Archive for the 'currency manipulation' Category

Currency Wars: The Next Generation

I saw an interesting news story on the Bloomberg website today. The title sums it up pretty well. “Currency Wars Evolve With Goal of Avoiding Deflation.” Just as Lars Christensen predicted recently, nervous — and misguided — talk about currency wars is spreading fast. Here’s what it says on Bloomberg:

Currency wars are back, though this time the goal is to steal inflation, not growth.

Brazil Finance Minister Guido Mantega popularized the term “currency war” in 2010 to describe policies employed at the time by major central banks to boost the competitiveness of their economies through weaker currencies. Now, many see lower exchange rates as a way to avoid crippling deflation.

Now, as I have pointed out many times (e.g., here, here, and most recently here), “currency war” in the sense used by Mantega, also known as “currency manipulation” or “exchange-rate protection” involves the simultaneous application of exchange-rate intervention by the monetary authority to reduce the nominal exchange rate together with a tight monetary policy aimed at creating a chronic domestic excess demand for money, thereby forcing domestic households and businesses to restrict expenditure to build up their holdings of cash to desired levels, resulting in a chronic balance of payments surplus and the steady accumulation of foreign-exchange reserves by the central bank. So the idea that quantitative easing had anything to do with “currency war” in this sense was a nonsensical notion based on a complete failure to understand the difference between a nominal and a real exchange rate.

“This beggar-thy-neighbor policy is not about rebalancing, not about growth,” David Bloom, the global head of currency strategy at London-based HSBC Holdings Plc, which does business in 74 countries and territories, said in an Oct. 17 interview. “This is about deflation, exporting your deflationary problems to someone else.”

Bloom puts it in these terms because, when one jurisdiction weakens its exchange rate, another’s gets stronger, making imported goods cheaper. Deflation is a both a consequence of, and contributor to, the global economic slowdown that’s pushing the euro region closer to recession and reducing demand for exports from countries such as China and New Zealand.

Well, by definition of an exchange rate (a reciprocal relationship) between two currencies, if one currency appreciates the other depreciates correspondingly. If the euro depreciates relative to the dollar, prices of the same goods will rise measured in euros and fall measured in dollars. The question is what has been causing the euro to depreciate relative to the dollar. The notion of a currency war is meaningless if the change in exchange rates is not at least in part being driven by a deliberate policy choice. So what kind of policy choices are we talking about?

Bank of Japan Governor Haruhiko Kuroda said last month he’d welcome a lower exchange rate to help meet his inflation target and may extend the nation’s unprecedented stimulus program to achieve that. Like his Japanese counterpart, European Central Bank President Mario Draghi has acknowledged the need for a weaker euro to avoid deflation and make exports more competitive, though he’s denied targeting the exchange rate specifically.

After the Argentine peso, which is plunging following a debt default and devaluation, the yen will be the biggest loser among major currencies by the end of 2015, according to median strategist forecasts compiled by Bloomberg as of yesterday. A 6 percent decline is predicted, which would build on a 5.5 percent slide since June.

The euro is also expected to be among the 10 biggest losers, with strategists seeing a 4.8 percent drop. The yen traded at 107.21 per dollar 10:18 a.m. in New York, while the euro bought $1.2658.

Notice that there is no mention of the monetary policy that goes along with the exchange-rate target. Since the goal of the monetary policy is to produce inflation, one would imagine that the mechanism is monetary expansion. If the Japanese and the Europeans want their currencies to depreciate against the dollar, they can intervene in foreign-exchange markets and buy up dollars with newly printed euros or yen. That would tend to cause euros and yen to depreciate against the dollar, but would also tend to raise prices of goods in terms of euros and yen. How does that export deflation to the US?

At 0.3 percent in September, annual inflation in the 18-nation bloc remains a fraction of the ECB’s target of just under 2 percent. Gross-domestic-product growth flat-lined in the second quarter, while Germany, Europe‘s biggest economy, reduced its 2014 expansion forecast this month to 1.2 percent from 1.8 percent.

Disinflationary pressures in the euro area are starting to spread to its neighbors and biggest trading partners. The currencies of Switzerland, Hungary (HUCPIYY), Denmark, the Czech Republic and Sweden are forecast to fall from 3.8 percent to more than 6 percent by the end of next year, estimates compiled by Bloomberg show, partly due to policy makers’ actions to stoke prices.

“Deflation is spilling over to central and eastern Europe,” Simon Quijano-Evans, the London-based head of emerging-markets research at Commerzbank AG, said yesterday by phone. “Weaker exchange rates will help” them tackle the issue, he said.

Hungary and Switzerland entered deflation in the past two months, while Swedish central-bank Deputy Governor Per Jansson last week blamed his country’s falling prices partly on rate cuts the ECB used to boost its own inflation. A policy response may be necessary, he warned.

