On the 'Correctness' of Currency Policy

I'm catching a lot of flack at the moment for my attempts to put a different 'spin' on the dollar decline situation, and on the inactivity of the G7. Today it's Joerg's turn to try to wrong foot me:

regarding the "argument about the absence of a currency policy instrument": Please explain what you consider to be the correct stance for a central bank to take. The Mexicans are selling incoming dollars off at a daily auction. They are playing the game according to the rules of a true floating-exchange-rate regime. In my view, they are the "best practices"-model of behavior the larger banks need to ultimately emulate. If they do not, a well-managed fixed-rate regime would be preferable to what might ensue from attempts at running a "beggar-thy-neighbour-strategy" with manipulated, flexible pseudo-floating rates. Note also that the choice the central banks are confronted with is structurally similar to the menu of options available during the 1920s and 1930s in regard to the maintenance of the gold standard. The rules for that game had been laid down by Ricardo, but they were not fully implemented at the time. There was a tendency to add to the gold reserves - which lengthened the list of causes contributing to the plunge into and the persistence of the depression. It may seem to be difficult to mismanage all four variables - trade, money, taxes and budgets - that were apparently misadjusted at one point or another of the evolving Great Depression, but considering the fact that there is no need to get them all wrong at the same time I would think there is a a fair chance of history repeating itself.

..............I cannot see how this points in any other direction but that of a repeat performance of historical mistakes. I would also like to point out that it is not "money" itself that is at fault here. Money is a technology that comes with a users´ manual. Unfortunately, central banks currently seem to use a new release of the tool - the floating-exchange-rate version originally launched by Milton Friedman many decades ago and now in widespread use all over the world - in conjunction with the old manuals that are detailing how to operate a fixed- or semi-fixed exchange-rate system. If the instructions in the new manuals were already being followed, it would be clear to everybody that the monetary instrument does not allow for such a thing as a currency policy. Playing an updated game according to the old rules, however, will certainly wreak havoc. There is always the option to return to the older system - which we can be sure will ultimately not be exercised -, but unfortunately a mix-and-match style of operation is a recipe for disaster.

My first observation is that I am not especially comfortable in the role of having to try and explain a 'correct' central bank strategy since I do not consider myself to be in any way qualified to set myself up as a 'currency theorist'. I find myself being lead into this minefield by the need to try and make some coherent sense out of what is happening on the global economy front, and finding that in order to do this I need to take account of the strategy being adopted by the US treasury. Also, by way of parenthesis, I should note that in principal I have difficulty with the term 'correct' here, and would prefer to speak of 'possible' strategies. One of the great problems with being pragmatic is that the simplicity of the extremes is not available, and at the same time it is often difficult to give the kind of clear and precise answers which may be offered by the more dogmatic orthodoxies. So I can say quite happily that I think neither fixed nor floating exchange rates, offer, in and of themselves, a way forward. This is like asking if you believe in free markets, well yes, and no. I believe in regulated 'free' markets. And I believe in 'regulated' floating exchange rates - and in no case fixed rates (this explains my reasoning on the Euro, and I guess I'm going to have to explain this more another day, since Frans, at least, is still waiting for an explanation). Of course, in both cases, the issue turns on what you mean by 'regulated'.

In the modern world things aren't so simple as when Friedman started writing. In particular we've discovered 'expectations', and this means that the principal players are constantly 'intervening' in the markets by what they do and say, whether or not this is supported by any classic currency measures. In other words I am saying that absence of intervention (or saying you are comfortable with a process) is itself a form of intervention. Currency strategy is a game of constant guessing. The question is to know whether anyone is about to get the 'big hammer' out. So the central banks - or the Treasury Departments according to country - try to ride the wave. They try to steer the markets by the use of gesture and intonation, politics is, after all the pursuit of war by other means, and non-intervention is the pursuit of intervention by other means.

