Democracy and accountability

Megan McArdle has a very interesting piece addressing the legitimacy of the Fed's aggressive, central role in the policy response to the ongoing financial crisis:

But here's the problem: the Fed has performed vastly better on any
metric except "being elected" than the Congress. There's little doubt in
my mind that if we had not had an independent central bank, unemployment would
be many percentage points higher, GDP would have contracted much more strongly,
and we wouldn't now be making optimistic noises about the thing bottoming
out...

I think that the political process will hopelessly screw up the
management of this crisis (something which libertarians are perfectly able to
see when the government screwing things up is a left-wing populist one in Latin
America). But maybe The People, God bless them, deserve to screw up their
economy if they want. On principle, I am opposed to saving people from
themselves. And anyway, maybe I'm wrong and the wisdom of crowds will
prevail.

On the other hand, do they have a right to screw things up for everyone
else? Should a populist 60% be allowed to plunge their neighbors deeper
into crisis? In the case of America, to plunge the whole
world deeper into crisis?

The uncomfortable conclusion I'm coming to is that yes, they
should. Ben Bernanke should be hamstrung even though it's likely that this
would make everyone worse off. And people who advocate for ending the
independence of the central bank should be willing to accept all that this
entails: inflationary monetary policy (the people love inflation!), bad
and unpredictible banking policy, the collapse of the US economy. I just
wish I didn't have to go along for the ride.

Huh? I don't follow her logic at all. A modern democracy is a sophisticated political system. For some specialist functions like monetary policy, undemocratic actors do a much better job. In such cases, democratic lawmakers can voluntarily cede authority to an institution that's insulated from political pressure.

But here's the catch. No one's saying they couldn't take that power back if they wanted to. The Fed's only independent because elected lawmakers chose to make it so. They did this because they judged it to be in the long-term interests of the country.

So do we still have to hamstring Ben Bernanke? I'm just asking. He seems like a pretty nice guy.

Update: By sheer coincidence, Dave writes almost the exact same post at IPE Journal. Really, it's kind of spooky how similar they are.

Quantitative easing explained

The FT has a great new interactive feature explaining the central bank policy of quantitative easing. The British narrator sounds reassuringly competent.

The new administration's approach to China

Most foreign governments have rallied behind the call brought forth by President Obama to restore the spirit and the strength of the United States - even the Chinese (though with a few concerns I will outline here). While most are looking forward to a "new chapter" and anxiously awaiting an opportunity to embrace the forthcoming change, there is cause for some nations to wonder what the rejuvenation of America will bring. After just a few days under the Obama administration, it is clear that China has become one of these, cautiously optimistic, nations. No one is overlooking the longstanding issues between China and the US: especially, China's human rights record, environmental standards, public censorship, fixed currency, and increased military spending. Not listed however, may be a bigger and more subtle challenge for the Chinese: both the United States and the Chinese have developed an insurmountable political ego. A renewed global, American presence means these two countries will inevitably step on each others toes.

Not suprisingly, this happened within minutes of President Obama's Inauguration. During the live broadcast of the Inaugural address, Chinese officials moved quickly to censor remarks on communism and fascism, in addition to a call for an end to the "silencing of dissent." For most of us watching in the United States these comments elicited historical nostalgia, but word of the Chinese censorship highlights how drastically the American worldview differs from the Chinese. In a country where a large portion of the population sees their brand of communism as a centerpiece of national pride and lives a separate struggle for prosperity, it is unlikely that such references would have been well received. More importantly, an educated audience would know that President Obama's words had less to do with the communism we see in China and more to do with American history and its historical rival. What is intriguing, is that the omission of these comments may have been a favor to the United States, in addition to a precaution meant to quell a growing sense of nationalism in China that could easily turn on either government. For the Chinese, it is possible that letting a stab at communism pass without notice would just be plain bad form. China would like to display President Obama as the charismatic leader that he has become and avoid the possibility that the public might falsely interpret his comments as opposition to the Chinese political system.