If the Swedish central bank thinks that it is experiencing deflation, it has tools with which to prevent deflation from occurring. It is bizarre to suggest that a rate cut by ECB could be causing deflation in Sweden.

While not strictly speaking stimulus measures, the Swiss, Danish and Czech currency pegs — whether official or unofficial — have a similar effect by limiting gains versus the euro.

The Swedes could very easily adopt a similar currency peg to avoid any appreciation of the Swedish krona against the euro.

Measures like these are necessary because, even after a broad-based dollar rally, eight of the Group of 10 developed-nation currencies remain overvalued versus the dollar, according to a purchasing-power parity measure from the Organization for Economic Cooperation & Development.

If these currencies are overvalued relative to the dollar, according to a PPP measure, they are under deflationary pressure even at current exchange rates. That means that exchange rate depreciation via monetary expansion is essential to counteracting deflationary pressure.

The notion that exchange-rate depreciation to avoid deflation is a beggar-thy-neighbor policy or a warlike act could not be more wrong. If exchange-rate depreciation by one country causes retaliation by other countries that try to depreciate their currencies even more, that would be a virtuous cycle, not a vicious one.

In his book Trade Depression and the Way Out, Hawtrey summed it up beautifully over 80 years ago, as I observed in this post.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better.

The only small quibble that I have with Hawtrey’s discussion is his assertion that a fall in the real wage is necessary to restore equilibrium. A temporary fall in real wages may be part of the transition to equilibrium, but that doesn’t mean that the real wage at the end of the transition must be less than it was at the start of the process.

Can We All Export Our Way out of Depression?

Tyler Cowen has a post chastising Keynesians for scolding Germany for advising their Euro counterparts to adopt the virtuous German example of increasing their international competitiveness so that they can increase their exports, thereby increasing GDP and employment. The Keynesian response is that increasing exports is a zero-sum game, so that, far from being a recipe for recovery, the German advice is actually a recipe for continued stagnation.

Tyler doesn’t think much of the Keynesian response.

But that Keynesian counter is a mistake, perhaps brought on by the IS-LM model and its impoverished treatment of banking and credit.

Let’s say all nations could indeed increase their gross exports, although of course the sum of net exports could not go up.  The first effect is that small- and medium-sized enterprises would be more profitable in the currently troubled economies.  They would receive more credit and the broader monetary aggregates would go up in those countries, reflating their economies.  (Price level integration is not so tight in these cases, furthermore much of the reflation could operate through q’s rather than p’s.)  It sometimes feels like the IS-LM users have a mercantilist gold standard model, where the commodity base money can only be shuffled around in zero-sum fashion and not much more can happen in a positive direction.

The problem with Tyler’s rejoinder to the Keynesian response, which, I agree, provides an incomplete picture of what is going on, is that he assumes that which he wants to prove, thereby making his job just a bit too easy. That is, Tyler just assumes that “all nations could indeed increase their gross exports.” Obviously, if all nations increase their gross exports, they will very likely all increase their total output and employment. (It is, I suppose, theoretically possible that all the additional exports could be generated by shifting output from non-tradables to tradables, but that seems an extremely unlikely scenario.) The reaction of credit markets and monetary aggregates would be very much a second-order reaction. It’s the initial assumption–  that all nations could increase gross exports simultaneously — that is doing all the heavy lifting.

Concerning Tyler’s characterization of the IS-LM model as a mercantilist gold-standard model, I agree that IS-LM has serious deficiencies, but that characterization strikes me as unfair. The simple IS-LM model is a closed economy model, with an exogenously determined price level. Such a model certainly has certain similarities to a mercantilist gold standard model, but that doesn’t mean that the two models are essentially the same. There are many ways of augmenting the IS-LM model to turn it into an open-economy model, in which case it would not necessarily resemble the a mercantilist gold-standard model.

Now I am guessing that Tyler would respond to my criticism by asking: “well, why wouldn’t all countries increase their gross exports is they all followed the German advice?”

My response to that question would be that the conclusion that everybody’s exports would increase if everybody became more efficient logically follows only in a comparative-statics framework. But, for purposes of this exercise, we are not starting from an equilibrium, and we have no assurance that, in a disequilibrium environment, the interaction of the overall macro disequilibrium with the posited increase of efficiency would produce, as the comparative-statics exercise would lead us to believe, a straightforward increase in everyone’s exports. Indeed, even the comparative-statics exercise is making an unsubstantiated assumption that the initial equilibrium is locally unique and stable.

Of course, this response might be dismissed as a mere theoretical possibility, though the likelihood that widespread adoption of export-increasing policies in the midst of an international depression, unaccompanied by monetary expansion, would lead to increased output does not seem all that high to me. So let’s think about what might happen if all countries simultaneously adopted export-increasing policies. The first point to consider is that not all countries are the same, and not all are in a position to increase their exports by as much or as quickly as others. Inevitably, some countries would increase their exports faster than others. As a result, it is also inevitable that some countries would lose export markets as other countries penetrated export markets before they did. In addition, some countries would experience declines in domestic output as domestic-import competing industries were forced by import competition to curtail output. In the absence of demand-increasing monetary policies, output and employment in some countries would very likely fall. This is the kernel of truth in the conventional IS-LM analysis that Tyler tries to dismiss. The IS-LM framework abstracts from the output-increasing tendency of export-led growth, but the comparative-statics approach abstracts from aggregate-demand effects that could easily overwhelm the comparative-statics effect.

