More on Competitive Currency Devaluations

There is nothing preventing the Federal Reserve from buying up any financial asset it so chooses with money it creates out of thin air. In fact, I seriously doubt that the vaunted bond market vigilantes would be able to cause US interest rates to go up if the Federal Reserve decided to target long-dated Treasuries for purchase. Bruce Krasting made just this point yesterday using Ben Bernanke’s own words. (hat tip Scott)

The Fed could stimulate spending by lowering rates further out along the Treasury term structure. There are at least two ways of bringing down longer-term rates:

(I) Fed could commit to holding the overnight rate at zero for some specified period.

(II) A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities.

Ben Bernanke as quoted by Bruce Krasting

This quote is from Ben Bernanke’s famous helicopter speech from 2002 in which the present Chairman of the Federal Reserve Board also says:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

My point? Ben Bernanke, if one takes him at his word, is committed to preventing deflation in America by all means necessary. This includes:

There are a few other policies that the Fed has taken on as well. What the Federal Reserve has yet to do is target long-term interest rates directly by buying up long-dated government paper.

Here’s the thing though. In our monetary system, the Federal Reserve controls short-term interest rates through open market operations. Bank reserves normally serve this purpose. If the Fed wants a higher Fed Funds rate, it drains reserves by selling financial assets and buying up reserves. If the Fed wants a lower rate, it adds reserves by buying up financial assets – usually Treasury bonds, but more recently it has taken to buying other assets. The quantity of reserves, of course, is irrelevant; the interest rate is what counts for the economy. [Scott Fulwiler reminds us that the Fed doesn’t actually change the quantity of reserves; it just announces a new target, and stands ready to "defend" the target via repos/reverse repos if the market doesn’t move to the new rate. With a large quantity of excess reserves and the target rate set at the remuneration rate, the Fed just changes the interest rate on excess reserves.]

Now, if the Federal Reserve has absolute control over short-term rates, why isn’t it reasonable to assume it also has absolute control over long-term rates too? After all, I just showed you how long-term interest rates are really a series of short-term rates smashed together. The real reason that the Federal Reserve would lose control over short-term interest rates is because the economy was operating at full capacity and creating inflation which provoked an increase in rates.

MMT: Market discipline for fiscal imprudence and the term structure of interest rates

But, of course, the Federal Reserve wants inflation. It is deflation that Ben Bernanke is worried about. Now, if all of this doesn’t work, Ben Bernanke has already said he is willing to get people to spend by buying up long-dated Treasury securities until those rates come to heel – just as short-term rates do. To prop up asset markets, the Fed could even buy equities; it already has bought mortgage-backed securities to prop up the housing sector and we know the Japanese bought equities during their bouts with deflation.

The point is the dollar is a fiat currency and the government controls its creation.

As I have been saying for some time, the issues in the US and the UK are not ones of interest rates or national solvency but of currency depreciation and inflation. I hope the paragraphs above illustrate why. But, clearly, if the Federal Reserve takes on a policy of buying up assets with printed money, it will cause the US dollar to weaken.  But isn’t that the point?  Unless, the Europeans do the same, we have a de facto beggar thy neighbour currency devaluation policy.

But, of course the Europeans are looking to depreciate their currency too. This is already having an effect in China and Japan. UBS’ Andy Lees writes:

Japan’s May trade figures showed a slowdown in exports for the 3rd consecutive month, down 1.2% m/m. “Exports grew at a slower than expected pace apparently due to the effects of China’s tightening” of banks reserve requirements according to the Norinchukin Research Institute in Tokyo, which also expects the weaker euro to impact because of the resulting loss of Chinese competitiveness; “Europe’s debt crisis is also expected to impact China’s exports to Europe in the coming months as the euro’s drop hurts Chinese firms competitiveness. This in turn is likely to prevent Japan’s exports from recovering fully”. What it seems to be saying is that the model of outsourcing to China and then onward export has lost its competitive edge against Europe given the euro fall. This follows the Herald Tribune report earlier in the week, quoting BIS data, suggesting that Chinese competitiveness has fallen to its lowest level since 1994. As far as direct exports to Europe go, they rose 17.4% y/y (+2.4% m/m) due to demand for auto parts, electronic parts from Germany and other capital goods such as chemicals and metal products registering double digit gains.

