Blog Comment on Italy

This was recently posted by a reader:

I’m from Italy so I can answer your question. The general and most accepted ideas in Italy are:

  • “The problem is president Berlusconi.”
  • “We need structural reforms!” (In every pub people love to say that, to feel themselves intelligent, the same that are in precarious financial conditions.)
  • “We are not credible.”
  • “We live beyond our means.”

And the best:

  • “Without the Euro it would be a catastrophe, fortunately, we have a strong currency.”

China Frets About Spreading EU Debt Woes

Yes, they want to support the euro with their fx reserves to support their exports to that region, but there is no equivalent of US Treasury securities that they can hold.

It’s as if they could only buy US state municipal debt, and not Treasury secs, Fed deposits, and other direct obligations of the US govt with their dollars.

So the only way they can support exports to the euro zone is to take the credit risk of the available investments.

Now add to that their inflation problems.

The traditional export model is to suppress domestic demand with some type of tight fiscal policy, and then conduct fx purchases of the currency of the target export zone.

The euro zone does the tight fiscal but can’t do the fx buying, so the policy fails as the currency rises to the point net exports don’t increase.

China does the fx buying, but has also recently used state lending and deficit spending to increase domestic demand, which increases domestic prices/inflation, including labor, which works to weaken the currency and retard net exports.

So China fighting inflation and the euro zone fighting insolvency both look to keep aggregate demand down for 2011.

And I don’t see the deficit terrorists about to take their seats in the US Congress doing anything to increase aggregate demand either.

So all that and the Fed still failing to make much headway on either of its dual mandates, 30 year 0 coupon tsy’s at about 4.75% (and libor + as well) look like a pretty good place for a pension fund to get some duration and lay low, at least until there’s some visibility from the new US Congress.

China Frets About Spreading EU Debt Woes

By Langi Chiang

December 21 (Reuters) — China urged European authorities to back their tough talk with action on Tuesday by showing they can contain the euro zone’s simmering debt problems and pull the bloc out of its crisis soon.

China, which has invested an undisclosed portion of its $2.65 trillion reserves in the euro, said it backed steps taken by European authorities so far to tackle the region’s debt problems, but made clear it would like to see the measures having more effect.

“We are very concerned about whether the European debt crisis can be controlled,” Chinese Commerce Minister Chen Deming said at a trade dialogue between China and the European Union.

“We want to see if the EU is able to control sovereign debt risks and whether consensus can be translated into real action to enable Europe to emerge from the financial crisis soon and in a good shape,” he said.

Concerns that Europe’s debt problems will spread beyond euro zone’s periphery to engulf bigger economies such as Spain and Italy have weighed on global financial markets this year and taken a toll on the euro.

In part to protect its investments, China has repeatedly expressed its support for the single currency.

In October, Premier Wen Jiabao promised to buy Greek government bonds once Greece returned to debt markets, in a show of support for the country whose debt burden pushed the euro zone into a crisis and required an international bailout.

Fed foreign currency swap lines


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(IF ANYONE HAS BUITER’S EMAIL ADDRESS KINDLY FORWARD THIS, THANKS)

The question is, why has the Fed entered into new swap lines to be able to borrow foreign currency from several CBs who already have Fed dollar lines?

Several possibilities not mutually exclusive:

  1. They may have agreed on some kind of international currency stability scheme that use swap lines to keep currencies stable to each other.
  2. More likely is the notion that these lines are needed to control global interest rates in one’s own currency. The Fed started extending the swap lines to control USD LIBOR which was partially determined by banks outside the US.
  3. Yes, it worked to do this, but as previously explained, (indirectly) lending to lesser, foreign credits at low rates to keep rates down threatens a much larger problem.

    Note that it was announced last week that Mexico was drawing down its $30 billion line from the Fed. How much sense does it make for the Fed to lend Mexico 30 billion dollars, functionally unsecured, just to somehow help keep LIBOR down? Mexican banks aren’t even in the LIBOR basket. There are other options to get LIBOR down without extending unlimited dollar loans to unknown and potentially high risk borrowers. What the Fed has done is reckless at best.

