The Buck Stops Here: A BRIC Wall
IN THIS EDITION
Already on the defensive due to a persistent failure to achieve its stated policy aims, the US Fed was subject to much fresh criticism over the past week, including from the BRIC nations, collectively the largest foreign holders of US dollar reserves. While the dollar remains the world’s pre-eminent reserve currency, there is growing recognition everywhere, except inside the Fed itself, that a choice will soon have to be made: Either the Fed must move to implement a credible, rules-based monetary policy, focused primarily on preserving the purchasing power of the dollar, or the dollar will lose reserve currency status, initiating a vicious spiral of dollar and US Treasury market weakness, which would quickly spill over into the financial system generally. Were that to happen, the current debate about how to reduce the US budget deficit would be promptly settled, as it would become impossible for the US to finance public sector deficits in the first place. Does the Fed, or the government, see the danger? Regardless, investors need not only to see it, but to understand it and to act accordingly. Time may be shorter than I previously thought.
Professor Taylor Channels Friedman
Few US monetary economists have as solid a reputation as Professor John Taylor of Stanford University and the Hoover Institution. In a recent op-ed in the Wall Street Journal, “The Dangers of an Interventionist Fed,” he succinctly and persuasively argues that the Fed is damaging both the economy and its own credibility with serial, extraordinary market interventions. Here is a relevant excerpt:
The combination of the prolonged zero interest rate and the bloated supply of bank money is potentially lethal. The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself.1
Arbitrary intervention in or manipulation of financial markets is anathema to Taylor and other members of the Monetarist, Chicago school of economics, associated with the late Milton Friedman. Rather, the central bank should follow strict rules instead. As long as the central bank can maintain a stable money supply, or at least a stable, low rate of growth thereof, it is assumed that economic stability will generally follow or, at a minimum, that the central bank will not be the source of instability. (Bad economic policy will always be a source of instability, regardless of the quality of monetary policy.)
Taylor goes on to write that consequences of recent and possible future arbitrary actions are likely to be severe, as “the Fed is distorting incentives and interfering with price discovery with unintended consequences throughout the economy”. As I wrote in a similar if less diplomatic vein in last month’s Amphora Report, “Through the Broken Window”:
[I]f policymakers keep mucking around with the marketplace, the economy will not only fail to improve sustainably on its own; rather, it will descend into a vicious spiral of stagnation, capital flight and eventually an outright decline in living standards.2
Taylor’s proposed solution is to put the Fed back into a rules-based box. Specifically, he recommends that the Congress pass the recently introduced “Sound Dollar Act”:
The Sound Dollar Act of 2012, a subject of hearings at the Joint Economic Committee this week, has a number of useful provisions. It removes the confusing dual mandate of "maximum employment" and "stable prices," which was put into the Federal Reserve Act during the interventionist wave of the 1970s. Instead it gives the Federal Reserve a single goal of "long-run price stability."
Long-run price stability. Well isn’t that a nice idea? The problem here is that ever since president Nixon abruptly severed the link between the dollar and gold in August 1971, the Fed has not achieved long-run, rather, only temporary price stability. Taylor is nevertheless confident that the Sound Dollar Act could work, in part due to some additional provisions:
To further limit discretion, restraints on the composition of the Federal Reserve's portfolio are also appropriate, as called for in the Sound Dollar Act.
And perhaps the most important provision of all:
Giving all Federal Reserve district bank presidents—not only the New York Fed president—voting rights at every Federal Open Market Committee meeting, as does the Sound Dollar Act, would ensure that the entire Federal Reserve system is involved in designing and implementing the strategy. It would offset any tendency for decisions to favor certain sectors or groups in the economy.
This last part is highly significant because it does try to fundamentally reform the distribution of power at the Fed. In a 2010 Amphora Report, “A Century of Money Mischief”, I wrote about how the Fed’s formal voting arrangements invariably favour the large, politically-connected New York banks over their generally smaller, regional counterparts:
[P]lease consider the Federal Open Market Committee (FOMC) voting structure: Whereas each member of the Board of Governors in Washington and the President of the New York Fed always has a vote, only four of the regional presidents may also vote at any one time, on a rotation basis. This implies that, even in the event that all four voting regional presidents dissent from a vote, the Board of Governors in DC and the NY Fed President will nevertheless carry a 2:1 majority! In other words, the power resides clearly at the political centre, not the periphery. And historically, dissenting votes have come overwhelmingly from the periphery.3
Professor Taylor and other proponents of the Sound Dollar Act are thus on the right track: They understand not only that arbitrary monetary policies can be highly damaging to an economy, but also that the Federal Reserve Act, as drawn up in 1913, invariably favours large banks over small, in other words, favours Wall Street over Main Street.
