Accusations Against the Fed

To be honest, I don't quite understand this one. Can someone explain to me whether the conclusion in this article is true (namely, that the Fed is acting in violation of the Constitution)?

It had generally been assumed that the AIG payouts of 100% on credit swaps (when the insurer was under water and bankrupt companies do not satisfy their obligations in full) was the result of some gap in oversight plus traders at AIG exercising discretion (they were unhappy about bonus rows and had reason to curry favor with dealers, who were potential employers).

The article makes clear that AIG had been negotiating to settle on the swaps prior to getting aid from the government, and was seeking a 40% discount. The Fed might not have gotten that much of a discount, but there was clearly no need to pay out at par.
...
After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.
...
As Vickrey indicates, the fact that this was a backdoor rescue means the Fed is acting as an extra budgetary vehicle of the Treasury. This is a violation of the Constitution and shows how patently false the Fed’s claims of independence are.

Onto other reading...

• David Brooks with some more criticism of the idiotic government decision to police pay and whatnot:
  
  

  Now in disgrace, Wall Street firms are rewriting their rules, but the Obama administration has decided it should take control of compensation reform. Nobody seriously believes high pay caused the financial meltdown; it was bubblicious groupthink. But cutting executive pay just polls so well. ...
  Treasury officials are now making individual pay-package decisions across an array of different companies — and they must have really big brains to understand the motivational psychology of all those different people. The Federal Reserve, meanwhile, has decided to police banks and veto pay deals that lead to excessive risk. Those experts must have absolutely gigantic brains if they can define excessive risk years before investments pay off.
  ...
  The best and the brightest in government are now rewriting existing pay contracts and determining that certain firms will be compelled to pay much less than their competitors. They’re not leveling the playing field, as a humble government would do. They’re making it less level in complicated ways.
  
  

• A case for big banks, and a rebuttal.
• A really interesting read on the dollar.
• On the new tools of monetary policy:
  
  

  Participants in this session were asked to address two basic questions. The first is whether the Fed's targeted liquidity operations were necessary and effective. My answer is probably yes, though I would have a hard time persuading someone if they were not already convinced of that. The second question is whether such operations should be considered an important part of central banks' arsenal of tools in the future. To that my answer is categorically no. From virtually any perspective of our current problems, it would have made far more sense to address these problems with proper regulatory supervision prior to the crisis instead of targeted liquidity operations after the crisis unfolds.
  

  
  
  
  

This Isn't Needed Regulation

I'm appalled by what the government is up to right now.
In case you haven't heard, the Pay Czar, Kenneth Feinberg, just started instituting pay cuts at Wall St. firms that used TARP money:

Mr. Feinberg, the Treasury Department's special master for compensation, will lower total compensation for 175 employees at seven firms including AIG, Citigroup, Bank of America and GM, by an average of 50%, people familiar with the matter said. He will also demand a series of corporate-governance changes at the firms, including splitting the positions of chairman and chief executive officer; requiring boards of directors to create a committee to assess risk, and eliminating staggered boards.

Some of that actually sounds not so bad, such as splitting the positions of chairman and CEO. However, this is not the way to go about fixing anything! What is Feinberg trying to accomplish? Here's the best I've found:

Summers said Feinberg's rulings -- which are expected to be publicly released in the coming days -- will ensure taxpayers' interests come before those of shareholders and incumbent management at the beleaguered firms.

