Dissenters Speak Out

Before discussing what the Fed might do next, we would note that it has recently 'wheeled out the hawks'. We have noticed that there seems to be a method behind the Fed's communications tactics. Naturally it is possible that we're just a bit too paranoid, but it appears to us that between FOMC meetings, we always get to hear from the perceived 'hawks' (who really aren't all that hawkish, they're only less dovish than their colleagues) relatively early before the next meeting approaches. Their speeches add to the sense that there is someone responsible lurking at the Fed, someone who cares about manipulating the currency 'just right'. Moreover, by getting their remarks out of the way early, it is possible for the Fed to gauge how the markets react to what they say and ideally, from its point of view, make use of the reaction. It is a good bet that if there is a reaction at all, it will be negative from the 'risk assets' side, as Messrs. Plosser, Kocherlakota, Fisher and Lacker (the current crop of dissenters/doubters) all talk about wanting to pursue less rather than more inflation.

If such an effect sets in, it actually helps to strengthen the impact of the 'announcement effect' of any more dovish assertions that we get to hear about later as the FOMC meeting comes closer and/or the effect of whatever new set of policies then is announced at the next meeting. In other words, if the stock market and other 'risk asset classes' (all non-US government types of bonds including junk bonds and commodities) are relatively weak ahead of the meeting, the probability of a positive impact is heightened.

One of the reasons why we think there is actually such a communications tactic employed is that the people manning the Fed are not stupid. They are surely well aware of the dangers of the inflationary policy to some degree. 'Expectations management' is therefore an important part of their strategy. It is much easier to pursue an inflationary policy at a time when inflation expectations are low than when they are already high and rising. Nowadays inflation expectations are mainly ruled by the moves in asset prices, because asset prices are the ones that currently react most violently and quickly when new money enters the economy.

Having said all that, it is nonetheless clear that the Fed is currently a bit constrained: it faces strong political headwinds. In a recent debate between the GOP candidates for the 2012 nomination, every single one of them condemned  Ben Bernanke and vowed to sack him if he were to become president. A falling  stock market is always bad for incumbents and that goes for incumbent bureaucrats as well (if the S&P 500 were at a new high, we would surely not hear anyone call for Ben Bernanke's head). 

Other than that, this is of course just political theater. The calculation is as follows: if we can put pressure on the nominally independent Fed, it may not pump as much prior to the 2012 election than it otherwise would – this in turn may help the eventual Republican challenger to unseat Obama. Once in power, every president wants a Bernanke clone at the Fed. So even if a Republican (other than Ron Paul of course) wins the presidency  and then goes through with the pledge of sacking the Fed chief (which is by no means a certainty, in spite of all the talk), he will very likely nominate another 'dove' in his stead. 

The last time a president was truly opposed to a centralized producer of easy money was when Andrew Jackson refused to renew the charter of  the Second Bank of the United States (SBUS) in the mid 1830's. The SBUS had created a massive economic boom that turned to bust in 1819 by over-issuing currency. It created another artificial boom in its final years of operation beginning in 1830, which was then extended further by the State banks after Jackson decided to move government deposits from the SBUS to the State banks (then known as 'Jackson's pets').

Both the booms leading up to the panic of 1819 and the bust of 1837 (over which the just inaugurated Martin van Buren had the misfortune to preside) were the result of massive money supply inflation beyond the amount of specie backing held by the banks. As an aside to this, van Buren had the good sense to refuse to intervene in the bust, a fact that allowed market forces to quickly reestablish a sound foundation for the economy. Nonetheless, his principled approach (as well as his refusal to immediately annex Texas) eventually cost him the presidency – in 1844, James K. Polk received the Democratic nomination instead (readers should note here that the Democratic party of the 19th century was a completely different organization from today's).



A $1,000 promissory note issued by the Second Bank of the United States – click for higher resolution.

(Image source: Wikimedia Commons)



Contemporary caricature: General Jackson 'slays the many headed monster'. As an investigation into the bank's affairs ordered be Jackson revealed, the SBUS was engaged in a great many frauds and attempted to influence elections.

(Image source: Wikimedia Commons)



Jackson's successor Martin van Buren: his 'laissez faire' approach to the bust that began in 1837 saved the economy from a far worse fate, but even back then the populist policy would have been interventionism. His principled stance may well have cost him the nomination in 1844.

