Brad Setser

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Does the Fed’s mandate now extend to Beijing, Moscow and Riyahd?

by Brad Setser
June 27, 2008

The Financial Times, in a leader, says yes.

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed itself would — I suspect — argue that it has to worry about a fall in the dollar, a rise in commodity prices or a fall in the dollar that spurs a rise in commodity prices only to the extent that such developments risk prompting a rise in US inflation, and thus affect the Fed’s ability to guide the US economy. That is a formulation that doesn’t generate any conflict between the Fed’s domestic mandate and the dollar’s global role. The Fed only should care about the dollar’s external value to the extent it influences the Fed’s ability to meet its domestic objectives.

The FT leader goes much further. It argues that dollar pegs generates such large benefits to the US — namely cheap financing — that the US should be willing to adopt a monetary policy that is right for the entire dollar zone even if it is wrong for the US. The FT:

The Fed has another reason to worry as well. The greater the inflationary pressure, and the more Asian countries are forced to raise interest rates, the greater the risk that they dump their pegs to the dollar. The results for the US would be unpleasant: a currency crash and even higher domestic inflation. The US benefits from the dollar’s use as a reserve currency; the price is that the Fed cannot forget the effects of its policy on the wider world.

The Fed’s Vice-ChairDon Kohn seems to disagree. He argues, more or less, that if US monetary policy isn’t right for fast growing economies in the emerging world, they should importing US monetary policy. Dollar pegs — not US rates — should change. That at least is what Krishna Guha of the FT inferred from Kohn’s speech:

[Kohn] appeared to call on fast-growing emerging markets to drop their exchange rate pegs to the dollar and adopt independent monetary policies – so they no longer import Fed monetary policy. Mr Kohn said “in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability”.

The Fed vice-chairman did not specify what steps he thought should be taken to restrain demand in these overheating countries. However, he said economies “benefit from having independent monetary policies that provide room to respond flexibly” to different economic shocks. He added “these benefits could be increased if exchange rate flexibility were to become more widespread”.

These remarks reflect Fed frustration at the way in which fixed exchange rate regimes transmit low interest rates meant to address US economic weakness to rapidly growing emerging economies – fuelling demand for commodities.

Mr Kohn’s speech suggests that the Fed believes that the global economic system would function better if these emerging economies had a greater degree of monetary independence, allowing them to set the interest rates appropriate for their own economies.

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

Is the FT leader right? Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US — and the world — would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Dollar pegs have created a set of fundamental problems for the world economy.

First, dollar pegs have linked the currencies of the regions of the world with the largest current account surpluses to the currency of the world’s largest deficit country. That creates a set of underlying tensions that have contributed to the recent surge in inflation in many emerging economies. The dollar needs to depreciate in real terms to help bring the US deficit down. The currencies of the surplus countries, by contrast, need to appreciate in real terms. Yet so long as the currencies of regions with different fundamentals are tied together, the only way this adjustment can happen is if prices in the US fall faster than prices in the rest of the dollar zone, or if prices in the surplus countries rise faster than in the US. Current high levels of inflation in the big surplus countries* can thus be viewed as a natural product of their own choice to maintain currencies linked to the dollar — combined with the United States aversion to deflation.

Second, the large amounts of financing the US now receives from countries that are managing their currencies against the dollar is a mixed blessing. It has helped some parts of the US economy, but hurt others. Large reserve inflows from 2002 to 2006 likely contributed to the excesses in the housing market that are now causing the world so much trouble. And it has had costs as well as the benefit to those countries that have managed their currencies against the dollar: their export sectors have been helped, but they have also sunk a large share of their national wealth into depreciating dollar-denominated assets.

Here it is important to note that both costs and benefits of the dollar’s role as a global reserve currency have been dramatically magnified in recent years. In the 1990s, emerging market central banks typically added somewhere between $100 and $200b to their foreign exchange reserves in a non-crisis year — and somewhat less to their dollar reserves. That reserve growth was generally financed by capital inflows from the advanced economies. Basically, capital inflows from the advanced economies financed both reserve growth and the emerging world’s aggregate current account deficit.

That kind of world that is consistent with a small US current account deficit, or even a small surplus. It also is a world where the dollar’s status as a reserve currency generates modest but important benefits to the US (the US effectively finances its investment abroad with low-yielding debt placed with central banks).

It, however, is no longer accurately describes the world. Emerging market reserve growth is now far larger — it topped $1 trillion dollars in 2007, according to the IMF’s data. It looks set to top $1 trillion in 2008 as well. China alone is on track to add close to $1 trillion to its foreign assets this year. The oil exporters won’t be far behind.

The current level of reserve growth reflects both the emerging world’s large current account surplus and net private capital inflows to the emerging world. With Japan also running a small surplus (which is now falling slightly), a world where emerging Asia and the oil-exports both have large surpluses necessarily requires large deficits in either the US or Europe. It is also a world where those deficits will be financed in large part by the sale of American and European financial assets — stocks (or companies) if not bonds — to the governments of the emerging world.

And it is a world that doesn’t strike me as being in the long-term interest of either the US or the emerging world.

It isn’t clear that there is a political consensus in China to lose money lending to the US rather than say investing more in Chinese public schools, but that in effect is what the China’s policy of managing its currency against the dollar now requires. At least if China wants to limit inflationary pressures. It isn’t clear that the residents of the Gulf would support the kind of financing the Gulf now provides the US if they had any say in the matter. The lack of domesitc support for the Gulf’s financing of the US is one reason why some think the US shouldn’t press too hard on transparency.

