Ruminations, November 4, 2012
Oh, what tangled webs we weave when first we practice to manipulate currency
— Have you ever gotten yourself into a situation where you can’t extract yourself? And if you try to extract yourself, you make matters worse?
Meet Fed Chief Ben Bernanke and zero interest rates. Bernanke, because of an act of Congress (the Unemployment Act of 1946), is charged with keeping the currency stable and keeping unemployment low. He has attempted to do this primarily by keeping long-term interest rates near zero (through a program that is called quantitative easing – QE for short). It is the goal of the Fed to help create economic expansion by making investment funds available. How’s he doing?
Not so good. Not only are business firms not borrowing money to expand, they are sitting on cash. (Actually, had businesses been spending the cash on hand and, at the same time, availing themselves of the Fed’s largesse, inflation could be moving up a lot faster.) As far as keeping the currency stable, Bernanke has been pretty good but a lot of that “goodness” is due to the fact that the euro and yen are in bad shape. Were they stronger, then the dollar would be weaker. And conversely, were the dollar stronger, then the euro and yen would be weaker. (Actually, this may be part of Bernanke’s sub rosa plan: work with the international community to ensure that the major currencies are of relative equal strength and attempt to right all economies worldwide at the same time. But this is a topic for another time.)
Some economists believe that the Fed should be more active in promoting lower interest rates – though when the rate is close to zero, it would be hard to determine the additional action.
Other economists believe that the Fed has gone too far. Domestically, these folks believe, the Fed has created “asset bubbles,” by encouraging overinvestment in assets driving the price of the asset beyond its value. This occurred before 2007, when real estate prices soared and everyone jumped in the market to cash in. At the same time, the stock market grew to new highs. All this occurred in part because Bernanke and his predecessor kept interest rates low and investors sought a relatively safe investment that paid a higher interest rate than the Fed would pay.
Today, we see housing prices again beginning to grow, the stock market near its all-time high and gold over $1,700 an ounce. Is there a link between the Fed’s policies and the prices of these assets? Bernanke believes this link between the interest rates the Fed sets and the movement of capital investment is overblown. Indeed, he said at the recent Tokyo Conference, “The linkage between advanced-economy monetary policies and international capital flows is looser than is sometimes asserted.” Maybe. How loose is “looser?”
Although we have explored this ad nauseum in past Ruminations, we are beginning to see negative consequences in other countries due to the Fed’s policies. Guido Mantega, Brazil’s Finance minister, said that the Fed’s QE is in fact driving down the dollar and, in an unintended consequence, is driving capital flows into developing nations such as Brazil. From 2007 to 2011, according to Mantega, housing prices in Brazil increased 83 percent – shades of the U.S. housing bubble. Then too, Brazil believes that QE and the capital inflows that QE generated have contributed to inflation in Brazil. Unfortunately, for Brazilians, wage inflation has not kept pace with housing inflation (i.e., bubble), with the result that fewer and fewer Brazilians can afford houses.
But Bernanke has said that Brazil and other similarly situated countries can mitigate their problems by not manipulating their currencies. Fair enough. But coming from a man who has been manipulating the dollar it rings hollow.
But let’s be reasonable, folks. Brazil is a developing country and has a lot of problems. Maybe – just maybe – Mantega is overwrought and Bernanke’s policy isn’t as bad for Brazil as Mantega thinks it is. Maybe we should just listen to a neutral party like the head of the International Monetary Fund, Christine LaGarde. In Tokyo, LaGarde said “Accommodative monetary policies [QE] … could strain the capacity of those [developing] economies to absorb the potentially large flows and could lead to overheating asset price bubbles,” In other words, Mantega is right and Bernanke is wrong.
But what’s the Fed to do? If the Fed drops QE, then the asset bubbles will burst in the U.S. as well as in other countries. Reliving the economic problems of 2007 and 2008 is not an ideal way to go. Well, maybe if Bernanke just began to ease back a little on QE and let the interest rates gradually move up. But international money managers may read this as the end of QE and dump the bubbled assets that they own. For now, it appears Bernanke will continue to do what he has been doing – and more from believing he is correct than believing that QE needs to be halted. Inertia is always easier.
As we said up top, Bernanke is in a situation where he can’t extract himself. And if he tries to extract himself, he may make matters worse.
Quote without comment
Guido Mantega, Brazil’s finance minister, at the Tokyo Conference, October, 2012: “Emerging markets can’t passively endure large and volatile capital flows and currency fluctuations caused by rich countries’ policies … “[A]dvanced countries cannot count on exporting their way out of the crisis at the expense of emerging-market economies.”