Tim Duy: The Perils of Being the Reserve Currency

Tim Duy argues that "Fed Chairman Ben Bernanke can be criticized for following the wrong playbook" in his response to the financial crisis:

The Perils of Being the Reserve Currency, by Tim Duy: With inflation expectations in the US on the rise, the Fed is facing a withering round of Monday-morning quarterbacking. Have policymakers becomes hostage to Wall Street? And was the ransom demanded by Wall Street excessively stimulative? I tend to think policy is excessively stimulative, and the results incredibly predictable. Last October I wrote:

For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions - the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy…

…In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

In my opinion, the surge in commodity prices since the Fed initiated its easing campaign should be no surprise. Too many of the world’s global central banks choose to follow Fed nearly lockstep, unleashing that wave of global liquidity I feared would come. Brad Setser reports:

Loose monetary policy globally has helped to offset the US slowdown. Much of the emerging world is booming on the back of negative real interest rates. But it also has pushed up inflation globally. The Economist reports that the average global real interest rates is negative (”global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative”) largely because of very high rates of inflation in the emerging world.

The recent acceleration in the rate of inflation in the emerging world reflects — I suspect — the enormous acceleration in reserve growth among the world’s emerging economies that took place last year. Such reserve growth has been hard to sterilize, so it has bled in very rapid growth in the monetary supply of many emerging economies.

From this perspective, Fed Chairman Ben Bernanke can be criticized for following the wrong playbook. Years of academic research led Bernanke to conclude that the Fed’s best response to the financial crisis is that which should have been deployed during the Great Depression. Fine on paper, but in practice he is using 1930’s monetary policy in the economy of 2008. And that 70+ year gap is exceedingly important in many respects, but perhaps none is more important than the current status of the US Dollar as a reserve currency, a status that allows the US to run a gaping current account deficit. The concern is that the Fed treats the external sector with something of a benign neglect when setting policy, effectively ignoring the reserve currency function of the Dollar. Hence, in a bow to Wall Street, policymakers unwittingly created an overly stimulative environment that feeds back to the US in the form of higher inflation.

This simply implies that the Fed does not sufficiently consider the reaction functions of other central banks when setting policy. Should they? In a world with limited capital flows, no. But in today’s globalized financial environment, the answer is increasingly yes. In effect, by encouraging open capital flows, the US has ceded some amount of domestic policy control.

Moreover, while being the producer of the reserve currency yields some benefits, notably the ability to run massive current account deficits at low cost, there are responsibilities as well. Namely, the responsibility to maintain the value of the currency. But the Fed has no such mandate. The Fed has a dual mandate of price stability and maximum employment. Protecting the external value of the Dollar is not the mission of the Fed until the Dollar falls so low as to be relevant to its legal mandate. Interestingly, only recently have other nations started to realize that the Fed’s objectives are thus nearly diametrically opposed from their own. From Brad Setser again:

Mei goes on to argue that if the US doesn’t do more to defend the dollar, it is effectively defaulting on China. “The negative results of the US dollar’s decline are evident: the rising prices of all primary products, the intensified pressure on inflation globally, the confusion in the settlement of international transactions, etc. Worst of all, this is the US’ disguised way of avoiding paying off its debts to foreign countries.

To give the Fed some credit, they are not entirely responsible for the dilemma they face because of the Dollar’s status. A final thought from Setser in his comments section (I have been mentally compiling his work in recent weeks, and that compilation is beginning to spill out of my head):

As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising.

And the another reason they did that was that they were also terrified of a repeat of the Asian crisis in 1998 and having to beg and plead from the IMF for emergency stabilization loans. Every emerging market wants huge currency reserves so that in a crisis they can tell that the nice man from the IMF to go to hell.

I think Brad lets his former employers at the US Treasury off the hook a bit too easy here. In the “what goes around comes around” category from the Wall Street Journal:

[New York Federal Reserve President Timothy] Geithner, whose father worked for the U.S. government and the Ford Foundation, was raised in the U.S., Asia and Africa. After college, he worked for Henry Kissinger's consulting firm, then joined the Treasury Department in 1988. As a key international aide to Treasury Secretary Robert Rubin, then to his successor, Lawrence Summers, Mr. Geithner was involved in bailouts of Mexico, Indonesia and Korea.

