Thursday, July 01, 2004

Monetary Policy: When Central Bankers Go Senile

I've been very tough on Greenspan, but to be honest I've been holding back. I'm not sure what the hell the Federal Reserve Bankers are thinking, but the only thing which I really have to hold on to in order to keep my sanity that they can't be really as stupid as they act others are. It's one thing to run a scam and it's another thing to fall for it.

In the real world, when you have a choice between malice and incompetence always go with malice. Malice implies intelligence and rational motivation. This is far preferable to blundering idiots. Contrary to many liberals, I accept the prima facie argument that the Bushites didn't lie but didn't just didn't know any better. What I reject is the conventional wisdom that incompetence is less henious a crime than malicious conduct. I completely accept the assertion that Bush, Dick, Rummy, Rice, Powell and their subordinates for the most part simply didn't know how to do things any better than they did. What I reject is the notion that incompetence is any less than a death penalty offense as a crime against the state.

Better a wicked ruler who knew what they were doing, than an incompetent who will pave the way to hell with good intentions.

So far however I have been keeping to the maxim that Greenspan has been playing a very clever game, perhaps a malicious one, but a deliberate one rather than buying into his own press. This has been amplified by reported conversations from Greenspan where he took much more radical positions toward reforming corporate governance, tax cuts, etc. in private than public.

Lately however, I'm not entirely sure anymore. I keep on trying to come up with rational reasons why the Federal Reserve system wouldn't act to make credit more expensive and force thereby a reconsolidation of the public finance system. There's broadbased grassroots support for it. We have the most high profile and popular Federal Reserve Chairman in the history of the United States. If not to expend that political capital now in order to rectify the clearly the imbalance then when?

The Economist discusses this mystery as it attempts to plumb the mind of Greenspan on the topic of inflation.

The Washington-based governors of the central bank fit broadly into this sanguine camp. Some of them place considerable weight on the slack that remains in the economy. Donald Kohn, a Fed veteran and perhaps the governor who is closest to Mr Greenspan, made clear in a speech earlier this month that much of the inflation acceleration in early 2004 was a rebound from “unexplainably low inflation last year” as well as the one-off effect of higher prices for energy and other commodities as well as a weaker dollar. Though the analysis was filled with caveats about how little is known about the inflationary process, it endorsed a gradualist strategy.

By contrast, the presidents of the regional Federal Reserve banks are traditionally a more hawkish bunch, less trusting of “output-gap” based analyses of inflation. But their influence is also much smaller.

Easily the most important factor, however, is what Mr Greenspan himself thinks. Formally sworn in to a fifth term as Fed chairman on June 19th, Mr Greenspan dominates the discussion of monetary policy. Though famously sceptical of any single model of the economy, he has led the gradualist argument. But recently he has sounded both concerned and sanguine in quick succession.

In a speech on June 8th, he pointedly noted that the central bank would do “what is required” to maintain price stability. Financial markets interpreted a hawkish signal and quickly anticipated sharply rising interest rates. A week later, in his comments to senators, Mr Greenspan adopted a more relaxed tone, and financial markets readjusted their expectations to a quarter-point rise on June 30th. The truth is that Mr Greenspan probably believes the central bank can act gradually, but wants to keep the option of ratcheting up rates if necessary.

Appealing as it sounds, this kind of wait-and-see approach poses problems. Over the next few months the economic statistics are unlikely to “prove” that either the hawks or doves are right. As Jan Hatzius of Goldman Sachs points out, the one-off effect of higher input prices alone could boost consumer prices for several more months. Given that last year's inflation was so low, arithmetic suggests there will be big year-on-year rises in consumer prices, even if the monthly figures remain well behaved. Yet these figures might help to raise people's expectations of further inflation. The real problem, however, is that by the time you are sure inflation is taking off, it is too late: it takes many months for higher interest rates to dampen inflation.

