Friedman, Schuler and Hanke on exchange rates – a minor and friendly disagreement

Before Arthur Laffer got me very upset on Monday I had read an excellent piece by Kurt Schuler on Freebanking.org about Milton Friedman’s position on floating exchange rates versus fixed exchange rates.

Kurt kindly refers to my post on differences between the Swedish and Danish exchange regimes in which I argue that even though Milton Friedman as a general rule prefered floating exchange rates to fixed exchange rates he did not argue that floating exchange rates was always preferable to pegged exchange rates.

Kurt’s comments at length on the same topic and forcefully makes the case that Friedman is not the floating exchange rate proponent that he is sometimes made up to be. Kurt also notes that Steve Hanke a couple of years ago made a similar point. By complete coincidence Steve had actually a couple of days ago sent me his article on the topic (not knowing that I actually had just read it recently and wanted to do a post on it).

Both Kurt and Steve are proponents of currency boards – and I certainly think currency boards under some circumstances have some merit – so it is not surprising they both stress Friedman’s “open-mindeness” on fixed exchange rates. And there is absolutely nothing wrong in arguing that Friedman was pragmatic on the exchange rate issue rather than dogmatic. That said, I think that both Kurt and Steve “overdo” it a bit.

I certainly think that Friedman’s first choice on exchange rate regime was floating exchange rates. In fact I think he even preffered “dirty floats” and “managed floats” to pegged exchange rates. When I recently reread his memories (“Two Lucky People”) I noted how often he writes about how he advised governments and central bank officials around the world to implement a floating exchange rate regime.

In “Two Lucky People” (page 221) Friedman quotes from his book “Money Mischief”:

“…making me far more skeptical that a system of freely floating exchange rates is politically feasible. Central banks will meddle – always, of corse, with the best of intentions. Nevertheless, even dirty floating exchange rates seem to me preferable to pegged rates, though not necessarily to a unified currency”

I think this quote pretty well illustrates Friedman’s general position: Floating exchange rates is the first choice, but under some circumstances pegged exchange rates or currency unions (an “unified currency”) is preferable.

On this issue I find myself closer to Friedman than to Kurt’s and Steve’s view. Kurt and Steve are both long time advocates of currency boards and hence tend to believe that fixed exchange rates regimes are preferable to floating exchange rates. To me this is not a theoretical discussion, but rather an empirical and practical position.

Finally, lately I have lashed out at some US free market oriented economists who I think have been intellectually dishonest for partisan reasons. Kurt and Steve are certainly not examples of this and contrary to many of the “partisan economists” Kurt and Steve have great knowledge of monetary theory and history. In that regard I am happy to recommend to my readers to read Steve’s recent piece on global monetary policy. See here and here. You should not be surprised to find that Steve’s position is that the main problem today is too tight rather than too easy monetary policy – particularly in the euro zone.

PS I should of course note that Kurt is a Free Banking advocate so he ideally prefers Free Banking rather anything else. I have no disagreement with Kurt on this issue.

PPS Phew… it was much nicer to write this post than my recent “anger posts”.

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Related post:
Schuler on money demand – and a bit of Lithuanian memories…

The luck of the ‘Scandies’

This week we are celebrating Milton Friedman’s centennial. Milton Friedman was known for a lot of things and one of them was his generally skeptical view of pegged exchange rates. In his famous article “The Case for Flexible Exchange Rates” he argued strongly against pegged exchange rates and for flexible exchange rates.

Any reader of this blog would know that I share Friedman’s sceptical view of fixed exchange rates. However, I will also have to say that my view on exchange rates policy has become more pragmatic over the years. In fact one can say that I also in this area have become more of a Friedmanite. This could seem as a paradox given Friedman’s passionate defence of floating exchange rates. However, Friedman was not dogmatic on this issue. Rather Friedman saw exchange rate policy as a way to control the money supply and he often argued that small countries might not have the proper instruments and “infrastructure” to properly control the money supply. Hence it would be an advantage for certain countries to “outsource” monetary policy by pegging the currency to for example the US dollar. Hong Kong’s currency board and its peg to the dollar was his favourite example. I am less inclined to think that Hong Kong could not do better than the currency board, but I nonetheless think Friedman was right in the sense that there fundamentally is no difference between using for example interest rates to control the money supply and using the exchange rate.

In his highly recommendable book Money Mischief Milton Friedman discusses the experience with fixed exchange rates in Chile and Israel. Friedman documents Chile’s horrible experience with fixed exchange rates and Israel’s equally successful experience with fixed exchange rates. It is in relation to these examples Friedman states that one never should underestimate the importance of luck of nations. That credo has been a big inspiration in my own thinking and has certainly helped me understand the difference in performance of different economies during the present crisis. It is not only about policy. With the right policies this crisis could have been avoid, but on the other hand despite of less than stellar conduct of monetary policy some countries have come through this crisis very well. Luck certainly is important.

The Scandinavian economies provide an excellent example of this. Denmark and Sweden are in many ways very similar countries – small open economies with high levels of GDP/capita, strong public finances, an overblown welfare state, but nonetheless quite flexible product and labour markets and a quite high level of social and economic cohesion. However, Denmark and Sweden differ in one crucial fashion – the monetary policy regime.

Denmark has a fixed exchange rate (against the euro), while Sweden has a floating exchange rate and an inflation targeting regime. The different monetary policy regimes have had a significant impact on the performance of the Danish and the Swedish economies during the present crisis.

2008-9: Sweden’s luck, Denmark’s misery

When crisis hit in 2008 both Denmark and Sweden got hit, but Denmark suffered much more than Sweden – not only economically but also in terms of financial sector distress. The key reason for this is that while monetary conditions contracted significantly Sweden did not see any major monetary contraction. What happened was that as investors scrambled for US dollars in the second of 2008 they were selling all other currencies – also the Swedish krona and the Danish krone.

The reaction from the Danish and the Swedish central banks was, however, very different. As the Danish krone came under selling pressures the Danish central bank acted according to the fixed exchange policy by buying kroner. As a result Denmark saw a sharp contraction in the money supply – a contraction that continued in 2009 and 2010, but the peg survived. The central bank had “won” and defended the peg, but at a high cost. The monetary contraction undoubtedly did a lot to worsen the Danish financial sector crisis and four years later Danish property prices continue to decline. On the other hand when the demand for Swedish krona plunged in 2008-9 the Swedish central bank allowed this to happen and the krona weakened sharply. Said in another way the Swedish money demand dropped relative to the money supply. Swedish monetary conditions eased, while Danish monetary conditions tightened.

