Grexit, Germany and Googlenomics

The talk of Greece leaving the euro area – Grexit – is back. Will Grexit actually happen? I don’t know, but I do know that more and more people worry that it will in fact happen.

This is what Google Trends is telling us about Google searches for “Grexit“:

Grexit

And guess what? While this is happening euro zone inflation expectations have collapsed. In fact this week 5-year German inflation expectations turned negative! This mean that the fixed income markets now expect German inflation to be negative for the next five years!

It is hard to find any better arguments for massive quantitative easing within a rule-based framework in the euro zone (with or without Greece). And this is how it should be done.

PS it has been argued recently that euro zone bond yields have declined because the markets are pricing in QE from the ECB. Well, if that is the case why is inflation expectations collapsing? After all investors should not expect monetary easing to led to lower inflation (in fact deflation) – should they?

PPS I do realise that the drop in oil prices play a role here, but the markets (forwards) do not forecast a drop in oil prices over the coming five years so oil prices cannot explain the deflationary expectations in Europe.

Yet another year of asymmetrical monetary policy – revisiting the Weidmann rule

Nearly a year ago – January 2 – I wrote a blog post on what I termed the Weidmann rule. In the blog post I argued that the ECB is basically following a rule – named after Bundesbank boss Jens Weidmann – which is asymmetrical. The ECB will tighten monetary conditions in the event of a positive aggregate demand (velocity) shock, but will not ease in the event of a negative demand (velocity) shock to the euro zone economy.

This means that the ECB monetary policy set-up basically ensures that we are in a classical world when demand is picking (the budget multiplier is zero), but is in a basically keynesian world when we have negative demand shocks (the budget multiplier is positive). The world is not “naturally” keynesian, but the ECB’s policy regime makes the euro zone economy is essentially 50% keynesian.

A year ago I argued that the Weidman rule would be deflationary. Hence, “if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).”

This is of course exactly what we have seen over the past year – US NGDP remains on its 4% path, while euro zone has averaged less than 1% over the past year and the gap between US and euro zone NGDP is therefore growing larger and larger.

Add to that that euro zone has seen as least two negative demand shocks in 2014. First of all and likely most important the Russian (Ukrainian) crisis, which is likely to lead to a double-digit contraction in Russian real GDP in 2015 and second renewed concerns over the political situation in Greece and other Southern European countries (particularly separatist worries in Spain). These shocks are so far not major shocks and with a proper monetary policy set-up would like have very limited impact on the European economy. However, we do not have a proper monetary policy set-up and therefore every even smaller negative demand shock will just push Europe deeper and deeper into a deflationary spiral.

It is correct that the ECB has done a bit to offset these shocks – which in quantity theoretical context essentially are negative velocity shocks – by cutting interest rates and indicated that we will get some sort of quantitative easing in 2015.

However, with the euro zone money base basically still contracting, M3 growth being lacklustre, inflation expectations declining and NGDP growth being very weak it is hard to argue that the ECB has done a lot. In fact it has not really done anything to even offset the negative velocity/demand shocks we have seen in 2015.

Therefore, we unfortunately have to conclude that the Weidmann rule still the name of the game in Frankfurt and all indications are that the Bundesbank remains strongly opposed to any quantitative easing.

What the ECB needs to do is of course to once and for all to demonstrate that it will indeed offset any shock to velocity – both negative and positive to ensure nominal stability. A 4% NGDP target rule would do the job (see here) and would be fully within ECB’s mandate.

PS These days Jens Weidmann is arguing that things will be a lot better in the euro zone because the drop in oil prices is a positive demand shock (yes, this is basically what he is saying) and that monetary easing therefore is not needed. In 2011 the Bundesbank of course was eager to see interest rate hikes in response to increased oil prices because the risk of “second-round effects” (horrible expression!). It is hard to get any better illustration of the just how asymmetrical the Bundesbank’s preferred monetary policy rule is.

PPS Tim Worstall has an excellent post on Jens Weidmann and the Bundesbank here.

Political unrest is always and everywhere a monetary phenomenon – also in Greece

This is Sara Sjolin at MarketWatch.com:

Greece’s Athex Composite tanked almost 13% Tuesday — the biggest drop for the index on record, according to FactSet. The renewed jitters came after the government, in a surprise move late Monday, said it would bring forward presidential elections to Dec. 17, potentially, setting the scene for snap elections in early 2015.