Given this lag, and given the extraordinarily low level of rates today, the Fed's gradualism is surely a gamble. Last week, Mr Greenspan, an avid golfer, told Congress that while he reckoned the Fed was on track to normalise interest rates while keeping the economy stable, it was not a “gimme” putt (a putt so easy that other players give you the shot). In fact, another metaphor may be more appropriate. In the friendlier sort of golf, if you mess up a shot, your opponent can let you take a “Mulligan” and try again. The American economy is less charitable.

The answer I keep on coming up is "hubris". Hubris is the condition where some otherwise very intelligent people come to take completely unjustifiable press. They are aware of the odds but they take them anyway, believing themselves immune because of a history of long success from the consequences of their actions. The question is not whether or not this policy is a massive gamble on the part of Alan Greenspan. It is the biggest gamble in history. The question is what makes Alan Greenspan think he can singlehandedly take this risk on behalf of the entire American economy? What gives him the right to decide that we will risk a debt default because there is a remote possibility of a spontaneous restructuring of the economy to increase production if he makes enough credit sufficiently available?

This isn't a question of models, but rather blind faith. Greenspan has been betting the entire economy on the notion that the political leadership is irrelevant and that he can sidestep them. He is figuring that no matter what choices they make, that as Federal Reserve Chairman he can ensure that sufficient credit is supplied to domestic capital asset investment in order to finance not only the mistakes of the politicians but also create net wealth besides. This is the course he has taken to the classic alternative of increasing the price of money and creating market incentives for the politicians to clean up their act. That would only happen at the cost of a contraction of consumption to equilibriate with the long term production exchange value of the economy. So Greenspan feels he can avoid the hard choice by inflating the market.

To clearly see exactly what kind of titanic risk Greenspan is undertaking, one has to refer to Buttonwood's reference to America as a single giant hedge fund.
The current account essentially comprises two things: the trade balance and overseas investment income. America’s trade deficit is bad and getting worse, even though the dollar has fallen by 23% from its recent high in February 2002. A $46.6 billion trade deficit in March had risen to $48.3 billion in April. In the absence of a net surplus from foreign investment, notes Jim O’Neill, the chief international economist at Goldman Sachs, this would mean a current-account deficit for the year of more than $600 billion, or getting on for 6% of GDP. No problem, say the more sanguine: America has long been able to finance its large and growing deficit because it is such a wonderful place in which to invest.

There are, however, a couple of snags with this argument. The first is that Americans find foreign climes more attractive to invest in than foreigners regard America: net foreign direct investment (FDI) has amounted to minus $155 billion over the last 12 months. And who can blame them? Returns on FDI into America were 5.5% in the first quarter, compared with returns of 11.7% on American firms’ foreign investment. Nor is this an aberration: the returns in America have been consistently lower for many years.

This gap has been plugged by portfolio flows (investment in such things as stocks and bonds) but of late the overwhelming majority of these have been due to foreign central banks, particularly Asian ones, trying to stop their currencies rising against the dollar, and buying Treasuries as a by-product of this intervention. Foreign central banks now hold $1.2 trillion of Treasury bonds. As growth and inflation rise in Asia (or in Japan’s case, as deflation eases), the arguments for intervening look much shakier. Japan, indeed, seems almost to have stopped wading into the foreign-exchange markets. Foreign central banks are, moreover, starting to fret about the amount that they hold in dollars. None of this bodes well for the dollar’s future value.

Nor does the net income that America makes on foreign investment. In the first quarter, this surplus amounted to almost 0.5% of GDP. This seems extraordinary, for reasons that have everything to do with the BEA’s annual survey. This showed that America's net foreign liabilities have continued to rise, standing at over 24% of GDP at the end of last year, up from almost 23% in 2002. Despite that, the country still managed to make more money from investing abroad than it had to pay to foreigners, for the simple reason that American investors’ domestic financing costs were so much lower than their overseas returns. In other words, says Mr O’Neill, the United States is like a giant hedge fund, borrowing huge wodges of cheap money at home and then investing it in higher-yielding foreign assets.