Unfortunately, you can be on the right track and still go off the rails. This is because whoever happens to be driving the train at any point in time is still going to be prone to political influence or simply to making mistakes. To understand this point better, let’s consider a brief history of Monetarist economics.
Monetarism grew out of criticisms of Keynesian policies, which in general place much importance in fiscal policy as a means of managing business cycles. As we know, Keynesian-style demand management fell out of favour in the 1970s, the decade of the dreaded stagflation, and Monetarism, along with Rational Expectations Theory (RET), inspired the explicit monetary-targeting policies of the Volcker Fed, beginning in 1979.
The battle against the 1970s stagflation had been won by the mid-1980s and Monetarists basked in empirical as well as apparent theoretical success. But by the late 1980s, the Fed was at it again, keeping rates lower for longer than implied by money supply and credit growth. A bubble formed in southwestern US real estate and blew up in the late 1980s, crippling the Savings and Loan industry (S&Ls) and resulting in the largest US financial sector bail-out to that time. A series of bubbles and bailouts have followed, under Greenspan and now Bernanke.4
Notwithstanding a Nobel prize and much other recognition for his Monetarist work, in later life, Milton Friedman became increasingly skeptical that the US Fed or other central banks for that matter were capable of implementing strict monetary rules over the long-term. There was just too much empirical evidence of arbitrary actions taking precedence over rules, with perhaps the Bundesbank and Swiss National Banks providing partial exceptions to the rule. But this presented Friedman with an intractable problem: For Monetarism to have any practical value depends critically on the ability and willingness of a monetary authority to implement consistent rules, rather than to subordinate such rules to arbitrary, crisis-driven action.
Friedman struggled with this problem for years. Eventually he came up with an answer that might surprise some: If the Fed can’t do it, why then should the government:
Any system which gives so much power and so much discretion to a few men, [so] that mistakes—excusable or not—can have such far reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic—this is the key political argument against an independent central bank. To paraphrase Clemenceau: “Money is much too serious a matter to be left to the Central Bankers.”5
And if the government can’t be trusted, why then perhaps a foreign central bank should be: Just anchor your currency to a more stable one with a more credible central bank standing behind it:
The surest way to avoid using inflation as a deliberate method of taxation is to unify the country’s currency [via a fixed exchange rate] with the currency of some other country or countries. In this case, the country would not have any monetary policy of its own. It would, as it were, tie its monetary policy to the kite of the monetary policy of another country—preferably a more developed, larger, and relatively stable country.6
Indeed, the concept of a ‘currency board’, where monetary policy is ‘outsourced’ to a foreign central bank, became popular in the wake of the Latin American debt crises of the 1980s. Argentina, for example, made much economic progress under a currency board policy in the 1990s, only to be overwhelmed by large budget deficits in the early 2000s, resulting in a major devaluation of the peso.7 (As an aside, this is yet another illustration of my view that, “consumer prices are inflation past; money and credit growth are inflation present; government budget deficits are inflation future.”)
While a currency board might appear an elegant solution, it cannot apply to the central bank of the world’s largest economy and provider of the primary reserve currency, as there is no “more developed, larger, relatively stable country,” at least not yet. No, the US must discipline itself instead.
Returning now to John Taylor’s proposed solution, he clearly has the best of intentions. He wants to put the Fed back into a box of strict policy rules and to redistribute power at the Fed away from the Board of Governors in Washington. The problem, however, is that this is not going to prevent the government running deficits, nor the ongoing political pressure to accommodate these with lax monetary policy. And even in the event that such deficits or associated pressure were not forthcoming—a rather remote possibility for the coming decade, to be sure—naturally there would still be the risk that the Fed, comprised of “a few men”, prone to “mistakes—excusable or not,” would fail to restore a sufficient degree of trust and credibility in the dollar.
