Is Ben Bernanke an Inflation Dove?

This week Tennessee Senator Bob Corker (R) called Federal Reserve Chairman Ben Bernanke “the biggest dove since World War II.”  He means to say that Bernanke has not done enough to prevent inflation.  This sets up an interesting question: How do Fed Chairmen stack up next to one another on key variables such as unemployment and price stability?

Figure One is a key component of my survey, but I'll break it down by tenure.  The figures were taken as percent change from previous month and annualized from those figures for each term.  It will go from the Fed Chairman with the lowest average inflation to the highest.

Figure 1

Federal Reserve Performance by Chairmen:

Eugene Meyer (1930-1933)

(photo: Harris & Ewing)

Eugene Meyer presided over the worst parts of the Depression, including the failure of many banks including the Bank of United States.  His average annualized inflation rate is -9.8% and his average annualized change in GDP is a staggering -19.7%.

 

Roy Young (1927-1930)

Roy Young presided during the Stock Market crash of 1929.  He had an average inflation rate of -1.6%.

 

Daniel Crissinger (1923-1927)

(photo: Harris & Ewing)

Crissinger's era is also considered to be the Benjamin Strong era, because Strong was Governor of the Bank of New York and exerted significant influence on Federal Open Market Committee meetings.  Crissinger's average inflation rate was 0.6%.

 

William Martin (1951-1970)

(photo: Federal Reserve)

William McChesney Martin is perhaps the ideal central banker.  He practiced under the gold standard and the Bretton-Woods system.  He did not write books on monetary policy, but he did unorthodox maneuvers such as the original Operation Twist.  He spoke against inflation constantly, but promoted removing elements of the gold standard during his tenure.  The practice of regional Fed Governors sharing their information days before Federal Open Market Committee meetings originated with him and led to many unanimous votes.

"Any presumed benefits that flow from inflation are based on self-deception.  We will certainly grow faster and stronger if we do not pretend that we can enrich ourselves depreciating our currency.  Stable prices and a sound currency that both we and the rest of the world can rely upon is the only seal that is morally and economically defensible."

His average inflation rate was 2%; his average change in GDP was 6.6% and his average change in unemployment was -0.1%.

 

Benjamin Bernanke (2006-present)

(photo: Gerald Ford School of Public Policy)

Bernanke has overseen a major financial crisis and the Great Recession, and is still attempting to return the unemployment rate to its natural rate (between 5-6%).  His average inflation rate is currently 2.2%; his average change in GDP is currently 3.2% and his current average change in unemployment is 0.4%.

 

Thomas McCabe (1948-1951)

McCabe negotiated the 1951 Accord which re-established Federal Reserve independence.  During the war, Marriner Eccles agreed that interest rates would be kept accommodatingly low irregardless of price stability factors because funding the nation during the war was a national priority.  The 1951 Accord ended this accommodation.  His average inflation rate was 2.7% and his average change in GDP was 6.5%.

 

Alan Greenspan (1987-2006)

(photo: Financial Times)

Greenspan's tenure started rocky in October 1987 when the Dow Jones Industrial Average dropped 22.6% in one day.  The rest of his term have been called the great moderation because it was known as a long period of only slight recessions and generally modest growth.  His average inflation rate was 3%; his average change in GDP was 5.6% and his average change in unemployment was -0.1%.

 

Charles Sumner Hamlin (1914-1916)

(photo: Harris & Newman)

The first head of the Federal Reserve.  His average inflation rate was 3.9%.

 

Marriner Eccles (1934-1948)

The Federal Reserve board building in Washington D.C. is named after Eccles.  He is another looming Fed figure along with New York Fed Governor Benjamin Strong.  He presided over the 1937 recession within the Great Depression and Fed operations during World War II.  He acquiesced to President Roosevelt by making monetary policy accommodating during World War II and the post-war period resulting in the nation's most significant inflation event (see figure 1).  His average inflation rate was 4.3% and his average change in GDP was 11%.

 

Eugene Black (1933-1934)

Black was one of the first Fed heads to use activist monetary methods.  He was promoted from Governor of the Federal Reserve Bank of Atlanta to being Chairman of the Board of Governors after his easy lending policies in the early 1930's showed that significantly fewer banks in the Atlanta region failed.  His average inflation rate was 5% and his average change in GDP was 6.6%.

 

Paul Volcker (1979-1987)

(photo: Harvard Ethics)

Paul Volcker is known as the ultimate inflation hawk.  So why is he so far down this list?  Volcker's place on this list also shows a major defect in the methodology of this list.  Each Chairman's average begins with their first month as Chairman, but because the methods and channels of monetary transmission are muted at best, their impact is only felt months later.  It would be impossible to make a uniform number of months after because the methods of Fed communication have varied significantly over the century.

Volcker entered as chairman when inflation was significantly high, and he raised interest rates into double digits to control it.  Unfortunately he also caused a significant recession by these actions, but it did kill the major inflation of the 1970's.  His average inflation rate was 5.6%; his average change in GDP was 8% and his average change in the unemployment rate was 0.1%.

