QE: Does Ben Bernanke Seek Power?

Wow, I just read a defense of the independence of central banks by Ben "BB QE" Bernanke. I will hit the highlights, and explain why I think Bernanke is such a fraud, though I agree with his central premise (and disagree with well-meaning libertarians like Ron Paul), that the Fed Reserve should  remain independent from policymakers in Congress.

This exercise in hypocrisy would be hilarious if it weren't such a serious issue.  What's sad is that I generally agree with all of the points Bernanke makes, especially since his arguments seem systematically designed to discredit his own actions as Chairman of the Fed.  Here's the link if you want to read it yourself.
http://www.realclearpolitics.com/articles/2010/05/25/central_bank_independence_transparency_and_accountability_105733.html

The first argument Mr. QE proposes is absolutely true.  "To achieve both price stability and maximum sustainable employment, monetary policymakers must attempt to guide the economy over time toward a growth rate consistent with the expansion in its underlying productive capacity.  Because monetary policy works with lags that can be substantial, achieving this objective requires that monetary policymakers take a longer-term perspective [than politicians] when making their decisions."  I agree. We know that politicians only think about short-term considerations like getting elected, and couldn't care less about the mess that their successors inherit.  There is no doubt in my mind that if Legislators or even Executives were given direct control over the Central Bank, monetary policy would become a direct tool in the re-election of politicians.  Central Banks simply must have a longer time horizon to remain effective.  As Bernanke says, 'political interference...lead[s] to both a less stable economy and higher inflation.' 

Of course, Quantitative Easing also leads to both a less stable economy and higher inflation.  QE is the process by which the central bank (in this case the Fed) buys government bonds in secondary markets from private banks to increase the bank's reserve ratio...the amount of money the bank has 'in reserve.'  This allows the banks to lend much more money into the economy.  For example, if law requires that banks keep 10% of the value of loans in reserve, then for every $10,000 of debt purchased by the Fed, the bank can loan another $100,000 to businesses, or (as usually happens in times of high uncertainty) buy more government debt.  This drives down the interest rate that the Federal Government pays on its debt, while driving up the amount of money available in the marketplace for loans.   Theoretically, this is an emergency measure used only when deflation is a real threat, since monetizing the debt is quite literally creating money from air.

The practical impacts of QE are many, but here are some of the most interesting.  First, QE allows the government to continuing borrowing money indefinitely with little risk of paying more in interest to service its debt.  In fact, at the present time, the interest rate on U.S. treasuries is at the lowest point in years at precisely the same moment that the % of debt to GDP ratios have skyrocketed far beyond historical norms.  Why?  QE.

Second, QE is directly and intentionally inflationary.  Inflation has thousands of impacts, including serving as a hidden tax on unsophisticated savers, increasing competitiveness of exporters (a stated Obama policy goal), and perhaps most importantly decreasing the real value of the massive government debt and deficit which increase every year no matter what political party is in charge. 

Interestingly, Bernanke states that "the costs of undue government influence on the central bank's quantitative easing decisions could be especially large, since such influence might be tantamount to giving the government the ability to demand the monetization of its debt, an outcome that should be avoided at all costs."

Hah!  So true...and yet so frightening.  Lets take a moment to consider a few aspects of the timing of Bernanke's first and second rounds of QE. 

QE1: Just after Barack Obama was elected in Nov 2008, BB announced the first round of QE which he then amped up in Dec and again in March 2009.  Shortly afterward, Obama announced that he was renominating the 'politically independent' BB for another 4 year term starting Feb 1, 2010.  Of course we know that for a government, especially a liberal government with ambitions as large as Obama's absolutely must have a low interest rate on debt, otherwise deficit hawks will begin to howl and independent voters just might listen.

QE2: Just after the Nov 2010 elections (sound familiar?), BB announces that he is set to embark on yet another round of QE.  Why might he do that you ask?  After all, it will be the president elected in 2012 that will decide whether to keep him in his position of power.  Well, he just might be worried about those short term political implications that he argues (and I agree) should not be used to make monetary policy.  Consider this:  If the economy and employment make a recovery (even short term spike that is ultimately damaging in the long term), then Obama (who knows that there will be no second stimulus) will likely...secretly...credit BBQE for his contribution to Obama's re-election, thus ensuring that BB will be reappointed.  Even if Obama is not re-elected, the savvy politician who replaces him will know that BBQE has his back, especially since BB might well repeat his antics after the election in 2012 to help aid the incoming president in the same way he aided Obama. 

If my allegations are true--and there's no guarantee that they are, then BB QE is a total fraud and knowing liar.  If this is central bank independence, then I'd hate to see what integration looks like.

