from Follow the Money

Feldstein disagrees with Greenspan (politely)

December 22, 2005

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I am a bit late here, John Berry reported on Martin Feldstein's paper on monetary policy in a world of more integrated global capital markets over a month ago.

But it is still interesting to read Feldstein's paper along side Greenspan's latest musing on US external deficits. 

It turns out Martin Feldstein thinks that central bank reserve accumulation has a thing or two to do with the fall in home bias that Alan Greenspan emphasized in his speech.  Greenspan portrays the fall in observed home bias as the result of capital market integration, the retreat of the state from the market and private investment decisions.  Feldstein seems to disagree:

"Although these government purchases of dollar bonds appear to be an increase in global capital market integration, it is really very different from the kind of capital market integration that standard textbook analysis envisions."

I, obviously, have a great deal of sympathy for Feldstein's view.   

One of the more interesting points Feldstein makes is that the fall in home bias among OECD countries - and the resulting gap between national savings and national investment - seems far more pronounced for small countries than or large countries.  Weight the data by GDP, and you get a different result. 

Feldstein notes that the fall in home bias among small OECD countries - what Greenspan would call increased dispersion between national savings and national investment - seems driven by two countries in particular.  Ireland, with a history of large current account deficits financed by large capital inflows from abroad, and Norway, with its large current account surplus.   Both Ireland's deficit and Norway's surplus are arguably the result of unusual circumstances.  Ireland emerged as one of the world's favorite tax havens - leading a whole host of US pharmaceutical firms to locate drug manufacturing there.   And Norway's large current account surplus reflects the Norwegian decision to use their oil windfall to build up their petroleum fund's external assets. 

Feldstein makes another argument that is worth discussing - namely, that if long-term (market) interest rates have not risen as the Fed has increased short-term (policy) rates, it is possible that long-term interest (market) interest rates might not fall (or at least might not fall by much) if the US economy slowed and the Fed started to reduce short-term policy rates.   And the other channel by which low short-term rates stimulate the economy - a weaker dollar - also might not come into play if China and others continue to peg to the dollar (a recent estimate put the dollar's weight in China's currency basket at 98%, so I don't think it makes sense to continue to maintain the charade of talking about China's basket peg).

Listen to Feldstein ponder the Fed's options should aggregate demand slow and inflation fell below the level the Fed desires:

"In a relatively closed economy or in a world with a segmented global capital market, an easing of the federal funds interest rate would cause longer-term interest rates to fall because capital would not leave the US in pursuit of higher yields elsewhere.  The lower rates would stimulate domestic spending by consumers and businesses ... .  In addition, the reduced interest rates and weaker economy activity would cause the dollar to fall, stimulating exports and making imports less attractive.  In these ways, the reduced federal funds rate would contribute to the economic recover. 

But if long-term capital is very mobile among the OECD countries while Asian countries prevent their currencies from rising against the dollar, these channels of influence would not work.   Long-term bond rate would not fall and the dollar would not become more competitive against its Asian trading partners.  ....

We may now be facing something of a hybrid situation in which the dollar is flexible against the euro and some other non-Asian currencies but not against the Chinese yuan and other Asian currencies.  ...  In such a context, monetary policy would be relatively weak ... and expansionary fiscal policy would be more effective than it would be if all currencies were flexible."

Interesting thoughts. 

I am not sure that monetary policy would necessary be totally ineffective.   The lesson of the last period of low Fed rates is that lower rates lead to pressure on the dollar, that Asia resists this pressure and tries to keep their currencies from falling against the dollar, and that in the process of resisting, Asia ends up accumulating dollars that it lends back to the US.  And lending dollars back to the US helps keep interest rates relatively low.    US residents still seem to have a bit of home bias - the inflows coming into the US from Asian central banks are not immediately shipped off to Europe to look for higher returns.

But this impact all hinges on the willingness of Asian countries to add to their reserves to maintain a stable yuan-dollar, or won-dollar, rupiah-dollar or you-name-the-Asian currency-dollar.   At least in China's case, that implies that China might have to step its reserve accumulation.  And it would be stepping up its reserve accumulation for an already elevated pace.

But the argument that expansionary fiscal policy is more effective certain is consistent with US experience from 2001-2003.   Normally, expansionary fiscal policy drives up real interest rates, pushes up the dollar and crowds out private investment, particularly in interest-sensitive sectors.  In other words, expansionary fiscal policy normally would trade off against a boom in housing, and a surge in residential investment.  That clearly did not happen.  

The interesting question is whether the US has scope for further fiscal expansion - given that it now has a structural fiscal deficit - if the US economy slows and if, as Dr. Feldstein suggests, the combination of fixed exchange rates in parts of the world and more integrated capital markets in other parts of the world may mean that monetary policy is losing some of its oomph.   But the impact of any US fiscal expansion in some sense hinges on whether the rest of the world would be willing to finance larger US fiscal deficits at current (or close to current) US interest rates.   If the financing is there, it would be expansionary; if the financing was only available at higher US rates, not so much.

Reading between the lines, I think it is also safe to say that Martin Feldstein worries a bit more than Alan Greenspan about the size of the US current account deficit.  Stephen Kirchner of Institutional Economics may need to add the Harvard economics department to his list of folks who worry too much.

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