor -- and noting that boosting demand in industrialized societies would only increase carbon emissions, and thus exacerbate the problem -- the role of the Federal Reserve cannot be dismissed so easily:

That's a pretty close association, and even more impressive as it tracks non-linearly.

And now the scholarly evidence is starting to mount. Here's another paper:

Released in July 2008, What’s Driving Food Prices? identified three major drivers of prices—depreciation of the U.S. dollar, changes in production and consumption, and growth in biofuels production.

More recently, David Leblang of the University of Virginia has presented a conference paper arguing that, through the channel of increased commodity prices, Federal Reserve interventions did have a role in the onset of the Arab Spring, via the mechanism of commodity price volatility. I can't find an online version of the paper, but he makes a persuasive argument.

This follows a lot of previous literature suggesting that commodity price volatility is associated with conflict in less-developed areas, and the Fed actions are associated with commodity price movements. In other words, the theoretical story is pretty sound. All you have to do is connect the dots. To connect the dots, you need to think systemically.

So this is the potential downside of a currency war: monetary stimulus in the countries which control major currencies, and volatility everywhere else. This is why the term "currency war" was coined by a Brazilian (and reiterated by a Russian), not a German. In the worst case scenario relatively rich people in what used to be called the global North get richer, while relatively poor people in the global South get poorer, and possible even face political instability and violence.

I'd like to see what Jay Ulfelder thinks about this line of thinking. In any case, the logic appeals to me.

DeLong Smackdown Watch(?): Central Banking Edition

Brad DeLong takes Marco Rubio to task for not understanding how central banking works:

Rubio, you see, wants the Federal Reserve to stabilize three things: 

1. The path of the price level, 

2. The value of the dollar, and 

3.The level of interest rates.  

But you cannot do this. cannot stabilize the path of the price level and the exchange rate and nominal interest rates. Were we to confirm The One Who Is to chair the Fed, she could not do it.

If you stabilize the exchange rate--i.e., set up a gold standard and join it--interest rates and the price level will do their thing.  

If you stabilize the nominal interest rate, you will find yourself in either an inflationary or deflationary spiral.  

And if you stabilize the path of the price level, you will have to do some serious leaning against the wind with interest rates, and that will set the currency bouncing around.

This is true of the proverbial "small open economy" that macroeconomists generally model, and is therefore true for most actually-existing counties. But it is not necessarily true of the United States. Why? Because of the fact that in a world with n countries there are n-1 exchange rates. Whichever country controls the base currency has quite a bit more policy flexibility than all the others.

The United States is still that country, despite not having a formal exchange rate peg since the end of Bretton Woods. Other countries still conduct monetary policy with a view towards impacting exchange rates vis-a-vis the US dollar. So long as those countries are stabilizing (nominal) exchange rates, the US central bank can conduct monetary policy with an eye towards stabilizing the path of the price level and interest rates. Absent shocks on the real side, these are the same thing.

This is not what Rubio is saying... DeLong is right about that. What Rubio actually wants -- "The Federal Reserve Board should publish and follow a clear monetary rule – to provide greater stability about prices and what the value of a dollar will be over time" -- is a new way to criticize the Fed. But on its face this is not so crazy. It is what Scott Sumner wants: a stated 5% nominal GDP growth target. Others want some form of a Taylor Rule. The Fed itself actually has stated a goal of 2% long-run inflation. To the extent that the effectiveness of monetary policy depends on expectations, wanting a clearly-articulated policy is perfectly sensible.

How the Fed Is Constrained

Blogging has been light as Real Work has pressed, but there is something I don't want to let go. Dan Nexon linked to this post and asked:

The question remains, however, what mechanisms translate [the] pressure [on Bernanke] into constraint [preventing more aggressive monetary policy]?

It's a very good question. I think I've answered it over the past few years, but spread across a number of posts. So it's worth spelling out the mechanisms that could be operating. Some of these are supported by academic literature, some of them are more speculative. I could go into much greater detail on each of these, and have in the past, but I'll try to keep each point brief for now. So:

1. One constraint comes from the Fed itself. That is, Bernanke is not a dictator... he's a chairman of a corporation. This gives him quite a lot of latitude, but not omnipotence. The Fed has a Board of Governors, not all of whom are academics, and the strong norm is to operate by consensus at least as much as is possible. In addition, there are Presidents of the twelve regionals banks that constitute the Federal Reserve System and they also have influence. Remember: a big function of the Fed is to not freak everybody out. If major disagreements within the institution become public, everyone could get freaked out. So Bernanke, as the leader of this institution, may be willing to accept a somewhat sub-optimal outcome if he believes than an even more sub-optimal outcome is likely to obtain if he chooses to hold no prisoners. Central bankers aren't like op-ed writers (or bloggers)... their decisions actually matter. I imagine there is a strong bias against killing the patient that may sometimes preclude aggressive treatment.