    So in a world of CBs who put the highest priority on being able to control their interest rates and don’t recognize the risk of extending potentially bad loans to do it, using these swap lines for interest rate control make perfect sense.

  4. The Fed could also be worried about the dollar getting weak and not having foreign currency reserves to directly intervene. This could be signs of the heightened level of this insecurity from having ‘increased the money supply’ by ‘printing money’ and a zero rate policy, as none of them understand that the size of their balance sheet and the low interest rate policy have nothing to do with inflation.

What they do with their balance sheet is about price and not quantity.

And with the non government sectors quickly becoming net savers to the tune of nearly $10 trillion lowering rates is fiscally contractionary. Not to mention rates are a marginal cost of production, and nowadays ‘inflation’ most often comes through the cost side.

So the Fed arranging foreign currency credit lines might be a ploy to show the other CBs they are serious about the value of the dollar long term. Of course, Bernanke has many times stated to Congress the value of a weak dollar and in his mercantilist view he’s trying to support exports and narrow our trade gap that he sees as a ‘bad thing’ per se, as he still holds on to the gold standard construct of ‘national savings’ and sees our trade gap as an imbalance, rather than an enhancement of our real terms of trade and real standard of living. So I’d say that unless something changes the Fed would welcome a weak dollar and not use the new swap lines to support it. In fact, it is more likely that in addition to getting USD interest rates down to support lending, the Fed also acted to support demand for US goods and services by keeping the world USD ‘short’ position from strengthening the dollar and hurting US exports.

Functionally these swap line advances are like World Bank or IMF lending. While the advances by those agencies always start out as loans, historically they have morphed into fiscal transfers, as, in real terms, it all becomes a race to the bottom whereby whoever borrows the most and inflates the most wins.

These central bankers, however, (errantly) rely on ‘inflations expectations theory’ for their understanding of inflation, which of course is inapplicable, but it’s all they have and it’s deeply believed.

Therefore they aren’t worried about the inflationary aspects of swap lines,
and the incentive for an inflationary race to the bottom. (They do however worry to some degree about weak currencies causing inflation expectations to elevate)

So currently, for example, the Fed is hanging out a free lunch to any Central Bank that stops worrying about the possibility of paying back the Fed, and simply starts behaving as if the dollar loans are fiscal transfers, by looking the other way when their member banks start using them as such. I see signs of this possibility in the eurozone where the borrowings have been outstanding far too long for comfort that the banks are making good faith efforts to pay them down.

Regarding USD LIBOR, if I were running the Fed I’d ban the use of LIBOR with member banks. The idea of a mob of old men in bow ties sipping sherry at 9am arbitrarily setting my interest rates that flow through to trillions of my banking system’s dollar loans just doesn’t seem optimal for public purpose.

Lastly, to address a technical issue that’s been raised, while the lines are swaps, they provide usable currency deposits only for the counter party that activates the line.

For example while the ECB has borrowed dollars from the Fed and has provided euro deposits for the Fed as collateral, the Fed can’t use those euro deposits except in the case of an ECB default. And even if was somehow agreed that the Fed could use those euro deposits, when the ECB payed back the dollar loans the Fed would have to pay back the euro deposits, which is an unworkable arrangement.

So even with euro deposits as collateral for its dollar loans to the ECB, if the Fed wants to spend euro it has to borrow them. Hence the new lines to the Fed from the ECB and others.

Bottom line? The CBs think they have ‘learned something’ from the crisis- swap lines can be used to help CBs control interest rates in their currencies around the world, and therefore it makes sense to set them up in advance for that purpose.

That’s what happens with a world that doesn’t fully understand reserve accounting, monetary operations, and that the currency is a public monopoly. Never in a crisis have the CBs done so much that actually accomplished so little- at least not in the desired direction.

Why did the Fed, the Bank of England, the ECB, the Bank of Japan and the Swiss National Bank announce a dubbel openslaande porte-brisée deur?

by Willem Buiter

April 9 (Financial Times) — On April 6, 2009, the Fed, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank simultaneously made announcements about currency swap arrangements. I consider these statements to be misleading and quite possibly redundant.

