Crisis Note 2008-3: Thoughts on Fed/ECB Jawboning


The ECB is talking about raising rates to curb inflation. The Fed is also hinting at it. The hope is for a stronger currency - the traditional interest rate parity argument.

This has all the market pundits all-aflutter. This is a DUMB reaction, and shows how little the economists understand about economics.

Rate changes ONLY work to tighten or loosen monetary policy IF the banking system is healthy, and there is lending (and multiplier effects) going on. Without lending to curb, a rate rise won't have much impact.

This is the corollary of what I discussed last year when I said rate cuts won't have much impact. This has proven to be the case. Money data suggests that what little money growth we are seeing is similar to the velocity of the early 90s, when the banks were bust. I doubt this is keeping up with inflation. And I'll speculate that much of the corporate debt issuance that we've seen is being used to refinance short term debt, or to hoard cash. Were it being used to multiply money, we'd have seen lower unemployment numbers.

Thus the rate cuts of last year had NO significant impact on fixing the crisis and allowing us to inflate out of it.

Raising rates now will thus have no impact either, in my opinion.

The current commodity inflation (oil and food) we are facing has other causes. It is not caused by excessive money supply from the rate cuts of last year. If Bernanke is raising rates to fight commodity inflation, he is barking up the wrong tree.

Here's some radical thinking.

- Lets accept that Western economies as a whole created too many assets (way more than we needed) during the boom years of easy leverage. This mostly happened in the countries (or regions) with fiat currencies that were traditionally reserve currencies for the rest of the world.

- Maybe what we are experiencing now is an ASSET deflation of our national balance sheets- a wiping out of the excess assets we created. With less faith in reserve currencies to express values, this is now being reflected in terms of global commodities.

- Commodities are thus taking the place of fiat currencies as stores of value. The WSJ, for example, had an interesting article comparing the price of gold to that of rice.

- If this is the case, this will continue until the excess asset valuations is completely wiped out, and the national balance sheets' value has declined to some 'natural' level based on the productivity of the citizens and their ability to use these assets.

- This is happening in tandem with an increased demand for improved standards of living in the emerging (growing GDP) economies.

- Equilibrium will occur when the emerging growth countries (India, China, Russia, Brazil, for example), that are experiencing asset and income creation in tandem with rising commodity prices (neutralizing the pain of higher nominal commodity prices), stop growing their economies - ie GDP growth falls below nominal inflation.

- Here's some interesting data, courtesy the CIA Fact Book (end of 2007).

Country                       Inflation              GDP                 GDP    
                                                            real growth      purchasing                                                                                                                 rate                  rate                power parity   
Russia                          11.9%                  8.1%                $2.1T              
India                               5.9%                  8.5%                $3.0T              
China                             4.7%                 11.4%               $7.0T              
Brazil                              4.1%                  4.5%                $1.8T              
United States                2.7%                  2.2%              $13.9T                        
South Korea                  2.5%                  4.9%                $1.2T  
Germany                        2.0%                 2.6%                $2.8T  
EU                                   1.8%                  3.0%              $14.5T            
Japan                              0.0%                  1.9%                $4.4T  

- In other words, this translates into a transfer of national living standards from the developed countries to the developing countries.

- If this is the case, higher rates (for us) will NOT lead to a stronger currency. Our (western) currencies will continue to depreciate.

- Taking this thought process to its logical conclusion, I truly believe that we are on the cusp of a unprecedented and major rethinking of money and currencies, financial institutions and central banking, and the role of nations. Over the past decade, barriers to capital flows have been torn down, resulting in central bankers being unable to control their nominal money supplies any more. Over the next decade, we will see the emergence of one global currency and the elimination of individual central banks. While religion, politics, nationalism and communism will hinder this process, I believe this process will be unstoppable.

Samir Shah, 06/10/2008