Tuesday, October 19, 2010

Bernanke makes Europe unhappy

The FT (10/15):
The dollar tumbled against most major currencies on Thursday, prompting warnings that the weakness of the world’s reserve currency could destabilise the global economy and push other countries into retaliatory devaluations to underwrite their exports.

Increasing expectations the Federal Reserve will pump more money into the US economy next month under a policy known as quantitative easing sent the dollar to new lows against the Chinese renminbi, Swiss franc and Australian dollar. It dropped to a 15-year low against the yen and an eight-month low against the euro. The dollar index, which tracks a basket of currencies, reached its lowest level this year.

A senior European policy-maker, who asked not to be named, said a further aggressive round of monetary easing by the US Federal Reserve would be “irresponsible” as it made US exports more competitive at the expense of its rivals.

What is going on? In simple terms: there are two competing philosophies in money policy today:

1. Orthodoxy
Orthodox money policy says that the role of the central bank is to provide a currency with a stable value. The central bank is not responsible for economic growth.
Poor economic performance is due to structural factors such as labor immobility, sticky wages, unions, etc. Seeking to create growth “artificially” by stoking inflation is self-defeating and dodges the need for permanent structural reform.
Orthodoxy is the religion of the Bundesbank, the ECB, the BoJ (until lately), the FOMC hawks, and most of the Republican party. [It is not the religion of the French government, which is a vocal dissenter.] Orthodoxy is the preferred religion of “conservatives” who are against soft money and in favor of free-market structural reforms.

2. The Depression School
There is a long line of American academic economists (all students of US monetary policy during the Great Depression) stretching from Milton Friedman to Ben Bernanke who believe that the role of the central bank is to provide a currency with a stable value as well as economic growth. This school has an advantage in the US because the Fed has a growth mandate, and because the US (outside of the South) has never gone through the hyperinflations suffered by Germany and Japan.
The core belief of this school is that the catastrophic deflation of 1930-33 was avoidable, and that deflation is always and everywhere a monetary phenomenon. This school believes that monetary malpractice causes recessions, not structural factors. (Structural factors retard growth, they do not cause the business cycle.) The Depression School believes that the conduct of successful monetary policy requires a stable financial system such that banks do not default upon their debts.
Unlike the Orthodox, the Depression School is a mixed-bag ideologically, including libertarians such as Milton Friedman and liberals such as Paul Krugman.

Historically, both of the above schools have had representatives on the FOMC, and Greenspan was a master of herding them all toward his desired (middle-of-the road) consensus. But now, facing the failure of the Fed to achieve its twin policy goals, the conflict between the hawks and th doves has never been more consequential. And it would appear that the doves are winning, thus resulting in the plan to adopt price-level targeting at the next meeting.

This is creating (as desired) inflationary expectations and a weak dollar. The goal is to achieve stronger nominal growth and to reduce unemployment. As the US is the engine of global demand, this should be welcome news to our trading partners.

But the Germans are having none of this. They and their instrument, the ECB, are firmly in the Orthodox seat, and they oppose QE, unconventional policy, and currency devaluation. Hence statements such as that above that FOMC easing is “irresponsible”. Of course, to those of us in the Bernanke school, it is the ECB’s deflationary policies that are irresponsible, and which will ultimately lead to the breakup of the euro.

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