Yves here. This post is a devastating critique of current Fed policy. But Alford sets his stage carefully before delivering his conclusions, so don’t be deceived by the tone of the early sections.
By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side
In the last two years, some economists and even current policymakers have acknowledged that interest rate policy and financial stability are connected. They’ve also admitted external factors can have have a significant impact on US economic performance. However, economic policy itself still ignores these issues. Today, US monetary policy is based on a very narrow interpretation of the Fed’s legal mandate. The central bank pursues price stability and full employment without considering possible negative feedback loops via the financial markets or from abroad.
Policymakers Admit Financial Stability Matters to Monetary Policy, but…
More and more economists recognize that monetary policy plays a role in financial fragility and crisis. Yet, most Fed officials have failed to acknowledge the contribution of US monetary policy to the financial crisis of 2007. They also deny the possibility that policy since the crisis could be stoking financial vulnerability in the US and/or abroad.
In a recent op-ed piece, Adair Turner, former Chairman of the UK’s Financial Services Authority, discussed how accelerated rates of credit creation affects economic growth and economic and financial stability:
In fact, much credit growth is not critical to economic growth, because it does not play a direct role in financing consumption or investment. Economics textbooks often describe how households deposit money in banks, which lend to businesses to finance capital investment…– this story is largely fictional, because such lending accounts for only a small share of the total.
Instead, a large part of bank lending finances the purchase of existing assets, particularly commercial or residential real estate, the prices of which primarily reflect the value of the underlying land. Such existing-asset finance does not directly stimulate investment or consumption. But it does drive up asset prices, causing lenders and borrowers to believe that even more credit growth is both safe and desirable.
Lending to finance existing assets, primarily in real-estate markets, can thus play an asymmetric role in the real economy. While it has little impact on demand, output, and prices during the boom, it results in debt overhang, deleveraging, and depressed demand in the post-crisis period.
These observations are consistent with both the idea that monetary policy affects financial stability and with US monetary policy having contributed to the financial crisis of 2007. They also suggest an unfavorable trade-off: growth accelerates in economic growth during a long-lived, credit-driven boom but suffers in the subsequent bust due to deleveraging and depressed demand.
Paul Tucker, former Deputy Governor for Financial Stability at the BOE and currently a Senior Fellow at both the Harvard Kennedy and Business Schools, recently gave a speech directed at least in part at US policymakers. While the subject of the speech was macroprudential policy, capital controls and the international monetary system since the crisis of 2007, he made a number of observations pertinent to the analysis of the role of US policy in the run-up to the crisis. He also highlighted the international dimension of both the crises and the policy response:
The 2007/08 financial and economic crisis prompted a large and obviously overdue overhaul of an international economic system that had proved fatally frail. The official sector set up two programmes. One, entrusted to the Financial Stability Board, was to overhaul the rules of the game for the financial system itself….
The other was to reform the International Monetary System (IMS) itself, whose flaws had led to unsustainable global macroeconomic imbalances…
In focusing on the shortcomings of the global policy response, Tucker went on to repeat the point made by then Secretary of State Schultz in 1972 that surplus countries are unwilling to adjust policies to reduce global imbalances:
The collective reforms of the financial system have made good progress, while the top-down efforts on the IMS got nowhere slowly. That is basically because G-20 officials got stuck on the inevitable issue of how to get to a world of more symmetric adjustment to cumulative current account deficits. Guess what, the surplus countries didn’t want to play ball.
While Tucker, highlighted the role of surplus countries in the trade imbalances and the resulting net capital flows prior to and post the crisis, this does not relieve the US of a share of the responsibility for the crisis, as it ran a policy mix, including stimulative monetary policy, that encouraged the growth of the global imbalances. Both the US and its trading surplus counterparties were willing partners in a dance that could not end well. Policymakers in all countries failed to address the imbalances.
Tucker also devoted a healthy portion of the speech to the role of gross financial flows. While the net international capital flows offset trade deficits, the gross capital flows also reflected the financing and purchase/sale of financial assets, e.g., purchase of US MBS funded by the sale of short-term dollar- denominated securities by non-US based market participants. He presents the argument in terms of gross flows to EMEs as wells as to developed countries:
For anyone familiar with financial markets, a prevalent trading strategy and a key mechanism behind short-term price developments has long been the cross-border, cross-currency carry trade. But until recently, this was frequently met with disbelief in official circles — because how could anyone bet rationally against uncovered interest parity (sic) — and neglected amongst academic macroeconomists. That myopia impoverished debates about the IMS…
Reinforcing a point made by Borio and Disyatat in 2011, Tucker places the gross capital flows at the center of international financial disruption post-Lehman:
The common thread is a vulnerable, fragile liability structure in part of the national balance sheet…
The importance of the pattern of gross capital flows and of the structure of the national balance sheet should not get lost again…
Time and again policymakers have had to be reminded that gross capital flows matter as well as net flows. (Editor’s note: Could Tucker be gently chiding US policymakers who repeatedly cited the net flows arising from the Asian “savings glut”, but never cited gross capital flows when discussing interest rates and quality spreads in the US capital markets?) In the 1990s Asian crisis, the sectors under pressure varied according to who had borrowed short term in foreign currencies in external markets…. In the early stages of the current crisis, for example, Euro Area (EA) central banks borrowed dollars from the Fed to on-lend to needy local banks, even though the current account position of the currency-area as a whole was broadly balanced. The dollars were lent as the vulnerabilities in Europe would otherwise have flowed back violently to the US, just as the US subprime crisis had spilled over to Europe in the first place. The balance sheet weaknesses were intertwined…
US Policymakers Still Set Policy As If the US Were a Closed Economy
Federal Reserve Bank of New York President Dudley recently gave a speech in which he acknowledged that US economic policy, specifically monetary policy, can affect the financial markets and economies of other countries, especially emerging market economies:
“…Changes in Fed policy, and especially moves in the past to tighten monetary policy, have often created challenges for emerging market economies (EMEs)… given the role of the dollar as the global reserve currency, the Federal Reserve has a special responsibility to manage policy in a way that helps promote global financial stability.
