“The sole use of money is to circulate consumable goods.” – Adam Smith
In a recent op-ed for the Wall Street Journal, Morgan Stanley economist Ruchir Sharma observed that while the world is seemingly “turning inward,” this comes “in a period when countries are more beholden than ever to one institution, the U.S. Federal Reserve.” Interesting about Sharma’s piece is that if anything, it revealed the Fed’s growing irrelevance.
Sharma provided readers with the too-often-forgotten truth that alongside the Fed’s quantitative easing (QE) experiment in which it sought to “inject dollars” into the U.S. economy, “tens of billions flowed out of the country every month.” And that’s the point.
It’s exactly what I argued in my recently released book, Who Needs the Fed? While the central bank can pay interest on reserves held by banks at the Fed only to inject those reserves into other banks through bond buying, it cannot drive dollar lending in an economy that doesn’t rate the lending.
I made Sharma’s argument by pairing impoverished Baltimore with booming Silicon Valley. With Baltimore, imagine a scenario in which the Fed, eager to boost lending in Charm City, were to buy bonds held by Baltimore banks with an eye on increasing lendable funds in the city. The Fed’s actions would fail between breakfast and lunch.
They would fail simply because banks can’t long stay in business if they’re lending in areas where productivity is low, and where borrowers lack the means to pay the money back. In that case, any dollar increase inside Baltimore banks would quickly flow outside the city thanks to the city’s financial institutions lending to more credible opportunities away from Baltimore, and likely outside the state of Maryland itself.
Reducing all of this to the absurd, imagine a literal helicopter drop of dollars into Baltimore’s city center, and then imagine what is even less likely: that all the dollars would be spent inside Baltimore. If so, no business is going to expand based on a helicopter drop, at which point the windfall would be banked by businesses only for the money to once again be loaned outside Baltimore.
Moving across the United States to Silicon Valley, imagine if the Fed, worried about frothy growth, were to sell bonds to banks as a way of reducing the supply of lendable dollars. If we ignore that Silicon Valley’s dynamism means that banks don’t have much of an effect on economic activity out there as is, the Fed’s machinations would once again fail. We live in a global economy, and savers are lined up trying to direct their wealth toward those with the means to pay back monies borrowed. The Fed couldn’t keep so-called “money supply” out of Silicon Valley on its very best day. Silicon Valley never has a “money supply” problem, while Baltimore always will so long as production there is slight.
Sharma’s op-ed reveals the Fed’s powerless situation. While it has attempted to boost the U.S. economy through increased dollar balances at banks since 2008, its QE theories ignored that lending is an effect of credible, booming economic activity, not a driver of same. The Fed’s efforts to boost lending in the United States only succeeded insofar as dollars migrated to better lending options outside the country. The Fed quite simply can’t increase dollar credit if economic activity doesn’t rate it in the first place. Money supply doesn’t drive economic growth as much as money is plentiful wherever economic growth is plentiful.
In suggesting that the world is reliant on the Fed to grow, Sharma is putting the proverbial cart before the horse. If America’s economy were booming at present, the majority of the dollars the Fed vainly attempted to push into U.S. banks would be right here, as opposed to exiting the United States en masse. If so, the global economy wouldn’t fall into a “tizzy” as Sharma asserts; rather other globally credible currencies would be being used as substitutes for the dollar. Figure that over the last 15 years the British pound, euro, yen, and Swiss franc have held their value much better than the dollar has.
Sharma’s point in another sense is that the world’s payment system is to some degree reliant on abundant dollar supply, but he ignores that money is but a measure. It’s not credit, it’s merely a measure that facilitates trade among producers, along with lending and investment. When dollars flow around the world they do so for what dollars can be exchanged for—products like trucks, tractors, computers, desks, chairs, and most of all, labor. While the U.S. Treasury has practiced “benign neglect” to the dollar’s value-detriment since 2001, it remains the world’s currency as Sharma rightly stresses.
Where Sharma misses is in presuming that the Fed is necessary for the maintenance of a global payments system. In truth, no nation need ever worry about having too much or too little money. Beverly Hills and Greenwich, Connecticut never suffer money shortages, while money is nearly always scarce in West Virginia and Mississippi. The Fed can’t change that, and it can’t alter a similar reality globally. In a global sense, Singapore and Switzerland will never experience money shortages, but Nigeria, Haiti and Peru always will until their governments get out of the way so that the economies there can grow.
Sharma ties the Fed funds rate to the value of the dollar. He posits that raising this rate is the same as strengthening the dollar, but as the experience of the 1970s through the 1990s reveals, his assumption is somewhat backwards. The Fed’s rate target soared in the 1970s, but the dollar plummeted. In the ensuing two decades, the target fell and the dollar soared. This truth is a reminder that the Fed’s machinations vis-à-vis banks, which represent only 15 percent of U.S. lending, are but a sideshow relative to the stance of the dollar’s actual mouthpiece: the U.S. Treasury.
As for his assertion that central banks are what keep currencies and equity markets afloat, he might explain why Japan’s yen has not only surged against the dollar over the decades despite much lower rates across the yield curve, but also why equities never soared in Japan despite the maintenance of zero rates over much of that timeframe.
Money supply is certainly an indicator of a currency’s health, and there Sharma has a point. In truth, it’s the weak currencies that are near non-existent in the global payments system, while at the same time the Swiss franc is not only abundant but strong despite the country from which it hails being very small in population terms. Good money is everywhere, but bad money hard to find. No producer will exchange with it, nor will any saver comfortably lend it out.
It also rates a mention that the Fed and global central banks presume to influence economic activity through the economic channel they oversee: the banks themselves. The obvious problem there is that banks are rather dated as source of productive lending, which helps explain why the market share of U.S. banks as a source of loanable funds is in freefall. This is to the economy’s betterment when we remember that banks can’t allocate always precious capital in dynamic fashion. The Fed is pushing on a string as it were given its reliance on a shrinking source of credit as its pathway to influencing the economy, here or overseas.
More broadly, while what Sharma is saying about the dollar’s importance to the global economy is true, the importance he ascribes to it has little to do with the Fed. Its value as a fairly good measure facilitating exchange and investment is a tautology, but since the Fed doesn’t control the dollar’s exchange rate as a rule, it by definition doesn’t play a role in rendering the dollar so valuable to the global payments system. The U.S. Treasury is once again the dollar’s mouthpiece, and this is why the value of same has always been a function of the Treasury’s stance, as opposed to what the Fed does. As Sharma implicitly acknowledges, QE and low rates didn’t lead to a collapse in the dollar despite the expectations of many in the economic space that they would.
Sharma describes a world reliant on “easy money,” but in making this suggestion he misses the point. Money, once again, is always easy where there’s production and it’s always scarce where there isn’t. Only in academia and among economists can central banks decree money “easy.”
Back in the private sector economy, the world is certainly reliant on somewhat credible currencies like the dollar and Swiss franc. But let’s not delude ourselves. At least as far as the dollar is concerned, we don’t need nor do we require the Fed to focus on the relative stability of the greenback such that it’s useful as a global currency. What we do need, and what the world needs, is much better currencies (this includes a more stable dollar) that hold their value.
What’s important is that a central bank is not required to maintain currency stability. Not only is the Fed irrelevant in light of Sharma’s correct point about the dollar as the world’s currency, Sharma’s very own statistics on money flows remind us that the Fed’s ability to influence much of anything in the United States—and by extension, globally—is in rapid decline.