The high cost of currency (rouble) stability

This is from Reuters today:

“The Russian currency has opened higher Thursday, continuing its recovery from the biggest intraday drop since 1998 default on so-called ‘Black Tuesday’. The dollar was down 65 kopeks at the opening on the Moscow Exchange, while on the stock market, the dollar-denominated RTS index was up 6.5 percent. That’s was hours before President Vladimir Putin commenced his much-anticipated Q&A marathon, in which he’s expected to face tough economic questions about the ruble and turmoil in the financial markets. ….On Wednesday, the ruble jumped 6 percent against the US dollar to finish trading at 60.51 against the Greenback. On ‘Black Tuesday’ the ruble dipped to as low as 80 rubles against the US dollar and hit a threshold of 100 against the euro.”

So after a terrible start to the week the Russian rouble has stabilised over the past two days. However, the (temporary?) stabilisation of the rouble has not been for free. Far from it in fact. Just take a look at this story from ft.com also from today:

Russian banks are getting cautious about lending each other money, with the interest rate on three-month interbank loans hitting its highest since at least 2005. The three-month “mosprime” interbank lending rate has soared to 28.3 per cent, which is its highest since it hit its financial crisis peak of 27.6 in January 2009. The rate is also sharply higher than it reached on Wednesday – the day after the Central Bank of Russia hiked interest rates to 17 per cent to stem a plunge in the rouble – when it closed at 22.33. Stresses have been building in Russian economy because of Western sanctions and a sharp fall in the oil price But another reason for the mosprime spike is that Russian banks are unsure about the state of each other’s businesses. Russian bank customers have been rushing to withdraw their roubles out of their bank accounts and convert them to dollars or euros.

Hence, the rouble might have stabilised, but monetary conditions have been tightened dramatically. So the question is whether the benefits of a (more) stable rouble outweigh the costs of tighter monetary conditions?

We might get the answer by looking that the graph below. The consequence of higher interest rates in 2008-9 was a 10% contraction in real GDP. This week’s spike in money market rates is even bigger (and steeper) than the spike in rates in 2008-9. Is there any good reason why we should not expect a similar contraction in real GDP this time? I think not… MosPrime 3m RGDP

PS obviously I would be the first to acknowledge that money market rates is not the entire story about monetary contraction and money market rates are only used for illustrative purposes here. There are also some differences between 2008-9 and now, but it should nonetheless be noted that the recent drop in oil prices is similar to what we saw in 2008-9.

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Turning the Russian petro-monetary transmission mechanism upside-down

Big news out of Moscow today – not about the renewed escalation of military fighting in Eastern Ukraine, but rather about Russian monetary policy. Hence, today the Russian central bank (CBR) under the leadership of  Elvira Nabiullina effectively let the ruble float freely.

The CBR has increasing allowed the ruble to float more and more freely since 2008-9 within a bigger and bigger trading range. The Ukrainian crisis, negative Emerging Markets sentiments and falling oil prices have put the ruble under significant weakening pressures most of the year and even though the CBR generally has allowed for a significant weakening of the Russian currency it has also tried to slow the ruble’s slide by hiking interest rates and by intervening in the FX market. However, it has increasingly become clear that cost of the “defense” of the ruble was not worth the fight. So today the CBR finally announced that it would effectively float the ruble.

It should be no surprise to anybody who is reading my blog that I generally think that freely floating exchange rates is preferable to fixed exchange rate regimes and I therefore certainly also welcome CBR’s decision to finally float the ruble and I think CBR governor Elvira Nabiullina deserves a lot of praise for having push this decision through (whether or not her hand was forced by market pressures or not). Anybody familiar with Russian economic-policy decision making will know that this decision has not been a straightforward decision to make.

Elvira has turned the petro-monetary transmission mechanism upside-down

The purpose of this blog post is not necessarily to specifically discuss the change in the monetary policy set-up, but rather to use these changes to discuss how such changes impact the monetary transmission mechanism and how it changes the causality between money, markets and the economy in general.

Lets first start out with how the transmission mechanism looks like in a commodity exporting economy like Russia with a fixed (or quasi fixed) exchange rate like in Russia prior to 2008-9.

When the Russian ruble was fixed against the US dollar changes in the oil price was completely central to the monetary transmission – and that is why I have earlier called it the petro-monetary transmission mechanism. I have earlier explained how this works:

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

This effectively means that in such a set-up the CBR will have given up monetary sovereignty and instead will “import” monetary policy via the oil price and the exchange rate. In reality this also means that the global monetary superpower (the Fed and PBoC) – which to a large extent determines the global demand for oil indirectly will determine Russian monetary conditions.

