Unintended Consequences


I would like to share two quick thoughts with you that fall
under the heading of Unintended Consequences.


Sectarian strife in
: Late Monday I attended a presentation at the New America Foundation
by Wadah Khanfar, the director general of the Al Jazeera Network (the Arab TV
news network headquartered in Qatar, now with an English language channel). He
is a very interesting and impressive guy. His first observation was to totally
refute the nonsense that Muslims, Arabs or Arab Muslims dislike American values
of liberty, respect for the individual, religious freedom, etc. (it’s the
policies stupid).


Mr. Khanfar was the Al Jazeera bureau chief in Baghdad
during America’s invasion of Iraq. At Monday’s presentation he was asked if Al
Jazeera had a Sunni or Shia bias in its Iraq reporting. He replied that Al
Jazeera has strict, professional reporting standards and does its best to
adhere to them. He noted that in 2003 he and his fellow reporters did not even
know whether public figures in Iraq were Sunni, Shia, Christian, Jewish or
something else. Only when the U.S. designed elections requiring a balance of
religious group representation on slates of candidates did these officials need
to state their religious affiliations, thus bringing that issue into public
focus—the opposite of the intended purpose. You can see his entire presentation
here: http://www.youtube.com/watch?v=thg0owasbLw


Executive pay and
corporate governance
: A cornerstone of capitalism is the belief that the
desire for profit by owners will maximize the prospects over time of capital
being allocated to the uses most wanted by consumers. Long-run profit
maximization is a good thing. Venture capitalists deliberately take large risks
for potentially big gains knowing that they will often fail, but it is their
money they are risking. Owners (shareholders) of established companies are
generally interested in the long-run survival and profitability of the firms
they own and are thus less interested in short-run gains that jeopardize the
long run profits of these firms. If paying high prices for the best talent
contributes to the prospects of greater profits over time, owners will want to
do so.


This characterization of capitalism is hard to reconcile
with the rules of corporate governance we now have in the U.S. “New York
Attorney General Andrew M. Cuomo reported that the nation’s nine largest banks
handed out $32.6 billion in bonuses last year even as they ran up more than $81
billion in losses and accepted tens of billions of dollars in emergency federal
Do such bonus rules reflect the judgment of owners of how to maximize profits
or the exploitation by management of short-term rents at the expense of
owners?  It may shock you, as it
did me, to learn how little owners can control the remuneration of those who
manage the firms they own.


“’Under this bill, the question of compensation amounts will
now be in the hands of shareholders and the question of systemic risk will be in
the hands of the government,’ said Rep. Barney Frank (D-Mass.), who leads the
House Financial Services Committee and who authored the bill.”[2]
Among other things the “bill also gives shareholders the right to reject a pay
package, but their vote would be
[3] I always
thought that they had the full authority to approve pay packages. This is
shocking. Corporate governance rules need to be strengthened more than Barney Frank’s timid bill to put owners in
charge of managers.

[1] By David
Cho and Tomoeh Murakami Tse
, "House
Backs Greater Say on Pay by Shareholders"
  The Washington Post,
August 1, 2009, page A9.

[2] Ibid.

[3] Ibid.

Econ Lesson: The Rationing of Medical Care

 Like most things, the use of medical services must be
rationed. But who should do the rationing?

All things that are desired and cannot be provided without
cost (as we used to say about air) must be rationed. This is exactly what
markets do by discovering the price at which buyers are not willing to pay more
for more and producers/sellers are not willing to provide more at that price.
This market-clearing price has the interesting property of maximizing the value
(utility) of each person’s income because a reallocation of that person’s
spending would result in having more of things less valued and less of things
more valued. If you spend more on one thing you will have less income with
which to buy other things (what economists call the budget constraint). Each
person’s tastes and choices are different but each person can satisfy this
utility maximization goal in a free market by tailoring the mix of her
purchases to her own tastes. In short, the market-clearing (equilibrium) price
maximizes the value of each person’s income for each person. Why in the world
do they call this the dismal science?

While I know very little about the health industry, it is
obvious that the necessary rationing of medical services if we are to get the
best value from our incomes faces some challenges. The share of GDP going to
medical care in the U.S. has reached over 16% and is still climbing. This is at
least twice the level of spending of other developed countries, but the result
is not healthier Americans on average. For example, infant mortality rates in
the U.S. are about 40% higher than those in other high-income OECD countries
(World Bank data).

If medical care is provided to users free of charge (i.e. if
someone else pays the actual cost of producing it), those users will consume
medical services until the marginal value of an additional amount is zero (even
though the actual cost is far from zero).
Such users have no need and thus no incentive to restrict (ration) the
medical services they consume in order to save the income for something else
they value more. If insurance pays the full cost of all medical services, the
consumer, at the margin, is getting them free. This is why co-payments are now
usually required and serve the useful purpose of returning some incentive to
the consumer to ration services more carefully (e.g., should you ask for a
simple blood test or a much more expensive comprehensive one?).

If consumers don’t pay, other mechanisms for rationing are
required if gross over provision of medical services is to be avoided and it is
obvious that the escalating costs of such services (without a commensurate
increase in benefits) arise in part for this reason. Insurance companies
themselves ration by establishing what they will pay for and how much they will
pay for it. Ideally consumers would choose insurance plans that ration in ways
that match their own preferences as closely as possible. However, competition
among insurance providers over such cost/benefit decisions is limited by the
fact that since World War II employers have generally provided health insurance
to their employees (because the government subsidizes employer provided
insurance by exempting that form of employee remuneration from taxation). Thus
the employers rather than the actual consumers of medical services decide which
insurance plans to provide. This restricts competition among insurance
companies to provide the mix desired by consumers. Employer provided health
insurance also makes it harder for workers to change jobs and increases the
hardship of unemployment because it also result results in the loss of
insurance coverage.[1]  A national Insurance Exchange through
which everyone could chose competing insurance programs, as is now being
considered, would also increase competition for insurance plans.[2]

One problem with insurance (including Medicare) deciding how
to ration services is that they often do not know as well as trained and
experienced doctors which services (treatments, medications, and technology)
are most cost effective for each situation. So if consumers have little
incentive to ration, maybe doctors should make such decisions for them. Indeed
they are surely the most knowledgeable for making good judgments about the medical
services that are most appropriate and cost effective and in fact we rely
heavily on their judgments in this area. Unfortunately, doctors have several
strong incentives to over supply expensive services. Most doctors in the United
States are paid on the basis of the tasks performed (fee for service) rather
than on the basis of the services rendered (treating pneumonia, or setting a
broken bone) or the results of their efforts (curing a back pain). The more
they do the more they are paid whether they make the best choices or not. Some
medical practices, such as the Mayo Clinic have obtained good cost containment
with high quality service by making their doctors employees rather than paying
them fees for services. If the Mayo Clinic, or Doctors Inc. charge a fixed fee
for treating a particular ailment, they have an incentive to find the most cost
effective ways of doing so for each patient. But then they might have an
incentive to cut too many corners to save money.  HMO’s are another approach to rationing in an effort to deliver
good service at a reasonable cost. They have been unpopular with many people,
but might be the best choose for some if offered as one of many options.

