The Free Thinker

Nomination: IMF for World's Federal Reserve

"Chinese officials call for displacing dollar, in time" (Reuters)

BEIJING (Reuters) - The financial crisis has laid bare defects in the dollar-led global economy and the world should look to displace the U.S. currency, even if that will take many years, Chinese officials said in comments published on Monday.

The push for fundamental, if gradual, reform of the international financial system comes just before the Group of Eight summit in Italy, where China's willingness to question the dollar's role could fuel debate.

The Special Drawing Right (SDR), a unit of account used by the International Monetary Fund, presents a viable alternative to the dollar as a global reserve currency, said Li Ruogu, chairman of the Export-Import Bank of China, a major state-run bank.

"It is a feasible plan to reform the present SDR and make it into a real settlement currency, a universally accepted 'currency basket' that would replace the dollar at the heart of the monetary system," Li was cited as saying in Financial News, a newspaper published by the central bank.

I'm for it.  The success of the euro suggests that transnational monetary experiments.  (The euro hasn't overcome Eurosclerosis in Germany and France, but it has held together pretty well so far, and Ireland, Spain, and Greece have been thriving until last year.  Overall it seems like a success.)  I don't think it does the United States any good to have the world's reserve currency.  It just encourages politicians to overspend, because Congress's ability, at the end of the day, to commandeer the Fed and print money to pay our debts persuades foreigners that the US won't default, and therefore gives the government unlimited access to foreign capital, which they waste, crowding out more productive private sector economic activity.  And anyway, it does seem more fitting somehow for the provider of the world's reserve currency to have a worldwide mandate.

"Summers, Geithner Are Silent as IMF Loses Grip" (Bloomberg):

The “Asian Monetary Fund,” so passionately derided by Summers and Geithner [in 1997/8], is back. There is little a crisis-plagued U.S. can do to stop Asia’s $120 billion foreign- exchange reserve pool. Its creation is the clearest sign yet that Asia's getting serious about combating the global crisis. Done right, it will bode well for the region’s outlook...

[Summers' and Geithner's] concern [in 1997/8] was that [an Asian Monetary Fund] would eclipse the IMF in the region and, by extension, the U.S.’s say in how Asia retooled economies. They feared doling out billions of dollars in aid with few policy-change strings attached would prove dangerous. And they got their way. That changed this week.

From 1997 to 1998, the IMF arranged about $100 billion of loans to Indonesia, South Korea and Thailand as currencies collapsed. In return, governments had to cut spending, raise interest rates and sell state-owned companies. The IMF’s policies needlessly deepened the turmoil. 

Aside: Asia recovered quickly under IMF "austerity" policies.  I doubt we'll recover so fast.  If only we could be under the stern tutelage of the 1997-8 IMF instead of under the Obama administration.

During this global crisis, nations sought help from neighbors instead of borrowing from the IMF.  Indonesia, for example, raised $5.5 billion of standby loans from theAsian Development Bank, World Bank, Australia and Japan, and increased the size of its currency-swap arrangements with China and Japan to bolster access to foreign exchange.

Asia’s new fund takes things to another level. On May 3, the Association of Southeast Asian Nations, together with Japan, China and South Korea, agreed on terms for the so-called Chiang Mai Initiative and to use the funds in times of trouble. The pool, to be ready by year-end, largely neuters the IMF in Asia.

Granted, $120 billion seems like a paltry sum in today’s world of cascading markets and recession. American International Group Inc. alone received $183 billion worth of public bailouts. The size of the stockpile isn’t the issue. It can always get bigger.  China and Japan boast almost $3 trillion of currency reserves. It’s the symbolism that really matters here.

Asia as been lacking in the cooperation department as the U.S. redit crisis infected global markets. Meeting in Bali, Indonesia, this week, governments put their money where their vulnerabilities are, and it’s about time.

Nice to hear of initiatives originating elsewhere.  Somebody needs to take the reins of world leadership now that we're falling apart.

Debt-Deflation

Ed Glaeser:

In the stock market, crashes can happen in hours or even minutes.  In the housing market, crashes take months and years.  Homeowners with their houses on the market, don’t just get up one morning, smell the coffee and decide to reduce their asking prices by forty percent.  It takes time for people to recognize that a bubble has burst, and plenty of sellers never do.  They just sit on their homes for years until the market turns around. 

As we are in the midst of the slowly unfolding collapse of the greatest housing price bubble in the short history of well recorded housing prices, each month’s data brings little change.  Instead, month after month, we got the slow wheeze of a bubble bursting.  The January 2009 Case-Shiller house price data, released this morning, by Standard and Poor’s, looked a lot like last month’s data. The decline between November and December for the composite 20 index was 2.6 percent; the decline between December and January was 2.8 percent.    Don’t get excited by the fact that last drop was a little higher: those numbers are essentially indistinguishable. 

