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Thursday, March 27, 2003

Talk Isn't Cheap

A couple of weeks ago, Stephen Kirchner pointed to the an FT article about the volatility caused by comments made by US Treasury Secretary John Snow:

The strong dollar has long been more of a rhetorical gesture than a policy goal. The phrase was adopted by Robert Rubin, Treasury secretary between 1995 and 1999, to allay concerns that the US would seek to devalue the dollar as a way of boosting exports.

The strength of the dollar was crucial in keeping the US economy on track during the boom of the late 1990s, helping to suppress inflation and interest rates at a time of rampant growth in domestic demand. Strong dollar rhetoric also helped to attract the foreign capital needed to fund the ballooning US current account deficit.

One result of this history is that the market has become addicted to sporadic assurances that the administration continues to favour a strong dollar. Having ploughed huge sums into US asset markets in recent years, fund managers are extremely sensitive to indications that the value of their investments will be eroded further by the weakness of the dollar. Many have been rushing to hedge their US investments anyway. European fund managers who failed to hedge their exposure to the dollar over the past year would have seen an investment in the S&P 500 fall by 43 per cent, compared to a 28 per cent fall in local currency terms.

15 months ago, Michael Lewis wrote about Snow's immediate predecssor, Paul O'Neill, in the New York Times Magazine:

[T]he larger category of O'Neill's indiscretions are the many things he has said that are true, and that most people know to be true, but that treasury secretaries are not supposed to say. Included here [is] his observation that despite decades of treasury secretaries suggesting otherwise, the United States government does not pursue a ''strong dollar policy'' and that in any case the Treasury has no ability to affect the level of the dollar.

Going on, Lewis notes:

To the financial-establishment mind, O'Neill's approach to Treasury Department big-shot-dom is a travesty. It violates the central tenet of Washington financial life: never use the English language to convey meaning. The idea is that the economy benefits when important financial policy makers preserve their mystique and that they do this only when they avoid saying what's on their minds. The assumption underpinning this behavior is that the financial markets need to feel as if there is someone somewhere who knows something that they don't and who can, in a pinch, fix things. Greenspan has made a living by saying nothing in the most complicated possible ways and letting other people infer his genius. O'Neill's immediate predecessors, Robert Rubin and Lawrence Summers, took a slightly more direct approach but still stopped well short of saying anything worth discussing. And in any case, Rubin, who created the model Summers followed, was genuinely so diffident that his opinions were never likely to get him into trouble.

For better or worse, O'Neill instinctively takes the opposite view: that people are more likely to prosper if you develop positive opinions on subjects and tell them what you think in plain English. ''I thought there would be a bigger market here than there is for clarity of expression,'' O'Neill says. He remains incredulous about the outrage over some of his comments. Take his remark about the strong dollar. It was simple fact: the value of the dollar is determined in the long run not by some Treasury policy but by America's growth rate relative to that of other nations. ''But nobody wrote that,'' he says. ''Not one person. All they wrote was 'controversy!'''

Lewis also gets to the heart of the matter:

The odd thing about being treasury secretary is that while people may pay attention to what you say, you can't actually do very much. ''When you're treasury secretary,'' says Bo Cutter, who, in addition to serving in Jimmy Carter's O.M.B., worked under Rubin in Clinton's White House, ''you get to talk about the world economy, but you can't actually do anything about the world economy. By definition, you get invited to the meetings, but you don't by definition get to control them.'' The sort of power even the most exalted treasury secretary has is only the power to persuade. He has, at best, the power to manipulate public perception of big events and to infect the mind of the president with his ideas.

The most powerful "finance minister" (treasury secretaries have little direct fiscal power) in the world is Britain's Gordon Brown, who has 1) domestic power and 2) the gravitas to affect international financal frameworks, as he has done in reforming the IMF and establishing the G-20. The US treasury secretary, on the other hand, while influential, works mainly in the world of expectations, where credibility is key. What remains?

A lot of people at the moment are worried about the movment of the US dollar. Jane Galt points to a Robert Shapiro article in Slate about the dollar's possible collapse because of the war:

Given a bulging current-account deficit, slow growth, and a prospect of years of huge budget deficits, a bad war might just trigger a real currency crisis. In 1997 and 1998, Thailand, Malaysia, Indonesia, and South Korea found out how fragile prosperity can be when it depends on foreign capital that can be yanked when a currency weakens. We're in a stronger position because our underlying economy is so much sounder and because foreign investors have so few other, plausible places to park their money.

But a currency crisis could still hit us like a hurricane. Suppose two or three of the top 10 things that could go wrong for us in the war do go wrong and the liberation of Baghdad begins to look like the siege of Stalingrad. That kills hopes for a quick victory-bounce in the U.S. economy, and foreign investors accelerate their shift from U.S. to European securities. As the dollar sinks along with our stock market, more foreign investors rush to sell, and the declining dollar turns into a run and finally a rout.

