Friday, November 21, 2008

The Myth of Economic Trinitarianism

The Fed’s ability to set the short-term interest rate independently of foreign financial conditions depends critically, of course, on the fact that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets. If the dollar’s value were fixed in terms of another currency or basket of currencies, the Fed would be constrained to set its policy rate at a level consistent with rates in global capital markets. Because the dollar is free to adjust, U.S. interest rates can differ from rates abroad, and, consequently, the Fed retains the autonomy to set its federal funds rate target as needed to respond to domestic economic conditions. Ben Bernanke

Early in 2007 I dubbed Fed Chairman, Ben Bernanke, the Super (as in Superman) Central Banker in response to the above claim. While mere mortals, like BoE head, Mervyn King, worry about the effects of stable exchange rates on monetary policy, Mr. Bernanke leaps over this concern with a single assertion- FX markets are open and competitive. In a sense, shifting from a comic book to a Theological metaphor, Mr. Bernanke is an Economic Trinitarianist- he believes in the consubstantiality of stable exchange rates, open capital accounts and domestic monetary autonomy.

That makes me, and, it would seem, Mr. King, heretics. We believe this Trinity to be impossible.

To be fair to my Catholic, Anglican and other Trinitarian (including Hindu) friends, I'm not arguing against Theological Trinitarianism, just using the metaphor as heuristic device.

17 Centuries ago, Emperor Constantine, in an attempt to unify the Christian faith he had adopted, called an Ecumenical Council to Nicaea to define the Christian God-head. At the time a debate was raging about the divinity of Christ. Was Christ a man who became God, as the Arian Heretics argued, or was he always God, as Athanasius argued for the majority.

In the end, the Trinitarian Orthodox view won out- the "Father, Son and Holy Ghost" were declared consubstantial (thus the importance of that phrase) or, in Latin, homoousian. Those who believed this Trinity impossible were branded heretics and persecuted with varying vigor for centuries. Defense of Arianism was a rallying cry for Goths and Vandals in their conflicts with Rome.

Fortunately, Economic Trinitarianism is an empirically testable theory which few economists hold. Even Mr. Bernanke, I'm sure, would dispute it in theory. It is the application in practice where I believe he errs, and which is a growing impediment to US real sector recovery.

The creed of Economic Arianism, if you will, is aptly put by Mervyn King:

Perhaps the key difference between the world of Bretton Woods and the world today is the size and volatility of private capital flows. Then, as now, it was recognised that no system could ensure the compatibility of:

(i) Domestic monetary autonomy; (ii) Stable exchange rates; (iii) Free capital mobility.

This "impossible trinity" has been at the heart of the debate on the international monetary and financial system for many years. A sustainable system must sacrifice one of these three objectives

Notice Mr. King places no emphasis on "open and competitive FX markets." For him, FX market stability, such as results from an exchange rate "peg" or even, as Mr. King knows all too well from the Bank of England's attempt to maintain the value of the British Pound in the European Exchange Rate mechanism, simple intervention to support a currency when private sector flows are outgoing, is enough to reduce domestic monetary autonomy.

Mr. Bernanke engages in a bit of mental slight of (invisible) hand with his assertion that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets. This dogma disregards public sector efforts to support the US$, both domestically, such as occurs when the Fed buys US$s, or internationally, such as occurs when the ECB, Central Bank of China or SAMA (to name a few) intervene to stop their currencies from appreciating against the US$. Contra Mr. Bernanke, I argue, the US$ would be much lower if it was freely floating- its current stability debunks his premise.

Decades ago, when international capital flows were smaller, and the US economy (and Fed balance sheet) was much larger relative to the rest of the dollarized world (i.e. when Russian and Chinese capital markets were mainly closed and the emerging world's GDP was small) the effect of exchange rate pegs had much less effect on US monetary policy.

As Russian and Chinese capital markets opened and, in a sense, dollarized and as the third world developed their own capital markets, and domestic savings to invest therein, the effects of exchange rate pegs grew.

The Asian, Russian and LatAm crises of the late 90s were the first warning that the rest of the world was no longer the tail to the US's dog. The Fed was forced to accept easier money than it desired in 1998 (thus adding further fuel to to Tech Boom) or risk an even more severe contraction in Asian and Latin American markets. The tail of the developing world was starting to wag the US dog.

The rapid growth of the BRICs (Brazil, Russia, India and China) and Middle Eastern oil exporters has, in my view, as I've recently been arguing, reversed their position vis-a-vis the US. The rest of the world is the dog and the US is the tail.

The US$ is too small, if you will, to serve as anchor for the world. If we are to regain domestic monetary autonomy, and get the stimulus, currently in the form of increased financial sector recapitalization, flowing to the US real sector, the US$ must float freely- pegs must be cut.

The recent collapse of US real sector activity contrasts sharply with the more robust (albeit inflationary) growth apparent earlier in the year when the US$ was sinking and seems to me proof enough that Mr. Bernanke's faith (via his mental slight of (invisible) hand) in Economic Trinitarianism was misplaced.

As Mr. King argued in 2001: what is clear is that both in theory and practice there is now a recognition that pegged (fixed but adjustable) exchange rates do not provide a viable long-term middle course. More interesting, perhaps, is the absence of serious debate on the merits of the third position, namely the willingness to forego freedom of capital movements in order to retain domestic monetary autonomy and stable exchange rates. That is perhaps surprising in the light of the experience of the two major countries in Asia that escaped the financial crisis of 1997-98, namely India and China, which had in common the presence of capital controls.

Either the US$ floats freely, perhaps sinks would be more appropriate, or if the current US$ stability is desired, capital control are imposed if the US wants domestic monetary autonomy. If the latter option is chosen, US rates (due to capital restrictions into Treasuries) and inflation will rise rapidly and substantially, while the former course will extend and mitigate the transition.

Foreign Official inflows to US Treasuries are hindering what I believe to be a necessary shift in global manufacturing distribution (and goods production in general) given (despite recent declines) rising transportation costs and decades of US trade deficits.

Even Brad Setser is troubled by the rapid decline in US Treasury rates. Without faith in the stability of the US$, those rates would be much higher, i.e. the risk of such flows would be much more apparent.

Outsourced US manufacturing needs to return home (and, as my friend, James Howard Kunstler has long been arguing, become more regionalized, i.e. more widely distributed). A weak US$ seems to me a great tool to achieve this goal as it will both make US exports more attractive and increase the risk of holding US Treasuries, which in turn will make real sector investments more attractive.


STS said...

A nice play on the "trilemma" of monetary policy.

The word homoousian is actually Greek, as I'm sure you know but mistyped in haste. It has been many a long year since I read this passage from "The Decline and Fall", but Gibbon is memorable on this point:

"The Greek word, which was chosen to express this mysterious resemblance, bears so close an affinity to the orthodox symbol, that the profane of every age have derided the furious contests which the difference of a single diphthong excited between the Homoousians and the Homoiousians."

Here's a handy source for the text.

I wonder if the expression "not an iota of difference" ultimately stems from this wordplay.