Thursday, July 3, 2008

Global monetary conditions

Naked Capitalism has a post putting together some stuff on the inflation-deflation debate and defending the Fed rate cuts in the face of the ECB. This would be related to my post of the other day where the PIMCO guy also defended the Fed, and suggested that there wasn't much danger of inflation in the US, given the weak position of labor, and that the problem with lower rates really stemmed from the currency pegs in the dollar block.

The crux of the problem seems to be what you do with the money supply when you experience a commodity price spike (if you are a commodity importer). To me, the logic of letting the money supply expand to deal with that shock, and thus balancing the pain of it between capital and labor, is pretty compelling. That seems especially true when the real wages of consumers are already tremendously fragile, and forcing them to bear all the burden would almost certainly tip us into a deep recession.

It seems to me that the normal consequence of this easing into negative real rates would be a fall in the dollar, as the US is essentially inflating away its obligations to the rest of the world (eve if domestic inflation remains fairly contained). The dollar would fall, the US would rebuild its manufacturing, and gradually we would save more and spend less and things would return to balance. In the middle US growth would be slow of necessity because 75% of GDP is consumption, which by hypothesis here has to fall relative to production.

The problem here is that the rest of the world isn't buying, and that in fact they're saving up all their dollars and refusing to let that currency adjustment happen. From their perspective this makes sense because letting their currencies appreciate makes all the dollar reserves they've built up over the years worth a whole lot less, and incidentally, reveals them as suckers once again in the game of global finance -- the insurance they bought by saving after the last round of problems in 98-99 turns out to be worthless.

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