Results for “interest rates risk fed”
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The monetary economics of Scott Sumner

Here is my latest column, on the monetary proposals of Scott Sumner.  You probably know Sumner from his blog TheMoneyIllusion and in my view he has become possibly the most astute commentator on monetary policy at this time.  Excerpt:

The Fed has already taken some unconventional monetary measures to
stimulate the economy, but they haven’t been entirely effective.
Professor Sumner says the central bank needs to take a different
approach: it should make a credible commitment to spurring and
maintaining a higher level of inflation, promising to use newly created
money to buy many kinds of financial assets if necessary. And it should
even pay negative interest on bank reserves, as the Swedish central
bank has started to do. In essence, negative interest rates are a
penalty placed on banks that sit on their money instead of lending it.

to the chagrin of Professor Sumner, the Fed has been practicing the
opposite policy recently, by paying positive interest on bank reserves
– essentially, inducing banks to hoard money.

The Fed’s balance
sheet need not swell to accomplish these aims. Once people believe that
inflation is coming, they will be willing to spend more money.

other words, if the Fed announces a sufficient willingness to undergo
extreme measures to create price inflation, it may not actually have to
do so. Professor Sumner’s views differ from the monetarism of Milton Friedman by emphasizing expectations rather than any particular measure of the money supply.

There are more excellent posts on Scott's blog than I am able to link to.  Read through it all, if you have any interest in these topics. 

One thing I learned from a systematic reread of Sumner is that he isn't quite the advocate of quantitative easing that I had thought.  All things considered, he seems to favor QE over doing nothing, but he also thinks that a truly credible commitment to future inflation can get us there without much painful-for-the-Fed's-balance-sheet QE being required.

While I think there is a very good chance Sumner is correct, my reread of his blog also gave me a better sense of, if he is wrong, why he is wrong or maybe incomplete is a better word.

In very general terms, think of our government, or central bank, as being able to do some good things by creating credibility, the rule of law being one example.  In this particular case the Fed could use its credibility to guarantee two to three percent price inflation annually or more exactly some target for nominal GDP growth.

One point is that bureaucracies tend to hoard credibility rather than to spend it.  That still could mean Sumner's advice is correct and this is simply why the Fed doesn't follow it.  There is, however, a deeper worry.  One possibility is that a weakened Fed cannot today precommit to delivering on two to three percent.  Let's say that Congress gets upset along the way, for whatever reason.  The Fed has then put its credibility on the line, including for the longer future, and that credibility is utterly refuted.  Ouch.  More technically, combine the two ideas of self-fulfilling prophecies and nested games.

Maybe the Fed is too risk-averse but there's also the possibility that the Fed is prudent in its unwillingness to stick its neck out.  Maybe the Fed has credibility only as long as it doesn't try to spend it (try modeling that).  This would bring us into the literature on creative ambiguity and signaling.

Another possibility is that, instead of Congress intervening, markets simply don't respond.  Sumner's theory makes sense to me, but how certain can we be?  The Fed again is putting a lot of longer-term credibility on the line.  Maybe the best the Fed can do is a kind of "inch-along" promise, which probably won't be very effective, as we are observing.

Perhaps the key question is just how credible a central bank can be, relative to its (possibly unjustified) risk aversion.

I now read Sumner much more as a "theorist of credibility," and thus as an implicit game theorist, than I used to. 

Unorthodox monetary policy vs. fiscal policy

The Fed is ready to do more, namely:

The Fed has already been buying mortgage-backed securities and said in
its statement that it would expand its intervention as needed. The
committee also served notice that it would purchase longer-term
Treasury bonds, a move that would drive down long-term interest rates of all types.

Two points are worth making.  First, defenders of large-scale stimulus point out that such measures may well not work.  That is true, but what are the conditions under which unorthodox monetary policy maybe will not work?  Low confidence and zombie banks, which are more or less the same conditions under which fiscal policy may not work either.  In that sense unorthodox monetary policy doesn't face a separate problem.

Second, cash and T-Bills have a broadly similar risk profile but cash and these other assets do not.  At some point monetary policy becomes fiscal policy too, as a quick look at the Fed's balance sheet will indicate.  So it's fiscal policy based on Treasury borrowing vs. fiscal policy based on Bernanke and money creation.  In a time of deflationary pressures, and a bad fiscal future, usually I would prefer Fed-led fiscal policy.  I do recognize that we are placing more weight on the Fed than it can bear, but of course at this point there are no good options.