The only positive note here is that Germany’s gain translates into some "increased demand for Japanese parts and materials" as Lees quotes Itochu Corporation as saying. Question: How long does it take before the Chinese get sick and tired of the Europeans and the Americans depreciating their currencies to try and export their deflation onto the backs of others? Hopefully, we won’t find out as we are a long way from the Fed buying up long-dated Treasuries. The global economy is still growing right now at a decent clip, thank you. Still, it makes you wonder.

9 Comments
  1. dansecrest says

    1. Bernanke agrees with Fullwiler that the Fed can control long term interest rates on U.S. government obligations.

    2. Since the Fed can always control interest rates on U.S. Treasury bonds, those who worry about bond vigilantes driving interest rates up are off the mark.

    3. When the Fed buys private assets (i.e. assets other than U.S. government bonds), they are getting into fiscal policy. Obviously, this behavior should be restricted to emergencies. (Who wants the Fed buying equities and mortgages as a standard practice?)

    4. Governments can engage in fiscal policy to promote employment. However, deficit spending may create asset bubbles instead of full employment. Something like this has happened recently in the U.S., with the stock market skyrocketing while unemployment has remained near 10%.

    5. Deficit spending that boosts employment, and does not include borrowing in foreign currencies, provides a sustainable road to recovery for an individual economy, and for the global economy as a whole.

    6. Countries with low inflation and high unemployment can boost domestic demand and therefore need not rely upon increased exports to inflate their economies.

  2. rn says

    i have two comments.
    (1)
    “We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
    – Fed can only create positive inflation. I can not generate higher spending. Fed has capability to distribute the generated money to banks.That is not enough to generate higher spending. High spending requires that the printed money should be distributed across all sections of the society. This requires fiscal stimulus. Monetary stimulus will not do the job.

    (2) I think there is an upper limit to fed’s ability to expand its balance sheet. It may be very high as it is. I do not know.

    The upper limit corresponds to the debt ceiling set by Congress.

  3. Namazu says

    If it embarked on an indiscriminate buying spree, the Fed would invite intense political backlash and legal challenges. It would damage its future as an institution. And it would do so knowing there’s a good case it didn’t work in Japan. While the “helicopter” speech bears frequent re-reading as a window into Bernanke’s thinking, I don’t believe it can be understood as a solemn pledge to go thermonuclear. Furthermore, what would he buy if we don’t go off the fiscal deep end? The Administration is boxed in by their rhetoric, and even if Paul Krugman transforms himself into Dale Carnegie, there’s no way the public will stand for the deficits he advocates. Bernanke is up against larger forces than he faced at Princeton.

    1. dansecrest says

      We’ll see how much the public cares about deficits when the stockmarket goes back down and the employment situation doesn’t improve…

  4. dansecrest says

    There is nothing wrong with the economy that cannot be cured by well-placed fiscal stimulus…

    1. As noted by Bernanke, the Fed can control long term interest rates on U.S. government obligations.

    2. Since the Fed can always control interest rates on U.S. Treasury bonds, those who worry about bond vigilantes driving interest rates up are off the mark.

    3. When the Fed buys private assets (i.e. assets other than U.S. government bonds), they are getting into fiscal policy. Obviously, this behavior should be restricted to emergencies. (Who wants the Fed buying equities and mortgages as a standard practice?)

    4. Governments can engage in fiscal policy to promote employment. However, deficit spending may create asset bubbles instead of full employment. Something like this has happened recently in the U.S., with the stock market skyrocketing while unemployment has remained near 10%.

    5. Deficit spending that boosts employment, and does not include borrowing in foreign currencies, provides a sustainable road to recovery for an individual economy, and for the global economy as a whole.

    6. Countries with low inflation and high unemployment can boost domestic demand and therefore need not rely upon increased net exports to inflate their economies.

    The prevailing sentiment seems to be against fiscal stimulus to boost employment more directly, so the currently stagnant economy is likely to worsen before it gets better…

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More