Views on the Greenspan Succession

Global Excess Liquidity?

I don't understand the argument that even though inflation is not accelerating, the world nevertheless suffers from "global excess liquidity":

Economics focus | A working model | Is the world experiencing excess saving or excess liquidity?: WHEN The Economist's economics editor studied macroeconomics in the 1970s, the basic model for understanding swings in demand was the so-called IS-LM framework, invented by Sir John Hicks in 1937 as an interpretation of Keynes's General Theory. In recent years it has gone out of fashion.... That is a pity, for... the model... casts useful light on why bond yields are so low.

America's Federal Reserve raised short-term interest rates again this week, to 3.5%, its tenth increase since June 2004. Yet over that period, long-term bond yields have fallen.... The most popular explanation is that there is a global glut of savings, which has driven yields down.... An alternative explanation, preferred by some economists, is that bond prices, like other asset prices, have simply been pushed up by excess liquidity....

The IS-LM model helps us to understand these two opposing theories.... The IS (investment/saving) curve represents equilibrium in product markets, showing combinations of output and interest rates at which investment equals saving and hence the demand for goods and services equals supply. The IS curve slopes downwards, because a higher interest rate reduces spending.... The LM (liquidity/money) curve represents equilibrium in the money market, showing combinations of output and interest rates where the demand for holding money, rather than interest-bearing assets, such as bonds, equals the supply of money. This curve slopes upwards, because a rise in income increases the demand for money and so raises the interest rate.... The point at which the two curves intersect is the only combination of output and interest rates (ie, bond yields) where both the goods and financial markets are in balance....

The left-hand chart shows the economy in equilibrium at interest rate r1 and output Y1. If desired saving increases relative to investment (ie, there is excess saving), the IS curve shifts to the left to IS2. Interest rates fall (to r2), and so also will output (to Y2). This does not fit the current facts: last year the world economy grew at its fastest pace for almost three decades, and this year remains well above its long-term average growth rate. The right-hand chart illustrates the alternative theory. A loose global monetary policy shifts the LM curve to the right, to LM2. Bond yields again fall, to r3, but this time output increases. In contrast to a shift in the IS curve, the economy has instead moved along the IS curve: lower interest rates stimulate global output and hence investment. This seems to fit the facts much more comfortably....

From my point of view, the Economist's story is incomplete. As the Economist admits, the "two theories are not mutually exclusive." What happened was not a rise in savings, but a fall in investment as first the collapse of the dot-com bubble and then 9/11 increased uncertainty and diminished businesses' willingness to undertake risky investments. That shifted the IS curve to the left. In response, the Federal Reserve (and other central banks) shifted to easy money--shifted the LM curve out--like so:

Are interest rates now "too low"? The usual answer is that interest rates are too low when inflation is accelerating. As long as inflation is stable, that means that the supply of goods and services is roughly equal to the demand for goods and services (if demand were outrunning supply, inflation would be accelerating). Inflation is roughly stable. So what's the worry?

The Economist thinks there is a worry:

[C]entral banks have created too much liquidity. Despite rising short-term interest rates in America, monetary policy is still unusually expansionary. Average short-term rates in America, Europe and Japan have remained below nominal GDP growth for the longest period since the 1970s. In addition, America's loose policy has been amplified by the build-up in foreign-exchange reserves and domestic liquidity in countries that have tied their currencies to the dollar, notably China and the rest of Asia. As a result, over the past couple of years, global liquidity has expanded at its fastest pace for three decades. If you flood the world with money, it has to go somewhere, and some of it has gone into bonds, resulting in lower yields. Or, more strictly, bond prices have been bid up until yields are so low that people are happy to hold the increased supply of money...

But if it's not producing accelerating inflation, and if higher interest rates would produce higher unemployment, what's the problem?

Where I see the potential problem is that the dollar is overvalued and may--any moment--fall by 40% or more, should international currency speculators decide that the dollar's run is over and should central banks decide that keeping the value of the dollar high is now too expensive. The United States currently imports 16% of GDP. A 40% price rise in 16% of GDP is a one-shot 6 percentage point increase in the price level. The Federal Reserve is not going to let the inflation rate jump far above 3% per year: it will respond to a falling value of the dollar and the resulting accelerating inflation by raising interest rates far and fast. Thus should a sudden 40% (or more) fall in the dollar take place, a big recession follows.

The way to try to head off this potential problem is to try to make sure that the decline in the dollar takes place slowly and gradually. Slowly shrink the federal government budget deficit--even move the government budget into surplus. Take other steps to shrink gross domestic purchases relative to gross domestic product. Allow other currencies to slowly appreciate relative to the dollar so that the supply shock delivered by dollar decline is spread out and small in any one time period.

But raising interest rates is not a way to head off this potential problem. A balanced increase in interest rates would not affect the dollar, and leave the dollar overvaluation problem as serious as ever. An increase in U.S. interest rates would make dollar-denominated assets more attractive, and increase the magnitude of the dollar valuation problem. An increase in U.S. interest rates would raise U.S. unemployment. And to what gain?