The Bank of England, for instance, made the following announcement:

“The Bank of England, the European Central Bank, the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing swap arrangements that would enable the provision of foreign currency liquidity by the Federal Reserve to US financial institutions. Should the need arise, euro, yen, sterling and Swiss francs would be provided to the Federal Reserve via swap agreements with the relevant central banks. Central banks continue to work together and are taking steps as appropriate to foster stability in global financial markets.

Bank of England Actions

The Bank of England has agreed that it would enter into arrangements to provide sterling liquidity to the Federal Reserve should it be required. The sterling would be provided via a swap arrangement with the Federal Reserve, similar to that which underpins the Bank of England’s US dollar repo operations. Both swap arrangements run until 30 October 2009.”

The Fed’s statement concerning this same swap arrangement was rather more illuminating. For starters, it actually gave the amounts of the swaps:

“The Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing swap arrangements that would enable the provision of foreign currency liquidity by the Federal Reserve to U.S. financial institutions. Should the need arise, euro, yen, sterling and Swiss francs would be provided to the Federal Reserve via these additional swap agreements with the relevant
central banks. Central banks continue to work together and are taking steps as appropriate to foster stability in global financial markets.

Federal Reserve Actions
The Federal Open Market Committee has authorized new temporary reciprocal currency arrangements (foreign currency liquidity swap lines) with the Bank of England, the ECB, the Bank of Japan, and the Swiss National Bank. If drawn upon, these arrangements would support operations by the Federal Reserve to provide liquidity in sterling in amounts of up to £30 billion, in euro in amounts of up to EUR80 billion, in yen in amounts of up to ¥10 trillion, and in Swiss francs in amounts of up to CHF 40 billion.

These foreign currency liquidity swap lines have been authorized through October 30, 2009.”

What this really amounted to was a renewal of swap arrangements agreed earlier (on September 18, 2008), which had expired on January 30, 2009. Canada, which was included in the earlier swap arrangement, is no longer a party to the new version.

The antecedents of the ‘new’ swap arrangements

The swap arrangements between the Fed and assorted foreign central banks that were the antecedent of the arrangement ‘announced’ on April 6, 2009, were initiated at the end of 2007. On September 18, 2008, the Fed made the following announcement, providing the most direct antecedents of the April 6, 2009 swap arrangements: “The Federal Open Market Committee has authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks.

The FOMC has authorized increases in the existing swap lines with the ECB and the Swiss National Bank. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $110 billion by the ECB, an increase of $55 billion, and up to $27 billion by the Swiss National Bank, an increase of $15 billion.

In addition, new swap facilities have been authorized with the Bank of Japan, the Bank of England, and the Bank of Canada. These facilities will support the provision of U.S. dollar liquidity in amounts of up to $60 billion by the Bank of Japan, $40 billion by the Bank of England, and $10 billion by the Bank of Canada.

All of these reciprocal currency arrangements have been authorized through January 30, 2009.”

In parallel with other central banks, the Bank of England extended, on 3rd February 2009, the term of this swap facility agreement with the Federal Reserve until 30 October 2009.

Framing matters
A swap is a swap is a swap. The arrangement between the Fed and the Bank of England provides the Fed with sterling and the Bank of England with US dollars. The swap arrangement with the ECB provides the Fed with euros and the ECB with US dollars. Etc. Etc. You don’t have to make two announcements, one that the Fed is getting Swiss francs, euros, yen and sterling and one, a couple of months later, that the SNB, the ECB, the BoJ and the BoE are getting US dollars. So why the redundant announcement on April 6, 2009?

With the original swap arrangements, the rationale for the arrangements was clearly a US dollar scarcity among financial institutions outside the US. Even with the extension of the September 18, 2008 arrangements announced on February 3, 2009, US dollar scarcity outside the US was given as the reason by the Bank of England: “To address continued pressures in global U.S. dollar funding markets, the temporary reciprocal currency arrangements (swap lines) between the Federal Reserve and other central banks have been extended to October 30, 2009.”

