Ben Bernanke vs. Edwin Truman on U.S. Domestic Demand

Ben Bernanke is back at it. In a speech before the Federal Reserve Bank of San Francisco, he noted that Asia continues to save too much and the United States too little. As a result, global economic imbalances may once again grow. Here is what he had to say about Asia:

For their part, to achieve balanced and sustainable growth, the authorities in surplus countries, including most Asian economies, must act to narrow the gap between saving and investment and to raise domestic demand. In large part, such actions should focus on boosting consumption.

Bernanke is saying Asian economies must increase their domestic demand going forward to help reign in global economic imbalances. He also acknowledges that U.S. domestic demand will have to come down via less fiscal stimulus for this endeavor to work. So, in short, the key to a rebalanced world economy is better management of domestic demand. Fine, but where was the Federal Reserve with managing U.S. domestic demand back in 2003-2005? If better management of domestic demand is key to removing global imbalances now, surely it would have helped in the early-to-mid 2000s. The Federal Reserve could have done a lot on this front. Had it reigned in U.S. domestic demand back then it seems likely Asia would have been more likely to switch to its own domestic demand sooner. As Mark Thoma notes, though, Bernanke fails to mention this point in his talk.

The Federal Reserve cannot claim ignorance on this point. Edwin Truman, one of its long-time former employees, argued forcefully for the Federal Reserve to take seriously the growth in U.S. domestic demand and its implications for the build up of global economic imbalances back in 2005:

What the Federal Reserve has not acknowledged is that monetary policy has a role to play in slowing the growth of total domestic demand relative to the growth of total domestic supply or domestic output. The issue of concern is not just the effects of external adjustment on financial markets, but also on the real economy. It is one thing for politicians to be reluctant to acknowledge the real economic costs of external adjustment. The Federal Reserve does not have that excuse.

The majority of the members of the FOMC apparently do not embrace the view that they should pay more attention to total domestic demand. They are mistaken. Monetary policy is not just about managing domestic output and employment; it is also about managing total domestic demand, and most importantly managing the balance between demand and output. The view that net exports are a “drag” on GDP rests on knee-jerk arithmetic analysis. Exports and imports of goods and services are jointly determined with consumption, investment, and many other macroeconomic variables. Moreover, policy should focus significant attention on total domestic demand. In particular, the Federal Reserve should ponder whether it is not unnatural to continue to stoke the furnace of domestic demand three years after the dollar has begun to weaken, the US economy has moved into an expansion phase, and the US external deficit has widened. It was wrong for Mexico to ignore the message for monetary policy from the foreign exchange markets in 1994 and for Thailand to do so in 1996. Is it wise for the Federal Reserve to do so in 2005?

Too bad his views were not embraced by the FOMC. Let's hope he gets more of hearing going forward.

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A Positive Global AS Shock + Loose U.S. Monetary Policy = Trouble

Menzie Chinn is not pleased with the new paper by Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg. In this paper the authors argue the underlying cause of the current crisis was a large positive labor supply shock to the global economy that originated in Asia:

Labor in developing countries – countries with vast pools of grossly underemployed people – can now augment labor in the developed world, without having to relocate, in ways not thought possible only a few decades ago. We argue that this large shock to the developed world’s labor supply, triggered by geo-political events and technological innovations is the major underlying cause of the global macro economic imbalances that led to the great recession. The inability of existing institutions in the US and the rest of the world to cope with this shock set the stage for the great recession[.]