George Will had a very interesting point to add, which I'm embarrassed I didn't think of myself. 
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/17/AR2010111705316.html?hpid=opinionsbox1
This article discusses the Fed's dual mandate of price stability and full employment which was first granted in 1977.  Not only does the goal of full employment conflict with the goal of price stability, but mandating the Fed to seek full employment is an explicit and intentional politicization of a supposedly apolitical independent force.  This adds credibility to my fears that BB QE is both aware of his political clout and exercising it in the pursuit of his power.  After all, if full employment is every politician's goal (and right now it ought to be), then BBQE's goals are directly aligned with those of the politicians.  The full employment mandate for the Fed dramatically increases the likelihood that the FED is not independent, but is actually another arm of government, working for the political goals of its Board of Directors. 

See why I'm so worried about all those problems that BB talked about if the Central Bank isn't independent?

Currency Noise: The Chinese Watch America Bluster

Glorified liberal simpleton economist Paul Krugman made waves in March when he suggested threatening China with a 25% surcharge on all imports to the United States, after a remarkably amateur reading of the global trade imbalances.  http://www.nytimes.com/2010/03/15/opinion/15krugman.html

This perceived threat to China's currency and the stability of the international market prompted some business groups in China to ask me for an analysis of the likelihood of a U.S. trade war.  In March 2010, I wrote this article at their request, so some of the details may seem superfluous to more knowledgeable followers of American Politics.  The most recent round of Quantative Easing has certainly thrown a new factor into the currency debate, but I will address that in a separate article.  All of the predictions in this article have held true, and I think they will continue to hold true for the foreseeable future. 

The Obama Perspective on Renminbi Revaluation

I.                   Introduction: Treasury Department’s April Report on Currency Manipulation

Under the Trade Act of 1988, duties are imposed on the Treasury Secretary of the United States.  In satisfaction of those obligations, the United States Department of Treasury will issue a report on currency manipulators on April 15^th, 2010.  No country has been identified as a manipulator by this process since 1994 when China was singled out for currency manipulation.  On two previous occasions April 15^th 2009, and October 15^th 2009, the Obama administration did not designate any currency manipulators.  The Obama administration most likely believes that China is manipulating their currency, and Obama will probably act in the way that he believes is most likely to result in revaluation of the RMB.

II.                Issues impacting the Obama Administration and Treasury Secretary Tim Geithner on their pending decision about currency manipulation.

a.       Domestic Political Pressures on the Obama Administration

                            i.      Unions and Union Sympathizers

The President’s political party, the Democratic Party, relies upon the support of unions (lobbying groups who represent organized labor).  Union leaders are resolutely in favor of protectionist measures such as tariffs to punish China for alleged currency manipulation because it would benefit the industries that these Union leaders represent.  This is particularly true for some the largest unions such as the Steelworkers Unions and the Textiles Unions.  The President has shown a past tendency to bow to the wishes of these unions by inserting special provisions into legislation, particularly the Healthcare Bill and the Stimulus Package.  However, these unions called for the designation of China as a currency manipulator last year and the President resisted those calls.

Economists allied with the Democratic Party such as Paul Krugman of the New York Times and Morris Goldstein of The Peterson Institute for International Economics have recently issued reports and newspaper articles providing support for Union arguments that a weak Renminbi serves to undermine the job market in the United States.  Paul Krugman, a Nobel Laureate perhaps the most prominent Democratic economist recently called for an imposition of a 25% tariff on all Chinese goods until the RMB was allowed to revalue.  This was widely viewed as a rather dramatic event, and it has helped to galvanize public opinion in support of political action against China.

                          ii.      Political Weakness and the November Elections

It is widely believed that the Democratic Party will lose a large number of elections this November.  Democrats are searching for ways to rally voters in support of the Democratic Party.  The weak economy and high unemployment numbers are the primary reason that Democrats are expected to lose.  Democratic Economists blame unemployment partly on the ‘unfair’ advantages obtained by China by undervaluing the RMB.  It is possible that Democrats will act to punish China in order to help win elections this November.

                          iii.      Economy and Joblessness

The economy in the U.S. is perceived as very bad.  All economists acknowledge that deteriorating economic relations with China would harm the U.S. economy, but some argue that it would harm China more and therefore pressure should be exerted on behalf of jobless Americans.  President Obama is not up for re-election this November and he has a longer view of the economy than the six month timeframe that shapes the opinions of U.S. Congressmen.  Since the performance of the U.S. economy is the most important factor in Obama’s re-election in 2012, and the detrimental impacts of diminished trade relations with China would manifest long before 2012, it is in the interests of the Obama Administration to avoid upsetting the trade relationship with China.  In short, Obama has a strong incentive to maintain normal relations with China. 