So my starting point here is that I am comfortable with this tendency to 'guide' and 'steer' the markets. Where I am not comfortable, is with the kind of guidance that is currently being given. Perhaps part of the problem is that I am not happy with the point of departure: I am not convinced that the dollar was anything like as over-valued as was being suggested. Over-valued, implies that something else is under-valued. So over-valued with respect to what? And what exactly was undervalued - the euro, the yen - I am not convinced? My fear is that the dollar is being allowed to fall to pursue two objectives (and yes, this is currency policy at work). Firstly to try to put a gun to the heads of the Europeans and the Japanese, to try to force through reforms by placing survival in danger: a very dangerous game this one. And, secondly, in case the first ploy doesn't work, to try and buy some anti-deflation insurance for the US. I am not convinced on either count. I think what is needed is a change of course, globally. Back to the days of Plaza and Louvre, to a more managed world where we tried to work in cooperative fashion to resolve our collective problems. In economics one winner doesn't need another loser: we could all sink or swim together.

The circumstances now confronting the US economy are unique in the modern era. The Federal Reserve has warned about the risk of deflation after a year in which the US dollar has fallen by nearly 30 per cent against many leading currencies. Despite the weakness of the currency, US Treasury bond yields have fallen to 45-year lows and are 37 basis points under the yields of German government debt. The dollar's decline has been painless for US financial markets because investors are complacent about inflation. The failure of bond yields to rise has also produced a policy of benign neglect in Washington. Federal Reserve officials say the falling dollar is a European problem, not a US one. John Snow, the US Treasury secretary, effectively abandoned the previous administration's strong dollar policy over the weekend by issuing his own definition of what constitutes a strong currency. It does not include market prices.

The dollar began to weaken more than a year ago but its decline has accelerated during recent weeks for three reasons. First, the markets are concerned that the Bush administration's fiscal policy could boost the federal budget deficit to $400bn-$500bn and create a domestic savings imbalance that will expand the current account deficit to $600bn. Second, the markets are alarmed that the US is embarking upon an imperialist foreign policy that will have unknown consequences for its fiscal position, foreign trade and relationships with other countries. In the heyday of empire, the UK ran large current account surpluses. There is no precedent for a country playing the role of global superpower with a large external payments deficit. During the cold war, the US was able to finance its defence spending in part through offset programmes with other countries. The Bundesbank, for example, stockpiled dollars as a quid pro quo for US defence spending in Germany. During the 1991 Gulf war the US received large subsidies from Japan, Saudi Arabia and other countries. With the US pursuing a more unilateralist foreign policy it will have to absorb all of the costs without help from traditional allies.

Last, the markets perceive a vacuum at the centre of US economic policymaking. In this administration power is highly centralised at the White House. The only highly visible cabinet ministers are at the departments of state and defence. The Treasury's stature and influence declined during the tenure of Paul O'Neill because of his caustic comments about many issues and his poor relationship with Congress. Mr Snow has worked hard to improve ties with Congress but the markets see him as a salesman, not an architect of policy. Larry Lindsey and Glenn Hubbard, the people who created the administration's economic policy, have resigned. The other institutions of economic policy are also weak. The new director of the national economic policy council is focused on internal administration rather than influencing markets. Mitch Daniels, director of the Office of Management and Budget, is leaving to pursue a political career in Indiana. The Council of Economic Advisors is being evicted from the White House. Economic policy appears to be under the control of White House political advisers, not the traditional institutions of government. In fact, the White House will not be able to encourage a dollar rally until Karl Rove holds a press conference on the subject.

As Mr Snow's recent comments have made clear, Washington will do nothing to stabilise the dollar until there is a big correction in bond prices that might jeopardise the boom in the US housing market. But in the absence of a threat to the US housing market, the burden of adjustment will fall elsewhere. Asia will resist dollar depreciation through large-scale market intervention. China's foreign exchange reserves will expand from $280bn to $330bn this year. Japan's foreign exchange reserves will mushroom from $500bn to $600bn this year and reach $1,000bn by 2008. If Asia is able to stabilise its exchange rates, the US will have to reduce its current account deficit through larger devaluations against other currencies. This pressure for devaluation will set in motion a process of competitive monetary reflation with the eurozone, Britain, Canada, South Africa and other countries with variable exchange rates. These countries will be compelled to cut interest rates to prevent their currencies from appreciating against the dollar.

