Monday, November 24, 2014

The Dollar and the Damage Done

BERKELEY – The US Federal Reserve is being widely blamed for the recent eruption of volatility in emerging markets. But is the Fed just a convenient whipping boy?

It is easier to blame the Fed for today’s global economic problems than it is to blame China’s secular slowdown, which reflects Chinese officials’ laudable efforts to rebalance their economy. Likewise, though Japan’s “Abenomics,” by depressing the yen, complicates policymaking for the country’s neighbors, it also constitutes a commendable effort to bring deflation to a long-overdue end. So, again, it is easier to blame the Fed.

And, for the affected emerging economies, the Fed’s tapering of its massive monthly purchases of long-term assets – so-called quantitative easing (QE) – is certainly easier to blame than their own failure to move faster on economic reform.

Still, the Fed should not be absolved of all guilt. The prospect of higher interest rates in the US weakens the incentive for investors to pour capital into emerging economies indiscriminately. Though a confluence of factors may have combined to upset the emerging-market applecart, Fed tapering is certainly one of them.

It is striking, therefore, that the Fed has made no effort to take into account the impact of its policies on emerging economies or the blowback from emerging markets on the US. Emerging markets comprise more than a third of global GDP. They have contributed considerably more than a third of global growth in recent years. What happens in emerging markets does not stay in emerging markets. Increasingly, what happens there has the capacity to affect the US.

Yet Fed officials, while commenting copiously about their motives for tapering QE, have said nothing about the impact of doing so on emerging markets. They have given no indication of being aware that US monetary policy can affect events outside of their narrow corner of the world.

This silence is all the more remarkable in view of two other recent developments in Washington, DC. First, the US Congress, as part of the government’s recent budget deal, refused to authorize an increase in America’s quota subscription to the International Monetary Fund. The financial commitment was essentially symbolic, but it was part of a larger agreement reached at the Seoul Summit of G-20 leaders to regularize the IMF’s resources and enhance the representation of emerging economies.

This failure to follow through reopens old wounds and raises troubling questions about the legitimacy of an institution that, reflecting the long shadow of history, is dominated by a handful of advanced countries. Emerging-market officials have been increasingly reluctant to turn to the IMF for advice and assistance, undermining its ability to play an effective global role.

The other development was the decision to make permanent the dollar swap arrangements put in place during the financial crisis by the Fed, the European Central Bank, and the central banks of Canada, the United Kingdom, Switzerland, and Japan. Under these arrangements, the Fed stands ready to provide dollars to this handful of favored foreign central banks – an acknowledgment of the dollar’s unique role in international financial markets. Because international banks, wherever they are located, tend to borrow in dollars, the swap arrangements allow foreign central banks to lend dollars to their local banks in times of emergency.

Put these three events – the tapering of QE, the torpedoing of IMF reform, and the entrenchment of dollar swaps – together and what you get is a US that has renationalized the international lender-of-last-resort function. Simply put, the Fed is the only emergency source of dollar liquidity still standing.

But the US has offered to provide dollars only to a privileged few. And in its policy statements and actions, it has refused to acknowledge its broader responsibility for the stability of the world economy.

So what should the Fed do differently? First, it should immediately negotiate permanent dollar swap lines with countries such as South Korea, Chile, Mexico, India, and Brazil.

Second, the Fed should adjust its rhetoric and, if necessary, its policies to reflect the fact that its actions disproportionately affect other countries, with repercussions on the US economy. Might this mean that the Fed should slow the pace of its tapering of QE? Yes, it might.

The Fed may hesitate to extend additional swap lines, because to do so could expose it to losses on foreign currencies. Moreover, it may worry about antagonizing countries that are not offered such facilities; and it may fear criticism from Congress for overstepping the bounds of its mandate if its talk and policies acknowledge its global responsibilities.

If US policymakers are worried about these issues, their only option is to agree to quota increases for the IMF, thereby allowing responsibility for international financial stability to migrate back to where it belongs: the hands of a legitimate international organization.

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    1. Portrait of Eduardo Moron

      CommentedEduardo Moron

      Excellent post. However, how sure are those swap lines? Will they last until needed, or might be gone when the FED decides?
      What if the FED ask for something in return to these additional systemic countries that you adding to the list of FED buddies? Last minor point, Chile is not systemic for the region, should not be on your list of additional countries. Cheers, Eduardo

    2. CommentedProcyon Mukherjee

      Some of the disturbing questions raised (together with KK's comments) need to be seen in the light of what change has happened post 2008. FED had introduced interest on excess reserves and this was a departure that has taken the commercial bank excess reserves to close to $1.8 Trillion from $2 Billion in 2008. This money sits on the liability side of FED balance sheet and has not moved to goods or services. So while QE induced $2 Trillion of Treasury Bond buying, it did not have the same effect as the erstwhile money creation did before 2008. No wonder the effect on inflation is rather mild.