And I would guess that there isn’t political consensus in the US to finance $750 billion current account deficits by selling $750 billion of US equity to the governments of the emerging world. Yet that is what is implied if emerging market governments decide to shift all their foreign asset growth to sovereign funds and state firms in order to try to get better returns.

I have little doubt that emerging market governments have bought something close to $750 billion in US bonds over the past year — far more than shows up in the (inaccurate) US TIC data. Actually, that needs to be amended to say added $750 billion to their dollar holdings, with the money split between bank accounts and bonds. For the sake of comparison, total sales of US stocks to foreign investors of all kinds in 2007 were only around $200b. $30 billion or so was sold to official investors according to the US data, but the US data understates true purchases by sovereign funds. The real number is at least twice that. But it is still a far cry from the kind of sales that would be required if the sale of US stock and US companies to emerging market governments become the dominant way of financing the US deficit.

The subprime crisis has led to an intensification of US reliance on emerging market governments for financing. The costs of this are now becoming clear. Emerging market reserve growth now seems to have exceeded the emerging world’s capacity to sterilize, contributing not just to high levels of inflation in the emerging world but global inflation.

It is true, as Tim Duy notes, that emerging market reserve growth allowed the US to cut rates and implement a fiscal stimulus without having too worry too much about how the large ongoing US external deficit was going to be financed. But the existing equilibrium isn’t one that anyone should hope lasts for too long. The challenge, in my view, is how to bring the world back toward a true equilibrium — one that requires less government intervention in the foreign exchange market — over time.

As often is the case, Martin Wolf’s suggestions are a good place to start.

*Some emerging economies with current account deficits also have high levels of inflation, notably some emerging Asian economies that have been hit hard by the recent rise in food and oil prices.


  • Posted by JKH

    “The Fed only should care about the dollar’s external value to the extent it influences the Fed’s ability to meet its domestic objectives.”

    Absolutely – and on this point, I would be very interested in your reaction to Paul McCulley’s recent piece, which is relevant to this topic, and particularly whether you agree with his presentation of the economic theory:

    On pegs and US monetary policy transmission – I vote FT wrong; Kohn, McCulley, and Setser right.

  • Posted by SGC

    “Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?”

    These are the same questions asked by the Macmillan Committee in 1929 (if you replace dollar with pound and the US with Britain). The Committee answered yes to both questions. It was however overruled and Britain went off gold in 1929. The ramifications for the US economy and the pound are history.

    The implications are clear: Your currency can be the world’s reserve currency OR you can have a domestically oriented monetary policy. No country can have it’s cake and eat it too. I wouldn’t want to be Bernanke’s shoes right now.

    Hopefully China will recognize the danger to its own economy and revalue the RMB. I hope that the Fed is trying to get talks going with whoever makes these decisions in China. Maybe they should coordinate: on the same day that China revalues by 20%, the Fed raises interest rates to 2.5%. They might need to do this a second time, and then we’d have hopes that the world economy could return to an even keel.

  • Posted by SGC

    Correction: Britain went off gold in September 1930.

  • Posted by Steven Warfel

    Brad, seldom have I agreed more with one of your pieces. I so welcome your going beyond documenting imbalances to discussing implications. Now can we start entertaining creating a financial system designed for a world economy? Like having a world currency not tied to any one country, and not having any pegs?

  • Posted by don

    “And it has had costs as well as the benefit to those countries that have managed their currencies against the dollar: their export sector has been hurt, but they have also sunk a large share of their national wealth into depreciating dollar-denominated assets.”
    Don’t you mean their export sector has been helped?

  • Posted by don

    “It is true, as Tim Duy notes, that emerging market reserve growth has allowed the US to cut rates and implement a fiscal stimulus without having too worry too much about how the large ongoing US external deficit is financed.”
    It would be better if they stopped the reserve growth and the fiscal stimulus and expansionary monetary policy went to increasing demand for U.S. output, rather than much of it being bled off to expand demand for imports.

  • Posted by bsetser

    Don — good catch. i meant helped. the text has been edited accordingly.

  • Posted by gillies

    there is no free helicopter confetti. repeat after me. there is no free helicopter confetti.

  • Posted by bsetser

    JKH –

    I am not sure I follow the following McCulley statement:

    “Therefore, the more flexible are wages in the face of a negative terms of trade shock, particularly if it coincides with asset price deflation, the greater is the risk of policy makers losing control of the economy on the downside.”

    But in general terms, i agree with notion that it is better economically to erode real wages through a bit more inflation than to rely on nominal wages to fall. and the same holds for real housing prices — a bit more inflation in everything else and stable housing prices in nominal terms is easier to absorb than big falls in nominal housing prices (’cause financial contracts tied to homes are in nominal $). The risk of course is that inflation stops lubricating a necessary adjustment and becomes a major problem.

    I see this happening now in the gulf — where the authorities have effectively opted for high inflation rates rather than nominal appreciation. negative real rates from high rate of inflation are triggering over investment in real estate. that obviously isn’t a risk in the us right now, but it is a caution against relying too heavily on inflation as an adjustment tool.

  • Posted by RealThink

    Brad, lots of wisdom. I particularly liked: “It isn’t clear that the residents of the Gulf would support the kind of financing the Gulf now provides the US if they had any say in the matter.” LOL! Trading oil from a finite, absolutely exhaustible endowment for pieces of paper worth less and less.

    On the other hand, the question “Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?” should more accurately end like “- in order to keep it acceptable for the world to continue using the dollar as the international trade and reserve currency?”

