Archive for the 'Max Corden' Category

What Is This Thing Called “Currency Manipulation?”

Over the past few years, I have written a number of posts (e.g., here, here and here) posing — and trying to answer — the question: what is this strange thing called “currency manipulation?” I have to admit that I was actually moderately pleased with myself for having applied ideas developed by the eminent Australian international-trade and monetary economist Max Corden in a classic paper called “Exchange Rate Protection.” Unfortunately, my efforts don’t seem to have pleased – even minimally – Scott Sumner who, in a recent post in his Econlog blog, takes me to task for applying the term to China.

Now I get why Scott doesn’t like the term “currency manipulation.” The term is thrown around indiscriminately all the time as if its meaning were obvious. But the meaning is far from obvious. The term is also an invitation for demagogic abuse, which is another reason for being wary about using it.

A country can peg its exchange rate in terms of some other currency, or allow its exchange rate against all other currencies to float, or it can do a little of both, seeking to influence its exchange rate intermittently depending upon a variety of factors and objectives. A pegged exchange rate may be called a form of intervention (which is not — repeat not —  a synonym for “manipulation”), but if the monetary authority takes its currency peg seriously, it makes the currency peg the overriding determinant of its monetary policy. It is not the only element of its monetary policy, because the monetary authority has another policy objective that it can pursue simultaneously, namely, its holdings of foreign-exchange reserves. If the monetary authority adopts a tight monetary policy, it gains reserves, and if it adopts a loose policy it loses reserves. What constrains a monetary authority with a fixed-exchange rate in loosening policy is the amount of reserves that it is prepared to forego to maintain that exchange rate, and what constrains the monetary authority in tightening its policy is the interest income that must forego in accumulating non-interest-bearing, or low-interest-bearing, foreign-exchange reserves.

What distinguishes “currency manipulation” from mere “currency intervention?” Borrowing Max Corden’s idea of exchange-rate protection, I argued in previous posts that currency manipulation occurs when, in order to favor its tradable-goods sector (i.e., exporting and import-competing industries), a monetary authority (like the Bank of France in 1928) chooses an undervalued currency peg corresponding to a low real exchange rate, or intervenes in currency markets to reduce its nominal exchange rate, while tightening monetary policy to slow down the rise of domestic prices that normally follows a reduced nominal exchange rate. Corden points out that, as a protectionist strategy, exchange-rate protection is inferior to simply raising tariffs on imports or subsidizing exports. However, if international agreements make it difficult to raise tariffs and subsidize exports, exchange-rate protection may become the best available protectionist option.

In his post, “Nominal exchange rates, real exchange rates and protectionism,” Sumner denies that the idea of currency manipulation, and, presumably, the idea of exchange-rate protection make any sense. Here’s what Scott has to say:

The three concepts mentioned in the title of the post are completely unrelated to each other. So unrelated that the subjects ought not even be taught in the same course. The nominal exchange rate is a monetary concept. Real exchange rates belong in course on the real side of macro, perhaps including public finance. And protectionism belongs in a (micro) trade course.

The nominal exchange rate is the relative price of two monies. It’s determined by the monetary policies of the two countries in question. It plays no role in trade.

Scott often cites sticky prices as an important assumption of macroeconomics, so I don’t understand why he thinks that the nominal exchange rate has no effect on trade. If prices do not all instantaneously adjust to a change in the nominal exchange rate, changes in nominal exchange rates are also changes in real exchange rates until prices adjust fully to the new exchange rate.

Protectionism is a set of policies (such as tariffs and quotas) that drives a wedge between domestic and foreign prices. Protectionist policies reduce both imports and exports. They might also slightly affect the current account balance, but that’s a second order effect.

A protectionist policy causes resources from the non-tradable-goods sector to shift to the tradable-goods sector, favoring some domestic producers and disfavoring others, as well as favoring workers specialized to the tradable-goods sector. Whether it affects the trade balance depends on how the policy is implemented, so I agree that raising tariffs doesn’t automatically affect the trade balance. To determine whether and how the trade balance is affected, one has to make further assumptions about the distributional effects of the policy and about the budgetary and monetary policies accompanying the policy. Causation can go in either direction from real exchange rate to trade balance or from trade balance to real exchange rate.

In the following quotation, Scott ignores the relationship between the real exchange rate and the relative pricesof tradables and non-tradables. Protectionist policies, by increasing the relative price of tradables to non-tradables, shift resources from the non-tradable-goods to the tradable-goods sector. That’s the sense in which, contrary to Scott’s assertion, a low real-exchange rate makes enhances the competitiveness of one country relative to other countries. The cost of production in the domestic tradable-goods sector is reduced relative to the price of tradable goods, making the tradable-goods sector more competitive in the markets in which domestic producers compete with foreign producers. I don’t say that increasing the competitiveness of the domestic tradable-goods sector is a good idea, but it is not meaningless to talk about international competitiveness.

