All posts in category Exchange rate policy

Russia’s slowdown – another domestic demand story

Today I am in to Moscow to do a presentation on the Russian economy. It will be yet another chance to tell one of my pet-stories and that is that growth in nominal GDP in Russia is basically determined by the price of oil measured in rubles. Furthermore, I will stress that changes in the oil price feeds through to the Russian economy not primarily through net exports, but through domestic demand. This is what I earlier have termed the petro-monetary transmission mechanism.

The Russian economy is slowing – it is mostly monetary

In the last couple of quarters the Russian economy has been slowing. This is a direct result of a monetary contraction caused by lower Russian export prices (measured in rubles). Hence, even though the ruble has been “soft” it has not weakened nearly as much as the drop in oil prices and this effectively is causing a tightening of Russian monetary conditions.

oil price rub

This is how the petro-monetary transmission mechanism works. What happens is that when the oil price drops it puts downward pressure on the ruble. If the Russian central bank had been following what I have called Export Price Norm the ruble would have weakened in parallel with the drop in the oil price.

However, the Russian central bank is not allowing the ruble to weaken enough to keep the price of oil measured in rubles stable and as a consequence we effectively are seeing a drop in the Russian foreign exchange reserves (compared to what otherwise would have happened). There of course is a direct (nearly) one-to-one link between the decline in the FX reserve and the decline in the Russian money base. Hence, due to the managed float of the ruble – rather than a freely floating RUB (and a clear nominal target) – we are getting an “automatic”, but unnecessary, tightening of monetary conditions.

This means that there is a fairly close correlation between changes in oil prices measured in rubles and the growth of nominal GDP. The graph below illustrates this quite well.

NGDP russia oil price

I should of course stress that the slowdown in NGDP growth not necessarily a problem. Unemployment has continued to decline in Russia since 2010 and is now at fairly low levels, while inflation recently have been picking up to around 7%. Hence, it is hard to argue that there is a massive demand side problem in Russia. Yes, both nominal and real GDP is slowing, but it is certainly not catastrophic and I strongly believe that the Russian central bank should target 5-8% NGDP growth rather than 20 or 30% NGDP growth (which is what we saw prior to the crisis erupting in 2008-9). In that sense the gradual tightening of monetary conditions we have seen over the last 2 years might have been warranted. The problem, however, is that the Russian central banks is not very clear on want it wants to achieve with its policies.

It is all about domestic demand rather than net exports

Many would instinctively, but wrongly, conclude that the recent drop in oil prices is a drop in net exports and that is the reason for the slowdown in economic activity. However, that is far from right. In fact net export growth has remained fairly stable with Russian exports and imports growing more or less by the same rate. Hence, there has basically been only a small negative impact on GDP growth from the development in net exports.

What of course is happening is that even though export growth has slowed so has import growth as a result of a fairly sharp slowdown in domestic demand – particularly investment growth.

In that sense the present slowdown is quite similar to the massive collapse in economic activity in 2008-9. The difference is of course that what we are seeing now is not a collapse, but simply a slowdown in growth, but the mechanism is the same – monetary conditions have become tighter as the ruble has not weakened enough to “accommodate” the drop in the oil price.

It should be noted that the ruble today is significantly more freely floating than prior and during the 2008-9 crisis. As a result the ruble has moved much more in sync with the oil price than was the case in 2008-9. So while the oil price has gradually declined since the highs of 2011 the ruble has also weakened moderately against the US dollar in this period. However, the net result has nonetheless been that the price of oil measured in ruble has declined by 25-30% since the peak in 2011. Furthermore, the drop in the oil price measured in rubles has further accelerated since March. As a consequence we are likely to see the slowdown in economic activity continue towards the end of the year.

Overall I believe that the  gradual and moderate tightening of monetary conditions in 2010-12 was warranted. However, it is also clear that what we have see in the last couple of months likely is an excessive tightening of monetary conditions.

 The Export Price Norm is still the best solution for Russia

I have earlier argued that the Russian central bank should implement a variation of what I have termed an Export Price Norm (EPN) and what Jeff Frankel calls Peg-the-Export-Price (PEP) to ensure a stable growth rate in nominal GDP.

I think simplest way of doing this would be to include the oil price in the basket of currencies that the Russian central bank is now shadowing (dollars and euros). Hence, I believe that if the Russian central bank announced that it would shadow a basket of 20% oil prices and 40% dollars and 40% euros to ensure stable NGDP growth for example 7% and allowed for a +/-15% fluctuation band around the basket then I believe that you would get a monetary regime that automatically and without policy discretion would provide tremendous nominal stability and fairly low inflation (2-4%). In such a regime most of the changes in monetary policy would be implemented by market forces. Hence, if the oil price dropped the ruble would automatically be depreciated and equally important if the NGDP growth slowed due to other factors – for example a fiscal tightening or financial distress – then the ruble would automatically weak relative to the basket within the fluctuation band. Obviously there might be – rare – occasions where the “mid-point” of the fluctuation band could be changed and market participants should obviously be made aware that the purpose of the regime is not exchange rate stability but nominal stability. In such a set-up the central bank’s policy instrument would be the level for the mid-point for the fluctuation band around the basket.

Alternatively the Russian central bank could also opt for a completely freely floating exchange rate with NGDP targeting or flexible inflation targeting. I, however, would be skeptical about such solution as the domestic Russian financial markets are still quite illiquid and underdeveloped which complicates the conduct of monetary policy. Furthermore, an EPN solution would actually be more rule based than a freely floating ruble regime as a freely floating ruble regime would necessitate regular changes in for example the interest rate (or the money base) to be announced by the central bank. That opens the door for monetary policy to become unnecessarily discretionary.

Russia’s biggest problems are not monetary

It is correct that Market Monetarists seem to be obsessed with talking about monetary policy, but in the case of Russia I would also argue that even though there is a significant need for monetary policy reform monetary policy is not Russia’s biggest problem. In fact I believe the conduction of monetary policy has improved greatly in the last couple of years.

