This post was written by StatsGuy, a regular commenter here and very occasional guest contributor. We asked him to expand on the ideas he put forward in this comment on the relationships between monetary policy, international capital flows, and bank capital requirements.
Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.
Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)
Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines). How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)
Here is a less semantic answer: When the Fed pumps money into the system to prevent deflation, the disincentive to holding cash/reserves is supposed to get money moving and thus restore the savings/investment equilibrium. In a sense, the goal is to decrease the incentive to use money as a store of value and therefore increase its use as a medium of exchange. Unfortunately, many conventional macroeconomists (unlike their brethren in the real-world finance schools) haven’t admitted that this monetary stimulus “leaks” out of their models (which focus on closed domestic economies without moral hazard). Where does it go?
Partly, it gets sopped up by large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit. Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities).
The monetary stimulus also “leaks” due to globalization of capital flows. It flows out of the country through a variety of mechanisms that traders might describe as dollar hedging (into commodities, foreign assets, and an anti-dollar carry trade). This is one of the most dominant trading features in the current market environment.
In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). This latter point is not entirely intuitive, and I might argue that the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.
So in these regards, Team Obama seems to “get it”. I concede that they have identified the right issues. How well they execute depends on many factors. As Professor Johnson notes, focusing on currency valuations (a very sensitive issue in China) on a highly public world stage like the G20 may not be productive. By contrast, quietly moving a bill through Congress might be a better option.
But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.* If it tries to support a weak economy by keeping the punchbowl on the table (as in 2003-2005, when we had a “jobless recovery”) then we get a really bad bubble.
That is what a central bank staffer called “Second Best Punchbowlism” on Brad DeLong’s blog, and it is a very scary prospect indeed. Remember when the Fed kept rates tight in August and early September 2008 (arguably to fight the commodity bubble/dollar run)? And when, in the post-September 2008 crisis, the Fed continued its deflationary policies, even though it was abundantly clear to the entire world that aggregate demand was (to paraphrase Warren Buffett) falling off a cliff? The Fed didn’t bring out the heavy weapons until March of 2009, until things looked pretty bleak indeed. This is what we can look forward to if the Fed’s new paradigm becomes Second Best Punchbowlism.
It’s also important to recognize that we can’t just kill the Fed right now. We NEED monetary policy to be effective in order to implement new financial regulation (especially higher capital asset ratios) without killing the US (and world) economy by reducing the total supply of money. As we phase in higher capital asset ratios and other regulations, we must compensate by injecting liquidity to offset a decrease in velocity. This must be done in a highly coordinated fashion. Otherwise, financial regulation that aims at a long term equilibrium with a more stable overall money velocity (which I would argue is a good thing) could risk deflation in the near future (which will undoubtedly cause people to blame the administration currently in charge).
*“I’m acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve’s institutional commitment to maintaining low and stable inflation will prevail.”