Russ Roberts

Eichengreen on the Dollar and International Finance

EconTalk Episode with Barry Eichengreen
Hosted by Russ Roberts
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Barry Eichengreen of University of California, Berkeley and author of Exorbitant Privilege talks with EconTalk host Russ Roberts about the history and importance of the dollar as the dominant international currency. Eichengreen explains the advantages to the United States of the dollar's dominance, the historical circumstances that led to its dominance, and the likelihood that the dollar might be supplanted by a competitor. Along the way they discuss China's currency policy, the state of U.S. monetary policy, the causes of the crisis, the risk of inflation in the United States, and the future of the Federal Reserve.

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0:36Intro. [Recording date: May 24, 2011.] Book is a brusque history of international finance, focusing on how the U.S. dollar became the dominant currency in the world and the possibility that that dominance might come to an end some time in the future. Why is it important that the dollar is the dominant currency? Why is that important to the United States? The fact that the dollar is the dominant currency is of considerable convenience to U.S. banks and firms. When they do business with foreign banks and firms, they can do it in their own currency without having to incur the cost of buying Euros or Swiss francs or British pounds, and they don't have to insure against the risk that the exchange rate will change while that business is underway. Other countries look at us--the Chinese look at us--and they see that it's an advantage for American banks and firms to be able to do business globally; and that's part of the motivation now for the Chinese to begin to move cautiously to internationalize their currency as well. Now, convenience is not the only privilege that having the dollar be the dominant currency gives us. And when we say dominant, we are talking about the fact that dollars are accepted in most international transactions. The price of oil is denominated in dollars. What are some of the other privileges that the United States accrues for the dominance of the dollar? The fact the dollar is viewed as the ultimate form of liquidity; that the U.S. Treasury bond market is the single most liquid financial market in the world makes it attractive to international investors, banks in other countries, and notably foreign central banks of other governments to hold dollars as a form of insurance against the possibility that something might go wrong in global financial markets. There is the possibility that food prices might go up, requiring countries that import food or energy to take another timely example--they might need additional dollars to finance their imports. So, as the global economy grows, foreign governments and central banks want to acquire more insurance. That allows the United States to export green pieces of paper, which cost very little to produce, and import Toyotas and BMWs and the like. Economists refer to this as seignorage--the ability of the United States to provide the global currency at low cost to ourselves. I estimate in the book, that living standards in the United States are about 3% higher in total than they would be otherwise as a result of this exorbitant privilege that at the moment only the United States possesses. Now the dominance of the U.S. Treasury market--that allows the United States to borrow money at slightly lower rates than it otherwise would, correct? Correct. So, one reason that U.S. living standards are higher than they would be in the absence of the fact that the dollar is not only our currency but the world's--one form in which that benefit accrues to us is indeed that the U.S. government can borrow money for less. Treasury Bond prices are higher, and yields are lower, than they would be otherwise because the People's Bank of China and the Brazilian Central Bank and others have been buying dollars big time. Why are they doing that? A couple of reasons. I alluded to one, which is that they value the liquidity of the dollar, and they see dollar balances, dollar reserves, as a form of insurance. But they are also buying dollars to keep their own currency sound, to keep their own exports competitive. For the last 30 years, China has been presumed a very successful development model, that has centered, as every American now knows, on exports. And to keep their exports competitive, they've been keeping their currency low. Another way of doing that is they have an interest in keeping the dollar high, and they've been buying U.S. Treasury Bonds before the crisis--not incidentally the securities of Freddie and Fannie, the government sponsored mortgage agencies, partly to achieve that, to keep their currencies down and their exports to the United States competitive. So, economists argue--as they do about many things--they argue about the relative importance of these two motives. Some countries are interested in obtaining dollars as insurance; others kind of accumulate them inadvertently, as a by-produce of their strategies of export-led growth.
7:07We are going to digress for a minute here, because I think this is so important; and the mechanics of this will be useful as we continue talking. This argument that China is trying to manipulate the price of its exports to the rest of the world through its behavior with the dollar. Walk me through that and how it interacts with the government-sponsored agencies. So, if I look at China, I see them taking dollars that they've earned from exports and using them to buy government-sponsored agency--Fannie and Freddy--bonds, which were attractive to them because they had a slightly higher yield. But they viewed them--correctly as it turned out--as being just as safe as U.S. Treasuries. How does that affect their currency? What does it have to do with it? There are a couple of different respects in which these transactions matter. One is that China is trying to make its exports to the United States as competitive as possible. For a long time, China has had unlimited supplies of labor to the modern manufacturing sector. I think that era may now be drawing to a close, but that's a different story. So, wages in China have been stable. And the way they have been able to keep their exports competitive is by keeping their currency stable, and thereby keeping their labor costs--their wages in terms of dollars--stable. And they do that by preventing their currency from rising against the dollar. They buy the dollar if it shows a tendency to fall against Chinese renminbi, and they therefore end up holding trillions of dollars in U.S. Treasury Bonds. That's how it matters for them. And the irony of that process is something that has benefited them greatly for the last 20 years--export-led growth has been an astounding success for China; but may now be coming back to haunt them, because if the dollar begins to decline against China's currency, as seems likely going forward, they are going to take losses on their holdings of U.S. Treasuries. The other respect in which it matters, I think, has been in terms of pouring more fuel on the fires that led to the financial crisis in the United States. So, the financial crisis had multiple causes; no event as serious as the financial crisis of 2007-2009 could result from only one factor. But among those causes, I