…Like other central banks, our monetary policy mandate is domestic. But, our actions often have global implications that feed back into the U.S. economy, and we need to always keep this in mind. We also need to be careful not to underestimate the consequences of our actions… when all of the indirect channels of feedback are aggregated properly—which admittedly is difficult to do—the effects may be considerably larger. My point is that we tend to underestimate these feedback effects. “
We are mindful of the global effects of Fed policy. Promoting growth and stability in the U.S., I believe, is the most important contribution we can make to growth and stability worldwide.… The fundamental issue is whether U.S. monetary policy has helped support our dual objectives of stable prices and maximum sustainable growth and whether this is consistent with a healthy global economy….
Federal Reserve Bank of Dallas President Richard Fisher gave a similar speech that was reported in the WSJ Blog, “Real Time Economics,” January 31, 2014. The blog provided some background and excerpts from Fisher’s speech:
The Fed’s decision came amid heavy turbulence in emerging markets. There, the reality of reduced Fed stimulus and an end to bond buying some time later this year, is causing severe market volatility. The stress has been great enough some market participants have argued the Fed should refrain from further cuts in stimulus so as to help calm these markets and reduce the chance their woes will inflect the U.S. financial system.
Mr. Fisher observed “some believe we are the central bank of the world and should conduct policy accordingly.” But that’s not true: “We are the central bank of America” and need to pursue actions that promote the mission Congress has charged the Fed with, he said.
Other nations have their own central banks that have “their own responsibilities,” the official said. Mr. Fisher added “we try to help each other” but “we are mandated to meet certain standards Congress gives us.” Other nations “have to figure out” how to deal with their own issues, he said.
These comments suggest that Fisher sees a dichotomy. Either the Fed sets policy as if US economic performance is entirely driven by domestic economic developments, or it violates its mandate. The dichotomy is a false one. As Dudley pointed out, the US is not a closed economy. Any US economic policy that does not reflect possible interactions and feedback loops between the US and the rest of the world is unlikely to deliver sustained price stability or full employment in the US.
However, the tone of Dudley’s speech and the absence of any objections from FOMC members to Fisher’s speech imply that the FOMC would see any Fed involvement in an internationally coordinated policy effort aimed at reducing the global imbalances as a violation of its mandate. (This assumes that the coordination would entail monetary policy that tolerated larger deviations from the inflation and employment target implied by a policy that focused exclusively on those targets.) In fact, Dudley’s and Fisher’s speeches can be viewed as a restatement of the view expressed by the FOMC in June of 2004 when, despite acknowledging the existence of an unsustainable current account deficit it said:
Monetary policy was not well equipped to promote the adjustment of external imbalances, but could best contribute to maintaining an environment of price stability that would foster maximum sustainable economic growth.
There is a shortcoming inherent in the FOMC’s position both in 2004 and presumably today, given Dudley’s and Fisher’s remarks. The FOMC is correct in that monetary policy is an inappropriate tool to promote the adjustment of an external imbalance. However, if sustainable growth is a goal and an external imbalance is unsustainable, then it is also inappropriate to set monetary policy as if the external balance does not exist or is being addressed by some other policy.
The US domestic-only policy focus raises an additional hurdle for international policy cooperation. The focus gives license to countries with trade surpluses to refuse to alter their policy mix to reduce their surpluses. Why should they change their chosen policy mix and miss hitting their domestic targets at the request of the US (and other trade deficit countries) if the Fed and the US will not alter policy and sacrifice hitting their domestic targets?
The US and other trade deficit countries have long complained about the asymmetric burden of adjustment to correct global imbalances. However, Fisher’s position, and presumably the position of the majority of the FOMC, is extreme. His comments suggest that he would not be satisfied even if the asymmetry was removed. His statement indicates that in order to satisfy him, the asymmetry would have to be reversed with all the burden of adjustment falling entirely on the surplus countries. Given history, this position renders any effort at global cooperation a non-starter and suggests that there will be no policy on anyone’s part to address global economic imbalances.
Trade deficit countries also have reason to object to this position. Reserve currency status has often been referred to as the “exorbitant privilege,” as it confers a host of benefits, e.g., lower interest rates and a greater degree of freedom to pursue domestic policy objectives, as well as generally lower volatility in the exchange rate and inflation. Fisher’s positions suggest that the Fed and the US still look upon the reserve currency status of the Dollar as a “free lunch”, i.e., benefits with no attendant policy constraints or responsibilities. Other countries may have reasonably assumed that the reserve currency status implied some obligation on the part of the US to set policy in a manner that is consistent with US external balance and that does not undermine global financial stability.
The speeches and the FOMC’s comment in 2004, reveal exactly how far the Fed has come since 1967 when then Chairman Martin gave his “International Responsibilities of the Federal Reserve” speech at the Guildhall in London. Fisher’s comments, in particular suggest that the Fed, as the bank of issue of the world’s reserve and principle trade financing currency, bears no responsibility to consider global economic or financial stability in the setting of policy. The most disturbing aspect is that Mr. Fisher totally ignores Mr. Martin’s point: it is in the interest of the US to set policy consistent with global economic stability, not because of altruism, but because global economic stability is in the long-run self interest of the US.