Real exchange rates influence the trade balance. When there is a change in either domestic saving or domestic investment, the real exchange rate must adjust to produce an equivalent change in the current account balance. A policy aimed at a bigger current account surplus is not “protectionist”, as it does not generally reduce imports and exports, nor does it drive a wedge between domestic and foreign prices. It affects the gap between imports and exports. . . .

A low real exchange rate is sometimes called a “competitive advantage”, although the concept has absolutely nothing to do with either competition or advantages. It’s simply a reflection of an imbalance between domestic saving and domestic investment. These imbalances also occur within countries, and no one ever worries about regional “deficits”. But for some odd reason at the national level they become a cause for concern. Some of this is based on the mercantilist fallacy that exports are good and imports are bad.

This is where Scott turns his attention to me.

Here’s David Glasner:

Currency manipulation has become a favorite bugbear of critics of both monetary policy and trade policy. Some claim that countries depress their exchange rates to give their exporters an unfair advantage in foreign markets and to insulate their domestic producers from foreign competition. Others claim that using monetary policy as a way to stimulate aggregate demand is necessarily a form of currency manipulation, because monetary expansion causes the currency whose supply is being expanded to depreciate against other currencies, making monetary expansion, ipso facto, a form of currency manipulation.

As I have already explained in a number of posts (e.g., here, here, and here) a theoretically respectable case can be made for the possibility that currency manipulation can be used as a form of covert protectionism without imposing either tariffs, quotas or obviously protectionist measures to favor the producers of one country against their foreign competitors.

I disagree with this. There is no theoretically respectable case for the argument that currency manipulation can be used as protectionism. But I would go much further; there is no intellectually respectable definition of currency manipulation.

Well, my only response is that I consider Max Corden to be just about the most theoretically-respectable economist alive. So let me quote at length from Corden’s essay “Macroeconomic and Industrial Policies” reprinted in his volume Protection, Growth and Trade (pp. 288-301)

There is clearly a relationship between macroeconomic policy and industrial policy on the foreign trade side. . . . The nominal exchange rate is an instrument of macroeconomic policy, while tariffs, import quotas, export subsidies and taxes and voluntary export restraints can all be regarded as instruments of industrial policy. Yet an exchange-rate change can have “industrial” effects. It therefore seems useful to clarify the relationship between exchange-rate policy and the various micro or industrial-policy instruments.

The first step is to distinguish a nominal from a real exchange-rate change and to introduce the concept of “exchange-rate protection. . . . If the exchange rate depreciates to the same extent as all costs and prices are rising (relative to costs and prices in other countries) there may be no real change at all. The nominal exchange rate is a monetary phenomenon, and it is possible that it is no more than that. A monetary authority may engineer a nominal devaluation designed to raise the domestic currency prices of exports and import-competing goods, and hence to benefit these industries. But if nominal wages quickly rise to compensate for the higher tradable-goods prices, no real effects – no rises in the absolute and relative profitability of tradable-goods industries – will remain. Monetary policy can influence the nominal-exchange rate, and possibly can even maintain it at a fixed value, but it cannot necessarily affect the real exchange rate. The real exchange rate refers to the relative price of tradable and non-tradable goods. While its absolute value is difficult to measure because of the ambiguity of the distinction between tradable and non-tradable goods, changes in it are usually – and reasonably – measured or indicated by relating changes in the nominal exchange rate to changes in some index of domestic prices or costs, or possibly to the average nominal wage level. This is sometimes called an index of competitiveness.

A nominal devaluation will devalue the real exchange rate if there is some rigidity or sluggishness either in the prices of non-tradables or in nominal wages. The nominal devaluation will then raise the prices of tradables relative to wage costs and to labour-intensive non-tradables. Thus it protects tradables. This is “exchange-rate protection”. It protects the whole group of tradables relative to non-tradables. It will tnd ot shift resources into tradables out of non-tradables and domestic demand in the opposite direction. If at the same time macroeconomic policy ensures a demand-supply balance for non-tradables – hence decreasing aggregate demand (absorption) in real terms appropriately – a balance of payments surplus (or at least a lesser deficit than before) will result. This refers to the balance of payments on current account since the concurrent fiscal and monetary policies can have varying effects on private capital inflow.

If the motive for the real devaluation was to protect tradables, then the current account surplus will be only a by-product, leading ot more accumulation of foreign exchange reserves than the country’s monetary authority really wanted. Alternatively, if the motive for the real devaluation was to build up the foreign-exchange reserves – or to stop their decline – then the protection of tradables will be the by-product.

The main point to make is that a real exchange-rate change has effects on the relative and absolute profitability of different industries, a real devaluation favouring tradables relative to non-tradables, and a real appreciation the opposite. A nominal exchange-rate change can thus serve an industrial-policy purpose, provided it can be turned into a real exchange-rate change and that the incidental effects on the balance of payments are accepted.

