In particular, the committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
The Fed is now publicly wedded to a set of numeric goals and committed to zero rates until those goals are achieved and perhaps even longer.
Three aspects of the Fed’s commitment stand out. The first is that the numeric targets of 6.5 percent unemployment and 2.5 percent inflation are thresholds, not triggers. The Fed did not say that it would raise rates when those levels were hit; it said it would not raise rates before those levels were hit. This leaves ample room to continue easy money even if unemployment falls to 6 percent or inflation rises to 3 percent. Second, the Fed said both targets would have to be satisfied before it raised rates, not just one or the other. This means that if unemployment is 7 percent, the Fed can continue its easy-money policy even if inflation rises to 3 percent or higher. Finally, the Fed’s inflation target is based on projected inflation, not actual inflation. This means that if actual inflation is 4 percent, it can continue with easy money so long as its subjective inflation projection is 2.5 percent or less.
This new policy is a brilliant finesse by the Fed. Superficially it pays lip service to Woodford’s recommendation for commitment to unambiguous goals; but in reality the goals are slippery and ill defined. No one knows if the Fed will slam on the brakes at 3 percent inflation, if unemployment is still 7 percent. No one knows how much time will elapse between the end of money printing and a rate increase. Yet the Fed’s new policy is consistent with its hidden 3 percent inflation goal under the carrots-and-sticks approach. The Fed can justify higher inflation if its employment goal is unmet. It can justify higher inflation if projected inflation is lower. It can justify higher inflation in all events because the numeric targets are thresholds and not triggers. The new policy puts no real constraints on higher inflation.
The PDS and BRITS framework and the Fed’s new policies converge around the specter of inflation, which lurks behind the academic theories and public pronouncements. Low borrowing costs and higher inflation are the only ways the Fed can improve deficit sustainability. Financial repression lowers borrowing costs, and quantitative easing can create higher inflation if the markets believe it will continue. The Fed’s December 2012 policy is a muddled version of Woodford’s recommendations. The Fed is pretending to have numeric goals while preserving the degrees of freedom it needs to reach any inflation target it finds necessary, but that involves a certain sleight of hand.
The Fed’s form of theft from savers has a name: it’s called money illusion by economists. The idea is that money printing on its own cannot create real growth but can create the illusion of growth by increasing nominal prices and nominal GDP. Eventually the illusion will be shattered, as it was in the late 1970s, but it can persist for a decade or more before inflation emerges with a lag and steals the perceived gains.
While the Fed’s goals of higher inflation and rising nominal GDP are clear, there is good reason to believe the Fed will fail to achieve these goals and may even produce disastrous consequences for the United States by trying. The Fed’s own staff have expressed reservations about whether forward guidance works at all in the time horizons the Fed is using. Prominent economist Charles Goodhart has said that nominal GDP targeting is “a thinly disguised way of aiming for higher inflation” and that “no one has yet designed a way to make it workable.”
Perhaps the most compelling critique of the flaws in nominal GDP targeting and the inflation embedded within it comes from inside the Fed board of governors itself. In February 2013 Fed governor Jeremy Stein offered a highly detailed critique of the Fed’s easy-money policy and obliquely pointed to its greatest flaw: that increased turnover is not the only channel money creation can find, and that other channels include asset bubbles and financial engineering.
Stein’s thesis is that a low-interest-rate environment will induce a search for higher yields, which can take many forms. The most obvious form is a bidding up of the price of risky assets such as stocks and housing. This can be observed directly. Less obvious are asset-liability mismatches, where financial institutions borrow short and lend long on a leveraged basis to capture a spread. Even more opaque are collateral swaps, where a financial institution such as Citibank pledges junk bonds to a counterparty in exchange for Treasury securities on an overnight basis, then uses those Treasury securities as collateral on a higher-yielding off-balance-sheet derivative. Such transactions set the stage for a run on Citibank or others if the short-term asset providers suddenly want their securities back and Citibank must dump other assets at fire-sale prices to pay up. The invisible web of counterparty risk increases systemic risk—and moves the system closer to a replay of the Panic of 2008 on a larger scale.
The scenarios sketched by Stein would rapidly undo the Fed’s efforts if such events came to pass. A market panic stemming from excessive leverage and risk taking occurring so soon after the Panic of 2008 would destroy the Fed’s efforts to lure consumers back into the lending and spending game of the early 2000s.
Stein’s paper has been taken to say that Fed must end QE sooner rather than later to avoid the buildup of hidden risk in financial institutions. But there is another interpretation. Stein himself warns that if banks do not take the hint and curtail risky financial engineering, the Fed might force them to do so with increased regulation. The Federal Reserve has life-and-death powers over banks in areas such as loss reserves, dividend policies, stress tests, acquisitions, capital adequacy, and more. Bank managers would be foolhardy to defy the Fed in the areas Stein highlights. Stein’s paper suggests a partial return to an older kind of financial repression through regulation.
