In partial response to Professor Keneth Rogoff's January 2009 article, "Has America Lost Its Mojo?" on Project Syndicate
(Dated: February 9, 2009)
(Dated: February 9, 2009)
America has not lost its mojo. However, the members of the American intellectual establishment -- in academia, in government, in the media, the Federal Reserve and the industry captains -- need to understand that they don't have an eternity and a blank-check to fix the crisis in the American economy that began as early as 2007 and has steadily gotten out-of-hand ever since.
1) Role of China: Several weeks ago, the Chinese government announced a two-year fiscal spending program of 4 trillion RMB Yuan, which in recent Dollar-Yuan exchange rates is equivalent to $586 billion. At the time of announcing this program, there was widespread skepticism about China's ability to maintain its GDP growth rate at above 8%, given the current worldwide economic crisis. However, on January 28, at the World Economic Forum in Davos, the Chinese Prime Minister, Wen Jiabao, explained the rationale for their growth target of 8% for 2009. China's finance industry and housing industry have not been affected by the mortgage crisis and the subsequent financial crisis in America. This leaves China free to spend the entire amount of $586 billion on its infrastructure, and to stimulate its consumer demand through tax cuts and subsidies. Thus the expected fall in its exports as a result of the fall in consumer demand in Western economies due to this worldwide economic crisis can be entirely replaced by this fiscal spending program announced by the Chinese government. Now, the nominal GDP of China for 2007 was around $3.5 trillion (in exchange rate terms). So, $586 billion is just over 16% of China's 2007 GDP. Thus merely by instituting a two-year fiscal program China can maintain an 8% annual GDP growth for the next two years.
China has been empowered to carry out such a huge fiscal program purely through the reckless spending of trillions of dollars by America, under the cheer-leading of its intellectual establishment. To my knowledge, the extra spending in America, that can be attributed to the prolonged crisis in the American economy, is already over 4 trillion dollars -- (i) TARP: $700 billion, (ii) Federal Reserve balance sheet expansion in the last nine months from $900 billion to $2.2 trillion, (iii) fiscal stimulus package for 2009: $800 billion, (iv) various stimulus packages under President Bush since January 2007: $300 billion+, (v) fiscal deficits for 2007-09 (including that part of the Iraq war expense that is financed through debt): $1 trillion+. Please note that this spending of $4 trillion, spread out over three years (2007 - 09), is just over 28% of the $14 trillion figure for the GDP of the United States for 2007.
Apart from this $4 trillion of spending, the Federal Reserve has been engaging in off-balance-sheet activities like bailouts of AIG, Bear Stearns and Citigroup. Another important point to note is that the Federal Reserve has undertaken extensive currency swaps with the central banks of Europe, England, Japan, Germany and other countries. Because of the widespread perception so far, that the financial crisis that originated in America is global in scope, there has been a flight to safety to the US dollar in the last six months. However, as time goes by, the experts are going to recognize that there are islands of strength in the world economy that have not been affected by the economic crisis in America. This would mean that it is going to get more and more difficult for the Federal Reserve to print dollars and release it into the global economy to finance its expansionary monetary policy. Also, the central banks of other countries are not going to be so eager to enter into currency swap agreements with the US Federal Reserve, if they find out in several months that their own economies are not directly affected by the mortgage crisis and the financial crisis that originated from the United States.
In the last two decades, world trade has been growing at a much faster pace than the average growth rate of annual GDP among the nations of the world. As a result, there has been a big surge in the demand for a world reserve currency. The US dollar, which has been serving as the de facto reserve currency of the world for the past fifty years, has been the direct beneficiary of this surge in world trade. This has been the most important reason why an expansionary monetary policy has not led to the drastic weakening of the dollar, even after taking into account, this $4 trillion of spending during 2007-09. America has been seen as the world's sole superpower from an economic and a military perspective, after the end of the cold war in the late 80s. However, starting from its economic liberalization in the late 70s, China has been emerging as an alternative economic giant, slowly and surely.
The American intellectual establishment needs to realize that it is not by accident that China has come to hold US treasury securities worth trillions of dollars in its reserves. Through its imperial mandarin system, China has acquired highly qualified, well-educated and very intelligent people in the upper levels of its bureaucracy. It would not be possible for America to simply transfer the negative effects of this current financial crisis to other countries by just printing up more dollars. Rather than buy these additional dollars for lack of any alternative, countries like China are going to take this opportunity to institute their own spending programs and to stimulate their own consumer demand, through tax cuts or subsidies. This also means that China would not have as much need for US dollars in the future to finance its exports, since exports would be a smaller proportion to domestic consumption.
Contrary to what the new US Treasury Secretary Timothy Geithner said in his confirmational hearing at the US Congress, a more accommodative policy towards China is in the long-term economic interest of America. Rather than unleash trade wars and currency wars with China, it would be far more sensible for America to get China to open its own hi-tech areas to foreign trade. Under the dire economic circumstances that America is currently in, a 'Live and Let Live' policy towards China is highly recommended.
2) Ideal response from the Federal Reserve: Firstly, Professor Ben Bernanke, the Chairman of the US Federal Reserve (Fed), must be commended for bringing tranparency to the Fed's culture of work. Secondly, by responding quickly and forcefully, he has helped to defuse the panic and the tension during some crucial moments of the financial crisis in the months of September and October of 2008. No doubt his active efforts in the last six months to ensure an adequate supply of dollars in the world markets has helped to stabilize the functioning of the global economy. Thirdly, he consulted regularly with his academic colleagues, both conservatives and liberals, and he drew upon his own academic and research experience in dealing with this crisis. These are all very sound contributions from Professor Bernanke and his team at the Fed.
However, when all the factors in this crisis are taken into account, it seems unavoidable that one has to say Professor Bernanke went more-than-a-little overboard. In particular, he paid too large a price for restoring calm in the markets. For one thing, he kept cutting interest rates recklessly. The ideal response would have been that he issued dire warnings about the economy throughout the latter half of 2008, and yet that he cut interest rates only by 50 basis points or less at a time. Moreover, he should have taken an informal break from cutting the rates, starting three weeks before and ending two weeks after the Presidential election on November 4, 2008. He should have aimed to have the Fed's target rate for overnight lending between banks to be at around 2% when the new President took office on January 20, 2009, instead of the current 0 - 1/4% range.
Professor Bernanke did not appreciate that the Fed needs to work in-sync with the political establishment to get maximum affect for its plans to get the economy out of the crisis. The Fed should coordinate its activities with the political cycle, even while retaining its own independence. However, Professor Bernanke seems to have followed a strange interpretation of this policy. This led him to lend moral and intellectual support to the ill-advised $700-billion TARP program proposed by the US Treasury Department. Professor Bernanke went to the extent of appearing on Congressional hearings alongside Henry Paulson, the then Treasury Secretary, with increasingly comical explanations of how the plan to spend $700-billion at the complete discretion of the Treasury Secretary could actually work. Instead of taking up a more political role in this situation, if Professor Bernanke had stuck to his usual scholarly disposition, he would have still retained his credibility as a serious thinker of the modern economy.
Another big mistake that Professor Bernanke made was his complete unwillingness to state that his expansionary monetary policy of the last six months is a temporary arrangement to stablize the functioning of the American economy as well as the global economy. He needed to demonstrate his resolve to rein in all the extra spending once the immediate crisis blows over. Instead, throughout December and in January, even after the Fed's target interest rate could not be cut any more, Professor Bernanke continued to proclaim that monetary policy is not ineffective, that he could always release more dollars into the economy (ref: Quantitative Easing). In short, he was still functioning in the crisis-prevention mode, when it was clear that the Fed needed to step aside and let other institutions -- like the new Presidency, the US Congress and the private sector -- contribute towards the recovery of the economy. He seemed to be thinking that the economy is too important to be entrusted to the politicians.
Next, the currency swap agreements with central banks of other countries ensured adequate supply of the US dollar in the world markets. This in turn had ensured the stability of the exchange rates of the dollar with other currencies, at a time when there was widespread flight to safety towards the dollar. However, the dollars that the foreign countries have received are being used by their trading communities for international trade, whereas the foreign currencies that the Fed has received in these swap agreements do not have as much use, since the dollar is the world's reserve currency. This means that the foreign countries have an incentive to print an equivalent amount of their local currency, without worrying about inflation, and use it to finance their own spending programs. Since the mortgage industries and finance industries in the foreign countries have not been as much damaged as in the US, the foreign countries could spend their money to strengthen the structure of their economies, instead of having to bail out their mortgage and finance industries. In the long run, this means they would come out stronger from this economic crisis than America would.
Moreover, as the immediacy of the crisis wanes, investors around the world are not going to need the dollar as a safehaven. This would lead steadily to an excess of dollars in the world markets, which in turn, would weaken the dollar. This would provide the foreign countries more incentives to print their own money and finance their spending programs, just as China has done recently. Thus the US Federal Reserve should monitor the currency markets closely in the coming months and draw up a plan to wind down the massive currency swap agreements that it entered into during the peak of the financial crisis in September and October of 2008.