Irony at its best – 10 years ago Geithner is instrumental in forming US policy during the Asian Financial Crisis, with the result that he helps enhance the status/necessity of the Dollar as a reserve currency. This triggers a flood of capital into the US, giving rise to the housing bubble and the financial frenzy that turns into a crisis that allows/forces Geithner, as head of the New York Fed, to extend the power of the Federal Reserve beyond a backstop to the banking system to a backstop for the economy as a whole.

I believe that along the way Geithner and other policymakers have done what they thought best given difficult situations. They are operating in a policy void left open by an ideological push for unbounded global financial markets that fails to fully appreciate the resulting loss of domestic policy control. In such a world, the Fed is allowed leeway to do whatever it takes to make the trains run on time, steadily gaining power over the last 20 years that is certainly well beyond that intended by the framers of the Federal Reserve act. Every 10 years the Fed extends its reach – Greenspan’s response to the 1987 stock market crash, the 1998 response to the LTCM crisis, and the 2008 loan to JP Morgan to buy Bear Sterns – with the result that increasingly large responsibility and power is concentrated on Constitution Ave.

A final thought – we are expected to take comfort in the Fed’s independence. After all, we are simply ceding increasing control to a group of like-minded technocrats outside of political influence. I would be wary on so eagerly accepting an omnipotent Fed as the solution to all of our problems. Politicians will be attracted to that power like moths to a flame….and note that the next Administration looks likely to be able to nominate four new governors, a majority of the Board. A more powerful Fed is up for grabs, ripe for politicization.

Comments

[paine]

wonderful meaty post

i completely lack its concern over
any global gathering wind storm called inflation

the dollar as imperial currency
needs to remain a cheap whore

if peggers inflate or tight assed floaters
crush themselves under the bulge of their
wildly positive real rates

that's the problem

the every man jack of us for ourselves
no concertation of policy
that is only rational if a co ordinated global policy
can not be found that is a win win all around

maybe so
but first lets define our domestic best options

the first is clearly NOT
allowing the dollar to rebound in value
against the euro and yen
as it did in the second phase
of correction this decade
at least
not until we have a north wide
consolidated co alition of the willing
ready and able to bust the south hemi
dollar peggers racket once and for all

and stop the galloping pace
of post industrialization
here in the north hemis western half

if we'll not pray together for planet wide guidance
then at least
might we not pause here
and take a fuller accounting
of what might have been lost
during this process
up here
by us of the preterite wagery
as well as what might have been gained
by our betters the stateless elites

[Mother Teresa]

Great article. It appears to me, that the Fed has increased its reserve capacity through the use of foreign central banks. Foreign central banks are holding almost one trillion dollars in US agency paper, and an even a larger amount of treasuries. With this spare capacity, there may be no end to how many illiquid mortgage backed securities the Fed can sterilize with foreign central banks supplying extra storage capacity.

[paine]

mt

obviously under your hard bitten
cynics cap
you share
doctor t duy's
earth wide inflation wave phobics

i have a simple test for job holder friendly vs job holder dangerous
econ ocon thinking

its prolly as old as the left ricardians
if not babeuf

inflation is never never never to be feared
let alone taken seriously
or avoided by means
of any sacrifice of wage demands
or warnings of draconian price controls
strict rationing
possible dirth and starvation etc etc etc

like heaven
inflation for prices means going up

its going down that burns you

[Mother Teresa]

Paine, inflation isn't the only ramification of a weak dollar policy. In 2007, Japanese office building prices increased by 27%. The Japanese banks smelled bubble, and seriously tightened up on LTV. This pretty much killed the 2008 office buying market in Japan.

This is an illustration of how Asian property values have matured to the point where our creditors will forgo spending their dollar reserves at home, and, instead, cash in their chips on distressed US property. We are selling off America's body parts at liquidation prices. We will soon be living on foreign owned reservations, and not because of karmic law. Better watch your local infrastructure, because foreign investors may already have a signed contract to buy the highway to your heart. I ain't talking 1980, pre-Plaza Accord Japan and trophy property Pebble Beach. I'm talking arms, legs and arteries. I will be meeting with one of these vulturish blind pool reps this week.

[Borrowers Are the Only Ones Who Matter]

"...this is the US’ disguised way of avoiding paying off its debts to foreign countries."

The disguise is wearing thin. Domestic savers have abandoned the inflation mediated slow default scheme. They were replaced by foreign savers who were newly rich, and didn't have much experience with the penchant for hidden default. The day may come when the dollar isn't worth a continental.

