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Thursday, September 11, 2008

Fed Watch: Get Shovel, Dig Deeper

Tim Duy says it is an "illusion that the US is like Japan," and the differences between the two cases matter for the conduct of monetary and fiscal policy:

Get Shovel, Dig Deeper, by Tim Duy: The US is not Japan.

I realize, however, that whenever I suggest this, I am viewed as downplaying the seriousness of the economic situation. That is not my intention – I simply think you need to break with the Japan framework to interpret the seemingly discordant nature of the data flow. Japan’s travails could be understood in terms of a simple closed-economy Keynesian framework, with an excess of domestic savings over investment. The current US situation requires a more comprehensive framework that includes analysis of massive capital inflows.

Indeed, in my opinion, the US can only wish it were Japan. This idea was driven home to me in the wake of the Fannie/Freddie bailout/nationalization. From the Wall Street Journal:

Foreign central banks had been among those voicing concerns in the weeks ahead of the government's seizure of Freddie and Fannie. The banks had steadily reduced their holdings of debt in the two firms in recent weeks as the turmoil around the firms worsened.

China's four biggest commercial banks, too, pared back their holdings in agency debt, with Bank of China Ltd., the largest holder of Fannie and Freddie securities among these banks, saying it sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30, down from more than $20 billion at the end of last year.

Treasury tried to head off such concerns by having David McCormick, the undersecretary for international affairs, call foreign central banks and other overseas buyers of the companies' securities or debt to reassure them of the instruments' creditworthiness. Over the weekend, Treasury officials called sovereign-wealth funds in Abu Dhabi and elsewhere in the Middle East, assuring them that they were working on financial issues involving Fannie and Freddie, says an individual apprised of the conversations.

Brad Setser adds:

I suspect this is the first case where foreign central banks exercised their leverage as creditors to push the US government to make a policy decision that protected their interests. The need for ongoing central bank financing certainly weren’t the only reason why the US government acted. US banks hold a lot of Agency debt too. But the need to maintain the confidence of the world’s central banks — and the attractiveness of Agencies as a reserve asset — was certainly a factor in the Treasury’s decision.

Take note of this milestone; US authorities effectively are ceding policy independence. To be sure, just a bit – a bailout of the mortgage behemoths was inevitable given the implicit Federal guarantee. Still, for all the humiliation heaped upon Japanese policymakers over the past decade by their American counterparts, who confidently and smugly offered economic “advice,” I never recall Japan’s officials having to bow to the will of their external creditors. This of course, is the benefit of being a creditor nation – Japan ran a current account surplus throughout the lost decade, leaving policymakers able to finance spending entirely from domestic resources. Arguably they could have done more, faster, as the resources were available, but that is their lesson, not ours.

No, the US is not Japan. But there is a list of nations that have had to go, hat in hands, to their creditors – Indonesia, South Korea, Thailand, Russia, Brazil, etc. The US had already implicitly joined that list, but now joins explicitly. Do the implications resonate in Washington DC? I don’t know to what extent US policymakers realize the importance of the external financing issues in defining the current turmoil. And, even if they do realize it, would they be willing to admit that the accumulation of US assets abroad has finally left the US vulnerable to external pressure?

I suspect US policymakers, from both sides of the aisle, would be loathe to make such an admission. Indeed, such an admission greatly complicates policy making. By ignoring the fact of America’s dependence on foreign capital flows (or, specifically, foreign official inflows), one can look to the lessons of the Great Depression, and have confidence that a scholar of that episode, such as Federal Reserve Chairman Ben Bernanke, is well-positioned to address the current crisis. But when a nation is dependent upon foreign inflows for survival, cutting short term rates to zero – the ultimate destination of the Bank of Japan – is not an option. Indeed, the limits of monetary policy may already have been reached. From Larry Summers via the Wall Street Journal:

Summers said the U.S. economy “remains in a highly uncertain state with very significant risks to the downside.” Yet the Federal Reserve’s powers are limited, he said, adding that it would be difficult for the central bank to lower interest rates without putting the U.S. dollar and commodity markets at risk.

Lacking an avenue for additional monetary stimulus, Summers call for fiscal stimulus:

“I believe the balance of risks suggest a compelling case for a significant fiscal stimulus program that increases the deficit in the short run” but not over the medium to longer term, he said. The program may be most beneficial if it includes new measures for food stamps, unemployment insurance and other policies aimed at supporting low-income families, said Summers. He also argued in favor of new infrastructure investment as well as changes in Medicaid reimbursement rules and new funding to help low-income residents pay their heating bills.

Note the logic – we can’t use monetary policy because we may tank the now stabilized Dollar, but instead we should float another couple of hundred billion dollars of Treasury debt to foreign central banks, continuing a process that gradually increases the supply of Dollars in the world that ultimately threatens to sink the Dollar anyway and strips the US of policy independence.

