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Federal Reserve: central bank policies have no effect

April 27, 2005

Tags U.S. EconomyPolitical Theory

The Federal Reserve seems determined to deny the role they and President Bush has played in creating the hugh U.S. current account deficit. First it was Ben Bernanke who tried to blame it on a "global savings glut", something which I have commented here and here.

Now Roger Ferguson has given a speech on the subject too. While both try to deflect the blame away from American policy makers and also say that the deficit is not really a problem, Ferguson's analysis is somewhat more "sophisticated" than Bernanke's, but in this context this is not really a good thing as it only means that his analysis is even more misleading.

Both Bernanke and Ferguson are saying that the explanation mostly or in part lies with a "savings glut" in Asia, Latin America and oil producing countries like Russia, Saudi Arabia and Norway. I do not in any way dispute that this is part of the explanation although I would prefer to call it "investment dearth" and would also say that it is less important than domestic U.S. factors. Both Bernanke and Ferguson also acknowledge that the U.S. budget deficit has played some role in creating the current account deficit, but both also is quick to cite econometric studies claiming to prove that the effect is near trivial. It is difficult for me who do not have access to these studies to evaluate their validity, but I have a strong feeling that they are misleading.

What separates Ferguson from Bernanke is that he tries to 3 other possible explanations, namely a "autonomous" decline in private savings, increased productivity and "improved global financial intermediation". His discussion of private savings is remarkable to say the least. He gives no explanation of the decline other than saying it is caused by some mystical X-factor holding down interest rates, pushing up asset values and expanding credit.

Hmmmm...., one would think that a member of the board of the Federal Reserve would not be unaware of which institution in American society who holds down interest rates. Apparently it is not a job requirement for Fed board members to be aware of the fact that they are the ones who set interest rates. His discussion becomes even more bizarre later when he dismisses this as a factor because the decline in savings caused by low interest rates would generate high interest rates! Again, he seems to be completely ignorant about what he normally does on his job, namely prevent interest rates from reacting to shifts in savings and investment.

His alternative explanations -which he with allegedly scientific econometric studies whose methodology and assumptions is not presented declares to be far more important than the budget deficit and the decline in private savings- namely higher productivity growth and improved financial intermediation which both allegedly have made the U.S. extremely attractive for investments fails a simple test of applicability to America's current situation.

If the deficit were really driven by foreign capital inflow, we would witness a rising value of the dollar in the foreign exchange markets. Simply put, if a deficit is driven by capital inflow the dollar will rise, but if the deficit is driven by excess domestic demand the dollar will decline. And while the increase in the current account deficit in the late 1990s was indeed driven by the perceived higher returns of American assets reflecting itself in a rising value of the dollar and rising investments, the trend during the last few years has been the opposite with a falling dollar and lower investments implying that the deficit is driven by low savings in America rather than any willingness of foreigners to invest in America. And moreover, the capital inflow that does come to America is to a large extent not driven by a perceived higher return but by foreign central banks wishing to prevent their currencies from rising in value. Until a few years ago foreign central bank purchases was at most a few tens of billions of dollars a year, but in 2004 it was $355 billion.

That someone like Roger Ferguson who not only is completely ignorant about basic facts about the U.S. economy but even seems ignorant about what he and his colleagues are doing at their job, is trusted to centrally plan the U.S. economy is quite unbelievable.

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