2. Another pressure comes from Congress, an institution which has recently blocked the appointment of a Nobel Prize winning economist because he (supposedly) lacked sufficient qualifications for the job. This pressure has, in turn, hamstrung the White House. For much of the last few years the Fed has been understaffed at senior levels, as the Obama administration tried to figure out who they could nominate that would a) be approved by Congress; b) not attract the ire of the progressives who were already upset that the neoliberal wing of the Democratic party -- Summers, Geithner, etc. -- held such sway. This led to the Fed Board of Governors to have persistent vacancies until this past May. Keep in mind that Congress oversees the Fed, and right now the committee charged with that task is helmed by Ron Paul, who wants to abolish the institution and has passed a law through the House to audit the Fed. As I mentioned in my previous post, Republicans in Congress oppose further stimulus by the Fed and Democrats are quiet on the issue. Bernanke's last reappointment vote was the most contentious since three decades, and that was before the Tea Party's 2010 electoral success. In short, the Fed is in a principal-agent relationship with Congress, and this fact is salient. All else equal, the Fed would like to protect its autonomy. (Although, ironically, this discussion suggests that it has no real autonomy.)

3. Much is said about the Fed's dual mandate -- to maintain low and steady inflation while promoting full employment -- but the Fed actually has a triple mandate: those two plus regulation of the commercial banking system. Previous research has shown that locating regulatory authority in the central bank biases monetary policymaking in favor of banks. To some extent, both the Tea Party movement and the Occupy Wall Street movement arose in direct protest against this dynamic, although it wasn't articulated very well. More recently, the Fed has come under fire over the JPMorganChase losses and the LIBOR scandal. Faced with populist opposition from both the right and the left, one could understand why the Fed might choose to shoot for the middle: prevent unemployment from skyrocketing but don't risk any spike in inflation; stabilize the banking sector but don't do much to help repair household balance sheets via an erosion of the real value of household liabilities -- which are, of course, bank assets.

4. Additionally, in an important sense the Fed is the central bank of the world. It acted as a global lender of last resort during the crisis, it injected liquidity into the global monetary system by opening up swap lines with every major central bank, and it's quantitative easing programs have reverberated through the global economy. The Fed, therefore, may be constrained by needing to maintain global stability. In pursuit of this, perhaps, the Fed is willing to accept a somewhat slower recovery in the U.S. in exchange for a reduction in international economic (and political) volatility.

5. The Fed has intellectual biases of its own. This is related to #1 and #3, but deserves its own point. The Fed's experience in the 1970s and 1980s was that it is better to keep inflation low over the long term than to try to correct every uptick in unemployment. The Fed's experience in the 1990s was that if it prevented collapses in the financial sector than than full employment would come more or less naturally. The result is that the Fed knows how to keep inflation low, and can stabilize a faltering financial system, but it's not as good at keeping unemployment low. Moreover, it's only tool to do so is indirect: pump cash into the banking system in the hopes that they'll lend. Not only do politicians on the right and left oppose this for ideological reasons, some members of the Fed appear to believe that many of the economic problems in the country are structural rather than cyclical. If the Fed believes that the economy needs to adapt structurally, it might not pursue policies that could help lower unemployment even if they thought they would be successful. Better to manage the needed adjustment than to prevent it from occurring. Folks like Krugman and Sumner have been arguing vehemently against this view for years, but that doesn't mean that some Fed members don't feel that way. (Keep in mind, too, that Fed policy tends to be more relaxed during Republican administrations.)

To my knowledge there is no good literature on #1. David Singer has done a good work on #2, including this book, and on #3 with this article (with Mark Copelovitch). I'm also doing some research on #3, currently R&R. I don't know of much recent published work describing #4 (although I know some folks are researching it now), but Charles Kindleberger described the dynamic in The World In Depression. I've also blogged about it a lot over the years [e.g. 1, 2, 3, 4, 5]. As linked above, Christopher Gandrud is doing some research with Cassandra Grafstrom on Fed partisanship.

The World's Central Banker, Yet Again

Tyler Cowen summons his inner Kindleberger and gets pessimistic:

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences. For historical reasons, Germany isn’t up to playing the role formerly held by Britain and, to some extent, still held today by the United States. (But when it comes to the euro zone, the United States is on the sidelines.)

It depends on what he means by "on the sidelines". The US Congress is certainly not doing anything about Europe. Short of a Marshall Plan for the GIPSIs I'm not sure what they could do, and there's no way that's happening. But that doesn't mean that the US government as a whole is showing no hegemonic leadership. I've written a number of posts arguing that Bernanke has been acting as the world's central banker during the crisis -- opening swap lines with every major central bank in the world, extending liquidity financing to foreign firms, not provoking currency wars that lead to competitive devaluations, etc. -- and that this has stabilized the core of the global financial system.

I'm not going to re-write all those posts here, but please click through and read them. The Fed has been engaged in hegemonic leadership, and has done pretty well so far. Its job is not to put out every fire everywhere; its job is to keep the center of the system intact. So far, at least, its actions have been sufficient.

