Bubble. Burst. Liquidity. Repeat

Increasing both

In March 2000 the dot com bubble burst. From a peak of 5,048.62 on March 10th, 24 percent up on late 1999, the NASDAQ Composite index had fallen to half that by late 2000. GDP growth slumped and unemployment steadily climbed from under 4 percent in late 2000 to a peak of 6.25 percent in mid-2003.

On January 3rd, 2001, Alan Greenspan acted and cut the Fed funds rate to 6 percent. By June 2003 it was down to 1 percent where it stayed until June 2004. The effects are well known. This wave of liquidity was directed by government action like the Community Reinvestment Act, government bodies like Fannie Mae and Freddie Mac, and a minefield of moral hazard in a financial sector which knew it would be bailed out of any trouble, into a housing bubble.

That bubble burst too. With inflation on its way up from 2 percent in mid-2003 to 4.7 percent in October 2005, Greenspan gradually raised the Fed funds rate, reaching 5.25 percent in June 2006. But this crippled many people who had borrowed at lower rates to buy property. The number of new foreclosure starts in the US increased by more than 50 percent to 1.1 million between 2006 and 2007.

Assets backed with these non-performing loans crashed in value. Banks holding them saw their balance sheets ravaged. Seeing counterparty risk everywhere, banks stopped lending to each other and the LIBOR, usually about 0.15 percent above where the market thinks the bank rate will be in three months’ time, shot up to over 6.5 percent in August 2007. The credit crunch had arrived.

And Greenspan, his academic successor Ben Bernanke, and central bankers around the world reacted as they had to the bursting of the dot com bubble. The Fed funds rate went back down from 5.25 percent in September 2007 to 0.25 percent in December 2008. Likewise, between July 2007 and March 2009 the Bank of England slashed its Base Rate from 5.75 percent to 0.5 percent. Even the supposedly cautious European Central Bank reduced its key rate from 4.25 percent in summer 2008 to 1 percent by the spring of 2009.

When this failed to have the desired stimulative effect central bankers began trying to pull down the long end of the yield curve. Under Quantitative Easing the Bank of England spent £375 billion of newly printed money on British government debt. The Federal Reserve is spending $85 billion dollars a month on bonds.

There is a pattern here. A bubble in assets (dot com stocks) bursts and central banks react by hosing liquidity into the system. But this liquidity inflates another bubble (property) and when that bursts central banks react by hosing liquidity into the system…

In the high Keynesian noon of the post-war period it was widely thought that monetary policy was ineffective for macroeconomic management (it is debatable how much this is actually owed to Keynes). All that could be hoped for from monetary authorities was support for the fiscal policies which really had the clout to equilibrate the economy.

But this Keynesian paradigm fell apart with the stagflation of the 1970s. Money mattered was the lesson and it became the primary tool of macroeconomic management, replacing fiscal action, at least until the ‘Return of the Master’ following the credit crunch.

But what has this meant in practice? As interest rates are lowered in response to an adverse shock investment, calculations change, especially when, like Alan Greenspan, those behind the policy publicly promise its continuance. To the extent that this fosters a wealth effect, consumption, as well as investment, may be stimulated. And this, in fact, is exactly the way the policy is supposed to work.

But the rates cannot stay that low indefinitely, nor, despite the jawboning by monetary policymakers, are they intended to. At some point they will rise. Again, this actually is the way the policy is supposed to work.

And when those rates do rise what happens to those marginal investors who made their decision when rates were at their lowest? What happened to the NINJAs who bought condos in Michigan when interest rates were 1 percent when the rates went up in 2006? They were scuppered. And what will happen to all the enterprises which are currently dependent on interest rates remaining at their historic lows when those rates start to rise? It is because more people are now asking that question that markets have turned skittish recently, since Ben Bernanke even began to discuss a possible future ‘tapering’ of Quantitative Easing.

Those rates will have to rise at some point. But, when they do, whichever bubble we have now will burst. Our monetary authorities have printed themselves into a corner.

This is what passes for macroeconomic management. As one of the high priests of this bubble-onomics, Paul Krugman, advised in 2002 in the wake of the dot com bust “To fight this recession the Fed needs…soaring household spending to offset moribund business investment…Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble”. And no, that’s not taken out of context.

