” … 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.”

Unsurprisingly since the consensus (weaker dollar/stronger yuan) is probably wrong. The peg is what it is, it serves the Chinese as well as it serves the US. At the same time, it allows the Fed to export inflation to China; it’s just another kind of carry trade.

What occurred to me, and maybe I’m just naive is that there is a major reason why China is wanting to establish some new neutral international reserve currency to replac the dollar: Currently they continuously invest in our economy, not to make money, but to support the value of our currency.

Another reserve currency handed to them on a plate is the only way the Chinese establishment can see their way out of the colossal jam they’ve made for themselves. The USA is too big to fail.

Since a new replacement reserve currency is not going to happen, China remains the 51st state.

Also, nice to read a solid article about the Fed, without the ‘Kill the Fed’ hysteria. No mention of energy, however. The economy runs on energy, credit is an outlier, it is simply another way to allocate (scarce) energy. Think about it.

We needed the four extra Saudi Arabias ten years ago to keep crude prices @ $15 a barrel. This conversation would not be taking place with those extra Saudi Arabias.

An asset bubble is just another way to hedge inexorably rising crude prices. This is why the establishment is working so hard to craft another one.

steve

http://www.cato.org/pubs/journal/cj29n1/cj29n1-9.pdf

I also enjoyed reading the exchange of ideas with BondGirl about bubbles and what will happen once they are defined. Personally, I think that once bubbles are defined there may be a few new tools for policy development that will help avoid imbalances between the real economy and financial sectors. I guess we’re just waiting to hear from those all from all those graduate students working on the problem!

I always liked reading Keynes so I can sincerely appreciate your hesitancy to shift away from the use of “leaks” in the system. (I have had to work really hard on realizing the limitations of a couple of Keynes’ interesting concepts). You gave me the sense that your use of the term “leaks” was qualified; “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).”
So tongue in cheek – do you think we need some new terms – such as “flood”, “gush” or “surge” or “swoosh” ? Just wondering!

I am looking forward to reading more!

The answer is that the liquidity generated by the Fed was not being channeled into productive investment, but rather was leaking into bubbles and capital flight due to poor regulation and an overvalued dollar. These leaks are crippling the effectiveness of monetary policy as a tool to avoid unnecessary drops in utilization rates, (and by extension widening the fiscal deficit due to lost taxes, lower growth, and costly social support/unemployment programs).

Oh yes we can!!!!! I think you are just worried about losing your overpaid job as an economist.

Oh yes you could… the way the AAA ratings were pointing at it as one of the greenest no-risk valley in town too much liquidity, even if not excessive, would have gone there.

That essentially was Greenspan’s argument. He nor you ever explained why the cost would be extreme. Is the cost greater than the cost of the current crisis- the most severe financial crisis since the great depression?

The current crisis has its origin in the housing bubble. You likely would not have had the bubble without the excess monetary liquidity.

The excess monetary liquidity enabled price speculation to develop and gain traction. That speculative opportunity was seized upon by mortgage investors and levered derivative players.

Without the initial Fed induced speculation, the mortgage speculators would not have had the opportunity which they took advantage of.

Its a lot like baseball: the Fed put the bubble across the plate; financiers drove it home.

http://books.google.com/books?id=neKm1X6YPY0C&pg=PA283&lpg=PA283&dq=%22caruana+lacorte%22&source=bl&ots=l2U0vjlPOV&sig=U8dnRRaKLRKsVd7HuphWxbiQxd4&hl=en&ei=vLXASvzQGZGgswOp9YUp&sa=X&oi=book_result&ct=result&resnum=3#v=onepage&q=%22caruana%20lacorte%22&f=false

His spanish wikipedia page has his full(?) name: Jaime Caruana LaCorte. There is also a Jaime ‘Felix’ Caruana LaCorte floating around out there. Same fellow?

Perhaps we would all have loved to have seen a bubble but in another sector, like that of renewable energy, as it seems that without such bubbles the world might not stand a chance.

One of the issues here is that (at least as I see it) Monetary Policy should be evolving over time to better develop techniques that will allow the fed to achieve it’s goals of maintaining price stability and full employment…

The fed is not just a tap of cash to turn on and turn off, in fact this function of the fed has been somewhat more of a science with techniques such as the Taylor Rule, which aim to make the determination of the interest rate a more mathematical and transparent procedure.

However other functions of a central bank, including operating the discount window, conducting open market operations, and intervening in the foreign exchange market, need a lot more judgment (and secrecy, imagine if traders knew that the Central Bank would always intervene in the Forex market given a specific ‘trigger’!).

One quite recent and important innovation is the ability for the fed to issue short term bonds, (which the Central Bank does here in New Zealand as well as in other countries). This innovation required congressional legislature to pass, but it will help the fed to put a floor on interest rates as they increase, by issuing extremely liquid short-term (overnight/30 day…) ‘bank bills’ that are for all intents and purposes, interest bearing cash.

Sweden has experimented with negative interest rates (-0.25%) on deposits held overnight at their reserve bank.

One potential (but unlikely in any country) policy that could be pursued by a central bank would be to limit the growth rate of the total pool of mortgage finance in the country. (This may sound easy to get around by calling loans non-mortgages, but non-mortgages require quite a lot of capital under Basel II, so ‘putting your house on your credit card’ would carry heavy interest rates) So the total pool if mortgage finance in a country would be pretty easy to regulate. You could set a growth rate each year at trend gdp. That would be pretty bubble-preventing.

But such innovations require a Central Bank with a lot of autonomy, independence, and clever people.

Now potentially, the gains of all these innovations (and of having a central bank at all!) are not large enough to justify the existence of the fed, or the people at the fed are just not clever enough to do any good! In either case it would be pretty reasonable for the fed to be reduced to a Taylor Rule, automatic punchbowl machine, or to go to commodity money.

I personally believe however, that central banks can do better, but must be able to innovate.

I just hope that we can help them break this cycle, because I actually feel that it will hold both of us and the world back from a better future sooner. I believe that whatever is good for the host is also good for the parasite (I don’t know who is who in this case, but maybe both are both in some ways.).

Much of the effectiveness of any cure for this issue will come from the Fed, Treasury and Congress getting serious about regulation, and bringing big finance back into its appropriate interest in the GDP (more like 15%, and less like the current, which is absurd at best.).

Back to Simon and James insofar as taming the oligarchs’ plutocracy. It’s probably time to get back to democracy and away from Michael Moore’s version of capitalism (right now our “capitalist” economy looks a lot like the French economy right before the revolution, and unless we can change, we will have our own version of 1775-6 in France, no doubt, and it won’t be pretty.).

http://baselinescenario.com/2009/07/20/efficient-market-hypothesis-no-free-lunch/

And Mike Rorty raised one practical problem that rarely gets any attention in formal models – the lack of unlimited liquidity.

http://baselinescenario.com/2009/08/21/the-limits-of-arbitrage/

As to a backgrounder, Wikipedia does it better justice than I could do on my better days anyway…

http://en.wikipedia.org/wiki/Efficient-market_hypothesis