Lets take the case of the People’s Bank of China (PBoC). If the PBoC ease monetary policy – increase monetary supply growth – then it will increase Chinese demand for oil and push up oil prices. Higher oil prices will push up currency inflows into Russia and will cause appreciation pressure on the ruble. If the ruble is pegged then the CBR will have to intervene to keep the ruble from strengthening. Currency intervention of course is the same as sell ruble and buying foreign currency, which equals an increase in the Russian money base/supply. This will push up Russian nominal GDP growth.

Hence, causality runs from the monetary policy of the monetary superpowers – Fed and the PBoC – to Russian monetary policy as long as the CBR pegs or even quasi-peg the ruble. However, the story changes completely when the ruble is floated.

I have also discussed this before:

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

If today’s announced change in monetary policy set-up in Russia is taken to be credible (it is not necessary) then it would mean the completion of the transformation of the monetary transmission which essentially was started in 2008 – moving from a pegged exchange/manage float regime to a floating exchange rate.

This will also means that the CBR governor Elvira Nabiullina will have ensured full monetary sovereignty – so it will be her rather than the Federal Reserve and the People’s Bank of China, who determines monetary conditions in Russia.

Whether this will be good or bad of course fully dependent on whether Yellen or Nabiullina will conduct the best monetary policy for Russia.

One can of course be highly skeptical about the Russian central bank’s ability to conduct monetary policy in a way to ensure nominal stability – there is certainly not good track record, but given the volatility in oil prices it is in my view also hard believe that a fully pegged exchange rate would bring more nominal stability to the Russian economy than a floating exchange rate combined with a proper nominal target – either an inflation target or better a NGDP level target.

Today Elvira Nabiullina has (hopefully) finalized the gradual transformation from a pegged exchange to a floating exchange rate. It is good news for the Russian economy. It will not save the Russia from a lot of other economic headaches (and there are many!), but it will at least reduce the risk of monetary policy failure.

PS I still believe that the Russian economy is already in recession and will likely fall even deeper into recession in the coming quarters.

 

 

Recession time for Russia – the ultra wonkish version

I have long been a proponent of what I have called the Export Price Norm (EPN). The idea with EPN is that commodity exporting countries can ensure stable nominal spending growth by pegging their currency to either the price of the country’s main export good or to a basket of the export product and a foreign currency.

The case of Russia is illustrative. Hence, one could imagine that the Russian central bank (CBR) implemented a variation of EPN by including oil prices in the basket of euros and dollars, which the CBR has been “shadowing” in recent years. I believe that this in general would lead to a stabilisation of nominal GDP growth in Russia.

The graph below, I believe, illustrates this well.

EPN Russia

We see that over the past 10 years there has been a very high and stable correlation between Russian NGDP growth and (the growth of) the price of oil measured in roubles. As the oil price in roubles seems to lead NGDP growth by 1-2 quarters it is clear that the CBR would have been able to stabilize NGDP growth by managing the rouble in such a way to ‘offset’ positive and negative shocks to the oil price. That of course would have happened “automatically” if the CBR had included the oil price in it’s EUR-USD basket – or alternatively allowed the rouble to float freely and communicated that it would allow the rouble to appreciate or depreciate to offset shocks to the oil price to ensure stable nominal spending growth in the Russian economy.

Nothing surprising about the slowdown in Russian growth

In the last couple of the years the Russian economy has slowed considerably. This I believe is due to the fact that the CBR effectively has been tightening the monetary conditions by keeping the rouble too strong relative to the development in oil prices.

Since early 2011 the oil price (in US dollars) has been declining moderately. This effectively has meant that the currency inflow into Russia has been slowing and not surprisingly this has put downward pressure on the rouble. This should be welcomed news, but the CBR has nonetheless kept monetary conditions too tight by not allowing a large enough depreciation of the rouble to fully offset the oil price shock.

As a result nominal GDP growth has slowed quite significantly and as prices and wages are sticky in Russia (as everywhere else) this has also led to a slowdown in Russian real GDP growth.

Why the EPN ‘prediction’ might be wrong this time around

However, things have been changing over the past year. So while the oil price has continued to “stagnate” the rouble has weakened significantly over the past year – as has been the case for most other Emerging Markets currencies in the world.

Hence, as the drop in the value of the rouble has been significantly larger than the change in the oil price (in USD) the oil price measured in roubles has increased somewhat.

As the graph above shows this de facto monetary easing has already started lifting NGDP growth and given the historical relationship between the oil price measured in rouble and NGDP growth then one should expect NGDP growth to pick up from well-below 10% to 13-14% y/y.

However, this “prediction” strictly based on the Export Price Norm is likely to be far too optimistic. The reason is that the Export Price Norm only ensures nominal stability if all shocks come from the export price – in the case of Russia from oil price shocks.