    Because there are two sustainable ways to “bring the world back toward a true equilibrium”, which is “that kind of world that is consistent with a small US current account deficit, or even a small surplus.”

    a) The FT approach: a tight US monetary policy aimed at preserving the purchasing power of the USD in terms of internationally traded goods. Result: a deep recession in the US with US imports dropping due to lack of demand.

    b) Brad’s approach: although you don’t explicitly say that, it means the loss of the USD status as the global trade and reserve currency. Result: the “Wily E. Coyote moment” for the USD, skyrocketing commodity prices in USD terms (actually the USD is no longer used for pricing), high inflation in the US with US imports dropping due to prohibitive prices of foreign goods.

    The US CA will get balanced either way, but I’m not sure the US will be better off along path b. (And I think your colleague Benn Steil is not sure either.)

    Ultimately, you are right in that “the Fed only should care about the dollar’s external value to the extent it influences the Fed’s ability to meet its domestic objectives.” The point is that the feedback mechanism can be highly nonlinear, and when the dollar loss of value and of its global role starts hitting in earnest it may be too late.

  • Posted by RebelEconomist

    SGC, a correction to your correction: September 1931.

  • Posted by RebelEconomist

    I can see the theoretical point that it is easier to absorb the negative terms of trade shock by allowing flexible prices to rise rather than tightening to bring down sticky wages. I note however, that this approach was not applied when the terms of trade shock was lowering import prices.

    The trouble with the Fed is that they have a lengthening record of clever excuses for erring on the easy side – seizing up of financial markets, avoiding the zero bound, “risk management”, subdued core inflation, unreliable bond-implied inflation expectations due to liquidity, subdued bond-implied inflation expectations (when surveys start rising), lower forecast inflation, changed inflation measure etc, etc. Their credibility is shot and people want things that have real value.

    I agree that the Fed should only take account of US inflation when setting its monetary policy, but the trouble is that it is not even doing that.

  • Posted by JKH

    Brad –

    Thanks for taking the time to read McCulley’s piece. Appreciate your feedback.

    Interesting – on the quote, I had a similar reaction. Maybe it’s a typo, and he meant to say inflexible wages (to the upside), which perhaps is why price shocks like oil might not lead to general inflation and even risk deflation instead.

    It seems to me like there are three components to domestic inflation transmission from the dollar – the extent of dollar depreciation pass through to the price of imports, the size of imports relative to GDP, and the propensity for each dollar of import price inflation to begin to spread and multiply out to broad GDP. Notwithstanding the huge oil and food price spike, the argument that the Fed can be somewhat patient on the dollar is supported somewhat by each of these factors being muted to some degree. McCulley’s argument I think focuses on the last factor.

    One thing I was struggling with in reading this was how to think about real terms of trade when the US runs such a huge current account deficit. I can see where it takes more hours worked to buy a barrel of oil, but how does this translate when the US is swapping financial assets rather than hours worked for oil?

  • Posted by bsetser

    JKH — the other potential channel is through feedback from the weak dollar into oil, and then from oil — which is an input into tons of other goods — into other prices. that is what worries me.

  • Posted by bsetser

    real think –

    I am not quite advocating your b. I am advocating a gradual return to a world where dollar reserve growth is at its 90s levels relative to GDP. the dollar would remain a reserve currency in that world, probably the most important reserve currency. but total reserve accumulation would slow.

    and I am implicitly assuming a path of adjustment that brings us from a world of 1.5 trillion in reserve/ sov fund fx growth a year (08, realistically) to a world with $150b of reserve growth a year. I would rather avoid the wile e coyote moment where reserve growth goes to zero overnight.

    concretely, that means that the countries now accumulating large amounts of fx would not jump from a world where they intervene massively to a world with no intervention overnight.

    i would also note that your option a) is bad for the debtor, who maintains the real value of creditor claims by deflating and your option b) is bad for the creditor, who incurs a big fx loss from nominal $ depreciation. the US tho loses out if creditors force the US to go cold turkey in scenario b) and the adjustment happens overnight. or perhaps that forces the US to move more toward option a).

    there also is an option c) where the world finances the US despite low us rates and the US doesn’t deflate to bring the deficit down and the can gets kicked down the road.

  • Posted by RealThink

    Brad, I wholly agree, adding two points.

    1. The US CA deficit and the Rest-of-World dollar reserve growth are basically two sides of the same coin. Therefore bringing down the latter implies bringing down the former. And I just don’t see that increasing US exports can do a substantial part of the job (except in an ultra-Malthusian scenario of skyrocketing agricultural prices). Therefore the adjustment implies bringing US imports down substantially. Which can happen due to US recession or USD devaluation.

    2. The problem with the desirable path of gradual USD devaluation is precisely that the graduality may not be feasible. That’s precisely the point Krugman made in his paper “Will there be a dollar crisis?.

    “Almost everyone believes that the US current account deficit must eventually end,
    and that this end will involve dollar depreciation. However, many believe that this
    depreciation will take place gradually. This paper shows that any process of gradual
    dollar decline fast enough to prevent the accumulation of implausible levels of US
    external debt would impose capital losses on investors much larger than they
    currently expect. As a result, there will at some point have to be a ‘Wile E. Coyote
    moment’ – a point at which expectations are revised, and the dollar drops sharply.”

  • Posted by Jeff Benson

    The most unfortunate part of our current fed policy is that no active measures have been taken to reduce demand for oil. I can’t help but think that the White House policy on oil has played a major part in driving oil and Haliburton to historical price peaks. I can’t believe we have a President with the balls (excuse the french) to suggest drilling the Alaskan reserves at a time when he has so thoroughly already enriched himself and his friends. I think that the US Government’s lack of action on oil policy could ultimately be our fatal flaw.

