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The exchange rate fallacy: Currency war or a race to save the global economy?

This is from CNB.com:

Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace…

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

This pretty much is what I would call the ‘exchange rate fallacy’ – hence the belief that monetary easing in someway is a zero sum game where monetary easing works through an “unfair” competitiveness channel and one country’s gain is another country’s lose.

Lets take the arguments one-by-one.

“…countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.”

The perception here is that monetary policy primarily works through a “competitiveness channel” where a monetary easing leads to a weakening of the currency and this improve the competitiveness of the nation by weakening the real value of the currency. The problem with this argument is first of all that this only works if there is no increase in prices and wages. It is of course reasonable to assume that that is the case in the short-run as prices and wages tend to be sticky. However, empirically such gains are minor.

I think a good illustration of this is relative performance of Danish and Swedish exports in 2008-9. When crisis hit in 2008 the Swedish krona weakened sharply as the Riksbank moved to cut interest rates aggressive and loudly welcomed the weakening of the krona. On the other hand Denmark continued to operate it’s pegged exchange rate regime vis-a-vis the euro. In other words Sweden initially got a massive boost to it’s competitiveness position versus Denmark.

However, take a look at the export performance of the two countries in the graph below.

swedkexports
Starting in Q3 2008 both Danish and Swedish exports plummeted. Yes, Swedish dropped slightly less than Danish exports but one can hardly talk about a large difference when it is taken into account how much the Swedish krona weakened compared to the Danish krone.

And it is also obvious that such competitiveness advantage is likely to be fairly short-lived as inflation and wage growth sooner or later will pick up and erode any short-term gains from a weakening of the currency.

The important difference between Denmark and Sweden in 2008-9 was hence not the performance of exports.

The important difference on the other hand the performance of domestic demand. Just have a look at private consumption in Sweden and Denmark in the same period.

SWDKcons

It is very clear that Swedish private consumption took a much smaller hit than Danish private consumption in 2008-9 and consistently has grown stronger in the following years.

The same picture emerges if we look at investment growth – here the difference it just much bigger.

swdkinvest

The difference between the performance of the Danish economy and the Swedish economy during the Great Recession hence have very little to do with export performance and everything to do with domestic demand.

Yes, initially Sweden gained a competitive advantage over Denmark, but the major difference was that Riksbanken was not constrained in it ability to ease monetary policy by a pegged exchange rate in the same way as the Danish central bank (Nationalbanken) was.

(For more on Denmark and Sweden see my earlier post The luck of the ‘Scandies’)

Hence, we should not see the exchange rate as a measure of competitiveness, but rather as an indicator of monetary policy “tightness”.When the central bank moves to ease monetary policy the country’s currency will tend to ease, but the major impact on aggregate demand will not be stronger export performance, but rather stronger growth in domestic demand. There are of course numerous examples of this in monetary history. I have earlier discussed the case of the Argentine devaluation in 2001 that boosted domestic demand rather exports. The same happened in the US when FDR gave up the gold standard in 1931. Therefore, when journalists and commentators focus on the relationship between monetary easing, exchange rates and “competitiveness” they are totally missing the point.

The ‘foolproof’ way out of deflation

That does not mean that the exchange rate is not important, but we should not think of the exchange rate in any other way than other monetary policy instruments like interest rates. Both can lead to a change in the money base (the core monetary policy instrument) and give guidance about future changes in the money base.

With interest rates effectively stuck at zero in many developed economies central banks needs to use other instruments to escape deflation. So far the major central banks of the world has focused on “quantitative easing” – increasing in the money base by buying (domestic) financial assets such as government bonds. However, another way to increase the money base is obviously to buy foreign assets – such as foreign currency or foreign bonds. Hence, there is fundamentally no difference between the Bank of Japan buying Japanese government bonds and buying foreign bonds (or currency). It is both channels for increasing the money base to get out of deflation.

In fact on could argue that the exchange rate channel is a lot more “effective” channel of monetary expansion than “regular” QE as exchange rate intervention is a more transparent and direct way for the central bank to signal it’s intentions to ease monetary policy, but fundamentally it is just another way of monetary easing.

It therefore is somewhat odd that many commentators and particularly financial journalists don’t seem to realise that FX intervention is just another form of monetary easing and that it is no less “hostile” than other forms of monetary easing. If the Federal Reserve buys US government treasuries it will lead to a weakening of dollar in the same way it would do if the Fed had been buying Spanish government bonds. There is no difference between the two. Both will lead to an expansion of the money base and to a weaker dollar.

“Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market”

This quote is typical of the stories about “currency war”. Monetary easing is seen as a zero sum game and only the first to move will gain, but it will be on the expense of other countries. This argument completely misses the point. Monetary easing is not a zero sum game – in fact in an quasi-deflationary world with below trend-growth a currency war is in fact a race to save the world.

Just take a look at Europe. Since September both the Federal Reserve and the Bank of Japan have moved towards a dramatically more easy monetary stance, while the ECB has continue to drag its feet. In that sense one can say that that the US and Japan have started a “currency war” against Europe and the result has been that both the yen and the dollar have been weakened against the euro. However, the question is whether Europe is better off today than prior to the “currency war”. Anybody in the financial markets would tell you that Europe is doing better today than half  a year ago and European can thank the Bank of Japan and the Fed for that.

So how did monetary easing in the US and Japan help the euro zone? Well, it is really pretty simple. Monetary easing (and the expectation of further monetary easing) in Japan and the US as push global investors to look for higher returns outside of the US and Japan. They have found the higher returns in for example the Spanish and Irish bond markets. As a result funding costs for the Spanish and Irish governments have dropped significantly and as a result greatly eased the tensions in the European financial markets. This likely is pushing up money velocity in the euro zone, which effectively is monetary easing (remember MV=PY) – this of course is paradoxically what is now making the ECB think that it should (prematurely!) “redraw accommodation”.

The ECB and European policy makers should therefore welcome the monetary easing from the Fed and the BoJ. It is not an hostile act. In fact it is very helpful in easing the European crisis.

If the more easy monetary stance in Japan and US was an hostile act then one should have expected to see the European markets take a beating. That have, however, not happened. In fact both the European fixed income and equity markets have rallied strongly on particularly the new Japanese government’s announcement that it want the Bank of Japan to step up monetary easing.

So it might be that some financial journalists and policy makers are scare about the prospects for currency war, but investors on the other hand are jubilant.

If you don’t need monetary easing – don’t import it

Concluding, I strongly believe that a global “currency war” is very good news given the quasi-deflationary state of the European economy and so far Prime Minister Abe and Fed governor Bernanke have done a lot more to get the euro zone out of the crisis than any European central banker has done and if European policy makers don’t like the strengthening of the euro the ECB can just introduce quantitative easing. That would curb the strengthening of the euro, but more importantly it would finally pull the euro zone out of the crisis.

Hence, at the moment Europe is importing monetary easing from the US and Japan despite the euro has been strengthening. That is good news for the European economy as monetary easing is badly needed. However, other countries might not need monetary easing.

As I discussed in my recent post on Mexico a country can decide to import or not to import monetary easing by allowing the currency to strengthen or not. If the Mexican central bank don’t want to import monetary easing from the US then it can simply allow the peso strengthen in response to the Fed’s monetary easing.

Currency war is not a threat to the global economy, but rather it is what could finally pull the global economy out of this crisis – now we just need the ECB to join the war.

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Argentina’s hidden inflation – another case of the horrors of price controls

In my previous post I discussed how price controls likely have created a wedge between inflation measured by CPI and by the GDP deflator in Malaysia. That made me think – can we find other examples of this in the world? And sure thing the story of Argentina’s inflation over the last decade seem to be more or less the same thing.

The graph below shows Argentine inflation measured by CPI and the GDP deflator since 2002. The difference is very easy to spot.

It is very clear that until 2005 the two measures of inflation tracks each other quite closely, but from 2005 a difference opens up. So what happened in 2005? Well, the story is exactly as in Malaysia – monetary policy is inflationary and the government tries to curb inflation not by printing less money, but by introducing price controls.

Here is a story from Bloomberg November 24 2005:

Argentine President Nestor Kirchner accused supermarkets of price fixing and said he would increase controls to slow a surge in inflation.

Kirchner, in a televised speech at the presidential palace, said agreements between supermarkets such as Coto CISA SA and Hipermercados Jumbo SA, a unit of Chilean retailer Cencosud SA, to increase prices would lead to 12 percent inflation next year. In the 12 months through October Argentina’s consumer prices rose 10.7 percent, the fastest rate of increase in 29 months.