Historically it has been a reasonable assumption that nearly all shocks to Russian aggregate demand are shocks to the oil price (remember in the case of Russia an oil price shock is a demand shock and not a supply shock). This is why we have such a good fit in the graph above.

But over the past year the Russian economy has been hit by another external shock and a lot of the outflows from Russia has been driven by other factors than oil prices. Hence, the general negative Emerging Markets sentiment over the past year has undoubtedly own its own contributed to the currency outflow.

Furthermore, and more importantly the sharply increased geo-political tensions in relationship to Putin’s military intervention on the peninsula of Crimea has clearly shocked foreign investors who are now dumping Russian assets on large scale. Just Monday this week the Russian stock market fell in excess of 10% and some of the major bank stocks lost 20% of their value on a single day.

In response to this massive outflow the Russian central bank – foolishly in my view – hiked its key policy rate by 150bp and intervened heavily in the currency market to prop up the rouble on Monday. Some commentators have suggested that the CBR might have spent more than USD 10bn of the foreign currency reserve just on Monday. Thereby inflicting greater harm to the Russian economy than any of the planned sanctions by EU and the US against Russia.

By definition a drop in foreign currency reserve translates directly into a contraction in the money base combined with the CBR’s rate hike we this week has seen a very significant tightening of monetary conditions in Russia – something which is likely to send the Russian economy into recession (understood as one or two quarters of negative real GDP growth).

This in my view illustrates a weakness in the very strict form of an Export Price Norm. If the central bank pegs the currency directly to the export price – for example oil prices in the case of Russia – then other negative external shocks – would effectively be monetary tightening.

CBR should implement a 40-40-20 basket with an adjustable +/-15% fluctuation band

Given this weakness in the strict form of the EPN I believe it would be better for the Russian central bank to implement a less strict variation of EPN.

The most obvious solution would be to include oil prices in the CBR’s present operational basket. Overall I think a basket of 40% euros, 40% dollars and 20% oil prices would be a suitable policy basket for the central bank. Furthermore, the CBR should allow for a +/-15% fluctuation band around this policy basket.

The reason I stress that it should be a policy basket is that the ultimate target of the CBR should not be that basket but rather to achieve a stable growth rate of nominal spending in the Russian economy – for example 8-10% NGDP growth.

I believe that under most circumstances the CBR could maintain composition of the policy basket and maintain the fluctuation band unchanged and that would to a large degree ensure nominal stability without changing the basket or the “parity” for this basket and long as the CBR communicates clearly that the purpose of this policy is to ensure nominal growth stability. Then the market would take care of the rest.

Unfortunately Putin’s Russia has much bigger (self-inflicted) problems than monetary policy these days…

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A Crimean style aggregate supply shock

It has been a busy couple of weeks for me. It is events in particularly Ukraine, Turkey and partly Venezuela that have kept me very busy so there has not been much time or energy for blogging.

My blog is mostly about monetary issues, but the most important thing going on in the global economy and markets right now in my view is not monetary affairs, but rather the escalation of geo-political risks or what Robert Higgs in the most general sense have called “regime uncertainty”.

So let me quote myself. This is from EMEA Weekly – a Weekly produced by my hard working colleagues in Danske Bank’s research department and myself. This is on the recent developments in Ukraine:

Centre of attention moves to Crimea

This week there has been a sharp increase in geopolitical tension on the back of the violent in recent weeks and particularly since the Ukrainian parliament voted to oust President Viktor Yanukovych at the weekend and appointed a new caretaker president and a new government ahead of presidential elections, which are now scheduled to be held in May.

As we pointed out in Flash Comment Ukraine – geopolitical risks increase, the events over the weekend sharply increased geopolitical risk and we expected the focus of the markets to turn to eastern Ukraine and the peninsula of Crimea. The events this week have confirmed this.

We also note that most of the population in Crimea is ethnic Russian and many hold a Russian passport. During the Russian-Georgian conflict in 2008, fears about increased separatist sentiment in Crimea increased tensions between the then Ukrainian government and Russia. These concerns have now returned. This morning a group of apparently pro- Russian armed men seized Crimea’s regional parliament and the government headquarters of the Russian-majority region.

Yesterday, Russian President Vladimir Putin ordered tests of the combat readiness of Russian armed forces in western and central Russia and today the Russian Ministry of Defence said it had put its fighter jets on ‘combat alert’ on its western border.

The new Ukrainian government has reacted angrily to recent geopolitical events. Hence, Ukraine’s interim President Olexander Turchynov has warned Russia against any ‘military aggression’ in Crimea.