Russia’s biggest problem is structural. The country is struggling with massive overregulation, lack of competition and widespread corruption. There are very esay solutions to this: Deregulation and privatization. Every sane economist would tell you that, but the political reality in Russia means that reforms are painfully slow. In fact if anything corruption seems to have become even more widespread over the past decade.

Russian policy makers need to deal with these issues if they want to boost real GDP growth over the medium term. The Russian central bank can ensure nominal stability but it can do little else to increase real GDP growth. That is a case for the Russian government. On that I am unfortunately not too optimistic, but hope I will be proven wrong.

Ease of doing business russia

PS My story that the drop in oil prices measured in ruble is about domestic demand rather than export growth is of course very similar to the point I have been making about Japanese monetary stimulus. Monetary easing in Japan might be weakening the currency, but it is not about lifting exports, but about boosting domestic demand. That be the way seem to be exactly what is happening in the Japan. See for example this story from Bloomberg from earlier today.

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3 Comments
by Lars Christensen on May 16, 2013  •  Permalink
Posted in Exchange rate policy, Export Price Norm, Jeffrey Frankel, Peg the Export Price (PEP), Russia
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Posted by Lars Christensen on May 16, 2013

http://marketmonetarist.com/2013/05/16/russias-slowdown-another-domestic-demand-story/

The RBA just reminded us about the “Export Price Norm”

In my view one of the key reasons that Australia avoided recession in 2008-9 was the Reserve Bank of Australia (RBA) effectively is operating what I earlier have called a “Export Price Norm”. Here is what I earlier had to say about that:

One of the reasons why I think the RBA has been relatively successful is that it effectively has shadowed a policy of what Jeff Frankel calls PEP (Peg the currency to the Export Price) and what I (now) think should be called an “Export Price Norm” (EPN). EPN is basically the open economy version of NGDP level targeting.

If the primary factor in nominal demand changes in the economy is exports – as it tend to be in small open economies and in commodity exporting economies – then if the central bank pegs the price of the currency to the price of the primary exports then that effectively could stabilize aggregate demand or NGDP growth. This is in fact what I believe the RBA – probably unknowingly – has done over the last couple of decades and particularly since 2008. As a result the RBA has stabilized NGDP growth and therefore avoided monetary shocks to the economy.

Under a pure EPN regime the central bank would peg the exchange rate to the export price. This is obviously not what the RBA has done. However, by it’s communication it has signalled that it would not mind the Aussie dollar to weaken and strengthen in response to swings in commodity prices – and hence in swings in Australian export prices. Hence, if one looks at commodity prices measured by the so-called CRB index and the Australian dollar against the US dollar over the last couple of decades one would see that there basically has been a 1-1 relationship between the two as if the Aussie dollar had been pegged to the CRB index. That in my view is the key reason for the stability of NGDP growth over the past two decade. The period from 2004/5 until 2008 is an exception. In this period the Aussie dollar strengthened “too little” compared to the increase in commodity prices – effectively leading to an excessive easing of monetary conditions – and if you want to look for a reason for the Australian property market boom (bubble?) then that is it.

This morning the RBA had it regular monetary policy meeting and see here what the bank had to say:

“The inflation outlook, as assessed at present, would afford scope to ease policy further, should that be necessary to support demand…On the other hand the exchange rate remains higher than might have been expected, given the observed decline in export prices”

This is a pretty clear restatement of the “export price norm” (“the exchange rate remains higher than might have been expected, given the observed decline in export prices”). Note also the wording “support demand”. “Demand” is basically an other word for nominal GDP.

So yes, the RBA did not cut interest rates, but it has used the market and particularly the exchange rate channel to ease monetary conditions. This is pretty much in line with Bennett McCallum’s suggestion that small open-economies that operate monetary policy with interest rates close to zero should utilize the exchange rate as a policy instrument. This is what McCallum has called the MC rule.

So effectively – the RBA is indirectly targeting NGDP and seems to pretty well understand the McCallum’s MC rule as it continues to utilize the “Export Price Norm”. So Australia is hardly my biggest worry at the moment.

5 Comments
by Lars Christensen on February 5, 2013  •  Permalink
Posted in Exchange rate policy, Exchange rates, Export Price Norm, McCallum, Reserve Bank of Australia
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Posted by Lars Christensen on February 5, 2013

http://marketmonetarist.com/2013/02/05/the-rba-just-reminded-us-about-the-export-price-norm/

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.

7 Comments
by Lars Christensen on January 20, 2013  •  Permalink
Posted in Bank of Japan, Currency war, Denmark, ECB, Exchange rate policy, Exchange rates, Federal Reserve, Japan, Mexico, Sweden
Tagged , , , , , , , ,

Posted by Lars Christensen on January 20, 2013

http://marketmonetarist.com/2013/01/20/the-exchange-rate-fallacy-currency-war-or-a-race-to-save-the-global-economy/

Sweden, Poland and Australia should have a look at McCallum’s MC rule

Sweden, Poland and Australia all managed the shock from the outbreak of Great Recession quite well and all three countries recovered relatively fast from the initial shock. That meant that nominal GDP nearly was brought back to the pre-crisis trend in all three countries and as a result financial distress and debt problems were to a large extent avoided.

As I have earlier discussed on my post on Australian monetary policy there is basically three reasons for the success of monetary policy in the three countries (very broadly speaking!):

1)     Interest rates were initially high so the central banks of Sweden, Poland and Australia could cut rates without hitting the zero lower bound (Sweden, however, came very close).

2)     The demand for the countries’ currencies collapsed in response to the crisis, which effectively led to “automatic” monetary easing. In the case of Sweden the Riksbank even seemed to welcome the collapse of the krona.

3)     The central banks in the three countries chose to interpret their inflation targeting mandates in a “flexible” fashion and disregarded any short-term inflationary impact of weaker currencies.

However, recently the story for the three economies have become somewhat less rosy and there has been a visible slowdown in growth in Poland, Sweden and Australia. As a consequence all three central banks are back to cutting interest rates after increasing rates in 2009/10-11 – and paradoxically enough the slowdown in all three countries seems to have been exacerbated by the reluctance of the three central banks to re-start cutting interest rates.