Note that in the op-ed Cowen more than once sounds a lot like an IPE scholar who has read no IPE literature. That is, he's asking the right questions but fumbles for answers to them. I have other things to write about the piece, but I'm going to break them up into pieces over the next day or two. Consider this a teaser.

The Fed Is Political

Today's edition: Mike Konczal tries to rally liberals around the Fed-bashing flag:

For most policymakers and commentators on the left, aggressive monetary policy and inflation has long taken a backseat to fiscal and financial sector issues when it comes to discussing how to return our economy to its full potential. That has allowed the conservative movement and the financial sector to dominate the monetary discussion throughout our current recession—and their focus, as we have seen in recent weeks, is a perpetual fear about imminent hyperinflation. But liberals should be addressing monetary policy head-on, and they should do so by challenging conservatives’ definition of the term “credibility” as it applies to our central bank.

So when can we stop talking about the Fed as if it were an apolitical, technocratic institution?

Fighting Words

Scott Sumner goes hard after American political science:

Just one more reason why academics should pay no attention to “public opinion” polls. There is no such things as public opinion, there is only election results. No one knows what Americans would believe about Medicare if that sat down with all the government programs and tax revenues in a spreadsheet front of them, and told they had to equate the NPV of all future taxes with the NPV of all future spending. We simply don’t know. And anyone who argues otherwise isn’t thinking deeply enough about the issue.

Sumner calls this post "Thinking like an economist", which reminded me of my past post on the problem with economists.

The UNC political science department is well-known in academic circles for the study of public opinion in American politics, and the consensus view in Hamilton Hall is not that public opinion doesn't matter, much less that there is "no such thing". I very much doubt that Sumner has any familiarity with this literature, but he could start here and here and here. Public opinion matters a lot for policymaking, especially on issues that are salient with voters*. It even matters for the judiciary, even those with extreme job security such as the Supreme Court (see first link). It's not about voters having policy expertise, or what they'd do if they had to match the NPV of spending and revenue. The public does not even have to be coherent to have a major impact on policymaking, and not just via elections.

Let's take an example. Sumner is frequently exasperated by the Federal Reserve. He notes that the economy remains depressed several years after the beginning of the recession. He notes that Ben Bernanke has said that the Fed has plenty of tools to boost nominal GDP even at the zero interest rate bound. He notes that Ben Bernanke did a lot of research on both the Great Depression and Japan's lost decade, and thus understands the situation we're in quite well. The Fed does not face elections and is considered one of the most independent central banks in the world. And yet despite possessing the requisite expertise and policy tools the Fed is nowhere near as activist as Sumner would prefer.

How can we explain this? It could be that the Fed are a bunch of idiots, but Sumner does not believe that to be true at least in Bernanke's case. Or it could be that the Fed has just witnessed a series of events that have made them cautious. The Tea Party has had a major effect on American politics, and one ideological leader of the Tea Party -- Ron Paul -- wants to abolish the Fed and is now chairman of the House committee that oversees the Fed. Paul's book *End the Fed* has 375 reviews on Amazon.com, and nearly all of them give the book four or five stars. A Nobel Prize-winning economist -- Peter Diamond -- was blocked from joining the Fed by this element of the contemporary GOP. The leading candidate for the GOP presidential nomination recently threatened Bernanke with bodily harm and insinuated that he was a traitor. And Bernanke is a fellow Republican who was appointed by a Republican president. He has also been criticized by the left for bank-friendly policies. All of these groups want a monetary policy that is tighter than Sumner's preferred policy, and that is what the Fed has done.

Given all of this, isn't it at least plausible that the Fed feels constrained by public opinion? To my knowledge no studies have focused directly on this question, but as a potential contributing factor to Fed policy choices it seems at least plausible. Even if public opinion doesn't affect the Fed, the finding that it affects the Congress, presidency, and judiciary is very robust. So to be so dismissive is really silly.

*My guess is that the specific issue Sumner is discussing -- the tax penalty for married couples -- is not highly salient for most people. When it is, couples can easily (and cheaply) get legally divorced or remain unmarried as Justin Wolfers and Betsy Stevenson have done.  

Anonymous Goes After the Fed

As of tomorrow, June 14th (Flag Day?), the cyber hacktivist group Anonymous is beginning "Operation Empire State Rebellion". The goal: take down Bernanke, and who knows what else. The purpose: I'm not sure. Justice? Apparently Bernanke has given trillions of "taxpayer" dollars to bankers and other wealthy people, despite not actually possessing that ability. He also stands accused of not prosecuting bankers for the economic crisis, which he also does not have the ability to do. Bernanke has "devalued" the dollar, and just you nevermind for now that that is good for the unemployed and less good for the asset owners. (Indeed, progressives now call for more inflation and more devaluation of the dollar, while the wealthy call for less of both.) I don't know how replacing Bernanke, or destroying the banking system, is supposed to help the common man -- that's not why we call the 1930s depression "Great" -- but who cares? Let's smash some shit up.

