Feature
- Manshel Lecture: Globalization and Monetary Policy
- Richard W. Fisher delivering the Fifth Warren and Anita Manshel Lecture in American Foreign Policy. Photo: Martha Stewart
William Gladstone, the four-time prime minister of Britain, probably summed up the gist of all the literature on money when he observed that “not even love had made so many fools of men as pondering over the nature of money.”
Yet that is what I am now paid to do as a Federal Reserve Bank president and member of the Federal Open Market Committee—contemplate the nature of money. Central bankers ponder money so as to protect its value, promote the maximum sustainable non-inflationary economic growth, manage the payments system, and keep the financial and economic infrastructure humming along at peak efficiency.
Money is the economy's lifeblood. The Federal Reserve's great responsibility is to maintain the cardiovascular system of American capitalism. The Fed's operations—from processing payments to regulating banks to trading foreign exchange to setting the federal funds rate—keep open the arteries, veins, and capillaries of capitalism.
We labor constantly to get it right, so as to avoid Gladstone's condemnation. This is no easy task in a constantly changing environment in which the economy is constantly evolving.
So, tonight, I want to talk about what I consider one of the biggest challenges my colleagues and I face: globalization's impact on the gearing of the economy and the making of monetary policy. Before I do, let me issue the standard disclaimer that I speak only for myself and no one else on the Federal Open Market Committee. These thoughts are my own.
The literature on globalization is large. The literature on monetary policy is vast. But literature examining the combination of the two is surprisingly small.
Tom Friedman's popular book The World Is Flat: A Brief History of the Twenty-First Century doesn't have a single entry on “money,” “monetary policy,” or “central banking.” And in Michael Woodford's influential book Interest and Prices: Foundations of a Theory of Monetary Policy, the word “globalization” does not appear in the index. Nor do the words “international trade” or “international finance.”
What gives? Is the process of globalization disconnected from monetary policy? Is the business of the central bank totally divorced from globalization?
I think not. I believe globalization and monetary policy are intertwined in a complex narrative that is only beginning to unfold. This isn't To the Lighthouse. It may be that the process of globalization might never end. But I believe it does have a plot, which I will turn to momentarily.
First, a definition, so that we can contemplate this matter together from common ground. There are many convoluted definitions of globalization. Mine is simple: Globalization is an ecosystem in which economic potential is no longer defined or contained by political and geographic boundaries. Economic activity knows no bounds in a globalized economy. A globalized world is one where goods, services, financial capital, machinery, money, workers, and ideas migrate to wherever they are most valued and can work together most efficiently, flexibly, and securely.
Where does monetary policy come into play in this world? Well, consider the task of the central banker, seeking to conduct a monetary policy that will achieve maximum sustainable non-inflationary growth.
Consider, for example, the experience of former Federal Reserve Governor Larry Meyer, articulated in his excellent little book A Term at the Fed. It was one of the first books I read this winter in Cambridge as I prepared for my new job. In it, you get a good sense of the lexicon of monetary policy deliberations. The language of Fedspeak is full of sacrosanct terms such as “output gap” and “capacity constraints” and “the natural rate of unemployment,” known by its successor acronym, “NAIRU,” the non-accelerating inflation rate of unemployment. Central bankers want GDP to run at no more than its theoretical limit, for exceeding that limit for long might stoke the fires of inflation. They do not wish to strain the economy's capacity to produce.
One key capacity factor is the labor pool. There is a shibboleth known as the Phillips curve, which posits that beyond a certain point too much employment ignites demand for greater pay, with eventual inflationary consequences for the entire economy.
Until only recently, the econometric calculations of the various capacity constraints and gaps of the U.S. economy were based on assumptions of a world that exists no more. Meyer's book is a real eye-opener because it describes in great detail the learning process of the FOMC members as the U.S. economy morphed into the new economic environment of the second half of the 1990s. At the time, economic growth was strong and accelerating. The unemployment rate was low, approaching levels unseen since the 1960s. In these circumstances, if you believed in the Phillips curve and the prevailing views of potential output growth, capacity constraints and the NAIRU, inflation was supposed to rise. That is precisely what the models used by the Federal Reserve staff were saying, as was Meyer himself, joined by nearly all the other Fed governors and presidents gathered around the FOMC table. Under the circumstances, they concluded that monetary policy needed to be tightened to head off the inevitable. They were frustrated by Chairman Greenspan's insistence that they postpone the rate hikes they were proposing, yet perplexed that inflation wasn't rising. Indeed, inflation just kept on falling.
- Members of the Manshel family greet Richard Fisher on November 3, 2005, at the Tsai Auditorium, Center for Government and International Studies. Photo: Martha Stewart
If the advice of Meyer and other devotees of the Phillips curve, capacity constraints, output gaps, and NAIRU had prevailed, the Fed would have caused the economy to seriously underperform. According to some back-of-the-envelope calculations by economists I respect, real GDP would have been lower by several hundred billion dollars. Employment gains would have been reduced by perhaps a million jobs. The costs of not getting these critical calibrations right would have been huge.
Now, how was Greenspan able to get it right when other very smart men and women did not? Well, we now recognize with 20/20 hindsight that Greenspan was the first to grasp the fact that an acceleration in productivity had begun to alter the traditional relationships among economic variables.
It is important to listen to the operators of our business economy. We have millions of experienced managers and decision makers in the private sector. This may be our greatest competitive advantage, for no other population has the length and depth of experience that U.S. business operators do.…What does an American manager—paid to enhance returns to shareholders by growing revenues at the lowest possible costs—do? Because labor accounts for, on average, about two-thirds of the cost of producing most goods and services, a business manager will go where labor is cheapest. She will have a widget made in China or Vietnam, or a software program written in Russia or Estonia, or a center for processing calls or managing a back office set up in India.