Which is where we return to the subject of higher interest rates. When interest rates go up, this net surplus on America’s investment income will turn into a deficit. A yield on ten-year Treasury bonds of 6%, says Goldman Sachs, would in the space of a few years add 1% of GDP to the current-account deficit, solely through higher interest charges. Whether or not yields reach such giddy heights depends mainly on two things: how much inflation is actually picking up; and foreigners’ continued willingness to supply the giant hedge fund known as the United States of America with cheap finance. Still, Mr O’Neill, for one, thinks it “virtually impossible to be a structural bull on the dollar”. Buttonwood finds it virtually impossible to disagree. His pony-mad younger daughter is enthralled by the idea of a holiday on a dude ranch.[emphasis added]

Of course the success of a hedge-fund ultimately lies in taking advantage of arbitrage, capitalizing on the inefficiences of the market. When systematic inefficiences occur because of government intervention, hedge funds can become overexposed and instead of minimizing risk they become vulnerable to both sides of the trade. This is what happened to Long Term Capital, normally counter-dependent assets and commodities began to synchronize and normally synchronized began polarizing. In this kind of situation a highly leveraged hedge-fund can by "betting against the market" (normally to hedge risk) enter into a kind of meltdown as it loses money coming or going.

As Buttonwood points out, this exact kind of divergence from normal trends has begun happening in the dollar:
Perhaps that is why, in recent weeks, the greenback has begun to slide again, while gold has staged a comeback to $400 an ounce. Since mid-May, the dollar has fallen by 4% on a trade-weighted basis. On the face of it, this seems peculiar. The dollar has started to fall again even as the chatter about interest-rate rises has got louder. Naively, you might expect a currency whose interest rates are about to rise to go up, not down. One explanation why the reverse has been the case is that the Fed has been late in stamping on inflationary pressures, so real interest rates—ie, adjusted for inflation—are falling even as nominal rates are expected to rise. There might, however, be another explanation: that rising rates will make an already awful current-account deficit worse still, and that markets are again starting to realise that the only way in which this can be corrected in the long term is by a sharply lower dollar.

Is there any sort of systemic situation in which this process will plateau? Alas, no. China's economy is in bubblesque proportions and Japan's is beginning to roar.
Even the economists were surprised, pleased with the short term but concerned about long-term prospects of sustainable economic recovery.

A closely watched measure of business sentiment among large Japanese manufacturers shows a considerable jump in June from the three months before, reflecting one of the most encouraging financial quarters in nearly 13 years, a Bank of Japan (BOJ) survey showed Thursday.

The central bank's tankan (short-term) quarterly survey showed that its measure for large manufacturers' current business conditions stood at plus 22, thus coming close to the plus 25 marked in August 1991.

The BOJ's mathematical gauge of the current business sentiment of large manufacturers, known as the Diffusion Index (DI), recorded plus 22 for June, up sharply from plus 12 for the three months ending in March. This was the fifth quarterly rise in a row, the central bank said.

But with the good news flowing in, central bankers also warned that continued high growth in the economy in the next few weeks and months may prompt a hard look at Japan's current "zero" interest rate policy, which since the start of this decade has been a key tool in fighting the scourge of deflation.

The trades selling short these currencies in order to go long the dollar will become increasingly untenable. As these currencies become stronger, combined with the downward pressure because of the counter-cyclical interest rate rises (normally interest rate increases increase dollar exchange value) a situation is created of potentially escalating losses as more and more people try to get out of the dollar and at the same time the only way to stabilize this is to attempt to raise interest rates even more. The Federal Reserve must pursue this role because it is by definition the lender of last resort of its debt. Rather like a slingshot effect the final result is that before interest rates stabilize the currency, the choice will be between hyperinflation or hyper-interest rates.

That is the risk that Alan Greenspan is taking. It needn't happen, but does he have the right as one man to take such a gamble just on the principle that he believes he can inflate the domestic capital asset investment market sufficiently to avoid a contraction of the economy while raising production to meet consumption, rather than drawing down consumption to meet production? I would be a little more sanguine about the gamble he were taking if he were more honest about it. However the complete lack of serious opposition to this monetary policy by the community of economists, along with the popular cult of personality, has empowered Greenspan to take this risk on all our behalfs.

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