Thursday, June 21, 2012

FOMC: ditch the sandbags, grab the buckets

The Federal Reserve Open Market Committee has decided not to take stronger action to get the United States economy out of this "Lesser" Depression. Okay, it's better than the Great Depression, but the U.S. economy was on the path to recovery shortly after FDR took office. To me, it's clear what the economy is lacking: spending, or what economists call aggregate demand (AD, for short). Consumers are unwilling/unable to spend (generally because they are trying to improve their finances: paradox of thrift, anyone?), businesses are uninterested in investing (because they don't see a fast recovery as a likely scenario), local governments are cutting back (balancing their budgets) and the Feds have recently "got religion" at the worst possible time (they have decided that poverty brings virtue and virtue will bring the economy gods to their side).

The Federal Reserve has seemingly decided that an inflationary flood is coming, while the economy is still in flames. This is a little worse than being Nero while Rome burns. This is like Nero sending out the Roman legions, the Spanish Guard and the Praetorian Guard to start filling sandbags, worrying about a flood, while Rome burns. We need the armies of Rome to act as firefighters, but they are focusing on a scenario that does not exist and will be easy enough to resolve when and/or if it comes. If recovery comes and inflationary pressures become a problem, the Federal Reserve can vacuum up the excess reserves by dumping Federal Treasuries on the market. It's not the easiest job ever, but it's a manageable job that the Fed knows how to do.

I have a modest policy proposal that I think will help speed recovery in both the United States and Europe (and help save the Euro, too). My idea is for the Federal Reserve to start doing monetary policy a little like Singapore (temporarily)... The Fed should purchase foreign government bonds of those countries in Europe which have the best purchasing power. I'm specifically thinking about Germany, France and Austria, although there might be a few others. The idea is to bring the relative value of the dollar down, somewhat, stimulate more exports from the US, bring extra liquidity to the countries with less inflation within the Eurozone than the peripheral countries, bringing the Eurozone toward equilibrium in purchasing power parity. I discuss the inflation divergence in Europe in more detail in "Gustav Cassel and the Euro Inflation Divergence". Injecting liquidity into these countries will result in a balance of payments surplus, which will need to be corrected by a deficit in the capital or current account. This means more foreign investment or imports, which could end up going to the crisis countries, but even if it doesn't, inflation in the core should make the periphery more competitive. And ultimately, the currency issued to pay for the bonds will come back to the US to redeem goods or services, as trade or investment.

Could it work? I think so. Should it be tried? Definitely, as it's potential effects are very positive and truly can present a "killing two birds with one stone" potential.


  1. I like your suggestion. It makes a lot of sense. Certainly it seems better than the race-to-the-bottom policies the government seems to favor now, nothing but "cuts". Your Nero analogy was also apt.

  2. It might work, but it might just encourage (and make it easier for) other countries to buy more of our bonds, negating the effect. What I'd like to see tried is a financial asset export tariff -- any foreign government, or anyone using a foreign account (any account not subject to US taxes) to buy a dollar denominated financial asset sold in the US must pay a tax on the export of that financial asset. This would have several effects: 1. It would make it more difficult to earn interest on money held in off-shore accounts, 2. Anyone earning interest in off-shore accounts would still be paying some taxes, 3. It would discourage use of the dollar as a reserve currency, 4. It would make it less likely that, when we purchase foreign goods in dollars, the dollars get loaned back to us instead of used to purchase domestic goods, so it would lower the trade deficit. And the nice thing is, it isn't a race to the bottom -- if other nations follow suit, they can't cancel out the effect, and unlike with import tariffs a trade war would not lead to a reduction in trade, only in trade deficits. If everybody does it, the end result is the race to the bottom strategy becomes hopeless; everyone gives up trying to become the country doing all the exporting (a strategy that can only work at someone else's expense).