This does not mean that it is an optimal form of industrial policy. . . . [P]rotection policy could be directed more precisely to the industries to be protected, avoiding the by-product effect of an undesired balance-of-payments surplus; and in any case it can be argued that defensive protection policy is unlikely to be optimal, positive adjustment policy being preferable. Nevertheless, it is not difficult to find examples of countries that have practiced exchange-rate protection, if implicitly. They have intervened in the foreign-exchange market to prevent an appreciation of the exchange rate that might otherwise have taken place – or at least, they have “leaned against the wind.” – not because they really wanted to build up foreign-exchange reserves, but because they wanted to protect their tradable-goods industries – usually mainly their export industries.

Scott again quotes me and then comments:

And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.

Because currency manipulation does not exist as a coherent concept, I don’t see any evidence that the Chinese did it. But if I am wrong and it does exist, then it surely refers to the real exchange rate, not the nominal rate. Thus the fact that the nominal value of the Chinese yuan was pegged for a period of time has no relevance to whether the currency was being “manipulated”. The real value of the yuan was appreciating.

One cannot conclude that an appreciating yuan means that China was not manipulating its currency. As I pointed out above, and as Corden explains, exchange-rate protection is associated with the accumulation of foreign-exchange reserves by the central bank. There is an ambiguity in interpreting the motivation of the central bank that is accumulating foreign-exchange reserves. Is it accumulating because it wants to increase the amount of reserves in its vaults, or are the increased holdings merely an unwelcome consequence of a policy being pursued for other reasons? In either case, the amount of foreign-exchange reserves a central bank is willing to hold is not unlimited. When the pile of reserves gets high enough, the policy causing accumulation may start to change, implying that the real exchange rate will start to rise.

The dollar was pegged to gold from 1879 to 1933, and yet I don’t think the US government was “manipulating” the exchange rate. And if it was, it was not by fixing the gold price peg, it would have been by depreciating the real value of the dollar via policies that increased national saving, or reduced national investment, in order to run a current account surplus. In my view it is misleading to call policies that promote national saving “currency manipulation”, and even more so to put that label on just a subset of pro-saving policies.

As in the case of the Bank of France after 1928, with a fixed exchange rate, whether a central bank is guilty of currency manipulation depends on whether the initial currency peg was chosen with a view toward creating a competitive advantage for the country’s tradable-goods sector. That was clearly an important motivation when the Bank of France chose the conversion rate between gold and the franc. I haven’t studied the choice of the dollar peg to gold in 1879.

If economists want to use the term ‘currency manipulation’, then they first need to define the term. I have not seen any definitions that make any sense.

I’m hoping that Corden’s definition works for Scott. It does for me.

Currency Depreciation and Monetary Expansion Redux

Last week Frances Coppola and I exchanged posts about competitive devaluation. Frances chided me for favoring competitive devaluation, competitive devaluation, in her view, accomplishing nothing in a world of fiat currencies, because exchange rates don’t change. Say, the US devalues the dollar by 10% against the pound and Britain devalues the pound by 10% against the dollar; it’s as if nothing happened. In reply, I pointed out that if the competitive devaluation is achieved by monetary expansion (the US buying pounds with dollars to drive up the value of the pound and the UK buying dollars with pounds to drive up the value of the dollar), the result must be  increased prices in both the US and the UK. Frances responded that our disagreement was just a semantic misunderstanding, because she was talking about competitive devaluation in the absence of monetary expansion; so it’s all good.

I am, more or less, happy with that resolution of our disagreement, but I am not quite persuaded that the disagreement between us is merely semantic, as Frances seems conflicted about Hawtrey’s argument, carried out in the context of a gold standard, which served as my proof text for the proposition that competitive devaluation really is expansionary. On the one hand, she seems to distinguish between the expansionary effect of competitive devaluation relative to gold – Hawtrey’s case – and the beggar-my-neighbor effect of competitive devaluation of fiat currencies relative to each other; on the other hand, she also intimates that even Hawtrey got it wrong in arguing that competitive devaluation is expansionary. Now, much as I admire Hawtrey, I have no problem with criticizing him; it just seems that Frances hasn’t decided whether she does – or doesn’t – agree with him.

But what I want to do in this post is not to argue with Frances, though some disagreements may be impossible to cover up; I just want to explain the relationship between competitive devaluation and monetary expansion.

