2011 Volume 14 Issue 1

A Consequence Analysis that Needs to be Shared

A Consequence Analysis that Needs to be Shared

The Downside of the Federal Reserve's Proposed Actions with Exchange Rates

The Federal Reserve continues a tradition of sharing little information with practitioners, increasing uncertainty and further hindering economic growth.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/winter2011/Stanley-consequence.mp3]

Exchange rateIn November 2010, Ben Bernanke, the Chairman of the U.S. Federal Reserve (Fed), suggested to other deficit trade nations in the Group of Twenty Finance Ministers and Central Bank Governors (G-20) that the U.S. was considering actions to revise exchange rates when they are not favorable to the country’s balance of payment position. While such actions are intended to stimulate U.S. Gross Domestic Product (GDP) growth, there are economic conditions under which they could have the opposite impact. The Federal Reserve’s failure to conduct thorough consequence analyses to identify potentially adverse outcomes of actions and its failure to share those potential consequences with practitioners is adding to economic uncertainty in the United States—the very thing that the Fed is tasked with remedying. This article examines the Fed’s proposed actions with exchange rates and provides a list of resulting economic conditions that macroeconomic theory would indicate could actually dampen U.S. GDP growth. The objective is to inform practitioners who are required to make decisions under uncertainty of the estimated potential for adverse outcomes under a variety of economic conditions, before they occur.

Overview and Context

As pressures mount to jump-start economic recovery, traditional monetary policy options have proven to be ineffective. Discount rates and Federal funds rates have been reduced and are near zero. Open Market Operations, which focus on buying and selling Treasury securities from member banks in the secondary bond markets in order to reduce or raise interest rates, have now reached record high levels including the purchasing of non-traditional instruments. Yet recent actions by the Federal Reserve in the United States and Central Banks in the G-20 countries continue a tradition of sharing little if any information about key proposals with practitioners. Such actions increase uncertainty for U.S. corporations, which may further hinder economic growth. For instance, in November 2010, General Electric (GE) decided to spend $2 billion dollars of their accumulated cash to invest in jobs in China, not the United States. The slower the economic recovery in the United States, the more companies will look to emerging countries for future growth.

Efforts to restore global growth and reduce unemployment are being tied to adjusting the value of the U.S. dollar relative to currencies of trade surplus countries such as China’s Renminbi. Using monetary policy to stimulate economic growth across national economies is risky and uncertain. There are limits to what monetary policy can do and the limits change over time. In 1944, the U.S. dollar was the world currency and was backed by gold. Countries had fixed (not market-based) exchange rate regimes, and the Bretton Woods Accord encouraged countries to revise exchange rates by 10 percent when exchange rates were not favorable to their balance of payments. In the 1990s, economists (including Alan Greenspan) declared that the Fed could best support economic growth by using its tools to maintain price stability—not to decrease unemployment. This contradicts the current “Quantitative Easing” approach, introduced in 2008. A wide range of financial and economic consequences may result from this contradiction, but no one clear outcome is evident. Uncertainty will be increased, which will make businesses less likely to recover.

This uncertainty is so significant that there is public discord by current Federal officials. The president of the Federal Reserve Bank of Dallas, Richard W. Fisher, noted that the uncertainly itself will result in “liquidity hoarding.” Hoarding occurs when the pubic chooses to hold cash rather than spend it. This would imply a rejection of at least the second wave of quantitative easing by the Fed.

The Consequences of Actions to Devalue the Dollar

The problems with the recovery have been diagnosed and the analysis shows that the traditional triggers—private-sector investment, job creation, new housing starts, and domestic consumption—will not be leading the resurgence. Private corporations are holding a lot more cash, reducing long-term debt and seeking to distance themselves from borrowing and financial institutions. They are managing revenue reductions, and becoming smaller and more profitable. With up to 40 percent of their cash held abroad and still subject to repatriation taxation, private companies do not appear interested in investing. If they do invest, they can choose to expand in America or in emerging markets. No one is certain how the expansion will be allocated.

In such an environment the primary tools of the Federal Reserve (and other Central banks in general) are not likely to be effective. The Federal Reserve appears to be opening the door to new agenda items: (1) Quantitative Easing on the domestic side; and (2) Currency adjustments on the international side to boost exports.