Let's do a quick history. First of all, lest we forget, the government forced these companies into accepting bailout money. Some argue that hey, if you take public money, you have to be prepared for public oversight ... but they didn't have a choice! Beyond that, it's not as if there were any particular requirements associated with the TARP money. For example, one way to look out for taxpayers might have been to get the banks taking TARP money to lend more, during a time when credit was/is tight. Did that happen? No. "Geithner did not require the Big Banks to loan money for commercial loans as a prerequisite for additional borrowings from the Fed."
And now Obama & Co. start trying to trim their pay? What are they accomplishing?? All that I'm seeing here is this: Dear Big Banks, if you get in trouble, we'll give you tons of money. In fact, we might even force it down your throats, but at least no matter how bad you screw up you know you won't go under. Then we'll let you do whatever you want with that money and achieve mind-blowing profits during a recession, which will naturally lead to fantastic compensation and plenty of public outrage. And since we used to work on/with Wall Street, we could basically predict all this would happen. And it's kinda messed up that we used to work with you and now we're giving you more-or-less free public money, but hey, that's what friends are for! But look, we'll have to pretend to be totally bewildered and fake some anger at you so the public doesn't tar-and-feather us.
Honestly, as far as I can tell, that's more or less the story so far. Ugh. Instead of focusing on useful policies that might prevent future issues (such as reinstatement of the Glass-Steagall Act, or something similar, which is sadly looking like it won't happen), they do worthless stuff that won't even really have a lasting impact:

Pay is the wrong way to tackle this problem. It’s a lazy, crowd-appeasing, intellectually dishonest approach. The out of line pay is a symptom, and any attempt to treat symptoms as causes is likely to be ineffective, more likely dysfunctional.
...
Now why is trying to control this through pay not such a hot idea? First, one hundred years of performance appraisal systems have proven them to be abject failures (aa 1992 paper by
Patrick D. Larkey and Jonathan P. Caulkin, “All Above Average and Other Unintended
Consequences of Performance Appraisal Systems,” did a brilliant job of dissecting why, but it was too heretical to get published. You can read a few key points here in the section “The Illusion of Meritocracy”). Second, comp systems are supposed to solve what is called a principal-agent problem. You the person hiring someone to work on your behalf wants to make sure they are operating in accordance with YOUR best interests in mind, not theirs.
But what did we learn from 20 years of executive rewards schemes that had lots of equity incentives that would supposedly align the interest of top brass with that of shareholders. We got instead an explosion of CEO pay and companies that are so fixated on quarterly earnings that they are reluctant to invest in growth. How did that come to pass?
BECAUSE THE AGENTS AND NOT THE PRINCIPALS DESIGNED THE PAY SCHEMES!  The foxes were running the hen house. Oh, sure, we had some fig leaves, it was the HR department that hired the compensation consultant, and the board (nominated by the incumbent management) that signed off on it, but it is pretty clear that a comp consultant that did not deliver a CEO-wallet-fattening plan was unlikely to get much repeat business.
And is anything going to be materially different? No. The conventional wisdom is that having employees take a high level of pay as equity is a magic solution, conveniently forgetting that Bear and Lehman both featured very high levels of shareholding among its top management and employees. Feinberg is only intervening in outliers, to collect a few scalps. He is in a very difficult position and is trying to make the best of it.
The financial services industry now has an unimaginably rich deal: privatized gains and socialized losses, and with tons of leverage too, which amps up the apparent profits and hence the pay levels these looters can claim they deserve. The way to attack this problem is to constrain the level of risk assumption. That in turn requires understanding the products and the markets, something the authorities have completely abdicated. With so much “talent” looking for jobs, now would be the perfect time to invest in catching up.

Sorry for the angry, poorly-written rant. And please keep in mind, I'm not exactly trying to defend banks here. In fact, I think I've been quite open on this blog about how immoral they've been and how dangerous they are to our country as they're currently constructed. The point here is, nothing useful is being done to correct this! All this Pay Czar junk is just political maneuvering. Real reform is not happening.

Lots of Reading

• A new book by the authors of Freakonomics, unsurprisingly called SuperFreakonomics, is reviewed by John Mason at Seeking Alpha and Krugman in multiple parts. I have not read Freakonomics, though I should. I believe the main premise is a study of how people respond to incentive.
• The Mess That Greenspan Made points us to "The Warning", a documentary by PBS about how a potential whisteblower on the financial crisis was shut down by figures such as (naturally) Greenspan, Rubin, and Summers. A damning preview:
  

  At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008. ...
  

  Greenspan, Rubin and Summers ultimately prevailed on Congress to stop Born and limit future regulation of derivatives. "Born faced a formidable struggle pushing for regulation at a time when the stock market was booming," Kirk says. "Alan Greenspan was the maestro, and both parties in Washington were united in a belief that the markets would take care of themselves."
  