But on April 6, 2009, the statement by the Fed is not about the Fed supplying US dollars to foreign central banks to meet an excess demand for US dollars by banks outside the US. The statement is all about foreign central banks supplying the Fed with euros, sterling, yen and Swiss francs to accommodate a US thirst for these foreign currencies: “The Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing swap arrangements that would enable the provision of foreign currency liquidity by the Federal Reserve to U.S. financial institutions. Should the need arise, euro, yen, sterling and Swiss francs would be provided to the Federal Reserve via these additional swap agreements with the relevant central banks. Central banks continue to work together and are taking steps as appropriate to foster stability in global financial markets.”

It may well be that in a swap arrangement between central banks, one party is the supplicant and the other party the bestower of favours. When Iceland tried to arrange swap arrangements with the ECB and the Fed in the spring of 2008, there certainly was very little appetite for Icelandic kroner in the ECB and the Fed – so little in fact, that Iceland failed in its attempt to arrange the swaps.

Two things are very weird about the April 6, 2009 announcement. The first is that it was redundant. It provided no new information beyond the extension of the old swap arrangements of September 18, 2008, that had been announced on February 3, 2009. The February 3, 2009 announcement extended the swap arrangements to October 30, 2009. The April 6, 2009 announcement did not change that. And the April 6, 2009 announcement did not change the size of the swap materially (the Bank of England can probably draw up to $44 bn or so under the latest swap arrangement).

It is conceivable – the statements are worded quite clumsily – that the April 6, 2009 announcement is about swap arrangements additional to the swaps previously announced (on February 3, 2009). In that case, the size of the swap arrangements has effectively been doubled. The redundancy objection disappears, but the misleading framing objection continues to apply in spades. If this is indeed the case, my concerns (explained below) about the fate of the US dollars provided by the Fed in the original swaps are strengthened.

The second strange feature is that the April 6, 2009 statement by the Fed is misleading. It is clearly phrased to convey a sense of the Fed needing foreign exchange (euros, yen, Swiss francs and sterling) to provide this foreign currency liquidity to US financial institutions. That is rhubarb. The US dollar shortage abroad continues today in much the same way as on February 3, 2009 or on September 18, 2008. Financial institutions in the US can get foreign exchange liquidity quite readily from the US subsidiaries of Euro Area, British, Swiss and Japanese banks. They don’t need the Fed for that.

On April 6, 2009 as on September 18, 2008, the non-US central banks were the beggars in the swap arrangements and the Fed the chooser. So why pretend that the opposite is the case? Why make a redundant and misleading announcement about the swap arrangements? The answer “beats me”, comes to mind. So does: “a collective central bank screw-up”. Finally there is the possible explanation that by re-framing an existing swap arrangements as the reflection of a Fed need for foreign exchange rather than as a non-US central bank need for US dollars, attention is diverted from foreign exchange shortages outside the US.

I can certainly make a quite convincing case that the UK is woefully short of foreign exchange reserves. At the end of March 2009, UK official foreign exchange reserveswere $49.3 bn gross and $28.3 bn net. The Bank of England’s net foreign currency assets are negligible ($6 mn at the end of 2008)

Clearly, the UK swap facility with the Fed is large relative to the size of UK Government Foreign Currency Assets. Gross foreign exchange reserves exceed the size of the swap facility ($44 bn, say) by less than $5 bn and net foreign exchange reserves are more than $15 bn lower than the size of the swap facility.

Small net or gross foreign exchange reserves don’t matter as long as the solvency of the government and the nation are beyond doubt, because in that case the authorities will always be able to borrow whatever foreign exchange reserves they require. This is arguably no longer the case anywhere. The massive prospective government deficits of the UK and the impressive size of the nation’s short-term foreign currency-denominated liabilities are such that one can without too much effort visualise a scenario where both the government and the private sector are rationed out of the foreign exchange markets and debt markets. When a ‘sudden stop’ is a non-negligible risk, foreign exchange reserves matter. Ask the Asian and South American countries that went through the 1997-1998 crises.

Recently, interest in the Bank of England’s US dollar repos has petered out, but at the beginning of the programme, amounts close to the $40 bn limit were taken up. If those US dollars were borrowed by banks like RBS and HBOS, both insolvent except for past, current and anticipated future government financial support, they may well have been lost. These banks (and other UK banks that are still standing more or less on their own two feet) had (and continue to have) very large US dollar exposures on which they made massive losses – well in excess of $40 bn. These banks also have few liquid foreign currency assets.