Now, to be fair, I must acknowledge that Tyler reaches a pretty balanced conclusion:

This interpretation of the meaning of zero-sum net exports is one of the most common economic mistakes you will hear from serious economists in the blogosphere, and yet it is often presented dogmatically or dismissively in a single sentence, without much consideration of more complex or more realistic scenarios.

That is a reasonable conclusion, but I think it would be just as dogmatic, if not more so, to rely on the comparative-statics analysis that Tyler goes through in the first part of his post without consideration of more complex or more realistic scenarios.

Let me also offer a comment on Scott Sumner’s take on Tyler’s post. Scott tries to translate Tyler’s analysis into macroeconomic terms to support Tyler’s comparative-statics analysis. Scott considers three methods by which exports might be increased: 1) supply-side reforms, 2) monetary stimulus aimed at currency depreciation, and 3) increased government saving (fiscal austerity). The first two, Scott believes, lead to increased output and employment, and that the third is a wash. I agree with Scott about monetary stimulus aimed at currency depreciation, but I disagree (at least in part) about the other two.

Supply-side reforms [to increase exports] boost output under either an inflation target, or a dual mandate.  If you want to use the Keynesian model, these reforms boost the Wicksellian equilibrium interest rate, which makes NGDP grow faster, even at the zero bound.

Scott makes a fair point, but I don’t think it is necessarily true for all inflation targets. Here is how I would put it. Because supply-side reforms to increase exports could cause aggregate demand in some countries to fall, and we have very little ability to predict by how much aggregate demand could go down in some countries adversely affected by increased competition from exports by other countries, it is at least possible that worldwide aggregate demand would fall if such policies were generally adopted. You can’t tell how the Wicksellian natural rate would be affected until you’ve accounted for all the indirect feedback effects on aggregate demand. If the Wicksellian natural rate fell, an inflation target, even if met, might not prevent a slowdown in NGDP growth, and a net reduction in output and employment. To prevent a slowdown in NGDP growth would require increasing the inflation target. Of course, under a real dual mandate (as opposed to the sham dual mandate now in place at the Fed) or an NGDP target, monetary policy would have to be loosened sufficiently to prevent output and employment from falling.

As far as government saving (fiscal austerity), I’d say it’s a net wash, for monetary offset reasons.

I am not sure what Scott means about monetary offset in this context. As I have argued in several earlier posts (here, here, here and here), attempting to increase employment via currency depreciation and increased saving involves tightening monetary policy, not loosening it. So I don’t see how fiscal policy can be used to depreciate a currency at the same time that monetary policy is being loosened. At any rate, if monetary policy is being used to depreciate the currency, then I see no difference between options 2) and 3).

But my general comment is that, like Tyler, Scott seems to be exaggerating the difference between his bottom line and the one that comes out of the IS-LM model, though I am certainly not saying that IS-LM is  last word on the subject.

Eureka! Paul Krugman Discovers the Bank of France

Trying hard, but not entirely successfully, to contain his astonishment, Paul Krugman has a very good post (“France 1930, Germany 2013) inspired by Doug Irwin’s “very good” paper (see also this shorter version) “Did France Cause the Great Depression?” Here’s Krugman take away from Irwin’s paper.

[Irwin] points out that France, with its undervalued currency, soaked up a huge proportion of the world’s gold reserves in 1930-31, and suggests that France was responsible for about half the global deflation that took place over that period.

The thing is, France itself didn’t do that badly in the early stages of the Great Depression — again thanks to that undervalued currency. In fact, it was less affected than most other advanced countries (pdf) in 1929-31:

Krugman is on the right track here — certainly a hopeful sign — but he misses the distinction between an undervalued French franc, which, despite temporary adverse effects on other countries, would normally be self-correcting under the gold standard, and the explosive increase in demand for gold by the insane Bank of France after the franc was pegged at an undervalued parity against the dollar. Undervaluation of the franc began in December 1926 when Premier Raymond Poincare stabilized its value at about 25 francs to the dollar, the franc having fallen to 50 francs to the dollar in July when Poincare, a former prime minister, had been returned to office to deal with a worsening currency crisis. Undervaluation of the franc would have done no permanent damage to the world economy if the Bank of France had not used the resulting inflow of foreign exchange to accumulate gold, cashing in sterling- and dollar-denominated financial assets for gold. This was a step beyond classic exchange-rate protection (currency manipulation) whereby a country uses a combination of an undervalued exchange rate and a tight monetary policy to keep accumulating foreign-exchange reserves as a way of favoring its export and import-competing industries. Exchange-rate protection may have been one motivation for the French policy, but that objective did not require gold accumulation; it could have been achieved by accumulating foreign exchange reserves without demanding redemption of those reserves in terms of gold, as the Bank of France began doing aggressively in 1927. A more likely motivation for gold accumulation policy of the Bank of France seems to have been French resentment against a monetary system that, from the French perspective, granted a privileged status to the dollar and to sterling, allowing central banks to treat dollar- and sterling-denominated financial assets as official exchange reserves, thereby enabling issuers of dollar and sterling-denominated assets the ability to obtain funds on more favorable terms than issuers of instruments denominated in other currencies.

