The U.S. government is creating the highest deficit in history and its going to get a lot worse.
China is still pegging its currency to the dollar making it difficult for the U.S. to fix its trade deficit. Wages and prices need to fall in real terms to help get the U.S. out of recession. (Wages are hard to reduce in nominal terms without strikes and lawsuits everywhere)
There is one simple solution. Devalue the dollar!
U.S. goods would become cheaper on the world market, foreign goods would become more expensive and the trade deficit would turn to surplus and employment would increase.
Debt to foreign countries would suddenly be paid off more easily as there would be a lot more (lower value) dollars lying around, and virtually all debt is denominated in dollars.
In some ways the U.S. is doing this already by having a very low interest rate. This means that that are trying get more dollars into the economy and drive down the demand for dollars, since people will fly away from dollars to get a higher return.
So what is the downside?
Most of the downside is quite fluffy.
The dollar is the international reserve currency and people will lose faith in it if the U.S. starts to use monetary policy to fix structural economic policy, but the U.S. has been doing this for years. The dollar could stop being the reserve currency but it was probably not as great as it looked anyway.
Devaluing may not affect the biggest trade deficits such as trade with China since China essentially pegs their currnecy to the Dollar.
The rich in america may get fed up when the value of their money in the world stage becomes a lot less. Will the Americans on the Forbes 500 richest really want to fall down a few notches.
The structural trade deficit clearly indicates the dollar is overvalued. I think a devaluation is on the cards.
Friday, September 18, 2009
Friday, September 4, 2009
Is the Fed the root of all Evil?
Being chairman of the Federal Reserve is ultimately a thankless job. If you wait around long enough you will be blamed for some disaster. America's love affair with Alan Greenspan was one of the longest in history but the laws of probability finally caught up with him and he is villain non-grata now.
The need for the Fed is not agreed upon by everyone. It was the ultimate in socialism for many who thought the government was messing too much with capitalism. Libertarians and Objectivists still view it as making matters worse, which is ironic since Alan Greenspan was an Objectivist for many years.
The legislators saw the biggest run on the banks they had ever seen in 1907 so they set up the Fed to prevent it from happening again in 1913. They failed miserably when an even greater run on the banks occurred 16 years later in 1929. Many economists, including Bernake, reckoned that the Fed made the Great Depression worse than it needed to be, although mainly by not doing enough like lending to small distressed banks. According to many, the Fed has failed again today, essentially fueling the housing crisis with years of loose money.
So what does the Fed do?
Its charter is long and complicated but in a nutshell, it houses the governments funds and bank reserves, gives emergency loans to banks if there is a panic and decides short term interest rates.
So how does the Fed control interest rates and inflation?
The Fed has a magic bank account where it keeps special dollars out of the hands of the population at large, the other banks and even from the Government. The Fed can essentially create money out of thin air for the sole purpose of controlling interest rates and inflation. When it want to flood the market with more dollars, it will buy up tons of securities, usually short term Treasury Bills (T-Bills). Those dollars will eventually end up in commercial bank account deposits somewhere and be loaned out by banks at about a 10:1 ratio - since banks only need 10% cash reserves. (Banks can issue 90% loans against cash deposits, not against T-Bills). In this way, the Fed controls the amount of new loans every year, and hence the amount of cash in the economy. Crazy as it sounds, the banks create the new money in the economy when they increase their loans and credit every year.
If you wait long enough, every $1 the Fed spends on T-Bills will result in $10 in new loans. Theoretically, if the Fed increases the cash in the economy by 0.3% using its special dollars, loans should go up by ten times this (3%). If the economy doesn't grow or shrink, they have just created 3% of inflation. In fact, the Fed indirectly increases money supply by about 6% every year. The economy typically grows by about 3% and inflation is about 3%. The economic growth comes from more people in the workforce and every person getting more productive.
If the Fed is buying a lot of T-Bills, the prices of T-Bills will go up and the interest rate will go down. This is how the Fed controls the short term interest rate.
If this doesn't sound disturbing you probably don't understand it, but the U.S. wants an elastic money supply and a President appointed guy (Bernake) holds the elastic band so it could be a lot worse. So, if oil gets expensive, if commodities get scarce, if a meteor wipes out the southeastern United States, the Fed has a tool to control what happens to inflation and hence hopefully people will keep using the dollar with some confidence.... except .....