The clear escalation of the geopolitical situation is now having a very clear impact on not only the Russian and Ukrainian markets. Hence, over the past couple of weeks there has been some contagion – so far fairly moderate – to other central and eastern European markets but, as of today, it seems that we are seeing an even broader spillover as fears of an armed conflict have increased.

The Ukrainian hryvnia has fallen sharply this week and today alone it is down around 10% against the US dollar. The Ukrainian central bank has effectively stopped defending the hryvnia as it has more or less run out of foreign currency reserves. Furthermore, it is very clear to us that the banking sector has effectively stopped working in Ukraine and the country is close to default. Indeed, we think it is impossible to avoid a sovereign default unless the Ukrainian government receives foreign financial assistance. This is also reflected in the pricing of Ukraine’s credit default swap.

The Russian rouble has also come under additional pressure. The rouble, which has been under pressure for some time and has lost some 20% in value over the past year. yesterday hit the weak end of the official fluctuation band against the basket of the euro and the US dollar.

This morning USD/RUB reached 36.11 – a five-year high. The dual currency basket hit a record high of 42.11. The Russian central bank Bank Rossii has refrained from significant support of the rouble, intervening by around USD300m per day and shifting repeatedly up the rouble’s trading band. We do not expect any significant turnaround in the rouble’s rate this year or any significant support from Bank Rossii as the authorities believe the rouble’s weakness helps the domestic economy.

As a direct consequence of recent events, we have changed our already very bearish forecast on the Ukrainian hryvnia to 15 against the dollar. This implies an almost 70% devaluation of the hryvnia compared with pre-crisis levels. We are also considering whether to revise our rouble forecast and it is obvious to us that there is considerable downside risk for the rouble if the geopolitical situation worsens further.

It is also obvious to us that these events have significant negative ramifications for both the Russian and Ukrainian economies.

I normally like to tell my stories within a simple AS/AD framework. If you want to understand the economics of what is going on right now in both Russia and Ukraine think of recent events as a negative aggregate supply shock to both economies. So we will have lower growth and higher inflation – as well as weaker currencies in both Ukraine and Russia as a result of these events.

This is how it looks – the geo-political shocks pushes the short-run aggregate supply curve (SRAS) to the left – from SRAS to SRAS’. This causes inflation to increase from p to p’ and real GDP growth drops to y’ from y.

AS AD SRAS shock

From a monetary policy perspective the worst thing to do would of course be to tighten monetary policy in response to such a shock. Interestingly enough it seems like both countries despite initially tighthening monetary conditions to “defend” their currencies now have accepted that this is a foolish policy and both countries’ central banks are now moving in the direction of freely floating exchange rates. So at least here there is some common ground.

Lets hope and pray that peace prevalence.

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.

Thinking about monetary policy in Russia – a useful DSGE model?

I am going to Moscow in a couple of weeks. Going to Russia always inspires me to think about monetary policy in commodity exporting countries. I recently found what looks to be an interesting paper on monetary policy in commodity exporting countries – Monetary Policy in an Economy Sick with Dutch Disease”. The paper is from 2007.

I have started reading the paper, but as usual I want to share my joy of having found the paper with my readers before actually having read the entire paper. Here is the abstract:

“The paper studies monetary policy in an economy, in which the manufacturing sector is ousted completely by the presence of a large natural resource industry. Thus, the economy produces only non-tradable goods, which can complement or substitute imported goods, and the primary shock to the economy comes from the fluctuations in the world price of the exported commodity. A model of such an economy is calibrated using parameters relevant for Russia, which is an example of an economy sick with Dutch Disease, and several conventional policy rules are considered. It is shown that in absence of a well-functioning fiscal stabilization fund, it may be optimal for monetary authorities to respond to the real exchange rate, as the Bank of Russia allegedly does, using purchases of foreign reserves as the policy instrument. The logic of these actions is to replace the absent fiscal stabilization policy. In case monetary policy is conducted using an interest rate instrument, there should be no reaction to the real exchange rate and only slight one – to inflation.”

In the paper the authors Kirill Sosunov and Oleg Zamulin present a DSGE model for the Russian economy. The model in many ways is similar to my own thinking of the Russian economy and I therefore think it would be interesting to update Zamulin and Sosunov’s work. It would for example be extremely interesting to simulate the 2008-9 shock in the model under different monetary policy rules and what rules would have done the least harm to the Russian economy. Would my suggestion that Russia should have followed an Export Price Norm for example have prevented the crisis?

I have earlier claimed the sharp contraction in the Russian economy in 2008-9 was due to monetary policy failure. My feeling is that Zamulin and Sosunov’s model would yield a similar result, but I am not sure.