To be continued . . .
3) Revisionist History on Lehman Brothers' fall:
4) Solution(s) for the Mortgage Crisis:
5) Neither fiscal stimulus nor tax cuts:
6) Comparison with the 1970s:
7) Conclusion:
1) Role of China: Several weeks ago, the Chinese government announced a two-year fiscal spending program of 4 trillion RMB Yuan, which in recent Dollar-Yuan exchange rates is equivalent to $586 billion. At the time of announcing this program, there was widespread skepticism about China's ability to maintain its GDP growth rate at above 8%, given the current worldwide economic crisis. However, on January 28, at the World Economic Forum in Davos, the Chinese Prime Minister, Wen Jiabao, explained the rationale for their growth target of 8% for 2009. China's finance industry and housing industry have not been affected by the mortgage crisis and the subsequent financial crisis in America. This leaves China free to spend the entire amount of $586 billion on its infrastructure, and to stimulate its consumer demand through tax cuts and subsidies. Thus the expected fall in its exports as a result of the fall in consumer demand in Western economies due to this worldwide economic crisis can be entirely replaced by this fiscal spending program announced by the Chinese government. Now, the nominal GDP of China for 2007 was around $3.5 trillion (in exchange rate terms). So, $586 billion is just over 16% of China's 2007 GDP. Thus merely by instituting a two-year fiscal program China can maintain an 8% annual GDP growth for the next two years.
China has been empowered to carry out such a huge fiscal program purely through the reckless spending of trillions of dollars by America, under the cheer-leading of its intellectual establishment. To my knowledge, the extra spending in America, that can be attributed to the prolonged crisis in the American economy, is already over 4 trillion dollars -- (i) TARP: $700 billion, (ii) Federal Reserve balance sheet expansion in the last nine months from $900 billion to $2.2 trillion, (iii) fiscal stimulus package for 2009: $800 billion, (iv) various stimulus packages under President Bush since January 2007: $300 billion+, (v) fiscal deficits for 2007-09 (including that part of the Iraq war expense that is financed through debt): $1 trillion+. Please note that this spending of $4 trillion, spread out over three years (2007 - 09), is just over 28% of the $14 trillion figure for the GDP of the United States for 2007.
Apart from this $4 trillion of spending, the Federal Reserve has been engaging in off-balance-sheet activities like bailouts of AIG, Bear Stearns and Citigroup. Another important point to note is that the Federal Reserve has undertaken extensive currency swaps with the central banks of Europe, England, Japan, Germany and other countries. Because of the widespread perception so far, that the financial crisis that originated in America is global in scope, there has been a flight to safety to the US dollar in the last six months. However, as time goes by, the experts are going to recognize that there are islands of strength in the world economy that have not been affected by the economic crisis in America. This would mean that it is going to get more and more difficult for the Federal Reserve to print dollars and release it into the global economy to finance its expansionary monetary policy. Also, the central banks of other countries are not going to be so eager to enter into currency swap agreements with the US Federal Reserve, if they find out in several months that their own economies are not directly affected by the mortgage crisis and the financial crisis that originated from the United States.
In the last two decades, world trade has been growing at a much faster pace than the average growth rate of annual GDP among the nations of the world. As a result, there has been a big surge in the demand for a world reserve currency. The US dollar, which has been serving as the de facto reserve currency of the world for the past fifty years, has been the direct beneficiary of this surge in world trade. This has been the most important reason why an expansionary monetary policy has not led to the drastic weakening of the dollar, even after taking into account, this $4 trillion of spending during 2007-09. America has been seen as the world's sole superpower from an economic and a military perspective, after the end of the cold war in the late 80s. However, starting from its economic liberalization in the late 70s, China has been emerging as an alternative economic giant, slowly and surely.
The American intellectual establishment needs to realize that it is not by accident that China has come to hold US treasury securities worth trillions of dollars in its reserves. Through its imperial mandarin system, China has acquired highly qualified, well-educated and very intelligent people in the upper levels of its bureaucracy. It would not be possible for America to simply transfer the negative effects of this current financial crisis to other countries by just printing up more dollars. Rather than buy these additional dollars for lack of any alternative, countries like China are going to take this opportunity to institute their own spending programs and to stimulate their own consumer demand, through tax cuts or subsidies. This also means that China would not have as much need for US dollars in the future to finance its exports, since exports would be a smaller proportion to domestic consumption.
Contrary to what the new US Treasury Secretary Timothy Geithner said in his confirmational hearing at the US Congress, a more accommodative policy towards China is in the long-term economic interest of America. Rather than unleash trade wars and currency wars with China, it would be far more sensible for America to get China to open its own hi-tech areas to foreign trade. Under the dire economic circumstances that America is currently in, a 'Live and Let Live' policy towards China is highly recommended.
