The Unloved World Dollar Standard: Greenspan-Bernanke Bubbles in the Global Economy

Ronald McKinnon Stanford University

The Political Economy of international Money: Common Currencies, Currency Wars, and Exorbitant Privilege Federal Reserve Bank of Dallas April 3, 2014

The Unloved World Dollar Standard 1945—2014

• • • • In major crises, IMF is lender of first resort but the Federal Reserve is the lender of last resort: Europe 2008 and 2011 Interbank dollar swaps However, in determining US monetary policy, the Fed is inward looking and ignores ROW Episodes of US easy money, and /or talking the dollar down, provoke hot money outflows From the Nixon Shock of 1971 to Greenspan Bernanke near-zero interest rates and quantitative easing in the new millennium

• • • •

From Tri-lemma to Dilemma for Emerging Markets (EM)

Wide interest differentials between the center and periphery induce hot money inflow to EM.

Contrary to conventional wisdom, EM with convertible currencies cannot achieve independent monetary policies by floating their exchange rates The dilemma for EM central banks: -float and appreciate, lose export competiveness. Dollar value of Brazilian Real doubled between 2003 and 2007. -or intervene to buy dollars and stabilize the exchange rate, lose monetary control, and inflate Collective monetary expansion and inflation in EM spawns bubbles in world commodity prices and other assets.

8,0 7,0 6,0 5,0 4,0 3,0 2,0 1,0 0,0 Source: FRED Figure 1: US Interest Rates USD Libor 10 Year Treasury

Figure 7.

GDP Weighted Discount Rate of BRICS and G3 12 % 6 4 10 8 2 0 2000 2001 Source: IMF, EIU 2002 2003 2004 2005 2006 BRICS 2007 G3 2008 2009 2010 2011 2012

8000 Figure 2. Emerging Markets and China, Foreign Exchange Reserves (Billion USD) 7000 6000 5000 4000 3000 2000 1000 0 янв.01

янв.02

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янв.05

янв.06

янв.07

Total Emerging Markets янв.08

янв.09

China янв.10

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янв.13

10 Figure 3 Headline CPI: EM and US 8 6 4 2 GDP Weighted EM CPI US Headline CPI 0 -2 Source: EIU, Author's Calculation Emerging Markest include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand

Carry Trades and Banking Crises

• • • • • Carry Traders exploit the interest differential by borrowing at low interest rates in “source” currencies to invest in high-interest “investment” currencies in EM.

They are unhedged risk takers who borrow at short term in source currencies from banks.

But if banks face an unexpected crisis, they stop lending to risky borrowers and refuse to roll over old credits Hot money then suddenly returns to the center— particularly to the US, which is seen as a safe haven under the dollar standard Dollar appreciates, EM currencies slump

Figure 2A Change of Reserves in Selected Emerging Countries Source: Financial Times

80 60 40 120 100 160 140 Figure 4 BRICS Currencies, LCU (local currency unit)/USD, Jan-2002=100 China Brazil Russia India South Africa

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Exchange Rate Behavior on the Periphery: China versus Brazil

Two Great Waves of hot money flows into the periphery: 2002 – 2007, mid 2009 to mid 2011 China keeps yuan/dollar rate fairly stable with slow RMB appreciation after mid 2005. Every morning, PBC sets Y/$ central rate at level of the close of previous trading day. Daily variation of ± 1 percent (increased to ± 2 percent in March 2014) is then permitted. Sustains high growth.

Brazil much closer to a free float. Dollar value of the real doubled between 2003 and 2007, and knocked Brazil off its high growth path.

Other BRICS more like Brazil than China; heavy interveners but not very successful in smoothing their dollar rates.

Figure 5. US Real Effective Exchange Rate, Jan-2000=100 125

Credit Crunch

120

Dollar Carry Trade

115 110 105 100 95 90 85 80

New Dollar Carry Trade Eurozone Crisis Emerging Market Slowdown

Source: Federal Reserves

Primary Commodity Bubbles

• • • • Loss of monetary control in EM collectively leads to bubbles in primary commodity prices, many EM are primary commodity producers Ultra low interest rates at the center attracts carry traders willing to bet on price increases.

But sudden increases in primary commodity prices can devastate political systems in LDCs which depend on low food and fuel prices. Witness food riots leading to the “Arab Spring”

Figure 6: The Greenspan-Bernanke Bubble Economy 2002 to 2013 (2005 =100) 240 220 200 180 160 140 120 100 80 2003 2004 2005 Case-Shiller Source: Bloomberg 2006 2007 2008 CRB Commodity Index 2009 2010 S&P 500 2011 2012 Core CPI 2013

Figure 8 Food/Agriculture Product Price (2005=100) 350 300 Start of Arab Spring Dec 2010 250 200 150 100 50 2005 Source: Bloomberg 2006 2007 2008 2009 UN Food And Agriculture World Cereals Price Index 2010 2011 2012 S&P GSCI Agriculture Index 2013

Figure 10. GDP growth: Developed vs. Developing World 10

%

8 6 4 2 0 -2 -4 -6 Source: IMF Advanced Economies Emerging and Developing Countries

Figure 9. Size of Central Bank Balance Sheet, % of GDP 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: Bloomberg, OECD Stat Japan UK US EuroArea

Springing the Low Interest Rate Trap

• • • • • Recognize that ultra low interest rates in the US are bad for it as well as for EM Near zero nominal interest rates in US distort financial intermediation: a supply constraint on bank- based or indirect finance that penalizes employment in SMEs, .

Corporations can desert banks and directly use bond or equity markets that thrive even at very low interest rates.

European economies are even more dependent on intermediating financial flows through banks, and thus are more damaged by near zero short-term interest rates. U.S start tapering by phasing in higher short rates up to a modest 2 %. Then phase out quantitative easing: let long rates be market-determined subject to the constraint that future short-term rates will remain modest. Other central banks in the industrial economies would (should?) follow.