The cities on sand—Phoenix and Las Vegas—continued to have some of the biggest price declines.  Phoenix prices dropped by 5.5 percent between December and January; they fell by more than five percent between November and December.  Las Vegas’ price declines have been trending at 4.5 percent down per month.  If the trend continues, by February, Phoenix prices will have dropped by more than 50 percent since the peak. 

I am somewhat surprised that these markets aren’t starting to settle down.  The defining characteristic of these two areas, and many other affordable, growing places like Dallas and Houston, is that their ability to supply housing is essentially unlimited.  Since builders can produce housing in practically enormous quantities at reasonable prices, and land is essentially infinite, it was always a little absurd for people to pay so much more than construction costs for housing in these areas.  But now prices are converging back on construction costs, which is where I had thought that they would land.  However, the rate of decline isn’t slowing, and it now looks as if prices might dip below these costs.  If that happens, then building will essentially cease.  This would be a colossal change, since the Phoenix and Las Vegas areas together permitted more than 30,000 units last year.

After these two places, the most diminished housing markets are in California and Florida. San Francisco, Miami and Tampa all continued to have dismal months. Prices in Los Angeles and San Diego each did slightly better, dropping by about 2.7 percent, but that looks good only by comparison. Prices in these five areas have declined by about 40 percent relative to the peak. These areas had some of the biggest price booms and now they are experiencing some of the biggest price busts. Reversion to the mean is a regular feature of housing markets and they are experiencing that now...

The housing news continues to be bleak for the financial actors who are holding mortgages, the value of which is tied to housing prices.  Continuing price declines probably mean that the banks will need even more bailout money. 

Yet, these declining prices aren’t all bad.  When prices fall, buyers get bargains.  One of the glories of America is that people are able to buy high quality houses at affordable prices.  We had lost some of that advantage during the unfortunate bubble, now we are getting it back. 

Yes, there's a bright side to falling real housing prices.  But falling nominal housing prices cause major institutional problems.  This is the phenomenon Irving Fisher called "debt-deflation" in the 1930s and identified as a major cause of the Great Depression: when the prices of assets that are used as collateral fall, the incentive-compatibility of loan contracts is destroyed.  That's why the Fed should not allow asset prices to rise so much.  The Fed should have choked off the housing bubble three or five or eight years ago with higher interest rates.  Now, however, it should do the opposite, and try to reflate housing prices-- nominal housing prices-- to something nearer their 2006 level, at the expense, if need be (and need probably will be) at the expense of fueling consumer price inflation. 

Fortunately this is sort of what the Fed is trying to do.  Monetary policy is by far the brightest spot in economic policy right now.  It's the one thing that definitely distinguishes the policy response today from that in 1929-33, when monetary policy was contractionary, and it's the main reason that this is not likely to be Great Depression II.  Most of the rest of what the government has done has been hapless at best and perverse at worst (the "stimulus," the Obama budget), and might just make this Great Depression II after all despite much better monetary policy.

World Money Revolution?

"Medvedev Talks Up Super Currency" (Moscow Times):

President Dmitry Medvedev called for a new world economic order, including the introduction of a new "super currency," on Tuesday as he prepared for a G20 summit in London, where Russia has been jockeying for a more prominent role.

Speaking at a summit of CIS finance ministers in Moscow and later at a meeting with German Chancellor Angela Merkel in Berlin, Medvedev reiterated the key points in Moscow's proposed revision of the world's financial system, including the creation of a new global currency to supplant the U.S. dollar.

"Many of our partners maintain the point of view that everything is fine in this area, that all that is needed is a slight strengthening of major worldwide currencies, including the dollar," he said in Moscow, Interfax reported. "We hold another point of view."

He called for the creation of a "new international currency system" and said the idea of the super currency that Russia had suggested was finding an audience among other countries.

"Many are now discussing a so-called super currency, a supranational currency," Medvedev said.

He repeated the proposal once again in Berlin, saying the global economy "cannot develop in the next 10 years if we do not create a new infrastructure, including new [currency] systems," Interfax reported.

Merkel agreed that a new world economic order was needed. "It is clear that decisions on the new financial architecture must be made," she said at a joint news conference with Medvedev late Tuesday, where they also discussed NATO and a gas dispute with Ukraine.

The Kremlin has persistently criticized the dollar's status as the dominant global reserve currency and has lowered its own dollar holdings in the last few years.

