Noah Millman worries that we can’t stimulate without fearing a foreign capital flight

If the Fed set out to convince the markets that he was actively trying to produce at least 3% inflation, and would not act to reduce inflation until domestic economic conditions were significantly improved, why wouldn’t China shift its portfolio out of Treasuries and into Euros; why wouldn’t investors, domestic and foreign, shift investment out of the U.S. and into jurisdictions that are either producing higher returns without accelerating inflation (such as some emerging markets) or that are still committed to aggressive disinflation (such as the Euro zone)? Quite apart from the direct negative effect this capital flight would have on the American economy, the indirect effect would be to make it much more difficult to finance our high fiscal deficits. Monetary stimulus would then lead to fiscal contraction.

This is actually a channel for stimulus. These things can trip a lot of people up because we are dealing with demand-side issues when the basic problem facing humanity under normal circumstances are supply-side issues. So many things are backwards.

If that made no sense to you fine.

Here is the play-by-play.

Bernanke convinces the world he is raising inflation expectations. Suddenly, dollars don’t look so good anymore. As an investor I move money into Euros.

However, to do this I must sell dollars and buy Euros. Doing so drives down the price of the dollar and up the price of Euros.

Now, as an investor I have my Euro denominated bond. What happens in America?

In America, I pulled out of the Treasury market. However, that is fine because there are tons of bank reserves sitting on the shelf to jump into the Treasury market. Nominal interest rates don’t move.

However, the dollar has fallen. This will make imports from Europe more expensive. No more 5-series BMWs 😦

However, it will make American made goods relatively cheaper for Americans. More 3-series BMWs 🙂 [They are made in South Carolina]

It also means that US goods are cheaper abroad – Woo! hoo! America sells more corn and 737s baby. 🙂

It also means that profits from American owned multinationals will look bigger in dollar terms to America investors. Go S&P 500!

Unfortunately it also means that oil will be relatively more expensive. High gas prices, boo** 😦

The dollar change in-and-of-itself* will lower US consumption. However, it will raise the demand for US products. That’s because a higher fraction of consumption will be American and foreigners will want to buy more American goods.

Thus even though the cheaper dollar means American get fewer things the net effect is simulative because more of those things are made by otherwise unemployed Americans.


*In fact American consumption will probably rise, but that’s because unemployment will fall, cash constraints will loosen and spending will rise. However, that’s most easily thought of as the effect of the stimulus.

** Jim Hamilton worries a lot about higher gas prices. In some sense this could make households more cash-constrained, which is a concern because then they would lower overall spending in an effort to build up cash reserves. Intuitively, it doesn’t seem like this will overwhelm the other affects but I couldn’t guarantee it.