The Czech interest rate fallacy and exchange rates

For many years Ludek Niedermayer was deputy central bank governor of the Czech central bank (CNB). Ludek did an outstanding job at the CNB where he was a steady hand on CNB’s board for many years. I have known Ludek for a number of years and I do consider him a good friend.

However, we often disagree – particularly about the importance of money. This is an issue we debate whenever we see each other – and I don’t think either of us find it boring. Unfortunately I have so far failed to convince Ludek.

Now it seems we have yet another reason to debate. The issue is over the impact of currency devaluation and the monetary transmission mechanism.

The Czech economy is doing extremely bad and it to me is pretty obvious that the economy is caught in a deflationary trap. The CNB’s key policy rate is close to zero and that is so far limiting the CNB from doing more monetary easing despite the very obvious need for monetary easing – no growth, disinflationary pressures, declining money-velocity and a fairly strong Czech koruna. However, the CNB seems nearly paralyzed. Among other things because the majority of CNB board members seem to think that monetary policy is already easy because interest rates are already very low.

What the majority on the CNB board fail to understand is of course that interest rates are low exactly because the economy is in such a slump. The majority on the CNB board members are guilty of what Milton Friedman called the “interest rate fallacy”.  As Friedman said in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Looking at the Czech economy makes it pretty clear that monetary policy is not easy. If monetary policy was easy then property prices would not be declining and nominal GDP would not be contracting. If monetary policy was easy then inflation would be rising – it is not.

It therefore obvious that the Czech economy desperately needs monetary easing and since interest rates are already close to zero it is obvious that the CNB needs to use other instruments to ease monetary policy. To me the most obvious and simplest way to ease monetary policy in the present situation would be to use the exchange rate channel. The CNB should simply buy foreign currency to weaken the Czech koruna until a certain nominal target is met – for example bringing back the level of the GDP deflator back to its pre-crisis trend. The best way to do this would be to set a temporary target on Czech koruna against the euro – in a similar fashion as the Swiss central bank has done – until the given nominal target is reached. This is what Lars E. O. Svensson – now deputy governor of the Swedish central bank – has called the foolproof way out of deflation.

CNB governor Miroslav Singer seems to be open to this option. Here is what he said in a recent interview with the Czech business paper Hospodarske Noviny (my translation – with help from Czech friends and Google translate…):

“We talked about it in the central bank’s board about what the central bank can buy and put the money into circulation. What all can lend and – in extreme case – we can simply hand out money to citizens. Something that is sometimes referred to as “throwing money from a helicopter.” If it really was needed, it seems to be the easiest to move the exchange rate. It is logical for the country, which exports the products of eighty per cent of its GDP. If we felt that in our country there is a long deflationary pressures, the obvious way to deal with it is through a weakening currency.”

It should be stressed that I am slightly paraphrasing Singer’s comments, but the meaning is clear – governor Singer full well knows that monetary policy works and I certain agree with him on this issue. Unfortunately my good friend Ludek Niedermayer to some extent disagrees.

Here is Ludek in the same article:

“It would mean leaving a floating exchange rate and our trading partners would be able to complain, that we in this way supports our own exports”

Ludek here seems to argue that the way a weakening of the koruna only works through a “competitiveness channel” – in fact governor Singer seems to have the same view. However, as I have so often argued the primary channel by which a devaluation works is through the impact on domestic demand through increased inflation expectations (or rather less deflationary expectations) and an increase in the money base rather than through the competitiveness channel.

Let’s assume that the CNB tomorrow announced that it would set a new target for EUR/CZK at 30 – versus around 24.90 today (note this is an example and not a forecast). Obviously this would help Czech exports, but much more importantly it would be a signal to Czech households and companies that the CNB will not allow the Czech economy to sink further into a deflationary slump. This would undoubtedly lead households and companies to reduce their cash reserves that they are holding now.

In other words a committed and sizable devaluation to the Czech koruna would lead to a sharp drop in demand for Czech koruna – and for a given money supply this would effectively be aggressive monetary easing. This will push up money-velocity. Furthermore, as the CNB is buying foreign currency it is effectively expanding the money supply. With higher money supply growth and higher velocity nominal GDP will expand and with sticky prices and wages and a large negative output gap this would likely also increase real GDP.

This would be similarly to what happened for example in Poland and Sweden in 2008-9, where a weakening of the zloty and the Swedish krona supported domestic demand. Hence, the relatively strong performance of the Swedish and the Polish economies in 2009-10 were due to strong domestic demand rather than strong exports. Again, the exchange rate channel is not really about competitiveness, but about boosting domestic demand through higher money supply growth and higher velocity.

The good news is that the CNB is not out of ammunition and it is similarly good news that the CNB governor Singer full well knows this. The bad news is that he might not have convinced the majority on the CNB board about this. In that sense the CNB is not different from most central banks in the world – bubble fears dominates while deflationary risks are ignored. Sad, but true.