One of the great myths in economics is that of some sort of stable equilibrium. It is apparent that active monetary policy is little better at producing that than fiscal policy proved. Instead the economy is characterised by crises of increasing frequency and amplitude and the only solutions policymakers appear to have to deal with them will buy ever shorter-lived respite at the cost of increasing both the frequency and amplitude of crises.

We are in an equilibrium of sorts, but it is an equilibrium of crises.

This article originally appeared at The Commentator

Is the Conservatives’ economic trump card warranted?

Let’s roll

It is part of Conservative Party mythology that it is repeatedly elected to clean up Labour’s economic messes. Indeed, 1931, 1951, 1979, and 2010 saw Labour bequeath the Conservatives a steaming pile to deal with. The only possible exception was 1970 when, following the calamitous sterling devaluation of 1967, Roy Jenkins wielded the austerity axe and got the British government’s finances into something approaching order.

Yet, truthfully, Britain has been plagued with economic mismanagement from both sides of the Commons and Labour could make much the same complaint of the Conservatives.

In 1929 Ramsay MacDonald’s Labour took over an economy wrecked by the attempt of Stanley Baldwin’s Conservative government to peg sterling to gold at pre-World War One parity. In both 1964 and 1974 Harold Wilson inherited the messy aftermath of pre-election booms engineered by Conservative chancellors Reg Maudling and Anthony Barber respectively. In 1987 the Conservatives inherited the messy aftermath of a pre-election boom they themselves engineered.

The Conservatives’ playing of their economic competence trump card always required a fair bit of bluff.

Recent developments suggest that George Osborne might think of delving into the same old bag of Conservative chancellors’ tricks as Maudling, Barber and Lawson. This government has nailed itself to the mast of the economy. Put simply, if the economy is growing healthily come 2015 the Conservatives will win. If not they are toast.

So far it’s not looking good. News that GDP contracted by 0.3 percent in the fourth quarter of 2013 meant that the UK economy continues to flat line. This is nothing to do with so called ‘austerity’ but the entirely predictable and unavoidable consequence of a massively indebted economy trying to reduce its indebtedness.

Either way, whether the dreaded ‘triple dip’ is avoided or not, it is looking increasingly unlikely that GDP growth in 2015 will be of the magnitude necessary to bring re-election.

So with 2015 approaching, Cameron and Osborne might come to look favourably on incoming Bank of England governor Mark Carney consummating his flirtation with Nominal GDP Targeting (NGDPT).

NGDPT starts from the observation that money supply targets proved a poor rudder for monetary policy due to problems of defining the money supply and changes in velocity, and inflation targeting proved unable to prevent asset price inflation. With NGDPT the idea is that the central bank sets a path for nominal GDP growth and manipulates the money supply sufficiently to achieve it.

So, if it’s decided that nominal GDP should grow by 5 percent a year, and nominal GDP looks to be increasing above that rate, the monetary authority engages in the sale of securities so as to suck money out of the economy to get nominal GDP growth back on target.

Likewise, if nominal GDP was growing at a rate below 5 percent, the situation we are currently in, the monetary authority engages in the purchase of securities so as to pump money into the economy and get nominal GDP growth back on target.

NGDPT and the market monetarists who propose it have faith in the power of monetary policy. Austrian liquidation or Keynesian liquidity traps can be blasted out of existence with a sufficient charge of base money. Or, as Ben Bernanke put it in one of market monetarism’s foundational statements:

“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.”

You can see the attraction of all this to Cameron and Osborne but will they be allowed to get away with it? The mass production of sterling dictated by NGDPT in our current predicament would, in theory, have the effect of reducing sterling’s value on the exchange markets which will make imports into Britain more expensive and Britain’s exports to everywhere else cheaper.

In practice this is exactly what has been happening. The massive expansion of its balance sheet by the Bank of England has seen sterling crash by 15 percent since 2008 which has propped up British exports (it is this avenue which wasn’t open to Ireland).

But if you devalue to boost your exports of goods and services, any increase in those exports is matched by a reduction in someone else’s. This is why the competitive devaluations of the 1930s, as countries scrambled for a share of diminishing world trade, became known as ‘beggar they neighbour’.

And it looks unlikely that our neighbours are going to let themselves be beggared by Britain’s NGDPT. The Federal Reserve continues to buy $85 billion of bonds each month. In Japan Shinzo Abe is pushing an inflation target of 2 percent in a bid to boost its flagging exports. This will come at the expense of German exports which might cause policymakers in Berlin look more kindly on François Hollande’s calls for a devaluation of the euro. The race is on to see who beggars who first.

