The CERF Blog

Some countries do not follow Milton Friedman’s freely floating exchange rate advice (see my recent blog). Instead, they peg their currency to the U.S. dollar. Sometimes they have logical reasons for doing so.  Usually, this is because their financial markets and banking systems are not yet developed enough to allow the hedging needed by enterprises that face currency risk.  This includes China.  It makes sense for a country like China to wait on adopting a freely floating market determined exchange rate until their banking and financial system is ready.  Given that China is now almost the world’s second largest economy, I encourage China to speed-up implementation of a modern financial system.

 Given a peg, what is the correct of the level of the peg? In China’s case, there has been recent commentary from high level United States government officials that China’s peg-level is inappropriate.  There are two ways that China’s economy could adjust the peg to a level that would be appropriate to its critics.  One is through trade, where if China revalued their currency, their products would be more expensive and adjustment would occur.  This would require, however, a reduction in GDP growth, something the Chinese will not willingly do.  The other way that adjustment could occur would be if Chinese domestic demand increased.  Then, some Chinese products would more easily be sold internally, maintaining their GDP growth without requiring such a large trade surplus by decreasing their saving rate. 

 I support dialogue with China rather than accusations that, to China, will appear as meddling with an economic policy that has internal consequences.  The dialogue could include the peg-level as well as ways that China might approach stimulating domestic demand.  China will likely be more interested in the domestic demand discussions than the peg-level discussions, but dialogue keeps the door open for future discussions on any topic.  The Chinese household savings rate tends to be high.  Part of the reason for this is due to precautionary saving.  In China, there is relatively little in the way of social safety net programs like unemployment insurance, which induces precautionary saving.  Domestic demand discussions with China could include ideas for implementing unemployment insurance programs and other social safety net programs.  If China’s precautionary savings rate fell, domestic demand would increase.  They might just move that direction, and in that case we could still maintain dialogue with China on the peg-level issue.

It has been 57 years since Milton Friedman wrote his paper “The Case for Flexible Exchange Rates” where he argued that the benefits from a market economy and a free trade system would be enhanced by flexible exchange rates. This implied a freely floating dollar, whose value was to be determined by the buying and selling by participants responding to incentives and economic activity. At the time of his article, the dollar was pegged to Gold, in the Bretton Woods international monetary system. About twenty years after Professor Friedman’s article, the Bretton Woods international monetary system completely collapsed. Since then, the United States dollar has been a fiat currency, de-linked from a real asset like gold. While speculative activity can influence the value of the dollar, fundamental factors play a larger role in the long-run, including beliefs about the economic fundamentals of the country and perceptions of political stability.

A chart of the dollar’s value, measured in real terms, show that it has been remarkably stable since 1973. The freely floating dollar has not caused a financial crisis since then. This includes, which is highly noteworthy, the major financial upheaval that the United States just went through in 2008. I provide a second chart that shows the same data from January 2005 until now, and we see that from a low in March 2008 the real dollar rose to a recent high in March 2009. This period included the financial crisis. In fact, not only was the dollar stable during the crisis, it rose. Given the experience of the last 37 years, Mr. Friedman’s theory is a good one. I see no reason for the United States to pursue a “strong dollar” policy.  All that is needed are responsible short and long run economic policies.

The February United States jobs report sent the equity markets up this morning while respected commentators like Edmund Phelps, (Columbia, Economics Nobel in 2006), remark that they worry that the “recovery” might not have legs.

It always a bit odd to discuss growth that is less negative but that is the situation we are in as jobs have been falling since early 2008. The year-over-year job decline measure improved by 50 basis points, from a decline of three to percent in January to a decline of two and a half percent in February. This is indeed encouraging and continues a trend that started in September of 2009, where the year-over-year job declines have been moderating by at least 30 basis points per month. At the rate of February’s improvement, year-over-year jobs would begin to grow by August 2010. That is still quite a way off, and highlights that while the economy appears to be improving, it was a deep enough recession that robust job growth will not occur anytime soon.

The other indicators from today’s Employment Situation report include long-term unemployed at 6.3 million persons. February’s unemployment rate of 9.7 was unchanged from January. The seasonally-adjusted non-farm job change was a decline of 0.3 percent, or a loss of 36,000 jobs. Charts are included below.

Vince Reinhart released a fascinating piece on February 25, 2010. I highly recommend reading it in its entirety. Here, I’d like to talk about two paragraphs:

How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. Over the past one and a half years, the Fed has piled on securities with long maturities and exposed itself to credit risk. If it sold those assets, it would post considerable losses, deadly to the institution’s already fragile reputation in the current political climate. Instead, the Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.) This matters because two slots on the board are currently open, giving the White House an important opportunity to shape monetary policy through future nominations. Indeed, given natural turnover among governors, President Obama will probably be able to appoint a majority of the board in a single term of office.

In the first paragraph, Vince highlights the flipside of quantitative easing. The Fed bought a bunch of long-term financial assets, the value of which will go down when interest rates go up. Now, owning these assets is a constraint on Fed actions. There is already plenty of pressure to reduce the already-compromised “Fed independence.” Selling those assets at a loss will further increase pressure for more congressional oversight.

This means the Fed will control inflationary pressure by increasing the rate they pay on excess bank deposits at the Fed. That will work, but it will likely have a more negative impact on economic activity than traditional methods. With high risk-free yields at the Fed, banks, already under regulatory pressure, undercapitalized, and risk averse after the 2008 meltdown, will have no incentive to lend. Small business, which traditionally funded growth with bank loans, will have difficulty obtaining capital. Big business, with direct access to debt and equity markets, will have easier access.

Economic growth, therefore, will probably be slower than under traditional Fed tightening, and it will be biased toward big business. Small business, handicapped by an uneven playing field, will almost surely decline as a percentage of business activity.

The second paragraph is important, because it implies that Fed policy will become more political. Given current and projected United States debts levels, political pressure to monetarize the debt will be strong. As debt levels and interest rates increase, interest costs will soar, as will the pressure to inflate. Will a more politicized Fed resist that pressure? I wouldn’t bet on it.

Jeff isn’t buying any of this. He says:

It seems peculiar to me that the Fed would conduct its monetary policy with a major constraint being the effect on its own profitability. While it might be embarrassing to sell some securities at a loss, it would be even more embarrassing to have a portfolio like the thrifts in the 1980s: long-term fixed rate assets funded with short-term liabilities in a rising rate environment. That would look really stupid.

Good point. We’ll see.

A lot of people who watch trade flows think that the United States is making a mistake by losing its manufacturing activities to other countries. They recognize that other countries can provide some manufactured goods at lower cost than the United States, lowering costs for consumers, and they recognize that free trade levels the playing field, allowing less developed countries to share in world commerce. Many understand that if there are net flows of manufactured durables from the United States’ there is an offsetting net inflow of financial (monetary) investments into the United States. This is a simple artifact of balance of payments accounting.

I say manufactured durables because people also believe that the value of an economy is based on the production of manufactured durables. They understand that the economy includes nondurables manufacturing and services but they believe that these activities are somehow “fake” since they are non-durable.

The reality of economic activity is that it continually changes over time. Let us roll history back a few millennia. In most communities, agriculture was still improving to a higher than subsistence level, freeing up a portion of the population from work in the fields. It was only when some of the population could pursue other activities that education, knowledge and inventions began to occur. Later, of course, there was a large-scale industrialization process that occurred. Recently, the economy has undergone a transformation that implies more non-tangible activity, the information economy if you will. The recent intensification of non-tangible economic activity implies that there is value in this activity. Lots of value, just ask Google.

Non-tangibles are very important in the modern United States economy. These include, besides the internet and software: education, job-specific knowledge, primary research, technology adoption, and others.

As we become wealthier and move up Maslow’s hierarchy of needs, utility increasingly comes from less-tangible sources. This is ok.

Data released today reveal a United States economy that remains unsettled.

Mass Layoffs

The Bureau of Labor Statistics’ report shows a 2 percent uptick in January seasonally-adjusted mass layoffs from December. The jump in mass layoff initial claimants for unemployment insurance was even larger at 19 percent over December.

Gross Job Gains

This report, which describes gross job gains and losses rather than the net result of the two opposing forces, shows perhaps surprisingly that gross job gains rose in mid-2009. However, gross job losses fell and fell enough to force the net jobs held to fall. Gross job gains typically rise in recessions due to a turnover effect. Comparing this recession to the recession of 2001 shows that the level of gross job gains is lower thus far compared with mid-2001, which makes sense given that this is a deeper recession.

