Some thoughts on currency crises and overshooting

So I've been teaching an international finance class, after a long while I might add. The discussion of currency crises models I think is interesting, since it is very revealing of the mainstream assumptions about the long run. Typical discussion would imply that in the long run the Quantity Theory of Money (QTM) and Purchasing Power Parity (PPP) hold. PPP means simply that the exchange rate adjusts for differences between the domestic and foreign price levels. Hence, we have that S =P/P*, where the star indicates foreign variable. If in addition we believe with the QTM that the central bank (CB) controls prices by controlling the money supply, then the CB can control the exchange rate indirectly.

In the figure below the 45o line shows the equilibrium levels of the exchange rate (S) as the price level, which is related to the money supply. Now suppose that the central bank fixes the exchange rate at S1 (the graph is based on Dornbusch representation in his classic paper; for now disregard the QQ curve). If the money supply is below the level that corresponds to P1, then the fixed exchange rate is too depreciated for the current stock of money, stimulating exports, discouraging imports, and leading to Current Account (CA) surpluses. In this case, the central bank would accumulate international reserves. The accumulation of reserves leads to increasing money supply and the economy moves to a new equilibrium.

If the central bank follows the rules of the game and it is credible (and the assumptions are also valid, meaning the economy has a tendency to full employment and increase in money supply only affect prices) then the money supply increases/decreases with the CA surpluses/deficits and the system converges to a stable equilibrium. However, if the commitment to the fixed-peg is not credible, and the rules of the game are not followed, then problems might arise. Imagine a situation in which the monetary authority continues to print money, to finance fiscal deficits for example, and the fixed exchange rate would now be below its equilibrium value (below the 45o line). Beyond the equilibrium point the central bank would start losing reserves. At some point, say when the money supply reaches the money supply level compatible with P2, the stock of reserves would be depleted. At this point, the central bank cannot defend the exchange rate anymore and the exchange rate jumps to S2. The Krugman model basically assumed exactly this, with the difference that if agents have rational expectations (perfect foresight in this case), then they would have an advantage to try to speculate against the currency before reserves are exhausted.*

In the model above the currency crisis occurs because the CB does not follow a monetary policy consistent with the fundamentals, that is, prints too much money to finance the government. Although, not immediatly obvious the model above is a simplified version of the Mundell-Fleming (MF) model, in the long run, when prices rather than income is the adjusting variable.In this case, the MF model can be represented with the exchange rate and prices, rather than output, as the adjusting variables. The QQ curve is a downward sloping curve, since higher prices increase money demand (or reduce the real money supply), leading to a higher rate of interest and a more appreciated exchange rate (lower S). Note the QQ curve is just the old LM for an open economy.

Also, because the QTM and PPP hold it must be true that increases in money supply lead to higher prices which lead to a proportional change in the nominal exchange rate, for a given foreign price and foreign money supply. In other words, the 45o degree line which corresponds to the proportional changes in domestic prices and the nominal exchange rate must still hold. We can derive the IS curve too, which would be upward sloping, but it is unnecessary, since if PPP holds then the economy must be in the long run on the 45o degree line.**

Dornbusch's trick, which was considered the first New Keynesian model (featuring both rational expectations and price rigidities), is that the nominal exchange rates adjusts faster than prices, then an increase in money supply would shift the QQ (LM) curve upwards. An increase in money supply reduces the domestic interest rate, leading to a depreciation of the currency. The economy moves from point A to point B. Then as depreciation increases net exports, and a lower rate of interest leads to more investment, there will be excess demand in the goods market, and for an economy that is at full employment, prices would go up. As prices go up, then the economy moves down the new QQ’ curve from point B to C, since with higher prices money demand increases and the rate of interest must increase (less than the initial decrease) causing some appreciation (less than the initial depreciation). At the new equilibrium the exchange rate is more depreciated than at the original equilibrium, but because of the short run rigidity of prices, the exchange rate overshoots its equilibrium value in the short-run. The point was that even if markets were efficient, in the sense that with price flexibility they tend to full employment and to the equilibrium exchange rate (PPP), the use of the exchange rate to deal with shocks might lead to excessive volatility.

There are many problems with the long run MF model (meaning the one solved in the S-P space). The obvious one is the notion that price flexibility leads to full employment, something that Keynes long ago suggested was NOT the case. Although Keynes was aware of the possibility of the system returning to full employment with price flexibility, he suggested that if lower prices had a negative impact on firms that are indebted, then investment would fall. In his own words: "indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment." In other words, with price flexibility the IS shifts back, and there is no tendency to full employment. That means that one should stick with the solution of the model in S-Y space, if one wants to introduce the open economy (one such model, without full employment and many other mainstream characteristics is available here).

