Topic: Finance, Banking & Monetary Policy

What Would Jesus Do as Zimbabwe’s Central Bank Chief?

Zimbabwe is a country descending into chaos through more ways than just its economy and political system. It seems that the very moral order is being turned upside down.

In an article in today’s Wall Street Journal, the head of Zimbabwe’s central bank, Gideon Gono, said that Jesus would approve of his stewardship of the nation’s currency.

Because of the disastrous policies of President Robert Mugabe, the traditional sources of government revenue have dried up, so the government has directed the central bank to print money to pay its soldiers, officials and other supporters of the regime. Mr. Gono has meekly complied, driving the inflation rate into the stratosphere. Under Gono’s watch, inflation in Zimbabwe has soared to an estimated annual rate of eight million percent.

To justify his mismanagement Gono cites the Bible and Christianity:

Anyone who says the bank governor should violate the head of state is violating a principle that Jesus Christ demanded of his disciples. A key element Christ looked for in his disciples was loyalty.

That begs the question: Loyalty to whom?

In reading his Bible, Mr. Gono must have missed the bit about “Thou shall not steal,” which is exactly what hyperinflation does. It massively expropriates wealth from private citizens and gives it to the government. When Peter and his fellow apostles were told by the government authorities of their day to stop preaching about Jesus (Acts of the Apostles, Chapter 5), they replied, “We must obey God rather than men.”

By propping up the Mugabe regime through hyperinflation, Mr. Gono has made a very different choice.

A Stagflation Sideshow: The Wall Street Journal’s Flawed Theory of Oil Prices

Yesterday’s Wall Street Journal editorial “The Stagflation Show” (June 9) has a graph showing the price of oil generally rising while the fed funds rate was falling (if you don’t look too closely at flat or falling oil prices from November through February).

The conclusion is that if the Fed had not cut interest rates since last September the oil price would not have go up. Perhaps so, but the most obvious reason for any link between Fed easing and oil prices is not mentioned at all. And the stated reason (a “dollar rout and commodity boom”) is at odds with the facts. The timing is way off.

The most obvious connection between oil prices and Fed policy is cyclical.

There have been nine big spikes in oil prices since the 1950s and every one of them was followed by a U.S./world recession within a year.

Every recession, in turn, was followed by a huge drop in the price of crude oil. West Texas crude fell by 44-71% in the wake of the last three recessions.

If the Fed had left the interest rates on bank reserves at 5 ¼% – the U.S. would very likely have led the world into a significant recession long before now. And a U.S./world recession would indeed have pushed the oil price down. But that is not what the Journal editorial page seems to be suggesting. Instead, they blame the Fed for a “dollar rout and commodity boom.”

The big spike in oil prices since early March happened when the dollar was not falling and also when prices of many non-energy commodity prices were falling. There has been no dollar rout and a no generalized commodity boom since February (when oil fell as low as $87 even as food prices soared).

The Fed’s trade-weighted index of the dollar’s value against 26 currencies was 95.77 in March and 95.83 in May. The narrower index of 7 major currencies was 70.32 in March and 70.75 in May.

From March 4 to June 3 The Economist index of 25 commodity prices – excluding oil –fell by 7.8% in dollars (from 271.9 to 250.6) but by only 5.7% in British pounds. The dollar price of wheat fell by 40%, cotton by 26%, and prices have also fallen sharply for livestock, lumber and most industrial metals. This is a “commodity boom”?

It is true that lower short-term interest rates have made it cheaper for producers and “speculators” to hold crude oil off the market (e.g., in tankers or in the ground) if they expect a higher price in the near future. But speculation in the futures market can’t keep prices in the cash (spot) market higher than the market will bear. And the world does not have an unlimited budget to pay more and more for petrochemicals and fuel. As firms cut back or shut down production in energy-intensive industries worldwide (U.S. airlines are just the most obvious example) the demand for oil can drop quickly.

Oil above $130 involves a massive transfer of income away from oil-importing countries, raising their cost of living and cost of production. That greatly increases the likelihood of a significant economic slowdown or contraction in most oil-importing countries, even India and China. And that, in turn, always causes the price of oil to collapse.