    Paulson’s visit to China and the subsequent release of price controls was a charade of false concern. After all, China produces the majority of its required oil, whereas the US is hugely dependent on imports. The political playwright was a classic maneuver of our current policy where we deceivingly place blame and solve a problem simultaneously, only to find out that the fault and solution are completely wrong. Its like attacking Iraq for the Trade Towers attack.

    The US Government knows that oil price inflation is a monetary and capital market structural problem. And while they will intervene in free markets abroad and at Bear Stearns they won’t intervene in high finance leveraged commodity market speculation. Particularly when the primary beneficiary has the big oval office next door.

  • Posted by Qingdao

    Here’s another cartoon: Tubby Panda climbs the bamboo stalk stuffing himself with leaves; as Tubby adds weight, the bamboo thins. Tubby plucks that last succulent leaf and down comes the bamboo, Tubby and all. I would like to hear what readers of this blog think will happen then.

  • Posted by Howard Richman


    I agree with so much of what you wrote in this posting. But you missed the disastrous effect of reserve accumulation upon the US production.

    You pointed out, correctly, that the exporting sectors of the emerging countries have been helped by their reserve accumulations, but you failed to point out the flip side, that exporting sectors of the US economy have been hurt. This is evident in the rapid fall in employment in the US manufacturing sector and the near zero net investment in US manufacturing.

    A graph that you posted on June 12 in “Can the debate over trade – or globalization – be separated from the debate over exchange rates?” ( ) shows the effect of these reserve accumulations. That graph showed that the emerging countries have been increasing their exports to the United States but not increasing their imports from us.

    Howard Richman

  • Posted by bsetser

    Qingdao — To make the cartoon work, should tubby panda be eating borrowed leaves?

    Some of us have been worried that the bamboo will come falling down for a long time — perhaps too long. It hurts our credibility when it doesn’t. And the willingness of tubby’s friends to keep on lending fresh bamboo might have something to do with that.

    that said, i recognize that there is a risk that I may have lost sight of the risk that America’s creditors patience isn’t infinite, and at some point, the credit line will run out. But so far, the worse the dollar does (and the worse the US economy does), the more central banks seem to want to lend to the US …

    so in a sense I have started to worry more about the consequences of a world where tubby can keep on borrowing bamboo than the risk that tubby will bring the bamboo down after eating the last leaf.

  • Posted by Rien Huizer

    Great piece and interesting comments. Does anyone see a practical solution for how to get from 1.5 tr to .15 tr annual reserve growth?

    Any scheme would involve changes in trade flows. In China, there is plenty of absorption capacity for a higher domestic supply (OK, time lags, inflexibility, exporting to US logistically easier than to Henan) and per capita these amounts are not to insurmountable. One would expect that non-democratic regimes would be pretty good at switches like these. Russia is still in the process of recovering industrially from the transition but may well become far more balanced in a few years. In the Gulf, there is none, unless the absorption capacities of Egypt, Pakistan, Turkey and Jordan are tapped (leaving out a few more problematic countries.
    And reducing trade balances requires not only that supply is absorbed domestically (through some sort of Keynesian mechanism, rich states can do that for a while), but also that the importers replace that supply domestically. Can the US do that, physically. For Chinese manufactures that may be difficult, for oil impossible (at least in the short/medium term). I guess we should be looking for some kind of fiscal solution to support a monetary one (leaving rates unchanged and let inflation run a bit, while foreigners stop pegging). Sympathy for any US position that does not involve greater fiscal austerity is likely to be low (it does not have to be income tax, one could think of a petrol tax, a VAT, etc, we are not yet talking about high percentages of GDP) . Do you think any of that would be politically feasible?

  • Posted by Howard Richman

    Rien Huizer asked: “Does anyone see a practical solution for how to get from 1.5 tr to .15 tr annual reserve growth?”

    Yes. We propose a new international system based upon balanced trade in our book, “Trading Away Our Future” ( ). The key is for the US to insist, unilaterally, on US trade with the reserve-accumulating countries moving toward balance over a period of 5 years. At the same time, the US has to take steps to enhance domestic saving.

    The immediate result of adopting such a policy would be a surge in investment in US exporting sectors.


  • Posted by Rien Huizer

    Right, I guessed that you would suspend or abandon WTO. What about the FTA countries such as Australia and Singapore? And I guess that your program to boost domestic savings would involve reducing the gvt deficit by increasing taxes? In fact, that would not be as bad for the world economy as many people would say. Probably better than a hard landing. Difficult to police though. US firms are among the most unpatriotic in the world I guess. Someone will find way to manufacture below US cost, somewhere. I would be in favor of fiscal policy, also because that would require courage and discipline from an increasingly populist congress. And that is what the world is waiting to see. Who is going to tell the politicians?

  • Posted by Rien Huizer

    Sorry Howard, too quick. Two little things, (1) just saw on your website that you are in fact preaching as I guessed you would (2) Australia is an FTA partner, is accumulating reserves (its successive governments are running sizable surpluses which are put into a kind of SWFs (one already functioning, several more announced) aiming exactly at boosting savings at the macro level) However Australia is also a country with very large BOP deficits, almost entirely made up by commercial banks funding themselves abroad and morgage securitization. With the US Oz has currently a small surplus, I believe (but planes and defense equipment may cause large swings).

  • Posted by flow5

    It should be self-evident that further depreciation of the dollar will not solve this country’s problems in meeting world competition. The solution runs much deeper. If fact, it requires nothing less than a drastic change in the way managers manage, and the way in which workers work, and much, much, more.