Assume one or more banks that borrowed US dollars from the Bank of England cannot pay them back. The Bank of England takes the collateral that secured these US dollar loans. Eligible collateral for these loans consists of those securities that are routinely eligible in the Bank’s short-term repo open market operations and Standing Facilities, as published on the Bank’s website, together with conventional US Treasury securities. Assume that little if any of the collateral offered for the US dollar loans from the Bank of England consisted of US Treasury securities. So the Bank gets a mitt full of sterling securities back in lieu of the US dollars it has lost. Nice, but not good enough. When the swap arrangements expires, the Bank of England has to repay the Fed in US dollars, not in sterling securities. So unless the swap arrangement is extended, or extended and expanded, the Bank of England would have to send the Fed an ‘Oops’ note.

If the full swap line was lost ($40 bn), the UK would be completely out of (net) foreign exchange reserves – if we consolidate the foreign exchange assets and liabilities of the government and the US dollar swap exposure of the Bank of England. Not a good place to be. Of course, the beauty of swaps if that they are off-balance sheet items.

I haven’t checked the details about the official foreign exchange reserves of Switzerland and the Euro Area nations, nor do I know much about the foreign exchange losses of Swiss and Eurozone banks, although I expect that these losses are vast. It is possible that the earlier use of the swap lines by the ECB and the SNB has also made a rather large dent in the net foreign exchange reserves of Switzerland and the Eurozone nations.

In any case, the Machiavallian interpretation of the redundant second announcement of the central bank swaps is that it was intended to divert attention from the dire condition of the official foreign exchange reserves of a number of European countries, especially the UK. Extending the duration of the swaps delays the moment that the loss of the US dollars will have to be recognised. If this was indeed the case, it is bound to fail. Markets can be stupid, but not that stupid. This will not reduce the risk that Reijkjavik-on-Thames will have to seek IMF assistance at some point.


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Obama believes China is manipulating currency


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Here we go:

Think they realize exports are real costs and imports real benefits???

Obama Deems China ‘Manipulating’ Yuan, Geithner Says

by Rebecca Christie and Mark Drajem

Jan 22 (Bloomberg) — President Obama — backed by the conclusions of a broad range of economists — believes that China is manipulating its currency,” Geithner said in the remarks, which were posted on the Senate Finance Committee Web site today. “The new economic team will forge an integrated strategy on how best to achieve currency realignment in the current economic environment.


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ECB council member foresees ‘tri-polar’ currency system


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(email exchange)

>   
>   On Sun, Oct 19, 2008 at 11:06 PM, wrote:
>   
>   Sure he can say that now so long as the Fed is there to
>   backstop everything. These Europeans have no shame.
>   

Right, the Eurozone is surviving on the unlimited Fed USD swap lines.

That’s a complete ideological failure for the Euro members.

It’s their worst nightmare- the ECB borrowing USD reserves to support the Euro Banking System.

ECB council member foresees ‘tri-polar’ currency system

By Jonathan Tirone

VIENNA, Austria — European Central Bank council member Ewald Nowotny said a “tri-polar” global currency system is developing between Asia, Europe, and the United States and that he’s skeptical the U.S. dollar’s centrality can be revived.


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Eurozone on the Brink


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Hi Joseph,

Agreed, and this attitude continues this morning, with comments like ‘Europe needs this slowdown to bring down inflation’ as their opinion leaders argue against a rate cut (not that a rate cut would actually help demand as they think it would, but that’s another story).

It seems they are actually welcoming this weakness, probably out of fear unemployment was getting far too low to ‘discipline’ the unions, as wage demands were anecdotally featured in the Eurozone news.

France’s proposal for a 300 billion euro wide fund to calm bank depositors was immediately shot down by Germany (not that it would have or could have been sufficient to stop a run on the banking system, but that too is another story).

It is also becoming more clear that effectively major euro lending institutions have found themselves massively ‘long’ euros and ‘short’ dollars. The Fed’s swap lines have grown to over $600 billion, mainly with the ECB. This means the ECB is borrowing USD from the Fed to lend to its banks. This represents the same kind of external debt that has brought down currencies since time began. Running up external debt to sustain your currency is highly unlikely to succeed.