It is often said, that Sweden’s stronger economic performance relative to Denmark in 2008-9 (and 2010-11 for that matter) is a result of the relative improvement in Swedish competitiveness as a result of the sharp depreciation of the Swedish krona. However, this is a wrong analysis of the situation. In fact the major difference between the Swedish economy and the Danish economy has very little to do with the relative export performance. In fact both countries saw a more or less equal drop in exports in 2008-9. The big difference was the performance in domestic demand. While Danish domestic demand collapsed and property prices were in a free fall, domestic demand in Sweden performed strongly and Swedish property prices continued to rise after the crisis hit. The difference obviously is a result of the different monetary policy reactions in the two countries.

This is basically luck – the Danish monetary regime led to tightening of monetary conditions in reaction to the external shock, while the Swedish central bank to a large extent counteracted the shock with an easing of monetary conditions.

2012: The useful Danish peg and the failures of Riksbanken

Today the Danish economy continues to do worse than the Swedish economy, but the luck is changing. And again this has to do with money demand. While the demand for Swedish krona and Danish kroner collapsed in 2008-9 the opposite is the case today. Today investors as a reaction to the euro crisis are running scared away from the euro and buying everything else (more or less). As a result money is floating into both Denmark and Sweden and the demand for both currencies (and Swedish and Danish assets in general) has escalated sharply. So contrary to 2008-9 the demand for (local) money is now rising sharply. This for obvious reasons is leading to appreciation pressures on the Scandinavian currencies.

Today, however, the Danes are lucky to have the peg. Hence, as the Danish krone has tended to appreciate the Danish central bank has stepped in and defended the peg by expanding the money base and for the first time in four years the Danish money supply (M2) is now showing real signs of recovering. This of course is also why Danish short-term bond yields and money market rates have turned negative. The money markets are being flooded with liquidity to keep the krone from strengthening. Hence, the Danish euro peg is doing a great job in avoiding a negative velocity shock. For the first time in four years Danes could be true happy about the peg.

On the other hand for the first time in four years the Swedish monetary policy regime is not work as well as one could have hoped. As the demand for Swedish krona has escalated Swedish monetary conditions are getting tighter and tighter day by day and the signs are pretty clear that Swedish money-velocity is contracting. This is hardly good news for the Swedish economy.

Obviously there is nothing stopping the Swedish central bank from counteracting the drop in velocity (the increased money demand) by expanding the money base and legendary Swedish deputy central bank governor Lars E. O. Svensson has been calling for monetary easing for a while, but the majority of board members in the Swedish central bank seem reluctant to step up and ease monetary policy even though it day by day is becoming evident that monetary easing is needed.

Good policies are the best substitute for good luck

Obviously neither the Danish nor the Swedish monetary policy regime is optimal under all circumstances and this is exactly what I have tried to demonstrate above. The difference between 2008-9 and 2011-12 is the impact on demand for the Danish and Swedish currency and these differences have been driven mostly by external factors.

Obviously one could (and should!) argue that Sweden’s problem today is not the floating exchange rate, but rather the inflation targeting regime. If Sweden instead had been targeting the (future) nominal GDP level then Riksbanken would already had eased monetary policy much more aggressively than has been the case to counteract the contraction in money-velocity.

Finally, it is clear that luck played a major role in how the crisis has played out in the Scandinavian crisis. However, with the right monetary policies – for example NGDP targeting – you are much more likely to have luck on your side when crisis hit.

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Related posts:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5
Milton Friedman on exchange rate policy #6
Is monetary easing (devaluation) a hostile act?
Danish and Norwegian monetary policy failure in 1920s – lessons for today
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
Bring on the “Currency war”
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

Danish and Norwegian monetary policy failure in 1920s – lessons for today

History is fully of examples of massive monetary policy failure and today’s policy makers can learn a lot from studying these events and no one is better to learn from than Swedish monetary guru Gustav Cassel. In the 1920s Cassel tried – unfortunately without luck – to advise Danish and Norwegian policy makers from making a massive monetary policy mistake.

After the First World War policy makers across Europe wanted to return to the gold standard and in many countries it became official policy to return to the pre-war gold parity despite massive inflation during the war. This was also the case in Denmark and Norway where policy makers decided to return the Norwegian and the Danish krone to the pre-war parity.

The decision to bring back the currencies to the pre-war gold-parity brought massive economic and social hardship to Denmark and Norway in the 1920s and probably also killed of the traditionally strong support for laissez faire capitalism in the two countries. Paradoxically one can say that government failure opened the door for a massive expansion of the role of government in both countries’ economies. No one understood the political dangers of monetary policy failure better than Gustav Cassel.

Here you see the impact of the Price Level (Index 1924=100) of the deflation policies in Denmark and Norway. Sweden did not go back to pre-war gold-parity.

While most of the world was enjoying relatively high growth in the second half of the 1920s the Danish and the Norwegian authorities brought hardship to their nations through a deliberate policy of deflation. As a result both nations saw a sharp rise in unemployment and a steep decline in economic activity. So when anybody tells you about how a country can go through “internal devaluation” please remind them of the Denmark and Norway in the 1920s. The polices were hardly successful, but despite the clear negative consequences policy makers and many economists in the Denmark and Norway insisted that it was the right policy to return to the pre-war gold-parity.

Here is what happened to unemployment (%).

Nobody listened to Cassel. As a result both the Danish and the Norwegian economies went into depression in the second half of the 1920s and unemployment skyrocketed. At the same time Finland and Sweden – which did not return to the pre-war gold-partiy – enjoyed strong post-war growth and low unemployment.

Gustav Cassel strongly warned against this policy as he today would have warned against the calls for “internal devaluation” in the euro zone. In 1924 Cassel at a speech in the Student Union in Copenhagen strongly advocated a devaluation of the Danish krone. The Danish central bank was not exactly pleased with Cassel’s message. However, the Danish central bank really had little to fear. Cassel’s message was overshadowed by the popular demand for what was called “Our old, honest krone”.

To force the policy of revaluation and return to the old gold-parity the Danish central bank tightened monetary policy dramatically and the bank’s discount rate was hiked to 7% (this is more or less today’s level for Spanish bond yields). From 1924 to 1924 to 1927 both the Norwegian and the Danish krone were basically doubled in value against gold by deliberate actions of the two Scandinavian nation’s central bank.

The gold-insanity was as widespread in Norway as in Denmark and also here Cassel was a lone voice of sanity. In a speech in Christiania (today’s Oslo) Cassel in November 1923 warned against the foolish idea of returning the Norwegian krone to the pre-war parity. The speech deeply upset Norwegian central bank governor Nicolai Rygg who was present at Cassel’s speech.

After Cassel’s speech Rygg rose and told the audience that the Norwegian krone had been brought back to parity a 100 years before and that it could and should be done again. He said: “We must and we will go back and we will not give up”. Next day the Norwegian Prime Minister Abraham Berge in an public interview gave his full support to Rygg’s statement. It was clear the Norwegian central bank and the Norwegian government were determined to return to the pre-war gold-parity.

This is the impact on the real GDP level of the gold-insanity in Denmark and Norway. Sweden did not suffer from gold-insanity and grew nicely in the 1920s.

The lack of reason among Danish and Norwegian central bankers in the 1920s is a reminder what happens once the “project” – whether the euro or the gold standard – becomes more important than economic reason and it shows that countries will suffer dire economic, social and political consequences when they are forced through “internal devaluation”. In both Denmark and Norway the deflation of the 1920s strengthened the Socialists parties and both the Norwegian and the Danish economies as a consequence moved away from the otherwise successful  laissez faire model. That should be a reminder to any free market oriented commentators, policy makers and economists that a deliberate attempt of forcing countries through internal devaluation is likely to bring more socialism and less free markets. Gustav Cassel knew that – as do the Market Monetarists today.

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My account of these events is based on Richard Lester’s paper “Gold-Parity Depression in Denmark and Norway, 1925-1928” (Journal of Political Economy, August 1937)

Update: Here is an example that not all German policy makers have studied economic and monetary history.

International monetary disorder – how policy mistakes turned the crisis into a global crisis

Most Market Monetarist bloggers have a fairly US centric perspective (and from time to time a euro zone focus). I have however from I started blogging promised to cover non-US monetary issues. It is also in the light of this that I have been giving attention to the conduct of monetary policy in open economies – both developed and emerging markets. In the discussion about the present crisis there has been extremely little focus on the international transmission of monetary shocks. As a consequences policy makers also seem to misread the crisis and why and how it spread globally. I hope to help broaden the discussion and give a Market Monetarist perspective on why the crisis spread globally and why some countries “miraculously” avoided the crisis or at least was much less hit than other countries.

The euro zone-US connection

– why the dollar’ status as reserve currency is important

In 2008 when crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused to drop by both a contraction in velocity and in the money supply. Reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss franc – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss franc will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over.

Why was the contraction so extreme in for example the PIIGS countries and Russia?

While the Fed failed to increase the money supply enough to counteract the increase in dollar demand it nonetheless acted through a number of measures. Most notably two (and a half) rounds of quantitative easing and the opening of dollar swap lines with other central banks in the world. Other central banks faced bigger challenges in terms of the possibility – or rather the willingness – to respond to the increase in dollar demand. This was especially the case for countries with fixed exchanges regimes – for example Denmark, Bulgaria and the Baltic States – and countries in currencies unions – most notably the so-called PIIGS countries.

I have earlier showed that when oil prices dropped in 2008 the Russian ruble started depreciated (the demand for ruble dropped). However, the Russian central bank would not accept the drop in the ruble and was therefore heavily intervening in the currency market to curb the ruble depreciation. The result was a 20% contraction in the Russian money supply in a few months during the autumn of 2008. As a consequence Russia saw the biggest real GDP contraction in 2009 among the G20 countries and rather unnecessary banking crisis! Hence, it was not a drop in velocity that caused the Russian crisis but the Russian central bank lack of willingness to allow the ruble to depreciate. The CBR suffers from a distinct degree of fear-of-floating and that is what triggered it’s unfortunate policy response.

The ultimate fear-of-floating is of course a pegged exchange rate regime. A good example is Latvia. When the crisis hit the Latvian economy was already in the process of a rather sharp slowdown as the bursting of the Latvian housing bubble was unfolding. However, in 2008 the demand for Latvian lat collapsed, but due to the country’s quasi-currency board the lat was not allowed to depreciate. As a result the Latvian money supply contracted sharply and send the economy into a near-Great Depression style collapse and real GDP dropped nearly 30%. Again it was primarily the contraction in the money supply rather and a velocity collapse that caused the crisis.

The story was – and still is – the same for the so-called PIIGS countries in the euro zone. Take for example the Greek central bank. It is not able to on it’s own to increase the money supply as it is part of the euro area. As the crisis hit (and later escalated strongly) banking distress escalated and this lead to a marked drop in the money multiplier and drop in bank deposits. This is what caused a very sharp drop in the Greek board money supply. This of course is at the core of the Greek crisis and this has massively worsened Greece’s debt woes.

Therefore, in my view there is a very close connection between the international spreading of the crisis and the currency regime in different countries. In general countries with floating exchange rates have managed the crisis much better than countries with countries with pegged or quasi-pegged exchange rates. Obviously other factors have also played a role, but at the key of the spreading of the crisis was the monetary policy and exchange rate regime in different countries.

Why did Sweden, Poland and Turkey manage the crisis so well?

While some countries like the Baltic States or the PIIGS have been extremely hard hit by the crisis others have come out of the crisis much better. For countries like Poland, Turkey and Sweden nominal GDP has returned more or less to the pre-crisis trend and banking distress has been much more limited than in other countries.

What do Poland, Turkey and Sweden have in common? Two things.

First of all, their currencies are not traditional reserve currencies. So when the crisis hit money demand actually dropped rather increased in these countries. For an unchanged supply of zloty, lira or krona a drop in demand for (local) money would actually be a passive or automatic easing of monetary condition. A drop in money demand would also lead these currencies to depreciate. That is exactly what we saw in late 2008 and early 2009. Contrary to what we saw in for example the Baltic States, Russia or in the PIIGS the money supply did not contract in Poland, Sweden and Turkey. It expanded!

And second all three countries operate floating exchange rate regimes and as a consequence the central banks in these countries could act relatively decisively in 2008-9 and they made it clear that they indeed would ease monetary policy to counter the crisis. Avoiding crisis was clearly much more important than maintaining some arbitrary level of their currencies. In the case of Sweden and Turkey growth rebound strongly after the initial shock and in the case of Poland we did not even have negative growth in 2009. All three central banks have since moved to tighten monetary policy – as growth has remained robust. The Swedish Riksbank is, however, now on the way back to monetary easing (and rightly so…)

I could also have mentioned the Canada, Australia and New Zealand as cases where the extent of the crisis was significantly reduced due to floating exchange rates regimes and a (more or less) proper policy response from the local central banks.

