Friday, January 9, 2009

The US Can't Unilaterally Inflate

Many people are either worried that all the excessive money creation and bailouts will create inflation, or hope that the Fed will create the necessary inflation to gradually reduce the burden debtors face.

There is little chance either will come to pass right now.

The US can't create or sustain moderate inflation without a little help from its friends.  This insight falls more into the category of "accounting identity" than "brilliant reasoning".

The Story

There are many countries that peg their currencies to the dollar in some form, but China is by far the biggest, most important, and most notorious.  But even Japan has a ceiling beyond which they won't let the JPY rise.  These pegs are not difficult to defend because their currencies are pegged too cheap, rather than too rich.  In fact, China absorbs massive amounts of USD in their interventions to enforce that peg.  Should they ever need to fight the other way, they can sell off USD and buy CNY until the crisis has passed, and the permanent, underlying current account surplus takes care of the problem.

Japan and China do not have any lasting inflation problem either, though both caught an inflationary wave during the commodity bubble.  They have certainly both experienced deflation in the recent past.  The economies survived, with a little discomfort.  There is very strong structural deflation in both economies, with extraordinarily deep capital, and in China's case at least, virtually limitless labor.  Deflation appears to be returning and it probably doesn't present a severe threat to either economy.

Deflation does pose a dire threat to the US economy.  With immense debt outstanding to GDP, far higher than anything seen before, the US economy may have approached the Chandrasekhar limit of debt.  Debt-deflationary spirals are not fun.  Even worse, we have very large, persistent trade deficits and a poor NIIP.

The US has also invested very little in tradeable sectors.  When we had all the cheap funding in the world, we built houses in the Inland Empire and bought a lot of cars.  Why did America choose to consume or invest in residential real estate, rather than a machine shop in Michigan?  Many ascribe that to avarice or stupidity, but it's unfortunately more likely a result of American workers and capital being totally uncompetitive at current and envisioned pricing.  As evidence, American exports did finally start to respond a bit when the dollar index sunk a long way, but they've begun to fall again now during the recession, while the dollar's rising again.  American goods and services need to be cheaper in other countries to be desirable.

The dollar can't weaken against major competitors, though.  China, Japan, and other pegging nations prevent it.  China probably can't really break their peg without bankrupting the PBoC, which holds dollars as assets and yuan as liabilities.  Much of the world, if revalued, could no longer rely on exports to America and Europe for growth, sinking into deeper -- more deflationary -- recessions of their own.  They will probably not revalue any time soon.

China has also demonstrated the ability to sterilize, effectively or at least marginally so, extremely high levels of intervention.  Enough for real exports and hot money when the global economy was fine, and certainly enough in our trade depressed world.  I believe that through greater bond issuance and raised required reserves, they can effectively sterilize a really, really big pile of yuan.  Japan has started running a trade deficit.

Why Inflation's Impossible

Now, let's imagine Bernanke has a magic wand that he can wave to set the US inflation rate to 12%, in order to increase wages and revenues and make debt and prices manageable.

A year passes.  Everyone charges 12% more dollars for everything: labor, haircuts, cheeseburgers, and so on.  That's okay, because everyone earns more too.

But every USD is still worth 6.83 CNY, and there was no inflation in China.  That means the price of US labor, haircuts, and cheeseburgers is 12% higher in real terms in China.  They can't buy as much.  That also means the price of Chinese t-shirts is 10.8% seems lower than it was last year, because Americans are all earning more.  I'll be more likely to buy things made in China.

China now exports much more to the US.  With the proceeds from these exports and the intervention, they would buy more US assets, but less relatively expensive US goods and services.  The trade balance worsens, the imbalances worsen, US workers and plants become even less competitive, China invests more in tradeables, US consumers go further into debt, and so forth.  Less employment, less exports, more debt, stronger deflationary forces.  Next year, things grow exponentially worse.

Unless the US miraculously becomes more efficient and productive, to avoid this scenario, the US must have a weakening real exchange rate (REER).  Because currency pegs prevent revaluation, that means China and Japan must run higher inflation rates than the US.  Twisting it around, in current conditions, the US cannot run a higher sustained inflation rate than China, Japan, and others.

The US must either:

1)  Persuade China, Japan, and others to allow their currencies to appreciate dramatically so the US can abruptly default on some of its debt to them, and reduce their exports considerably;
2)  Persuade China, Japan, and others to allow high domestic inflation.  If the US wanted 12% inflation domestically, it might ask for 16% or 17% inflation in China, if not a bit more;
3)  Do something crazy, like enact Smoot-Hawley Mark II and beat each other up at the WTO;
4)  Suffer through deflation.

72 comments:

Anonymous said...

Somewhat long-winded explanation, but I believe the so-called surplus available in Chinese banks, is really not a surplus. China has been printing RMB to purchase the Treasuries and Agency bonds for a long time to keep exports going and their labor employed. These imbalances are the accumulated result of all the currency manipulations that China indulged in for so many years. The US can default on this debt by claiming that this was the result of currency manipulation, and restart the clock just like one would on a personal bankruptcy. What is wrong with it?

ndk said...

Somewhat long-winded explanation

I agree. I guess I should've just posted the explanation of why inflation won't be possible. I have no idea what level of familiarity or background knowledge to assume with readers.

I believe the so-called surplus available in Chinese banks, is really not a surplus. China has been printing RMB to purchase the Treasuries and Agency bonds for a long time to keep exports going and their labor employed. These imbalances are the accumulated result of all the currency manipulations that China indulged in for so many years.

