March 5, 2012
The High Cost of the Fed's Cheap Money

Encouraging consumption at the expense of saving inhibits long-term economic growth.
By Andy Laperriere

During the past three years, the Federal Reserve has tripled the size of its balance sheet—in effect printing $2 trillionsomething it had never done in its nearly 100-year history. The Fed has lowered short-term interest rates to zero and signaled that it will keep them at that level for years. Inflation-adjusted short-term rates, or real rates, have been in the minus 2% range during the past couple of years for the first time since the 1970s.

The unfortunate fact is, as Milton Friedman famously observed, there is no free lunch. After the Fed's loose monetary policy helped spur the boom-bust in housing, it's remarkable how little attention has been devoted to exploring the costs of Fed policy.

A few critics of quantitative easing (QE) and the zero interest rate (ZIRP) have correctly pointed out that these policies weaken the dollar and thereby reduce the purchasing power of American paychecks. They increase the risk of future inflation, obscure the true cost of the unsustainable fiscal policy the federal government is running, and transfer wealth from savers to debtors.

But QE and ZIRP also reduce long-term economic growth by punishing savers, reducing saving and investment over the long run. They encourage the misallocation of resources that at a minimum is preventing the natural rebalancing of our economy and could sow the seeds of another painful boom-bust.

One intended effect of a loose monetary policy is a weaker dollar, which can help gross domestic product by boosting exports. But a weaker dollar also raises import prices (such as oil prices) for American consumers. For the average American family, this adverse impact has likely outweighed any positive impact from QE and ZIRP.

The cost of a weaker dollar for most people is not offset by temporarily higher stock prices for two reasons. First, most Americans don't own much stock. Second, stock prices are not going to be higher 10 years from now because of the Fed's policies, so the effect is to bring forward equity returns, not increase long-term returns.
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Artificially reducing Treasury yields provides a near-term benefit as federal borrowing costs are lower, but this unusually low cost of borrowing is enabling Congress and the president to run an unsustainable fiscal policy that could eventually lead to an economic calamity. Governments like Greece and Italy benefited from artificially low rates for years, and those low rates undoubtedly played a key role in those governments not confronting their serious fiscal imbalances.

Low rates have helped those who have been able to borrow or refinance their debts at lower rates, especially homeowners. But this has come at a high cost to savers. Zero rates are a major problem for any saver, but it is especially difficult for those in or near retirement. Government bonds are investments that now offer return-free risk.

The Fed is hoping the lack of return in certificates of deposit and bonds (or more accurately, negative returns, adjusted for inflation) will prompt investors to take on more risk by investing in stocks, high-yield corporate bonds and other investments. This is pushing people who have a low risk tolerance to take on more risk than may be advisable.

Moreover, QE and ZIRP are specifically designed to discourage saving and encourage people to consume more now to boost near-term gross domestic product. But saving is deferred consumptionpeople save to earn a return so that they may consume more in the future (say, for retirement or a major purchase).

Scores of economists have testified before Congress for decades that Americans don't save enough and that this inhibits long-term economic growth. Prosperity does not come from spending; it comes from work, saving and investment.

Defenders of QE and ZIRP would say that rather than borrowing economic growth from the future, these policies merely smooth the economic cycle and reduce the economic dislocation associated with deep recessions or weak recoveries. Of course, that was the rationale for the exceptionally low rates during the 2002-2004 period, which, like today, were specifically aimed at depressing saving and encouraging consumption. Rather than smooth the economic cycle, that strategy helped create an historic boom-bust.

Some say we must encourage higher consumption because it accounts for more than 70% of GDP, and the recovery is too fragile to risk allowing a rise in the savings rate. But the recession was officially over two years ago. For at least the past decade, monetary policy has consistently punished prudent savers.

Worse, the Fed is promising to keep these policies in place for years to come. When do we ever get to the point where we allow interest rates to return to some kind of natural equilibrium and allow the economy to gradually rebalance in a way that would boost long-term economic growth?

There is no doubt the Fed is doing what it believes is best. But in addition to the risk of inflation inherent in QE and ZIRP, which Chairman Ben Bernanke has said he is 100% confident he can prevent, Fed officials are dismissive of the notion that there are significant costs or trade-offs associated with the policy they are pursuing.