The Bush administration is prepared to pursue aggressive fiscal and monetary policies to ensure a healthy recovery in the run-up to the 2004 presidential election. Its new weak dollar policy is designed to put pressure on other countries to reinforce this domestic growth agenda. During the late 1980s Japan created a bubble economy with rocketing prices for land and equities by pursuing a monetary policy designed to stabilise the dollar. The coming round of competitive monetary reflation is also likely to force central banks to pursue far more aggressive interest rate cuts than they expect. If it does, President George W. Bush will not win re-election. There could be Bush bubbles in many asset markets during late 2004 and 2005.
Source: Financial Times
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Japan's Crisis Revisited

Stephen Roach again. Yesterday he informed us concerning Japan that "one of these days the logjam was destined to be broken. It's just a question of when - and under what circumstances. That day could well be at hand." Now I have learnt with the passage of time that forecasting when 'endgame day' might finally come in the case of Japan is an extremly hazardous business. Back in October (when few of you were reading me!) I posted a piece comparing Takenaka to Yamomoto (the reference being to the financial carnage that any Japanese 'hard landing' might cause over on Wall Street) which, apart from the theatricality, I would willingly post again if I thought Roach was right. Right, I mean, in the sense that 'high noon' is coming. Having burned my fingers by being precipitate first time round, I'm adopting a more cautious 'wait and see' approach. In particular in the meantime I've read Karel van Wolferen's The Enigma of Japanese Power which I highly recommend to anyone wanting to understand what is happening in Japan. Among other jems you can find there is the idea that Japan, in some ways is a non-geographical federal state, power in this case being distributed not between the regions, but between the competing power centres situated in the various ministries. The notion of a Japan which speaks with a single voice is therefore something of a contradiction in terms. However the current power battle between 'reformers' and 'non-reformers' plays out in practice, you can bet your life the path will be 'non-linear'.

Returning to the more substantial point, for once I am in complete disagreement with Stephen. Playing Russian roulette with the Japanese body politic will not give the desired result. First, it is a risk averse society and will never be persuaded to volunteer to press the trigger (but then I guess that is another dimension of the weak dollar policy, to try and leave them - and the Europeans - no alternative). But, secondly, what if - as I've being arguing here at Bonobo Land - the 'reforms' as they're presently conceived are a remedy worse than the disease. What if there is no growth 'recovery' as Stephen understands it, waiting just round the corner for Japan, and if all those government bonds which the BoJ is quietly accumulating will one day be virtually worthless - for if deflation accelerates, and the debt continues to grow, there will be no way to pay it off, ever, and one day the world will wake up to this unpleasant reality. What if the reform that is really needed is a complete change of mindset, a 'cultural' revolution which opens to the world, and at the same time opens the doors wide to immigration as the only short term stop-gap for an ageing and declining population. And what if Japan is only the first, and what if we are addicted to growth in a world where - like 'good lovin' - it proves hard to find. These are difficult and deep questions, and the answers won't be coming out of my keyboard in a rat-tat-tat fashion. Looking for solutions is going to be difficult, but the first step is to find the problem.

In that vein, it is critical to ponder the broad outlines of Japan’s potential endgame. There can be no mistaking the near-term implications of legitimate reform initiatives for the Japanese economy: Initially, reform-driven restructuring of the financial system and nonfinancial corporations will be extremely tough medicine to take. Unemployment will undoubtedly rise a good deal further from its near record level of 5.4%, as will the risks of renewed recession and intensified deflation. There is also the related risk that the pain of restructuring could lead to a financial crisis that obviously would have a more pervasive impact on the Japanese and world financial system. But with possession of the world’s largest reservoir of saving and currency reserves, Japan can afford to take these risks. In the end, there is no alternative to additional cyclical distress if, in fact, Japan is finally serious about the heavy lifting of reforms. What Japan cannot afford to do is strangle its economy. And at this late date, that remains the most realistic alternative to reform.

