Over a month ago — when Venezuelan’s were still living under the heel of Nicolás Maduro’s United Socialist party — Ilya Shapiro and I had a very interesting meeting with the folks behind DolarToday. As the Wikipedia article concerning it explains, DolarToday  “is an American [nota bene] website that focuses on Latin American politics and finance. The company is more known for being an exchange rate reference to the Venezuelan bolívar, a currency which is not freely convertible.”

My reason for attending the meeting was obvious enough: Venezuela has recently been suffering from the world’s highest inflation rate, making the Banco Central de Venezuela, Venezuela’s government-owned central bank, the current poster-child for government abuse of fiat money. Ilya, on the other hand, was there because, besides being a senior fellow in Constitutional Studies at Cato and editor-in-chief of the Cato Supreme Court Review, he’s a lawyer.

You see, the Banco Central de Venezuela decided to sue DolarToday for “destabilizing” Venezuela’s currency. That is, it claimed that the website, far from merely reporting the bolívar’s deterioration, was to blame for that deterioration and also for Venezuela’s general economic decline.

But hold on: doesn’t Wikipedia call DolarToday an “American” website? It does indeed, and quite correctly. The site is both Delaware-based and owned by U.S. citizens, who started it back in 2010. But that hasn’t stopped the Venezuelan authorities from trying to shut it down, by filing their suit in Delaware’s U.S. District Court.

The lawsuit itself offers a remarkable glimpse at the twisted logic of totalitarian regimes. The prologue to the plaintiff’s description of the action’s gravamen will give you the general idea:

How far will some go to enrich themselves (and their friends) and to regain the political power they crave to enrich themselves further? Would they go so far as to hurt their own countrymen by making their already challenging lives even harder? Defendants would. And they have.

The 32-page suit goes on to accuse DolarToday’s owners of everything from racketeering and cyber-terrorism to attempting to overthrow Venezuela’s government. Really you have got to read it to believe it. If I hadn’t been told otherwise I’d have thought it a spoof.

Except there’s nothing funny about it. Ludicrous as the suit is, the Venezuelan government isn’t laughing, which means that, although the odds of it making it to trial, much less of its ending with a decision for the plaintiff, are infinitely smaller than those of the Phillies winning the next three World Series, the defendants have got to…well, defend themselves. That costs money. And, despite what the Venezuelan suit alleges, the defendants aren’t rich — at least, they haven’t gotten so at Venezuela’s expense, through their website or otherwise.

But that’s not all. The lawsuit is just one of several hardball tactics that the Venezuelan government employed in its effort to shut down DolarToday. Back in July then-president Maduro accused the site’s owners of cyber-terrorism on national TV, threatening to have them extradited and given a dose of Venezuelan justice. The Banco Central has also tried to take advantage of the “discovery process” connected to its suit to determine the identity of DolarToday’s anonymous Venezuelan owners and supporters, so as to be able to persecute them and their family members.

In case you are short of lawyers to hate, you will be delighted to know that Squire Patton Boggs, a U.S. law firm, is assisting the Banco Central in this noble undertaking. So far it has pursued the case with great zeal, even going so far as to publish press releases repeating the cyber-terrorism charge along with the alleged terrorists photographs. If that’s not enough to make you want to want to add the firm’s partners to your Valentine’s-card mailing list, consider that the same firm also happens to be representing Campo Flores, Maduro’s stepson, who has been indicted on drug trafficking charges by the U.S. Justice Department.

Just how much, I wonder, do top U.S. law firms charge these days per billable hour spent intimidating U.S. citizens and their friends, for the purpose of suppressing freedom of information? Whatever it is, I’m sure the Central Bank of Venezuela can afford it. After all, what’s a few more bolívars to them?

Alas, Cato’s Center for Monetary and Financial Alternatives can’t print its own money, yet. But that doesn’t mean that we’re taking this lying down. In fact, we are doing something just by drawing attention to what the Banco Central is up to. But we are also making sure that, if anything should happen to DolarToday, it won’t do that bank or any other enemy of freedom a lick of good, because people will still be able to get all the information they want about the true state of Venezuela’s currency by looking it up on our own Troubled Currencies Project. There they will find all the information that DolarToday itself supplies, and much more besides, all of it thanks to Cato Senior Fellow and FX-expert extraordinaire Steve Hanke. Indeed, DolarToday just recently announced that it now relies entirely on Steve’s own estimates of Venezuela’s inflation rate.

So, if the Central Bank of Venezuela really wants to snuff-out information concerning its mismanagement of the bolívar, shutting down DolarToday just won’t cut it: it’s going to have to shut us down as well. So how ’bout it, guys? Our lawyers can’t wait!

[Cross-posted from Alt‑M.org]

CMFA Director George Selgin recently appeared on EconTalk, the weekly podcast from the Library for Economics and Liberty hosted by Russ Roberts. He and Russ discussed the causes of the 2007-08 financial crisis and the Fed’s response to it, with George drawing on his Alt‑M reviews (see here and here) of Ben Bernanke’s, The Courage to Act.

George and Russ begin by discussing the moral-hazard consequences of the Fed’s emergency lending during the crisis. While the roots of the moral hazard problem are traceable to the introduction of state-level and then nationwide deposit insurance schemes, George pointed out that the problem became much worse once the 1984 rescue of Continental Illinois established a precedent for bailing out “too-big-to-fail” financial institutions.