Should the government peg the S&P 500?

The very well known macroeconomist Roger Farmer says yes:

It is time for a greatly increased role for monetary policy through
direct intervention of central banks in world stock markets to prevent
bubbles and crashes. Central banks control interest rates by buying and
selling securities on the open market.

A logical extension of this idea is to pick an indexed basket of
securities: one candidate in the US might be the S&P 500, and to
control its price by buying and selling blocks of shares on the open

That is from the FT.  Though he says he is warming to the idea, to my ear Mark Thoma sounds skeptical as am I.  Public choice considerations aside, if the Dow is valued at 7000 in market opinion and the Treasury (Fed?) is propping it up at 8500, a lot of people will sell shares into the hands of the government.  How much are the shares worth then?  How hard will the government try to break the shorts who speculate on lower prices?  Will this work any better than currency pegs?  What are the implications for pursuing other monetary targets, such as the rate of inflation?  If the peg succeeds who would hold other, riskier assets?

Some people might even say that the "Greenspan put" was part of what got us into this hole in the first place.

Farmer is working on a book How the Economy Works and How to Fix it When it Doesn’t.

Who Killed Davey Moore?

Matt Yglesias points us to the following:

Federal Reserve Chairman Alan Greenspan said Monday [February 2004] that Americans’ preference for long-term, fixed-rate mortgages means many are paying more than necessary for their homes and suggested consumers would benefit if lenders offered more alternatives.

By the way, Greenspan’s recent Op-Ed claims he is not to blame, plus he disavows blame in his NPR segment the other morning

The other day I wrote of widespread fraud; I was referring to the fact that many lower income borrowers lied on their mortgage applications or failed to provide documentation of income.  Do any of you have figures here?

The New York Times today blames many factors, including lax and fragmented regulators, but most of all the irresponsible practices of mortgage-lending affiliates of nationally chartered banks.  Here are the now well-known warnings of Ed Gramlich.

If you are curious to evaluate my record as a prognosticator, my earlier posts on whether we are in a housing bubble are here [TC: it turns out I didn’t buy close to the peak] and here.  Am I to blame?  Here is Alex’s insightful post.  Most to the point, here is my post "If I Believed in Austrian Business Cycle Theory."

Some of the Austrians blame Greenspan for lowering short-run interest rates to one percent.  From another direction, here are tales of a real estate bubble on the moon.

I browsed through a New York Fed conference summary the other day; it was about "systematic risk" and it was held about a year ago.  I did not see a word about housing bubbles.  The surprise was not the bubble, but rather than its collapse could be such a source of systemic risk and that it could freeze broader credit markets so much. 

Paul Krugman claimed that the fundamental problem is lack of solvency, but he doesn’t make a clear enough distinction between insolvent homeowners (for sure) and insolvent banks (has he bought puts?).  I haven’t seen an estimate of the losses that is large enough to imply anything close to widespread bank insolvency.

Matters would be easier to understand if they were either much better or much worse than they are; it is the current state of hovering which is so puzzling.

Here is Bob Dylan on what went wrong.  It’s the best account I’ve heard so far.

The economic consequences of Mr. Bush?

Joseph Stiglitz writes:

You’ll still hear some — and, loudly, the president himself — argue that
the administration’s tax cuts were meant to stimulate the economy, but this was
never true. The bang for the buck — the amount of stimulus per dollar of
deficit — was astonishingly low. Therefore, the job of economic stimulation
fell to the Federal Reserve Board, which stepped on the accelerator in a
historically unprecedented way, driving interest rates down to 1 percent. In
real terms, taking inflation into account, interest rates actually dropped to
negative 2 percent. The predictable result was a consumer spending spree. Looked
at another way, Bush’s own fiscal irresponsibility fostered irresponsibility in
everyone else.

