In Defense of Bernanke

In a recent two-part series, I reviewed the pros and cons article of austerity vs. deficits in European countries and the US. I concluded that the US needed a new stimulus package.

And for those of you who disagree with me, I ask what level of unemployment you would tolerate for “austerity”. I estimated that without the existing ARRA stimulus, US unemployment would be over 11%. And because state and local governments cannot “print money” a further dramatic reduction in police, fire, and teachers in our own communities would have occurred. And now, with a very uncertain recovery, we need another stimulus: government spends money to put people back to work, and a weaker dollar will bring manufacturing jobs back to the US.

Bernanke, an expert on depressions and recovery, is of the same mind.  And yes, he also read in college what some “defunct economist” said about “liquidity traps”, and he knows we are in one now. So he does not expect that much job creation will come from $600 bond purchases? Probably not. But he also understands that the US Congress is so dysfunctional that it will not pass a new stimulus package in the foreseeable future. But he has another reason for his bond purchases that he cannot state publicly.

Consider the following: after this $600 billion bond purchase, the Fed will hold $1.4 trillion of Treasury Securities. That is less than the $1.7 trillion of Treasuries held together by China and Japan. Why did China and Japan buy all these Treasuries? To prop up the US$ artificially to take jobs away from the US and to build up their export markets.

Bernanke knows all this. He is also aware that the G-20 nations have agreed not to get in a currency war. However, he watches the numbers:

  • Japan, concerned about the weakening US$ against the Yen, increased its US government security holdings by $109 billion, or by 15% between August 2009 and 2010. Japanese companies already produce a significant portion of their autos in the US. That share could increase significantly with a weaker dollar.
  • China has taken the brunt of criticism for propping up the dollar. And partially as a result of this criticism, its holdings of US Treasuries fell by $61 billion, or by 7% between August 2009 and 2010.

The Chinese Commerce Minister was recently quoted as saying “In the mid-term, the US dollar will continue to weaken and the competition between major currencies on exchange rates will intensify, increasing risks for businesses and affecting international trade development. The Yuan is under enormous appreciation pressure. Both foreign exchange risks and competition pressures are on the rise for companies.”

I can imagine that Bernanke is thinking the following:

Maybe my purchase of securities will not generate many jobs in the US in the near term, but this is my first step to drive down the value of the dollar globally. And if this does not work, I will print more money. What I can do to generate jobs in the US is to drive down the dollar so global manufacturing will return to the US.

And if he is, hooray for Bernanke! It is time to “debase the dollar”!

Have I any concerns about this policy? Yes.

Take a look at the following table. We often hear about the trade balance or current account deficit but not so much about financial flows.

Item 2006 2007 2008 2009
Current Account, net -803 -718 -669 -378
Net Financial Flows (inflows (+), outflows (-) 809 638 578 216
US Investors Abroad -1,286 -1,476 156 -140
  U.S. government 5 -22 -530 541
  U.S. private -1,293 -1,453 691 -630
    Direct investment -245 -414 -351 -269
    Foreign securities -365 -367 198 -208
    Other -681 -673 839 -205
Foreign Investors in the United States 2,065 2,108 455 306
  Foreign governments 488 481 551 450
    U.S. government securities 428 270 591 441
    Other Foreign government 60 211 -41 9
  Private foreign investors in the United States 1,577 1,627 -96 -144
    Direct investment 243 271 328 135
    U.S. Treasury securities -58 67 161 23
    Private securities 683 605 -166 0
    U.S. currency 2 -11 29 13
    Other Private 707 694 -448 -314
Financial Derivatives, net 30 6 -33 51

Source: US Bureau of Economic Analysis

Note that the net financial inflows, including foreign government purchases of US Treasuries, have provided an offset to the US current account deficit.

But let’s focus on private capital flows. The following table presents private capital flows since 2006. In the financial panic at the end of 2008, everyone brought their money “home”. But in 2009, Americans started to invest overseas ($413 billion) and foreigners continued to withdraw funds from US capital markets ($278 billion).

Item 2006 2007 2008 2009
Direct Investment -2 -143 -23 -134
Other Private Capital
US -1,046 -1,040 1,037 -413
Foreign 1,334 1,355 -424 -278
Net 288 315 613 -691

If the expectation that the dollar will weaken becomes pervasive, what will happen? Americans will invest more of their assets offshore, and foreigners will reduce their dollar holdings: the $691 billion capital outflow number in all likelihood would become much larger.

In these circumstances, maybe you want to hold dollars. I do not.

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