  Now, with many of the same men who shut down Born in key positions in the Obama administration, The Warning reveals the complicated politics that led to this crisis and what it may say about current attempts to prevent the next one.
  

  "It'll happen again if we don't take the appropriate steps," Born warns. "There will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience."
  

  
  
• An interesting interview with Eric Maskin, the Albert O Hirschman Professor of Social Science at the Institute of Advanced Study in Princeton. Woo titles. He's also a Nobel Prize winner, though the legitimacy of that prize is a little questionable right now. Anyway, the interview talks mostly about regulation and the need for it through brief reviews of various papers and books. It's a good primer for those who want a really simple, layman's overview of banking, regulation, etc.
  
• Must read.
• In an about-face from his role as described in "The Warning", Summers calls for banks to accept more stringent regulation. I think the real issue, beyond even accepting regulation, is that the government needs to enforce them. This is a problem that I don't see a solution to yet.
• Problems and Solutions. I like the Solutions part.

Why Are We In A Recession?

A paper was recently published which I found very interesting. Written by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg (of Northwestern Kellogg, Indian School of Business, and the New York Fed respectively), it attempts to analyze the true cause of the recession.

...why are we in such a great recession? What is the cause?
According to folk wisdom, the financial crisis caused the recession. That leads to the question, what caused the financial crisis? The standard answer is, easy credit and lax regulation led to the crisis. But then, what caused easy credit and lax regulation? According to popular press it is due to the savings glut in Asia, and a major part of that savings flows into the the US with the result that there is too much money in the US financial system chasing too few opportunities. Why is there too much savings in Asia and why those savings flow to the US? Asians just like to save and Americans just like to consume more! According to this logic all that is needed to remedy the situation is to require Asians to save less and consume more.
In this paper we argue that this logic is misleading. All these phenomena – savings glut, easy credit and lax regulation, and financial crisis – are closely interlinked and there is a deeper driving force. While each piece is well understood, our focus here is to emphasize how a common driving force is linking them all together.
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In what follows we argue that this huge and rapid increase in developed world’s labor supply, triggered by geo-political events and technological innovations, is the major underlying force that is affecting world events today. The inability of existing financial and legal institutions in the US and abroad to cope with the events set off by this force is the reason for the current great recession: The inability of emerging economies to absorb savings through domestic investment and consumption caused by inadequate national financial markets and difficulties in enforcing financial contracts through the legal system; the currency controls motivated by immediate national objectives; the inability of the US economy to adjust to the perverse incentives caused by huge moneys inflow leading to a break down of checks and balances at various financial institutions, set the stage for the great recession. The financial crisis was the first symptom.

I should note that I've heard this argument before, although not so formally researched and argued. It is a very interesting piece of analysis and points to us being in the midst of a much larger correction that is taking place. One question to be asked, assuming the analysis is correct, is what is the solution to our problems here? They draw an interesting historical parallel to a rapid increase in labor supply that was solved as follows:

When millions of World War II soldiers returned home that increased the US labor force of about 60 million workers by almost 25% within a very short period of time. At that time the Department of labor, which certainly had no cause to accentuate the negative, predicted that 12 to 15 million workers would be unemployed. That did not happen! We managed that problem well leading to prosperity instead of doom, thanks in no small part to the GI Bill and other governmental fiscal intervention. We can manage this one as well.
For that to happen, the first step is to recognize the problem for what it is. A solution may well require actions similar in scope to the GI Bill and require a national debate.

This seems to be support for serious government intervention, which has already started.

But there's no sugarcoating of how America must deal with things. The authors definitively state that consumption must go down and competitiveness must go up. In other words, less shopping and more education. I'm sure kids around the country will just love to hear that.

A few more random quotes from the paper that are interesting:

As housing prices decline and the charade of cheap credit is lifted, there will be a severe contraction in consumption levels... We should therefore be prepared for a permanent 3% drop in consumption levels. This number does not account for the brewing trouble in the commercial real estate markets where many regional banks may yet be in trouble due to excessive exposures to bad loans which could further delay the recovery in the real economy.