    According to a Wall Street Journal report, the fast track to top jobs in our major corporations has been in sales and finance. These fields accounted for approximately 75%, while only 8% reached the top through engineering or other fields related to product design, manufacturing and quality control.

    Labor also is a part of the problem. Labor needs to be trained and retrained, on the job and off, made more efficient, accept more responsibility, become more participatory in the technical aspects of production and allowed the prospect of sharing in the fruits of improved productivity.

    Labor-management relations need to be more cooperative, less adversarial. In fact, our whole society suffers from the adversarial syndrome. The country literally is being suffocated by litigation. The highest monetary awards seem to be going to the financial manipulators rather than to those engaged in productive enterprises.

    A chronically depreciating currency is only symptomatic of these ills. Further depreciation of a currency, dollar, or whatever, will in no way correct these inadequacies.

  • Posted by flow5

    There seems no reasonable probability that the deficits will go away. Although the lags are sometimes unusually long between exchange rate changes and the changes in volume and value of trade, the present situation cannot be explained by these lags.

    Trade restrictions have some effect, but the U.S. is not immune from subsidizing exports and using numerous devious devices by the Customs Service to restrict imports.

    The real culprit seems to be the cost of our products relative to their quality. Inferior quality is not a good buy at any price. We are even getting a reputation for inferior products..

    A debtor country with a weak currency will not for long be the dominant economic power in the world.

  • Posted by flow5

    In evaluating the effects of central bank interventions it is easy to overestimate their importance. In terms of the total volume of transactions, central central bank purchases and sales are miniscule. While there are no specific figures on the volume of foreign exchange transactions, the New York Clearing House Interbank Payments System (CHIPS) reports that on an average business day about 1 trillion dollars of domestic and foreign payments are cleared by New York City banks and 250,000 interbank payments.

    With the exception of “command” economies the role of central banks in the foreign exchange markets has to be minimal, concerned only with trying to iron out unwarranted “blips”. Long term trend objectives are out. If we wish to stabilize the dollar or increase its value, it will be necessary to eliminate our trade deficits, and reduce drastically the expenses the federal government incurs in the financing of our foreign policy.

  • Posted by flow5

    If the E-D system, and the U.S. dollar is not to repeat the tragic record of all previous prudential reserve banking systems two thins are necessary: (1) the U.S. dollar must remain acceptable as the world’s transactions currency (This requires that the chronic deficits in the U.S. balance of payments cease), and (2) the E-D system must be subjected to the restraints of controllable legal reserves and reserve ratios.

    But this is only the beginning. After the legal structure has been put in place we will still need monetary authorities who understand the economics of money creation, the consequences of excessive money creation – and are willing to force on the governments and business communities of their respective countries the discipline of a properly regulated money supply. The latter problem will be with us whether control is vested in the central bankers, or the International Monetary Fund is made a world central bank and control of the Euro-Dollar is vested in it.

    But the alternative is, at some point in time, a flight from the U.S. dollar and, therefore, the Euro-dollar. This will generate hyperinflation in terms of U.S. and Euro-dollars, and an international financial crisis of unprecedented proportions. If history is a guide it is obvious these requisite conditions will not be achieved.

  • Posted by Ken

    We speak of going cold turkey, but wouldn’t that involve the dollar falling to the point where trade more or less balances? And with oil being such a key factor, one that isn’t as easy to stop both purchasing and importing than, say, furniture or granite countertops, won’t that really require a great depression in this country with something like 25% unemployment?

  • Posted by Don H

    Re: #9 “flexible” is the antonym of “perfect”(ly) indexed prices and wages.

  • Posted by Howard Richman


    You said: “Right, I guessed that you would suspend or abandon WTO.”

    –> Although I would not object to the United States suspending or abandoning the WTO, that action should not be necessary. Article 12 of the Uruguay Round of GATT and the IMF agreement would both justify US action to balance trade.

    You commented: “And I guess that your program to boost domestic savings would involve reducing the gvt deficit by increasing taxes?”

    –>Reducing government budget deficits would certainly increase domestic savings, but that’s not what we recommend in our book. Our book reflects the lead author’s specialization in public finance. (He did his dissertation under Milton Friedman at the U. of Chicago.) In our book we recommend the following changes to the tax code to increase domestic savings:

    1. Raising the capital gains tax to end the perverse incentive for corporations to buy back their own shares. We would accompany the tax hike with a provision that would allow taxpayers to reinvest their capital without paying tax, as homeowners now do when they sell one home and buy another. In other words, we would tax consumed capital, but not reinvested capital.

    2. Reducing or eliminating the corporate income tax would help since corporations are doing all of the savings in America today. Doing so would not only enhance domestic savings, it would also reduce the opportunity cost of capital, thus enhancing fixed investment.

    3. Moving away from income taxes and toward consumption taxes would help. We like the USA Tax, VAT, and FairTax. The USA Tax is the most progressive, but the VAT and FairTax have the advantage of being border adjustable, thus helping to level the playing field for American products.

    Howard Richman

  • Posted by Howard Richman


    I found your analysis interesting and I agree with your conclusion that we are eventually headed toward a flight from the dollar accompanied by hyperinflation if nothing is done about the underlying problem — our trade deficits.

    You have put your finger on the essential fallacy of those who want a stronger dollar by raising US interest rates. The problem is that making the dollar stronger would make our trade deficits worse. They are advocating a short-term fix that actually makes the long-term problem worse.

    However, I disagree with your analysis of what caused what. You hold that the promotion of financial specialists above engineers is the cause of US trade deficits. I believe it is a product of the foreign governnment reserve build-ups which have made (until recently) the financial sectors of our economy more profitable (because of the inflow of foreign loans) than the productive sectors (because they make American products less competitive).