 

Arthur Burns (1970-1978)

Arthur Burns was one of the foremost monetary theorists of the 20th Century, but his reputation was harmed by his tenure at the Federal Reserve and the inflation that started and continued during his tenure.  The prolonged period of inflation was accompanied by recessions creating a condition of "stagflation" which combined economic stagnation and inflation.  The "Nixon shock" took place during his term when Nixon abruptly ended the gold standard by issuing an executive order.  He was the first academic economist to head the Federal Reserve.  He taught future Nobel laureate Milton Friedman at Rutgers University and was heavily influential within the monetarist school of economic thought.  His average inflation rate was 6.3%; his average change in GDP was 9.5% and his average change in the unemployment rate was 0.5%, the highest of the survey.

 

William Harding (1916-1922)

(photo: Federal Reserve)

Harding's tenure included the end of World War I, a significant recession, and a notably quick recovery from that recession.  His average inflation was 7.2%.

 

G. William Miller (1978-1979)

Miller is notable for being the only Fed Chairman that also served as Secretary of the Treasury Department.  His average inflation rate was 10.7%, the highest of the survey.  His average change in GDP was 12.3%, the highest of the survey, and his average change in unemployment was -0.7%, the biggest drop in the survey.



So was Senator Corker being crazy when he called Federal Reserve a dove on inflation?  No, the Federal Reserve has taken unprecedented steps to provide the market accommodation in response to deflationary forces (see Figure 2).  He is being ignorant of Bernanke's results and the results of his predecessors.  As I've said time and time again, the challenge for Bernanke (as with any central banker in a recession) is two-fold: both to be accommodating enough, but then perhaps more difficultly to pull back appropriately.  Bernanke's moment to pull back has not happened yet, but it will likely be a challenge as well because so much of the Fed's asset purchases have been somewhat less than liquid.

Figure 2

The Ongoing Collapse of Greece's M2

Greece is going through something equivilant or worse than the Great Depression that occurred in the U.S. and Europe in the 1930's right now.  One of the hallmarks of this is their recent spate of public suicides as reported on by Reuters here.

Athens in April 2012 (photo: Jake Zalium)

The effects that this economic collapse has had on the people of Greece is nothing short of a tragedy.  This is not to excuse the role that Greeks have had in creating an unbalanced society, but their participation in the Euro has made them unable to help themselves through monetary policy, and their fiscal situation has made themselves completely dependent upon other Eurozone countries to finance any fiscal remedies (which have been non-existant, and in-fact negative, or "austerity programs").  I believe that Greece should exit the Euro for their own sake.  It would probably not be the best action for the rest of Europe, but Greece is facing a fate far worse by staying in the Euro, than by leaving.

All of the catastrophic pain that they would experience over the immediate term after exiting would help alleviate the long term hopelessness of what is an impossible recovery right now.  The fact is that Greece cannot recover within a currency that refuses to devalue itself despite economic conditions.  The European Central Bank has offered a great deal of lending to Eurozone banks in an effort to stimulate private and public lending.  While that has had some effect, it has not reversed the decline of Greece's M2, which has been in a tailspin for the past two years.

To review, the M2 is one of the broad measures of money within an economy.  It includes currency, money in checking accounts, savings accounts and short term CD's.  The annual decline in the M2 for 2011 in Greece was 15%.  It was 10% in 2010, and down an additional 1.9% from its peak in September 2009.  This decline has continued to get worse in 2012.  That has been about two and a half years of continual decline in the M2 for Greece.  I do not know of a country that has had economic growth while also having declining M2.  It sounds impossible.  The worst part of this situation is that as long as Greece is that this trend looks to remain the same for as far as I can see.  Surely that is not forever, but I do not know how this will change with Greece within the Eurozone.  They have little to no control over their own macroeconomic conditions.
One of the ironies of a potential move back to the Drachma is that the ten year program to exchange Drachnas for Euros ended March 1, 2012; perhaps to be reversed soon.

Inflation Targeting Formally Begins in the U.S.

The Federal Reserve just announced its first formal inflation target.  They set a target of 2% interest as a long term target for inflation.  This is in step with Bernanke's academic work on monetary policy and with the recent Fed moves towards transparency and their attempts to create expectations rather than simply respond to them.  Many central banks have already practiced this for some time.

Brief Case Study: Sweden

Sweden Consumer Price Index

Sweden has been targeting inflation since recovering from a currency crisis in 1993.  This gives us a long period of time to examine inflation targeting's effectiveness.  The first graph (above) shows the monthly inflation rate of Sweden since their online data begins in 1980.  Their maximum inflation rate during the period has been 5.2%, and the minimum -1.9% with the average being 1.56%.  The standard deviation has been 1.42%, but while it has had a lot of variation, it has been pretty centered around 1.5% as shown by the histogram below.

The histogram shows the number of times that Sweden has hit a given percentage of inflation since they introduced inflation targeting in 1993.  I added a box from 1% to 3%, with a line down the middle at 2% showing the target and the acceptable range.  This shows that Sweden has been conservative in their approach to their intention, which has been a static 2% inflation target ±1%.  It looks more like that they've targeted 0-3% inflation rather than 1-3%, which ended up with a median 1.5%.  This policy has been largely successful in creating relatively stable growth for their economy, as shown in the graph below which begins in 1993.

Target Too Low?

Almost immediately after releasing the target, it was criticized.  This is probably to be expected, but not in the way that I expected it to be.  One of the first critics of the policy was Paul Krugman, who argued that 2% is too low.  Two percent is a pretty standard number in inflation targeting central bank circles.  It would be more shocking if they chose to formally inflation target and didn't choose 2%.