Ultimately, their only exit is to sell euros and buy the USD needed to cover their net USD needs. The resulting fall in the currency can spiral into a serious run on the banking system. Unlike Americans who run to high quality securities in their local currency when they get scared, Europeans and their institutions tend to flee the currency itself.

While the national governments will attempt to contain any such run, they don’t have the capability, as they are all limited fiscally by both law and market forces, with the latter the far stronger force. Only the ECB can write the check of the size needed, no matter how large, but they are currently prohibited by treaty from making such a fiscal transfer.

I have serious doubts the Eurozone can get through this week without entering into a system wide banking crisis that will end with the payments system being closed down until it reopens with bank deposit insurance at the ‘federal level’- in this case from the ECB itself.

The Eurozone would have been ‘saved’ if the US has responded with a fiscal response in the range of 5% of GDP, and continued to increase imports and keep the world export industries alive.

But that didn’t happen, and, by design, that channel was cut off when Paulson, supported by Bernanke and Bush, managed to convince foreign central banks to stop accumulating USD reserves.

This both killed the goose laying the golden eggs for the US (imports are a real benefit and exports a real cost), as US exports have boomed and real terms of trade fell, and also triggered the looming collapse of the Eurozone as exports fell off and domestic demand remained weak.

Good morning!


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WSJ: An economist who matters


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An economist who matters


by Kyle Wingfield

(Wall Street Journal) Robert Mundell isn’t in the habit of making fruitless policy recommendations, though some take a long time ripening. Nearly four decades passed between his early work on optimal currency areas and the birth of the euro in 1999 – the same year he received the Nobel Prize for economics.

The Euro had nothing to do with the optimal currency area considerations.

Back in America, there’s an election going on. There’s also been a spate of financial problems, not the least of which is a weak dollar. But Mr. Mundell says “the big issue economically . . . is what’s going to happen to taxes.”

Democratic nominee Barack Obama regularly professes disdain for the Bush tax cuts, suggesting that those growth-spurring measures may be scrapped. “If that happens,” Mr. Mundell predicts, “the U.S. will go into a big recession, a nosedive.”

Even if the lost aggregate demand is more than replaced at the same time?

One of the original “supply-side” economists, he has long preached the link between tax rates and economic growth. “It’s a lethal thing to suddenly raise taxes,” he explains. “This would be devastating to the world economy, to the United States,

Even Laffer, the originator of his curve, does not agree with that.

and it would be, I think, political suicide” in a general election.

That may be true, but so far polls don’t show it.

Should taxes instead be cut again, I ask him, to stimulate the sluggish economy? Mr. Mundell replies that he favors a ceiling of 30% on marginal rates (the current top rate is 35%). He recounts how the past century experienced a titanic struggle over whether tax rates are too high or too low: from a 3% income tax in 1913; up to 60% during World War I; down to 25% before Congress and President Herbert Hoover raised taxes back to 60% in 1932 and “sealed the fate of our economy for a long, long time”; all the way up to 92.5% during World War II

When real output more than doubled, even as 7 million of our best workers went into the military.

before falling in three steps, reaching 28% under President Ronald Reagan; and back to nearly 40% under Bill Clinton before George W. Bush lowered them to their current level.

Deficit spending is much more of a driver of aggregate demand than marginal income tax rates.

In light of this fiscal roller coaster, Mr. Mundell says, “the most important thing that could be done with respect to tax rates now is to make the Bush tax cuts permanent. Eliminating that uncertainty would be more important than pushing for a further cut – in the income tax rates, anyway.”

One tax that he would cut, to 25%, is the corporate tax rate. “It could be even lower,” he says, “but I think it would be a big step to lower it to 25% . . . I made that proposal back in the 1970s.”

Very small potatoes from a macro point of view.

A long-haired Mr. Mundell spent that decade not only arguing for the euro, but laying the intellectual groundwork for the Reagan tax-cut revolution. Mr. Mundell says those tax cuts remain “as important to the United States as the creation of the euro was to Europe – a fundamental change.”

The deficit spending of the Regan years was the driver of the expansion- tax cuts and spending increases.

Combined with Paul Volcker’s tight-money policy at the Fed, which Mr. Mundell also championed, supply-side economics killed off stagflation.

And not the drop in crude prices due to a 15 million barrel per day supply response when natural gas prices were uncapped and utilities switched from oil to gas (and coal, etc.)???

Seems Mundell is pure propaganda.

Or at least it killed it off at the time. With prices again rising as growth slows, some economists are worried that stagflation could be making a comeback. Not Mr. Mundell – not yet.

He draws a comparison with the situation in 1979-1980. Start with the dollar price of oil, which he calls “one of the two most important prices in the world” (the other being the dollar-euro exchange rate, which we’ll get to in a moment).

“If you look at the price level since 1980,” he begins, “oil prices would naturally double by the year 2000. So from $34 a barrel in 1980 to $68 a barrel. And then . . . because the inflation rate’s about 3.5%, it would double again by 2020. So the natural price . . . would be something like $136 in 2020.

So ‘naturally’ doesn’t include inflation???

More to the point, the inflation rate was about 3.5% for 20 years or so with oil prices under $20, so now with oil spiking to $140, inflation should fall to the Fed’s target of maybe 2% due to a modest output gap?

“Now, we [already] got to $130-something, but . . . I really think the price is going to settle down, probably below $100, if not below $90. What I’m saying is we’re not so far off track.”

Guess he forgot the first week of micro that shows how monopolists set price?

As an economist, he should know Saudis are necessarily setting price.

American motorists still shocked by $4-a-gallon gasoline might think we’re rather more off track than Mr. Mundell suggests. Bolstering his case, he immediately moves on to another commodity often invoked to demonstrate inflation: gold.

“The price of gold in 1980 was $850 an ounce. And the price of gold today is about the same. It’s astonishing,” he says. “It’s true, gold did go up” to more than $1,000 an ounce earlier this year, “but the public doesn’t believe that there is inflation. If there was big inflation coming, then you’d see the price of gold going up to $1,500 an ounce very quickly, and that hasn’t happened.”

If they could take Nobel Prizes away, that statement would put him at risk.

In any case, don’t expect to hear Barack Obama or John McCain talk about the weak dollar’s contributions to any problem. “As [journalist] Robert Novak once put it, it’s like cleaning ladies who come in and say ‘I don’t do ironing.’

Good thing he isn’t running with a statement like that.

[Politicians] say, ‘I don’t do exchange rates,'” Mr. Mundell chuckles. “They think they can only lose by talking about exchange rates, because they don’t know enough about it, and it’s hard to predict anyway, for anyone.”

If Mr. Mundell had his way, there wouldn’t be anything for politicians to say about exchange rates. They would be fixed – as they were under the Bretton Woods arrangement after World War II until 1971, when President Nixon took the U.S. off the postwar gold standard and effectively launched the era of floating exchange rates.

“It’s a very poor and a dangerous system,” Mr. Mundell says of the floating regime, “because it creates exaggerated swings in the exchange rate.”

Vs. exaggerated swings in unemployment. Fixed foreign exchange regimes regularly ‘blow up’ with double digit or higher unemployment, negative growth, and actual blood in the streets. They have been abandoned for very good and practical reasons.

Case in point is the dollar-euro rate. From a low of about 82 cents in 2000, Europe’s common currency has risen fairly steadily and has been valued at more than $1.50 since late February, even breaking the $1.60 barrier once.

Without any negative growth, moderate inflation, and, in the Eurozone, declining unemployment.

“What people have to realize is there’s been a fundamental change in the way markets work in the past 20 years,” Mr. Mundell says. “Now, exchange rates are driven not so much by trade but by capital accounts and capital movements, and the huge amount of liquidity that’s sloshing around the world.”

Guaranteed he can’t discuss ‘liquidity sloshing around the world’ beyond that rhetoric.

Central banks world-wide, he notes, are trying to reach an equilibrium between dollars and euros in their $6.5 trillion worth of foreign reserves. Roughly two-thirds of these reserves are kept in dollars now, so they have about $1 trillion left to move into euros.