Consumer Confidence

The Conference Board’s measure of February’s consumer confidence fell to 46 from 56.5 in January and was lower than the consensus estimate of 55. The measure is at its lowest level in 10 months, which was when the economy was contracting rapidly, indicating that the comfort level of the household sector remains low.

Prices

The January Producer Price Index (PPI) data released yesterday February 18, appeared to show that price pressures were building up again with finished goods prices rising 4.6 percent over 12 months ago, and rising 1.4 percent over the prior month. The January Consumer Price Index (CPI) data, released today, showed that the all-items inflation measure subsided slightly from December’s 2.7 percent to 2.6 percent. The CORE measure, excluding the volatile food and energy components, was also down, from 1.8 in December to 1.6 percent in January. A chart of the CPI growth measures is included below.

Analysts sometimes see the PPI measure as a leading indicator of the CPI. This is truer for all-items CPI rather than core, since the PPI measure is more easily influenced by energy. So while the all-items inflation rate might grow in coming months, we do not expect that CORE inflation will be influenced much.

FED Policy

Yesterday, the FED announced that they have raised the discount rate from 0.50 to 0.75 percent. They indicated that “continued improvement in financial market conditions” allowed them this change in policy which is an attempt to “normalize” the Federal Reserve’s lending facilities. They noted that this change is not expected to lead to tighter financial conditions for households and businesses.

The FED has been gradually unwinding its extraordinary efforts to support the economy through the financial crises. Those extraordinary efforts have been underway since mid-2008, and the relatively long period of low-cost credit and bond-market support could bring inflation roaring to life. What has held inflation in check since mid-2008 has been the very weak economy.

We applaud these efforts, as long as the economy has indeed recovered from its illnesses, but we are concerned that it is premature. We are worried about ongoing problems in banking and real estate, and so we are worried about how healthy the patient really is. We hope that the FED is right – we hope the patient is truly getting better.

Today’s not-much-noticed Industrial Production data release showed that January’s Industrial Production was up a bit from December. This report also indicated that capacity utilization increased a bit in January from December. Notice, charts below, capacity utilization and industrial production have been improving for 6 months now. This is enough to indicate a trend, indicating that manufacturing and related sectors are slowly coming to back to life. The levels of these indicators are still low within a longer historical perspective; see the longer Industrial Production chart below. At the current rate of improvement, we might get to healthier levels by midyear.

I’ve seen lots of proposals on how to accelerate our economic recovery, but I haven’t seen any investment tax credit proposals. Maybe there are some out there, but I haven’t seen them.

The idea has merit, and now might be a good time to implement it. Business investment has been extraordinarily weak for a long time now. Businesses may be feeling the lack of investment, but they are unwilling to invest now, because of uncertainty about the recovery. A tax credit might be just what is needed to push some of them into investing. It would also encourage hiring. Capital and labor are compliments. More capital would improve the productivity of labor, reducing the cost of hiring.

Certainly, it would be better to run a deficit to fund investment than continue the existing program of funding current consumption with deficits. This policy would imply a higher steady-state level of future capital stock than with the current policy, with greater future productive capacity. The higher future capital stock means the economy would have more resources available for consumption, further investment, or (heaven forbid) paying down debt.

The Eurozone is a confederation of 16 European countries. When joining, countries abandon control of their currency to the European Central Bank, and they agree to significant constraints on their monetary policy.

Why would they do this? Countries join hoping to benefit from increased trade efficiency and access to markets. Are the benefits of joining the Eurozone worth the costs? That depends on how correlated a country’s economy is with the Eurozone economy.

If a country’s economy is highly correlated with the Eurozone economy, then that country will be happy with the European Central Bank’s monetary policy, and the fiscal constraints will likely be relatively minor irritants. However, if a country’s economy is not highly correlated with the Eurozone economy, the European Central Bank’s monetary policy could be counter-productive, and the constraints on fiscal policy can be painful. It can put a country in a bind.

That is exactly where countries such as Spain and Greece find themselves today, in a bind. If they could, these countries would follow a much more expansive monetary policy and an expansive fiscal policy. The price they pay for membership is higher unemployment, a slower-growing economy, and the potential for social unrest. For these countries, joining the Eurozone is starting to look like a deal with the devil. We may see some countries leave.