Post-inaugural remarks were decidely more focused, both in tone and detail. Timothy Geithner's statement to the Senate during his confirmation hearing directly accused China of manipulating its currency. Some sources are claiming the statement marks the beginning of a new era - one of hard line approaches to China's economic policy. China's adjustable currency rate has long been an issue among economists, but why did Geithner bother to bring it up now, except to please Senator Charles Schumer? Especially as the response was no small matter - when the Deputy Governor of the People's Bank of China politely reminds you that the widespread consequences of the current financial crisis and the trade imbalance in the United States will not be leveled by a mere currency revaluation, China means business. That friendly reminder definitely cost a few treasury bonds. Of course Tim Geithner wants our "major trading partners to operate with a flexible exchange rate system" and for "market forces [to] determine the value of the exchange rate." But I am certain that in the future, the Chinese will be quick to remind Mr.Geithner that he can't have everything he wants.

There are plenty of other issues for the United States and China to butt heads over, but I believe that the ball is in China's court. Tibet has been off the radar since negotions between the Dalai Lama and the Chinese came to a standstill and the world is already well aware of the floating smog cloud over the entire continent of Asia. (Also, our environmental woes are now officially mutual: note the literal "Collapse of the Clean Coal Myth" just days ago). However, there is one issue that China has made progress on faster than the Obama Administration likley expected. This is affordable health care. On Wednesday, China announced that it will bring Universal Health Care to 90% of the population by 2011 and spend as little as seventeen dollars per person. This is tough to believe, but if China can pull this one off, then touché. We have our work cut out for ourselves.

(Photo of Chinese currency from toesoxluver's photostream)

I was elected to lead, not to read!

Well we are at crisis levels. The bailout, which plenty of people say won't work anyway, has stalled in an incredible fashion today. I won't try to give a run down of the issues at hand, but let's be clear that neither I, the President, nor both candidates fully understood the subtleties of our current pickle, despite the stellar briefings I'm sure they have all received. Apparently neither do any of our elected representatives because despite all of the calls for immediate action we are being greeted with limp and tepid responses carrying no weight. For clear explanation read these concise and lucid treatments of what's happening and why.

As Brad Setser points out, the balance sheet of the Fed reveals the huge nature of the deal. It's sad, and in this situation downright scary, that an election season filled with promises of bipartisan compromise has devolved into another typical session of Washington malaise. To be perfectly frank I'm ready for some good 'ole unilateral, unchecked decision making rather than this current handwringing and indecision. And besides, Paulson isn't nearly as bad as Russ Cargill.

Recession obsession

News is trickling in on the backs of quarterly reports that suggests Asian and European economies are not nearly as decoupled from American economic conditions as previously thought. The contagion of the American "credit crunch" is spreading and though these markets may be technically independent from the US economy (i.e. they have not bought securitized loan packages from American banks) they still face a number of problems.

The instruments of financial (not monetary - the ECB is notoriously opaque) work in Europe are close to ours. The loan bubble that caused the "credit crunch" here exists in Europe as well; it simply manifests in a slightly different form. Look at the housing markets in Spain and Britain, unemployment pretty much anywhere but Germany, and contracting export margins throughout Europe and Asia (especially China and Japan). Unlike the quick action of the Fed, the sclerotic pace of EU regulation and the inflation-bent of the ECB won't do anything to counter these effects anytime soon.

There are a number of other significant problems in what is increasingly looking like a global recession, which Larry Summers ties up nicely. But the problems now seem beyond the scope of interventionist policy. Even if they were not, I am not convinced the Fed could responsibly round up enough liquid cash to implement any type of further "injection" to buoy the economy. With more and more banks facing huge writedowns and even insolvency, the Fed cannot feasibly expand its own balance sheet. The one thing policy wonks should not be adding to the cacophony is a cry for another stimulus. The term "credit crunch" conjures up ideas that the situation would be resolved if there was simply more money around to lend out. This simply isn't the case.

The Fed "injects" money into the economy (whether it's a tax stimulus or a bail-out) by controlling the reserve supply of cash to banks. To ease short term interest rates (and thus push money) the Fed buys securities by crediting the account of their primary dealer (who is free then to lend out these reserves) thus expanding its own balance sheet. This practice, if ensconced permanently in policy, will yield disastrous results: essentially, an even greater expansion of GSEs (and not just ones dabbling in mortgages either) with bills passed to the taxpayer and profits distributed to managers and shareholders. This encourages reckless and risky investment policies which will even further undermine the financial system.