Anyway, I hope to be able to do some work on that model myself – with the help of my colleague Jens Pedersen – in the coming weeks. Then we will see what we manage to get out of the model and I would of course encourage others out there with interest in DGSE model and particularly with interest in monetary policy in commodity exporting countries to have a look at the model for yourself (please drop me a mail if you are doing work on monetary policy in commodity exporting countries as well – lacsen@gmail.com).

Now back to reading the paper…

Causality, econometrics and beautiful Saint Pete

I am going to Russia next week. It will be good to be back in wonderful Saint Petersburg. In connection with my trip I have been working on some econometric models for Russia. It is not exactly work that I enjoy and I am deeply skeptical about how much we can learn from econometric studies. That said, econometrics can be useful when doing practical economics – such as trying to forecast Russian growth and inflation.

So I have been working on this model for the Russian economy. The main purpose of the model is to learn about what I would would call the petro-monetary transmission mechanism in the Russian economy. It is my thesis that the primary channel for how oil prices are impacting the Russian economy is through the monetary transmission mechanism rather than through net exports.

Here is my theory in short: The Russian central bank (CBR) dislikes – or at least used to dislike – a freely floating exchange rate. Therefore the CBR will intervene to keep the ruble stable. These days the CBR manages the ruble within a band against a basket of the US dollar and the euro. Today the ruble is much more freely floating than it used to be, but nonetheless the ruble is still tightly managed and the ruble is certainly not a freely floating currency.

So why is that important for my econometric models for Russia? Well, it is important because it means quite a bit to the causality I assume in the model. Lets look at two examples. One where the ruble is completely pegged against another currency or a basket of currencies and another example where the ruble is freely floating and the central bank for example targets inflation or nominal GDP.

Pegged exchange rate: Causality runs from oil to money supply and NGDP 

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

Now lets look at the case where we assume a freely floating ruble.

Floating ruble: Oil prices and monetary policy will be disconnected

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

Do I have to forget about econometrics? Not necessarily

So what do that mean for my little econometric exercise on the Russian economy? Well, basically it means that I have to be extremely careful when I interpret the econometric output. The models I have been playing around with I have estimated from 2000 and until today. I have done what is called Structural VAR analysis (with a lot of help from a clever colleague who knows econometrics much better than me). Some of the results we get are surely interesting, however, we got one major problem and that is that during the 12 years we are looking Russian monetary policy has changed significantly.

In the early part of the estimation period the Russian central bank basically maintained a quasi-pegged exchange for the ruble against the dollar. Later, however, the CBR started to manage the ruble against a basket of dollars and euros and at the same time the CBR would “adjust” the ruble rate to hit changing nominal targets – for example an inflation target. The CBR have had multiple and sometimes inconsistent targets during the past decade. Furthermore, the CBR has moved gradually in the direction of a more freely floating ruble by allowing for a wider “fluctuation band” around the euro-dollar basket.

So basically we would expect that causality in the Russian economy in 2000 would be pretty much as described in the pegged exchange rate case, while it today should be closer to the floating exchange rate case. That of course means that we should not expect the causality in our model to be stable causal structure. Econometricians hate that – to me it is just a fact of life or as Ludwig von Mises used to say “there are no constants in economics” (I am paraphrasing von Mises from my memory). This of course is also know as the Lucas Critique. Some would of course argue that we could take this into account when we do our econometric work, but regime changes do not necessarily happen from day to day. Often regime change is gradual, which makes it impossible to really to take into account in econometric studies.

And this is one of my problems with econometrics – or rather with how econometric studies often are conducted. They do not take into account regime change and therefore do not take into account expectations. As a result well-known correlations tend to breakdown. The best example is of course the disappearance of the Phillips curve relationship in the 1970s and 1980s. Another example is the breakdown of the causal relationship between money supply growth and inflation in 1990s.

So what do I do? Should I give up on my little econometric venture? No, I don’t think so. Econometrics can clearly be useful in determining the magnitude and importance of different shocks in the economy and surely some of our econometric results on the Russian economy seems to be pretty robust. For example over the estimation period it seems like a 10% increase in the oil prices have increased the M2 and nominal GDP by around 2%. That is nice to know and is useful information when you want to do forecasting on the Russian economy. But it would be completely naive to expect this relationship to be constant over time. Rather the Russian central bank is clearly moving in the direction of a more and more freely floating ruble so we should expect the correlation between oil prices one the one hand and M2 and NGDP on the other hand to decrease going forward.

Concluding, econometrics can be useful in doing “practical” economics like macroeconomic forecasting, but one should never forget to do the homework on the institutional structures of the economy and one should never ever forget about the importance of expectations. Economic reasoning is much more important than any statistical results.

