SNB, Currency Wars, and the China Peg

The currency wars are back. It was, of course, the neutral Swiss who fired the latest salvo in this "conflict" by announcing a minimum exchange rate target vis-a-vis the euro. This amounts to quantitative easing a l'outrance: the Swiss National Bank will print Swiss francs as necessary to buy up foreign exchange to hit its target. Markets certainly took note.

The dramatic impact of the SNB's announcement refutes claims that monetary policy is currently impotent. Even in a liquidity trap, a sufficiently radical monetary shock will undoubtedly jolt an economy back towards growth. But, as if often the case, there is a fallacy of composition problem here: everybody cannot devalue at the same time—right? Buttonwood of The Economist makes the case:

It seems that all countries would like to see their currencies decline bar the Chinese who will only let the renminbi strengthen gradually. Some currencies must rise, however, and the Europeans may not be too happy to see the Swiss trying to drive the euro up, especially if the Fed opts for a third round of QE.

Hence, the evocatively dubbed "currency wars", i.e. competitive devaluations. However, Buttonwood's fear that this will lead to a destructive game of "beggar-thy-neighbor" leads to a puzzling historical analogy. Again, from The Economist:

It is all a bit reminiscent of the 1930s. When countries went off the gold standard, they gained a competitive march on their rivals, increasing the pressure for such countries to leave the standard as well. If one country devalued by 10%, the next might do so by 15%. QE may similarly begat more QE.

Isn't this an argument in favor of currency wars? After all, abandoning the gold standard was effectively a prerequisite for reversing the precipitous decline of the Great Depression. Insofar as combatting the economic crisis of the 1930s required a coordinated international response, competitive devaluation acted as an organic catalyst for such collective action by prodding one nation after another to pursue more expansionary monetary policy. This was the invisible hand on the macro level. As Ryan Avent points out, all the better if the ECB or the Fed respond today with their own currency interventions; the global economy might just get QE all the way down, to recovery.

But what of China? Indeed, their currency peg to the dollar short circuits this potentially mutually beneficial game of competitive devaluation, and turns it into a zero sum one. Due to its capital controls, foreign governments cannot respond in kind to the Chinese government's currency interventions. This amounts to "stealing" demand from overseas. Ryan Avent argues, however, that this does not need to end badly:

Central banks can still print money, taxing the foreign government's ability to sterilise until it relents, and in the meantime supporting the domestic economy. Alternatively, a government in this position can use the free loans provided by the intervening foreign government to directly stimulate the economy, through fiscal spending and investment.

Put simply: QE can make a peg either impractical due to the inflation it would inflict, or impossible due to the limitless foreign exchange that would be necessary to sterilize inflows. The surge in Chinese inflation after QE2 would seem to confirm this viewpoint—except for the fact that China did not ditch its peg. Indeed, a country that considers a currency peg an integral part of its growth strategy will only jettison it as a last resort. China would rather hike interest rates or increase reserve ratios—which are obviously contractionary policies both domestically and abroad—than appreciate its currency.

Clearly, not all currency pegs are created equal. Consider Switzerland's de facto peg. If the ECB decided to embark on its own bond-buying program to counteract the SNB, the Swiss would presumably respond by printing more francs and increasing their own bond-buying. The result: expansionary monetary policy for both the Eurozone and Switzerland. China's capital controls and rigid defense of its own peg subvert this calculus: the United States buys bonds, and China raises interest rates. Rather than both economies giving themselves an economic boost, China curtails its own growth —which obviously has negative spillover effects for the myriad economies that depend on Chinese demand.

Of course, a determined Federal Reserve could overcome these obstacles, much as the SNB just did. If the Fed announced that it would pursue open-ended QE until the real exchange rate between the dollar and the yuan hit (and stayed at) an explicit target more in line with perceived fundamentals, it would almost certainly force Chinese officials to reassess their stance. A credible threat would be sufficient. But this ignores the modus operandi of modern central banks: only the threat of imminent deflation spurs them to embrace unorthodox policies. As long as core inflation creeps along near 2%, they consider it mission accomplished. It would take another drastic leg down before the Fed would countenance approximating anything close to such a seemingly radical policy.