George and Russ then turn to the Fed’s response to the crisis. First, George points out that the Fed’s emergency lending violated the famous “lender of last resort” rules laid out by Walter Bagehot, namely that central banks should only lend to solvent banks in need of liquidity, and then only at a high rate and against good collateral. In the cases of Bear Stearns, AIG, and Citigroup, however, the Fed went beyond providing liquidity to sound firms—these were bailouts, plain and simple.

Second, George argues that the Fed made a catastrophic mistake by sterilizing its early emergency lending—that is, by selling off its Treasury securities so that neither its balance sheet, nor the overall supply of credit, would expand—and by paying interest on bank reserves beginning October 2008. As George explains in detail here, both moves show that Bernanke and other Fed officials were more concerned with maintaining their target for the federal funds rate than they were with offsetting collapses in lending and spending.

The entire conversation, which provides a good summary of George’s views on the financial crisis and the Fed’s response to it, can be found here. Enjoy!

The Federal Reserve is set to act this week to raise short-term interest rates. There are a number of technical and policy questions raised by this long-anticipated decision. The Fed conventionally raises short-term interest rates by selling short-term Treasury obligations. It no longer owns any short-term Treasuries to sell.

Based on prior statements, the Fed is expected to increase the interest rate on reserves held by commercial banks at Federal Reserve banks. The Fed is operating in uncharted waters. It is not clear how increasing interest on reserves will affect other short-term interest rates. Further, the Fed is already paying commercial banks over $6 billion in interest payments annually. That amounts to a fiscal transfer from taxpayers to bankers. Raising rates will only increase that transfer. As we approach a presidential election year, that is likely to become grist for political mills.

The Fed could also raise the interest rate on reverse repurchase agreements at a facility at the New York Fed. The Fed is effectively borrowing money from financial institutions like money market funds. It functions as a subsidy to those institutions, as the Federal Reserve System has no business or policy reason for borrowing money. Once again, I would anticipate political questioning of such a move.

Free-market economists are in a policy conundrum. Most have long advocated higher interest rates. But the facilities through which that policy will now be effected have questionable validity. Some of the same economists advocating higher short-term rates have also been critical of the Fed’s payment of interest on reserves. Those economists must now ask for more of something they wanted none of. Operational considerations are confounding substantive policy.

All of the above is a consequence of the Fed’s having implemented extraordinary monetary policy. That included shedding all liquid, short-term Treasury obligations in favor of loading up on risky and illiquid, long-term debt obligations. Critics argued the Fed would rue the day it did that. Now that day has arrived.

[Cross-posted from Alt‑M.org]

When the Federal Open Market Committee (FOMC) meets in Washington next week, its members are widely expected to vote to raise interest rates for the first time since June 2006. By doing so, they will move towards monetary policy normalization, after more than seven years of near-zero interest rates, and a vast expansion of the central bank’s balance sheet.

But how did monetary policy become so abnormal in the first place? Were the Fed’s unconventional monetary policies a success? And how smoothly will implementation of the Fed’s so-called “exit strategy” go? These are among the questions addressed by Dan Thornton, a former vice president of the Federal Reserve Bank of St. Louis, in “Requiem for QE,” the latest Policy Analysis from Cato’s Center for Monetary and Financial Alternatives.

Thornton begins with an account of the Fed’s deliberations and actions during the early stages of the financial crisis. What’s particularly striking, looking back, is how the Fed resisted letting its balance sheet grow, or otherwise departing from its conventional, funds-rate targeting procedure, until the Great Recession was well underway.

In fact, from August 2007, when BNP Paribas suspended redemption of three of its investment funds, to September 2008, when Lehman Brothers filed for bankruptcy, the Fed loaned banks and others more than $300 billion. But these loans were sterilized—meaning that the Fed sold an equal amount of government securities. As a result, the Fed’s balance sheet didn’t grow, and neither did total bank reserves or the monetary base. For over a year, in other words, the Fed reacted to a growing liquidity crisis not by taking steps to boost credit in general, but rather by reallocating the existing supply of credit towards particular, troubled firms — a move George Selgin examined (and criticized) in detail in a recent post on this blog.

The Fed’s approach flew in the face of widely-acclaimed research presented by Milton Friedman and Anna Schwartz in their A Monetary History of the United States. As Thornton points out, Friedman and Schwartz “connected substantial reductions in the nominal quantity of money and credit to correspondingly large declines in economic activity, and declared it the Fed’s duty to act quickly to prevent such reductions by expanding the monetary base.” In 2007-08, however, no such action was forthcoming, and the crisis continued to intensify.

The sad part is that then-Fed chairman Ben Bernanke knew all this. Back in 2002, he concluded a speech in honor of Milton Friedman’s 90^th birthday by declaring: “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.” And yet, as Thornton makes clear, “it” — failing to expand the balance sheet in order to prevent a collapse of credit — is “precisely what the Fed did in the months leading up to Lehman Brothers’ failure.”

Eventually, the Fed was forced to change tack. Once Lehman Brothers collapsed, it found itself lending and buying assets on a scale that couldn’t possibly be sterilized via correspondingly large asset sales. The Fed’s balance sheet grew, bank reserves began to pile up, and the federal funds rate dropped well below the FOMC’s target. Unofficially, and almost by accident, quantitative easing (QE) began.