This article originally appeared at The Commentator

Bernanke stuck in a bunker

…QE4, QE5, QE6…

At a celebration of Milton Friedman’s 90th birthday in 2002, Ben Bernanke, then a newly appointed member of the Federal Reserve Board of Governors, said “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again”

Bernanke thought Milton had been right about the Great Depression. Until the early 1960s the common interpretation of the Depression was the Keynesian one, such as that put forward by Peter Temin, where a switch in “animal spirits” had caused aggregate demand to collapse. Then, in 1963, Friedman and his colleague Anna Schwartz produced a radical new interpretation in A Monetary History of the United States, 1867 to 1960.

In this mammoth, exhaustively researched book, Friedman and Schwartz argued that far from money being “neutral”, as was thought at the time, fluctuations in the money supply were closely linked to fluctuations in output. So, if you wanted to stabilise output you had to stabilise the money supply. Monetarism was born.

But the book’s centrepiece – so much so that it was released separately as a book in itself – was that covering the onset of the Depression, “The Great Contraction”. Here, Friedman and Schwartz claimed that a common or garden down turn (brought on by the tightening of monetary policy from 1928 which, they said, had triggered the Wall Street Crash) was turned into a Depression by the Federal Reserve allowing the money supply to shrink by a third between 1929 and 1933.

This, it was argued, had increased the real debt burden of businesses and individuals. As the money supply fell so did prices, this was deflation. Anyone who had debt to service had to service debts of fixed nominal amounts which had grown in real terms as the deflation set in, with money which had shrunk in value at the same time.

Though Friedman subsequently became linked with the fight against inflation he was also concerned about deflation. Friedman argued that a money supply which neither shrank nor grew too fast was needed to bring about the monetary stability which he saw a necessary precondition for economic stability.

So while, in the 1970s, Friedman advocated slowing the increase in the money supply to tame inflation, in the early stages of the Depression, he and Schwartz argued, the Federal Reserve should have fought deflation by expanding the money supply.

That the Federal Reserve didn’t do this was, to Friedman, the cause of the Depression. It was the supposed truth of this insight that Bernanke was acknowledging in 2002.

Ben Bernanke spent his academic career studying the Depression from a Friedmanite perspective, producing a dull but worthy book on the subject. When he took over from Alan Greenspan at the Federal Reserve in February 2006 the Great Moderation was still in full swing but when the downturn came in 2008 it would have been hard to find a more qualified man to have at the helm. It was a case of cometh the man cometh the hour.

In September 2008 Lehman Brothers collapsed, banks everywhere looked vulnerable and began hoarding cash. The US broad money supply collapsed. Bernanke acted quickly to apply the lessons of the Depression he had learned from Friedman. As one reviewer of his book put it, “He is practicing today what he preached in his book: Flood the system with money to avoid a depression.”

The Fed Funds rate, which had already been reduced from 5.25 percent in early 2007 to 2 percent when Lehman tanked, was cut further to a range between 0 percent and 0.25 percent by the end of 2008 where it remains today. Still, the money supply contracted.

In November 2008 Bernanke launched QE1. Changes in the Fed Funds rate are facilitated by the buying and selling of short term dated securities to alter short term interest rates. Quantitative Easing works the same way except via the purchase of long term dated securities so as to bring down longer term interest rates.

QE1 was an unprecedented attempt to infuse tottering banks with liquidity and shore up the money supply. By the time it came to an end in March 2010 the Federal Reserve had bought $1.75 trillion of mortgage-backed securities.

But still the money supply kept falling so in November 2010 Bernanke initiated QE2 which involved the purchase of $600 billion of Treasury securities. By the time QE2 docked in June 2011 the money supply had stopped shrinking. Indeed, it had returned to fairly brisk growth. Bernanke had made the moves straight out of Friedman’s playbook and staved off deflation.

But, apart from the Federal debt, the money supply was all that was experiencing brisk growth. GDP was slowing and unemployment remained stuck over 8 percent. Bernanke, with a theory of fighting inflation, was now coming under pressure to boost growth and employment.

He took over a year to arrive at his decision but last week Bernanke rolled the dice on QE3, an open ended commitment to spend 40 billion newly created dollars a month on mortgage backed assets until, well, until something turns up.