The world economy was able to withstand the French gold-accumulation policy in 1927-28, because the Federal Reserve was tolerating an outflow of gold, thereby accommodating to some degree the French demand for gold. But after the Fed raised its discount rate to 5% in 1928 and 6% in February 1929, gold began flowing into the US as well, causing gold to start appreciating (in other words, prices to start falling) in world markets by the summer of 1929. But rather than reverse course, the Bank of France and the Fed, despite reductions in their official lending rates, continued pursuing policies that caused huge amounts of gold to flow into the French and US vaults in 1930 and 1931. Hawtrey and Cassel, of course, had warned against such a scenario as early as 1919, and proposed measures to prevent or reverse the looming catastrophe before it took place and after it started, but with little success. For a more complete account of this sad story, and the failure of the economics profession, with a very few notable exceptions, to figure out what happened, see my paper with Ron Batchelder “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?”

As Krugman observes, the French economy did not do so badly in 1929-31, because it was viewed as the most stable, thrifty, and dynamic economy in Europe. But France looked good only because Britain and Germany were in even worse shape. Because France was better off the Britain and Germany, and because its currency was understood to be undervalued, the French franc was considered to be stable, and, thus, unlikely to be devalued. So, unlike sterling, the reichsmark, and the dollar, the franc was not subjected to speculative attacks, becoming instead a haven for capital seeking safety.

Interestingly, Krugman even shows some sympathetic understanding for the plight of the French:

Notice, by the way, that the French weren’t evil or malicious here — they were just adhering to their hard-money ideology in an environment where that had terrible adverse effects on other countries.

Just wondering, would Krugman ever invoke adherence to a hard-money ideology as a mitigating factor in passing judgment on a Republican?

Krugman concludes by comparing Germany today with France in 1930.

Obviously the details are different, but I would argue that Germany is playing a somewhat similar role today — not as drastic, but with less excuse. For Germany is an economic hegemon in a way France never was; it has responsibilities, which it isn’t meeting.

Indeed, there are similarities, but there is a crucial difference in the mechanism by which damage is being inflicted: the world price level in 1930, under the gold standard, was determined by the value of gold. An increase in the demand for gold by central banks necessarily raised the value of gold, causing deflation for all countries either on the gold standard or maintaining a fixed exchange rate against a gold-standard currency. By accumulating gold, nearly quadrupling its gold reserves between 1926 and 1932, the Bank of France was a mighty deflationary force, inflicting immense damage on the international economy. Today, the Eurozone price level does not depend on the independent policy actions of any national central bank, including that of Germany. The Eurozone price level is rather determined by the policy choices of a nominally independent European Central Bank. But the ECB is clearly unable to any adopt policy not approved by the German government and its leader Mrs. Merkel, and Mrs. Merkel has rejected any policy that would raise prices in the Eurozone to a level consistent with full employment. Though the mechanism by which Mrs. Merkel and her government are now inflicting damage on the Eurozone is different from the mechanism by which the insane Bank of France inflicted damage during the Great Depression, the damage is just as pointless and just as inexcusable. But as the damage caused by Mrs. Merkel, in relative terms at any rate, seems somewhat smaller in magnitude than that caused by the insane Bank of France, I would not judge her more harshly than I would the Bank of France — insanity being, in matters of monetary policy, no defense.

HT: ChargerCarl

Japan Still Has Me Worried

Last Thursday night, I dashed off a post in response to accusations being made by Chinese and South Korean critics of Abenomics that Japan is now engaging in currency manipulation. When I started writing, I thought that I was going to dismiss such accusations, because Prime Minister Abe has made an increased inflation target an explicit goal of his monetary policy, and instructed the newly installed Governor of the Bank of Japan to meet that target. However, despite the 25% depreciation of the yen against the dollar since it became clear last fall that Mr. Abe, running on a platform of monetary stimulation, would be elected Prime Minister, prices in Japan have not risen.

It was also disturbing that there were news reports last week that some members of the Board of Governors of the Bank of Japan voiced doubts that the 2% inflation target would be met.

Some of the members of the Bank of Japan (BOJ) board were doubtful about achieving the 2% inflation target projected by the bank within the two-year time frame, according to the latest minutes of the policy meeting.

