Money Has Been Too Tight Since The Early 2000s
Geez, that’s a bizarre assertion. After all, most economists believe that money was too easy in the early 2000s; as evidenced by the fact that the fed funds target rate was set below the level predicted by a simplified Taylor rule from 2001 to 2006.
Or if you ask those in the market-monetarist crowd, which favors a nominal-GDP-targeting rule to guide monetary policy, they will say that money didn’t become too tight until late-2008, when nominal GDP started to deviate from its longer-term trend.
Neither of these rules, however, says anything about the trade balance – which makes them both highly problematic.
In a system of floating exchange rates, monetary policy is supposed to be the channel through which trade imbalances are normalized. First, if a country is running a large trade deficit, it will act as a constraint on growth. In turn, the central bank, which cares about growth, will ease monetary policy by reducing short-term interest rates. A reduction in short-term interest rates will lead to an exchange-rate depreciation; because the returns to foreigners investing in the country’s assets will fall. And an exchange-rate depreciation will then reduce the country’s trade deficit, boosting growth.
In terms of the U.S. economy, however, this whole mechanism is currently screwed up because various countries around the world (most notably, China) purposefully peg their currencies to the dollar at artificially low rates. This is the reason why the U.S. trade deficit continued to widen, not narrow, after the Federal Reserve reduced short-term interest rates from above 6 percent to 1 percent in the early 2000s.
But a central bank with competent policymakers need not worry about the fact that Asian currencies are pegged to the dollar at artificially low rates. Suppose the Fed reduced real short-term interest rates to -5 percent in the early 2000s. Whether or not Asia maintained its currency peg would have been irrelevant to the United States. Why? Well, if Asia abandoned the peg, then the trade deficit would have narrowed, boosting real GDP growth. And it would have been nice to have had stronger real GDP growth in the previous cycle, which is now characterized as the weakest employment recovery in the United States since the Great Depression. But even if Asia maintained its currency peg after the Fed drove short-term interest rates to -5 percent, the United States would have still benefitted. Imagine if China had been paying 2 percent to 4 percent in interest to the United States on its $1.2 trillion in Treasury securities holdings rather than the other way around. If that were the case, then the United States would have been in a much better fiscal position to address the enormous demand gap created by last decade’s housing bubble and bust.
In other words, it’s not enough for central banks to target just low inflation and full employment, or just a steady growth trajectory for nominal GDP. Trade imbalances are hugely important. By definition, a trade deficit implies debt accumulation, which must occur in either the private sector, the public sector, or in some combination of both sectors. In the 2000s, the trade deficit led to an unprecedented debt buildup in the private sector that continues to restrain overall growth. What I’m basically saying is that if the Fed had eased monetary policy enough in the early 2000s, then either the trade deficit would have narrowed – in which case, the debt buildup in the private sector wouldn’t have occurred, meaning that the current slump in the United States would have ended a long time ago – or Asia would have been forced to finance the trade deficit for us, in the form of repatriated interest payments. Heads we win, tails Asia loses.
Instead, policymakers at the Fed cheered the massive trade deficit. To them, the trade deficit implied a strong currency, keeping domestic inflationary pressures low. And a strong currency plus low inflation helps to promote rent-seeking activities on Wall Street as well as cheap foreign vacations for U.S. executives. In other words, the problem is mostly political.
I don’t normally favor a return to the gold standard, which would normalize trade imbalances automatically. But if the alternative is a central bank that is too asleep at the wheel to recognize the damage that a widening trade deficit can inflict, then maybe we do need a gold standard after all.