Are half a million hardworking Poles to blame for the UK real estate bubble?

The answer to the question of course is no, but let me tell the story anyway. It is a story about positive supply shocks, inflation targeting, relative inflation and bubbles.

In 2004 Poland joined the EU. That gave Poles the possibility to enter the UK labour market (and other EU labour markets). It is estimated that as much as half a million poles have come to work in the UK since 2004. The graph below shows the numbers of Poles employed in the UK economy (I stole the graph from Wikipedia)

Polish-born_people_in_employment_in_the_UK_2003-2010_-_chart_2369a_at_statistics_gov_uk

 

 

 

 

 

 

 

Effectively that has been a large positive supply shock to the UK economy. In a simple AS/AD model we can illustrate that as in the graph below.

Positive supply shock

The inflow of Polish workers pushes the AS curve to the right (from AS to AS’). As a result output increases from Y to Y’ and the price level drops to P’ from P.

Imagine that we to begin with is exactly at the Bank of England’s inflation target of 2%.

In this scenario a positive supply – half a million Polish workers – will push inflation below 2%.

As a strict inflation targeting central bank the BoE in response will ease monetary policy to push inflation back to the 2% inflation target.

We can illustrate that in an AS/AD graph as a shift in the AD curve to the right (for simplicity we here assume that the BoE targets the price level rather than inflation).

The BoE’s easing will keep that price level at P, but increase the output to Y” as the AD curve shifts to AD’. Note that that assumes that the long-run AS curve also have shifted – I have not illustrated that in the graphs.

Positive supply shock and demand shock

At this point the Austrian economist will wake up – because the BoE given it’s monetary easing in response to the positive supply shock is creating relative inflation.

Inflation targeting is distorting relative prices

If we just look at this in terms of the aggregate price level we miss an important point and that is what is happening to relative prices.

Hence, the Polish workers are mostly employed in service jobs. As a result the positive supply shock is the largest in the service sector. However, as the service sector prices fall the BoE will push up prices in all other sectors to ensure that the price level (or rather inflation) is unchanged. This for example causes property prices to increase.

This is what Austrian economists call relative inflation, but it also illustrates a key Market Monetarist critique of inflation targeting. Hence, inflation targeting will distort relative prices and in that sense inflation targeting is not a “neutral” monetary policy.

On the other hand had the BoE been targeting the nominal GDP level then it would have allowed the positive shock to lead to a permanent drop in prices (or lower inflation), while at the same time kept NGDP on track. Therefore, we can describe NGDP level targeting as a “neutral” monetary policy as it will not lead to a distortion of relative prices.

This is one of the key reasons why I again and again have described NGDP level targeting as the true free market alternative – as NGDP targeting is not distorting relative prices contrary to inflation targeting,which distorts relative prices and therefore also distorts the allocation of labour and capital. This is basically an Austrian style (unsustainable) boom that sooner or later leads to a bust.

So is this really the story about UK property prices?

It is important to stress that I don’t necessarily think that this is what happened in the UK property market. First, of all UK property prices seemed to have taken off a couple of years earlier than 2004 and I have really not studied the data close enough to claim that this is the real story. However, that is not really my point. Instead I am using this (quasi-hypothetical) example to illustrate that central bankers are much more likely to creating bubbles if they target inflation rather than the NGDP level and it is certainly the case that had the BoE had an NGDP level targeting (around for example a 5% trend path) then monetary policy would have been tighter during the “boom years” than was actually the case and hence the property market boom would likely have been much less extreme.

But again if anybody is to blame it is not the half million hardworking Poles in Britain, but rather the Bank of England’s overly easing monetary policy in the pre-crisis years.

PS I am a bit sloppy with the difference between changes in prices (inflation) and the price level above. Furthermore, I am not clear about whether we are talking about permanent or temporary supply shocks. That, however, do not change the conclusions and after all this is a blog post and not an academic article.

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My very short interview on NGDP targeting with Izabella Kaminska

Here is a link to my 40 second interview on NGDP targeting with FTAlphaville’s Izabella Kaminska.

Niklas Blanchard is blogging again

Our good friend and Market Monetarist Niklas Blanchard is blogging again. See his excellent new post on “What Does the Market Know that John Taylor Knows that the Market Knows?”