This time around, however, the “rate cutting cycle” has been initiated from a lower “peak” than was the case in 2008 and as a consequence we are once heading for “new lows” on the key policy rates in all three countries. In fact in Australia we are now back to the lowest level of 2009 (3%) and in Sweden the key policy rate is down to 1.25%. So even though rates are higher than the lowest of 2009 (0.25%) in Sweden another major negative shock – for example another escalation of the euro crisis – would effectively push the Swedish key policy rate down to the “zero lower bound” – particularly if the demand for Swedish krona would increase in response to such a shock.

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap?” he discusses a new policy rule that could be highly relevant for the central banks in Sweden, Poland and Australia – and for matter a number of other central banks that risk hitting the zero lower bound in the event of a new negative demand shock (and of course for those who have ALREADY hit the zero lower bound as for example the Czech central bank).

What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target. Therefore we could also formulate the rule for example in terms of commodity prices (that would basically be Irving Fisher’s Compensated dollar standard) or for that matter stock prices (See my earlier post on how to use stock prices as a monetary policy instrument here). That is not really important. The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

“It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

Implementing a MC rule would be easy, but very effective

So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank or the Polish central bank (NBP) should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

You might object that in for example in Poland the key policy rate is still way above zero so why worry now? Yes, that is true, but the experience over the last four years shows that when you hit the zero lower bound and there is no pre-prepared operational framework in place then it is much harder to come up with away around the problem. Furthermore, by announcing such a rule the risk that it will have to “kick in” is in fact greatly reduced – as the exchange rate automatically would start to weaken as interest rates get closer to zero.

Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank, the Polish central bank and the Australian Reserve Bank could all avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

PS it should be noted that this post is not meant as a discussion about what the central bank ultimately should target, but rather about what instruments to use to hit the given target. McCallum in his 2005 paper expresses his MC as a Taylor style rule, but one could obviously also think of a MC rule that is used to implement for example a price level target or even better an NGDP level rule and McCallum obviously is one of the founding father of NGDP targeting (I have earlier called McCallum the grandfather of Market Monetarism).

18 Comments
by Lars Christensen on December 10, 2012  •  Permalink
Posted in CNB, Exchange rate policy, Exchange rates, McCallum, NBP, Reserve Bank of Australia, Riksbanken, Scott Sumner
Tagged , , , , , , , , , , ,

Posted by Lars Christensen on December 10, 2012

http://marketmonetarist.com/2012/12/10/sweden-poland-and-australia-should-have-a-look-at-mccallums-mc-rule/

Rerun: Daylight saving time and NGDP targeting

Today I got up one hour later than normal. The reason is the same as for most other Europeans this morning – the last Sunday of October – we move our clocks back one hour due to the end of Daylight saving time (summertime).

That reminded me of Milton Friedman’s so-called Daylight saving argument for floating exchange rates. According to Friedman, the argument in favour of flexible exchange rates is in many ways the same as that for summertime. Instead of changing the clocks to summertime, everyone could instead “just” change their behaviour: meet an hour later at work, change programme times on the TV, let buses and trains run an hour later, etc. The reason we do not do this is precisely because it is easier and more practical to put clocks an hour forward than to change everyone’s behaviour at the same time. It is the same with exchange rates, one can either change countless prices or change just one – the exchange rate.

There is a similar argument in favour of NGDP level targeting. Lets illustrate it with the equation of exchange.

M*V=P*Y

P*Y is of course the same as NGDP the equation of exchange can also be written as

M*V=NGDP

What Market Monetarists are arguing is that if we hold NGDP constant (or it grows along a constant path) then any shock to velocity (V) should be counteracted by an increase or decrease in the money supply (M).

Obviously one could just keep M constant, but then any shock to V would feed directly through to NGDP, but NGDP is not “one number” – it is in fact made up of countless goods and prices. So an “accommodated” shock to V in fact necessitates changing numerous prices (and volumes for the matter). By having a NGDP level target the money supply will do the adjusting instead and no prices would have to change. Monetary policy would therefore by construction be neutral – as it would not influence relative prices and volumes in the economy.

This is of course also similar to Milton Friedman’s analogy of monetary policy being like setting a thermostat (HT David Beckworth).

The conclusion therefore is that when you read Friedman’s “The Case for Floating Exchange Rates” then try think instead of “The Case for NGDP Level Targeting” – it is really the same story.

See my posts on Friedman’s arguments for floating exchange rates:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3

PS Do you remember reading this before then you are right – this is a rerun of what I wrote exactly a year ago.

2 Comments
by Lars Christensen on October 28, 2012  •  Permalink
Posted in David Beckworth, Exchange rate policy, Exchange rates, Milton Friedman, NGDP Targeting, Nominal Income Targeting
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Posted by Lars Christensen on October 28, 2012

http://marketmonetarist.com/2012/10/28/rerun-daylight-saving-time-and-ngdp-targeting/

Friedman, Schuler and Hanke on exchange rates – a minor and friendly disagreement

Before Arthur Laffer got me very upset on Monday I had read an excellent piece by Kurt Schuler on Freebanking.org about Milton Friedman’s position on floating exchange rates versus fixed exchange rates.

Kurt kindly refers to my post on differences between the Swedish and Danish exchange regimes in which I argue that even though Milton Friedman as a general rule prefered floating exchange rates to fixed exchange rates he did not argue that floating exchange rates was always preferable to pegged exchange rates.

Kurt’s comments at length on the same topic and forcefully makes the case that Friedman is not the floating exchange rate proponent that he is sometimes made up to be. Kurt also notes that Steve Hanke a couple of years ago made a similar point. By complete coincidence Steve had actually a couple of days ago sent me his article on the topic (not knowing that I actually had just read it recently and wanted to do a post on it).

Both Kurt and Steve are proponents of currency boards – and I certainly think currency boards under some circumstances have some merit – so it is not surprising they both stress Friedman’s “open-mindeness” on fixed exchange rates. And there is absolutely nothing wrong in arguing that Friedman was pragmatic on the exchange rate issue rather than dogmatic. That said, I think that both Kurt and Steve “overdo” it a bit.

I certainly think that Friedman’s first choice on exchange rate regime was floating exchange rates. In fact I think he even preffered “dirty floats” and “managed floats” to pegged exchange rates. When I recently reread his memories (“Two Lucky People”) I noted how often he writes about how he advised governments and central bank officials around the world to implement a floating exchange rate regime.

In “Two Lucky People” (page 221) Friedman quotes from his book “Money Mischief”:

“…making me far more skeptical that a system of freely floating exchange rates is politically feasible. Central banks will meddle – always, of corse, with the best of intentions. Nevertheless, even dirty floating exchange rates seem to me preferable to pegged rates, though not necessarily to a unified currency”

I think this quote pretty well illustrates Friedman’s general position: Floating exchange rates is the first choice, but under some circumstances pegged exchange rates or currency unions (an “unified currency”) is preferable.

On this issue I find myself closer to Friedman than to Kurt’s and Steve’s view. Kurt and Steve are both long time advocates of currency boards and hence tend to believe that fixed exchange rates regimes are preferable to floating exchange rates. To me this is not a theoretical discussion, but rather an empirical and practical position.

Finally, lately I have lashed out at some US free market oriented economists who I think have been intellectually dishonest for partisan reasons. Kurt and Steve are certainly not examples of this and contrary to many of the “partisan economists” Kurt and Steve have great knowledge of monetary theory and history. In that regard I am happy to recommend to my readers to read Steve’s recent piece on global monetary policy. See here and here. You should not be surprised to find that Steve’s position is that the main problem today is too tight rather than too easy monetary policy – particularly in the euro zone.

PS I should of course note that Kurt is a Free Banking advocate so he ideally prefers Free Banking rather anything else. I have no disagreement with Kurt on this issue.

PPS Phew… it was much nicer to write this post than my recent “anger posts”.

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Related post:
Schuler on money demand – and a bit of Lithuanian memories…

Leave a Comment
by Lars Christensen on August 8, 2012  •  Permalink
Posted in Currency board, Exchange rate policy, Exchange rates, Free Banking, Kurt Schuler, Reading recommendations, Steve Hanke
Tagged , , , , ,

Posted by Lars Christensen on August 8, 2012

http://marketmonetarist.com/2012/08/08/friedman-schuler-and-hanke-on-exchange-rates-a-minor-and-friendly-disagreement/

The luck of the ‘Scandies’

This week we are celebrating Milton Friedman’s centennial. Milton Friedman was known for a lot of things and one of them was his generally skeptical view of pegged exchange rates. In his famous article “The Case for Flexible Exchange Rates” he argued strongly against pegged exchange rates and for flexible exchange rates.

Any reader of this blog would know that I share Friedman’s sceptical view of fixed exchange rates. However, I will also have to say that my view on exchange rates policy has become more pragmatic over the years. In fact one can say that I also in this area have become more of a Friedmanite. This could seem as a paradox given Friedman’s passionate defence of floating exchange rates. However, Friedman was not dogmatic on this issue. Rather Friedman saw exchange rate policy as a way to control the money supply and he often argued that small countries might not have the proper instruments and “infrastructure” to properly control the money supply. Hence it would be an advantage for certain countries to “outsource” monetary policy by pegging the currency to for example the US dollar. Hong Kong’s currency board and its peg to the dollar was his favourite example. I am less inclined to think that Hong Kong could not do better than the currency board, but I nonetheless think Friedman was right in the sense that there fundamentally is no difference between using for example interest rates to control the money supply and using the exchange rate.

In his highly recommendable book Money Mischief Milton Friedman discusses the experience with fixed exchange rates in Chile and Israel. Friedman documents Chile’s horrible experience with fixed exchange rates and Israel’s equally successful experience with fixed exchange rates. It is in relation to these examples Friedman states that one never should underestimate the importance of luck of nations. That credo has been a big inspiration in my own thinking and has certainly helped me understand the difference in performance of different economies during the present crisis. It is not only about policy. With the right policies this crisis could have been avoid, but on the other hand despite of less than stellar conduct of monetary policy some countries have come through this crisis very well. Luck certainly is important.

The Scandinavian economies provide an excellent example of this. Denmark and Sweden are in many ways very similar countries – small open economies with high levels of GDP/capita, strong public finances, an overblown welfare state, but nonetheless quite flexible product and labour markets and a quite high level of social and economic cohesion. However, Denmark and Sweden differ in one crucial fashion – the monetary policy regime.

Denmark has a fixed exchange rate (against the euro), while Sweden has a floating exchange rate and an inflation targeting regime. The different monetary policy regimes have had a significant impact on the performance of the Danish and the Swedish economies during the present crisis.

2008-9: Sweden’s luck, Denmark’s misery

When crisis hit in 2008 both Denmark and Sweden got hit, but Denmark suffered much more than Sweden – not only economically but also in terms of financial sector distress. The key reason for this is that while monetary conditions contracted significantly Sweden did not see any major monetary contraction. What happened was that as investors scrambled for US dollars in the second of 2008 they were selling all other currencies – also the Swedish krona and the Danish krone.

The reaction from the Danish and the Swedish central banks was, however, very different. As the Danish krone came under selling pressures the Danish central bank acted according to the fixed exchange policy by buying kroner. As a result Denmark saw a sharp contraction in the money supply – a contraction that continued in 2009 and 2010, but the peg survived. The central bank had “won” and defended the peg, but at a high cost. The monetary contraction undoubtedly did a lot to worsen the Danish financial sector crisis and four years later Danish property prices continue to decline. On the other hand when the demand for Swedish krona plunged in 2008-9 the Swedish central bank allowed this to happen and the krona weakened sharply. Said in another way the Swedish money demand dropped relative to the money supply. Swedish monetary conditions eased, while Danish monetary conditions tightened.