    3. CommentedJames Edwards

      The FED's QE policies were the result of bickering between the Republican House and Presidency on over budget priorities that culumated to a shut down that pinned the blame on the Republicans. Bernanke has warned Congress, particularly the Republicans, many times their actions is creating uncertainty in the financial market that the FED decided to do something, hence being the whipping boy. Adding to the fact that the financial crisis precipated actions that stretched the boundary of FED mandate in order to keep the recovery from falling back.

    4. CommentedMarc Laventurier

      So is it any wonder that China is rumored to be bulking up on bullion?

        CommentedKir Komrik

        Hi Marc,

        I admire brilliant conciseness. The Fed is entering a fatal condition where they have to create exponentially increasing amounts of currency to match the new wealth being generated ... because so much of it is being generated not here, but overseas. And the rate at which that wealth is being denominated in USD is skyrocketing. But the Fed can't do this through promissory. That pipe isn't fat enough. But they can do it by purchasing USG instruments and selling them by the trillions ... like they did for China. That currency, also de novo, gets pumped through the New York Fed, to government bank accounts and out through government spending.

        And that's why we have such a large debt. This is not sustainable, imo. We need a more sophisticated system that doesn't _require_ promissory and the encumbrance of currency itself to do the infantile, kindergarten task of circulating currency in proportion to the emergence of new wealth.

        imo, it's barbaric, with roots in the shenanigans of street charlatans - con artists - of the 1300s. But getting people to change is obviously not easy in the realm of law and economics because Ignorance and superstition never quits.

        Yes, China knows that there is a fair chance the regnant system is going to collapse and we will be reduced to barter. The only way to save the system, imo, is to rebuild it from the ground up. Of course, all the benefactors will have to be grandfathered into the system somehow because they have too much to lose, but its still doable.

        - kk

    5. CommentedKir Komrik

      Apologies but I didn't realize there was not an edit button before I posted. The process of depositing currency de novo into a bank to match currency to existing wealth in the economy, then using a promissory to require the wealth creator to "repay" the "bank" for what they "borrowed" is called the confidence trick of false obligation and it began in Venice, Italy.

      If a fisherman, to keep it simple, catches 500 dollars worth of fish, he is _entitled_, by virtue of being the wealth creator, to receive currency that the market believes matches that value - 500 dollars. That is the whole point of currency. Instead, and in most real world cases, he sells those fish to someone who obtains a promissory through a bank. But the fisherman would have never produced the fish without the promissory because that is the _only_ (practically speaking) way he can receive currency for the fish. What we need is a more sophisticated means of distributing currency directly to the wealth creator without the "middle man" having to repay the "loan" (a false obligation), which in reality doesn't exist as a valid concept.

      There is a documentary coming out on this in the next year. It should be rather interesting. But it vividly demonstrates why this article is so far off the mark and missing something so fundamental, imo.

      - kk

    6. CommentedKir Komrik

      Great article, thank you for your willingness to share your views and be open to responses,

      The problem I see with this article's premise is endemic of the problem overall. We are in denial and refuse to accept that the problems we are facing are systemic and structural. We are using principles of governance over 1000 years old and somehow think this is going to scale to modern times.

      The Federal Reserve is not "to blame". No one is. The problem is that the Federal Reserve relies on a system that is unsustainable in a modern, technological world in which the population is connected and ... far less ignorant.

      Currency exists to facilitate trade and replace barter. Without that admittedly simple basis it really has no value to the ordinary person. But the Federal Reserve system uses a scheme that has been used for over 300 years that is antiquated. It relies on associating new wealth with new currency by depositing the new currency directly into banks, rather than disbursing that new currency to those that created the wealth. By the instrument of a promissory, even if the currency is credited to a bank account, the account holder is obliged to perversely "repay" the wealth they generated.

      This is fundamentally unjust to say the least and if we are to make any real progress in economics we need to start from the beginning and rebuild the system into something more modern and rational. All conversation without this one is meaningless.

      - kk

    7. Commentedhari naidu

      The problem is US Congress and its oversight relation with Fed. Any idiot listening to Republican - even some Dems - must come away that US Congress is demanding American Exceptionalism to apply (also) to EM and their domestic policy framework. Under no circumstances Fed can afford any more to expose itself to rightist attack in Congress on its international monetary policy considerations relations with rest of the world - not only major OECD CBs.