Related posts:
Next stop Moscow
International monetary disorder – how policy mistakes turned the crisis into a global crisis
Fear-of-floating, misallocation and the law of comparative advantages
PEP, NGDPLT and (how to avoid) Russian monetary policy failure
Should small open economies peg the currency to export prices?

The discretionary decision to introduce rules

At the core of Market Monetarists thinking is that monetary policy should be conducted within a clearly rule based framework. However, as Market Monetarists we are facing a dilemma. The rules or rather quasi-rules that is presently being followed by the major central banks in the world are in our view the wrong rules. We are advocating NGDP level targeting, while most of the major central banks in the world are instead inflation targeters.

So we have a problem. We believe strongly that monetary policy should be based on rules rather than on discretion. But to change the wrong rules (inflation targeting) to the right rules (NGDP targeting) you need to make a discretionary decision. There is no way around this, but it is not unproblematic.

The absolute strength of the way inflation targeting – as it has been conducted over the past nearly two decades – has been that monetary policy a large extent has become de-politicised. This undoubtedly has been a major progress compared to the massive politicisation of monetary policy, which used to be so common. And while we might be (very!) frustrated with central bankers these days I think that most Market Monetarists would strongly agree that monetary policy is better conducted by independent central banks than by politicians.

That said, I have also argued that central bank independence certainly should not mean that central banks should not be held accountable. In the absence of a Free Banking system, where central banks are given a monopoly there need to be very strict limits to what central banks can do and if they do not fulfil the tasks given to them under their monopoly then it should have consequences. For example the ECB has clear mandate to secure price stability in the euro zone. I personally think that the ECB has failed to ensure this and serious deflationary threats have been allowed to develop. To be independent does not mean that you can do whatever you want with monetary policy and it does not mean that you should be free of critique.

However, there is a fine line between critique of a central bank (particularly when it is politicians doing it) and threatening the independence of the central banks. However, the best way to ensure central bank independence is that the central bank is given a very clear mandate on monetary policy. However, it should be the right mandate.

Therefore, there is no way around it. I think the right decision both in the euro zone and in the US would be to move to change the mandate of the central banks to a very clearly defined NGDP level target mandate.

However, when you are changing the rules you are also creating a risk that changing rules become the norm and that is a strong argument for maintain rules that might not be 100% optimal (no rule is…). Latest year it was debated whether the Bank of Canada should change it’s flexible inflation targeting regime to a NGDP targeting. It was decided to maintain the inflation targeting regime. I think that was too bad, but I also fully acknowledge that the way the BoC has been operating overall has worked well and unlike the ECB the BoC has understood that ensuring price stability does not mean that you should react to supply shocks. As consequence you can say the BoC’s inflation targeting regime has been NGDP targeting light. The same can be said about the way for example the Polish central bank (NBP) or the Swedish central banks have been conducting monetary policy.

Market Monetarists have to acknowledge that changing the rules comes with costs and the cost is that you risk opening the door of politicising monetary policy in the future. These costs have to be compared to the gains from introducing NGDP level targeting. So while I do think that the BoC, Riksbanken and the NBP seriously should consider moving to NGDP targeting I also acknowledge that as long as these central banks are doing a far better job than the ECB and the Fed there might not be a very urgent need to change the present set-up.

Other cases are much more clear. Take the Russian central bank (CBR) which today is operating a highly unclear and not very rule based regime. Here there would be absolutely not cost of moving to a NGDP targeting regime or a similar regime. I have earlier argued that could the easiest be done with PEP style set-up where a currency basket of currencies and oil prices could be used to target the NGDP level.

Concluding, we must acknowledge that changing the monetary policy set-up involve discretionary decisions. However, we cannot maintain rules that so obviously have failed. We need rules in monetary policy to ensure nominal stability, but when the rules so clearly is creating instability, economic ruin and financial distress there is no way out of taking a discretionary decision to get of the rules and replace them with better rules.

PS While writing this I am hearing George Selgin in my head telling me “Lars, stop this talk about what central banks should do. They will never do the right thing anyway”. I fear George is right…

PPS Jeffrey Frankel has a very good article on the Death of Inflation Targeting at Project Syndicate. Scott also comments on Jeff’s article. Marcus Nunes also comments on Jeff’s article.

PPPS It is a public holiday in Denmark today, but I have had a look at the financial markets today. When stock markets drop, commodity prices decline and long-term bond yields drop then it as a very good indication that monetary conditions are getting tighter…I hope central banks around the world realise this…

Next stop Moscow

I am writing this as I am flying to Moscow to spend a couple of days meeting clients in Moscow. It will be nice to be back. A lot of things are happing in Russia at the moment – especially politically. A new opposition has emerged to President Putin’s regime. However, even though politics always comes up when you are in Russia I do not plan to talk too much about the political situation. Everybody is doing that – so I will instead focus my presentations on monetary policy matters as I believe that monetary policy mistakes have been at the core of economic developments in Russia over the last couple of years. I hope to add some value as I believe that few local investors in Russia are aware of how crucial the monetary development is.