These developments could have equally important implications for the rest of Asia and the broader global economy. More than a decade of near stagnation in Japan has all but neutralized its role as an engine of Asian growth. Whereas Japan accounted for approximately 10% of pan-Asian GDP growth over the 1985–94 period (on a purchasing power parity basis), our estimates suggest the share fell to a mere 4% in the 1995 to 2002 interval. Successful reforms will not change the balance of Asian growth over night. But as Japan comes out the other side, an externally-driven Asian economy will re-acquire an autonomous source of domestic demand. Today’s Japanese consumer probably has the greatest pent-up demand potential of any major economy in the modern era. As reform-induced layoffs mount, an increasingly saving-short Japanese consumer will undoubtedly exert even more restraint. But when there is a sense that the worst of the headcount carnage may be nearing an end — possibly 2–3 years down the road — a sharp rebound in private consumption is likely and Japan will then be in a good position to reclaim its role as the growth engine of Asia. The Japanese reform story is also critical for the world economy — especially the global rebalancing that a lopsided, US-centric world so desperately needs. The burden of this realignment must be shared by all. Just as a saving-short US economy must rein in the excesses of domestic demand, the structurally-impaired economies of Japan and Europe must unlock stagnant domestic demand by implementing long overdue reforms. Given America’s massive and ever-widening current-account deficit, I continue to believe that a sustained and significant weakening of the dollar will put increasingly greater pressure on Japan and Europe to shift the mix of economic growth away from currency-sensitive external demand. The recent weakening of the dollar lends credence to just such a possibility. Mounting pressures on the Japanese banking system only add to the tension, underscoring the perils of inaction. In the end, reforms are the only way to a successful global rebalancing. And wouldn’t you know it? Just when the world had written Japan off, the world’s second-largest economy may be starting to deliver.
Source: Morgan Stanley Global Economic Forum
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Resona Resonates

The world is gradually waking up to the significance of the timing and scale of the Japanese government intervention in Resona, the country's fifth largest bank. First Stephen Roach:

The just-announced injection of 2 trillion yen ($17 billion) of public funds into the Resona Bank may well be the functional equivalent of a de facto nationalization of Japan's fifth largest bank. Unlike most of Japan's banking reform initiatives, this action was not focused directly on the write-offs and disposal of nonperforming loans (NPLs). Instead, it was aimed at restoring the NPL-impaired capital base of this troubled institution to international standards. In doing so, it appears that the government will effectively own approximately 80% of Resona’s total capital — at least, that’s the inference that can be taken from a statement by Prime Minister Koizumi, who implied that the bank’s capital adequacy would rise from around 2% to about 10%. The magnitude and scope of this action are without precedent in the recent history of Japanese banking reform; the bailout is equal to a little more than 20% of all funds previously injected into the banking system, or the equivalent of 0.4% of total Japanese GDP. Moreover, Japanese press reports suggest that Resona’s president and four other senior executives will resign, presenting the government with an opportunity to install a new reform-minded leadership. As such, this initiative hints that the heavy lifting of Japanese financial sector reform could at long last be under way. If that’s the case — and it remains a big “if” — we then need to look at Japan in an entirely different light.
Source: Morgan Stanley Global Economic Forum
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No the big question is how much significance can we put on this intervention. Reading the tea leaves is a difficult job here. The key problem is whether the authorities acted as part of a concerted policy, or whether they had no alternative. Over to David Pilling, our 'man in Tokyo':

The Financial Services Agency yesterday insisted that the first it had heard of Resona's difficulties was on Saturday, the very day it agreed to inject about Y2,000bn ($17bn) into Japan's fifth-largest bank. If that is true, then the FSA's assurances that it was "not aware" of any other large Japanese bank being in trouble was not exactly reassuring. Yet the FSA was adamant yesterday that the decision to rescue Resona had been an auditing, and not a regulatory, one. "This is a matter between the bank and its auditor," an agency official said. "On 17 May, Resona reported formally that their capital adequacy ratio was going to be below [the required] 4 per cent . . . and we took reasonable action."