Let me return home to Harvard once more and read you three quotes from Joseph Schumpeter, who taught here from 1932 until 1949, and I think you will get the picture.
First, from Capitalism, Socialism, and Democracy:
The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers' goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.
From that same page:
The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory…illustrate the same process of industrial mutation…that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of creative destruction is the essential fact of capitalism. It is…what every capitalist concern has got to live in.
And from volume 1 of Schumpeter's Business Cycles:
A railroad through new country, i.e., a country not yet served by railroads, as soon as it gets into working order upsets all conditions of location, all cost calculations, all production functions within its radius of influence; and hardly any “ways of doing things” which have been optimal before remain so afterward.
String the key operative phrases of those three citations together and you get the plot of this story, the plot of globalization: “The opening up of new markets, foreign or domestic…revolutionizes the economic structure,…destroying the old one,…creating a new one.…[It] upsets all conditions of location, all cost calculations, all production functions,… and hardly any ways of doing things which have been optimal before remain so afterward.”
The master of creative destruction of syntax, Yogi Berra, put it more eloquently: Once you open new markets, “History just ain't what it used to be.”
The destruction of communism and the creation of vast new sources of inputs and production have upset all the calculations and equations that the very best economics minds, including those of the Federal Reserve staff—and I consider them the best of all—have used as their guideposts. The old models simply do not apply to the new, real world. This is why I think so many economists have been so baffled by the length of the current business cycle and the non-inflationary prosperity we have enjoyed over the past almost two decades.
From this, I personally conclude that we need to redraw the Phillips curve and rejig the equations that inform our understanding of the maximum sustainable levels of U.S. production and growth.
Let me illustrate the point by citing another fine writer, Greg Ip. In yesterday's Wall Street Journal, he noted that the “U.S. economy grew at a 3.8% annual rate in the third quarter [of this year], its eighth consecutive quarter at about that pace. That's above what most economists consider the economy's potential growth rate—that is, what it can produce with existing capital and labor.”
How can economists quantify with such precision what the U.S. can produce with existing labor and capital when we don't know the full extent of the global labor pool we can access? Or the totality of the financial and intellectual capital that can be drawn on to produce what we produce?
As long as we are able to hold back the devil of protectionism and keep open international capital markets and remain an open economy, how can we calculate an “output gap” without knowing the present capacity of, say, the Chinese and Indian economies? How can we fashion a Phillips curve without imputing the behavioral patterns of foreign labor pools? How can we formulate a regression analysis to capture what competition from all these new sources does to incentivize American management?
Until we are able to do so, we can only surmise what globalization does to the gearing of the U.S. economy, and we must continue driving monetary policy by qualitative assessment as we work to perfect our quantitative tool kit. At least that is my view.
The cost of capital is a critical variable in any business operation. The lower the cost in real terms—net of inflation—the better.
Get to a Bloomberg terminal and look across the world. Interest rates have been trending downward to post–World War II lows as inflation has trended downward. Over the past few years there has been a noticeable convergence of rates all along the yield curve—from the shortest term you can borrow money to the longest. (Indeed, due to increasing confidence in the determination and ability of central banks to hold inflation at bay, the term “long” has now been stretched out to 50 years.) This is true not just for the major economies. As a proxy for what this means to business borrowers worldwide, consider some sovereign credits. Greece, backed by the euro, borrows funds of 10-year maturity at 3.7 percent. Poland can borrow 10-year money at 5.2 percent. And here is my poster child for what I consider the miracle of globalized money markets. Let me read to you from the Financial Times of Oct. 28: “Vietnam yesterday raised $750 million with…a dollar denominated…10 year bond. Investors put in orders totaling $4.5 billion, six times the amount on offer. During trading in New York…the bond…was priced to yield 7.125%.”
I seriously doubt that had central bankers here or elsewhere in the world not managed their affairs in a manner that discourages inflationary expectations, this would be anywhere near possible. You cannot have the frenetic progress Tom Friedman describes in his book without the well-functioning, reliable monetary regimes central banks have been sustaining.
This is the great responsibility of the strange species known as central bankers. It is an especially intense responsibility for the Federal Reserve, as the central bank of the largest economy in the world, which prints the world's most utilized currency. One cannot make monetary policy without being aware of the forces of globalization acting upon our economy. Nor can one be oblivious to the need for us to conduct our policy without an awareness of how what we do impacts markets, and therefore, economic potential, worldwide.
A few weekends ago, I went to College Station, Texas, to watch Texas A&M play Baylor. One of the A&M regents tried to explain a coach's decision that I had questioned. I couldn't understand the logic after several tries. So my friend said, “Look, Harvard boy, let me lay it on you in Aggie Latin: Bubbus, sed possum explicare. Non sed possum comprehendere. ‘Bubba, I can explain it to you, but I can't understand it for you.’”
This evening, I have done my best to explain that there is a connection between globalization and monetary policy. I hope you take what I have said and come to understand what it means.
Richard W. Fisher delivered the Fifth Warren and Anita Manshel Lecture in American Foreign Policy. This text is an excerpt from his speech on November 3. Richard Fisher is the President and CEO of the Federal Reserve Bank of Dallas. Previously, Mr. Fisher was vice-chairman of Kissinger McLarty Associates, a strategic advisory firm. Ambassador Fisher is chairman of the American Assembly, co-chairman of the Madison Council's International Committee of the Library of Congress, and chairman of the Council on Foreign Relations Congressional Roundtable on International Trade & Economics. He is a member of the American Council on Germany and a member of the Trilateral Commission. He is an honorary fellow of Hertford College at Oxford University and a fellow of the American Academy of Arts and Sciences.