It is likely as recovery takes hold, the value of the U.S. dollar will decline substantially, and that alternative reserve currencies will begin to emerge.

Clearly China’s export led growth strategy of the past cannot continue indefinitely and domestic consumption must be allowed to grow as a share of GDP. At the same time, Western economies must adjust to a new equilibrium in which commodities are scarcer and households will face stiffer competition for jobs.

Reading

• In defense of Geithner's phone calls.
• More reasons on why a weaker dollar isn't all bad. Some interesting points here:

  A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ. ...The sensible goal of a more balanced world economy is entirely consistent with a weaker dollar and a stronger euro. I am not trying to make a short-term prediction. Foreign exchange markets are crazy, and I have been wrong too many times. But what persuades me that the dollar has further to devalue is the observation that, for once, politics and economics are pushing in the same direction.
  

  
  
• And immediately, a rebuttal to the weaker dollar argument:

  ...a certain amount of dollar weakness is a good thing and consistent with global rebalancing. On one level, this is a sensible and defensible view. But this view is implicitly based on the idea that the dollar will somehow find its “correct” level, more or less. ...But currencies are known for their propensity to overshoot and stay for long periods at levels not warranted by fundamentals.
  

  
  
• An argument for why fiscal stimulus is the right way to go, and worries about debt are misplaced:

  The textbook argument for fiscal stimulus still applies. We face a large output gap -- the difference between the amount the economy could produce and the amount it is producing -- because demand from households (for consumption) and companies (for investment) is low. The government should therefore increase spending in order to increase demand and help close the output gap. This should be balanced by lower spending or higher taxes when the economy has recovered. The fact that our baseline amount of debt has changed does not affect the validity of this principle.
  

  
  
• Of course, it's not clear that the fiscal stimulus has been executed properly. Good read at Models & Agents.
• More from Models & Agents (neat new blog I just discovered) ... a proposal for bank reform. It also includes critiques of other proposals. Really great read. Her proposal follows:

  So here is an idea: Extend the FDIC’s deposit-insurance framework to the entire financial sector. In other words, get financial institutions (i.e. not just commercial banks) to pay a fee to a dedicated FDIC-like fund, which would be financial subsumed to the Treasury. This fund would be available to cover the liabilities of a financial institution (i.e. its creditors, up to a given amount and level of seniority), if that institution failed.
  ...
  Importantly, the scheme could be so designed to address the need to discourage excessive risk-taking as well as a heavily procyclical behavior on the part of financial institutions: For example, the fee could be a function on an institution’s leverage, appropriately defined; and it could also be time-varying, in tune with the business cycle, to discourage heavily procyclical behavior.

  
  
  
  
  
• Not sure I totally follow this one, but here's an argument that M&A will make for a new bubble.
  

BlackRock's Potential Conflict of Interest

This is a somewhat alarming report.
From the WSJ:

BlackRock Inc., which scored multiple government assignments during the financial crisis, is a contender for another prestigious gig: helping state regulators size up risks in insurers' investments.
The money manager and risk-advisory outfit is among a handful of firms that have talked with officials from the National Association of Insurance Commissioners lately about possibly taking on a slice of work now done by the major ratings firms, according to regulators and an official at the NAIC.

Why is this alarming? From POGO:

Another company that is reportedly under consideration for the contract is PIMCO...
To understand why hiring a company like BlackRock or PIMCO could raise the risk for conflicts of interest, just take a look at BlackRock’s latest quarterly SEC filing. As of June 30, 2009, BlackRock is managing a whopping $1.37 trillion in assets, including $510 billion in bonds, $317 billion in cash products, $330 billion in stock funds, and $52 billion in alternative investments such as hedge funds. The company also advises clients on $166 billion in assets, including many of the same types of assets that it would be evaluating for the NAIC. And these numbers will soon be increasing thanks to BlackRock’s recent acquisition of Barclays’ investment unit, which, according to Bloomberg, will create a “company overseeing $2.7 trillion in assets—more than the Federal Reserve.”

To be fair, BlackRock told the WSJ that the company has “very strict policies and procedures in place to protect confidential client information and manage any potential conflicts of interest.” However, there's still potential for abuse if they get such a contract.