Why a 25% decline in the value of the yen in six months would not be enough to raise the rate of inflation to at least 2% is not immediately obvious to me. In 1933 when FDR devalued the dollar by 40%, the producer price index quickly jumped 10-15% in three months.

Moreover, the practice of currency manipulation, i.e., maintaining an undervalued exchange rate while operating a tight monetary policy to induce a chronic current-account surplus and a rapid buildup of foreign-exchange reserves, was a key element of the Japanese growth strategy in the 1950s and 1960s, later copied by South Korea and Taiwan and the other Asian Tigers, before being perfected by China over the past decade. So despite wanting to defend the new Japanese monetary policy as a model for the rest of the world, I couldn’t conclude, admittedly based on pretty incomplete information, that Japan had not reverted back to its old currency-manipulating habits.

My expression of agnosticism invited some pushback from Scott Sumner who quickly fired off a comment saying:

I don’t follow this. Why aren’t you looking at the Japanese CA balance?

To which I responded:

Scott, Answer 1, CA depends on many things; FX reserves depends on what the CB wants. Answer 2, I’m lazy. Answer 3, also sleep deprived.

Well, I’m sticking with answer 1, but as I am somewhat less sleep deprived than I was last Thursday, I will just add this tidbit from Bloomberg.com

Japan‘s current-account surplus rose in March to the highest level in a year as a depreciating yen boosted repatriated earnings and brightened the outlook for the nation’s exports.

The excess in the widest measure of trade was 1.25 trillion yen ($12.4 billion), the Ministry of Finance said in Tokyo today. That exceeded the 1.22 trillion yen median estimate of 23 economists surveyed by Bloomberg News.

Prime Minister Shinzo Abe’s revamp of Japan’s central bank to focus on ending deflation paid off when the yen today slid past 101 for the first time since 2009, helping exporters such as Toyota Motor Corp. (7203), which now sees its highest annual profit in six years. Sustaining a current-account surplus may help to maintain confidence in the nation’s finances as Abe wrestles with a debt burden more than twice the size of the economy.

“The currency’s depreciation is buoying Japan’s income from overseas investment at a pretty solid pace,” said Long Hanhua Wang, an economist at Royal Bank of Scotland Group Plc in Tokyo. “A weaker yen provides support for Japanese exports.”

The cost of a weaker yen is higher import costs, reflected in a ninth straight trade deficit in March. The current-account surplus was 4 percent lower than the same month last year and the income surplus widened to 1.7 trillion yen, the highest level since March 2010, the ministry said.

So contrary to what one would expect if the depreciation of the yen were the result of an inflationary monetary policy causing increased domestic spending, thereby increasing imports and reducing exports, Japan’s current account surplus is approaching its highest level in a year.

Then, on his blog, responding to a commenter who indicated that he was worried by my suggestion that Japan might be engaging in currency manipulation, Scott made the following comment.

Travis, I had trouble following David’s post. What exactly is he worried about? I don’t think the Japanese are manipulating their currency, but so what if they were?

OK, Scott, here is what I am worried about. The reason that currency debasement is a good and virtuous and praiseworthy thing to do in a depression is that by debasing your currency you cause private economic agents to increase their spending. But under currency manipulation, the desirable depreciation of the exchange rate is counteracted by tight monetary policy designed to curtail, not to increase, spending, the point of currency manipulation being to divert spending by domestic and foreign consumers from the rest of the world to the tradable-goods producers of the currency-manipulating country. Unlike straightforward currency debasement, currency manipulation involves no aggregate change in spending, but shifts spending from the rest of the world to the currency manipulator. I don’t think that that is a good thing. And if that is what Japan is doing – I am not saying, based on one month’s worth of data, that they are, but I am afradi that they may be reverting to their old habits – then I think you should be worried as well.

Is Japan a Currency Manipulator?

In his Wednesday column (“Japan’s bumpy road to recovery“) in the Financial Times, the estimable Martin Wolf provided a sober assessment of the recent gyrations of the Japanese bond and stock markets and the yen. I was especially struck by this passage.

[C]riticism over the decline in the yen is coming from abroad. Many, particularly in east Asia, agree with the warning from David Li of Tsinghua University that, far from a rise in Japanese inflation, “the world has merely seen a sharp devaluation of the yen. This devaluation is both unfair on other countries and unsustainable.” In a letter to the FT, Takashi Ito from Tokyo responded: “I just find it unbearable that countries that have debased or manipulated their currency can accuse Japan of depreciating the yen”. This does begin to look like a currency war.

In a couple of posts last November about whether China was engaging in currency manipulation, I first gave China a qualified pass and then reversed my position after looking a bit more closely into the way in which the Chinese central bank (PBoC) was imposing high reserve requirements on commercial banks when creating deposits, thereby effectively sterilizing inflows of foreign exchange, or more accurately forcing the inflow of foreign exchange as a condition for expanding the domestic Chinese money supply to meet the burgeoning domestic Chinese demand to hold cash.