It is often said, that Sweden’s stronger economic performance relative to Denmark in 2008-9 (and 2010-11 for that matter) is a result of the relative improvement in Swedish competitiveness as a result of the sharp depreciation of the Swedish krona. However, this is a wrong analysis of the situation. In fact the major difference between the Swedish economy and the Danish economy has very little to do with the relative export performance. In fact both countries saw a more or less equal drop in exports in 2008-9. The big difference was the performance in domestic demand. While Danish domestic demand collapsed and property prices were in a free fall, domestic demand in Sweden performed strongly and Swedish property prices continued to rise after the crisis hit. The difference obviously is a result of the different monetary policy reactions in the two countries.

This is basically luck – the Danish monetary regime led to tightening of monetary conditions in reaction to the external shock, while the Swedish central bank to a large extent counteracted the shock with an easing of monetary conditions.

2012: The useful Danish peg and the failures of Riksbanken

Today the Danish economy continues to do worse than the Swedish economy, but the luck is changing. And again this has to do with money demand. While the demand for Swedish krona and Danish kroner collapsed in 2008-9 the opposite is the case today. Today investors as a reaction to the euro crisis are running scared away from the euro and buying everything else (more or less). As a result money is floating into both Denmark and Sweden and the demand for both currencies (and Swedish and Danish assets in general) has escalated sharply. So contrary to 2008-9 the demand for (local) money is now rising sharply. This for obvious reasons is leading to appreciation pressures on the Scandinavian currencies.

Today, however, the Danes are lucky to have the peg. Hence, as the Danish krone has tended to appreciate the Danish central bank has stepped in and defended the peg by expanding the money base and for the first time in four years the Danish money supply (M2) is now showing real signs of recovering. This of course is also why Danish short-term bond yields and money market rates have turned negative. The money markets are being flooded with liquidity to keep the krone from strengthening. Hence, the Danish euro peg is doing a great job in avoiding a negative velocity shock. For the first time in four years Danes could be true happy about the peg.

On the other hand for the first time in four years the Swedish monetary policy regime is not work as well as one could have hoped. As the demand for Swedish krona has escalated Swedish monetary conditions are getting tighter and tighter day by day and the signs are pretty clear that Swedish money-velocity is contracting. This is hardly good news for the Swedish economy.

Obviously there is nothing stopping the Swedish central bank from counteracting the drop in velocity (the increased money demand) by expanding the money base and legendary Swedish deputy central bank governor Lars E. O. Svensson has been calling for monetary easing for a while, but the majority of board members in the Swedish central bank seem reluctant to step up and ease monetary policy even though it day by day is becoming evident that monetary easing is needed.

Good policies are the best substitute for good luck

Obviously neither the Danish nor the Swedish monetary policy regime is optimal under all circumstances and this is exactly what I have tried to demonstrate above. The difference between 2008-9 and 2011-12 is the impact on demand for the Danish and Swedish currency and these differences have been driven mostly by external factors.

Obviously one could (and should!) argue that Sweden’s problem today is not the floating exchange rate, but rather the inflation targeting regime. If Sweden instead had been targeting the (future) nominal GDP level then Riksbanken would already had eased monetary policy much more aggressively than has been the case to counteract the contraction in money-velocity.

Finally, it is clear that luck played a major role in how the crisis has played out in the Scandinavian crisis. However, with the right monetary policies – for example NGDP targeting – you are much more likely to have luck on your side when crisis hit.

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Related posts:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5
Milton Friedman on exchange rate policy #6
Is monetary easing (devaluation) a hostile act?
Danish and Norwegian monetary policy failure in 1920s – lessons for today
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
Bring on the “Currency war”
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

18 Comments
by Lars Christensen on August 2, 2012  •  Permalink
Posted in Denmark, euro crisis, Exchange rate policy, Exchange rates, Milton Friedman, Sweden
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Posted by Lars Christensen on August 2, 2012

http://marketmonetarist.com/2012/08/02/the-luck-of-the-scandies/

Danish and Norwegian monetary policy failure in 1920s – lessons for today

History is fully of examples of massive monetary policy failure and today’s policy makers can learn a lot from studying these events and no one is better to learn from than Swedish monetary guru Gustav Cassel. In the 1920s Cassel tried – unfortunately without luck – to advise Danish and Norwegian policy makers from making a massive monetary policy mistake.

After the First World War policy makers across Europe wanted to return to the gold standard and in many countries it became official policy to return to the pre-war gold parity despite massive inflation during the war. This was also the case in Denmark and Norway where policy makers decided to return the Norwegian and the Danish krone to the pre-war parity.

The decision to bring back the currencies to the pre-war gold-parity brought massive economic and social hardship to Denmark and Norway in the 1920s and probably also killed of the traditionally strong support for laissez faire capitalism in the two countries. Paradoxically one can say that government failure opened the door for a massive expansion of the role of government in both countries’ economies. No one understood the political dangers of monetary policy failure better than Gustav Cassel.

Here you see the impact of the Price Level (Index 1924=100) of the deflation policies in Denmark and Norway. Sweden did not go back to pre-war gold-parity.

While most of the world was enjoying relatively high growth in the second half of the 1920s the Danish and the Norwegian authorities brought hardship to their nations through a deliberate policy of deflation. As a result both nations saw a sharp rise in unemployment and a steep decline in economic activity. So when anybody tells you about how a country can go through “internal devaluation” please remind them of the Denmark and Norway in the 1920s. The polices were hardly successful, but despite the clear negative consequences policy makers and many economists in the Denmark and Norway insisted that it was the right policy to return to the pre-war gold-parity.

Here is what happened to unemployment (%).

Nobody listened to Cassel. As a result both the Danish and the Norwegian economies went into depression in the second half of the 1920s and unemployment skyrocketed. At the same time Finland and Sweden – which did not return to the pre-war gold-partiy – enjoyed strong post-war growth and low unemployment.