This is disconcerting. Is there really no chance, zero chance, the Fed will be late to pick up signs of inflation? What accounts for such confidence—given that the Fed dismissed criticisms from 2002-2004 that its policies would distort economic decisions and cause hard-to-predict imbalances, that it was oblivious to the housing collapse well into 2007, and that to this day many Fed officials refuse to accept that monetary policy played any role in creating the housing bubble?

During the bubble, Fed officials argued they couldn't spot bubbles in advance, but that an aggressive monetary policy response could limit the downside impact if a bubble were to burst. As it turns out, the dislocation from the housing bust and the financial crisis have been far more costly than almost anyone imagined. Shouldn't that cause policy makers inside and outside of the Fed to ask hard questions as it pursues its unprecedented campaign of quantitative easing and zero rates?

.Mr. Laperriere is a senior managing director in the Washington office of ISI Group.
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March 4, 2012 9:36 pm

The Bundesbank has no right at all to be baffled

One of the more intriguing recent developments of the eurozone crisis is the shock expressed by Germany’s economic establishment that the eurozone is, in fact, a monetary union. No one had apparently told them.

The story behind this is long, but needs to be told. At issue is a rather technical debate about imbalances in the eurozone’s central payment system, known as Target 2. Germany has built up claims of now more than €500bn ($660bn) against the eurosystem – the network that consists of the European Central Bank and the various national central banks. The Bundesbank is getting nervous about a counterparty risk if the euro were to collapse suddenly.


The discovery of the importance of Target 2 was made by Hans-Werner Sinn, president of the Ifo economics institute in Germany, and his co-author Timo Wollmershäuser*. They found that the Target 2 balance mirrors current account imbalances since the outbreak of the crisis. There was no problem before 2007, when current account balances were funded by commercial banks. Once that stopped, national central banks took over this role. Spanish banks can now refinance themselves with no limit from the Bank of Spain. If a Spanish company buys a German product, for example, the chain of transactions goes from the buyer’s Spanish bank to the Spanish central bank, which effectively creates the money for this transaction, and then sends it on to the Bundesbank, which records this transaction as a claim against the eurosystem.

The Bundesbank initially dismissed the Target 2 balance as a matter of statistics. Their argument was: yes, it is recorded in the Bundesbank’s accounts, but the counterparty risk is divided among all members according to their share in the system. But last week, Jens Weidmann, president of the Bundesbank, acknowledged the Target 2 imbalances are indeed important, and an unacceptable risk. The Bundesbank has now joined the united front of German academic opinion.

So, the twoTarget 2professors deserve credit for explaining the detailed mechanisms of how a monetary union functions in the presence of a broken banking sector. And they are also right in pointing out that if the euro were to collapse suddenly, Germany could stand to lose a large proportion of its claims – some 20 per cent of gross domestic product.

However, it is hard to understand why everybody feigns surprise at the fact that current account imbalances can be financed indefinitely in a monetary union. Is this not one of the characteristics that distinguish it from a fixed-exchange rate system?

As long as banks have access to the central bank, and can provide good collateral, countries can run current account deficits for an infinite period. A friend of mine once remarked – when I asked about the significance of intra-eurozone current account imbalances – that the way to solve the problem sustainably was no longer to publish the figures. He was only half joking.

The presence of unlimited funding does not mean imbalances are irrelevant. On the contrary, they have highly negative economic effects, as the crisis shows. The point is that in a monetary union, imbalances do not adjust automatically. If you want them to adjust, you need to do it yourself.

One would assume that the best policies would be those that attack the root of the problem – the imbalances themselves. One of the deep causes behind this problem is, of course, Germany’s persistent current account surplus. The problem can thus easily be solved through policies to encourage Germany to raise its imports relative to its exports.

You need policies that provide eurozone-wide backstops to the banking sector, and also policies to insure against asymmetric shocks. And you need to harmonise many aspects of structural policy to ensure imbalances do not become entrenched.

But there is no appetite for any of this in Germany. Instead, the Bundesbank prefers to solve the problem by addressing the funding side. Mr Weidmann proposed last week that Germany’s Target 2 claims should be securitised. Just think about this for a second. He demands contingent access to Greek and Spanish property and other assets to a value of €500bn in case the eurozone should collapse. He might as well have suggested sending in the Luftwaffe to solve the eurozone crisis. The proposal is unbelievably extreme.