First some context. One of the reasons that I — almost exactly four years ago – wrote my post about Hawtrey and competitive devaluations (aka currency wars) is that critics of quantitative easing had started to make the argument that the real point of quantitative easing was to gain a competitive advantage over other countries by depreciating – or devaluing – their currencies. What I was trying to show was that if a currency is being depreciated by monetary expansion (aka quantitative easing), then, as Frances now seems – but I’m still not sure – ready to concede, the combination of monetary expansion and currency devaluation has a net expansionary effect on the whole world, and the critics of quantitative easing are wrong. Because the competitive devaluation argument has so often been made together with a criticism of quantitative easing, I assumed, carelessly it appears, that in criticizing my post, Frances was disagreeing with my support of currency depreciation in the context of monetary expansion and quantitative easing.

With that explanatory preface out of the way, let’s think about how to depreciate a fiat currency on the foreign exchange markets. A market-clearing exchange rate between two fiat currencies can be determined in two ways (though there is often a little of both in practice): 1) a currency peg and 2) a floating rate. Under a currency peg, one or both countries are committed to buying and selling the other currency in unlimited quantities at the pegged (official) rate. If neither country is prepared to buy or sell its currency in unlimited quantities at the pegged rate, the peg is not a true peg, because the peg will not withstand a sufficient shift in the relative market demands for the currencies. If the market demand is inconsistent with the quasi-peg, either the pegged rate will cease to be a market-clearing rate, with a rationing system imposed while the appearance of a peg is maintained, or the exchange rate will be allowed to float to clear the market. A peg can be one-sided or two-sided, but a two-sided peg is possible only so long as both countries agree on the exchange rate to be pegged; if they disagree, the system goes haywire. To use Nick Rowe’s terminology, the typical case of a currency peg involves an alpha (or dominant, or reserve) currency which is taken as a standard and a beta currency which is made convertible into the alpha currency at a rate chosen by the issuer of the beta currency.

With floating currencies, the market is cleared by adjustment of the exchange rate rather than currency purchases or sales by the monetary authority to maintain the peg. In practice, monetary authorities generally do buy and sell their currencies in the market — sometimes with, and  sometimes without, an exchange-rate target — so the operation of actual foreign exchange markets lies somewhere in between the two poles of currency pegs and floating rates.

What does this tell us about currency depreciation? First, it is possible for a country to devalue its currency against another currency to which its currency is pegged by changing the peg unilaterally. If a peg is one-sided, i.e., a beta currency is tied to an alpha, the issuer of the beta currency chooses the peg unilaterally. If the peg is two-sided, then the peg cannot be changed unilaterally; the two currencies are merely different denominations of a single currency, and a unilateral change in the peg means that the common currency has been abandoned and replaced by two separate currencies.

So what happens if a beta currency pegged to an alpha currency, e.g., the Hong Kong dollar which pegged to the US dollar, is devalued? Say Hong Kong has an unemployment problem and attributes the problem to Hong Kong wages being too high for its exports to compete in world markets. Hong Kong decides to solve the problem by devaluing their dollar from 13 cents to 10 cents. Would the devaluation be expansionary or contractionary for the rest of the world?

Hong Kong is the paradigmatic small open economy. Its export prices are quoted in US dollars determined in world markets in which HK is a small player, so the prices of HK exports quoted in US dollars don’t change, but in HK dollars the prices rise by 30%. Suddenly, HK exporters become super-profitable, and hire as many workers as they can to increase output. Hong Kong’s unemployment problem is solved.

(Brief digression. There are those who reject this reasoning, because it supposedly assumes that Hong Kong workers suffer from money illusion. If workers are unemployed because their wages are too high relative to the Hong Kong producer price level, why don’t they accept a cut in nominal wages? We don’t know. But if they aren’t willing to accept a nominal-wage cut, why do they allow themselves to be tricked into accepting a real-wage cut by way of a devaluation, unless they are suffering from money illusion? And we all know that it’s irrational to suffer from money illusion, because money is neutral. The question is a good question, but the answer is that the argument for monetary neutrality and for the absence of money illusion presumes a comparison between two equilibrium states. But the devaluation analysis above did not start from an equilibrium; it started from a disequilibrium. So the analysis can’t be refuted by saying that it implies that workers suffer from money illusion.)

The result of the Hong Kong export boom and corresponding increase in output and employment is that US dollars will start flowing into Hong Kong as payment for all those exports. So the next question is what happens to those dollars? With no change in the demand of Hong Kong residents to hold US dollars, they will presumably want to exchange their US dollars for Hong Kong dollars, so that the quantity of Hong Kong dollars held by Hong Kong residents will increase. Because domestic income and expenditure in Hong Kong is rising, some of the new Hong Kong dollars will probably be held, but some will be spent. The increased spending as a result of rising incomes and a desire to convert some of the increased cash holdings into other assets will spill over into increased purchases by Hong Kong residents on imports or foreign assets. The increase in domestic income and expenditure and the increase in import prices will inevitably cause an increase in prices measured in HK dollars.