In a document released two weeks ago that contained suggestions for global economic reform that the Kremlin said it would pitch at the G20 summit, it called for the creation of a new reserve currency or using Special Drawing Rights, or SDRs, as a "superreserve currency accepted by the whole of the international community."

Although most political leaders, including U.S. President Barack Obama, dismissed the idea, it sparked international debate and found a powerful backer in China, which last week echoed the call for a global currency and less reliance on the dollar.

Finance Minister Alexei Kudrin said Tuesday that the Chinese yuan could become a global reserve currency in 15 years. (Story, page 7.)

"The Dollar isn't Going to Yield to the Yuan just Yet" (Bloomberg):

China’s idea of dumping the dollar as the world’s reserve currency has about as much appeal in today’s globalized economy as Esperanto.

It might be a good idea, but nobody’s ready to buy it.

China’s proposal isn’t about wobbly exchange rates. It’s about making a statement before this week’s Group of 20 summit. China, together with Russia and others, want to let Washington know that it is going to have to share the head table in what used to be an exclusive club.

China’s ascendancy was a fact before the financial crisis. Now its political clout is catching up with its economic might. But when it comes to currency, the dollar is still king, and will probably remain so for some time.

Think about it. Who seriously expects to see commodities -- from gold to cotton to oil -- priced in anything but greenbacks anytime soon? There have been times when Russia, Iran and Venezuela considered pricing crude in euros, but that idea evaporated for one simple reason: depreciating the dollar ends up harming those countries that hold them in reserve.

The first victim would be China, now the largest holder of U.S. treasuries -- about $740 billion-worth, more than a third of its entire foreign reserves.

The truth is you can’t dictate which reserve currency countries will use, any more than you can make people speak Esperanto, a universal language invented 112 years ago that still hasn’t taken off...

So far, no one has come with a good idea for an alternative to the dollar. China and Russia propose expanding the use of the International Monetary Fund’s Special Drawing Rights, a cumbersome vehicle whose value is set by a basket of currencies. Russia has added the idea of putting gold in the basket as a stabilizing element.

Dollar Defense

The IMF? Is that really the institution we want to manage complex international monetary politics? Critics have already questioned how the IMF would go about setting the value of the SDRs, and how it would resist political pressure to change the valuation.

For its part, the U.S. will obviously defend the dollar’s dominance as long as it can. Its status as the No. 1 currency means the U.S. doesn’t have to repay debts in foreign tender, keeping borrowing costs down. A weaker dollar would make it harder to sell the Treasuries the government needs to jump-start the economy.

This is strange: I find myself sort of agreeing with Medvedev and China.  I've come to suspect that having the world's reserve currency actually hurts us more than it helps.  For example, in the present case, I doubt that selling Treasuries to spend will jump-start the economy (though the economy will probably recover on its own, albeit weakly because of the increased burden of government); but a weaker dollar would jump-start the economy directly, by making US exports more competitive.  More generally, I think having the world's reserve currency is a little bit like having lots of oil: its a free lunch for the elite that fuels corruption and waste and does overall harm.

One thing's for sure: we'd be a lot better off right now if a dollar crash forced Obama to submit to the diktat of the IMF.

UPDATE: To clarify, I don't think Medvedev / China's plan is going to work.  But I wish it would.

Good Job, Ben

"Fed launches bold $1.2T effort to revive economy" (RealClearMarkets)

With the country sinking deeper into recession, the Federal Reserve launched a bold $1.2 trillion effort Wednesday to lower rates on mortgages and other consumer debt, spur spending and revive the economy.
To do so, the Fed will spend up to $300 billion to buy long-term government bonds and an additional $750 billion in mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac.
Fed Chairman Ben Bernanke and his colleagues wrapped a two-day meeting by leaving a key short-term bank lending rate at a record low of between zero and 0.25 percent. Economists predict the Fed will hold the rate in that zone for the rest of this year and for most — if not all — of next year.
The decision to hold rates near zero was widely expected. But the Fed's plan to buy government bonds and the sheer amount — $1.2 trillion — of the extra money to be pumped into the

U.S.

economy was a surprise.
"The Fed is clearly ready, willing and able to be the ATM for the credit markets," said Terry Connelly, dean of