think, were the low interest rates on relatively safe securities like U.S. Treasury Bonds that led other investors--banks and investment funds in the United States to stretch for yields in other financial markets, like the subprime market. The subprime securitization market and all that. I find that claim a bit mystifying, but I found your earlier claim equally so. We'll get back to the crisis later. This idea--and tell me if I'm using this phrase correctly, because I find this equally perplexing--China in your story about their export-led growth wants a strong dollar, which means relative to other currencies. They want a weak Chinese currency in order that Chinese goods should be cheap. Is that a correct summary of what you said? So far, so good. Okay; so that's good for the United States it seems on average. It's not good for every person in the United States. But you are suggesting that despite their extraordinarily low labor costs, which would certainly be part of the reason that their exports are so attractive, despite that, they have decided to encourage an even further cheapening of the price of their goods to American consumers, thereby giving us a windfall. Is that correct or not correct? Yes, that's basically correct. Why do they do that? Well, look at the Chinese economy. Household consumption is only 1/3 of Chinese national income. Barely half what you would see in an advanced economy. It's about 2/3. People there are interested in forgoing current consumption, current gratification in order to generate faster growth and higher living standard in the future. So, Chinese leadership is engaged in this calculated strategy where they think there is a lot of learning by doing and learning by exporting in particular; by building assembly platform, not only for their producers but for our producers and foreign multinationals. They will acquire foreign technology and know-how, and by sacrificing gratification now, they will have faster growth and living standards in the future. Could be. And conversely, if Americans get to live beyond their means for a period, we were running current account deficits, essentially trade deficits, of 6% of GDP before the crisis, consuming 6% more than we produced as a nation, that was something that the Chinese were willing to finance for a time as the price to be paid for a 10% growth.
14:11Now, there are some people--language is perhaps difficult to use precisely, especially in economics; that's why we have all our jargon--but what you said, the first part, is very straightforward: When we import more than we export by 6%, our trade deficit, that allows us to consume more than we produce. Now, a household can do that by borrowing. But as you point out in the book, a nation can do that without borrowing if it provides something of value that makes the currency flows attractive to finance that current account or trade deficit. And I use the word "finance"--that's one of those words that's a little bit hard to know exactly what that means. But I'm being a little bit of a stickler here on behalf of my colleague, Don Boudreaux, who always likes to point out that when you run a trade deficit it does not mean you are going into debt. As you point out in the book, if the Chinese are willing to hold U.S. dollars, for whatever reason--whether it's this currency issue or insurance or whatever it is--if the United States is an attractive place to invest, we can live beyond our means in a way without going into debt. Is that correct? That is correct. I said, in the interest of fairness, acknowledged that there is a second explanation for why the United States is running the use of persistent external deficits, and countries like China have been running persistent external surpluses. That second explanation saying that there is a shortage of safe, liquid assets in the world, and only the United States is really in a position to supply them. So I think historically that explanation has a lot of merit to it. Absolutely. Going forward into whether a lot of these U.S. assets are really going to work in the future. There are two aspects of safe, one of which I think everybody understands. The other you don't talk about in your book, and I was surprised. One definition of safe is that the country honors its promises. The country doesn't default. There isn't a revolution, so you can't get into the bank where your stuff is. That's one measure of safe. The other measure of safe is stable--meaning that the purchasing power of the asset is relatively stable. Inflation--more accurately relative inflation rates--would seem to be extremely important? Are they empirically? In other words, the United States historically has run relatively low inflation rates relative to other nations. But they are not the only country that has run relatively low inflation. It's interesting to me that other countries are not more successful in being a source of foreign funds, for that reason. I think price stability is important and I would politely disagree with your characterization before that I don't talk very much about stability in the book. Price stability--inflation. I do think that price stability is important, if a country is going to retain its status as a global currency. And liquidity is important as well. Have to be able to convert an asset into something else you want--energy or food or some other essential import without driving down the price of that asset when you sell it off. The United States has the advantage of liquid financial markets and it has done well over the last 50 years in terms of maintaining price stability, relatively speaking. So, I do think both aspects matter. I would finally observe that we had a period of bad performance in terms of inflation in the 1970s. And there were a lot of predictions at that point about migration away from the dollar and toward alternative units like the Japanese yen or the German deutschemark. There was no euro at the time. It didn't happen. I do think inflation poses a risk to currency stability, but you've got to do a really bad job for an extended period before a currency like the dollar loses the advantages of incumbency. One phrase you hear sometimes is the dollar retains its attractiveness because it's the tallest pygmy. So, even though the dollar is not doing very well, everybody is doing worse. It's the relative performance that matters. Certainly in the 1970s the United States wasn't the only country experiencing inflation; that may have been part of the reason it was able to survive it. The other way people put it is the least ugly contestant at the beauty pageant. That continues to support the dollar's role today--that the alternatives probably all have problems of their own.