Menzie notes there is (1) no discussion in the paper on the role U.S. economic policies played in contributing to the financial crisis and (2) it implies that forces outside the U.S. are the sole driver of U.S. macroeconomic activity. I too am skeptical of studies that suggest developments elsewhere alone are the source of our current problems. However, this study does make a good point in that there was a large positive labor supply shock to the global economy with the opening up of China and India over the past decade. This development created a large positive global aggregate supply shock (AS) that--in addition to positive AS shocks coming from ongoing IT gains--had implications for the global economic policy. The primary implication is that global interest rates should have gone up since the return to the global capital stock increased as a result of this shock (i.e. the marginal product of the global capital stock increased as the global labor supply increased). Instead, the global monetary superpower, the Federal Reserve, pushed global short-term interest rates down and created a global liquidity glut. Throw in some financial innovation, credit market distortions, complacency created by the Great Moderation and the stage is set the greatest financial crisis in the world since the 1930s Great Depression. This point was made by The Economist magazine back in July 2005 in an article titled "From T-Shirts to T-Bonds." Here is a key excerpt:

The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a is allocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.

So, contrary to the paper's assertions, the U.S. could have handled this global AS shock better had its monetary policy been more appropriate. Until we began to take seriously the role U.S. economic policy played in the buildup of global imbalances that ultimately led to this global crisis we are bound to repeat history.

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Obstfeld and Rogoff's New Paper

Mark Thoma directs us to a new paper by Maurice Obstfeld and Kenneth Rogoff titled Global Imbalances and the Financial Crisis: Products of Common Causes. In this paper the authors acknowledge that highly accommodative U.S. monetary policy in the early-to-mid 2000s in conjunction with other developments played an important role in the build up of global economic imbalances. In their discussion of U.S monetary policy, interest rates, and global liquidity conditions they miss, however, some important points on the issues of (1) productivity growth and (2) the monetary superpower status of the Federal Reserve. Let me take each point in turn.

The first point comes up when Obstfeld and Rogoff criticize the saving glut explanation for the decline in long-term interest rates that began in the early 2000s. They rightly expose the holes in the saving glut story but then turn to a less-than-convincing explanation for the decline in the long-term interest rates. Here are the key excerpts:

[T]he data do not support a claim that the proximate cause of the fall in global real interest rates starting in 2000 was a contemporaneous increase in desired global saving (an outward shift of the world saving schedule)... according to IMF data, global saving (like global investment, of course), fell between 2000 and 2002 by about 1.8 percent of world GDP... [A]n end to the sharp productivity boom of the 1990s, rather than the global saving glut of the 2000s, is a much more likely explanation of the general level of low [long-term] real interest rates.

So their story is that the productivity surge of the 1990s ended and pulled down long-term interest rates. This is a plausible story since productivity growth is a key determinant of interest rates, but the data does not fit the story. Below is a figure showing the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed (Click on figure to enlarge):


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. Rather than pushing interest rates down this indicates they should have gone up. That still leaves the question of why long-term interest rates declined during this time. My tentative answer is that it was some combination of (1) a drop in the term premium that itself was the result of a false sense of security created by the Great Moderation and (2) and expectations of future short-term interest rates being low because of accommodative monetary policy.

The productivity point, however, does not end there. It becomes important in understanding why the Fed continued to keep interest rates so low for so long. As the authors note in the paper:

In early 2003 concern over economic uncertainties related to the Iraq war played a dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first time that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Deflation was viewed as a real threat, especially in view of Japan’s concurrent struggle with actual deflation, and the Fed intended to fight it by promising to maintain interest rates at low levels over a long period. The Fed did not increase its target rate until nearly a year later.

In other words, the fear of deflation is what motivated Fed officials to keep interest rate low for so long. As I have noted many times before, though, the Fed's fear of deflation at this time was misplaced. Deflationary pressures emerged not because the economy was weak, but because TFP growth was surging as shown above. The Fed saw deflationary pressures and thought weak aggregate demand when in it fact it meant surging aggregate supply. Making this distinction is important if monetary policy wishes to fulfill its mandate of maintaining full employment. Not making this distinction in 2003-2004 meant an economy already buffeted by positive aggregate supply shocks (i.e. productivity surge) got simultaneously juiced-up with positive aggregate demand shocks (i.e. historically low interest rate policy). This was a sure recipe for economic imbalances to emerge somewhere.