Olivier Blanchard was an early major economist to write of raising the inflation target in his paper (along with Giovanni Dell'Ariccia and Paolo Mauro) "Rethinking Macroeconomic Policy" which considered more than monetary policy, but also fiscal and tax policies as well.  Blanchard mainly asks if there would be substantially higher costs and benefits to targeting 4% compared to 2% inflation.

Stephanie Schmitt-Grohe and Martin Uribe wrote an interesting paper in 2010 titled, "The Optimal Rate of Inflation" where they attempt to formalize some aspects of the debate on inflation targeting.  "For a realistic model of the monetary transmission mechanism must incorporate both major sources of monetary nonneutrality, price stickiness and a transactional demand for fiat money. Indeed, in such a model the optimal rate of inflation falls in between the one called for by the money demand friction—deflation at the real rate of interest—and the one called for by the sticky price friction—zero inflation. The intuition behind this result is straightforward. The benevolent government faces a tradeoff between minimizing price adjustment costs and minimizing the opportunity cost of holding money. Quantitative analysis of this tradeoff, however, suggests that under plausible model parameterizations, this tradeoff is resolved in favor of price stability."

They bring up an incredible amount of ideas that I hadn't considered.  They examine ways in which the Friedman rule, or the optimal monetary policy that focuses on zero opportunity cost to holding money,  could break down.  All three of these ways are related to taxation, whose relation to monetary policy I had not considered.

While I'm not sure if I agree with them, all of these are important concepts to consider, especially when current monetary policy is constrained by the Zero Lower Bound due to our current liquidity trap.  Formally announcing a target seems to be a way of creating expectations both for better and for worse.  The better is that it signals to the market that the central bank is taking steps to create inflation, and the market can often help by making the claim a self-fulfilling prophecy.  Similarly for worse, inflation hawks can be cooled by the setting of a reasonable level of inflation target.

The latter of the two is important as the Federal Reserve will eventually have to perform a tricky dismount of these current monetary policies.  They have undoubtedly increased the monetary base in shocking amounts.  Much of this has been done with relatively normal operations using Treasury security repo's, but much of it has been done with alternative monetary policies.  This has been done to combat liquidity trap conditions, but as those conditions ease, longer term inflation problems will start.  The Fed has a large amount of sub-prime mortgages and it is unclear whether, even now, that there is a market for those assets.  The point being that many of the assets that the Fed purchased might not be incredibly easy to sell.

John B. Taylor has talked about crisis policies of the Fed being unprecedented and that there is a need for a clear exit strategy.  This is due to the fact that if or when inflation does creep above the target, all of the old devilish aspects of relatively high inflation will creep back into society.  The chief of those being: increases in the cost of capital to the user.  I recently wrote an article in praise of Chairman Bernanke, and I stand by that post, but to be clear... the most tricky part for Bernanke's Fed is still to come.

References:

Blanchard, Olivier and Giovanni Dell'Ariccia and Paolo Mauro.  "Rethinking Macroeconomic Policy."  Washington DC: IMF.  2010. 

     Working Paper.

Cohen, Darrel, Kevin Hassett, and R. Glenn Hubbard.  ED: Martin Feldstein.  The Costs and Benefits of Price Stability.  "Inflation

     and the User Cost of Capital: Does Inflation Still Matter?"  Chicago: University of Chicago Press.  NBER Conference Report. 

     1999.  Print.

Krugman, Paul.  "Two Percent is Not Enough."  The New York Times.  New York: New York Times Publishing.  1/26/12.  Web. 

      http://krugman.blogs.nytimes.com/2012/01/26/two-percent-is-not-enough/

McCallum, Bennett.  "Should Central Banks Raise Their Inflation Targets?  Some Relevant Issues."  Economic Quarterly. 

     Richmond: Federal Reserve Bank of Richmond.  Vol. 97, No. 2.  2011.  Journal.

Schmitt-Grohe, Stephanie and Martin Uribe.  "The Optimal Rate of Inflation."  2010.  Working Paper.

Taylor, John B.  ED: John B. Taylor.  The Road Ahead for the Fed.  "The Need for a Clear and Credible Exit Strategy."  Stanford:

     Hoover Institution Press.  2009.  Print.

Federal Open Market Committee.  "Press Release."  Washington DC: Federal Reserve System.  1/25/12.  Web. 

     http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm

What to do When You're in a Liquidity Trap?

These are trying times in macroeconomy.  There have been several ways of dealing with severe drops in output.  The first is to lower interest rates, which creates the potential for a liquidity trap after they're lowered to zero.  At that point, we enter the liquidity trap and our knowledge of monetary economics becomes wholly incomplete.  There have been several ways that have been proposed to deal with this problem, and all of them deserve review.

A liquidity trap is defined specifically as the point when bonds and cash become perfect substitutes and traditional monetary policy is no longer effective.  The metaphor that economists use for this situation is that central bankers are "pushing on a string."  These are the situations that cause catastrophic recessions.



 The chart above shows the liquidity trap situation in an IS-LM chart.  Important things to note are that at the point of equilibrium, the LM's slope is flat (indicating the issues surrounding the lower boundary) and equilibrium is to the left of 'full employment' level GDP.