The oversupply of services by doctors has another cause as
well. American malpractice liability laws encourage lawsuits by offering very
large damages, sometimes in cases of reasonable judgments that proved wrong.
Malpractice insurance, often costing individual doctors several hundred
thousand dollars per year, has added considerably to medical costs directly. But
the threat of such suits has also added considerably to such costs indirectly
(with no real benefit) through the defensive, over use of extensive diagnostic
tests by doctors to ensure that they are protected from nuisance lawsuits. Most
professional practitioners (lawyers, engineers, directors, etc.) are protected
from such suits if they have adhered to established norms (protocols) of
decision making even if in retrospect their decision was wrong or not the best.
Reform of malpractice law for medicine along similar lines is needed.

Individual doctors rely on medical boards to establish
protocols for what is best practice in treating each disease and condition.
President Obama wants to establish professional boards to set such standards
for insurance coverage and to evaluate and propose the most cost effective
treatments. It is clear that individual doctors do not have the time and
resources with which to do so and still practice medicine. The American Medical
Association develops such protocols, but it also restricts medical practice in
ways that limit competition among doctors and techniques (e.g., phone or
internet consultations across state lines). As with other services, progress
comes from competition and experimentation. If doctors can never try new
techniques or technologies because they are dealing with human beings, medicine
would be frozen where it is (or where it was).

All of the above reflect failures or weaknesses in
traditional market rationing of medical services. They have contributed to the
high cost of these services in the United States in relation to the quality of
these services. In some cases services are expensive but produce superior
results (new medicines and machines) but in many cases they are wastefully
expensive without providing better results. As in other areas of providing
goods and services, financial and other incentives need to be properly aligned
to provide the best serve at the least cost, which is the level of service and
related cost desired by each consumer from the offered options. And all
services need to be competitively provided (insurance, doctors, labs,
hospitals, etc.). Currently medical services are not being properly rationed. I
wish I knew the answer to the best way forward. Generally the best approaches
result for experimentation and the survival of the best in the market place.
Medical care to too regulated for this traditional approach to work well, but
keeping in mind the importance of getting the incentives right will be part of
improving our system of delivering medical services in the U.S.


[1] Ruth Marcus,
Bipartisan Plan on Health Care? Try Two”
, The Washington Post, July 29, 2009, page A17.

[2] Ezra Klein, “A
Market for Health Reform”
, The
Washington Post
, July 29, 2009, page A17.

Government corruption of our economy

I have noted on several occasions (most recently “State Ownership of Businesses) the growing threats to America’s economic productivity of ever greater government involvement in the economy. This productivity is the basis of our high standard of living and of our influence in the world. It is almost impossible for the government to get involved, especially as a shareholder without replacing commercial judgment and considerations with political considerations. Rather than better goods and services at lower prices we get more expensive goods that provide employment or profits for the benefit of a congresswoman’s constituents at tax payer expense. Today’s Washington Post has an article that so clearly illustrates this corrosive danger that I must pass it on: "Time to Click and Drag Car Sales into the 21 Century". The government’s involvement in the economy reduces its productivity but of equal if not greater importance it erodes the integrity of government.

On Friday in Las Vegas I debate whether we should get rid of the Federal Reserve as part of FreedomFest. If interested, you can see it on C-SPAN.

Best wishes,


State Ownership of Businesses

Whatever you think about the necessity of the various government bailouts of banks, insurance companies, investment banks and now auto makers, we should all clearly recognize the inevitable consequences of state ownership and thus ultimately control of enterprises. When governments own enterprises, they have an obligation to the tax payers to ensure that their oversight of the companies they finance serves the public interest. History is full of examples of how this has worked out in practice around the world—bloated work forces (how can a caring public official say no to unemployed relatives); thus high cost, uncompetitive outputs; misdirected investments (how can a caring public official say no to constituents in his home town); thus low productivity and losses; thus lower growth and per capital income—but our Congress has wasted no time in demonstrating how it works.


This morning’s Washington Post reports that "Lawmakers Chide Automakers Over Dealership Cuts". Surely no one imagines that Congressmen have better judgment about the contribution to the profits and thus the financial viability of GM of its dealer franchise arrangements than GM does itself. Congressmen are responding to the complaints and pressures from GM dealers in their congressional districts. Why would these dealers go to their congressmen to try to pressure bankrupt GM to give them a better deal with tax payers’ money? Well, of course, because the U.S. government and thus Congress now own a significant share of GM and thus have a say in its business decisions. You might hope that your congressman puts the national interest first (the restoration of a viable profitably GM), but you will generally be disappointed (unless you are a GM car dealer). It is our representative’s local congressional district voters who put and keep him/her in office and whose interests must come first. This is the nature of and the way government works and is one of the many reasons it should not own enterprises.

In yesterday’s Post Steven Pearlstein gave one of many specific examples of this behavior: “For sheer hypocrisy, however, you can’t beat Republican Sen. Bob Corker of Tennessee. Last November, Corker took to the Senate floor to denounce the Bush administration’s proposal for bailing out domestic auto manufacturers, saying it didn’t force the companies to do enough to restructure their costs and their operations. Among his big concerns: oversize dealer networks that prevented even the strongest dealerships from making a decent profit.

“Fast forward to today, as Chrysler and GM are finally undergoing the radical downsizing and restructuring that Corker had long demanded. And what does Corker have to say about that? He’s outraged at the way the discontinued dealers have been treated and is pushing legislation to ensure that they get at least six months to wind down their operations and receive full refunds from the automakers for any unsold cars or parts.”[1]

From across the isle Rep John P. Murtha (D-Pa) says it all (in connection with his investigation for favors to and from the “military industrial complex?): "If I’m corrupt, it’s because I take care of my district."[2]

When President Bush first proposed bailing out GM and Chrysler, I argued that if they could not raise the money they needed in the market they should seek the protection of bankruptcy, which provides a well defined and orderly process for restructuring (if warranted) under Chapter XI. A year later both have declared bankruptcy, but the new Obama administration has managed to make mush of the legal bankruptcy process (e.g. treating junior creditors better than senior credits[3]) further politicizing our economy and eroding the rule of clearly defined property rights, which provide the basis on which investors act. I still have confidence that most policy makers of both parties understand the risks of moral hazard and the importance of incentives in guiding behavior, but if they ever get out of hole they dug in crisis mode to start rebuilding a sounder long run, they will have many steps to climb to get out of the policy mess we are in. But for the sake of the country we need to reclarify what should be rendered unto Caesar and what is ours.

[1] Steven Pearlstein,  "Crisis Managers vs. Naysayers" The Washington Post, Friday June 12, 2009

[2] The Washington Post,   "Eye-Opening Earmarks" June 14, 2009 Page A16.     