There are two ways to end a currency crisis like that: Hike interest rates far and fast to draw back capital, stalling economic growth as a consequence; or get the world's major central banks to intervene in the currency markets by buying dollars. In the current diplomatic deepfreeze, I wouldn't count on the European Central Bank. Instead, we would have to rely on Japan, China, and other Asian countries to bail the dollar out. These are all high-saving nations with large foreign-exchange reserves, and, more important, export-based economies that would be hit nearly as hard as we would by a cheap dollar. But that's not a favor that an American president with his sights on North Korea might want to ask for.

Are things that bad? Current economic sluggishness has people worrying about cyclical deflation, and the American fiscal imbalance leads to worries about long-run inflation. Where do expectations come in to this? Edward Hugh has a possible answer:

The job, right now, of the American president is to convince the markets and the American consumer that there is going to be inflation: this remember is to escape from the zero bound trap. But not inflation right now, since everyone believes that the Fed being the serious entity it is, this would soon be brought back under control. No, what they have to do is convince everyone that there is going to be serious long-term inflation. If I am right, in doing this they hope to avoid short-term deflation (remember we have serious papers knocking around out there with titles like "On the Responsibility of Being Irresponsible"). So what better way to convince everyone that this is going to happen than sell the image of your 'polyvalent loony', the president whose only interest is to keep his rich friends happy, and use it to ram home the point - inflation is on the way. And it seems to be working: Certainly an economist as prestigious as Paul Krugman is convinced there is going to be serious inflation in ten years time, and to put his money where his mouth is he has taken out a fixed rate mortgage. And if Paul Krugman is convinced, then so too are a lot of readers of the NYT, etc etc. What I would like to believe, since I have always respected Krugman as an economic thinker, is that he is as recursively aware of his own part in the theatre as Bush possibly is. Of course, once everyone is suitably convinced, and deflation is avoided (this, of course, on the conventional view of the deflation problem which I personally don't accept!!) then we might find them saying, aha, caught you, only kidding.

At the risk of oversimplying, the Bush Administration may be planning, pace Barro and Gordon, to cheat its way to economic stability. Now, expectations clearly matter, but can people be fooled like this? Under rational expectations (a strong assumption, I admit, but work with me here) without binding rules (like an independent central bank) or a solid reputation for sound policy, economic actors should expect such cheating, and act to neutralise the policy. In spite of wonderful papers on the subject, no government in the world except New Zealand's has an unambiguously clear fiscal policy framework, and Brad DeLong's continuing exercise of "banging his head against a wall", to name but one, sould lead one to conclude that, as far as a fair number of people of concerned, the administration's economic policy is far from credible.

Information moves markets, that is certain, and statements from senior officials are a part of this. The FT and Lewis quotes above don't make it sound so clear, though. What is apparent is that some people, at least in the financial markets, want to be fooled. Take Paul Krugman, for one, comparing Paul O'Neill to Robert Rubin:

[O]verseeing world financial markets is nothing at all like running a large, very old-economy, command- and-control corporation (or, for that matter, working the details of the federal budget). Mr. Rubin excelled at the deft strategic intervention — persuading investors, when the situation was on a knife edge, not to pull their money out and turn a temporary loss of confidence into a self-fulfilling prophecy of collapse.

Yes, Rubin handled the Mexican and LTCM crises well, but the notion that someone "oversees" world financial markets is close to being spurious. Lots of people and institutions look for trouble, but oversight also requires crisis prevention, not merely deft last-minute handling. When is comes to some global markets there is little real effective oversight; hedge funds, for example, are unregulated. Nevertheless people, even on Wall Street, like to maintain the fiction that there is someone to watch over them. Expectations matter, therefore, but they are only rational in part.

Credibility counts for a lot, especially given the limited policy instruments at a government's disposal. This matters more the larger the economy is; Argentina, for example, tried for too long and lost all of its credibility with a bang. This is why speculators, much reviled by some government leaders, are a good thing--they are able to spot imbalances and show that a ruse is in fact a ruse. The British learnt this the hard way on Black Wednesday.

How credible is Bush? Well, we don't know. Why? In spite of the headbanging and other complaints, the Bush Administration has not really done all that much besides the 2001 tax cut. While that is very important, it is still only a sample size of one, and does not leave much to form any notion of revealed preference. Much of the rhetoric against Bush's proposed dividend would lead you to think that it's already happened. Perhaps that is because of Bush's determination--people expect it to happen. Clinton lacked credibility for much of his domestic policy, especially after the failure of health care reform in 1994. Aside from the tax cut and the Education Bill, Bush is AWOL on domestic policy--including the economy. To jump to another area, Robert Zoellick would be a lot more credible in trade negotiations if people thought the president really cared about what he was up to. That possible source of recovery for the world economy is now stalled, and off the radar until the war is over.

My advice is to wait and see. Bush has not, say, had to fight to get an economic proposal though Congress, and that will be the true test of his credibility. Until then, all that remains are words, which oddly enough seem to give people a lot of comfort.