The liquidity trap is a phenomenon of monetary policy.  While the liquidity trap is a somewhat rare situation, it has become a major problem in the past few years for several major economies including the United States.  There has been quite a bit written about this phenomenom in the past ten years starting with essays confronting Japan's economic malaise.

Japan was one of the countries that people described as an 'economic miracle' much like Germany in the same era or China and India in the 2000's.  In the early 1990's, they began having a prolonged economic downturn that never returned to robust growth (yet).  The chart above includes Japan's annual growth rate.  It mostly describes growth around 0-1% with several downturns in 1994, 1998, 2002, and a particularly severe one in 2009.

This chart shows the base borrowing rate that the Bank of Japan uses to affect the economy.  It has been very low for a very long time.  During 2002 and 2009, we can observe liquidity trap, or near liquidity trap conditions.  In 2001, the Bank of Japan pursued a novel alternative monetary policy called Quantitative Easing."  The purpose of this program was to quickly inject more money into the economy under the zero limit boundary conditions.  Current Governor of the Bank of Japan, Masaaki Shirakawa writes about the experience in a working paper, "One Year Under Quantitative Easing."  Some issues that he brings up in the paper are that hoisting up asset prices becomes an act of fiscal policy rather than monetary policy, and that this lends itself to the debate on whether fiscal policy is helpful at all in stimulating an economy.

In the 2008 financial crisis and 2009 global recession, many countries were confronted with a similar situation.  Pronounced contractions while central bank interest rates are already low.  Many countries quickly found themselves in liquidity trap situations.  The ways that they addressed these issues varied.  Lars Svennson was deputy governor of the Riksbank in Sweden, and had already written extensively on such a scenario.  He was most famous for being a proponent of inflation targeting, but also for "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap."

Svennson advocated announcing upward sloping short term price levels coupled with small long term inflation targets.  Then announcing that the currency would be devalued and that the exchange rate would be pegged.  The Central Bank would make a commitment to buy and sell as much currency as they need to maintain the peg.  Once that short term price level target is reached, then the peg is abandoned.

When Sweden found itself in a liquidity trap, Svennson did something that most monetary economists said was impossible.  The Sveriges Riksbank became the first central bank to announce negative interest rates.

There have not been any academic papers about the Swedish experience yet, but it can be said that Sweden had the most growth (nearing 8% one quarter) of any European country coming out of the recession in 2010.  At first glance, it is was successful policy.

The chart above shows that the United States has had several episodes of near zero interest rates.  During the "Great Depression" of the 1930's, interest rates were very low.  These were also the times that John Maynard Keynes originally advocated for activist monetary policies, and even fiscal policies when those were ineffective.  He did not use the term liquidity trap, but The General Theory of Employment, Interest, and Money is basically written from that perspective.

In 1961, the Federal Reserve adopted "Operation Twist" during a period of low interest rates (not zero), as an alternative monetary policy to stimulate the economy.  Now, we have been confronted with near zero interest rates since 2009.  The general economy has recovered to modest growth, but unemployment has remained high due to structural changes in our economy.

This high rate of unemployment has led to a general sentiment that even though we are technically not in a recession, it still feels like recession-like conditions.  It harks back to the old expression that a recession is when your neighbor loses his job and a depression is when you lose yours.  Jobs play a critical part in any economy, and the current jobless recovery has left many Americans dissatisfied with economic policymakers' results.  Above shows that drastic uptick in unemployment, accompanied with relative price stability.  It shows that we did have a period of pronounced deflation despite the fact that the Federal Reserve cut rates, and pursued several rounds of Quantitative Easing.  The United States also engaged in fiscal stimulus.

 CONCLUSION

We still do not have a great idea of how to tackle the liquidity trap.  The typical policies of fiscal stimulus, and alternative monetary policies have (for the most part) been lackluster.  The liquidity trap is one of the most difficult and vexing situations in economics and deserves much more study.  Another issue that confronts policy makers is a large part of economics blames monetary policy for the problem in the first place and are wholly dissatisfied with the remedies.  One fact that they point to is the enormous growth in the monetary base and central bank assets.  They point to this as a sign of coming hyperinflation.  This makes it difficult for policy makers to pursuade the public that the inflation that they are pursuing is managable and desirable, rather than a prelude to hyperinflation.  There is also the problem of the lower boundary.  Bennett McCallum predicts that this might not be zero, but it likely still does exist, so there are still issues there even if it is not quite zero.

It is very possible that Europe may be facing this situation very soon, and perhaps other countries such as the United States would follow in that case.  For that reason, this will remain a critical issue to study in 2012.


REFERENCES:

Krugman, Paul.  "IS-LMentary"  The New York Times.  10-9-11.  Web.

Krugman, Paul, Kenneth Rogoff, and Kathryn Dominquez.  "It's Baaack: Japan's Slump and the return of the Liquidity Trap." 
     Washington DC: Brookings Papers on Economic Activity.  Vol. ? No. 2.  1998.  Journal.
McCallum, Bennett.  "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates."  Boston: NBER.  2000. 
     Working Paper.
Shirakawa, Masaaki.  "One Year Under 'Quantitative Easing'."  Tokyo: Bank of Japan.  No. E3.  2002.  Working Paper.
Svennson, Lars E.  "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others."  The Journal of Economic
     Perspectives.  Vol. 17, No. 4.  Journal.
The Federal Reserve System Purposes and Functions.  Washington D.C.: Board of Governors of the Federal Reserve.  2002. 
     Print.