Here’s why that’s important: Far-left party Syriza currently is leading the early polls and it seems likely they would win a snap election. This is how to think about Syriza:

  • The party has been calling for an end to austerity in Greece
  • Has been campaigning for market-unfriendly measures
  • Is firmly against the international bailout program that helped the country avoid a default during the depths of its financial crisis.

How bad is Greece’s Tuesday collapse? It’s worse than the 9.7% drop the market saw Oct. 24, 2010, at the peak of Greek debt worries. The drop also eclipses the 10% fall Greek markets saw in 1989 during a bout of political turmoil.

…With Greece’s problems once again in the limelight, investors all across Europe. the Stoxx Europe 600 index slumped 2.3%, while Germany’s DAX 30 index fell 2.2% and France’s CAC 40 index  gave up 2.5%.

Greek government bond yields  jumped 75 basis point to 7.90%, according to electronic trading platform Tradeweb.

So once again political news slips in to the financial section of the news. As Scott Sumner once expressed it about his studies of the Great Depression:

“And the worst part was the way political news kept slipping into the financial section. Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc. In the 1930s the readers didn’t know what came next—but I did.”

I must admit that the similarities between the continued euro crisis and the situation during the 1930s worries me a great deal and my regular readers well-know that I to a large extent blame the deepening political troubles in Europe on the deep economic crisis caused mainly by extremely tight monetary conditions in the euro zone.

Just to remind everybody how bad it is in Greece. Take a look graph below comparing the real GDP lose in Austria during Great Depression and Greece during the present crisis (Year 0 is 1929 for Austria and 2008 for Greece.)

I used Austria as a comparison because the country had massive banking crisis (in 1931), had one of the deepest depressions of all of the European economies during the Great Depression and maintained the Gold Standard the longest.

Greece Austria

Given the scale of the crisis in Greece it is hardly surprising that extremist parties like Syriza and Golden Dawn are very popular parties. After all Austria disintegrated politically during the 1930s and eventually ceased to exist as an independent nation in 1938.

European horror graph of the day – the Greek price level collapse

It has been said that the recent decline in European inflation to a large extent is due to a positive supply shock. This is to some extent correct and it is something I have acknowledged on a number of occassions. However, the main deflationary problem comes from the demand side of the European economy and the fact that monetary policy remains extremely tight in the euro zone is the main cause of the deflationary pressures in the European economy. A simple (but incomplete) way to strip out supply side effects from the price level is to look at the GDP deflator. This is what I here have done for Greece. This is the horror graph of the day – it is the level of the Greek GDP deflator relative to the pre-crisis trend (2000-7).

greek-price-level

I challenge my readers to find ANY example from history where such a collapse in the price level has ended in anything else than tears. PS note that there are no signs of inflationary pressures in the Greek economy escalating prior to the crisis. This is not about imbalances, but about a negative monetary policy shock.

Deflation – not hyperinflation – brought Hitler to power

This Matt O’Brien in The Atlantic:

“Everybody knows you can draw a straight line from its hyperinflation to Hitler, but, in this case, what everybody knows is wrong. The Nazis didn’t take power when prices were doubling every 4 days in 1923– they tried, and failed — but rather when prices were falling in 1933.”

Matt is of course right – unfortunately few European policy makers seem to have studied any economic and political history. Furthermore, few advocates of free market Capitalism today realise that the biggest threat to the capitalist system is not overly easy monetary policy. The biggest threat to free market Capitalism is overly tight monetary policy as it brings reactionary and populist forces – whether red or brown – to power.

Update: This is from the German magazine Spiegel:

From 1922-1923, hyperinflation plagued Germany and helped fuel the eventual rise of Adolf Hitler.”

…I guess somebody in the German media needs a lesson in German history.

HT Petar Sisko.

PS Scott Sumner has a new blog post on how wrong many free market proponents are about monetary issues.

PPS take a look at this news story from the deflationary euro zone.

Greece in the news – 81 years ago…

This is from the “The Brisbane Courier” April 18 1932

Suspension by Greece

GENEVA, April 15

M. Venizelos, the Prime Minister of Greece, told the League of Nations today that Greece would be unable to balance her budget without suspending her debt payments abroad. He hoped the necessity for such suspension would be only temporary.