Fear-of-floating via inflation targeting

Some countries fall in the category between the PIIGS et al and Sweden-like countries. That is countries that suffer from an indirect form of fear-of-floating as a result of inflation targeting. The most obvious case is the ECB. Unlike for example the Swedish Riksbank or the Turkish central bank (TCMB) the ECB is a strict inflation targeter. The ECB does target headline inflation. So if inflation increases due to a negative supply shock the ECB will move to tighten monetary policy. It did so in 2008 and again in 2011. On both occasions with near-catastrophic results. As I have earlier demonstrated this kind of inflation targeting will ensure that the currency will tend to strengthen (or weaken less) when import prices increases. This will lead to an “automatic” fear-of-floating effect. It is obviously less damaging than a strict currency peg or Russian style intervention, but still can be harmful enough – as it clear has been in the case of the euro zone.

Conclusion: The (international) monetary disorder view explains the global crisis

I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also lead to a monetary contraction in especially Europe. Not because of an increase demand for euro, lats or rubles, but because central banks tighten monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as member of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

The international transmission was not caused by “market disorder”, but by monetary policy failure. In a world of freely floating exchange rates (or PEP – currencies pegged to export prices) and/or NGDP level targeting the crisis would never have become a global crisis and I certainly would have no reason to write about it four-five years after the whole thing started.

Obviously, the “local” problems would never have become any large problem had the Fed and the ECB got it right. However, the both the Fed and the ECB failed – and so did monetary policy in a number of other countries.

DISCLAIMER: I have discussed different countries in this post. I would however, stress that the different countries are used as examples. Other countries – both the good, the bad and the ugly – could also have been used. Just because I for example highlight Poland, Turkey and Sweden as good examples does not mean that these countries did everything right. Far from it. The Polish central bank had horrible communication in early 2009 and was overly preoccupied the weakening of the zloty. The Turkish central bank’s communication was horrific last year and the Sweden bank has recently been far too reluctant to move towards monetary easing. And I might even have something positive to say about the ECB, but let me come back on that one when I figure out what that is (it could take a while…) Furthermore, remember I often quote Milton Friedman for saying you never should underestimate the importance of luck of nations. The same goes for central banks.

PS You are probably wondering, “Why did Lars not mention Asia?” Well, that is easy – the Asian economies in general did not have a major funding problem in US dollar (remember the Asian countries’ general large FX reserve) so dollar demand did not increase out of Asia and as a consequence Asia did not have the same problems as Europe. Long story, but just show that Asia was not key in the global transmission of the crisis and the same goes for Latin America.

PPS For more on the distinction between the ‘monetary disorder view’ and the ‘market disorder view’ in Hetzel (2012).

Fear-of-floating, misallocation and the law of comparative advantages

The first commandment of central banking should be thou shall not distort relative prices. However, central bankers often tend to forget this – knowingly or unknowingly. How often have we not heard stern warnings from central bankers that property prices are too high or too low – or that a currency is overvalued or undervalued. And in the last couple of years central bankers have even tried to manipulate the shape of the bond yield curve – just think of the Fed’s “operation twist”.

Central bankers are distorting relative prices in many ways – by for example by trying to prick bubbles (or what they think are bubbles). Sometimes the distortion of relative prices is done unknowingly. The best example of this is when central banks operate an inflation target. Both George Selgin and David Eagle teach us that inflation targeting means that central banks react to supply shocks and thereby distort relative prices. In an open economy this will lead to a distortion of the relative prices between trade goods and non-traded goods.

As I will show below central bankers’ eagerness to distort relative prices is as harmful as other distortions of relative prices for example as a result of protectionism and will often lead to numerous negative side-effects.

The fear-of-floating – the violation of the Law of comparative advantages

I have recently given a bit of attention to the concept of fear-of-floating. Despite being officially committed to floating exchange rates many central banks from time to time intervene in the FX markets to “manage” the currency. As I have earlier noted a good example is the Norwegian central bank (Norges Bank), which often has intervened either directly or verbally in the currency market or verbally to try to curb the strengthening of the Norwegian krone. In March for example Norges Bank surprisingly cut interest rates to curb the strengthening of the krone – despite the general macroeconomic situation really warranted a tightening of monetary conditions.

So why is Norge Bank so fearful of a truly free floating krone? The best explanation in the case of Norway is that the central bank’s fears that when oil prices rise then the Norwegian krone will strengthen and hence make the non-oil sectors in the economy less competitive. This is what happened in 2003 when a sharp appreciation of the krone cause an “exodus” of non-oil sector companies from Norway. Hence, there is no doubt that it is a sub-target of Norwegian monetary policy to ensure a “diversified” Norwegian economy. This policy is strongly supported by the Norwegian government’s other policies – for example massive government support for the agricultural sector. Norway is not a EU member – and believe it or not government subsidies for the agricultural sector is larger than in the EU!

However, in the same way as government subsidies for the agricultural sector distort economic allocation so do intervention in the currency market. However, while most economists agree that government subsidies for ailing industries is violating the law of comparative advantages and lead to a general economic lose in the form of lower productivity and less innovation few economists seem to be aware that the fear-of-floating (including indirect fear-of-floating via inflation targeting) have the same impact.

Lets look at an example. Let say that oil prices increase by 30% and that tend to strengthen the Norwegian krone. This is the same as to say that the demand curve in the oil sector has shifted to the right. This will increase the demand for labour and capital in the oil sector. In a freely mobile labour market this will push up salaries both in the oil sector and in the none-oil sector. Hence, the none-oil sector will become less competitive – both as a result of higher labour and capital costs, but also because of a stronger krone. As a consequence labour and capital will move from the non-oil sector to the oil sector. Most economists would agree that this is a natural market process that ensures the most productive and profitable use of economic resources. As David Ricardo taught us long ago – countries should produce the goods in which the country has a comparative advantage. The unhampered market mechanism ensures this.

However, if the central bank suffers from fear-of-floating then the central bank will intervene to curb the strengthening of the krone. This has two consequences. First, the increase in profitability in the oil sector will be smaller than it would have been had the krone been allowed to strengthen. This would also mean that the increase in demand for capital and labour in the oil sector would be smaller than it would have been if the krone had been allowed to float completely freely (or had been pegged to the oil price). Second, this would mean that the “scaling down” of the non-oil sector will be smaller than otherwise would have been the case – and as a result this sector will demand too much labour and capital relative to what is economically optimal. This is exactly what the central bank would like to see. However, I think the example pretty clearly shows that such as policy is violating the law of comparative advantages. Relative prices are distorted and as a result the total economic output and welfare will be smaller than would have been the case under a freely floating currency.

It is often argued that if the oil price is very volatile and the krone (or another oil-exporting country’s currency) therefore would be more volatile and as a consequence the non-oil sector will see large swings in economic activity and it would be in the interest of the central bank to reduce this volatility and thereby stabilise the development in the non-oil sector. However, this completely misses the point with free markets. Prices should be allowed to adjust to ensure an efficient allocation of capital and labour. If you intervene in the market process allocation of resources will be less efficient.

