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.
Leave a comment


  1. Max

     /  July 4, 2012

    Let me clarify what I mean by hostile act. If country X does something to make country X better off _that all countries could do_, then I wouldn’t consider that a hostile act. That’s just smart policy.

    All countries can inflate. But all countries can’t use the exchange rate as a policy instrument. That’s what makes it “hostile”.

  2. You are only pro currency war as long as the countrys dont overshot there NGDP target, right? It clearly cant be good if all countrys creat artefical inflation.

  3. nickikt, yes you are clearly right. Competitive devaluation obviously would not be warranted in a situation of high global inflation – like in the 1970s.

  4. Diego Espinosa

     /  July 4, 2012

    Great post. A few observations:

    -The Eurozone was created to prevent member countries from engaging in monetary easing relative to one another. EU founders believed the resulting currency devaluations to be “hostile”.
    -If I remember correctly, Svensson argues that devaluation is only “foolproof” when done relative to other currencies — i.e. in a hostile manner.
    -The Argentina case arguably exhibits path dependency. In other words, it was the initial export boom that subsequently caused investment demand and later consumption to rise.

    On the last point: in New Hampshire, highways run north-south, with mountain ranges in between. The old saw is that when a tourist asks how far a neighboring town is, a native answers, “about 30 miles, but you can’t get there from here.” Without the improvement in the export sector, I think an Argentine native would have said the same thing (about NGDP expectations) to a visiting economist in 2001.

    • Diego,

      As always thanks for your comments.

      Yes, the euro zone has partly been justified by the attempt to avoid competitive devaluation. That obviously was a mistake – had Europe had floating exchanges then I am pretty sure we would not have been in this mess.

      Regarding Svensson it is correct that some tis some “hostility” in what he is suggesting (given his model). However, it is also important that Svensson especially stress the importance of expectations rather than competitiveness.

      Regarding Argentina there was no path dependency. There was no initial export boom – so that did not cause investment and private consumption to pickup.

      • Diego Espinosa

         /  July 4, 2012

        Good point on Argentine exports. Having been there around that time, I should have said the tradables sector was the only one not to collapse! For instance: NGDP-sensitive property values initially dove as levered holders went bankrupt. Only later did property boom. It was the tradables sector that carried the economy through the trough.

        On the Euro, I think what gets overlooked is that periphery sovereign yields today are roughly at pre-Euro levels. In other words, to a certain extent, the current “mess” is simply a return to normal. The whole point of the Euro experiment was to exert German discipline on these countries to cure them of stagflation. It worked for a bit then failed, so they are back to stagflation as soon as they exit the Euro. Blaming the Buba for this round-trip is like blaming the Fed for Argentina’s round-trip from stagflation to convertibility and back.

  5. rob

     /  July 4, 2012

    I agree 100% with the economic analysis in this post but somewhat agree with Max for the following reason.

    If the US says “we will increase NGDP by 15% and not worry about the effect on the exchange rate” then this is a policy that they have total power to achieve.

    If they say “We will target a currency depreciation of 15% as a way of increasing NGDP” then acts of other countries may prevent the target being met. However in the attempt to meet the target NGDP will still increase with the expected benefits (some of which will themselves tend to increase the exchange rate.) .

    So given that increased NGDP is the aim and not a particular exchange rate why not target it directly rather than use exchange rate target that has the potential to be missed.

    I think the exchange rate example is a great and simple way of explaining why an NGDP task could always be met – but I do not see many situations where it would actually be the optimal policy.

    • Rob, I do agree this is not an optimal policy. I have use the example in the previous two posts to illustrate that any NGDP target can be meet. That said, I increasingly believe that using the exchange rate channel good be the best way to achieve the the desired end (the NGDP target). However, from “monetary diplomatic” perspective the central bank should make it clear that the policy has the aim of increasing the money supply and money-velocit rather than to gain a competitive advantage. Therefore some coordination might be desirable.

      For small countries like for example the Czech Republic with very illiquid money and bond markets I think it is obvious that the use of the FX channel could provide some clear advantages if it is done within a clear NGDP level targeting regime (or a price level target for the matter).

  6. “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.”

