Winding down the world money machine

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Each year in August, the Federal Reserve Bank of Kansas City brings world central bankers and top economists together to brainstorm about global finance. The meetings are held in Jackson Hole, Wyoming, a good trout fishing spot, not a financial centre. It was chosen in 1982 to entice noted angler and Federal Reserve Board Chair Paul Volcker to speak about the major downturn in the world economy that was then underway, thanks to the greatest hike in interest rates in recorded history, engineered by Volcker and the Fed.

This past weekend, Ben Bernanke became the first U.S. central bank head since 1982 to decline an invitation to Jackson Hole. His term ends this December, and his absence signals his intention not to seek re-appointment.

Naturally the gathering featured gossip about who would be named by President Obama to replace Bernanke. Would it be Vice-Chair Janet Yellen, the preferred candidate of liberal Democrats, or one-time Obama economic adviser Larry Summer, who has been Harvard President, U.S. Treasury Secretary and Deputy Treasury Secretary, private investment banker, academic economist of note, and rates as the financial establishment candidate. Or would Obama choose a compromise candidate like former Fed Vice-Chair Don Kohn?

Under Ben Bernanke, since the onset of the financial crisis, the U.S. Fed has been flooding the world with new money. Each month it has been purchasing $45 billion in U.S. treasury bills and $40 billion in mortgage-backed securities (MBS). The Fed writes cheques to make these purchases and the cheques get deposited into the U.S. banking system.

This policy, called quantitative easing or QE, coupled with an interest rate set by the Fed on its own lending to the banks that is "zero bound," have kept interest rates abnormally low in the U.S.

Recently Bernanke has mused about changes to QE or what Jackson Hole participants called "unorthodox monetary policy," since it amounts to the Fed printing money.

In its jargon, the Fed has referred to "tapering" as in tapering off the monthly purchases of treasury bills and MBS. The taper is seen as a step on the return trip to monetary orthodoxy, even if the monthly purchases only drop by increments of $5 or $10 billion.

At Jackson Hole, economists debated the impact of the Fed continuing to run the money machine each month. Monetary hawks argue Fed purchases have only a small effect today, but create inflationary conditions for tomorrow. Two economists argued for halting the purchases of T-bills but continuing to support the housing market through purchases of MBS.

Given that the U.S. dollar is a close approximation of a world monetary unit, what happens to U.S. monetary policy matters to the world outside the U.S. This does not mean American central bankers think about what is good for the rest of the world when deciding the cost of lending, or the expansion of the money supply.

This past weekend at Jackson Hole as participants were discussing the link between national monetary policy and global finance, cross-border financial flows sent the Indian rupee and the Brazilian real sliding.

As a result of loose U.S. monetary policy, money has been flowing out of the U.S. and seeking positive rates of return in so-called emerging markets, through purchases of, say, Brazilian or Indian bonds.

When countries like Brazil complained about the effects inflows from the U.S. were having on the Brazilian economy (pushing up asset prices), Bernanke retorted that Brazil only had to let its currency float upwards to deal with the problem.

Brazil replied the problem originated in the U.S., which was seeking to gain an unfair advantage through a competitive devaluation of the U.S. dollar.

Events this passed week showed Brazil had the argument right, but it has a new problem. Sudden capital outflows from Brazil (also India and other emerging economies) have created foreign exchange problems for Brazil as its currency plummets.

Indeed, Brazil's central banker made news at Jackson Hole by cancelling his scheduled appearance. Ominously, the Brazilian central bank chief stayed home to deal with a serious slide in its national currency on international markets.

At Jackson Hole, Hélène Rey of LSE raised the big question of cross-border financial flows and the floating exchange rates which were supposed to keep them under control. Professor Rey questioned floating exchange rates, a market mechanism, as a technique for preserving monetary independence in emerging economies.  

An intellectual history of Jackson Hole would show participants jumping from one policy preference to another as events overtook whatever was considered sound monetary policy.

U.S. policymakers do not question capital mobility. But until cross-border financial flows are brought under direct control by central banks, international financial turmoil and financial fragility are going to continue.

Duncan Cameron is the president of rabble.ca and writes a weekly column on politics and current affairs.

Photo: U.S. Federal Reserve System Headquarters. Credit: Adam Fagen/flickr

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