Over the short run, national savings rates are not immediately discouraged by slow default via inflation. Over the long run, they are. We may one day wake up to find that no saver is left who is willing to lend to us. Creating new money to loan out will destroy what is left of confidence in the dollar.

Then we can create a new currency, and start all over again.

[paine]

mt

since he or she don't
why should a pure jobster
care who owns the place
only gypt sellers care about price
not on lookers
in fact they might take a certain glee in it all

[groucho]

Not usually a big TD fan but he nailed this sucker.

The FED(Greenspan and the other major scribblers) has set back the US a whole generation. A good story for the history books, but not a pleasant experience for those on the receiving end of such nonsense(citizens).

The proper globalisation monetary policy(for the west) should have been a deflationary policy. Decreasing margin/leverage and incentive to save(no liquidity floods)

[paine]

we need to identify who among foreigners are holding signifigant dollar piles
beyond the transaction needs
surely its only sovereigns ...eh ??
and no one yet has a model of sovereign rationality
talk about a potential for far horizon thinking
after all
a sovereign looks at
the appreciation of taxable
income producing real assets

just an off hand example
people citizens subjects
tax payers etc
with skills aquired
while producing products
sold because of their dollar cheap wage cost
into sophisticated
world class north hemi markets
are appreciating in value
simply by what they are learning by doing

[paine]

groucho
"The proper globalisation monetary policy(for the west) should have been a deflationary policy..."

do you also recommend
hair shirts
weaving by candle light
a thousand push ups a day
cold water baths in winter
and the occasional bout of self flagulation

[Mother Teresa]

Sounds like spin doctoring third world, low wage slavery.

[paine]

"We may one day wake up to find that no saver is left who is willing to lend to us"

assuiming you mean foreign ....SAVERS

recall this fact

nations are not households
they live thru their people
if their people remain productive

who cares who owns the factory
if all i do is get hired to do work in it

focus on trade gaps
note
not payments gaps

once the whole damn place is sold off
except our over mortgaged house lots
then our foreign bought politicians
will suggest what ???

a licensed hunting season for aliens
wanting to shoot and eat
property free prole natives ???

yes trades the thing to trap the conscience of the foreign king

get us producing tradeable shit
and you'll reach the right
solution to the real national problem

[paine]

"foreign investors may already have a signed contract to buy the highway to your heart"
my heart can only be reached on foot
and by tramping over some nasty broken ground

everything nice and nasty
eventually comes down to
boots on the ground

[Factory Dreams]

"who cares who owns the factory
if all i do is get hired to do work in it"

If retired citizens own the factories, they can live off of the profits. If foreign citizens own the factory, profits go overseas. Workers get taxed more to support retired workers. Total lower standard of living for both active workers, and retired workers.

Big mess just so borrowers could consume more for a few decades.

[Trade Our Way to Fortune]

"get us producing trade-able shit
and you'll reach the right
solution to the real national problem"

You are right. Hard to compete when the cost of living is so much higher here though. Indian workers don't get paid enough to cover the taxes needed to build our bridges to nowhere. So we import stuff that can be traded on the international market on credit, and lobby for licenses to grant us a monopoly on moving each other's furniture as a career.

[paine]

trade

let me het u to the full value of one point

there is no reason we can't balance trade

the dollar just has to fall till we're in balance

the social problem
real cost to households
of higher import prices
and higher prices
for domestic substitutes
for low dollar
rubbed out imports

but that to can be solved
at the national level
indirectly
by a hyper employment fiscal budget
a beefed up eitc /wage min pathway
and slashing payroll taxes
and a health sector
market anti inflation plan

no not thru hand outs
but higher total domestic output value
lets get fully back to job work

[paine]

If retired citizens own the factories, they can live off of the profits

what ??
retired citizens
oughta live right
just off the transfer system

ie a system that extracts retirement for workers
off the wages of workers

that is our sacred our own job class contained
new deal social contract
run it big enough
and we won't
need no stinkin' property ownership income

[paine]

"If foreign citizens own the factory, profits go overseas "

so what how does that effect your job work income ???

remember they can take it home
but they got to buy something we make with dollars
or trade em to some one else who will buy our stuff
with the dollars

man you gotta get with the full circle here

[paine]

if you want property income then socialize the process
set up personal accounts
with a hunk of the payroll tax

call it forced savings

trick is
don't let private hi fis in on this
it all gets bought for uncles account by uncle himself
but
uncle lets you choose your investments
off a list of acredited investments
virtual ownership

[lark]

The recent acceleration in the rate of inflation in the emerging world reflects — I suspect — the enormous acceleration in reserve growth among the world’s emerging economies that took place last year. Such reserve growth has been hard to sterilize, so it has bled in very rapid growth in the monetary supply of many emerging economies.