Also making an appearance: our old friends the global banking cabal, which controls everything all the time. I was waiting for a more explicit reference to Jews, but (thankfully) it didn't quite sink to that level. And the Freemasons haven't shown up yet, either. But just you wait.

The conspiracies revolving around the Federal Reserve are not new of course. And there's certainly been a resurgence in recent years. There are elements both in the Tea Party movement (influenced by Ron Paul), and in the anti-corporatist/neo-anarchist sentiment that Anonymous is tapping into. A decent segment of the college-aged population has been exposed to Zeitgeist, which melded Christ-myth and 9/11 "trutherism" with old-fashioned bankers-run-everything to explain how the "one world government" will soon take over everything, and unfortunately many find it at least somewhat persuasive.

In belittling Anonymous and Zeitgeist I do not mean to say that monetary policy doesn't have important distributional implications, or that politics doesn't matter, or even that bankers don't have disproportional effect over politics. Regular readers will know that those are not my views. But unfortunately reality is not as simple as "the Fed gives away our tax dollars to international bankers". Policy has real tradeoffs, which should be debated and judged by an informed populace. But this type of conspiratorial propaganda obfuscates more than it enlightens.

So it will be interesting to see what Anonymous is able to do to disrupt the Fed. It has threatened the IMF, although the recently-disclosed attack appears to have come from another group, and clearly has geopolitical intentions. But let's hope, for the sake of the very people Anonymous purports to be defending, that they fail.

Creditor-Debtor Politics

There's been some good discussion of this report by Robert Kuttner, explaining the political battle between creditors and debtors. Kuttner starts off:

Economic history is filled with bouts of financial euphoria followed by painful mornings after. When nations awake saddled with debts incurred to finance wars, episodes of failed speculation, or grand projects that haven’t paid off, they have two choices. Either the creditor class prevails at the expense of everyone else, or governments find ways to reduce the debt burden so that the productive power of the economy can recover.

Creditors—the rentier class in classic usage—are usually the wealthy and the powerful. Debtors, almost by definition, have scant resources or power. The “money issue” of 19th century America, about whether credit would be cheap or dear, was also a battle between growth and austerity.

And concludes:

These issues are treated as either impossibly technical or as non-debatable. They are neither. We need to democratize the money issue once again.

I like this framing because it moves us past lax psychological explanations ("pain caucus"), willful ignorance ("economists have unlearned what Say and Mill knew"), and hard-money/anti-debtor moralizing. It gets us to what's really important, which is the political dynamic of creditor-debtor relations, and the fact that different groups have different preferences over policies which are motivated by their interests. In other words, we're talking about political economy, which I obviously think is a step in the right direction. As I argued in my anti-econ rant from a few weeks back, talking about optimal policy makes little sense when you start from the assumption that there is not optimal policy; that policy is about distribution.

And there's a lot of research in IPE and CPE linking governments controlled by left parties to higher inflation, indicating that interest-based explanations work pretty well*. See, eg, this classic 1977 study by Hibbs, and this article by Franzese on how central bank independence is a myth. There's a lot of stuff since then too (see cites on the first page of this article on trade by Milner and Judkins).

Here's Krugman:

I don’t mean to suggest that it’s all cynical; my experience is that there are relatively few people who consciously keep a secret set of intellectual books, who preach Neanderthal goldbuggism because it’s in their interests while rereading Keynes by dead of night to figure out what’s really happening. Instead, people generally manage to believe whatever is in their interests. ...

Still, thinking of what’s happening as the rule of rentiers, who are getting their interests served at the expense of the real economy, helps make sense of the situation.

In a follow-up, he took a rough cut at figuring out who belongs in which group. Yglesias notes that older people, who are out of the labor market, have fewer debts, and have more financial assets that could lose value via inflation, are another interested group. And, of course, older Americans tend to vote more often than younger votes.

Steve Randy Waldman picked up on the financial political economy angle:

Banks, after all, are not only creditors. They are also the economy’s biggest debtors. In theory, bank loyalties ought to be mixed. On the one hand, banks prefer deflationary, zero-forgiveness tight-money policies, to maximize the real value of their assets and of the lending spread from which they draw profits and bonuses. On the other hand, troubled banks are very happy to support loose money and expansionary policy, even at risk of inflation. For bank managers and shareholders, it is bad to have the value of past loans eroded by inflation. But it is much worse to lose their franchises entirely, to have their wealth, prestige, and freedom put at risk in the aftermath of an explicit bank failure. When banks are in trouble, they are perfectly happy to support all manner of expansionary policy, as long as short-term interest rates are kept low. Even a broad-based inflation helps troubled banks twice over, by increasing borrowers incomes and by steepening the yield curve. Increased incomes ensure that loans will be repaid in nominal terms, preventing insolvency due to credit losses. A steep yield curve permits banks to recapitalize themselves via maturity transformation, using deposits to purchase Treasury notes while the central bank promises to hold short rates low for a few years.