19:57Let's talk about monetary policy. You have a lot of very interesting historical episodes where central banks, either American or non-American, struggle to deal with the fact that they had one goal domestically that conflicted with an international goal. I think the subtlety of that dilemma escapes many of us. Can you give us some examples of that or just speak generally about the advantage the United States has over other central banks given that the dollar is the international currency; and that other central banks struggle because of that and it's a dilemma. The problem that other central banks face is there are all kinds of firms and banks and households in their countries who have debts in other currencies--in other people's money. So, in Hungary, for example, most of the car loans are not in Hungarian forints. But they are in Swiss francs, because Swiss banks have lent money to Hungarian banks, and the Hungarian banks turn around and make the car loans to car purchasers in Budapest in Swiss francs. So, if the Hungarian forint depreciates, it loses value against the Swiss franc; suddenly the Hungarian worker, household that has bought a car finds that its wages in forints won't pay for the car loan any more. The Hungarian central bank, therefore, cannot let the currency fall too much against the Swiss franc. It may want an accommodating monetary policy, a low-interest rate policy, to support the economy; but if it sees the florint falling against the Swiss franc, it's going to have to tighten up regardless of the other consequences. The United States doesn't have to worry about that. At his famous press conference last month, Mr. Bernanke--famous because of its uniqueness--said: We believe in a strong dollar. But the United States can follow a policy of what's called benign neglect toward the exchange rate of the dollar and basically worry entirely about what policies are appropriate for the U.S. economy. With the only risk that it could kill the goose that lays the golden egg. If it abuses that exorbitant privilege excessively it will call into question the value of the currency as an international exchange mechanism, so there are potentially costs. But they are nothing like what other nations have to deal with. Exactly. Are you familiar with Doug Irwin's argument about the role that gold flows in the run-up to the Great Depression played in France? That France was hoarding currency, forcing the United States and other nations to absorb deflation? Yes, I'm familiar with the argument and have written along similar lines in my earlier book, Golden Fetters. There are those parallels between what France did then in the runup to the Great Depression and what China has been doing recently. Why is that? I interviewed Doug and we discussed his work. Explain how China, through its policy--and I'm a skeptic on this because it's hard to know--is following this deliberate policy; how would that hurt us, or cause deflation or some other monetary impact that we would be unable to offset? The problem at the moment--and there are other folks like Paul Krugman who are more articulate exponents of this particular story than I am--is that the United States would like to offset the deflationary impact of low prices caused in part by cheap goods coming in from China. But we have a variety of constraints now that prevent us from doing anything about that. One is that it's hard to use monetary policy any more extensively than we've used it. The Fed is up against what is called the zero bound; and fiscal policy is not available, either for economic reasons, if you are worried about the medium term, debt dynamics in the United States, or for political reasons. I don't understand that argument. Let me try to explain my confusion. I suspect you are as articulate as Mr. Krugman; maybe you are a little quieter. He does yell about it; he's worked up over it. I don't understand it. We could think of three ways that China could deliver us cheap manufactured goods. More than three, but I'll just pick a few. One is, they could artificially subsidize them directly through domestic tax subsidy policies. They could do it through the currency, as you are suggesting that they do. It could happen because they have a very low labor cost or those costs are falling. Or, they could just be very productive, or increasingly productive, so they continue to deliver us inexpensive goods. All of those things would be good for us. And, they wouldn't be deflationary. They'd be deflationary for manufactured goods, but in the absence of overall monetary policy being different, other prices would rise and the price level as a whole would be neither deflationary nor inflationary, in those different scenarios. What am I missing? You are missing the importance of aggregate demand. That, much of what you were describing before is about the supply of Chinese goods and the benefits to American consumers of the fact that flat screen TVs are cheaper at Best Buy than they would be if China was not following its current policies. But the argument goes, and at the moment I think it has merit, that we also have a problem of aggregate demand; there has to be a demand for American goods in order to get employment growth going. We have a serious unemployment problem in the United States that we will only get traction on if we get the economy to grow faster. We can't stimulate domestic demand using the normal policy instruments because we've fired those bullets and we're out of them; so the argument goes, China is artificially diverting the fixed lump of demand that we have in the United States at the moment partly toward its own cheap exports; and that's leaving less work for Americans. There are other ways of solving that problem over time. American workers need to become more productive; we need more capital formation; we need to invest in skills and training. But right now, 9% unemployment is a problem, and I think Chinese policy contributes to that. I'm not saying China is responsible for our 9% unemployment, but it's policies are not helping.
28:59So, I'm not a Keynesian--which is neither here nor there; I don't want to get into the intricacies of aggregate demand management--but maybe it's thinking about it when we are not in a crisis time. But if another nation makes stuff better than we do through what we usually call either creative destruction or through comparative advantage, we go on to make something else. And it's easier to do because we don't have to devote as many resources as we used to to make flat screen TVs. I don't want American workers to get more competitive at making flat screen TVs. Let's let the Chinese make them. Why would we want to do that? So, you've put your finger on it. In a crisis time, in a period when there is inadequate aggregate demand, the effects of foreign policies on the United States are different than in normal times. In a fully employed economy or something close to that, your argument about how the Chinese have a comparative advantage in assembling consumer electronics so Americans can move into other activities--and everybody is better off--is exactly right. But we are not in that full employment world at the moment. So, I'm going to avoid labels entirely, but I would ask you whether an economy with 9% unemployment, whether we can really apply your story about comparative advantage is all that matters, and aggregate demand doesn't to an economy with 9% unemployment where we don't have tools at home to stimulate demand at the moment. I guess the disagreement there would be: the tools that we have, we don't agree on whether they work or not; whether the past stimulus package helped, whether it did nothing, whether it was inadequate, not big enough. Let me make an historical remark which you bring up in the historical section of the book: Keynes, who was a classical liberal in many dimensions before the Great Depression, did find himself advocating protectionism at various times, to the surprise and disappointment of some of his colleagues; but it's exactly for the reason you are talking about. He felt that foreign exports were taking up jobs. Which he would not have said in healthy times--he was a free trader, historically. He had been a dedicated free trader; he found himself in 1931 in a situation where unemployment in Britain was approaching 20%, where for a combination of reasons the government didn't have other tools with which to address it. He reluctantly concluded that a tariff to bottle up the fixed lump of demand that Britain had at home was the best of a variety of bad choices. What happened next, of course, was that Britain went off the gold standard, and monetary policy became available to the Bank of England; and Keynes changed his mind yet again. His famous phrase was: When the circumstances change, I change my mind, young man; what do you do? So, he said a tariff is no longer appropriate now that we have monetary policy again.