Alternative (classical-Keynesian, post-Keynesian or whatever you prefer to call them) models would not only emphasize the role of quantity adjustments, but also the the sustainability of the current account (CA), rather than fiscal deficits in the explanation of currency crises. While conventional currency crises models of all generations (including the more heterogeneous 3rd generation models) suggest that at the heart of currency crisis there is a fiscal crisis, post-Keynesians emphasize terms of trade shocks and hikes to foreign rates of interest, highlighting the role of the balance of payments constraint in currency crises. Note that the economy in this view is not at full employment, and, hence the effect of fiscal expansions is not on prices, but on the level of activity. Higher level of income leads to increasing imports and a deteriorating CA. It’s the deteriorating CA and not the fiscal deficits that matter and the CA position might worsen even if the fiscal accounts are balanced. Further, after a currency crisis the central bank hikes the rate of interest, increasing the costs of debt-servicing, and, hence, government spending, at the same time that the recession reduces the revenue, leading to a weakening of the fiscal accounts. In this case, it is the external currency crisis that causes the domestic fiscal crisis. Causality is reversed. My two cents.

* Later models, like Obstfeld's, shown that if the costs of defending the parity are high, for example because in order to preclude the loss of reserves associated with a currency attack, the central bank hikes the rate of interest and pushes the economy into a recession, then there is a chance that self-fulfilling speculation might lead to a crisis.

** The IS curve would be positively sloped and steeper than a 45o line, since depreciation creates excess demand in the goods market. To restore equilibrium, domestic prices would have to increase, though proportionately less, since an increase in domestic prices affects aggregate demand, both via the relative price effect and via higher interest rates.

PS: I had posted before on my course here, were there is a link to Serrano and Summa's critique of the MF model.

Not even the IMF believes in Reinhart and Rogoff debt limits

From the intro to a new paper by two economists from the research department at the IMF:

"Influential papers such as Reinhart and Rogoff (2010) and Reinhart, Reinhart, and Rogoff (2012) argue that there is a threshold effect: when debt in advanced economies exceeds 90 percent of GDP there is an associated dramatic worsening of growth outcomes. Others dispute the notion that there is such a clear threshold and suggest that it is weak growth that causes high debt rather than high debt that causes weak growth (Panizza and Presbitero, 2012; Herndon, Ash, and Pollin, 2013). Using a new approach we found little evidence that there is any particular debt ratio above which growth falls sharply."

Not that there was much of a debate at this point. 

Economists and austerity errors

By Srinivas Raghavendra

Sir, – The famously infamous spreadsheet error by economists Carmen Reinhart and Kenneth Rogoff (Martin Wolf, Business, April 24th) and the subsequent debate on austerity has rightly or wrongly brought forth one important issue: the sensitivity of techniques, tools and methods that economists use to analyse economic data have immense consequences for economic policy.

The Massachusetts economists’ study that replicated the original Reinhart and Rogoff’s paper argues that in addition to the coding error they have also uncovered a non-standard weighting scheme and selective exclusion of available data, and they show that taking all these into account leads to the conclusion that the average GDP growth for countries with public-debt-to-GDP ratio of over 90 per cent is actually 2.2 per cent and not -0.1 per cent as estimated by Reinhart and Rogoff.

Read the rest here.

Who's afraid of foreign public debt?

Ricardo Hausmann decided to get his two cents on the public debt debate started by the Reinhart and Rogoff debacle. Hausmann was a famous defender of dollarization (see here his instructions for implementation, because, you know, it's a no brainer; you can go here to see his predictions that emerging markets will no longer have national currencies, since they cannot borrow long term in their own currencies) in the past, when he was the chief economist at the Inter-American Development Bank, and was for it in Argentina, Ecuador and other places.

Coming from Venezuela, Hausmann knows that foreign debt and domestic debt should not be mixed. He fudges the issue and does not explicitly says that public debt in national currency is not a problem (and that you cannot default on a currency you print), but he does say that: "The level of debt does matter, and its currency composition matters even more." In other words, foreign denominated debt does matter, since a government cannot monetize a foreign denominated debt. The level that matters is the foreign one, that is, the composition. That's all, and actually this points out a significant problem in Reinhart and Rogoff's work, which does not distinguish carefully enough between foreign and domestic denominated debt.

Note that the examples given by Hausmann of countries were high public debt became problematic ("Mexico in 1994, Russia in 1998, Ecuador in 1999, Argentina in 2001, Uruguay in 2002, the Dominican Republic in 2003, and even the UK in 1976") are all in countries which debt was denominated in foreign currency (dollars for the most part). His explanation that Spain could not pursue expansionary fiscal policy, because as deficits increased interest rates also increased, misses the point that Spain debt is in Euros, and the European Central Bank (ECB) has been, for the most part, unwilling to buy enough Spanish bonds to keep their interest rates low.*

So his conclusion that you must be an Austerian in a boom in order to be able to be a Keynesian in the crisis is plain wrong. Like his defense of dollarization (which he later retracted, and suggested a plan B for Argentina). The principle that debt in domestic currency is not problematic is fine, but his defense of austerity in the face of a recession for certain situations is just plain wrong. Hopefully he will change his principles on this subject too.