Should the Fed now refrain from setting policy that reduces US and global financial riskiness because it causes dislocation in some markets? No. However, the Fed, the US and the global economy would not be in the position that they are in had the Fed not set policy prior to 2007 as if the US were a closed economy and had considered the implications of the announced low-for-long policy stance for domestic and global financial stability.
Given the closed economy mentality, it is not surprising that US policymakers have also failed to learn from the experiences of other countries. In 2002, Bernanke said the US would avoid a Japan-like crisis and lost decades with slow growth and elevated rates of unemployment. However, since 2006 the US has experienced a financial crisis, a severe recession and an unsatisfactorily slow recovery. While the US and Japanese economic policy responses have not been identical, they have been very similar.
After two decades of failed counter-cyclical stimulative monetary and fiscal policy, policymakers in Japan have called for a policy mix that has been dubbed the “three arrows,” i.e., stimulative monetary, expansionary fiscal policy, and a laundry list of growth supporting structural reforms (including an as yet failed effort to stimulate exports).
In contrast to the “three arrows’ approach in Japan and despite Bernanke’s statement in July of 2011 that monetary policy is no panacea, Fed policymakers are still acting as if monetary policy is a panacea. The Fed is still setting policy with an eye to promoting a satisfactory monetary policy induced sustained recovery even though there are no proposed structural reforms to speak of, e.g., no trade, Dollar or competitiveness policies, and with fiscal policy largely a captive of inherited levels of debt and political paralysis.
Policy and the Dual Mandate
The recent comments made by Dudley acknowledge that international considerations and financial stability concerns should enter the policy calculus. However, he and Fisher argue that a successful focus on the Fed’s dual mandate is the best contribution that the Fed can make to global economic and financial stability.
The problem with that position should be obvious. The Fed succeeded in achieving price stability and full employment in the years just prior to the financial crisis of 2007, but policy also encouraged unsustainabilities and fragilities, including:
• the growth of the unsustainably large trade deficit,
• the dependence of growth on housing price appreciation to drive consumption and residential real estate investment,
• the growth of debt relative to GDP,
• the increased and use of leverage and maturity mismatches by financial institutions and households, and
• the reaching for yield by investors
that in turn brought on the crisis and recession.
If post 2000, the Fed had interpreted its mandate to require it to set policy based on:
1. The premise that the US is an open economy and that large external imbalances are inconsistent with sustainable growth (The US trade deficit in 2006 was 5.5% of GDP);
2. A goal of promoting a sustainable pattern of demand i.e. final sale to domestic purchasers equal to estimated potential output (with trade and Dollar policy responsible for external balance – hence the equating of aggregate demand with final sales to domestic purchasers); and
3. The recognition that interest rate policy has implications for financial stability,
then:
1. Other US policymakers would have had greater incentive to address the global trade imbalances via trade, competitiveness and exchange rate adjustments;
2. Both the trade deficit and the net capital flows would have been smaller;
3. The higher short-term Dollar interest rates would have reduced investors’ willingness to reach for yield by investing in lower-quality assets classes;
4. The interest rate stance would have reduced the incentive for US financial institutions (regulated and non-regulated) to leverage up and run maturity mismatches;
5. The interest rate stance would have reduced the incentive for non-US financial institutions to run maturity mismatches in Dollar markets;
6. The interest rate stance would have reduced the incentive for financial institutions to use short-dated Dollar borrowings to fund longer-dated position in non-Dollar asset markets.
As a result, the real global economic imbalances, as well as the net and gross capital flows would have been smaller. Financial fragility would have been less. There would have been costs. Unemployment would have been higher in the US and growth would have been slower during the expansion, but, at a minimum, the crisis and recession would not have been nearly as deep or as intractable, if not avoided entirely.
The crisis and recession of 2007 is not the only example of financial crises and recessions that followed periods of price stability and low inflation rates. The “lost decades” in Japan followed a period of stable growth with low inflation and unemployment. The Great Depression in the US followed a period of strong growth and low inflation.
History aside, the continued adherence to the narrow interpretation of the Fed’s dual mandate is not without risks. The current policy mix is again promoting the same unsustainable pattern of demand as existed prior to the crisis of 2007, i.e., 1) high levels of consumption relative to income (a low savings rate), and 2) investment in the housing sector, while real non-residential investment remains subdued, as well as 3)the reaching for yield by investors.
Furthermore, the trade deficit, while a smaller fraction of GDP than in 2006, is still unsustainable and at a minimum is a significant fraction of estimates of the US output gap. According to the BEA, the trade deficit in 2013 was 3.0% of GDP. In a brief piece published in February of 2014, Weidner and Williams updated the results of their 2009 piece: “How Big Is the Output Gap?” It presented seven estimates of the output gap, all of which employ different methodologies and data sources. The update reflects new and revised estimates. The estimates of the output gaps (as a % of GDP) for 2013Q4 are:
CBO output-based -3.8
Laubach-Williams 0.1
Capacity utilization -2.1
CBO unemployment–based -2.5
Job market perceptions -3.0
Business survey -1.3
Job vacancies -1.0
Hence, the trade deficit, as reported by the BEA, is in most cases larger than the output gap (ignoring the negative signs) and at least 75% of the estimated output gaps as reported by Weidner and Williams. Even if one assumes a larger output gap, the trade deficit will remain a substantial fraction of it. Yet any effort to correct the trade deficit is conspicuous in its absence.