33:02Let's go back to U.S. history. You tell a very interesting story of the evolution of the dollar from the very beginning; go back to colonial times. For the listeners--I said brusque at the beginning; I meant short. I think it's 177 pages; read it on my Kindle so I don't have the page numbers exactly, but it's not long. So, when we talk about these historical episodes, you do a very nice job in talking about them in short but very illuminating strokes. So, you go back to colonial times, and the United States doesn't even have a currency to start with. It only has British pounds because it's a British colony. In its early days it struggles to create any traction for the dollar at all in any international sense. Somehow it manages--as if that's a meaningful phrase--historical events occur by which the dollar overtakes the pound sterling. Try to give us a thumbnail sketch of how that very unpredictable event took place. It took place through a combination of conscious policy initiatives by U.S. politicians and officials on the one hand, and historical circumstances on the other. There was a big financial crisis in the United States in 1907 that was managed by J. P. Morgan and his right-hand man, Benjamin Strong, a New York banker, in the absence of a central bank. The lesson drawn from that was that the United States should have a central bank, and that led to the Federal Reserve Act and the founding of the Fed in 1914. The Act in 1913 and the opening in 1914. As you said, the history is brusque. I love that kind of precision; thank you. The other thing the founders were concerned about was that the dollar played no international role; that U.S. importers and exporters, when they needed trade credit, had to go to London to an English bank; that they bore the additional transaction costs of having to buy a foreign currency. If a U.S. importer of coffee beans from Brazil wanted to pay his Brazilian counterparty, he had to ask his local bank for a letter of credit; the local bank had to ask a correspondent bank in London for the letter. Everything was denominated in pounds sterling, and that was a considerable disadvantage for U.S. merchants and traders and producers. One of the things you highlight was the challenge of buying things from other countries, which we take totally for granted in today's world. But for much of the early part of U.S. history, as you point out, you had to pay this guy in Brazil something he could use. He didn't want dollars, usually. And almost without exception they didn't want dollars. They didn't know about dollars; they didn't regard dollars as convenient. London was the global financial center. It was in 1914 what New York is today. Everybody kept their deposits in London; got their trade finance, their credit, in London. All of that was denominated in sterling. So, the founders of the Fed basically set out to change that by creating a central bank that could provide liquidity to U.S. financial markets. The instrument they created was called the Trade Acceptance, which was basically a security that was used to finance trade; and the Fed began to buy and sell those big time. The word "credit"--the average American thinks of it as what you need if you can't afford something right now. But if you are a commercial producer, you've got to have credit because the timing is always a little bit different. Just to be a going concern, you have to be able to get access to money before the money comes in to pay it off. So, the American importer of coffee beans from Brazil is going to import the bags full of beans; he's got to pay for that now. He will roast the beans and sell them, and get the income from that, but that's down the road. He needs some credit in the meantime. Extraordinary thing that we don't ever think about, doing that internationally. In the absence of the central bank and of this asset you are talking about, you described the process: you'd have to get a letter of credit, go to your local bank to get a letter from an English bank. Wasn't that timing extraordinarily costly? Or did it come to be somewhat smoother as people trusted reliable merchants and banks? It was expensive by our modern standards, when we are used to paying only a couple of dollars when we stick a bank card into a cash machine in a foreign airport. But it became more efficient with the passage of time. So, the city of London--the name for London's financial center--really came to specialize over the course of the 19th century in providing this credit. The banks in London were referred to as merchant banks. We would call them investment banks, using 21st century lingo. But they were merchant banks because they specialized in providing credit for merchants who were doing import and export trade. And they got pretty good at it.
40:07So, the Federal Reserve comes along; they start providing a market in these import-export credits that make it a little easier for American firms to operate abroad. How do you get from there to dominating the pound sterling? This market grows very quickly, and there's another big event--WWI--that intervenes, that kind of cuts the city of London off from its customary business. The two things combine by 1924. The dollar has moved from a point where, 10 years earlier, it was not used internationally at all, to where now it's used in 1924 to finance more foreign trade; as the currency in which more international bonds are issued. It's already more important as a reserve currency than the pound sterling. That's a very rapid changing of the guard, and it reflected two things--the creation of the Fed and the Fed's campaign to create these markets and internationalize the dollar. Plus, the disruptions of WWI. What's interesting about the story and the way you structure the book is that if it's possible for an upstart currency to overcome some of the advantages of an incumbent currency, you start to wonder whether it can happen again. We'll come back to that and talk about China and maybe the euro as well. But the other factor, I assume, is the absolute growth in the U.S. economy as a market for economic activity generally. That's relevant as well, correct? Yes. If you ask me what are the pre-conditions for your currency to be the dominant global unit, I would answer three things: 1. A big platform--that you do a lot of international trade and investment. 