The Fed’s manipulations have left it in the position of a tightrope walker with no net, one who must exert all his energy in a concentrated effort just to keep moving forward, even as the slightest slip or unexpected gust could cause a catastrophic end to the enterprise. The Fed must promote inflation (while not acknowledging it) and must inflate asset prices (without causing bubbles to burst). It must exude confidence while having no idea whether its policies will work or when they might end.
In short, the Fed is caught between its roles as proprietor of the debt-as-money contract and as the singular savior of sovereign debt. It is unlikely to succeed in only one of these roles; it shall succeed, or fail, at both.
CHAPTER 8
CENTRAL BANK OF THE WORLD
The optimum currency area is the world.
Robert A. Mundell
Recipient, Nobel Prize in Economics
I haven’t read the Governor’s proposal. . . . But as I understand . . . it’s a proposal designed to increase the use of the IMF’s special drawing rights, . . . ah . . . and . . . ah . . . we’re actually quite open to that.
Timothy Geithner
U.S. Treasury secretary
in reply to a reporter’s question about a Chinese government proposal
March 25, 2009
The IMF has refined, repurposed, and restocked its toolkit.
Christine Lagarde
IMF managing director
September 19, 2013
■ One World
To meet Dr. Min Zhu is to see the future of global finance. He stands out in a crowd, his six-foot-four-inch frame reminding financiers of the late twentieth century’s most powerful bankers, Paul Volcker and Walter Wriston, who dominated a room not just with intellect but with physical presence. Min Zhu belongs not to the twentieth century but to the twenty-first, and it is difficult to name anyone who bette
r personifies the conflicting forces—east versus west, gold versus paper, state versus markets—coursing through the world today.
Min Zhu is the IMF’s deputy managing director, among the most senior positions in the IMF, reporting directly to the managing director, Christine Lagarde. The IMF is one of the key institutions established at the 1944 Bretton Woods Conference, which created the framework for the international monetary system in the aftermath of the Great Depression as the Second World War drew to a close. Since its founding, the IMF has been the great enigma of global finance.
The IMF is quite public about its operations and objectives. At the same time, it is little understood even by experts, in part because of the unique role it performs and the highly technical jargon it uses in doing so. Specialized university training at institutions like the School of Advanced International Studies in Washington, D.C., is a typical admission ticket to a position at the IMF. This combination of openness and opaqueness is disarming; the IMF is transparently nontransparent.
The IMF’s mission has repeatedly morphed over the decades since Bretton Woods. In the 1950s and 1960s, it was the caretaker of the fixed-exchange-rate gold standard and a swing lender to countries experiencing balance-of-payments difficulties. In the 1970s, it was a forum for the transition from the gold standard to floating exchange rates, engaging in massive sales of gold at U.S. insistence to help suppress the price. In the 1980s and 1990s, the IMF was like a doctor who made house calls, dispensing bad medicine in the form of incompetent advice to emerging economies. This role ended abruptly with blood in the streets of Jakarta and Seoul and scores killed as a result of the IMF’s mishandling of the 1997–98 global financial crisis. The early 2000s were a period of drift, during which the IMF’s mandate was unclear and experts suggested that the institution had outlived its usefulness. The IMF reemerged in 2008 as the de facto secretariat and operating arm of the G20, coordinating policy responses to the financial panic that year. Today the IMF has capitalized on its newfound role as global lender of last resort: it has become the central bank of the world.
Min Zhu holds the highest-ranking position ever held by a Chinese citizen at the IMF, the World Bank, or the Bank for International Settlements, the international monetary system’s three multilateral pillars. His career personifies China’s financial rise in nuce. He graduated in 1982 from Fudan University in Shanghai, among the most prestigious schools in China. He obtained a Ph.D. in economics in the United States, before moving through various jobs at the World Bank and the international division of the Bank of China. In 2009 he became China’s central bank deputy governor. In May 2010 he was handpicked by Dominique Strauss-Kahn, then IMF chief, to be his special adviser. Finally in 2011 Strauss-Kahn’s successor, Christine Lagarde, selected him to be the IMF’s deputy managing director.
Zhu has a relaxed demeanor and good sense of humor, but when pressed hard on a policy he feels strongly about, he can suddenly turn strident, as if he were lecturing students rather than engaging in debate. His slightly accented English is excellent, but his soft-spoken style is difficult to hear at times. His background is unique: he has operated at the highest levels at a central bank under Chinese Communist Party control and at the highest levels of the IMF, an institution ostensibly committed to free markets and open capital accounts.
Zhu travels continually on official IMF business, for university lectures, and to attend prestigious international conferences such as the Davos World Economic Forum. Private bankers and government officials eagerly seek his advice at the IMF’s Washington, D.C., headquarters and on the sidelines of G20 summits, while Communist Party Central Politburo members do the same on his periodic trips to Beijing. From East to West, from communism to capitalism, Min Zhu straddles the contending forces in world finance today, with a foot in both camps.