The word "formally" possibly sheds light on what happened. What seems most likely is that the regulator, at least informally, had known very well what was happening for weeks and had been discussing the issue with Resona behind the scenes. An associate of Heizo Takenaka, financial services minister, yesterday said that the agency had been fully aware that Resona had potential problems with its auditor since mid-April. The confusion over what the FSA knew, and when, begs the most fundamental question of the whole episode. Did the FSA decide that it was time to make an example of one bank by forcing it to accept capital? Or did it desperately try to salvage Resona, before reluctantly bowing to the inevitable and agreeing to provide fresh funds? According to Jean-Francois Minier, managing director of Dresdner Kleinwort Wasserstein, the decision must have come from the government. "At the end of the day it would be hard for the auditor to get tougher on its own," he said. "I'd be surprised if they were to do this independently." Mr Minier said that, if the government wanted to make an example of one bank, Resona was the one to go for.

First, it was purely domestic, having ditched its international businesses in the run-up to merger. That meant the government did not have any international repercussions to worry about, particularly in dealing with counterparties. Second, Resona, being so heavily dependent on deferred tax assets to pad its capital base, was in no position to object. There were suggestions that some Resona executives were furious at the government yesterday. But, officially, they asked the state for money and fell on their swords. That saved any messy recriminations linked to enforced nationalisation, which some senior executives at bigger banks have vowed to fight in court. That is the positive spin on events. But what if what the FSA said is taken at face value? What if it really did not know that Resona was about to be declared dangerously undercapitalised?

The ramifications of that are even more startling. To begin with, it would mean that Japan's financial regulator was woefully in the dark about the state of the institutions it is entrusted to monitor. For months now, senior FSA officials have been denying that the financial system had any problems that could not be solved through existing policies. But if the agency got Resona so wrong, it is possible that it is also misinformed about the real financial health of other Japanese banks, national and regional. Even more worrying, if the decision to pull the veil off Resona was really an auditing one, then auditors are now arguably the most powerful force in Japan. Because there is not, as yet, any clearly defined political decision on how to deal with tax deferred assets, a policy void has opened up. It is now apparently up to auditors to interpret current guidelines. In other words, as talk of bank nationalisation grows, the real decisions about what to do about Japan's shaky financial system may just have been privatised.
Source: Financial Times
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IMF Deflation Revisited

The new IMF publication Deflation: Determinants, Risks and Policy Options is, like many documents of its type, something of a mixed bag. What I think is important is that they're getting the discussion up and running, this should at least be a wake-up call for Brussels and Frankfurt, and the debate can become more 'refined' as we move down the road a little. One BIG complaint is the fact that demographic changes don't seem to get a look in anywhere! Now I may be willing to grant that I'm overstating the case (I'm not convinced that I am, but it's important always to accept the possibility that you may be mistaken), but that it has no part to play in explaining the big picture (in understanding why, for example, Germany is so 'boxed-in' fiscally) this is surely impossible to accept. So why the distinguished absence. Really I am at a loss to understand this. This absence isn't the only major gaffe however, try this one for size. Speaking of economic growth and deflation in the 19th century, it says the following:

Prices declined in large part because of the constraints imposed by the Gold Standard in an environment in which there was a significant excess demand for gold. Increasing demand for money was being driven by technological change and population growth. At the same time, the supply of gold was largely fixed. The constraints imposed by the limited supply of gold manifested in part in the deflationary episodes and relatively weak growth: despite the extraordinary technological revolution, annual U.S. real GDP growth per capita was just above 1½ percent over the entire century; in the U. K. it was just under 1 percent.