The crunch needs to be felt by those who helped cause it, not passed indefinitely down the line. Free markets need to be free in the good times and the bad. If only Paulson had seen it coming.

Warmflation

Thomas Friedman's piece in the New York Times yesterday was nothing special. In fact it amazes me how often such dribble is placed on the Op-Ed pages of major newspapers. Vague references to anecdotal experiences of climate change backed with murky statistics and little fact. Even if you're an ardent environmentalist, the cliched, opaque writing is tough to swallow.

That being said, he manages to produce one interesting thought (not original, but an opinion of Minik Thorleif Rosing, an accompanying Danish geologist).

" 'Most people will actually feel climate change delivered to them by the postman,' he explains. It will come in the form of higher water bills, because of increased droughts in some areas; higher energy bills, because the use of fossil fuels becomes prohibitive; and higher insurance and mortgage rates, because of much more violently unpredictable weather. "

Not only does this strike me as incredibly insightful and true (regardless of how much we may improve energy efficiency), but it raises an interesting question given the existing economic worries. Could the effects of climate change collude with rising commodity prices to increase, and even entrench, inflation? Some economists are already preaching the danger of entrenching inflationary expectations. And they are right to do so. Expectations of continuing inflation affects consumer behavior and could do much to offset recent actions aimed at promoting, or at least, maintaining growth.

Ben Bernanke's job is hard enough. You better believe financial organizaitons will start pricing inflation into their lending and investing practices but central bankers should not be forced to consider such subtle (and even tenuous) connections in shaping monetary policy. But if politicians do not start seriously confronting the dangers climate change poses across the board then the men at the Fed may soon find themselves with NO room left between the rock and the hard place. Whether funded with carbon or windfall taxes (let's hope not), while credit remains tight, "green subsidies" may not only save the planet, but perhaps even our dollar.

Inflation woes

The Central Bank of Zimbabwe is set to lop some more zeroes off the Zimbabwe dollar. They knocked off three back in 2006, and this round is set to see another 3-6 zeroes get the chop. Excuse this humble commentator for his cynicism, but when the annual rate of inflation is above 2.2 million per cent, this isn't going to help much. It will likely improve transaction efficiency for a short period of time, but unless Zimbabwe takes some concrete steps to rein in inflation, sooner than later the currency will be just as worthless as it is today.

Venezuela tried this trick last year, when it introduced the Strong Bolivar, which President Hugo Chavez promised would help curb inflation. A 'Strong' Bolivar is essentially just a normal Bolivar, Venezuela's unit of currency, with three zeroes lopped off. Unfortunately, Venezuelan inflation has actually gotten worse since then, reaching 32% in Caracas in the month of June.

I wrote last month about how inflation is fast becoming a major financial worry. This is especially true in developing countries and emerging markets . As painful as the medicine may be, now is the time when such countries should be prioritizing inflation control over economic growth. The short term losses are undesirable, but the long term dangers are too real to ignore. Keynes said it best:

As inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundations of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

It's troubling when there exists such chronic financial mismanagement in economies like Venezuela and Zimbabwe, which could both be in much better shape than they are. But they're not, and unfortunately it is the citizens of those countries who pay the highest price for that.

Steady as she goes

The FED opted yesterday to keep interest rates at 2%, indicating that while inflation is a growing concern, it is still secondary to stimulating growth. Meanwhile, the ECB is getting even more hawkish on the issue, with Trichet signaling that they will likely raise rates by 0.25 points to 4.25%.

Essentially, the US and the EU are taking opposite bets on what's a bigger economic threat: recession or inflation. In a way this is par for the course: as an institution modeled on the Bundesbank, the ECB is much more inflation-adverse by design. But you can't help wonder if somebody's making a mistake.

That the dollar is still the world's primary reserve currency only complicates things. Countries pegged to the dollar cede their monetary autonomy to the FED and have to follow its decisions or get knocked off their peg. In China, where inflation is closer to 8%, low interest rates are probably not what you want.

Add to this the fact that lower interest rates are more likely to cause further dollar depreciation, and you've got some real problems. Especially when you need to import things like oil (black gold, Texas tea), where contracts are denominated in dollars. If dollars are worth less, it will drive up the price. 

Spooky, scary, indeed.