Fiscal Cliff, Platinum Coin, and Reign of the Dollar

Almost two years ago, Barry Eichengreen published an op-ed called "Why the Dollar's Reign is Near and End." The article condenses many of the arguments of his book Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. He writes (my emphasis added):

Finally, there is the danger that the dollar's safe-haven status will be lost. Foreign investors—private and official alike—hold dollars not simply because they are liquid but because they are secure. The U.S. government has a history of honoring its obligations, and it has always had the fiscal capacity to do so. 

But now, mainly as a result of the financial crisis, federal debt is approaching 75% of U.S. gross domestic product. Trillion-dollar deficits stretch as far as the eye can see. And as the burden of debt service grows heavier, questions will be asked about whether the U.S. intends to maintain the value of its debts or might resort to inflating them away. Foreign investors will be reluctant to put all their eggs in the dollar basket. 

The recent fiscal cliff fiasco and the current debt ceiling and platinum coin issues make me wonder if Eichengreen's prophesy is coming closer to fruition. So I started by looking at the exchange rate of the dollar against some other currencies from 2011 onwards. I chose the Canadian Dollar (blue line) and the Australian Dollar (green line), since the IMF recently declared them official reserve currencies, and since they are not as contaminated by recent events as the Euro and the yen. Look at the very far right of the graph, and you see both series drop down. That means that the dollar lost value relative to those currencies. One U.S. dollar can buy less Canadian or Australian dollars than before. In other words, the U.S. dollar got weaker.

Let's zoom in and have some fun with Google. I looked at Google trends data for the term "fiscal cliff." Google Trends gives you a measure of search volume for a particular term over time. The thick green line is the search volume for "fiscal cliff" and the dashed line marks its maximum. Notice how, when concern about the fiscal cliff got really high, the dollar got weaker. After President Obama signed the bill on January 2, the dollar continued to weaken, though not as drastically (the flatter downward slope). This is just a "playing around" finding and obviously not econometrically rigorous, but lends some anecdotal evidence to Eichengreen's predictions. Severe fiscal problems are chipping away at the dollar's "exorbitant privilege." If you want to have some fun, try out making a similar graph with the search term "platinum coin."

Kristoffer Nimark on "Man-bites-dog business cycles"

I am excited to attend the UC San Diego macroeconomics seminar tomorrow at 3:30. Kristoffer Nimark will be presenting a paper called "Man-Bites-Dog Business Cycles." From the abstract:

The newsworthiness of an event is partly determined by how unusual it is and
this paper investigates the business cycle implications of this fact. We present a tractable
model that features an information structure in which some types of signals are more likely
to be observed after unusual events. Counterintuitively, more signals may then increase
uncertainty. When embedded in a simple business cycle model, the proposed information
structure can help us understand why we observe (i) large changes in macro economic
aggregate variables without a correspondingly large change in underlying fundamentals (ii)
persistent periods of high macroeconomic volatility and (iii) a positive correlation between
absolute changes in macro variables and the cross-sectional dispersion of expectations as
measured by survey data.

There is still a lot to learn about how information and uncertainty affect the macroeconomy. There are so many news headlines like ``Prolonged Uncertainty Impacting Small Businesses’ Ability to Create Jobs" and "Weak job picture, uncertainty drove QE3," but very little understanding of how uncertainty is generated and propagated and how it interacts with the business cycle. One interesting recent paper on this topic is Nicholas Bloom and Scott Baker's paper, "Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments." I am doing some research in this area myself.

Copernicus and the Platinum Coin

Fun fact: Copernicus was a monetary theorist. Yes, the astronomer extraordinaire who worked out a theory of the revolution of celestial spheres also turned his attention back down to earth to consider currency reforms in his native Poland. At the time (early 16th Century), Poland had three different types of currency. All were made of precious metals, but were subject to frequent debasement, since the state could alter their value by decree.

Copernicus explained that Gresham's law was at work. When multiple coins are in circulation, those with cheaper metallic content relative to their value will be used for payment, while those with more expensive metallic content will be melted down for their metal and disappear from circulation. In short, "bad money drives out good." Copernicus also was an early developer of the quantity theory of money, that prices vary directly with the size of the money supply. He thought that the government needed to stop minting so many coins if they wanted to solve the inflation problem. He published his monetary ideas in Monetae cudendae ratio in 1526.

Copernicus focused on coins whose value derived from their metallic content. Today, of course, our paper currency does not get its value based on the value of the paper itself; it is not commodity currency, but fiat currency. What about the trillion dollar platinum coin we keep hearing about in the debt ceiling discussions? It would not get its value from its metallic content either. The government does not actually have a trillion dollars worth of the commodity platinum to mint into a coin. The coin would just use a small amount of platinum, and have its value by fiat. It is just as if the President were allowed to print a trillion dollars of paper money, which he's not. (That's why the platinum coin scenario is called a loophole.)

