Tuesday, November 25, 2008

Geithner is a Monetary Arian too

There are other factors at work as well, however, that have less favorable implications. Part of this recent dynamic in financial markets is a consequence of the present state of the international monetary system, in which a substantial part of the world economy runs exchange rate regimes tied in some way to the dollar. This has entailed a sustained period of very substantial official accumulation of dollar reserves, putting downward pressure on U.S. interest rates and upward pressure on U.S. asset prices.

These forces are surely transitory, but their impact on capital flows, interest rates and asset prices are important, not just in terms of their short-term impact on growth. If they are large enough, they have the potential to alter or distort current decisions about investment and consumption in a way that could be detrimental to our longer-run growth prospects. And they are important because they work to mask or dampen the effects on risk premiums in financial markets that we might otherwise expect to be associated with the expected trajectory of the fiscal and external imbalances in the United States. Tim Geithner, NY Fed Jan. 11, 2007

The first thought that came to mind upon reading of Obama's selection of Tim Geithner as Treasury Secretary was, "at least Larry Summers (whose decision to reduce the duration of US Federal Debt by, inter alia, repay old and slow issuance of 30 year Bonds set the stage for our current explosion in short term finance) didn't get the job." Mr. Summers is, by all accounts, very intelligent, which, in light of that decision, should not be confused with far-sighted.

The second thought was, "what are Mr. Geithner's views on finance?"

A check of the NY Fed site led me to a few speeches of his and I was pleased to find he too was concerned about the effects of officially induced stable exchange rates on US monetary policy.

Further research shows Mr. Geithner has been concerned about the link between (mainly) Asian Economies and the US$ for years.

As he argued early in 2006: this pattern [FX "pegs"- formal or informal, which necessitate increased purchases of US Treasury Debt] of exchange rate and monetary policy arrangements and the associated scale of official intervention in markets complicate our ability to assess the underlying economic conditions in our economies and to forecast the future path of output and inflation. If the effects of these policies are large enough to alter or distort the relationship between asset prices and the underlying fundamentals in our economies, and this seems likely to be the case, then we can take less comfort from traditional relationships between those variables.

The fact that official purchases of financial assets are driven by different factors than those driving private investors suggests that we would probably see a somewhat different combination of capital flows, exchange rates and interest rates in the absence of official intervention. This makes the task of assessing the probable trajectory of growth and inflation more complicated. It makes it harder to assess the likely evolution in financial conditions and asset prices. And it makes it harder to assess the effects of the present stance of monetary policy on aggregate demand and inflation.

He continues: To the extent that these forces act to raise asset prices, lower interest rates and reduce risk premia, it is harder for the markets to assess how much of the very favorable conditions are likely to reflect fundamentals and prove more durable. This can contribute to an increased willingness to raise leverage in the investment community and to take on more exposure to risk. [and so it did]

For the same reason, this phenomenon can act to mask or offset the effects of high levels of present and expected future government borrowing on interest rates, perhaps contributing to a false sense of reassurance that we can continue to run large structural deficits without risk of crowding out private investment and damaging future growth.

If Obama was looking for a guy at Treasury who saw some of our current problems before they manifested, Geithner seems a wise choice.

I'm intrigued to discover how he intends to fix the problem.