Comment 27: Globalization, Greenspan, Bernanke, trade-deficit-dollars, oil, and all that. (Feb. 7, 2006)

At the time when the stewardship of The Federal Reserve Board, abbreviated as FRB, has changed from Greenspan to Bernanke, some financial media are fanning a sensation to treat Greenspan like a god. To those Greenspan true believers, every ebb and flow of the economy, during Greenspan's rein or before it, are all attributed to the doing of Greenspan, even at the price of ignoring what Greenspan himself is saying; Greenspan is repeatedly saying in recent months that FRB has lost quite a bit of influence on regulating the course of economy, and the flat yield curve that results from its prolonged interest rate raising campaign does not mean that a recession is coming (see Comment 23 for details). This kind of financial media sensationalism is creating a vast uncertainty in the mind of many people, including many readers of this website, leading them to doubt the ability of the coming Bernanke FRB to keep the status quo of US economy. It is instructive for us to look into the fact, that is, what Greenspan has not done and what can be really attributed to him. Only through such a study we will be able to judge objectively what Bernanke FRB can and cannot do to influence the economy.

Fans of Greenspan cite the persistent disinflation and two long lasting economic expansions as his legacy, whereas those who dislike Greenspan quote the run away US trade deficit and the continuing flow of jobs from US to China and India as the proof of his disastrous performance. If both sides take some time out and study the actual economic data, they will find that the disinflation since 1980's has started in 1983 when FRB under the leadership of Volcker had finally defeated the hyperinflation of late 1970's, and the long lasting Reagan era economic expansion had started at the same time. On the other hand the run away trade deficit had also started in 1983. In other words the persistent disinflation, the long lasting economic expansions and the run away trade deficit are all the manifestations of the same phenomenon, that is, the globalization. The start of the globalization was several years before Greenspan became the chairman of FRB. We refer readers interested in the evolution and the effects of the globalization scheme to Article 1, Article 2, and Article 2A for detailed discussions. Greenspan is only one of the promoters of the globalization scheme, and cannot be responsible for all the grandiose things, good or bad, happened under the scheme. Greenspan's true legacy is rather that he has flowed along the deluge of globalization, and smoothed out the rough edges of the flow here and there to lessen its side effects, but he has not been able to eliminate the ups and downs in the economy destined to be brought on by the globalization scheme. If the globalization really turns the world into a global utopia as the supporters of the scheme believe, Greenspan will be honored as one of the chief guardians of the system. However, if the globalization scheme turns into a disaster, like transforming USA into a third rate banana republic that literally spends itself into bankruptcy through run away trade deficits, then Greenspan will be viewed by later historians as one of the group of mad economists whose experiment ruins a super power, just as the another such experiment that destroyed The Soviet Union.

Once the role of Greenspan is understood, it is rather straightforward to project the role of Bernanke FRB, that is, it will continue to play the role, just as Greenspan FRB, to flow with the globalization scheme and to try to smooth out its rough edges, but otherwise it is totally powerless to counter ups and downs that the globalization scheme will bring on US economy and beyond. The most important weapon of FRB to influence the economy is to inject or withdraw liquidities from the banking system, called open market operations. Let us look into this apparatus with some details to see what it can do and how the effectiveness of the weapon is vastly reduced by the globalization. To engage in open market operations FRB needs some guideline, called the target, so it will know when to inject and when to drain liquidity from the banking system. Only for a short period from late 1970's to early 1980's, when Volcker was fighting the hyperinflation, FRB used money supplies as the target for open market operations. In all other times FRB targeted an overnight interest rate called Federal Fund's rate, and we should assume that this practice would continue as far as eyes can see. Federal Fund's rate is the interest rate at which big banks borrow and lend money among themselves for a period of overnight, that is, less than 24 hours. FRB has set a target of 4.5% for this Federal Fund's rate recently. When the amount of cash in the hands of big banks is plentiful, the rate will fall below the target rate of 4.5%. FRB will sell short-term treasury bills to those big banks to drain the cash from the banking system and thus force the rate to go back up to the target, that is, 4.5%. On the other hand if the cash in the hands of big banks is tight, Federal Fund's rate will move above the target rate of 4.5%. FRB will buy short-term treasury bills from big banks and thus inject cash into the banking system to bring down Federal Fund's rate back to the target. In the case that FRB is raising the target rate, short-term interest rates in the banking system and in the money market will naturally rise with Federal Fund's rate. In the money market before the globalization, buyers of long-term debt instruments will be lured to higher interest rate and much more risk-free short-term debt instruments, and gradually sell off their long-term debt instruments in order to buy into short-term debt instruments as Federal Fund's rate is raised. Thus long-term interest rates will follow short-term interest rates with a slight time lag. As interest rates, short-term and long-term, rise in tandem, the borrowing activity across the board will slow down, and so will the economic activity. If FRB wants to stimulate the economy, the opposite route of lowering the target Federal Fund's rate will be taken. However, in the age of globalization with huge trade imbalances, this seemingly idealistic mechanism for FRB to regulate the economic growth is facing a huge challenge from the flow of trade deficit dollars that reduces the effectiveness of FRB's open market operations significantly.