Furthermore, the central bank cannot permanently distort relative prices. If the currency is kept artificially weak by easier monetary policy it will just inflated the entire economy – and as a result capital and labour cost will increase – as will inflation – and sooner or later the competitive advantage created by an artificially weak currency will be gradually eaten by higher prices and wages. In an economy where wages and prices are downward rigid – as surely is the case in the Norwegian economy – this will created major adjustment problems if oil prices drops sharply especially if the central bank also try to curb the weakening of the currency (as the Russian central bank did in 2008). Hence, by trying to dampen the swings in the FX rates the central bank will actually move the adjustment process from the FX markets (which is highly flexible) to the much less flexible labour and good markets. So even though the central bank might want to curb the volatility in economic activity in the non-oil sector it will actually rather increase the general level of volatility in the economy. In an economy with fully flexible prices and wages the manipulation of the FX rate would not be a problem. However, if for example wages are downward rigid because interventionist labour market policy as it is the case in Norway then a policy of curbing the volatility in the FX rate quite obviously (to me at least) leads to lower productivity and higher volatility in both nominal and rate variables.

I have used the Norwegian economy as an example. I should stress that I might as well have used for example Brazil or Russia – as the central banks in these countries to a much larger degree than Norges Bank suffers from a fear-of-floating. I could in fact also have used the ECB as the ECB indirectly suffers from a fear-of-floating as the ECB is targeting inflation.

I am not aware of any research on the consequences for productivity of fear-of-floating, but I am sure it could be an interesting area of research – I wonder if Norge Banks is aware how big the productive lose in the Norwegian economy has been due to it’s policy of curbing oil price driven swings in the krone. I am pretty sure that the Russian central bank and the Brazilian central bank have not given this much thought at all. Neither has most other Emerging Market central banks that frequently intervenes in the FX markets. 

PS do I need to say how to avoid these problems? Yes you guessed right – NGDP level targeting or by pegging the currency to the oil price. If you want to stay with in a inflation targeting framework then central bank central bank should at least target domestic demand inflation or what I earlier inspired by David Eagle has termed Quasi-Real inflation (QRPI).

PS Today I am spending my day in London – I wrote this on the flight. I bet a certain German central banker will be high on the agenda in my meetings with clients…

Exchange rates are not truly floating when we target inflation

There is a couple of topics that have been on my mind lately and they have made me want to write this post. In the post I will claim that inflation targeting is a soft-version of what economists have called the fear-of-floating. But before getting to that let me run through the topics on my mind.

1) Last week I did a presentation for a group of Norwegian investors and even thought the topic was the Central and Eastern European economies the topic of Norwegian monetary politics came up. I am no big expert on the Norwegian economy or Norwegian monetary policy so I ran for the door or rather I started to talk about an other large oil producing economy, which I know much better – The Russian economy. I essentially re-told what I recently wrote about in a blog post on the Russian central bank causing the 2008/9-crisis in the Russian economy, by not allowing the ruble to drop in line with oil prices in the autumn of 2008. I told the Norwegian investors that the Russian central bank was suffering from a fear-of-floating. That rang a bell with the Norwegian investors – and they claimed – and rightly so I think – that the Norwegian central bank (Norges Bank) also suffers from a fear-of-floating. They had an excellent point: The Norwegian economy is booming, domestic demand continues to growth very strongly despite weak global growth, asset prices – particularly property prices – are rising strongly and unemployment is very low and finally do I need to mention that Norwegian NGDP long ago have returned to the pre-crisis trend? So all in all if anything the Norwegian economy probably needs tighter monetary policy rather than easier monetary policy. However, this is not what Norges Bank is discussing. If anything the Norges Bank has recently been moving towards monetary easing. In fact in March Norges Bank surprised investors by cutting interest rates and directly cited the strength of the Norwegian krone as a reason for the rate cut.

2) My recent interest in Jeff Frankel’s idea that commodity exporters should peg their currency to the price of the main export (PEP) has made me think about the connect between floating exchange rates and what monetary target the central bank operates. Frankel in one of his papers shows that historically there has been a rather high positive correlation between higher import prices and monetary tightening (currency appreciation) in countries with floating exchange rates and inflation targeting. The mechanism is clear – strict inflation targeting central banks an increase in import prices will cause headline inflation to increase as the aggregate supply curve shots to the left and as the central bank does not differentiate between supply shocks and nominal shocks it will react to a negative supply shock by tightening monetary policy causing the currency to strengthen. Any Market Monetarist would of course tell you that central banks should not react to supply shocks and should allow higher import prices to feed through to higher inflation – this is basically George Selgin’s productivity norm. Very few central banks allow this to happen – just remember the ECB’s two ill-fated rate hikes in 2011, which primarily was a response to higher import prices. Sad, but true.

3) Scott Sumner tells us that monetary policy works with long and variable leads. Expectations are tremendously important for the monetary transmission mechanism. One of the main channels by which monetary policy works in a small-open economy  – with long and variable leads – is the exchange rate channel. Taking the point 2 into consideration any investor would expect the ECB to tighten monetary policy  in responds to a negative supply shock in the form of a increase in import prices. Therefore, we would get an automatic strengthening of the euro if for example oil prices rose. The more credible an inflation target’er the central bank is the stronger the strengthening of the currency. On the other hand if the central bank is not targeting inflation, but instead export prices as Frankel is suggesting or the NGDP level then the currency would not “automatically” tend to strengthen in responds to higher oil prices. Hence, the correlation between the currency and import prices strictly depends on what monetary policy rule is in place.

These three point leads me to the conclusion that inflation targeting really just is a stealth version of the fear-of-floating. So why is that? Well, normally we would talk about the fear-of-floating when the central bank acts and cut rates in responds to the currency strengthening (at a point in time when the state of the economy does not warrant a rate cut). However, in a world of forward-looking investors the currency tends move as-if we had the old-fashioned form of fear-of-floating – it might be that higher oil prices leads to a strengthening of the Norwegian krone, but expectations of interest rate cuts will curb the strengthen of NOK. Similarly the euro is likely to be stronger than it otherwise would have been when oil prices rise as the ECB again and again has demonstrated the it reacts to negative supply shocks with monetary easing.

Exchange rates are not truly floating when we target inflation 

And this lead me to my conclusion. We cannot fundamentally say that currencies are truly floating as long as central banks continue to react to higher import prices due to inflation targeting mandates. We might formally have laid behind us the days of managed exchange rates (at least in North America and Europe), but de facto we have reintroduced it with inflation targeting. As a consequence monetary policy becomes excessively easy (tight) when import prices are dropping (increasing) and this is the recipe for boom-bust. Therefore, floating exchange rates and inflation targeting is not that happy a couple it often is made out to be and we can fundamentally only talk about truly floating exchange rates when monetary policy cease to react to supply shocks.

