Arnold Kling  

What Could Go Wrong?

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Suppose Scott Sumner or his evil twin took over the Fed. The Fed would try to create expectations of returning nominal GDP back to trend relatively soon. These expectations would hit financial markets before they hit goods markets. They will hit prices before they hit wages. Presumably, the public would sell dollar-denominated bonds to try to get into foreign bonds, commodities, or possibly stocks.

The U.S. dollar depreciates, so that exports grow faster than imports. Maybe nominal interest rates do not rise as rapidly as inflation expectations, so we get an investment bubble somewhere. Overall, demand for output rises, and real wages fall, so labor demand picks up, and we return relatively quickly to full employment. That is if all goes well.

But perhaps all will not go well.


a chorus of Chinese officials and advisers is demanding that China switch reserves into gold or forms of oil. As this anti-dollar revolt gathers momentum worldwide, the US risks losing its "exorbitant privilege" of currency hegemony - to use the term of Charles de Gaulle.

Some possible unintended consequences should the Fed adopt a Sumnerian policy that the markets find credible:

1. The massive shift out of long-term nominal bonds into short-term instruments and commodities causes large financial institutions to go under. Imagine, on top of everything else, large European and American banks having to mark down the value of their long-term bond holdings by 30 percent or more.

2. The commodity boom destabilizes the global economy. Commodity-rich countries grapple with inflation and bubbles, while commodity-poor countries grapple with poverty, famine, and civil war.

3. The loss of confidence in the monetary unit creates problems in financial contracting. Capital suppliers and demanders find it very costly to develop instruments to protect themselves against extreme volatility in relative currency values and inflation rates. Capital investment plummets.


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CATEGORIES: Monetary Policy



COMMENTS (12 to date)
Babinich writes:
The U.S. dollar depreciates, so that exports grow faster than imports.

Arnold,

How does a lower dollar benefit us if those we export to implement tariffs?

fundamentalist writes:

Babinich, exactly! What good will a trade war do us? Does the Fed honestly believe that the rest of the world holding dollars are going to sit back and smile while we ram this rod up their posterior?

And don't expect a lower dollar to boost exports and reduce imports. There is virtually no statistical correlation between FX and trade.

Brett writes:
a chorus of Chinese officials and advisers is demanding that China switch reserves into gold or forms of oil. As this anti-dollar revolt gathers momentum worldwide, the US risks losing its "exorbitant privilege" of currency hegemony - to use the term of Charles de Gaulle.

Wouldn't that actually help the US in a number of ways? Dumping a bunch of dollars would lower the value of the currency, boosting our exports.

mlb writes:

We discover that wages are not the issue limiting hiring. Inflation does rise - but it all comes in the form of commodities & "costs of living" and very little comes in the form of wages or rent/house appreciation. The cost of living rises while the poorer population remains out of work. The people who consider themselves "have-nots" (probably 50% of the population at this point) finally wake up and discover that they are a massive voting contingent and elect someone who promises radical wealth redistriubtion. Capital flees and class warfare becomes front-and-center.

Hyena writes:

The question always begged is: where does that money go? Europe doesn't write enough bonds, no other capital markets are deep enough. Worse still, the investment has to be somewhere that gives a good return to pegs with a low seigniorage risk.

So where do these countries invest their currency peg holdings? Swiss francs?

They could invest in a "basket of currencies" but we've all seen just how willing anyone is to actually do that. Moving trillions of dollars in peg funds to a "basket of currencies" will probably deeply upset that basket and the largest holders are probably aware of that.

mlb writes:

Hyena, as a small hedge fund manager I can tell you my vote for a USD-alternative would some sort of commodity-linked notes. That is a massive risk to the financial system. The US benefits very little from commodity appreciation.

John writes:

"The massive shift out of long-term nominal bonds into short-term instruments and commodities causes large financial institutions to go under. Imagine, on top of everything else, large European and American banks having to mark down the value of their long-term bond holdings by 30 percent or more."

You seem to be saying that a Sumnerian policy would cause the nominal yield curve to steepen and the banks would get hit by the duration.
1) After the adjustment process, the higher nominal interest rates would also encourage more people to lend money than they would have at the lower rates.
2) A 30% decline in the value of their long-term bonds sounds a bit excessive. If Treasuries have a duration of 7, a -30% decline implies more than a 4% rise in rates. Unlikely that happens immediately following the announcement. Further, you said that nominal rates will rise less slowly than inflation expectations. I'm not sure Sumner is looking for more than 1%(current)+4%=5% inflation.
3) Many corporate bonds pay floating rates tied to Libor and if they don't the banks can swap the fixed payments for floating.
4) They could still swap fixed government rates for floating if they wanted to manage that risk and bring down the duration of their bond portfolios. Of course, this would only make the adjustment happen more quickly.

Philo writes:

You should not say that there would be a "massive shift out of long-term nominal bonds into short-term instruments and commodities" if the Fed credibly promised to goose future NGDP. The prices of long-term nominal bonds would decline, but why think the amount of such bonds issued or outstanding would decline? True, the prices of commodities would increase, and this might well increase the supply (in spite of the increased cost of production)--indeed, that's part of the point, to "get the economy moving again." But this would not constitute a "shift": a shift out of *bonds* into *commodities* is possible for an individual investor, but makes no sense for the economy as a whole.

Philo writes:

Sumnerian Fed easing would cause no loss of confidence in the dollar. Everyone would be supremely confident that the dollar would decline in value by about 2% per annum, indefinitely. Any "volatility in relative currency values" would be due to volatility in the other currencies, not in the dollar.

Hyena writes:

MLB,

I wish Bancor would die already.

The most likely dump-the-dollar scenario is actually that Asia starts dropping its currency pegs altogether. That's incredibly unlikely because, to be honest, export-oriented economies are their version of the American military: a pointless source of national pride.

mlb writes:

Hyena, i would have agreed a year ago but I think the export-oriented economies are starting to realize the game is ending. There is no point taking massive capital losses to serve a customer that is shrinking.

Hyena writes:

MLB,

Got some actual examples?

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