2. Stability--low inflation and all that. 3. That your financial markets are liquid and used with confidence. So, let's turn to China. They're pretty good on the first one. Enormously growing, at least for now; some say that maybe it won't last. They are a big platform. Second is price stability--hard to know. They are a little bit opaque, which will be one challenge. We have our opaqueness in the United States, unfortunately; by the tallest pygmy, we're less opaque compared to China. Third, liquidity; and as you point out in the book, China has been very uneasy about opening its foreign currency to easy liquid international transactions. Talk about that. I think you put it well. The Chinese understand these different dimensions of global currency status. International currency status has different aspects to it. Your currency can be used as a means of payment and a unit of account for imports and exports; and they are now moving very rapidly to encourage their companies and foreign companies to do cross-border trade using their means of payment and unit of account, the renminbi. Two years ago, zero Chinese companies used their own currency in import and export trade. Now, something on the order of 70,000 do so. So, they are moving pretty fast. The second thing they have to do is enhance the liquidity of their financial markets and open them to investors. That's going to be harder. It will create risks to their economy if they go to fast; and creating confidence on the part of foreign investors so that private investors and central banks are willing to park their money in Shanghai is going to be harder. But they are moving in that direction, as well. So, they've allowed a bunch of companies to issue Chinese renminbi-denominated bonds--dim sum bonds, they're called. McDonald's, Caterpillar, have done it; and they've used the revenues to invest in operations in China. They've authorized a number of banks in Hong Kong to invest in the interbank market in mainland China, as well. So, they are gradually letting foreign investors in, to a limited extent. Completing that process and really turning Shanghai into an international financial center, their stated goal by 2020 is going to be a lot harder. What's their stated goal by 2020? Well, they've said Shanghai should be a true international financial center to rival London and New York by 2020. Hard to accomplish; but I'd also observe that we've repeatedly underestimated how fastthe Chinese can move before. They may well achieve that.
46:25Let's talk about what the United States could do in the negative sense--what mistakes we could make or choices that might be forced on us--that would make that transition easier for the Chinese. One thing many people might worry about and I'm agnostic about it, slightly worried, is the magnitude of the reserves that U.S. banks hold on the Fed's balance sheet and the potential for those reserves to come out when things get a little bit better and be inflationary. Which would, for example, not literally lead to a default but which would lower the value of what we repay foreigners for debts we've incurred, Treasuries and those other assets we were talking about earlier, agency securities. What are your thoughts on that and is that the right thing to worry about? Are there other things to worry about? If I'm worried about that 3% bonus we are getting from the dollar? As I say in the book, the Chinese are not going to cause a dollar crash. If there is one, we Americans will do it to ourselves. But I would draw a very strong distinction between the monetary risks and the budgetary risks. I think I would disagree with you about the danger posed by Fed policy. The Fed has been thinking long and hard about its exit strategy--how to shrink its balance sheet, how to prevent that liquidity from doing what the Mississippi River is doing near Baton Rouge. I think they will be able to reverse out those liquidity injections and shrink their balance sheet when the time comes. The danger to the dollar comes from medium term fiscal policy. I think if foreigners conclude that responsible adults are not making fiscal policy in the United States and if the winner of the 2012 Presidential election doesn't use his honeymoon to push through a credible medium-term fiscal plan, then foreigners could decide there are risks of some kind of open or covert debt default in the United States the pressure to inflate away the spiraling U.S. debt will become irresistible; they'll dump their Treasury securities and at some point the dollar will crash. That, to my mind, is the worry. So, I wrote in the book how we have maybe 5 years to get our fiscal house in order. I've grown more pessimistic; I think 2013 will be roughly the last chance from this point of view. There's not a lot of encouraging signs on the political horizon--that responsible adults are acting accordingly. Scary time. My monetary worries come from an observation that Allan Meltzer made on this program, that while the Fed understands how to reverse that flow of funds, it will not have the political will to do so; that as the economy is finally starting to recover and unemployment is starting to come down, it will be very difficult for the Fed to follow a tight money policy. That's the issue. Yes, and I see the merit to that argument. If the economy is weak, a sharply lower asset price--which would be the implication of the Fed selling off a lot of its stock--would not have happy effects.
50:45Let's talk a little bit about the crisis and maybe some of the international aspects to it. You give a very nice survey of the different contributing factors. You leave out a factor I'll come back to, but you do at the end suggest that a lot of these factors--overconfidence in risky assets and the techniques to assess risk, like value at risk, that we've talk on this program a lot about; the originate-and-distribute model--the idea that mortgage originators were not holding the paper that they originated and therefore were not as careful; the role of ratings agencies; the search for yield. But at the end you say that maybe a lot of this might not be so important had monetary policy not been so accommodating. I really want to just ask you a technical question about monetary policy. Long-time listeners will understand my relentless confusion and curiosity about this. You, as many do, including John Taylor, who has talked about it on the program, focus on interest rate changes and the channel by which interest rates affect asset prices, send signals about costs, etc. But in the old days, we focused on the money supply, the liquidity that was out there that made, financed, much of this activity. When we talk about Alan Greenspan in the 2003-2005 period, 2002-2004, where he has just before that lowered interest rates dramatically and then suddenly increases them--what does that have to do with the supply of money? In your way of organizing your thinking, the lens you use to view the world, do you think about both? Just interest rates? How do you think about that? I think about both. I'm a student of Jim Tobin at Yale, and Tobin believed that money and bonds and stocks and other securities are all imperfect substitutes for one another. Changes in the price of one will kind of cascade over into changes in the prices of the others. You've got to worry about the whole collection. So, I don't think there is a single magic monetary variable, either a price or a quantity, that will tell you whether monetary policy is too tight or too loose. John Taylor would look at one policy rate and compare it to the rate spit out by his particular model of optimal Fed policy rates. I think kind of the whole vector, whole range of interest rates matters. You've got to look at quantities as well as prices. I'm sorry