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Thursday, September 11, 2008


outsourcing fiscal and monetary policy

tim duy posted his latest installment of his fed watch, and it highlights the most important observation related to the GSE bailout -- marking a turning point in global monetary policy control. the united states was compelled to refinance the GSEs with the government balance sheet because foreign central banks commanded them to.

consider that for a moment; it is a watershed event. the united states called the shots and commanded the infrastructure of global finance explicitly from the second world war, indeed implicitly quite possibly since the end of the first world war.

that period perhaps implicitly ended earlier in this administration. but it explicitly ended this week with a thump. foreign central banks now command the broad allocation of credit -- and call the winners and losers -- within the united states.

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. ...

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. ...

Take note of this milestone; US authorities effectively are ceding policy independence. ... 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. ...

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. ...

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.

Lacking an avenue for additional monetary stimulus, Summers call for fiscal stimulus ... [but] 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. ...

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.

... 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.

i have expressed skepticism over the likelihood of a purposeful severe inflation, as the deflation of a credit bubble should dwarf the real capacity of the politicized fed or treasury to inflate. but duy is absolutely right to point out that japan had the advantage of being able to finance itself.

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