If you are going to do a job you need the appropriate tools. QE and the mass monetary intervention executed so far by Bernanke were designed to stop the money supply contracting. Eventually it did. But the money supply is not now contracting, it is growing. QE is totally inappropriate now even on Monetarist grounds.

In desperation, with the economy stagnating and fiscal policy at its capacity, Bernanke, to the great relief of the Obama administration, is deploying a policy tool conceived and designed to achieve stability of the money stock, to boost the real variables of output and employment. Increasingly Bernanke resembles a golfer with one club. He’s stuck in a bunker and all he has is a driver.

This article originally appeared at The Commentator

It’s anything but the economy, stupid

Wrigley Field, Chicago, 2040 AD

Walking around the ruins of the old Roman town of St Albans can make you feel like Shelley’s “traveller from an antique land”. As you look down into the remains of the Roman amphitheatre, where the town’s inhabitants flocked in the second and third centuries AD, you wonder what those people thought and talked about as Roman Britain approached its collapse.

You’d like to think they talked about that looming collapse. Perhaps they did. It was, after all, the existential issue of the day. But looking at behaviour in another, contemporary, troubled great power, you do wonder.

The United States government hasn’t balanced its budget since 2001. In the past ten years, starting in 2002 when Republicans controlled the Congress and the White House, Federal government debt has more than doubled from $6.5 trillion to over $15 trillion, or nearly $51,000 for every US citizen. Since September 2007 that debt has been increasing by nearly $3.9 billion a day. The Congressional Budget Office reported last week that in 2012 the Federal government’s debt increased by over a trillion dollars for the fourth year running.

Over the same ten year period the dollar has lost about 25 percent of its value. The rampant credit creation of the Federal Reserve which fuelled the housing bubble has created $1.4 trillion of new base money since 2000. At the moment most of this is sitting on banks’ balance sheets but if it emerges into the wider economy the US will have an inflation crisis.

Likewise, if the foreigners who hold nearly a third of America’s debt decide to dump these depreciating assets, the dollar will collapse.

These are the existential issues for the United States as November’s presidential election nears. But to look at the media you’d never know it.

Instead the American media has lately been preoccupied with a fast food chicken chain. More precisely, it has been preoccupied with what the president of that chain thinks of gay marriage.

“Who cares?” might have been the appropriate response. If you’re a Chick-fil-A shareholder and you don’t agree with him, sell up and invest somewhere else. If you’re a customer, go and buy your artery clogging food down the street. Capitalism, more so than any other system, gives you scope to exercise your morality.

Instead the views of one guy became a minutely discussed national news event. Democrats in a number of cities called for local branches of Chick-fil-A to be shut down, a curious course of action in the face of high unemployment. Supporters of Dan Cathy’s views had a Chick-fil-A Appreciation Day where they filled their faces to show solidarity. They should have called it Cholesterol for Christ.

Then, last week, media attention fixed upon the previously little known Republican Representative from Missouri, Todd Akin. In an interview with a local TV station Akin aired the unusual view that women couldn’t become pregnant through “legitimate rape”.

Worryingly Akin sits on the House Science Committee. This provides yet another argument for leaving more to free markets and less to government. Under free markets science ends up in the hands of people like Bill Gates and Steve Jobs. Only government could put someone like Akin in charge of science.

Neither gay marriage nor rape should be belittled as issues. Laurie Penny, not someone I’m given to quoting approvingly, noted in a moving blogpost that between ten and twenty percent of women in America have experienced rape, 90,000 in 2008 alone. This is awful and ought to be tackled.

But neither should silly remarks from a silly man like Todd Akin drown out the great existential issue in American politics: the economy.

And America’s solvency ought to matter to everybody. It ought to matter to Democrats who care about redistribution of wealth: watch your economy disappear over a cliff and then try and redistribute nothing; see how far that gets you.

It ought to matter to neo-conservatives: America’s economic wellbeing is a sine qua non of American strength. The United States did not become rich because it had powerful armed forces; it got powerful armed forces because it was rich. If the wealth goes so does the power.

And, most importantly, it ought to matter to every ordinary American citizen who will suffer if the economy continues on its current, Hellenic path.

But instead of this discussion we have the ongoing row about Mitt Romney’s taxes. With unemployment stuck above 8 percent and poverty at record levels, Obama’s supporters are trying to turn an election that should be about how much money Americans have in their pockets into one about how much money Mitt Romney has in his.