Stiglitz seems to claim that Bush will go down with a lower reputation, in economic terms, than Herbert Hoover.  I have not been a huge fan of Bush’s fiscal policy, but I can add: a) Bush is not to blame for loose Fed policy, b) it remains debatable among honest Democratic economists whether loose Fed policy was bad, c) U.S. consumption has been robust for a long time, and d) changes in real interest rates do not explain much of the variation in private consumption, and that’s even assuming you manipulate the ex ante vs. ex post distinction to suit your convenience.  The first two sentences of this paragraph are plausibly true but then the text deteriorates rapidly and is determined to blame as many things on Bush as possible.  The paragraph ends up attacking Bush for promoting a "consumer spending spree" when Stiglitz had started by arguing for traditional Keynesian fiscal stimulus, the purpose of which is to promote…a consumer spending spree.

Stiglitz also argues that Bush is in large part (he won’t say how large) to blame for high oil prices.  In his view the war in Iraq led to political instability and stifled investment in the region, I say that Saudi oil wells are running dry anyway and increased demand — most of all from China — is the fundamental issue.  Note also that for many plausible parameter values, political instability leads to more pumping today and thus lower prices; the counterweighing cycle of less exploration and exploitation can take a long time to kick in.

It’s also worth noting how much the arguments run counter to Stiglitz’s own (earlier) writings on macroeconomics.  He used to preach that a) banks are excessively reluctant to lend to risky borrowers (compare to his discussion of the subprime crisis), b) changes in real interest rates generally don’t matter much, c) adverse selection makes it hard to sell non-transparent assets for a reasonable price (compare to his discussion of securitization), and d) we cannot expect monetary policy to be especially effective but rather we must focus on the extent of credit rationing.  Stiglitz of course has the right to change his mind, but if the shift is so big surely this is news.

There are many good arguments against many of Bush’s economic policies, and many other arguments which are maybe wrong but at least plausible or possibly true.  But essays such as this are not promoting the public’s understanding of economics.

The pointer is from Mark Thoma

Does anyone understand macroeconomics?

Ponder this one on your daily walk:

The key question asked by standard monetary models used for policy analysis is, How do changes in short-term interest rates affect the economy?  All of the standard models imply that such changes in interest rates affect the economy by altering the conditional means of the macroeconomic aggregates and have no effect on the conditional variances of these aggregates.  We argue that the data on exchange rates imply nearly the opposite: the observation that exchange rates are approximately random walks implies that fluctuations in interest rates are associated with nearly one-for-one changes in conditional variances and nearly no changes in conditional means.  In this sense standard monetary models capture essentially none of what is going on in the data.  We thus argue that almost everything we say about monetary policy using these models is wrong.

Or put it this way:

We have focused on exchange rates rather than the term structure of interest rates because the implications of exchange rates are so striking.  Specifically, if exchange rates are random walks, then all of the fluctuations in interest differentials are accounted for by fluctuations in conditional variances and none by fluctuations in conditional means.  The data are so opposite of what standard models assume that even the most die-hard defenders of them should take note:  If these data are accurate, then almost everything we say about monetary policy is wrong.

That is from the May 2007 American Economic Review, here is an earlier version of the paper.  I doubt if changes in interest rate differentials are driven by risk premia of the standard sort; I would sooner cite "noise plus news," but resist the pull toward calling that a "conditional mean."  I’ll also note that calling exchange rates a "random walk" is in the "do not reject" rather than "accept" statistical category.  Both asset price moves contain lots of junk information, so we shouldn’t be totally surprised if they don’t fit together in some simple manner.  Those moves weaken the paradox presented, but don’t come close to offering a coherent account of what is going on.

Fun with Central Bankers

1. Alan Greenspan certainly has been heard from a lot since his "retirement". Apparently current club members don’t like it as Bank of England Governor Mervyn King put a brutal slam on Greenie last week (as the article details though, Alan is laughing all the way to the bank). I approve of anything that makes central banking more like professional wrestling.

2. Guillermo Ortiz (or the Alan Greenspan of Mexico) is closing in on 9 years as Head of Mexico’s central bank. He inherited an inflation rate of 19%, which was steadily reduced.  It is around 4% today and much less volatile than in the past. Good job, Guillermo!

3. Central Banking, Japanese style.  With the country beset and bedeviled by deflation and stagnant growth, the BOJ stuck with a virtually zero interest rate for almost 6 years before getting frisky and raising rates to .25% last July. By all accounts it was so much fun they wanted to do it again the next month but were heavily pressured by the Government to hold off. This winter they raised rates again to .5%. Now, prices and wages have started falling again in Japan, but the BOJ boys can at least hold their heads up high at the next club meeting.