    Interesting. If we combine this remark with Scott’s observation (in his latest post) that the Fed is making profits higher than anyone in history, then could we not use simple microeconomics to explain the state of the world economy today? The world’s central banks have formed a cartel like OPEC, to keep the world money supply contracted in order to maximize profits. Gold hoarding in the 20’s and 30’s could be seen as much the same phenomenon. The missing link in the explanation is how central bankers or politicans themselves would profit from this…

    • Saturos, that is a very, very interesting point. However, you would need to be able to explain game theoretically why nobody is breaking ranks…

      • Well, the Economist has long believed that governments conspire internationally to prevent competition between them … Perhaps cartel breaking is easier when control over the use of force lies outside the cartel itself?

      • Philippe Bélanger

         /  July 5, 2012

        Mr. Christensen, your posts are always very enlightening. My macro textbook has a passage that tries to answer why, during the gold standard, countries did not engage in competitive devaluation, since it would clearly have been in their short-run advantage. The best answer the author can find is that it would have run counter to what they considered “economic orthodoxy” and it would have harmed their credibility, which sounds very familiar to what the central banks are saying today.

  7. Diego,

    It is correct that for example Italian yields are “just” at the pre-euro levels. However, there is one major difference. At that time NGDP growth was equally high (mostly due to high inflation). Today Italian NGDP is contracting and the ECB has “promised” as all that it will continue to conduct monetary policy in such a fashion that there will be no recovery in PIIGS NGDP. Thats why I and others blame the ECB/the Bundesbank. Obviously this is just a demonstration that the euro zone is not a optimal currency area.

    • Diego Espinosa

       /  July 5, 2012

      If Italy has an NGDP problem, they are free to restructure or re-adopt the Lira. The former is politically impossible. The latter is unfortunately likely to be highly disruptive to contracts. So was (a priori) exiting the gold standard in the 30’s. Yet most argue, in hindsight, that exit was the optimal policy choice.

  8. Suppose the world is on a gold standard. Further suppose, the point of devaluation isn’t to increase domestic spending, but rather to accumulate gold reserves. And finally, suppose that gold reserves are especially useful in time of war to fund purchases from neutrals. Hey, maybe even mercenaries can be hired for gold.

    Devaluation is a hostile act.

    Of course, none of that applies today really. But some folks have fully absorbed the change.

  9. Saturos, Lars Christensen the libertarian tends to buy your idea, while the Lars Christensen the economist (and he is in charge here) tells me that I want to see a better “model” of this idea. Anyway, I am certainly intrigued.

  10. Sarturos,

    The rest of the government is collected much less tax revenue because of the reduced nominal expenditure. Central bankers do this so that they can provide a larger proportion of the government budget? Why doesn’t the rest of the government just replace them?

  11. Lars

    1. Agree that devaluations work mostly through inflation expectations than through export competitiveness.

    2. However, you can’t escape the point about coordination. If all central banks engage in printing their own currency and using that to try and buy some basket of international assets, money supply and money velocity might indeed increase – but only in the Fx markets. You might just see a lot of churn, some arbitrage profits, some arbitrage losses, huge commissions, and no impact on ‘real’ velocity.

    Follow the flow of funds data. These days, the first effects of most nominal easing goes straight into financial/asset flows. You cut rates people engage in carry trades with some other currency. You buy up safe assets to lower the yield on them people shift their portfolios, but not towards household and business lending but towards commodities.

    SNB has a peg for a while now. Meanwhile, Swiss consumer price inflation is in the range of -0.5% to 0.5%, and house prices/ other asset prices are going through the roof.

  12. Philippe, It has always been puzzling to economic historians why it took governments so long to give up the gold standard in 1930s. Eichengreen and Temin point to what they call the “gold standard mentality”. Swiss economic historian Tobias Strauman in his new book “Fixed Ideas of Money” has a very good discussion of the same topic.

    It seems like central bankers today are suffering from a similar fear of doing something “outside the box”.

  13. Ritwik,

    I am not sure I completely follow your argument, but it seems like you think there is some kind of “FX liquidity trap”. However, it goes directly contrary to the evidence I site in my comment: Denmark vs Sweden in 2008/9, Argentina in 2002 and the US in 1933. In all case monetary easing through devaluation/depreciation engineered recoveries. I could also have mentioned Poland, Turkey, Australia and Canada in 2008/9. Everywhere the story was the same – higher money supply growth and the fact that a drop in velocity was avoided helped these economies to recover.