Thus, insofar as income, expenditure and prices are rising in Hong Kong, the immediate real exchange rate advantage resulting from devaluation will dissipate, though not necessarily completely, as the HK prices of non-tradables including labor services are bid up in response to the demand increase following devaluation. The increase in HK prices and increased spending by HK residents on imported goods will have an expansionary effect on the rest of the world (albeit a small one because Hong Kong is a small open economy). That’s the optimistic scenario.

But there is also a pessimistic scenario that was spelled out by Max Corden in his classic article on exchange rate protection. In this scenario, the HK monetary authority either reduces the quantity of HK dollars to offset the increase in HK dollars caused by its export surplus, or it increases the demand for HK dollars to match the increase in the quantity of HK dollars. It can reduce the quantity of HK dollars by engaging in open-market sales of domestic securities in its portfolio, and it can increase the demand for HK dollars by increasing the required reserves that HK banks must hold against the HK dollars (either deposits or banknotes) that they create. Alternatively, the monetary authority could pay interest on the reserves held by HK banks at the central bank as a way of  increasing the amount of HK dollars demanded. By eliminating the excess supply of HK dollars through one of more of these methods, the central bank prevents the increase in HK spending and the reduction in net exports that would otherwise have occurred in response to the HK devaluation. That was the great theoretical insight of Corden’s analysis: the beggar-my-neighbor effect of devaluation is not caused by the devaluation, but by the monetary policy that prevents the increase in domestic income associated with devaluation from spilling over into increased expenditure. This can only be accomplished by a monetary policy that deliberately creates a chronic excess demand for cash, an excess demand that can only be satisfied by way of an export surplus.

The effect (though just second-order) of the HK policy on US prices can also be determined, because the policy of the HK monetary authority involves an increase in its demand to hold US FX reserves. If it chooses to hold the additional dollar reserves in actual US dollars, the increase in the demand for US base money will, ceteris paribus, cause the US price level to fall. Alternatively, if the HK monetary authority chooses to hold its dollar reserves in the form of US Treasuries, the yield on those Treasuries will tend to fall. A reduced yield on Treasuries will increase the desired holdings of dollars, also implying a reduced US price level. Of course, the US is capable of nullifying the deflationary effect of HK currency manipulation by monetary expansion; the point is that the HK policy will have a (slight) deflationary effect on the US unless it is counteracted.

If I were writing a textbook, I would say that it is left as an exercise for the reader to work out the analysis of devaluation in the case of floating currencies. So if you feel like stopping here, you probably won’t be missing very much. But just to cover all the bases, I will go through the argument quickly. If a country wants to drive down the floating exchange rate between its currency and another currency, the monetary authority can buy the foreign currency in exchange for its own currency in the FX markets. It’s actually not necessary to intervene directly in FX markets to do this, issuing more currency, by open-market operations (aka quantitative easing) would also work, but the effect in FX markets will show up more quickly than if the expansion is carried out by open market purchases. So in the simplest case, currency depreciation is actually just another term for monetary expansion. However, the link between monetary expansion and currency depreciation can be broken if a central bank simultaneously buys the foreign currency with new issues of its own currency while making open-market sales of assets to mop up the home currency issued while intervening in the FX market. Alternatively, it can intervene in the FX market while imposing increased reserve requirements on banks, thereby forcing them to hold the newly issued currency, or by paying banks a sufficiently interest rate on reserves held at the central bank to willingly hold the newly issued currency.

So, it is my contention that there is no such thing as pure currency depreciation without monetary expansion. If currency depreciation is to be achieved without monetary expansion, the central bank must also simultaneously either carry out open-market sales to mop the currency issued in the process of driving down the exchange rate of the currency, or impose reserve requirements on banks, or pay interest on bank reserves, thereby creating an increased demand for the additional currency that was issued to drive down the exchange value of the home currency

Competitive Devaluation Plus Monetary Expansion Does Create a Free Lunch

I want to begin this post by saying that I’m flattered by, and grateful to, Frances Coppola for the first line of her blog post yesterday. But – and I note that imitation is the sincerest form of flattery – I fear I have to take issue with her over competitive devaluation.

Frances quotes at length from a quotation from Hawtrey’s Trade Depression and the Way Out that I used in a post I wrote almost four years ago. Hawtrey explained why competitive devaluation in the 1930s was – and in my view still is – not a problem (except under extreme assumptions, which I will discuss at the end of this post). Indeed, I called competitive devaluation a free lunch, providing her with a title for her post. Here’s the passage that Frances quotes:

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. (pp. 154-57)

Here’s Frances’s take on Hawtrey and me:

The highlight “in terms of gold” is mine, because it is the key to why Glasner is wrong. Hawtrey was right in his time, but his thinking does not apply now. We do not value today’s currencies in terms of gold. We value them in terms of each other. And in such a system, competitive devaluation is by definition beggar-my-neighbour.