LONDON, April 16

The Greek Legation announces that in accordance with M Venizelos’s explanation the bond holders are to be requested to consent to the suspension of payments on account of loans and sinking fund for five years and to the non-transfer of the payment coupons of these loans, which are due on May 1 until the Powers have granted Greece assistance in accordance with the recommendations of the League of Nations’ Finance Committee

Two weeks later Greece defaulted and gave up the gold standard…

 

Papers about money, regime uncertainty and efficient religions

I have the best wife in the world and she has been extremely understanding about my odd idea to start blogging, but there is one thing she is not too happy about and that is that I tend to leave printed copies of working papers scatted around our house. I must admit that I hate reading working papers on our iPad. I want the paper version, but I also read quite a few working papers and print out even more papers. So that creates quite a paper trail in our house…

But some of the working papers also end up in my bag. The content of my bag today might inspire some of my readers:

“Monetary Policy and Japan’s Liquidity Trap” by Lars E. O. Svensson and “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rate” by Bennett T. McCallum.

These two papers I printed out when I was writting my recent post on Czech monetary policy. It is obvious that the Czech central bank is struggling with how to ease monetary policy when interest rates are close to zero. We can only hope that the Czech central bankers read papers like this – then they would be in no doubt how to get out of the deflationary trap. Frankly speaking I didn’t read the papers this week as I have read both papers a number of times before, but I still think that both papers are extremely important and I would hope central bankers around the world would study Svensson’s and McCallum’s work.

“Regime Uncertainty – Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” – by Robert Higgs.

My regular readers will know that I believe that the key problem in both the US and the European economies is overly tight monetary policy. However, that does not change the fact that I am extremely fascinated by Robert Higgs’ concept “Regime Uncertainty”. Higgs’ idea is that uncertainty about the regulatory framework in the economy will impact investment activity and therefore reduce growth. While I think that we primarily have a demand problem in the US and Europe I also think that regime uncertainty is a highly relevant concept. Unlike for example Steve Horwitz I don’t think that regime uncertainty can explain the slow recovery in the US economy. As I see it regime uncertainty as defined by Higgs is a supply side phenomena. Therefore, we should expect a high level of regime uncertainty to lower real GDP growth AND increase inflation. That is certainly not what we have in the US or in the euro zone today. However, there are certainly countries in the world where I would say regime uncertainty play a dominant role in the present economic situation and where tight monetary policy is not the key story. My two favourite examples of this are South Africa and Hungary. I would also point to regime uncertainty as being extremely important in countries like Venezuela and Argentina – and obviously in Iran. The last three countries are also very clear examples of a supply side collapse combined with extremely easy monetary policy.

Furthermore, we should remember that tight monetary policy in itself can lead to regime uncertainty. Just think about Greece. Extremely tight monetary conditions have lead to a economic collapse that have given rise to populist and extremist political forces and the outlook for economic policy in Greece is extremely uncertain. Or remember the 1930s where tight monetary conditions led to increased protectionism and generally interventionist policies around the world – for example the horrible National Industrial Recovery Act (NIRA) in the US.

I have read Higg’s paper before, but hope to re-read it in the coming week (when I will be traveling a lot) as I plan to write something about the economic situation in Hungary from the perspective of regime uncertain. I have written a bit about that topic before.

“World Hyperinflations” by Steve Hanke and Nicholas Krus.

I have written about this paper before and I have now come around to read the paper. It is excellent and gives a very good overview of historical hyperinflations. There is a strong connection to Higgs’ concept of regime uncertainty. It is probably not a coincidence that the countries in the world where inflation is getting out of control are also countries with extreme regime uncertainty – again just think about Argentina, Venezuela and Iran.

“Morality and Monopoly: The Constitutional political economy of religious rules” by Gary Anderson and Robert Tollison.