Something Economists Can Agree On

It turns out economists can agree on something: why they disagree. Chicago Booth conducts an "Economic Experts Panel" that asks top economists from top departments their opinions on economic policy questions. Along with their answers, the economists say how confident they are of their answers. Weighted by confidence, 98% of economists either agreed or strongly agreed with the following statement:

Question C: Although they do not always agree about the precise likely effects of different tax policies, another reason why economists often give disparate advice on tax policy is because they hold differing views about choices between raising average prosperity and redistributing income.

None of the economists disagreed with the statement, and just a handful did not answer or had no opinion. Richard Thaler agreed, and wrote in the comment, "duh."

This just serves as a reminder, in the ongoing tax debates, of what we are actually debating. Not "taxes are good" versus "taxes are evil," but the relative benefits of raising average prosperity versus redistributing income. Raising average prosperity and redistributing income are not necessarily opposed, but different policies do a different balance of the two.

What's the Basel Buzz?

The financial press is abuzz this morning with news about a decision to ease the Basel rules regulating international banking. What does this mean? Are we entering a new period of financial deregulation so soon after the financial crisis?

In short, no. The Basel regulation at issue is the Liquidity Coverage Ratio (LCR), which will require banks to hold an adequate buffer of highly liquid assets--basically things like cash and treasuries-- to help them meet unexpected short term needs. In a period of financial distress, a lot of people might want to withdraw their money from the banks, but if the bank has too much money tied up in illiquid assets, then it won't be able to meet this demand for liquidity, and the central bank will have to step in and rescue the bank by acting as lender of last resort.

Banks don't earn much money on the liquid assets they hold, so they would gladly hold less of them and let the central bank come to the rescue when needed. But the central bank and the taxpayers want to keep expensive rescue efforts to a minimum, via regulations that require banks to hold adequate liquidity. Basel tries to harmonize regulations across countries so that a bank can't just move its headquarters to the country with the least strict regulations.

The LCR was set to be fully implemented by 2015. The decision this weekend was to implement it gradually, starting in 2015, but not fully until 2019. The other part of the decision was to count a wider variety of assets as highly liquid. So the news is not that an existing requirement is being loosened, but that a future requirement is being pushed further into the future and slightly loosened. Banks in 2015 and in 2019 will still be more regulated than they are today. Most of the press coverage notes how European bank stocks have surged at the news. Stock prices reflect expected future profits. Since banks will be able to hold less liquid assets from 2015 to 2018 than they would have without this decision, their profits will be higher in those years, so their stock price is higher now. There is also a greater chance that government bailouts may be needed.

The financial crisis inspired a lot of new proposed regulations. Many of them are so controversial that their implementation keeps being delayed. I see regulations set to be implemented several years from now as still subject to revision, and do not count revisions as deregulation.

Central Bank Independence

I remember a worksheet my teacher gave us in early elementary school called "Smiley Words and Frowny Words." We had a vocabulary list and were supposed to draw the appropriate smiley or frowny face to match the positive or negative connotation of the word. Most of the words-- freedom, fortune, distress-- had definitely positive or definitely negative connotation. But I remember being puzzled when I started trying to classify all the other words I could think of, and most seemed neither smiley nor frowny. Some words have emotions already attached, but the vast majority have a neutral connotation, and gain meaning only from context. This was astounding to me as a seven year old, and may explain some part of why I became a scientist and a writer, and my approach to both of those roles.

In my last post I wrote about a threat to central bank independence in Japan. At least, that is how it was phrased in all of the news articles that covered the story. None of the articles explained what central bank independence actually means, or why it matters. But at least to American ears, independence is a happy word. For anyone who went through the American school system, the word brings about a mental image along the lines of Thomas Jefferson waving the Star Spangled Banner while an eagle soars overhead. Oh, and plenty of fireworks. Yes, independence sounds good, and a threat to independence sounds like something we should be very angry about.

But when it comes to central banks, the concept of independence should, a priori, be neutral. Economists don't actually have conclusive evidence about whether or not central bank independence is beneficial-- probably in some cases it is, and in some cases it isn't, and it all depends on how you want to define independence and beneficial. I listened to some top economists discuss the matter for four hours on Friday, at two sessions of the American Economics Association conference, and reach no strong consensus. After one of the sessions, Fox almost instantly published an article crying  that "Central banks have sacrificed some of their cherished political independence."

The article makes no indication that this cherished political independence is of questionable value. Nobel Prize winner Joseph Stiglitz has remarked that
"...one of the central principles advocated by Western central bankers- the desirability of central bank independence-was questionable at best…In the crisis, countries with less independent central banks-China, India, and Brazil-did far, far better than countries with more independent central banks, Europe and the United States. There is no such thing as truly independent institutions. All public institutions are accountable, and the only question is to whom."
The issue of central bank independence is very relevant right now, not just for Japan but also for the United States, India, and much of Europe. I think, because of the connotation of the word independence, that people will just assume that more independence is better. And it really does matter what the public thinks, since this is a highly political issue. What we really need is central bank effectiveness, and in some cases that may come from more cooperation with other parts of government. In Japan, where inflation is too low, the new Prime Minister Shinzo Abe is pressuring the Bank of Japan to share a 2 percent inflation target with the government. The Bank of Japan will vote on the new target on January 21-22. A united front by the Bank and the government might be just the ticket to making the inflation target credible and reviving the long-suffering Japanese economy. 

I may write more about central bank independence in a future post, but the point I really want to make is that the economy depends on policies and politics, which depend on public perceptions. And as much as economists would like to believe that people are all perfectly rational and attentive decision-makers, really almost all of us make a lot of decisions really quickly, based on gut responses emotional reactions. We skim an article and make a smiley face or a frowny face. That's not a bad thing; gut responses and emotional responses make life worth living. It is just something economists and readers of economics need to be aware of, and part of the reason why it is so important for economists to learn to communicate better.

Communication about economics the topic of a panel discussion I attended yesterday called "Models or Muddles: How the Press Covers Economics and the Economy." Some of the biggest names in economic journalism were there-- Tyler Cowen, Adam Davidson, Kelly Evans, Chrystia Freeland, and David Wessel. Adam Davidson, from NPR's Planet Money, talked about the craft of making an emotionally compelling narrative in economic journalism while remaining intellectually upright. He mentioned how a story about the housing crisis, for example, should have a human element but shouldn't feature the "most sad-sack" person you can find just to make the banks seem evil. I couldn't agree more.

Inflation Targeting Pressure in Japan

I recently wrote an article for the forthcoming Global Economic History Encyclopedia about inflation targeting. I only submitted the article for editing a few days ago, but it looks like it may be due for updates before the encyclopedia even comes out! The reason is news that Shinzo Abe, future premier of Japan, is pressuring the Bank of Japan (BOJ) to adopt a 2% inflation target. Apparently, if the bank refuses, Abe will try to change the law guaranteeing BOJ independence. Currently, the BOJ has a 1% inflation target. This is pretty big news, but I haven't seen any economist's analysis in the press yet, so I'll try to walk through some of the basic implications.

The Japanese economy experienced deflation and economic stagnation in the 1990s, recovered somewhat from 2003 to 2007, then fell back into recession. Consumer prices have fallen 6.8% since 1997. Richard Koo's book calls the extended Japanese recession "The Holy Grail of Macroeconomics" because of the light it can shed on macroeconomic theory. Paul Krugman has also repeatedly looked to Japan to study the macroeconomy under conditions of recession, deflation, and the liquidity trap.

To analyze the news about the possible 2% target, something to keep in mind is the relationship between interest rates and inflation. The nominal interest rate is the real interest rate plus expected inflation. There is a zero lower bound (ZLB) on nominal interest rates, since potential lenders would rather just hold cash than lend at negative nominal interest rates. Real interest rates affect decisions about spending and investing now versus later, so they affect aggregate demand. Typically in a recession, monetary authorities want to lower interest rates to boost aggregate demand. A certain level of real interest rates would theoretically restore full employment. But, especially when inflation is low or negative, the ZLB on nominal interest rates can prevent the real interest rate from going sufficiently low. This situation is called a liquidity trap, and renders conventional monetary policy obsolete.

Since the real interest rate is the nominal rate minus expected inflation, raising expected inflation can help lower the real interest rate. But raising expectations about future inflation is not a straightforward task. If a central bank starts printing a lot of money, the public still might not believe that it would continue to do so in the future, when the bank's incentives would be different. One purported solution is for the bank to publicly and explicitly commit to an inflation target. The public commitment is intended to add credibility, so that expectations will actually change.

The other relevant relationship is between exchange rates and inflation. If inflation in Japan is expected to be higher, then the yen will have less purchasing power in the future, so the yen will depreciate. Depreciation of the yen makes Japanese exports relatively cheaper and imports relatively more expensive. So a higher inflation target could reduce Japan's trade deficit, which has been large this year.

My final comment is that central bank independence is not a goal in and of itself. It may be a means of arriving at the goal of effective monetary policy, or it may not. Typically, central bank independence does facilitate effective monetary policy by adding credibility. But at the moment, the BOJ is not credible enough to achieve its 1% inflation target. Maybe if the 2% target were instituted by another part of the government considered more credible, it would actually be more effective. In conclusion, I am somewhat hopeful that Japan is headed in a good direction. Either the BOJ will adopt a 2% target, which will be seen as more credible due to government support, or the government will itself impose the target, which would be drastic enough to cause the markets to notice, bringing about some aggregate demand stimulus.

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P.S. I haven't written in awhile for two exciting reasons. First, I have been working on articles for the Global Economic History Encyclopedia. Along with inflation targeting, I have written about the euro area, the Basel Accords, the National Monetary Commission, the gold standard, the Glass-Steagall Act, Wildcat Banking, the Credit Anstalt Crisis, and a few others.

Second, I haven't been writing because I was too busy getting married and going on a honeymoon! I married Joe Binder on December 1 at Christ the King Catholic Church in Dallas, TX. Then we drove across the Southwest for our honeymoon, stopping at a lot of national parks and monuments including Carlsbad Caverns, Guadalupe Mountain, White Sands, Tucson, Sedona, the Gila Cliff Dwellings, and the Grand Canyon. We feel so happy and blessed and are excited about our first Christmas together!