Let me explain. Hawtrey defines currency values in relation to gold, and advertises the benefit of devaluing in relation to gold. The fact that gold is the standard means there is no direct relationship between my currency and yours. I may devalue my currency relative to gold, but you do not have to: my currency will be worth less compared to yours, but if the medium of account is gold, this does not matter since yours will still be worth the same amount in terms of gold. Assuming that the world price of gold remains stable, devaluation therefore principally affects the DOMESTIC price level.  As Hawtrey says, there may additionally be some external competitive advantage, but this is not the principal effect and it does not really matter if other countries also devalue. It is adjusting the relationship of domestic wages and prices in terms of gold that matters, since this eventually forces down the price of finished goods and therefore supports domestic demand.

Conversely, in a floating fiat currency system such as we have now, if I devalue my currency relative to yours, your currency rises relative to mine. There may be a domestic inflationary effect due to import price rises, but we do not value domestic wages or the prices of finished goods in terms of other currencies, so there can be no relative adjustment of wages to prices such as Hawtrey envisages. Devaluing the currency DOES NOT support domestic demand in a floating fiat currency system. It only rebalances the external position by making imports relatively more expensive and exports relatively cheaper.

This difference is crucial. In a gold standard system, devaluing the currency is a monetary adjustment to support domestic demand. In a floating fiat currency system, itis an external adjustment to improve competitiveness relative to other countries.

Actually, Frances did not quote the entire passage from Hawtrey that I reproduced in my post, and Frances would have done well to quote from, and to think carefully about, what Hawtrey said in the paragraphs preceding the ones she quoted. Here they are:

When Great Britain left the gold standard, deflationary measure were everywhere resorted to. Not only did the Bank of England raise its rate, but the tremendous withdrawals of gold from the United States involved an increase of rediscounts and a rise of rates there, and the gold that reached Europe was immobilized or hoarded. . . .

The consequence was that the fall in the price level continued. The British price level rose in the first few weeks after the suspension of the gold standard, but then accompanied the gold price level in its downward trend. This fall of prices calls for no other explanation than the deflationary measures which had been imposed. Indeed what does demand explanation is the moderation of the fall, which was on the whole not so steep after September 1931 as before.

Yet when the commercial and financial world saw that gold prices were falling rather than sterling prices rising, they evolved the purely empirical conclusion that a depreciation of the pound had no effect in raising the price level, but that it caused the price level in terms of gold and of those currencies in relation to which the pound depreciated to fall.

For any such conclusion there was no foundation. Whenever the gold price level tended to fall, the tendency would make itself felt in a fall in the pound concurrently with the fall in commodities. But it would be quite unwarrantable to infer that the fall in the pound was the cause of the fall in commodities.

On the other hand, there is no doubt that the depreciation of any currency, by reducing the cost of manufacture in the country concerned in terms of gold, tends to lower the gold prices of manufactured goods. . . .

But that is quite a different thing from lowering the price level. For the fall in manufacturing costs results in a greater demand for manufactured goods, and therefore the derivative demand for primary products is increased. While the prices of finished goods fall, the prices of primary products rise. Whether the price level as a whole would rise or fall it is not possible to say a priori, but the tendency is toward correcting the disparity between the price levels of finished products and primary products. That is a step towards equilibrium. And there is on the whole an increase of productive activity. The competition of the country which depreciates its currency will result in some reduction of output from the manufacturing industry of other countries. But this reduction will be less than the increase in the country’s output, for if there were no net increase in the world’s output there would be no fall of prices.

So Hawtrey was refuting precisely the argument raised  by Frances. Because the value of gold was not stable after Britain left the gold standard and depreciated its currency, the deflationary effect in other countries was mistakenly attributed to the British depreciation. But Hawtrey points out that this reasoning was backwards. The fall in prices in the rest of the world was caused by deflationary measures that were increasing the demand for gold and causing prices in terms of gold to continue to fall, as they had been since 1929. It was the fall in prices in terms of gold that was causing the pound to depreciate, not the other way around

Frances identifies an important difference between an international system of fiat currencies in which currency values are determined in relationship to each other in foreign exchange markets and a gold standard in which currency values are determined relative to gold. However, she seems to be suggesting that currency values in a fiat money system affect only the prices of imports and exports. But that can’t be so, because if the prices of imports and exports are affected, then the prices of the goods that compete with imports and exports must also be affected. And if the prices of tradable goods are affected, then the prices of non-tradables will also — though probably with a lag — eventually be affected as well. Of course, insofar as relative prices before the change in currency values were not in equilibrium, one can’t predict that all prices will adjust proportionately after the change.

To make the point in more abstract terms, the principle of purchasing power parity (PPP) operates under both a gold standard and a fiat money standard, and one can’t just assume that the gold standard has some special property that allows PPP to hold, while PPP is somehow disabled under a fiat currency system. Absent an explanation of why PPP doesn’t hold in a floating fiat currency system, the assertion that devaluing a currency (i.e., driving down the exchange value of one currency relative to other currencies) “is an external adjustment to improve competitiveness relative to other countries” is baseless.