It's important to note that this is a severe strike against traditional ratings agencies, who have been increasingly viewed as major culprits in the recent crisis. However, I don't think the solution is to simply ignore them. Consider the fact, instead, that ratings agencies are for-profit institutions, which in and of itself raises conflicts of interest. A hypothetical: suppose JPMorgan goes to Moody's to ask for a rating on some assets they want to securitize. Moody's comes back with a bunch of poor grades. Well, Standard & Poor's could easily jump in with its own 'research', claiming they are able to rate the assets at a higher level which would allow JPM to create a more stable security, though in reality the assets are now of unclear strength. S&P, looking for customers, has every incentive to do something like this when regulatory enforcement is weak. That link has an SEC report about how much conflict of interest exists for ratings agencies, and how the SEC did absolutely nothing about it. All bark, no bite.
One possible solution (and I'm just throwing something out there) is for all ratings agencies (at least, all of the Big 3, or perhaps some combination of the Big 3 and other smaller firms) to be required to independently rate assets when any one of them is asked, and investors be required to use the 'average' of the three ratings. The problem there is increased cost to investors, but perhaps that would give investors incentive to do a little research of their own and not waste time on potentially risky assets. Does this make any sense?

Update: Good read from Fortune on the current state of affairs with ratings agencies.

Criticism and Solutions

I've read a lot of articles about the crisis over the past year. Lots and lots of articles. I've started to notice that the vast majority of them (including my own, to be fair) tend to be focused on criticizing mistakes. What bothers me is that articles providing solutions, not just criticism, are few and far between. I'm going to try to focus future posts, both links to articles along with my own thoughts, on solutions. Criticism leads to pointless debate; proposals lead to useful debate. Granted, the tiny debates that occur here are hardly meaningful, but I'm doing my best!

Anyway, sorry for the rant. On to some good reading:

• An article from the Economist, pointing out that the failure of regulators in this past crisis may have been due to a lack of incentive to regulate. Interesting, though not particularly novel, insight. Thankfully, in line with my earlier diatribe, there is a proposed solution in the article (though I think it's a weak solution, in that there's not much substance offered):
  

  Incentives also help explain why regulators resist the delegation of powers to supranational institutions. Supervisors may wish to protect the local industry or secure a competitive edge over other financial centres. Even without a protectionist agenda, supervisors are prone to capture: because they talk to local institutions on a daily basis, they are likely to empathise with the competitive pressures that those banks face. Pay is also a problem. In most countries compensation structures for national supervisors will involve low salaries, no bonuses and small rewards for doing a good job. Supervisors get into trouble if they go out on a limb and make a technical mistake (and a bank sues), but face fewer problems if everybody makes the same material mistake and the system goes down. It does not help that officials are repeatedly told that the smartest people go where the money is—into the banks, in other words, not the agencies that regulate them. ... The solution to the problem of local regulatory capture would be to rely more on supranational authorities. ...And beyond Europe, too, policymakers ought to match their new-found focus on incentives in the private sector with more attention to their own.

• Geithner has been known to be very close with top banks on Wall St. This AP article shows just how close using phone records obtained via FOIA:
  

  After one hectic week in May in which the U.S. faced the looming bankruptcy of General Motors and the prospect that the government would take over the automaker, Geithner wrapped up his night with a series of phone calls. First he called Lloyd Blankfein, the chairman and CEO at Goldman. Then he called Jamie Dimon, the boss at JPMorgan. Obama called next, and as soon as they hung up, Geithner was back on the phone with Dimon.
  While all this was going on, Geithner got a call from Rep. Xavier Becerra, a California Democrat who serves on committees that help set tax and budget policies.
  Becerra left a message.
  In the first seven months of Geithner's tenure, his calendars reflect at least 80 contacts with Blankfein, Dimon, Citigroup Chairman Richard Parsons or Citigroup CEO Vikram Pandit. Geithner had more contacts with Citigroup than he did with Rep. Barney Frank, the lawmaker leading the effort to approve Geithner's overhaul of the financial system. Geithner's contacts with Blankfein alone outnumber his contacts with Sen. Christopher Dodd, D-Conn., chairman of the Senate Banking Committee.
  