But banks’ interests are aligned with those of debtors only to the degree that banks, like debtors, are at risk of real insolvency. When we committed to a policy of “no more Lehmans”, when we made clear via TARP and TGLP and the Fed’s alphabet soup that big banks would have funding on demand and on easy terms, when we modified accounting standards to eliminate the risk that bad loans on the books would translate to failures, when we funded their recapitalization on the sly, we changed banks. We transformed them from nervous debtors into pure rentiers, who see a lot more upside in squeezing borrowers than in eliminating a crippling debt overhang. And since banks are, shall we say, not entirely disenfranchised among policymakers, we increased the difficulty of making policy that includes accommodations between creditors and debtors, accommodations that permit the economy to move forward rather than stare back over its shoulder, nervously and greedily, at a gigantic pile of old debt.

This dynamic is part of what drives the results I found in this paper, discussed here and here, except I added in politics of central banking and regulation as well. One implication is that regulatory central banks essentially have no choice but to provide easy money to banks during downturns. Banks know they'll have access to these funds when needed, so they act more riskily during booms. It's monetary moral hazard**. In other words, I believe this same rentier/debtor politics can make financial crises more likely.

There is another element to this. Increased inflation in the US will narrow the real exchange rate adjustment that is boosting American competitiveness relative to exporting countries like China. To the extent that we want to boost employment through exporting, increased inflation could prolong that process. And if the problem is not just immediate unemployment, but medium-run global rebalancing, then it might not be as simple as "poor want inflation, rich want deflation".

This political cleavage is what the current austerity/stimulus battles are about, in both Europe and the US. I previously surveyed some of the IPE literature on this question, discussing its findings in relation to the eurozone, here.

*Sometimes these are phrased in terms of resolving the Phillips curve tradeoff in one direction or the other. More recent econ work has questioned the validity of the Phillips curve, but that doesn't necessarily imply that the perceived politics changes. This isn't my area of substantive expertise, and I understand that there's a bit of controversy in the comparative literature, but I believe the implications for monetary politics hold up pretty well.

**Note that we haven't seen the ECB behave this way, at least not on the level of the Fed, which is why the political battles in Europe are over fiscal transfers.

The World's Central Banker

I've written about this in terms of lender of last resort, but Edward Hugh says the Fed's importance goes well beyond that:

If the global economy has been growing reasonably well over the last six months it is because what Nouriel Roubini once called a “wall of liquidity” is seeping out of the United States, where solvent domestic demand for credit is flat and will remain flat due to the private indebtedness problem (remember US “over consumption” (the high proportion of GDP which has been consumption driven) has only been the mirror image of Chinese “over investment” and we that live in a world which badly needs to rebalance).

This “wall of liquidity” has been force feeding strong growth in a number of key emerging markets, and this growth has been generating strong demand for exports from a number of developed economies, and most particularly from Germany. Thus the German boom is no mystery, and has been intimately tied to the implementation of QE2 in the US. Note, in the chart below, how the German manufacturing PMI was slowing in the summer of 2010, how it surged in the autumn (QE2) and how it is now swooning again. There is no mystery to these “soft spots”, all you need to ask yourself is where the demand is coming from. ...

Maybe it seems peculiar to be arguing that policy in the Federal Reserve should be partially conditioned by policy failures in countries like Italy, Spain and Greece, but such is the nature of the inter-connected world we live in.

This is Kindleberger's Decession Politics.

Why the Fed Isn't a Tough Regulator

Felix Salmon asks when the Fed will start caring about banking regulation, and points to this column by Jesse Eisinger. I'm not sure whether the question is serious or facetious, but I have an answer: never. And it's not really the Fed's fault.

What do I mean? As it happens, I wrote my thesis on this question*. The paper jumps off of previous literature that has established that monetary policy and regulatory policy have a natural tension. Monetary policy is counter-cyclical, regulatory policy is pro-cyclical. The principal-agent dynamic that exists when central banks are also bank regulators is such that central banks cannot credibly commit to either let struggling banks fail, or to tighten monetary policy when that might be damaging to banks. As a result, banks know they'll get liquidity support from regulatory central banks when needed, so they act more riskily than they otherwise would. It's a form of moral hazard that is distinct from the typical TBTF hazard, because the mechanism is monetary rather than fiscal, but it operates similarly. And it may be worse: it applies to all banks, not just TBTF banks.

To answer the question, I compare overall bank capitalization ratios across OECD countries and time (1992-2007) using a standard time series cross-sectional econometric model. These countries were all in compliance with the Basel accords by at least 1999, so they all subscribed to some broadly similar regulatory guidelines, and probably as far back as 1992. I use fixed effects to isolate changes within countries (so the stats aren't biased by idiosyncratic variation), and look at two interventions into the time series: the introduction of the Euro in 1999, which removed monetary authority from a number of domestic central banks and gave it to the ECB; and the reorganization of domestic regulatory institutions in five countries, all of which shifted regulatory authority away from their central banks in 1999-2000. I find that where monetary authority and regulatory authority were split, banking systems had higher capital ratios than when they were unified**. The coefficients are substantively large and statistically significant at the usual levels. The results are robust to the inclusion of controls (sorry Phil) and alternative specifications.

