Daily Archives: November 30, 2011

Responses to MMP Blog #26: Sovereign Curreny in the Open Economy

Thanks for comments.I hope you all recognize that this was blog 26; half way through a year ofblogs—52 of them to be exact. Half way. A Job Well-Done I hope you all willagree. We are now half-educated. Half-wits, so to speak. It is all down-hillfrom here. We’ve done the hard lifting, now we apply what we’ve learned. Anway,on to the Q&A for the week.

Q1: What are pros and cons of having an open capitalaccount? If Central Bank wants to defent currency parity by hiking interestrates in an environment of free capital movements, is the supposed mechanismthat interest rate hikes should cause capital account inflows because privatesector starts to borrow more in foreign currency? What are limits to thisstrategy? Some eastern european countries have most of their private debtnominated in foreign currency, for example 90% of mortgages in some countries.What limitations this puts on domestic policy options? In the GFC they chose todefend their exchange rates, taking deflationary domestic policy decisionsinstead. Was it mistake to allow private sector to became indebted in foreigncurrencies?Does MMT recognize balance of payments accounting identity explainedhere: http://en.wikipedia.org/wiki/B…,that Current Account + Capital Account + Change in Reserves = 0?

A: I’m generally skeptical of anything that is advertised as“free”, including “free” trade, “free” capital flows” or “free” markets moregenerally. There must be a catch. There is always a catch. So I have no problemwith those who argue that capital “flows” must be constrained. Of course. All“flows” need constraints. Unconstrained “flows” will lead to floods anddisasters. It is elementary, Dear Watson.

The Neoclassical view is that “free” flows are fine because“prices” will adjust. In the correct direction. This is faith-based economics,and it ain’t my religion. No, prices almost always run in the wrong direction,helping to fuel booms and busts. Any sovereign government that adopts “free”trade or capital “flows” on the belief that markets will be self-adjusting iseither a fool or worse, a stooge. They don’t. They won’t.

Denominating debt in a foreign currency is almost always amistake, and is fueled by the same Theoclassical religion that promotes “free”markets and capital “flows”. On one hand, it is hard to argue against theproposition that fools ought to be allowed to lose their money; but at the sametime it is easy to argue that government and institutions designed to operatein the public purpose should be restrained from parting with “taxpayermoney”.  Of course, it is not taxpayermoney, since every dollar came from the public sphere to begin with. Lettingthem fail is often the best option.

Finally, I neverargue with identities. They are true. And that is an important one.

Q2: A“anation cannot run a current account deficit unless someone wants to hold itsIOUs. We can even view the current account deficit as resulting from a rest ofworld desire to accumulate net savings in the form of claims on thecountry.” China, like Germany, wishes to be a net exporter.  Maybethey are crazy, but that is what they want and that is how they run theireconomic policy.  Is China reallyaccumulating dollars only because they have a desire toaccumulate dollars?  Or is it that if they were to sell their enormousquantities of dollars in the fx market rather than holding on to them theywould drive up the value of their own currency in terms of dollars, and theyfear that such an increase would affect their ability to continue running atrade surplus?  In fact, besides running a trade surplus, don’t theyintervene in fx markets specifically to prop up the dollar and to hold down thevalue of their own currency?  
I can see a strong motivation for holding dollars because they want to preventa rising Yuan, but I have yet to hear an explanation for why they wouldwant to hold dollars as their ultimate goal.  I think they hold dollarsonly to facilitate their trade policy.  Isthere a point where they will no longer need to do this?  If they becomethe largest economy in the world, for instance, might they want to divesttheir depreciating dollars, driving the dollar down even faster?

A: Certainly it is hard to explain Chinese accumulation ofdollar assets simply on the basis that they want dollar assets. It must also beremembered that China learned from the Asian Tiger experience: they pegged ratesto remove uncertainty. But the problem is that this committed them to makingpayments in a foreign currency—the US dollar. Eventually mkts doubted theirability to meet those commitments so all hell broke loose. So the Chinese learnedthat several trillion of dollar reserve assets is a good idea. Further, theyunderstand that export led growth is temporary; they will raise wages andreduce exports.

Q3: A ExpandIn a world without import/exportrestrictions and where every country had a floating currency, would there stillbe foreign trade “imbalances” or would exchange rates move so thatthe “imbalances” balance out? Why do certain countries decide to pegtheir currency against a foreign currency (e.g. US Dollars)? When is it beneficialto peg or not peg?

A: Answer to first question: NO! As discussed below, we’vegot a current account (deficit) that is offset by a current account surplus. Itis sustainable. Exchange rates do not move to balance trade. They must alsoplay a role in investment gooods and financial assets.

Q4:  “The reason is becausethose economists who had believed that exchange rates adjust to
eliminate current account surpluses and deficits had not taken into account thatan “imbalance” is not necessarily out of balance. As discussed previously, acountry can run a current account deficit so long as the rest of the world wantsto accumulate its IOUs.”  But why doesthe rest of the world want to accumulate our IOUs?  Isn’t it mostlycountries like China looking to accumulate foreign
reserves to defend their peg against the US?  It seems the players thatmatter haven’t yet adopted floating exchange rates, so I am not sure how fairit is to critique Milton’s hypothesis in this
light.  Your point is taken about the semantic usage about the words‘trade imbalance,’ although I imagine people like Milton also use it morebroadly in the sense that they believe deviations
from free trade practices result in ‘imbalances,’ or in other words, the differencein outcomes between a world with free trade and one without.

A: Uncle Milty knew almost nothing about money, banking, orinternational trade. He thought floating exchange rates would resolve trade“imbalances” through adjustment of exchange rates. No, they won’t. He ignores therole that currencies play in taking positions in assets. He thought money hasto do with “trade” or “exchange” but in reality that is a tiny slice of thepie. Most “transactions” are financial, and are tens or hundreds of times thevolume of “trade”. So, no, free trade and floating rates won’t balance tradeaccounts. Still macro balances do balance. It is just amazing. But not if yourealize there must be an identity.

Q 5: Maybe you could say something about the different typesof pegs — i.e. crawling pegs, currency board etc.

A: Will do. Later.

Q6: Are you going to get into more detail on the topic ofcapital controls? I’d be interested to learn more about the policy options andtheir implications in that regard.

A: Sure. Sovereign countries should never submit them to thecontrol by Wall St or London.

Q7: A 1 comment collapsed CollapseExpand“Inflation andcurrency depreciation are possible outcomes if government spends toomuch.”
Here we get into the different definitions of ‘inflation’. The main concern Ialways get when I put the ‘just let the currency float’ argument is that therewill be a ‘currency crisis’. In the UK that translates into a Sterling Crisisand is embedded in the domestic psyche much like Weimar is in Germany – due tothe 1976 ‘crisis’. The main argument is that the price of things will shoot up,ie we will have ‘inflation’ in the common sense. Really a reduction in thestandard of living in economic terms due to supply side inflation. What can adomestic government do to buffer the effects of a ‘currency crisis’?

A: Currency crises so faras I am aware ONLY affect countries that try to peg. The UK tried that, andfailed. Then they joined the floating world. No more currency crises. Now, canexchange rates flux on a floating system? You betcha. Will that be more painfulfor a country like Oz that exports its commodities? You betcha. Cowboy up, aswe say in America. It is better than the alternative: exchange rate crises anddefault. Look at the EMU.