Wednesday, August 5, 2009

A Market Grade for the Obama Economic Policy

There is a brutal way to grade administrations on their economic policies: look at what foreign exchange traders do to the currency of a country. This has been a test of political administrations around the world since the world removed itself from the gold standard in August 1971.

If we use the movement of the value of a country’s currency as a grading mechanism then this is how the Obama administration stacks up since it took office on January 20, 2009. The value of the dollar against the Euro from January 20 through July 31, 2009 has dropped 9.3%. Using early morning figures registered today, the drop has been 10.1%. The value of the dollar against Major Currencies has dropped 9.5%.

These are not very good grades!

What are the underlying factors behind this decline? First, the administration is proposing a huge deficit for this year, $2.0 trillion, a deficit that dwarfs all other deficits in United States history! And, some experts are projecting deficits that will continue to average around $1.0 trillion per year for the next ten years or so. Second, a monetary policy that is keeping short term interest rates extremely low, and it has been stated that these rates will be kept that low until possibly 2011.

Any comparisons?

The Bush administration saw the value of the dollar peak in March 2002 and then decline about 40% into 2008.

What were the underlying factors behind this decline? First, the administration created huge deficits by historical standards, deficits that continued throughout the entire Bush administration. Second, there was a monetary policy that kept short term interest rates extremely low, and it kept them at an extremely low level for two years or so.

Let me quote Paul Volcker once again. He has written that “a nation’s exchange rate is the single most important price in its economy.” This is from the book “Changing Fortunes: The World’s Money and the Threat to American Leadership,” by Paul Volcker and Toyoo Gyohten (Times Books: New York), page 232.

When are we going to learn?


Flow5 said...

Paul Volcker was the most ignorant, and most arrogant, economist to sit as Chairman.
He was an asshole.

Flow5 said...

In 1980, Paul Volcker, Past chairman of the Board of Governors of the Federal Reserve System, appeared before the House Domestic Monetary Policy Subcommittee. In response to a question as to why the Fed had supplied an excessive volume of legal reserves to the member banks in the third quarter 1980 (annual rate of increase 13.2%), Volcker's defense was that there are two types of legal reserves: 1) borrowed (reserves obtained by the banks through the Federal Reserve Bank discount windows), and 2) non-borrowed (reserves supplied the banking system consequent to open market purchases). He advised the congressmen to watch the non-borrowed reserves -- "Watch what we do on our own initiative." The Chairman further added --- "Relatively large borrowing (by the banks from the Fed) exerts a lot of restraint."

This is of course, economic nonsense. One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was immaterial. A new advance can be obtained, or the borrowing bank replaced by other borrowing banks. The importance of controlling borrowed reserves was indicated by the fact that at times nearly 10% of all legal reserves were borrowed.

Flow5 said...

On October 6, 1979 Paul Volcker, Chairman, Board of Governors of the Federal Reserve e System promised that the Fed was going to mend its ways. Hereafter the Fed would deemphasize the control of the federal funds rate and concentrate on holding the monetary aggregates in check. We were advised to “watch the money supply”.

For approximately the first four months following this pronouncement the money supply increased at an annualized rate of 20 percent... Up from the 8 percent increase in the prior five months... Obviously there had been no significant change in monetary policy. Why? Apparently the Manager of the Open Market Account who operated from an office in the Federal Reserve Bank of New York and who is in charge of all open market purchases and sales for all 12 Federal Reserve banks decided there should be no change in monetary policy. Note: the actual monetary policy of the Fed during the 1980 was only nebulously related to the official policies of the Federal Open market committee (FOMC) as published in the Federal Reserve Bulletin. Open market purchases were of such a magnitude in this period member bank legal reserves expanded at an annualized rate of 20 percent. The excessive increase in the money supply made possible by this growth in reserves was accompanied by a continuing raise in the transactions velocity (rate of turnover) of money at an annualized rate of 24.9 percent. Consequently monetary flows (aggregate monetary purchasing power) shot up to annual rate of 33.3 percent –an excessively easy money policy in view of the virtual stagnation of real GDP growth during this period.

During the next 3 months or to the end of April 1980the fed slammed on the brakes. Member bank legal reserves decreased at an annualized rate of 20 percent, and money flows declined at an annual rate of 16.8 percent as a consequence of a small drop in transactions velocity. Unfortunately the Fed reversed its tight money policy toward the end of April, and went on a monetary binge. For the six month period ending in December, member bank legal reserves were inflated at a 15 percent annualized rate, and the money supply expanded at an annualized rate of 20 percent and monetary flows (MVt) surged at an estimated annual rate of 29 percent.

Government and Federal Reserve economists contend it is impossible to control both interest rates and money, and that the shift to a monetarist policy from October 1979 – 1980 was the root cause of the excessively high and volatile interest rates that have prevailed over the past year. The fact is the Fed has never tried a monetarist policy except for the three months ending in April 1980. Monetarism is more than watching the aggregates – it also involves controlling them properly. The Fed cannot control interest rates even in the short end of the market except temporarily. And by attempting to slow the rise in the federal funds rate the Fed will pump an excessive volume of legal reserves into the member banks. This, as noted, will fuel a multiple expansion in the money supply, increase monetary flows and generate higher rates of inflation – and higher interest rates including federal funds rates.

If the money supply is controlled properly, the determination of interest rates can be left to market forces because the rate of inflation will be brought down to tolerable levels.

The federal funds brackets were widened, not abandoned.