I agree with you on the fundamental reasons, which is one more reason China is very unlikely to let their currency appreciate any further against the dollar.

The US can default on this debt by claiming that this was the result of currency manipulation, and restart the clock just like one would on a personal bankruptcy. What is wrong with it?

I put explicit default or repudiation of debt by the US on its obligations into the category of "doing something crazy" from our present perspective, but it could be an eventual solution. China and other creditors would not be happy, and it would be something of an international incident. Cowen and Hummel run through the scenario in their minds.

Anonymous said...

There's something I don't understand in your treatment of this issue. Bernanke doesn't have a magic wand that can make inflation in the U.S. 12%. The U.S. does however have, as Bernanke has said many times, a printing press.

Let's suppose the printing press is used, as Bernanke has said it may be, to fight deflation. For example, let's say the U.S. prints, say, five trillion dollars. Then the Chinese will not be able to both maintain their peg to the dollar and avoid domestic inflation. Lots of dollars would be used to purchase things from China, causing domestic scarcities. The Chinese government would have to print lots of yuan to buy up the dollars. There would have to be export controls on things like pigs that were needed domestically.

Could you explain why this is unlikely? It seems inevitable to me. I am guessing that the only weapon foreign governments have against this is a threat to require the denomination of US Treasuries in foreign currencies.

ndk said...

Let's suppose the printing press is used, as Bernanke has said it may be, to fight deflation. For example, let's say the U.S. prints, say, five trillion dollars.

Remember that there is no such thing as a pure printing press.

I'll try to do a post on it sometime, but the gist of it is that the Fed can create an arbitrarily large dollar asset/liability pool on its balance sheet. The asset is hard currency, and the liability is the same hard currency.

The Fed then must purchase something with its dollars to get the dollars into the system. That something becomes the Fed's asset, and the liability remains the dollars. Doing this above and beyond what the banking system needs or wants is quantitative easing, and we've already tried that. There's already $800 billion dollars just sitting in banks doing nothing.

The Fed could increase that to $5 trillion, but it's not clear that would increase the amount of lending going on. There are other problems caused by this process but I'll go over them later. For now, it's enough to say that the private sector is unwilling or unable to spend dollars, so to enact your scenario, the public sector would have to do so in its stead.

Lots of dollars would be used to purchase things from China, causing domestic scarcities. The Chinese government would have to print lots of yuan to buy up the dollars. There would have to be export controls on things like pigs that were needed domestically.

I don't think China exports pigs, but they import a lot of them. We could, though, offer to pay a preposterous price for pork bellies. Let's step through this, bearing in mind that our goal is to increase the profits of domestic production and increase domestic wages.

When consumers in the US and Europe had their voracious appetite for finished goods from China, it wasn't sufficient to result in any good inflation or broad wage gains in China. Prior to '06, China was hovering around 0% inflation, gradually floating into and out of deflation. During '06-'07, the inflation China experienced was like the inflation we experienced: food, energy, real estate, and stocks. The wage gains China experienced were also like the wage gains the US experienced: protected and monopolistic industries, CEO's and other executives, and little to nothing for most workers.

To get wage inflation by increasing the price of finished goods, you would need the USG to purchase at least as many finished goods from China as had been previously consumed, and probably a lot more.

You could aim for cost factor inflation by, for example, skipping the middle man and having the Fed purchase $5 trillion of pork bellies. That's economic cluster bombing, because it would raise the price of pork globally. It almost certainly wouldn't result in matching wage gains for average workers, because what they do and sell has not gone up in value at all.

Even worse, any of these moves if successful would exacerbate the problem. Think of the USG's purchases of these goods or services as an implicit subsidy. That will tend to increase investment in such goods and services beyond what the market would naturally desire. It'd result in even greater resulting structural overcapacity and stronger deflationary forces in the future.

Anonymous said...

Your trap leaves protectionism (or Buffet's import certificates) as the only answer. Not a good answer. The only answer.

Anonymous said...

@ndk,

Damm you, for creating your own blog, now I must add it to a long list of daily reading. JK, well done and good on you! Look forward to viewing your thoughts, cooking in their own pot, should be very enlightening. I will forward your site to all my friends.


Skippy

Marlowe said...

ndk, thanks for doing a longform, patient explanation. If what you say is true, we're screwed.

Timo said...

I would say NDK is wrong about inflation. Hyperinflation happens:

1) When there is scarcity of essentials because of the logistic system is broken up (lack of payments, massive wave of bankruptcies, social unrest etc etc..) AND

2) Government is trying to print itself out of the mess because ALL other possible means of financing have been shutdown. USA 2010?

It is a special case in which normal conditions cannot be applied. It is more like besieged city; who gives a damn how high/low the real-estate prices are when all you can do is to try to survive.

USA is heading that way...

donebenson said...

To NDK, Thanks for your effort [it was not long winded in my opinion], I very much look forward to reading future comments from you [as I have in the past]. Keep up the good work!

[and Yves, thanks for posting this, and for encouraging NDK]

Anonymous said...

NDK,

I see your new blog is up and running the day after our little discussion re central bank solvency on Naked Cap (NY Times: China Cooling on US Debt).

Good stuff. I like your generous use of links within the text; particularly those that go directly to the statistical data series - for those of us who are too lazy to seek them out otherwise.

Best of luck.

Anonymous said...

