How quantitative easing works — or doesn’t (Part Four: Globalization and prices)
The failure of monetary and fiscal policy to stem deflation can be best understood by the economist’s simple-minded term, leakage. A leakage, in the economist’s lexicon of idiot phrases, is the unintended consequence of monetary or fiscal policy incurred when national economic policy has a bigger effect on the trade position of a country more than its actual target — the domestic economy.
Suppose, for example, the Bank of England wanted to maintain a rate of inflation of two percent a year. It would set its monetary policy to achieve this level of inflation, and the British government might boost spending as well to reinforce this policy by running a bigger deficit. If successful, prices will indeed rise by two percent, with no increase in output; or, if there is an increase in output, total prices will rise two percent faster than total output.
The British sheeple end up working more hours without seeing any improvement in their real material standard of living.
Now, suppose, as a result of this inflation, goods manufactured in China become increasingly competitive with those manufactured in Britain. British retailers could, by sourcing their product from China, further fluff up their profits beyond already obscene levels. Since, they are only interested in their profits and not employment, employment growth would shift to Chinese factories, while British employment would sag. With employment depressed in Britain, wages would begin to fall of a cliff, or, at least, fail to keep up with the cost of living. Ultimately, this begins to feedback into the demand for Chinese manufactured goods, leading to deflation.
Although the Bank of England and the British government intended to increase prices, the ultimate result of their activities is a deflation of prices.
But, it gets worse: the more the trade deficit with China widens over time, as each new round of easing takes place, the less effective the policy becomes, the larger the stimulus must be to be effective, and the shorter the period of time before it is overtaken by a further expansion of the trade deficit and deflation. Eventually, economic policy becomes altogether ineffective because its effects leak out more quickly than they can be implemented.
The approaching failure of economic policy, however, is celebrated by our simple-minded economist who will regard the declining rate of inflation as proof he has successfully solved the problem of managing a permanent low inflation economic expansion — which he fatuously names, The Great Moderation.
Then Federal Reserve Bank Governor Ben S. Bernanke was one of those simpletons who imagined that the increasingly obvious failure of monetary policy was, in fact, a sign of success:
The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.
Forty-eight months later, with Bernanke now Chairman of the Federal Reserve Bank, the United States entered the greatest period of financial contraction it has experienced since the Great Depression. It was altogether fitting that our simple-minded economic theorists, who did not take into account that there was no longer any such thing as a national economy in the age of a globalized production process, should have celebrated their triumph at the very moment when their pet economic theories were in catastrophic failure!
Indeed this is just the picture we see in the graph below as the Federal Reserve drove the effective Federal Funds rate down to zero in a feverish struggle to keep the general price level from going negative.
A globalized production process is an idle dream unless there are also globalized prices for the output that production process creates. And globalized prices, if this term is to have any meaning at all, presupposes the loss of national economic policy. National economic policy tries to set national prices for output and ensure those prices, denominated in the national currency, rise at some determined rate each year; globalization, however, presupposes uniform production prices irrespective of the country of origin of the product or the national currency in which the good is denominated.
This may seem like a esoteric point, but it actually isn’t.
All you need understand is that the dollar is the most widely held reserve currency, constituting 62 percent of all exchange reserves held by countries and financial institutions. The Euro is the next largest reserve currency, constituting about 27 percent of the remaining reserves. The rest of the world combined make up the remaining 11 percent.
The great mass of liquid global social wealth is held in the form of dollars by central banks, corporations and financial institutions the world over; the vast majority of daily transactions between countries take the form of exchange of dollars for some product of labor; and the dollar is the most popular vehicle currency (currency of account) for exchange between various countries.
Essentially, for purposes of economic policy, the dollar price of a good is THE PRICE for that good; the global price of world GDP is denominated in dollars. The inflation targets of the European Central Bank, the Bank of England or the Bank of Japan is quite irrelevant. Under conditions of a globalized production process the only monetary policy that matters is that of the Federal Reserve Bank.