A Health Fed?

Lots of people, on both the Left and the Right, want government to plan economic activity.  Honest central planners recognize that highly concentrated and well-organized groups of producers and consumers typically hijack the plan’s new taxes, subsidies, and regulations.  The central planners are typically horrified to see what their carefully laid plans look like after being put through the political grinder.

Clever central planners look for ways to protect their plans from the influence of their fellow citizens.  For example, some planners seek to restrict their fellow citizens’ right to petition the government for a redress of grievances.  (I have often remarked that if you can’t implement your plans without taking away someone else’s First Amendment rights, maybe you should rethink your plans.)

Other central planners seek to create special government bodies to execute their plans.  These bodies would have the power to tax, spend, and regulate, but their decisions could only be overturned by the people’s representatives with great difficulty.  Indeed, the very purpose of these bodies is to allow the planners to govern their fellow citizens without having to worry so much about the consent of the governed. 

Certain health care reformers have set about this path.  Across the political spectrum, observers acknowledge that government wields enormous power over America’s health care sector, and that those powers are often co-opted to serve private ends.  For example, former Senate Majority Leader Tom Daschle (D-SD) recently remarked:

Congress is just not capable of being the manager of a health care system and yet it’s largely Congress today that has that responsibility. It hasn’t worked for the last 50 years. It’ll work even less in the next 50.

As a result, Daschle and others propose that Congress create a “federal health board” to manage the health care sector.  The Federal Health Board would do things like require you to purchase health insurance, dictate what kind of health insurance you will purchase, set the prices for health insurance and medical goods and services, etc..  In other words, the Federal Health Board would have the power to bankrupt corporations, to force doctors to change the way they do business, to deny medical care to patients, and to shift massive amounts of resources from one part of the country to another.  The problem is, some corporations, doctors, patients, and regional interests would try to block parts of The Plan, either on their own or through their representatives in Congress.

Since it would be so hard for the Federal Health Board to do its job with all that meddling by the governed, Daschle et alia want to insulate the Board from the political process.  Specifically, they want Congress to model a new Federal Health Board on the existing Federal Reserve Board.  That would enable the “health Fed” to focus on the public good, much like the Federal Reserve Board manages the money supply and guides interest rates without any of the unseemly pandering to special interests that goes on in Congress and other government bodies.  Because that’s how the Fed operates, right?

Maybe not.  Economist Allan H. Meltzer of Carnegie-Mellon University has read the transcripts of every meeting of the Fed’s Open Market Committee going back to 1913, and has written a two-volume history of the Federal Reserve.  Interviewed recently for one of Russ Roberts’ excellent EconTalk podcasts, Meltzer dismissed the idea that the Federal Reserve is immune from political pressures:

We talk about an independent Federal Reserve, but in reading and writing the history of the Federal Reserve, there are very few occasions since the 1930s when the Fed actually practiced independence.  There was the [Paul] Volcker era; he was certainly an independent central bank governor.  But [current Fed chairman Ben] Bernanke is anything but an independent central bank governor.  He is being leaned on by the Congress, and he accedes to them.  So even though he may worry about inflation … he’s … trying to respond to the short-term pressures instead of thinking ahead and thinking longer-term …

That brings him to the interest rate, because that’s the thing that people in the market see.  The Wall Street people …  put him under great pressure because they own a lot of bonds and mortgages.  And they believe that if he lowers the federal funds rate, it will lower the price of their mortgages and bonds, and they will have smaller losses.  And so they are on his back all the time to do more, to cut the interest rate that he controls, hoping that the rates that they see and own will go down, and their … losses will become smaller …

In reading the minutes of the Fed and watching what they do, the Fed has always been very much afraid of Congress.  And it took someone with the stamina and arrogance, in a way, of Volcker to be able to get around that … By the summer of 1982, [Congress was] facing an election and they were on his back to ease up … He wouldn’t admit that he was [easing up], but he did …

The idea of having a really independent agency in Washington, that’s just not going to happen … The Federal Reserve derives its power from Congress … The Fed’s power is delegated, and they are very much aware that Congress could always change that … [The Fed] manages to hang on to some measure or vestige of independence, but it is very much concerned – always – about what the Congress is doing, and doesn’t want to deviate very far from that.