Scott Sumner also comments on John Taylor’s WSJ article – as do Marcus Nunes.

Banking, regulation and monetary policy failure – blog posts I didn’t write today

Today I participated in a very interesting conference organized by the Danish Institute for International Studies on Central Banking at a Crossroads: Europe and Beyond”.  So far the conference has been extremely good despite the fact that I disagreed with most of what I heard all day. I could write a long post on my reflections on today’s conference, but instead I will just give you the seven headline on papers or blog posts I would like to have written today. Here they are:

1) The Public Choice Theory of Banking Resolution

2) Why Bryan Caplan’s theory of rational irrationality will teach you that deposit insurance is counterproductive

3) Regulators as cheerleaders of the boom

4) Why Goodhart’s law is telling us that macroprudential indicators are useless

5) Why banking crisis is a result of monetary policy failure rather than market failure

6) Bank of Japan’s “dual mandate” – price stability and financial stability. The BoJ failed on both for 15 years.

7) Dodd-Frank and the Patriot act – a reflection of the same kind of regulatory irrationality.

I think you get the drift – I am not too impressed with the idea that the solution to today’s problems is more regulation. Today’s crisis is primarily a result of failed monetary policy rather too little regulation.

The ZLB – not the BoJ – should worry the BoK

The continued sharp weakening of the Japanese yen is beginning to worry policy makers (and commentators) in South East Asian and that is especially the case in South Korea. Just see this comment from Andy Mukherjee over at Reuters Breakingviews:

Japan’s weak yen policy could be South Korea’s biggest economic enemy this year. The strengthening won, which has risen 23 percent against the yen in the past six months, was partly to blame for the country’s anaemic GDP growth in the fourth quarter. It’s also putting the squeeze on manufacturers like Hyundai. Lower interest rates could help to ease the pressure.

An appreciating currency is a big dilemma for South Korea’s central bank. Investors are betting the Bank of Korea’s policy interest rate of 2.75 percent, which it last reduced in October, will remain unchanged as the incoming government of President Park Geun-hye boosts public spending in an attempt to revive growth.

But the wait-and-watch approach is risky because it could engender expectations that the central bank is not particularly worried about the country’s exports losing some of their price competitiveness.

With the likes of Hyundai and Samsung competing directly against Japan’s Honda and Sony, a cheaper yen will undermine the profitability of Korean exporters. The surprise 6 percent drop in Hyundai Motor Co’s net profit in the final quarter of 2012 underscores the risk. And now that the Bank of Japan has agreed to support Prime Minister Shinzo Abe’s plan by printing 13 trillion yen ($145 billion) in new money every month starting in January 2014, the yen could weaken further.

There is nothing wrong with Andy’s observations as such. It is obvious that Korean and Japanese eletronic and cars producers are major competitors in the global markets and Korean exporters are likely suffering relative to Japanese exporters. That said Andy’s comments smells of currency war-rhetoric, which always worries me.

In that regard I will make two observations. First, the aggressive change in monetary stance from the Bank of Japan is likely to give a major boost to the second (or third) largest economy in the world and is therefore likely to be good news for the global economy and particularly for the Asian economies. That certainly will help Korean exporters. Second – as I have argued in the case of Mexico – no country is forced to import monetary easing or tightening. Hence, the Bank of Korea (BoK) is completely free to conduct monetary policy in way to serve the interest of the Korean economy. If the BoK don’t like the strengthening of the won it can simply counteract it with monetary easing in the form of interest rate cuts, quantitative easing or intervention in the currency markets. Hence, in my view the BoK can alway “neutralize” any impact on the Korean economy from the strengthening of the won.

Disregarding “currency war” monetary easing is nonetheless warranted

The continued strengthening of the won obviously is a sign that Korean monetary conditions are tightening and judging from recent economic data the tightening of monetary conditions certainly is not welcomed news – rather monetary easing is warranted. However, the reason is not really the performane of Korean exports – in fact the Korean export performance has been quite strong in recent years and export growth actually remains fairly high. Contrary to this domestic demand has been slowing and especially investment growth is weak.