(Image source: Wikimedia Commons)



However, let's return to today's central bank. As we mentioned above, recently the 'hawks' have been heard from. Narayana Kocherlakota held his first speech spelling out in detail the thinking behind his dissent regarding the just announced 'Operation Twist' and the pledge to keep 'ZIRP' in place until 2013. As reported by Bloomberg, Kocherlakota's main concern is that the Fed may imperil its 'credibility':

The committee’s actions at the last two meetings are inconsistent with a systematic pursuit of its communicated objectives,” Kocherlakota said today in a speech in Sidney, Montana. “It follows that these actions diminish the committee’s credibility and so reduce the effectiveness of future committee actions and communications.”

The speech marked the first time Kocherlakota has spoken about policy since opposing a Federal Open Market Committee decision to sell $400 billion of short-term Treasury securities and replace them with $400 billion of longer-term securities.

“I believe that the FOMC’s ultimate effectiveness relies critically on its communication and the credibility of that communication,” Kocherlakota told business leaders from the Sidney area in eastern Montana. “I’ve dissented at the last two meetings because I believe that the committee’s decisions at those meetings diminish that requisite credibility.”


„Kocherlakota said the recovery has been slower than expected, adding “some have suggested that the unexpected slowness of the recovery is a justification for the FOMC’s increasing the level of monetary accommodation over the past couple of months. But I disagree with this argument.”

“As the economy recovers, the FOMC should respond by reducing the level of monetary accommodation,” Kocherlakota said.  “The FOMC should only increase accommodation if the economy’s performance, relative to the dual mandate, actually worsens over time,” he said, referring to the central bank’s goals of maintaining price stability and ensuring full employment.“


Kocherlakota said in response to audience questions that the plan to swap short-term debt for longer-term debt, known as Operation Twist for its attempt to bend the yield curve, is “not a game changer.” The policy will probably have stimulative effects roughly equivalent to cutting the Fed’s target interest rate by 0.5 percentage point, he said.  Kocherlakota also said that the Fed’s low-interest rate policy has “redistributional” effects on the economy.

“When we keep rates low that ends up helping some people more than it helps others,” he said, citing the example of retirees who may be living off fixed-income investments. “Those people have certainly been hurt by interest rate policy.” Still, overall, “the net benefit from stimulating the economy outweighs those losses.”


“Actions speak louder than words,” Kocherlakota said. “The committee can claim that it intends to make monetary policy so as to fulfill its dual mandate. But the public will watch its actions carefully in this regard,” he said.  “If the committee fails to reduce its immense amount of accommodation in a timely fashion, the public will begin to doubt the committee’s claims about its goals,” he said.

Kocherlakota noted that the current 9.1 percent rate is an improvement from the 9.8 percent rate in November last year. The rate is little changed from January.  Inflation has accelerated since last year too. Prices rose 2.9 percent in August from a year earlier, according to the personal consumption expenditures index. Costs excluding food and energy rose 1.6 percent.

“In response to these changes in economic conditions, the committee should have lowered the level of monetary accommodation over the course of the year,” Kocherlakota said. “Instead, through actions taken at its last two meetings, the committee has raised the level of monetary accommodation. In this sense, the committee’s recent actions in 2011 are inconsistent with the evolution of the economic data in 2011.”


(emphasis added)

As you can see from the points highlighted above, Kocherlakota is mainly worried about the 'expectations management' we referred to earlier. He seems to think that the best approach available to the central planners is to follow every small tick in the economic data in as timely a fashion as possible (so that if e.g. the unemployment rate ticks down from 9.8% to 9.1%, monetary policy should immediately be tightened a bit).

To this we would note that the economic data themselves are highly suspect. They often get revised considerably and with a large time lag – more on this further below.