The goal of currency adjustments in the United States is to increase U.S. exports, thereby raising Gross Domestic Product and increasing U.S. jobs. Specifically for the United States and the European Union, the path to increasing exports is to counter what the Fed sees as undervalued currencies, such as the Chinese Renminbi. If the U.S. can decrease the value of the dollar, exports should increase if all else is held constant. But this also assumes that Trading partners will retain or raise the values of their currencies, inflation will remain low, and incomes in other countries will remain stable or increase. These conditions are volatile and it’s unlikely they will remain constant.

The following is a list of economic conditions that could impact the effectiveness of the Federal Reserve’s actions to reduce currency values and increase GDP growth. Each “IF” statement describes an economic condition that is publicly being discussed in different practitioner communities today. Each “Potential Consequence” describes how the condition could adversely affect currency values and impede the desired growth. The outcomes are not predictions, but consequences based on established macroeconomic theory. On its own, each individual condition could dampen expected currency value decreases and increases in exports from the proposed Fed actions, it is their combined potential to actually reverse the anticipated effects that should concern practitioners.

Economic Conditions that Reduce U.S. GDP Growth

“IF” Condition

Potential Consequence

If a large second round of worldwide foreclosures (this time from prolonged unemployment) hits the financial sector, increasing “stress” levels…

…there will be a reduction in lending. Lower lending reduces expanding investment in foreign markets and fewer U.S. goods being purchased by foreign purchasers. Other countries will not purchase U.S. goods even if they are cheaper.

If unemployment remains high in America, as well as worldwide, and if new job creation is slow…

…there will be low consumption demand. This becomes a larger problem if public sector employees are laid off, thereby increasing total unemployment.

If other countries move to deep austerity programs so they can avoid debt repayment issues…

…government jobs will be lost and national income decreased. The British Government has committed itself to such a drastic orientation. The currencies of other countries can fall faster than the U.S. dollar.

If the European Union and other advanced countries implement programs to devalue their currencies…

…the “relative” changes in currency values will be minimized. The U.S. dollar will not fall in value, exports will not rise, and GDP will not grow from expanding exports.

If China seeks to decrease its Capital Account deficit by expanding its orientation to creating gold-back debt securities, and if they carry the program to the next level with international trustees for the debt rather than domestic trustees…

…this will allow China to maintain its growth even if its currency value increases. Increased consumption of U.S. goods in China could be offset by increased imports to the United States, which would decrease GDP.

If the new healthcare program increases healthcare costs for businesses and consumers…

…that could combine with rising food prices and increase inflationary pressures. Of course the big unknown is housing prices, which could remain stable or even go down if foreclosures increase. Inflation will force the Fed to dampen GDP growth.

If the increased amount of money in the economy due to a second round of Quantitative Easing (QE2) reduces purchasing power…

…this could very well result in stagflation (rising inflation in a stagnant economy), especially if businesses see input prices rise (such as labor requiring cost of living adjustments). This could drive jobs offshore as businesses focus more on international markets. Further, unemployment increases would lower income, consumption, and offset higher export levels, leaving GDP unchanged.

If inflation takes off in commodities consumers must buy (oil and food), but things they own (stocks, bonds, and real estate) decline…

…the economic recovery, at whatever stage it may be, will collapse. In the short-term, there could be a sharp increase in the purchase of foreign-made items due to rising prices, which would dampen long-term purchases of American goods.

The Fed is not an Island

Federal Reserve System stampThere are indeed many critics of the proposed currency actions, both domestically and internationally and from both the private and government sectors. Leaders in emerging economies have expressed extreme displeasure with the move, such as Chinese central bank adviser Xia Bin speaking for the central bank of China in their newspaper just prior to the recent G-20 summit. He stated that “as long as the world exercises no restraint in issuing global currencies such as the dollar—and this is not easy—then the occurrence of another crisis is inevitable, as quite a few wise Westerners lament.” Xia Bin is clearly warning that the occurrence of another crisis is inevitable.

The Fed has used up most of its traditional monetary tools and is being asked to do more than it ever has in the past. Indeed, current monetary policy could be well beyond what we should even expect of them. The results, as noted, could be disastrous, as one or more negative scenarios come true. As noted Joseph Carson, the Fed is simply attempting to use monetary policy to increase nominal growth before economic and financial fundamentals are in place. This places the economy at high risk.