2) Ideal response from the Federal Reserve: Firstly, Professor Ben Bernanke, the Chairman of the US Federal Reserve (Fed), must be commended for bringing tranparency to the Fed's culture of work. Secondly, by responding quickly and forcefully, he has helped to defuse the panic and the tension during some crucial moments of the financial crisis in the months of September and October of 2008. No doubt his active efforts in the last six months to ensure an adequate supply of dollars in the world markets has helped to stabilize the functioning of the global economy. Thirdly, he consulted regularly with his academic colleagues, both conservatives and liberals, and he drew upon his own academic and research experience in dealing with this crisis. These are all very sound contributions from Professor Bernanke and his team at the Fed.
However, when all the factors in this crisis are taken into account, it seems unavoidable that one has to say Professor Bernanke went more-than-a-little overboard. In particular, he paid too large a price for restoring calm in the markets. For one thing, he kept cutting interest rates recklessly. The ideal response would have been that he issued dire warnings about the economy throughout the latter half of 2008, and yet that he cut interest rates only by 50 basis points or less at a time. Moreover, he should have taken an informal break from cutting the rates, starting three weeks before and ending two weeks after the Presidential election on November 4, 2008. He should have aimed to have the Fed's target rate for overnight lending between banks to be at around 2% when the new President took office on January 20, 2009, instead of the current 0 - 1/4% range.
Professor Bernanke did not appreciate that the Fed needs to work in-sync with the political establishment to get maximum affect for its plans to get the economy out of the crisis. The Fed should coordinate its activities with the political cycle, even while retaining its own independence. However, Professor Bernanke seems to have followed a strange interpretation of this policy. This led him to lend moral and intellectual support to the ill-advised $700-billion TARP program proposed by the US Treasury Department. Professor Bernanke went to the extent of appearing on Congressional hearings alongside Henry Paulson, the then Treasury Secretary, with increasingly comical explanations of how the plan to spend $700-billion at the complete discretion of the Treasury Secretary could actually work. Instead of taking up a more political role in this situation, if Professor Bernanke had stuck to his usual scholarly disposition, he would have still retained his credibility as a serious thinker of the modern economy.
Another big mistake that Professor Bernanke made was his complete unwillingness to state that his expansionary monetary policy of the last six months is a temporary arrangement to stablize the functioning of the American economy as well as the global economy. He needed to demonstrate his resolve to rein in all the extra spending once the immediate crisis blows over. Instead, throughout December and in January, even after the Fed's target interest rate could not be cut any more, Professor Bernanke continued to proclaim that monetary policy is not ineffective, that he could always release more dollars into the economy (ref: Quantitative Easing). In short, he was still functioning in the crisis-prevention mode, when it was clear that the Fed needed to step aside and let other institutions -- like the new Presidency, the US Congress and the private sector -- contribute towards the recovery of the economy. He seemed to be thinking that the economy is too important to be entrusted to the politicians.
Next, the currency swap agreements with central banks of other countries ensured adequate supply of the US dollar in the world markets. This in turn had ensured the stability of the exchange rates of the dollar with other currencies, at a time when there was widespread flight to safety towards the dollar. However, the dollars that the foreign countries have received are being used by their trading communities for international trade, whereas the foreign currencies that the Fed has received in these swap agreements do not have as much use, since the dollar is the world's reserve currency. This means that the foreign countries have an incentive to print an equivalent amount of their local currency, without worrying about inflation, and use it to finance their own spending programs. Since the mortgage industries and finance industries in the foreign countries have not been as much damaged as in the US, the foreign countries could spend their money to strengthen the structure of their economies, instead of having to bail out their mortgage and finance industries. In the long run, this means they would come out stronger from this economic crisis than America would.
Moreover, as the immediacy of the crisis wanes, investors around the world are not going to need the dollar as a safehaven. This would lead steadily to an excess of dollars in the world markets, which in turn, would weaken the dollar. This would provide the foreign countries more incentives to print their own money and finance their spending programs, just as China has done recently. Thus the US Federal Reserve should monitor the currency markets closely in the coming months and draw up a plan to wind down the massive currency swap agreements that it entered into during the peak of the financial crisis in September and October of 2008.
To be continued . . .
3) Revisionist History on Lehman Brothers' fall:
4) Solution(s) for the Mortgage Crisis:
5) Neither fiscal stimulus nor tax cuts:
6) Comparison with the 1970s:
7) Conclusion:
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