The FOMC is setting monetary policy as if the output gap were solely a reflection of a deficiency in domestic animal spirits. Policy remains focused on promoting demand, i.e., offsetting the unsustainable trade deficit by further encouraging the growth of consumption relative to GDP. This is despite the fact that consumption is already well above historical norms as a fraction of GDP. Furthermore, the almost exclusive reliance on monetary policy implies that asset prices, quality spreads, and the use of leverage are approaching levels last seen just before the crisis of 2007.
Policy has not evolved in light of the crisis of 2007 and the recession. Fed policymakers continue to adhere to a narrow and myopic interpretation of the dual mandate. This interpretation allows policy to 1) encourage domestic and global financial instability, and 2) to promote unsustainable patterns of demand and growth.
Policy did not solve a problem during the Great Moderation, but rather traded a then-current problem for a future problem. There is a risk that it is doing it again. In the absence of effective regulatory, Dollar and competitiveness policies, the US will experience crises in the future if, Fed policy only reflects international considerations and financial stability concerns at times of crisis.
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The other was to reform the International Monetary System (IMS) itself, whose flaws had led to unsustainable global macroeconomic imbalances…
There’s no such thing as a global macroeconomic imbalance. Every surplus is balanced by a deficit and every deficit by a surplus. It sounds like Turner is engaged in scapegoating of “them dirty ferners” in an effort to exonerate our own gentle, friendly policy elites.
As for Alford, I’m not sure what he means by trade deficits being unsustainable; he doesn’t bother to tell us why this is other than to obliquely suggest it’s responsible for our currently insufficient effective demand. But then we read the next sentence:
In the absence of effective regulatory, Dollar and competitiveness policies, the US will experience crises in the future
“Competitiveness” is always always always code for “American workers have it too good.” So it appears to me Alford is in favor of both weakening the dollar and a simultaneous internal devaluation for the U.S. This is of course incoherent, as an internal devaluation via austerity will actually strengthen the dollar and reduce competitiveness.
The global macro-economy does not function as a global balance sheet.
Global macro-economic imbalances are real and functions as one nation’s ‘economic whatever’ balances being systemically and substantially out of whack with another nation’s balances of same…… the result of which is the inability of the deficient nation to achieve its macro-economic objectives. Laissez-faire money policies always lead to these imbalances. as they are domestically-oriented based on the nature of governmental and central bank money system operations.
This ain’t about functional finance, which is a single-nation economic analysis construct, where the design of the functional economic sectors GUARANTEES that the sum of the sectoral balances equals zero just because one sector’s surplus must be the other sector’s deficit.
May I suggest a subscription to the central bank research hub, and a query to the work done on global systemic imbalances for a more clear understanding of this very real phenom. .
There cannot be an imbalance in a closed economy, which the planet as a whole certainly is. Just as there cannot be a global savings glut.
Accounting applies to all transactions.
That’s not what “imbalance” means in this context Ben. Obviously the idealized universal balance sheet balances. But that doesn’t mean that it isn’t possible for there to be an imbalance in the distribution of assets. If everybody in America owed $100,000 to Bill Gates, and those were all of Bill Gates’s financial assets, then the sum of those liabilities exactly equals the sum of Bill Gates’s assets. But clearly the economic situation is unbalanced and financially fragile.
o/t to Dan Kervick: Did you leave a comment here recently where you were angry and said gift economies didn’t work? I’m actually trying to refer to it now in reference to trying to understand what “sharing economy” actually means, but can’t find it. What am I thinking of? I am so hazy. Thanks.
(I’m in the Links diary looking at this link: http://www.shareable.net/blog/comprehensive-disobedience-occupying-the-sharing-economy-in-spain)
That sounds like something I would have said, but I can’t remember when I said it.
My question is whether what the Comprehensive Disobedients in Spain are calling “sharing economy” is the same thing that Uber is. They have a whole list of ways they are trying to bypass govt/financial intermediaries, and words “sharing economy” and “gift economy” are used — but isn’t Uber and its algorithm all about being the middleman, and isn’t Uber called “sharing economy” too? I am easily confused.
I guess i’m lost. What does Uber have to do with sharing?
Uber, Airbnb etc being examples of new peer-to-peer sharing economy — wikipedia footnotes to Salon criticism.
http://en.wikipedia.org/wiki/Sharing_economy#Criticism_and_controversies
Maybe this is a Michael Hudson MMT question, I also remember he made a comment recently about the problem of figuring out how to delineate/encourage work-based money instead of financier-based stuff — which I also can’t remember exactly, but that’s what I’m hazily groping toward. Is Spain figuring out a way to do it or are they being fooled, or is “sharing economy” being used to name two very different things? (Who’s on first?)
Dan, then what is the imbalance? China imports X value of U.S. currency and the U.S. imports Chinese goods of precisely the same value. How does this result in an unsustainable relationship, and why would it be better for the U.S. to import a quantity of yuan equal to the quantity of our currency which China imports?
In that case it might not be unsustainable. It all depends on how long people are around the world are willing to accumulate and hold surplus dollars as a reserve currency. In Europe on the other hand, with a single currency, countries can’t go on indefinitely consuming more imports from their neighbors than they are are producing for them for export.
I’m just saying that when people talk about various kinds of imbalances – trade, capital flows, credit – they don’t mean that there is an accounting imbalance on a balance sheet. They are talking about some kind of flow that is unsustainable.