President Obama’s economic track record has been dismal so you can’t blame him for running away from it. Bill Clinton’s strategist James Carville famously said it was “The economy, stupid” but Obama and his supporters are desperately trying to shift the focus of this election to anything but. And the Republicans have been lead-footed enough to let them.

Ultimately, Americans have a decision to make. What matters most: Tax returns or job reports?

This article originally appeared at The Commentator


Coming to a condo near you

With his history in the transfer market there is no guarantee that Carlos Tevez won’t still end up at Brazilian side Corinthians. But even if he doesn’t, some are saying that the bid itself represents a shift in power away from the European clubs, which have traditionally benefited from the players produced in Brazil, and towards Brazilian clubs themselves.

Brazil’s new found wealth is being flaunted elsewhere. Last month Bloomberg reported on a growing number of Brazilians buying property in Florida. According to the report:

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The Fed giveth and the Fed taketh

The Maestro

Alan Greenspan’s pronouncements used to be described as ‘Delphic’ because of their rarity and mystery of meaning. So his blunt attack on the monetary policies of his successor, Ben Bernanke, last week on CNBC was quite striking.

“I am ill-aware of anything that really worked. Not only QE2 but QE1” Greenspan said, elaborating “There is no evidence that huge inflow of money into the system basically worked”. No doubt it will come as a shock to hear the man who gave his name to the use of huge inflows of money into the system to combat any downturn – the ‘Greenspan put’ – turning his back on the method. It will likewise surprise some, perhaps, to see the man who presided over a dollar which lost about a quarter of its value against the euro expressing concern about policies which might “continue erosion of the dollar”. That would be the erosion he played a large part in.

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S**t my economist says #6

The credit crunch has a thousand fathers

It’s amazing how much foresight economist have. With hindsight. Browsing in the economics section in Waterstones the other day I picked up a book whose blurb informed me that the author “was one of the few economists who warned of the global financial crisis before it hit”. It reminded me of the blurb on another book whose author predicted “the recent crisis well in advance of anyone else” or yet another, the author of which “predicted the slump years ago”. In fact it turns out that the credit crunch was so widely predicted among academic economists you almost long to meet the economist who didn’t predict the credit crunch. He must be out there.

Oh yes, I forgot, Ben Bernanke is now Chairman of the Federal Reserve.

The causes and consequences of a falling dollar


QE3 remains in dry dock for now but the dollar is still shipping water. Last week the dollar tumbled to its lowest level since July 2008 against a basket of five major currencies on speculation that Ben Bernanke, Chairman of the Federal Reserve, plans to hold interest rates to the historic lows of 0-0.25%, where they have been since 2008.

Bernanke’s dollar printing is based on the thinking that “price stability should be a key objective of monetary policy”. If the price level falls, deflation, debtors see the real value of their debts increase and have to devote a greater portion of their wealth to paying them off. Likewise, it is believed, consumers seeing falling prices may hold off on purchases in expectation of even lower prices in the future. Both forces will act to decrease spending and kick the economy into a downward spiral. Following Milton Friedman and Anna Schwartz’ prescription for the Depression, Bernanke sees the Fed as having to pump as much money as it takes into a failing economy to keep prices stable.

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Commodity prices then and now

Before Bernanke there was Arthur F Burns

As subprime mortgages tanked in May 2007, Ben Bernanke, Chairman of the Federal Reserve, told Congress “At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained”. Coming at the start of the biggest bust since the Depression he made his name studying, it might be best to take his utterances with a pinch of salt.

So it with his latest, defending the Federal Reserve from charges that its rampant money printing, academically dignified as ‘quantitative easing’, is causing the commodity price rises which, in food prices, helped trigger the unrest that is shaking the Middle East.

Last week Bernanke claimed that his injection of $600 billion dollars into the economy was not inflationary. Commenting on a rise in the United Nations Food and Agriculture Organization’s food price index to 230.7 points from 206 points in November, Bernanke said “Clearly what’s happening is not a dollar effect, it’s a growth effect”

This came soon after Bernstein, a research house whose oil price predictions proved uncannily accurate in 2010, predicted an average price of $90 per barrel over 2011. Cotton prices hit a 150 year high.