Gustav Cassel strongly warned against this policy as he today would have warned against the calls for “internal devaluation” in the euro zone. In 1924 Cassel at a speech in the Student Union in Copenhagen strongly advocated a devaluation of the Danish krone. The Danish central bank was not exactly pleased with Cassel’s message. However, the Danish central bank really had little to fear. Cassel’s message was overshadowed by the popular demand for what was called “Our old, honest krone”.

To force the policy of revaluation and return to the old gold-parity the Danish central bank tightened monetary policy dramatically and the bank’s discount rate was hiked to 7% (this is more or less today’s level for Spanish bond yields). From 1924 to 1924 to 1927 both the Norwegian and the Danish krone were basically doubled in value against gold by deliberate actions of the two Scandinavian nation’s central bank.

The gold-insanity was as widespread in Norway as in Denmark and also here Cassel was a lone voice of sanity. In a speech in Christiania (today’s Oslo) Cassel in November 1923 warned against the foolish idea of returning the Norwegian krone to the pre-war parity. The speech deeply upset Norwegian central bank governor Nicolai Rygg who was present at Cassel’s speech.

After Cassel’s speech Rygg rose and told the audience that the Norwegian krone had been brought back to parity a 100 years before and that it could and should be done again. He said: “We must and we will go back and we will not give up”. Next day the Norwegian Prime Minister Abraham Berge in an public interview gave his full support to Rygg’s statement. It was clear the Norwegian central bank and the Norwegian government were determined to return to the pre-war gold-parity.

This is the impact on the real GDP level of the gold-insanity in Denmark and Norway. Sweden did not suffer from gold-insanity and grew nicely in the 1920s.

The lack of reason among Danish and Norwegian central bankers in the 1920s is a reminder what happens once the “project” – whether the euro or the gold standard – becomes more important than economic reason and it shows that countries will suffer dire economic, social and political consequences when they are forced through “internal devaluation”. In both Denmark and Norway the deflation of the 1920s strengthened the Socialists parties and both the Norwegian and the Danish economies as a consequence moved away from the otherwise successful  laissez faire model. That should be a reminder to any free market oriented commentators, policy makers and economists that a deliberate attempt of forcing countries through internal devaluation is likely to bring more socialism and less free markets. Gustav Cassel knew that – as do the Market Monetarists today.

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My account of these events is based on Richard Lester’s paper “Gold-Parity Depression in Denmark and Norway, 1925-1928″ (Journal of Political Economy, August 1937)

Update: Here is an example that not all German policy makers have studied economic and monetary history.

14 Comments
by Lars Christensen on June 12, 2012  •  Permalink
Posted in Deflation, Denmark, Economic and monetary history, euro crisis, Exchange rate policy, Gold Standard, Gustav Cassel, Norway, Reading recommendations
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Posted by Lars Christensen on June 12, 2012

http://marketmonetarist.com/2012/06/12/danish-and-norwegian-monetary-policy-failure-in-1920s-lessons-for-today/

International monetary disorder – how policy mistakes turned the crisis into a global crisis

Most Market Monetarist bloggers have a fairly US centric perspective (and from time to time a euro zone focus). I have however from I started blogging promised to cover non-US monetary issues. It is also in the light of this that I have been giving attention to the conduct of monetary policy in open economies – both developed and emerging markets. In the discussion about the present crisis there has been extremely little focus on the international transmission of monetary shocks. As a consequences policy makers also seem to misread the crisis and why and how it spread globally. I hope to help broaden the discussion and give a Market Monetarist perspective on why the crisis spread globally and why some countries “miraculously” avoided the crisis or at least was much less hit than other countries.

The euro zone-US connection

– why the dollar’ status as reserve currency is important

In 2008 when crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused to drop by both a contraction in velocity and in the money supply. Reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss franc – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss franc will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over.

Why was the contraction so extreme in for example the PIIGS countries and Russia?

While the Fed failed to increase the money supply enough to counteract the increase in dollar demand it nonetheless acted through a number of measures. Most notably two (and a half) rounds of quantitative easing and the opening of dollar swap lines with other central banks in the world. Other central banks faced bigger challenges in terms of the possibility – or rather the willingness – to respond to the increase in dollar demand. This was especially the case for countries with fixed exchanges regimes – for example Denmark, Bulgaria and the Baltic States – and countries in currencies unions – most notably the so-called PIIGS countries.

I have earlier showed that when oil prices dropped in 2008 the Russian ruble started depreciated (the demand for ruble dropped). However, the Russian central bank would not accept the drop in the ruble and was therefore heavily intervening in the currency market to curb the ruble depreciation. The result was a 20% contraction in the Russian money supply in a few months during the autumn of 2008. As a consequence Russia saw the biggest real GDP contraction in 2009 among the G20 countries and rather unnecessary banking crisis! Hence, it was not a drop in velocity that caused the Russian crisis but the Russian central bank lack of willingness to allow the ruble to depreciate. The CBR suffers from a distinct degree of fear-of-floating and that is what triggered it’s unfortunate policy response.

The ultimate fear-of-floating is of course a pegged exchange rate regime. A good example is Latvia. When the crisis hit the Latvian economy was already in the process of a rather sharp slowdown as the bursting of the Latvian housing bubble was unfolding. However, in 2008 the demand for Latvian lat collapsed, but due to the country’s quasi-currency board the lat was not allowed to depreciate. As a result the Latvian money supply contracted sharply and send the economy into a near-Great Depression style collapse and real GDP dropped nearly 30%. Again it was primarily the contraction in the money supply rather and a velocity collapse that caused the crisis.

The story was – and still is – the same for the so-called PIIGS countries in the euro zone. Take for example the Greek central bank. It is not able to on it’s own to increase the money supply as it is part of the euro area. As the crisis hit (and later escalated strongly) banking distress escalated and this lead to a marked drop in the money multiplier and drop in bank deposits. This is what caused a very sharp drop in the Greek board money supply. This of course is at the core of the Greek crisis and this has massively worsened Greece’s debt woes.

Therefore, in my view there is a very close connection between the international spreading of the crisis and the currency regime in different countries. In general countries with floating exchange rates have managed the crisis much better than countries with countries with pegged or quasi-pegged exchange rates. Obviously other factors have also played a role, but at the key of the spreading of the crisis was the monetary policy and exchange rate regime in different countries.