  This is pretty disturbing stuff. The Baseline Scenario points out that it wasn't even that he was calling the biggest or most troubled banks. He was calling his friends. Although that's fine when one is in the private sector, I think it's quite wrong for a public servant. Then again, who really thinks of Geithner as a public servant after how he bailed out the banks?
  
• The NYT talks about how the debt-securitization market is still pretty frozen:
  

  Many investors have lost trust in securitization after losing huge sums on packages of subprime mortgages that had high default rates. The government has since spent more than $1 trillion trying to restore the markets, with mixed success.
  Until more of the securitization market revives, or some new form of financing takes its place, a wide range of loans needed to secure a lasting economic recovery will remain elusive, experts said.
  

  The question here is, why should we want to return to securitization? Naked Capitalism and Krugman both comment on this. I like that Krugman offers a solution, though an oft-repeated one.
  NC:
  

  What is intriguing about these comments is the tacit assumption that we have to go back to status quo ante, of having a significant amount of loans on-sold into credit markets rather than retained on bank balance sheets. Yet we have seen the superficial appeal of that system comes at considerable cost. Securitization allows for more “efficient” banking, in the sense that banks can operate with far less equity than if they conducted banking the old-fashioned way, by holding the loans they originate.
  But this prized efficiency comes at high social cost. First, the idea that these loans were really off balance sheet in many cases was spurious. For some types of conduits, like credit card trusts and SIVs, banks did intervene when the supposed off balance sheet vehicles got in trouble. Indeed, credit card receivables could not have been off-loaded absent parent support. So the supposed efficiency gain was phony; the banks were simply using off balance sheet vehicles as a way to run with less equity than they actually should have had, but the regulators accepted the charade and looked the other way.
  Second, as we know, securitization reduces the incentives to do proper borrower assessment and even worse, means no one is monitoring the borrower on an ongoing basis.
  

  Krugman:
  

  But here’s my question: why does it have to be a return to shadow banking? The banks don’t need to sell securitized debt to make loans — they could start lending out of all those excess reserves they currently hold. Or to put it differently, by the numbers there’s no obvious reason we shouldn’t be seeking a return to traditional banking, with banks making and holding loans, as the way to restart credit markets.
  

Quick Links

Sorry for the lack of posts recently - been quite busy. Here are a few articles I think are worth reading:

• The Baseline Scenario writes about monetary policy, taking a look at hawks vs. doves in the Fed. I never quite thought of hawks or doves in monetary policy, but it's a neat take.
  
  

  Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do.
  

• This is interesting, and for Americans, potentially alarming: China, Russia, Japan, France, and some Middle Eastern countries are planning to "end dollar dealings for oil." There's been quite a bit of noise over the past months about shifting away from the dollar as the main international currency, but (at least in articles I read, which I must note tend to be written by Americans) such talk has been largely dismissed. Apparently, we shouldn't dismiss so easily. The dollar is already weak in value, and such a move only further hurts its reputation. If this is actually going to happen, it will increase tension between China and America. It is also interesting that Japan, who has been a pretty close trade partner and ally since WWII, is part of this non-dollar alliance.
• A profile of Larry Summers and his team.
  
• Mish arguing that deflation is no longer a looming threat, it is here. Furthermore, he argues that it's a good thing! Take a look:
  
  

  Deflation is not a threat because deflation is here by any practical measurement. Deflation is also here by impractical measurements such as falling prices. See Humpty Dumpty On Inflation and Daniel Amerman vs. Mish: Reflections on the Great Inflation/Deflation Debate for a further discussion of a practical definition of deflation, a contraction of money supply and credit marked to market, not falling prices.
  
  Moreover, deflation is not a threat in a second sense. Deflation is needed to purge the excesses of the last credit cycle. Attempts to defeat deflation by force will only prolong the agony while accumulating government debt, just as happened in Japan's two lost decades.
  
  Finally, deflation is not a threat in a third sense. Falling prices are a natural state of affairs because of rising productivity over time.
  