Right, Dan Kervick.
Perhaps some see the 99 Percent versus the One Percent results as not being an “imbalance” just because the Ninety Percent’s debts are ‘balanced’ (perfectly) by the One Percent’s financial assets……….. but to some of us, that is an oligarchic created imbalance of society’s wealth and income production within our domestic economy.
You’re quite right Ben. “Imbalance” means next to nothing at all. (Imbalances? What Imbalances?) Of course they are “unsustainable” – everything under and including the sun is unsustainable. No particular reason that things people call unsustainable are particularly unsustainable though. Like trade deficits etc. Functional finance is not “a single-nation economic analysis construct”. It is just that if one looks at things properly, the closed economy/single nation analysis requires “little or no modification” for the open economy case (Abba Lerner Economics of Employment, from memory). Open economies are special cases of closed economies, not just vice versa. Keynes, eventually convinced by Lerner, presciently saw that Lerner’s deceptively simple and lucid thought would be not really be understood at first, and it still is not. Cf Keynes own anticipations – his National Self-Sufficiency essay in The Nation and his calling FDR’s torpedoing of the 1933 London conference “magnificently right”.
Almost always, calls for a nation to shoulder international economic responsibilities above national ones, calls for concerted action are calls to sacrifice the nation’s people on the altar of the insatiable greed and hunger for power of international banksters and comprador elites. Except for ceasing its own destabilization, and carrying out the regulatory responsibilities it ignores, as does this article, the Fed cannot do much for price stability or against unemployment. Which is why its Chairman is built up as the Wizard of Oz. But if what little they can do lowers domestic unemployment – good for them. It was a good deed that fostered financial stability and other nations’ prosperity, not the reverse. What really mattered was the abandonment of full employment and rational thought in economics decades ago, which made crisis inevitable, irrespective of Fed monetary manipulations for good or ill.
Can you please cite which Chapter in Lerner’s Economics of Employment to prove how ‘functional finance’ has any relevance toward solving global imbalances…..except through a tangential contagion. Thanks.
For sure, high employment, stable purchasing power and reducing the output gap in any nation will spillover positively towards other economies.
But the external sector in FF is merely an identity of the current account balances of the total national economic accounts.
FF is relevant to every nation, as a nation, but I have never seen it being applied towards inter-governmental accounting relationships
The essence of its constructs are to empower national government(the state) towards understanding the sectoral relationships in order use all their tools for resolving economic issues, and , as yet, there is no international government that could be applying FF tenets to relationships outside national economic boundaries.
Or, none that I am aware of.
The two last chapters of Lerner’s Economics of Employment are on international economics. (There might be a conclusion after them; I don’t have the book at hand.) They’re among the best things he ever wrote, the best MMT analysis of international economics.
has any relevance toward solving global imbalances The whole point is as Wray says – “Imbalance, what imbalance? Questions, problems are always assumed to exist, alluded to – but never stated. Just nudge, nudge – “what you mean you don’t see the problem?”. But there isn’t really any problem.
Lerner goes into the case of a trade deficit – like today’s USA – the surplus nation example given is France, and he describes the situation as a “hostile gift”. The upshot is – always apply functional finance, as if France were just some domestic France, Inc. All the crazy arguments for obsessing about fx and the like apply equally to a domestic company running a company town and using company scrip. But in that case we see that they are crazy arguments to enrich the company’s banksters.
Contrary to Alford, and perhaps our esteemed hostess, who says: he’s arguing that the Fed can’t keep running monetary policy as if the US is a closed economy.:
The Fed can & should run monetary policy as if the US is a closed economy. The MMT recommendation – according to Mosler also supported by the first Council of Economic Advisers, back when economists knew some economics – is to have a low (or zero) interest rate schedule – and fix it there forever.) Not much to run then.
For sure, high employment, stable purchasing power and reducing the output gap in any nation will spillover positively towards other economies. Right. You’re quoting Lerner almost. The point is that this is not tangential, but essential. That monetary policy should substantially weigh nondomestic considerations is to obsess about “tangential contagions.”
as yet, there is no international government that could be applying FF tenets to relationships outside national economic boundaries.
Relationships outside national boundaries are either entirely outside (rest of world =ROW to itself) , or have one end inside national boundaries.(Country to ROW) . The country can’t really do anything about the first, and concerning the second, it is in control of one end, and therefore exerts control on the rest of the world. Is “an international government”. If it has some monopoly power over exports or monopsony power over imports, it can exert that if it wants to be a tough guy. Lerner’s earlier Economics of Control goes into that in detail.
The whole point is as Wray says – “Imbalance, what imbalance? Questions, problems are always assumed to exist, alluded to – but never stated. Just nudge, nudge – “what you mean you don’t see the problem?”. But there isn’t really any problem.
Right, never stated. As if one so indifferent to evidence would ever trouble himself to check:
Our system is engineered to generate unpayable debt through the math of compound interest. The liabilities are ever so real; the counterparty’s assets must at some point be marked to market, his own liabilities repudiated domino-style in turn.
We in the Soddy camp recognize that debt is autonomic. Assets and liabilities do not balance in the aggregate, as they do on planet MMT. That’s a matter of math, not maldistribution.
To put it another way: add all deficits and surpluses in a particular category together and they will sum to zero. Even across a planet.