Why did Sweden, Poland and Turkey manage the crisis so well?

While some countries like the Baltic States or the PIIGS have been extremely hard hit by the crisis others have come out of the crisis much better. For countries like Poland, Turkey and Sweden nominal GDP has returned more or less to the pre-crisis trend and banking distress has been much more limited than in other countries.

What do Poland, Turkey and Sweden have in common? Two things.

First of all, their currencies are not traditional reserve currencies. So when the crisis hit money demand actually dropped rather increased in these countries. For an unchanged supply of zloty, lira or krona a drop in demand for (local) money would actually be a passive or automatic easing of monetary condition. A drop in money demand would also lead these currencies to depreciate. That is exactly what we saw in late 2008 and early 2009. Contrary to what we saw in for example the Baltic States, Russia or in the PIIGS the money supply did not contract in Poland, Sweden and Turkey. It expanded!

And second all three countries operate floating exchange rate regimes and as a consequence the central banks in these countries could act relatively decisively in 2008-9 and they made it clear that they indeed would ease monetary policy to counter the crisis. Avoiding crisis was clearly much more important than maintaining some arbitrary level of their currencies. In the case of Sweden and Turkey growth rebound strongly after the initial shock and in the case of Poland we did not even have negative growth in 2009. All three central banks have since moved to tighten monetary policy – as growth has remained robust. The Swedish Riksbank is, however, now on the way back to monetary easing (and rightly so…)

I could also have mentioned the Canada, Australia and New Zealand as cases where the extent of the crisis was significantly reduced due to floating exchange rates regimes and a (more or less) proper policy response from the local central banks.

Fear-of-floating via inflation targeting

Some countries fall in the category between the PIIGS et al and Sweden-like countries. That is countries that suffer from an indirect form of fear-of-floating as a result of inflation targeting. The most obvious case is the ECB. Unlike for example the Swedish Riksbank or the Turkish central bank (TCMB) the ECB is a strict inflation targeter. The ECB does target headline inflation. So if inflation increases due to a negative supply shock the ECB will move to tighten monetary policy. It did so in 2008 and again in 2011. On both occasions with near-catastrophic results. As I have earlier demonstrated this kind of inflation targeting will ensure that the currency will tend to strengthen (or weaken less) when import prices increases. This will lead to an “automatic” fear-of-floating effect. It is obviously less damaging than a strict currency peg or Russian style intervention, but still can be harmful enough – as it clear has been in the case of the euro zone.

Conclusion: The (international) monetary disorder view explains the global crisis

I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also lead to a monetary contraction in especially Europe. Not because of an increase demand for euro, lats or rubles, but because central banks tighten monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as member of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

The international transmission was not caused by “market disorder”, but by monetary policy failure. In a world of freely floating exchange rates (or PEP – currencies pegged to export prices) and/or NGDP level targeting the crisis would never have become a global crisis and I certainly would have no reason to write about it four-five years after the whole thing started.

Obviously, the “local” problems would never have become any large problem had the Fed and the ECB got it right. However, the both the Fed and the ECB failed – and so did monetary policy in a number of other countries.

DISCLAIMER: I have discussed different countries in this post. I would however, stress that the different countries are used as examples. Other countries – both the good, the bad and the ugly – could also have been used. Just because I for example highlight Poland, Turkey and Sweden as good examples does not mean that these countries did everything right. Far from it. The Polish central bank had horrible communication in early 2009 and was overly preoccupied the weakening of the zloty. The Turkish central bank’s communication was horrific last year and the Sweden bank has recently been far too reluctant to move towards monetary easing. And I might even have something positive to say about the ECB, but let me come back on that one when I figure out what that is (it could take a while…) Furthermore, remember I often quote Milton Friedman for saying you never should underestimate the importance of luck of nations. The same goes for central banks.

PS You are probably wondering, “Why did Lars not mention Asia?” Well, that is easy – the Asian economies in general did not have a major funding problem in US dollar (remember the Asian countries’ general large FX reserve) so dollar demand did not increase out of Asia and as a consequence Asia did not have the same problems as Europe. Long story, but just show that Asia was not key in the global transmission of the crisis and the same goes for Latin America.

PPS For more on the distinction between the ‘monetary disorder view’ and the ‘market disorder view’ in Hetzel (2012).

11 Comments
by Lars Christensen on May 11, 2012  •  Permalink
Posted in ECB, Emerging Markets, euro crisis, Exchange rate policy, Exchange rates, Fear-of-floating, Federal Reserve, Gold Standard, Jeffrey Frankel, Luck, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, Peg the Export Price (PEP), QE, Robert Hetzel, Russia, The euro, The Great Recession, Transmission mechanism
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Posted by Lars Christensen on May 11, 2012

http://marketmonetarist.com/2012/05/11/international-monetary-disorder-how-policy-mistakes-turned-the-crisis-into-a-global-crisis/

Fear-of-floating, misallocation and the law of comparative advantages

The first commandment of central banking should be thou shall not distort relative prices. However, central bankers often tend to forget this – knowingly or unknowingly. How often have we not heard stern warnings from central bankers that property prices are too high or too low – or that a currency is overvalued or undervalued. And in the last couple of years central bankers have even tried to manipulate the shape of the bond yield curve – just think of the Fed’s “operation twist”.

Central bankers are distorting relative prices in many ways – by for example by trying to prick bubbles (or what they think are bubbles). Sometimes the distortion of relative prices is done unknowingly. The best example of this is when central banks operate an inflation target. Both George Selgin and David Eagle teach us that inflation targeting means that central banks react to supply shocks and thereby distort relative prices. In an open economy this will lead to a distortion of the relative prices between trade goods and non-traded goods.

As I will show below central bankers’ eagerness to distort relative prices is as harmful as other distortions of relative prices for example as a result of protectionism and will often lead to numerous negative side-effects.