I would also add a semantic point about this part of Frances’s argument:

We do not value today’s currencies in terms of gold. We value them in terms of each other. And in such a system, competitive devaluation is by definition beggar-my-neighbour.

Unfortunately, Frances falls into the common trap of believing that a definition actually tell us something about the real word, when in fact a definition tell us no more than what meaning is supposed to be attached to a word. The real world is invariant with respect to our definitions; our definitions convey no information about reality. So for Frances to say – apparently with the feeling that she is thereby proving her point – that competitive devaluation is by definition beggar-my-neighbour is completely uninformative about happens in the world; she is merely informing us about how she chooses to define the words she is using.

Frances goes on to refer to this graph taken from Gavyn Davies in the Financial Times, concerning a speech made by Stanley Fischer about research done by Fed staff economists showing that the 20% appreciation in the dollar over the past 18 months has reduced the rate of US inflation by as much as 1% and is projected to cause US GDP in three years to be about 3% lower than it would have been without dollar appreciation.Gavyn_Davies_Chart

Frances focuses on these two comments by Gavyn. First:

Importantly, the impact of the higher exchange rate does not reverse itself, at least in the time horizon of this simulation – it is a permanent hit to the level of GDP, assuming that monetary policy is not eased in the meantime.

And then:

According to the model, the annual growth rate should have dropped by about 0.5-1.0 per cent by now, and this effect should increase somewhat further by the end of this year.

Then, Frances continues:

But of course this assumes that the US does not ease monetary policy further. Suppose that it does?

The hit to net exports shown on the above graph is caused by imports becoming relatively cheaper and exports relatively more expensive as other countries devalue. If the US eased monetary policy in order to devalue the dollar support nominal GDP, the relative prices of imports and exports would rebalance – to the detriment of those countries attempting to export to the US.

What Frances overlooks is that by easing monetary policy to support nominal GDP, the US, aside from moderating or reversing the increase in its real exchange rate, would have raised total US aggregate demand, causing US income and employment to increase as well. Increased US income and employment would have increased US demand for imports (and for the products of American exporters), thereby reducing US net exports and increasing aggregate demand in the rest of the world. That was Hawtrey’s argument why competitive devaluation causes an increase in total world demand. Francis continues with a description of the predicament of the countries affected by US currency devaluation:

They have three choices: they respond with further devaluation of their own currencies to support exports, they impose import tariffs to support their own balance of trade, or they accept the deflationary shock themselves. The first is the feared “competitive devaluation” – exporting deflation to other countries through manipulation of the currency; the second, if widely practised, results in a general contraction of global trade, to everyone’s detriment; and you would think that no government would willingly accept the third.

But, as Hawtrey showed, competitive devaluation is not a problem. Depreciating your currency cushions the fall in nominal income and aggregate demand. If aggregate demand is kept stable, then the increased output, income, and employment associated with a falling exchange rate will spill over into a demand for the exports of other countries and an increase in the home demand for exportable home products. So it’s a win-win situation.

However, the Fed has permitted passive monetary tightening over the last eighteen months, and in December 2015 embarked on active monetary tightening in the form of interest rate rises. Davies questions the rationale for this, given the extraordinary rise in the dollar REER and the growing evidence that the US economy is weakening. I share his concern.

And I share his concern, too. So what are we even arguing about? Equally troubling is how passive tightening has reduced US demand for imports and for US exportable products, so passive tightening has negative indirect effects on aggregate demand in the rest of the world.

Although currency depreciation generally tends to increase the home demand for imports and for exportables, there are in fact conditions when the general rule that competitive devaluation is expansionary for all countries may be violated. In a number of previous posts (e.g., this, this, this, this and this) about currency manipulation, I have explained that when currency depreciation is undertaken along with a contractionary monetary policy, the terms-of-trade effect predominates without any countervailing effect on aggregate demand. If a country depreciates its exchange rate by intervening in foreign-exchange markets, buying foreign currencies with its own currency, thereby raising the value of foreign currencies relative to its own currency, it is also increasing the quantity of the domestic currency in the hands of the public. Increasing the quantity of domestic currency tends to raise domestic prices, thereby reversing, though probably with a lag, the effect on the currency’s real exchange rate. To prevent the real-exchange rate from returning to its previous level, the monetary authority must sterilize the issue of domestic currency with which it purchased foreign currencies. This can be done by open-market sales of assets by the cental bank, or by imposing increased reserve requirements on banks, thereby forcing banks to hold the new currency that had been created to depreciate the home currency.