“We will fight to defend consumers’ pockets,” Kirchner said, without specifying how he would slow price increases.

The accusation underscores the government’s concern over quickening inflation, which may increase poverty in a country where almost 50 percent of the population cannot afford to cover their food and other basic needs, said economist Rafael Ber of Argentine Research brokers in Buenos Aires.

Rising prices may also hurt the ability of Argentine producers to compete with foreign goods, Ber said.

Kirchner has already attacked private companies for increasing prices. In April, he called on consumers to boycott The Royal Dutch Shell Group after the energy company increased prices.

So there you go – price controls in response to inflation. That is never good news and the result has been the same in Argentina as in Malaysia (actually it is much worse) – shortages (See also my previous discussion of food shortages in Venezuela and Argentina here).

Price controls always have the same impact – shortages – and if you think Malaysia and Argentina are the only countries in the world to make this kind of policy mistakes think again. Here is from the US, where a Republican governor these days is experimenting with price controls and the result is the same as in Argentina and Malaysia – shortages!

PS it should be noted that the Argentine inflation data very likely is manipulated so there is more to it than just price controls – we also has a case of the books being cooked. See more on that here.

Regime Uncertainty, the Balkans and the weak US recovery

Today I have been in Oslo, Norway for client meetings. The topic on the agenda is Central and Eastern Europe and particularly the investment climate in South Eastern Europe. That gives me reason to discuss a favourite topic of mine – “regime uncertainty – as defined by Robert Higgs – and why the present lacklustre recovery in the US economy is unlikely in anyway to be related to such regime uncertainty.

As an economist who have been working professionally with Emerging Markets for more than I decade I know about regime uncertainty. In fact I think you to some extent can define an Emerging Markets economy as an economy where regime uncertainty is a dominant factor in the economy.

Robert Higgs basically defines regime uncertainty as a lack of protection of property right and a lack of respect for the rule of law. This is a serious problem in many Emerging Markets – including in the South Eastern European countries, which has been the focus of my meetings today.

My favourite source for a numerical measure of these uncertainties is the conservative Heritage Foundation’s Economic Freedom Index. We can use the sub-index for “Rule of Law” in the Economic Freedom Index as a proxy for “regime uncertainty”.

Let’s as an example look at two random South Eastern European countries – Albania and Bulgaria. Here is what Heritage Foundation has to say about the “Rule of Law” in Albania:

Albania still lacks a clear property rights system, particularly for land tenure. Security of land rights remains a problem in coastal areas where there is potential for tourism development. Although significant reforms of the legal system are underway, the courts are subject to political pressures and corruption. Protection of intellectual property rights is weak. Albania is a major transit country for human trafficking and illegal arms and narcotics.”

And similarly for Bulgaria:

“Respect for constitutional provisions securing property rights and providing for an independent judiciary is somewhat lax. The judicial system is unable to enforce property rights effectively, and inconsistent application of the rule of law discourages private investments. Despite legal restrictions, government corruption and organized crime present a threat to Bulgaria’s border security.”

In my view the Heritage Foundation’s description of the lack of respect for the rule of law and property rights in Albania and Bulgaria is pretty close to the reality in these two countries. So there is no doubt that there in both countries are a considerably degree of regime uncertainty.

This heightened level of regime uncertainty very likely is having a considerably negative impact on both foreign direct investments and domestic investments in both countries and therefore on the long-term growth prospects of these countries. Who would for example invest in a sea sight hotel in Albania it might be stolen from you tomorrow or in a year – maybe even with the tacit support of government officials?

Bulgaria and Albania are just two examples of serious regime uncertainty, but many (most!) developing economies and Emerging Markets around the world have serious problems with regime uncertainty. Therefore, as an Emerging Markets economist I find this issue highly relevant. However, I should also stress that I believe regime uncertainty is a supply side phenomenon. Regime uncertainty hampers investment, which reduces the productive capacity of the economy and hence reduces productivity growth, but as aggregate demand in the economy is determined by monetary factors regime uncertainty – in Higgs’ sense – cannot be a demand phenomenon. Yes, regime uncertainty can impact the composition of demand but not aggregate demand in the economy.

The best way to illustrate that regime uncertainty is a supply side phenomenon is to look at three contemporary examples – Venezuela, Argentina and Iran. The regimes in all three countries obviously have very little respect for the rule of law and there is weak protection of property rights in all three countries. However, all three countries also are struggling with high – and to some extent even escalating – inflation. If regime uncertainty were a demand phenomenon then inflation would be low and falling in these countries. It is not.