Bernanke is surely right that demand pull pressures are playing a role in this. According to the International Energy Agency global oil use is predicted to be 89 million barrels per day this year, up 17% from the 2001 figure of 76 million barrels per day. But the price, $30 per barrel in 2001, has tripled. Plainly something else is also at work.

We have been here before. The 1970’s were famously a decade of rising prices. In 1975 future Nobel Laureate Robert Mundell produced a paper titled ‘Inflation From an International Viewpoint’. He noted that the Bretton Woods arrangement of fixed but variable currencies, in which the dollar was tied to gold at $35 an ounce and other countries fixed to the dollar, had broken down due to excessive pressure on the dollar-gold link by excessive money creation by the Federal Reserve. Realising the weakness of the link holders of dollars began to cash them in for gold. It soon became apparent that there wasn’t enough gold in the US to redeem all these promises so, on August 15th 1971, President Nixon suspended dollar convertibility. Without the ‘wobbly anchor’ of the gold link the Fed’s printing presses could run free.

Almost immediately, as noted by Nathan Lewis in his book ‘Gold – The Once and Future Money’, OPEC members, who priced their oil in dollars, became understandably worried about being paid in increasingly worthless dollars. In September 1971 OPEC resolved

that Member Countries shall take necessary action and/or shall establish negotiations, individually or in groups, with the oil companies with a view to adopting ways and means to offset any adverse effects on the per barrel real income of Member Countries resulting from the international monetary developments of 15th August 1971

Mundell recorded, as quoted in the excellent new book ‘Econoclasts’ by Brian Domitrovic,

Confidence in currencies in general declined and a shift out of money and financial assets commenced. A worldwide ‘scarcity’ of land and…raw materials…emerged. [Soon] the prices of metals, foods and minerals more than doubled. Shortages of beef, sugar and grains appeared, but gold and oil led to the most dramatic ‘crises’ and received the most attention from the public

Sound familiar?

As now, the blame was placed on supply and demand factors. Rocketing oil prices were blamed on the OPEC embargo which followed the Yom Kippur war in 1973. This despite the fact that oil prices had been rising rapidly before the embargo, since, in fact, Nixon’s floating of the dollar. As Lewis notes, following Robert Bartley’s ‘The Seven Fat Years’,

Oil had traded around $2.90 per barrel, or 1/12 ounce of gold, at $35 per ounce. On the eve of the “oil shocks”, with the dollar around $100 per ounce and OPEC still accepting about $2.90 per barrel for oil, the OPEC producers were getting only 1/35 of an ounce of gold for their oil. After they pushed the price to around $10 a barrel in early 1974, with the dollar around $120 per ounce and falling, they were getting around 1/12 ounce of gold for a barrel of oil. OPEC was simply raising its prices, like every other shopkeeper, in response to currency devaluation

The same was true of other commodities. Wheat, corn and soybean prices began rising on the demise of Bretton Woods. As Lewis notes

[OPEC] was actually rather late to the game; prices of most other internationally traded commodities had been rising in response to the sinking dollar since the late 1960’s. There had already been a sharp rise in food prices in 1972 – 1973

This didn’t stop policymakers fishing for explanations in the now discredited ‘Population Bomb’ as they laid the blame for rising oil prices at the door of OPEC. These, Lewis says,

gave the country a popular foreign scapegoat when it’s elites weren’t quite ready to accept the fact that they had brought the disaster upon themselves

As we face similar circumstances now, just pose this simple thought exercise to people: divide the number of dollars in the world by the number of units of a given commodity to get its price. Now double the number of dollars and do the same thing. What happens?

As we’ve noted here before, Keynes once famously wrote

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

The whirring of Ben Bernanke’s printing press overturning the unpopular regimes of the Middle East. Will it stop there?

This article originally appeared at The Cobden Centre

The causes and consequences of a falling dollar

On July 15th both sterling and the euro gained on the dollar, the latter hitting a two month high. Why is the dollar losing its value and what will be the consequences if it continues?

The exchange rate is simply the price of one currency stated in another currency. So an exchange rate of £1 = $1.54 means it takes one pound coin to buy a dollar note and fifty-four cents or vice versa. Put this way its easy to see why currencies rise or fall in value. Price, like an exchange rate, reflects relative supply and demand pressures. If supply rises relative to demand or if demand falls relative to supply then the price will fall. If, on the other hand, supply falls relative to demand or demand rises relative to supply the price will rise.

Yesterdays fall was, apparently, caused by a fall in demand relative to supply. The Federal Reserve issued a fairly gloomy prediction for the prospects of the US economy over the next few years, notably forecasting that “the unemployment rate was generally expected to remain noticeably above its long-run sustainable level for several years”. But this demand side issue is only half of the story. The other half is the supply side.

The supply of dollars has exploded in recent years. Alan Greenspan, who became chairman of the Fed in 1987, inherited a reasonably tight monetary policy from his predecessor Paul Volcker who had raised the Fed funds rate to choke off the double digit inflation of the 1970’s. Almost immediately Greenspan was faced with stock market crash of October 1987 and responded by slashing interest rates to boost the economy and keep it from recession.

It is important to bear in mind how this works. Interest rates are just the price of money and are as bound by supply and demand pressures as is any other price including the exchange rate. To push this price, the interest rate, down, the Fed increases the supply of dollars. It worked in 1987 and recession was avoided but Greenspan pulled the same trick in 1998 when the Asian financial crisis struck and again in 2000 when the dotcom bobble burst. This technique of using floods of dollars to cushion downturns became known as the ‘Greenspan put’ and his successor, Ben Bernanke, has tried it again in the face of the bursting of the housing bubble and the resultant credit crunch.

But each of these injections of liquidity have piled upon one another. According to the Federal Reserve Board of Governors between 1987 and 2006 the amount of dollars in circulation, on the M3 measure, increased from about $3.5 trillion to over $10 trillion. One analyst, Adrian Van Eck, estimated that $3 trillion dollars were created between 2003 and 2006 alone. In early 2006 the Fed stopped counting M3.

So, coupled with the short term ‘demand shock’ of the Fed’s report yesterday we also have the longer term pressure of rapidly increasing supply on the value of the dollar.

What are the potential consequences of all this? To answer this we must first answer another question; why hasn’t this tidal wave of dollars created rampaging inflation as almost every school of economic thought suggests it should?

The answer lies on the demand side. As fast as the Federal Reserve has been able to pump dollars out America’s trading partners have been sucking them in. From the late 1980’s onwards large swathes of the planet embraced economic liberalization, most notably China, and began to trade. China sent cheap goods to the United States and the United States sent dollars to China. China accumulated over $1 trillion and the dollar holdings of Abu Dhabi, Saudi Arabia, Kuwait and Qatar were estimated at $2.1 trillion.

Inflation is caused by the growth of the money supply relative to the amount of goods and services in an economy. The entrance of emerging markets into the global economy increased the amount of goods and services available and offset the growth of the supply of dollars. Instead of staying at home and pushing up inflation the dollars printed in the US went abroad.

This brings us to the consequences of a falling dollar. As the Fed pumps out more and more dollars to revive the American economy the dollars value falls. This pushes down the value of these foreign dollar holdings. At a certain point the sheiks or politburo members will wonder just how long they want to hold onto a depreciating asset. And when they decide they no longer want to an awful lot of dollars will head back to the one place they can be redeemed; the United States.

With demand for dollars falling its exchange value will collapse. The dollars flooding back into the US will cause inflation as the holders of foreign dollars repatriate them and try to cash their depreciating dollars in for other American assets. Anything not nailed down between Cape Cod and Honolulu will be bought and shipped abroad. There are 8.9 million mobile homes in the US so perhaps shipping these off to Beijing and Bahrain could ease the housing glut.

How likely is this doomsday scenario? As we’ve seen, like all else in economics, it depends on supply and demand. On the demand side if foreign holders of US debt are content to keep hoovering up dollars its value will be maintained. There are reasons to think they might. A collapse in the value of the dollar, beyond the creaking seen yesterday, would see the value of dollar holdings decimated. Also, China might find the leverage it now has over the US useful in any future dispute over, say, Taiwan. The threat of currency mayhem could castrate a United States response.

Other factors work the other way. The continuing weakness of the US economy, as highlighted by the Fed, will give foreign dollar holders pause for thought as will the Fed’s policy of creating dollars if continued beyond some point. Then the dollar will fall and inflation will follow.

On the supply side it is clear that the more dollars the Fed creates the greater a tumble in its value prompting an exchange rate dive and inflation. The Fed can only influence the demand side indirectly. The supply side is in its own hands.