Golden Gate

University

's Ageno School of Business in

San Francisco

.
Wall Street was buoyed. The Dow Jones industrial average, which had been down earlier in the day, rose 90.88, or 1.2 percent, to 7,486.58. Broader indicators also gained.
And government bond prices soared. Heralding a coming drop in mortgage rates, the yield on the benchmark 10-year Treasury note dropped to 2.50 percent from 3.01 percent — the biggest daily drop in percentage points since 1981.
The dollar, meanwhile, fell against other major currencies. In part, that signaled concern that the Fed's intervention might spur inflation over the long run.
If the credit and financial markets can be stabilized, the recession could end this year, setting the stage for a recovery next year, Bernanke has said in recent weeks. The Fed chief and his colleagues again pledged to use all available tools to make that happen, and economists expect further steps in the months ahead.
Since the Fed last met in late January, "the economy continues to contract," Fed policymakers observed in a statement they issued Wednesday.
"Job losses, declining equity and housing wealth and tight credit conditions have weighed on consumer sentiment and spending," they said.
The Fed's announcement that it will spend up to $300 billion over the next six months to buy long-term government bonds was something that in January it had hinted it would do. But some officials had seemed to back off from the idea in recent weeks.
Such action is designed to boost Treasury prices and drive down their rates, as it did Wednesday. Rates on other kinds of debt are likely to fall as well.
"This is going to help everybody," said Sung Won Sohn, economist at the Martin Smith School of Business at

California

State

University

. "This might help the Fed put Humpty Dumpty back together again."
The last time the Fed set out to influence long-term interest rates was during the 1960s.
The Fed's decision to buy an additional $750 billion in mortgage-backed securities guaranteed by Fannie and Freddie comes on top of $500 billion in such securities it's already buying. It also will double its purchases of Fannie and Freddie debt to $200 billion.
Since the initial Fannie-Freddie program was announced late last year, mortgage rates have fallen. Rates on 30-year mortgages now average 5.03 percent, down from 6.13 percent a year ago, according to Freddie Mac. The Fed's decision to expand the program could further reduce rates, analysts said.
"This is not only going to keep mortgage rates low for a long period of time," said Greg McBride, a senior financial analyst at Bankrate.com. "The mere announcement may produce a honeymoon effect and bring mortgage rates down to even lower levels in the coming days."
The goal behind all the Fed's moves is to spur lending. More lending would boost spending by consumers and businesses, which would revive the economy.
The Fed also said it would consider expanding another $1 trillion program that's being rolled out this week. That program aims to boost the availability of consumer loans for autos, education and credit cards, as well as for small businesses.
Where does the Fed get all the money? It prints it.

Inflation is the least of the various evil outcomes to fear at this point.  The dollar seems to have sunk a few euro cents, and might have further to fall.  Meanwhile, I don't understand this:

If Chinese PremierWen Jiabao is so worried about the safety of China’s investment in U.S. Treasury securities, he can order the money be moved elsewhere.
Of course, that likely would drive down the value of the dollar, push up U.S. interest rates and cause huge losses in China’s $700 billion portfolio of Treasuries.
The reality is that Wen and China are stuck. They have no viable alternative so long as China continues to accumulate large amounts of foreign currencies as a result of its big trade surplus.
Chinese authorities took offense when Treasury Secretary Timothy Geithner, during his confirmation hearing on Jan. 21, accurately labeled China as a currency manipulator. Wen’s gratuitous and inaccurate remarks about U.S. assets are just as offensive.
“We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets” Wen said during a March 13 press conference. “To speak truthfully, I do indeed have some worries.”
The U.S. isn’t about to default on its government debt, and Wen knows it.

I don't see the justification for calling Wen's remarks "gratuitous and inaccurate."  They say they're worried.  That's surely accurate.  Probably Wen is more afraid that we'll inflate our way out of debt, trashing the T-bills China's holding as security, than that we'll default outright.  But I wouldn't rule out the latter.  Newt Gingrich and the Contract with America Congress were threatening to stop payment on US Treasury bills in 1995.  Funny thing is that as crazy as that sounds it was instrumental in bringing us the only period in the past generation where fiscal policy was actually on a sound, sustainable basis, and probably played an important role in the great 1990s boom.  Given how radically the political class has been experimenting with the economic constitution lately, I'd put the probability of a US debt default a lot higher than a year ago.  Not high, certainly.  But not zero.

I'd get out if I were them.  Invest the money at home.  And repeal the one-child policy for heaven's sake.  Let China rely on its own children to secure its future, not on US promises.

UPDATE: Dick Morris and EIleen McGann dismiss the Fed's move:

IN an effort to promote liquidity and boost the economy, the Federal Reserve yesterday announced plans to grow the money supply by another 50 percent to 60 percent. This ignores the profound observation of Gen. George Patton: "You can't push a string."