At the end of his article, Taylor concludes that the Fed’s priorities should boil down to “a more predictable policy centered on maintaining the purchasing power of the dollar.” Yet as shown above, the Sound Money Act of 2012 fails to get at the ultimate roots of the problem. It neither addresses the fiscal profligacy in Washington specifically, nor the general inability of policymakers, wherever they might be, to somehow do for free capital markets what they can and should do for themselves.
I applaud Professor Taylor for at least pointing out that the US Fed is, to put it bluntly, out of control, and that fundamental reforms are necessary if more damage is not to be done. Certainly it would be welcome were the US to take the initiative in getting its economic and monetary house in order. As it happens, however, the US may not have the luxury of time to do so. In the following section, we explore the ominous implications of last week’s BRIC+SA (Brazil, Russia, India, China plus South Africa) summit in New Delhi, India.
Building the BRIC Wall: The Delhi Declaration Translated
Unless coming from North Korea or another dysfunctional dictatorship, diplomatic language is normally notoriously vague and, when on occasion specific, is so watered-down that it can be served up to minors. Not so, however, with last week’s BRIC+SA Delhi Declaration. When it comes to diplo-speak, this is rather blunt stuff indeed. Here are a few relevant excerpts, with my proposed translations from diplo-speak into plain English:
The build-up of sovereign debt and concerns over medium to long-term fiscal adjustment in advanced countries are creating an uncertain environment for global growth. Further, excessive liquidity from the aggressive policy actions taken by central banks to stabilize their domestic economies have been spilling over into emerging market economies, fostering excessive volatility in capital flows and commodity prices.
“We know that the unsustainable debt burdens of ‘advanced’ countries are going to be inflated away or defaulted on. Indeed, the associated inflation is already showing up, wreaking havoc with commodity prices, our domestic capital markets and economies.”
We recognize the importance of the global financial architecture in maintaining the stability and integrity of the global monetary and financial system. We therefore call for a more representative international financial architecture, with an increase in the voice and representation of developing countries and the establishment and improvement of a just international monetary system that can serve the interests of all countries and support the development of emerging and developing economies. Moreover, these economies having experienced broad-based growth are now significant contributors to global recovery.
“You folks in ‘advanced’ economies have mucked things up badly for all of us with your flawed debt-based monetary system. We demand more say going forward so that you don’t just try to foist your burdens of adjustment on us. After all, we have gone out of our way in recent decades to implement market-based reforms, contributing far more to real, sustainable global economic growth than your credit-fueled bubbles. Ignore our interests at your peril.”
We have considered the possibility of setting up a new Development Bank for mobilizing resources for infrastructure and sustainable development projects in BRICS and other emerging economies and developing countries, to supplement the existing efforts of multilateral and regional financial institutions for global growth and development. We direct our Finance Ministers to examine the feasibility and viability of such an initiative, set up a joint working group for further study, and report back to us by the next Summit.
“Because we don’t trust you to act in good faith on the above, we are now planning to set up our own IMF/World Bank. After all, we run huge current account surpluses so it is only natural that the money we are constantly lending to you can also be lent out, if we so choose, to each other or to emerging markets instead. We expect to have plans for such in place within one year. The clock is ticking.”
We welcome the conclusion of the Master Agreement on Extending Credit Facility in Local Currency under BRICS Interbank Cooperation Mechanism and the Multilateral Letter of Credit Confirmation Facility Agreement between our EXIM/Development Banks. We believe that these Agreements will serve as useful enabling instruments for enhancing intra-BRICS trade in coming years.
“We are sick and tired of being dependent on your inflating currencies. In case you haven’t noticed, we have largely completed work on arrangements that will allow us to rely significantly more on our own currencies for bilateral trade in future.”
Global interests would best be served by dealing with the [Syria] crisis through peaceful means that encourage broad national dialogues that reflect the legitimate aspirations of all sections of Syrian society and respect Syrian independence, territorial integrity and sovereignty.
“Stop mucking around in Syria and arming the rebels. Syria is a sovereign nation that has some issues to sort out, but those are internal matters.”
We are concerned about the situation that is emerging around Iran’s nuclear issue. We recognize Iran’s right to peaceful uses of nuclear energy consistent with its international obligations, and support resolution of the issues involved through political and diplomatic means and dialogue between the parties concerned, including between the IAEA and Iran and in accordance with the provisions of the relevant UN Security Council Resolutions.