The Fed is like a giant with huge grubby fingers trying repair a delicate watch. Trying to change one thing in the economy actually clumsily changes ten things with unexpected side effects. Additionally, it take months, if not years for the effects of a Fed move to be reflected in the greater economy (e.g. exchange rate, growth, unemployment etc) so it is almost flying blind. To add to the confusion, the primary goal of the Fed, to generate confidence in the U.S. dollar and U.S. banking has been completely sabotaged with new contradictory goals, the main one being to prevent recessions. One could also argue that it is meant to prevent bubbles but there is less political will to prevent bubbles while they are happening since someone important is always profiting.
So recessions are considered evil, but no one knows why. The current system built on the theory that the economy has to grow forever or the whole pyramid comes crashing down, but growing forever is impossible in the long term. Our consumption of goods and services (which is what an economy is), will reach physical limits such as how much production can the planet sustainably provide. It is inevitable, if we want to survive, that economies will have to reach equilibrium eventually where there will be as many growth years as decline years. In the future, recessions will not be a bad thing, but a natural thing. Also, the idea that recessions causes greater poverty does not necessarily have to be true. Some European systems keep unemployment benefits high during recessions meaning that there is cushioning while the economies adjust and the affect on poverty is very small. If we expect recessions, they don't have to be so bad.
In the Bush years, the Fed lowered interest rates (read "flooded the economy with cheap money") to protect America from the recession that was threatened after the collapse of the dot com bubble. Hence they helped create a Housing bubble. Admittedly, a bubble probably would have occurred anyway with Wall Streets new clever securities that allowed Banks to flood America with loans with virtually no risk to themselves.
The Fed has lowered interest rates again today to try to cushion the falling of the property and investment market, but insecure banks are using a lot of this money to get better loan/deposit ratios, not to issue new loans. The banks are instead issuing fewer loans with higher profit per loan. Hence the "10 times" effect is not exactly 10 anymore. In reality, the Fed will need to inject more and more cash to get the same effect as before. T-Bills interest can't go much lower so the Fed is losing the most powerful tool in its arsenal. It has discussed doing longer term T-Bills which could add some tools to its quiver but the incumbent banks are trying to prevent this since the banks could lose some control over long term interest rates. Currently the Fed only exercises control over short term T-Bills.
So, what recently has the Fed done:
(1) Created a property Bubble
(2) Devalued the U.S. dollar as an international currency, making the Dollar less desirable as the international reserve currency.
(3) Made bank savings interest rate very low, essentially 0%
(4) Took some important steps to help out weak banks in the recent crisis, mainly with loans, although most of this is directed by the Treasury, not the Fed.
(5) Now is encouraging loans and spending again by flooding the economy with dollars, time will tell if this is a good or bad thing.
Its hard to tell what would have happened without the Fed. Its track record is mixed. Personally, I think it should stick to keeping the financial system sound and stay away from trying to prevent recessions and bubbles. Ironically, this is what Bernake promised when he took over the Fed, but I guess politics gets in the way. I'm not convinced it makes recessions worse, its just that I don't know what the Fed is doing to the economy when it tries to correct structural problems in the economy and history suggests that it doesn't know either.
The need for the Fed is not agreed upon by everyone. It was the ultimate in socialism for many who thought the government was messing too much with capitalism. Libertarians and Objectivists still view it as making matters worse, which is ironic since Alan Greenspan was an Objectivist for many years.
The legislators saw the biggest run on the banks they had ever seen in 1907 so they set up the Fed to prevent it from happening again in 1913. They failed miserably when an even greater run on the banks occurred 16 years later in 1929. Many economists, including Bernake, reckoned that the Fed made the Great Depression worse than it needed to be, although mainly by not doing enough like lending to small distressed banks. According to many, the Fed has failed again today, essentially fueling the housing crisis with years of loose money.
So what does the Fed do?
Its charter is long and complicated but in a nutshell, it houses the governments funds and bank reserves, gives emergency loans to banks if there is a panic and decides short term interest rates.
So how does the Fed control interest rates and inflation?
The Fed has a magic bank account where it keeps special dollars out of the hands of the population at large, the other banks and even from the Government. The Fed can essentially create money out of thin air for the sole purpose of controlling interest rates and inflation. When it want to flood the market with more dollars, it will buy up tons of securities, usually short term Treasury Bills (T-Bills). Those dollars will eventually end up in commercial bank account deposits somewhere and be loaned out by banks at about a 10:1 ratio - since banks only need 10% cash reserves. (Banks can issue 90% loans against cash deposits, not against T-Bills). In this way, the Fed controls the amount of new loans every year, and hence the amount of cash in the economy. Crazy as it sounds, the banks create the new money in the economy when they increase their loans and credit every year.