Today Michael Pettis puts that this way: "Chinese monetary policy is now driven primarily by RMB speculation."

That's putting the responsibility where it belongs.
link:
http://www.piaohaoreport.sampasite.com/china-financial-markets/blog/Chinese-monetary-policy-is-drive.htm

Tim Duy's argument is that because the dollar is a reserve currency, our responsibility is to maintain conditions favorable to China's peg. That's nonsense.

[Rajesh Raut]

"... the surge in commodity prices since the Fed initiated its easing campaign should be no surprise."

Doesn't this ignore that the rise in commodity prices predates Ben Bernanke as Chairman of the Federal Reserve. Oil, Copper and Gold prices began their upward trajectory during the "measured" interest rate increases of the Greenspan Fed.

It is true that agricultural prices have shot up more recently and oil has had another spike but gold prices have been relatively tame. And some would blame global warming and the diversion of food crops for biofuels for the rise in food prices and Peak Oil for the large rise in oil prices.

While easy money has played some part in the unprecedented rise in energy prices, the difference in scales between the different commodities suggest that much of this is relative price movement.

It is true that Bernanke has thrown the dollar under the bus but that downtrend also was well established when he became Chairman.

Dr. Bernanke may be using the wrong playbook, but only because the right playbook has yet to be written. When it is, it will probably include some of the innovations the Fed has recently introduced and other ideas yet to be publicly debated.

[Pay any Cost, Bear any Burden]

"the social problem
real cost to households
of higher import prices
and higher prices
for domestic substitutes"

True, but their is an unwillingness to bear this social cost (lower standard of living). We keep importing ever more on credit.

[Rebel]

"what ??
retired citizens
oughta live right
just off the transfer system"

It is not large enough now. Workers don't want to pay any more transfer tax. They complain now about how high it is. Combine social cost of fewer imports with more worker produce going to elderly. Workers rebel. Workers want more, not less. Borrowers want more, but no one left to lend. Print money to lend, more inflation, workers not allowed to get CPI adj. Workers support elderly via payroll tax, borrowers via inflation, and not have enough left to make them happy.

Workers import stuff on credit to make up difference now.

[Circle]

"so what how does that effect your job work income ???

remember they can take it home
but they got to buy something we make with dollars
or trade em to some one else who will buy our stuff
with the dollars"

More transfer to elderly, less take home. If elderly live mostly off profit, less transfer, more take home.

Foreigners owners buy our stuff, sure. This means our stuff is enjoyed by foreign owners instead of us or our parents. Better for us and our parents to enjoy our stuff. Better for our parents to own factory and get profit. More total stuff enjoyed in US that way.

[Trust Fund]

"if you want property income then socialize the process
set up personal accounts
with a hunk of the payroll tax"

Use trust fund to buy world stock index fund, world commodity index fund, etc... Profit goes to Social Security. Eventually taxes can be lower, and Social Security checks higher.

Can't use excess payroll tax to build any more bridges to nowhere, but who cares?

[Balanced Trade versus Trade Deficit]

Balanced trade is we give stuff we make well, and get stuff they make better in return. Everyone is better off.

Deficit trade is we get stuff, and sell factory in return. We are better off for a little while, as we have lots of stuff to consume. Later on, we send some of our stuff (profit) overseas, and get nothing back. Not so good, as we now have less stuff than before we sold the factory. Bad deal for us in the long run.

Even worse deal is to print new money, and give the new money to only a few people. The few people live high, and everyone else has less. Such a deal.

[Lafayette]

Learning curve-ball

Article: Nick: McCain is less principled, and will probably cave to some version of a public bailout

It seems that not enough attention is being paid to the fact that both commodity foods and petroleum prices are going up because of both climatic and resource shortages, the former of which were unpredictable and the latter of which was totally predictable but uncontrollable. (The petroleum market is an unregulated cartel, let us not forget.)

There's not much that central bankers can do about those factors. Here in Europe, the BCE of the EU (now around half a billion people), has steadfastly maintained an anti-inflationist monetary policy, with no real lowering of i-rates for the past four years -- much to the chagrin of national politicians who think that, as in the past, they should be able to spend their way out of an economic funk.