about giving you a wooly answer to a very precise question, but I'm not of the view that there is either one magic monetary aggregate or one magic interest rate that will tell you whether monetary policy is too hot, too cold, or just right. I'm a wooly guy myself. I just think it's interesting how we look at one or the other sometimes when we are telling stories, and I don't see a lot of people looking at the supply of money when they are looking in the last 3 or 4 years or longer, going back the last decade. Most people just look at the price--at the discount rate--and they don't look at the implications of quantities. So, when I look at Bernanke again, and I'm talking about the current situation we are in, I see this weird world where he is paying--unprecedented--paying interest for banks to hold their money with them, which I view as just a back-door subsidy to the balance sheets of banks to prevent a catastrophe or to help them if you have a sinister view of the world. Very untraditional monetary policy, but that if it were left alone and those reserves do go out, it's a quantity issue I'm going to be worrying about, not a price issue. That's the way I think about it. I find it somewhat confusing, to be honest. I can certainly agree with the confusion part. We talk a lot in terms of the prices, the interest rates, because that's what the talking heads on CNN and the market participants talk about, so maybe academics like you and me ought to try to compensate for that by talking more about the quantities. I'm just back from Brazil where they talk about the quantities all the time. They are experiencing big capital inflows that are fueling rapid growth of bank lending and they are worried about the consequences. That's why they've slapped on some controversial capital controls. In other parts of the world the quantities are pretty prominent. When I interviewed Milton Friedman back in 2006, I asked him this question and he said: The Fed likes to talk about interest rate policy but they are really only paying attention to M2. Something we don't even talk about any more. Do we keep track of M2? I think we do. One of them got cut recently. What we have discovered in my view is that the relationship between the different Ms and the real economic activity has been shifting around because we've had a lot of financial innovation in recent decades. That means that M2 is not always a reliable compass for what monetary policy is going to do to the real economy. The discount rate may not be a reliable compass by itself, either.
57:38Challenge you on something you talk about in the book about the crisis. It's a very well written summary, 5 or 10 pages that really help the uninitiated reader into some of the mysteries of what happened. One thing you leave out, which is my personal pet peeve, so I want to raise it with you, is the role of past bailouts, particularly of creditors, particularly of lenders to large financial institutions in making leverage as easy as it became in the crisis. I understand the emphasis on inadequate regulation and a free market ideology, but most of the free market ideologues in the history of the last 25 years--they were only free market ideologues when it was convenient. When it wasn't convenient, they were interventionists. When those bailouts came along, they always found a reason to help out the financial sector. What do you think about the importance of that in the financial crisis? I agree with the analytical point that a pattern of bailouts over time will encourage risk-taking. But, when I look at Bear Sterns before the crisis and ask myself, why did they have a leverage ratio of 33 to 1, I don't think it was primarily because they expected to be rescued if a bad thing happened. I think it was primarily because they were being squeezed by competition from a variety of new rivals following the elimination of the Glass-Steagall Act and a variety of other financial innovations. So, they levered up their bets in this gamble to survive. My claim is then: Why did people lend them the money? Those are the people that I think are the people who contributed to the crisis. They were often competing financial institutions that had seen what had happened in the past when financial institutions went bust--their creditors got 100 cents on the dollar; the equity holders got wiped out. So Bear--actually Bear didn't get rescued so I don't think they were counting on the rescue. It's their creditors that were rescued, and they were made whole by the acquisition by J. P. Morgan Chase. I think moral hazard, which is what we are talking about, is effective there. The world would be a safer place if there were alternatives to bailouts. I think to assume we can safely let tightly connected financial institutions fail is too easy. Lehman Brothers reminds us that it's too easy. But we've got to do a variety of things to make financial institutions more transparent and to deal with the problems of interconnectiveness that have made policy makers feel like bailouts are the only alternative. I agree it shouldn't be that way and I agree that the world would be a safer financial place otherwise. I still don't entirely agree with you about the Bear Sterns points. Bear had lots of creditors, most of whose portfolios were only a small fraction invested in this one problematic financial institution. So, yes, moral hazard may have been on the mind of Bank of America and J.P. Morgan and others, but again, I don't think it was the major driver in the crisis.
1:01:54Let's close with an open-ended question about the Fed. The Fed, in the crisis, as we've been dancing around a little bit, has done a number of unprecedented things. It's a very autonomous organization in a sense. It's independence is much talked about. Of course it's also a very political organization. It is subject to political forces of various kinds, despite its so-called independence. Do you think there are any governance or institutional changes coming for the Fed, especially that are relevant to your discussion of the dollar as a dominant currency? Or, do you think the Fed's going to continue to be as it is? Well, I think the two things that will have to change are, one, residual secretiveness of the temple culture. The Fed will have to explain better how and why what it is doing are good for the average American. So, Mr. Bernanke's press conference and his appearances on 60 Minutes are, I think, necessary. The Fed will have to become more open and transparent in order to retain its legitimacy. Number two, I think the way the presidents of regional reserve banks are appointed will change over time. For historical reasons they tend to be appointed by committees of local businessmen and bankers; and I think it's not only the businessmen and bankers who have to be represented in that decision. It's pretty bizarro, isn't it. When you think about, especially the New York branch, it's not just the banks that happen to be operating in New York. It's, rather, the most influential and largest financial institutions in the world having a say, and then on the Board of, the representative who is their main conduit to Washington. It's a rather unhealthy political situation, it seems to me. Yes, I think it is a bizarre legacy of the past. We want to be careful in how we change it. You don't want the decision of who to appoint to become too political, too politicized. But, I think the old ways there are on the way out.

