Four points against the conventional wisdom

1. Eurozone breakup is bullish.

The conventional wisdom sees eurozone breakup as calamitous. This view has even been supported by scholars who should know better. In my private discussions with “2nd tier” scholars (i.e. people well below the radar), our only conclusion is that these high-profile scholars are trapped. They’re in a predicament familiar to the credit ratings agencies: if they pronounce on the inevitable breakup of a  currency regime, they bring that day forward. Imagine the weight of responsibility. So, here’s the question: What would you do if you knew that eurozone breakup was bullish but that you would take some of the blame if your pronouncement helped bring that about? I’m leaning toward integrity in life in general. You should say what you think, be damned the consequences. Will things get better if you keep silent? Of course not. The longer this predicament is left unresolved, the more misery endured.

To the mechanics. Euro breakup will reset national prices to a level that makes the economy’s traded sector competitive. These economies no longer can rely on growth in the non-traded sector. This is not a zero-sum question: a group of growing economies will specialize in different items; their growth will generate demand for each others’ output and services. Will it be difficult? Yes, of course. But it won’t be the calamity envisioned by some. And for the close neighbours with floating exchange rates (think UK or Turkey), what would you choose for these benighted eurozone members: A moribund neighbour locked in terminal deflation and inactivity (recession), or a rebounding one? Your exchange rate can offset some of the shock from their re-introduction of national currencies. Number 10 Downing Street should think carefully when it lines up behind Berlin-Paris in support of ‘rescue’ packages that lock these countries into interminable decline, rescuing only their creditors. (To be clear: I have no moral opinion on the euro. In fact, I love the spirit of it (not to mention the convenience). And I am all for the EU and the ‘European project’. What we must not do is conflate the European project with the euro itself.)

2. Reserve currency status for the US dollar is a poisoned chalice.

Most commentary on the US dollar’s international value treats reserve currency status as something precious, to be safeguarded at all costs. First, to clarify: “reserve” currency status is a bit of a red herring. For the most part, a currency is appealing for a reserve asset if its price against your currency is a target of policy. In English: if you are worried about the US dollar exchange rate against your own currency (let’s say, Brazilian real), then you intervene in the real/dollar foreign exchange market. And you accumulate/decumulate dollar reserves. You don’t hold dollars because they are the world’s best reserve asset; you hold them as a byproduct of your exchange-rate regime. So when you hear about “reserve” currency status, think instead “numeraire” currency status, because it’s the dollar price of your economy’s output that matters. International trade is overwhelmingly quoted in US dollars.

When you hear that the dollar’s international status must be preserved, you must ask, For whom? Let me cut right to the chase. It’s good for the financial services industry. And just as the US financial services industry has become politically influential, so too did that in London (where it’s known as “the City”, akin to “Wall Street”). The City can be found standing behind a number of critical junctures in UK currency policy, which proved difficult if not disastrous for the real (i.e. non-financial) economy. This is true of going back on gold at an unrealistic exchange rate in the middle 1920s and entering into the Exchange-Rate Mechanism, the forerunner of the euro, in 1990. That there is still a UK manufacturing sector is testament to some incredible resilience in UK manufacturing. And make no mistake — there is still a vibrant UK manufacturing sector. My point is that it’s been an uphill battle with an overvalued currency, and too much of the country reflects the blight of an abandoned productive heritage. Some very high proportion of working-age UK adults outside of the London/Southeast-England region are on a government payroll in some capacity.

Reserve currency status (really, “numeraire” currency status) is a poisoned chalice. The financial services sector likes it, because it wants to intermediate the world’s capital flows. But the price is high for important parts of the rest of the economy. If this can be relinquished anytime soon to the Chinese (fat chance), so much the better. (What does it say that the leading Congressional advocate of a stronger Chinese currency represents Wall Street? It says to me that dollar strength is secure with Congress. In other words: don’t believe for one second that Congress will be led into a robust currency confrontation with China. The US financial services industry has no desire to see this.)

3. Quantitative Easing by the Fed is covert US exchange-rate policy. It’s a good move but insufficient.

The conventional wisdom is concerned that the Fed’s purchases of long-term assets, dubbed quantitative easing, will “debase” the dollar. The reality is that this would be a good outcome. If the Fed, through QE, can push down the dollar’s international value, that’s a godsend for this economy. QE is Washington’s only exchange-rate policy instrument. Because the dollar is the global numeraire, most currency pegs are pegs to the dollar. This goes beyond the explicit pegs like Hong Kong; it includes the de facto pegs like China and the heavily interventionist regimes in East Asia and beyond. The particular exchange rate between the dollar and any of these currencies is not “floating”, no matter what US currency policy is (it’s “floating”). What can the USA do about these policies?

