Originally published November 30, 2011 on the New Economic Perspectives blog.
Thanks for comments. I hope you all recognize that this was blog 26; half way through a year of blogs—52 of them to be exact. Half way. A Job Well-Done I hope you all will agree. We are now half-educated. Half-wits, so to speak. It is all down-hill from here. We’ve done the hard lifting, now we apply what we’ve learned. Anway, on to the Q&A for the week.
Q1: What are pros and cons of having an open capital account? If Central Bank wants to defent currency parity by hiking interest rates in an environment of free capital movements, is the supposed mechanism that interest rate hikes should cause capital account inflows because private sector starts to borrow more in foreign currency? What are limits to this strategy? Some eastern european countries have most of their private debt denominated in foreign currency, for example 90% of mortgages in some countries. What limitations this puts on domestic policy options? In the GFC they chose to defend their exchange rates, taking deflationary domestic policy decisions instead. Was it mistake to allow private sector to became indebted in foreign currencies? Does MMT recognize balance of payments accounting identity explained here: http://en.wikipedia.org/wiki/B…, that Current Account + Capital Account + Change in Reserves = 0?
A: I’m generally skeptical of anything that is advertised as “free”, including “free” trade, “free” capital flows” or “free” markets more generally. There must be a catch. There is always a catch. So I have no problem with those who argue that capital “flows” must be constrained. Of course. All “flows” need constraints. Unconstrained “flows” will lead to floods and disasters. It is elementary, Dear Watson.
The Neoclassical view is that “free” flows are fine because “prices” will adjust. In the correct direction. This is faith-based economics, and it ain’t my religion. No, prices almost always run in the wrong direction, helping to fuel booms and busts. Any sovereign government that adopts “free”trade or capital “flows” on the belief that markets will be self-adjusting is either a fool or worse, a stooge. They don’t. They won’t.
Denominating debt in a foreign currency is almost always a mistake, and is fueled by the same Theoclassical religion that promotes “free”markets and capital “flows”. On one hand, it is hard to argue against the proposition that fools ought to be allowed to lose their money; but at the same time it is easy to argue that government and institutions designed to operate in the public purpose should be restrained from parting with “taxpayer money”. Of course, it is not taxpayer money, since every dollar came from the public sphere to begin with. Letting them fail is often the best option.
Finally, I never argue with identities. They are true. And that is an important one.
Q2: “a nation cannot run a current account deficit unless someone wants to hold its IOUs. We can even view the current account deficit as resulting from a rest ofworld desire to accumulate net savings in the form of claims on the country.” China, like Germany, wishes to be a net exporter. Maybe they are crazy, but that is what they want and that is how they run their economic policy. Is China really accumulating dollars only because they have a desire to accumulate dollars? Or is it that if they were to sell their enormous quantities of dollars in the fx market rather than holding on to them they would drive up the value of their own currency in terms of dollars, and they fear that such an increase would affect their ability to continue running a trade surplus? In fact, besides running a trade surplus, don’t they intervene in fx markets specifically to prop up the dollar and to hold down the value of their own currency?
I can see a strong motivation for holding dollars because they want to prevent a rising Yuan, but I have yet to hear an explanation for why they would want to hold dollars as their ultimate goal. I think they hold dollars only to facilitate their trade policy. Is there a point where they will no longer need to do this? If they become the largest economy in the world, for instance, might they want to divest their depreciating dollars, driving the dollar down even faster?
A: Certainly it is hard to explain Chinese accumulation of dollar assets simply on the basis that they want dollar assets. It must also be remembered that China learned from the Asian Tiger experience: they pegged rates to remove uncertainty. But the problem is that this committed them to making payments in a foreign currency—the US dollar. Eventually mkts doubted their ability to meet those commitments so all hell broke loose. So the Chinese learned that several trillion of dollar reserve assets is a good idea. Further, they understand that export led growth is temporary; they will raise wages and reduce exports.
Q3: In a world without import/export restrictions and where every country had a floating currency, would there still be foreign trade “imbalances” or would exchange rates move so that the “imbalances” balance out? Why do certain countries decide to peg their currency against a foreign currency (e.g. US Dollars)? When is it beneficial to peg or not peg?
A: Answer to first question: NO! As discussed below, we’ve got a current account (deficit) that is offset by a current account surplus. It is sustainable. Exchange rates do not move to balance trade. They must also play a role in investment goods and financial assets.
Q4: “The reason is because those economists who had believed that exchange rates adjust to
eliminate current account surpluses and deficits had not taken into account that an “imbalance” is not necessarily out of balance. As discussed previously, a country can run a current account deficit so long as the rest of the world wants to accumulate its IOUs.” But why does the rest of the world want to accumulate our IOUs? Isn’t it mostly countries like China looking to accumulate foreign reserves to defend their peg against the US? It seems the players that matter haven’t yet adopted floating exchange rates, so I am not sure how fairit is to critique Milton’s hypothesis in this light. Your point is taken about the semantic usage about the words ‘trade imbalance,’ although I imagine people like Milton also use it more broadly in the sense that they believe deviations from free trade practices result in ‘imbalances,’ or in other words, the difference in outcomes between a world with free trade and one without.
A: Will do. Later.
Q6: Are you going to get into more detail on the topic of capital controls? I’d be interested to learn more about the policy options and their implications in that regard.
A: Sure. Sovereign countries should never submit them to the control by Wall St or London.
Q7: “Inflation and currency depreciation are possible outcomes if government spends too much.”
Here we get into the different definitions of ‘inflation’. The main concern I always get when I put the ‘just let the currency float’ argument is that there will be a ‘currency crisis’. In the UK that translates into a Sterling Crisis and is embedded in the domestic psyche much like Weimar is in Germany – due to the 1976 ‘crisis’. The main argument is that the price of things will shoot up, ie we will have ‘inflation’ in the common sense. Really a reduction in the standard of living in economic terms due to supply side inflation. What can a domestic government do to buffer the effects of a ‘currency crisis’?
A: Currency crises so far as I am aware ONLY affect countries that try to peg. The UK tried that, and failed. Then they joined the floating world. No more currency crises. Now, can exchange rates flux on a floating system? You betcha. Will that be more painful for a country like Oz that exports its commodities? You betcha. Cowboy up, as we say in America. It is better than the alternative: exchange rate crises and default. Look at the EMU.