Therefore, the best way to ensure true exchange rates flexibility is through NGDP level targeting and if we want to manage exchange rates then at least do it by targeting the export price rather than the import price.

“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression

Even though I am a Danish economist I am certainly no expert on the Danish economy and I have certainly not spend much time blogging about the Danish economy and I have no plans to change that in the future. However, for some reason I today came to think about what would have been the impact on the Danish economy if the Danish krone had been pegged to the price of bacon rather than to gold at the onset of the Great Depression in 1929. Lets call it the Bacon Standard – or a the PIG PEG (thanks to Mikael Bonde Nielsen for that suggestion).

Today less than 10% of Danish export revenues comes from bacon export – back during in the 1920s it was much more sizable and agricultural products dominated export revenues and Denmark’s main trading partner was Great Britain. Since bacon prices and other agricultural product were highly correlated (and still are) the bacon price probably would have been a very good proxy for Danish export prices. Hence, a the PIG PEG would basically have been similar to Jeff Frankel’s Peg the Export Price (PEP) proposal (see my earlier posts on this idea here and here).

When the global crisis hit in 1929 it put significant downward pressure on global agricultural prices and in two years most agricultural prices had been halved. As a consequence of the massive drop in agricultural prices – including bacon prices – the crisis put a serious negative pressures on the Danish krone peg against gold. Denmark had relatively successfully reintroduced the gold standard in 1927, but when the crisis hit things changed dramatically.

Initially the Danish central bank (Danmarks Nationalbank) defended the gold standard and as a result the Danish economy was hit by a sharp monetary contraction. As I argued in my post on Russian monetary policy a negative shock to export prices is not a supply shock, but rather a negative demand shock under a fixed exchange rate regime – like the gold standard. Said in another way the Danish AD curve shifted sharply to the left.

The shock had serious consequences. Hence, Danish economic activity collapsed as most places in the world, unemployment spiked dramatically and strong deflationary pressures hit the economy.

Things got even worse when the British government in 1931 decided to give up the gold standard and eventually the Danish government decided to follow the lead from the British government and also give up the gold standard. However, unlike Sweden the Danish authorities felt very uncomfortable to go it’s own ways (like today…) and it was announced that the krone would be re-pegged against sterling. That strongly limited the expansionary impact of the decision to give up the gold standard. Therefore, it is certainly no coincidence that Swedish economy performed much better than the Danish economy during the 1930s.

The Danish economy, however, started to recovery in 1933. Two events spurred the recovery. First, FDR’s decision to give the gold standard helped the US economy to begin pulling out of the recovery and that helped global commodity prices which certainly helped Danish agricultural exports. Second, the so-called  Kanslergade Agreementa political agreement named after the home address of then Prime Minister Thorvald Stauning in the street Kanslergade in Copenhagen – lead to a devaluation of the Danish krone. Both events effectively were monetary easing.

What would the Bacon standard have done for the Danish economy?

While monetary easing eventually started to pull Denmark out of the Great Depression it didn’t happen before four year into the crisis and the recovery never became as impressive as the development in Sweden. Had Denmark instead had a Bacon Standard then things would likely have played out in a significantly more positive way. Hence, had the Danish krone been pegged to the price of bacon then it would have been “automatically” devalued already in 1929 and the gradual devaluation would have continued until 1933 after, which rising commodity prices (and bacon prices) gradually would have lead to a tightening of monetary conditions.

In my view had Denmark had the PIG PEG in 1929 the crisis would been much more short-lived and the economy would fast have recovered from the crisis. Unfortunately that was not the case and four years was wasted defending an insanely tight monetary policy.

Monetary disequilibrium leads to interventionism   

The Danish authorities’ decision to maintain the gold standard and then to re-peg to sterling had significant economic and social consequences. As a consequence the public support for interventionist policies grew dramatically and effectively lay the foundation for what came to be known as the danish “Welfare State”. Hence, the Kanslergade Agreement not only lead to a devaluation of the krone, but also to a significant expansion of the role of government in the Danish economy. In that sense the Kanslergade Agreement has parallels to FDR’s policies during the Great Depression – monetary easing, but also more interventionist policies.

Hence, the Danish experience is an example of Milton Friedman’s argument that monetary disequilibrium caused by a fixed exchange rate policy is likely to increase interventionist tendencies.

Bon appetite – or as we say in Danish velbekomme…

Should small open economies peg the currency to export prices?

Nominal GDP targeting makes a lot of sense for large currency areas like the US or the euro zone and it make sense that the central bank can implement a NGDP target through open market operations or as with the use of NGDP futures. However, operationally it might be much harder to implement a NGDP target in small open economies and particularly in Emerging Markets countries where there might be much more uncertainty regarding the measurement of NGDP and it will be hard to introduce NGDP futures in relatively underdeveloped and illiquid financial markets in Emerging Markets countries.

I have earlier (see here and here) suggested that a NGDP could be implemented through managing the FX rate – for example through a managed float against a basket of currencies – similar to the praxis of the Singaporean monetary authorities. However, for some time I have been intrigued by a proposal made by Jeffrey Frankel. What Frankel has suggested in a number of papers over the last decade is basically that small open economies and Emerging Markets – especially commodity exporters – could peg their currency to the price of the country’s main export commodity. Hence, for example Russia should peg the ruble to the price of oil – so a X% increase in oil prices would automatically lead to a X% appreciation of the ruble against the US dollar.

Frankel has termed this proposal PEP – Peg the Export Price. Any proponent of NGDP level target should realise that PEP has some attractive qualities.

I would especially from a Market Monetarist highlight two positive features that PEP has in common in (futures based) NGDP targeting. First, PEP would ensure a strict nominal anchor in the form of a FX peg. This would in reality remove any discretion in monetary policy – surely an attractive feature. Second, contrary to for example inflation targeting or price level targeting PEP does not react to supply shocks.

Lets have a closer look at the second feature – PEP and supply shocks. A key feature of NGDP targeting (and what George Selgin as termed the productivity norm) is that it does not distort relative market prices – hence, an negative supply shock will lead to higher prices (and temporary higher inflation) and similarly positive supply shocks will lead to lower prices (and benign deflation). As David Eagle teaches us – this ensures Pareto optimality and is not distorting relative prices. Contrary to this a negative supply shock will lead to a tightening of monetary policy under a inflation targeting regime. Under PEP the monetary authorities will not react to supply shock.

