Debtor's Blessing
You Can Have an Interest Rate Policy or a Currency Policy: But Not Both!
It is also the case that fixed income managers and foreign exchange managers play different games, even though they, like equity and fixed income managers, traffic on common macroeconomic terrain. Most important, in a world of fiat currencies, we both look to central banks for direction. It is an undisputed fact that central banks can peg either the short-term interest rate for borrowing/ lending their currency or peg the exchange value of their currency against others. But they cannot do both at the same time! Put more technically, once a central bank, with monopoly power over the creation of its currency, pegs either its short-term interest rate or the foreign exchange value of its currency, the non-pegged variable becomes market determined.
Thus, strictly speaking, it is impossible for a country to have both an interest rate policy and a currency policy, even though an interest rate policy influences currency outcomes and a currency policy influences interest rate outcomes. And the dominant channel of influence is the inflation rate.
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If an interest rate peg is too high, it will tend to beget a market-driven deflationary appreciation for the currency, forcing the central bank to consider lowering the interest rate peg. And if the interest rate peg is too low, it will tend to beget an inflationary depreciation for the currency, forcing the central bank to consider raising the interest rate peg.
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If a currency peg is too high, it will tend to beget a market-driven deflationary bull flattening/inversion in the yield curve, forcing the central bank to consider lowering the currency peg and cutting short-term interest rates. And if the currency peg is too low, it will tend to beget a market-driven bear steepening in the yield curve, forcing the central bank to consider lifting the currency peg and hiking short-term interest rates.
Yes, as some of you are no doubt thinking, the interest rate/currency nexus is, in the first instance, a 2-by-2 matrix, with four possible combinations between high and low interest rates and high and low currency values. I only wish it was so simple, which it ain’t.
A global system of fiat central banking demands that any individual central bank consider the choices of all other central banks when deciding whether its own interest rate peg or currency peg is too high or too low. Well, not actually "all" other central banks, but rather ones that matter in the aggregate picture of global money creation, which determines the global outcome for inflation (the exchange value of a global basket of fiat currencies for a global basket of goods and services).
Commodity Standard or Fiat Standard?
This is where it gets interesting, turning the game of global monetary policy into a game of leadership, followship, or coordination; or all three at the same time! Indeed, the Bretton Woods arrangements in place from the end of World War II until 1971 involved all three: America led by pegging the dollar to gold at $35 per ounce the rest of the world followed by pegging their currencies to the dollar; and the game was coordinated by capital controls and official lending, which thwarted market-driven forces when they threatened to overturn the game. Which they ultimately did, of course, when America refused to honor other central banks’ demands to exchange their intervention-driven accumulation of dollars into gold.
Ever since, the global monetary policy exercise has been an uncoordinated game, punctured by periodic bouts of failed coordination. More technically, the game has been one dominated by American self-interest, unconstrained by dollar convertibility into anything except more dollars. And, to America’s credit, the game has not necessarily been badly played, as articulated this summer by none other that Alan Greenspan himself, in response to questioning from Congressman Ron Paul:
Congressman Paul: "So my question to you is: How unique do you think this period of time is that we live in and the job that you have?
To me, it’s not surprising that half the people think you’re too early and the other half think you’re too late on raising rates. But since fiat money has never survived for long periods of time in all of history, is it possible that the formidable task that you face today is an historic event, possibly the beginning of the end of the fiat system that replaced Bretton Woods 33 years ago?
And since there’s no evidence that fiat money works in the long run, is there any possibility that you would entertain that we may have to address the subject of overall monetary policy not only domestically but internationally in order to restore real growth?"
Chairman Greenspan: "Well, Congressman, you’re raising the more fundamental question as to the issue of being on a commodity standard or a fiat money standard. And this issue has been debated, as you know as well as I, extensively for a very significant period of time.
Once you decide that a commodity standard such as the gold standard is, for whatever reasons, not acceptable in a society and you go to a fiat currency, then - unless you have government endeavoring to determine what the supply of the currency is - it is very difficult to create what effectively the gold standard did.
I think you will find, as I’ve indicated to you before, that most effective central banks in this fiat money period tend to be successful largely because we tend to replicate what would probably have occurred under a commodity standard in general.