The Fed, as noted by the quotes above, is demanding that the Obama administration and Congress take a far more proactive role in stimulating the economy through fiscal policies. This would lessen the dependency of the economy on the monetary policy of the Fed. Obama’s recent appointment of Gene Sperling as chairman of the Council of Economic Advisors may be a step in that centralist-progressive, pro-growth, fiscal policy orientation. In his 2005 book, The Pro-Growth Progressive, Sperling noted that trade-related issues require “deep, honest exploration that does not easily fit with any right-left, pro-globalization-anti-globalization perspectives.” This is a pro-growth, progressive orientation in contrast to a  “big government,” progressive position. President Clinton went with Sperling his last six years. Will Obama?

Recent comments and appointments by Obama indicate that this could be a possibility. The appointment of Jeffrey Immelt, CEO of GE, to replace Paul Volcker, and the change of the name of the advisory board to the “President’s Council on Jobs and Competitiveness” signals a concern for exports driven by quality and value instead of exports driven by the decline of the dollar, like all other banana republics. The President himself, in his January 25, 2011 State of the Union speech, noted this need. Two polar opposite publications, The Wall Street Journal and The New York Times, both focused on this segment of his speech. The Wall Street Journal printed the headline, “Obama: U.S. Must Compete,” while The New York Times noted “Obama Sees Global Fight for U.S. Jobs.”

Bill Gross, well-known fund manager at Pacific Investment Management Company (PIMCO), said that the actions of the Fed could lead to a 20 percent drop in the dollar. Famed financier George Soros has often mentioned 25 percent. But a lot depends on other currencies and economic conditions. The simple fact is that no one knows what will happen to the dollar under these unchartered economic conditions. A worst-case scenario would be that the increased level of uncertainty results in a loss of credibility in the Fed’s ability to assess the consequences of its actions and make decisions that help recovery. When lending fund managers recommend moving to cash, experts suggest returning to the gold standard, and legislators and the public learn after the fact that the Fed secretly lent billions to foreign banks during the recent contraction the Fed’s credibility is already in question.,,


The potential high-risk consequences of the Fed’s current monetary policy initiatives to stimulate trade have not been shared with practitioners. The late Milton Friedman, a Nobel-prize winning economist, was an advocate of transparency of the Fed. He stated that “they’re always shifting their rhetoric. You have to distinguish rhetoric from substance.” In today’s economic environment, substance often loses out.

Perhaps the biggest hurdle to consequence analysis is the need to translate the multiplicity of event options into a single outcome of importance to practitioners. Starting “simple” is practical. Here the use of monetary policy and its ability to improve exports and the economy could be substantively reported by the Fed as a listing of the economic conditions that could dampen or reverse the effects and an estimate of the likelihood that their combined effects would actually decrease the GDP. Reporting a downside outcome and the probability associated it would allow practitioners to expand and improve expected value calculations for such actions as hiring and physical capital expansion projects.

Business practitioners must recognize the high uncertainty of the Fed actions and act accordingly, as General Electric did in their decision to invest in jobs in China. First, take advantage of the current low-cost debt and purchase appropriate plants and equipment in productive assets that will respond favorably, regardless of the economic outcome. Second, acquire needed commodities on a long-term basis, such as Southwest Airlines did in their acquisition of favorably priced long-term fuel contracts. Third, invest in countries with natural resources. Fourth, buy companies with natural resources, but do not buy American oils as the Obama administration is seeking ways to transfer wealth from them to so-called “green technology companies.”

Giles, Chris, Alan Beattie, and Christian Oliver. “G20 Shuns U.S. on Trade and Currencies.” The Financial Times, November 12, 2010. Accessed November 20, 2010. http://www.ft.com/cms/s/0/e65d6a44-ee2e-11df-8b90-00144feab49a,dwp_uuid=60a3db68-b177-11dd-b97a-0000779fd18c.html#axzz15XF7OoVU.

“FRB: Federal Open Market Committee.” Board of Governors of the Federal Reserve System. Accessed November 22, 2010. http://www.federalreserve.gov/monetarypolicy/fomc.htm.

Jie, Liu. “GE Makes $2b Chinese Investment.” China Daily, November 11, 2010.

Walker, Andrew and other BBC staff. “G20 to Tackle US-China currency concerns.” BBC, November 12, 2010. Retrieved November 17, 2010. http://www.bbc.co.uk/news/business-11739748.

R.F. Mikesell, The Bretton Woods Debates: A Memoir, Essays in International Finance 192 (Princeton: International Finance Section, Dept. of Economics, Princeton University, 1994).

“Testimony of Chairman Alan Greenspan.” Federal Reserve Board’s semiannual Monetary Policy Report to the Congress, Before the Committee on Financial Services, U.S. House of Representatives. February 11, 2004. http://www.federalreserve.gov/boarddocs/hh/2004/february/testimony.htm.

“A Symposium: What Should the Federal Reserve Do Next.” The Wall Street Journal – Wsj.com. Accessed November 28, 2010. http://online.wsj.com/article/SB10001424052748704358904575477580959771188.html.

Krantz, Matt. “Companies Hold Record $837B in Cash, Yet Won’t Hire Workers – USATODAY.com.”  Accessed November 29, 2010. http://www.usatoday.com/money/companies/2010-07-28-cashcows28_ST_N.htm.

Porter, Richard D., and Ruth A. Judson. “The Location of U.S. Currency: How Much Is Abroad?” Federal Reserve Bulletin, October 1996. Accessed November 29, 2010. http://www.federalreserve.gov/pubs/bulletin/1996/1096lead.pdf.

“Emerging Economies Vow to Combat QE2 in US.” November 5, 2010. http://economictimes.indiatimes.com/news/international-business/Emerging-economies-vow-to-combat-QE2-in-US/articleshow/6874377.cms.

Carson, Joseph G., “FED Debates Radical Policy Shift to Lift Inflation,” AllianceBernstein Bulletin, October 8, 2010. http://www.alliancebernstein.com/CmsObjectABD/PDF/EconomicPerspectives/EPUS_101008_JC.pdf, Retrieved November 27, 2010.

Sperling, Gene B. The Pro-growth Progressive: an Economic Strategy for Shared Prosperity. New York: Simon & Schuster, 2005.

Scheiber, Noam. “Clintonism 2.0.” The New York Times, January 22, 2006, Books sec. http://www.nytimes.com/2006/01/22/books/review/22scheiber.html?_r=1&pagewanted=2.

Weisman, Jonathon, and Janet Hook. “Obama: US Must Compete.” The New York Times, January 26, 2011, A1 sec. http://online.wsj.com/article/SB20001424052748704698004576104134043682882.html.

Stolberg, Sheryl Gay. “Obama Sees Global Fight for US Jobs.” NDTV.com, January 26, 2011. http://www.ndtv.com/article/world/obama-sees-global-fight-for-us-jobs-81637.

Kinsley, Michael. “My Inflation Nightmare.” The Atlantic, April 2010. Accessed December 5, 2010. http://www.theatlantic.com/magazine/archive/2010/04/my-inflation-nightmare/7995/.

Clark, Stephen. “Federal Reserve Under Fire for Lending Big to Foreign Banks During Financial Crisis.” FoxNews.com. Accessed December 5, 2010. http://www.foxnews.com/politics/2010/12/02/federal-reserve-loaning-trillions-foreign-banks-financial-crisis/.

Walcoff, Matt. “Manulife’s Rich Urges Move to Cash, Saying Fed Boost Will Fail – Businessweek.” Bloomberg BusinessWeek. October 27, 2010. Accessed December 6, 2010. http://www.businessweek.com/news/2010-10-27/manulife-s-rich-urges-move-to-cash-saying-fed-boost-will-fail.html.

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Authors of the article
Darrol J. Stanley, DBA
Darrol J. Stanley, DBA, is a professor of finance at the Graziadio School of Business and Management. He is well-known as a financial consultant with special emphasis on valuing corporations for a variety of purposes. He has also rendered fairness opinions on many financial transactions, and he has been engaged by corporations to develop strategies to enhance their value. He has served as head of corporate finance, research, and trading of four NYSE member firms. He likewise has been the principal of an SEC-registered investment advisor. He has completed global assignments as well as having served as Chief Appraiser of International Valuations/Standard & Poor’s in Europe, Central Europe, and Russia.
Donald M. Atwater, PhD
Donald M. Atwater, PhD, is a practitioner faculty of economics at the Graziadio School of Business and Management. Previously, he served as chief executive for a southern California technology company, the chief financial officer of an international, value-added software company, a principal in the human resources and compensation practice at William M. Mercer, and a director and co-founder of several start-up companies. He has created decision-support technologies and implemented them in a number of Fortune 100 companies, including AT&T, Intel, Dell Computer, Apple Computer, and Nestle USA. Dr. Atwater has also worked with many public organizations, including the U.S. Navy, the General Accounting Office, the state of California, and both the county and city of Los Angeles. His work has been published in the Monthly Labor Review and he has co-authored numerous papers. Today he owns and operates a company dedicated to building goal-driven communities.
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