Thoughts on the G-20 given the so-called currency war

The heads of state of the world’s twenty largest economies are set to meet in Seoul, South Korea to discuss the global economy. The so-called currency war will be of particular interest during this session because of an escalation in rhetoric regarding trade and currency tensions. I don’t believe anything successful will be achieved at this meeting. Rather, the escalation of rhetoric is likely to continue unless we see a more robust economic outcome in the U.S. and western Europe.

Here’s the problem. The U.S. was particularly blameworthy for creating the financial crisis through two decades of easy money and anti-regulatory policies which allowed its financial sector to lever up, creating a credit bubble in the private sector. Every time there has been a crisis, the prescription has been the same, more cowbell – lower interest rates and liquidity in the form of purchasing Treasury securities. The result – predictably, for anyone watching debt stocks – has been a systemic crisis. In fact, the higher the private sector debt levels went, the more severe the crises became. The question for policy makers was how to respond in this particular crisis. The answer? More cowbell.

For most non-US observers, the policy mix of zero rates and quantitative easing is seen as exporting inflation in a bid to ‘steal growth’ by bidding up asset prices in the U.S. and abroad via a speculative move into risk assets.  The Fed Chair Ben Bernanke has admitted this is his aim, writing in the Washington Post this past week:

The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment.

Ben S. Bernanke – What the Fed did and why: supporting the recovery and sustaining price stability

Again, the explicit policy here is to lower rates and provide enough liquidity to convince market participants to buy stocks, to convince prospective homebuyers to pull the trigger, and to convince companies to make capital investments. Same as it ever was.

For you doom and gloomers, let’s remember that monetary stimulus can actually work for a very long time. Don’t underestimate the power of printing money.

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe. Knowing this shapes the psychology of economic forecasting and is why missing the turn is disastrous for one’s career. Efforts to avoid missing the turn are also part of a very large pro-cyclical psychological force underpinning a cyclical bull market.

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

Is economic boom around the corner?, Sep 2009

But we do know that it is exactly this policy mix which led to the financial sector’s systemic failure. I expect the same to re-occur when the fake recovery peters out. And that’s where the likes of Angela Merkel are going to attack the US. They are afraid of the consequences of the US policy mix. And they have accused the US of hypocrisy over exchange rates by pointing the finger at China and saying ‘that’s the bad guy’ when the US is clearly manipulating interest rates, financial investment flows and the exchange rate with it.

Now, a lot of US commentators favouring more quantitative easing have taken exception to various criticisms of Fed policy. They say the Fed isn’t printing money to begin with, ask what else the US could do with China manipulating its currency, or say that the greater risk is deflation so, with fiscal policy off the table, we should err on the side of more monetary stimulus rather than less. I find each of these arguments problematic. 

The part about QE not being money printing is pure semantics. Whether the ‘money’ ends up in consumers’ hands is another story altogether. It’s still money printing. If the Fed is going to print money to reflate the economy, a helicopter money drop would be preferable, since at least the pretence that no money printing is occurring would be off the table – and consumers would get the benefits of the printing. I got into a bit of this when I asked Does Ben Bernanke Believe The Stuff He Writes?

As for monetary policy, while QE does not create new net financial assets, it is money printing because it is a swap of bonds for electronic credits of equivalent value i.e. money. The Fed is effectively ‘monetizing’ the government’s debt…

And notice the hoops that the ‘independent’ Federal Reserve must jump through in order to monetize the government’s debt. They are forbidden from buying debt at auction. But they can buy it in the secondary market – only up to 35% per security issued. Again, these are all ‘artificial and imposed’ constraints to give the public the illusion that the Federal Reserve is independent authority and not a political organization which facilitates government in spending to its heart’s content.

In going with QE2, the Fed has done a few reckless things by ending this charade. First, the self-imposed 35% limit is now gone. Second, the Fed has openly admitted for the first time that it is targeting asset prices. This is a mistake because the ‘Audit the Fed’ movement is very much alive and well.  The Fed will come under much greater scrutiny going forward -rightfully so, I might add.

With Ron Paul in charge of Federal Reserve oversight in Congress expect the Fed to have a lot of political problems shortly.

The part about China is absolutely spurious. “China is cheating, so we should too.” It’s the moral equivalent of Carl Lewis saying, "Ben Johnson was doping and winning so I did too." No one in the US was complaining about the Chinese currency peg in 2007 or 2008 when the dollar was low compared to sterling or the euro. It’s hypocrisy, pure and simple. When the going gets tough, the US looks for someone else to blame when the reality is that they are looking to export their way out of a crisis created by the easy money they continue to supply.

From a purely political perspective, arguments for QE are counterproductive because it opens the US up to the kind of charges now being levelled by a multitude of policy makers from Brazil, Germany, China and elsewhere. So from a practical perspective QE doesn’t work either because it creates more tension rather than alleviating it.