[3] George F Will, "More Judicial Activism, Please", The Washington Post, June 14, 2009, A15.

Econ lesson: Getting Our Money’s Worth

Our defense budget, like any other budget, is finite. Our resources are limited. To get the maximum value from limited reserves, their deployment must be carefully directed and prioritized.

Defense Secretary Gates, along with the Secretary and the Chief of Staff of the Air Force, want to end production of the F22 in order to shift limited resources to other more pressing needs. "The Air Force’s top two leaders explained … that … they couldn’t justify spending billions more on stealth fighters when other higher service priorities exist and money is tight. The $13 billion for the 60 additional fighters could be better used to repair the service’s nuclear enterprise, ramp up its unmanned aircraft fleet and better fight irregular wars.”[1]

I cheered when I read this and said to myself, we will now see how deeply the military industrial complex President Eisenhower warned us about is entrenched in defense policy making, just as Wall Street is currently demonstrating its power to influence the government’s financial policy (and what a mess that is). Lockheed Martin and Boeing have scattered their F-22 plants widely around the country, but “strangely” concentrated them in the states of the congressional members of the defense appropriations committees. This has nothing to do with economic efficiency and everything to do with political support for keeping the money coming.

“Lockheed Martin Corp. is lobbying the Obama administration to purchase additional F-22 fighter jets by arguing that continued production of the plane would preserve nearly 100,000 jobs across the country, including 19,500 in California…. The F-22 program is directly responsible for 25,000 jobs at Lockheed and its major suppliers. But Lockheed officials say when jobs from sub-suppliers are added in, the F-22 program maintains 95,000 jobs in 44 states.”[2]

Shame on Lockheed. If jobs were the reason for keeping up the production of the world’s best jet fighter (designed to out maneuver Soviet Migs), we would do better (and for less) to hire several million people to sweep streets with brooms. But it should be obvious that the nation’s output available to be shared around and consumed one way or another, not to mention the nation’s defense capability, would be much less in that case. So “jobs” is not the right criteria for choosing the government’s expenditure priorities. In the case of the military budget, the goal should be to produce the maximum defense possible from a given level of expenditures (determined by defense needs relative to the needs for other government services and the fact that the more government takes from us in order to provide these services the smaller and weaker our economy, which builds these things, will be). Budgets are about priorities, and trade offs, and hopefully efficiency.

The private market produces efficiency by forcing low priority and/or inefficient producers from the market, thus freeing up the resources (including workers) they used for better things. Fortunately, the government is demanding increased efficiency from GM and Chrysler as a condition for the injection of additional taxpayer money. This means fewer jobs at GM and Chrysler as the price of the prospect to survive (eventually) on their own. It was a mistake (by the Bush administration) for the government to interfere in the first place rather than to allow the existing tools of bankruptcy to clean up and restructure these firms if need be, but at least Obama has drawn a line in the sand on the use of additional tax payer bailout money (at least with regard to GM and Chrysler).

We are a wealthy nation, able to support the strongest military in history AND to enjoy a very high standard of living for the average person, because each person is able to produce a lot. This results from the very careful allocation of our resources (people, capital, and technology) to their most productive uses (minimizing the number of people needed for each activity so that they may engage in other activities thus increasing our overall output). With changing tastes and technologies this needs to be a very dynamic process. If the jobs to produce no longer wanted products are artificially preserved, the value of our output will decline.

The profit incentive of the private sector rewards good resource allocation decisions and punishes poor (or unlucky) ones. Government is needed to establish and enforce reliable and predictable rules of the game for private interaction, but government over reach can undermine the virtuous workings of the profit incentive in competitive markets. Competition and consumer sovereignty in the private help direct man’s natural greed (i.e. self interest) toward the social good and help keep it in check. Government has a more difficult time of it. It is difficult for an individual congressman to uphold the national interest against the interest of his constituency to preserve their jobs. But our national defense and general well being demand it. Good luck Mr. Gates.

[1] Robert O’Harrow Jr., "An Era Begins Closing On F-22", The Washington Post, April 13, 2009.

[2] Julian E. Barns, "Lockheed Lobbies For F-22 Production on Job Grounds", Los Angeles Times, February 11, 2009.

Comments on : “Is there Inflation Ahead?”

Dear Friends,

As always, some of you made interesting comments on my Inflation note.


May I infer that what you expect is significantly higher interest rates AND inflation significantly above 2 per cent? If so, other than writing a letter to our Congresswoman (who can’t vote) and perhaps buttonholing Barney Frank at your next Christmas eve party, what else? Could you write a second piece looking at investment strategies—what investments one might make to neutralize, or even benefit from, higher interest rates 2-3 years from now, raging inflation and a devalued dollar? All of your friends would be DEEPLY INDEBTED to you for this kind of advice. I’m refinancing my apartment, capturing 4.65 interest rates for 30 years. But what else?


Charles [Krause, Washington DC]


So the answer is "maybe"?
Russ [Schrader, San Francisco, CA]



Nice to hear from you. I hope to visit that region of the world again at some point. Relaxing by the Dead Sea is no doubt nice, but so is dancing with the Dead! I’ve recently attended a few concerts by the remaining members of the original Grateful Dead who are on tour this spring.

The Dead began doing shows around 1966. For more than 40 years, presidents have come and gone while they just keep playin’ in the band, sharing their music with whomever happens their way.

They met briefly with President Obama during there stop-over in Washington. Probably moreso for Obama to pay homage to them, then vice versa. Someone associated with the band was quoted in the Post saying "there were no ties, and no tie-dyes." Ah, the Jeffersonian spirit lives. An extended hand of friendship with all, at least initially, and alliances with none.

There’s something about the scent of patchouli, the glow of fire in glass as the lights go out, the haze that engulfs a roaring crowd as the band takes to the stage, and the music of the ages that pours forth like a favorite wine.

How does any of that relate to the economy and inflation? The best things in life do not come from government, they are not expensive (although they are precious), and they are readily available to all who have ears and wish to hear, and all who have eyes who wish to see, in a manner of speaking.

Nero may have fiddled while Rome burned, but Rome had no business in Israel, and they never should have killed Jesus.

"I spent a little time on the mountain,

spent a little time on the hill.

saw some things gettin’ out of hand,

and I guess they always will…"

(from New Speedway Boogie, 1969)

David Garland [Richmond VA]



  Right on target!

Jim [Dorn, Cato Institute, Washington DC]



Thanks for this.  Feldstein had a piece in the WSJ or FT yesterday giving a more pessimistic scenario about in inflation, and Volcker and Don Kohn got into a public verbal argument about it.

RWR [Richard Rahn, Great Falls VA]


Dear Warren’

Many thanks for the insight. It was very helpful to me. I hope you are doing well….


Tolga [Sobaci, Istanbul, Turkey]


Hi Warren,

Very interesting article.

I hope I’m clever enough to buy long bonds when rates are way up, as they probably will  be at some point over the next 10 years…   if  we had bought 30-yr. bonds in Sept. or Oct. 1981, we’d still today be earning 15% per annum, that’d be wonderful!

Writing one’s congressman may not be enough, there may simply be too many powerful constituencies in favor (maybe without openly expressing it) of a sharp burst of debt-reducing inflation, or in favor of sustained not-extreme but not-so-moderate inflation (+5% per annum).

I do – sort of – remember the late 70s & early 80s, I was 10-15 yrs. old during that period. I remember going to Europe in 6th grade, my dad took me over for about three weeks, that must have been around 1979, and the dollar had recently reached a postwar low, I  remember how grumpy my dad was when I’d ask for walking-around money in London, hahaha and with 2,000 Ital. lira equaling a dollar, even at that tender (but no longer virginal) age, I somehow instinctively understood that this "goofy" exchange rate reflected past inflation, that the Italians hadn’t started out with a currency worth a tenth or a twentieth of a penny.   

Anyway, welcome back from Jordan.

Wolfie [Ernest McCall, Istanbul/Washington DC]


Thanks Warren – a fantastic note! This is exactly what we are currently studying in my International Economics course (whether Fiscal policy has an effect on Monetary policy).

Hope all is well!



Alex Seleznyov

Georgetown University

McDonough School of Business class of 2010

[Almaty, Kazakhstan]


Dear Warren,

Speaking of future inflation, have you read Greg Mankiw’s crazy article in Sunday’s New York Times ("Maybe the Fed Should Go Negative", NYTimes, April 19, 2009:  http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1). 

After reading it, I was reminded of Lord Acton’s statement, "There is no error so monstrous that it fails to find defenders among the ablest men."

Basically Mankiw advocates a partial (10%) repudiation of Federal Reserve Notes in a desperate effort to get the public to buy Treasuries that pay negative interest rates.  He believes this extreme measure is necessary to jump start the economy and reignite inflation, his ultimate goal.  Each year he would have the Treasury choose a random 10% of all banknotes and repudiate their legal tender status as a way to encourage people to buy T-bills that pay less at maturity.  

That’s got to be one of the most dangerous policy ideas since Keynes endorsed Silvio Gesell’s "stamped" money idea and "zero money rate of interest" …Keynes himself labeled Gesell a "crank" (General Theory, pp. 353-57).  If enacted, Mankiw’s dollar repudiation idea would surely panic the public into withdrawing billions from bank accounts and into gold. 

With hair-brained schemes like this one, I can see why the country is losing faith in its government and economics profession.  And this is coming from the #1 econ textbook writer! 

It’s highly doubtful the Treasury would adopt Mankiw’s crazy idea, but it won’t enhance Mankiw’s reputation as a sound thinker. 

I’ve known Greg for many years and have told him that he’s making a serious blunder that will come back to haunt him. 

BTW, in the same New York Times yesterday, they had a sample AP exam in econ.  Amazingly, I got a "5" point scale ("extremely well qualified").  You can take the quiz online by going to:  http://www.nytimes.com/interactive/2009/04/19/education/edlife/20090419EdlifeQuiz.html?scp=1&sq=economics%202009%20ap&st=cse

Best wishes, AEIOU,

Mark [Skousen, NY]

Is There Inflation Ahead?

In reaction to the financial and credit crisis that seized American and international financial markets last September, the Federal Reserve has pumped enormous quantities of credit into the market in an effort to unblock clogged credit flows. The Fed creates this credit out of thin air, or as Fed Chairman Bernanke put it, it is printing money. Knowing that inflation is ultimately the result of the central bank (the Federal Reserve) printing too much money, many people are concerned that the Federal Reserve’s recent and current policies doom the U.S. and the dollar to serious inflation in the next few years. This note reviews the historical relationship between the growth in the money supply and prices (inflation) and the recent behavior of the money supply, and presents my assessment of the prospects for inflation over the next few years.


The simplest analytical framework for understanding inflation is the quantity theory of money. This framework may be presented in two different ways. As economists prefer to think of price determination in terms of supply and demand, our preferred formulation of the theory says that the value (purchasing power) of money (“the price level” P) results from its supply (M) relative to its demand and that (as the simplest assumption) its demand is proportional (k) to real output (real GDP–q) or M = kqP. An increase in the supply of money (M) will cause prices to raise (P) until the demand for money (kqP) matches the increase in its supply. Both theory and evidence says that the money supply has no long run effect on real output (q), thus ultimately the entire effect of money growth is on the price level (CPI).


Thus inflation (which is the rate of change or growth rate of the price level) reflects the growth rate of the money supply or ΔM = Δq + ΔP (where k is constant, q is independently determined by growth in labor, capital and productivity, and Δ is the change from one period to the next in whatever it refers to). Hence inflation is determined by the economy’s real economic growth rate and the growth rate of the money supply:

ΔP = ΔM – Δq.[1] If the economy is growing at 3% per year and the money supply is growing at 5% per year, inflation will be approximately 2% per year. However, historical evidence reveals a lag of one to two years between changes in money growth rates and inflation. If money growth increases to say 10%, the impact on inflation would not materialize for another one to two years.


Instead of the demand for money formulation described above, the quantity theory of money is sometime presented in term of money’s velocity of circulation (V): MV = Pq. The two versions are equivalent (V = 1/k). The key point is that with a lag of a year or two increases in the rate of growth of the money supply cause a comparable increase in inflation.


These are long run relationships. In the short run other factors can dominate the behavior of inflation. In the long run a reduction in the economy’s growth rate (Δq) increases the inflation rate resulting from a given rate of growth of the money supply. However, in the short run if real income growth slows or even falls (with no change in its long run potential growth rate) it has the opposite effect on inflation. Economists refer to this as the output gap (between real output and potential or full employment output). When actual output falls below its potential, as occurs during recessions, inflation is reduced for a given rate of growth in the money supply (the demand for money—k—increases temporarily).


Our central bank–the system of Federal Reserve Banks–indirectly controls the money supply (currency held by the public and the public’s deposits with banks) and its rate of growth. There is a link between the money created by the Fed (called base money) and the broader money supply (M). The two are related by the so called the “money multiplier.” Usually the money supply grows at about the same rate as base money.


With these ideas in mind the huge injection of liquidity by the Fed is worrying many people. The Fed has increased base money as a result of large loans to banks and other financial institutions and as the result of buying government securities and mortgage backed securities from the market. By two measures the increase has been huge. Total Federal Reserve Credit has more than doubled over the last year from 0.90 trillion dollars on April 11, 2008 to 2.15 trillion on April 15, this year. Almost all of that increase occurred since September. As a result, base money almost doubled over the same period, rising from 874 billion Sept 10, 2008 to 1,726 billion March 25th of this year.


