Let me start the week with a new blog. So much has been going on recently (central bank policy, financial market turbulance - or a lack of it, indicating complacency -, international policy coordination - or a lack of it, especially when looking underneath the surface -, etc.) , that it becomes increasingly difficult to choose just one topic and elaborate upon it. Especially if, like me, you just want to read and know everything. Little time left then to reflect and write down your thoughts. However, that is what I will try to do. This time it's about international policy coordination, trade, competitive currency devaluations covered up as monetary easing, and the promises made during the G20 meeting last weekend.
Some good news after the G20 meeting of central bankers and finance ministers: the IMF's legitimacy was said to be enhanced by a shift of votes and quotas from the 6% most overrepresented to the 6% most underrepresented members. Great, of course, as it is a big surprise that the members agreed, but will this really change the way China approaches its diplomatic relations? Moreover, the problem of the illegitimacy of the IMF was just a top of the iceberg of problems that the political world-stage is dealing with today.
Just underneath the surface are currency issues. Although the Brazilian finance minister even mentioned a "currency war", it has not come this far (yet). For now, countries seem willing to cooperate. The G20 communiqué mentioned that: "we [read: the G20] will, continue to resist all forms of protectionist measures and seek to make significant progress to further reduce barriers to trade.", and "... continue with monetary policy which is appropriate to achieve price stability". Okay, this sounds good. Or, does it really? Monetary policy to achieve price stability? That is what the Fed is trying to achieve. However, it requires QE2 according to the Fed, and that is exactly what more the communiqué is saying countries should NOT do: "we will [...] refrain from competitive devaluations of currencies".
Unfortunately, the G20 lacks supranational power and the apparent willingness to cooperate might go no further than the communiqué. None of these agreements are binding. Moverover, since the dispute is mainly between China and the U.S., there is no member strong enough to exert the political pressure that would force them to come to a solution.
So China and the U.S. would have to come to a solution over the currency dispute on their own. And will this dispute get settled? Not if the U.S. keeps desiring fast Yuan appreciation in order to make Chinese imports less attractive and their exports to China more attractive, and if China maintains committed to very slow appreciation of the Yuan in order not to hurt the export sector's very thin profit margins and provoke social unrest. Overall, it is very unlikely that the dispute gets settled on its own, given that neither of the two is willing to give in.
And then there is the deeper lying issue of trade imbalances. The G20 communiqué shortly addressed this, by stating that the G20 will "strengthen multilateral cooperation to promote ... reducing excessive imbalances and maintain current account imbalances at sustainable levels". But since when are imbalances not excessive, and since when can imbalances be at sustainable levels? Apparently, leaders at the G20 could not agree on when, how, and why to address these imbalances that are one of the main causes of the crisis.
The bottom line is that the deeper lying issues will not get resolved. The path of the least resistance is that countries (the U.S. first, and other countries could follow) resort to some kind of protectionism. Either in the form of trade measures or in the form of quantitative easing. The first is less likely to occur, as the biggest and most efficient U.S. companies are the ones that engage in exporting and importing, and precisely these profit-generating firms stand to loose from this. Given their large profit-making potential, it would be a very silly move. Nevertheless, it would not be the first time that politicians made silly moves (silly being a heavy understatement) .The second option, quantitative easing, is more likely, even though the G20 communiqué explicitly tells countries to refrain from competitive devaluations of currencies. The Fed, for example, can resort to its dual mandate to explain the need for further monetary easing and claim that devaluation of the U.S. dollar is just a side effect. Nobody in the real world, obviously, believes this, but it is just part of the political game.
Monday, 25 October 2010
Tuesday, 19 October 2010
Demand and supply forces? How the Fed tries to fool us.
These are truly very interesting times to be an economist, or an intern that is supposed to keep track of basically everything that is going on today on the financial markets. Let alone in politics. Besides interesting, it is funny as well.
The famous quote goes: you can fool some of the people all of the time, and all people some of the time, but you cannot fool all of the people all of the time.
Personally, I really like the sarcasm of this quote by Abraham Lincoln, but that's not the point I want to make.
One of the people that can be fooled all of the time is Trichet. Or does he seriously believe that in is in the US' best interest to have a strong dollar, while everything the US are doing leads me to conclude that they rather want a weak dollar?
And then there are people that try to fool all of the people, all of the time. Or they are trying to fool themselves, all of the time. Choose either one you want.