This article is based on a presentation by Joseph Ward, Hares Fakoor, and Olivia Gonzalez for an intermediate macroeconomics course.

The Increasingly Transparent Federal Reserve

The Federal Reserve has become significantly more transparent in the past few years.  Amid appeals from Congress and the public to "audit the Fed," they posted to their homepage, that they get audited by the Government Accountability Office.  Chairman Bernanke has even recently started giving press conferences and this week they announced that they would release their Federal Funds Rate forecasts.  They announced it from the minutes from the December F.O.M.C. meeting.  This has been a pet project of Chairman Bernanke for some time, he gave a speech in 2010 on the subject.  To many, this might come as an obvious positive step, but I'm left scratching my head a bit.  I'm thinking... how is this going to help and how might it harm the pursuit of monetary policy?



(photo: MeDill News Service)



There are two issues in monetary policy that relate to this, and they are (as most things in monetary policy) opposing relationship to one another.  The first issue is central bank credibility.  It could be said that the Federal Reserve's reputation as a Central Bank has suffered in the past few years (rightly or wrongly) in the eyes of the general public.  In this sense their credibility has gone down.  Most monetary economists, not the Austrian school (of course), give high marks for the job that they have done.



The second issue is information asymmetry.  Not many people write about it (perhaps because it is elementary Keynesian economics, but perhaps not), but nominal price changes waxing over real price changes is a product of not much more than an enormous information asymmetry problem with regard to fiduciary media (money).  Robert Barro was (maybe) the first to write about it in his article "Rational Expectations and the Role of Monetary Policy." (gated)  I'm writing about the issue as a potential moral dilemma in "The Morality of Monetary Policy" (forthcoming).  The root of this idea is a purely Keynesian one, "Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labor whenever there is a rise in the price of wage-goods.  It is sometimes said that it would be illogical for labor to resist a reduction of money-wages, but not to resist a reduction of real wages." (Keynes, The General Theory of Employment, Interest and Money, 9) This demonstrates what has come to be known as wage rigidity, an example of sticky prices.

So, if information asymmetry is essential for nominal changes in prices to affect positive changes in output, then why is Bernanke's Fed reducing it?  I think that is because of rational expectations.  Rational expectations involve what the public thinks the future value of money will be.  Typically, expectations are formed from the average of the past few quarters price movements (inflationary or deflationary).  This is why monetary economists are interested in trend inflation, because we think that we are measuring expectations.  There can be deviations from this when the consumer has information that runs strongly counter to this.  Also, inflation can deviate from this when it begins to escalate take on a momentum of its own.

Keeping expectations within trend inflation is easy for a central bank with a good reputation, but not easy for one that does not.  Bernanke's moves towards transparency likely show that he is interested in promoting the Central Bank as credible, and promoting the effects of shrinking the money supply as soon as he can or sooner.

This is likely a good move, as long as he understands that when or if the Fed needs to expand the money supply again... they likely will need to increase information asymmetry rather than decrease it.  So if Bernanke is using this as a tool to promote Fed actions to curb inflation when inflation becomes more of a problem, I'm all for it.  If he's planning to be more transparent generally... we'll have to see how it impacts the implementation of monetary policy.

One last thing to note is the stark comparison for how the Bernanke Fed uses information to transmit monetary policy and affect behavior versus the way that every other Fed administration has.  Obviously they've been much more vocal and transparent.  One could compare if the public has been more sensitive and responsive to changes in the money supply when they are expecting it and understand the reasoning better or when it just occurs without comment.  I think this would be an good research project.

Will the ECB's 'fine tuning' Avert a Crisis?

The European Central Bank (ECB) just offered their first of two "fine tuning operations."  These seem like the opposite of fine tuning, because the first is one of the largest loan operations in ECB history.  They loaned 640 billion euros to banks at 1% for three years.  The second fine tuning operation will take place March 22, 2012.

Mario Draghi (photo: Daniel Fallenstein)

This comes after ECB President Mario Draghi had announced that he wouldn't be purchasing sovereign debt to hold down the interest rates.  The ECB was criticized for this stance, and comparisons to Nero playing his fiddle while Rome burned were made.  Part of this might be a misunderstanding.  One important thing to note is that the ECB does not work exactly like the Fed.

When the Fed wants to increase the money supply, they enter into repurchase agreements with banks involving short term Treasury securities.  When they want to make longer term monetary policy decisions, they purchase the securities or bonds outright.  So, the Fed doesn't buy U.S. debt directly from the U.S. government but it allows for them to have influence over the U.S. bond interest rate and prices in addition to providing liquidity to the banks and the economy at large which is the ultimate goal.

The ECB operates slightly differently.  When they want to make monetary policy decisions, they loan directly to one of their member banks.  That loan might be short or longer term, depending on the policy goals.  So their influence on sovereign debt interest rates is much more indirect.

This action by the ECB is the first credible step that they have made to stabilize this crisis.  For one thing it directly injects much needed liquidity into the economy.  If banks purchase sovereign debt, it could push down yields and provide much needed breathing room for Greece, Italy, Portugal, Spain, etc.  Of course, they don't have to... and in the days following these loans, the yields for Italian bonds which have really become the weather vane for Europe, have not gone down.