Quantitative easing was put on a formal footing in March 2009, when the FOMC announced the combined purchase of $750 billion of mortgage-backed securities and $300 billion of Treasuries. From the very beginning, however, it was clear that the Fed was not belatedly adopting a Friedmanite approach. The stated purpose of their asset purchases was not to boost the monetary base — that was just a side effect. Instead, the Fed’s goal was to manipulate the yields on certain long-term assets, in the hope that this would spill over into broader markets, and the economy as a whole.

How was it meant to work? Well, as Thornton points out, the rationale was “vague and highly uncertain,” and developed over time as QE was put into effect. But the general idea was twofold.

First, by forcing down yields on the long-term assets it was purchasing, the Fed hoped other investors would be induced to substitute those assets for similar, but somewhat higher-yielding alternatives. In turn, that shift in demand would push down yields on the alternative assets, encouraging investors who held them to rebalance their portfolios as well. As this ripple effect spread through the financial markets, equilibrium interest rates would fall.

Second, the Fed hoped that QE announcements would signal to markets that monetary policy was going to be “persistently more accommodative” — Ben Bernanke’s words — than previously thought. This would lower investor expectations for the path of short-term interest rates, and in so doing put additional downward pressure on long-term interest rates.

In short, then, the Fed expected QE to boost the economy through the interest rate channel of monetary policy: lower interest rates would boost equity prices and weaken the dollar; lower borrowing costs, higher wealth, and greater international competitiveness would drive spending, investment, and exports, and stimulate an ailing economy.

So did QE actually work in this way? Thornton assesses these claims in detail (see, in particular, pp. 12–22 of his analysis), and finds little — either in economic theory or in empirical evidence — to support them.

For one thing, as large as the Fed’s asset purchases were relative to previous open market operations, they were modest compared to financial markets as a whole. It is therefore “difficult to believe,” as Thornton puts it, “that the distributional effects of the FOMC’s quantitative easing policy could have had a significant effect on either relative yields or the level of the entire interest rate structure.” What’s more, the event-study literature on QE announcements does not offer any convincing evidence of their effectiveness, once you account for the effect of other, simultaneous announcements (Fed statements typically contain a variety of news capable of influencing bond yields).

The claim that QE announcements changed expectations for the path of short-term interest rates is similarly hard to substantiate, not least because event studies only show the immediate impact of such announcements — and for QE to reduce long-term interest rates via this signaling channel, its effect on expectations must be persistent. It is telling, moreover, that the Fed’s QE announcements did not even produce a consensus among FOMC participants about the expected path of the federal funds rate. That being the case, it is hard to see how those same announcements could have had a significant impact on market expectations — especially when it is well-established that interest rates are, in Thornton’s words, “essentially unknowable beyond horizons of a few months.”

Of course, that QE did not work as the Fed hoped does not mean it had no effect at all. As Thornton points out, “a monetary policy directed at keeping interest rates on low-risk securities near zero … is sure to cause people to seek higher yields by purchasing more risky assets.” Thornton suggests that pension funds, in particular, have been forced to hold riskier portfolios to generate the returns necessary to meet their obligations. As well as raising concerns about future financial crises, this distortion of investor behavior has had distributional effects: wealthy investors, who are better able to assume more risk, have benefited from booming equity prices, whereas as less well-off pensioners — who have good reason to be risk averse — have had to settle for miserly returns on their fixed-income portfolios.

What QE hasn’t done, however, is enhance the aggregate supply of credit to the market. This is hardly surprising, given that the Fed began paying interest on bank reserves in October 2008 — a move designed to encourage banks to build up excess reserves, instead of increasing lending. Indeed, when it came up at FOMC meetings, Ben Bernanke, Janet Yellen, and others expressly rejected the idea that QE would stimulate the economy by boosting bank lending. Still, when you couple this absence of increased credit with the lack of evidence that QE worked the way the Fed thought it would, you would be forgiven for wondering whether QE had any significant impact on output and employment at all.

What now? The Fed’s large-scale asset purchases are over, and the FOMC’s interest rate target looks set to gradually rise. But the Fed’s “exit strategy” remains a work in progress. Interest on reserves (IOR), for example, may yet prove a troublesome way of raising the federal funds rate. As Thornton points out, “An IOR of 3 percent … would see the Fed paying nearly $80 billion a year in interest to the commercial banking sector — something that is unlikely to prove popular in Congress or among the general public.”

Meanwhile, the Fed’s preferred alternative, overnight reverse repurchase agreements, would have to be rolled over continuously to have any effect on the size of the Fed’s balance sheet. A better approach, according to Thornton, would be to “begin the process of policy normalization by selling long-term securities slowly … If things go well, sales could subsequently be accelerated.” But the Fed seems reluctant to consider outright asset sales at all. This suggests that the bloated central bank balance sheet that QE created could be with us for some time to come — whether or not the FOMC votes next week to begin the process of policy normalization.

Yet the real legacy of QE may come in how the FOMC reacts to the next crisis. One concern is that the Fed seems to have lost “all confidence in the ability of markets to heal themselves,” and now assumes that “only monetary or fiscal policy actions” can “restore the economy’s health.” Another worry is mission creep: “If the Fed can support the mortgage and commercial papers markets … why shouldn’t it support the market for student loans — or any other market for that matter?” It’s a dispiriting prospect, but both of these observations suggest an increasingly hyperactive monetary authority going forward.

Ultimately, says Thornton, we should prepare ourselves for more of the same: given the opportunity, “the Fed will continue to distort markets until, by some as-yet-unknown magic, those markets return to normal.” One suspects that such magic may be a long time coming.

[Cross-posted from Alt‑M.org]

At the risk of belaboring the obvious, I feel compelled to begin this second installment of my response to Ben Bernanke’s memoirs with an observation — a platitude, if you like — concerning the proper role of emergency central-bank lending in a generally free economy.

The observation is simply that emergency lending, far from being an end in itself, is but one of many possible means by which a central bank might achieve the ultimate end of avoiding general reductions in lending and spending that might otherwise result in more general business failures — that is, in a recession or depression. For so long as the overall flow of spending remains stable, it must be the case, as a matter of simple logic, that aggregate business receipts do not fall remarkably short of aggregate outlays, and that the flagging incomes of particular firms are matched by the net revenues of others.

From this banal observation two others follow. The first is that central bank emergency lending can be justified only to the extent that it succeeds in keeping overall spending stable. The second is that a central bank that allows the overall volume of spending to collapse has blown it, no matter how much emergency lending it undertakes. Indeed, to the extent that a central bank engages in emergency lending while failing to preserve aggregate spending, it may be guilty of compounding the damage attributable to the collapse of spending itself with that attributable to a misallocation of scarce resources in favor of irresponsibly-managed firms. Thanks to moral hazard, the extent of such misallocation, instead of being proportionate to the actual volume of emergency lending, is augmented by the expectation that such lending will continue to be resorted to in the future.

In a previous post, I took Ben Bernanke’s Fed to task for contributing to the moral hazard problem during the recent crisis. It did this by repeatedly violating Walter Bagehot’s “dictum” (“lend freely at a high interest rate, against good collateral”), especially by extending credit to troubled institutions on collateral that was neither “commonly pledged” nor “easily convertible.” Although Bagehot himself never spoke in such terms, it seems to me that his emergency lending principles are broadly consistent with the overarching goal of preserving overall spending while limiting risk subsidies.

I now turn to consider the bearing of the Fed’s actions on the course of spending. As I have plenty to say on the topic, I plan to divide my observations into two posts, with this one dealing with the period prior to October 2008, and the next addressing developments after that. Still, I don’t want to keep anyone in suspense, so allow me to come right out and state my conclusion: Far from seeing to it that its emergency lending and subsequent large-scale asset purchases served to preserve the flow of aggregate spending, or to revive that flow following its collapse, Bernanke’s Fed went out of its way to make sure that the programs in question did no such thing.

Note that I am choosing my words quite deliberately: the Fed did not merely fail in its efforts to revive the flow of spending. It deliberately prevented such a revival, and by so doing prolonged the Great Recession.

Of course Bernanke and other Fed officials did not see things this way. They viewed the steps they took as ones essential to maintaining control of monetary policy. But what they imagined they were doing, and what they actually did, were two very different things.

What steps? Until the AIG bailout, the Fed made a point of “sterilizing” its emergency lending. Afterwards, finding that it lacked the resources it needed to continue to sterilize its loans and asset purchases, it sought to achieve similar results by alternative means. On September 17, 2008, the Treasury, at the Fed’s request, inaugurated its “Supplementary Financing Program,” whereby it issued additional Treasury bills, the proceeds of which were deposited in a new Fed account created for the purpose. Then, on October 1st, the Board of Governors announced that it would soon begin paying interest on depository institutions’ required and excess reserve balances. The Fed took these steps, which served either to drain reserves from the banking system, or to immobilize excess reserves that remained outstanding, for one reason only, to wit: to make sure that its crisis-related lending and asset purchases did not sponsor any corresponding increase in bank lending.

You need not take my word for it. Here is Bernanke’s own explanation of the Fed’s decision to sterilize its emergency loans:

We were facing what might prove to be a critical question: Could we continue our emergency lending to financial institutions and markets, while at the same time setting short-term interest rates at levels that kept a lid on inflation? Two key elements of our policy framework — lending to ease financial conditions, and setting short-term interest rates — could come into conflict.

When the Fed makes a loan, taking securities or bank loans as collateral, the recipient of the loan deposits the funds in a commercial bank. The bank in turn adds the funds to its reserve account at the Fed. When banks hold substantial reserves, they have little need to borrow from other banks, and so [sic] the interest rate that banks charge each other for short-term loans — the federal funds rate — tends to fall (p. 236).

Bernanke’s account calls for some further elaboration. It is, of course, not lending on the federal funds market per se, but a more general increase in lending, that has the capacity to “raise the lid” on inflation. Bernanke’s concern must, in other words, have been that the Fed’s emergency lending would result, not merely in a reduced federal funds rate, but in a general loosening of credit. Such a loosening was, evidently, not what Bernanke had in mind in claiming that the Fed’s emergency lending was supposed to “ease financial conditions.”

Sterilization, Bernanke goes on to explain, involved

selling a dollar’s worth of Treasury securities from our portfolios for each dollar of our emergency lending. The sales of Treasuries drained reserves from the banking system, offsetting the increase in reserves created by our lending (p. 237).

The sterilization shows up in the chart below (reproduced from James Hamilton’s Econbrowser) as a decline in the light-gray field representing the Fed’s holdings of (mostly Treasury) securities, which served to more-or-less perfectly offset its pre-AIG emergency lending.