Moreover, the two series of data that appear most important for the Fed's impossible to fulfill 'dual mandate' – unemployment and CPI's rate of change – are themselves subject to so many influences due to the dynamic processes of the market economy, including considerable time lags, that it is impossible to come to a correct 'policy conclusion' from observing them. The bureaucrats can not escape the central problem that bedevils all forms of central planning: they can simply not know what interest rate would most closely reflect the natural interest rate determined by market forces. The mere fact of the Fed's existence creates a feedback loop with the marketplace that means that interest rates are at all times distorted, as they always incorporate market expectations about the Fed's likely next policy moves. The Soviet GOSPLAN agency was at least able to observe the prices of goods and services in the capitalist economies when it made up its five year plans. Had the agency operated in complete isolation, the command economy it steered would have collapsed much earlier.  The Fed can not even observe a 'risk-free' interest rate yardstick that exists outside of its influence, as prevailing market interest rates perforce must reflect expectations about the Fed's manipulations.

Kocherlakota is of course correct to worry about people's expectations – if people were to come to the conclusion that a deliberate inflationary policy is being pursued and that there is no chance that it  will one day be abandoned again, the demand for money could fall suddenly and precipitously – and then the Fed would have a real problem.

It is noteworthy that he admits to the 'redistributional effects' of the Fed's polices. This is something we rarely hear from an FOMC member. Alas, in the same breath he says that the 'price paid by those hurt by the policy' is 'worth it in exchange for stimulating the economy'. This confirms that he is not really a 'hawk' at all. It also confirms that he is among those who believe that wealth creation can be helped by monetary pumping – an idea that is utterly wrong.



Narayana Kocherlakota in front of a few equations. He worries about the Fed's credibility, but remains a firm believer in the central planing of money.

(Image source: University of Minnesota)



Next up to bat was Charles Plosser, who like Kocherlakota does not believe that 'Operation Twist' will make a big difference to the economy. He even suspects that it reaches into the realm of fiscal policy, since the treasury could itself alter the term structure of its outstanding debt (alas, we would note that this could be quite risky). He also correctly perceives that the treasury can easily undo the effects of 'OT', by simply issuing more long term debt, offsetting the Fed's buying of same.

Like Kocherlakota, Plosser expresses worries about the central bank's credibility. According to Bloomberg:

Operation Twist risks damaging the Fed’s credibility and is likely to reduce yields on the 10-year Treasury note by “less than 20 basis points,” Plosser said. A basis point is 0.01 percentage point. His remarks at the Zell/Lurie Real Estate Center fall members’ meeting today were similar to those given in Radnor, Pennsylvania, on Sept. 29.

“Operation twist in my view is a fiscal operation. It is not monetary policy,” Plosser said in a question-and-answer session after his speech. “What we’re doing with Operation Twist could be done by the U.S. Treasury,” and the Treasury could “undo it on their own” by issuing longer-term securities.

Plosser, Fisher and Kocherlakota also dissented when U.S. central bankers in August said they planned to hold interest rates near zero until at least mid-2013. That replaced their prior pledge to keep rates low for an “extended period.”

“The actions taken in August and September risk undermining the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery,” Plosser said. “It is my assessment that they will not.”  He said the August and September actions “will do little to improve the near-term prospects for economic growth or employment, but they do pose some real risks.”

Plosser forecast that the unemployment rate will fall to 8 percent to 8.5 percent at the end of 2012 from 9.1 percent in September, and that inflation will “moderate” as commodity prices decline. He also renewed his calls for the Fed to adopt an explicit target for inflation.“


(emphasis added)

We think Plosser may be overoptimistic on the economy's chance of recovery, but much will of course depend on future Fed and government policy. In the near to medium term, the economy is once again forced to liquidate the new malinvestments that have piled up in the meantime due to the policies implemented since the 2008 bust.

As regards adoption of an 'explicit target for inflation' – the method pursued (or rather, not pursued when it seems opportune to just drop it) by the BoE and ECB, this harbors its own problems. Note that  the term 'inflation' here refers once again to the rate of change of CPI, not money supply growth. We have often discussed that this erroneous definition is the cause of a lot of mischief, so we won't reiterate these arguments here, but would point readers to a previous article on the risks posed by this type of 'price stability policy'.


Adopting Specific Targets

Nonetheless, as the recently released minutes of the September FOMC meeting reveal, the Fed is indeed debating the question of whether it should adopt certain 'targets' that will need to be reached before it considers ending its current extremely easy monetary policy stance.

As reported by Bloomberg:

Federal Reserve officials moved closer to setting targets for economic performance such as inflation to decide how long to keep interest rates at a record low, an action analysts said may come as soon as next month.

Most of the central bank’s 17 governors and regional bank presidents “saw advantages” in the approach and judged it would make policy more effective, the Fed said yesterday in minutes of its Sept. 20-21 meeting in Washington. Some officials wanted to keep more bond purchases as an option, the minutes said.

Chairman Ben S. Bernanke is trying to find new ways to spur growth and reduce joblessness stuck around 9 percent, while cushioning the economy from risks including the housing slump and Europe’s debt crisis. He may set the new policy benchmarks as early as his planned press conference following a two-day gathering of policy makers on Nov. 2, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. (JPM) in New York.

“That seems like a logical next step” by officials should they decide the economy needs another jolt, said Feroli, a former Fed researcher. “There’s pushback in terms of properly implementing it, but the idea itself didn’t seem to generate a lot of intrinsic opposition” at the meeting last month.

The policy would aim to discourage investors from expecting higher interest rates until economic measures such as inflation or employment reach specified levels, thereby keeping borrowing costs low.”


(emphasis added)

As far as we can tell, nobody actually expects higher administered interest rates anyway. After all, the FOMC already pledged to hold 'ZIRP' (a federal funds rate between zero and 0.25%) in place until 2013.

We believe the most significant possible application of this 'goalpost' policy is what we have termed the 'Evans gambit', after Chicago Fed president Charles Evans. Evans argues that the Fed should not only aim for a conservative 'inflation' target, but should actually aim for 'higher than normal inflation' in the misguided belief that this would lower unemployment.

The Bloomberg article continues by highlighting some of the problems of central planning we have mentioned above:

“Some Fed officials support incorporating the so-called Taylor Rule, which measures where the policy interest rate should be set based on inflation and growth, said Plosser, one of three officials to dissent from the easing in August and September.  A portion of officials suggested at the meeting that the Summary of Economic Projections, which explains policy makers’ forecasts and will next be released Nov. 22, could be a vehicle for providing more information about the Fed’s long-run goals and the “likely evolution of monetary policy,” the minutes said.

The Fed’s challenge is deciding which “economic mileposts,” or variables, to use, said Dana Saporta, a U.S. economist at Credit Suisse in New York. The Fed would have to choose between measures of employment, including the jobless rate and changes in payrolls, and between inflation gauges that the Fed prefers or are better known to the public, she said.

“The unemployment rate is a very tricky statistic these days because it’s being moved around by forces other than job creation,” Saporta said. A drop in labor-force participation accounts for much of the decline in the unemployment rate to its most recent level of 9.1 percent in September from 10.1 percent in October 2009, Saporta said.

Fed officials also discussed ways to better specify the central bank’s long-run objectives for inflation and jobs, the minutes said. U.S. central bankers currently stop short of formal targets for prices or unemployment, instead stating levels that represent where data would “converge over time under appropriate monetary policy and in the absence of further shocks.”

Several policy makers last month were reluctant to identify an unemployment goal, because it’s influenced “importantly by nonmonetary factors,” in contrast to a central bank’s control over inflation, according to the minutes.”


(emphasis added)

This is precisely what we noted earlier – there is no way to determine the relevance of the various data sets nor can it be determined to what extent changes in monetary policy influence the data. It is in short simply impossible to implement a successful central planning agenda or precisely measure its effects.

Luckily it appears that so far, the only supporter of the 'Evans gambit' is Charles Evans himself:

Only Chicago Fed President Charles Evans has publicly supported the idea of allowing consumer-price increases faster than 2 percent annually as a way to lower unemployment. The interest-rate commitment should be contingent on joblessness falling to around 7 percent or 7.5 percent as long as inflation stays below 3 percent in the medium term, Evans said Sept. 7. Fed policy makers aim for long-run inflation of about 1.7 percent to 2 percent.”


(emphasis added)

As regards 'Operation Twist' (OT), our friend Bart over at 'NowAndFutures' has taken the time to make a chart of the effects of of 'OT' in the 1960's, when the policy was first tried out, from 1961 to 1965. We reproduce it below.

We would note to this that it is by no means certain that the current iteration of 'OT' will end up having similar effects. The current economic backdrop is markedly different from the early 1960's, so the forces influencing the shape of the yield curve aside from the Fed may in fact overwhelm the Fed's activities in the government bond markets.