It also tells us something else: by seeking insurance against a collapse of the euro, the Bundesbank tells us it no longer regards the demise of the euro as a zero-probability event. If the Bundesbank seeks insurance, so should everybody else.

The Target 2 debate is important because it goes to the root of the problem. But Germany’s economic establishment is disingenuous. What people are really saying is that they no longer want a monetary union. They want a looser single currency regime.


Copyright The Financial Times Limited 2012

March 4, 2012 9:30 pm

Emerging markets must lead banking reform

When global banks first expanded into emerging markets, the idea was that they would bring greater efficiency and foster competition. And there is evidence it didfor a while. But the financial crisis changed that: faced with the need to deleverage and meet higher capital requirements, they are now reducing their exposure to emerging markets, prompting damaging credit crunches, and using profits obtained from subsidiaries to recapitalise parent banks.

Emerging markets must take action. They should implement a new model of international banking that limits global banks’ expansion. Simultaneously, they should enforce a regulatory framework that ringfences subsidiaries from parent banks’ weaknesses. There could be no better time: global finance is being redesigned to avoid a repetition of one of the worst ever banking crises. The outcome will have important implications for banks’ profitability, solvency and capitalisation. But emerging markets have so far had limited participation in this debate.


Prior to Lehman Brothers’ 2008 collapse, globalisation of the banking system was the prevailing paradigm. The need to recapitalise banking systems in emerging markets in the wake of previous crises created a unique opportunity for global banks to expand. Their presence in emerging markets grew considerably. Within a decade, foreign ownership of banks almost tripled, surpassing 50 per cent of total emerging markets banks’ assets by 2005 (excluding China). It was seen as a strength, granting subsidiaries access to the capital and liquidity of a more solid parent. As a result, the debate on cross-border regulation centred on who would be responsible if the subsidiary became insolvent (the home bank and/or local authorities).

But as the 2008 crisis broke many old paradigms crumbled. Parent companies lacked the capital to meet regulatory requirements. By contrast, subsidiaries had strengthened their financial profile in response to more prudent regulatory frameworks and tighter local supervision. Unlike in other episodes of stress, emerging markets banks became a source of stability. Many eurozone banks face a vicious circle of lower profitability, limited growth, higher delinquencies and write-offs, and higher capital requirements. So they are either turning to subsidiaries in search of profits, liquidity and capital, or reducing their exposure to emerging markets banks by deleveraging and selling assets.

Emerging Europe and Latin America have the most to fear from eurozone banks’ weaknesses. In eastern Europe, foreign subsidiaries accounted for more than 70 per cent of total assets, but recently foreign banks have been reducing their exposure there. Latin America has a lower exposure to western European banks but the deleveraging process is also affecting subsidiaries.

A case in point is Mexico. After the 1994tequilacrisis, the government bailed out depositors and implemented reforms to rescue Mexico’s banking system. Since local investors were unwilling to inject fresh capital, foreign participation to recapitalise banks was allowed. After this recapitalisation and a balance-sheet clean-up, banks achieved higher profitability, leading to an rise in dividend payments. In short, this has been an incredibly profitable business for international banks.

Not for Mexico, though. The value of the five largest banks (at two times book value) is about $75bn. Moreover, between 2003 and 2011, dividends paid by foreign-owned banks were $20bn (approximately what was paid for the banks), a dividend pay-out of three-quarters of annual profits. If they had followed instead the one-fifth average pay-out of local banks, more capital would have been deployed in Mexico. The credit to gross domestic product ratio would be 5-15 percentage points higher than the current 23 per cent.

Today domestic savings are being used to recapitalise foreign banks, depriving Mexico, and emerging markets generally, of resources.

Emerging markets should consider obliging subsidiaries of global banks to limit dividend payments and/or to list on local stock markets. The listing of subsidiaries would align the bank’s interests with those of host countries, and probably moderate the transfer of resources to parent companies. Action is called for sooner not later.

The writer is chairman of Grupo Financiero Banorte, and formerly governor of Banco de México and Mexican minister of finance

Copyright The Financial Times Limited 2012.

March 4, 2012
States of Depression

The economic news is looking better lately. But after previous false starts — remember “green shoots”? — it would be foolish to assume that all is well. And in any case, it’s still a very slow economic recovery by historical standards.

There are several reasons for this slowness, with the most important being the overhang of household debt that is a legacy of the housing bubble. But one significant factor in our continuing economic weakness is the fact that government in America is doing exactly what both theory and history say it shouldn’t: slashing spending in the face of a depressed economy.

In fact, if it weren’t for this destructive fiscal austerity, our unemployment rate would almost certainly be lower now than it was at a comparable stage of the “Morning in Americarecovery during the Reagan era.

Notice that I said “government in America,” not “the federal government.” The federal government has been pursuing what amount to contractionary policies as the last vestiges of the Obama stimulus fade out, but the big cuts have come at the state and local level. These state and local cuts have led to a sharp fall in both government employment and government spending on goods and services, exerting a powerful drag on the economy as a whole.

One way to dramatize just how severe our de facto austerity has been is to compare government employment and spending during the Obama-era economic expansion, which began in June 2009, with their tracks during the Reagan-era expansion, which began in November 1982.

Start with government employment (which is mainly at the state and local level, with about half the jobs in education). By this stage in the Reagan recovery, government employment had risen by 3.1 percent; this time around, it’s down by 2.7 percent.

Next, look at government purchases of goods and services (as distinct from transfers to individuals, like unemployment benefits). Adjusted for inflation, by this stage of the Reagan recovery, such purchases had risen by 11.6 percent; this time, they’re down by 2.6 percent.

And the gap persists even when you do include transfers, some of which have stayed high precisely because unemployment is still so high. Adjusted for inflation, Reagan-era spending rose 10.2 percent in the first 10 quarters of recovery, Obama-era spending only 2.6 percent.

Why did government spending rise so much under Reagan, with his small-government rhetoric, while shrinking under the president so many Republicans insist is a secret socialist? In Reagan’s case, it’s partly about the arms race, but mainly about state and local governments doing what they are supposed to do: educate a growing population of children, invest in infrastructure for a growing economy.

Under President Obama, however, the dire fiscal condition of state and local governments — the result of a sustained slump, which in turn was caused largely by that private debt explosion before 2008 — has led to forced spending cuts. The fiscal straits of lower-level governments could and should have been alleviated by aid from Washington, which remains able to borrow at incredibly low interest rates. But this aid was never provided on a remotely adequate scale.

This policy malpractice is doing double damage to America. On one side, it’s helping lose the future — because that’s what happens when you neglect education and public investment. At the same time, it’s hurting us right now, by helping keep growth low and unemployment high.

We’re talking big numbers here. If government employment under Mr. Obama had grown at Reagan-era rates, 1.3 million more Americans would be working as schoolteachers, firefighters, police officers, etc., than are currently employed in such jobs.

And once you take the effects of public spending on private employment into account, a rough estimate is that the unemployment rate would be 1.5 percentage points lower than it is, or below 7 percentsignificantly better than the Reagan economy at this stage.

One implication of this comparison is that conservatives who love to compare Reagan’s record with Mr. Obama’s should think twice. Aside from the fact that recoveries from financial crises are almost always slower than ordinary recoveries, in reality Reagan was much more Keynesian than Mr. Obama, faced with an obstructionist G.O.P., has ever managed to be.

More important, however, there is now an easy answer to anyone asking how we can accelerate our economic recovery. By all means, let’s talk about visionary ideas; but we can take a big step toward full employment just by using the federal government’s low borrowing costs to help state and local governments rehire the schoolteachers and police officers they laid off, while restarting the road repair and improvement projects they canceled or put on hold.       

Alexander Hamilton’s Eurozone Tour
.Harold James

PRINCETON – Europe’s debt crisis has piqued Europeans’ interest in American precedents for federal finance. For many, Alexander Hamilton has become a contemporary hero. Perhaps one day his face should appear on the €10 banknote.