The natural bias towards timidity among central bankers—at least when it comes to trying to create inflation—is perhaps the most compelling argument in favor of a so-called currency war. It forces stimulative action. Still, capital controls can complicate the advantages of competitive devaluation; a positive sum currency war can devolve into a zero sum trade war. It is well within the power of central banks to forestall such a breakdown, but unfortunately far too many still seem obsessed with Don Quixote economics. It is a dangerous moment. Will the Fed and ECB notice?

Quantitative Easing Or Helicopter Drop? What Should Ben Bernanke Do?

A lonely nation turns its eyes to you, Ben Bernanke.

Double dip fears run rampant (despite a better than expected August ISM number). Fiscal stimulus is waning -- much of it undone by draconian cuts at the state and local level. Housing looks poised to go cliff-diving again now that the homebuyer's tax-credit has expired. And, of course, unemployment remains stubbornly high.

The high priests of economic orthodoxy assure us if we just embrace fiscal austerity or higher interest rates that we can ward off the dangers of debt deflation. Which is to say, they are incoherently grasping at any justification to foist contractionary policies onto a weak economy, all in order to fight the specter of incipient -- only in their minds -- inflation.

But with short-term rates up against the zero bound, what ammo does the Fed have left to support the fragile recovery? Here are the usual suspects of unconventional policy tools:

1) Resume quantitative easing. It's debatable how much banks substituting one non-interest bearing asset for another helps the real economy. Additional cash seems likely to either pile up as excess reserves, filter into the markets or get arbitraged via more Treasuries. Still, it's better than nothing.
2) Credibly commit to a higher inflation target in the medium-term. Targeting a 4% inflation rate over a prolonged period obviously not only makes holding cash less appealing, but also reduces real debt burdens. Of course, Messrs. Fisher and Hoenig would do everything in their power to undermine such a project to return to 1980s-level inflation.
3) Buy longer-dated Treasuries. Pushing down yields on longer-dated Treasuries makes other, riskier assets more attractive. Even just credibly threatening to buy up longer-dated Treasuries could be enough, if yields aren't already too low.
4) Eliminate IOER. The Fed currently pays out 0.25% on excess reserves, but why not cut that down to zero? Or even impose a penalty rate? Banks would pile into other short-term assets and increase their vault cash, but at least some of that otherwise idle money would leak into new loans (although there could be some unintended consequences vis-á-vis money market accounts).

Those are just the more conventional "unorthodox" measures the Fed could pursue. Another option would be quantitative easing to non-banks, i.e. direct lending. This is where monetary and fiscal policy meet. The key is that it would entirely eliminate the excess reserves problem, though it would introduce the question of favoritism -- an issue the Fed would be loathe to raise given the recent assault on Fed secrecy.

Still, the radical idea of the Fed giving money to businesses and households rather than to banks liable to sit on it holds some appeal. The so-called helicopter drop would accelerate the deleveraging process, effectively papering over bad household debt. Indeed, from what we know about lump sum tax rebates, we would expect households to save/pay down debts with their one-time check from the Fed. So a good portion of this newly minted money would still end up at the banks, just as with quantitative easing, though it would come at the cost of reducing the banks' claims on households.

But wouldn't this debauch the currency? If the Fed gave away free money, essentially accepting anything as collateral, they wouldn't have the assets to sop up the excess liquidity and prevent out-of-control inflation on the other side. This is the issue some have raised with the Fed accepting MBS as collateral: the Fed is holding MBS at inflated values, so when it comes time to sell that paper, the Fed won't take out as much money as it put into the system -- hence, inflation.

This is where the Treasury comes in. As MIT professor Ricardo Caballero points out, the Treasury could simply transfer T-Bills to the Fed to sell, basically the reverse of monetizing the debt. The Fed would never countenance such extreme action but it's worth remembering that Ben Bernanke circa 2002 was correct: a determined Fed should be able to reverse deflation. Too bad he's not running things nowadays.