The Federal Reserve argues that this will not cause inflation for two reasons. First, the large increase in the provision of Federal Reserve Credit and base money was undertaken because of a large increase in the demand for liquidity by banks and other financial institutions in response to the subprime mortgage crisis. Thus doubling base money has not increased the money supply by nearly as much. Using a popular, relatively broad definition of money (MZM), the money supply rose from 8.6 trillion on April 7 2008 to 9.4 trillion on April 6, 2009. Stated in terms of growth rates, which can be directly related to inflation rates, the growth in MZM over the past year (year on year) was 9.7%. This is already significantly reduced from the year on year increase of 14.5% on January 19th of this year and only modestly above the 8.7% average annual rate of growth over the decade ending December 2008 during which inflation averaged 3.0% (the demand for money, k, grew about 2% per year on average over this period).


Secondly, the Fed estimates that over the past year the public’s demand for money has increased temporarily as the public “moved to safety” in the holding of its assets (currency and insured bank deposits). An increase in money demand (k) or equivalently a decrease in its velocity of circulation (V) means that the supply of money can grow more rapidly to that extent without increasing inflation. In addition, the recession with its increasing “output gap” further reduces inflation (temporarily).


Finally, the Fed intends to withdraw the extra liquidity it has injected (and thus reduce base money) as the credit crunch eases and the economy begins to recover. It remains committed to its target for inflation of around 2%. Thus the answer to the question of whether Fed policy will produce inflation in a year or two depends primarily on whether it successfully withdraws the large amounts of liquidity injected over the past six months. I have confidence that it will be able to do so more or less (but not exactly) at the right time and pace.


The real risk of inflation, however, is political. The Federal budget has unfunded liabilities (the difference between the cost of the benefits promised and the revenue now legislated to pay for them) that simply cannot be paid for. The Federal budget deficit expected over the next three or four years as a result of the financial crisis, recession and foreign wars of several trillion dollars is nothing compared to the present value of the government’s unfunded obligations to pay out Social Security benefits of about 13 trillion dollars. The present value of unfunded liabilities of Medicare commitments’ is six time (yes six times) that. It is not possible to raise taxes enough to cover these commitments. Promised benefits will have to be cut. Invariably tax rates will be raised as well and the slowing of economic growth resulting from all this will make the burden of these deficits even harder to carry. In addition, the rest of the world will not continue to finance as much of our annual deficits (and thus to own as much of the outstanding debt) as they have in the past, i.e. the market will force our external trade deficits to contract.


All of this adds up to higher, potentially significantly higher, interest rates in the years ahead (once we have recovered from the current recession) to enable the government to raise the money needed (sell its bonds) to finance its revenue shortfalls. Just how high interest rates will raise will depend on how much government spending can be cut and future entitlement promises reduced, how efficient and productive the economy will be and thus how high its growth rate will be, and how large a trade deficit the rest of the world lets us have.


“Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road.”[2] The short run effect of monetary growth is the opposition of its long run effect. Increasing the Fed’s creation of money initially pushes down interest rates as it buys more government securities or increases its lending to banks. However, as the higher money growth rate increases inflation, higher expected inflation gets build into new borrowing and lending interest rates pushing rates up eventually.


Current monetary policy does not need to result in higher inflation down the road. But the higher interest rates we are in for risk generating misguided political pressure on the Fed to try to keep them low. If the Federal Reserve gives in to the pressure, inflation will be higher and as soon as the economy comes to expect that higher inflation nominal interest rates will end up being even higher still. Try to remember the inflation and high interest rates of the 1970s through 1981 and tell your congressman to resist the inflation solution.

[1] This is a simplification of the following ΔP/P = ΔM/M – Δk/k – Δq/q, more correctly reflects the percentage rate of change of each variable.


[2] Richard W. Fisher (President of the Federal Reserve Bank of Dallas), "Storms on the Horizon",  Remarks before the Commonwealth Club of California, San Francisco, California,  May 28, 2008.

What are SDRs?

The very large increase in world trade (globalization) over the last four decades has enormously reduced poverty and raised living standards for very large numbers of people. Government policies in the U.S., China and elsewhere have produced large, unsustainable trade imbalances (mismatch of imports and exports). Free trade on its own would not produces such imbalances.  New Global Studies has just published my article “Time for a New Global Currency?” http://www.bepress.com/ngs/vol3/iss1/art5. The article explains what the IMF’s Special Drawing Rights (SDRs) are following the G 20s recommendation that the IMF allocate an additional 250 billion dollars worth of them, and how they might facilitate achieving and maintaining better global balance.

Time for a New Global Currency?



The U.S. dollar is the world’s primary international reserve currency. Most international payments are made in dollars, many globally traded commodities (such as oil) are priced in dollars, and almost two thirds of the world’s official (government owned) foreign exchange reserves of 6.7 trillion dollars are held in dollars. The only other important currency in foreign exchange reserves is the Euro with 27% of the total.


When central banks want to increase the size of their foreign exchange reserves (as most did after the Asian financial crisis in the late 1990s) they will largely want to do so in dollars and this will result in (only be possible from) larger than otherwise U.S. trade deficits. The U.S. trade deficit is the means by which the rest of the world accumulates the dollars it wants. This arrangement and the global imbalances it sometime promotes has long been a source of concern.


Both the Governor of the Peoples Bank of China (China’s central bank) and the President of Russia have recently called for the ultimate replacement of the U.S. dollar as the world’s reserve currency with one issued by the IMF (the Special Drawing Right—SDR).[2],[3]  The SDR was created in 1969, just before the collapse of the Bretton Woods international currency system, precisely for this purpose. With the abandonment of the gold exchange standard and the floating of the dollars exchange rate in 1971, the need for SDRs became less pressing. The G20 heads of state meeting in London in early April called for an additional $250 billion dollar allocation of SDRs, almost an eight fold increase over the current stock of $32 billion.

Special Drawing Rights


Most people have forgotten what SDR’s are (if they ever knew). Like dollars or any other currency, the SDR is both a unit of account and a means of payment. The value of the SDR was originally defined as the market value of 0.888671 grams of fine gold, which in 1969 was equal to one U.S. dollar. Currently one SDR is the market value of a basket of 0.632 U.S. dollars, 0.41 Euros, 18.4 Japanese yen, and 0.0903 Pound sterling. At the time the current basket was adopted (January 1, 2006—its valuation basket or method of valuation is reviewed and adjusted every five years) these amounts reflected weights of 44 % for the U.S. dollar, 34% for the euro, and 11% each for the Japanese yen and pound sterling. Over time these weights vary with the exchange rates of the fixed currency amounts in the basket. The U.S. dollar values of the amounts of each currency in the valuation basket are determined in the market each day and added up to determined that day’s value of the SDR (see the table below).


All of the IMF’s financial activities, in particular its loans, are valued in SDRs. These SDR denominated loans are not SDRs proper any more than U.S. Treasury bonds are U.S. dollars proper. The SDR amount of credit due to the IMF varies over time as its lending activity varies. IMF loans are actually disbursed to borrowing central bank largely in member currencies (primarily U.S. dollars), but the obligations are denominated in SDRs.