4. In the US the FOMC now has an unprecedented level of academic economic expertise. Start with Chairman Bernanke, who is ranked 107 in this list of top 1000 economists by publications from 1990-2000, then add longtime MR friend Randall Kroszner (ranked 363) and Fredrick Mishkin (ranked 93). In addition, St. Louis Fed President William Poole is a voting member this year. Poole is among the top ranked economists by publications from 1969 – 2000, as is alternate member Charles Plosser, ex-editor of the Journal of Monetary Economics and President of the Philadelphia Fed (Plosser is also ranked very high on citations from 1975 – 2000). Whether this is a good or bad thing remains to be seen!

5. Finally, for those hoping that new president Sarkozy will lead real reform in France, it turns out that he has met the enemy and it is the ECB!! This doesn’t seem good to me, though after taking a lot of hits Sarkozy has apparently backed down at bit.

Ben Bernanke is not a Credit Snob

Ben Bernanke argues that subprime mortgage lending is a natural and positive outgrowth of financial innovation.  Although some problems have occured they are being self-corrected and do not threaten the financial system.

…subprime mortgage lending began to
expand in earnest in the mid-1990s, the expansion spurred in large part by
innovations that reduced the costs for lenders of assessing and pricing risks.
In particular, technological advances facilitated credit scoring by making it
easier for lenders to collect and disseminate information on the
creditworthiness of prospective borrowers. In addition, lenders developed new
techniques for using this information to determine underwriting standards, set
interest rates, and manage their risks.

The ongoing growth and development of the secondary mortgage market has
reinforced the effect of these innovations. Whereas once most lenders held
mortgages on their books until the loans were repaid, regulatory changes and
other developments have permitted lenders to more easily sell mortgages to
financial intermediaries, who in turn pool mortgages and sell the cash flows as
structured securities. These securities typically offer various risk profiles
and durations to meet the investment strategies of a wide range of investors.
The growth of the secondary market has thus given mortgage lenders greater
access to the capital markets, lowered transaction costs, and spread risk more
broadly, thereby increasing the supply of mortgage credit to all types of

The expansion of subprime mortgage lending has made homeownership possible
for households that in the past might not have qualified for a mortgage and has
thereby contributed to the rise in the homeownership rate since the mid-1990s…

As the problems in the subprime mortgage market have become manifest, we have
seen some signs of self-correction in the market. Investors are scrutinizing
subprime loans more carefully and, in turn, lenders have tightened underwriting
standards. Credit spreads on new subprime securitizations have risen, and the
volume of mortgage-backed securities issued indicates that subprime originations
have slowed. But although the supply of credit to this market has been
reduced–and probably appropriately so–credit has by no means evaporated.

More from Bernanke here.  Previous posts on credit snobs here, here and here.

What does an inverted yield curve mean?

This is one of those headache topics.  Daniel Gross presents a clear treatment:

…the yield curve…describes the relationship between interest rates on long-term and short-term U.S. government bonds. Interest rates on the shortest-term bonds correlate very closely with the interest rates set by the Federal Reserve Board. Long-term interest rates, by contrast, are influenced by many more factors, ranging from China’s purchase of debt to investors’ optimism about inflation and growth. Typically, bonds that mature further in the future pay higher yields–compensation for the risk of locking up money for a longer period.

The yield curve rarely inverts. And when it does, it usually spells trouble for the economy. It means that investors and the Federal Reserve are fretting about inflation in the short term, and that investors are pessimistic about long-term growth. According to Brian Reynolds, chief market strategist at MS Howells & Co., in the last 30 years, periods of prolonged inversion of the curve between two-year and 10-year government bonds have generally presaged recessions. The most recent period of inversion ran from February 2000 through December 2000–just before the 2001 recession.

A year ago, the yield curve was rather steep. But in the last year, the Federal Reserve Open Market Committee has taken the short-term Federal Funds rate from 1 percent to 3 percent in eight straight tightenings, the most recent one in May. (All the Fed’s 2005 actions can be seen here.) Today, with two-year bonds at about 3.5 percent and the 10-year bond having fallen to about 3.9 percent, only a few dozen basis points separate the two.