This might mean that one of the key differences between the ECB and the Fed, might be a critical problem for Eurozone countries suffering through this debt crisis.  This "fine tuning" is a positive first step towards stabilizing the Eurozone, but if interest rates do not fall, the ECB should consider modifying their loan program in March towards a more Fed-like system.

The Avoidable Catastrophe

European Union leaders concluded their latest summit, with their usual small solutions to enormous problems.  Here is a link to their release, detailing their new agreement.  They have decided to offer up more funds for member state bond market stabilization and redoubling their efforts at austerity, which has only exacerbated this problem thus far (including a ridiculous tax on countries that go over the 3% rule).  They still have Italy contributing 17% and Spain 11% of the EFSF funds, which sounds ridiculous given the fact that they are currently mired in severe deficits and Italy is already paying high interest rates to service its debt.  The only good thing to come out of this summit was that nobody has left the Euro (yet).

During the summit, fears and rumors led to multinational corporations reportedly moving their money from countries rumoured to be exiting the Euro to presumed safe countries.  That also probably compounded the bank runs problem in Greece.

Despite markets being up Friday, these problems will likely continue as none of the them have really been solved.  This means that none of the uncertainties that have created deflationary conditions in southern Europe will go away, and the economic conditions will continue to deteriorate.



European leaders signing the Treaty of Rome in 1957



Speculation of this variety does not help, but for countries that could be forced out or leave the Euro, this could amount to an economic catastrophe.  Their country will likely be almost immediately bankrupt unless Eurozone countries agree to continue bailout loans, or a bailout fund through the IMF.  It is hard to imagine that their currency will have any reputation as a store of value.  Their central banks will have little in the way of credibility to create monetary policy.  This will leave these countries in something like a liquidity trap because any monetary policy they try to employ will have little effect.  Deflation will be immediate and substantial, and it will be difficult to turn that around towards inflation or GDP growth.

A liquidity trap is defined as the point that monetary policy is no longer effective because bonds and money are perfect substitutes.  This situation is slightly different, because there will likely be so little demand for bonds, coupled with little central bank credibility that they will not be able to hold down interest rates to stimulate the economy in a meaningful way.  This means that monetary policy will be an ineffective tool to stimulate the economy.  Similarly, these countries will likely not have full sales of their bond offerings, and will have to cut government expenses even more significantly.  GDP will almost assuredly nosedive.  This should be classified as something worse than a liquidity trap because it will be a situation where neither monetary nor fiscal stimulus will be possible.

IS-LM in a Liquidity Trap (Krugman)

What would be left of the Eurozone will not be spared from a significant contraction.  Mark Cliffe of ING speculates that the new currencies would plunge.  His white paper speculates on a full break up of the Euro, but similar movements would be felt from select countries exits.  Similarly, northern European countries will inevitably feel the effects of the severe economic contractions of southern European countries in the form of contractions of their own.  These contractions could last a year in the case of northern Europe and years of severe contraction for southern economies.

The only possible heroes are the European leaders, but it looks as though they are still not truly believing in their own shared destiny.  The main villain can easily be viewed as the European Central Bank (ECB).  Their strong currency position has strained the growth of southern European countries, and even this Spring, they raised rates because of inflation fears.  Thursday, they cut rates, but at a paltry .25%; when Greece, Spain and Italy were literally having capital streaming out of their banks, economy, and even geography.  Much of this agreement seems to be stressing an increased ECB role, but hard to imagine them doing what is necessary to help southern economic conditions.  They will be acting as the operating agent of the EFSF and ESM funds to purchase sovereign debt.  Hopefully they will be more active in that pursuit, than they have in monetary policies.


Solution:

I would argue that there is still time and opportunity to avoid this recession.  I think the best solution is to pool credit risk.  An agency such as the European Stability Mechanism or the European Financial Stabilization Mechanism or another more robust agency could purchase all the debt of all member nations, and in turn issue Euro bonds.  The Eurozone, in total, has a debt to GDP ratio of 85%, which is below the United States and within an acceptable range.  The Euro as a currency has and would continue to have significant transaction demand, and the ECB would continue to have legitimacy and credibility for creating monetary policy.

Creating a true fiscal union (as opposed to the current proposal which merely acts as an enforcement agency of the 3% rule) would also be important to insure that this does not become a repeated problem, and (of course) to pay down the Eurobonds, and pool more government expenses.  These two solutions (Eurobonds and fiscal union) might cause Eurozone nations to rethink whether they actually want to remain in the currency.  It is hard to imagine EU members that have not adopted the Euro join this arrangement which would leave countries like the U.K. and Sweden out.  For that reason, I think secondary treaties such as a greater European community (but explicitly non-EU) would be important for keeping important commercial and economic ties, while being excluded from a federal system and unified currency and bonds.

It does not look like enough European leaders are interested in this arrangement.  I think we are still staring at a difficult situation in Europe that hasn't really been solved.  If conditions continue to deteriorate, European leaders will be forced to hold another summit, and who knows how much longer bond markets are going to tolerate these half-steps.  They're barely tolerating it now!