No one, including central bank governors and Madame Lagarde herself, is more aware than Zhu of the international monetary system’s hidden truths, which makes his global economic and financial views especially significant. He is an adamant globalist, reflecting his position between the worlds of state capitalism and free markets. He does not think of the world in traditional categories of north-south or east-west but rather as country clusters based on economic factors, supply-chain linkages, and historical bonds. These clusters intersect and overlap. For example, Austria belongs to a European manufacturing cluster that includes Germany and Italy, but it is also part of a central European clutch of former Austro-Hungarian Empire nations, including Hungary and Slovenia. As that group’s leader, Austria is a “gatekeeper” that gives the Austro-Hungarian group access to the European manufacturing cluster through a nexus of subcontracting, supply chains, and bank lending. These linkages might, for example, facilitate sales by a Slovenian auto parts manufacturer to Fiat in Italy. The Slovenian-Italian link runs through gatekeeper Austria.
This paradigm of clusters, overlaps, and gatekeepers results in unexpected alignments. Zhu places South America in a China–western hemisphere supply-chain cluster, a point also made by Riordan Roett, a leading scholar of Latin American economics. Zhu’s view is that U.S. economic hegemony stops at the Panama Canal, while most of South America is now properly regarded as a Chinese sphere of influence.
Zhu’s cluster paradigm is of more than academic interest because it is beginning to have a direct impact on IMF policy as it relates to surveillance of its 188 member countries. The paradigm provides a basis for the study of national policy “spillover” effects as labeled by the IMF. The IMF treats spillovers in the same way that bank risk managers talk about contagion—the rapid uncontrolled transmission of collapse from one market to another through a dense web of counterparty obligations and collateral pledges, in a blind stampede for liquidity in a financial panic. Spillovers happen within clusters when national economies are tightly linked, and between clusters when gatekeepers are in distress. Min Zhu is helping the IMF to develop a working risk-management model based on complexity, one that is far more advanced than those used by individual central banks or private financial institutions.
■ Updating Keynes
Zhu is showing traditional Keynesians how their model of policy action, in conjunction with an individual or corporate response, is obsolete. This two-part action-response model must be modified to place financial intermediation between the policy maker and the economic agent. This distinction is illustrated as follows:
Classic Keynesian Model
Fiscal/Monetary Policy > Individual/Corporate Response
New IMF Model
Fiscal/Monetary Policy > Financial Intermediary > Individual/Corporate Response
While financial institutions in earlier decades had been predictable and passive players in policy transmission to individual economic actors, today’s financial intermediaries are more active and materially mute or amplify policy makers’ wishes. Private banks may use securitization, derivatives, and other forms of leverage to greatly increase the impact of policy easing, and they can tighten lending standards or migrate to safe assets like U.S. Treasury notes to diminish the impact. Banks are also the main transmission channels for spillover effects. Zhu makes the point that Keynesian analysis fails in part because it has not fully incorporated the role of banks into its functions.
Clustering, spillover, and financial transmission are the three theoretical legs supporting the platform from which the IMF surveys the international monetary system. New concepts of this kind can percolate in university economics departments for decades before they have practical effect. Despite a preponderance of Ph.D.’s in its ranks, the IMF is not a university. It is a powerful institution with the ability either to preserve or condemn regimes through its policy decisions on lending and the conditionality attached. Zhu’s paradigm offers a glimpse of the IMF’s plans: clustering implies that economic linkages are more important than sovereignty. Spillover effects mean top-down control is needed to contain risk. Financial t
ransmission suggests that banks are the key nodes in the exercise of control. In a nutshell, the IMF seeks to control finance, to contain risk, and to condition economic development on a global basis.
This one-world mission requires assistance from the most talented and politically powerful players available. The IMF executive suite is an exquisitely balanced microcosm of the global economy. In addition to Min Zhu and managing director Christine Lagarde, the IMF top management includes David Lipton from the United States, Naoyuki Shinohara from Japan, and Nemat Shafik from Egypt. Group diversity is more than an exercise in multinationalism. Lagarde represents the European interest, Min Zhu the Chinese, Lipton the American, Shinohara the Japanese, and Shafik the developing economies. The top five managers at the IMF, seated around a conference table, effectively speak for the world.
David Lipton’s is the single most powerful voice, more powerful than Christine Lagarde’s, because the United States has a veto over all important actions by the IMF. This doesn’t mean Lipton doesn’t play for the team; on many issues the United States and the IMF see eye to eye—including the dollar’s eventual replacement as the global reserve currency. Lipton’s veto power means that changes will take place at a tempo dictated by any quid pro quo that the United States demands.
Lipton is one of numerous Robert Rubin protégés, who include Timothy Geithner, Jack Lew, Michael Froman, Larry Summers, and Gary Gensler. These men have for years controlled U.S. economic strategy in the international arena. Robert Rubin was Treasury secretary from 1995 to 1999, after having worked several years in the Clinton White House as National Economic Council director. Before joining the U.S. government, Rubin was Goldman Sachs co-chairman; he worked at Citigroup in the chairman’s office from 1999 to 2009, and he briefly served as Citigroup chairman at the start of the financial markets collapse in 2007. Lipton, Froman, Geithner, Summers, and Gensler all worked for Rubin at the U.S. Treasury in the late 1990s, Lew at the White House. Lipton, Lew, and Froman later followed Rubin to Citigroup, while Summers later worked as a Citigroup consultant.
The Death of Money Page 22