  • Posted by Rien Huizer

    1. remark re WTO basically a colloquially phrased statement of presumed fact. No irony intended. I did not want to suggest it could not be done, and I believe firmly that blancing trade (or getting fair bit closer) would take more than just getting nominal rates closer to PPP rates of exchange. But would no doubt be politically costly.And the adjustment would take time, during which the claims would continue to mount. But then again, the current administration has nothing to lose and could introduce discriminatory trade restrictions, except that it would not pass congress without time consuming modifications (probably no serious objection against the basic idea, but every politician wants to have credit for the gainers and no blame for the losers, locally that is. Ideally, a nation intending to fight a trade war should be able to make credible threats, rather than resorting to welfare destroying measures immediately. I do not believe the US has that credibility right now, unless/until the US consumer is facing severe budget constraints or a external catastrophe occurs that exonerates policians, except ons out of office. Any new administration would need to invest considerably in whatever credibility it would like to have. You do not swing from suicidal unilateralism to profitable multilateralism that easily.There tends to be a considerable domestic cost up front. And the US does not have the constitutional properties that facilitate things like surprise, deceit and mobility, the sort of things that help winning contests (if only by occasionally demonstrating credibility).
    2. I have not read the book, but familiar with attempts at making the US tax system more efficient. And I guess that is what you would like to do. Very few economists these days would recommend keeping the kind of taxes most countries are stuck with.
    However, if the imperative would be to boost savings in the short term, consumption taxes should be introduced while the old taxes are still in place (perhaps on a temporary basis), after that a gradual reduction of income-dependent taxes and repairs of glaring inconsistencies should be considered.The politically hard part would be the consumption tax, and possibly the capital gains tax. Inidentally, if companies would not be taxed (only their shareholders) the incentive to buy back stock and increase leverage would diminish considerably. But then of course what about managerial incentives. We know that borderline investment grade credit ratings are the best way to keep managers on their toes.Very low debt dos not do that. Also, would you like the Japanese carmakers in the US (plus BMW/Merc) to face no corporate tax either. What about a very steep dividend witholding tax for non residents? And so on.

    3 Managing the USD on a global basis would be wonderful if this would involve coordination of fiscal policies. As is well known, the greatest problem facing the EUR is a very weak mechanism for fiscal policy coordination (essentially a maximum deficit rule that is (a) poorly defined -pension liabilities etc excluded and (b) not pracically enforcable). The EUR area faces hardly any BOP deficit risk, but its internal structure asks for trouble. Likewise, on the surface, a USD area without fiscal coordination would probably be financially autarchic but turn the US into … an Italy.
    Brad, your option C seems by far the most likely.
    My point has ben: show me any (politically) realistic (and non-military, an important option that I would prefer to leave ignored) measures that can be used fast and intensively enough to redress the imbalances (with China and the OPEC), without too many negative externalities. Perhaps I should change my focus: how exactly will the inevitable catastrophe evolve (when the can runs off the road). What would be the early signals. Where would the uncrowded exits be, etc. Is it already happening?

  • Posted by Howard Richman


    Thank you for your thoughtful responses. Let me address each of your points:

    1.Political Feasability. Actually “balanced trade” would win the election for the candidates that advocate it. (See our commentary “How to recapture the Republican advantage on trade” . Probably the only action that would need to be taken would be to announce to the mercantilist governments that they had better start reducing their trade surpluses with us on their own, or we will impose Import Certificates. The mercantilist countries would reverse the policies they are using to keep out imports from the US. China, for example, has the equivalent of an 80% duty on most US imports (25% tariff, 15% VAT, 40% currency manipulation).

    2. Changing tax system. You may be correct that the changes in the tax system we advocate would change managerial incentives. I would like to think they would produce positive changes in incentives. As flow5 points out, the current system promotes managers who are financial experts over managers who are engineers.

    3. Coordination of fiscal policies. The current international system is coming apart because the stagnating economy of the United States cannot provide ever increasing demand for the mercantilist countries exports. If the movement toward trade balances is gradual, I see no need for international cooperation to get the mercantilist countries to increase aggregate demand. The mercantilist countries would discover on their own that they would need to increase their own aggregate demand in order to avoid recession.

    Howard Richman

  • Posted by bsetser

    I am not advocating going cold turkey, only breaking the trend. and I am not as convinced as some that large deficits with the oil exporters are inevitable. the oil exporters will over time spend and invest more at home. that already is happening. some oil exporters could cover their import bill with an oil price of $20 five years ago. THis year is could be more like $70 for most oil exporters. $70 is also the average price of oil in 2007. If oil stops rising and stabilizes — even as high level — spending will catch up. that will help all the oil-importing (i.e. exporters of non-petroleum goods and services) countries.

    it also would tend to increase china’s surplus with the world. and here i see no reason why the same adjustment mechanisms that have brought America’s trade deficit with Europe and Canada down wouldn’t also work. $ depreciation has pulled down the non-oil deficit. And we know why the RMB isn’t appreciating; that is a direct policy choice of China’s government. a faster pace of appreciation that produced a 30% plus nominal appreciation against a basket would have an impact, especially in a world where high oil is creating an incentive to minimize transportation costs. china though has to be willing to support a period of domestic demand growth — and it has the capacity to do so.

    there are government deposits of north of 10% of China’s GDP sitting on the PBoC’s balance sheet — deposits that could be run down to finance spending if they weren’t needed as a sterilization tool. The CIC could be recast as what the CDB could have been, issuing bonds to finance domestic investment. Some of that could be subsidized — China has been willing to take losses lending to the US, but not to subsidize its own consumption/ infrastructure development. That could change.

    and the US could, i might add, help bring about a global adjustment in energy prices by raising its own energy taxes.