I’ve stated in the past that I’ve always thought that fiat currencies by their nature are inflationary. I was taken back by observing the fact that from the early 1990s forward Japan demonstrated that fact not to be a broad, universal principle."
Where You Stand Depends Upon Where You Sit
In this fiat global monetary policy game, the world has depended upon (1) the good judgment of Alan Greenspan coinciding with (2) global economic conditions coinciding with the self-interest of the United States. To wit, the world has been hostage to what is good for America being good for the world, not unlike the notion long ago that what was good for business was good for America. And, truth be told, what has been good for America has, in fact, been overwhelmingly good for the developed world since the end of the Bretton Woods system. As Greenspan intoned, the Fed deserves excellent marks for getting a grip after the 1970’s global inflationary hangover from the bust-up of Bretton Woods, and winning the Great Disinflationary War of the 1980s and 1990s.
Developing countries should not, equal truth be told, be so charitable in grading the Greenspan Fed. While the Fed has done a fine job of stabilizing inflation at a low level for a basket of goods and services in America and other developed countries, the cost of that "victory" has been a boom and bust pattern for globally-traded goods and in particular, globally-traded commodities, as vividly displayed in the chart on the cover.
For good or for bad, developing countries have a comparative advantage versus developed countries in commodities, both literal commodities and goods (and, increasingly, services) that embody commodity-like labor (known as sweat-of-the-brow labor, where I grew up in the Shenandoah Valley of Virginia). Accordingly, when a highly-developed country like America is driving the global monetary game, developing countries are the whipping boys, punished unwarrantedly when non-traded services in developed countries are inflating undesirably, and rewarded unwarrantedly when growth in non-traded services in developed countries is faltering undesirably.
Yes, I’m a principled populist and I have a real problem with the reality that "price stability" in the developed world implies soaring inflation followed by plummeting inflation in the developing world. America may have a comparable advantage in the creation of re-runs of Baywatch, but I have both economic and moral problems with America manipulating its terms of trade between inches of re-runs of Baywatch and ounces of what emerging market countries have a comparative advantage in producing. America preaches free trade, but until the day in which there is free trade in developed countries’ passports (like with New York City taxi medallions!), globalization will be a comparative advantage game tilted to the advantage of the haves relative to the have-nots.
I hasten to stress - with fist on pulpit! - that such bastardized globalization is not absolutely bad for developing countries. Quite to the contrary, even trickle-down globalization is absolutely good for the poor, as globalization is the means by which the technological innovations of the rich are diffused to the poor. For good or for bad, the best way to get rich is to go to school on the rich man’s know how. The long-run consequence is an increasing standard of living for both the rich man and the poor man. But the real-time journey is fraught with the potential for destabilizing currency and asset price adjustments, both up and down (as well as bouts of protectionist whiplash).
A De Facto Monetary Union
The best way to define the monetary arrangement between the United States and China over the last decade is a de facto Bretton Woods arrangement, in which China has pegged the Renminbi at 8.3 to the dollar, while America has pegged its currency to the good judgment of Alan Greenspan.
Nobody, at least nobody that I know who wears properly-fitted macroeconomic trousers, would argue that the United States and China represent an "optimal currency zone," per Nobel Prize winner Mundell’s framework. Yet for the last decade, the United States and China have operated as a de facto monetary union. Therefore, we must conclude (at least!) two things:
* It has been in the mutual best interests of the United States and China to operate as a dollar block, even though such an arrangement defies sustainable macroeconomic logic; and
* This arrangement is destined to ultimately unwind, as global capital flows eventually expose, exploit and explode the arrangements’ internal contradictions of logic.
But as both Bills have taught me, it is no easy task to handicap the timing of the demise of the unsustainable. Or, as Lord Keynes said long ago:
"…an investor who proposes to ignore near-term market fluctuations needs great resources for safety and must not operate so large a scale, if at all with borrowed money. Finally, it is the long-term investor, he who promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committee or boards or banks. For it is the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness, and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
This is particularly the case when speculating on the demise of fixed exchange rate regimes - de facto monetary unions - because central bankers are not constrained by the same profit-maximizing exigencies of market mavens. Men (and women!) with presses that print money, and who get their ink for free, are different than the rest of us. Most importantly, central bankers can always stop appreciation of their currencies. That’s not to say they should, but a central bank does have that ability: it can keep printing its currency until it stops going up. In contrast, central bankers cannot always stop depreciation of their currencies; a central bank can only buy its currency to the limit of its reserves of other currencies and/or its ability to borrow other currencies.