* Interestingly enough Spain is like a dollarized country, something he defended in the past.

Should the AER retract Reinhart and Rogoff's paper?

The case of Dutch social psychologist Diederik Stapel fraud, now in the news, which led to the retraction of several of his papers by academic journals suggests that this might be the right course of action for the American Economic Review (AER). Even if Reinhart and Rogoff's (RR) results do not necessarily amount to fraud, something that I'm sure could become a matter of dispute, it's still a fact that they are incorrect, as admitted by the authors. So the AER should clear the record and retract the paper that suggests that growth collapses when a country has a debt-to-GDP ratio of more than 90%.

PS: As the NYTimes notes there is a blog about scientific papers that are retracted here. The blog dealt with RR case here.

Rogaine and Braveheart on Austerity

More on the Reinhart and Rogoff debacle. It says a lot about the state of mainstream economics.

Does High Public Debt Consistently Stifle Economic Growth?

Thomas Herndon, Michael Ash and Robert Pollin show in this new paper that the studies by Carmen Reinhart and Kenneth Rogoff which correlate national debt-to-GDP ratios over 90% with sharp declines in growth are not correct. They find that when properly calculated, meaning using the full data set not just part of it, the average real GDP growth rate for countries carrying a public debt-to-GDP ratio of over 90% is actually 2.2 percent, not -0.1 percent as published in Reinhart and Rogoff (RR). That is, contrary to RR, average GDP growth at public debt/GDP ratios over 90% is not dramatically different than when debt/GDP ratios are lower. Reinhart and Rogoff claim the mistake resulted from a technical error involving a spreadsheet, and say that they “do not, however, believe this regrettable slip affects in any significant way the central message of the paper.” You would think that growing at 2.2% rather than a recession of 0.1% would make them think that their results are incorrect.

Ramblings on 21st century macroeconomics

Guillermo Calvo wrote a post on what he thinks is the new macroeconomics. Minsky gets cited, but that's pretty much the only concession to heterodox macroeconomics. The interpretation of what the "new" macro for the 21st century should be is basically New Keynesian price/wage rigidities models cum debt-deflation (the finance and Minsky part). But even the understanding of debt-deflation is limited to the notion of sudden stops (slowdown or reversal of capital inflows).

According to him:

"many of us have been involved in developing and testing theories in which imperfections in financial markets play a central role – and coining new terms like Sudden Stop and Phoenix Miracles. The dominant view, however, was that financial crises in EMs reflected weak institutions in that part of the world, and could not possibly take place in advanced economies. Unfortunately, the subprime crisis revealed, to the dismay of many in advanced economies, especially in Europe, that the world is more uniform than we thought!"

In other words, he seems to think that market imperfections are pervasive and that developed countries are vulnerable to sudden stops, like emerging markets (a terrible name popularized in the 1990s for developing countries, as if the only thing were the 'markets'). Note that while developing countries have not experienced sudden stops with the financial crash of 2008, and have used international reserves to insure against the volatility of financial markets (and often introduced capital controls too, when those were not already in place), no significant sudden stop affected the US, the epicenter of the crisis.

As noted by several heterodox economists the crisis in the US the deep causes of the crisis were associated to wage stagnation (worsening income distribution) and the associated increase in private debt, which led to a collapse of spending in the aftermath of the Lehman crisis. Mind you, at that point capital flows went into Treasury bonds, and no sudden stop affected the American economy (in contrast to say Argentina in 2002). So no, the world is not flat or "more uniform" that Calvo thought.

Just for those that might not remember, on dollarization this is what Calvo (paper with Carmen Reinhart) used to say back in 2000 (a few years before the Argentinean crisis; he was rumored as a possible finance minister at the time in Argentina, and the notion was that he was for dollarization):

"Exchange rate movements are costly in this environment. If policymakers take a hard look at the options for exchange rate regimes in emerging economies, they may find that floating regimes may be more of an illusion and that fixed rates--particularly, full dollarization--might emerge as a sensible choice for some countries, especially in Latin America or in the transition economies in the periphery of Euroland."

The sensible choice was dollarization (sic)! Note that his point was that with sufficient fiscal austerity, credibility would be restored, and capital would flow in the right direction (if you are from Greece, you should be afraid if this is the 'new' macro).