  • Posted by Rien Huizer

    Howard, yr #1: maybe it would win votes but would it attract professional politicians (and why not, scratch, scratch) #2 and 3 , if so, probably, yes.

    Brad, we probably agree that dealing with the China surplus is something that can be approached both like an intellectual puzzle as well as a political issue between two rather different political cultures (but not as different as Japanese and Americans, and the Chinese have far more people who not only understand the US cognitively, but like it without guilt -sorry for the pseudo psycho rubbish, but this is what my experience taught me. Plus in China someone is in charge) . But it will be hard and the current vacuum at the US top does not help. No one will want to deal with an institution, certainly not a Chinese. But you agree that it will take more than just FX realignment.However trade war could be avoided. (Somewhere along the line, if the US does not learn to do a few things differently, they will not be able to fight one, but that is another story.
    Re the OPEC countries, I was surprised to see that the EIA (Energy Information Administration) uses roughly half the current oil price in its scenarios (Annual outlook 2008 published a few days ago). That is not far from your USD 70 that it (implicitly) would take to balance OPEC/non OPEC trade in few years (their estimates for domestic oil production cost are also much higher than a few years ago indicating that the portion of oil production (standard) cost spent in the OECD has gone up quite a bit.
    Anyway, it remains an interesting subject for speculation. Let’s see how the oil price comes back to earth first.

  • Posted by Howard Richman


    I agree with three points that I heard you saying:

    1. That over time the oil exporting countries will import more goods.

    2. That China could encourage lending to the Chinese instead of using their funds to sterilize dollars.

    3. That the adjustment in China’s reserve purchases could be gradual. There is no need to go cold turkey.

    The only thing missing from your post is a motive why the Chinese should change away from a policy which is working. They are about to purchase GE’s appliance business and grab its US market share. Detroit is on the ropes and they will soon move in to the US car market. Airbus is starting to move production to China so they should soon gradually be getting the commercial aircraft production business. They are building three new factories to compete with one of America’s remaining exports – heavy mining machinery.

    I suspect that Japan changed policy in 2004 partly because they didn’t want to destroy America as a counterweight to China in Asia. China has no such motive.

    Howard Richman

  • Posted by bigdog


    aren’t you basically repeating what every commentator said in the early 80s when the US was faced with competition from Japan, and the US was supposed to be swamped within a decade? How did that turn out?

  • Posted by RealThink

    One way to implement the FT approach would be to peg the dollar to a commodity basket, within a very broad horizontal band.

    To make a very simple example, let’s assume the commodity basket consists just of crude oil, and that the band is 100 to 200 USD per barrel.
    So, if the oil price is:
    > 150, no loosening of monetary policy takes place.
    > 166, tightening of at least 25bp per FOMC meeting
    > 180, tightening of at least 50bp per FOMC meeting
    > 190, tightening of at least 75bp per FOMC meeting, and aggressive selling of oil by the Fed, both in the futures and spot markets (from the Strategic Petroleum Reserve).

    When oil approaches $100 the opposite occurs. In this case, if the US economy does not need loosening of monetary policy, the Fed could just buy oil aggressively for the SPR. (As a peak oiler, I don’t worry much about oil going below the lower band.)

    Notably, this policy would be in line with the proposals in the recent Foreign Affairs article “In the Tank – Making the Most of Strategic Oil Reserves” by David G. Victor and Sarah Eskreis-Winkler.

    As a peak oiler, I am also aware that this monetary policy would require a consistent US energy policy that encourages or better yet forces conservation. For that reason, global warmers would probably applaud this policy too.

  • Posted by RealThink

    I forgot in my simple example above to account for the trend. Obviously no additional tightening would take place if the price is in a band after having come down from a higher band.

  • Posted by flow5

    The financial CEO was a real example. I’m saying that many companies emphasize the wrong qualifications for many executive positions (esp. high tech co’s.).

    But concentration and new incentives for improvements in production, innovation, and product quality are required before we can overtake (increase our exports), or even maintain our trade position relative to our international competitors. And we are not operating with a level playing field. And we are currently at a disadvantage, e.g., there are more lawyers in the U.S. than engineers.

    Your observation gives the answer as to where the excess demand for dollars, or hot money flows, (contribution to housing speculation) came from – it was fueled by foreigners.

    But to avoid dire consequences in the future, it will be necessary to eliminate the trade deficit and operate with a trade surplus sufficient to eliminate the capital deficit and the “Pentagon’s” deficits.

    This cannot be attained by allowing the dollar to continue to depreciate or by resorting to any type of financial gimmickry. To say the task is “Herculean” is an understatement.

    Unless we are willing to make those fundamental reforms requisite to successfully competing in international markets, the continued decline of the dollar will finally force a payments balance on us.

    Under these circumstances, we can expect a long-term deterioration in the standard of living of the vast majority of the people in this country.

  • Posted by flow5

    For the people of limited foresight, which apparently includes a substantial majority, debt expansion can be very exhilarating. One’s standard of living can take a quantum leap forward. Taxpayers are currently being subsidized, in terms of taxes not paid, more than $248 billion annually (06). It is called the federal budget deficit. Consumers are being subsidized by approximately $812 billion current account deficit in 2006/annually, of which, $302 billion is for oil (37%). It is called the foreign trade deficit.