To understand just how misguided the Fed’s sterilized lending program was, it helps to go back to the event that marked the beginning of the crisis: BNP Paribas’ August 9, 2007 decision to suspend withdrawals from three of its subprime mortgage funds. The French bank’s announcement had banks everywhere scrambling for liquidity. Bernanke’s description of the Fed’s response to that event makes for a revealing comparison with his subsequent defense of sterilized lending:

That morning, I emailed Brian Madigan…to instruct the New York Fed to buy large quantities of Treasury securities on the open market. The cash that the sellers of the securities received from us would end up in banks, meeting the banks’ increased demand for cash. If banks had less need to borrow, the federal funds rate should move back to target and the pressure in short-term funding markets should ease. If all went well, we would withdraw the cash from the system in a day or two.

Walter Bagehot’s lender-of-last-resort concept argues that central banks should stand ready during a panic to lend as needed, which in turn would help stabilize financial institutions and markets. Later that morning, consistent with Bagehot’s advice and my instructions to Brian, the New York Fed injected $24 billion in cash into the financial system (pp. 143–4).

Although Dan Thornton is probably correct in calling the Fed’s response to the BNP Paribas event “anemic,” the point remains that at the time Bernanke understood the Fed’s responsibility as being that of avoiding a general contraction of bank lending by seeing to it that the U.S. banking system as a whole remained well-stocked with reserves, which the Fed made available by means of net open-market asset purchases. A plot of excess reserves during 2007 and the first quarters of 2008 makes the point better than words can:

Notice that the increase in banks’ excess reserves in August 2007 was due to the Fed’s having expanded the monetary base, so as to loosen credit, and not to its having rewarded banks for holding reserves, as it was to begin doing in October 2008. Although paying banks to hold reserves led to very substantial growth in banks’ excess reserve holdings, that policy served not to loosen credit but to tighten it.

In contrast to the Fed’s actions in August 2007, its subsequent turn to sterilized lending had it, not buying, but selling Treasury securities, with the aim of preventing its emergency lending from resulting in any overall increase in the supply of bank reserves. Financial conditions were thus “eased,” not generally, but for particular institutions and their creditors. For the rest, credit was actually tightened. Because it serves to redistribute credit rather than to alter its overall availability, sterilized lending is properly regarded, as Marvin Goodfriend insists, as an exercise in fiscal policy rather than one in monetary policy in the strict sense of the term. The principal beneficiaries of this fiscal policy were the creditors of the aided institutions, while the losers were those prospective borrowers who were denied credit because the Fed had directed the reserves that might have supported lending to them elsewhere.

Between December 2007 and September 2008, the Fed sold over $300 billion in Treasury securities, withdrawing a like amount of reserves from the banking system, or just enough to make up for reserves it created through its emergency lending, chiefly through its Term Auction Facility. Bank lending suffered, because available reserves, instead of being augmented to accommodate the increased demand for liquidity that normally accompanied worsening economic conditions, were instead withdrawn from relatively well-capitalized institutions while being supplied to ones that were more likely to be capital-constrained.

After mid 2008, commercial and industrial bank loans, having peaked as borrowers drew on existing lines of credit, went into sharp decline:*

The reduced lending contributed to an equally precipitous decline in overall spending, as measured by nominal GDP:

What was the FOMC thinking? It isn’t the case that it was blind to what was happening to bank lending, or to the fact that the economy was contracting. “In a particularly worrisome development,” Bernanke writes concerning the situation as of August, 2008,

our quarterly survey of bank loan officers had revealed that banks were tightening the terms of their loans, especially loans to households, very sharply. The staff maintained its view, first laid out in April, that the economy was either in or would soon enter recession (p. 238).

In fact, as the NBER subsequently determined, the Great Recession began back in December 2007. Yet even with the benefit of hindsight Bernanke insists that sterilization was called for, because it alone allowed the Fed “to make loans as needed while keeping short-term interest rates where we wanted them” (ibid.). In particular, the Fed wanted to keep the federal funds rate at 2 percent, where it had been since April.

But why 2 percent, rather than 1 percent, or (for that matter) zero percent? According to Bernanke, the Fed determined to keep its rate target unchanged owing to concerns about inflation. In early August the Fed’s economists were predicting a core CPI inflation rate of 2.5 percent (which was also the rate over the course of the proceeding year) — high enough to cause one FOMC hawk, Richard Fisher, to actually favor raising the federal funds target rate. According to Bernanke, the FOMC

could not completely dismiss inflation concerns. Oil prices had fallen to $120 per barrel from their record high of $145 in July. However, staff economists still saw inflation running at an uncomfortable 3–1/2 percent in the second half of the year. Even excluding volatile food and energy prices, the staff expected inflation to pick up around 2–1/2 percent, more than most FOMC members thought was acceptable (p. 238).

In retrospect it is all too clear that the hawks were mistaken, and that the FOMC ought to have paid less attention to inflation (and to headline inflation especially), and more attention to NGDP and other measures of total spending. Scott Sumner and other Market Monetarists have harped on this for some time, so I won’t bother to repeat their arguments.

But there’s a more fundamental point I think worth emphasizing, which is that conceiving of monetary stability as a matter of stability of total spending, or aggregate demand, or NGDP — call it whatever you like — makes nonsense of any supposed “conflict” between maintaining an appropriate monetary policy stance (“setting short-term interest rates”) and keeping the financial system liquid (“eas[ing] financial conditions”), for the connection between a sufficiently liquid financial system and a stable flow of spending is (or ought to be) obvious in a way that the connection between a sufficiently liquid financial system and, say, a stable rate of inflation, is not. Had the Fed acted to preserve overall liquidity in the financial system, instead of letting would-be borrowers go begging for the sake of bailing-out troubled firms, overall spending might never have collapsed.

Please do not misunderstand me: I am not claiming that the Great Recession was entirely due to the Fed’s failure to maintain a steady flow of overall spending during 2008. I am not pretending that by doing so it could somehow have erased all the losses and prevented all the failures connected to the subprime bust, let alone prevented the bust itself. Nor do I mean to deny that easy money contributed to the boom that led to the bust. I am saying that, whatever part the Fed played in the boom, it also deepened the bust by keeping money excessively tight throughout much of 2008. There is no economic law that says that central banks must err only on the side of loose money, or only on the side of tight money. They can, and do, err both ways.

Just as a rising tide lifts all boats, a collapse in aggregate spending depresses all markets, including the market for overnight funds. The collapse was therefore bound eventually to undermine the Fed’s 2 percent funds target, and (as the chart below suggests) would have done so even if the Fed had continued to sterilize its emergency lending. The irony of this is that, by attempting, by hook and by crook, to hold the federal funds rate at 2 percent, the FOMC, far from succeeding in keeping interest rates a safe distance from their zero lower bound, propelled them in that direction. As any fan of Knut Wicksell will tell you, this outcome was, according to that great economist, inevitable once the “natural” funds rate fell below the Fed’s target.

With its September 2008 rescue of AIG, the Fed exhausted its capacity to sterilize its emergency loans. Yet instead of giving up its goal of keeping the fed funds rate pegged at 2 percent, and allowing its emergency asset acquisitions to assist a revival of bank lending in what was by then a downward-spiraling economy, the Fed remained determined to keep a lid on credit. It found a new means for doing so in the permission Congress had given it two years earlier, for reasons quite unrelated to the crisis, to pay banks interest on their excess reserves. I plan to discuss the consequences of that fateful discovery in another post.

***

P.S.: In a post he published yesterday, David Beckworth offers some further evidence of the Fed’s having engaged in what he calls “passive tightening.”

______________________

*I have corrected the graph after having originally published an erroneous one.

In the late 1990s, as the Banco Central de Ecuador rapidly expanded the quantity of its currency–the sucre–prices denominated in sucres soared into hyperinflation. In response, Ecuadorians spontaneously adopted the U.S. dollar as a far safer savings vehicle, a far less chaotic pricing unit, and a far more reliable medium of exchange. Demand to hold sucres all but disappeared. With the collapse of the sucre, Ecuador’s government finally bowed to the market verdict and officially dollarized in January 2000. (I have previously written about these events here).

Dollarization has been a clear success. The Ecuadoran monetary and banking systems have been much more stable and trustworthy (real bank deposits have grown considerably) since dollarization, and the economy has enjoyed better growth despite being ruled by a political party that speaks and acts in anti-market tones. Because of its success, dollarization is enormously popular. Even President Rafael Correa, who has complained that dollarization is a “straitjacket” because it prevents expertly managed monetary policy (this is in fact its greatest virtue), promises not to undo dollarization.

This background is useful for considering a recent Wall Street Journal news analysis article entitled “Cheap Oil and Strong Dollar: Ecuador’s Twin Troubles” by Carolyn Cui and Manuela Badawy. As many other writers have done, Cui and Badawy suggest that dollarization is currently hurting Ecuador, that the country “has the misfortune to be an oil producer with a ‘dollarized’ economy that uses the U.S. currency as legal tender.”

Compared to what are these misfortunes? Having oil resources is better than not having them (provided that the wealth is not entirely squandered in battles to control it). And being dollarized has clearly been better for Ecuador than the unanchored monetary policy that preceded it.

Cui and Badawy acknowledge that “dollarization helped officials rein in inflation in 2000.” But this is oddly put. Dollarization is not a policy that local experts can manipulate as a tool, so it is odd to say that it “helped officials” to reduce inflation. Dollarization itself has reined-in inflation. Local officials merely got out of the way. Under dollarization, arbitrage in traded goods ties the dollar price level in Ecuador to the dollar price level in the United States, more or less tightly, just as it ties the California price level to the overall U.S. price level. Inflation rates cannot widely diverge. No local management is needed.

Cui and Badawy immediately continue with the supposed downside: “Now, [dollarization] is depriving them of the relief valve a depreciating local currency can provide at a time when the drop in oil prices is hurting its exports.” This is exactly the line taken by President Correa, who a year ago said that “Dollarization was a bad decision” and that “Right now, it is doing exactly the opposite of what it must do to address the scenario of falling oil prices.”

How might a depreciating currency provide a “relief valve” in a period of declining oil export revenues? Relief can’t come from changing the world prices of Ecuador’s other main exports. Just as oil is competitively and flexibly priced in dollars on world markets, so too are fresh flowers, fresh fruit, and seafood. Flowers grown in a weak-currency country do not have a selling-price advantage over flowers grown in a strong-currency country. The coherent argument for a “competitive depreciation” is rather that considered in dollar terms it cuts wages and other input payments that are priced in local currency. Such input price reductions, the argument goes, are appropriate given the reduced demand for labor and other inputs that follows from the drop in oil revenue (or similar negative productivity shock). And depreciation makes the reductions faster (in a world of “sticky” wages and prices) than can be achieved by waiting for unemployment to force reductions in nominal wages and other input prices. Non-oil export businesses can take advantage of higher profit margins to expand their output and sales.