My question is this: who is the leader that brings the world together and shows the fortitude to prevent this escalating to the next step of capital controls followed by tariffs. Is it Obama? Rousseff? Medvedev?  I just don’t see the scenario where this de-escalates. I’m having a tough time figuring out how this problem goes away. Perhaps a multi-year recovery and asset price boom will do the trick. In that scenario, emerging markets would outperform and productivity would increase, allowing the developing nations to handle the increased debt that their economic growth and turbo-charged asset markets would create. So, either the Fed successfully inflates asset prices, shifting some of the debt burdens abroad without retaliation or we are going to have serious problems.

Brazil: “The last time there was a series of competitive devaluations. . . it ended in world war two.”

How would the US accomplish this? Here’s a potential train of events.

  1. The FOMC buys an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August. This approach eases financial conditions as stock prices rise and long-term interest rates fall.
  2. Critically, the benefit occurs because of cheaper funding and a perception of a Bernanke put on risk-taking causing an increase in investment into riskier assets like emerging markets bonds, longer duration assets, financial commodity assets, stocks and high yield (all documented here in posts at Credit Writedowns). Within the US, speculative finance and higher beta investments benefit disproportionately.
  3. Economies leveraged to commodities or with high growth benefit from this flood of money more than the US. Countries with dollar pegs like Saudi Arabia or China may benefit even more because of a depreciating dollar. Their rate of growth increases and financial markets there boom. Some of this new wealth will be recycled into the US via purchases of US goods and services.
  4. The boom causes a leveraging up in emerging economies much as the housing boom in the U.S. promoted the accumulation of debt. 
  5. Tax revenue increases. With revenue increasing, government increases spending. The government of a country benefitting from this like Brazil or Saudi Arabia goes on a binge by buying US products like weapons or planes.
  6. If the emerging economies accept this flood of money without capital controls, the U.S. can effectively export inflation to emerging economies via the carry trade, reducing its debt burden in the meantime as debt loads in the emerging economies increase.

The preceding is the multi-year boom story that, while no longer my baseline because of problems in the U.S. and the euro zone, has a fairly high probability. If this occurs, we could see a boom – more in emerging markets than the US or Western Europe, but a boom nonetheless. What comes after the boom, then?

  1. jimh009 says

    Superb post, Edward.

    If the train of events you wrote about comes true, it seems that little of it will benefit the majority of Americans. Instead, it almost seems as if the lower/middle tiers of the US will be harmed by it due to higher commodity/asset prices and since people in the lower/middle tiers don’t have access to cheap money to “speculate” in the markets, particularly those abroad and in the commodity sphere. Or am I missing something?

    One question. If this isn’t your baseline scenario, what is? Considering how dreary the scenario you outlined is, I’m almost hesitant to ask about your baseline scenario!

    OK, second question. In the scenario you laid out, is $600 billion really enough to cause such a train of events in the world economy? In this day and age, $600 billion is, well…nothing.

    1. Edward Harrison says

      My baseline is a double dip – or what I call a Shiller double dip:

  2. jimh009 says

    Also, realized I had yet another question I forgot to ask.

    > If the emerging economies accept this flood of money without capital controls, the U.S. can effectively export inflation to emerging economies via the carry trade, reducing its debt burden in the meantime as debt loads in the emerging economies increase.

    OK. I understand the part about exporting inflation. But how does that reduce the internal debt load of the United States. If other countries take on more debt and become more leveraged (both in the governmental and private sphere), I have a hard time seeing how that automatically will lead to lower debts here in the US. Isn’t inflation needed here in the US to effectively “whittle down” the value of US debt over time?

    1. Edward Harrison says

      I was really thinking more in terms of relative debt as a percentage of GDP. The US had been the engine of global growth via excess consumption and an increase in private sector debt loads. That growth engine will be located more firmly in the BRICs and other emerging markets. The result is that the debt loads there will increase much more quickly – much of this due to liquidity coming from the west. So I am also still sceptical whether the US can reduce its absolute debt burden or even its burden relative to GDP (especially if we see a more austere future there). But the burden relative to the debt burden in emerging markets is likely to shrink as a direct result of liquidity from the west. Only if we see capital controls can this be stopped.

  3. DavidLazarusUK says

    Capital controls will come, and I think that they may become permanent as way of stopping countries with loose monetary policy flooding its markets with cheap money. Cheap money has not helped the US. It is addicted to cheap money. All it does is lead to speculation as the rewards outweigh the risks. With higher interest rates businesses will actually invest properly because they need better quality income to cover the interest bill. It is the short term attitude of Wall Street that has lead main street businesses to think short term and fail to invest properly.

    1. Edward Harrison says

      It is interesting that the BoE has decided against QE for now. They will hold off with the backlash against the US brewing, leaving the Americans to take all of the criticism. Smart move given the fact that the BoE seemed to prepping for QE before this all started.

      1. DavidLazarusUK says

        QE does not work when people are de-leveraging. It might be better to simply use QE to take all new gilts and effectively cover the deficit until the economy is growing again and then slowly exit the market. That way the government does not have to be so savage with its austerity program. That will reduce the impact of the austerity and keep growth higher.

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