Crisis Note 2008-4:  Inflation and Central Banking


* Foreign holdings in US treasuries are dropping. This is understandable.
* At least some Chinese officials believe that US Treasuries don't offer value.
[Links to news stories deleted - they stopped working]

Given the asset deflation that is happening in the US, I surprised that more countries have not formed a similar opinion. Maybe there is no choice for many countries - everyone should read 'Confessions of an Economic Hit Man'.

My opinion is that the Fed should have raised rates last year, instead of cutting them. Read my Crisis Notes from last year. It's too late now for a rate rise to have any positive impact. Any move in the opposite direction will only CONFIRM to the markets that the Fed has no idea what is going on, that their policy moves last year were not considered, and that they are just flopping around like dying fish out of their element. Big Ben should learn a lesson from Paul Volker, and learn that what markets want is price visibility and stable future expectations.

My opinion is that the Fed and most developed nation central banks do not control money supply anymore. YOU CANNOT CONTROL MONEY SUPPLY IN ECONOMIES WITH NO BARRIERS TO CAPITAL MOVEMENTS. The Fed Funds rate is a toothless monetary policy instrument, and should be relegated to history.

In "developed nations", money is created synthetically by banks, and at the margin, it has been off balance sheet money (SIVs, Yen Futures, etc., re-read my Crisis Notes from last year) that has resulted in money supply, our standard of living, and the bubbles we love. It totally bypasses the central banks. The only solutions are to abolish central banks, and let markets dictate rates and money supply (which will eventually result in one global currency for nations with this financial structure - for now, this currency has become commodities). Or if you really want distinct currencies, close off capital flows and control them (which is what China and India do - restrict foreign investment flows in order to manage money supply and inflation).

Until we close our economy to foreign financial flows (I don't believe this will happen, I'm a Chicago school geek!), the correct things for the Fed to do is to continue focusing on financial price stability - by taking the things that have worked (TAF, etc. - providing balance sheet and emergency funding to IBs) to their logical conclusion - charge investment banks for the insurance, treat them the same as banks, and deal with the risk and capital requirement issues of off-balance-sheet structures. In order words, eliminate itself as a central bank, and become a regulator. 

‚ÄčSamir Shah, 06/13/2008