It is evidently not a criteria for public office that politicians be well-grounded in economics. So let's be thankful that, at least, some central bankers (in the EU) have kept cooler heads whilst pundits around them are losing theirs.

The subprime mess is America's baby -- handle it and assume the consequences. Thank Robert Rubin for having convinced Billy-boy Clinton to deregulate investment banking. Which unleashed the rapacious greed of Wall Street "financial engineers", an appellation that is evidently an oxymoron.

Little boys, if left unsupervised, WILL play with fire ... and we all get burnt as a consequence. Will this be apparent next time around? I doubt it.

It hasn't been before (S&L, dot.com, subprime) when greed has raised its ugly head -- so why the next time? These jerks never learn -- trust them at your peril.

[Spectator]

Balanced Trade's comment is a great glimpse of what's been going on, disguised as a great economy. All enabled by elaborate theories that defy common sense from well-meaning economists.

Socialist central planning dies hard, particularly with overbearing intellects. They're convinced their next great handout scheme will solve world hunger. And so they meddle, waste, reduce incentives to produce, and destroy the fabric of a productive society. When that experiment failed spectacularly on the real economy, they moved on to the monetary system. Say goodbye the dollar and the wealth of the middle class.

[hari]

Let me summarize using Paine as the *gestalt tanke* - he's on right track when it comes to *national interest*:-

*inflation is afterall a path to development/growth - in terms of political economy of the world - given all its negative after effects in terms of purchasing power constraints - in Asean market + mainland China and India.
Average rate of country-specific inflation is getting closer to 10% or more! It may mean finally changes in government....

*dollar reserve role is real political reason for SWF and arbitrage going on in commodity markets - ie. savings glut by SWFs.

*Me - I've been preaching here for Atlantic cooperation between Fed/ECB to coordinate their rate policy with regard to finding an optimal stabalization of currencies. If Fed powers are on the rise, more reason for it to now to deal with *externalities* (I hate the term!) in order to avoid dollar devaluation - inspite of Paine's mantra! Southern Hemisphere currencies can only be stabalized (up/down) by Fed/ECB cooperation in the long run.

*Asian emerging markets may find it optimal at this point in time to consider alternative to dollar reserves - however their (regional) political economy is still not on the right course to impact global developments (outside of FDI/trade).

Interesting Geitner's role in Asian currency crisis - crisis brought about principally by speculative currency bubble (not FDI) - a rising star to replace BB one day!

[Lafayette]

Spec: Socialist central planning dies hard, particularly with overbearing intellects. They're convinced their next great handout scheme will solve world hunger. And so they meddle, waste, reduce incentives to produce, and destroy the fabric of a productive society.

Oh bollocks to this rant. Wake up, the world has left such arch-Right myopia long since behind. Both Ayn Rand and Karl Marx are dead and long since forgot.

Socialist Europe has a lower Gini-coefficient than the US, meaning fairer income distribution and, at least, as high a standard of living with an even better Health Care system.

This Spectator needs new glasses. Then he can set foot beyond the 3-mile limit to spectate how the rest of the developed world functions.

[BJ Feng]

No one forced these countries to adopt a dollar peg. No one forces them to buy US Treasuries. The vast majority of Treasuries are owned by US citizens and residents, not foreigners. To say that the FED should cater to foreign nations and make sure they get a good return on their investment is ridiculous and offensive. The FED's duty is to stabilize and balance the US economy, not the rest of the world's. Saudi Arabia can hold Zimbabwe dollars if they want, or Venezuelan Bolivars, or Euros, or any currency they wish.

The author also neglects the real growth in demand of commodities thanks to the surging economies of China and other emerging markets. The amount of resources demanded has grown by double digits year after year after year, yet that is not going to effect commodity prices? That's not going to stoke inflation? It's all the FED's fault? Give me a break!

Furthermore, let's say that the FED did follow the author's suggestion and tightened monetary policy during the 2000 recession as well as today with the housing bust. Would this author be content with even higher default rates and even greater burden on Americans? I doubt it. More than likely an Op-Ed would appear blasting the FED for not easing in a downturn and making the situation worse for Americans. The FED wants to preserve the dollar's status as the reserve currency at the expense of the working American, would probably be the gist of the message. You can't have it both ways. And to say that other countries have been misled into believing a mandate that the FED never ever had, to make sure their dollar investments keep their value, is absurd to say the least. How this guy can be taken seriously has to be called into question. Lack of critical thinking, that's the real issue here.

[berni]

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