Re: monetary question
Source Jim Devine
Date 00/01/12/10:56

According to the textbooks, an open economy with easy flow of financial
money capital and flexible exchange rates makes monetary policy _more_
powerful. If the Fed lowers rates, that causes a lower dollar, cet. par.
(due to capital mobility), which eventually increases the volume of US net
exports. (This doesn't happen immediately, since there's a J-curve effect,
in which the immediate effect of a lower dollar is to reduce net exports.)

In addition, if we're talking about a financial "collapse" (which then
spreads to the rest of the economy), the Fed is quite practiced at arriving
at Wall Street with trucks of cash to prevent contagion, as with the crash
of 1987. (The infusion of cash into financial markets would threaten
anti-inflation goals, but I'm sure that Saint Alan values the Market more
than he does price stability.) Of course, there's little Saint Alan can do
about contagion to financial markets and institutions out of the U.S.
unless He can quickly get other Central Bankers to also pump in the cash.

One problem with the Fed-induced fall in the dollar is that it might cause
a sudden fall, which would encourage a speculative collapse of the dollar,
encouraging the dollar to lose its status as the world's main reserve
currency (encouraging international financial chaos). That would likely
encourage the Fed to engage in tight monetary policy, because the US does
not want the dollar to lose its exalted status, especially if it might be
replaced by the Euro. This fall from grace would be made worse if the
nabobs of the financial markets consider His policy to be inflationary (and
they're typically big inflation hawks unless their skins are on the line).

It seems to me that the best the Fed can do is to induce a gradual fall in
the dollar (probably with some sort of prior announcement of the general
plan for depreciation). This fall might occur too slowly to prevent,
moderate, or reverse a US recession, especially given the J-curve effect.
BTW, if the Fed ups rates this week, they're moving exactly in the opposite
direction from a gradual fall of the dollar. But Saint Alan has reversed
himself in the past, as when he cut rates in response to the East Asian
financial crisis. So it's possible that the Fed could switch to the
"gradual fall" policy.

Even if the dollar's fall is gradual, it would encourage inflation in the
US, since so many important goods are imported. It would also undermine the
trade surpluses of other countries, which would undermine their economies
further. The US -- or rather the US private sector, especially consumers --
is acting as the consumer of the last resort to the rest of the world. A
fall in the dollar would end this stimulus, as would a recession in the US
as consumers adjust their consumption to be in line with their incomes.

It's quite possible that the resulting fall in the rest of the world's
economies could lead to a fall in US net exports, encouraging a further
fall in the US economy (note that I'm assuming a recession here), which
then bounces back to depress the rest of the world. (This is an
international multiplier effect.) This vicious circle could cause a
deepening world depression. Note that if all -- or almost all -- countries
are suffering from recessions, exchange rates would stay roughly constant,
so that none would benefit from the usual domestic demand stimulus
resulting from a lower currency.

The best way for Him to prevent a world depression (while preserving the
dollar's status) would be to engineer a coordinated cut in interest rates
among the major Central Banks. But this would likely preserve the large and
growing US current-account deficit. That is representing a growing problem.

More and more I get the feeling that the US growth process is one that is
based on optimism (a bubble extending beyond financial and other asset
markets), with increasing amounts of optimism being needed to sustain the
process. Falling interest rates could substitute for optimism, but that
would encourage the bubble more, encourage increased consumer indebtedness
more, and threaten the reserve status of the dollar. So there are clear
limits on His ability to pull off a miracle. It's a little like the cartoon
character Wile E. Coyote who runs off the cliff and then keeps on running,
not knowing that the abyss is below. (Alain Lipietz used this metaphor
years ago, to describe a "slow 1929." More and more I think it's

I have to go now, so the above feels pretty incomplete. I recommend Tom
Palley's article in the most recent issue of CHALLENGE (despite the
grevious editing errors), Robert Blecker's article "The Ticking Debt Bomb"
at , and Wynne Godley's article "Seven Unsustainable
Processes." at .

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