‘The Fed is operating in a fog of uncertainty’

Good morning. The stock market rebounded strongly yesterday after unemployment claims came in lower than expected. Unhedged expects the positive trend to continue until the next piece of economic data appears. At which point everything will be different. Email us with your mindless overreactions: robert.armstrong@ft.com and aiden.reiter@ft.com.

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Friday interview: Barry Eichengreen

Barry Eichengreen, professor of economics and political science at the University of California Berkeley, is the pre-eminent expert on the dollar and its role in the global economy. He spoke to Unhedged this week, covering the Federal Reserve, the dollar, reserve currencies, crypto and much more.

Unhedged: The market has gone a little crazy this week. Given the massive shocks of recent years, how accurately can we analyse this economy? 

Eichengreen: The Fed is operating in a fog of uncertainty. Several of the financial anchors they relied on in the relatively placid period prior to Covid have been dragging subsequently. There’s debate about what the underlying equilibrium real interest rate is, for example, and about whether it has moved significantly because of changes in the structure of the economy and in the levels of indebtedness around the world. Therefore, there’s considerable uncertainty about the level of interest rates the Fed should be aiming at (the so-called neutral rate), for example.

There’s uncertainty about the relationship between policy targets and variables, and uncertainty about the cycle, as well. People are uncertain whether a modest uptick in unemployment is really a leading indicator of a recession, or not. No one knows for sure.

Unhedged: So we were hoping that you, the wise professor, would resolve some of our uncertainty. But you’ve made it worse! 

Eichengreen: I guess there are two kinds of professors: the ones who acknowledge that the world is an uncertain place and that there are different models for understanding it, versus the true believers. Now you know which class I fall into. 

Unhedged: Shifting topics, for the US, how much debt is too much? We seem to be testing that limit in the past couple of years. 

Eichengreen: Once upon a time — 15 years ago — there was a school of thought that argued that there was a magic number, say a debt-to-GDP ratio of 90 per cent. After you reached that number, the roof would fall in. What we’ve learned over time is there is no single magic number. How much debt a country can incur depends, for example, on how fast it can grow its economy; how fast it can grow the denominator of the debt-to-GDP ratio, in other words. 

Last summer, I co-authored a paper that examined heavily indebted countries, looking at when they can sustain high debts and bring them down. We found that there were two robust determinants of success. One was if you could grow the denominator of the debt-to-GDP ratio. The other was whether your political system was characterised by high or low levels of political polarisation. High political polarisation makes it hard to stay the course and maintain balanced budgets over time. It makes it hard to stabilise and bring down high debt ratios.

So if we now circle back to the United States, there’s good news and bad news. The good news is that the US has been growing faster than other advanced economies. On the other hand, we decidedly have a political polarisation problem.

Unhedged: Isn’t there a third variable — the amount of payment that the holders of the debt insist on? 

Eichengreen: It’s definitely a relevant variable, but it didn’t show up as a leading determinant of success or failure in our empirical work. That’s because real interest rates — the interest rate adjusted for inflation — tend to move slowly. Generally speaking, they don’t differ dramatically across advanced economies, and they don’t change sharply over time. They depend, in turn, on other slowly moving variables like demographics and the trend rate of productivity growth. For example, during the burst of inflation that we saw in 2021-22, interest rates went up, but inflation rates went up as well. The real interest rate therefore actually moved down.

That’s another way you can temporarily improve the debt-to-GDP ratio, by the way: inflating your GDP. It doesn’t help in the long run, but it helped in 2022 and brought the US government debt ratio down a little bit. 

Unhedged: The US’s debt-to-GDP ratio has been essentially flat since 2008. Is that just evidence that the US economy is growing sufficiently to manage its debt? 

Eichengreen: I look in particular at debt in the hands of the public. If the government issues debt to itself, it’s just shifting money from one public pocket to another. And that has jumped up since 2008, first in the wake of the global financial crisis, and then again, at the beginning of the Covid period. 

But, given US growth rates and real interest rates, I think the fact that debt in the hands of the public as a share of GDP is now about 99 per cent indicates that, if we avoid a bout of political craziness, the government still has some runway ahead of it before investors begin to get really antsy about holding Treasuries. 

Unhedged: One of the presidential candidates suggests that a weak dollar would be good for the US. Can a weak dollar policy be made to work? 

Eichengreen: You can push the dollar down against the euro, the yen, and other currencies if you set your mind to it. But if you push the dollar down, and you ignite a bout of inflation in the US at the same time, American exports don’t end up being any more competitive. The trick is not pushing down the dollar, per se. To make an effective devaluation policy, you would have to push the dollar down without encouraging inflation. 

Unhedged: Can that be done?

Eichengreen: [Donald] Trump says that he is a low interest rate man. So he, or another leader, could twist the arm of the Fed into expansionary policies that would push the dollar down. But again, that would push inflation up. On the other hand, you could adopt a really crazy policy of taxing or prohibiting foreigners from buying US Treasury bonds and other dollar assets. Less demand for dollars would weaken the currency.

