Posts Tagged 'quantitative easing'

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

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Stephen Williamson Gets Stuck at the Zero Lower Bound

Stephen Williamson started quite a ruckus on the econblogosphere with his recent posts arguing that, contrary to the express intentions of the FOMC, Quantitative Easing has actually caused inflation to go down. Whether Williamson’s discovery will have any practical effect remains to be seen, but in the meantime, there has been a lot head-scratching by Williamson’s readers trying to figure out how he reached such a counterintuitive conclusion. I apologize for getting to this discussion so late, but I have been trying off and on, amid a number of distractions, including travel to Switzerland where I am now visiting, to think my way through this discussion for the past several days. Let’s see if I have come up with anything enlightening to contribute.

The key ideas that Williamson relies on to derive his result are the standard ones of a real and a nominal interest rate that are related to each other by way of the expected rate of inflation (though Williamson does not distinguish between expected and annual inflation, that distinction perhaps not existing in his rational-expectations universe). The nominal rate must equal the real rate plus the expected rate of inflation. One way to think of the real rate is as the expected net pecuniary return (adjusted for inflation) from holding a real asset expressed as a percentage of the asset’s value, exclusive of any non-pecuniary benefits that it might provide (e.g., the aesthetic services provided by an art object to its owner). Insofar as an asset provides such services, the anticipated real return of the asset would be correspondingly reduced, and its current value enhanced compared to assets providing no non-pecuniary services. The value of assets providing additional non-pecuniary services includes a premium reflecting those services. The non-pecuniary benefit on which Williamson is focused is liquidity — the ease of buying or selling the asset at a price near its actual value — and the value enhancement accruing to assets providing such liquidity services is the liquidity premium.

Suppose that there are just two kinds of assets: real assets that generate (or are expected to do so) real pecuniary returns and money. Money provides liquidity services more effectively than any other asset. Now in any equilibrium in which both money and non-money assets are held, the expected net return from holding each asset must equal the expected net return from holding the other. If money, at the margin, is providing net liquidity services provided by no other asset, the expected pecuniary yield from holding money must be correspondingly less than the expected yield on the alternative real asset. Otherwise people would just hold money rather than the real asset (equivalently, the value of real assets would have to fall before people would be willing to hold those assets).

Here’s how I understand what Williamson is trying to do. I am not confident in my understanding, because Williamson’s first post was very difficult to follow. He started off with a series of propositions derived from Milton Friedman’s argument about the optimality of deflation at the real rate of interest, which implies a zero nominal interest rate, making it costless to hold money. Liquidity would be free, and the liquidity premium would be zero.

From this Friedmanian analysis of the optimality of expected deflation at a rate equal to the real rate of interest, Williamson transitions to a very different argument in which the zero lower bound does not eliminate the liquidity premium. Williamson posits a liquidity premium on bonds, the motivation for which being that bonds are useful by being readily acceptable as collateral. Williamson posits this liquidity premium as a fact, but without providing evidence, just an argument that the financial crisis destroyed or rendered unusable lots of assets that previously were, or could have been, used as collateral, thereby making Treasury bonds of short duration highly liquid and imparting to them a liquidity premium. If both bonds and money are held, and both offer the same zero nominal pecuniary return, then an equal liquidity premium must accrue to both bonds and money.

But something weird seems to have happened. We are supposed to be at the zero lower bound, and bonds and money are earning a liquidity premium, which means that the real pecuniary yield on bonds and money is negative, which contradicts Friedman’s proposition that a zero nominal interest rate implies that holding money is costless and that there is no liquidity premium. As best as I can figure this out, Williamson seems to be assuming that the real yield on real (illiquid) capital is positive, so that the zero lower bound is really an illusion, a mirage created by the atypical demand for government bonds for use as collateral.

As I suggested before, this is an empirical claim, and it should be possible to provide empirical support for the proposition that there is an unusual liquidity premium attaching to government debt of short duration in virtue of its superior acceptability as collateral. One test of the proposition would be to compare the yields on government debt of short duration versus non-government debt of short duration. A quick check here indicates that the yields on 90-day commercial paper issued by non-financial firms are very close to zero, suggesting to me that government debt of short duration is not providing any liquidity premium. If so, then the expected short-term yield on real capital may not be significantly greater than the yield on government debt, so that we really are at the zero lower bound rather than at a pseudo-zero lower bound as Williamson seems to be suggesting.

Given his assumption that there is a significant liquidity premium attaching to money and short-term government debt, I understand Williamson to be making the following argument about Quantitative Easing. There is a shortage of government debt in the sense that the public would like to hold more government debt than is being supplied. Since the federal budget deficit is rapidly shrinking, leaving the demand for short-term government debt unsatisfied, quantitative easing at least provides the public with the opportunity to exchange their relatively illiquid long-term government debt for highly liquid bank reserves created by the Fed. By so doing, the Fed is reducing the liquidity premium. But at the pseudo-zero-lower bound, a reduction in the liquidity premium implies a reduced rate of inflation, because it is the expected rate of inflation that reduces the expected return on holding money to offset the liquidity yield provided by money.