Still, Obama would certainly like to see a revaluation of the RMB because it is believed that a revaluation would improve employment numbers in the U.S. and thus aide his political popularity.  The question becomes…What does Obama believe is the most effective strategy for encouraging revaluation of the RMB?  This judgment will rely upon Obama’s perception of likely Chinese responses to pressure and legal and economic conditions explored below.

b.      Domestic Legal Considerations

                          i.      Letter by Congressmen

A Letter written March 15, 2010 by U.S. Congressmen Mike Michaud and Tim Ryan was signed by 130 of the 535 members of the two legislative bodies of the United States.  The signatories represent both of the political parties that rule under the U.S. political system, but at a ratio of nearly 3:1, they represent the President’s party, the Democratic Party.  This is not the first attempt to persuade the Obama Administration to label China a currency manipulator.  Persuasion attempts have been made every year since 2002, but none have been as significant as this year.  By itself, this letter has no legal impact, but Congressmen do have the power to pass laws.

            There is a proposed bill in the U.S. Senate that would legally require the U.S. to take action to retaliate against China for alleged currency manipulation.  The details of this bill are not yet written, but it would be unlikely to require countervailing duties (Tariffs) on Chinese products as suggested by the March 15 letter from congressmen. 

            A powerful Senator named Charles Schumer has said, “Now more than ever, there is a consensus to finally confront China's currency manipulation,” Schumer claimed that he would attach the retaliation bill to a piece of “must-pass” legislation. “It is the single biggest step we can take to promote U.S. job creation, particularly in the manufacturing sector. We plan to move forward with revamped legislation on this issue in the coming days.”

            Attaching a controversial policy like retaliation for currency manipulation to a spending bill that must be passed for the government to function (“must-pass”) is a common tactic to pass unpopular legislation.  As Chairman of the powerful Senate Finance Committee, Schumer is in a position to carry out his threat, but it is far from clear that he will do so.  The Obama administration holds considerable influence over the Senator and it is unlikely that Schumer would propose legislation that Obama opposes. 

                          ii.      WTO rules for Trade Protectionism

Included in the Congressional letter is a call for the Secretary of Commerce to file a lawsuit with the World Trade Organization (WTO) claiming that China’s currency manipulation is a protectionist measure that triggers the WTO rules on countervailing duties, “China’s exchange rate misalignment meets all three parts of [the countervailing duty] test and therefore merits the WTO-permitted application of countervailing duties.”  Any international lawyer could tell you that it is very difficult to trigger the standard for countervailing duties, and this case is very unlikely to qualify.  The WTO would almost certainly rule against the United States.  Any countervailing duties imposed by the U.S. will be imposed in direct violation of the WTO.  The likely result of this action would be widespread violations of the WTO around the world, resulting in an immense threat to the global economy.  For this reason, the U.S. is extremely unlikely to impose countervailing duties.  Any retaliation for manipulation will likely be outside of the WTO.  For example, Senator Schumer proposes stopping all federal procurements from China.  The U.S. government would then stop buying Chinese made products.  Other similar actions might be taken.

c.       Geopolitical Cooperation on Matters of Strategic Import

It is clear that labeling China a currency manipulator would have a variety of impacts on the Obama administration’s foreign policy.  These should be considered.

                          i.      Unease by American Allies in EU, Brazil and others.

Some members of the EU and the community of nations are upset with China for alleged currency manipulation but are in no position to act.  They are encouraging the Obama administration to take action.  This problem is best solved by an alternative solution of reforming the WTO or potentially the IMF.

                          ii.      Iran

The Iranian regime is a top concern for U.S. foreign policy.  Policy analysts from both political parties consider Iranian nuclear weapons a threat to the U.S. and its valued ally, Israel.  In the U.N. Security Council, no actions can be taken against Iran without China’s vote or abstention.  Any action by the Obama administration against China on currency manipulation could destroy the administration’s hope for strong sanctions against Iran.  This factor weighs heavily against deeming China a currency manipulator.

                          iii.      Climate Change

The Obama administration is committed to bringing about international action on climate change.  Such action will be impossible without the cooperation of China.  Like the Iranian issue, deeming China a currency manipulator could destroy the possibility of China working with Obama on global climate issues.  Again, this weighs heavily against deeming China a currency manipulator.

III.             Chinese Considerations in Revaluing the RMB

These considerations are important to the Obama Administration’s decision on whether to label China a currency manipulator because Obama will try to choose the course of action that he believes is most likely to lead to a revaluation.  There are a number of issues that the Chinese Government must consider before a revaluation of the RMB.

a.       Inflationary Impact of U.S. Fiscal and Monetary Policy on the RMB

Prolific deficit spending in the United States and risk of a new round of quantitative easing, combined with a decrease in tax revenues has the potential to produce inflationary pressure on the dollar.  With the RMB pegged to the dollar, these inflationary pressures will also affect the RMB and appreciation of the value of the RMB relative to the dollar amounts to currency deflation.  In his recent yearly speech, Premier Wen Jiabao set an inflationary target of 3% for China this year.  Excessive inflation is destabilizing because it increases the price of food, housing and fuel, so the Chinese government has a strong incentive to maintain inflation at target levels.  Market analysts believe the Premier’s 3% inflation target will be difficult to reach if the RMB is not allowed to appreciate against the dollar.  Reforms of energy and resource pricing have prompted Barclays Capital to change its estimate of RMB inflation from 3% to 3.5% this year.  If these inflationary trends continue, it provides a strong incentive for the Chinese government to allow the RMB to ‘float’ or gain value against the dollar to counter inflation.  This conclusion is supported by a statement from Central Bank Governor Zhou Xiaochuan, who said on March 6 that crisis measures such as pegging the RMB to the dollar must end ‘sooner or later.’

b.      Japanese Lesson

In the 1980’s, the U.S. had complaints against Japan that are echoed by the complaints against China today.  Like today, there were trade imbalances and the undervaluation of the Japanese Yen was thought to be the cause.  In 1985, the Plaza Agreement essentially forced the Japanese Yen into a free floating mode against other currencies.  This caused a series of rapid revaluations that fueled uncertainty, harmed the Japanese economy, and undermined stability.  The Chinese Government has certainly studied this history and will not allow the RMB to fluctuate wildly like the Yen did from 1985-1995.  This historical example demonstrates the need for the Chinese government to allow the RMB to gradually increase value against the dollar.  Gradual change takes time, and thus it should be started sooner rather than later.  This argues in favor of the Chinese Government beginning a slow revaluation process in the coming months.  If Obama believes that such a revaluation is likely, he will not deem China a currency manipulator.

c.       Protection of Image

It is known to all that a strong government cannot afford to bow to pressure.  China is no exception.  If the U.S. attempts to pressure China into currency revaluation, market analysts and political analysts all agree*…China will respond by keeping the RMB pegged exactly where it is.  Obama should consider this.  If he deems China a currency manipulator, it will be perceived as an attempt to force a revaluation.  China will not revalue under these circumstances.  This is the strongest argument against the Obama administration deeming China a currency manipulator.

IV.              Conclusion and Forecast of Upcoming Actions

a.       Market Predictions

Currently, the market predicts the RMB will appreciate in value at approximately 2.9% in the next twelve months.  While the market is not always correct, it is a truly objective indicator.  Since the market concurrently believes that any action to force China to revalue (such as deeming them a currency manipulator) would likely result in China refusing to bow to international pressure out of a sense of pride*, the forecast of appreciation in the RMB is simultaneously a forecast that the Obama administration will not deem China a currency manipulator.  The collective opinion of people who are willing to place their money at risk is often a very good predictor of the future. 

*This claim is based on many statements from managers of investment firms and foreign policy analysts.

b.      An Alternative U.S. Policy

The Obama Administration has recently been presented an alternative solution by the influential Arvind Subramanian of the Peterson Institute for International Economics.  In a March 18, 2009 article in the Financial Times, Mr. Subramanian recommends that the U.S. seek to reform the WTO.  He recommends that Obama negotiate with China to upgrade the Chinese market status from nonmarket to ‘market economy’.  This upgrade would provide substantial benefits for China under the rules of the WTO.  In exchange for this concession to China, Obama should seek adding undervalued exchange rates to the list of ‘protectionist practices’ under WTO rules.  This would give the U.S. a way to protest if they believe that China’s currency is undervalued in the future.  This diplomatic path will take considerable time to develop and would require patience on the part of the U.S.

c.       Political Probabilities

The Obama administration is currently weakened by unemployment and domestic strife.  Weak governments often act desperately, especially when their allies are encouraging desperate action.  Lawmakers, Unions, Economists, Journalists, and even foreign countries aligned with the Obama administration are strongly in favor of deeming China a currency manipulator.  Obama does not want to appear soft to his allies, and this is a strong incentive for the administration to act. 

Despite this, I believe the Obama administration will follow past precedent and abstain from deeming China a currency manipulator because he will seek the policy that is most likely to result in a revaluation.  Pressure is likely to result in a Chinese entrenchment on currency policy, which would undermine Obama’s goals, and Obama cannot afford to alienate the Chinese if he hopes to make progress on issues like Iran and climate change.  Mr. Subramanian provides a realistic and mutually beneficial multilateral option for negotiations with China on this sensitive issue.  In my opinion, this is Mr. Obama’s most likely course.