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.