Williamson argues that by reducing the liquidity premium on holding money, QE has been the cause of the steadily declining rate of inflation over the past three years. This is a very tricky claim, because, even if we accept Williamson’s premises, he is leaving something important out of the analysis. Williamson’s argument is really about the effect of QE on expected inflation in equilibrium. But he pays no attention to the immediate effect of a change in the liquidity premium. If people reduce their valuation of money, because it is providing a reduced level of liquidity services, that change must be reflected in an immediate reduction in the demand to hold money, which would imply an immediate shift out of money into other assets. In other words, the value of money must fall. Conceptually, this would be an instantaneous, once and for all change, but if Williamson’s analysis is correct, the immediate once and for all changes should have been reflected in increased measured rates of inflation even though inflation expectations were falling. So it seems to me that the empirical fact of observed declines in the rate of inflation that motivates Williamson’s analysis turns out to be inconsistent with the implications of his analysis.

Liquidity Trap or Credit Deadlock

In earlier posts in my series about Hawtrey and Keynes, I’ve mentioned the close connection between Hawtrey’s concept of a “credit deadlock” and the better-known Keynesian concept of a “liquidity trap,” a term actually coined by J. R. Hicks in his classic paper summarizing the Keynesian system by way of the IS-LM model. As I’ve previously noted, the two concepts, though similar, are not identical, a characteristic of much of their work on money and business cycles. Their ideas, often very similar, almost always differ in some important way, often leading to sharply different policy implications. Keynes recognized the similarities in their thinking, acknowledging his intellectual debt to Hawtrey several times, but, on occasion, Keynes could not contain his frustration and exasperation with what he felt was Hawtrey’s obstinate refusal to see what he was driving at.

In this post, commenter GDF asked me about the credit deadlock and the liquidity trap:

Would you mind explaining your thoughts apropos of differences between Hawtrey’s credit deadlock theory and Keynes’ liquidity trap. It seems to me that modern liquidity trapists like Krugman, Woodford etc. have more in common with Hawtrey than Keynes in the sense that they deal with low money demand elasticity w.r.t. the short rate rather than high money demand elasticity w.r.t. the long rate.

To which I answered:

My view is that credit deadlock refers to a situation of extreme entrepreneurial pessimism, which I would associate with negative real rates of interest. Keynes’s liquidity trap occurs at positive real rates of interest (not the zero lower bound) because bear bond speculators will not allow the long-term rate to fall below some lower threshold because of the risk of suffering a capital loss on long-term bonds once the interest rate rises. Hawtrey did not think much of this argument.

Subsequently in this post, commenter Rob Rawlings suggested that I write about the credit deadlock and provided a link to a draft of a paper by Roger Sandilands, “Hawtreyan ‘Credit Deadlock’ or Keynesian ‘Liquidity Trap’? Lessons for Japan from the Great Depression” (eventually published as the final chapter in the volume David Laidler’s Contributions to Economics, edited by Robert Leeson, an outstanding collection of papers celebrating one of the greatest economists of our time). In our recent exchange of emails about Hawtrey, Laidler also drew my attention to Sandilands’s paper.

Sandilands’s paper covers an extremely wide range of topics in both the history of economics (mainly about Hawtrey and especially the largely forgotten Laughlin Currie), the history of the Great Depression, and the chronic Japanese deflation and slowdown since the early 1990s. But for this post, the relevant point from Sandilands’s paper is the lengthy quotation with which he concludes from Laidler’s paper, “Woodford and Wicksell on Interest and Prices: The Place of the Pure Credit Economy in the Theory of Monetary Policy.”

To begin with, a “liquidity trap” is a state of affairs in which the demnd for money becomes perfectly elastic with respect to a long rate of interest at some low positive level of the latter. Until the policy of “quantitative easing” was begun in 2001, the ratio of the Japanese money stock to national income, whether money was measured by the base, M1, or any broader aggregate, rose slowly at best, and it was short, not long, rates of interest that were essentially zero. Given these facts, it is hard to see what the empirical basis for the diagnosis of a liquidity trap could have been. On the other hand, and again before 2001, the empirical evidence gave no reason to reject the hypothesis that a quite separate and distinct phenomenon was at work, namely a Hawtreyan “credit deadlock”. Here the problem is not a high elasticity of the economy’s demand for money with respect to the long rate of interest, but a low elasticity of its demand for bank credit with respect to the short rate, which inhibits the borrowing that is a necessary prerequisite for money creation. The solution to a credit deadlock, as Hawtrey pointed out, is vigorous open market operations to bring about increases in the monetary base, and therefore the supply of chequable deposits, that mere manipulation of short term interest rates is usually sufficient to accomplish in less depressed times.