Now this argument is really lamentable. By what standard is it possible to talk of overall growth in the 19th century as 'weak'. In comparison with any other known period of human history it was stunning. It is only by looking at the 19th century in comparison with the 20th century that we can look negatively on the 19c, and it only by looking back from the 1990's that we can talk about 20th century growth as 'moderate'. The question is (and it is, as we'll see as our investigations advance, an important one) can this process be sustained. Further, we should try and avoid falling into the trap of assessing all of human history using the yardstick of what just happened, we can gets things seriously out of perspective. Anyway I'll let Brad make the point:

.........the twentieth century is unique. Such rapid growth in standards of living has never been seen before, anywhere, anywhen. The nineteenth century saw perhaps a a tripling or quadrupling real growth und proper account is taken of the impact of new technologies like the railroad and the telegraph, and the expanded range of technological capabilities. And nineteenth century growth was itself fast compared to what had come before: people called it the "industrial revolution" for a reason.

Before the nineteenth century growth was even slower. The standard of living in the Netherlands, probably the richest economy in the world at the end of the eighteenth century, might (or might not) have been some fifty percent higher than it had been three centuries before, at the time of the Renaissance. And before that? Upper classes certainly lived better on the eve of the industrial revolution than they had beforehand, but for the average guy? Was it better to be a slave of the Roman politician Marcus Tullius Cicero or an enserfed peasant under the Han dynasty in the first century B.C., or was it better to be a slave of the American politician Thomas Jefferson or a casual laborer working the Canton docks in the late eighteenth century? As best we can tell, it is very close to being a tossup.
Source: Brad Delong: How Fast is Modern Economic Growth
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That having been said the document is, as I've already indicated, interesting. They do, after all, distinguish between deflation in the late 19th century - which if not entirely benign, was at least not lethal - and deflation 1930's style. This contrast is also reflected in the classification of contemporary Chinese (non-disastrous) and Japanese (lethal dose stuff) deflation. From their analysis the economists at the IMF derive four sets of indicators: (i) aggregate prices; (ii) measures of excess capacity, or output gap (iii) asset markets; and (iv) credit market and monetary indicators. In addition, they mention structural characteristics, and the room for maneuver on the policy front as having a role to play in the overall assessment. Clearly I disagree with non of these as pointers to watch, but could it not be that some of them, at least, have demographically related roots: for example the relation between aggregate demand and the supply of savings? And still we are left with no mechanism to explain why all this should be happening now. I think it goes without saying that I do not accept the simple business cycle plus shocks version.

On the German front the document doesn't mince its words:

With broadly stable prices over the past six months, the German economy faces substantial demand driven drag to growth. Credit growth, production, and incomes weakened considerably during 2001 and 2002, and the labor market has been coming under pressure. House prices have been falling; equity markets have adjusted more than in the other advanced economies (Charts 12a and 12b); and corporate balance sheet adjustments still have some way to go. Furthermore, banks and insurance companies are, by their own admission, undergoing the most challenging period since World War II. Thus the near-term outlook for a recovery in investment remains more clouded than in the other advanced economies. The Phillips curve analysis for Germany suggests that for mild deflation to take hold, the output gap would need to rise 1 to 2 percentage points. At the same time, the unemployment gap would have to increase by 2 percentage points. For persistent deflation, the output and employment gaps would have to increase by 2½ to 3½ percentage points. The staff’s central projection sees a widening of the output gap on the order of 1 percentage point this year because real GDP growth would remain around ½ percent. However, the unemployment rate would increase relatively modestly.

Accordingly, the probability of mild deflation taking hold over the next year is considerable. Of course, as prices in Germany decline relative to its trading partners, particularly in the euro area, the improvement in its competitiveness will stimulate exports and investment. This may prevent expectations of falling prices from becoming entrenched. However, this mechanism is likely to operate only slowly, and can do little to remedy difficulties in financial intermediation that could develop rapidly in a deflationary environment. Unlike in other economies, the room for policy maneuver is constrained, if not absent altogether. Fiscal policy is set to become restrictive (cutting the cyclically adjusted deficit by ¾ percent of GDP this year)––in support of Germany’s commitments under the Maastricht Treaty. While monetary conditions have tightened given the euro appreciation, monetary policy may not ease significantly because of greater price pressures in Germany’s euro-area partners.
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