What can’t come through in a transcription is that Meltzer chuckled at “the idea of having a really independent agency in Washington.”

So if the central planners seek to insulate their health care reforms from the political process, modeling a new health planning board on the Fed won’t achieve that goal.  That’s probably a good thing.  Power with accountability is dangerous enough.  Power without accountability is truly frightening. 

An important advantage of free-market health care reforms is that they provide accountability without allowing anyone to consolidate much power at all.  That seems a much happier state of affairs.

Re: Wall Street Journal Editorials — The Fed Caused the Rise in Food and Oil Prices?

In numerous unsigned editorials, The Wall Street Journal has argued that cutting the federal funds rate to 2% from 5 1/4% last September has been the main reason prices of crude oil and food commodities have soared in recent months. Such commodities are priced in dollars and the dollar was generally falling through February, though not in the past two months (even though the funds rate was reduced by one percentage point).

An April 28 editorial, “The Fed’s Bender,” notes that “since 2003 the dollar price of oil has climbed far more rapidly than the euro price — 273% in dollars, compared to 146% in euros.” It is not likely that the whole 2003-2008 picture reflects “the European Central Bank’s sounder monetary management,” as the editorial implies. The euro had dropped to below parity with dollar until late 2002. And the fed funds rate was repeatedly increased from 1% in 2003 to 5 ¼% in mid-2006 (well above the ECB’s equivalent 4% rate). The euro rose partly because it had first fallen, but also for reasons other than central bank interest rates (economists have no reliable model for forecasting floating exchange rates).

The editorial boldly concludes that “had the dollar merely retained the same purchasing power as the euro, today’s price of oil would be below $70 a barrel.” That is a counterfactual exercise that makes little sense.

Even if we accept the half-true premise that the dollar-euro exchange rate is sensitive to relative short-term interest rates, the dollar might have “retained the same purchasing power as the euro” by having the ECB lower interest rates to 3% and the Fed to keep ours at 3%. Or the Fed might have kept the funds rate at 5% and the ECB at 4%. Although either option might have stabilized that particular exchange rate, they would not have had the same effect on global economic growth and therefore on the world demand for oil.

If oil had been priced in dollars and the euro had not appreciated against the dollar, then the euro area would not have been as insulated as it was against the rising cost of oil. Because demand is responsive to price (particularly business demand), Europe would have bought less oil than it did. Or, to use the editorial version, if the U.S. still faced $70 oil then we would try to buy more. Either way, the price in dollars would not have remained the same.

The Economist index covers the prices of 25 commodities, excluding oil and gold, with food accounting for 56% of the index. By April 22 it was up 31% for the year and 3.7% for the month, when measured in dollars.

That was mostly because of food. Industrial commodities were up only 1.6% for the year.

If we are going to blame the rising price of oil and food commodities on the dollar, do we need a different theory to explain why industrial commodities have barely risen?

Here’s another anomaly: Measured in British pounds, the commodity index was up about the same as it was in dollars—31.6% for the year and 4% for the month. That can’t be because Britain has a weak currency—the pound buys 8.9% more dollars than it did a year ago. It can’t be because the Bank of England cut interest rates too much, since 3-month interest rates are 5.86% in Britain, compared with 1.97% in the U.S.

I happen to agree that the Fed (and ECB) have paid too little attention to the impact of exchange rates on prices of internationally traded commodities. And I suspect the Fed has already gone too far with rate cuts and will have to put rates back up shortly after the election. But to single-out a few sensitive commodity prices that have risen the most (in dollars or pounds) and blame just those prices on the Fed is going too far.

Re: Martin Feldstein — The Fed Should Stop Helping Commodity Speculators?