Unhedged: There are respectable people who think that is a good idea. 

Eichengreen: US Treasury securities provide the liquidity that greases the wheels of global trade and finance. We’re in a period of some retrenchment of globalisation, but we all know that the US and the world have benefited enormously from the economic opening and integration of recent decades. Disrupting that process through some kind of hairbrained financial experiment would be extremely dangerous. 

Unhedged: Some have argued that global imbalances force the US to have a strong dollar, a big current account deficit and high debts.

Eichengreen: The additional demand for dollars that flows from the currency’s reserve currency status does make the US exchange a bit stronger. But when people attempted to put numbers on this, they concluded that the dollar is only very slightly stronger than it would be otherwise, and that interest rates in the US are only slightly lower. We’re talking maybe 10 to 30 basis points lower in terms of the yield on US Treasury bonds. So I would put this phenomenon as item number nine on the descending list of factors that determine the competitiveness of the US economy. Higher on the list would be innovation, education, R&D, infrastructure and so forth.

Unhedged: Countries such as China and Germany have high savings and low consumption. Is that a problem for the US?

Eichengreen: That China consumes so little, and invests and exports so much, is a problem for China and the world. But if the next president forces the Fed to lower interest rates or tries to push the dollar down, will that make Chinese consumers spend more? Or get the Chinese government to change its balance between savings and investment? 

Unhedged: You’ve written a lot about global reserves. It seems like central banks are buying a bit more gold and more non-dollar assets. Is this a blip at the margin, or are we seeing a trend? 

Eichengreen: We’re seeing a fully emerged trend. Fifteen years ago, I wrote a book called Exorbitant Privilege in which I made three predictions — one of which proved to be right. I predicted that over time, the dominance of the dollar in the international reserve system would decline, and we would move toward a more multipolar international monetary and reserve system that better matched the more multipolar structure of the world economy. That turned out to be right. 

But the other two predictions turned out to be wrong. The first one was that we would move at a brisk pace toward a less dollar-dominated system. We’ve been moving very slowly. Fifteen years ago the dollar accounted for a little more than 70 per cent of global foreign exchange reserves. Now it accounts for a little less than 60 per cent of the world total. So it has been losing only half a percentage point a year.

The other incorrect prediction was that the dollar would lose ground to the currencies of the two other big economies: the euro area and China. That hasn’t happened. The euro has gained no ground over time, largely because of the euro crisis and because they never completed their capital markets union. The Chinese have started out very far behind. Their currency accounts for about 2 per cent of global reserves, versus 58 per cent for the dollar. They’re running as fast as they can. But they are held back by their capital controls and political system, which render foreign governments and central banks reluctant to park their reserves in Shanghai. 

What has happened instead is that reserves have moved toward the currencies of small, well-managed economies, countries like Australia, New Zealand, South Korea, Singapore, Denmark, Norway. This trend has been helped by the development of digital technologies and new trading platforms, which make it easier to buy, sell and hold these currencies.

Unhedged: We have seen a couple of political leaders put increased importance on international currency usage. For example, Narendra Modi has said he wants the rupee to be used by India’s neighbours. What do you make of those kinds of pronouncements?

Eichengreen: It makes sense for countries to be interested in promoting wider cross-border use of their own currencies. It is a convenience for your domestic banks and firms to be able to do cross-border business in their own currency. But it’s a hard slog. India and Russia talked for nearly two years about doing more bilateral trade in the rupee and the rouble. But those talks collapsed, because India figured out it didn’t want roubles, and, similarly, Russia didn’t want the rupee. They both wanted dollars, or in Russia’s case, Chinese renminbi. 

China, however, is serious about this, and is building the necessary infrastructure. It wants an international currency as a security blanket, given increasing US recourse to financial sanctions. China built an interbank clearing house in 2016. But it clears only 3 per cent of the value of transactions that the New York clearing house does each day. Again, they’re running as fast as they can, but they’re starting out way behind.

Unhedged: Do you think that there are technological innovations that can help international finance and the global economy?

Eichengreen: We’ve had significant financial innovation over time. But more concretely, I’m not a believer in bitcoin and crypto-like assets, which I don’t think have utility. I’m also not a believer in stablecoins, because I fear that they are, in fact, unstable, especially if they’re not fully collateralised. And if fully or overcollateralised, I don’t think they will scale; no honest business person wants to pay more than one US dollar for one dollar’s worth of a stablecoin.

That leaves wholesale central bank digital currencies, which the central bank issues to commercial banks or dealers, who then issue them to you. They could create alternative plumbing, which could make it easier for countries that wish to use their own currencies for cross-border transactions to find willing partners. Something could happen there in the long run.

Unhedged: Before we finish up, we thought we would ask you a very general question: what’s on your mind? What are you working on? What are you worried about?

Eichengreen: So like everybody else, I’m watching the markets and trying to anticipate how policymakers will respond. And like everyone else, I’m trying to understand better what kind of economic policies our candidates are likely to favour. I find it quite remarkable how little detail and how little clarity both sides have given so far.

One good read

Longevity.