The Fed, Mugabe Bucks, and the Yuan

One of the nice things about the Christmas holiday period is the chance to catch up on some reading. I finally put the finishing touches on two really interesting books; Tim Geithner's memoir, Stress Test, and a book Lawrence McDonald's Colossal Failure of Common Sense about the failure of Lehman Brothers. Both are compelling points of view on the unprecedented and chaotic days of 2007-2009. One of the most interesting elements of both books is the role of the state, and officials at the U.S. Federal Reserve, in particular.

Is Monetary Policy Out of Bullets?

Over the years, I have become more and more interested in the conduct of monetary policy, perhaps because it seems to be in a fascinating period of sustained crisis and re-evaluation. Monetary policy has always been an inexact kind of policy instrument aimed at mainly at price stability, but in a kind of mission creep, has also become responsible for stimulating employment. The most obvious way in which the Federal Reserve indirectly influences the interest rates you and I pay, and therefore economic activity, is by altering the Fed Funds Rate; the interest rate the Fed charges commercial banks to borrow money. For almost a decade, the Fed Funds Rate has been set close to zero. Because the Financial Crisis essentially froze much of the lending between banks and from banks to consumers, the Fed has been loathe to increase the interest rates it charges banks to borrow. In effect, the Fed has been without one of its chief policy instruments for a decade.


As the U.S. economy has slowly recovered, the Fed has been looking for ways to raise interest rates and give itself some policy latitude-- put the Fed Funds Rate back in its policy arsenal. After more than a year of hand-wringing and telegraphing that it would do so, the Federal Reserve raised that rate by 0.25% to 0.5%. That's not a lot of wiggle room. Moreover, the Fed is signalling that it would like to give itself some additional wiggle room with another increase in 2016. Let's be frank, these are not big increases. Rather, the angst about these increases is indicative of the angst being felt about the health of the global economy generally.

 Central bankers like Janet Yellen (Fed), Mario Draghi (ECB), or Mark Carney (Bank of England) have been assigned-- unfairly-- a kind of clairvoyant status where the management of the economy is concerned. Indeed, Fed Chairs have acquired a strange cult-like status both on Wall Street and Main Street. 

Their importance should not be understated. Yet, the modern demands of central banks seem to be testing the outer boundaries of what they can reasonably be expected to do. The Federal Reserve now has a significantly increased role in bank supervision and monitoring for systemic risk. Moreover, the Fed's Quantitative Easing program added more than $4 trillion to its balance sheet between 2008 and 2014. How all of those asset purchases will be unwound by the Fed is the topic of considerable debate, even among the architects of QE within the Federal Reserve System itself.

A lot of this uncertainty over the conduct of monetary policy has led to plenty of critiques and proposals for reform. Some in the U.S. Congress would like to see far more transparency in terms of Fed decision-making, including regular audits. Indeed, we have seen the revival of some very old debates; some called for a return to a system of fixed exchange rates (a Bretton Woods-like system) or even the Gold Standard in which the role of central banks in the management of monetary policy would be severely curtailed. Yet, such a shift entails a degree of international coordination and a set of trade offs-- many wrapped up in what economists call the Impossible Trinity-- few governments are prepared to entertain. If you don't know what the Trinity is, this short video is one of the better explanations I've found. 

Mr. Mugabe Bucks

This brings me to Mr. Mugabe's Zimbabwe. One of the oldest debates in monetary relations is whether or not to fix your exchange rate. There are sound reasons for fixing or floating your exchange rate. In the aftermath of the currencies crises of the late 1990s, the best advice on that from the IMF was that fixing your currency was a risky proposition for rapidly growing developing countries. Wild swings in capital flows in and out of such countries could rapidly undermine the commitment to a fixed exchange rate. Better to let your currency float, letting it fluctuate roughly in line with supply and demand, all while preserving your monetary policy sovereignty.

However, Robert Mugabe's Zimbabwe is a great example of what happens to a country when the mismanagement of monetary sovereignty actually destroys the nation's currency. In the mid-2000s, the Zimbabwe Dollar experienced a series of government directed revaluations that completely undercut its value. New dollars were issued to replace old dollars which would themselves be exchanged for foreign currency at an official rate set by the state, all of it making Zimbabweans poorer along the way.