    In the longer term the problem of servicing all this debt, consumer, corporate, and federal poses daunting problems. And that is a gross understatement. We have temporarily concealed the underlying factors that will shortly push down the future standard of living of most people in the U.S. These circumstances, as we know, are of our own making. The country has not been invaded, and our productive resources have not been destroyed, or even impaired, by national calamities.

  • Posted by flow5

    The trade deficits would have forced a much sharper decline in the dollar had there not been a massive shift by foreign investors to equities and real estate (10/9/08 & 2/1/02) respectively.

    Declining interest differentials plus a falling dollar made creditor ship obligations relatively unattractive compared to stocks and real estate.

    This is the principle reason common stocks and real-estate were propelled to levels that seem unjustified in terms of dollars, but are bargains in terms of our major trading partners.

  • Posted by flow5

    Had a few more points then I’ll just read.

    1. The trade deficits, plus the unilateral transfers of funds by the Federal Government to foreigners, transformed this county from the world’s largest creditor to the world’s largest debtor.

    2. Central Bankers are powerless to alter long-term factors that determine the supply of, and the demand for, any particular country’s currency. The chronic and accelerating deficit in our balance of trade is one such factor; all of their powers have a limited and short-term effect. With regard to deficits, the federal budget deficit or the foreign trade deficit, the powers of the Fed are marginal at best.

    3. Rates now are determined in the open market subject to all of the vicissitudes of a competitive market. Consequently, the market registers many unwarranted speculative fluctuations. These fluctuations unnecessarily increase the costs and risks of doing business.

    4. Reducing our internal deficit would reduce pressure on the capital markets, thereby reducing interest rates and the foreign demand for dollars. But this would have only a minor effect on the foreign exchange value of the dollar.

    5. With a chronically depreciating dollar, foreigners will be much less inclined to invest in the U.S. on a creditor ship basis, thus pushing up interest rates. The rising cost and diminishing volume of imports will contribute to an increase in inflation, and the expectation of further inflation will also push up interest rates. This spells stagflation.

    6. Obviously the dollar neither fulfills the standard-of-value function (the currency around which all other currencies fluctuate) nor can a depreciating currency serve as a reserve currency. While still the World’s dominant transactions currency, that role is also diminishing. Other countries are conducting more of its trade in terms of the EURO, etc.

    7. Some have declared the dollar “overvalued”. The assumption being that if the dollar depreciates enough it will mitigate most of our “terms of trade” problems. Such reasoning ignores the basic fact that strong economies have strong, not weak and depreciating currencies: A country cannot be made strong by depreciating its currency.

    8. A weak currency is not a cause; rather it is a symptom of a weak, noncompetitive economy. IN time, of course, a declining dollar will eliminate the deficit in our balance-of-trade. But the price exacted will be a sharp decline in imports and the purchase of foreign services, reflecting our relative poverty and inability to compete in the international economy.

    9. The problem is that further depreciation of the dollar will not correct our foreign trade deficit. In fact, further depreciation will only make our stocks and land, urban and rural even cheaper and even more attractive. We have become a financial hostage to the Pacific Rim’s & Oil producing countries.

    10. This is the first time that a reserve currency country could operate with chronic international deficits and not have its currency “dethroned”

    11. We have no choice but to curtail those types of foreign military, and economic expenditures, which create a drain on the dollar… If we do not, the dollar will cease to be a convertible currency, will cease to be a reserve currency, and the United States will be forced into a high degree of economic isolation and perhaps into an increasingly totalitarian mold

    12. Note that the “Pentagon’s” deficit is the most dangerous of all. Its expansion simultaneously increases both the federal deficit and the balance-of-payments deficit.

  • Posted by flow5

    This is all

    1. As the number of banks participating in E-D increased, the E-D bankers discovered that the E-D deposits they created for borrowers often did not result in any diminution of their U.S. dollar balances – the System was merely shifting balances within itself. That is, drafts drawn on E-D banks increasingly were deposited in other E-D banks.

    2. Thus was laid the economic basis of an international system of “prudential” reserve banking – the discovery that the amount of actual U.S. dollar reserves required to support the E-D bank’s convertibility commitment need be only a fraction of the volume of E-D loans made – and E-D deposits (money) created.

    3. The E-D has been a superfluous and harmful addition to the already excessive national monetary stocks of the world. Moreover, the acceptability of the E-D is totally dependent on the acceptability of the U.S. dollar. The viability of the U.S. and Euro-dollar as international units of account is threatened by the huge trade deficits

    4. The situation requires measures be taken which will reverse the deterioration of the dollar’s integrity. What is required is no less than an end to the chronic liquidity deficits in our balance of payments, and a halt to the excessive creation of U.S. and Euro-credit dollars.

  • Posted by Howard Richman


    You are correct in your depressing analysis of where we are headed if current trends continue.

    However, I think there is an element of hope that you have overlooked. If something causes a surge of investment in America’s productive sectors, that investment could solve our trade problems.

    Howard Richman, co-author
    Trading Away Our Future

  • Posted by RebelEconomist

    For what it is worth, I agree with flow5 about the fundamental causes of the US current account deficit. I see similar problems in the UK – apparently only one British school in four now has a specialist physics teacher, for example. Blaming “mercantilists” is just an excuse for failing to compete and then refusing to live commensurately.

  • Posted by Howard Richman


    I think that the mercantilism came first before the lack of investment. Mercantilism took the profits out of American production that competes with foreign production. The lack of investment follows from losing the profits.


  • Posted by Twofish

    flow5: And we are currently at a disadvantage, e.g., there are more lawyers in the U.S. than engineers.

    I’m one of the few people who thinks that this is a good thing and not a bad one. Without a good legal system in place, engineers don’t end up doing very much useful.