When the Fed expands the money supply, it doesn't pass out $100 bills on Broadway. It gives lines of credit to banks and other financial intermediaries to generate some money and also buys up Treasury bills in circulation to pump out more cash.

But the money supply has already expanded by 271 percent in the past five months. Why does the Fed expect what hasn't worked to suddenly start working?

Right now, there is about $800 billion plus currency in circulation sitting in wallets, purses and cash registers around the country. Another $800 billion is sitting in a vault at the Federal Reserve Board, for a total monetary supply of about $1.6 trillion.

In a vault? Yes. When Congress voted the TARP program to bail out banks, the banks actually took only a small part of the money. The rest they used to offset losses on their balance sheets while letting the Fed hold onto the money.

Why didn't the banks want the money? Because they're not about to make loans in this economy. They're more than happy to let the cash sit at the Fed earning them interest. (The Fed decided to start paying interest last November).

So now the Fed will, in essence, be creating another trillion of money supply to sit in the vault alongside the $800 billion already there. The new money will remain idle for the same reason the old money has because banks won't make loans in this environment.

And what of the money that is going out the door to buy Treasury bills? Those selling Treasuries won't run out and spend the money on flat-screen TVs. With higher taxes coming up next year and the economy in the tank, they won't spend it or lend it they'll probably just turn around and buy more T-bills.

They could be right but I doubt it.  First, it's not clear that the Fed's monetary policy so far "hasn't worked."  The economy has been sinking, but maybe-- I think-- not as far and fast as it would have without the extra money.  Monetary expansion, I suspect, has been the one good thing the government has done, and has helped offset the effects of the other policies which are almost all bad.  Second, buying Treasuries is the right thing, because the simple thing, to do.  And there are only so many Treasuries to buy, anyway.  The world is about to be flooded with them by the Obama administration's budgets, of course, but still, it's a finite amount, and if the Fed buys more, private individuals will have to hold less T-bills, and more money.

Is There a Dollar Bubble?

I didn't understand what could justify the run-up of housing prices, but I was hesitant to call bubble.  I didn't have faith that markets knew what they were doing, but I was reluctant to trust my own judgment that they were out of line.

Maybe economists should be more willing to second-guess markets.  Here's what I'll say now.  The recent run-up in the dollar, as shown in these two charts...

   

... doesn't make sense.  The first chart shows the dollar against the euro over the past year, the second, over the past five years.  Since last summer and especially since last October, the dollar has risen strongly.  It briefly lost about half its gains this month but is now recovering them.  Why?  The 5-year chart shows that the dollar has been sliding since the beginning of 2006.  This made sense: the US has long been running a current-account deficit and strong growth elsewhere in the world made their currencies look better.  As the dollar weakened, US exports became more competitive and surged.  That made sense.

That the dollar rose amidst the crisis is a comforting reminder of the confidence foreigners still have in the US.  They're not wrong: the US is stable, and the dollar will retain much of its value in any case.  But I think the 2005-08 trend was more reflective of fundamentals.  The dollar rally in the past few months is, I suspect, driven by speculation and capital flight, and that's not a stable motive.  Particularly because the Fed is printing so many.  So, my tentative guess is that the dollar may be in a bubble, and we might see it pop soon.  That wouldn't be a bad thing for the US, which could use the exports.

"Watch out world, Americans are saving again"

In one of the biggest and most misunderstood changes in modern economic history, citizens of the largest economy in the world are suddenly doing something they haven't done in years: They're saving money. It is having myriad consequences, including a tsunami of money in one part of the world, and an air pocket in demand in other parts of the world, especially China.

Americans are suddenly spending less than they earn. While that might not sound heretical or surprising - how long can you go on spending more money than you earn? - it is an epochal moment for the free-spending United States. After saving an average of more than 7 per cent of disposable income until almost 1990, the United States went into a savings tailspin. Savings rates fell, in fits and starts, from 8 per cent, through 6 per cent in the early 1990s, to 2 per cent around 2000, to the ignominy of a negative savings rate by mid-2005.

Now, however, that is changing rapidly. November economic data showed U.S. savings spiked to 2.8 per cent of disposable income, up from zero at the beginning of 2008. Is it that Americans have suddenly figured out that saving is a good thing, or are they taking some sort of moral stand against profligate spending?

Be serious. Americans remain the wild-eyed spenders of the world, and that was never likely to change without external pressure. They have, however, been forced into this, with their equity investments and real estate investments all sliding into nothingness, and with the economy in a deep recession. They must repair their broken personal balance sheets, and so, as painful as it might be, they are saving money.