So once again I think it is useful to see the currency as an indicator of monetary policy “tightness” rather than a cause of the problems in itself. The strengthening of the won is a clear sign that Korean monetary conditions are getting tighter. But the worry is not really on the export side of the economy – even though I readily admit that Korean exporters are suffering at the moment – but the real worry is the slowing domestic demand. The graph below illustrates that.

korea exconsinv

Obviously central banks should  not concern themselves with the composition of growth , but that of course do not mean that the BoK should worry at all.

As Andy notes:

With inflation slowing to just 1.4 percent in December, much lower than the central bank’s target range of 2.5 percent to 3.5 percent, the monetary authority certainly has the scope to reduce interest rates. The Bank of Korea should grab the lacklustre GDP figures as an opportunity to give the economy another monetary boost.

So judging from BoK’s own inflation target monetary easing seems warranted. The story is the same if we take a look at the ultimate Market Monetarist benchmark – the development in nominal GDP in South Korea.

NGDP korea

The graph is pretty clear – the BoK more or less managed to bring back NGDP to the pre-crisis trend level 2009-10, but since 2011 NGDP has been “softening”, which clearly indicates that monetary easing is needed.

Beware of the Zero Lower Bound!

With the BoK’s key policy interest rate at 2.75% there is still room for use it’s “normal” monetary policy instrument to ease monetary policy. That said, in an environment where the won is strengthening significantly the BoK first needs to “neutralize” the effect of this strengthening with rate cuts and then additionally needs to ease “on top” of that to push NGDP back on track.

That could in a negative scenario easily bring the BoK’s key policy rate down close to zero. Just imagine a new escalation of the euro crisis or a new financial shock of some kind.

In such a scenario the BoK would be unable to ease monetary policy further through interest rate cuts as interest rates effective would hit the the zero lower bound (ZLB).

While we are someway away from the ZLB in Korea it is also clear that the risk of hitting it should not be ignored. In fact I believe that the zero lower bound should be a bigger worry for the BoK than the BoJ’s monetary easing.

Luckily the BoK can do something about it. The most simple thing to do is simply to pre-announce what policy instrument it will resort to in the event that interest rates where to get too close to zero. A possibility is simply to state that if interest rates hit zero then the BoK will switch to a Singapore style monetary policy, where the central bank conduct monetary policy through the exchange rate channel.

A pre-announcement of this sort would likely avoid bringing the BoK in a situation where it actually would have to intervene in the FX market as the markets expectations of FX intervention would on it own lead to a weakening of the won. This effectively would be what I have called McCallum’s MC rule.

In Indian inflation is always and everywhere a rainy phenomenon

Take a look at this “Phillips” curve for India (its not really a real Phillips curve – as it is the relationship between annual real GDP growth and inflation):

Phiillips curve India Do you notice something?

Yes you are right – the slope of the Phillips curve is wrong. Normally one would expect that there was a positive relationship between real GDP growth and inflation, but for India the opposite seems to be the case. Higher inflation is associated with lower GDP growth.

The reason for this obviously is that supply shocks is the dominant factor behind variations in Indian inflation. That should not be a surprise as nearly 50% of the consumption basket is food.

Rain as a supply shock

A closer scrutiny of the Indian inflation data will actually show that the swings in Indian inflation primarily is a rainy phenomenon. Hence, the Indian monsoon and the amount of rainfall greatly influences the food prices and as a result short-term swings in inflation is primarily due to supply shocks in the form of more or less rainfall.

Obviously if the Reserve Bank of India (RBI) was following a strict ECB style inflation target then monetary policy would be strongly pro-cyclical in India as negative supply shocks would push up inflation and down real GDP growth and that would trigger a tightening of monetary policy. This would obviously be an insanely bad way of conducting monetary policy and the RBI luckily realises this.

The RBI therefore focuses on wholesale prices (WPI) rather than CPI in the conduct of monetary policy and that to some extent reduces the problem. The RBI further try to correct the inflation data for supply shocks to look at “core” measures of inflation where food and energy prices are excluded from the inflation data.

However, the problem with use “core” inflation that it is in no way given that changes in food prices is driven by supply factors – even though it often is. Hence, demand side inflation might very well push up domestic food prices as well. Hence, it is therefore very hard to adjust inflation data for supply shocks. That said it is pretty hard to say that the RBI has followed any consistent monetary policy target in recent years and inflation has clearly been drifting upwards – and food prices can likely not explain the uptrend in inflation.