    In the case of Switzerland the case is slightly different as the SNB has moved to counteract a massive increase in money demand. Therefore, we can not see SNB’s 1.20-target on EUR/CHF as monetary easing in the sense that the money supply certainly has not been increased MORE than money demand.

  14. Lars

    You realise that your argument is tautological, right? For every country that is able to expand through devaluation, you will claim credit. (Notwithstanding the fact that Sweden, Australia etc. did NOT face the kind of currency wars that you describe – but like I said, I buy the point about devaluation creating inflation expectations if not opposed by other economies). For every country where I will show you an inflation expectation that is still stuck where it should not be, you will say ‘they did not do ENOUGH).

    My point with SNB and flow of funds is very simple – since the SNB’s intervention is keeping the CHF at a significantly lower level than it would have been otherwise, we should have seen a biggish jump in inflation. And indeed, we see that jump. But not in consumer prices/wages – which is what the point of these pegs is. Instead, we see the inflation in house prices and financial assets, because the SNB peg is effectively acting like a subsidy for those who are clamouring for safe Swiss assets.

    Of course, you can argue (as you have done) that had the SNB not intervened, goods price/wage inflation would have been -3% (say) and not -0.5%. Could be. We’ll never know. It’s a poorly defined debate.

  15. Incidentally, much is made of the Japanese situation and BoJ’s reluctance to intervene in the Fx markets to boost inflation expectations by passing that off as a Treasury decision and so outside its remit. I believe the reality is less political and simpler. BoJ believed (rightly so, I think) that a yen peg would do nothing but boost the arbitrage profits available in the massive yen-dollar carry trade.

  16. To be clear, I’m not saying that a devaluation (through an explicit exchange rate target) does not work. It obviously does in some cases. But it may not in others. I’d argue that a few factors important for determining whether or not it will work are
    1) Debt overhang in the domestic economy – economies with debt overhang might find that financial flows dominate real flows and nominal easing is channelled into carry trades
    2) Commodity terms of trade of the country – countries that have large commodity imports relative to their GDP might find that the increased food and energy prices force nominal spending to be channelled towards these essentials and decline on other more inflationary kinds of spending. (Nominal income expectations will rise, sure, but it’s a question of which effect happens first or dominates)
    3) Countries with safe asset/ reserve asset status in times of fear – in this case the peg may simply act like a subsidy for those seeking the safe assets. Financial flows again dominate real flows and asset prices increase in the domestic currency while consumer prices and wages stay where they are.
    4) Countries with the ‘original sin’ of the banking system/ corporates borrowing heavily in foreign currencies.
    5) A currency war – it may boost AD in all the countries involved, or it may just all flow into Fx trading churn.

    Don’t forget that Argentina did not just devalue – it also defaulted on its debt. If creditors across the board in the disinflationary developed economies would take principal losses, nominal easing (of all kinds) would make a lot more sense.

    A common theme in all of these is – follow the flow of funds. Nominal easing is helpful, but which economic agents have first and best access to the effects of that easing and what are the goals/constraints of those economic agents matters A LOT to determine how helpful it is and which kind of nominal easing is most helpful.

    The only reason that one could dismiss these *structural* concerns is by assuming 1) ratex 2) zero dissonance between asset markets and the real economy 3) assume away the possibility of multiple equilibria.

    The other way to devalue a currency, by plainly and simply debauching it through direct money-financed transfers/ tax cuts would probably work in most states of the world. Monetize the deficit – not the current debt-financed deficit but a one time monetization of current and expected future deficits.

    Helicopter drop, essentially. Fiscal/monetary/whatever. It will probably work. Highly negative interest rates would work as well, but for that you would have to eliminate or tax currency. You’d need, say, -3%. -0.5% won’t work.

  17. dwb

     /  July 5, 2012

    excellent post.

    two comments:
    1. if you wait long enough Romney will say something completely different on Chinese currency manipulation. Anyway, the political reality in the US is that no matter what the candidates *say* as they pander to some of the heavy-hit swing states, its pretty rare that a US president goes through with these things. Don’t forget that Kerry accused Bush of abetting currency manipulation in the 2004 election, and in 2008 then-candidate Obama threatened to get tough over Chinese currency manipulation as well.

    Reality check: Policy, especially foreign policy, rarely changes much from Prez to Prez. The best predictor of what the next Prez will do is what the last Prez did (I can give a long list, they are more similar than different, with some exceptions of course).

    I do not think the electorate as a whole takes statements like this seriously. I certainly do not and would be shocked if he went through with it.

    Romney’s economic advisers BTW, are Mankiw, Hubbard, and Taylor. I don’t think they approve of many of Romney’s comments (like him saying 4% unemployment is a achievable a few months ago). After the election they would provide different policy advice from the pure campaign pandering.

    2. I doubt the direct effects of Yuan revaluation/devaluation or tariffs would be “massive”. The impact of China on the US economy is vastly overrated, i think the impact would be very small. Chinese imports are something like 3% of personal consumption expenditures (i did see a presentation once that 10% of Chinese exports go through Walmart). We export i think $25 Bn or so i recall, very small.

    The effects, if any would be indirect: Signalling of a major shift in US economic policy that supports free trade; Impact on commodity prices due to Chinese recession; And the impact if any other Asian nations follow a similar path.

    I think the signalling effect would be the largest effect.

  18. ReturnFreeRisk

     /  July 5, 2012

    “In fact the purpose of the devaluation should be to increase prices (and wages) and hence nominal GDP.”

    It is a fact that wages have NOT risen for years. Monetary easing notwithstanding.
    Please present the channels through which QE type policies are going to increase wages. I am tired of listening to NGDP targeting or QE advocates claims about rising prices of commodities NOT hitting consumption in some magical way.

  19. ReturnFreeRisk

     /  July 5, 2012

    “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.”

    Increase in monetary velociy? Are you serious? Have you seen the data?

    • RFR,

      Well, I am not sure that you are reading what I wrote. I give concrete examples: Argentina 2002, Denmark vs Sweden 2008/9 and the US 1933. I suggest you consult the data. In all these case both the money supply and velocity increased. Please study economic history – it comes in handy.

      • ReturnFreeRisk

         /  July 5, 2012

        I appreciate your reply. But 1933 was a real deval under a gold standard. What is the modern day fiat money analogue? More to the point, why is money velocity collapsing in the US right now? And can the Fed do anything to prevent it? THey add more reserves via QE and the velocity goes down.

        I would love for you to elaborate how, mechanically, putting more reserves in the system raises NGDP. I cant just assume that. Please. My puny brain does not see how it is automatic.

  20. ReturnFreeRisk

     /  July 5, 2012

    “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.”

    How does it follow that nominal GDP will end UP a lot as a result of falling FX? And if it is just prices of imported goods, commodities etc, how does the general populace not suffer – NO ONE HAS GOTTEN RAISES IN 5 YEARS.

  21. felipe

     /  July 5, 2012

    I think a part of the puzzle is left out in this post. In particular you say:

    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!

    That goes very well for the advanced economies. The US is depressed, the EZ too, and Japan does too. But the term currency war was not “invented” by either of those. It was brought into the post-crisis debate by Brazil. And for them augmenting inflationary pressures is not welcome. It seems to me that for most developing countries any measure that increases inflationary pressures is definitely hostile. There is no reason for me to believe that emerging economies would like NGDP-raising policies being forced upon them by foreign countries.

    Can your argument be modified to take into account economies that are not (already) depressed?

    • Felipe, thanks for your feedback.

      It is correct that the term currency war was invented by Brazilian finance minister Mantega. And it is correct that if for example the US would undertake massive monetary easing and thereby weaken the US dollar then it would likely increase the demand for Emerging Market currencies like the Brazilian real. This would effectively be monetary tightening in Brazil if the Brazilian central bank did not act and hence allowed a “passive tightening” of Brazilian monetary conditions. Would that be bad? Not if Brazilian inflation was too high compared to the Brazilian central bank’s target – as was the case for example in the second half of 2010 when the Fed announced QE2. Had the Brazilian economy on the other been depressed then the Brazilian central bank could just ease monetary policy itself. In fact if the Brazilian central bank had a clear NGDP level target the market would price this in and likely the strengthen of the real would be very moderate.