Well sure. But suppose the US decide to put $10 billion dollars worth of capital equipment on tankers every day, ship it to Asia and unload it there for free. And it did that day after day after day. Every day the US supply of capital decreases by $10 billion and the rest of the world’s supply increases by $10 billion. The global accounting sheet shows no net change in capital stock, since the changes here sum to zero. But clearly this would be an unsustainable practice based on an unbalanced flow of real wealth, and a disaster for the US.
Putting all the blame for so-called trade imbalances on the Fed sure seems a bit exaggerated.
Europe – with a output gap even higher than the U.S. – would be well-advised to stimulate its economy by abandoning “austerity”. That would lead to higher imports from the U.S. and thus help to reduce America’s foreign deficit.
Europe’s current account surplus is the mirror image of the U.S. deficit. The Treasury Secretary’s recent criticisms of European (especially German) mercantilist policies were right on target. It’s a pity that the author of this piece simply ignores this side of the story.
This is one of those alternate universe interpretations where the Fed is not an engine of kleptocracy and monetary policy is not about looting.
There are things about this post that baffle me. For the dollar to be the world’s reserve currency, the US must run sizable, ongoing trade deficits. Yet Alford says these trade deficits are unsustainable and should be reversed. It really doesn’t say how this would affect the dollar’s reserve status.
Alford focuses on the Fed’s dual mandate of price stability and full employment. For those interested this is how the 1977 amendment to the Federal Reserve Act containing the dual mandate runs:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
Now full employment has never been a goal of the Fed and indeed shortly after this amendment, the Fed under Volcker began its 35 year effort at wage suppression by treating wage increases as inherently inflationary and to be combatted by higher interest rates. This war on labor resulted in major transfers of wealth to the rich and facilitated the cash flows Alford is describing. So what is Alford’s proposal? to raise interest rates which would again suppress wages and which even he admits would result in higher unemployment. And there we have it. To achieve full employment we must tolerate higher unemployment. To reverse cash flows we must pursue the same wage suppressing, wealth transferring interest rates which created them.
Looking on all this as looting is a lot more straightforward and avoids the contradictions.
‘So what is Alford’s proposal?’
Can’t quite make it out, but his premises are clear: (1) the dual mandate is a tenable basis for monetary policy; and (2) experts with PhDs can successfully implement it.
Basically Alford applies a seemly veneer of science and technocracy to central planners who are making it up as they go along … and screwing up on an epic scale.
In the Church of the Economists this passes for an earnest homily. But to lay listeners, it’s unintelligible. That’s because it’s pseudo-scientific gibberish.
Thanks.
There needs to be a giant plaque over the doors of both the Eccles Building and 33 Liberty that announces:
“”REMEMBER, we’re making this up as we go along.””
No, Jim, Alford explicitly questions to adequacy of the dual mandate:
However, he and Fisher argue that a successful focus on the Fed’s dual mandate is the best contribution that the Fed can make to global economic and financial stability.
The problem with that position should be obvious. The Fed succeeded in achieving price stability and full employment in the years just prior to the financial crisis of 2007, but policy also encouraged unsustainabilities and fragilities, including:
• the growth of the unsustainably large trade deficit,
• the dependence of growth on housing price appreciation to drive consumption and residential real estate investment,
• the growth of debt relative to GDP,
• the increased and use of leverage and maturity mismatches by financial institutions and households, and
• the reaching for yield by investors
that in turn brought on the crisis and recession.
What Alford is describing so vaguely there is the housing bubble and even more vaguely the derivatives and CDS bubble behind that.
But the thing is the economy wasn’t at full employment in 2006-2007. The participation rate averaged 66.1% during this 24 month period down from its high of 67.3% in the first quarter of 2000.
The unemployment rate varied between 3.8-4.1% in 2000 and between 4.4-5.0% in 2007.
The December 2006-December 2007 change in the CPI-U was 4.1% whereas the previous Dec. to Dec. change was 2.5%.
So I am not real sure with where Alford is coming up with his assertion that prices were stable and employment was at its maximum in the timeframe he is referencing.
I agree. Alford questions the adequacy of the dual mandate – and proposes to add considerations/exceptions/new mandates for global stability and future stability. These new mandates would weaken the dual mandate considerably. The Fed could justify almost anything action it takes.
But rather than simply add to the current dual mandate, it would be logical for the Fed to attempt to formally change its current mandate – especially by eliminating the employment mandate which they have complained about in the past and which provides fodder for ‘populist’ politicians.
Alford neatly glides past the fact that in the run-up to the 2008 GFC the Fed failed to take protective action like:
1) raising rates when housing was clearly in a bubble;
2) cracking down on lax underwriting standards and fraudulent valuations;
3) reigning in speculative behavior and the growth of shadow banking.
See more in my comments below.
And, of course, we now know that all of these Fed failings were preventable. Fed researchers did spot the bubble. The Fed had the legal authority and the resources they needed.
Hugh,
Spot on. Very good points.
The key to the Fed’s ‘money mandate’ is not the goals, whether full or maximum employment, stable purchasing power and accommodative interest rates, but rather that the Fed , “”SHALL maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production,””(my emphasis)
So, there does exist a public policy mandate (shall maintain aggregates) for monetary economic intervention. What is lacking is any tools, Fed or otherwise, to accomplish that mandate.
Monetary and credit aggregates in this endogenous money system are strictly the purview of the private bankers, UNLESS the Fed could somehow manage to make M-0 ‘cash’ equal to M-1 monies.
Which, it can’t.
Only the GUV could issue monies, as called for (POMF) in Turner’s paper, to ensure that the aggregates are sufficient to achieve economic production potential.