Consider that aside from a brief recession in 1961, the early 1960's were a time of economic expansion accompanied by a massive secular 'reflation' bull market in stocks.



Operation Twist in the early 1960's – it mainly affected the yield curve, flattening it considerably – clcik for higher resolution.



How to Achieve More Money Supply Inflation Surreptitiously

All of the above leaves us with a major question: given the political headwinds the Fed faces, how could it see to it that monetary inflation accelerates without arousing the ire of  GOP politicians or provoking a public backlash?

It appears to us that at the moment, an overt 'QE3' announcement would not be a viable option, although we do expect that the Fed will eventually move  to try out even more 'non-traditional' policies, such as the monetization of debt issued by the private sector and even that of debt issued by foreign governments. All of these options were discussed by Ben Bernanke in 2002, and if inflation expectations were to fall further – a distinct possibility in the face of the euro-area's debt crisis – then we would expect to see all or most of his proposals to be implemented at some point.

Steven Saville recently mentioned an idea in the 'Speculative Investor' newsletter (this letter is one of the few on our 'must read' list) which we and others (such as e.g. Gary North) have also briefly discussed in the past. As he correctly notes, this is the very thing the Fed could do next to increase the pace of monetary inflation without immediately provoking a backlash.

It concerns the mobilization of the vast amount of 'excess reserves' held by commercial banks at the Fed.

As the chart below shows, these excess reserves amount to nearly $1.6 trillion at the moment.



Excess reserves held by commercial banks at the Fed stand at nearly $1.6 trillion – clcik for higher resolution.



These reserves, as the name implies, are in excess of the paltry $45-$60 billion in 'required' reserves that used to support the deposit money in the US banking system prior to the 2008 crisis. In 'normal' times nearly all the money substitutes in the US banking system consisted of fiduciary media for which there existed no backing, as the 'sweeps' (MMDA's) introduced by the Greenspan Fed in 1995 have allowed the banks to lower the level of required reserves to almost nil (Greenspan did away with reserve requirements for everything except demand deposits, and sweeps allow the banks to let the bulk of their demand deposits 'masquerade' as savings deposits overnight, so in effect reserve requirements have almost ceased to exist).

At present the money substitutes in the US banking system amount to over $7 trillion (consisting of demand deposits and savings deposits that are effectively available on demand).

If the Fed wishes the private sector to 'take over' its 'money printing duties' without running the risk of the political backlash that 'QE3' would at this time very likely produce, it can simply try to tinker with the rate paid on excess reserves.  It can experimentally cut them to zero, and if that doesn't work, impose a penalty rate (a 'negative' interest rate).

The commercial banks can in theory lever up their $1.6 tr. in excess reserves to create up to $16 trillion in new deposits in favor of borrowers (most likely the the government nowadays) – generously assuming that a 10% fraction in reserves will be kept in place.

So buyers for the entire amount of outstanding government debt and more could be mobilized fairly easily and the money supply could in theory be tripled from where it is now. The Fed need not do much at all, except tinker a bit with the rate paid on excess reserves.

Naturally, this presupposes that the commercial banks will react as expected. Cutting the rate on excess reserves to zero may not necessarily do the trick: the banks may still prefer the safety of their cash assets parked with the Fed over the risk of creating new loans and deposits.

However, we are pretty sure the banks would think twice about that if the Fed were to impose a penalty and actually being to charge them for holding excess reserves with it. In that case we would expect the banks to accommodate in the main new borrowing by the US treasury, as private sector borrowers continue to delever and are in any case viewed as far too risky prospects by the banks at present. Uncle Sam remains the borrower who presents the least amount of risk in the market's eyes (as evidenced by the ten year note yielding just above 2% at the moment).

Up until now, the money supply inflation we have seen since the beginning of the 2008 crisis has largely been the result of active monetary pumping by the Fed, while concurrently, massive debt issuance by the treasury helped keep the amount of total credit market debt in the economy growing in spite of private sector deleveraging.

However, we agree with Messrs. Saville and North that the excess reserves of commercial banks – which so far have been 'quietly lying in wait' – could be mobilized for the additional money creation if the Fed so wishes.

