Don’t Cry for Me, Ben Bernanke
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Financial volatility since Federal Reserve Chairman Ben Bernanke’s announcement in May that the Fed would “taper” its monthly purchases of long-term assets has raised a global cry: “Please, Mr. Bernanke, consider conditions in our (non-US) economies when you determine when to end your quantitative-easing policy.”
That is not going to happen. The Fed will decide on monetary policy for the United States based primarily on US conditions. Economic policymakers elsewhere should understand this and get ready.
It is true that, in recent years, the Fed has shown more concern about financial conditions in other parts of the world. In the fall of 1998, then-Fed Chairman Alan Greenspan favored lowering interest rates, in part because of the emerging-markets crisis in Asia and Russia. For those efforts, he got his picture on the cover of Time magazine as part of the so-called “committee to save the world.”
More recently, the Fed extended credit – known as “swap lines” – to a select number of emerging markets and, most importantly, to the European Central Bank. The problem in the eurozone from 2007 on was that some of Europe’s largest banks had borrowed heavily in dollars and, when credit conditions tightened, could not easily obtain the dollars needed to continue funding their operations. Without question, the Fed has greatly helped the European banking system to stay afloat.
But this is not the same thing as setting monetary policy based on economic conditions abroad. By statute, the Fed is responsible for keeping US unemployment and inflation low. To be sure, the relevant decision-makers – members of the Federal Open Market Committee (FOMC) – have some latitude to interpret exactly what this means. For example, their views on what is a reasonable target for unemployment have shifted over time, and they have not always concentrated as much as they do today on 2% as a reasonable target for inflation.
Of course, the FOMC fully understands the central role of the US dollar in the world economy. The origins of this role go back a long way, but at the Bretton Woods conference in 1944 it was an important tenet of US policy that countries should be encouraged to hold part of their reserves in dollars. As the world’s largest creditor in the aftermath of World War II, the US got its way. When the Bretton Woods system of fixed exchange rates collapsed in the early 1970’s, some thought that the dollar’s importance as an international reserve currency would wane.
Nothing could have been further from the truth. Prior to 1971, central banks held dollars because they believed that greenbacks could, if necessary, be exchanged for gold – the anchor of the system. But after President Richard Nixon broke – under great pressure – the link between the dollar and gold, exchange rates started to fluctuate much more than before. Central banks looking for a safe place to keep their reserves increasingly came to believe that a larger stockpile of US dollars (or dollar-denominated claims on the US government, in the form of some kind of Treasury debt) was the best solution. Today, the volume of dollars held voluntarily as reserves is far greater than it was in 1971. Private investors, too, consider the US dollar a safe haven.
The dollar’s predominance in trade and international financial transactions has remained strong; at the same time, the scale of those transactions has continued to increase relative to the world economy. Rival currencies have risen like heavyweight contenders, only to fall back as economic conditions in their home economies became more complicated – think of the yen or the euro. The next challenger will be the Chinese renminbi; but who wants to bet heavily on economic and financial stability in China over the next two decades?
Ultimately, the American promise is that you can take your money and go home. Or you can go shopping in the US – buy anything you want, as long as it is legal. The ability to convert money into goods at prevailing prices is fundamental for any reserve currency, which is why other types of money, like the International Monetary Fund’s Special Drawing Rights, are not likely to displace the dollar.
Admittedly, this means that the rest of the world has some exposure to US monetary policy. When US policy is easier, lower interest rates encourage capital to flow elsewhere – tending to expand credit in many other economies. And when the US tightens policy, higher interest rates encourage capital to flow out of some emerging markets.
All of this is just hard reality. The best way to prepare is to limit the use of credit in boom times, prevent individuals and companies from borrowing too much, and set high capital requirements for all banks and other financial institutions.
The Fed surprised markets last week by deciding to maintain its quantitative-easing policy. But that underscores a larger point for non-US economies: You never know when the Fed will tighten. Get ready.
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