Policy simply becomes much harder when you are forced to factor in the importance of global financial flows. You have to admit to the American public that their debt supported lifestyle is unsustainable, an especially difficult admission when that lifestyle keeps hidden stagnate real incomes during this administration and lagging incomes for the past three decades. But worse yet for many, an admission that unfettered capital flows have cost the US its policy independence would force a generation of technocrats to reconsider their pursuit of open capital markets essential to furthering their fetish of liquidity. Indeed, I believe this reconsideration should have occurred long ago, as capital inflows, specifically those from foreign central banks, have hopelessly distorted trading patterns in such a way that needlessly undermines the case for free trade in goods and services.

Additional fiscal stimulus at this juncture is a case of digging our hole deeper. And yet, sadly, it may simply be inevitable. There is no will to address the underlying economic policy challenges facing the US. And even less to tackle the deficiencies of the global financial architecture. Indeed, policymakers are focused on trying to keep the current system intact. Official foreign capital from the rest of the world was channeled to US consumer via mortgage markets (hence their interest in the stability of Freddie and Fannie). When this channel broke, we switched to the Treasury debt – tax rebate channel that supported household consumption in the first half of this year. That channel is now exhausted, bringing calls for a fresh round of fiscal stimulus - I suspect it will come in the opening days of the next Administration.

Anticipating a continuation of the status quo, my soothing advice this week was:

Moreover, the bailout provides an important policy lesson – nothing truly bad can happen as long as the US Treasury is willing and easily able to float debt onto the global financial markets. Presumably, Treasury will finance any cash injections into Fannie and Freddie by issuing debt that will be forced fed to foreign central banks, the same way Treasury financed the now forgotten stimulus package. The US can always inflate away the real value of that debt at a later time. As long as foreigners are willing to continue to take that risk, let them.

Perhaps this was a bit more blasé than I feel tonight, but in the short run, it is difficult to expect anything else. Which is why, worry as we might about the potential liabilities the Treasury and Fed are accepting on behalf of the US taxpayer, the US Treasuries market, not to mention the Dollar, remains resilient – as long as foreign central banks continue to play this game, rates stay low and a collapse of the Dollar is avoided. As long as the music is still playing, we can just keep walking in circles around the chairs.

My view, however, does not necessarily imply that policymakers just sit back and let the implosion occur; there is domestic justification for nationalization of Freddie and Fannie. And we can learn a lesson from the early stages of the Asian financial crisis, when governments were encouraged to cut budgets regardless of the domestic costs. Policy should cushion the downside, easing the structural transition to economy not dependent upon foreign official financing, but with the adjustment always in mind. Instead, policy lurches from one open-ended commitment to the next, a desperate attempt to maintain the status quo, without an endgame that addresses the underlying challenges of the US economy. Maintaining the illusion that the US is like Japan allows policymakers the freedom of this approach, as the problem is simply one of too little demand, rather than too much demand relative to resources.

So I can remain comfortable with the short-term implications of one stimulus package after another, one bailout after another (is Detroit next?), knowing that as long as the Bank of China is willing to absorb the associated costs and the risks, nothing truly bad can happen. But I worry greatly about the price that will ultimately be paid for such fecklessness, a debt that may not come due for a year, five years, or a decade. It will, however, come due – the pressure placed by our creditors in the issue of Freddie and Fannie should be our wake up call, and likely reveals to those creditors the extent of their power. US policymakers should define their own structural adjustment program before one is defined for them.

Update:

The Wall Street Journal reports that some policymakers are seeing the implications of Chinese influence on the Freddie/Fannie bailout:

The topic has elicited concern from lawmakers such as Rep. Luis Gutierrez D., Ill.), who chairs the panel.

“One of my chief concerns is that, through their funds, some countries may have too much influence in U.S. financial institutions,” said Gutierrez, who mentioned government-sponsored entities as financial institutions at risk.

Also, Yves Smith and Brad Setser both note that some nations are selling Dollars to support their currencies, suggesting that foreign central bank reserve growth is slowing. With the US current account position likely improving on the back of import compression, export expansion, and declining oil prices, the need for capital inflows to sustain the deficit should lessen. US policymakers have a choice – let this adjustment continue with its coincident domestic weakness or try to offset it with additional stimulus. The long term inflation risk lies in continuous resistance to that adjustment.

Note how quickly the economic landscape is shifting with the last deficit-financed stimulus package behind us. Coincidental? I doubt it.

    Posted by on Thursday, September 11, 2008 at 12:33 AM in Economics, Fed Watch, Financial System, Fiscal Policy, Monetary Policy | Permalink  TrackBack (0)  Comments (86)

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