“Even more important, lay off Iran. They have every right to peaceful nuclear power, just like the rest of us. We prefer a negotiated solution and can no doubt bring much pressure to bear in this regard. Don’t expect us to support the recent hysterical sanctions cutting Iran off from the global financial system. Notwithstanding such sanctions, we’re more than happy to keep trading with Iran through barter arrangements or even for gold. We’re looking to reduce our dependence on the dollar anyway.”
Translated into plain language, the BRICs are sending a clear message that the US economic and monetary policy mainstream, so far at least, appears not to hear. Yes, well-intentioned folks like John Taylor recognise that US economic policy is off the rails and are proposing ways in which it might get back on track. But the BRICs have already lost patience and, I would argue, are increasingly acting as if the US and most other ‘advanced’ economies are simply beyond the point where they can reform themselves, absent clear and present international pressure to do so.
Implicit in the Declaration is that the BRICs are laying the appropriate groundwork for their own monetary system: Bilateral currency arrangements and their own IMF/World Bank. The latter could, in principle, form the basis for a common currency and monetary policy. At a minimum it will allow them to buy much global influence, by extending some portion of their massive cumulative savings to other aspiring developing economies or, intriguingly, to ‘advanced’ economies in need of a helping hand and willing to return the favour in some way.
In my new book, The Golden Revolution (John Wiley and Sons, 2012), I posit the possibility that the BRICs, amid growing global monetary instability, might choose to back their currencies with gold. While that might seem far-fetched to some, consider that, were the BRICs to reduce their dependence on the dollar without sufficient domestic currency credibility, they would merely replace one source of instability with another. Gold provides a tried, tested, off-the-shelf solution for any country or group of countries seeking greater monetary credibility and the implied stability it provides.
Now consider the foreign policy angle: The Delhi Declaration makes clear that the BRICs are not at all pleased with the new wave of interventionism in Syria and Iran. While the BRICs may be unable to pose an effective military opposition to combined US and NATO military power in either of those two countries, they could nevertheless make it much more difficult for the US and NATO to finance themselves going forward. To challenge the dollar is to challenge the Fed to raise interest rates in response. If the Fed refuses to raise rates, the dollar will plummet. If the Fed does raise interest rates, it will choke off growth and tax revenue. In either case, the US will find it suddenly much more expensive, perhaps prohibitively so, to carry out further military adventures in the Middle East or elsewhere.
Would the BRICs shoot their own, export-oriented economies in the foot this way? It all boils down to national priorities. Iran is an important BRIC trading partner, Syria less so. No country willingly chooses an economically damaging confrontation unless it feels the alternative would be even worse. Yet to stand by and let the US and NATO interfere with one important BRIC trading partner after another could be costly indeed in the long run. At some point, they may decide, collectively, to challenge the dollar.
In The Golden Revolution, I apply a Nash equilibrium game-theory analysis to the current set of global monetary arrangements to demonstrate how even minor policy shifts by one or a handful of small countries can lead to major policy shifts by larger ones, eventually replacing an unstable global equilibrium centered around an unbacked fiat reserve currency with a more stable one backed by gold. The Delhi Declaration indicates that the transition from one to another is closer than previously thought.
With time to prepare potentially running short, my recommendations to investors remain unchanged. Reduce holdings of dollars and other fiat currencies that do not represent a stable store of value. Favour liquid over illiquid and real over nominal assets. Most important, to paraphrase Andrew Mellon: Diversify! Diversify! Diversify!
1 This article can be found on the Wall Street Journal’s website here.
2 This Amphora Report can be found here.
3 This Amphora Report can be found here.
4 For more detail on the largely forgotten boom-to-bust cycles of recent decades, please see “Of Bubbles and Bailouts,” Chapter Three of The Golden Revolution (Hoboken, NJ: John Wiley and Sons, 2012). Find the book on Amazon here.
5 This quote and other related quotes from Friedman can be found here.
6 Friedman, Milton, “Monetary Policy in Developing Countries.” In P. A. David and M. W. Reder (eds.) Nations and Households in Economic Growth (New York: Academic Press), p. 270.
7 As it happens, Argentina’s currency board was not 100% backed, something which contributed to the severity of their 2001-03 crisis.
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