One aspect not discussed by these writers is that the Fed would have to communicate to its member banks that the size of its balance sheet will not be subjected to sudden shrinkage anytime soon. We believe that one of the reasons the banks keep holding on to the bulk of their excess reserves (aside from the fear of a repeat of the funding problems seen after the Lehman collapse) is that the Fed keeps intimating that the increase in its balance sheet is a 'temporary measure' and that one day, it will shrink it back to a size more commensurate with 'normal' circumstances by selling securities and extinguishing the corresponding liabilities to the same extent, effectively shrinking the monetary base by bringing excess reserves down again.

We don't believe this will ever happen, for the simple reason that is has never happened. The Fed is the engine of inflation and inflation that has already occurred is never voluntarily taken back. Note here that the money supply deflation of the early 1930's was not due to the Fed's failure to pump, as is widely – and wrongly – assumed.  Even Ben Bernanke himself appears to believe this, judging from his speech on the occasion of Milton Friedman's 90th birthday.

The Fed in fact increased free bank reserves by more than 400% between the fall of 1929 and the summer of 1933. The money supply deflated in spite of these efforts, because first of all, a great many banks were still outside the Federal Reserve system at the time, and secondly and more importantly, there was no FDIC that could have stopped bank runs or bailed out depositors of failed banks. Thus the amount of fiduciary media in the banking system began to shrink due to the combination of bank runs and failing banks taking   deposit money with them to 'money heaven'.

We certainly do not believe the Fed can successfully plan the economy – this should be quite obvious even to all those people that are not conversant with the theoretical arguments against central planning or the socialist calculation debate.

If the Fed it could indeed successfully plan the economy and ensure smooth economic development by means of its price fixing and money supply manipulation, there would never have been a bust in the first place.  The bust itself is prima facie evidence that the Fed and other central banks have failed.

However, we do believe that the members of the Fed are politically astute. As is the case with every bureaucracy, the Fed's primary interest is its own survival and growth. 

Even the concerns of the dissenting 'hawks' we talked about above are closely intertwined with this dynamic. Their worries about the institution's 'credibility' go beyond the effects its policies have on the market economy. They concern to some extent the viability of the institution itself and reflect the growing unease over  the political backlash it currently experiences. After all, before the Fed entered the scene, two previous attempts to introduce central banking to the US were aborted by politicians.

At the same time, we know for a fact that the entire board of governors and several notable regional presidents such as Charles Evans and Eric Rosengren stand fully behind the Bernankean policy of monetary pumping. Clearly, judging from their speeches, their votes and their papers, all these people believe that a socialistic monetary system is appropriate to a market economy and that the apparatus implementing it is effectively able to 'stimulate economic growth', i.e., contribute to the creation of wealth.

Therefore, the notion that they will come up with new 'creative solutions' to increase the growth of the money supply while attempting to avoid the public criticism of their policies can not be dismissed. The excess reserves of commercial banks are a lever that can always be employed to pursue this agenda.


The Problem With Economic Data

We also want to point readers to a recent article that appeared at the FT's Alphaville blog, entitled 'Ignorance Is Not Bliss – It Can Ruin Your Economy'.

The article discusses the fact that the size of the late 2008/early 2009 economic downturn keeps getting revised upward. What was initially thought to have been a contraction of 3.8% of GDP has by now been revised to a contraction of 8.9%.

The article bemoans the ineffectiveness and inaccuracy of the government's economic data collection and calculation efforts. As can be seen by the comments of many observers cited in the article, it is generally assumed that the government's reaction to the downturn could have been improved by better knowledge about its extent.

This line of argument completely misses the point in our opinion. It assumes without further elucidation or debate that government intervention on account of a downturn – such as a deficit spending spree in the form of 'stimulus spending'  – is an unalloyed positive. The implication in this particular case is that the spending spree – the biggest in post WW2 history –  should have been even bigger!