"The Fed then must purchase something with its dollars to get the dollars into the system. That something becomes the Fed's asset, and the liability remains the dollars.Doing this above and beyond what the banking system needs or wants is quantitative easing, and we've already tried that. There's already $800 billion dollars just sitting in banks doing nothing."

umm.. how exactly are dollars a liability for the Fed? the dollars are redeemable for...dollars.
Also i dont agree with your explanation of quantitative easing. While QE does involve increasing excess ES reserves, that is not the defining feature of it.
The Fed could purchase bonds, MBS, stocks, houses- any asset- targeting a 100% increase in price and i bet you there will be inflation.

Stephen said...

Your accounting identity holds for US Chinese trade. However, the Yan, Remnibi (whatever) will devalue with the US dollar versus all other floating currencies.

I am sure there is significant distance this scenario could go, but at some point the effect of this feeds back into China. It is an effective cut in the standard of living, as it is with US population.

Pegging means the Chinese accept a US inflation rate, and all of the implications that a high and non predictibale inflation rate command.

So I don't believe the inflation pegging non effect can go on forever. At some point the rest of the world intervenes on this and the Chinese would find either that foreign goods from non US sources become so expensive that they cannot buy, this includes machinery, technology, FOOD, and other commodities.

It is an unsustainable scenario. Unless the circumstances in China and the US remain similar then running a hard peg, effectively abandoning Chinese monetary policy to Washington, will create hardship in China one way or another.

Pegged curencies eventually break, the longer it is allowed to continue the greater the tears are when the Peg cannot be maintained. What is unique here is that the size of the economies might just allow it to continue for a long time, but each economy has significant trade outside the Peg. These are what will end it, unless the political backlash caused by an unreasonable Peg don't get it first.

Rememeber, in the 30's there was the "Growth Bloc", the commonwealth, who maintained Free Trade under Imperial Preference. They emerged earlier and faster from the Depression.

China can either work on appreciating its currency, and letting its populations standard of living increase or it can wait for a sudden jump and all of the attendent issues that a dislocation like that causes. They can either be in control of that over time or just let it happen.

I don't think the hard Peg is sustainable and I dn think the Chinese wish to lash themselves to such a wildly divergent monetary policy.

ruetheday said...

"But every USD is still worth 6.83 CNY, and there was no inflation in China."

This is where your analysis goes wrong. If the US were to effectively double the dollar money supply, China would have to double the Yuan supply in order to maintain the 6.83:1 peg. Doubling the Yuan money supply would obviously cause domestic inflation in China. China is unable to maintain the numeric peg in the face of dollar creation without also engaging in Yuan creation. You included one too many constraints in your analysis.

Anonymous said...

Why do all inflationary bail-out scenarios begin with sending dollars to the banks? What would happen if a truly massive number of taxable dollars (lets say 3 million) were distributed to each of the bottom 90% of wage earners in the US, along with a price fix on tangible goods (not intellectual property or wages)?

is it possible that the US cannot inflate from the top (relying on trickle-down simply does not work), but must do it from the bottom (consumer) level?

Gu Si Fang said...

How could the PBoC (or any central bank for that matter) go bankrupt? It has no liabilities.

Outstanding yuans are not a liability : the PBoC has no committment whatsoever relating to these yuans. In particular, it does not have to convert them into anything.

Similarly, the outstanding PBoC debt which was created to sterilize dollar reserves is labeled in yuan. The PBoC's liability to repay this debt is fake, since it can inflate to repay it.

As I see it, the PBoC cannot go bankrupt.

Anonymous said...

Nice to see you had a change of heart:

ndk said...

Anonymous said...

NDK:

I always enjoy your thoughtful comments over at NC. Glad to see you have decided to start your own blog.

IdahoSpud (too lazy for blogger login)

Mikkel said...

"It is an unsustainable scenario. Unless the circumstances in China and the US remain similar then running a hard peg, effectively abandoning Chinese monetary policy to Washington, will create hardship in China one way or another."

I can't disagree with ndk economically speaking, but this is the most important point politically speaking. Like Yves has posted, China already feels duped, and if they are really going to try to hold onto us while we're drowning then they are in for a world of pain. And you know what they say to do if you try to rescue someone that's drowning and they are pulling you down as well...punch them out.

I think at some point in the next few years they'll realize that they are in for bad times no matter what, stop supporting us, blame us for all their troubles, and then send out tanks to put down anyone that agitates. That is perhaps even the most rational thing to do.

CTMM said...

Um.

This is all assuming that the average Chinese worker in the average Chinese shoelace factory is perpetually willing to work for crap wages just so you & I can continue to buy flat screen t.v. sets, live in suburbia and eat Wendy's Baconators in our S.U.V.'s.

Even if we completely ignore the ethical treatment of people (you work, we profit) in the current system, we'd be fools to think that a large country like china with an emerging industrial base is going to keep working for chump change.

Somewhere out there is a magical tipping point where it suddenly becomes more advantageous for the chinese to ditch the U.S. (this is also the same magic moment when the dollar becomes worthless internationally)

Were I a betting man, I'd wager at some point in the near future declines in international oil production expose the U.S. as the holder of paper, not actual resources, and we will see China quickly realign with their neighbors to the north and west.

David Pearson said...

ndk,

Great post and discussion.

I think you may be overlooking two things. First, velocity. Second, velocity.

You take it for granted that "deflation" means "falling velocity". True to some extent. But Brazil and other countries have shown that Central Banks have something to say about velocity. They somehow are able to communicate to economic actors that reserve increases are PERMANENT and ONGOING. Once actors believe this, money leaks out from reserves not to CREDIT, but to hard goods. The loan to asset ratios of Brazilian banks, for instance, remained at roughly 50% through much of that country's inflation.