The takeaway is that institutional design is important here. If you give one institution conflicting mandates -- one to act counter-cyclically, and one to act pro-cyclically -- then at the relevant margin one of those two has to give. Private sector actors are smart enough to know that, and adjust their behavior accordingly.

*I'll post it soon, but I need finish up a couple of minor edits before sending it off to a journal.

**The only exceptions are the PIGS (actually just Portugal, Greece, and Spain).

UPDATE: This paper from Douglas Diamond and Raghuram Rajan, uploaded to NBER this week (ungated version), appears to be making a similar theoretical argument, although I haven't had time to go through it carefully yet.

ANOTHER UPDATE: The link to my paper is here.

Some Politics of U.S. "Hooliganism"

Paul Krugman sends us to Vlad "the Destroyer" Putin:

“Look at their trade balance, their debt, and budget. They turn on the printing press and flood the entire dollar zone — in other words, the whole world — with government bonds. There is no way we will act this way anytime soon. We don’t have the luxury of such hooliganism,” he said.

As Krugman notes, it takes two to tango. A big reason the U.S. has such a large trade deficit is because emerging markets have undervalued their currencies relative to the dollar*. And the big reason the U.S. has engaged in so much monetary stimulus is to boost employment, some of which would could have happened through the nominal exchange rate if so many other countries weren't actively managing their currencies. But adjustment still needs to happen, so now we're seeing pressures on the real exchange rate rather than the nominal exchange rate. In other words, inflation in emerging economies will rise until things become more into balance. And now Russia, and China, and Brazil, and others are complaining about the inflationary pressures that U.S. monetary policy is putting on their economies. But they can't have it both ways: while the U.S. economy is depressed, adjustment has to coming through the nominal exchange rate or the real exchange rate.

This isn't hooliganism. This is using monetary policy in textbook ways. As it happens, U.S. monetary policy has a great effect on external economies, which is why Putin calls the whole world the "dollar zone", but let's be clear: those countries want the U.S. to pursue less expansionary monetary policy so they can free-ride on it. It's fine for them to have that preference, and as I've argued before, I think the U.S. should allow some free-riding. But the U.S. government has citizens to satisfy as well, so those countries can't very well expect the U.S. to pursue a contractionary policies while the economy is so weak.

Krugman explains this as "capital wants to go South". I actually don't think that's right. I think capital "wants" to go North: witness the flight to safety, the historically low U.S. bond rates, the fact that the S&P downgrade warning had no effect on those rates, the rallying U.S. equity markets. Look at how developed countries increased their holdings in U.S. banks immediately following the banking crisis (clear in the animation here).

There's nothing preventing capital flight from the U.S., and yet that hasn't happened. Likely because while the U.S. has some problems, compared to many other large economies they are manageable. They aren't trying to stave off the collapse of a currency union, or a nuclear meltdown, or all the things China has to deal with. There's a high demand for safe, liquid assets, and the U.S. public and private sectors can provide more of those anyone else. The U.S. is at the center of the global financial network, which appears to behave in some ways according to a preferential attachment decision rule. Remember the Leontief paradox: factor-price equalization is not always the norm.

The U.S. government, on the other hand, wants some capital to go South. In other words, it doesn't want deflation, and it does want some dollar depreciation to boost employment via exports. The South, on the other hand, doesn't want capital inflows. Brazil has put currency controls in place, China has a closed capital account and fixed exchange rates, etc. The U.S. is trying to force adjustment through the real exchange rate, meaning higher inflation in exporting economies with managed exchange rates. These choices are political, not responsive to some economic natural laws.

*There's a lot of moving pieces here: budget deficits are a result of tax cuts + spending hikes (Medicare Part D plus wars), and then the recession. This also feeds into the national accounts. And while that is an accounting identity, not a behavioral relationship, I don't think it's a stretch to say that deficit spending is encouraged by low borrowing costs. Indeed this is what the Keynesians are arguing now, and it's one reason why Dick Cheney said that "deficits don't matter". During Bretton Woods II, there's been a huge rightward shift in the supply curve of funds available for the U.S. (either as sovereign, or as businesses and individuals) to borrow. When that happens, we'd expect the quantity demanded and thus equilibrium debt levels of the U.S. to also go up.

Mysteries of the Universe

Matt Taibbi asks a good question:

Why, I wondered, would the Federal Reserve be giving Muammar Qaddafi $26 billion in near-zero interest loans?

I have no idea.

New Research

All NBER working papers, except the last one which is from the SanFran Fed. Excerpts are abstracts.

First (Ryan Avent discusses this here. We've discussed similar things a lot, see e.g. here.):

When Fast Growing Economies Slow Down: International Evidence and Implications for China
Barry Eichengreen, Donghyun Park, Kwanho Shin
NBER Working Paper No. 16919
Issued in March 2011
Using international data starting in 1957, we construct a sample of cases where fast-growing economies slow down. The evidence suggests that rapidly growing economies slow down significantly, in the sense that the growth rate downshifts by at least 2 percentage points, when their per capita incomes reach around $17,000 US in year-2005 constant international prices, a level that China should achieve by or soon after 2015. Among our more provocative findings is that growth slowdowns are more likely in countries that maintain undervalued real exchange rates.

Second (Which is somewhat-related to some of my research, which I'll post soon):

Monetary Policy as Financial-Stability Regulation
Jeremy C. Stein
NBER Working Paper No. 16883
Issued in March 2011
This paper develops a model that speaks to the goals and methods of financial-stability policies. There are three main points. First, from a normative perspective, the model defines the fundamental market failure to be addressed, namely that unregulated private money creation can lead to an externality in which intermediaries issue too much short-term debt and leave the system excessively vulnerable to costly financial crises. Second, it shows how in a simple economy where commercial banks are the only lenders, conventional monetary-policy tools such as open-market operations can be used to regulate this externality, while in more advanced economies it may be helpful to supplement monetary policy with other measures. Third, from a positive perspective, the model provides an account of how monetary policy can influence bank lending and real activity, even in a world where prices adjust frictionlessly and there are other transactions media besides bank-created money that are outside the control of the central bank.

Third (Which has implications for a discussion I had with some IPE folks recently):

Are Large-Scale Asset Purchases Fueling the Rise in Commodity Prices?
By Reuven Glick and Sylvain Leduc
Prices of commodities including metals, energy, and food have been rising at double-digit rates in recent months. Some critics argue that Federal Reserve purchases of long-term assets are fueling this rise by maintaining an excessively expansionary monetary stance. However, daily data indicate that Federal Reserve announcements of large-scale asset purchases tended to lower commodity prices even as long-term interest rates and the value of the dollar declined.

OMG WTF Federal Reserve Fact of the Day

Via Felix Salmon:

At the end of 2010, the Federal Reserve system had $2.423 trillion in assets and $2.367 trillion in liabilities, which means that the simplest measure of its total equity — assets minus liabilities — comes to $56.6 billion. The Fed also managed to earn net income of $80.9 billion in 2010. Which means that its return on assets was incredibly high at 3.3%, while its return on equity was an astonishing 143%.

I think it’s fair to say that no bank in the history of the world has ever had income of anywhere near $80 billion in one year: that’s over $700 per US household. Somehow, the Fed is making roughly $60 per household per month, and remitting that money straight to the Treasury.

Much of this is TARP, but also QE1 and QE2. On net I'll take it as a good thing that the Fed is giving billions to the Treasury, but the scale of interventions in asset markets is so large that it can't but make me nervous.

This is also another reminder that the U.S. Federal Reserve is the most powerful and important actor in the global economy, bar none. Its actions have far-reaching ramifications, and its capabilities are enormous. Sometimes that's good. Other times, probably not.

Or, it's better to say that when the Fed acts, it can help some groups quite a lot, and can devastate others.

Gimme Some Truth

So a few days ago I posted a somewhat-oblique response to this quip from Felix Salmon:

Which leads me to the conclusion that a lot of what we’re seeing is a lack of genuine independence at the Fed, which became indistinguishable from Treasury during the crisis, and which has yet to break free from Treasury’s grasp.

I suggested that there was one truth, one half-truth, and one non-truth there. The truth is that there is a lack of genuine independence at the Fed, as I discussed here.

The half-truth is that the Fed became indistinguishable from the Treasury during the crisis. It's half-true because the two were often operating in tandem during the crisis, but their core missions and behaviors since the crisis have diverged. Treasury has moved to recoup its "investments" in the financial industry -- and has done a fairly good job at that -- while the Fed has maintained the status quo and perhaps even loosened policy. In other words, Treasury and the Fed have separated because of the different tools at their disposable. Monetary policy moves last, as they say, but it also moves longest. Fiscal policy is good for immediate injections of cash, but almost by definition there is only one or two bullets in that gun. A more sustained monetary effort is needed to help banks repair their balance sheets, increase lending, and reestablish credit lines to get the economy moving again. This process is somewhat long with somewhat variable lags, but it's Fed policy.

The non-truth is that the Fed has yet to break free from the Treasury's grasp. Which institution is more constrained right now, the Fed or Treasury? The Fed gained regulatory authority following the financial crisis, the Fed can increase QE (or not) and Treasury can do little about it, the Fed can set policy reactive to the Treasury. If anything, then, it would be more accurate to say that Treasury is constrained by the Fed than the converse.

At least, that's the way I see it.

Savvy By the Fed

Quantitative easing and devaluation with actually doing anything:

The Federal Reserve broke a taboo yesterday when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low.