Hence, if the currency is peg to export prices and the economy is hit by an increase in import prices (for example higher oil prices – a negative supply shock for oil importers) then the outcome will be that prices (and inflation) will increase. However, this is not monetary inflation. Hence, what I inspired by David Eagle has termed Quasi-Real Prices (QRPI) have not increased and hence monetary policy under PEP is not distorting relative prices. Any Market Monetarist would tell you that that is a very positive feature of a monetary policy rule.

Therefore as I see it in terms of supply shocks PEP is basically a variation of NGDP targeting implemented through an exchange rate policy. The advantage of PEP over a NGDP target is that it operationally is much less complicated to implement. Take for example Russia – anybody who have done research on the Russian economy (I have done a lot…) would know that Russian economic data is notoriously unreliable. As a consequence, it would probably make much more sense for the Russian central bank simply to peg the ruble to oil prices rather than trying to implement a NGDP target (at the moment the Russian central bank is managing the ruble a basket of euros and dollars).

PEP seems especially to make sense for Emerging Markets commodity exporters like Russia or Latin American countries like Brazil or Chile. Obviously PEP would also make a lot for sense for African commodity exporters like Zambia. Zambia’s main export is copper and it would therefore make sense to peg the Zambian kwacha against the price of copper.

Jeffrey Frankel has written numerous papers on PEP and variations of PEP. Interestingly enough Frankel was also an early proponent of NGDP targeting. Unfortunately, however, he does not discussion the similarities and differences between NGDP targeting and PEP in any of his papers. However, as far as I read his research it seems like PEP would lead to stabilisation of NGDP – at least much more so than a normal fixed exchange regime or inflation targeting.

One aspect I would especially find interesting is a discussion of shocks to money demand (velocity shocks) under PEP. Unfortunately Frankel does not discuss this issue in any of his papers. This is not entirely surprising as his focus is on commodity exporters. However, the Great Recession experience shows that any monetary policy rule that is not able in someway to react to velocity shocks are likely to be problematic in one way or another.

I hope to return to PEP and hope especially to return to the impact of velocity-shocks under PEP.

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Links to Frankel’s papers on PEP etc. can be found on Frankel’s website. See here.

Remember the mistakes of 1937? A lesson for today’s policy makers

Since the ECB introduced it’s 3-year LTRO on December 8 the signs that we are emerging from the crisis have grown stronger. This has been visible with stock prices rebounding strongly, long US bond yields have started to inch up and commodity prices have increased. This is all signs of easier monetary conditions globally.

We are now a couple of months into the market recovery and especially the recovery in commodity prices should soon be visible in US and European headline inflation and will likely soon begin to enter into the communication of central bankers around the world. This has reminded me of the “recession in the depression” in 1937. After FDR gave up the gold standard in 1933 the global economy started to recover and by 1937 US industrial production had basically returned to the 1929-level. The easing of global monetary conditions and the following recovery had spurred global commodity prices and by 1937 policy makers in the US started to worry about inflationary pressures.

However, in the second half of 1936 US economic activity and the US stock market went into a free fall and inflationary concerns soon disappeared.

There are a number of competing theories about what triggered the 1937 recession. I will especially like to highlight three monetary explanations:

1) Milton Friedman and Anna Schwartz in their famous Monetary History highlighted the fact that the Federal Reserve’s decision to increase reserve requirements starting in July 1936 was what caused the recession of 1937.

2) Douglas Irwin has – in an excellent working paper from last year – claimed that it was not the Fed, but rather the US Treasury that caused the the recession as the Treasury moved aggressively to sterilize gold inflows into the US and thereby caused the US money supply to drop.

3) While 1) and 2) regard direct monetary actions the third explanation regards the change in the communication of US policy makers. Hence, Gauti B. Eggertsson and Benjamin Pugsley in an extremely interesting paper from 2006 argue that it was the communication about monetary and exchange rate policy that caused the recession of 1937. As Scott Sumner argues monetary policy works with long and variables leads. Eggertson and Pugsley argue exactly the same.

In my view all three explanations clearly are valid. However, I would probably question Friedman’s and Schwartz’s explanation on it’s own as being enough to explain the recession of 1937. I have three reasons to be slightly skeptical about the Friedman-Schwartz explanation. First, if indeed the tightening of reserve requirements caused the recession then it is somewhat odd that the market reaction to the announcement of the tightening of reserve requirements was so slow to impact the stock markets and the commodity prices. In fact the announcement of the increase in reserve requirements in July 1936 did not have any visible impact on stock prices when they were introduced. Second, it is also notable that there seems to have been little reference to the increased reserve requirement in the US financial media when the collapse started in the second half of 1937 – a year after the initial increase in reserve requirements. Third, Calomiris, Mason and Wheelock in paper from 2011 have demonstrated that banks already where holding large excess reserves and the increase in reserve requirements really was not very binding for many banks. That said, even if the increase in reserve requirement might not have been all that binding it nonetheless sent a clear signal about the Fed’s inflation worries and therefore probably was not irrelevant. More on that below.

Doug Irwin’s explanation that it was actually the US Treasury that caused the trouble through gold sterilization rather than the Fed through higher reserve requirements in my view has a lot of merit and I strongly recommend to everybody to read Doug’s paper on Gold Sterilization and the Recession 1937-38 in which he presents quite strong evidence that the gold sterilization caused the US money supply to drop sharply in 1937. That being said, that explanation does not fit perfectly well with the price action in the stock market and commodity prices either.

Hence, I believe we need to take into account the combined actions of the of the US Treasury (including comments from President Roosevelt) and the Federal Reserve caused a marked shift in expectations in a strongly deflationary direction. In their 2006 paper Eggertsson and Pugsley “The Mistake of 1937: A General Equilibrium Analysis” make this point forcefully (even though I have some reservations about their discussion of the monetary transmission mechanism). In my view it is very clear that both the Roosevelt administration and the Fed were quite worried about the inflationary risks and as a consequence increasing signaled that more monetary tightening would be forthcoming.

In that sense the 1937 recession is a depressing reminder of the strength of the of the Chuck Norris effect – here in the reserve form. The fact that investors, consumers etc were led to believe that monetary conditions would be tightened caused an increase in money demand and led to an passive tightening of monetary conditions in the second half of 1937 – and things obviously were not made better by the Fed and US Treasury actually then also actively tightened monetary conditions.

The risk of repeating the mistakes of 1937 – we did that in 2011! Will we do it again in 2012 or 2013?

