Monday, April 14, 2008
the nervous dollar watch
I fully appreciate the current policy dilemma Bernanke & Co. face – this is not your garden variety Keynesian slowdown. The yawning current account deficit represents consumption in excess of productive capabilities, and we are resolving that imbalance. The resolution entails accepting some moderation of domestic demand in concert with expansion of external demand that will be consistent with a new constellation of interest rates, exchange rates, and prices. It is not obvious, a priori, that we know the monetary policy consistent with that new equilibrium. But policymakers should realize that implications of that adjustment when setting policy.
My concern remains that the Fed has panicked in setting a rate policy that treats the external sector – and therefore, the current account adjustment – as a mere curiosity, giving little thought to their role in supporting the adjustment. In effect, policy, both monetary and fiscal, has degraded into an effort to dig the economy out of a hole by shoveling deeper. We built the most recent expansion on the back of debt financing, driving consumption gains while real median incomes stagnated on the theory that you can borrow your way to prosperity. That theory has proven ill-advised at best; the inability to continuously fuel the borrowing binge through housing provided the initial blow to the consumer. The second blow was the softening job market due to the first blow. The third blow was the inflation driven by the policy response designed to minimize the impact of the first two blows. The question now is: does the Fed read the increased pain of consumers as a reason to cut rates 50bp at the next outing of the FOMC? I hope not – but I cannot rule it out.
Then again – perhaps we are simply at the point where inflation is the only politically palatable option. The Bear Sterns rescue is the basis for a massive, fully monetized bailout of the financial sector…and Congress and the next President would oblige. If that is where we are headed, somebody needs to start thinking about capital controls before the rest of the world realizes the US intends to repay its obligations with very devalued Dollars.
Bottom Line: As has been the case for months, I would be much less concerned about the path of monetary policy in the absence of rapidly increasing commodity prices and a declining Dollar. I do not believe it is advisable to let the Dollar completely disintegrate. And given the increasingly clear link between monetary policy, the Dollar, and commodity prices, the Fed would be best to served to moderate the pace of easing. I think they understand this, but I remain worried that fundamentally, they only have one tool, and they will feel a need to keep using it if only to look like they are doing something. This is especially worrisome given that low interest rates are apparently not providing much of a fix for Wall Street – for that, the Fed needs to focus on reducing counterparty risk.
as previously noted, the currency consequences of a negative real policy rate may, from this precarious setup, put the fed exactly where it was in 1931 -- compelled to raise rates in order to defend the currency despite the knowledge that raising rates will deepen the depression.
the fed may well be about to take the other road this time -- as noted in dupuy's link, to the second option mentioned by brad delong for a third order financial crisis -- a general inflation. the wall street journal editorial page is already bleating for it.
but i remain doubtful that such an outcome is really possible. again, with a credit bubble of something on the order of $50tn -- as shown in the fed's most recent quarterly z.1 report table d.3, total outstanding financial and non-financial debt was estimated at $47.0tn -- now potentially on the brink of deflating, can the fed really print enough money on a monetary base of $850bn? and if it tries, would it not force a repudiation of dollar-denominated instruments globally -- something dupuy suggests could force the institution of "capital controls"?
it's a question that's impossible to answer yet (and hopefully remains so). but one way or another, these graphs have to be resolved. the first is a plot (in blue) back to 1984 of the total financial and nonfinancial claims reported in the z.1 table d.3 divided by the monetary base as reported through the saint louis fed. the second (green) is the year-over-year growth rate of that ratio. recessions are in red -- and as you can see essentially amount to a contraction in the amount of claims on the monetary base. the mild 2001 recession of course was mild in large part because the contraction of the ratio was itself mild; the 1990-1 recession more severe correspondingly.
these suggest that a "normalization" of the ratio can be achieved by driving the ratio back under 40 -- representing either i) a fall of the claims from $47tn to something closer to $34tn, a 27% collapse in credit; or ii) a rise in monetary base from $855bn to $1175bn, a 37% growth; or iii) some combination.
using nonfinancial outstanding debt, one can paint this picture back to 1959 using FRED data. one must recall that 1986-1994 was a period of difficulty for american banking which encompassed the savings and loan disaster, considered by many to be a forerunner writ small of the current housing collapse. one can see how monetary base expanded much faster than nonfinancial debt during the period.
furthermore, the spectacular divergence of total against nonfinancial debt since 1995 is more visible here -- the gap between the two plots is by and large financial sector debt. i strongly suspect a similar (qualitatively, at least) divergence probably was visible in the 1920s. the birth of the financial sector boom notably corresponded to the first explicit efforts to repeal the glass-steagall act of 1933 -- see articles here and here -- which led to the gramm-leach-bliley act. this was viewed by some at the time as a serious mistake in deregulation, and still is seen as so by many critics of financialization. seems to me that's exactly what it has been.
again this is the YoY growth. periods of zero or near-zero expansion -- as well as periods of the highest rate of contraction -- have marked economic weakness. the magic data for comparisons to the great depression are not here available; as one can see, this entire period is essentially a long, great leveraging of the monetary base.