How does a Central Bank convince actors of their inflationary intentions? Its both harder and easier than you think. HARDER, because no one much believes anything these CB's say. EASIER, because the need to create permanent reserves at some point becomes structural.

A structural need for Central Bank reserves occurs when a country moves on a trajectory towards debt default. That is, given the need for new debt to avoid deflation, and given the inability of income growth to service even the old debt, it becomes clear to most actors that the government will eventually default. At that point in time, a Central Bank intent on preventing default has only one option: to support the debt by financing it permanently and in every-larger sizes.

What happens in countries like Brazil and Argentina has everything to do with debt service. We're in same boat, and we will proceed along the same path not because our Central Bank wants to, but because our people will choose Central Bank debt financing over the alternative any time.

Sorry for the long post, but remember that the key flawed assumption of deflationists is they don't think the U.S. faces default. Make that assumption, and everything deflationists say is true. Relax it, and the inflationist argument comes into play.

Anarchus said...

Great post.

Somewhat along the same lines, there's an interesting post over at Bob McTeer's blog on whether or not the Fed is Printing Too Much Money (short answer - the Fed doesn't print money, it just creates it):

http://www.bob-mcteer-blog.com/fed-printing-too-much-money/#more-440

There are two points or questions I had about your post:

1. I'm not sure I agree with your observation regarding Japan and China that "There is very strong structural deflation in both economies, with extraordinarily deep capital, and in China's case at least, virtually limitless labor." Now Japan does have very strong structural deflation in part because its labor force stopped growing in 1998 and is extremely unlikely to start growing again anytime in the next century. China's demographics may be equally awful in a decade or two but they're not at that point yet. Based on discussions I had last Fall with a lot of companies with operations in China, the supply of good-quality labor stopped being limitless sometime in the Spring of 2008. No one has great data, but it seems that the tidal wave of hard working migrants moving from the rural areas into the cities was finite rather than limitless. Anyway, the economic slowdown will likely balance out the labor issue in China for the next year or two, but I don't think the evidence supports the idea that China has the same surplus of cheap labor going forward that it enjoyed in the 1998-2008 era.

2. One way to look at "quantitative easing" is that the Fed has gone to war with the money market savers in the U.S. By easing so aggressively (and buying so much non-gov't paper)that not only t-bill yields are driven to zero but also yields on CP and every other s-t financial instrument not nailed down approach zero as well, MM rates either approach zero or could conceivably go negative.

At that point, MM savers have to start moving money somewhere a bit further out the risk curve - intermediate IG bonds, bank CDs, or someplace. When we get there, isn't there a risk that all the monetary liquidity that's just laying around bank vaults unused gets a spark of inflation rekindled? Just wondering.

Guest said...

Some time ago Roubini established a correlation between China's economic health and the duration and depth of the US/World recession.( link ). A current article by Michael Pettis (Martin Wolf forum in the FT) discusses the issue of trade vis a vis the collapse of consumption in the US and its impact on exporting nations, specifically China. ( link ). Setser, in his Jan 11 article identifies a serious collapse in exports from Korea and Taiwan pointing to the possibility of more serious trouble in China.

Your contention that "Much of the world, if revalued, could no longer rely on exports to America and Europe for growth, sinking into deeper -- more deflationary -- recessions of their own. They will probably not revalue any time soon." is on the mark IMO.

As Pettis states "The way Chinese production adjusts to the adjustment in US consumption will be the most important story of 2009."

ndk said...

This is where your analysis goes wrong. If the US were to effectively double the dollar money supply, China would have to double the Yuan supply in order to maintain the 6.83:1 peg. Doubling the Yuan money supply would obviously cause domestic inflation in China. China is unable to maintain the numeric peg in the face of dollar creation without also engaging in Yuan creation. You included one too many constraints in your analysis.

That's not necessarily true in several ways, ruetheday:

1) The connection between money supply and inflation is very tenuous at best in our current world. China's money supply was growing far more rapidly than their inflation rate, as was that in the US and Europe.
2) Not all the money the US creates would end up in, or even affect the holdings of, China. Maintaining the peg just depends on covering for the trade surplus, and to some extent the current account surplus. China's capital account is supposed to be quite closed. Hot money found a way around that anyway, but it's coming back big time now.
3) Sterilization. There are a lot of ways that a government can lock down new money so that it isn't inflationary. China sold sterilization bonds, which took yuan out of circulation for extended periods of time. They also sterilized other intervention by raising the required reserves ratio (RRR), which would strengthen the banking system and decrease money creation, at least if it were enforced well.

Thanks a lot to the major blogs for the links, and everyone here for taking a read and posting some comments. :D This won't really be a blog, so much as a place I can explain and store some of my weirder thoughts.

Anonymous said...

How do you see an even 12% CPI? If it were 12%, the interest rates on US Treasuries would be above 12%. That means that current US Government's public debt payments would skyrocket 5 times and bond prices would collapse 5 times. That would lead to total political and societal disintegration of USA. Your scenario is not even possible for theoretical purposes.

ndk said...

How could the PBoC (or any central bank for that matter) go bankrupt? It has no liabilities.

Central banks very much have liabilities, Gu Si Fang. In fact, every piece of currency is a liability of the issuing central bank. They also have a balance sheet, just like any other. The PBoC holds almost entirely foreign currency as its assets.

If China broke the peg and made its yuan much richer, the central bank would have a busted balance sheet. Its assets would shrink by ~20%, but its liabilities would remain unchanged.

The question is: does that matter, in any practical sense? I'll probably do a post on that at some point, but for now, here are Willem Buiter's thoughts, which are much more valuable than mine anyway.

Anonymous said...

One of London Banker's final posts was on his conversion to the deflation side - here is the link to that article (you appear to be in good company) and perhaps are filling a hole left by his departure from the blogosphere.

Deflation has become inevitable

ndk said...

At that point, MM savers have to start moving money somewhere a bit further out the risk curve - intermediate IG bonds, bank CDs, or someplace. When we get there, isn't there a risk that all the monetary liquidity that's just laying around bank vaults unused gets a spark of inflation rekindled? Just wondering.

It depends how you see inflation, Anarchus. From a CPI perspective, monetary aggregates are basically worthless as predictors. While interest rates, money supply, and financing costs can affect those, they aren't the sole determinants. Sometimes, they're not even the primary determinants. Check the Wikipedia article on monetarism for some discussion.

How do you see an even 12% CPI? If it were 12%, the interest rates on US Treasuries would be above 12%. That means that current US Government's public debt payments would skyrocket 5 times and bond prices would collapse 5 times. That would lead to total political and societal disintegration of USA. Your scenario is not even possible for theoretical purposes.

If you follow the link, anonymous, it's not mine. It's also not deeply considered, but an arbitrary number thrown out there. I agree that the consequences of successful reflation are a lot more significant than they seem from our current seats, but that's a topic for another day.

ndk said...

Your accounting identity holds for US Chinese trade. However, the Yan, Remnibi (whatever) will devalue with the US dollar versus all other floating currencies.

I am sure there is significant distance this scenario could go, but at some point the effect of this feeds back into China. It is an effective cut in the standard of living, as it is with US population.


Devaluation of the RMB might not be so bad from China's perspective, Stephen; in fact, they've repeatedly suggested they'd like it. The decline of the dollar from '03 to '07 was superb for growth in Chinese exports to Europe.

A resurgence in commodity inflation would be much less welcome, but with structural oversupply in commodities, there is probably a limit to how far prices can be pushed by more money. And, as I noted above, if we push prices above their natural level, more eventual oversupply is the result.

I think at some point in the next few years they'll realize that they are in for bad times no matter what, stop supporting us, blame us for all their troubles, and then send out tanks to put down anyone that agitates. That is perhaps even the most rational thing to do.

This seems plausible to me, Mikkel.

One of London Banker's final posts was on his conversion to the deflation side - here is the link to that article (you appear to be in good company) and perhaps are filling a hole left by his departure from the blogosphere.

I loved his posts too and agree with his conclusions, but I'm vastly less qualified than he, and should be taken correspondingly less seriously.

That is, given the need for new debt to avoid deflation, and given the inability of income growth to service even the old debt, it becomes clear to most actors that the government will eventually default.

Yeah, David, I agree that deflation is certainly not by definition a problem. It's debt deflation that's the doozy, and last I checked, we've unfortunately got a couple dollars of that kicking around our system.

Sorry for the long post, but remember that the key flawed assumption of deflationists is they don't think the U.S. faces default. Make that assumption, and everything deflationists say is true. Relax it, and the inflationist argument comes into play.

I very much think the US faces default, with all the serious commitments on- and off-balance-sheet that the government has made. I don't see how that necessarily implies inflationary default, because with poor traction and limitations like the ones mentioned in this post, inflation may not be possible to create in sufficient quantities to default successfully that way. I suspect a default in other ways is more likely.

RebelEconomist said...

ndk,

This is not too long-winded for my liking. The more readers that can follow your explanation, the more relevant the comments should be. Well done.

I am only in limited agreement with your conclusion though. As you point out, the peg ties the renminbi/dollar exchange rate. As long as Chinese sterilisation is successful, however, the peg does not tie the US and Chinese inflation rates. If the US did manage to create inflation, the dollar would probably depreciate against non-pegged currencies such as the euro, so the renminbi would too. In the absence of higher Chinese inflation, the Chinese trade surplus with, say, Europe would grow. Given that the Chinese authorities (practically) do not intervene against the euro, either the Chinese private sector would have to accumulate euro assets or they would have to raise their renminbi prices - ie inflation. To resist this, the Chinese authorities would have to tighten monetary policy - ie sell more debt. I doubt that the Chinese are such keen savers that this debt could be absorbed on top of the existing supply of sterilisation bonds without driving up Chinese interest rates. I presume that at some point this would prove unacceptable to the Chinese.

So the US could force China off its peg by engineering inflation. No doubt the Chinese would resent this though, and given that China bought treasuries on the understanding that the Fed has a mandate to maintain price stability, it would be of dubious morality.

john bougearel said...

"I have no idea what level of familiarity or background knowledge to assume with readers."

Don't matter at all NDK what are level of background is, you are a good educator to all of us.

"This won't really be a blog, so much as a place I can explain and store some of my weirder thoughts."

That is how it all starts NDK... :-)Congrats on starting to blog. You will need an rss email feed so we know when you post.

SpaceFury said...

Great discussion. I want to press the CPI/interest rate constraint on inflation.

If we manage to get 12% price gains and 12% wage gains (and correspondingly easier ability to pay off debts), that's great for the debtors. On the lending side, who would loan out money at 5% in this environment? I'm thinking home loans in particular. Nobody would loan money at a negative real interest rate, since the lenders would lose out on every transaction. Thus mortgage rates would _have_ to climb to over 12%. That's just fundamental.

With housing so leveraged (20% down or less), this would force nominal house prices down faster than people's inflated nominal wage gains (and possible monthly payments). Think double the monthly payment against just 12% higher wages. This would make more owners underwater, and actually worsen the housing situation in many ways (until wages start to catch up--if the feedback from a damaged housing market still allows it).

I don't see how it's possible to just "inflate away" debt like this. I think the same argument does apply to Treasuries too. Even high inflation (let alone hyperinflation) would be extremely destructive, hard to say if it's truly a much better scenario than deflation. "Inflating away" sounds a whole lot easier than actually putting it into practice.

I've not seen anywhere an actual counterargument to this, and would love to hear one.

ndk said...

Given that the Chinese authorities (practically) do not intervene against the euro, either the Chinese private sector would have to accumulate euro assets or they would have to raise their renminbi prices - ie inflation.

Are you sure they don't really intervene against the Euro, FE? It's not what they're pegged to, but they already have a lot of Euro reserves. In fact, Fan Gang came out and attributed some of the recent fall in FX reserves as measured in USD to the depreciation of the Euro. Either way, China could always just sell those EUR for USD, or vice versa, so to some extent it's just a portfolio decision. Maybe Setser has something I missed on that.

Thanks for coming by. :D

Anonymous said...

Let's look at an extreme case. Never mind borrowing. Just create new dollars to fund government expenditures, which can be made as large as we want. Eliminate taxes; just print money. If need be, establish negative taxes -- e.g., stimulus checks -- to put more dollars in the hands of consumers. At some point, the rest of the world will be unwilling to give us stuff with real value -- cars, toys, oil -- for dollars that have essentially no value. Granted that this is the extreme; lesser versions should produce results in the same direction.

-Kunst

ruetheday said...

ndk - You are correct that the link between money supply and price indexes is not exact, due to changing velocities of circulation, international flows, etc. However, the point you were trying to make in your entry was that the US cannot unilaterally inflate so long as China maintains its peg, and that position is simply incorrect because it ignores HOW China maintains a peg in the presence of a dollar devaluation (by increasing the supply of Yuan). If there is a point to be made here, it's a far subtler one - that in the presence of significant volumes of international trade and finance, monetary policy actions may affect trade and finance flows more than they affect domestic demand.

Moopheus said...

"The Fed then must purchase something with its dollars to get the dollars into the system. That something becomes the Fed's asset, and the liability remains the dollars."

Isn't this precisely what the Fed plans to do with its proposal to purchase MBS and mortgages from the GSEs, funded by the "creation of additional reserves," as they put it. The goal is to drive down interest rates on those loans, and by making servicing costs more "affordable," help keep housing prices from deflating further. Since this money will be lent out to people who will in turn spend it, do you think it could have an inflationary effect? Personally, I feel that house prices should be allowed to fall further without further attempts to prop them up. It seems to me that the Fed is playing a game of "kick the can," trying to delay the resolution of certain problems, without carefully considering the consequences.

Guest said...

From the archives

Commercial History and Review of 1930
The Economist Feb 14, 1931

United States

"Continuous but orderly deflation in security prices, commodity prices, credit outstanding and in the manufacture, distribution and sale of goods has been characteristic of the past year...Perhaps the most upsetting influence was the severe decline in prices of wheat and cotton both of which fell to the lowest level since 1915, and the reduced output and low prices of corn, tobacco and other farm products...Steel ingot production, according to the AISII was 39.6m tons, the smallest since 1924 and a drop of 27% from 1929...Motor production was estimated by the Department of Commerce at 2.5m vehicles, 38% under 19229 level. Railway freight car loadings were reported by the ARA at 45.8m, a reduction of 13.1% from 1929...Credit deflation and the decline in interest rates and loss of deposits made the year a rather indifferent one for the commercial banks...Federal Reserve Bank policy was one of consistently cheap money. The decline in the New York discount rate began in the autumn of 1929 and for reductions brought the rate down from 4 to 2 percent, the lowest in the history of the Reserve system."

David Pearson said...

ndk,

You agree that the U.S. faces default, but not inflation. Its not clear why.

If the Fed were to buy up every dollar of public and private credit in America, and also continue to extend new credit, there would be no default. By definition, you cannot default against someone willing to always extend you credit at zero cost.

Of course, if the Fed did that, it would be wildly inflationary. The nominal value of the debt would plummet. That's where you get your de facto, inflationary "default".

James Hamilton has a nice way of putting it: Assume, as deflationists do, that the Fed cannot print enough money to create inflation. The Fed would be able to buy up every asset in the U.S. without creating inflation. The Fed would then proceed to buy every asset in the world without creating inflation. How much would it cost? Let's say, I dunno, 1000 trillion dollars? They can have the money to pay for it by Monday, as soon as they power up their computers.

Of course the Fed can't buy every asset in the world with printed currency, since by trying to do so they would just drive up the price of those assets. This is called inflation.

RebelEconomist said...

ndk,

The reason why I say that the Chinese "practically" do not intervene against the euro is that they are supposed to peg the renminbi to a currency basket which includes the euro but which has undisclosed weights and seems in practice to be dominated by the dollar.

Anyway, I believe that it is not necessary for a country to match the currency composition of its reserves holdings to its peg currency or currency basket, as I argue in a post on my own humble blog.

ndk said...

Anyway, I believe that it is not necessary for a country to match the currency composition of its reserves holdings to its peg currency or currency basket, as I argue in a post on my own humble blog.

I agree, but that certainly doesn't mean the Chinese private sector has to accumulate a huge amount of RMB. I could just as well point out that sterilization rate is totally decoupled from the amount of intervention performed.

The really funny part of this is that fact combined with the peg is that, to some extent, the EUR/USD cross level represents a portfolio decision by SAFE.

David said...

I don't agree. The US can inflate and Asia can't stop it. It goes like this. First of all, there are other ways to create money besides bank lending. If needed, the Fed could print money and send it directly to US consumers; the helicopter drop. They can call it a tax rebate or whatever but it is still just a helicopter drop.

So can China and Japan stop this by printing enough of its own currency? Yes, but only if they are willing to alienate the rest if the world including the US. The US can always threaten to restrict Chinese imports. Starting a trade war has one big downside and that is (for the US) inflation. But if inflation is what you are trying to get then that is NOT a downside. More importantly, a collapse of trade would hurt China a LOT more then the US. The US would get inflation and China would get a complete economic collapse probably leading to an overthrown of the current government.

If the US is trying to prevent a dollar collapse then they are relatively powerless. But if they WANT a dollar collapse then are in a position of strength. Whether engineering a dollar collapse is in our best interests is another issue.

ndk said...

I don't agree. The US can inflate and Asia can't stop it. It goes like this. First of all, there are other ways to create money besides bank lending. If needed, the Fed could print money and send it directly to US consumers; the helicopter drop. They can call it a tax rebate or whatever but it is still just a helicopter drop.

David, you should read Buiter's latest piece on exactly how money printing works. I've got a link to it here. While the Fed could do that(and though probably illegal, that sure hasn't stopped us lately), it would create an equally large naked liability on the Fed's balance sheet, making it quite clearly insolvent.

Does that matter? We'll explore that soon.

Starting a trade war has one big downside and that is (for the US) inflation.

I've mused about the merits and demerits of trade wars once or twice in the past, spurred on by some clever reasoning by Rodrik. More than any other question in our current situation, that one's got me in knots.

David said...

Yeah, I read the Butler piece. I don't really buy this idea of looking at central banks (especially the Fed) like regular banks. That is, don't believe that they really have liabilities. I don't believe that the Fed can be insolvent or that it matters. How are dollars liabilities when it is a fiat currency?

It seems that everyone is recognizing the unsustainability of the strong dollar. The Chinese can't really expect the US to keep running a trade deficit forever. It is clear that the dollar needs to drop and that the US needs and deserves a bigger share of the export pie. Such a thing needs to happen if globalization is going to continue. If China (or Asia in general) refuses to agree to that, well then world trade will split in two. But that is worse for them than for us so I think they will give in and allow a stronger dollar.

Anonymous said...

Is there any way to subscribe to a direct email feed of NDK postings?
Thanks for the great discussion!
Jon

ndk said...

How are dollars liabilities when it is a fiat currency?

To prevent inflation, the Fed must get the fiat currency back into the Fed's hands and destroy it. To do that, it must offer something of value from its assets. If it is sufficiently insolvent, it can't get the dollars back through selling assets. Offering two dollars later in exchange for one dollar today is about all it can do, and that's precisely why some people think paying interest on reserves is going to be just fine for inflation prevention, so let them own crap.

I have a lot of thinking to do before I have a good answer, but something just doesn't smell right. This would imply a central bank could go arbitrarily broke before it had any real impact, beyond possibly higher interest rates, which would only increase the appeal of the currency.

ndk said...

Is there any way to subscribe to a direct email feed of NDK postings?
Thanks for the great discussion!
Jon


Probably, but I have no idea how, and would appreciate pointers from someone more conversant in Blogger. :D I already tried adding the "Subscribe To" in the right column.

Thanks for coming by to read, Jon.

Anonymous said...

I receive by email the Naked Capitalism through what seems a nice setup, and think I saw him referenced above...
Jon

David said...

Well again. The Fed has assets: Treasuries, Agencies, Commercial Paper, AIG stock, subprime CDOs, Gold etc. It has no real liabilities. If and when the economy turns around and it wants to defend (i.e. strengthen) the dollar, it will have to sell these assets. Even if these assets fetch much less than what the Fed paid, they will take some dollars out of circulation. If they can't take them all out this way, this will result in permanent devaluation, that is true.

But why should the US care if the dollar is devalued? It needs to be devalued until there is some semblance of trade balance. Plus it makes our debt easier to pay back.

Same with protectionism. It will be good for US. It will create jobs in the US, push unemployment down and wages up so that the middle class can better service their debt load. Time for labor in the US to get some of the pie. I honestly don't see any other way. This is not going to be good for the capitalists in the short term but that is always how it has to happen. It can't be good for the capitalists and bad for labor all the time. That does not lead to a prosperous society. And no, we can't all be capitalists.

wunsacon said...

NDK,

>> Remember that there is no such thing as a pure printing press.

Would you please elaborate on this statement??

ndk said...

Okay, I snooped around on naked capitalism, and there's something up there now. Let me know if it doesn't work.

ndk said...

Would you please elaborate on this statement??

Buiter did it before I could, unfortunately, wunsacon. My basic point is that the Fed needs to buy something to get the money into the system, and buying something always has ramifications.

The ramification I'm worried about is threatening the Fed's own solvency. That is to say, if the Fed needs to take back the dollars in order to stop inflation, just what can it offer the dollar holders?

There's actually a small variety of answers to this question, some of which are more Ponzi than others. I'll have something up soon.

Anonymous said...

If Zimbabwe can inflate then so can the USA. You are all to young to remember the days when the USA had THREE currencies used in commerce. There were gold certificates, silver certificates and United States Notes unbacked by anything but the 'full faith and credit...'. You can think of them as a t bill which doesn't mature and pays no coupon. They are 'auctioned' directly to businesses and workers who take them in payment for goods and services. If US Notes were good enough to win the second world war then they're good enough now.