This blog is about monetary policy issues and that is what I spend my time writing about, but I do certainly have other interests. There is no doubt that I am an economic imperialist and I do think that economics can explain most social phenomena – including religion. My recent trip to Provo, Utah inspired me to think about religion again or more specifically I got intrigued how the Church of Jesus Chris Latter day Saints (LDS) – the Mormons – has become so extremely successful. When I say successful I mean how the LDS have grown from being a couple of hundreds members back in the 1840s to having millions of practicing members today – including potentially the next US president. My hypothesis is that religion can be an extremely efficient mechanism by which to solve collective goods problems. In Anderson’s and Tollison’s paper they have a similar discussion.

If religion is an mechanism to solve collective goods problems then the most successful religions – at least those which compete in an unregulated and competitive market for religions – will be those religions that solve these collective goods problems in the most efficient way. My rather uneducated view is that the LDS has been so successful because it has been able to solve collective goods problems in a relatively efficient way. Just think about when the Mormons came to Utah in the late 1840s. At that time there was effectively no government in Utah – it was essentially an anarchic society. Government is an mechanism to solve collective goods problems, but with no government you have to solve these problems in another way. Religion provides such mechanism and I believe that this is what the LDS did when the pioneers arrived in Utah.

So if I was going to write a book about LDS from an economic perspective I think I would have to call it “LDS – the efficient religion”. But hey I am not going to do that because I don’t really know much about religion and especially not about Mormonism. Maybe it is good that we are in the midst of the Great Recession – otherwise I might write about the economics and religion or why I prefer to drive with taxi drivers who don’t wear seat belts.

—-

Update: David Friedman has kindly reminded me of Larry Iannaccone’s work on economics of religion. I am well aware of Larry’s work and he is undoubtedly the greatest authority on the economics of religion and he is president of the Association for the Study of Religion, Economics and Culture. Larry’s paper “Introduction to the Economics of Religion” is an excellent introduction to the topic.

Greece is not really worse than Germany (if you adjust for lack of growth)

Market Monetarists have stressed it again and again – the European crisis is primarily a monetary crisis rather than a financial crisis and a debt crisis. Tight monetary conditions is reason for the so-called debt crisis. Said in another way it is the collapse in nominal GDP relative to the pre-crisis trend that have caused European debt ratios to skyrocket in the last four years.

That is easily illustrated – just see the graph below:

I have simply plotted the change in public debt to GDP from 2007 to 2012 (2012 are European Commission forecasts) against the percentage change in nominal GDP since 2007.

The conclusion is very clear. The change in public debt ratios across the euro zone is nearly entirely a result of the development in nominal GDP.

The “bad boys” the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain (and Slovenia) are those five (six) countries that have seen the most lackluster growth (in fact decline) in NGDP in the euro zone. These countries are obviously also the countries where debt has increased the most and government bond yields have skyrocketed.

This should really not be a surprise to anybody who have taken Macro 101 – public expenditures tend to increase and tax revenues drop in cyclical downturns. So higher budget deficits normally go hand in hand with weaker growth.

The graph interestingly enough also shows that the debt development in Greece really is no different from the debt development in Germany if we take the difference in NGDP growth into account. Greek nominal GDP has dropped by around 10% since 2007 and that pretty much explains the 50%-point increase in public debt since 2007. Greece is smack on the regression line in the graph – and so is Germany. The better debt performance in Germany does not reflect that the German government is more fiscally conservative than the Greek government. Rather it reflects a much better NGDP growth performance. So maybe we should ask the Bundesbank what would have happened to German public debt had NGDP dropped by 10% as in Greece. My guess is that the markets would not be too impressed with German fiscal policy in that scenario. It should of course also be noted that you can argue that the Greek government really has not anything to reduce the level of public debt – if it had than the Greece would be below to the regression line in the graph and it is not.

There are two outliers in the graph – Ireland and Estonia. The increase in Irish debt is much larger than one should have expected judging from the size of the change in NGDP in Ireland. This can easily be explained – it is simply the cost of the Irish banking rescues. The other outlier is Estonia where the increase in public debt has been much smaller than one should have expected given the development in nominal GDP. In that sense Estonia is really the only country in the euro zone, which have improved its public finances in any substantial fashion compared to what would have been the case if fiscal austerity had not been undertaken. The tightening of fiscal policy measured in this way is 20-25% of GDP. This is a truly remarkable tightening of fiscal policy.

Imagine, however, for one minute that Greece had undertaken a fiscal tightening of a similar magnitude as Estonia and assume at the same time that it would have had no impact on NGDP (the keynesians are now screaming) then the Greek budget situation would still have been horrendous – public debt would have not increase by 50% %-point of GDP but “only” by 30%-point. Greece would still be in deep trouble. This I think demonstrates that it is near impossible to undertake any meaningful fiscal consolidation when you see the kind of collapse in NGDP that you have seen in Greece.

Concluding, the European debt crisis is not really a debt crisis. It is a monetary crisis. The ECB has allowed euro zone nominal GDP to drop well-below its pre-crisis trend and that is the key reason for the sharp rise in public debt ratios. I am not saying that Europe do not have other problems. In fact I think Europe has serious structural problems – too much regulation, too high taxes, rigid labour markets, underfunded pension systems etc. However, these problems did not cause the present crisis and even though I think these issues need to be addressed I doubt that reforms in these areas will be enough to drag us out of the crisis. We need higher nominal GDP growth. That will be the best cure. Now we are only waiting on Draghi to deliver.

PS The graph above also illustrate how badly wrong Arthur Laffer got it on fiscal policy in his recent Wall Street Journal article – particular in his claim that Estonia had been got conducting keynesian fiscal stimulus. See here, here and here.

Remember the last time Greece was kicked out of a monetary union?

Speculation about a Greek exit for the euro zone continues ahead of the weekend’s Greek parliament elections. If Greece leaves the euro (or is kicked out) then it will not be the first time Greece has been forced out of a currency union.

This is from a 2003 working paper from the Greek central bank(!):

“The Latin Monetary Union (LMU) is thought by many to be the 19th predecessor of the recent venture of the European Monetary Union. It was designed for the same reasons that led to the adoption of the euro in the dawn of the new millennium, i.e. “the creation of a lake of monetary stability in the very perturbed ocean of the international monetary system”… The LMU was in essence a metallic monetary system in which the two precious metals, gold and silver, were used as a numeraire, i.e. as a unit for determining the value of all the other currencies. The benefit from the creation of the LMU was the moderation of fluctuations observed in the market prices of gold and silver, caused by the discovery of new supplies of precious metals.

…Although participation in the LMU demanded strict monetary discipline, this was not secured via an institutional framework that would impose firm criteria for fiscal management.

…The need to reform the Greek monetary system became urgent in the mid-1860s when Spain abandoned the monetary system that was based on the distilo. At that time, international trade transactions were made in currency directly convertible into precious metals at a fixed rate, and, therefore, Greece had to adopt a monetary system that would be acceptable by other countries. The Greek governments expected that by joining the LMU the country could enjoy monetary stability. First, Greece would no longer face money scarcity since domestic transactions would also be carried out in French francs; second, tying the drachma to the French franc at a fixed rate would reduce exchange rate fluctuations; and, third, Greece would improve her solvency in the international capital market of Paris.

…Beginning in the mid-1870s, political instability in Greece led to an increase of fiscal deficits. The segmentation of the Parliament into many small political parties and the short-lived governments caused a loss of revenues due to the laxity in tax collection and an increase in expenditure due to the numerous dismissals and transfers of civil servants that accompanied each change of government. None of the 19th century governments dared to undertake a budget reform, namely to improve the tax collection system and raise revenues from income taxes.Public expenditures – overwhelming government consumption – were financed by domestic borrowing contracted on unfavourable terms to the government, resulting in an excessive burdening of the budget during the second half of the 1870s.

In an effort to ensure banknote convertibility, the Greek government tried to avoid inflation as a tax instrument but rather incurred welfare losses in return for income tax revenues. However, the Russo-Turkish War of 1877-78 caused new wartime emergencies and aggravated the position of the budget even further. Considering the rise of its defence expenses as temporary and with the intention to maintain the specie convertibility rule during the war, the government tried – unsuccessfully – to finance them by domestic debt issuance. The loans, however, were only partly covered and, ultimately, the government relied on inflation finance to meet its borrowing requirements.

…However, the new system only lasted nine months, as the government failed to control the fiscal deficits and thus to support the credibility of the system. The high interest payments as well as the economic crisis, which had started out as a commercial crisis near the end of 1884, caused large gold outflows. In addition, the long-lived fiat standard that the country experienced prior to 1885 caused a lack of confidence in the domestic currency, which resulted in a massive de-hoarding of banknotes immediately after the restoration of specie standards.”

And it goes on and on…

“Foreign creditors demanded the presence of foreign experts for the monitoring of the economic policy pursued and, especially, of the tax collection and management systems. This demand was seen as a pre-condition for the government to pursue a monetary and fiscal policy, which would ensure both the regular repayment of the foreign debt, as well as its repayment in drachmas convertible to gold at par value. After her humiliating defeat in the Greco-Turkish war of 1897 and the resulting huge war indemnity she had to pay to Turkey, Greece was forced to accept the presence of the International Committee for Greek debt management. 1898 was the beginning of a period of intensive disinflation. Successive Finance Ministers curtailed expenditures and increased indirect taxes in an effort to balance the budget.

But prudence apparently never lasts for long in Greece and in 1908 the other countries in the currency union had it enough and effectively expelled Greece. However, Greece was allowed back in in 1910, but when first World War broke out in 1914 the Latin Currency Union effectively collapsed.

This is what University of Chicago economist Henry Parker Willis had to say about the whole thing in his 1901 report ‘History of the Latin Monetary Union’ (I got this from Oliver Marc Hartwich):

“It is hard to see why the admission of Greece to the Latin Union should have been desired or allowed by that body. In no sense was she a desirable member of the league. Economically unsound, convulsed by political struggles, and financially rotten, her condition was pitiable. Struggling with a burden of debt, Greece was also endeavouring to maintain in circulation a large amount of inconvertible paper. She was not territorially a desirable adjunct to the Latin Union, and her commercial and financial importance was small. Nevertheless her nominal admission was secured, and we may credit the obscure political influences … with being able to effect what economic and financial considerations could not. Certainly it would be hard to understand on what other grounds her membership was attained.”

Surreal isn’t it?


Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

I think Rob who is one my readers hit the nail on the head when he in a recent comment commented that one of the things that is clearly differentiating Market Monetarism from other schools is our view of the monetary transmission mechanism. In my reply to his comment I promised Rob to write more on the MM view of the monetary transmission mechanism. I hope this post will do exactly that.

It is well known that Market Monetarists see a significantly less central role for interest rates in the monetary transmission mechanism than New Keynesians (and traditional Keynesians) and Austrians. As traditional monetarists we believe that monetary policy works through numerous channels and that the interest rate channel is just one such channel (See here for a overview of some of these channels here).

A channel by which monetary policy also works is the exchange rate channel. It is well recognised by most economists that a weakening of a country’s currency can boost the country’s nominal GDP (NGDP) – even though most economists would focus on real GDP and inflation rather than at NGDP. However, in my view the general perception about how a weakening the currency impacts the economy is often extremely simplified.

The “normal” story about the exchange rate-transmission mechanism is that a weakening of the currency will lead to an improvement of the country’s competitiveness (as it – rightly – is assumed that prices and wages are sticky) and that will lead to an increase in exports and a decrease in imports and hence increase net exports and in traditional keynesian fashion this will in real GDP (and NGDP). I do not disagree that this is one way that an exchange rate depreciation (or devaluation) can impact RGDP and NGDP. However, in my view the competitiveness channel is far from the most important channel.

I would point to two key effects of a devaluation of a currency. One channel impacts the money supply (M) and the other the velocity of money (V). As we know MV=PY=NGDP this should also make it clear that exchange rates changes can impact NGDP via M or V.

Lets start out in a economy where NGDP is depressed and expectations about the future growth of NGDP is subdued. This could be Japan in the late 1990s or Argentina in 2001 – or Greece today for that matter.

If the central bank today announces that it has devalued the country’s currency by 50% then that would have numerous impacts on expectations. First of all, inflation expectations would increase dramatically (if the announcement is unexpected) as higher import prices likely will be push up inflation, but also because – and more important – the expectation to the future path of NGDP would change and the expectations for money supply growth would change. Take Argentina in 2001. In 2001 the Argentinian central bank was dramatically tightening monetary conditions to maintain the pegged peso rate against the US dollar. This send a clear signal that the authorities was willing to accept a collapse in NGDP to maintain the currency board. Naturally that lead consumers and investors to expect a further collapse in NGDP – expectations basically became deflationary.  However, once the the peg was given up inflation and NGDP expectations spiked. With the peso collapsing the demand for (peso) cash dropped dramatically – hence money demand dropped, which of course in the equation of exchange is the same as an increase in money-velocity. With V spiking and assuming (to begin with) that  the money supply is unchanged NGDP should by definition increase as much as the increase in V. This is the velocity-effect of a devaluation. In the case of Argentina it should of course be noted that the devaluation was not unexpected so velocity started to increase prior to the devaluation and the expectations of a devaluation grew.

Second, in the case of Argentina where the authorities basically “outsourced” the money policy to the Federal Reserve by pegging the peso the dollar. Hence, the Argentine central bank could not independently increase the money supply without giving up the peg. In fact in 2001 there was a massive currency outflow, which naturally lead to a sharp drop in the Argentine FX reserve. In a fixed exchange rate regime it follows that any drop in the foreign currency reserve must lead to an equal drop in the money base. This is exactly what happened in Argentina. However, once the peg was given up the central bank was free to increase the money base. With M increasing (and V increasing as argued above) NGDP would increase further. This is the money supply-effect of a devaluation.

The very strong correlation between Argentine M2 and NGDP can be seen in the graph below (log-scale Index).

I believe that the combined impact of velocity and money supply effects empirically are much stronger than the competitiveness effect devaluation – especially for countries in a deflationary or quasi-deflationary situation like Argentina was in in 2001. This is also strongly confirmed by what happened in Argentina from 2002 and until 2005-7.

This is from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

Hence, the Argentine example clearly confirms the significant importance of monetary effects in the transmission of a devaluation to NGDP (and RGDP for that matter) and at the same time shows that the competitiveness effect is rather unimportant in the big picture.

There are other example out there (there are in fact many…). The US recovery after Roosevelt went of the gold standard in 1933 is exactly the same story. It was not an explosion in exports that sparked the sharp recovery in the US economy in the summer of 1933, but rather the massive monetary easing that resulted from the increase in M and V. This lesson obviously is important when we today are debate whether for example Greece would benefit from leaving the euro area or whether one or another country should maintain a pegged exchange rate regime.

A bit on Danish 1970s FX policy

In my home country of Denmark it is often noted that the numerous devaluations of the Danish krone in the 1970s completely failed to do anything good for the Danish economy and that that proves that devaluations are bad under all circumstances. The Danish example, however, exactly illustrate the problem with the “traditional” perspective on devaluations. Had Danish policy makers instead had an monetary approach to exchange rate policy in 1970s then the policies that would have been implemented would have been completely different.

Denmark – as many other European countries – was struggling with stagflation in the 1970s – both inflation and unemployment was high. Any monetarist would tell you (as Friedman did) that this was a result of a negative supply shock (and general structural problems) combined with overly loose monetary policy. The Danish government by devaluating the krone (again and again…) tried to improve competitiveness and thereby bring down unemployment. However, the high level of unemployment was not due to lack of demand, but rather due to supply side problems. The Danish economy was not in a deflationary trap, but rather in a stagflationary trap. That is the reason the devaluations did not “work” – well it worked perfectly well in terms of increasing inflation, but it did not bring down unemployment as the problem was not lack of demand (contrary to what is the case most places in Europea and the US today).

Conclusion – it’s not about competitiveness

So to conclude, the most important channels of exchange rate policy is monetary – the velocity effect and the money supply – the competitiveness effect is nearly as irrelevant as interest rates is. Countries that suffer from too tight monetary policy can ease monetary policy by announcing a credible devaluation or by letting the currency float. Argentina is a clear example of that. Countries that suffer from supply side problems – like Denmark in 1970s – can not solve the fundamental problems by devaluation.

PS the discussion above is not an endorsement of general economic policy in Argentina after 2001, but only meant as an illustration of the exchange rate channel for monetary policy. Neither is it an recommendation concerning what country XYZ should should do in terms of monetary and exchange rate policy today.

PPS Obviously Scott would remind us that the above discussion is just a variation of what Lars E. O. Svensson is telling us about the fool proof way out of a liquidity trap…

Update – some related posts:

The Chuck Norris effect, Swiss lessons and a (not so) crazy idea
Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief
Argentine lessons for Greece

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