Given that the output gap here IS related to a lack of domestic aggregate demand, the objective of policy seems, as always, more correct than its results would indicate.,
QE drives up asset prices and promotes financialization, two indicators that we remain totally on the wrong track.
Perhaps Ms. Yellin will get that ‘monetary and credit aggregates’ thing, as her focus seems on employment and incomes.
Well, that was long, and it all seemed to be building up to something, but I’m unclear as to the policy takeaway. I gather Alford would like to see higher interest rates, and thinks persistently low rates can lead, and have led, to financial instability through enlarged, fragile balance sheets and a dangerous, speculative reach for yield both at home and abroad.
Or is he more interested in direct microprudential and macroprudential regulation of lending? Anyway, the call for central banks – and governments generally – to make the pursuit of financial stability a key policy goal along with the traditional goals of price stability and full employment, is well-taken.
If the goal is to achieve full employment in the context of economic stability, while reducing both the overall level of private sector debt to GDP and the ratio of consumption to capital investment, then it seems to be that all points to (i) national income policies which redistribute income and reverse the trend of substituting of credit for income in driving private sector spending, (ii) a larger leadership role for the state in promoting innovation, economic transformation and fixed capital investment, and (iii) a move to a retirement system based on direct government transfers to retirees rather than flows of savings into large private funds in search of private sector yields.
‘a larger leadership role for the state’
Why, of course. It’s doing such a great job now, obviously we should enlarge its mandate. Let’s put Kathleen Sebelius in charge of the effort.
Hay… corporate sector HR is just doing its job, just ask Penny.
No, we need to hire some visionary thinkers, not political hacks.
We live on a small, warming, overcrowded planet overrun with financial sector predators and parasites collecting rent for their masters on a stagnant, failing 20th century order, opposed by nothing but decadent, consumerist pseudo-democracies.
There is no avoiding this interconnected planet and its global problems, and no solution in laissez faire escapism or romantic localism. The coming century is going to require a lot more planning and explicit coordination than we have been accustomed to in recent years. Governments are going to have to purge the parasites, take on the neo-feudal private empires and lead.
This just about says it all. Thanks Dan!
So, the takeaway here must be that Fed-think is too narrow to achieve not only its domestic policy goals, but also to positively affect the needs of the integrated global money systems.
The sum of the thinking puts Adair Turner’s proposals, for what seems like “priority use” of money policies toward real-economy results, at the head of the class, especially domestically.
His paper on “”Debt, Money and Mephistopholes” spells out his plans to achieve the real economy benefits of what he calls ‘Permanent Overt Money Finance’(POMF), it is a reform to monetary policy-think that can best be called the public financing of deficits via fiat money creation through coordinated fiscal-monetary public policy.
http://www.group30.org/images/PDF/ReportPDFs/OP%2087.pdf
What he is calling for is sort of what the MMTers think the Government does now….creating M-1 money when it POMF-spends. The results would be powerful and positive.
Important that the statement, below, should underline that real-estate price inflation due to “investment” (speculation) raises the cost of living and producing in this country – as it does in the rest of the world that forgets ‘land’ as the passive part of production.
Does land price appretiation count as inflation?? If it does not….it should. The more one spends on a place to shelter…the less one has to spend on other things (overall demand is reduced)
“Instead, a large part of bank lending finances the purchase of existing assets, particularly commercial or residential real estate, the prices of which primarily reflect the value of the underlying land. Such existing-asset finance does not directly stimulate investment or consumption. But it does drive up asset prices, causing lenders and borrowers to believe that even more credit growth is both safe and desirable.”
All this financing does is create a compound interest stream for the lender while driving up ‘land’ prices (the passive factor in all production) which, when added to capital formation and labor costs (Land+Labor+Capital) drives prices higher for all things produced…while lowering the standard of living.
Well, said. Economists are always talking about inflation policies. But I don’t think they are very good at measuring it.
Tom,
Very true. Well said.
But…… isn’t this ….
“”All this financing does is create a compound interest stream for the lender while driving up …… prices””
TRUE for every dollar of debt-based money that has ever been created under fractional reserve banking.??
EVERY dollar, ever created.
Still, paying the interest.
See Dr. Margrit Kennedy’s “”Interest and Inflation Free Money””.
I think the trade deficits are unsustainable as they are a not a healthy way to run a global reserve currency. As other currencies get stronger such as the yuan this will lead to a more balanced global economy where currencies will have to ‘pull their own weight’.
This means that the US will have to develop a real rather than a financial economy. It can’t rely on asset price appreciation and speculation but has to properly develop land value and labor.
Capital development has to have much more state involvement as the stock market has essentially turned into a failed system of looting.
I see this as mostly an argument for ending the dual mandate. The Fed has always felt burdened by any obligation to labor.
Its interesting how, at the end of the article, Alford points out that “the absence of effective regulatory, Dollar and competitiveness policies” are actually more important issues (but those are not on the table).
Given how Benanke’s Fed was used politically to first extend and then make most of the Bush Tax cuts permanent, one can almost sympathize with Alford’s intent.
As always, Alford pretends to criticize the Fed while lobbying for the Fed.
No, he’s arguing that the Fed can’t keep running monetary policy as if the US is a closed economy.
He also says that if the Fed recognized that the US was not a closed economy, it would worry more about trade deficits.
And did you miss that trade deficits are bad for labor? It means that US demand is supporting jobs overseas. So he is saying that the Fed position is actually anti labor.
This is hardly a pro-Fed paper, and it would behoove you to understand Alford’s argument rather than making off-base accusations.
He’s still arguing for an end of the dual mandate. He is doing so by arguing FOR a change Fed scope due to US having an open economy. The fact is trade is a fraction of the US economy and the Fed’s use of headline unemployment numbers as a measure is an embarrassment (that maybe Yellen is more sensitive to than was Bernanke).
The dual mandate can not survive that increased scope. No US politician would approve of the Fed specifically factoring in employment as part of a new ‘global mandate’ because then the Fed will be implicitly required to consider non-US employment in their policy-making.
Also, one could well wonder why this is a concern now. We have had an open economy and large deficits for many years. Could it be that the Fed has been doing studies about how they would operate after ObamaTrade?
Note: the increased scope he seeks is not just global but also forward-looking.
One way to see thru Alford is by appreciating his slight of hand.
Alford says, essentially, that if the Fed has taken a more global view then the Fed would not been so easy with money prior to the 2008 GFC and all sorts of good things(tm) would’ve happened. He lists these as:
This implies that the GFC (or the worst effects) could’ve been avoided by a global mandate. But Alford IGNORES the Fed’s failures to act:
1) after being warned of the housing bubble;
2) against lax underwriting standards and fraudulent valuations;
3) as the massive the shadow banking industry grew to massive size.
The Fed ignored these things because that’s what the banks wanted. Its what they always want: for the party to go on. Why doesn’t Alford’s talk of the Fed’s management and regulatory lapses? Why doesn’t he talk about restoring mark to market? These are just as, if not more important, for stability than monetary policy.
The fact is, the Fed has a political problem that centers on the dual mandate. Populists US politicians could use this to attack the Fed and possibly force an easier monetary policy that would be adverse to FIRE interests. Alford serves these interests well by presenting a clever argument for removing this nuisance.
Although it is much too soon to draw meaningful conclusions, there are hints that with respect to regulatory policy, Yellen may be a horse of a different stripe than her immediate predecessors: http://finance.yahoo.com/news/yellen-prepares-wall-street-more-124647084.html
Most people will probably see this article as supporting a (very) gradual end to QE so as to not cause the kind of disruption in emerging markets that we saw earlier this year. But Alford, it seems to me, seeks to seize upon the emerging markets turmoil to make a case for a continuing global and ‘future risks’ mandate. Each of these might trump the Fed’s current dual mandate.
The next logical question is: what are the implications of such a mandate change? Reasonable people may differ on that, but I am suspicious of anyone that whitewashes how the Fed failed us.
In any case, Yellen must now clean up the mess of her predecessors. I don’t envy her that job.
Actually, most concerned about a clever end run that results in surrendering or material erosion of monetary sovereignty under the guise of reserve currency stewardship and monetary system responsibility.
Adair Turner, oh dear, oh dearie me. The man writes epics like ‘Just Capital’ and when you leave the sense of disappointment you were mug enough to read soars like an inflating Zimbabwean dollar. The saga linked by JuneTown finishes with long statements of:
1. a bit of good old fashioned money printing may be no bad thing, but might be if done in excess
2. if private debt and leverage dropped us in the do-do, it probably isn’t a good thing for us to climb out on.
It’s 48 pages to get to this. He mentions Goethe’s Faust. Issuing paper money on gold and silver yet to be dug was innovative back in that day. Giving people the homes they live in and starting off on an economy that eschews poverty as a motivator might be innovative now.
copped,
Good that you bothered to read and glean your own conclusions.
“”Giving people the homes they live in and starting off on an economy that eschews poverty as a motivator might be innovative now.””
“”if private debt and leverage dropped us in the do-do, it probably isn’t a good thing for us to climb out on.””
Indeed, those things do make perfect sense from Turner’s money proposals.
But, for some reason, if that’s the right word, you loosely associate this highly controversial yet respected proposal by the former chief of the UK’s Financial Services Authority with Zimbabwean hyper-inflation. Just to clear, Zimbabwe increased its money supply by more than a hundred billion TIMES. Could be that the Turner proposal would fall a bit short of that.
There’s some irony and some error in your observations.
The error is to simply ignore that the Turner proposal is limited to advancing the economy’s production to its demand potential, which as I have said, is the same mandate as that of the Fed. Turner definitely did recognize that “debt contracts” are a huge monetary-economic factor that is preventing the economy from moving towards its potential, and he dared to broach the economic science taboo of public-money issuance when seeking solutions.
The irony is that he does indeed identify these ‘debt-contracts’ as the thing that prevents socio-economic progress, including like for your proposal of a housing transition, and actually aims to solve for just that reason.
What is your proposal for achieving those innovative results?
Alford raises some important questions here IMO. Thank you for this post.
I would have welcomed more foundational background by the author, including the roots of “globalization” and the offshoring of U.S. manufacturing and services jobs. I sensed that the immediate impetus for this article was the very public disagreement between the Central Bank of India’s Chairman Rajan and former Fed Chairman Bernanke over the Fed’s policy responsibilities, and specifically QE-ZIRP policy, at the Brookings Institution on 4/10/14.
I appreciate Alford’s raising the issue about whether the Fed’s domestic policy sets as U.S. central bank are reconcilable with its role as the central bank of the nation responsible for the global reserve currency, and which set of policies should be given primacy. Given what has occurred and its sensitivity internationally, this issue together with fiscal policies should be elevated in the public discourse, including in the halls of Congress.
One of the interesting things I think is that rebalancing the trade imbalance would be good for the 99% of both China and the US and negative for the 1% of each country.