Anonymous said...

Correction: The USA had FOUR currencies. US Notes, silver certificates, gold certificates and Federal Reserve Notes. There is nothing in the constitution which prevents the issuing of US Notes.

Johnny said...

What is your opinion on Great Britain - will the QE have inflationary effect on that country?

ndk said...

What is your opinion on Great Britain - will the QE have inflationary effect on that country?

That's a good question, Johnny. I think there's a much greater chance it will be inflationary there because all these fundamental forces preventing the dollar from falling are certainly much weaker for the pound. Whether or not the pound suffers inflation depends on portfolio allocation decisions of SAFE and other major surplus recyclers. To the extent they hold pounds as a reserve, it would suppress inflation and pound devaluation, but I wouldn't be at all surprised to see the pound continue to weaken and a resurgence of inflation in the UK.

VangelV said...

When the Fed starts to buy USTs because others refuse to do so the people who claim that inflation is not possible will get a big surprise. The simple fact is that if the supply of money and credit explodes so will prices of goods and services. Whether we like it or not the price of oil and gold should be much higher in the next two years than it is today.

David said...

There is yet another kind of currency called US Treasury bills. They have zero yield and so are effectively the same as Federal reserve notes. They just come in bigger denominations.

Andrew Gould said...

Is NDK a physicist? Who else would know what the Chandrasekhar limit is?

CTMM said...
This comment has been removed by the author.
CTMM said...

"Andrew Gould said...
Is NDK a physicist? Who else would know what the Chandrasekhar limit is?"

A Sci-fi enthusiast?

A Scientific America Collector?

A modern-day Warrior-poet?

Come on, black-hole trivia is pretty common. It's not like he was comparing the Treasury's balance sheet to a tessellated hypercube...

ndk said...

Is NDK a physicist? Who else would know what the Chandrasekhar limit is?

Nope, but I do a lot of plumbing for them. The LHC's sensor arrays churn out vulgar volumes of data.

Physicists always seem to be the best politicians amongst scientists. I think it's got something to do with the grant funding required for meaningful experimentation.

tessellated hypercube

My brain overloads at around 2 dimensions, I'm afraid.

Stevie b. said...

NDK - I guess I've arrived late at this particular party/thread, but I want to say it's still been a thrill to read & I look forward to more of the same please.

I recall from a recent thread on NC that you said the UK is "vastly worse off" than the US. Given your belief that inflation is a more realistic prospect in good old Blighty than the US, would you still stick to this belief if the UK engineered inflation and the US did not?

Detroit Dan said...

BEST THREAD EVER. Thanks to ndk and all the thoughtful commenters,

Detroit Dan

ndk said...

I recall from a recent thread on NC that you said the UK is "vastly worse off" than the US. Given your belief that inflation is a more realistic prospect in good old Blighty than the US, would you still stick to this belief if the UK engineered inflation and the US did not?

I think the UK can engineer inflation just fine if it tries hard enough, yes, because there is little to prevent a significant decline in the pound. It wouldn't be expected to cause inflation in the rest of the world as a knock-on, though, any more than Iceland has triggered inflation abroad. Also, the nickname Old Blighty rocks, so thanks for reminding me of it. :D

BEST THREAD EVER. Thanks to ndk and all the thoughtful commenters,

More owed to y'all than me.

cap vandal said...

Good post. The idea that a little Fed engineered inflation is impossible strikes me as extreme. However, the idea that it would be easy or without serious problems (as discussed above) is also unrealistic.

It isn't like we need a lot of inflation -- a small dose would do wonders, but once again, I don't disagree with the assertion that these things aren't easy to accomplish without pain and unintended consequences.

As far as trade, there are a lot of things that could be done to improve our trade competitiveness without tariffs. Simply getting health care out of the private sector would be big. Then VAT's instead of payroll taxes would help. That would be equivalent to a 25% devaluation on the labor component of exports. This would just level the playing field between us and Europe.

Steel Phoenix said...

I'll be interested to see what China does if the dollar does begin a rapid decline.

A great post. I haven't read the rest of your blog, but I've added your feed to my reader based on the strength of this post alone. I've also dropped a link here from one of my own posts on the subject.
http://www.theallegator.com/free-market/the-nature-of-the-global-free-market/

babar ganesh said...

very interesting post.

i wonder how much the PBoE cares about being insolvent. in any case, if they will allow inflation they can solve that problem.

if the peg stays in place though we won't be able to tell whether CNY or USD is the real reserve currency.

ironically, the word verification thingie is asking me to type 'develate'

CouldMarxBeRight said...

Thank you for such an inspiring post. I am certainly late to the game but I'm glad I'm here anyway. I think you are absolutely on your mark in this unconventional viewpoint. And I had an unusual epiphany after reading yours. I think you argued why there can't be high inflation but you might not have argued why there can't be even moderate (2%) inflation. I think US has to go through inevitable deep structural deflation unless China relents on the peg. Otherwise the US economy is just too uncompetitive versus China. Moreover, due to the yuan peg and the size of Chinese economy, US can't even devalue against euro without China's consent. The euro flows into SAFE's portfolio is too big that SAFE will be dictating the relative cross of EUR/USD.

CouldMarxBeRight said...

I put my thoughts on my blog. If you're interested, here it is. Could Marx Be Right

Anonymous said...

Great explanation for a topic frequently discussed and rarely explained. Thanks.

I run across your comments frequently at different finance sites. I always appreciate your contributions.

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