When I listen to the present political-economic debate in the US many conservative and libertarians economists and commentators (who I would normally tend to agree with) point to regime uncertainty as a key reason for the weak US recovery. Frankly speaking while I acknowledge that there might have been a rise in regime uncertainty in the US – in frank I am certain there has been – I doubt that it in any meaningful way can be said to have had a notable and sizable negative impact on US investment activity. Furthermore, the US economy is showing all the signs of having a demand side problem rather than a supply side problem. If the US economy had undergone a serious negative supply shock then US inflation would has been increasing – as is the case in for example Iran. US inflation is not increasing – rather since 2008 US PCE core inflation has averaged a little more than 1% a year on average.

Furthermore, even though uncertainty about the outlook for US tax rules have increased and Obamacare likely have had a negative impact on the overall investor sentiment in the US it would be rather foolish to claim that property rights are not well-protected in the US.  This is what Heritage Foundation has to say about the rule of law in the US:

“Property rights are guaranteed, and the judiciary functions independently and predictably. Serious constitutional questions related to government-mandated health insurance have been under consideration in the courts. Corruption is a growing concern as the cronyism and economic rent-seeking associated with the growth of government have undermined institutional integrity.”

Even though Heritage Foundation highlights some negative factors the US can hardly be said to be Bulgaria and Albania. In fact the US is in the very top in the world when it comes to protection of property rights and the respect for the rule of law. I therefore doubt that US multinational companies like Apple of Coca Cola are seriously concerned about the rule of law in the US when you take into account that these companies have been seeing there strong sales and income growth in Emerging Markets like China, India, Russia and Brazil.

In fact I could understand if these US companies would be concerned about the present regime uncertainty in China in connection with the ongoing leadership change in the Chinese communist party, the crackdown on freedom of speech in Russia under president Putin’s leadership, the scaling back of economic reforms in India or the ad hoc nature of changes to taxation of inward investments into Brazil.

So while I certainly remain concerned about the regulatory developments in the US over the past decade (yes it started well before Obama became president) I doubt that the present lacklustre recovery can be blamed on these problems. The reason for the lacklustre recovery is rather monetary uncertainty rather than regime uncertainty. Since 2008 US monetary policy has moved away from a ruled based regime to a highly discretionary and to some extent highly unpredictable regime. That is the problem.

So yes, US companies are likely worried about regime uncertainty, but it likely worries about regime uncertainty in China or Brazil rather than regime uncertainty in the US.

A simple way to illustrate this is to look at the Heritage Foundation’s score for protection of property rights in some of the countries mentioned in this blog post. Heritage Foundation considers a score between 80 and 100 to be a “free country”. It is very clear from the graph that investors should worry (a lot) about the protection of property rights in Albania, Bulgaria or in the so-called BRIC economies, but I doubt that many international investors have sleepless nights over the whether or not property right will be well-protected in the US.

Finally I am as worried about the rise of interventionist economic policies in the US and in Europe as anybody else, but we should be right for the right reasons. Interventionist economic policies surely reduce the growth prospects in the US and Europe, but that is supply side concerns for the longer run and we can’t blame these failed policies for the weak recovery.

Papers about money, regime uncertainty and efficient religions

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

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

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

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

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

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

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

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

“World Hyperinflations” by Steve Hanke and Nicholas Krus.

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

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

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

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

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

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

Is monetary easing (devaluation) a hostile act?

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

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

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

Is monetary easing a hostile act?

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

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

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

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

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

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

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

Is global monetary cooperation needed? No, but…

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

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

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

Unfortunately Mitt Romney seems to think as Max

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

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

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

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

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

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

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

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

The worst central banker in the world

Zimbabwean central bank governor Gideon Gono has long held the title as the worst central banker in the world. However, I would suggest there might be a new candidate – Argentine central bank governor Mercedes Marcó del Pont.

Here is some quotes from a recent interview:

“it is totally false to say that printing more money generates inflation”

If that does not make you scream then listen to this:

We discard that financing the public sector is inflationary because according to that statement the increase in prices are caused by an excess of demand, something we do not see in Argentina. In our country the means of payment are adjusted to the growth of demand and tensions with prices must be looked on the supply side and the external sector”.

