from Follow the Money

Blog envy: on Europe, the G-7 and the Fed

April 16, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Paul Krugman (who hardly needs a plug from me), Macro Man and Steve Waldman (of interfluidity) have all written posts that I wish I had written.

Krugman elegantly shows that a lot of American stereotypes about Europe are based on data from the 1990s. By some measures, Europe’s labor markets no longer look more sclerotic than America’s labor markets. The percentage of French men between 25 and 54 without jobs is now pretty much the same as the percentage of American men between 25 and 54 without jobs.

The similarities don’t end there. The European Union as a whole also now runs a current account deficit financed in no small part by the world’s emerging economies.

Macroman had the brilliant idea to compare the most recent G-7 Communique to the G-7 (and G-5) communiqués that marked big changes in the foreign exchange market. The most recent communiqué clearly contained new exchange rate language – language no doubt intended to give a boost to the sagging dollar. But the G-7’s new language lacked the vigor of the key communiques of the past. Back in 85 and 95, the G-7 didn’t just complain about disruptive moves. It indicated the direction it wanted the market to move.

Moreover, as Macroman notes, the G-7 countries themselves aren’t necessarily the key countries setting G-7 exchange rates. The amount of dollars that China, Russia and the Gulf want to sell for euros, pounds and other currencies also matters:

"it’s far from clear that the G7 are the relevant authorities; after all, it’s not Japan or Germany or the UK that is buying billions of EUR/USD every month; it’s China and Russia and the Middle Eastern Countries. And Macro Man didn’t see their names attached to any document expressing concern."

I also recommend Dr. Chinn’s analysis and -- if you have an RGE subscription/ receive BNP research - Lee and Speranza’s post G-7 rant (link is through the RGE subscription service). They argue that the G-7 spent its time focusing on currencies when currency markets aren’t the problem -- as dollar weakness basically reflects weak US fundamentals -- and didn’t do anything to address distress in the credit markets. Lee and Speranza, speaking to the G-7:

"Didn’t you notice that the USD assets are at the centre of a global financial storm .... Have you noted that the US has slashed rates when it is has been massively reliant on foreign inflows ... to fund its deficit."

With the dollar heading toward 1.60, the market certainly doesn’t seem to have noticed the G-7 statement.

Finally, Steve Waldman – who has built quite a following with his trenchant commentary on the credit crisis – drew attention to the large recent changes in the composition of the Fed’s balance sheet and the debate over whether the Fed is running out of ammunition. That debate remains a relevant: a host of indicators suggest ongoing trouble in the banking sector. Waldman notes (quite correctly) that it possible for the Fed to expand its balance sheet beyond the monetary base.

"In an excellent summary, Greg Ip describes the various options the Fed would have if it were to run low on Treasuries.

Fundamentally, the Fed would have two options: It could increase the size of its balance sheet by issuing cash, which would require sacrificing its target Federal Funds rate target and letting that rate drop to zero. This option is referred to in the trade as "quantitative easing", but that’s just a fancy term for printing money and tolerating any inflation that results. Alternatively, the Fed could expand its balance sheet by borrowing from someone else — from the US Treasury, from banks with excess cash, or from the public directly. This would permit the Fed to increase the scale of its asset swaps without sacrificing its ability to conduct ordinary monetary policy."

Waldman though argues that this is not just a technocratic decision, but rather a political decision.

Fundamentally, the Fed’s balance sheet constraint is and should be a political constraint. The size of the Fed’s balance sheet defines how much capital taxpayers and holders of currency are making available to the Fed to do whatever it is it’s doing ... I don’t know whether expanding the Fed’s balance sheet is a good idea, if it comes to that. ... What I do know is that a decision to expand the Fed’s balance sheet ought not be treated as technocratic monetary policy. However funds are raised, their repayment would be guaranteed, so all downside risk would be borne by the public. Expanding the Fed’s balance sheet would represent a sizable investment of the public’s wealth, and the public ought have as much say over that decision as over any other investment of public money.

I agree. So does Dr. Hamilton: "[J]ust as I don’t want Congress deciding how much money to print, I don’t want the Fed deciding how much taxpayer money is appropriate to pledge for purposes of promoting financial stability."

The Fed seems reluctant (perhaps because it lacks the legal authority) to start to issue its own “federal reserve bills” to raise funds that it could lend out. The Fed would rather that the Treasury issue more Treasury bonds than it needs and place the surplus funds on deposit at the Fed. Those deposits in turn could be used to buy Treasuries in the market -- and those Treasuries could then be swapped for other assets. Or the funds placed on deposit at the Fed could even be used to purchase risky bonds directly. Relying on Treasury bond issuance for funding has the virtue of requiring a higher degree of "political" approval than a surge in Fed bill issuance.

The high-quality comments on Waldman’s post almost matched the quality of the orginal post. JHK noted that China’s central bank has expanded its balance sheet well beyond the money base as part of its exchange rate policy.

"Finally, at a global and more philosophical level, if China’s central bank can subsidize exports to the tune of $ 1.5 trillion in foreign exchange reserves, and if that policy has helped create the global savings glut, and it that phenomenon has led to the US credit crisis, then why can’t the Fed get creative by doing some balance sheet ‘subsidization’ of its own?"

JKH is right. The PBoC is taking on big risks -- risks that likely will have a fiscal cost -- to pursue non-monetary policy objectives (like supporting exports). If China had a different political system, I would think that the decision to expand the PBoC’s balance sheet and to take on a truly extraordinary level of currency risk would be one that would need to be ratified by the political system. The PBoC though isn’t independent, so the expansion of its balance sheet necessarily came with the backing of China’s top political leaders.

I wonder though if a democratically elected legislature would have been willing to authorize such an expansion. Buying reserves that you don’t need rather than investing at home is often hard to explain …

It is noticeable that more and more financial risks globally are being assumed by central banks. Currency risk in the emerging world. Credit risk in the industrial world. The old days when central banks issued currency against domestic tTreasury bonds – without taking on currency or credit risk -- are starting to seem a bit quaint. Call the expansion of central bank balance sheets – and the evolution in the composition of their balance sheets -- part of a new world of state capitalism.

I actually suspect that emerging market central bank activity in the currency market helped create the conditions that has prompted industrial country central bank activity in the credit markets. The IMF hints as much in Chapter 1 of the WEO. But that is a story (or an argument) for a different time.

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