Federal Reserve and Monetary Policy: In the movie “Sky Captain and the World of Tomorrow”, an alternate universe was depicted

In the movie “Sky Captain and the World of Tomorrow”, an alternate universe was depicted.

In that alternate universe, there was no WWII. One can use writer's liberties and add another chapter to that saga. In the new chapter, WWII is a fight between currencies.

“Our story begins at the conference table of the European Union Summit. The proposal was simple in thought, yet complex in action. The proposal would allow EU member nations to loosen their fiscal restrains. This simple action would go down in history as the “shot” that started World War II”.

Western Europe has the same structural problem as the US. The US favorite off-shore destinations are China, India and other Asia countries that has cheap labor to offer. Western Europe's off-shore destinations are Eastern Europe, Russia, and other former Soviet backed Warsaw pact nations. Fiscal responsibility meant that Western Europe was not willing to go into multi-trillion dollar debt. However, all has now changed. Economist, in the US, were urging their counterparts to persuade their elected officials to do “what it takes” to get Western Europe's economies growing.

There are 2 scenarios;
1)The invested money is poured directly into Western Europe's labor market. This is a dollar positive scenario. Western Europe grows, which in turn will allow more US exports to be sold. US's current account deficit shrinks. More revenue is generated by US workers, which into turn shrinks the US government debt.
2) The invested money winds up in the hands of Western Europe's off-shoring countries. There will be no real economic growth in this scenario. This is dollar negative.

The investment would most likely come from Asia, whose central banks has stated that they will divest their US dollar holdings. All of these scenarios will put upward pressure on commodity prices.

It really doesn't matter which scenario comes true, the US economy will go into recession. International markets are floating in an “ocean” of US dollars. The Federal Reserve's action of increasing fed funds rate will not drain the “ocean” of dollars. The problem with the US economy is “structural”. The reason behind the weak dollar is due to the negative productivity gap. See box 1 of the paper: To What Extent Does Productivity Drive the Dollar?

The Federal Reserve has only 2 rational options. The Fed can raise the reserve requirement of the banks. The Fed can drain the money out of the system by open market action.

It is really up to the US government to come up with a plan that will shove 10's of million labors out of the new “tradable” sectors into the “non-tradable” sectors. A solid economic growth plan should includes environmental statues. In other words, force the compliance of US environmental law. This is not a draconian proposal. It is a proposal that has a fundamental economic law. Environmental equipment becomes a “tradable” product. Trade in environment equipment will reduce our cost of compliance. See any text book an the effects of trade on a product.

Also, drop the privatization of SS. Invest the surplus into Municipal Bonds. Start buying Municipal Bonds instead of US Treasuries. Muny Bonds have a higher interest rate, they rebuild US infrastructures, the money is kept in the US economy, they are safer than the equity market and there is no borrowing.

The US is in fact having trouble with its output. The US's “Real Output” has exposed the problems at GM and the Pension Guarantee Corporation. Municipal Bonds will help in this transitional phase.