If countries leave the Euro, France and Germany will instead likely be somewhat forced to bail out banks that will be overexposed to southern European debt or too weak to withstand this recession (Commerzbank, which is trading at an awfully low price of € 1.37 might be the first) or face a more severe recession of their own.  Southern Europe will be have negative economic growth for years.  It should be considered a failure of leadership that Europe was not able to find a way towards this solution over the past year and a half.

Washington's Frustration with China

Recently, the United States Senate passed the Currency Exchange Rate Oversight Reform Act of 2011.  This act follows allegations by the International Monetary Fund that China is still significantly undervaluing the Renminbi.

The Act states that the Treasury Department will monitor exchange rates between the U.S. and its major trading partners and report to Congress about it twice a year.  It also amends the Tariff Act of 1930 in regards to anti-dumping to establish export prices if a currency is considered fundamentally misaligned.  President Obama has not taken a public position on the legislation, and the House of Representatives' leadership have spoken out against it, so the legislation is unlikely to become law.  Indeed, some might say that a government that devalues its currency as much as the United States does passing legislation against another country that pegs its currency (in part) to the former's currency is a bit like the pot calling the kettle black.

A black pot and a black kettle (photo: Mark Corbin)

Most countries around the world engage in currency manipulation to varying degrees.  Almost all countries have fiat currencies, these are currencies that are controlled by central banks rather than being valued based on a commodity as was common in past times.  The Federal Reserve is an example of a central bank that has sought to weaken its currency in the past couple years.  Some countries that do not have reliable or credible governments or central banks use a system of fixed exchange rates.  China has had a system that tied their currency directly to the dollar.


(source: IMF)

The issue has quite a bit to do with the relative ascendancy of the Chinese economy to the rest of the world.  China has had significant growth in a time when the United States has struggled to maintain positive growth.  Much of their growth has been based on exports which have been helped by their currency's low and steady value.  The Peterson Institute for International Economics has released a working paper that China and Singapore have undervalued currencies, while the United States has an overvalued currency in terms of trade weight.



Shanghai (photo by ふみこ)



These allegations suggest that China has allowed its currency to depreciate, which has not been the case.  China's Renminbi has actually slightly appreciated relative to the dollar, and it has begun to have (slight) fluctuations because of the Renminbi's pegging to a basket of currencies rather than simply to the dollar.  As you can see in the chart below, these appreciations and fluctuations have been minor compared to the 8-14% annual growth that the Chinese economy has had overall.

A lot of this strain is caused by China's policy of continuing to peg its currency rather than let it float with the strength of its economy's.  It is often a positive thing for all countries involved when a developing or unstable country or currency pegs itself to a stronger currency.  It is another thing altogether for a relatively strong economy to do this.  A strong country pegging a currency can cause distortions throughout the international economy.  China is strong enough to stand on its own, and its currency is as well.  They should stop pegging their currency altogether and become an leader within the international economic community.

ED: Here is the People's Bank of China's response:

The xx - "VCR"

Trying to Have It Both Ways

The Federal Open Market Committee announced that it would do the twist.  In particular, they announced that they would sell $400,000,000,000 in short term (30 days to three years) U.S. treasury securities, and purchase the same amount of long term (6-30 years) U.S. treasury securities by next June.  This is meant to influence long term interest rates, as to stimulate investment in things such as mortgages.

What was very telling for me is that they left the federal funds rate target at 0-.25%.  The Federal Reserve performs open market operations to keep that rate at its target usually by entering into repurchase agreements on short term treasuries (usually 30 days) because that is what they consider to be the best way to remain flexibly sensitive to target fluctuations.  If they decide that the monetary base is likely to depreciate for a substantial amount of time, then they purchase bonds outright.  They've already been flat out buying bonds, and now they're buying longer term bonds, because they believe that they will need to keep the monetary base larger for a long period of time.


The Eccles Building (photo: Margit Myers)

The problem with 'the twist' is that long term treasury securities don't directly compete with federal funds.  They are different loans that attract buyers for different purposes.  So while these actions may directly increase the monetary base in the same way that the Fed is used to, they may have less of an impact on the federal funds target rate.  Essentially, the Fed is trying to have it both ways and influence both short and long term interest rates.  If the target rate changes because of all of this selling, what will the Fed do?  The Fed will likely buy more short term securities to put downward pressure on the Federal Funds target rate.

So while the Fed says that they are buying long term securities, and I certainly believe that they will buy 400 billion dollars worth.  I am not so sure that they will sell all of the 400 billion if those actions influence the Federal Funds rate to rise above the target.

I think all of the fanfare surrounding this 'twist' is actually a smoke screen to try and please two different constituencies.  On the one hand, they want to the markets to believe that they are performing stimulative measures, and on the other hand they want those wary of inflation to believe that they are not really performing stimulative measures.  Again, they are trying to have it both ways.

Another byproduct of these actions is that the Fed has made the job of quickly shrinking the monetary base a bit harder.  This will already be a difficult job if inflation ever gets out of hand.  Much of the assets that they've bought are those so-called toxic mortgage backed securities that will be very difficult to unload off of their balance sheet, and now they are loading up on longer term assets.  These treasuries will probably not be hard to sell to the market, but they won't be quite as easy as just letting them expire.  Of course, one also wonders how much the Fed needs to buy treasuries or how much the Treasury department needs the Fed to buy treasuries.