If you wait long enough, every $1 the Fed spends on T-Bills will result in $10 in new loans. Theoretically, if the Fed increases the cash in the economy by 0.3% using its special dollars, loans should go up by ten times this (3%). If the economy doesn't grow or shrink, they have just created 3% of inflation. In fact, the Fed indirectly increases money supply by about 6% every year. The economy typically grows by about 3% and inflation is about 3%. The economic growth comes from more people in the workforce and every person getting more productive.
If the Fed is buying a lot of T-Bills, the prices of T-Bills will go up and the interest rate will go down. This is how the Fed controls the short term interest rate.
If this doesn't sound disturbing you probably don't understand it, but the U.S. wants an elastic money supply and a President appointed guy (Bernake) holds the elastic band so it could be a lot worse. So, if oil gets expensive, if commodities get scarce, if a meteor wipes out the southeastern United States, the Fed has a tool to control what happens to inflation and hence hopefully people will keep using the dollar with some confidence.... except .....
The Fed is like a giant with huge grubby fingers trying repair a delicate watch. Trying to change one thing in the economy actually clumsily changes ten things with unexpected side effects. Additionally, it take months, if not years for the effects of a Fed move to be reflected in the greater economy (e.g. exchange rate, growth, unemployment etc) so it is almost flying blind. To add to the confusion, the primary goal of the Fed, to generate confidence in the U.S. dollar and U.S. banking has been completely sabotaged with new contradictory goals, the main one being to prevent recessions. One could also argue that it is meant to prevent bubbles but there is less political will to prevent bubbles while they are happening since someone important is always profiting.
So recessions are considered evil, but no one knows why. The current system built on the theory that the economy has to grow forever or the whole pyramid comes crashing down, but growing forever is impossible in the long term. Our consumption of goods and services (which is what an economy is), will reach physical limits such as how much production can the planet sustainably provide. It is inevitable, if we want to survive, that economies will have to reach equilibrium eventually where there will be as many growth years as decline years. In the future, recessions will not be a bad thing, but a natural thing. Also, the idea that recessions causes greater poverty does not necessarily have to be true. Some European systems keep unemployment benefits high during recessions meaning that there is cushioning while the economies adjust and the affect on poverty is very small. If we expect recessions, they don't have to be so bad.
In the Bush years, the Fed lowered interest rates (read "flooded the economy with cheap money") to protect America from the recession that was threatened after the collapse of the dot com bubble. Hence they helped create a Housing bubble. Admittedly, a bubble probably would have occurred anyway with Wall Streets new clever securities that allowed Banks to flood America with loans with virtually no risk to themselves.
The Fed has lowered interest rates again today to try to cushion the falling of the property and investment market, but insecure banks are using a lot of this money to get better loan/deposit ratios, not to issue new loans. The banks are instead issuing fewer loans with higher profit per loan. Hence the "10 times" effect is not exactly 10 anymore. In reality, the Fed will need to inject more and more cash to get the same effect as before. T-Bills interest can't go much lower so the Fed is losing the most powerful tool in its arsenal. It has discussed doing longer term T-Bills which could add some tools to its quiver but the incumbent banks are trying to prevent this since the banks could lose some control over long term interest rates. Currently the Fed only exercises control over short term T-Bills.
So, what recently has the Fed done:
(1) Created a property Bubble
(2) Devalued the U.S. dollar as an international currency, making the Dollar less desirable as the international reserve currency.
(3) Made bank savings interest rate very low, essentially 0%
(4) Took some important steps to help out weak banks in the recent crisis, mainly with loans, although most of this is directed by the Treasury, not the Fed.
(5) Now is encouraging loans and spending again by flooding the economy with dollars, time will tell if this is a good or bad thing.
Its hard to tell what would have happened without the Fed. Its track record is mixed. Personally, I think it should stick to keeping the financial system sound and stay away from trying to prevent recessions and bubbles. Ironically, this is what Bernake promised when he took over the Fed, but I guess politics gets in the way. I'm not convinced it makes recessions worse, its just that I don't know what the Fed is doing to the economy when it tries to correct structural problems in the economy and history suggests that it doesn't know either.
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