  
  
  
  
  

The Weak Dollar Policy

I received an email from a friend, Nicholas Kreifels, recently. He reads this blog on occassion and wanted to send some thoughts on what he thinks is a "weak dollar policy". I got his permission to post his thoughts here:

...in regards to the Fed's current solution to the crisis.  I think of it like this, they are pouring all the water on the floor (i.e. liquidity flood) and not mopping it up.  Big banks continue to devour smaller, weaker banks, consolidating capital, posing an even larger systemic threat to the global economy.  The dollar weakens each day, which poses a severe threat to the U.S. economy in the long run by depreciating our currency and threatening our reserve currency status.  After all the liquidity floods the market, are we any better off?  I see one of two things happening, domestic companies mop up the liquidity, fueling the inflation of another bubble (think 90s S&L crisis), or inflation balloons and foreign investment, already declining, packs its bags and heads for the hills.  The U.S. has carried a trade deficit since I was born.  I think it's time to realize we need to raise interest rates and let the export industry take it on the chin in order to help the majority (companies that import).  The trade deficit partnered with our currency deficit increases the problems for the U.S.  What will we do when China stops borrowing?  Or, when the dollar is no longer the reserve currency?  I think the negative implications of a weak dollar policy far outweigh its benefits.

I asked for further clarification on what he meant by "I think it's time to realize we need to raise interest rates and let the export industry take it on the chin in order to help the majority (companies that import)." Here is his followup:

The sentence about "taking it on the chin" references basic strong/weak dollar policy.  If the dollar is weak, compared to foreign currencies, this proves to be in an exporter's advantage because he can sell his goods cheaply, due to the fact that foreign countries' purchasing power increases as the dollar weakens.  We know that the U.S. maintains a trade deficit, which signals that our economy is IMPORT heavy.  Hence, it appears, based on trade, that the U.S. has more domestic companies that import than export, making the majority of domestic companies importers and the minority exporters.  By instituting a strong dollar policy, the export companies take a direct hit (also known as taking it on the chin) because they cannot sell their goods as cheaply as before.

My argument is to institute a strong dollar policy to benefit the majority (importers), instead of the minority (exporters).  Not only does the weak dollar policy hurt the majority of the companies, it harms the status of the dollar as the reserve currency because weak dollar policy promotes inflation.  The Fed has expanded its balance sheet by 2 trillion dollars, and it currently practices a weak dollar policy.  Inflation, if not monitored closely, can flame up quickly.  I understand the Fed's motive to promote and thaw the credit markets; however, the liquidity in the market is there, the banks simply are not lending it.  So, the question becomes: when will the Fed cease to flood the market with liquidity?  I don't see an end in sight, and that is discouraging. 

Does anyone have thoughts on this? I have not thought about the strength of the US Dollar, and how that affects our country, much at all. However, at first glance, it's not clear to me that having a weaker dollar is all bad, at least in the short-term. First of all, I don't see any other currency that can legitimately replace the US Dollar as the global reserve currency. Though some countries may diversify into Euros, or other globally respected currencies, the dollar is in my mind still the safest play due to the position of the US economy. This economy is the largest and strongest in the world despite the downturn, and no other country is as of yet ready to take that role. Also, might it not be a good thing for us to start exporting more? This may lead to job creation in manufacturing or services industries, providing both blue- and white-collar jobs that would greatly help the middle-class.
I have written about the inflation scare potential, and it indeed lurks on the horizon. In this, I feel Nick is correct: we will eventually see inflationary issues from all the money the Fed has pumped into the system (note: I wrote that the short-term worry is actually deflation. I should revisit this topic at some point.). That is intentional, as Nick articulates: the Fed is purposefully practicing a weak dollar policy. I also feel the long-term dangers are severe. Though in the short-term, this policy could help alleviate the recession, a long-term weakened dollar doesn't help our country.
I'd love to get some opinions on this weak dollar policy business. Is Nick's premise correct? If so, are the repercussions he envisions, and his preferred response, with merit? Does my response have any merit? Any thoughts on Bernanke's policy in general?