  22. RFR..

    So you argue that an increase in the money supply will not be inflationary? Or increase inflation expectations? An increase in inflation expectations would truly led to higher velocity as people reduce their money demand. I think that is pretty simple.

    But let me ask a question – what would be the reaction to inflation expectations, money demand and velocity if Gideon Gono – the Zimbabwean central bank governor was appointed new Fed chairman?

    Take a look at these two posts:

    And finally take a look at what happened to nominal GDP, the money and velocity when Argentina gave up their insane currency board in 2002. That should answer your question.

    By the way you seem to have the same view as Williamson that all monetary easing in the US just end up in excess reserves. Is that a natural law? Or is it a result of a policy mistake on part of the Fed? If it is a policy mistake the Fed can and should correct it.

  23. ReturnFreeRisk

     /  July 5, 2012

    Let me answer your questions.
    “So you argue that an increase in the money supply will not be inflationary? Or increase inflation expectations? ”
    An increase in money supply directly controlled by central bank will not lead to inflation without spending by the fiscal arm of the government. How does the Fed inflate while the economy has a large slack and the government deficits are not blowing out enough to make up for it?

    “An increase in inflation expectations would truly led to higher velocity as people reduce their money demand. I think that is pretty simple.”
    Inflation expectations (I call it inflation fairy) is a temporary phenomenon, IMO, based on the actions of the commodity traders bidding up tradeable commodities based on QE announcements by the Fed. The gains in commodity prices (and the contemporaneous inflation expectation measures) have had a tendency to come right back down in response to an economy that is not going anywhere fast. You might argue that the Fed’s reluctance to be reckless reigns in these expectations. But I have no way of proving you wrong or right. In my defense, the BOJ has been unable to magically lift inflation expectations even though they have wanted to for a long time.

    Monetary easing just ends up as reserves (excess or otherwise is just a technical definition) – yes. The Fed controls the total amount of reserves through open market operations. THe banking system can not lend these out or get rid of them. Moreover, the banks are a long way from being constrained by reserves. In fact, Bernanke has talked about getting rid of reserve requirement altogether. So your argument agains interes on reserves does not seem significant to me.

    The whole disagreement revolves around the concept of how inflation expectations evolve. In the absence of a threat of default by the US treasury and the lack of foreign currency denominated debt (which sets the US apart from your Argentina case), how does the faith of the USD holders be shaken for them to expect higher inflation or flee the dollar? In fact, nominal yields and inflation expectations fell during the July/Aug 2011 debt debate. My question to you is – how do you explain nominal yields falling at the same time as gold goes up massively at the same time? Just saying that they did not do QE massive enough does not convince people like me.

    Bottom line, in the wake of asset deleveraging in housing, the Fed’s monetary policy transmission is impaired. The housing market channel (which would not work in the absence of GSEs that well) is dead. The asset price inflation channel (wealth effect) has been inadequate and hitting the wrong people. And the rest looks hocus pocus in absence of real demand generation (screaming for fiscal stimulus).

    Also, I would love to see an actual model of NGDP targeting. has anyone done a historical simulation to see how it would behave in the past?

  24. ReturnFreeRisk

     /  July 5, 2012

    By the way you seem to have the same view as Williamson that all monetary easing in the US just end up in excess reserves. Is that a natural law? Or is it a result of a policy mistake on part of the Fed? If it is a policy mistake the Fed can and should correct it.

    This is the same as my argument regarding velocity. Why should it be stable? it is just a technical artifact to me. Nevertheless, I agree-If it is due to a Fed policy mistake, then it can be manipulated and used. I dont think so. But you certainly do.

  25. RFR: how do you explain nominal yields falling at the same time as gold goes up massively at the same time?

    Gold prices are primarily driven by the fact that the expanding middle classes of India (100m+) and that of China (200m+) are becoming newly rich and gold has profound wealth-display and hedge value in both countries. The two countries regularly account for 60% of gold demand, see here:

  26. ReturnFreeRisk

     /  July 6, 2012

    Not convincing Lorenzo. When they are trading tick for tick during US trading hours, this story about secular demand from Asia does not ring true. btw, what happened to the ever increasing demand for gold in the last few months? or is it the fact that Bernanke refuses to do more QE?

  27. RFR Which bit does not ring true? I am not making up the fact that India and China account for about 60% of gold sales and that their share has increased massively in recent years.