This sort of currency manipulation, or exchange-rate protection, as Max Corden referred to it in his classic paper (reprinted here), is very different from conventional currency depreciation brought about by monetary expansion. The combination of currency depreciation and tight money creates an ongoing shortage of cash, so that the desired additional cash balances can be obtained only by way of reduced expenditures and a consequent export surplus. Since World War II, Japan, Germany, Taiwan, South Korea, and China are among the countries that have used currency undervaluation and tight money as a mechanism for exchange-rate protectionism in promoting industrialization. But exchange rate protection is possible not only under a fiat currency system. Currency manipulation was also possible under the gold standard, as happened when the France restored the gold standard in 1928, and pegged the franc to the dollar at a lower exchange rate than the franc had reached prior to the restoration of convertibility. That depreciation was accompanied by increased reserve requirements on French banknotes, providing the Bank of France with a continuing inflow of foreign exchange reserves with which it was able to pursue its insane policy of accumulating gold, thereby precipitating, with a major assist from the high-interest rate policy of the Fed, the deflation that turned into the Great Depression.

Economic Prejudice and High-Minded Sloganeering

In a post yesterday commenting on Paul Krugman’s takedown of a silly and ignorant piece of writing about monetary policy by William Cohan, Scott Sumner expressed his annoyance at the level of ignorance displayed people writing for supposedly elite publications like the New York Times which published Cohan’s rant about how it’s time for the Fed to show some spine and stop manipulating interest rates. Scott, ever vigilant, noticed that another elite publication the Financial Times published an equally silly rant by Avinah Persaud exhorting the Fed to show steel and raise rates.

Scott focused on one particular example of silliness about the importance of raising interest rates ASAP notwithstanding the fact that the Fed has failed to meet its 2% inflation target for something like 39 consecutive months:

Yet monetary policy cannot confine itself to reacting to the latest inflation data if it is to promote the wider goals of financial stability and sustainable economic growth. An over-reliance on extremely accommodative monetary policy may be one of the reasons why the world has not escaped from the clutches of a financial crisis that began more than eight years ago.

Scott deftly skewers Persaud with the following comment:

I suppose that’s why the eurozone economy took off after 2011, while the US failed to grow.  The ECB avoided our foolish QE policies, and “showed steel” by raising interest rates twice in the spring of 2011.  If only we had done the same.

But Scott allowed the following bit of nonsense on Persaud’s part to escape unscathed (I don’t mean to be critical of Scott, there’s only so much nonsense that any single person be expected to hold up to public derision):

The slowdown in the Chinese economy has its roots in decisions made far from Beijing. In the past five years, central banks in all the big advanced economies have embarked on huge quantitative easing programmes, buying financial assets with newly created cash. Because of the effect they have on exchange rates, these policies have a “beggar-thy-neighbour” quality. Growth has been shuffled from place to place — first the US, then Europe and Japan — with one country’s gains coming at the expense of another. This zero-sum game cannot launch a lasting global recovery. China is the latest loser. Last week’s renminbi devaluation brought into focus that since 2010, China’s export-driven economy has laboured under a 25 per cent appreciation of its real effective exchange rate.

The effect of quantitative easing on exchange rates is not the result of foreign-exchange-market intervention; it is the result of increasing the total quantity of base money. Expanding the monetary base reduces the value of the domestic currency unit relative to foreign currencies by raising prices in terms of the domestic currency relative to prices in terms of foreign currencies. There is no beggar-thy-neighbor effect from monetary expansion of this sort. And even if exchange-rate depreciation were achieved by direct intervention in the foreign-exchange markets, the beggar-thy-neighbor effect would be transitory as prices in terms of domestic and foreign currencies would adjust to reflect the altered exchange rate. As I have explained in a number of previous posts on currency manipulation (e.g., here, here, and here) relying on Max Corden’s contributions of 30 years ago on the concept of exchange-rate protection, a “beggar-thy-neighbor” effect is achieved only if there is simultaneous intervention in foreign-exchange markets to reduce the exchange rate of the domestic currency combined with offsetting open-market sales to contractnot expand – the monetary base (or, alternatively, increased reserve requirements to increase the domestic demand to hold the monetary base). So the allegation that quantitative easing has any substantial “beggar-thy-nation” effect is totally without foundation in economic theory. It is just the ignorant repetition of absurd economic prejudices dressed up in high-minded sloganeering about “zero-sum games” and “beggar-thy-neighbor” effects.

And while the real exchange rate of the Chinese yuan may have increased by 25% since 2010, the real exchange rate of the dollar over the same period in which the US was allegedly pursuing a beggar thy nation policy increased by about 12%. The appreciation of the dollar reflects the relative increase in the strength of the US economy over the past 5 years, precisely the opposite of a beggar-thy-neighbor strategy.

And at an intuitive level, it is just absurd to think that China would have been better off if the US, out of a tender solicitude for the welfare of Chinese workers, had foregone monetary expansion, and allowed its domestic economy to stagnate totally. To whom would the Chinese have exported in that case?


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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