On the other hand NGDP targeting provides the perfect adjustment for supply shocks  and it would therefore be much better for the RBI to implement an NGDP target rather than  a variation of inflation targeting. Unfortunately at the present the RBI don’t really officially target anything and monetary policy can hardly be said to be rule based. As I stressed in my earlier post on Indian monetary policy the RBI needs to move away from the present ad hoc’ism and introduce a rule based monetary policy.

PS Monetary policy is certainly not India’s only economic problem – and not even the most important economic problem. I my view India’s primary economic problem is excessive interventionism in the economy, which greatly reduces the growth potential of the economy.

PPS see also this fairly new IMF Working Paper on monetary policy rules. The conclusions are quite supportive of NGDP targeting.

PPPS The link between rain, inflation and monetary policy in India is being complicated further by the fiscal response in the form of food and agricultural subsidies in India, but that is a very long story to tell…

New book on Market Monetarism from Nunes and Cole

I don’t have much time for blogging, but buy this new book written by my good friends Marcus Nunes and Benjamin Cole:  Market Monetarism Roadmap to Economic Prosperity

here is the book description:

Market Monetarism – Roadmap to Economic Prosperity takes readers though a succinct, entertaining and accessible history of United States monetary policy in the postwar era, and how the Federal Reserve Board propelled the nation into The Great Inflation (think 1960s-1970s), a brief Volcker Transition (early 1980s), then a pleasant sojourn to The Great Moderation (mid-1980s-2007), before a trip to The Great Recession (2008–). Abundant charts clearly and amply illustrate monetary and economic events. The concepts of Market Monetarism and nominal GDP targeting are also introduced, which provide a policy framework for the Federal Reserve Board and other central bankers to avoid future inflationary and recessionary traps.

And here is what I have to say about it on the cover of the book:

“Nunes and Cole have written the first fully Market Monetarist account of post-second world war US monetary history. They forcefully demonstrate the monetary nature of both the Great Inflation and the Great Recession. They show that the Federal Reserve is to blame both for the high inflation of the 1970s and the horrors of the Great Recession. I gladly recommend this book to the layperson and the economist alike who would like to understand why and how failed monetary policy caused the present crisis.”

 

Update: Scott Sumner also comments on the book.

India needs Market Monetarism

There is no doubt that the popularity of NGDP level targeting is increasing and with that partly also the popularity of Market Monetarism. However, as the popularity is growing so is the misunderstandings about both.

First, I would stress that while Market Monetarists advocate NGDP level targeting the two things should not be seen as the same thing. NGDP level targeting is a monetary policy advocated by Market Monetarists, but also by others – such as certain New Keynesian economists such as Christina Romer and Michael Woodford. Market Monetarism on the other is an economic school – or said in another way – it is a way to think about monetary policy and monetary theory.

Today I came across an interesting article by Niranjan Rajadhyaksha with the intriguing headline “India does not need market monetarism” that illustrates some of the misunderstandings about Market Monetarism and NGDP level targeting.

Here is from the article:

The Bank of Japan said on Tuesday that it would try to push up inflation as part of a new strategy to stimulate the economy. Such an attempt would have been met with gasps of disbelief a few years ago, when low inflation was the central quest of monetary policy. A higher inflation target is now becoming an important part of the ongoing policy debate, at least in the developed countries that are still struggling to recover from the economic effects of the financial crisis.

What has just happened in Japan is another victory for a group of economists called market monetarists, who have argued over several years that policymakers should target the nominal gross domestic product (NGDP), which is a combination of real output and inflation. Targeting nominal GDP can be contrasted with what the two main schools of macroeconomics suggest: the traditional monetarists look at money supply and the new Keynesians look at interest rate.

Well, yes it is a victory in the sense that the Bank of Japan now finally is clear on what the central bank is targeting (2% inflation). However, Market Monetarists would certainly have preferred an NGDP level target to an inflation target.

Niranjan continues:

The market monetarists once tried to be heard from the sidelines. They have since gained popularity and are now an important voice in the corridors of power. The US Fed has not yet embraced nominal GDP targeting, but there are signs that market monetarism is getting heard in that institution. Chicago Federal Reserve president Charles Evans is one important convert.