  28. ReturnFreeRisk

     /  July 6, 2012

    Just that Asian demand is not behind the speculative ups and downs in the gold price.

  29. Norme

     /  September 26, 2012

    Lars, nice point on China. Let’s say I made $1000 a week and could buy 6000 yuan worth of Chinese goods. Suddenly, China chomps it’s money supply by 40%. Yes, that’s entirely deflationary in China and disastrous. But, that’s China’s problem for now.

    Certainly the opposite effect would be transmitted to the US as the yuan strengthened. By now, I can only purchase (without doing the math) say 3500 yuan of Chinese goods. That’s inflationary to me. My dollar is not worth as much in terms of Chinese goods as import prices rise. The Fed sees a spike in inflation and tightens.

    Now, dollars become more scarce and more valuable. Against the yuan, the value of the dollar could climb (just say) back to the point I can once again buy 6000 yuan worth of Chinese goods and services. Truth is, all imports are now cheaper and inflation is falls.

    But, of course, this means deflationary pressure in the US domestic economy. One would hope it’s just dis-inflation and not a full blown deflation as US prices adjust. However, I can consume more domestic products on the same wage, even if Chinese prices do not reach the level they began. I am still better off as a consumer and consumers better off consume better.

    Producer inputs, such as commodities are cheaper in dollar terms. So, my wage should not affect profits (provided this can be pulled off perfectly in an ideal world, which it can’t. But the trend is the same.) The problem is, now financial assets for the rest of the world feeding the savings glut are more expensive and foreign corporate earnings are down on the strong dollar. But, treasury yields are higher (possibly flatter) because the Fed raised short term rates, and investment flows into US treasuries and folks buy homes.

    But, at least we have a healthy middle class that is able to consume domestically and imports and not loosing them to the poverty line. Maybe if we bought some olive oil, the Greek money supply and ability to tax and service it’s debt would improve.

    And the truth is, the dollar floats for a reason. The Fed does not have to concern itself with a foreign currency peg, it is free to manipulate the US money supply without worrying about such things.

    The US is (or was) the world’s consumer, and since the great moderation we’ve relied largely on debt to do so. It’s a bonanza for the financial markets selling our debt as financial assets, and a bust for the middle class as the great moderation collapsed on bubbles, stagnate wages trailing productivity with “moderate” inflation, and heavy debt. But, that’s the whole point of returning to the pre crisis trend, to reinstall the system that simply blew up and does not seem to be responding to base money growth.

    And yes, the roots of the crisis are in Europe, you are correct. The US housing downturn is the catalyst that brought the monetary union and the globe to it’s knees. When banks (commercial or free) fail, this is what happens. Ask Lehman. There is nothing wrong with the important intermediation process and profits free banking offers, until it costs the global economy dearly. The wealthy can get as rich as they please lending and investing, no problem. It could well have been the commercial banking system that failed, but they sold their mortgages and had federal backing. Now they are free to expand the money supply, but just can’t seem to do so at such low rates and demand for US debt keeping inflation expectations under wraps.

    But, really, despite the Fed’s easing, we are still headed down the deflationary (or dis inflationary) trail just as Japan has been and is. The dollar will be stronger in the end, just as the yen. It appears there is little the Fed can do to push folks into borrowing further debasing the currency as large sums of base money remain trapped in limbo. Japan failed (by and large) even with open ended buying and Chuck Norris in the room. In fact, Japan is still fighting it and continually debasing it’s currency to this day.

    Sorry for the length, but nGDP targeting is an interesting subject. I just don’t think it can work. Maybe it shouldn’t work, not in the system that just failed, anyway. I do not have any problem with inflation driving investment and consumption (and wages), but the process of unlimited buying distorts everything, including the supply (and price) of US treasuries. Low yields do not speak to inflation, ask the BoJ…

    Anyway, thanks…I am sure we both hope for prosperity ahead, just differ on how to get there.

  30. If these arguments are correct, why doesn’t every nation devalue its currency ad infinitum? There must be conditions under which currency devaluation is harmful?

    • You should rather ask under what circumstances are monetary easing harmful? And there the answer obviously is that if you have very strong aggregate demand growth and strong inflation pressures then you obviously should not ease monetary policy (in any way including through devaluation).

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