The Casselian-Mundelian view: An overvalued dollar caused the Great Recession

This is CNBC’s legendary Larry Kudlow in a comment to my previous post:

My friend Bob Mundell believes a massively over-valued dollar (ie, overly tight monetary policy) was proximate cause of financial freeze/meltdown.

Larry’s comment reminded me of my long held view that we have to see the Great Recession in an international perspective. Hence, even though I generally agree on the Hetzel-Sumner view of the cause – monetary tightening – of the Great Recession I think Bob Hetzel and Scott Sumner’s take on the causes of the Great Recession is too US centric. Said in another way I always wanted to stress the importance of the international monetary transmission mechanism. In that sense I am probably rather Mundellian – or what used to be called the monetary theory of the balance of payments or international monetarism.

Overall, it is my view that we should think of the global economy as operating on a dollar standard in the same way as we in the 1920s going into the Great Depression had a gold standard. Therefore, in the same way as Gustav Cassel and Ralph Hawtrey saw the Great Depression as result of gold hoarding we should think of the causes of the Great Recession as being a result of dollar hoarding.

In that sense I agree with Bob Mundell – the meltdown was caused by the sharp appreciation of the dollar in 2008 and the crisis only started to ease once the Federal Reserve started to provide dollar liquidity to the global markets going into 2009.

I have earlier written about how I believe international monetary disorder and policy mistakes turned the crisis into a global crisis. This is what I wrote on the topic back in May 2012:

In 2008 when the 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 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 meet 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 francs – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss francs 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…

…I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also led to a monetary contraction in especially Europe. Not because of an increased demand for euros, lats or rubles, but because central banks tightened monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as members 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.

So there you go – you have to see the crisis in an international monetary perspective and the Fed could have avoided the crisis if it had acted to ensure that the dollar did not become significantly “overvalued” in 2008. So yes, I am as much a Mundellian (hence a Casselian) as a Sumnerian-Hetzelian when it comes to explaining the Great Recession. A lot of my blog posts on monetary policy in small-open economies and currency competition (and why it is good) reflect these views as does my advocacy for what I have termed an Export Price Norm in commodity exporting countries. Irving Fisher’s idea of a Compensated Dollar Plan has also inspired me in this direction.

That said, the dollar should be seen as an indicator or monetary policy tightness in both the US and globally. The dollar could be a policy instrument (or rather an intermediate target), but it is not presently a policy instrument and in my view it would be catastrophic for the Fed to peg the dollar (for example to the gold price).

Unlike Bob Mundell I am very skeptical about fixed exchange rate regimes (in all its forms – including currency unions and the gold standard). However, I do think it can be useful for particularly small-open economies to use the exchange rate as a policy instrument rather than interest rates. Here I think the policies of particularly the Czech, the Swiss and the Singaporean central banks should serve as inspiration.

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This is why we love Scott Sumner

This is Scott Sumner:

And don’t say that “everyone is entitled to an opinion,” or that the bubble thing is a valid perspective. No, as Paul Krugman pointed out in Pop Internationalism, if you don’t understand the theory of comparative advantage you are not entitled to an opinion that protection makes sense today because comparative advantage doesn’t apply to the modern world for blah blah blah reasons. And I would say that people who don’t understand basic AS/AD are not entitled to an opinion that unconventional monetary policies that focus on “art and wine” markets are needed. First you have to show you understand conventional policies. And everywhere we look we see fewer and fewer people on both the left and the right that understand even economics 101. People who don’t are not entitled to an opinion. People who do, but still reject econ101, are entitled to an opinion.

This is exactly why Scott is one of the most popular Econ bloggers in the world. He just writes great stuff. Have a nice weekend all of you.

PS I know you all read the quote before at Scott’s blog – after all nobody would be reading my blog had it not been for Scott.

 

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.

Visiting Scott in Boston

I have spent the last couple of days in the US – in New York and in Boston. Even though I have been working I have also had time to meet up with friends.

Today in Boston Scott Sumner was my host. It was actually the first time Scott and I met – two left-handed monetary geeks. I am not sure we realized what was happening around us as we spent all afternoon talking about economics, politics, American versus European culture and a shared disillusion with monetary policy makers (in a disillusion with all policy makers).

We covered a lot of stuff in a few hours this afternoon, but a key take away is our common concern about the supply side impact of this crisis. Both Scott and I fear that five years into this crisis the lack of an appropriate monetary policy response have led to very unfortunate policy decisions in other areas.