Here are my main topics:

1) The crucial link between oil prices, exchange rate developments and monetary policy. Hence, what we could call the petro-monetary transmission mechanism in the Russian economy

2) Based on the analysis of the petro-monetary transmission mechanism I will demonstrate that the deep, but short, Russian recession in 2008-9 was caused by monetary policy failure. This is what Robert Hetzel calls the “monetary disorder view” of recession

3) Why the Russian economy is in recovery and the role played by monetary easing

4) Changing the monetary regime: The Russian central bank (CBR) has said it wants to make the Russian ruble freely floating in 2013 (I doubt that will happen…). What could be the strategy for CBR to move in that direction?

The petro-monetary transmission mechanism
When talking about the Russian economy with investors I often find that they have a black-box view of the Russian economy. For most people the Russian economy seems very easy to understand – too easy I would argue. On the one hand the they see oil prices going up or down and on the other hand they see growth going up or down.

And it is also correct that if one has a look at real or nominal GDP growth of the past decade then one would spot a pretty strong correlation to changes in oil prices. That makes most people think that when oil prices increase Russian exports increase and as result GDP increases. However, this is the common mistake when doing economics based on a simple quasi-Keynesian national accounting identity Y=C+I+X+G+NX.

What most people believe is happening is that net exports (NX) increase when oil prices increase. As a result Y increases (everything else is just assumed to be a function of Y). However, a closer look at the Russian data will make you realise that this is not correct. In fact during the boom-years 2005-8 net exports was actually “contributing” negatively to GDP growth as import growth was outpacing export growth.

So what did really happen? Well, we have to study the crucial link between oil prices, the ruble exchange rate and money supply.

As I have described in an earlier post the Russian central bank (CBR) despite its stated goal of floating the ruble suffers from a distinct fear-of-floating. The CBR simply dislikes currency volatility. Therefore, when the ruble is strengthening the CBR would intervene in the FX market (printing ruble) to curb the strengthening. And it would also intervene (buying ruble) when the currency is weakening. In recent years it has been doing so by managing the ruble against a basket of euros (55%) and dollars (45%).

This is really the reason for the link between oil prices and the GDP (both real and nominal) growth. Imagine that oil prices increases strongly as was the case in the years just prior to crisis hit in 2008. In such that situation oil exports revenues will be increasing (even if oil output in Russian is stagnated). With oil revenues increasing the ruble would tend to strengthen. However, the CBR is keeping the ruble more or less stable against the EUR-USD basket and it therefore will have to sell ruble (increase the money supply) to avoid the ruble strengthening (“too much” for CBR’s liking).

This is the petro-monetary link. Increased oil prices increase the money supply as a result of the CBR quasi-fixing of the ruble.

Therefore, it makes much more sense instead of a national account approach to go back to the most important equation in macroeconomics – the equation of exchange:

(1) MV=PY

Russian money-velocity (V) has been declining around a fairly stable trend over the past decade. We can therefore assume – to make things slightly easier that V has been growing (actually declining) at a fairly stable rate v’. We can then write (1) in growth rates:

(2) m+v’=p+y

As we know from above money supply growth (m) is a function of oil prices (oil) – if CBR is quasi-pegging the ruble:

(3) m=a*oil

a is a constant.

Lets also introduce a (very!) simple Phillips curve into the economy:

(4) p=by

p is of course inflation and y is real GDP growth. Equation 2,3 and 4 together is a very simple model of the Russian economy, but I frankly speaking think that is all you need to analyse the business cycle dynamics in the Russian economy given the present monetary policy set-up. (You could analyse the risk of bubbles in property market by introducing traded and non-trade goods, but lets look at that in another blog post).

If we assume oil prices (oil) and trend-velocity (v’) are exogenous it is pretty easy to solve the model for m, p and y.

Lets solve it for y by inserting (3) and (4) into (2). Then we get:

(2)’ a*oil+v’=(1+b)y

(2)’ y= a/(1+b)*oil+1/(1+b)*v’

So here we go – assuming sticky prices (the Phillips curve relationship between p and y) we get a relationship between real GDP growth and oil price changes similar to the “common man’s model” for the Russian economy. However, this link does only exist because of the conduct of monetary policy. The CBR is managing the float of the ruble, which creates the link between oil prices and real GDP growth. Had the CBR instead let the ruble float freely or linked the ruble in some way to oil prices then the oil price-gdp link would have broken down.