So why is all this important? Because we risk repeating the mistakes of 1937. In 1937 US policy makers reacted to rising commodity prices and inflation fears by tightening monetary policy and even more important created uncertainty about the outlook for monetary policy. At the time the Federal Reserve failed to clearly state what nominal policy rule it wanted to implemented and as a result caused a spike in money demand.

So where are we today? Well, we might be on the way out of the crisis after the Federal Reserve and particularly the ECB finally came to acknowledged that a easing of monetary conditions was needed. However, we are already hearing voices arguing that rising commodity prices are posing an inflationary risk so monetary policy needs to be tighten and as neither the Fed nor the ECB has a very clearly defined nominal target we are doomed to see continued uncertainty about when and if the ECB and the Fed will tighten monetary policy. In fact this is exactly what happened in 2011. As the Fed’s QE2 pushed up commodity prices and the ECB moved to prematurely tighten monetary policy. To make matters worse extremely unclear signals about monetary policy from European central bankers caused market participants fear that the ECB was scaling back monetary easing.

Therefore we can only hope that this time around policy makers will have learned the lesson from 1937 and not prematurely tighten monetary policy and even more important we can only hope that central banks will become much more clear regarding their nominal targets. Any market monetarist will of course tell you that central bankers should not fear overdoing their monetary easing if they clearly define their nominal targets (preferably a NGDP level target) – that would ensure that monetary policy is not tightened prematurely and a well-timed exist from monetary easing is ensured.

PS I have an (very unclear!) idea that the so-called Tripartite Agreement from September 1936 b the US, Great Britain and France  to stabilize their nations’ currencies both at home and in the international FX markets might have played a role in causing a change in expectations as it basically told market participants that the days of “currency war” and competitive devaluations had come to an end. Might this have been seen as a signal to market participants that central banks would not compete to increase the money supply? This is just a hypothesis and I have done absolutely no work on it, but maybe some young scholar would like to pick you this idea?

Bring on the “Currency war”

I have been giving the issue of devaluation a bit of attention recently. In my view most people fail to understand the monetary aspects of currency moves – both within a floating exchange rate regime and with managed or pegged exchange regimes.

I have already in my post “Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons” argued that what we should focus on when we are talking about the effects of devaluation is the impact on the money supply and on money-velocity rather than on “competitiveness”. In my post “Mises was clueless about the effects of devaluation” I argued that Ludwig von Mises basically did not fully comprehend the monetary nature of devaluations.

The failure to understand the monetary nature of devaluation often lead to a wrongful analysis of the impact of giving up pegged exchange rates or leaving a currency union – or for that matter giving up the gold standard. It also leads to a very wrong analysis of what has been called “competitive devaluations” – a situation where different countries basically are moving to weaken their own currencies at the same time. This discussion flared up in the second half of 2010 when (the expectations of) QE2 from the Federal Reserve triggered a strengthening of especially a number of Emerging Market currencies. Many EM central banks moved to counteract the strengthening of their currencies by cutting interest rates and intervening in the FX markets – basically undertaking QE on their own. Brazilian Finance Minister Guido Mantega even talked about currency war (and he has apparently just redeclared currency war…)

However, the term “currency war” is highly misleading. In a world of depressed global NGDP and deflationary tendencies there is no problem in competitive devaluations. The critiques would argue that not all countries can devalue and that the net impact on global economic activity therefore would be zero. This, however, is far from right. As I have earlier argued devaluation is not primarily about competitiveness, but rather about the impact on monetary conditions. Hence, if countries compete to devalue they basically compete to increase the money supply and velocity. This obviously is very positive if there is a general global problem of depressed nominal spending. Hence by all means bring on the currency war! Furthermore, it should be noted that in a situation where there is financial sector problems it is likely that the transmission mechanism would work much stronger through the FX channel than through the credit channel. See my related post on this here.

Imagine this highly unrealistic scenario. The ECB tomorrow announces a target for EUR/USD of 1.00 and announce it will buy US assets to achieve this target. The purpose would be to increase the euro zone’s nominal GDP by 15% and the ECB would only end its policy once this target is achieved. As counter-policy the Federal Reserve announces that it will do the opposite and buy European assets until EUR/USD hits 1.80 and that it will not stop this policy before US NGDP has been increased by 15%. Leave aside the political implications of this (the US congress would freak out…) what would happen? Well basically the Fed would be doing QE in Europe and ECB would be doing QE in the US. EUR/USD would probably not move much, but I am pretty sure inflation expectations would spike and global stock markets would increase strongly. But most important NGDP would increase sharply and fast hit the 15% target in both the euro zone and the US. Obviously this policy could lead to all kind of unwarranted side-effects and I would certainly not recommend it, but it is a illustration that we should not be too unhappy if we have “friendly” currency war. By “friendly” I mean that the currency war does not trigger capital restrictions and other kind of interventionist policy and that is clearly a risk. However, it is preferable to the present situation of depressed global NGDP.

Matthew O’Brien the associate editor at The Atlantic reaches the same conclusion in a recent comment. In “Currency Wars Are Good!” Matthew aruges along the same lines as I do:

A currency war begins, simply enough, when a country decides to push down the value of its currency. This means either printing money or just threatening to print money. A cheaper currency makes exports cheaper, and more competitive exports means more growth and happier people. Well, everybody except people in other countries who were just undersold and lost exports. That’s why economists call this kind of devaluation a “beggar-thy-neighbor” policy: Countries boost exports at the expense of others.

This sounds bad. Rather than cooperating, countries are fighting over trade. But in this case, some fighting is good, and more fighting is better. Countries that lose exports want to get them back. And the best way to do that is to devalue their own currencies too. This, of course, causes more countries to lose exports. They also want to get their exports back, so they also push down their currencies. It’s devaluation all the way down. All thanks to economic peer pressure.

The downside of devaluation is that no country gains a real trade advantage, and weaker currencies means the prices of commodities like oil shoot. But — and here’s the really important part — devaluing means printing money. There isn’t enough money in the world. That’s the simple and true reason why the global economy fell into crisis and has been so slow to recover. It’s also the simple and true reason why the Great Depression was so devastating. We know from the 1930s that such competitive devaluation can turn things around.

War is good if it creates more of something you want. A “charity war” between friends is good because it leads to more donations. A currency war is good because it leads to more money. If war is politics by other means, a currency war is stimulus by other means.

So true, so true. So next time somebody starts to worry about “currency war” please tell them that is exactly what we want and for those countries where monetary policy is not too tight tell them to let their currencies appreciate. It will not do them harm. Is monetary policy is already too loose currency appreciation will be a welcomed tightening of monetary conditions.

PS you obviously don’t want to see competitive devaluations in a world of high inflation. That is what happened during the 1970s, but we can hardly talk of high inflation today – at least not in the US and the euro zone.

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