Great. Good for Americans, right? Savings über alles! Well yes, but there is much more to it than that. For starters, the U.S. savings rate won't stop at 2.8 per cent. My guess is it will rapidly rise to 4 per cent by the end of the year, and will likely hit 7 per cent by late 2010.

But in the end, fixating on those numbers misses everything that matters because that money has to come from somewhere. Your savings, in some sense, represent my lost income.

Not if my savings go into a bank, which lends them out to an entrepreneur, who starts a new business and hires you.  But will that happen?

It should be said that the supposed low savings rate was always a little bit misleading.  Why save when your net worth is rising anyway because of rising home and/or stock prices?  Low official savings rates were the flip side of the asset bubble.  People want their net worth to rise over time.  Now that rising asset prices aren't raising their net worth for them, they're saving instead. 

It's too bad, though, that we piled up so much debt to the Chinese to build houses we didn't need.  Don't forget that a lot of the blame for that belongs to Freddie Mac and Fannie Mae, and the mortgage-interest tax deduction, and the misguided policies that tried to drive homeownership rates artificially high.

Brad DeLong: Republic of the Central Banker

Ben Bernanke is the closest thing to a central economic planner the United States has ever had. He bestrides our narrow economic world like a colossus. Unelected (he was appointed by President George W. Bush and confirmed by an overwhelming majority in the Senate) and unaccountable (unless the Congress decides that it wishes to amend the Federal Reserve Act and take the blame for whatever else goes wrong with the economy), he is responsible only to his conscience -- and his open-market committee of himself, the other six governors of the Federal Reserve Board, and the 12 presidents of the regional Federal Reserve banks.

The fate of the economy in the next administration depends far less on the president than on this moral-philosopher-prince to whose judgment we have entrusted a remarkable share of control over our destiny.

How did an ivory-tower academic whose specialty is the details of the Great Depression get to this position? What does he do all day? How did so much power come to rest in a single institution, a single individual? The current system is the product of a century and a half of evolution in the role of a central bank, on both sides of the Atlantic, through a series of accidents and crises. For a generation, the idea of social democracy -- with government ownership, control, and regulation of at least the "commanding heights" of the economy -- has been in retreat. But in the middle of this market economy is an immense island of central planning: the Federal Reserve. In normal times, the Fed -- not the market -- decides what the short-term interest rate is. The interest rate is perhaps the key price in the economy. It is the price at which we trade wealth in the present for wealth in the future.

When the interest rate is low, our focus is on the future: Businesses and consumers borrow and invest. When the interest rate is high, our focus is on the present because distant-future promises of cash are not worth very much in today's dollars. You might think that if there were ever a decision we would leave to the market and the aggregated preferences of millions of individuals, it would be the terms on which we trade present comfort off for future wealth. But we don't. We leave that decision to the discretion of the philosopher-prince Bernanke and his committee. And in extraordinary moments like the September Wall Street crisis, when the flow of funds through financial markets dries up, we leave the decisions of which banks to nationalize, which to close down, which to forcibly merge, and which to rescue and on what terms to our financial overlords in the Eccles Building on the National Mall.

It is very odd, isn't it?  The case that has been made-- and accepted!-- for central bank independence is pretty explicitly anti-democratic.  Basically, politicians are subject to short-term pressures that make them manage the economy for their short-term electoral interests in ways that are harmful in the long run.  It's probably true!  But it's not as if we have a good theoretical reason to believe that a philosopher-king will do things better.  This is why the libertarian idea of "free banking," though it has a quixotic flavor, has an enduring appeal.  If so many other goods are made and circulated in a decentralized way, why not money?

The Case for Shock Therapy

Dani Rodrik, writing last week, is one of several to compare the current US financial crisis to the 1997 crisis in Thailand:

The financial crisis that has developed around subprime mortgages is so so astounding in so many different ways that, like many others I suppose, I am still having difficulty getting my mind around it.  The whole thing is a big surprise for me.  I would have been pretty ready to assert, as late as 6 months ago, that financial crises of this magnitude had become solely a developing-country phenomenon and that rich countries had developed the regulatory and other mechanisms that would prevent them from getting into such a mess.  Yes, there would be smaller scale hiccups, such as the S&Ls or LTCM, but you certainly couldn't have a meltdown a la East Asia 1997-98 or Mexico 1994 in an economy such as the U.S.

Now we know that I would have been wrong.  What is happening in the U.S. is no different from what took place in Thailand in 1997 or in Argentina in 1999, with the entire financial sector going belly-up.  The only thing that remains to be seen is whether the costs to the real economy will be as high too.  The rough rule of thumb for emerging markets is that banking crises are associated with an output loss of around 10% (see here for example).