For the sake of argument, let us suppose that a prompt reduction of wage rates in dollar terms by a certain percentage is indeed prudent in this case and that a timely, well-measured depreciation of the local currency could accomplish this. Is this a cost of dollarization? Yes. It is nonetheless a mistake to think that it follows that the country would be better off with a monetary regime in which the currency sometimes depreciates against the dollar.

Depreciation is not a measure that can be considered in isolation. It is only possible under a different monetary regime. We need to compare total costs and benefits of alternative regimes. Or in statistical terms: a regime that commits some Type I errors may still be much better than a regime that commits massive costly Type II errors.

There are two alternative regimes to dollarization to consider: an adjustable peg against the dollar and freely floating exchange rates. The first problem with an adjustable peg is that no expert knows in real time exactly how much wages and other input prices should be cut in dollar terms, and therefore the central bank cannot know just how much to devalue the currency against the dollar. It can easily err in the direction of overdoing it. The second and larger problem is that a pegging regime is simply not viable in a world of free capital flows. When the market begins to suspect that a devaluation is coming, speculators attack the currency, draining dollar reserves from the central bank, and forcing a devaluation that is likely to be larger than what was theoretically desired.

A freely floating exchange rate regime avoids the problem of speculative attack. And the market rather than the local central bank adjusts the exchange rate. But floating has its own fundamental problem: it removes the constraint that dollarization provides against the chronic problem of excessive money creation by the central bank. The “fear of floating” historically exhibited by many Latin American countries is justified: floating makes the inflation rate and the exchange rate unpredictable, which damages local capital markets and the financing of productive investment. High devaluation risk means highly risky real returns on long-term claims denominated in the local currency (call it “pesos”). The market for long-term peso bonds and mortgages evaporates. Foreign investors with dollars are similarly discouraged from bringing them into the peso economy by devaluation risk. Economic growth suffers.

The relevant alternative to dollarization is thus not an imagined regime in which precisely calibrated depreciations of the local currency’s exchange rate are administered by experts to adjust wages. To give a central bank like Ecuador’s discretion in issuing its own currency is to discard the dollar anchor that currently holds the public’s inflation expectations in place and thereby stabilizes the system. There is no way for the central bank to make a credible pre-commitment to use depreciation only for warranted real wage corrections.

The replacement of the dollar by a New Sucre that can be depreciated by the Banco Central would immediately be greeted by justified suspicion that, as with the old sucre, the New Sucre will be copiously issued and depreciated. Few would voluntarily switch from dollars to the New Sucre. Forced conversions of currency and deposit holdings would be necessary to get the new currency into circulation, hardly a sign that the new regime would improve consumer welfare. Inflation expectations would once again be unmoored, and indeed the public would justifiably fear a return to very high inflation. Speculative attacks would likely drive depreciation far beyond any extent desired by the experts. Exchange-rate chaos would return.

The lesson here is that Ecuador’s exchange rate against the dollar cannot be re-pegged while the benefits of dollarization are retained. Re-pegging implies a fundamental change in the monetary regime, which history and theory tell us would be a strong turn for the worse. The suggestion that dollarization is hurting Ecuador is based on a very myopic accounting of the costs and benefits.

[Cross-posted from Alt‑M.org]

More than two hundred people gathered at the Cato Institute last Thursday for our 33rd Annual Monetary Conference. Over the course of three addresses and four panel discussions, a distinguished cast of speakers — including St. Louis Fed president James Bullard, Richmond Fed president Jeffrey Lacker, and Stanford economist John Taylor — covered topics ranging from the rights and wrongs of monetary rules, to the ins and outs of the Fed’s long-awaited “exit strategy” from quantitative easing and near-zero interest rates. If you didn’t make the event, here’s a synopsis.

Opening Keynote

Bullard kicked things off with the keynote address, noting that while he favors policy normalization — that is, a return to the kind of monetary policy (and Fed balance sheet) that prevailed between 1984 and 2007 — there is a risk that we’ll get stuck at “Permazero” if the economy fails to take off, or suffers new negative shocks. He speculated that inflation would stay persistently below target in such a scenario, while monetary policy would lose its power to stimulate or stabilize. Long-run growth would continue to be driven by real factors, but asset prices could become very volatile. Bullard stressed that this was just one possible interpretation, and that it didn’t change his view that the Fed should begin raising rates and shrinking its balance sheet. Nevertheless, he said, we should be prepared for the possibility that things do not go according to plan.

Panel 1: What Monetary Policy Can and Can’t Do

The day’s first panel, moderated by Wall Street Journal chief economics correspondent Jon Hilsenrath, focused on what monetary policy can and cannot do. There was a broad consensus among the panelists — the Richmond Fed’s Jeffrey Lacker, the Bank of Mexico’s Manuel Sanchez, and George Tavlas of the Bank of Greece — that monetary policy should focus on price stability, while steering clear of objectives it is less suited to, like boosting growth, guaranteeing financial stability, or pricking asset bubbles. Within that discussion, Tavlas made the case for monetary rules over “constrained discretion,” suggesting that Milton Friedman might be sympathetic to the Taylor rule if he were around today.

Panel 2: Inflation, Deflation, and Monetary Rules

Monetary rules were the focus of the next panel, which featured John Taylor (he of the eponymous rule), former Philadelphia Fed president Charles Plosser, the Mercatus Center’s Scott Sumner, and our very own George Selgin. Although all four panelists favored a shift towards rule-based monetary policy, each took a different approach.

Plosser noted that the Fed already runs five different monetary rules through its model of the economy when preparing for Federal Open Market Committee meetings. So why not release the results of that analysis, and use it to explain how policy decisions are made? Sumner advocated a similarly incremental approach, suggesting the Fed could be “nudged” towards his favored paradigm — NGDP targeting — with requirements that it clearly define the “stance of monetary policy” in its communications, regularly review its past policy decisions, and set “guardrails” for the maximum permissible fluctuations in aggregate demand. Selgin drew a distinction between rules and “pseudo-rules,” arguing that the former must be strictly enforced, hard to “innocently” break, and possible to stick to during a crisis. Taylor, meanwhile, argued that capricious monetary policy was promoting massive capital flows between emerging and developed economies, stoking exchange rate volatility, and giving rise to widespread capital controls and currency manipulation. Rule-based monetary policy, he suggested, is a necessary complement to open capital markets and floating exchange rates — and legislation in the U.S. would set a great example for the rest of the world.

Luncheon Address

Claudio Borio, the head of the monetary and economic department at the Bank for International Settlements (BIS), delivered the conference’s luncheon address, arguing that we need to reassess “three pillars” of received monetary policy wisdom — first, that the natural rate of interest is best defined in terms of output and inflation; second, that money is neutral; and third, that deflation is always and everywhere a disaster. Borio rejected all three premises. He preferred to think of the “natural rate” as one which is consistent with good, sustainable macroeconomic performance. According to this view, financial imbalances (such as asset price bubbles) are the key signifier of disequilibrium. Borio also questioned the idea of monetary neutrality, arguing that credit-induced resource misallocation is central to an accurate understanding of the economic cycle. This means that easy money can’t always solve our problems; you need structural and balance sheet reform after a crisis. Finally, on deflation, Borio highlighted BIS research suggesting that there is only a weak association between deflation and economic contraction. What link there is derives largely from the Great Depression and is more aptly attributed, in that case, to a collapse in asset prices. In reality, said Borio, garden-variety falls in the prices of goods and services do not always portend doom — and shouldn’t always spur offsetting policy actions.

Panel 3: Monetary Policy and the Knowledge Problem

The monetary conference’s third panel discussion focused on Hayek’s knowledge problem in the context of monetary policy. Cato senior fellow Gerald O’Driscoll suggested that the knowledge problem explains why rule-based monetary policy is superior to central bank discretion — we don’t know enough to design an optimal monetary policy, so we’re better off using rules to create a monetary order and anchor expectations. The American Enterprise Institute’s Alex Pollock took a similar approach, asking, “Does the Federal Reserve Know What It’s Doing?” His answer was a resounding “no” — but it’s not their fault, said Pollock; it’s fundamental uncertainty, not incompetence, that dooms the Fed to recurring failure. Speaking last, David Malpass of Encima Global LLC added his voice to calls for monetary policy normalization, arguing that the Fed’s zero-interest rate policy is actually weighing down economic growth.

Panel 4: The Fed’s Exit Strategy vs. Fundamental Reform

The prospect of monetary policy normalization provided the backdrop to the day’s final panel discussion: “The Fed’s Exit Strategy vs. Fundamental Reform.” Alt‑M contributor and George Mason University economics professor Larry White tackled the first half of that title. He argued that quantitative easing (QE) wasn’t really a monetary policy at all: by deciding to pay interest on bank reserves held at the Fed, policymakers effectively “sterilized” QE, which meant it barely affected the broad-money (M2) aggregates. What sterilized QE did do, however, was to preferentially allocate credit towards housing over other uses. In this context, an “exit strategy” worthy of the name must put an end to this discretionary credit allocation — but, alas, there’s little indication that the Fed has any intention of doing that. Jerry Jordan, former president of the Cleveland Fed, was similarly gloomy about the prospects for a meaningful exit strategy, arguing that monetary policy has lost its potency now that banks are no longer reserve-constrained, and questioning the Fed’s ability to normalize policy even if it wants to. Kevin Dowd, an adjunct scholar at Cato’s Center for Monetary and Financial Alternatives, brought the session to a close by outlining a bold agenda for fundamental monetary and financial reform, eschewing incremental steps in favor of a re-commoditized dollar, an entirely new bank capital regime, radically reformed bank governance, and a thoroughgoing roll-back of government intervention in the United States’ monetary and financial system.

Closing Address

The closing address of the 33rd Annual Monetary Conference was delivered by Rep. Bill Huizenga (R‑Mich.), who chairs the House Financial Services Subcommittee on Monetary Policy and Trade. His remarks focused on the draft legislation he unveiled earlier this year, which would require the Fed to adopt an explicit policy rule, and grant greater auditing power to the Government Accountability Office, among other reforms.

If you missed the conference, video footage of all the sessions is available here, on Cato’s website. The papers submitted to the conference will also be published in next year’s Spring/​Summer issue of the Cato Journal.