This shows why econometric and empirical approaches are so harmful – the debate should not be over the quality of the statistics, it should be over the policy prescriptions themselves. In our opinion it would be best if the government collected no economic statistics at all. As Sir John James Cowperthwaite, the former governor of Hong Kong argued in this context, collecting economic statistics only invites government meddling in the economy. Cowperthwaite informed an astonished delegation of bureaucrats that had been sent from England that he didn't collect statistics on unemployment and could therefore not tell them how high unemployment in Hong Kong was. After all, what was the point? The governor wished Hong Kong to have a 'laissez faire' economy – and collecting economic data would only have raised the probability of someone eventually interfering with this objective. We would note to this that Hong Kong's subsequent enormous economic growth underscores nicely that Cowperthwaite was perfectly correct.

No wonder that today's mainstream economics are in a cul-de-sac and have very little of value to offer in terms of explaining economic phenomena or coming up with viable policy ideas. The terms of the debate need to be urgently changed.



Former governor of Hong Kong, Sir John James Cowperthwaite: collecting economic statistics only invites government meddling in the economy.

 (Image source: Wikimedia Commons)




A friend pointed us to an excellent blog post criticizing the current populist protectionist efforts aimed at China. It can be found at the 'California Beach Pundit' site and is entitled 'Why Romney is Wrong About China'.

We highly recommend reading the post in its entirety. As it were, the continued popularity of mercantilist and protectionist fallacies is very difficult for us to understand. Even prominent 'economists' (we use the term loosely here…) like Paul Krugman are among the regular China bashers. In our opinion, ever since Frederic Bastiat exploded the protectionist fallacies in the mid 19th century, there is nothing left to discuss. Denying that free and open trade is economically beneficial is like denying the existence of gravity – it is a completely futile effort. The fact of the matter is that the alleged 'unfairness' of  China's mercantilist policy only harms China itself. Everybody else profits from the fact that they get to buy its exports cheaply. Protesting against this is as though shoppers were to stage a sit-in at Wal-Mart accusing the company that it isn't charging them enough. It is utterly absurd.

Below are a few pertinent snips from the 'Pundit's' post:

“Romney said that "if he were elected president he would immediately launch a combative relationship with Chinese leaders and attack their currency and trade policies." I wouldn't mind seeing him elected, but I sure hope that before he takes office, someone tells him he is dead wrong on China.

I sense that these words resonated with a lot of folks, and that's very unfortunate. Romney's great weakness as a leader is that he is a slick politician who crafts a message that he thinks people like to hear. He may understand a lot about how businesses and economies work, but he has no grounding at all in trade policy.

For those who disagree, let me first say there is a huge body of research, backed by sound economic theory, that says that free trade is an unmitigated good: no exceptions. Second, let me note that imports from China are such a small part of what we buy that trying to correct our supposed trade imbalance with China can't possibly be worth the risk of starting a trade war with such an important trade partner.


Goods and services from China accounted for only 2.7% of U.S. personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to U.S. businesses and workers transporting, selling, and marketing goods carrying the "Made in China" label. Although the fraction is higher when the imported content of goods made in the United States is considered, Chinese imports still make up only a small share of total U.S. consumer spending.


Third, let me quote from the excellent Don Beaudreaux, who, in an open letter to Romney, demolished Romney's position using simple logic:


… you complained that Beijing pursues policies that make Chinese products less expensive than American products.

I overlook the fact that, because only 2.7 percent of Americans’ personal consumption expenditures are on goods and services produced in China, 97.3 percent of the goods and services bought by American consumers obviously are less expensive to Americans than are Chinese-made equivalents.

Instead, let me here go to the heart of your argument and accept your presumption that party A harms party B if A offers to sell goods or services to B at prices lower than what it would cost B to produce those goods or services himself.
Accepting this presumption, I’m obliged to advise you that you can make yourself and your family better off by styling your own hair. Your current stylist obviously does a fine job – strong evidence in support of my suspicion that that stylist has pursued policies that make it less costly for you to use his or her styling services than it would be for you to design and maintain your coiffure yourself.

If that's not enough, because you think that it's China's subsidizing of its exports that is harmful to us, consider this
open letter written by Boudreaux to Robert Samuelson:

You argue that we Americans are harmed by foreign subsidies that lower the prices of our imports (“Our one-sided trade war with China,” Oct. 7). But why? Why are we harmed by these lower-priced imports if (as I know you agree) we benefit from imports whose prices are lowered by natural market forces?

In both cases, some U.S. workers lose jobs. And in both cases, not only does Americans’ cost of living fall, but, also, opportunities are thereby opened in America for the creation of new industries and new opportunities that would otherwise be economically out of reach. In America, absolutely nothing about jobs lost to imports whose prices are made lower by foreign subsidies distinguishes them from jobs lost to imports whose prices are made lower by natural market forces.

If you’re skeptical of my claim, ask first: Would you oppose the successful private efforts of a Chinese physician to invent an inexpensive pill that safely and completely cures people of cancer? I’m sure not, despite the fact that such a pill would destroy many American jobs – from those of physicians to hospital orderlies. Now ask, would you oppose the successful efforts of the Chinese government to subsidize the invention and production of such a pill for export to America?

The logic of your position is that such subsidies would hurt Americans and, therefore, Uncle Sam should retaliate with measures to protect us from the scourge of such a low-priced cancer-curing pill.

These examples show nicely what is wrong with protectionist ideas. The problem is, even if people like Romney only use these populist fallacies in an attempt to angle for votes and have no intention to actually implement punitive tariffs and similar policies, they run the risk of setting in motion a self-feeding dynamic that then leads to the implementation of such policies 'by mistake'. When the Smoot-Hawley tariff law was implemented, a great many economists protested that it would do incalculable harm. The economists were right as subsequent events showed: world trade collapsed and the Great Depression ravaged the economy. However, the political dynamic was such that they could no longer stop the passage of the bill. A similar fatal process could be on the verge of being repeated.


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8 Responses to “The Fed’s Options”

  • worldend666:

    Hi Floyd

    I have to agree. I think there is a difference between harmonious trade under normal circumstances and political strategy in a game which will reshape the world.

    There is also a difference between the aims of Chinese citizens and Chinese power players. Government may well be quite willing to sacrifice the well being of its population in order to gain a long term strategic advantage over its peers.

    China now is the manufacturing engine of the world, regardless of who owes who what and who appears to be richer in terms of dollars and cents. That is the undeniable goal of the strategic thinkers there, and if some time in the near future currencies do evaporate who will be in the better position? The Chinese with their shipyards and computer plants or the USA with it’s shopping malls?

    • zerobs:

      There is also a difference between the aims of Chinese citizens and Chinese power players.

      Hard to believe someone can completely blind to the exact same dynamic going on in one’s own country.

  • Floyd:

    Thanks Pater for you post.
    Questions/thoughts wrt to China:

    Suppose China is flooding the market with goods aiming to eliminate competitors, so it can raise prices later (or not lower then further due to extant competitive pressure).
    Wouldn’t that be an issue (paying cheap now, but possibly dearly later)?

    Similarly, suppose that China having lax environmental and labor regulations enable it to undercut competition.
    Isn’t that an issue (if we compete by relaxing said regulation it is a loss, if we don’t it is a job loss)?

    Suppose China undercuts the market with nefarious methods as such, we still get real products for mounts of paper. Not a bad exchange for the US gov – it seems so.
    However, a byproduct is that the working class erodes (assuming they don’t find equally-or-better paying jobs), and gov growth (as it issues said paper handed to China in this weird exchange).

    PS: This is not to say that we aren’t acutely over regulated, but I doubt it that all regulation is ill-conceived.

    What am I missing?

  • JBVO:

    Bank reserves are a liability of the Fed which finance its assets, as are currency, reverse repos, and deposits at the Treasury.

    If the Fed incents the banks to put those reserves to work in the market, what will replace them as a significant funding source for the Fed?

    • All that would happen would be that some of the reserves would move from the ‘excess reserves’ to the ‘required reserves’ category. The size of the Fed’s balance sheet should actually not be altered if the banks were to use their excess reserves to pyramid new loans on them.

  • SMaturin:


    Love the nod to Bastiat!

    Richard Fisher’s remarks about OT and inflation bear examining. He may be the most rational voice currently on the FOMC:


    • I actually briefly discussed this Fisher speech here a little while back. I first wrote about his views last year when he began to discuss ‘regime uncertainty’ for the first time. Right after Hoenig, he is the Fed president who ‘gets it’ the most. I think this has to do with the fact that he’s actually a businessman with some experience in the real world, not just an ivory tower economist. And he has undoubtedly a sharp intellect.

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