I published a column yesterday about some relative recent academic research which suggests that deleveraging by European banks could have a drastic contractionary impact on credit conditions in the United States. One possible solution to that, being implemented today by the Federal Reserve Bank in coordination with other major central banks, is to drastically lower the price that foreign central banks have to pay to obtain dollars. Then those central banks can pass the cheap dollars on to the banks they supervise. Will this work? Is it fair? Is it a good idea?
THE GOOD: In terms of credit conditions in the United States, this should work. Foreign banks hold about half the dollars in circulation, and they make loans based on those holdings. Those loans largely go to American households or firms operating in the United States since this, at the end of the day, is where you buy things with dollars. If they started hoarding dollars instead of using them as the basis for loans, that would have thrown a ton of sand into the gears of the American economy.
THE BAD: This appears to be driving the Euro/Dollar exchange rate up which is going to make the underlying economic problems in Spain, Italy, Greece, Portugal, and even France worse. There’s still a need for the European Central Bank to target sovereign debt yields and for Germany to consider buying more stuff as an appealing alternative to bailouts. Meanwhile it continues to be the case that both the Fed and the ECB would do well to start adopting more growth-oriented targets for medium-term monetary policy. All these sporadic “emergency” actions leave everyone scratching their heads about the future.
THE UGLY: As with the Federal Reserve’s secret lending to American banks in late 2008 actions of this sort raise fundamental issues about fairness. Handing out cheap money to European banks will help bolster them, which will help stabilize the economy. But the exact same logic applies to all sorts of distressed institutions in the world today. Where’s the free money for American municipalities? Where’s the free money for debt-constrained households? Beyond the operational details, where’s the targeting of full employment? In its November meeting, the Fed’s Open Market Committee rejected NGDP targeting as too risky and unorthodox to be worth trying even though it might create millions of new jobs. Then European banks run into trouble, and suddenly nobody cares about being risky and unorthodox.
At the end of the day the conjunction of these kind of actions with continued inability to return us to full employment makes it all but inevitable that the “End The Fed” crowd’s voices are going to grow louder. The world’s central banks badly need to wake up and realize that it’s time to go “all in” on doing everything the possibly can to solve the developed world’s demand shortfall.