And yet, in a way, an analogy to Thailand makes for a hopeful scenario.  The Asian crisis of 1997-8 caused horrendous pain: GDP dropped steeply everywhere, and there was a sharp slowdown in growth.  But it was brief.  The next year, Asia started growing at its old rates again-- the fastest in the world-- and it's been booming ever since.  The Asian countries had the good fortune, perhaps, that the IMF meddled.  The IMF was accused of "shock therapy," but it claimed that the reforms it pushed on the Asian countries were necessary for long-term growth.  We don't know the counter-factual, i.e., what would have happened if the IMF had not intervened.  But the subsequent economic success seems to vindicate the IMF.

In Japan, which experienced a real estate bubble and bust and then a financial crisis in 1995, the government was more interventionist.  The crisis there lasted much longer.

On balance, I think Paulson's bailout plan is most likely to make matters worse.  There may be an ideal solution that shores up the financial system without costing the taxpayer too much.  But we're unlikely to find it.  The whole problem is fiendishly complex.  Nobody understands it all.  People who understand some parts of it are likely to have blind spots.  And any action undertaken, even the most well-designed, will create major perverse incentives as private-sector agents try to position themselves to benefit from the next bailout.

I'm not saying "do nothing."  Certain lines must be held at all cost, e.g., deposit insurance: if commercial banks fail, the FDIC must be ready to give despositors their money back.  Other creative measures might be taken... 

For example, just to brainstorm, maybe the government could offer to buy back the homes of people who can't pay their mortgages at purchase price - 25%.  The government could pay this money to the bank, then pay the bank a bit more (but not all; banks should take a "haircut" of 5-10% on bad loans) for the rest of the debt, so that people would owe the government instead of the bank. Then the government could offer generous forebearance on repaying the loan, e.g., a two- or three-year suspension of payments and interest.  People who accepted this deal could then be allowed to rent back their homes temporarily at a low rate, with the government reserving the right to terminate this arrangement with six months' notice whenever the state of real estate markets makes resale seem advantageous.  This plan would (a) revalue some mortgage-backed securities, (b) ease the liquidity situation of people who can't pay their mortgages while punishing them in the medium run, and (c) destroy some of the housing stock, in effect, since homeowners-turned-renters would lose the incentive to maintain/improve the homes they live in.  Effect (c) is desirable because it would help bring housing prices back up. 

The above paragraph is just an example, and there may be problems with it, economically, legally, and/or administratively.  My point is, though, that we should brainstorm creative fixes, but Congress shouldn't pass anything it doesn't understand-- and even Paulson probably doesn't clearly understand the Paulson plan-- just because they're hearing doomsday scenarios.  Shock therapy may be preferable to a cancerous fusion of Washington and Wall Street.

And Steve Landsburg explains why a Great Depression is unlikely:

In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent.

One more thing: the IMF's been a bit underemployed lately, to the point of having to lay off a lot of staff.  We could probably hire a large share of the institutional capacity of the IMF for the duration of this crisis for a couple of hundred million.  Million-- note the "m."  They have experience with this kind of thing-- see the swift return of the pronounced-dead Asian boom.  I have a suspicion they'd do as well as Paulson.  At any rate, we could get a second opinion.

(Just my luck: the moment I decide to stop political blogging, an economic-political issue explodes that makes it impossible to blog economics without it having political ramifications.  Still, I've steered clear of partisan politics.)

Free Banking

Alvaro Vargas Llosa advocates one of the battiest, or perhaps the most brilliant, libertarian ideas, the abolition of the Federal Reserve ("Government Solving Its Own Crises", TCS Daily, 24 Mar 2008):

The Federal Reserve recently announced new measures to tackle the current financial crisis. They include helping J.P. Morgan Chase acquire Bear Stearns, lowering the discount rate and offering short-term loans to about 20 investment banks-- and they came only days after the government said it would inject $200 billion into the financial system.

These are the latest steps taken by the U.S. government to solve a problem created in large measure by the government itself. We have seen this movie before.  As a reaction to the bursting of the dot-com and telecom bubbles at the end of the 1990s, the Fed inflated the currency through the actions of its Open Market Committee. By June 2003, the policy of easy money was reflected in the drop of the federal funds rate to 1 percent. The loose monetary policy was maintained, with variations, for almost five years. The result was a fiction economy in which millions of people borrowed and consumed too much. The fact that mortgage loans were turned into sophisticated securities traded internationally made the fiction global.