The second point with the Obsteld and Rogoff's paper is that it fails to appreciate how important is the Fed's monetary superpower status. As I have explained before

the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Obstfeld and Rogoff actually hint at this possibility briefly when they say the following:

the dollar’s vehicle-currency role in the world economy makes it plausible that U.S. monetary ease had an effect on global credit conditions more than proportionate to the U.S. economy’s size.

But then they go on to say

While we do not disagree entirely with Taylor [who believes the Fed was too accommodative in the early 2000s], we argue below that it was the interaction among the Fed’s monetary stance, global real interest rates, credit market distortions, and financial innovation that created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis.

I agree that there were many factors at work, but if you accept that the Fed is a monetary super power and therefore helped generate the global liquidity glut then it could have also tightened global liquidity conditions and helped pushed the global interest rates toward a more neutral stance. And without the global liquidity glut it seems that many of the other credit market distortions that arose at the time would have been far less pronounced.

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Another Nail in the Global Saving Glut Coffin

David Laibson and Johanna Mollerstrom have a new paper--see here for a shorter version--that further undermines the popular global saving glut theory (GSG). According to the GSG theory there was an increase in global savings beginning in the mid-to-late 1990s that originated in Asia and to a lesser extent in the oil-exporting countries. This surge in global savings found its way into the United States via large current account deficits that, in turn, created the asset bubbles of the past decade. Laibson and Mollerstrom argue the GSG theory has the causality backwards: the asset bubbles in the advanced economies came first and spurred consumers to go on a consumption binge. That consumption binge, in turn, was financed by savings from abroad. The smoking gun in their story is that had the foreign funding been truly exogenous then there would have been a far larger investment boom given the amount of foreign lending. Instead, there was a consumption boom which is more consistent with causality starting from an asset bubble. Their paper adds to their growing chorus of SGT skeptics including Menzie Chinn, Maurice Obstfeldt andKenneth Rogoff, Guillermo Calvo, and myself.

Interestingly, Laibson and Mollerstrom note that their story fails to answer two important issues:

There are many open questions that we have failed to address, but two stand out in our minds. First, our model takes the existence of the asset bubbles as given and does not explain their origins.

[...]

Second, our model does not explain why global interest rates fell between 2000 and 2003, and thereafter stayed at a relatively low level.

Well let me help Laibson and Mollertrom here. The actions of U.S. monetary policy can answer the first question and at least the first part of the second question for this period. As I have written before, this is easy to see given the Fed's monetary superpower status:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

In short, the Fed set global monetary conditions at the time and pushed global short-term rates below their neutral level which, in turn, started the asset booms. Of course, financial innovations and credit abuses also played a role and may explain the persistence of the low global interest rates. I think my monetary superpower hypothesis fits nicely with the Laibson and Mollertrom story. One more nail in the saving glut coffin.

P.S. In case you are wondering, here is evidence the Fed kept the federal funds rate below the neutral rate during the early-to-mid 2000s (source). Here is more formal evidence from the ECB.

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Monetary Policy and the Saving Glut Both Mattered for the Boom

That is what Filipa Sá, Pascal Towbin, and Tomasz Wieladek find in their new paper. Moreover, they find that the effects of monetary policy and the saving glut were more pronounced in those economies with more developed and securitized mortgage markets.  On this latter point, Roger Ahrend similarly finds that easy monetary policy had its biggest effect on housing in periods of financial deregulation and innovation.  The Sá et al. paper also is consistent with the findings of Thierry Bracke and Michael Fidora who show that monetary policy shocks and global saving glut shocks contributed to the buildup of global economic imbalances.  These nuanced studies that take a global perspective and find both monetary policy and global savings to have mattered are far more satisfying than the "Not us!" research being pushed by former and current Fed officials lately.  

It would be nice, however, if these nuanced studies did more to tease out (1) how much of the saving glut was due to truly exogenous developments in the emerging economies versus (2) how much was due to endogenous responses by these economies to the Fed's loose monetary policy.  In other words, how much of the saving glut was simply recycled U.S. monetary policy? 

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