China has, of course, proven the inherent power of a central bank to prevent appreciation of its currency, creating Renminbi and selling them for dollars so as to preserve the 8.3 Renminbi peg, notwithstanding U.S. Treasury Secretary Snow’s incessant requests for China to let the Renminbi appreciate against the dollar. But as macroeconomic logic dictates, there is a cost to China’s currency policy: the inability to run an independent Chinese interest rate policy. Alan Greenspan runs China’s interest rate policy. And as macroeconomic logic again dictates, America’s interest rate policy is not necessarily conducive to China’s long-term best interest, given that China and America are not an "optimal currency zone."
Most notably, made-in-America interest rate policy is fostering asset speculation in China, in fixed investment and perhaps even more critically, property markets. Such speculation is ineluctably setting China on a boom-bust course, as bubbles are as bubbles do, in the words of that famous economist Forrest Gump.
Accordingly, it is becoming less and less appropriate for China to choose a peg for its currency rather than to peg its interest rates. In contrast, there is no reason whatsoever for America to be upset about China’s currency peg to the dollar, notwithstanding Mr. Snow’s constant carping. The peg allows America to sustain a higher investment course and a higher trajectory for its living standard than would be the case were China to let its currency appreciate. To be sure, the China peg implies a faster growth path than otherwise would be the case for America’s international "indebtedness"; but rising debt is not, per se, an evil. This is particularly the case when a country’s international debt is denominated in its own currency, which can be printed up at will for free.
Okay, not for free in the long turn, as a falling dollar implies higher United States inflation than otherwise would be the case. But higher inflation is not an evil, either. It is, of course, if you are a lender; but if you are a borrower, higher inflation is actually your friend. Accordingly, since America is a net international borrower, in its own currency, there is little to fear from a lower dollar.
Unless, of course, the Fed were to get wrapped ‘round the axle of orthodoxy and partially surrender its autonomous interest rate policy on the altar of defending the dollar. In that scenario, which is highly unlikely, in my opinion, America would be inviting an asset deflation-driven recession upon itself. And if America were to do such a stupid thing, the rest of the world would suffer, too, including most importantly, perhaps, China.
Thus, in the famous words of Richard Nixon’s Secretary of Treasury, shortly after the break-up of the Bretton Woods arrangements, "the U.S. dollar is America’s currency, but a falling U.S. dollar is the rest of the world’s problem!" But more bluntly, the right time for America to debauch its currency, as all right-thinking countries who issue debt in their own currency should want to do, is when a falling dollar inflicts more growth pain on countries with appreciating currencies than it does inflationary pain on the United States.
Bottom Line
Now is such a time. Indeed, it’s been debauch-in-the-dollar time for a long time. In that connection, I would change only a few words of a sermon I wrote on the subject two years ago on these pages1:
"The time has come for the Fed and the U.S. Treasury to join forces, with Alan Greenspan cutting short rates and Paul O’Neill explicitly declaring that a strong dollar is not in America’s interest. It is also time for America to announce to its G-3 partners that a weaker dollar is not a problem to be solved, but an opportunity to be seized by Euroland and Japan to aggressively ease monetary policy, using all available means, including non-sterilized intervention to temper the dollar’s fall."
What would I change? I’d call for Mr. Greenspan to announce a pause in the Fed’s current tightening course, rather than cutting rates. And I’d urge Mr. Snow, who replaced Mr. O’Neill, to quit embarrassing himself and the President by uttering the words "strong dollar". It is patently clear that America doesn’t have - can’t have! - a currency policy, strong or weak, if it wants to retain sovereignty with respect to its interest rate policy.
But other than that, things are much as they were two years ago: the burden of adjustment for global imbalances - assuming they must be rebalanced, of course! - lies with countries experiencing deflationary appreciation of their currencies, not with America, for whom a depreciating dollar is not a problem but a debtor’s blessing.
Paul McCulley
Managing Director
November 21, 2004
mcculley@pimco.com
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