The new Bank of England governor Mark Carney is known to be sympathetic to the market monetarist cause. Japanese Prime Minister Shinzo Abe has also been talking about pushing up Japanese nominal GDP, and his influence in evident in the new Bank of Japan policy statement. All implicitly believe that a higher inflation target will goad rational consumers to spend before prices go up, thus boosting economic activity

So far so good, but again an higher inflation target in Japan is not an NGDP level target, but certainly better than the non-target the BoJ has effectively been practicing for the past 15 years.

But then it goes wrong for Niranjan:

The situation in India is very different. It is unwise to use higher inflation as an important part of any strategy for economic recovery, though there has been loose talk of allowing the Reserve Bank of India to let its unofficial inflation target rise. India already suffers from structurally high inflation. Inflation expectations seem to have drifted up in recent years. These will damage the economy in the long run.

Yet the Indian government has been following a perverse variant of nominal GDP targeting. High inflation has led to robust nominal GDP growth despite the slowdown in real output, which in turn has ensured that the burden of public debt in India has not expanded despite large fiscal deficits. Look at the numbers. Nominal growth in fiscal 2011 was 17.5%, the highest in 20 years. Nominal GDP growth has been growing faster in the four years after the global financial crisis than in the four years that preceded it. In other words, the Indian government has been inflating away its old debts, most of which are held by Indian households through the banking system.

Market monetarism and nominal GDP targeting may make sense in economies that have persistent negative output gaps and interest rates at the lower bound. India is in a different situation. It needs lower inflation to get its economy back on track.

Niranjan seems to equate Market Monetarism and NGDP level targeting with a desire for higher inflation. The fact is, however, that Market Monetarists don’t advocate higher inflation. We advocate a higher level of NGDP for countries such as the US or the euro zone where the level of NGDP is well below the pre-crisis trend level. We don’t concern ourselves with the “split” between real GDP and the price level – the only thing we concern ourselves with is the NGDP level.

Furthermore and much more importantly we are advocating a rule based monetary policy – so we are not advocating the central bank should jump from one stance of policy to another in a discretionary fashion.

In addition Market Monetarists are not “hawks” or “doves”. We are doves when the actual level of NGDP is below the targeted level of NGDP and hawks when the opposite is the case. So yes, for the US or the euro zone we might sound as “doves” in the sense that we (the Market Monetarist bloggers) have been advocating easier monetary policy to bring back NGDP “on track”. What we are arguing is not “stimulus” in a discretionary fashion, but rather a return to a rule based monetary policy.

But what about India?

From 2000 and until the outbreak of the Great Recession in 2008 Indian NGDP grew by around 12% a year. There is is obviously nothing “optimal” about that number, but lets as a starting point see that as our benchmark.

The graph below shows the actual level of Indian NGDP and a 12% growth path for NGDP starting in 2000.

NGDP India
The graph is pretty clear – actually NGDP has been running well above the 12% path in recent years. So if the Reserve Bank of India (RBI) had targeted a 12% NGDP level path then it would certainly had kept a tighter monetary stance in recent years than what actually have been the case.

Hence, the Market Monetarist advise to the RBI would be to tighten monetary policy – rather than the opposite.This illustrates that Market Monetarism is not about being “hawkish” or “dovish”. It is about advocating a rule based monetary policy and at the moment a 12% NGDP level target for India would mean that the RBI should tighten – rather than ease . monetary policy.

Therefore, Niranjan is certainly right when he is arguing that India does not need monetary easing, but that is exactly the conclusion you would reach as a Market Monetarist!

In fact I think that most Market Monetarists would think that a 12% NGDP level target for India is too high and I would personally think a long-term NGDP level target path should be around 7-8% rather than 12%.

Concluding, if the RBI had an NGDP targeting rule it would have kept monetary policy significantly tighter in recent years. The actual conduct of monetary policy in India has nothing to do with Market Monetarism. The only difference between the ECB and the RBI is that the ECB failed on the “tight side” while RBI failed on the “easy side”.

So Niranjan, you are right to worry about the RBI’s overly easy monetary policy, but don’t blame Market Monetarism. You should rather endorse it. We are with you – the RBI has failed exactly because it has not conducted monetary policy within a rule based framework and the RBI should tighten monetary policy sooner than later. And of course introduce an NGDP targeting rule asap.