The CBR caused the 2009 crisis

You can easily use the model above to analyse what happen to the Russian economy in 2008-2009. I have already in a previous post demonstrated that the CBR caused the crisis in 2008-9 by not allowing the ruble to depreciate enough in the autumn of 2008.

Lets have a short look at the crisis through the lens of the model above. What happened in 2008 was that oil prices plummeted. As a consequence the ruble started to weaken. The CBR however, did not want to allow that so it intervened in the FX market – buying ruble and selling foreign currency. That is basically equation (3). Oil prices (oil) dropped, which caused the Russian money supply (m) to drop 20 % in October-November 2008.

As m drops it most follow from (2) that p and/or y will drop as well (remember we assume v’ to be constant). However, because p is sticky – that’s equation (4) – real GDP (y) will have to drop. And that is of course what happened. Russia saw the largest drop in real GDP (y) in G20.

It’s really that simple…and everything that followed – for example a relatively large banking crisis – was caused by these factors. Had the ruble been allowed to drop then the banking crisis would likely have been much smaller in scale.

Recovery time…

On to the next step. In early 2009 the Federal Reserve acted by moving towards more aggressive monetary easing and that caused global oil prices to rebound. As a result the ruble started to recover. Once again that CBR did not allow the ruble to be determined by market forces. Instead the CBR moved to curb the strengthening of the ruble. We are now back to equation (3). With oil prices (oil) increasing money supply growth (m) finally started to accelerate in 2009-10. With m increasing p and y would have to increase – we know that from equation (2) – and as p is sticky most of the initial adjustment would happen through higher real GDP growth (y). That is exactly what happened and that process has continued more or less until today.

It now seems like we have gone full cycle and that the Russian economy is operating close to full capacity and there are pretty clear signs that we now are moving back to an overly expansionary monetary policy. The question therefore is what is next for the CBR?

Time to move to a new monetary regime

The Russian central bank has announced that it wants to move to a freely floating ruble in 2013. That would make good sense as the discussion above in my view pretty clearly demonstrates that the CBR’s present monetary policy set-up has been extremely costly and lead to quite significant misallocation of economic resources.

Furthermore, as I have demonstrated above the link between economic activity and oil prices only exist in the Russian economy do to the conduct of monetary policy in Russia. If the ruble was allowed to fluctuate more freely, then we would get a much more stable development in not only inflation and nominal GDP (which is fully determined by monetary factors), but also in real GDP.

But how would you move from the one regime to the other. The simple solution would of course be to announce one day that from today the ruble is freely floating. That, however, would still beg the question what should the CBR then target and what instruments should it use to achieve this target?

Obviously as a Market Monetarist I think that the CBR should move towards a monetary regime in which relative prices are not distorted. A NGDP level targeting regime would clearly achieve that. That said, I am very sceptical about the quality of national account data in Russia and it might therefore in praxis be rather hard to implement a strict NGDP level targeting regime (at least given the present data quality). Second, even though I as a Friedmanite am strongly inclined to be in favour floating exchange rates I also believe that using the FX rate as a monetary instrument would be most practical in Russia given it’s fairly underdeveloped financial markets and (over) regulated banking sector.

Therefore, even though I certainly think a NGDP level target regime and floating exchange rates is a very good long-term objective for Russia I think it might make sense to move there gradually. The best way to do so would be for the CBR to announce a target level for NGDP, but implement this target by managing the ruble against a basket of euros and dollars (that is basically the present basket) and oil prices (measured in ruble).

Even though the CBR now is targeting a EUR-USD basket it allows quite a bit of fluctuations around the basket. These fluctuations to a large extent are determined by fluctuations in oil prices. Therefore, we can say that the CBR effective already has included oil prices in the basket. In my view oil prices effectively are somewhere between 5 and 10% of the “basket”. I think that the CBR should make that policy official and at the same time it should announce that it would increase the oil prices share of the basket to 30% in 1-2 years time. That I believe would more or less give the same kind of volatility in the ruble we are presently seeing in the much more freely floating Norwegian krone.

Furthermore, it would seriously reduce the link between swings in oil prices and in the economy. Hence, monetary policy’s impact on relative prices would be seriously reduced and as I have shown in my previous post there has been a close relationship between oil prices measured in ruble and nominal GDP growth. Hence, if the stability of oil prices measured in ruble is increased (which would happen if oil prices is included in the FX basket) then nominal GDP will also become much more stable. It will not be perfect, but I believe it would be a significant step in the direction of serious increasing nominal stability in Russia.

I am now finishing this blog post in the airport in Moscow waiting for a local colleague to pick me up, while talking to a very drunk ethic Russian Latvian who is on his way to Kazakhstan. He is friendly, but very drunk and not really interested in monetary theory…I hope the audience in the coming days

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).

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