US trade deficit for year 2005 has expanded to over 600 billion dollars. To appreciate the size of this trade deficit, we may compare it with the size of monetary base, currently around 800 billion dollars. Monetary base is the sum of currency in circulation and the reserves that banks must hold against their deposits. Monetary base is directly affected by the open market operations of FRB, and is a measure how tight the liquidity in the banking system is. The huge US trade deficit means that those 600 billion dollars must be handed over to foreign suppliers. Since US Dollar is not the legal tender in foreign countries, those foreign suppliers must sale those dollars in the currency markets for their own currencies in order to sustain their operations. Those dollars from US trade deficit eventually end up in the hands of foreign institutions and must be brought back to US to be reinvested, mostly in US Dollar denominated debt instruments, to generate interest incomes. The question is who are those foreign institutions that reinvest those trade deficit dollars, and how they are going to invest those dollars. If the foreign institutions are mostly private institutions like commercial banks and life insurance companies, they have similar profit motives as domestic institutions and have similar risk assessments too so that their behavior will be synchronized with the open market operations of FRB. Under this circumstance FRB retains its effectiveness of regulating US economy in spite of the rapidly expanding trade deficit. However, after so many years of run away US trade deficits and the resulting tremendous amount of trade deficit dollars that must be absorbed by foreign institutions, the ability of foreign private institutions to absorb more trade deficit dollars is very limited. If currency markets are left by themselves, the enormous sale pressure of trade deficit dollars would have made US Dollar collapse against foreign currencies long time ago. For example, US Dollar would have collapsed to 50 Japanese Yen/Dollar in the second half of 1990's, and one US Dollar probably can only buy 4 to 5 Chinese Yuans at present. If that would have been the case, US personal consumption would be significantly smaller than the current level, US inflation rate much higher and US trade deficit much smaller, implying substantial lower living standard in US since US citizens would have to produce majority of products and services that they consume, not allowed to borrow from foreigners and spend as they are doing today. That is why US administrations, under the catch phrase of "strong dollar policy", have been authorizing foreign governments with large trade surplus against US, especially Japanese government, to buy those unwanted trade deficit dollars from the currency markets to sustain US Dollar at a highly overvalued level and to keep US trade deficit expanding rapidly. Japan is a close ally of US. When Japanese government reinvests the trade deficit dollars in its hand, it defers the investment decision to US FRB by asking FRB to handle its vast dollar holding. FRB can synchronize the reinvestment of Japan's dollar holding with its own monetary policy to lessen ill effects. For example, when FRB is lowering the target of Federal Fund's rate to stimulate US economy, it will invest Japan's dollar holding into long-term treasuries in order to bring down the long-term interest rates. When FRB is raising Federal Fund's rate, it can direct Japan's dollars into short-term treasuries so that long-term interest rates will rise in tandem. The amount of trade deficit dollars that Japanese government bought has been escalating rapidly. In the stretch from the middle of 2003 to the spring of 2004, Japanese government bought around 400 billion surplus dollars from currency markets. However, this massive dollar buying activity had generated sharp criticism within Japan in a bizarre fashion (see Article 8 for the matter). Since the spring of 2004, Japanese government has been absent from the currency market. It is China and other Asian countries now buying a significant portion of the trade deficit dollars, but is not enough to absorb all the surplus dollars. US FRB has been raising Federal Fund's rate since May of 2004 in order to induce foreign private institutions and oil rich countries to hold dollars so that Dollar will not collapse. During 2005 China alone bought 200 billion dollars, and other Asian countries, excluding Japan, bought around 100 to 150 billion dollars. Differing from Japan, those Asian countries mostly manage their own foreign currency reserves, not to defer the decision making to FRB as Japan had done. Those Asian governments are buying dollars not for profit motives, but to sustain Dollar at over valued level so that US consumers can continue to spend and continue to buy goods and services from their exporters. The best way to encourage US consumers to spend is apparently to keep US long-term interest rates low. Thus Asian governments, excluding Japan, has been buying long-term dollar denominated debt instruments, and keeping long-term interest rates capped at the time of steadily rising short-term interest rates. That is the reason why the yield curve is so flat today, and is the answer to the so-called "conundrum" of interest rates. With the heavy involvement of foreign governments, the money market is not free anymore. Thus the flat yield curve cannot be interpreted as the expectation of the free money market for a coming recession, but is the result of foreign governments supporting US economic growth. This is a vivid example how foreign governments are usurping the power of regulating US economy and render the actions of FRB less effective, an unavoidable outcome as US is indulging in the policy of run away trade deficit.