—-

PS a major advantage of NGDP level targeting compared to inflation targeting is that NGDP level targeting would “ignore” supply shocks. This is very important for an Emerging Market economy like India where headline inflation often is driven by supply shocks in the form of changes in food and energy prices.

Hence, it is well-known that most of the short-term variation in Indian inflation is driven by food prices. A strict inflation targeting central bank would react to higher inflation by tightening monetary policy – this is of course the ECB style inflation targeting regime. Contrary to this an NGDP level targeting central bank would not react to supply shock and instead just keep NGDP on track.

The exchange rate fallacy: Currency war or a race to save the global economy?

This is from CNB.com:

Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace…

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

This pretty much is what I would call the ‘exchange rate fallacy’ – hence the belief that monetary easing in someway is a zero sum game where monetary easing works through an “unfair” competitiveness channel and one country’s gain is another country’s lose.

Lets take the arguments one-by-one.

“…countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.”

The perception here is that monetary policy primarily works through a “competitiveness channel” where a monetary easing leads to a weakening of the currency and this improve the competitiveness of the nation by weakening the real value of the currency. The problem with this argument is first of all that this only works if there is no increase in prices and wages. It is of course reasonable to assume that that is the case in the short-run as prices and wages tend to be sticky. However, empirically such gains are minor.

I think a good illustration of this is relative performance of Danish and Swedish exports in 2008-9. When crisis hit in 2008 the Swedish krona weakened sharply as the Riksbank moved to cut interest rates aggressive and loudly welcomed the weakening of the krona. On the other hand Denmark continued to operate it’s pegged exchange rate regime vis-a-vis the euro. In other words Sweden initially got a massive boost to it’s competitiveness position versus Denmark.

However, take a look at the export performance of the two countries in the graph below.

swedkexports
Starting in Q3 2008 both Danish and Swedish exports plummeted. Yes, Swedish dropped slightly less than Danish exports but one can hardly talk about a large difference when it is taken into account how much the Swedish krona weakened compared to the Danish krone.

And it is also obvious that such competitiveness advantage is likely to be fairly short-lived as inflation and wage growth sooner or later will pick up and erode any short-term gains from a weakening of the currency.

The important difference between Denmark and Sweden in 2008-9 was hence not the performance of exports.

The important difference on the other hand the performance of domestic demand. Just have a look at private consumption in Sweden and Denmark in the same period.

SWDKcons

It is very clear that Swedish private consumption took a much smaller hit than Danish private consumption in 2008-9 and consistently has grown stronger in the following years.

The same picture emerges if we look at investment growth – here the difference it just much bigger.

swdkinvest

The difference between the performance of the Danish economy and the Swedish economy during the Great Recession hence have very little to do with export performance and everything to do with domestic demand.

Yes, initially Sweden gained a competitive advantage over Denmark, but the major difference was that Riksbanken was not constrained in it ability to ease monetary policy by a pegged exchange rate in the same way as the Danish central bank (Nationalbanken) was.

(For more on Denmark and Sweden see my earlier post The luck of the ‘Scandies’)

Hence, we should not see the exchange rate as a measure of competitiveness, but rather as an indicator of monetary policy “tightness”.When the central bank moves to ease monetary policy the country’s currency will tend to ease, but the major impact on aggregate demand will not be stronger export performance, but rather stronger growth in domestic demand. There are of course numerous examples of this in monetary history. I have earlier discussed the case of the Argentine devaluation in 2001 that boosted domestic demand rather exports. The same happened in the US when FDR gave up the gold standard in 1931. Therefore, when journalists and commentators focus on the relationship between monetary easing, exchange rates and “competitiveness” they are totally missing the point.

The ‘foolproof’ way out of deflation

That does not mean that the exchange rate is not important, but we should not think of the exchange rate in any other way than other monetary policy instruments like interest rates. Both can lead to a change in the money base (the core monetary policy instrument) and give guidance about future changes in the money base.

With interest rates effectively stuck at zero in many developed economies central banks needs to use other instruments to escape deflation. So far the major central banks of the world has focused on “quantitative easing” – increasing in the money base by buying (domestic) financial assets such as government bonds. However, another way to increase the money base is obviously to buy foreign assets – such as foreign currency or foreign bonds. Hence, there is fundamentally no difference between the Bank of Japan buying Japanese government bonds and buying foreign bonds (or currency). It is both channels for increasing the money base to get out of deflation.

In fact on could argue that the exchange rate channel is a lot more “effective” channel of monetary expansion than “regular” QE as exchange rate intervention is a more transparent and direct way for the central bank to signal it’s intentions to ease monetary policy, but fundamentally it is just another way of monetary easing.

It therefore is somewhat odd that many commentators and particularly financial journalists don’t seem to realise that FX intervention is just another form of monetary easing and that it is no less “hostile” than other forms of monetary easing. If the Federal Reserve buys US government treasuries it will lead to a weakening of dollar in the same way it would do if the Fed had been buying Spanish government bonds. There is no difference between the two. Both will lead to an expansion of the money base and to a weaker dollar.

“Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market”

This quote is typical of the stories about “currency war”. Monetary easing is seen as a zero sum game and only the first to move will gain, but it will be on the expense of other countries. This argument completely misses the point. Monetary easing is not a zero sum game – in fact in an quasi-deflationary world with below trend-growth a currency war is in fact a race to save the world.

Just take a look at Europe. Since September both the Federal Reserve and the Bank of Japan have moved towards a dramatically more easy monetary stance, while the ECB has continue to drag its feet. In that sense one can say that that the US and Japan have started a “currency war” against Europe and the result has been that both the yen and the dollar have been weakened against the euro. However, the question is whether Europe is better off today than prior to the “currency war”. Anybody in the financial markets would tell you that Europe is doing better today than half  a year ago and European can thank the Bank of Japan and the Fed for that.

So how did monetary easing in the US and Japan help the euro zone? Well, it is really pretty simple. Monetary easing (and the expectation of further monetary easing) in Japan and the US as push global investors to look for higher returns outside of the US and Japan. They have found the higher returns in for example the Spanish and Irish bond markets. As a result funding costs for the Spanish and Irish governments have dropped significantly and as a result greatly eased the tensions in the European financial markets. This likely is pushing up money velocity in the euro zone, which effectively is monetary easing (remember MV=PY) – this of course is paradoxically what is now making the ECB think that it should (prematurely!) “redraw accommodation”.

The ECB and European policy makers should therefore welcome the monetary easing from the Fed and the BoJ. It is not an hostile act. In fact it is very helpful in easing the European crisis.

If the more easy monetary stance in Japan and US was an hostile act then one should have expected to see the European markets take a beating. That have, however, not happened. In fact both the European fixed income and equity markets have rallied strongly on particularly the new Japanese government’s announcement that it want the Bank of Japan to step up monetary easing.

So it might be that some financial journalists and policy makers are scare about the prospects for currency war, but investors on the other hand are jubilant.

If you don’t need monetary easing – don’t import it

Concluding, I strongly believe that a global “currency war” is very good news given the quasi-deflationary state of the European economy and so far Prime Minister Abe and Fed governor Bernanke have done a lot more to get the euro zone out of the crisis than any European central banker has done and if European policy makers don’t like the strengthening of the euro the ECB can just introduce quantitative easing. That would curb the strengthening of the euro, but more importantly it would finally pull the euro zone out of the crisis.

Hence, at the moment Europe is importing monetary easing from the US and Japan despite the euro has been strengthening. That is good news for the European economy as monetary easing is badly needed. However, other countries might not need monetary easing.

As I discussed in my recent post on Mexico a country can decide to import or not to import monetary easing by allowing the currency to strengthen or not. If the Mexican central bank don’t want to import monetary easing from the US then it can simply allow the peso strengthen in response to the Fed’s monetary easing.

Currency war is not a threat to the global economy, but rather it is what could finally pull the global economy out of this crisis – now we just need the ECB to join the war.

David Friedman speaking in London

Earlier this week I was in London. Luckily it coincided with David Friedman speaking at the National Liberal Club in London. So I attended David’s presentation. The event was arranged by the Adam Smith Institute.

I am a great fan of David and since David is so nice to drop my blog from time to time I think it is fitting to post a link to David’s presentation here (even though it is certainly not about monetary theory or policy).

Take a look at David’s presentation “Law without the state” here.

You might recognise these two gentlemen (thanks to Brian Micklethwait for taking the picture).

David Friedman Lars Christensen

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