Victor A. Canto

Monetary Views: Part I

While there is considerable disagreement as to the role of monetary policy in the United States and other economies of the world, these differences tend to arise as a result of the differences of opinion regarding the impact of money on prices and the real economy. Traditionally, most US monetary analysis assumes either implicitly or explicitly that the domestic monetary equilibrium is determined by the US demand for and supply of money. Another common assumption made is that the Fed controls the quantity of money. In this section, we will retain these two assumptions. Much has been written on this and other topics regarding the proper role of monetary policy. It is hard to keep track of all the arguments without a reference point or scorecard. Hence, we are in need of a framework that could help us keep track of the issues and make sense of the situation. To accomplish these goals, we have settled on a simple textbook version of the equation of exchange to organize the different points of view and to see whether the implications derived from these views conform to the current economic realities.

Self-Sufficiency, Nationalism, and Protectionism: The Common Elements

Whenever a country has a trade deficit in a commodity or service, politicians are quite fond of arguing that we need to become self-sufficient in the commodity or service in question. Usually the proponents of this viewpoint argue that by becoming self-sufficient, employment in that commodity will improve. So far, we have no complaints about this argument. Then, more often than not, the policymakers and politicians extend the conclusion to the general economy. Unfortunately, while politically appealing, these self-sufficiency, nationalist, and sometimes protectionist arguments do not always deliver the goods. In fact, a strong argument can be made that nonmarket actions taken to induce the self-sufficiency will make the economy worse off in addition to being ineffective.

Migration: A Political Problem, an Economic Problem, or Both?

Trade in goods is a substitute for factor mobility, as far as profit maximization is concerned. A policy-cum-investment question is to determine which of the global market clearing mechanisms that the profit maximizing process will choose: migration or trade in goods and services. Profit maximizing agents will always choose the least costly way, and that depends on true transportation costs, trade barriers, and any other obstacles that a national government, trade union, or any other national group may impose on the flow of goods, migration, and mobility across the domestic economy, as well as across national borders. One important point to keep in mind is that goods and services crossing the national borders do not vote or impact the make up of society, while immigration does. Hence the voters must recognize that political decisions on immigration have a real and significant economic impact on an economy, as well as on the political process over time.

The Financial Crisis: Inflection Point or Black Swan?

This chapter, argues against the view that the financial crisis was a Black Swan event. It reaches this conclusion by drawing a parallel between the S&L crisis of the 1990s and the financial crisis of 2007. It argues that the creation of the Resolution Trust Corporation (RTC) during the S&L crisis allowed the real estate market to clear relatively quickly, thereby reducing the economy’s recovery time to the adverse real estate shock without significantly impacting its growth rate. The parallels also raise the possibility that had the Bush and Obama administration adopted a policy that created an RTC-like institution, the recovery may haven stronger and faster. Like the S&L crisis, it would not have become the major event that the Great Recession became. This possibility is explored in subsequent chapters.

Arbitrage, Mobility, and Equilibrium Prices

This chapter explores the implications of a world in which economic agents maximize profits and their economic well-being, where goods and services and factors of production are free to move across national borders without facing any impediment or “transportation costs.” The analysis focuses on the market clearing process, which leads to the identification of global and national equilibrium prices. Then the analysis is extended to include transportation costs, different degrees of factor mobility effects on the equilibrium, the relative prices between two commodities, and the terms of trade between two economies. The process yields several insights, which we use to examine the impact or incidence of alternative policies on the economy and the effect of restrictions in the movement of goods or factors of production and whether these policies in fact produce the results that the pundits and policymakers expect? The analysis also allows us to identify the policies that, in the context of our framework, will deliver the desired objectives and those who would not.

Yields, Risk Premium, and Terms of Trade

The theoretical framework, Purchasing Power Parity (PPP), and Interest Rate Parity (IRP) have very clear implications. Under such idealized conditions, we expect that in an unfettered free market, real rates of returns will be equalized. Add tax rates, regulations, and/or transportation costs, and we can easily explain how economic disturbances give rise to deviation from PPP and IRP, which are correlated to the stock market’s relative performance. More importantly, some of the arguments presented here suggest that fiscal policy differences and other economic shocks will give rise to the changes in terms of trade, as well as impacting the risk premium as we have defined it. To the extent that we can establish the connection between the shocks/policy changes and the terms of trade and risk premium, one can easily develop a country-based portfolio strategy. For large enough economic shocks, the disturbance could last several months or years, creating a long wave that an astute portfolio manager with the appropriate framework may ride to the top of the charts.

The US Inflation Rate

The strict monetarist view assumes that money is only a veil and has no effect on the real economy. The textbook assumptions associated with the monetarist model help us identify the relevant aggregates. The monetarists assume that through open market operations, the Fed controls the monetary base. Through the discount window and reserve requirements, the Fed controls the money multiplier. It also assumes that the demand for money is stable (i.e., the velocity is assumed to be constant). A floating exchange rate isolates the domestic economy from the rest of the world’s monetary shocks. The relaxation of these different assumptions gives rise to alternative specifications regarding the appropriate monetary aggregates, as well as the proxies for money demand. We want to see what the data tells us.

The Greenspan Monetary Rule

The remarks of Alan Greenspan at the 2005 Jackson Hole conference sponsored by the Kansas City Fed were quite enlightening. The Maestro touched on what he considered were the most important developments on the way monetary policy has been approached and implemented under his tenure. The presentation is important for another reason. It documents how the quantity rule and price rule have had an impact on the design and implementation of US monetary policy. His presentation recounts what he considered important developments in central banking and the implementation of monetary policy.

Monetary Policy and the Interaction Between the Money and Credit Markets

The propagation of monetary and credit shocks to other sectors of the economy is something that concerns us. What we have in mind is that under fractional reserve banking, the provision of transaction money (MZM) and credit creation are linked together. This fact alone suggests that policymakers must take into consideration that disturbances in a market can be propagated to other markets based on the degree of substitutability between the market where the disturbance originated and other markets. The central bankers should also keep in mind the interconnection between the two. Disturbances in one market will affect the equilibrium conditions in the other market. Finally, this analysis suggests that policymakers have to be mindful of expected and unexpected shocks, some caused by policy changes and others by shocks to the real economy that affect either the money markets, the credit market, or both.

Exchange Rates, Devaluations, and the Terms of Trade

The nominal exchange rate is only the appropriate measure of the real exchange rate or terms of trade when the Consumer Price Index (CPI) remains unchanged. The nominal exchange rate and real exchange rate provide the same signal only if the CPI changes do not offset the nominal exchange rates. Our theory suggests a simple testable implication. When the real and nominal exchange rates diverge, the terms of trade or real exchange rate provides the correct signal.