Gross is an excellent economic journalist but I must differ on one key point.  The yield curve is overrated as a predictor of future output.  Here is a more cautionary and accurate analysis:

…the 1985-95 sub-sample completely reverses the results.  The yield spread becomes the least accurate forecast, and adding it to lagged GDP actually worsens the fit.

Another recent study shows that the short rate, not the yield spread, holds most of the relevant predictive power.

The bottom line: The previous power of the inverted yield curve was based on a few good predictions.  But no such predictor will stand up over time.  First, asset prices are very noisy.  Second, knowledge that we had an accurate predictor would itself change the relationship we are trying to predict. 

We face some serious economic problems today; savings may be taking the wrong form (capital gains rather than income reallocation), and perhaps we are in a housing bubble.  But observed spread in the term structure of interest rates does not add to my worries. 

My Ph.d. Macro reading list

Books: J. Bradford DeLong: Intermediate Macroeconomics, and Paul Blustein, And the Money Kept Rolling in (and Out)

Real Business Cycles

Stadler, George. “Real Business Cycles,” Journal of Economic Literature, December 1994, 1750-1783.

Long, John B. and Plosser, Charles. “Real Business Cycles,” Journal of Political Economy, 1983, 39-69.

Barsky, Robert and Miron, Jeffrey. “The Seasonal Cycle and the Business Cycle,” Journal of Political Economy, 1989, 503-534.

Prescott-Summers debate, Quarterly Review, Minneapolis Fed., “Theory Ahead of Business Cycle Measurement,” “Some Skeptical Observations on Real Business Cycle Theory,” and “Response to a Skeptic.”

Bils, Mark. “The Cyclical Behavior of Marginal Cost and Price,” American Economic Review, 1987, 838-55.

Romer, Christina. “Changes in Business Cycles,” Journal of Economic Perspectives, Spring 1999, 23-45.

Black, Fischer. “Noise,” Journal of Finance, 1986.

Mehrling, Perry. “Understanding Fischer Black,” you can find this paper at:

Finance and interest rates

Ross, Stephen. “Finance,” In The New Palgrave, pp.322-336.

Chapters six and seven, “Objects of Choice,” and “Market Equilibrium”.

Jagannathan, Ravi  and McGrattan, Ellen. “The CAPM Debate.” Federal Reserve Bank of Minneapolis,  Fall 1995, 2-17.

Campbell,  John Y. and Vuolteenaho, Tuomo, “Bad Beta, Good Beta,” American Economic Review, December 2004, 1249-1275.

Campbell, John, “Some Lessons for the Yield Curve,” Journal of Economic Perspectives, Summer 1995, 129-152.

Siegel, Jeremy and Thaler, Richard. “The Equity Premium Puzzle,” Journal of Economic Perspectives, Winter 1997, 191-200.

Kocherlakota, Narayana R. “The Equity Premium: It’s Still a Puzzle,” Journal of Economic Literature, March 1996, 42-71.

Lee, Charles, Shleifer, Andrei, and Thaler, Richard. “Anomalies: Closed End Mutual Funds,” Journal of Economic Perspectives, Fall 1990, 153-164.

Keynesian Economics

Cowen, Tyler. “Why Keynesianism Triumphed Or, Could So Many Keynesians Have Been Wrong?”, Critical Review, Summer/Fall 1989, 518-530.

“Symposium: Keynesian Economics Today,” Journal of Economic Perspectives, Winter 1993, 3-82.

“Is There a Core of Practical Macroeconomics That We Should All Believe?” American Economic Review, symposium, May 1997, 230-246.

Taylor, John. “Reassessing Discretionary Fiscal Policy,” Journal of Economic Perspectives, Summer 2000, 21-36.

Bernheim, B. Douglas. “A Neoclassical Perspective on Budget Deficits,” Journal of Economic Perspectives, Spring 1989, 55-72.

Eisner, Robert. “Budget Deficits: Rhetoric and Reality,” Journal of Economic Perspectives, Spring 1989.

Stiglitz, Joseph E. “The Causes and Consequences of the Dependence of Quality on Price.” Journal of Economic Literature, March 1987, 1-48.