  • International agreement is a non-starter. No amount of moral suasion from the IMF is going to change these countries’ currency policies. The plain truth is that the only semblance of an international currency agreement is the IMF’s revised Articles of Agreement. These enjoin member economies not to engage in policies that explicitly promote their balance of payments position. The burden of proof here would be too difficult to take seriously. International law in this regard simply does not carry the weight that it does in trade, for example. Nor should it. The currency is a sovereign matter and it’s for each country to decide how to manage theirs. The USA has almost never been willing to manage its economy in a way to serve some currency purpose. Why should it expect others to? In fact, attempts multilaterally to coordinate currency policies have often had undesirable consequences. The 1985 Plaza Accord is one, with unappealing consequences for Japan. This is a big reason why Beijing is not keen to put its currency policy in a multilateral framework. (The Fed in 1928 agreed to reduce US interest rates in order to alleviate pressure on the pound sterling. Again, the consequences were unfortunate. This policy poured fuel on the fire of a gigantic US stock market bubble.) 
  • How about a unilateral import surcharge? Nixon did it in August 1971 partly to strong-arm US trade partners into revaluing their pegs to the dollar. It worked. 
  • Quantitative easing. If worries over the effect of QE on the US money supply underpin a flight from the dollar, so much the better. 

So QE is a good move as an exchange-rate policy. In most other respects it’s insufficient. The Fed is being incredibly conservative. It is buying only government bonds. And its efforts reach only as far as the banking system, which is not intermediating credit right now. The only money the Fed is capable of generating is “central bank money” aka “base money”. The only glimpse you have of this is the cash in your wallet. Period. Think of all the financial assets you own — bank account, savings account, retirement account, etc. None of this is central bank money. If you are in good financial shape, then cash is a very small fraction of your wealth. If you are in bad financial shape, then cash might in fact be pretty big for you. (Keep in mind that cash here does not include the loose usage of the term, i.e. money at short-term in the money market or in a checking account, which is often referred to as “cash”.)

So far, the Fed has not put cash in your hands, but it could. Right now, the central bank money being created by the Fed is being credited to the banking system’s deposits at the Fed. This money can be used by banks as the foundation for lending. But the banks don’t want to lend and the private sector doesn’t want to borrow. In other words, QE is pushing on a string. Yes, it might be pushing down interest rates on the assets it buys, and that’s a good thing. But it is not injecting new money into the non-financial economy, so long as the money it creates sits in reserve at the central bank.

4. Much economic commentary in the USA is stuck in the status-quo ante.

Much of the punditocracy is still thinking in status-quo-ante terms. In other words, all the indicators that signalled growth before the crisis continue to be treated the same way today. The easiest way to think of this is in a relative-price framework. Before the crash, arguably for two decades until the crash, growth was centered in non-traded activities. This was credit-fuelled and foreign-capital-fuelled. It meant that consumer spending equalled growth, never mind that the local content of those purchases went down and down. It meant that housing was a driver of the economy. It meant that Wall Street earnings were a bullish indicator. Housing and Wall Street are key non-traded sectors. They draw in resources from abroad.

That game is up. Growth will need to come from traded activities. Propping up US house prices does not support this transition — it stifles it. Propping up the financial services industry does not support this transition. So when you hear about the latest housing or consumer credit report, ask whether the way it’s being interpreted is appropriate now or for the status quo ante. My guess is you’ll hear a lot of the latter. This raises the question: what policies could the US administration be supporting to emphasise the transition to traded sectors over non-traded? As mentioned, QE is one — though it is a policy of the Fed. Another would be a different approach to housing. The administration should not seek to prop-up prices; it should seek to salve the balance sheet consequences of price decline.

One might ask, what is the traded sector? The key thing is to keep in mind the purposeful use of the word “traded” sector rather than “exports”. The boost will come in large part from a diversion in spending to US output. This is plausible. Start with the easy part. A weaker dollar will divert some tourism money away from overseas and toward the USA. It will divert some spending toward US-based services too. And not least it will divert some spending to US manufacturing. I think we’ll be surprised by the extent to which manufacturing turns up with a more competitive currency.

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One Response to Four points against the conventional wisdom

  1. Scott says:

    And it is in this context that we should consider the periodic Chinese admonitions to maintain “a stable value” of the dollar. Why would we want to support the dollar? We did not, and are not, asking the Chinese to amass US dollar assets. We have no duty of care regarding their eventual value. Believe me, I’m as a big a Sino-phile as they come. So this comment is not, in any way, a form of China-bashing.

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