In The Wall Street Journal on April 15, Martin Feldstein of Harvard took a position between Makin and Chapman, saying the Fed should have left the federal funds rate at 2 1/4%, because a lower rate would cause “rising food and energy prices.” Feldstein told The Guardian the dollar had to fall further on April 11, so the link he envisions between Fed policy and commodity markets is not through exchange rates (I’ll discuss that in a later post), but just upside speculation alone:

Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates.

But investors go short as well as long–betting the price will fall– and they can use credit for that too.

The only reason to make a leveraged bet that the price of oil, gold or corn will go higher is if you expect the prices to rise by enough (during the holding period) to exceed the interest expense.

Ignoring trading costs, if you can borrow at 5% to invest in something whose price is expected to rise by 8% that may look like easy money. Yet oil futures are cheaper than near-term spot prices, and gold has recently fallen by about 13%, so momentum trading is dangerous. It is properly called “greater fool investing” – just like paying too much for a Las Vegas condo on the assumption that some greater fool will later pay even more.

It seems unlikely that today’s quarter-point cut in the fed funds rate will result in lower margin rates for commodity traders. But even if it did that is not nearly enough to make a significant difference for more than a day or two.

U.S. politicians seem equally angry with upside “speculators” and downside “shorts,” but it is the contest between the two that constantly gropes for the right price.

I am shorting oil through an exchange-traded fund (DUG), and shorting precious metals through a mutual fund (SPPIX). I’m also slightly long the dollar (UUP). Don’t try this at home without a net. But if I win those bets, the world economy wins too.

Re: John L. Chapman — The Fed Should Tighten to Slow the Growth of MZM?

In The Wall Street Journal on April 29, another AEI economist, John L. Chapman, took the exact opposite position from John Makin. Chapman suggested the Fed “should soon begin a series of rate increases.” The title was “The Fed Must Strengthen the Dollar,” but that is not what he wrote. Chapman just advocated “a stable dollar.”

The dollar was stable in March and April. The Fed’s index of the dollar’s value against a broad basket of currencies (Jan. 1997=100) was 95.84 on March 6 and 95.81 on April 29. The index against major currencies (1973=100) remained close to 70. That was just two months, of course. But those were the months when we were deluged by editorials blaming rising prices of food and oil on “the falling dollar.” In any case, if the goal is being achieved with current Fed policy, then changing that policy would mean deviating from that goal.

Chapman, like some other economists, sees “inflation warnings” in rapid growth of a measure of money supply (or demand) known as MZM (money with zero maturity), which is largely driven by institutional money market funds. These short-term investments tend to expand when corporations and financial fiduciaries are nervous about investing longer-term, and therefore park more cash in money market funds for security.

The trouble with using MZM as an omen of inflation is that it has never worked.

MZM grew rapidly in 2001, during a recession, but MZM was nearly flat in 1973 when inflation began to explode. MZM fell from $854.3 billion in September 1978 to $827.3 billion in April 1980, yet this was a period of rapidly escalating inflation. Core inflation, excluding food and energy, reached 8.5% in the year ending December 1978, then 11.3% and 12.2% in the following years.

There may be an argument for raising the fed funds rate whenever oil and food prices rise, but MZM is not it.

Re: Ronald McKinnon — The Fed Should Tighten to Push the Euro Down?

In The Wall Street Journal of April 25, Ronald McKinnon of Stanford proposed “raising the fed funds rate as much as necessary to strengthen the dollar.” McKinnon’s argument had little to do with inflation, so he could just as well have asked the European Central Bank to lower interest rates as much as necessary. Yet he just asked the U.S. to “cooperate with foreign governments to halt and reverse the appreciation of their currencies against the dollar.”

McKinnon’s main argument for raising the fed funds rate is because he imagines that “foreigners are disinvesting from private U.S. assets.”

Net foreign purchases of U.S. stocks in the fourth quarter were $55.6 billion. Net foreign purchases of U.S. corporate bonds were $39.1 billion. Foreign direct investment in the United States increased by $39.9 billion in the fourth quarter, following an increase of $101.3 billion in the third.

There will surely be a good argument for raising the fed funds rate, sooner or later, but an exodus of foreign investment is not it.