So to answer the question whether Japan has been manipulating its currency to drive down the value of the yen, the place to start is to look at what has happened to Japanese foreign-exchange holdings. If Japan has been manipulating its currency, then the reduction in the external value of the yen would be accompanied by an inflow of foreign exchange. The chart below suggests that Japanese holdings of foreign exchange have decreased somewhat over the past six months.

japan_forex_reserves

However, this item from Bloomberg suggests that the reduction in foreign exchange reserves may have been achieved simply by swapping foreign exchange reserves for different foreign assets which, for purposes of determining whether Japan is manipulating its currency, would be a wash.

Japan plans to use its foreign- exchange reserves to buy bonds issued by the European Stabilitylity Mechanism and euro-area sovereigns, as the nation seeks to weaken its currency, Finance Minister Taro Aso said.

“The financial stability of Europe will help the stability of foreign-exchange rates, including the yen,” Aso told reporters today at a briefing in Tokyo. “From this perspective, Japan plans to buy ESM bonds,” he said. The purchase amount is undecided, Aso said.

The move may help Prime Minister Shinzo Abe temper criticism of Japan’s currency policies from trading partners such as the U.S. The yen has fallen around 8 percent against the dollar since mid-November on Abe’s pledge to reverse more than a decade of deflation as his Liberal Democratic Party won an election victory last month.

“The Europeans would be happy to see Japan buy ESM bonds, so Japan can avoid criticism from abroad and at the same time achieve its objective,” said Masaaki Kanno, chief economist at JPMorgan Securities Japan Co. and a former central bank official.

So I regret to say that my initial quick look at the currency manipulation issue does not allow me to absolve Japan of the charge of being a currency manipulator.

It was, in fact, something of a puzzle that, despite the increase in Japanese real GDP of 3.5% in the first quarter, the implicit Japanese price deflator declined in the first quarter. If Japan is not using currency depreciation as a tool to create inflation, then its policy is in fact perverse and will lead to disaster. It would also explain why doubts are increasing that Japan will be able to reach its 2% inflation target.

I hope that I’m wrong, but, after the high hopes engendered by the advent of Abenomics, I am starting to get an uneasy feeling about what is happening there. I invite others more skillful in understanding the intricacies of foreign exchange reserves and central bank balance sheets to weigh in and enlighten us about the policy of the BoJ.

Currency Manipulation: Is It Just About Saving?

After my first discussion of currency manipulation, Scott Sumner responded with some very insightful comments of his own in which he pointed out that the current account surplus (an inflow of cash) corresponds to the difference between domestic savings and domestic investment. Scott makes the point succinctly:

There are two views of current account surpluses.  One is that they reflect “undervalued” currencies.  Another is that they reflect saving/investment imbalances.  Thus the CA surplus is the capital account deficit, which is (by definition) domestic saving minus domestic investment.

The difference is that when an undervalued currency leads to a current account surplus, the surplus itself tends to be self-correcting, because, under fixed exchange rates, the current account surplus leads (unless sterilized) to an increase of the domestic money stock, thereby raising domestic prices, with the process continuing until the currency ceases to be undervalued. A current account surplus caused by an imbalance between domestic saving and domestic investment is potentially more long-lasting, inasmuch as it depends on the relationship between the saving propensities of the community and the investment opportunities available to the community, a relationship that will not necessarily be altered as a consequence of the current account surplus.

From this observation, Scott infers that it is not really monetary policy, but a high savings rate, that causes an undervalued currency.

Actual Chinese exchange rate manipulation usually involves three factors:

1.  More Chinese government saving.

2.  The saving is done by the central bank.

3.  The central bank keeps the nominal exchange rate pegged.

But only the first is important.  If the Chinese government saves a huge percentage of GDP, and total Chinese saving rises above total Chinese investment, then by definition China has a CA surplus.  And this surplus would occur even if the exchange rate were floating, and if the purchases were done by the Chinese Treasury, not its central bank. That’s why you often see huge CA surpluses in countries that don’t have pegged exchange rates (Switzerland (prior to the recent peg), Singapore, Norway, etc).  They have government policies which involve either enormous government saving (Singapore and Norway) or policies that encourage private saving (Switzerland.)  It should also be noted that government saving does not automatically produce a CA surplus. Australia is a notable counterexample.  The Aussie government does some saving, but the private sector engages in massive borrowing from the rest of the world, so they still end up with a large CA deficit.

I think that Scott is largely correct, but he does overlook some important aspects of Chinese policy that distinguish it from other countries with high savings rates. First, Scott already observed that it is not savings alone that determines the current account surplus; it is the difference between domestic savings and domestic investment. China has a very high savings rate, but why is China’s domestic saving being channeled into holdings of American treasury notes yielding minimal nominal interest and negative real interest rather than domestic investment projects? While the other high-savings countries mentioned by Scott, are small wealthy countries with limited domestic investment opportunities, China is a vast poor and underdeveloped country with very extensive domestic investment opportunities. So one has to wonder why more Chinese domestic savings is not being channeled directly into financing Chinese investment opportunities.