Hence, both Scott and I agree that moral hazard problems in global financial system have become a lot worse during this crisis than before. I think that both Scott and I will blog a lot more about that in the future. In that sense I think it is save to conclude that as particularly the US economy is moving back to some “normality” and quasi-nominal stability our focus will increasingly be on supply issues. That is not to say that we will stop talking about monetary policy. Both of us have been obsessed with monetary policy issues for decades so we will certainly not stop talking about it.

Furthermore, as the particularly the US is gradually (and too slowly) exiting the crisis it will become important to win the intellectual fight over the history of the Great Recession.

The Great Recession was not caused by market failure. The Great Recession was a result massive monetary policy. The Sumnerian-Hetzelian analysis is correct. Monetary policy became insanely tight in 2008 both in the US and Europe. There was a lot of other things went wrong in the lead up to the crisis – for example the expansion of the global financial safety net which massively increase the fragility of the global financial system prior to the crisis, but it was the monetary contraction in 2008 which was the main cause of the crisis.

If we fail to get that message across then policy makers are doomed to repeat the failures of 2008.

I shouldn’t really share the picture below, but this probably is a pretty good illustration of how two monetary policy nerds look like. Here Scott and I are on the road on the way to Scott’s home.

ScottandME

Thanks for a great day Scott!

PS I am toying with an idea that I want to write two blog posts about the medium-term outlook for the US economy. One positive and one negative. during the last couple of days I mostly got material for the optimistic post. The US is still a great nation and I am always happy to visit and I look forward to be back soon.

Going Down Under with Scott Sumner

This is Scott Sumner (“A New View of The Great Recession”):

”Five years on, economists still don’t agree on the causes of the financial crisis of 2007–08. Nor do they agree on the correct policy response to the subsequent recession. But one issue on which there is almost universal agreement is that the financial crisis caused the Great Recession. In this essay, I suggest that the conventional view is wrong, and that the financial crisis did not cause the recession—tight money did.

This new view must overcome two difficult hurdles. Most people think it is obvious that the financial crisis caused the recession, and many are incredulous when they hear the claim that monetary policy has been contractionary in recent years. The first part of the essay will explain why the conventional view is wrong; monetary policy has indeed been quite contractionary in the United States, Europe and Japan (but not in Australia.) The second part will explain how people have reversed causation, attributing the recession to the financial crisis, when in fact to a large extent the causation went the other direction.”

Would you like to read more? You can if you get a copy of Australia’s leading free market think tank Centre for Independent Studies’ excellent quarterly journal Policy. Policy is edited by Stephen Kirchner. Stephen also blogs at Institutional Economics.

You can subscribe to Policy here.

And there is more good news for the Australians. Scott will soon visit the country Down Under. Scott will attend CIS’s Consilium conference next month.

The young Keynes was a monetarist

I am continuing my reporting on my survey of monetary thinkers’ book recommendations for students of monetary matters. The next “victim” is Scott Sumner and lets jump right into it. Here is Scott’s book list:

David Hume.  Essays on Economics

Irving Fisher. The Purchasing Power of Money

Keynes.  A Tract on Monetary Reform

Ralph Hawtrey.  The Gold Standard in Theory and Practice

Friedman and Schwartz. A Monetary History of the US

David Glasner.  Free Banking and Monetary Reform

Robert Barro.  Macroeconomics

I had asked for five book recommendations, but Scott gave me seven to choose between, but that doesn’t really matter the important thing is that we inspire people to read these books. Nonetheless Scott told me that if we had to cut it to five we should cut out Hume and Keynes. So my next step is not completely fair – I will focus on Keynes’ “A Tract on Monetary Reform”.

The reason is that Tract is a popular book among many of the monetary thinkers I have surveyed and it is not only Scott who has it on his list. The reason I find it interesting is that Tract is really a monetarist book rather than a Keynesian book. Keynesian here meaning the Keynes is The General Theory – Keynes’ most famous book.

To realise that Tract is very much a monetarist book just take a look at that preface. Here is a photo from my own copy of the book:

Tract

The point Keynes makes here is that in a free market without money the markets will tend to “clear” – supply and demand will match each other. This is basically a Walrasian world. However, once we introduce money there is a possibility that if get a disequilibrium between money supply and money demand this disequilibrium will spill-over into other markets or as Keynes express it:

“But they (other markets) cannot work properly if money, which they assume as a stable measuringrod, is undependable.”

In fact this is very much how Leland Yeager or Clark Warburton would explain macroeconomic disequilibrium – recession, deflation, inflation are results of monetary policy failure. It doesn’t get anymore monetarist than that.

Brad DeLong in an excellent review of Tract from 1996 went so far as to say that it was “the best monetarist economics book ever written”. I wouldn’t go so far as Brad, but I certainly agree that Tract fundamentally is monetarist and that is also is very good book. But it is not the best monetarist book ever written – far from it.

In general I would very much like to recommend Brad’s 1996 review of the Tract. It covers all five chapters of the book and  in my view gives a pretty good description of Keynes’ views from the period prior to he became an “Keynesian”.

Get the monetary framework right and let the market take care of the rest

The overall message in the Tract in my view is that Keynes wants to demonstrate that if you mess up the monetary system you will mess up the entire economy. But if on the other hand ensures a stable and predictable – rule based – monetary system then the free market will tend to work well and the price mechanism will more or less ensure an efficient allocation of economic ressources. This of course has been Scott Sumner’s message all along. The Federal Reserve should conduct monetary policy based on – a predictable rule NGDP level targeting – and then the free market will take care of the rest.

The Federal Reserve and other central banks since 2008 has messed up the monetary system and as a result they have done great economic damage. Keynes has a message to today’s central bankers (also from the preface):

“Nowhere do conservative notions consider themselves more in place than in currency; yet nowhere is the need for innovation more urgent. One is often warned that a scientific treatment of currency questions is impossible because the banking world is intellectually incapable of understanding its own problems. If this is true, the order of Society, which they stand for, will decay. But I do not believe it. What we have lacked is a clear analysis of the real facts, rather than ability to understand an analysis already given. If the new ideas, now developing in many quarters, are sound and right, I do not doubt that sooner or later they will prevail.”

I find Keynes’ words from 1923 extremely suiting for the crisis of central banking today and even more suiting for Scott Sumner’s endless campaign to enlighten central bankers and the general society about the importance of proper “Monetary Reform”. In that sense Scott Sumner follows in the footsteps of the younger Keynes, Gustav Cassel, Leland Yeager and Milton Friedman in advocating radical monetary reform.

And finally I should of course note that later in the year Scott’s great work on the Great Depression will be published. I am sure it will become a classic on its own. I have been so privileged to read a draft version of the book and I hope you all buy it when it is published. Scott tells me the title of the book will be  “The Midas Paradox: A New Look at the Great Depression and Economic Instability” 

PS I just have to share Brad Delong’s great comments about the young and the old Keynes:

“The implicit point of view is that if the value of money is dependable then leaving saving to the private investors and investment to business will work well. The magnitude of the Great Depression of the 1930s would destroy Keynes’s faith in the proposition that stable internal prices implied a well-functioning macroeconomy and small business cycles. But from our perspective today–in which the Great Depression is seen as a unique disaster brought on by an unprecedented collapse in financial intermediation and in world trade, rather than as the largest species of the genus of business cycles–it is far from clear that Keynes of 1936 is to be preferred to Keynes of 1924. Besides, Keynes of 1924 writes better: his prose is clearer, less academic, less formal; his argument is more straightforward, linear, easier to follow; his style is as witty.”

PPS It is Sumner in Skyrup…

Tract white wine

Denmark and Utah – Miles Kimball and me

Scott Sumner has an interesting new post in which he argues that Utah is “America’s Denmark”. I like Scott’s theory a lot. Mostly because I think of Utah is how Denmark used to be. I really don’t like to write about Denmark, but this topic is too interesting to miss.

I left a long answer to Scott on his blog. This post is based on that answer.

Lets start out with Scott’s PS:

“I knew Miles and Lars had something in common”

Scott obvious thinks of Miles Kimball and yours truly. If I am not wrong Miles grew up in Utah as a Mormon (Miles in no longer a Mormon).

Miles and I indeed have a lot in common. So Scott is on to something – Utah in fact is “Danish” in the sense that a large share of the early Mormon pioneers in Utah in fact came from Denmark. In fact Miles is 1/4 Danish. Miles’ grandfather was named Elmer (Madsen). Elmer happens to be my son’s middle name (a very rare name in today’s Denmark).

Last year I spoke at Brigham Young University in Utah. At my presentation I was asked how the Danish welfare model could work. My answer was “because we are like you”. Ever since I visited Utah last year I have been thinking about the early Mormon society as an anarchic form of a welfare society. A society where collective goods problems are solved through common norms (religion). Denmark of the 1950s and Utah of the 1860s probably have that in common. That is not a surprise – a lot of the people in both places of course were/are Danes. As Miles’ grandfather and my grandfather. In fact I have for some time had the crazy idea that I want to try to write a book in the topic of how collective goods problems were solved in early Mormon society in Utah. As a Dane I might have a comparative advantage in that endeavor (The other thing is that I don’t have time to undertake this task… )

My argument was that the “original” Danish welfare state really just is a form of the Mormon style welfare system. Everybody in society are very similar and as a consequence there is little difference between a “one-size-fits-all” tax funded system and a private based system like the Mormon private based welfare system.

The interesting thing here is that the Mormon pioneers in Utah established a basically anarchic welfare system that basically covered everybody. That worked fine and I believe that is not really that different in the foundation form the Danish Welfare system. What is different is how the two systems developed over time. In fact I believe that had Utah not become part of the United States Utah might very well have developed into Danish style welfare state. This of course is somewhat os a paradox – anarchic welfare society that develops into a society with a very large public sector. Maybe some of the Bleeding Heart Libertarians have a view on this topic.

However, I am too optimistic on the future of the Danish welfare model. First of all I think it is extremely important to notice that the Danish model really was largely private sector based until the late 1960s. In fact until the mid-1960s the size of the public sector in Denmark (and all the other Nordic countries) was smaller than in public sector in the US (as share of GDP). Hence, when Milton Friedman wrote Capitalism and Freedom (in 1962) Denmark really was closer to his ideal than the US was.

In the end of the 1960s the public sector in Denmark started growing very dramatically until the early 1980s. In that period Denmark also started its relative income decline.

Finally I would note that in a society where everybody “normally” works and where most people are very similar people would tend to be “honest” and not misuse public benefit systems and because your neighbours come knocking on your door and tell you to get your act together if you want to be invited over for BBQ etc. That undoubtedly was the case in Denmark until the early 1970s. However, that changed in the 1970s.

Two things happened. First of all, unemployment rose dramatically in Denmark in the early 1970s as a result of the first oil crisis AND a sharp increase in benefits levels. That made it “socially acceptable” to be unemployment and live of taxpayer money. Second, Denmark saw a sharp increase in immigration from the late 1960s and until the early 1980s. That changed Denmark from an extremely homogeneous society to a more multicultural society. These two factors in my view removed the implicit ‘social threat’ that your neighbors would think of you as an idiot if you remained on the dole for years. That effectively sharply reduced the cost of misusing the public welfare system.

As consequence while Dane used to the work ethics as Utah Mormons Denmark today is a “leisure society” with low work ethics. This in my view probably is the biggest threat to the “Danish model”. A new working paper by Casper Hunnerup Dahl has an interesting discussion of this topic.

Finally, the strength of the “flexicurity system” in my view is mostly a myth. Yes, we have a very flexible labour market in Denmark with low levels of labour market regulation. There is for example no official state sponsored minimum wage and firing and hiring rules are liberal. However, high benefit levels is a massive burden to public finances and in the long-term the model will not survive in its present form.

Denmark, however, still benefits from have a fairly homogenous society in the sense that it probably has positive impact on the political system. Hence, while the welfare state is overblown Danish policy makers over the last three decades in general have agreed on the overall need for scaling back the public sector and continue economic reforms. Hence, since the early 1980s different (left and right) governments have tried to reform the welfare state. Hence, had it not been for the policy mistakes of the late 1960s and early 1970s Denmark would probably have had a public sector of a similar size to Switzerland. Incredibly enough the present centre-left government has – much against its voters wishes – pushed from reforms of welfare benefits, educational reform and pension reforms.

Concluding, I believe Scott in general is right. Utah might be America’s Denmark, but it is probably the Denmark of 1960 rather than of today.

PS I hope Scott will soon visit Denmark to take a look for himself. I know Miles will soon be here.

Scott Sumner: “It’s Complicated: The Great Depression in the US”

Yesterday I was surfing the internet for some information on events in 1937 – the year of the Recession in the Depression. While doing that I found a great lecture Scott Sumner did at Oxford Hayek Society in 2010.

Scott’s lecture basically is a wrap-up of his forthcoming book on the Great Depression. Scott tells me the book likely will be published later this year. I have had the pleasure and honor of reading a draft of the book. You all have have something to look forward to – it is a great book!

The thesis in Scott’s book is that the Great Depression in the US was a combination of two shocks. A negative demand shocks – excessive monetary tightening – and a series of negative supply shocks caused by Roosevelt’s New Deal policies particularly the National Industrial Recovery Act (NIRA) and the Wagner Act. His arguments are extremely convincing and I believe that you cannot understand the Great Depression without taking both these factors into account.

Scott does a great job showing that policy failure – both in the terms of monetary policy and labour market regulation – caused and prolonged the Great Depression. Hence, the Great Depression was not a result of an inherent instability of the capitalist system.

Unfortunately policy makers today seems to have learned little from history and as a result they are repeating many of the mistakes of the 1930s. Luckily we have not seen the same kind of mistakes on the supply side of the economy as in the 1930s, but in terms of monetary policy many policy makers seems to have learned very little.

I therefore hope that some of today’s policy makers would take a look at Scott’s lecture. You can watch it here.

Scott has kindly allowed me also to publish his PowerPoint presentation from the lecture. You can find the presentation here.

And for those who are interested in studying the disastrous labour market policies of the Rossevelt administration I strongly recommend the word of Richard Vedder and Lowell Gallaway – particularly their book “Out of Work”. Furthermore, I would recommend Steve Horwitz’s great work on President Hoover’s policy mistakes in the early years of the Great Depression.

The Kuroda recovery will be about domestic demand and not about exports

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

The weaker yen is an indicator of monetary easing – but not the main driver of growth

I think that the way we should think about the weaker yen is as a indicator for monetary easing. Hence, when we seeing the yen weakeN, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expect the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate. So it is no wonder that equity analysts feel more optimistic about Japanese companies’ earnings.

Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

The focus on competitiveness is completely misplaced

I have in numerous earlier posts argued that when a country is going through a “devaluation” as a consequence of monetary easing the important thing is not competitiveness, but the impact on domestic demand.

I have for example earlier demonstrated that Swedish growth outpaced Danish growth in 2009-10 not because the Swedish krona depreciated strongly against the Danish krone (which is pegged to the euro), but because the Swedish Riksbank was able to ease monetary policy, while the Danish central bank effectively tightened monetary conditions due to the Danish fixed exchange rate policy. As a consequence domestic demand did much better in Sweden in 2009-10 than in Denmark, while – surprise, surprise – Swedish and Danish exports more or less grew at the same pace in 2009-10 (See graphs below).

Similarly I have earlier shown that when Argentina gave up its currency board regime in 2002 the major boost to growth did not primarly come from exports, but rather from domestic demand. Let me repeat a quote 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.”

And if we want to go further back in history we can look at what happened in the US after FDR gave up the gold standard in 1933. Here the story was the same – it was domestic demand and not net exports which was the driver of the sharp recovery in growth during 1933.

These examples in my view clearly shows that the focus on the “competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

Finally if anybody still worry about “currency war” they might want to rethink how they see the impact of monetary easing. When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

HT Jonathan Cast

—-

PS Scott Sumner also comments on Japan.

PPS An important non-competitiveness impact of the weaker yen is that it is telling consumers and investors that inflation is likely to increase. Again the important thing is the signal about monetary policy, which is rather more important than the impact on competitiveness.

Monetary policy works just fine – Exhibit 14743: The case of Japanese earnings

The graph below shows the ratio of upward to downward revisions of equity analysts’ earnings forecasts in different countries. I stole the graph from Walter Kurtz at Sober Look. Walter himself got the data from Merrill Lynch.

Just take a look in the spike in upward earnings revisions (relative to downward revision) for Japanese companies after Haruhiko Kuroda was nominated for new Bank of Japan governor back in February and he later announced his aggressive plan for hitting the newly introduced 2% inflation target.

This is yet another very strong prove that monetary policy can be extremely powerful. The graph also shows the importance of the Chuck Norris effect – monetary policy is to a large extent about expectations or as Scott Sumner would say: Monetary Policy works with long and variable leads - or rather I believe that the leads are not very long and not very variable if the central bank gets the communication right and I believe that the BoJ is getting the communication just right so you are seeing a fairly strong and nearly imitate impact of the announced monetary easing.

PS As there tend to be a quite strong positive correlation between earning growth and nominal GDP growth I think we can safely say that the sharp increase in earnings expectations in Japan to a large extent reflects a marked upward shift in NGDP growth expectations.

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