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My lecture at Columbia University on the euro crisis

As the followers of my blog would know I recently did a 11 day speaking tour in the US. I want to share a bit of that with my readers.

Here you can watch my lecture at Columbia University on the euro crisis.

And this is the Powerpoint presentation from the lecture.

I want to thank my big hero Adam Tooze who is head of the Europe Institute of Columbia University for the invitation to speak at Columbia.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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The Euro – A Monetary Strangulation Mechanism

In my previous post I claimed that the ‘Greek crisis’ essentially is not about Greece, but rather that the crisis is a symptom of a bigger problem namely the euro itself.

Furthermore, I claimed that had it not been for the euro we would not have had to have massive bailouts of countries and we would not have been in a seven years of recession in the euro zone and unemployment would have been (much) lower if we had had floating exchange rates in across Europe instead of what we could call the Monetary Strangulation Mechanism (MSM).

It is of course impossible to say how the world would have looked had we had floating exchange rates instead of the MSM. However, luckily not all countries in Europe have joined the euro and the economic performance of these countries might give us a hint about how things could have been if we had never introduced the euro.

So I have looked at the growth performance of the euro countries as well as on the European countries, which have had floating (or quasi-floating) exchange rates to compare ‘peggers’ with ‘floaters’.

My sample is the euro countries and the countries with fixed exchange rates against the euro (Bulgaria and Denmark) and countries with floating exchange rates in the EU – the UK, Sweden, Poland, Hungary, the Czech Republic and Romania. Furthermore, I have included Switzerland as well as the EEA countriesNorway and Iceland (all with floating exchange rates). Finally I have included Greece’s neighbour Turkey, which also has a floating exchange rate.

In all 31 European countries – all very different. Some countries are political dysfunctional and struggling with corruption (for example Romania or Turkey), while others are normally seen as relatively efficient economies with well-functioning labour and product markets and strong external balance and sound public finances like Denmark, Finland and the Netherland.

Overall we can differentiate between two groups of countries – euro countries and euro peggers (the ‘red countries’) and the countries with more or less floating exchange rates (the ‘green countries’).

The graph below shows the growth performance for these two groups of European countries in the period from 2007 (the year prior to the crisis hit) to 2015.

floaters peggers RGDP20072015 A

The difference is striking – among the 21 euro countries (including the two euro peggers) nearly half (10) of the countries today have lower real GDP levels than in 2007, while all of the floaters today have higher real GDP levels than in 2007.

Even Iceland, which had a major banking collapse in 2008 and the always politically dysfunctionally and highly indebted Hungary (both with floating exchange rates) have outgrown the majority of euro countries (and euro peggers).

In fact these two countries – the two slowest growing floaters – have outgrown the Netherlands, Denmark and Finland – countries which are always seen as examples of reform-oriented countries with über prudent policies and strong external balances and healthy public finances.

If we look at a simple median of the growth rates of real GDP from 2007 until 2015 the floaters have significantly outgrown the euro countries by a factor of five (7.9% versus 1.5%). Even if we disregard the three fastest floaters (Turkey, Romania and Poland) the floaters still massively outperform the euro countries (6.5% versus 1.5%).

The crisis would have long been over had the euro not been introduced  

To me there can be no doubt – the massive growth outperformance for floaters relative to the euro countries is no coincidence. The euro has been a Monetary Strangulation Mechanism and had we not had the euro the crisis in Europe would likely long ago have been over. In fact the crisis is essentially over for most of the ‘floaters’.

We can debate why the euro has been such a growth killing machine – and I will look closer into that in coming posts – but there is no doubt that the crisis in Europe today has been caused by the euro itself rather than the mismanagement of individual economies.

PS I am not claiming the structural factors are not important and I do not claim that all of the floaters have had great monetary policies. The only thing I claim is the the main factor for the underperformance of the euro countries is the euro itself.

