The Unloved World Dollar Standard: Greenspan-Bernanke Bubbles

in the Global EconomyRonald McKinnon

Stanford University

The Political Economy of international Money: Common Currencies, Currency Wars, and Exorbitant Privilege

Federal Reserve Bank of DallasApril 3, 2014

The Unloved World Dollar Standard1945—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.

Figure 1: US Interest Rates

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

USD Libor10 Year Treasury

Source: FRED

Figure 7. GDP Weighted Discount Rate of BRICS and G3

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

2

4

6

8

10

12

BRICS G3

%

Source: IMF, EIU

Figure 2. Emerging Markets and China, Foreign Exchange Reserves (Billion USD)

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-130

1000

2000

3000

4000

5000

6000

7000

8000

Total Emerging Markets China

Figure 3 Headline CPI: EM and US

Jan-02Jul-0

2Jan-03

Jul-03

Jan-04Jul-0

4Jan-05

Jul-05

Jan-06Jul-0

6Jan-07

Jul-07

Jan-08Jul-0

8Jan-09

Jul-09

Jan-10Jul-1

0Jan-11

Jul-11

-2

0

2

4

6

8

10

GDP Weighted EM CPI

US Headline CPI

Source: EIU, Author's CalculationEmerging 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

Figure 4 BRICS Currencies, LCU (local currency unit)/USD, Jan-2002=100

Jan-02

Jul-0

2

Jan-03

Jul-0

3

Jan-04

Jul-0

4

Jan-05

Jul-0

5

Jan-06

Jul-0

6

Jan-07

Jul-0

7

Jan-08

Jul-0

8

Jan-09

Jul-0

9

Jan-10

Jul-1

0

Jan-11

Jul-1

1

Jan-12

Jul-1

2

Jan-13

Jul-1

3

40

60

80

100

120

140

160

ChinaBrazilRussiaIndiaSouth Africa

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

20002001

20022003

20042005

20062007

20082009

20102011

20122013

201480

85

90

95

100

105

110

115

120

125

Dollar Carry Trade

Credit Crunch

New Dollar Carry Trade

EurozoneCrisis

Source: Federal Reserves

Emerging Market Slowdown

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)

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 201380

100

120

140

160

180

200

220

240

Case-Shiller CRB Commodity Index S&P 500 Core CPI

Source: Bloomberg

Figure 8 Food/Agriculture Product Price (2005=100)

2005 2006 2007 2008 2009 2010 2011 2012 201350

100

150

200

250

300

350

UN Food And Agriculture World Cereals Price Index S&P GSCI Agriculture IndexSource: Bloomberg

Start ofArab SpringDec 2010

Figure 10. GDP growth: Developed vs. Developing World

20042005

20062007

20082009

20102011

20122013

-6

-4

-2

0

2

4

6

8

10

Advanced Economies Emerging and Developing Countries

%

Source: IMF

Figure 9. Size of Central Bank Balance Sheet, % of GDP

Jun-06

Sep-06

Dec-06

Mar-07

Jun-07

Sep-07

Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

Jun-09

Sep-09

Dec-09

Mar-10

Jun-10

Sep-10

Dec-10

Mar-11

Jun-11

Sep-11

Dec-11

Mar-12

Jun-12

Sep-12

Dec-12

Mar-13

0%

5%

10%

15%

20%

25%

30%

35%

40%

Japan UK US EuroAreaSource: Bloomberg, OECD Stat

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.