“If you did a hundred billion dollars” annually, Mr. Mundell points out, “you’d need 10 years to build that up, and that amount of capital movement has a tremendous effect in keeping the euro overvalued. It’s not good for Europe

It does help their real terms of trade, but maybe he doesn’t think that’s ‘good.’

and . . . ultimately it would cause more inflation in the United States.”

It already is, but here he’s denying it.

But this continuing shift doesn’t mean that the dollar’s status as the world’s dominant currency is in danger, at least not in the short run. Countries like Iran may be pushing for the pricing of oil in another currency, “but it wouldn’t happen unless Saudi Arabia and the Gulf states moved in that direction, and I don’t see any way in which they would do this,” Mr. Mundell says.

He also doesn’t ‘see’ that it doesn’t matter what currency anything is ‘priced in’ as it’s just a numeraire. What matters is the currency they ‘save in’ as he mentions when he estimates how they want to hold their reserves and how that matters.

“It would be very damaging to the relations between the United States and the Gulf countries. There’s an implicit defense alliance between those, and that’s what overrides as a top priority.”

Nor is there a macroeconomic argument for demoting the dollar. “Remember, the growth prospects for the United States are probably stronger than that of Europe, because you’ve got continued and substantial population growth in the United States, and zero population growth in Europe,” Mr. Mundell says. “Quite apart from the fact that the U.S. economy is innovating more rapidly, and the population is younger and not getting old as rapidly, so they pick up new technology faster. So I look upon the United States still as the main sparkplug of economic growth in the world.”

He misses his own argument. It’s about what currency non-residents want to ‘save in’ that determines reserve levels and the dollar being a reserve currency.

As for the euro’s overvalued status, he forecasts deflation in Europe,

Negative CPI???

along with a slowdown and an end to its housing boom.

Already happening to some degree.

The answer, he suggests, is for the Federal Reserve and the European Central Bank to cooperate in putting a floor and a ceiling on both the euro and the dollar. “You have to grope” to the appropriate range, he maintains, but a good starting point would be to keep the euro between 90 cents and $1.30.

That would mean the ECB buying $ and giving the appearance that the $ is ‘backing’ the Euro as the ECB collects dollar reserves. This is probably unthinkable politically for the Eurozone as they want the Euro to be the world’s reserve currency, not the $.

Even better, in his mind – and now we’re really talking long term – would be to have a global currency. This could take the form of a new money or a dominant existing one to which all others are fixed – probably the dollar. “As Paul Volcker says,” Mr. Mundell relates, “the global economy needs a global currency.”

With no global fiscal authority to regulate aggregate demand? That’s a prescription for economic disaster.

To get there, he proposes holding a new, Bretton Woods-type meeting in 2010 at the Shanghai World’s Fair. Mr. Mundell, who has been spending “a lot of time” in China advising the government, says reviving an international system of fixed exchange rates would be a tremendous help to Beijing as it tries to fend off demands from U.S. and European politicians that it appreciate or float its currency.

Here, he recalls Washington’s similar “bashing” of the Japanese yen in the 1980s, and its ultimately disastrous effects: “Japan got stuck with an overvalued currency for a decade, and suffered from a perpetual deflation in its housing market from 1990 until just a couple of years ago. And China doesn’t want to have the same problem.”

Japan ran/allowed a budget surplus from 1987 to 1992 that wiped out demand and the economy didn’t begin to recover until subsequent deficits got over 7% of GDP.

China isn’t making that mistake.

Another part of his solution is for Asian countries to form their own currency bloc. If they did so, he says, “it’d be comparable in size to the European and the American bloc. And then it would not be so much the question of . . . the U.S. and Europe bashing China” or other rising economies.

He totally misses the roll of aggregate demand.

These three currency blocs, he predicts, would be large enough to weather wide swings in their exchange rates. But the swings would still do economic damage, so “the best thing you could do is to stabilize them, and that’s where the global currency comes in.”

Could it happen? Mr. Mundell allows that three decades may pass, but predicts that like the euro and the Reagan revolution before it, the global currency’s time, too, will come. Any skeptics might want to review the last few decades before betting against him.

I agree the world might do something counter productive like that. Unless there’s something worse they could do that pops up.

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