PPS one could argue that the German ‘D-mark’ is freely floating and all other euro countries essentially are pegged to the ‘D-mark’ and that this is the reason for Germany’s significant growth outperformance relative to most of the other euro countries.

Update: With this post I have tried to demonstrate that the euro does not allow nominal adjustments for individual euro countries and asymmetrical shocks therefore will have negative effects. I am not making an argument about the long-term growth outlook for individual euro countries and I am not arguing that the euro zone forever will be doomed to low growth. The focus is on how the euro area has coped with the 2008 shock and the the aftermath. However, some have asked how my graph would look if you go back to 2000. Tim Lee has done the work for me – and you will see it doesn’t make much of a difference to the overall results. See here.

Update II: The euro is not only a Monetary Strangulation Mechanism, but also a Fiscal Strangulation Mechanism.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Greece versus Turkey: It’s the exchange rate exchange rate regime stupid!

A history of political dysfunctionality, corruption, military coups, military conflict with a neighboring country, large current deficits and weak fiscal management.

Greece fits that description perfectly well, but so does Turkey. So why don’t we have a major crisis in Turkey and why is Turkey not on the brink of default when neighboring Greece is?

The answer is simple – It’s the exchange rate exchange rate regime stupid!

In 2001 Turkey was forced by a major crisis to abandon it’s managed/crawling peg regime and instead introduced a floating exchange rate regime and the Turkish central bank introduced an inflation targeting regime.

14 years later Turkey is still in many ways politically dysfunctional – in fact it has gotten worse in recent years – there has been rumours of plans of military coups, there has been major corruption scandals even involving the Prime Minister (now president Erdogan) and the governing AKParty and lately the civil war in Syria has created a massive inflow of refugees and increased tensions with Turkish Kurdish population.

All this has to a large extent been reflected in the value of the Turkish lira, which have been highly volatile since 2001 – and increasingly so since 2008, but the floating exchange rate regime means that we have not seen the same kind of volatility in the domestic Turkish economy, which was so common prior to 2001.

While Turkey in 2001 floated the lira Greece gave up having a monetary policy of its own and instead joined the euro. We know the story – while the first years of euro membership in general was deemed succesfull that hardly has been the case since 2008: The economy has collapsed, unemployment increased dramatically, debt has skyrocketed, we effectively have had sovereign default and we are on the brink of an euro exit.

Milton Friedman used to say “never underestimate the importance of luck of nations” referring to how pegged exchange regimes might be succesfull for a while, but also that it could have catastrophic consequence to maintain a pegged exchange rate regime.

In 2008 Greece ran out of luck because it made the fatal decision to join the euro in 2001. Today is it blatantly obvious that Greece should have done as Turkey and floated the drachma. It now seems like after 14 years Greece will be forced by a major crisis to do exactly that.

Greece Turkey GDPcapUSD

 

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

The EM sell-off and China as a global monetary superpower

This is what I just told Ambrose Evans-Pritchard at the Telegraph:

“We have all these countries in trouble like Argentina, Ukraine and Thailand that are each local cases, but behind the whole emerging market story is Fed tapering and worries about slowing Chinese growth…China is now a global monetary superpower, co-leader with the US. When China tightens, that hits trade and commodities across the world.”

…and about the emergency monetary policy meeting of the Turkish central bank (coming up late Tuesday):

“Danske Bank said the Turkish authorities may have to raise rates by 200 to 300 basis points to placate the markets, a shock treatment that risks going badly wrong. “They are tightening to defend their currency, and in doing so killing the economy. In the end they will be forced to give up. There is the same risk in India,” said Mr Christensen.”

This is essentially the same message I also spelled out in my post yesterday – “Please don’t fight it – the risk of EM policy mistakes”

Sino-monetary transmission mechanism

I have talked and written about China as a global monetary superpower before and I think it is useful to repeat (part of) this story to help better understand what presently is going on in Emerging Markets.