Hall, Robert E. “Employment Fluctuations with Equilibrium Wage Stickiness,” American Economic Review, March 2005, 50-65.

Summers, Lawrence. “The Scientific Illusion in Empirical Macroeconomics,” Scandinavian Journal of Economics, 1991, 129-148.

Monetary Policy

Blinder, Alan. “What Central Bankers Can Learn From Academics – and Vice Versa,” Journal of Economic Perspectives, Spring 1997, 3-20.

Bernanke, Ben and Mishkin, F. “Inflation Targeting,” Journal of Economic Perspectives, Spring 1997, 97-117.

Aiyagari, S. Rao, “Deflating the Case for Zero Inflation,” Federal Reserve Bank of Minneapolis, Quarterly Review, Summer 1990, 2-11.

“Symposium on the Monetary Transmission Mechanism,” Journal of Economic Perspectives, Fall 1995, 3-96.

Roberds, William. “What Hath the Fed Wrought? Interest Rate Smoothing in Theory and Practice,” Federal Reserve Bank of Atlanta, Economic Review, January/February 1992.

Shafir, Eldar, Diamond, Peter, and Tversky, Amos. “Money Illusion,” Quarterly Journal of Economics, May 1997, 341-374.

Caplin, Andrew and Spulber, Daniel. “Menu Costs and the Neutrality of Money,” Quarterly Journal of Economics, November 1987, 703-725.

Sargent, Thomas and Wallace, Neil. “Some Unpleasant Monetarist Arithmetic,” Federal Reserve Bank of Minneapolis, Quarterly Review, 1985, 1-17.

Wallace, Neil. “A Legal Restrictions Theory of the Demand for “Money” and the Role of Monetary Policy,” Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1983.

Posen, Adam. “Why Central Bank

Independence Does Not Cause Low Inflation: There is No Institutional Fix for Politics,” in Finance and the International Economy, edited by Richard O’Brien, 1993.

Garrison, Roger, “The Austrian Theory of the Business Cycle,” At  href=""

Krugman, Paul. “The Hangover Theory,” at

Cowen, Tyler. Risk and Business Cycles, chapter three.

Savings and social security

Hubbard, R. Glenn and Skinner, Jonathan. “Assessing the Effectiveness of Savings Incentives.” Journal of Economic Perspectives, Fall 1996, 73-90.

Choi, Laibson, Madrian, and Metrick, “Optimal Defaults,” American Economic Review, May 2003, also at ttp://

Samwick, Andrew. Voxbaby weblog, read the entries on social security.

International Economics

Current issues:

“If I Believed in Austrian Business Cycle Theory,” by

Tyler  Cowen, on

Brad Setser’s WebLog.

Dornbusch, Rudiger. “Purchasing Power Parity,” in The New Palgrave.

Friedman, Milton. “The Case for Flexible Exchange Rates.” In Essays in Positive Economics, 1953, University Chicago Press.

Mundell-Fleming model, see Brad’s book.

The World


Krugman, Paul R. “It’s Baaack:

Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on Economic Activity, 1998, 29, 2, 137-87.

Kashyap, Anil K. “Sorting out Japan’s Financial Crisis,” Federal Reserve Bank of Chicago Economic Perspectives, 2002, 26, 4, 42-55.





Developing Nations



Bordo, Michael D. “Essays in Exploration: A Survey of the Literature,” Explorations in Economic History, 1986, 339-415.

“Symposium: The Great Depression,” Journal of Economic Perspectives, Spring 1993, 3-102.

Romer, Christina H “What Ended the Great Depression?” Journal of Economic History, 1992, 52, 4, 757-84.

Here is a searchable link to Brad DeLong’s website:

Huge errors we might possibly make

Using the threat of tariffs to pressure the Chinese to revalue their currency

Matt Yglesias considers the politics, don’t forget Dan Drezner either.  Brad DeLong offers the full economic analysis.  The bottom line is a bit difficult to parse from Brad’s lengthy post, but I’ll offer my summary. 

The Chinese (and other foreigners) are offering a massive subsidy to current levels of U.S. federal spending.  It happens to coincide with their desire to subsidize their exporters.  A low renminbi implies high Chinese exports, high dollar reserve accumulation in China, and relatively low interest rates in the U.S..  Forcing this picture to end overnight would run a significant risk of plummeting U.S. asset prices and a run on the dollar.  In the longer run the not-really-stable Chinese currency might end up whipsawed by international capital markets (Indonesia?  Thailand?  Argentina?).