Which led to this:

Kathleen Madigan points out that the language led to an immediate decline in the dollar, which should boost exports and, through rising import prices, inflation.

More here. Was this purposeful or accidental?

There Is No Such Thing As Central Bank Independence

Not really. Economics of Contempt is puzzled about this. He should not be:

[W]hat's the point of having the independence they're so jealously guarding if they're not going to actually use it? Politicians are always going to say idiotic things, and populists are always going to claim that the Fed is in bed with the big banks. But if the mere threat of "political interference" is enough to circumscribe Fed policy, then is the Fed really "independent" in the first place?

Central banks are in principal-agent relationships with governments. If governments don't like what they are doing, they can remove authority from central banks. They only sense in which central banks are "independent" is that governments can make commitments not to interfere with them. Which has happened, to greater or lesser extent, in most developed countries. But when politicians are making loud noises about restricting the Fed's authority, auditing its activities, and when the current Fed chairman was barely re-approved just a few months ago, there is no reason for them to think the government has made any such commitment. That's what Dallas Fed president Richard Fisher is talking about here:

[W]e at the Fed must continue to comport ourselves in a manner that exorcises any lingering worries about our willingness to brook any political interference with our commitment to fostering price stability and maximum sustainable employment. We delivered on our duty to restore liquidity to the commercial paper, asset-backed securities, interbank lending and other markets. We then closed out all of our extraordinary liquidity facilities, doing so without costing the taxpayer a dime (imagine that: a government agency that closes programs after they have outlived their usefulness!). We have worked hard to earn the respect of the marketplace and of the nation, and we dare not risk it at a time when there is so much uncertainty elsewhere.

The Fed is a political, and politicized, institution. As it must be. This should not come as a surprise.

Bernanke Update

Fed Chairman Ben Bernanke just cleared a major hurdle a few minutes ago when the Senate voted 77-23 to end debate (cloture vote) on his reappointment. This means that there should be a final up or down vote coming sometime this afternoon/evening. I'll throw up the final vote tally when it becomes available.

UPDATE (4:24pm): Ben Bernanke has been confirmed by the US Senate 70-30.

Interesting fact: Bernanke received more “no” votes than any nominee for Fed chairman since Paul Volcker was confirmed to a second term by a vote of 84 to 16 in 1983.

So Lemme Get This Straight

Ben Bernanke is not concerned enough about the short run, and in the long run we're all dead.

Ben Bernanke is too concerned about the short run, and in the long run he's gonna kill us.

Got it?

Playing Mind Games with the Fed

Brad DeLong says that Ben Bernanke is unprofessional, and recants his support for another term for Bernanke as Fed chair. Why? Because Bernanke said this:

At his confirmation hearing for a second term as chairman, Bernanke emphasized that the government has spent less than half of the money in the $787-billion package passed earlier this year and that analysts are still determining its impact. "Only about 30 percent of the funds have been disbursed," Bernanke said. "It's a little bit early to make a strong judgment, a little bit early to decide whether or not to do additional fiscal actions..."

Meanwhile, Kevin Grier notices Philadelphia Fed President Charles Plosser making noises about an exit strategy for the massive government involvement in the financial sector, and a pullback from its loose monetary policy:

Arguing that the U.S. economy has entered sustained recovery and forecasting growth rates of 3% for next year and 2011, Plosser said the Fed must take “appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available to the economy.”

This could include hiking rates from their current level near zero even “before unemployment or other measures of resource slack have diminished to acceptable levels.”

On the one hand, we could take these statements at face value: the Fed is concerned about the 1970s experience with overreach, stagflation, and the effect of massive public debt on the currency and broader economy. These are valid concerns. Of course there are other valid concerns, like 1937, that points to keeping the pursestrings open for a good while longer. There is good reason to have both experiences in mind, and of course it is always difficult for the Fed to thread the needle between overreach and undershooting.

But there are reasons to not take these statements literally. The Bernanke Fed has had its independence challenged and has faced criticism for too-loose policies and the bailouts. Meanwhile, the Congress seems to have no desire to try to pass a second massive stimulus and is facing massive popular pressure to not explode the deficit much more. So Bernanke's statement during his confirmation hearing may be viewed as telling the Congress what they want to hear in order to reassure them that the Fed is not a loose cannon and is going to act responsibly in the coming years. Why? So they will confirm Bernanke and leave the Fed's independence alone. After all, Bernanke doesn't control the fiscal purse anyway... his every incentive is to dish some cheap talk to Congress.

Plosser's statement may be viewed in a similar light: reassure the government that the Fed isn't going to go crazy and thus try to keep Fed policy off of the Capitol floor. As Grier concludes:

If I were a Fed President (YIKES!!), I guess I would make speeches like this one in public, but support leaving easing in place until unemployment and other measures of slack have turned the corner in private.

I'm not saying this is the only way to read the situation -- Bernanke and Plosser may truly be very concerned about the exploding deficits and the demonstrated lack of political will in Congress to cut back when it truly is necessary -- but it's certainly one way.