In my follow-up post to the one Scott was commenting on, I pointed out the role of high Chinese reserve requirements on domestic bank deposits in sterilizing foreign cash inflows. As China develops and its economy expands, with income and output increasing at rates of 10% a year or more, the volume of market transactions is probably increasing even more rapidly than income, implying a very rapid increase in the demand to hold cash and deposits. By imposing high reserve requirements on deposits and choosing to let its holdings of domestic assets grow at a much slower rate than the expansion of its liabilities (the monetary base), the Chinese central bank has prevented the Chinese public from satisfying their growing demand for money except through an export surplus with which to obtain foreign assets that can be exchanged with the Chinese central bank for the desired additions to their holdings of deposits.

Now It is true, as Scott points out, that an export surplus could be achieved by other means, and all of the alternatives would ultimately involve increasing domestic saving above domestic investment. But that does not mean that there is nothing distinctive about the use of monetary policy as the instrument by which the export surplus and the excess of domestic saving over domestic investment (corresponding to the increase in desired holdings of the monetary base) is achieved. The point is that China is using monetary policy to pursue a protectionist policy favoring its tradable goods industries and disadvantaging the tradable goods industries of other countries including the US. It is true that a similar result would follow from an alternative set of policies that increased the Chinese savings relative to Chinese domestic investment, but it is not obvious that other policies aimed at increasing Chinese savings would not tend to increase Chinese domestic investment, leaving the overall effect on the Chinese tradable goods sector in doubt.

So it seems clear to me that Chinese monetary policy is protectionist, but Scott questions whether the US should care about that.

In the end none of this should matter, as the job situation in the US is determined by two factors:

1.  US supply-side policies

2.  US NGDP growth (i.e. monetary policy.)

After all, in a strict welfare sense, it would seem that China is doing us a favor by selling their products to us cheaply. Why should we complain about that? US employment depends on US nominal GDP, and with an independent monetary authority, the US can control nominal GDP and employment.

But it seems to me that this sort of analysis may be a bit too Ricardian, in the sense that it focuses mainly on long-run equilibrium tendencies. In fact there are transitional effects on US tradable goods industries and the factors of production specific to those industries. When those industries become unprofitable because of Chinese competition, the redundant factors of production bear heavy personal and economic costs. Second, if China uses protectionism to compete by keeping its real wages low, then low Chinese wages may tend to amplify downward pressure on real wages in the US compared to a non-protectionist Chinese policy. If so, Chinese protectionism may be exacerbating income inequality in the US. Theoretically, I think that the effects could go either way, but I don’t think that the concerns can be dismissed so easily. If countries have agreed not to follow protectionist policies, it seems to me that they should not be able to avoid blame for policies that are protectionist simply by saying that the same or similar effects would have been achieved by a sufficiently large excess of domestic savings over domestic investment.

More on Currency Manipulation

My previous post on currency manipulation elicited some excellent comments and responses, helping me, I hope, to gain a better understanding of the subject than I started with. What seemed to me the most important point to emerge from the comments was that the Chinese central bank (PBC) imposes high reserve requirements on banks creating deposits. Thus, the creation of deposits by the Chinese banking system implies a derived demand for reserves that must be held with the PBC either to satisfy the legal reserve requirement or to satisfy the banks’ own liquidity demand for reserves. Focusing directly on the derived demand of the banking system to hold reserves is a better way to think about whether the Chinese are engaging in currency manipulation and sterilization than the simple framework of my previous post. Let me try to explain why.

In my previous post, I argued that currency manipulation is tantamount to the sterilization of foreign cash inflows triggered by the export surplus associated with an undervalued currency. Thanks to an undervalued yuan, Chinese exporters enjoy a competitive advantage in international markets, the resulting export surplus inducing an inflow of foreign cash to finance that surplus. But neither that surplus, nor the undervaluation of the yuan that underlies it, is sustainable unless the inflow of foreign cash is sterilized. Otherwise, the cash inflow, causing a corresponding increase in the Chinese money supply, would raise the Chinese price level until the competitive advantage of Chinese exporters was eroded. Sterilization, usually conceived of as open-market sales of domestic assets held by the central bank, counteracts the automatic increase in the domestic money supply and in the domestic price level caused by the exchange of domestic for foreign currency. But this argument implies (or, at least, so I argued) that sterilization is not occurring unless the central bank is running down its holdings of domestic assets to offset the increase in its holdings of foreign exchange. So I suggested that, unless the Chinese central holdings of domestic assets had been falling, it appeared that the PBC was not actually engaging in sterilization. Looking at balance sheets of the PBC since 1999, I found that 2009 was the only year in which the holdings of domestic assets by the PBC actually declined. So I tentatively concluded that there seemed to be no evidence that, despite its prodigious accumulation of foreign exchange reserves, the PBC had been sterilizing inflows of foreign cash triggered by persistent Chinese export surpluses.