And what's wrong with that?  Who's to say that people borrowed and consumed "too much?"  Isn't consuming more better than consuming less?  Unless it leads to catastrophe.  But it hasn't, yet-- no, a financial crisis that has had very little effect on the real economy so far doesn't qualify.

Greedy investors and profligate consumers are but a symptom of the real problem, which is monetary policy. The history of the boom-bust cycle since the creation of the Federal Reserve in 1913 has been the deliberate increase of the money supply, the misallocation of resources due to the perverse incentives of inflation, and eventually the bursting of the bubble. It is the consequence of the Federal Reserve system, a central bank that confers upon a chosen elite -- the Federal Reserve governors -- the monopoly of money creation and the power to decide what amount of money is appropriate for an economy in which millions of people are making decisions they cannot anticipate.

The Fed was created as a response to the periodic bank runs of the late 19th and early 20th centuries. Some of the greatest economists have explained that part of that instability was caused not because private banks were free to issue currency (even as late as 1907) but because the government maintained a policy of rewarding irresponsible behavior by rescuing financial institutions when they reached the verge of collapse. In any case, as Milton Friedman wrote, the instability of the pre-Federal Reserve years was nothing compared to the booms and busts caused by the monetary authorities after 1913.

To be specific, Milton Friedman blamed the Great Depression on stupid policy by the Federal Reserve.  But not stupid inflationary policy, stupid deflationary policy.  And that was seventy years ago.  We haven't had any Great Depressions then; the Fed seems to have learned its lesson.  On the contrary, economic performance has been pretty satisfactory.  Of course, we might have done even better without the Fed.  It's implausible to interpret 20th-century US economic history as a cautionary tale.

Nobel laureate Friedrich Hayek, whose free-market ideas triumphed with the collapse of the Soviet Union, frequently denounced the connection between central banks and the boom-bust cycle. In an interview conducted in 1977, he said, "If it were not for government interference with the monetary system, we would have no industrial fluctuations and no periods of depression. ... The mistake is the creation of a semi-monopoly where the basic money is controlled by the government. Since all the banks issue secondary money (in the form of loans based on deposits), which is redeemable in the basic money, you have a system which nobody can control." 

In many countries, money used to be in private hands (think House of Rothschild). The fact that money was issued by private institutions in part accounts for the extraordinary prosperity that Argentina enjoyed in the 19th century.

In a system of free banking, institutions that do not protect the value of the currency simply collapse -- and their collapse does not wreck the entire economy. Under a rule of law that punishes fraud and counterfeiting, the risk of failure without bailouts is enough to guarantee a more stable system. And in such a system, it would be harder for the government to spend as much money as it does now -- a major factor in the devaluation of the dollar -- because it could not create money, only tax and borrow.

Advocating the abolition of the Federal Reserve, an institution people take for granted, seems too radical for most people, who think financial crises are the result of too little, not too much, government regulation.

I think this line of thought, the position that even money creation should be a private function, is called free banking.  Llosa's argument for it is hardly convincing.  People have differences preferences with respect to inflation.  He seems to be eccentrically and groundlessly extreme in his opposition to inflation, and cantankerously unwilling to consider that others might not regard the mild inflation we have experienced in the past 25 years, or perhaps even a slightly higher rate of inflation that might be in store for us in the next few years, as a serious harm.

The truth is that no one really knows how a free banking system would work.  Yes, we sort of had it in the 19th century, and it's very questionable that it was more stable.  Llosa cites Argentina, and Argentina did have a great 19th century and a lousy 20th, but it is exceptional in that regard.  Anyway, in the 19th century there was the gold standard.  A bank could issue notes redeemable in gold, but being on the gold standard was a policy choice.  It has been persuasively argued that the gold standard was the reason the Great Depression became international.  Gold is a terrible currency for a growing world economy, because the supply of gold has natural limits and can't track the expansion of the need for currency, so there has to be either steep deflation or continuous increase of the money multiplier.  It has been persuasively argued that the gold standard was the key factor in deepening, prolonging and spreading the Great Depression.

But what if we allowed Visa, MasterCard, etc., not to print notes based on promises of gold, but to print, in effect, fiat money, whose value they themselves were responsible for maintaining and defending?  What would happen if we privatized the dollar, selling the right to print the dollar to whatever consortium of banks won a fair auction, and allowed other firms to issue competing currencies at will?  What would be the dynamics of the currency market under free banking?  Nobody knows.  There are no historical examples.  I don't think anyone really knows how to model it.  With the new agent-based computational techniques it might be more doable now.  It's possible that Hayek and Llosa are right, and that the Fed and its money are distortionary in ways that nobody understands because we don't know anything else.  If so, it would be fascinating to find out.