Among the many things Mr. Mugabe has done to ruin Zimbabwe's economy is the use of the central bank as his own piggy bank; most importantly, the use of the printing press to create more and more money and in the process generating some of the worst hyperinflation on the planet. The printing of currency soon became so outlandish that the central bank more or less ran out of room to add zeros. While on a trip to Africa a few years ago, a student of mine brought me this little novelty:

Yes, that's a Ten Trillion Dollar note. Needless to say, there was a point where burning stacks of them in your fireplace to stay warm was more useful than as a store of value, medium of exchange, or unit of account-- the main characteristics of currency. Instead, other currencies, notably the U.S. Dollar, became the de facto medium of exchange on a growing black market in a country beset by shortages of anything that needed to be imported. In early 2009, the Bank of Zimbabwe essentially gave up and one the de facto currencies of the Zimbabwe economy became the U.S. Dollar (Euro, Yen, and Pound as well).

While the Zimbabwe Dollar was worthless, accepting the U.S. dollar presents several problems, including the complete loss of monetary sovereignty. In other words, the central bank loses its ability to manage inflation and employment via interest rate setting (albeit, Zimbabwe made a hash of it). Indeed, sending a signal to markets about your intentions as a state is one of the most important reasons for adopting some form of fixed exchange rate. By doing so, the country is saying they will no longer inflate away the value of the currency by printing more and more of it. In Zimbabwe's case, the decision to Dollarize was not exactly theirs to make. Most of Zimbabwe's citizens had abandoned domestic currency in favor of what ever foreign currencies they could get their hands on. By abandoning the Zimbabwe Dollar in early 2009, the government was simply catching up to what had already happened.

The most extreme form of fixed exchange rate is, of course, adopting another country's currency. In this case, you are not just announcing restrictions to your monetary sovereignty, you are actually ceding that policy sovereignty to another country's central bank; in this case the U.S. Federal Reserve, the European Central Bank, or the Bank of Japan.

Legitimacy for the Yuan?

In one of the more farcical political and economic tie-ups I've seen in a while, China and Zimbabwe are seeking closer economic ties; Zimbabwe through accepting the Yuan as one of its official currencies, China more credibility for the Yuan by having it accepted as legal tender in more places. If you can stop laughing at all of this, particularly the awarding of the Confucius Peace Prize to Mugabe, the issues swirling around all of this are actually quite interesting. Some of them swirl around the basic trade-offs associated with different currency regimes and the neoclassical stages of integration I've spouted off about in this blog before (Greece and the 2014 Scottish Referendum). In the cases of Greece and Scottland, economic legitimacy was an underlying issue, but it's even more so here.

Zimbabwe is trying to wiggle out of the restrictiveness of having only a couple of global currencies as legal tender by adopting yet another. Given Zimbabwe's tangles with the IMF over the years, it is interesting that this is also advice offered by the IMF. Yet, it comes with challenges.

Neither the Fed, ECB, nor the Bank of England consider Zimbabwe when setting monetary policy for their currency areas. Indeed, it's possible that the 0.25% interest rate hike by the Fed last week is exactly the opposite of what Zimbabwe needs for its economic health. Higher interest rates mean higher borrowing costs and an appreciating U.S. dollar that makes everything Zimbabwe sells to other countries more expensive. This could be problematic since, as the IMF notes, Zimbabwe's largest trading partner is South Africa. An appreciation of the U.S. Dollar, over which Zimbabwe has no control, could undercut its bilateral trade. Moreover, in a Dollarized economy, Zimbabwe needs to earn from abroad (export earnings) every dollar that it spends. Adopting the Yuan and, in all probability, trading more directly with China will help Zimbabwe get around this. It may or may not simply help Mr. Mugabe continue to blame outsiders for the problems in the Zimbabwean economy.

China, on the other hand, is hoping to win legitimacy for the Yuan where ever it can. Indeed, the size and importance of the Chinese economy suggest the Yuan ought to play a larger role in global finance. In early December, the IMF added the Yuan to its list of "reserve currencies," pushing the Yuan further down the road toward international legitimacy and convertibility. Moreover, China has been extending its global footprint, particularly in Africa, with significant infusions of capital. Loans and other forms of Yuan denominated financing to Zimbabwe, coupled with Zimbabwe's acceptance of the Yuan as legal tender, will undoubtedly stimulate the consumption of Chinese goods. China's toe-hold in Africa will undoubtedly become a foot-hold.

Nevertheless, seeking legitimacy through a currency adoption arrangement with one of the world's most notoriously mismanaged economies strikes me as a strange way to win legitimacy.