Currency Wars: Monetary Policy as a Zero-Sum Game

For every action there is an equal and opposite reaction -Sir Isaac Newton

I have always thought that Isaac Newton would have been a great investor and/or economist. Not because of his rigorous dedication to his craft. Not because of his mathematical ingenuity. But because of his ability to step outside of conventional thinking and to see the bigger picture. Isaac Newton advanced the field of physics, but he could have equally advanced the field of economic theory. He understood that forces don’t exist in a vacuum and came to realize that every action has its consequences. In fact, forces between people and governments are strikingly similar to forces in nature.

John Makin, a resident scholar at the American Enterprise Institute (AEI), recently published an informative piece on Japan’s two-decade period of stagnation and provided a few takeaways for current U.S. policy. You can read it here.

After the Japanese real estate bubble burst in 1990, the Japanese economy has more than just struggled to regain its footing. Makin points to deflation as the primary cause in the prolonged stagnant economy. Because the Yen hasn’t appreciated in twenty years, debt levels have soared. Governments must pay down their debts in nominal terms, and unlike a country that experiences a reasonable inflation rate of 2% per year, the tax base has also remained stagnant. His proposed solution is to print money, ramp up inflation, increase the tax base, force investors into riskier assets, devalue the Yen, and boost export competitiveness.

So far, so good. This is very sound economic advice and advice that the Japanese government is starting to reflect in their own policy changes. Yesterday, Japanese prime minister, Shinzo Abe, chose Haruhiko Kuroda to stabilize Japan’s money supply. However, Abe has made a very, clear mandate for the new central bank governor: print money. Following up on that dovish promise, Abe has chosen someone who is willing to devalue the currency, avoid deflation at all costs, and set an inflation target to help out Japanese industrial competitiveness. So much for central bank independence.

I agree that in an insular world, this policy makes the most economic sense. It may be a Keynesian way of thinking, but it is a policy that should stimulate an economy that has been stagnant for way too long.

Unfortunately for Japan (and for the rest of the world), monetary policy doesn’t exist in a vacuum. As one country devalues, every other country revalues. Like physics, it is an inherent law that any currency devaluation is followed by a currency revaluation on the other end.

The Federal Reserve, the ECB, and the BOE have all pursued aggressive monetary policies as of late. In September when Bernanke proposed yet another round of quantitative easing, Brazilian finance chief, Guido Mantega, expressed his disapproval. While Bernanke may have been focused on easing credit markets, this action weakened the US dollar and strengthened other currencies around the world, including the Brazilian Real.

In Europe, the ECB has long been expanding its balance sheet (more out of political necessity than economic self-interest). The BOE continues to pursue aggressive monetary policy and has even spoken of negative nominal interest rates, which would entail charging banks a fee for keeping money with the central bank.

So is Japan just playing catch up. Yes, they are. But what happens when the end goal is currency competitiveness and everyone is acting towards the same goal. Like any prisoners’ dilemma game, no one wins. But even worse, everyone loses.

Why does everyone lose? Because the transmission mechanism for expansionary monetary policy (aka printing money) is lowering interest rates. And when short-term rates are at 0%, you lower long-term rates. And suddenly, no one is better off and the economy looks a lot more fragile, with interest rates that are not in line with economic fundamentals.

Many of the fundamental economic problems in the US are large and quickly expanding entitlement programs, like Social Security and Medicare. If the American taxpayer believes he will need to pay more taxes in the future, he will demand a higher return for lending his money to the Federal government. The way to push long-term rates down and incentivize risk-taking is to reform these medium-run obstacles in Congress, not by printing more money at the Fed. Again, structural problems need to be solved structurally. Any monetary remedies are just band-aids.

It is worth noting that many central bankers do believe that lower interest rates (rather than a competitive currency) is key to economic growth. Others, however, tend to disagree. Jeremy Stein, a  member of the Federal Reserve Board of Governors, has alluded to the problem of pushing interest rates far beyond their fundamental range. In this speech, he discusses some of the problems with low interest rates, most notably excessive risk-taking. While the Fed is actively encouraging investors to take risks, too much easing can incentivize excessive risk-taking, much like we saw in the run up to the 2008 financial crisis. A summary of his talking points can be found here.

The global economy is stagnating, not because monetary policy is too tight, but because of political uncertainty. The Yen fell after Kuroda’s appointment, but jumped right back up earlier today when the Italian election results added more uncertainty to the Eurozone mess. Meanwhile in Washington, Bernanke testified before the Senate Banking Committee, reaffirming his bond-purchasing mandate.

How do we get rid of political uncertainty? A currency war will certainly not help. There needs to be more coordinated action at the national level with regards to both fiscal and monetary policy. While monetary policy is supposed to be independent of politics, that independence has unfortunately been compromised. Open communication between central bank governors would help move the global economy in the right direction. Much like meetings between G20 finance ministers, central bank governors should meet more often and make their monetary goals more transparent. The Fed, ECB, BOE, and BOJ need to lead the way; presumably, other countries would follow. However, if the banks continue to fight for a competitive currency, no one wins, and we all lose.

Zero-bound: An argument against another round of quantitative easing

There has been a lot of speculation and eager anticipation of another round of quantitative easing by the Federal Reserve. The market is rooting for it, and it looks like we will see some “help” from Bernanke & Co. sometime this September.