Take DeLong. I did not agree with his articles stating that US Congress should spend more, even when Obama signed the huge fiscal stimulus bill in 2009, but that was more on philosophical grounds. In a current article of him at Project Syndicate (Economics for Parrots), he argues that economics is all about supply and demand. If there is a shortfall in demand, prices will drop. A shortfall in supply? Prices will rise. Current prices for government bonds are rising, so he concludes that it must be true that there is a shortage in supply of government bonds. Thus, the government should issue more debt. This is also what people are saying when they claim that the government should engage in further fiscal stimulus, since interest rates have never been this low.
However, an utmost important fact that DeLong (and others) are ignoring, is that the Fed is intervening heavily in the market for government bonds. It is the Fed that is exerting such enormous pressure on the Treasury market, that prices remain high (and interest rates low). (Additionally there is the uncertainty about the economic outlook that leads people to look for a safe haven.) If it is the Fed itself that is creating the superfluous demand, then one cannot conclude that for demand and supply factors, there is a shortage of supply of government bonds.
The Fed is thereby also trying to fool all of the people, all of the time. They wish to keep nominal interest rates low, while striving for higher inflation. They will likely aim for inflation somewhat above the current target of 2% by creating a price target. This is a paradox. If people believe both that nominal rates will remain depressed, but that inflation will rise during the coming years, nominal rates must go up. And probably more than just by the rate of expected inflation, because the risk premium that investors demand also rises on the fear of higher inflation than expected. Overall, the Fed will probably get more inflation than it wished for.
Except, of course, when it can fool all of the people, all of the time.
The famous quote goes: you can fool some of the people all of the time, and all people some of the time, but you cannot fool all of the people all of the time.
Personally, I really like the sarcasm of this quote by Abraham Lincoln, but that's not the point I want to make.
One of the people that can be fooled all of the time is Trichet. Or does he seriously believe that in is in the US' best interest to have a strong dollar, while everything the US are doing leads me to conclude that they rather want a weak dollar?
And then there are people that try to fool all of the people, all of the time. Or they are trying to fool themselves, all of the time. Choose either one you want.
Take DeLong. I did not agree with his articles stating that US Congress should spend more, even when Obama signed the huge fiscal stimulus bill in 2009, but that was more on philosophical grounds. In a current article of him at Project Syndicate (Economics for Parrots), he argues that economics is all about supply and demand. If there is a shortfall in demand, prices will drop. A shortfall in supply? Prices will rise. Current prices for government bonds are rising, so he concludes that it must be true that there is a shortage in supply of government bonds. Thus, the government should issue more debt. This is also what people are saying when they claim that the government should engage in further fiscal stimulus, since interest rates have never been this low.
However, an utmost important fact that DeLong (and others) are ignoring, is that the Fed is intervening heavily in the market for government bonds. It is the Fed that is exerting such enormous pressure on the Treasury market, that prices remain high (and interest rates low). (Additionally there is the uncertainty about the economic outlook that leads people to look for a safe haven.) If it is the Fed itself that is creating the superfluous demand, then one cannot conclude that for demand and supply factors, there is a shortage of supply of government bonds.
The Fed is thereby also trying to fool all of the people, all of the time. They wish to keep nominal interest rates low, while striving for higher inflation. They will likely aim for inflation somewhat above the current target of 2% by creating a price target. This is a paradox. If people believe both that nominal rates will remain depressed, but that inflation will rise during the coming years, nominal rates must go up. And probably more than just by the rate of expected inflation, because the risk premium that investors demand also rises on the fear of higher inflation than expected. Overall, the Fed will probably get more inflation than it wished for.
Except, of course, when it can fool all of the people, all of the time.
Monday, 11 October 2010
Note to "Bad news is good news"
No matter how strongly I believe that further quantitative easing will not help the U.S. economy move forwards, this does not mean the Fed will not engage in QE2, unfortunately. I believe they have gone down a road and now cannot turn back, because:
- Markets have priced in a large amount of possible further easing. Announcing no or only little QE2 will shock the markets, but in the wrong direction (stocks, gold and commodities will decline);
- The first round of QE helped (although back then loose monetary policy served the completely different purpose of providing liquidity to a system in need of liquidity);
- With fiscal policy offering little help, the Fed must do (rather: try to do) something (it's in their mandate);
- Future disadvantages to QE2 are far away, and very much unknown (unknown also are the benefits, but hey...), and;
- Bernanke is in favour of QE2, and so are most Fed members (and Krugman)
With this in mind, I think it is just much more likely the Fed will announce on 2-3 November a shocking package of purchases of government bonds and private assets.
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