The Fiery Furnaces - "Benton Harbor Blues"

The German Dilemma

Simon Maughan of MF Global summed up the current European financial situation very well when he was interviewed last Wednesday on Bloomberg Surveillance.  He posed the question:

Spoken like a true banker, but that is Germany's current dilemma.  Maughan also spoke about Basel III and other European financial issues.

Simon Maughan on Bloomberg Surveillance (MP3) via Bloomberg

The Inflation Tiger

Notes:  

This essay won the 2011 F.A. Hayek Award at George Mason University.  The topic was: “Hayek famously warned that policy makers engaged in discretionary monetary policy are in effect holding a “tiger by the tail.”  From that perspective, how would you judge contemporary monetary policy since 2008?” 

This essay was written on Federal Reserve System monetary policy, and not United States public policy.  These two subjects are closely linked, but I did not address public policy issues because of the scope of the essay topic.

Did We Kill the Golden Goose?

The American Armageddon was averted earlier this week when Congress and the President reached a deal to raise the debt ceiling and avoid defaulting on its obligations.  Since the deal was reached, many on both sides are fuming about various aspects of the deal.  Presidential candidates are already using it to position themselves to constituency and the world is still turning.  One of the questions that is being brought up in the wake of falling stock markets and general media inquiry, did we kill the golden goose?  Will we lose our AAA bond status?  Are bond purchasers going to be less attracted to our securities?

Chart 1 - Dow Jones Industrial Average (7/29/11-8/4/11)

Chart 1 shows the Wall Street sell off this week.  Is this sell-off because of insecurity about the U.S. government paying its bills based on resistance to raise the debt ceiling?

Chart 2 - Dow Jones Industrial Average (8/3/09-8/3/11)

You can see the market has been climbing quite a bit in the past year.  I suppose our outlook has grown rosier in the past two years, but perhaps it is getting more pessimistic with job numbers at almost negative growth and GDP about the same.  Market bull runs tend to take on a momentum of their own and continue past the point that economic indicators begin hinting at weakness, so perhaps the market is finally succumbing to neutral economic indicators and is beginning to feel alarmed.

Chart 3 - One Month Treasury Note Rates (8/3/09-8/3/11)

Please note the scale on Chart 3, the reason that it looks as variable as it does is only because of how little variability there actually has been in it.  If one view this graph from before the recession began, it looks quite different.

Chart 4 - One Month Treasury Note Rates (8/3/02-8/3/11)

This graph gives a bit more history to the debate.  What I notice is how closely it follows the Federal Funds rate that the Federal Open Market Committee sets.  This makes sense because the main way that the Fed does this is through Treasury Note repurchase agreements with Treasury Department primary dealers.




Chart 5 - Federal Funds Effective Rate (8/3/02-8/3/11)



The grey portion in Chart 5 shows a period of recession.  The Federal Reserve's Federal Open Market Committee meets once every seven weeks (roughly) to decide whether to raise or lower interest rates.  They then set a target rate, and it is up to the traders at the Fed Board and regional Reserve Banks to meet that target.  It's easy to be oblivious to the ways in which the government intervenes in our markets.  But these last two graphs show pretty well why the U.S. Treasury bond market wouldn't and perhaps couldn't react to any insecurity over a potential U.S. default.

Chart 6 - 100 Oz Gold in Dollars (5/3/11-8/3/11)

This chart shows the price of 100 ounces of gold over the past three months.  I use this chart to show the decline of the Dollar.  One could argue that there is a significant speculative market in gold, but I would counter that this speculation is actually a short on the major world currencies.  Surely these speculators are not guessing that the demand for gold jewelry has risen 10% over the past month!

Ordinarily, when someone is trying to show weakness in the Dollar, they would compare it to another world currency such as the British Pound, Japanese Yen, or more recently the Euro.  This would be fine, but the Dollar has been somewhat on par compared to these currencies because most developed economies are in lackluster shape and sovereign debt levels are high for most of these countries.





So have we killed the golden goose?

Many are speculating the Republicans have killed the golden goose by showing that Congress may not have the political will to pay back its debtors.  I think this is attacking the wrong problem.  Even if we had not had this debacle with the debt ceiling, I think it is likely that we would be facing credit rating downgrades.  The reason we will face those downgrades is because our debt to income to ratio has been  quickly rising.  Our prospects of lowering it, or even significantly slowing this rising ratio only came about because of Republican hold-outs last week.  The truth is the the U.S. debt rating has already been lowered by one agency that I know of (大公国际资信评估有限公司, in China).  It is the largest credit rating agency in China (I don't know if that means anything) but I don't know if that has truly affected rates.  Then again I'm not sure that even a Moody's downgrade will affect us after looking at that Federal Funds Rate (Chart 5) compared to Treasury One Month Rates (Chart 4).  It appears that the Fed is willing to do whatever it takes to hold down Treasuries.

All this sort of exposes the United States as becoming a banana republic.  The government spends our money, and then taxes us through the backdoor via inflation.  I've long wondered that with the United States having such a large debt for so long, what it would take to go bankrupt.  It seems to have a bottomless pit to borrow and repay yesterdays loans (read: ponzi scheme).  It seems then that the true way that the U.S. Federal government would ever go bankrupt is by holding a Treasury bond auction that nobody came to.  So perhaps we have killed the golden goose, but not in a way that is at all obvious, yet.