COMMENTS (18 to date)
Gu Si Fang writes:

Sorry for this trivial question: did I hear Russ saying he has read Eichengreen's book on his Kindle? I can't find it on the Kindle store...

Mikekikon writes:

How can there possibly ever be deficient aggregate demand? Is such 'aggregation of demand' even a useful concept? People always want more if they can afford it. If people are unemployed, it's not because people don't want stuff, it's because so many resources and people were employed in the wrong ways leading up to the crisis (based on distorted market signals) and now there is a slow but necessary reallocation process underway to find out where they really belong.

If we artificially create demand, we'll have to create it in places where it probably shouldn't exist. That will employ people temporarily, but it won't be sustainable and will just put us back in the same rut we were in before, but without the resources we wasted while "stimulating" the economy.

This is just going to further inhibit the reallocation and put more people out of work.

I wish you had pushed back on this, Russ. Eichengreen sounds like a really smart guy. His perspective on the trade deficit, which at first sounded like pure populist protectionism (and unfortuately the general public would probably interpret that way), were quite intricate and insightful after he spelled them out. For him to just claim a deficiency in aggregate demand without defining the term or explaining his reasoning and then to just pretend like it was just a fact of reality requiring no further elaboration left me with a bad taste in my mouth.

Otherwise, very interesting discussion.

emerich writes:

Isn't there a glaring contradiction in Mr. Eichengreen's positions? (1) the U.S. gets major benefits from seigneurage, the world's willingness to accept dollars for trade and to hold as reserves; (2) the Chinese get major benefits from buying our dollar's and holding them as reserves; this policy drove their successful "export development." In discussing point #2, he clearly implied that the U.S. was being hurt. Yet isn't China's policy just the flip side of (1)?

Evolutionarily writes:

I enjoyed this podcast. Despite knowing Russ would be in disagreement with all manner of things mentioned by Barry, it was very amicable.

David B. Collum writes:

Again, great interview. I would say that to be a "going concern" you do not have to have credit. In lieu of a credit line, you could have money in the bank.

This gets to one of my minor peeves that involves analysts' assertions that Corporate America's balance sheets are bloated with cash. This can be shown to be flawed by looking at the cash-to-debt proportions of the DOW. You quickly discover that the DOW 30, despite amazing cash balances from several of its components (MSFT being the standout), has more debt than cash by slightly under a trillion dollars. This net indebtedness means that they have collectively no cash in the bank, only bountiful lines of credit supporting a rather extraordinary amount of debt. (In case you are thinking that the big imbalances stem from the banking components, curiously they are not the big net debtors. Back to my first assertion, companies can run off cash, but they currently don't.

stephan writes:

@emerich
Aren't you mixing up agents there?

As I understood it, the Chinese government has the advantage of currency manipulation on their side. This may benefit Chinese companies in terms of exports, but overseas investments will always have the currency risk attached.
On the other hand, American companies have the advantage of not having to worry/hedge currency risk.

I'm not sure on how those two things interact but I don't find it intuitive that they are two sides of a coin.

Schepp writes:

Dr. Eichengreen and Dr. Roberts,

I thank both of you for doing this. Clearly there we different views on material positions of each of you. I thought to some extent their was some tension due to the differences, but the excellent discourse between two economist who disagree surely produces more learning than preaching to the choir.

To emerich's point...

Isn't there a glaring contradiction in Mr. Eichengreen's positions? (1) the U.S. gets major benefits from seigneurage, the world's willingness to accept dollars for trade and to hold as reserves; (2) the Chinese get major benefits from buying our dollar's and holding them as reserves; this policy drove their successful "export development." In discussing point #2, he clearly implied that the U.S. was being hurt. Yet isn't China's policy just the flip side of (1)?
Russ touched on this contradiction as well, and I think it can be understood by saying that China has an 'agency problem'. Devaluation of Chinese currency does not benefit the people of China as a whole but it benefits the State. Obviously, the people have no say so in the matter but they are being impoverished (relatively speaking) so that infrastructure of the Chinese economy (which is largely State-owned) can grow. The physical (factories) and financial (dollars) capital of the state continues to grow at the expense of 'labor'. Ironic since China is ostensibly a Marxist state.

I actually think this is not unlike the agency problem that exists when companies acquire competitors at prices that do not enhance shareholder value. Bad for shareholders but possibly good for management in that it enables them to expand their skill set, and might potentially improve their job security.

joe writes:
How can there possibly ever be deficient aggregate demand? People always want more if they can afford it.

There is insufficient demand because they can't afford to purchase what they need. According to the NFIB small business survey from May 2011, the #1 concern with small business is weak sales. The customers are broke. That's the basis for a balance sheet recession. Go to the NFIB web site and downlaod the latest survey. Look at page 20.

Russ Roberts writes:

Joe,

It's a little more complicated than that. The fact that businesses lists sales as their #1 concern doesn't prove much about macroeconomic theory. More here if you're interested.