Somehow this did not seem right, and I now think that I understand why not. The answer is that reserve requirements imposed by the PBC increase the demand for reserves by the Chinese banking system. (See here.) The Chinese reserve requirements on the largest banks were until recently as high as 21.5% of deposits (apparently the percentage is the same for both time deposits and demand deposits). The required reserve ratio is the highest in the world. Thus, if Chinese banks create 1 million yuan in deposits, they are required to hold approximately 200,000 yuan in reserves at the PBC. That 200,000 increase in reserves must come from somewhere. If the PBC does not create those reserves from domestic credit, the only way that they can be obtained by the banks (in the aggregate) is by obtaining foreign exchange with which to satisfy their requirement. So given a 20% reserve requirement, unless the PBC undertakes net purchases of domestic assets equal to at least 200,000 yuan, it is effectively sterilizing the inflows of foreign exchange. So in my previous post, using the wrong criterion for determining whether sterilization was taking place, I had it backwards. The criterion for whether sterilization has occurred is whether bank reserves have increased over time by a significantly greater percentage than the increase in the domestic asset holdings of the PBC, not, as I had thought, whether those holdings of the PBC have declined.

In fact it is even more complicated than that, because the required-reserve ratio has fluctuated over time, the required-reserve ratio having roughly tripled between 2001 and 2010, so that the domestic asset holdings of the PBC would have had to increase more than proportionately to the increase in reserves to avoid effective sterilization. Given that the reserves held by banking system with the PBC at the end of 2010 were almost 8 times as large as they had been at the end of 2001, while the required reserve ratio over the period roughly tripled, the domestic asset holdings of the PBC should have increased more than twice as fast as bank reserves over the same period, an increase of, say, 20-fold, if not more. In the event, the domestic asset holdings of the PBC at the end of 2010 were just 2.2 times greater than they were at the end of 2001, so the inference of effective sterilization seems all but inescapable.

Why does the existence of reserve requirements mean that, unless the domestic asset holdings of the central bank increase at least as fast as reserves, sterilization is taking place? The answer is that the existence of a reserve requirement means that an increase in deposits implies a roughly equal percentage increase in reserves. If the additional reserves are not forthcoming from domestic sources, the domestic asset holdings of the central bank not having increased as fast as did required reserves, the needed reserves can be obtained from abroad only by way of an export surplus. Thus, an increase in the demand of the public to hold deposits cannot be accommodated unless the required reserves can be obtained from some source. If the central bank does not make the reserves available by purchasing domestic assets, then the only other mechanism by which the increased demand for deposits can be accommodated is through an export surplus, the surplus being achieved by restricting domestic spending, thereby increasing exports and reducing imports. The economic consequences of the central bank not purchasing domestic assets when required reserves increase are the same as if the central bank sold some of its holdings of domestic assets when required reserves were unchanged.

The more general point is that one cannot assume that the inflow of foreign exchange corresponding to an export surplus is determined solely by the magnitude of domestic currency undervaluation. It is also a function of monetary policy. The tighter is monetary policy, the larger the export surplus, the export surplus serving as the mechanism by which the public increases their holdings of cash. Unfortunately, most discussions treat the export surplus as if it were determined solely by the exchange rate, making it seem as if an easier monetary policy would have little or no effect on the export surplus.

The point is similar to one I made almost a year ago when I criticized F. A. Hayek’s 1932 defense of the monetary policy of the insane Bank of France. Hayek acknowledged that the gold holdings of the Bank of France had increased by a huge amount in the late 1920s and early 1930s, but, nevertheless, absolved the Bank of France of any blame for the Great Depression, because the quantity of money in France had increased by as much as the increase in gold reserves of the Bank of France.  To Hayek this meant that the Bank of France had done “all that was necessary for the gold standard to function.” This was a complete misunderstanding on Hayek’s part of how the gold standard operated, because what the Bank of France had done was to block every mechanism for increasing the quantity of money in France except the importation of gold. If the Bank of France had not embarked on its insane policy of gold accumulation, the quantity of money in France would have been more or less the same as it turned out to be, but France would have imported less gold, alleviating the upward pressure being applied to the real value of gold, or stated equivalently alleviating the downward pressure on the prices of everything else, a pressure largely caused by insane French policy of gold accumulation.

The consequences of the Chinese sterilization policy for the world economy are not nearly as disastrous as those of the French gold accumulation from 1928 to 1932, because the Chinese policy does not thereby impose deflation on any other country. The effects of Chinese sterilization and currency manipulation are more complex than those of French gold accumulation. I’ll try to at least make a start on analyzing those effects in an upcoming post addressing the comments of Scott Sumner on my previous post.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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