It gets worse…

“We’re recovering the sovereign capacity to formulate and implement economic policy”, said Marcó del Pont who anticipated some pictures will be coming down from the bank’s hall of fame “beginning with Milton Friedman.”

Ok, I kind of guessed that the governor doesn’t like Milton Friedman, but this is bad. It might be that US and euro zone monetary policy is too tight, but that is certainly not the case in Argentina. Instead all signs are that inflation is getting increasingly out of control in Argentina. However, that is not visible in the official Argentine statistics. You will see the reason here. Sad, sad story…

 

UPDATE: Marcus Nunes has exactly the same story, but as usual Marcus was faster.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A bit on Danish 1970s FX policy

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

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

Conclusion – it’s not about competitiveness

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

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

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

Update – some related posts:

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

Argentine lessons for Greece

As Greek Prime Minister George Papandreou is fighting to putting together a new government after he yesterday survived a no-confidence vote in the Greek parliament I am once again reminded by the Argentine crisis of 2001-2002.

In my view the similarities with the Argentine crisis are striking – and most of the mistakes made by Argentine policy makers and by the international institutions are being repeated today in regard to the Greek crisis. Most important both in the Argentine case and in the Greek case policy makers refused to acknowledge that monetary policy is at the root of the problems rather than fiscal matters.

My favourite account of the Argentine crisis is the excellent book “And the Money Kept Rolling in (And Out)” by Paul Blustein.

You can’t help thinking of Greece and the efforts of the last year to “save“ the country when you see the title of Chapter 7: “Doubling a Losing Bet”.

I highly recommend Blustein’s book for those who want to understand how international institutions like the IMF works and why they fail and to understand how monetary regimes like Argentina’s currency board become “sacred” – in the same as the gold standard used to be – and this leads to crisis.

But back to Greece – or rather to the parallels to the Argentine crisis.

It has been rumours that former Greek central bank governor Lucas Papademos could take over as new Prime Minister in Greece. I have no clue whether this is going to happen, but the story made me think.

When you are in serious trouble you call in a well-respected former central banker to get some credibility. Argentina did that when Domingo Cavallo – the former successful central bank governor – became economics minister. Cavallo became economics minister on March 20 2001. He then tried to push through a number of austerity measures. He resigns on December 20 after massive protest and violence that kills 20 people. So far there has luckily been less killed in Greece.

So Cavallo lasted only 8 months – even respected central bankers cannot preform fiscal miracles in insolvent nations. But Cavollo’s 8 months as economics minister might be a benchmark for how long a central banker can stay on as economics minister – or Prime Minister.

Another measure of how long Papademos will be able to survive as Prime Minister if he indeed where to succeed Papandreou is to look at how many presidents Argentina had in 2001.

First president to step down was Fernando de la Rúa – on December 20 2001 – the same day Cavallo stepped.

Next one to step down was Adolfo Rodríguez Saá after 7 days in power on December 30 2001.

Eduardo Duhalde came into office January 2 2002 and stays on until May 25 2003. Duhalde a populist famously defaulted on Greece foreign debt – and is more popular with the Argentine public than with foreign creditors.

The question is whether Papademos would be Cavallo, Saá or Duhalde. He can’t really be Cavallo – as we are too long into the process and as Greece has already defaulted on some of the debt, but on the other hand the EU has not pulled the plug on Greece yet. It was really the IMF’s stop for funding of Argentina on December 5 2001 that “killed” Saá. Saá, however, while in government defaulted on foreign private debt on December 7 2001 (Greece effective defaulted on a large share of the private sector debt last week).

The Argentine currency board came to an end on January 6 2002 – around a month after the default on foreign debt and three weeks after Saá resigned…

If this is any guidance for the Greek situation we are surely in the end game…

PS I met Cavallo at a seminar back in 2008 – I was somewhat shocked to hear that he still thinks it was wrong that Argentina gave up the currency board despite more than 20 people died in civil unrest while he was economics minister. The Argentine economy rebound strongly after the currency board was given up and has growly strongly since then.I am certainly not claiming everything is fine in Argentina, but things are certainly better than in 2001.

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Update: Cavallo indeed has a view on Greece in the light of his own expirience. See his comment here. Lets just say I think he is mostly wrong…

Update 2 (November 13): Scott Sumner is out with an excellent comment on the lessons from Argentina.

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