The fear-of-floating – the violation of the Law of comparative advantages

I have recently given a bit of attention to the concept of fear-of-floating. Despite being officially committed to floating exchange rates many central banks from time to time intervene in the FX markets to “manage” the currency. As I have earlier noted a good example is the Norwegian central bank (Norges Bank), which often has intervened either directly or verbally in the currency market or verbally to try to curb the strengthening of the Norwegian krone. In March for example Norges Bank surprisingly cut interest rates to curb the strengthening of the krone – despite the general macroeconomic situation really warranted a tightening of monetary conditions.

So why is Norge Bank so fearful of a truly free floating krone? The best explanation in the case of Norway is that the central bank’s fears that when oil prices rise then the Norwegian krone will strengthen and hence make the non-oil sectors in the economy less competitive. This is what happened in 2003 when a sharp appreciation of the krone cause an “exodus” of non-oil sector companies from Norway. Hence, there is no doubt that it is a sub-target of Norwegian monetary policy to ensure a “diversified” Norwegian economy. This policy is strongly supported by the Norwegian government’s other policies – for example massive government support for the agricultural sector. Norway is not a EU member – and believe it or not government subsidies for the agricultural sector is larger than in the EU!

However, in the same way as government subsidies for the agricultural sector distort economic allocation so do intervention in the currency market. However, while most economists agree that government subsidies for ailing industries is violating the law of comparative advantages and lead to a general economic lose in the form of lower productivity and less innovation few economists seem to be aware that the fear-of-floating (including indirect fear-of-floating via inflation targeting) have the same impact.

Lets look at an example. Let say that oil prices increase by 30% and that tend to strengthen the Norwegian krone. This is the same as to say that the demand curve in the oil sector has shifted to the right. This will increase the demand for labour and capital in the oil sector. In a freely mobile labour market this will push up salaries both in the oil sector and in the none-oil sector. Hence, the none-oil sector will become less competitive – both as a result of higher labour and capital costs, but also because of a stronger krone. As a consequence labour and capital will move from the non-oil sector to the oil sector. Most economists would agree that this is a natural market process that ensures the most productive and profitable use of economic resources. As David Ricardo taught us long ago – countries should produce the goods in which the country has a comparative advantage. The unhampered market mechanism ensures this.

However, if the central bank suffers from fear-of-floating then the central bank will intervene to curb the strengthening of the krone. This has two consequences. First, the increase in profitability in the oil sector will be smaller than it would have been had the krone been allowed to strengthen. This would also mean that the increase in demand for capital and labour in the oil sector would be smaller than it would have been if the krone had been allowed to float completely freely (or had been pegged to the oil price). Second, this would mean that the “scaling down” of the non-oil sector will be smaller than otherwise would have been the case – and as a result this sector will demand too much labour and capital relative to what is economically optimal. This is exactly what the central bank would like to see. However, I think the example pretty clearly shows that such as policy is violating the law of comparative advantages. Relative prices are distorted and as a result the total economic output and welfare will be smaller than would have been the case under a freely floating currency.

It is often argued that if the oil price is very volatile and the krone (or another oil-exporting country’s currency) therefore would be more volatile and as a consequence the non-oil sector will see large swings in economic activity and it would be in the interest of the central bank to reduce this volatility and thereby stabilise the development in the non-oil sector. However, this completely misses the point with free markets. Prices should be allowed to adjust to ensure an efficient allocation of capital and labour. If you intervene in the market process allocation of resources will be less efficient.

Furthermore, the central bank cannot permanently distort relative prices. If the currency is kept artificially weak by easier monetary policy it will just inflated the entire economy – and as a result capital and labour cost will increase – as will inflation – and sooner or later the competitive advantage created by an artificially weak currency will be gradually eaten by higher prices and wages. In an economy where wages and prices are downward rigid – as surely is the case in the Norwegian economy – this will created major adjustment problems if oil prices drops sharply especially if the central bank also try to curb the weakening of the currency (as the Russian central bank did in 2008). Hence, by trying to dampen the swings in the FX rates the central bank will actually move the adjustment process from the FX markets (which is highly flexible) to the much less flexible labour and good markets. So even though the central bank might want to curb the volatility in economic activity in the non-oil sector it will actually rather increase the general level of volatility in the economy. In an economy with fully flexible prices and wages the manipulation of the FX rate would not be a problem. However, if for example wages are downward rigid because interventionist labour market policy as it is the case in Norway then a policy of curbing the volatility in the FX rate quite obviously (to me at least) leads to lower productivity and higher volatility in both nominal and rate variables.

I have used the Norwegian economy as an example. I should stress that I might as well have used for example Brazil or Russia – as the central banks in these countries to a much larger degree than Norges Bank suffers from a fear-of-floating. I could in fact also have used the ECB as the ECB indirectly suffers from a fear-of-floating as the ECB is targeting inflation.

I am not aware of any research on the consequences for productivity of fear-of-floating, but I am sure it could be an interesting area of research – I wonder if Norge Banks is aware how big the productive lose in the Norwegian economy has been due to it’s policy of curbing oil price driven swings in the krone. I am pretty sure that the Russian central bank and the Brazilian central bank have not given this much thought at all. Neither has most other Emerging Market central banks that frequently intervenes in the FX markets. 

PS do I need to say how to avoid these problems? Yes you guessed right – NGDP level targeting or by pegging the currency to the oil price. If you want to stay with in a inflation targeting framework then central bank central bank should at least target domestic demand inflation or what I earlier inspired by David Eagle has termed Quasi-Real inflation (QRPI).

PS Today I am spending my day in London – I wrote this on the flight. I bet a certain German central banker will be high on the agenda in my meetings with clients…

8 Comments
by Lars Christensen on May 9, 2012  •  Permalink
Posted in David Eagle, Exchange rate policy, Exchange rates, Fear-of-floating, Financial markets, George Selgin, Norway, Quasi-Real Price Index, Russia
Tagged , , , , , ,

Posted by Lars Christensen on May 9, 2012

http://marketmonetarist.com/2012/05/09/fear-of-floating-misallocation-and-the-law-of-comparative-advantages/

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