Friday, April 03, 2009


Currency amount under Rule O-1

Exchange rate 1

U.S. dollar equivalent

Percent change in exchange rate against U.S. dollar from previous calculation






Japanese yen





Pound sterling





U.S. dollar







U.S.$1.00 = SDR

0.666621 2

-0.233 3

SDR1 = US$

1.50010 4






The exchange rate for the Japanese yen is expressed in terms of currency units per U.S. dollar; other rates are expressed as U.S. dollars per currency unit.



IMF Rule O-2(a) defines the value of the U.S. dollar in terms of the SDR as the reciprocal of the sum of the equivalents in U.S. dollars of the amounts of the currencies in the SDR basket, rounded to six significant digits. Each U.S. dollar equivalent is calculated on the basis of the middle rate between the buying and selling exchange rates at noon in the London market. If the exchange rate for any currency cannot be obtained from the London Market, the rate shall be the middle rate between the buying and selling exchange rates at noon in the New York market or, if not available there, the rate shall be determined on the basis of euro reference rates published by the European Central Bank.



Percent change in value of one U.S. dollar in terms of SDRs from previous calculation.



The reciprocal of the value of the U.S dollar in terms of the SDR, rounded to six significant digits.


Prepared by the IMF Finance Department



What we might call the SDR proper, the SDR denominated reserve asset allocated by the IMF—the SDR the Governor of the Peoples Bank of China was referring to, has played a very limited role to date. The IMF has only issued SDR 21.433 billion of them (the equivalent of about 32 billion U.S. dollars at current exchange rates). For perspective, this might be compared with the amount of credit directly created by the Federal Reserve (Federal Reserve Credit) of about $2 trillion dollars or the 250 billion U.S. dollar allocation (as the creation of SDRs is called) proposed by the G20. The new allocation, by raising the stock of SDRs from 21.4 billion to $271.4 billion, will provide a very big boost to the SDR.


An SDR allocation is similar to a line of credit. The 250 billion in new SDRs will be “allocated” to IMF members in proportion to their quotas in the IMF, which roughly reflect their economic size and importance in world trade. Bulgaria, for example, with a quota currently of 640.2 million SDRs, which is 0.29% of the total (financial) size of the IMF, would receive an allocation of 725 million SDRs (250 billion times 0.29%). These will be credited to Bulgaria’s SDR account with the IMF as additional SDRs owned and held by Bulgaria. At the same time Bulgaria’s SDR account with the IMF will record a liability for the same amount. Bulgaria will earn interest at the SDR interest rate on what ever SDRs it holds[4] and must pay interest at the same rate on its SDR liabilities. If it continues to hold the SDRs it was allocated, Bulgaria will earn the same interest income that it pays on its allocation.[5] In short, if it does not use any of its SDRs and does not acquire additional ones in payments from other IMF members or other holders or buy them, its interest income on its SDR holdings and payments on its net cumulative allocations will be equal and will thus cancel out. Bulgaria will enjoy larger foreign exchange reserves at no cost (but with no net interest return). If Bulgaria uses 100 million of its SDRs, its interest income will fall by that amount times the SDR interest rate, but its charges for its net cumulative allocation will remain unchanged (other than from changes in the SDR interest rate). In short, Bulgaria would then have a net charge to the extent of its use of its SDRs. This is the sense in which an SDR allocation is like a line of credit (without the commitment charge or risk of cancelation). Conversely, if Bulgaria acquires additional SDRs from other central banks so that its holdings of SDRs exceed its net cumulative allocation, it will enjoy net income to that extent at the SDR interest rate.


If the demand for SDRs equals or exceeds their supply, countries could use their SDRs directly. The Chinas of the world, with foreign exchange reserves of $2 trillion (mostly in U.S. dollars), would be happy to accept and hold them in payment for another country’s financial obligations or to buy them (rather than dollars) for dollars that the selling country could use to settle obligations with someone else unable or unwilling to accept SDRs. For the past twenty five years virtually all SDRs have been used in this way. Most countries using their SDRs first converted them into dollars by selling them for dollars to another central bank in so called “Transactions by Agreement.” However, the system also has a mechanism, so called “Transactions with Designation,” by which countries with a strong balance of payments can be designated to buy SDRs for dollars, or Euros (or another freely useable currency) when a holder wishing to sell them for currency cannot find a buyer in a Transaction by Agreement. With the huge allocation now being proposed, it is likely that some users will again need to resort to this obligatory purchase requirement for a while.


Global imbalances


Twenty years ago as the Berlin Wall came tumbling down the United States imported $580 billion worth of goods and services from the rest of the world (1989). This was about 11% of U.S. domestic production (GDP). The U.S. paid for most of that by exporting $487 billion worth of goods and services. The shortfall (trade deficit) of $93 billion was more than paid for by the net income received by American’s from their investments abroad. This modest trade deficit of 1.7% of GDP rose to an unsustainable 5.7% of GDP by 2006. The gradual depreciation of America’s overvalued dollar over the last few years has begun to correct this global imbalance and this last year (2008) saw a reduction in the U.S. trade deficit to the still very high level of 4.7% of GDP. Though American imports continued to grow (to almost 18% of GDP in 2008), its exports grew more rapidly over the last few years thus replacing some of the lost consumer spending as households starting to pay off excessive debt and to rebuild their savings. This desirable correction has been temporarily interrupted by a global recession and creeping protectionism in the U.S. and elsewhere.


These large global imbalances contributed significantly to the U.S. housing bubble and the financial crisis it created. Large U.S. trade deficits (the U.S. imported much more than it paid for with exports) financed largely by Chinese and Japanese trade surpluses invested in the U.S. (largely U.S. Treasury bills and bonds) kept interest rates in the U.S. low despite large U.S. government deficits and very low household savings rates. Excessive borrowing and housing demand in the U.S. resulted.


The rapid increase in world wide trade (globalization) over the last several decades benefited American consumers and workers world wide (including in the U.S. where unemployment reached historically low levels). But U.S. trade imbalances (the mismatch between imports and exports and the balancing capital flows to the U.S.) reached unsustainable levels and will have to contract. There are limits to the number of U.S Treasury bills the Peoples Bank of China is willing to hold (it still continues to add to that number but at a slower rate). There is also a limit to the amount of debt the U.S. Treasury can service (pay interest on) and financial markets have already begun to reflect a higher (though still low) probability of U.S. default on its huge and rapidly growing public debt.


The lowering of tariffs and other trade barriers (e.g. transportation costs) permitted this rapid growth in trade, which doubled the incomes of a third of the world’s population, something aid could never have accomplished. Why then didn’t markets operate to limit trade imbalances to sustainable levels? The failure reflects the failure of government policies in China and the U.S. and elsewhere to play by the rules of international finance and the accumulation of the U.S. dollar in international reserve holdings made this failure easier.


When a country buys more from the rest of the world (imports) than it sells to the rest of the world (exports), it must borrow from the rest of the world to pay the difference (or use its reserves of foreign currencies). If the rest of the world is not eager to lend or otherwise invest in the borrowing deficit country, exchange rates will adjust in international currency markets (or the “real exchange rate” will adjust via domestic inflation or deflation). The simple market reality is that consumers tend to buy where they get the best deal (price and quality mix). When comparing a product of comparable quality produced in China verses the same product produced in Indiana, the price to an American is the dollar cost of producing it in and shipping it from Indiana or the Chinese Renminbi cost of producing it in and shipping it from China times the exchange rate between the Renminbi and dollar. The exchange rate plays a critical role in determining the cost of American exports to the Chinese or of Chinese imports to Americans. Thus the statement that Chinese labor is cheap so of course they can sell it to Americans cheaper, is half (the exchange rate half) meaningless and totally wrong.


The rule of international finance with regard to exchange rates is that governments should not interfere with this price (exchange rate) adjustment process. The market process for maintaining the desired external balance can be illustrated with examples from two opposite exchange rate regimes. The gold standard, the most recent and most important global currency and a the time tested example of a fixed exchange rate regime, and a freely floating (market determined) exchange rate with a domestic inflation or monetary aggregate target.


If two countries (or the whole world) are on the gold standard, the exchange rate of their currencies for each other are determined and fixed by the prices (exchange rates) of each of their currencies for gold. The rules of a pure gold standard, like those of modern currency boards (e.g. Bosnia, Bulgaria, and Estonia), require that the monetary authority passively provides its currency for gold (at the officially fixed price of gold) or gold for its currency (buying it back) as demanded by the market. With open and free trade, this system insures that the market produces and maintains balanced trade between these two countries (or the whole world). Balanced trade here mains a trade surplus or deficit (exports minus imports) just sufficient to satisfy the net desire of residents to invest abroad (investment abroad minus foreign investment at home). Let’s leave this complication aside and assume that markets desire on net to invest in their own countries so that market forces produce a balance between imports and exports and let’s stick with the example of the U.S. and China representing the rest of the world. How does the gold standard produce balanced trade?


The mechanism can be most easily explained be starting with a balanced situation (equilibrium) and introducing a disturbance. If the value of American exports to China equals the value of America’s imports from China at the fixed exchange rate between their currencies (via the gold prices of each), the sudden discovery of oil in China (or an increase in the price of oil where the U.S. is an oil importer) would raise the value of American imports from China. This introduces an imbalance in their trading relationship (an American trade deficit). The U.S. is no longer able to pay for all of its imports with exports. If must pay for the more expensive oil with gold (any dollars sold by American importers for Renminbi that are not wanted by Chinese importers to pay for their imports will be sold to the American central bank for gold). This outflow of gold from the U.S. reduces the money supply in the U.S., which lowers the average price level in terms of dollars (the value of dollars and gold are increased relative to American goods and services). This process makes Chinese goods relatively more expensive to American’s, who will thus import less and American goods relatively cheaper to Chinese, who will thus buy more of them. Gold flows out and the U.S. money supply and dollar prices of American goods and services fall until balance is restored between imports and exports (with the higher price of oil).  No unsustainable global imbalance is possible (other than temporarily while the “real” exchange adjusts as described above) as long as neither country’s central bank interferes with this process.


Taking the same example of an oil price increase, but with a freely floating, market determined exchange rate, the adjustment in the real exchange rate that the market demands takes place via a depreciation in the nominal exchange rate of the dollar for the Renminbi (i.e. an appreciation of the Renminbi). In this case the surplus of dollars in the foreign exchange market described above cannot be sold to the American central bank as was the case with the gold standard. As a result the excess supply in the foreign exchange market drives down the price of the dollar relative to the Renminbi. Under both regimes the real exchange rate adjusts as required to restore trade balance. An unsustainable global imbalance is not possible unless one or the other central banks intervenes in the process.


Normally to import a country must sell its currency in the foreign exchange market for the currency of the country whose goods and services it wants to buy. Similarly when some of its companies export they will only accept payment in their own currency, which requires the country buying them to sell its currency in the foreign exchange market for the currency of the exporter. The U.S. is unique in this regard because it issues the reserve currency of the system. Other countries will accept and sometime hold dollars when they sell their goods and services to the U.S. or to other countries. If they do not use these dollars to import (from the U.S. or other countries) they will invest them in the U.S. buying U.S. securities (often government securities), U.S. companies or shares in companies or even real estate.


The U.S. and China (to continue with our two country example) have interfered in the market’s natural equilibrating tendency in two ways. China has not wanted to let its currency appreciate against the dollar because its rapid growth is largely driven by exporting (foreign demand) and an appreciation would reduce foreign demand for Chinese exports. Thus the Peoples Bank of China (its central bank) intervened in the foreign exchange market to buy up the excess dollars resulting from China’s trade surplus in order to keep the exchange rate of its currency constant (or to slow its appreciation). When the Peoples Bank buys dollars it does so with its own currency. Under the rules of the game, if the Peoples Bank wants to peg its nominal exchange rate it must allow the increase in the supply of Renminbi in China and the Renminbi inflation it would cause when it buys dollars in the foreign exchange market. However, the People’s bank has resisted this alternative means of appreciating the real exchange rate of its currency through what economists call sterilized intervention. The Peoples Bank prevents the increase in its money supply caused when it buys dollars by buying the Renminbi back through the use of other central bank policy instruments (such as selling Chinese government securities and retiring the Renminbi received for them)—hence the term “sterilized” intervention.


The U.S. for its part has kept interest rates higher than they otherwise would be by running large fiscal deficits and as a result of very low private sector savings rates. Such rates encourage China and other countries to invest more in the U.S. than they otherwise would. China points attention to this U.S. pull of foreign investments into the U.S. The U.S. points to the Peoples Bank’s sterilized intervention and undervalued exchange rate as pushing investment into the U.S. of its resulting increase in foreign exchange reserves. The fact that China’s exchange rate policy has resulted in rapid and large increases in its foreign exchange reserves (U.S. dollars) has pushed so much into U.S. investments that U.S. interest rates remained low despite low savings rates and fiscal deficits.[6]


A Future for the SDR?


In the above examples, if the SDR replaced the U.S. dollar as the international reserve asset, any dollars purchased by the Peoples Bank to preserve its nominal exchange rate (as in the gold standard example) would be sold to the U.S. for SDRs. It would hold SDRs rather than dollars in its reserves. The U.S. could no longer print dollars (issue Treasury securities) to satisfy China’s demand for reserves. If its holdings (reserves) of SDR’s ran short, it would need to allow the upward pressure on its interest rates in order to increase capital inflows to provide it with the SDR’s demanded by China. The market adjustment mechanism would work as described above.[7] It would be more difficult for the U.S. to undermine the global balance adjustment mechanism as it does now.


The key advantages of the SDR over the U.S. dollar (or any reserve currency issued by a national central bank) are that its value is more stable relative to currencies in general (being a currency basket)[8], its supply is determined by collective decision of the IMF’s member countries, it is added to each countries’ reserves (to the extend of each countries allocation) without cost (now countries must sell their goods and services to acquire additional net foreign reserves), and the global supply can be increased without the need for a current account (or trade) deficit by the issuing country. These are formidable advantages.


Getting from here to there will take more than additional allocations of SDRs, though that will be part of the evolution. Most central bank reserve transactions are not with other central banks. They are with the market. The Peoples Bank of China buys dollars in the foreign exchange market (i.e. from banks and other foreign exchange dealers) and uses them to buy U.S. government securities in American markets (not from the U.S. Treasury directly). Thus the acceptance and growth of the “official” SDR (those allocated to central banks by the IMF), will require the development of private ones (private SDR denominated financial instruments) and mechanisms for linkages between the private and the official ones.[9] This was the path followed by the Euro (and its predecessor the Ecu).[10]


The extent to which the world chooses to hold and deal in SDRs rather than dollars will reflect the extent to which individuals and governments are more confident in the valuation of the SDR than the dollar or other possible units and the convenience (cost) of dealing in the asset. The world has changed its reserve currencies from time to time to align with the dominant economic power of the time, but such changes have always been gradual. If the SDR catches on, its displacement of the dollar would also be gradual, taking place over many years of growing use.


An important advantage of an international currency like the SDR emphasized by People’s Bank Governor Xiaochuan is that the U.S. would be subject to much stronger market pressure (in the form of exchange rate adjustments) that would maintain better balance between imports and exports than is now the case. The U.S. would also face far less risk of the central banks of the world losing confidence in the dollar and sharply reducing their willingness to hold them. As the SDR does not and is not likely ever to exist in currency form, the U.S., and increasingly the E.U. are likely to continue to enjoy the seniorage profits from selling their currency to the citizens of rest of the world.




Warren Coats, "The SDR as a Means of Payment," IMF Staff Papers, Vol. 29, No. 3 (September 1982) (reprinted in Spanish in Centro de Estudios Monetarios Latinoamericanos Boletin, Vol. XXIX, Numero 4, Julio–Agosto de 1983).

            "SDRs and their Role in the International Financial System," International Banking and Global Financing, proceedings of a Conference held at Pace University, New York City, May 1983.

            With William J. Byrne, "The Special Drawing Right:  Composite Currencies: SDR, ECU, and Other Instruments," Euromoney, 1984.

            With Jacob Gons, Thomas Leddy, and Pierre van den Boogaerde, "A Comparative Analysis of the Functions of the ECU and the SDR," in The Role of the SDR in the International Monetary System, Occasional Paper No. 51 (Washington, D.C., IMF) (March 1987).

            "Enhancing the Attractiveness of the SDR," World Development, Vol. 18, No. 7 (July 1990).

            With Reinhard W. Furstenberg and Peter Isard, "The Use of the SDR System and the Issue of Resource Transfers?," Essays in International Economics, International Finance Section, Department of Economics, Princeton University, No. 180 (Dec. 1990).

            "Developing a Market for the Official SDR," Current Legal Issues Affecting Central Banks, Volume 1, International Monetary Fund (Washington, D.C.) May 1992.

            "In Search of a Monetary Anchor: Commodity Standards Reexamined," in Framework for Monetary Stability, ed. by T. J. Baliño and C. Cottarelli , (Washington: International Monetary Fund, 1994).

Dmitry A. Medvedev, "Building Russian–U.S. Bonds" The Washington Post, March 31, 2009, Page A17.

Zhou Xiaochuan, "Reform the International Monetary System", Website of the Peoples Bank of China, March 23, 2009.



[1] I was Chief of the SDR division of the Finance Department of the IMF from 1982 – 1986.

[2] Zhou Xiaochuan, "Reform the International Monetary System", Website of the Peoples Bank of China, March 23, 2009.

[3] Dmitry A. Medvedev, "Building Russian–U.S. Bonds" The Washington Post, March 31, 2009, Page A17.

[4] The SDR interest rate is also determined daily on the basis of three month government securities with the same weights as the currency basket.

[5] Each new allocation is added to all previous ones and the total is called the “net cumulative allocation.”

[6] I have often wondered whether those politicians demanding an appreciation of the Renminbi realized that it would raise interest rates in the U.S. when the Peoples Bank no longer had such large foreign exchange reserves to invest in the U.S..

[7] This describes a relative imbalance rather than a global shortage of reserves. If as now the world were in recession or suffering a global shortage of reserves (which would otherwise require a global deflation to overcome) the IMF’s members could authorize a further allocation of SDRs as the G20 has just recommended.

[8] The SDR’s value could also be fixed to gold, as it was initially, or to baskets of commodities or goods and services. See Coats, 1994.

[9] Coats, 1990.

[10] Coats, Gons, Leddy, and van den Boogaerde, 1987.

Relaxing Bank Accounting Standards—A Big Mistake

“The board that sets U.S. accounting rules voted yesterday to let financial firms report higher values for some troubled assets, a controversial step likely to increase some banks’ reported earnings but also heighten suspicions that the companies are concealing problems.”[1] The vote Thursday by the Financial Accounting Standards Board (FASB) is a very bad development for several reasons.

1. The FASB caved in to very ill advised pressure from Congress to rush through this dilution of accounting standards, thus undermining the independence and professionalism of the Board.

2. While we don’t know the details, because the new ruling has not actually been written yet, a key lesson from Japan’s lost decade and every other major banking crisis of the last century is that denying or hiding bank losses is a big mistake. “This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle. To break this cycle, the government must force the banks to acknowledge the scale of their problems.”[2] Thus the FASB’s ruling is a step backward. It will undermine market confidence in banks further and make the resolution of the problem harder and slower.

3. If banks can record higher values for some of their assets (especially mortgages and Mortgage Banks Securities) it is much less likely that they will sell them to other investors under the Treasury’s new toxic asset purchase scheme, because they will then need to value them at the actual (lower) sale price. When assets are actually sold, mark to market accounting will still apply. One arm of government is undercutting the policies of another.

Arthur Levitt, a former chairman of the SEC said, "I was very disappointed in the process in that the independent agency buckled to the strong-armed tactics of Congress, This is a step toward the kind of opaqueness that created the economic problems that we’re enduring today."[3] “If investors believe banks are overpricing assets, "the capital markets will remain closed to major banks and other financial intermediaries for an extended period of time," the CFA Institute, an investor advisory organization, said in an analysis. The group, which opposed the change, said "investors will not be willing to commit capital to firms that hide the economic value of their assets and liabilities."[4]

This is a potentially dangerous mistake.

[1] Binyamin Appelbaum and Zachary A. Goldfarb, "Under New Accounting Rules, Toxic Assets May be Revalued", The Washington Post, April 3, 2009, Page A15.

[2] Simon Johnson, "The Quiet Coup–The Way Out", The Atlantic, May 2009.

[3] Op. cit., Appelbaum and Goldfard.

[4] Ibid.