Here’s a brief overview of how monetary policy (at least in the United States) works. For those who don’t need a history lesson, feel free to skip ahead.

In 1913, the United States founded the Federal Reserve System in response to a number of financial panics in the early part of the 20th century. As the United States’ central bank, its mission is to maximize employment, control inflation, and maintain moderate long-term interest rates. In short, it has the ability (i.e. a massive balance sheet) to control the U.S. money supply to incentivize Americans to spend or save. When inflation is too high, it has the authority to buy U.S. currency to limit the money supply, thus driving down inflation. When unemployment is too high, it has the authority to buy assets with cash, an attempt to send U.S. dollars into the market, giving the financial system a little bit of a kick, get money flowing, and get people spending money. As the money supply increases, interest rates decrease, and thus the incentive is to spend. As the money supply contracts, interest rates rise, and thus we wish to save.

This should all make some sense to those with a basic understanding of economics. Now, let’s throw in a bit of a twist (no pun intended). Let’s say interest rates are at 50 basis points (0.5%), and the Fed wants to stimulate the economy. Well, it has a few options. It can buy more and more foreign assets which not only increases our money supply but can in turn, contract the money supply of other countries. It can also buy longer term U.S. treasuries and sell some its shorter term U.S. debt. This helps drive down interest rates on longer term debt, further incentivizing spending.

However, these market actions have a lesser and lesser impact as bond rates go to zero, or in some cases, turn negative (this can happen when inflation outpaces nominal interest rates). That is, for every action the Fed takes, its impact on interest rates diminishes.

This is the zero-bound, and truthfully, no one is quite sure what is really going on there. When things approach zero and get infinitely small, strange things happen. At absolute zero, motion stops and life ceases to exist. When we look for smaller and smaller particles, we get quantum physics which is unlike any other type of physics that we can observe. And when bond rates approach zero…well, we don’t really know.

But we do know. It’s quite clear to anyone who can step outside of the economic games and puzzles, and actually dare to look at what’s happening in our economy and our financial system. We have mountains of debt. And I don’t mean just Americans, I mean everyone. Total debt levels in 2002 were no more than 20 trillion. Just 10 years later, we’ve doubled those debt loads. We now, as a world, owe 45 trillion U.S. dollars to ourselves.

It’s kind of weird to think about that, but it makes sense if you think about it in a different way. We have spent 45 trillion dollars worth of credit (money we didn’t have) and agreed to pay back that 45 trillion dollars at some future point in time. Let me rephrase that once again. We spent 45 trillion dollars today instead of saving it for tomorrow.

Now, is this starting to click? We are thinking in the short term at the expense of the long term. We are being foolish now, and will have to pay for it later. Really, the 45 trillion isn’t the problem. If we had borrowed 45 trillion and invested it in something worth more later, then that’s called saving. We’ve been spending. The subtle difference is on the productivity of the assets. And, boy have we been wasteful. Wars in the Middle East. Bigger and bigger houses. Things that doesn’t help us in the future, but merely satisfies our current needs. We’re sort of kicking the can down the road.

It’s not just us, it’s everyone. China is building cities that no one can live in or afford, leading to a proliferation of ghost towns throughout the struggling country. Europe has been strangled by its own short-sightedness in forming a monetary union without bothering to keep its governments on the same page fiscally. The United States borrowed money to build houses that led to a bubble, an internal market collapse, and an external market collapsed fueled by a bunch of greedy Goldman bond traders who decided to ship all their MBSs and CDOs and other crap to Germany and Japan. Where are the productive assets? How can we learn to save and start spending more wisely?

This is the problem with our economy. We don’t need to be incentivized to spend, we need to be incentivized to save! Interest rates at zero tell the American people to borrow. Let me make clear that borrowing is not the real problem. What you eventually do with that borrowed money is the problem. And right now, no one really knows what’s going to give us good returns on our capital. Hedge funds are closing their doors because in reality, there’s not much that is growing in value right now. A lot of it goes back to our political systems which are so horribly inefficient, that no one has faith in what will happen tomorrow. It’s like trying to find value on a freight train when you know that train is going to crash and burn.

Let me give one more quick history lesson as I close out my long-winded post. After the dot-com bubble at the turn of the millenium, the U.S. government drove interest rates to record lows (and consequently worldwide interest rates drove to record lows). Their message was simple: borrow money and spend it.  Additionally, deregulation across the financial industry masked what people were doing with this newly borrowed money. If you haven’t read Boomerang by Michael Lewis, I highly recommend you do so. His premise was simple: If you give people a bunch of money in a dark room, what are they going to do with it? This phenomenon drove everyone across the globe to do bizarre, short-sighted, and rather stupid things. Things that would cost them a good amount of welfare in the future.

So now, let me ask a question. Do we really need more Fed stimulus? Do we really need lower interest rates? Do we really need more incentives to borrow money that we don’t have, to spend it on things that we don’t need? And yet the financial markets will cheer once Bernanke decides to make it easier for everyone to borrow more money.

What we really need are some productive assets. We need something that is going to give us a return on our capital tomorrow. The problem is that our capital is all sitting on a freight train. And that train is going to crash and burn.