Sam writes:

Russ I'm not sure you could say Japan's a democracy but Korea and Singapore are not, in my mind they're all pretty close together on the sliding scale measure of democracy. I mean the LDP was in power for 54 years straight in Japan, the PAP in Singapore still needs another decade in power to reach that mark. Also Japan's a long long way off from having free reporting, particularly on elections.

Is China that much of a mystery? Isn't it really just harnessing the incredible work ethic of North East Asian cultures and mimicking successful industrial policy in Japan and Korea. Take ship building, first Japan starts building them cheaper than Europe, then as Japan develops and cost rise Korea can build them cheaper than Japan, then China builds them cheaper than Korea. Move on to automobiles and repeat. But Tyler is right, catch up growth CAN sprint but something like stagnation follows e.g. Japan.

John Berg writes:

Somehow what happened to GM's Bond Holders during GM's bankruptcy strikes me as the opposite of "moral hazard." With the clear demonstration of what government can do, why would I buy bonds? What did actually happen to those bond holders?

John Berg

W.E. Heasley writes:

In the early part of the broadcast you mention James and Jane Goodfellow can choose to live a 1875 life style if they choose… albeit with influence of today’s technology.

That speaks volumes.

xian writes:

russ:

speak to someone in business. if they peak into they're books, they'll tell u that they started letting people go the moment sales crashed.

this was well before anyone could predict/fear "regime uncertainty", as u put it.

it's not "regime uncertainty", it's uncertainty in general. one month sales looked a bit softer than the month before, reinforcing a trend that appeared 6 or so months prior (ie JAN08-ish) and then, in a matter of days, sales vanished like a like some kaiser soze.

shop floors were vacant and all anyone with a decent stake could hear about was crashing asset values and failing- supposed- stalwarts like citigroup.

that was the uncetainty. it still is. talk to them, business owners werent shellshocked and risk averse bc of taxes- which have only trended downward in the last 2 yrs. admittedly, they arent permanent, but this "goosing" of ag demand (cash on hand after labor or investment) was just sugar on the bitter pill of >400k joblosses/month.

u remember right?

immelt said it best, something to the effect of "this is isnt a downturn, this is a full reset of the global economy"

regime uncertainty? it's just uncertainty- which arose when lightning struck and all the sales evaporated.

no one in business at the time had ever seen a "sudden stop" in an advance economy- and those who had known of them, knew there was no that is our uncertainty.

im not sure about the best policy and kinda think AFCA was way off tune, but the problem is volume of sales.

the result is now booming growth in corporate profits as they "reset" to growth overseas which benefits from the "goosing" which hasnt been tied to within our borders.

im not sure they should/could b.

JP Koning writes:

Russ, Eichengreen gave you a story of Federal Reserve competence to explain the rise of the dollar. The Fed-influenced rise of the bankers' acceptance market was the pillar of his argument.

This ignores the other side of the coin; the bureaucratic incompetence that prevented the acceptance market from appearing earlier than it did. The National Banking Act and other existing federal legislation prohibited US banks from branching abroad and purchasing bankers' acceptances. The 1913 Federal Reserve Act simply removed these barriers.

Perhaps the rise of the US dollar had something to do with conscious design by the Fed, but it probably had as much to do with problems on the other side of the ocean. Britain went off gold in 1914, back on again in 1926, and off again in 1931... the US dollar retained its gold link through that entire period. People who use currency and units of account like stability and as a result spurned the pound for the least worst alternative, the dollar.

JP Koning writes:

Eichengreen is optimistic about the renminbi's chances as a challenger to the US: "Two years ago, zero Chinese companies used their own currency in import and export trade. Now, something on the order of 70,000 do so."

As a good counterbalance to this, I'd suggest everybody read Michael Pettis's peice available here:

http://seekingalpha.com/article/272717-chinese-trade-and-the-rmb

In a nutshell, Pettis says that most companies could be participating in the renminbi trade to speculate on what is perceived to be a guaranteed rise in the currency, and not for actual import/export purposes.

Robert Wiblin writes:

This was a very interesting exchange and on a topic not often discussed. Good work.

Charlie writes:
Isn't there a glaring contradiction in Mr. Eichengreen's positions? (1) the U.S. gets major benefits from seigneurage, the world's willingness to accept dollars for trade and to hold as reserves; (2) the Chinese get major benefits from buying our dollar's and holding them as reserves; this policy drove their successful "export development." In discussing point #2, he clearly implied that the U.S. was being hurt. Yet isn't China's policy just the flip side of (1)?

He's implicitly arguing that the cost of 2 is greater than the harm it would do to 1. He gives some implicit reasons why that might be true. If the Fed prints more dollars and buys for T-bills, the rest of the world may see that as a beggar thy neighbor policy, whereas China doing it would not be. Also, since China's exchange rate with the dollar (and rest of the world) would rise much more in the second scenario, perception likely matches reality. He also argues that the Fed isn't expansionary enough. This may be, because they fear the loss of seigniorage, they lack the political will/support, they "can't" (or the policies that would be needed lack will/support) or are even dangerous, and last, maybe they are just being dumb.

Regardless, if you think the Fed is not being expansionary enough for any reason, then it follows that you think China's exchange policy is suppressing U.S. aggregate demand and hurting the U.S.

Of course, if you think the U.S. problems are entirely structural, then it follows that China's policies are a net benefit to the U.S.

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