Specifically, for European states groaning under unbearable debt burdens, Hamilton’s negotiation in 1790 of the new federal government’s assumption of the states’ large debts looks like a tempting model. Indeed, after Thomas Sargent won the Nobel Prize in Economics last year, he cited it as a precedent in his acceptance speech.

Hamilton argued – against James Madison and Thomas Jefferson – that the debts accumulated by the states during the War of Independence should be assumed by the federation. There were two sides to his case, one practical, the other philosophical.

Initially, the most appealing argument for his plan was that it would provide greater security to creditors, and thus reduce interest rates, from the 6% at which the states financed their debt to 4%. Hamilton emphasized the importance of a commitment to sound finance as a prerequisite to public economy. “When the credit of a country is in any degree questionable,” he argued, “it never fails to give an extravagant premium upon all the loans it has occasion to make.”

While that logic certainly appeals to Europeans today, Hamilton insisted on a stronger reason for pursuing sound finance than merely the pursuit of expediency. There is, he maintained, “an intimate connection between public virtue and public happiness.” That virtue consisted in honoring commitments, and it would build solidarity in the new political community of the United States.

Indeed, public virtue made federal finance what he called “the powerful cement of our union.”
The condition for success in the American case was that the US raised its own revenue, with federally administered customs houses initially providing the bulk of its receipts. The logic of a need for specific revenue applies also in modern Europe, where a reformed fiscal system might include common administration of value-added tax (with the additional benefit of eliminating a considerable amount of cross-border fraud).

In the American case, however, unity carried a price: a ceiling was imposed on Virginia’s exposure to the common debt. Only this inducement to the most powerful state in the union persuaded Madison to drop his opposition to the proposal. That compromise (which also led to the US capital’s relocation to the District of Columbia, on the border of Virginia and Maryland) may serve as a precedent for limiting Germany’s liabilities if Eurobonds, or some other debt-mutualization scheme, are introduced.

The US experiment in federalized finance was not immediately successful. Two important components of Hamilton’s financial architecture were not realized, or were realized imperfectly. He proposed a model of joint-stock banking on a national scale, which ran into immediate opposition (curiously, his proposal was much more influential in Canada). Second, opponents eventually blocked his proposal for a national central bank. The charter of the First Bank of the United States was allowed to lapse in 1811; a generation later, in 1836, President Andrew Jackson successfully opposed the charter of the Second Bank of the United States.

Nor did the Hamiltonian scheme of federal finance guarantee a peaceful commonwealth. In fact, the fiscal union proved to be explosive rather than adhesive. As international capital markets developed in the early nineteenth century, state governments borrowed on a large scale, quickly turning them from creditors into debtors. A wave of state defaults followed in the late 1830’s.

A generation later, in the 1860’s, the Civil War between northern and southern states resulted in large part from a dispute about the character of financial burdensat least from the South’s perspective. Abraham Lincoln’s original proposal to end the immoral practice of slavery by compensating slave owners for manumission was unacceptably expensive, so the Union, according to the slave-holding Confederacy, was determined to expropriate the South.

The federal assumption of states’ debts by itself could not guarantee political order. The Civil War revealed the centrality of a common foundation of morality to Hamilton’s approach to debt and public finance. As a result, his approach foundered on the differences between the different states’ conception of morality.

Europeans today have latched onto the practical side of Hamilton’s argument – that is, the idea that debt mutualization might be a means to cheaper credit; but they have worked out neither the political institutions, nor the shared public virtue, that Hamilton deemed crucial. The extended and politicized debate about debt restructuring has made a Hamiltonian solution more difficult, because the credit of the countries that would be party to it has become questionable.

An obvious starting point for a Hamiltonian Europe would be to set some standard limit for federalized national debt – perhaps the tarnished threshold of 60% of GDP that was mandated (without adequate enforcement) by the Maastricht convergence criteria, or perhaps a lower limit. Debt exceeding that amount would be left to the responsibility of the member states.

Collective burden-sharing is in the long run the only non-catastrophic way out of Europe’s current crisis, but that requires a substantially greater degree of political accountability and control on a European level. The lesson to be learned from Hamilton and the US is that the necessary institutions will not function without a greater degree of moral consensus as well.

Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. He is the author of The Creation and Destruction of Value: The Globalization Cycle.

Copyright: Project Syndicate, 2012.