Now the conditions for a liquidity trap might indeed have existed in Japan in the 1990s. Until the credit deadlock affecting its monetary system was broken by quantitative easing in 2001 . . . it was impossible to know this. As it has happened, however, the subsequent vigorous up-turn of the Japanese economy that began in 2002 and is still proceeding is beginning to suggest that there was no liquidity trap at work in that economy. If further evidence bears out this conclusion, a serious policy error was made in the 1990s, and that error was based on a theory of monetary policy that treats the short interest rate as the central bank’s only tool, and characterizes the transmission mechanism as working solely through the influence of interest rates on aggregate demand.

That theory provided no means for Japanese policy makers to distinguish between a liquidity trap, which is a possible feature of the demand for money function, and a credit deadlock which is a characteristic of the money supply process, or for them to entertain the possibility that variations in the money supply might affect aggregate demand by channels over and above any effect on market rates of interest. It was therefore a dangerously defective guide to the conduct of monetary policy in Japan, as it is in any depressed economy.

Laidler is making two important points in this quotation. First, he is distinguishing, a bit more fully than I did in my reply above to GDF, between a credit deadlock and a liquidity trap. The liquidity trap is a property of the demand for money, premised on an empirical hypothesis of Keynes about the existence of bear speculators (afraid of taking capital losses once the long-term rate rises to its normal level) willing to hold unlimited amounts of money rather than long-term bonds, once long-term rates approach some low, but positive, level. But under Keynes’s analysis, there would be no reason why the banking system would not supply the amount of money demanded by bear speculators. In Hawtrey’s credit deadlock, however, the problem is not that the demand to hold money becomes perfectly elastic when the long-term rate reaches some low level, but that, because entrepreneurial expectations are so pessimistic, banks cannot find borrowers to lend to, even if short-term rates fall to zero. Keynes and Hawtrey were positing different causal mechanisms, Keynes focusing on the demand to hold money, Hawtrey on the supply of bank money. (I would note parenthetically that Laidler is leaving out an important distinction between the zero rate at which the central bank is lending to banks and the positive rate — sufficient to cover intermediation costs – at which banks will lend to their customers. The lack of borrowing at the zero lower bound is at least partly a reflection of a disintermediation process that occurs when there is insufficient loan demand to make intermediation by commercial banks profitable.)

Laidler’s second point is an empirical judgment about the Japanese experience in the 1990s and early 2000s. He argues that the relative success of quantitative easing in Japan in the early 2000s shows that Japan was suffering not from a liquidity trap, but from a credit deadlock. That quantitative easing succeeded in Japan after years of stagnation and slow monetary growth suggests to Laidler that the problem in the 1990s was not a liquidity trap, but a credit deadlock. If there was a liquidity trap, why did the unlimited demand to hold cash on the part of bear speculators not elicit a huge increase in the Japanese money supply? In fact, the Japanese money supply increased only modestly in the 1990s. The Japanese recovery in the early 200s coincided with a rapid increase in the money supply in response to open-market purchases by the Bank of Japan.  Quantitative easing worked not through a reduction of interest rates, but through the portfolio effects of increasing the quantity of cash balances in the economy, causing an increase in spending as a way of reducing unwanted cash balances.

How, then, on Laidler’s account, can we explain the feebleness of the US recovery from the 2007-09 downturn, notwithstanding the massive increase in the US monetary base? One possible answer, of course, is that the stimulative effects of increasing the monetary base have been sterilized by the Fed’s policy of paying interest on reserves. The other answer is that increasing the monetary base in a state of credit deadlock can stimulate a recovery only by changing expectations. However, long-term expectations, as reflected in the long-term real interest rates implicit in TIPS spreads, seem to have become more pessimistic since quantitative easing began in 2009. In this context, a passage, quoted by Sandilands, from the 1950 edition of Hawtrey’s Currency and Credit seems highly relevant.

If the banks fail to stimulate short-term borrowing, they can create credit by themselves buying securities in the investment market. The market will seek to use the resources thus placed in it, and it will become more favourable to new flotations and sales of securities. But even so and expansion of the flow of money is not ensured. If the money created is to move and to swell the consumers’ income, the favourable market must evoke additional capital outlay. That is likely to take time and conceivably capital outlay may fail to respond. A deficiency of demand for consumable goods reacts on capital outlay, for when the existing capacity of industries is underemployed, there is little demand for capital outlay to extend capacity. . .

The deadlock then is complete, and, unless it is to continue unbroken till some fortuitous circumstance restarts activity, recourse must be had to directly inflationary expedients, such as government expenditures far in excess of revenue, or a deliberate depreciation of the foreign exchange value of the money unit.


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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