It is worth to look deeper into the trade deficit dollars to understand their importance in influencing US economy and US interest rates. As mentioned in the previous paragraph, more than 600 billion dollars, the amount of US trade deficit, has been paid out to foreign suppliers and must be brought back to US money market in 2005. If those trade deficit dollars were brought back reluctantly, Dollar would fall against foreign currencies, US trade deficit will shrink with a lag time of roughly two years, and US economy will fall into a recession in 2007 and 2008, the time span very close to the next general election. US government and FRB want to prevent such happenings at all costs. The amount of trade deficit dollars that a foreign country must reinvest back to US does not need to equal its trade surplus with US but is related to its total trade surplus. Let us take China as an example. China had a total trade surplus of around 100 billion dollars in 2005. About 50 billion dollars of foreign investments flowed into China in 2005. Also there were about 50 billion dollars of hot money flowed into China; some of the hot money went into China expecting for Yuan's upward revaluation and some went into China to engage in real estate speculations. Thus totally about 200 billion dollars had flowed into China and had to be bought up by Chinese government to maintain the peg of Yuan with Dollar. It is accidental that this 200 billion dollars bought by Chinese government roughly equals the trade surplus of China with US. Taiwan had a total trade surplus of around 60 billion dollars in 2005, so Taiwanese government was forced to buy up a substantial portion of those 60 billion dollars and reinvest them in US money market, though Taiwan's trade surplus with US is much smaller. South Korea's total trade surplus in 2005 was around 50 billion dollars. Other Asian governments needed to buy up much smaller amount of dollars compared to the three countries mentioned above due to their relatively small total trade surpluses. Overall, Asian countries other than Japan bought about 350 billion dollars in 2005. Japan had a trade surplus over 100 billion dollars and Euro region had a trade surplus around 50 billion dollars in 2005. Since both Japanese government and European central bank are not manipulating the currency market to buy up those dollars in 2005, the burden to buy up those 150 billion dollars and to reinvest back in US falls on Japanese and European private institutions. Finally there are oil exporting countries with a total trade surplus over 100 billion dollars in 2005. Those oil dollars also needed to be brought back to US. Since oil exporting countries and private institutions of Japan and Europe do not have any special reason to buy US dollars and reinvest them back into US, they must be induced to do so to prevent the collapse of Dollar. The only way to induce them to buy dollars is higher interest rates in US. That is why when Japan stopped the currency market manipulation in the spring of 2004, Greenspan FRB was forced to pick up the burden of defending Dollar and has started to raise the target of Federal Fund's rate steadily until today, though officially it says that the rise of interest rates is necessary to prevent inflation. The situation will not change for Bernanke FRB. Even if FRB tries to stop raising short-term interest rates for a short while, it will be forced to resume the interest rate raising activity through 2006 to prevent the collapse of Dollar under the weight of continuing huge US trade deficit. Thus the theoretical claim of Bernanke about inflation targeting is not likely to be implemented before 2007, since inflation targeting will require the lowering of the short-term interest rates. FRB can afford to let Dollar sink substantially in 2007 since the effect of the lower Dollar in 2007 will show up in 2009 that is after the general election of 2008. Thus there is the possibility of lower short-term interest rates in 2007 in the name of inflation targeting.

The above analysis has illuminated a unique character of the globalization and the run away trade deficit. The negative effect on the economy from the persistently rising short-term interest rates is substantially diluted by the counter action of foreign governments', that is, their continued buying of long-term dollar denominated debt instruments. On the other hand rising short-term interest rates in 2005 has induced dollar buying from private Japanese and European institutions and oil-exporting countries, and has lifted the value of Dollar. With roughly two years of time delay, the higher Dollar in 2005 will be translated into renewed rapid expansion of US trade deficit and a strong economic growth in 2007. If short-term interest rate is lowered in 2007, in short-term US economy will boom since foreign governments have no reason to counter the act that will boost the US economy. However, lower US short-term interest rate means substantially lower Dollar. Even if Japanese government returns to the currency market in 2007 to buy up dollars, all it can do is to prevent a spectacular collapse of Dollar but not a substantially lower Dollar. Thus in 2009 both trade deficit and the economy will shrink. It is a vivid example how globalization and the run away trade deficit have made obsolete the conventional dogma that rising short-term interest rates hurt economy and the falling short-term interest rates boost the economic growth.

The wild card to the scenario outlined here is the development of Iranian nuclear energy crisis. If worse comes to the worst and the shipments of oil from the whole gulf region is disrupted, oil price can climb to an unimaginable high for a prolonged time and ill effects are bound to show up on US and global economies. Before 1980's, international trade of manufactured goods was not such a big factor for the global economy. US labor unions were at the pinnacle of their powers, and a large portion of US wages was indexed to inflation. As oil prices rose, inflation rate naturally rose with it and pushed up wages. The rising wages then lifted the prices of non-oil related goods and services. Thus the core inflation rate, the inflation rate excluding energy and food, rose with oil prices and had induced economic recessions. This picture has changed substantially in the globalization era. The linkage between US wages and inflation rate has diminished substantially as the power of labor unions has waned rapidly under the onslaught of inexpensive foreign imports of goods and services. On the other hand major exporters like China tries to keep their domestic oil prices suppressed at the face of rising international oil prices through government subsidies, in order to keep the price of their exports steady. Therefore, US import price, excluding oil imports, does not follow the oil price, and so is the core inflation rate (see Comment 24 for details). As the developing countries, China and India, emerging as the major exporters of goods and services, their energy demand surges rapidly since by definition developing economic entities are much more energy inefficient than the developed economic entities. On the other hand, immersed in the borrow and spend boom US consumers opted for bigger and bigger cars and thus more gasoline consumption. These tow factors combined have boosted the global demand of oil substantially and strained the world oil supply. As the result oil prices have risen significantly in recent years. If Iranian crisis further pushs up oil prices, the ability of US consumers to buy non-oil related goods and services will be reduced. If that scenario unfolds, core inflation rate in US will not follow oil price to go up, but US economic growth will slow substantially. It will create a very difficult situation for FRB, to follow skyrocketing oil price to raise short-term interest rates or to lower short-term interest rates to fight the slowing economy and the stagnating core inflation rate. We will discuss this dilemma later as the situation about Iran develops.