I’ll make all the concessions here you want.  The current Chinese arrangement is screwy and harms the Chinese citizenry.  I don’t usually favor fixed exchange rates or export subsidies, implicit or explicit.  Somehow, sometime, someway, the Chinese should look toward another policy.  I’ll make those concessions until they are coming out of my ears.  But I still won’t favor dropping a lit match on an open field of gasoline, which is what this American pressure would amount to.  Nor does it matter whether or not you "trust the Chinese," whatever that might mean.  This is not the right way to deal with them, and yes it will remind them of the Opium Wars.

I am not a pessimist about our current economic course, but we can still wreck things if we choose.  And right now we may well make this gross mistake.

Does it matter that the dollar is falling?

I have heard several accounts of why a low or falling dollar is bad:

1. U.S. citizens hold a relatively high percentage of dollar-denominated assets, so they are now poorer.

2. It looks bad when "the world’s strongest country" has a currency low in value.  Perhaps OPEC will start pricing oil in terms of Euros.

3. Markets dislike uncertainty per se.  People start wondering what a dollar is really worth and this causes them to hold off on other investments and purchases.  This hurts financial markets and the economy more generally.

4. The real problem concerns interest rate hikes.  The Fed won’t let the dollar fall too far, for some of the other reasons listed.  It will stop a dollar free-fall by raising interest rates, which is bad for the economy.

5. If the dollar is falling, people will expect it to fall more and unload dollar-denominated assets.  This one, however, is tricky.

If the dollar is expected to fall, we would expect nominal interest rates on dollar-denominated assets to rise (or the dollar must fall in value immediately).  A reasonable equilibrium will obtain and dollars will once again be an attractive asset to hold.

My take: #1 is correct, but not a major problem.  Imports are not a huge part of our economy, and often the exporter eats the currency loss, at least for a while.  I don’t put much stock in #2.  #3 and #4 are real.  #5 makes little sense to me, but I cannot rule out its role in today’s world.  How can it work?  Perhaps portfolio managers bear a special penalty from being thought stupid if they hold onto dollars while a falling dollar makes the headlines.  In this case a falling dollar would continually increase the real risk premia on dollar assets, even if traditional measures of risk do not much vary.

Keep in mind that the dollar did have a "soft landing" in the 1985-1989 period, so these are all possible costs, not necessary outcomes.

I cannot do links from this unusual Calcutta terminal, but read Brad DeLong’s recent posts on the dollar as well.

Lending American capital to Mexicans

Seeking to tap into the billions of dollars that Mexicans working in the United States send home each year, a Mexican mortgage finance company is opening a New York branch on Thursday to offer loans to Mexicans who want to buy a house in their country.

Last year, Mexicans sent home $13.27 billion, more than the country earned from foreign tourism. The money lifts many families out of poverty and in some regions is the only source of income.

Many Mexicans working in the United States hope to save enough to buy a house in Mexico and return. But the money they send home is often consumed by daily needs.

Under the lending plan created by Hipotecaria Nacional, Mexico’s largest mortgage finance company, a Mexican working in the United States – legally or illegally – will be able to apply for a loan and pay the monthly installment in dollars through an American bank.

Relatives in Mexico must also sign the loan, which is issued in Mexico in pesos and backed by Mexico’s national mortgage bank, Sociedad Hipotecaria Federal.

And what do the stats look like?

…a worker would need to pay $400 a month for a 15-year mortgage at 15 percent interest on a house valued at about $36,000 with a 20 percent down payment. That interest rate, which would be quite high in the United States, is reasonable by Mexican standards, given higher base interest rates, inflation and the greater risk of default.

I’ll add that a house in rural Mexico costs only a few thousand dollars to buy or construct.

Nor are real estate-based capital movements restricted to mortgages proper:

…it has been Mexican companies that have come up with the most innovative ideas. Since 2001, Cemex, the cement giant, has allowed Mexicans to pay for bags of cement in the United States that relatives pick up in Mexico to build houses. The company, which has five offices in California and one in Chicago, even offers free engineering advice.

Here is the full story.