David Beckworth has argued (see for example here) that the Federal Reserve is a monetary superpower as “it manages the world’s main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. “

I believe that the People’s Bank of China to a large extent has the same role – maybe even a bigger role for some Emerging Markets particularly in Asia and among commodity exporters. Hence, the PBoC can under certain circumstances “dictate” monetary policy in other countries – if these countries decide to import monetary conditions from China.

Overall I see three channels through which PBoC influence monetary conditions in the rest of the world:

1) The export channel: For many countries in the world China is now the biggest or second biggest export market. So a monetary induced slowdown in the Chinese economy will have significant impact on many countries’ export performance. This is the channel most keynesian trained economists focus on.

2) Commodity price channel: As China is a major commodity consumer Chinese monetary policy has a direct impact on the demand for and the price of commodities. So tighter Chinese monetary policy is causing global commodity prices to drop. This obviously is having a direct impact on commodity exporters. See for example my discussion of Chinese monetary policy and the Brazilian economy here.

3) The financial flow channel: China has the largest currency reserves in the world . This means that China obviously is extremely important for demand for global financial assets. A contraction in Chinese monetary policy will reduce Chinese FX reserve accumulation and as a result impact demand for for example Emerging Markets bonds and equities.

For the keynesian-trained economist the story would end here. However, we cannot properly understand the impact of Chinese monetary policy on the rest of the world if we do not understand the importance of “local” monetary policy. Hence, in my view other countries of the world can decide to import monetary tightening from China, but they can certainly also decide not to import is monetary tightening. The PBoC might be a monetary superpower, but only because other central banks of the world allow it to be.

… China can act as a monetary superpower and determine monetary conditions in the rest of the world, but also that this is only because central banks in the rest of world … allow this to happen. Malaysia or Hong Kong do not have to import Chinese monetary conditions. Hence, the central bank can choose to offset any shock from Chinese monetary policy. This is basically a variation of the Sumner Critique. The central bank of Malaysia obviously is in full control of nominal GDP/aggregate demand in Malaysia. If the monetary contraction in China leads to a weakening of the ringgit monetary conditions in Malaysia will only tighten if the central bank of Malaysia tries to to fight it by tightening monetary conditions.

Update 1: The Turkish central bank did not listen to me and instead hiked interest rates very aggressively – trying to stabilize the lira, but likely also killing growth. Recession can no longer be ruled out in Turkey. See my day-job comment on the Turkish ultra aggressive rate hike here.

Update 2: David Beckworth has an excellent comment on Ambrose and me. Read it! After it was David who came up with the term monetary superpower.

Please don’t fight it – the risk of EM policy mistakes

Emerging Markets are once again back in the headlines in the global financial media – from Turkey to Argentina market volatility has spiked from the beginning of the year.

The renewed Emerging Markets volatility has caused some commentators to claim that the crisis back. It migtht be, but also I think it is very important to differentiate between currency movements on its own and the underlying reasons for these movements and in this post I will argue that currency movements in itself is not necessarily a problem. In fact floating exchange rate regimes mean that the currency will move in response to shocks, which ideally should reduce macroeconomic volatility.

Imagine this would have been 1997

I think it is illustrative to think about what is going on in Emerging Markets right now by imagining that the dominant monetary and exchange rate regime had been pegged exchange rates as it was back in 1997 when the Asian crisis hit.

Lets take the case of Turkey and lets assume Turkey is operating a pegged exchange rate regime – for example against the US dollar. And lets at the same time note that Turkey presently has a current account deficit of around 7% of GDP. This current account deficit is nearly fully funded by portfolio inflows from abroad – for example foreign investors buying Turkish bonds and equities.

As long as investors are willing to buy these assets there is no problem. But then one day investors decide to close down their positions in Turkey – for example because of they expect the dollar to appreciate because of the Federal Reserve tightening monetary conditions or because investors simply become more risk averse for example because of concerns about Chinese growth. Lets assume this leads to a “sudden stop”. From day-to-day the funding of Turkey’s 7% current account deficit disappears.

Now Turkey has a serious funding problem. Turkey either needs to attract investors to fund the current account deficit or it needs to close the current account deficit immediately. The first option is unlikely to work in the short-term. So the current account deficit needs to be closed. That can happen either by a collapse in imports and/or through spike in exports.

To “force” this process the central bank will have to tighten monetary conditions dramatically. This happens “automatically” in a fixed exchange rate regime. As money leaves the country the lira comes under pressures. The central bank will then intervene in the market to curb to the currency from weakening thereby reducing the foreign currency reserve and in parallel the money base drops. The drying up of liquidity will also send money market rate spiking. This is a sharp tightening of monetary conditions. The result is a collapse in private consumption, investments, asset prices and increased deflationary pressures (inflation and wage growth drop). An internal devaluation will be underway. The result is normally a sharp increase in public and private debt ratios as nominal GDP collapses.

This process will effectively continue until the current account deficit is gone. This would cause a massive collapse in economic activity and as asset prices and growth expectations drop financial distress also increases dramatically, which could set-off a financial crisis.

This is the kind of scenario that played out during the Asian crisis in 1997, but it is also what happened in Turkey in 2001 and forced the Turkish government to eventually give up a failed pegged (crawling) peg regime.

Luckily we have floating exchange rates in most Emerging Markets

Compare that to what has been going on the Emerging Markets over the past 6-7 months. We have seen widespread sell-off in Emerging Markets and yes we have seen growth expectations being adjusted down (mostly because some EM central banks have been fighting the sell-off by tightening monetary policy). BUT we have not seen financial crisis and we have not seen a collapse in Emerging Markets property markets. We have not seen major negative spill-over to developed markets. Hence, the sell-off in Emerging Markets currencies cannot be called a macroeconomic or a financial crisis.

In fact the sell-off in EM currencies means that we have avoided exactly the 1997 scenario. That is not to say that everything is fine. It is not. Anybody who have been following the still ongoing corruption scandal in Turkey or the demonstrations in Ukraine and Thailand know these countries are struggling with some real fundamental political and economic troubles. In fact I fear that a number of Emerging Markets countries at the moment are seeing an erosion of their long-term growth potential due to regime uncertainty and general macroeconomic mismanagement. But we are not seeing an unnecessary economic, financial and political collapse induced by a foolish exchange rate regime. Luckily most Emerging Markets today have floating exchange rate regimes.

But some foolishness remain   

So yes, I believe we – and the populations in most Emerging Markets – are lucky that fixed exchange rate regimes mostly are a thing of the past in Emerging Markets today, but unfortunately it is not all Emerging Markets central bankers who have learned the lesson. Hence, many central bankers still suffer from a fear-of-floating.

Just take the Turkish central bank (TCMB). On Tuesday it will hold an emergency monetary policy meeting to discuss measures to curb the sell-off in the lira. Officially it about ensuring “price stability”, but the decision to have an emerging meeting only a week after a regular monetary policy meeting smells of desperation on part of the TCMB.

It is widely expected that the TCMB will hike its key policy rate – the market is already pricing a rate hike in the order of 200bp. If the TCMB delivers this then it will only have marginal impact on the lira – if the TCMB delivers more then it could prop up the lira at least for the short-run. But a larger than expected rate hike would also be constitute monetary policy tightening and given the present sentiment in the global Emerging Markets the TCMB likely will have to do something very aggressive to have a major impact on the lira. And what would the outcome be? Well, it is pretty easy – we would get a major contraction in Turkish growth to well-below potential growth in the Turkish economy.

Given the fact that inflation expectations (24 month ahead) is around 7% and hence the TCMB official 5% inflation target there might certainly be a need for a moderate tightening of monetary policy in Turkey, but should that happen as an abrupt tightening, which would send the Turkish economy into recession? I think that would be foolish. The TCMB should instead try to get over its fear-of-floating and focus on ensuring nominal stability. It is failing to do that right now by pursuing what mostly look like 1970s style stop-go policies.

Luckily the stop-go policies of TCMB is no longer the norm for Emerging Markets central banks who generally seem to understand that the level of the exchange rate is best left to the market to determine.

PS see also my preview on Tuesday’s Turkish monetary policy meeting here.

PPS This post is about value of floating exchange rates and even though I think floating exchange rate regimes now substantially reduce the risk of major Emerging Markets financial and economic crisis I am certainly not unworried about the state of Emerging Markets. I already noted my structural concerns in a number of Emerging Markets, but I am even more worried about the monetary induced slowdown in Chinese growth and I am somewhat worried that the PBoC might “mis-step” and cause a major financial and economic crisis in China with global ramifications particularly is it fails to keep the eye on the ball and instead gets preoccupied with fighting bubbles.

Update: My friend in Malaysia Hishamh tells the same story, but focusing on Malaysia.

The antics of FX intervention – the case of Turkey

I have often been puzzled by central banks’ dislike of currency flexibility. This is also the case for many central banks, which officially operating floating exchange rate regimes.

The latest example of this kind of antics is the Turkish central bank’s recent intervention to prop as the Turkish lira after it has depreciated significantly in connection with the recent political unrest. This is from cnbc.com:

“On Monday, the Turkish central bank attempted to stop the currency’s slide by selling a record amount of foreign-exchange reserves in seven back-to-back auctions. The bank sold $2.25 billion dollars, or around 5 percent of its net reserves, to shore up its currency – the most it has ever spent to do so”

A negative demand shock in response to a supply shock

I have earlier described the political unrest in Turkey as a negative supply shock and it follows naturally from currency theory that a negative supply shock is negative for the currency and in that sense it shouldn’t be a surprise that the political unrest has caused the lira to weaken. One can always discuss the scale of the weakening, but it is hard to dispute that increased ‘regime uncertainty’ should cause the lira to weaken.

It follows from ‘monetary theory 101’ that central banks should not react to supply shocks – positive or negative. However, central banks are doing that again and again nonetheless and the motivation often is that central banks see market moves as “excessive” or “irrational” and therefore something they need to “correct”. This is probably also the motivation for the Turkish central bank. But does that make any sense economically? Not in my view.

We can illustrate the actions of the Turkish central bank in a simple AS/AD framework.

AS AD SRAS shock Turkey

The political unrest has increased ‘regime uncertainty’, which has shifted the short-run aggregate supply curve (SRAS) to the left. This push up inflation to P’ and output/real GDP drops to Y’.

In the case of a nominal GDP targeting central bank that would be it. However, in the case of Turkey the central bank (TCMB) has reacted by effectively tightening monetary conditions. After all FX intervention to prop up the currency is “reverse quantitative easing” – the TCMB has effectively cut the money base by its actions. This a negative demand shock.

In the graph this mean that the AD curve shifts  to the left from AD to AD’. This will push down inflation to P” and output to Y”.

In the example the combined impact of a supply shock and the demand shock is an increase in inflation. However, that is not necessarily given and dependent the shape of the SRAS curve and the size of the demand shock.

However, more importantly there is no doubt about the impact on real GDP growth – it will contract and the FX intervention will exacerbate the negative effects of the initial supply shock.

So why would the central bank intervene? Well, if we want to give the TCMB the benefit of the doubt the simple reason is that the TCMB has an inflation target. And since the negative supply shock increases inflation one could hence argue that the TCMB is “forced” by its target to tighten monetary policy. However, if that was the case why intervene in the FX market? Why not just use the normal policy instrument – the key policy interest rates?

My view is that this is a simple case of ‘fear-of-floating’ and the TCMB is certainly not the only central bank to suffer from this irrational fear. Recently the Polish central bank has also intervened to prop up the Polish zloty despite the Polish economy is heading for deflation in the coming months and growth is extremely subdued.

The cases of Turkey and Poland in my view illustrate that central banks are often not guided by economic logic, but rather by political considerations. Mostly central banks will refuse to acknowledge currency weakness is a result of for example bad economic policies and would rather blame “evil speculators” and “irrational” behaviour by investors and FX intervention is hence a way to signal to voters and others that the currency sell-off should not be blamed on bad policies, but on the “speculators”.

In that sense the central banks are the messengers for politicians. This is what Turkish Prime Minister Erdogan recently had to say about what he called the “interest rate lobby”:

“The lobby has exploited the sweat of my people for years. You will not from now on…

…Those who attempt to sink the bourse, you will collapse. Tayyip Erdogan is not the one with money on the bourse … If we catch your speculation, we will choke you. No matter who you are, we will choke you

…I am saying the same thing to one bank, three banks, all banks that make up this lobby. You have started this fight against us, you will pay the high price for it.

..You should put the high-interest-rate lobby in their place. We should teach them a lesson. The state has banks as well, you can use state banks.”

So it is the “speculators” and the banks, which are to blame. Effectively the actions of the TCMB shows that the central banks at least party agrees with this assessment.

Finally, when a central bank intervenes in the currency market in reaction to supply shocks it is telling investors that it effectively dislikes fully floating exchange rates and therefore it will effectively reduce the scope of currency adjustments to supply shocks. This effective increases in the negative growth impact of the supply shock. In that sense FX intervention is the same as saying “we prefer volatility in economic activity to FX volatility”. You can ask yourself whether this is good policy or not. I think my readers know what my view on this is.

Update: I was just reminded of a quote from H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”

The Turkish demonstrations – and the usefulness of the AS/AD framework

Peter Dorman has a blog post that have gotten quite a bit of attention in the blogosphere on the AS-AD model and why he thinks it is not a useful framework. This is Peter:

“Introductory textbooks are supposed to give you simplified versions of the models that professionals use in their own work.  The blogosphere is a realm where people from a range of backgrounds discuss current issues often using simplified concepts so everyone can be on the same page.

But while the dominant framework used in introductory macro textbooks is aggregate supply—aggregate demand (AS-AD), it is almost never mentioned in the econ blogs.  My guess is that anyone who tried to make an argument about current macropolicy using an AS-AD diagram would just invite snickers.  This is not true on the micro side, where it’s perfectly normal to make an argument with a standard issue, partial equilibrium supply and demand diagram.  What’s going on here?”

I am somewhat surprised by Peter’s statement that the AS-AD framework is never mentioned on the econ blogs. That could indicate that Peter has never read my blog (no offense taken – I never read Peter’s blog before either). My regular readers would of course know that I am quite fund of using the AS-AD framework to illustrate my arguments. Other Market Monetarists – particularly Nick Rowe and Scott Sumner are doing the same thing quite regularly. See Nick’s discussion of Peter’s post here.

The purpose of this post, however, is not really to discuss Peter’s critique of the AS-AD framework, but rather to show the usefulness of the framework with a example from today’s financial news flow. Furthermore, I will do a Market Monetarist ‘spin’ on the AS-AD framework. Hence, I will stress the importance of monetary policy rules and what financial markets tell us about AD and AS shocks.

The Istanbul demonstrations as an AS shock 

Over the weekend we have seen large street protests in Istanbul in Turkey. The demonstrations are the largest demonstrations ever against the ruling AKP party and Prime Minister Erdogan. Mr. Erdogan has been in power for a decade.

The demonstrations today triggered a 10% drop in the Istanbul stock exchange so there is no doubt that investors think that these demonstrations and the political ramifications of the demonstrations will have a profound negative economic impact.

I believe a core insight of Market Monetarist thinking is that financial markets are very useful indicators about monetary policy shocks. Hence, we for example argue that if the US dollar is depreciating, market inflation expectations are rising and the US stock market is rallying then it is a very clear indication that US monetary conditions are getting easier.

While the focus of Market Monetarists have not been as much on supply shocks as on monetary policy shocks (AD shocks) it is equal possible to ‘deduct’ AS shocks from financial markets. I believe that today’s market action in the Turkish markets are a pretty good indication of exactly that – the combination of lower stock prices, higher bond yields (higher risk premium and/or higher inflation expectations) and a weaker lira tells the story that investors see the demonstrations as a negative supply shock. It is less clear whether the shock is a long-term or a short-term shock.

A short-run AS shock – mostly about disruption of production

My preferred textbook version of the AS-AD model is a model similar to the one Tyler Cowen and Alex Tabarrok use in their great textbook Modern Principles of Economics where the model is expressed in growth rates (real GDP growth and inflation) rather than in levels.

It is obvious that the demonstrations and unrest in Istanbul are likely to lead to disruptions in production – roads are closed down, damages to infrastructure, some workers are not coming to work and even some lines of communication might be negatively impacted by the unrest. Compared to the entire Turkish economy the impact these effects is likely quite small, but it is nonetheless a negative supply shock. These shocks are, however, also likely to be temporary – short-term – rather than permanent. Hence, this is a short-run AS shock. I have illustrated that in the graph below.

AS AD SRAS shock

This is the well-known illustration of a negative short-run supply shock – inflation increases (from P to P’) and real GDP growth declines (from Y to Y’).

This might very well be what we will see in Turkey in the very short run – even though I believe these effects are likely to be quite small in size.

However, note that we here assume a “constant” AD curve.

Peter Dorman is rightly critical about this assumption in his blog post:

“…try the AD assumption that, even as the price level and real output in the economy go up or down, the money supply remains fixed.”

Peter is of course right that the implicit assumption is that the money supply (or money base) is constant. The standard IS/LM model suffers from the same problem. A fact that have led me to suggest an alternative ISLM model – the so-called IS/LM+ model in which the central bank’s monetary policy rule is taken into account.

Obviously no analysis of macroeconomic shocks should ignore the monetary policy reaction to different shocks. This is obviously something Market Monetarists have stressed again and again when it for example comes to fiscal shocks like the ‘fiscal cliff’ in the US. In the case of Turkey we should therefore take into account that the Turkish central bank (TCMB) officially is targeting 5% inflation.

Therefore if the TCMB was targeting headline inflation in a very rigid way (ECB style) it would have to react to the increase in inflation by tightening monetary policy (reducing the money base/supply) until inflation was back at the target. In the graph above that would mean that the AD curve would shift to the left until inflation would have been brought down back to 5%. The result obviously would be a further drop in real GDP growth.

In reality I believe that the TCMB would be very unlikely to react to such a short run supply. In fact the TCMB has recently cut interest rates despite the fact that inflation continue to run slightly above the inflation target of 5%. Numbers released today show Turkish headline inflation was at 6.6% in May.

In fact I believe that one with some justification can think of Turkish monetary policy as a “flexible NGDP growth targeting” (with horrible communication) where the TCMB effectively is targeting around 10% yearly NGDP growth. Interestingly enough in the Cowen-Tabarrok version of the AS-AD model that would mean that the TCMB would effectively keep the AD curve “unchanged” as the AD curve in reality is based in the equation of exchange (MV=PY).

The demonstrations could reduce long-term growth – its all about ‘regime uncertainty’

While the Istanbul demonstrations clearly can be seen as a short-run supply shock that is probably not what the markets are really reacting to. Instead it is much more likely the the markets are reacting to fears that the ultimate outcome of the demonstrations could lead to lower long-run real GDP growth.

Cowen and Tabarrok basically think of long-run growth within a Solow growth model. Hence, there are overall three drivers of growth in the long run – labour forces growth, an increase in the capital stock and higher total factor productivity (TFP – think of that as “knowledge”/technology).

I believe that the most relevant channel for affecting long-run growth in the case of the demonstrations is the impact on investments in Turkey which likely will influence both the size of the capital stock and TFP negatively.

Broadly speaking I think Robert Higgs concept of “Regime Uncertainty” comes in handy here.  This is Higgs:

“The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,”  … To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

I think this is pretty telling about the fears that investors might have about the situation in Turkey. It might be that the Turkish government is not loved by investors, but investors are clearly uncertain about what would follow if the demonstrations led to “regime change” in Turkey and a new government. Furthermore, the main opposition party – the CHP – is hardly seen as reformist.

And even if the AKP does remain in power the increased public disconnect could lead to ‘disruptions of production’ (broadly speaking) again and again in the future.  Furthermore, the government hard-handed reaction to the demonstrations might also “complicate” Turkey’s relationship to both the EU and the US – something which likely also will weigh on foreign direct investments into Turkey.

Hence, regime uncertainty therefore is likely to reduce the long-run growth in the Turkish economy. Obviously it is hard to estimate the scale such effects, but at least judging from the sharp drop in the Turkish stock market today the negative long-run supply shock is sizable.

I have illustrated such a negative long-run supply shock in the graph below.

LRAS shock

The result is the same as in the short-run model – a negative supply shock reduces real GDP growth and increases inflation.

However, I would stress that the TCMB would likely not in the long run accept a permanent higher rate of inflation and as a result the TCMB therefore sooner or later would have to tighten monetary policy to push down inflation (by shifting the AD curve to the left). This also illustrates that the demonstrations is likely to become a headache for the TCMB management.

Is the ‘tourism multiplier’ zero? 

Above I have primarily described the Istanbul demonstrations as a negative supply shock. However, some might argue that this is also going to lead to a negative demand shock.

Hence, Turkey very year has millions of tourists coming to the country and some them will likely stay away this year as a consequence of the unrest. In the Cowen- Tabarrok formulation of the AD curve a negative shock to tourism would effectively be a negative shock to money velocity. This obviously would shift the AD curve to the left – as illustrated in the graph below.

AD shock

Hence, we initially get a drop in both inflation and real GDP growth as the AD curve shifts left.

However, we should never forget to think about the central bank’s reaction to a negative AD shock. Hence, whether the TCMB is targeting inflation or some kind of NGDP growth target it would “automatically” react to the drop in aggregate demand by easing monetary policy.

In the case the TCMB is targeting inflation it would ease monetary policy until the AD curve has shifted back and the inflation rate is back at the inflation target.

This effectively means that a negative shock to Turkish tourism should not be expected to have an negative impact on aggregate demand in Turkey for long. This effectively is a variation of the Sumner Critique – this time, however, it is not the budget multiplier, which is zero, but rather the ‘tourism multiplier’.

Hence, from a macroeconomic perspective the demonstrations are unlikely to have any major negative impact on aggregate demand as we would expect the TCMB to offset any such negative shock by easing monetary policy.

That, however, does not mean that a negative shock to tourism will not impact the Turkish financial markets. Hence, there will be a change in the composition of aggregate demand – less tourism “exports” and more domestic demand. This likely is bad news for the Turkish lira.

Mission accomplished – we can use the AS-AD framework to analysis the ‘real world’

I hope that my discussion above have demonstrated that the AS-AD framework can be a very useful tool when analyzing real world problems – such as the present public unrest in Turkey. Obviously Peter Dorman is right – we should know the limitations of the AS-AD model and we should particularly be aware what kind of monetary policy reaction there will be to different shocks. But if we take that into account I believe the textbook (the Cowen-Tabarrok textbook) version of the AS-AD model is a quite useful tool. In fact it is a tool that I use every single day both when I produce research in my day-job or talk to clients about such ‘events’ as the Turkish demonstrations.

Furthermore, I would add that I could have done the same kind of analysis in a DSGE framework, but I doubt that my readers would have enjoyed looking at a lot of equations and a DSGE model would likely have reveal little more about the real world than the version of the AS-AD model I have presented above.

PS Please also take a look at this paper in which I discuss the politics and economics of the present Turkish crisis.

PPS Paul Krugman, Nick Rowe and Mark Thoma also comment on the usefulness of the AS-AD framework.

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).

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