PS I strongly recommend for anybody who can read Czech – or can use Google translate – to read the entire interview with Miroslav Singer. Governor Singer fully well understands that he is not out of ammunition – that is a refreshing view from a European central banker.

Related posts:

Is monetary easing (devaluation) a hostile act?
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons
Mises was clueless about the effects of devaluation
The luck of the ‘Scandies’
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Monetary disorder in Central Europe (and some supply side problems)

About these ads

Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard – policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.

——

PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”

 

 



The Tragic year: 1931

Benjamin Anderson termed 1931 the “the tragic year” – these are some of the events in that tragic year: 

  1. One of Europe’s largest banks with large exposure to Central and Eastern Europe gets into serious trouble (It is of course Austria’s largest bank Österiechishe Kredit Anstalt – and it of course collapsed)
  2. Europe’s Sovereign debt crisis is threatening financial stability and currency collapse (It’s the Germans that are to blame – they can’t pay their war debts)
  3. Major international banks push for a big country to save the sinners (The US banks ask US president Hoover to help ease the pain on Germany)
  4. Debt restructuring (The Hoover moratorium gives Germany a bit of relief – the US banks are happy to begin with)
  5. Monetary policy keeps deflationary pressures on (The French central bank keeps hoarding gold)
  6. An insane commitment to a failed monetary system (the gold standard mentality keeps the commitment to the gold standard despite the fact that it is killing Europe)
  7. Some countries have had enough and give up the monetary standard (The UK leaves the gold standard – the Scandinavian countries follows suit – and recover fast from the Great Depression)
  8. Technocracy is popular and it suggested that indebted nations should be run by technocrats (The so-called Technocracy Movement became increasingly popular in German)

And here we are 80 years on…do you see any similarities? I wonder what 2012 will bring – in 1932 10 countries (or so…) defaulted…

Roubini of Central and Eastern Europe? Me?

From FT Alphaville:

“Lars Christensen, head of research at Danske Bank – the Nouriel Roubini of eastern Europe thanks to his perennial bearishness Cassandra-like status after warning of dangerous imbalances in emerging Europe in 2006 – reckons so. The Swiss National Bank should restate in strong terms it will provide liquidity to a select few central banks in the region and the IMF could signal its willingness to proffer contingent credit lines, he tells FT Alphaville. These are fair points but we are not so sure that the SNB will be willing to take proactive measures to help Hungary, for example, after its aggressive and contentious move to restructure FX mortgages, sparkingaccusations of asset expropriation.”

I am not really head of research at Danske Bank, but head of Emerging Markets at Danske Bank, but ok close enough. Nouriel is a Keynesian – that I am certainly not…

Please help Mr. Simor

He is a challenge for you all.

András Simor is governor of the Hungarian central bank (MNB). Next week he will meet with his colleagues in the MNB’s Monetary Council. They will make announcement on the monetary policy action. Mr. Simor needs your help because he is in a tricky situation.

The MNB’s operates an inflation-targeting regime with a 3% inflation target. It is not a 100% credible and the MNB has a rather unfortunate history of overshooting the inflation target. At the moment inflation continues to be slightly above the inflation target and most forecasts shows that even though inflation is forecasted to come down a bit it will likely stay elevated for some time to come. At the same time Hungarian growth is basically zero and the outlook for the wider European economy is not giving much hope for optimism.

With inflation likely to inch down and growth still very weak some might argue that monetary policy should be eased.

However, there is a reason why Mr. Simor is not likely to do this and that is his worries about the state of the Hungarian financial system. More than half of all household loans are in foreign currency – mostly in Swiss franc. Lately the Hungarian forint has been significantly weakened against the Swiss franc (despite the efforts of the Swiss central bank to stop the strengthening of the franc against the euro) and that is significantly increasing the funding costs for both Hungarian households and companies. Hence, for many the weakening of the forint feels like monetary tightening rather monetary easing and if Mr. Simor was to announce next week that he would be cutting interests to spur growth the funding costs for many households and companies would likely go up rather than down.

Mr. Simor is caught between a rock and a hard. Either he cuts interest rates and allows the forint to weaken further in the hope that can spur growth or he does nothing or even hike interest rates to strengthen the forint and therefore ease the pains of Swiss franc funding households and companies.

Mr. Simor does not have an easy job and unfortunately there is little he can do to make things better. Or maybe you have an idea?

PS The Hungarian government is not intent on helping out Mr. Simor in any way.

PPS When I started this blog I promised be less US centric than the other mainly US based Market Monetarist bloggers – I hope that his post is a reminder that I take that promise serious.

PPPS if you care to know the key policy rate in Hungary is 6%, but as you know interest rates are not really a good indicator of monetary policy “tightness”.

Follow

Get every new post delivered to your Inbox.

Join 3,625 other followers

%d bloggers like this: