Is monetary easing (devaluation) a hostile act?

One of the great things about blogging is that people comment on your posts and thereby challenge your views and at the same time create new ideas for blog posts. Therefore I want to thank commentator Max for the following response to my previous post:

“I don’t think exchange rate intervention is a good idea for a large country. For one thing, it’s a hostile act given that other countries have exactly the same issue. And it can’t work without their cooperation, since they have the power to undo the intervention.” 

Let me start out by saying that Max is wrong on both accounts, but I would also acknowledge that both views are more or less the “consensus” view of devaluations and my view – which is based on the monetary approach to balance of payments and exchange rates – is the minority view. Let me address the two issues separately.

Is monetary easing a hostile act?

In his comment Max describes a devaluation as a hostile act towards other countries. This is a very common view and it is often said that it is a reflection of a beggar-thy-neighbour policy for a country to devalue its currency. I have two comments on that.

First, if a devaluation is a hostile act then all forms of monetary easing are hostile acts as any form of monetary easing is likely to lead to a weakening of the currency. Let’s for example assume that the Federal Reserve tomorrow announced that it would buy unlimited amounts of US equities and it would continue to do so until US nominal GDP had increased 15%. I am pretty sure that would lead to a massive weakening of the US dollar. In fact we can basically define monetary easing as a situation where the supply of the currency is increased relative to the demand for the currency. Said, in another way if the currency weakens it is a pretty good indication that monetary conditions are getting easier.

Second, I have often argued that the impact of a devaluation does not primarily work through an improvement in the country’s competitiveness. In fact the purpose of the devaluation should be to increase prices (and wages) and hence nominal GDP. An increase in prices and wages can hardly be said to be an improvement of competitiveness. It is correct that if prices and wages are sticky then you might get an initial real depreciation of the currency, however that impact is not really important compared to the monetary impact. Hence, a devaluation will lead to an increase in the money supply (that is how you engineer the devaluation) and likely also to an increase in money-velocity as inflation expectations increase. Empirically that is much more important than any possible competitiveness effect.

A good example of how the monetary effect dominates the competitiveness effect: the Argentine devaluation in 2002 actually led to a deterioration of the Argentine trade balance and what really was the driver of the recovery was the sharp pickup in domestic demand due to an increase in the money supply and money-velocity rather than an improvement in exports. See my previous comment on the episode here. When the US gave up the gold standard in 1933 the story was the same – the monetary effect strongly dominated the competitiveness effect.

Yet another example of the monetary effect of a devaluation dominating the competitiveness effect is Denmark and Sweden in 2008-9. It is a common misunderstanding that Sweden grew stronger than Denmark in 2008-9 because a sharp depreciation of the Swedish krona led to a massive improvement in competitiveness. It is correct that Swedish competitiveness was improved due to the weakening of the krona, but this was not the main reason for Sweden’s relatively fast recovery from the crisis. The real reason was that Sweden did not see any substantial decline in money-velocity and the Swedish money supply grew relatively steadily through the crisis.

Looking at Swedish exports in 2008-9 it is very hard to spot any advantage from the depreciation of the krona. In fact Swedish exports did more or less as badly as Danish exports in 2008-9 despite the fact that the Danish krone did not depreciate due to Denmark’s fixed exchange rate regime. However, looking at domestic demand there was a much sharper contraction in Danish private consumption and investment than was the case in Sweden. This difference can easily be explained by the sharp monetary contraction in Denmark in 2008-9 (both a drop in M and V).

Furthermore, let’s assume that the Federal Reserve announced massive intervention in the FX market to weaken the US dollar and the result was a sharp increase in US nominal GDP. Would the rest of the world be worse off? I doubt it. Yes, the likely impact would be that for example German exports would get under pressure as the euro would strengthen dramatically against the dollar. However, nothing would stop the ECB from also undertaking monetary easing to counteract the strengthening of the euro. This is what somebody calls “competitive devaluations” or even “currency war”. However, in a deflationary environment such “currency war” should be welcomed as it basically would be a competition to print money. Hence, the “net result” of currency war would not be any change in competitiveness, but an increase in the global money supply (and global money-velocity) and hence in global nominal GDP. Who would be against that and in a situation where the global economy continues to contract and as such a currency war like that would be very welcomed news. In fact we can not really talk about a “war” as it would be mutually beneficial. So I say please bring on the currency war!

Is global monetary cooperation needed? No, but…

This brings us to Max’s second argument: “And it can’t work without their cooperation, since they have the power to undo the intervention.

This is obviously related to the discussion above. Max seems to think a devaluation will not work if it is met by “competitive devaluations” from all other countries. As I have argued above this is completely wrong. It would work as the devaluation will increase the money supply and money-velocity even if the devaluation has no impact on competitiveness at all. As a result there is no need for international monetary cooperation. In fact healthy competition among currencies is exactly what we need. In fact every time the major nations of the world have gotten together to agree on realigning exchange rates it has had major negative consequences.

However, there is one argument for international coordination that I think is extremely important and that is the need for cooperation to avoid “competitive protectionism”. The problem is that most global policy makers perceive devaluations in the same way as Max. They see devaluations as hostile acts and therefore these policy makers might react to devaluations by introducing trade tariffs and other protectionist measures. This is what happened in the 1930s where especially the (foolish) countries which maintained the gold standard reacted by introducing trade tariffs against for example the UK and the Scandinavian countries, which early on gave up the gold standard.

Unfortunately Mitt Romney seems to think as Max

Republican presidential hopeful Mitt Romney has said that his first act as US president would be to slap tariffs on China for being a “currency manipulator”. Here is what Romney recently said:

“If I’m president, I will label China a currency manipulator and apply tariffs” wherever needed “to stop them from unfair trade practices”

The discussion above should show clearly that Romney’s comments on China’s currency policy is economically meaningless – or rather extremely dangerous. Imagine what would be the impact on the US economy if China tomorrow announced a 40% (just to pick a number) revaluation of the yuan. To engineer this the People’s Bank of China would have to cause a sharp contraction in the Chinese money supply and money-velocity. The result would undoubtedly throw China into a massive recession – or more likely a depression. You can only wonder what that would do to US exports to China and to US employment. Obviously this would be massively negative for the US economy.

Furthermore, a sharp appreciation of the yuan would effectively be a massive negative supply shock to the US economy as US import prices would skyrocket. Given the present (wrongful) thinking of the Federal Reserve, that might even trigger monetary tightening as US inflation would pick up. In other words the US might face stagflation and I am pretty sure that Romney would have no friends left on Wall Street if that where to happen and he would certainly not be reelected in four years.

I hope that Romney has some economic advisors that realize the insanity of forcing China to a massive appreciation of the yuan. Unfortunately I do not have high hope that there is an understanding of these issues in today’s Republican Party – as it was the case in 1930 when two Republican lawmakers Senator Reed Smoot and Representative Willis C. Hawley sponsored the draconian and very damaging Smoot-Hawley tariff act.

Finally, thanks to Max for your comments. I hope you appreciate that I do not think that you would like the same kind of protectionist policies as Mitt Romney, but I do think that when we get it wrong on the monetary impact of devaluations we might end up with the kind of policy response that Mitt Romney is suggesting. And no, this is no endorsement of President Obama – I think my readers fully understand that. Furthermore to Max, I do appreciate your comments even though I disagree on this exact topic.

PS if you want to learn more about the policy dynamics that led to Smoot-Hawley you should have a look at Doug Irwin’s great little book “Peddling Protectionism: Smoot-Hawley and the Great Depression”.

Update: Scott Sumner has a similar discussion of the effects of devaluation.

The Fed can hit any NGDP target

I hate getting into debates where different bloggers go back and forth forever and never reach any conclusion. I am not blogging to get into debates, however, I must admit that Steven Williamson’s recent posts on NGDP level targeting have provoked me quite a bit.

In his first post Williamson makes a number of claims, which I find highly flawed. However, Scott Sumner has already at length addressed most of these issues in a reply to Williamson so I don’t want to get into that (and as you guessed I am fully in agreement with Scott). However, Williamson’s reply to Scott is not less flawed than his initial post. Again I don’t want to go through the whole thing. However, one statement that Williamson makes I think is a very common mistake and I therefore think a comment is in order. Here is Williamson:

“The key problem under the current circumstances is that you can’t just announce an arbitrary NGDP target and hit it with wishful thinking. The Fed needs some tools, and in spite of what Ben Bernanke says, it doesn’t have them.”

This is a very odd comment coming from somebody who calls himself a (New) Monetarist. It is at the core of monetarism in the sense of Friedman, Brunner, Meltzer, Cagan, Schwartz, Warburton and Yeager etc. that nominal GDP is determined by the central bank and no monetarist has ever acknowledged that there is a liquidity trap. Williamson claims that he does not agree with everything Friedman said, but I wonder what Friedman said he agrees with. If you don’t believe that NGDP is determined by the central bank then it makes absolutely no sense to call yourself a monetarist.

Furthermore, if you don’t think that the Fed can hit an NGDP target how could you think it could hit an inflation target? Both changes in NGDP and in prices are monetary phenomena.

Anyway, let’s get back to the question whether the central bank can hit an NGDP target and what instruments could be used to hit that target.

The simplest way to do it is actually to use the exchange rate channel. Let’s assume that the Federal Reserve wants to increase the US NGDP level by 15% and that it wants to do it by the end of 2013.

Scott has suggested using NGDP futures to hit the NGDP target, but let’s assume that is too complicated to understand for the critics and the Fed. Instead the Fed will survey professional forecasters about their expectations for the level of NGDP by the end of 2013. The Fed will then announce that as long as the “consensus” forecast for NGDP is below the target the Fed will step up monetary easing. The Fed will do the survey once a month.

Let’s start out with the first announcement under this new regime. Initially the forecasters are skeptical and forecast NGDP to be 12% below target. As a consequence the Fed announces a Swiss style exchange target. It simply announces that it will intervene in the FX market buying unlimited amounts of foreign currency until the US dollar has weakened 20% in nominal effective terms (and yes, the Fed has the instruments to do that – it has the printing press to print dollars). I am pretty sure that Williamson would agree that that directly would increase US NGDP (if not I would love to see his model…).

The following month the forecasters will likely have moved their forecasts for NGDP closer to the target level. But we might still have too low a level of forecasted NGDP. Therefore, the Fed will the following month announce a further “devaluation” by lets say 5%. The process will continue until the forecasted level for NGDP equals the target level. If the consensus forecast starts to overshoot the target the Fed will simply announce that it will reverse the process and revalue the dollar.

Therefore there is certainly no reason to argue 1) that the Fed can not hit any NGDP target 2) that the Fed does not have an instrument. The exchange rate channel can easily do the job. Furthermore, if the Fed announces this policy then it is very likely that the market will be doing most of the lifting. The dollar would automatically appreciate and depreciate until the market expectations are equal to the NGDP target.

If you have heard all this before then it is because this a variation of Irving Fisher’s compensated dollar plan and Lars E. O. Svensson’s foolproof way out of a liquidity trap. And yes, I have previously suggested this for small open economies, but the Fed could easily use the same method to hit a given NGDP target.

Update: I should note that the example above is exactly that – an example. I use the example to illustrate that a central bank can always increase NGDP and that the exchange rate channel is an effective tool to achieve this goal. However, the numbers mentioned in my post are purely “fictional” and again it example rather than a policy recommendation. That said, I am pretty that if the Fed did exactly as what I suggest above the US would very fast bee out of this crisis. The same goes for the ECB.

Update II: Marcus Nunes and Bill Woolsey also comment on Williamson. Nick Rowe comments on David Adolfatto’s anti-NGDP targeting post(s).

%d bloggers like this: