What’s Wrong with Fed Policy?

[FRED]

What’s Wrong with Fed Policy?
July 17, 2006 (National Review)

There are well-known dangers in relying on a reserve currency that lacks a built-in control or alarm signal. The problem is currently illustrated by China’s ability to collect “rents” on its resource of a large, low-cost labor pool, which China’s rulers suddenly allowed to be “discovered” by the rest of the world. China recycles a substantial portion of its export earnings by purchasing U.S. Treasury bonds. Money leaves the U.S. and comes right back — regardless of the level of U.S. interest rates. A long-lasting deficit can develop in the U.S. balance of payments because foreign settlements no longer automatically reduce the amount of credit available at home.

Suppose, however, that the Chinese government decides, under pressure, to let its currency float and the yuan appreciates against the dollar. China will then expand its economy at a slower rate, collect fewer rents on its labor pool, and consequently recycle fewer dollars via Treasury purchases. (This outcome will be averted only if the country democratizes its domestic capital markets, a reform not currently contemplated by its communist government.)

Both countries may experience bank failures, recession, and inflation due to the resulting reduction in both growth rates and global demand for dollar liquidity. The source of the problem is the Fed’s reliance on mis-measured aggregates to control the supply of dollar liquidity, rather than market prices — such as gold, commodity prices, and yield curves. Until it turns its attention to market-based indicators, global central banks and governments involved in managing a reserve currency, as well as other countries linking their currencies to those reserve currencies, may compound their mistakes by perpetuating policies premised on current fads and a casual disregard of facts.

AntiSpin: One warning after another, for years on end, the policies that will lead to crisis go unheaded by the economic McNamaras of the current administration. The Fog of Economic Folly continues, the warnings unheeded, and may soon be compounded by the Fog of War, the chaos that may result if Syria and Iran are drawn into all-out regional war in the Middle East. Conditions support John Serrapere's defensive positions.

[blazespinnaker]

Re: What’s Wrong with Fed Policy?

this is a great post. it's the hole in the 'globalisation' will fix everything.

not necessarily, because a good part of the globalisation is underpinned by currency manipulation.

china needs to start slowly floating their currency and soon. one wonders that they're not doing it because they have a plan to put megapressure on the US at the right time (say, just before 2008?)

the only problem with that, is that the two contestants - mccain and hillary, really are not that far apart politically.

[jk]

Re: What’s Wrong with Fed Policy?

i don't understand why people analyze the u.s.-chinese economic relationship by looking at the theoretical consequences of momentous and precipitate shifts in policy which will never happen. [what if they sell all their bonds? what if they go to a free float next week?] if the chinese government's decision to allow a 2%[?] range for a formerly fixed yuan doesn't convince you that they'll move slowly, i don't know what will.

i think any attempt to understand what might happen should be predicated on gradual shifts in position. yes, there can be exogenous shocks of some kind. but there won't be a massive sale of the pboc's treasury bonds next wednesday.

the u.s. and china are currently chained together, addicted to one another's bad habits - u.s. debt financed consumption, chinese profitless prosperity and heedless capital investment. dealing with this will be like trying to separate siamese twins joined at the forehead, the abdomen and the groin.
what's wrong with fed policy isn't some arcane problem like using the wrong metric. what's wrong is having to deal with the legacy of greenspan's political cowardice, his habit of giving the economy ever increasing "fixes" of liquidity to help it avoid any pain.

[blazespinnaker]

Re: What’s Wrong with Fed Policy?

It's a good point, JC, however the chinese are not following a gradualist philosophy, even though they say they are.

If they were, would they be tripling their military spending? would they have an 11% growth in GDP? There is nothing gradualist about this at all.

Imagine, though, if you had a button you could pressure which could fire a salvo at your enemy at any point in time you wished. Wouldn't you like to load up the gun?

Purchasing treasuries at a massive rate is China loading up the gun. When they want to, they can send the US economy into a tailspin. Sure, it'll risk social unrest in China, but as we can see, China has ways of dealing with such a thing.

China wants power, and manipulating currency is their power. If they were to just float the currency, then they'd just be a cog in the international wheel of commerce. If they were christain democratic, I'm sure that would be a fine place to be. But, they are not. They are an overpopulated country which is emerging economy coming from the world of tiananmen square and the communist revolution of mao tse tung.

[jk]

Re: What’s Wrong with Fed Policy?

It's a good point, JC, however the chinese are not following a gradualist philosophy, even though they say they are.

If they were, would they be tripling their military spending? would they have an 11% growth in GDP? There is nothing gradualist about this at all.

Imagine, though, if you had a button you could pressure which could fire a salvo at your enemy at any point in time you wished. Wouldn't you like to load up the gun?

Purchasing treasuries at a massive rate is China loading up the gun. When they want to, they can send the US economy into a tailspin. Sure, it'll risk social unrest in China, but as we can see, China has ways of dealing with such a thing.

China wants power, and manipulating currency is their power. If they were to just float the currency, then they'd just be a cog in the international wheel of commerce. If they were christain democratic, I'm sure that would be a fine place to be. But, they are not. They are an overpopulated country which is emerging economy coming from the world of tiananmen square and the communist revolution of mao tse tung.

in economic matters they are gradualist in the sense of wishing to avoid any risk of social upheaval. god knows what their gdp really is, since so much is still the province of state owned enterprises. the chinese have the demanding task of finding employment for an enormous number of new workers as well as the underemployed working in aforesaid soe's. they have increasing outbreaks of local protest and even violence in the hinterlands, and the desire to increase development in the interior and the west to try to ameliorate the increasing income and wealth disparities, but which is resisted by cadres with their hands in the till along the coast. their development is reminiscent of a runner who has tripped and has to run all the faster in the hope of keeping his feet under his body well enough to keep from falling on his face.

of course they are ginning up their military. they expect to be at least a regional power and will no longer kow tow [think about the derivation of that phrase] to the 7th fleet. one day they likely expect to be more than a regional power.

they dare not destroy the dollar without risking shooting themselves in the process. yes, they will try to wean themselves from the american market, but that won't happen overnight. if there were a confrontation over taiwan, then, yes, they might go to war economically before risking war militarily. but short of something momentous [to them], it won't happen. they have too many people whose employment is conditional on their exports.