But back to sudden stops, which is the basis of his claim to have introduced financial markets into modern macro, here is what he had to say in his post, about the puzzles ahead:

"As recent empirical research has amply demonstrated, financial crisis follows credit boom; this is somewhat of a puzzle, but the most challenging puzzle in my opinion is that credit flows (both gross and net) increase in the run up of crisis, only to crash precipitously after the crisis' onset. ... In other words, if herding is the key word, forget about microfoundations of macroeconomics. I must confess that I am not ready to take such a radical stance. My view is that perhaps this very puzzling phenomenon is linked to liquidity and, more to the point, endogenous liquidity, a phenomenon that has been largely ignored in 20th century macroeconomics."

In other words, sudden stops are associated with collapse of liquidity, and those might be associated to herding behavior, which is irrational and is not amenable to formalizing microfoundations along conventional lines. There are so many misconceptions in this quote that one wonders when is he going to get the Sveriges Riksbank Prize (the often referred to as Nobel).

Endogenous liquidity, or endogenous money is no puzzle, and in fact, mainstream models that accept a Taylor rule have basically incorporated it, like Wicksell. Herding is not that complicated to understand, and is NOT the main problem with microfoundations. The problem with microfoundations is not lack of rationality of economic agents, but the fact that even with very rational (even by the limited mainstream standards) you cannot prove that markets lead to full utilization of resources, with flexible prices and full information (yes please go read on the capital debates).

Note that the effects of debt-deflation on demand are not discussed by Calvo. Or income distribution for that matter. Let alone the recognition that the idea of a natural rate is very difficult to defend, and I don't even mean logically, just empirically after this crisis. The essential information out of this piece is about the degree of confusion of the mainstream. It is increasingly clear that that we are living in a period of decadence of economics as a science, in which the profession is dominated by Vulgar economics.

Not so fast, the premature recovery problem

There is a certain brouhaha about the speed of the recovery. John Taylor says financial crises do not lead to slow recoveries (also Michael Bordo here). On the other hand, Krugman (and also Reinhart and Rogoff here) say that slow recoveries from financial crises are the norm. At stake, obviously, whether Romney is right and Obama is at fault for the slow recovery. Don't get me wrong, I would tend to agree that recoveries are relatively slow after a financial crisis, since deleveraging is a slow process.

Yet, that is not the main issue about this debate. The point is that ALL involved agree that the system has a natural (automatic) tendency to move back to the trend. Bordo refers nicely to Friedman's 'plucking' model. He reminds us, how it works:

"Friedman imagined the U.S. economy as a string attached to an upward sloping board, with the board representing the underlying long-run growth rate. A recession, in this view, was a downward pluck on the string; the recovery was when the string snapped back. The greater the pluck, the faster the bounce back to trend."

So the deeper the recession was, the faster would the recovery be. In other words, for the GOP economists (Taylor in this case) Obama is aborting holding back the economy and precluding what should be a premature or fast recovery. However, the point the critics make is that debt deleveraging makes the recovery slow, but it is more or less automatic anyway. Government is necessary to speed up something that markets, if they weren't imperfect, would do.

Krugman ideas are based on a recent paper on what he called the Fisher-Minsky-Koo model. Steve Keen has provided a full critique of a previous version here (h/t Lord Keynes who also provides an invaluable bibliography on debt deflations here). The essential point that generates an imperfection in the case of Krugman's model is that an external shock (a Wile E. Coyote moment in his terms, since agents finally notice the floor is gone) brings down the natural rate of interest, which becomes negative for a while (see my discussion on Krugman and the natural rate here). In that case, monetary stimulus is not capable of getting the economy naturally back on track, since the interest rate cannot fall below zero, and as a result agents cannot increase consumption enough to bring full employment automatically.

Hence, in the New Keynesian model of debt-deflation the change from more conventional neoclassical models is that they allow for a sudden (and exogenous) reduction in the debt limit that agents can borrow to reduce the natural rate. It's a financial shock (not a real one) that makes the rate of interest that would equilibrate investment with full employment savings (the inverse of consumption) negative. Agents suddenly understand that they would need a negative interest rate to satisfy their intertemporal consumption plans. From a post-Keynesian (I prefer classical-Keynesian but who cares), the problems are not related at all with the natural rate (yes the capital debates have shown that this makes no sense, where did I read that before?). So deleveraging has a direct effect on the ability of consumers to spend, and there would be no automatic bounce back if the equilibrium rate was not negative.

You may think it is a minor issue, and from a policy point of view it certainly the differences are minor. However, note that the New Keynesian version of the recovery suggests that markets are fundamentally, in the long run, efficient (again against logic and evidence) which is an essential totemic myth that they need to preserve.* And that has policy implications. Recoveries from financial crises are slow, as Krugman says, but not because the natural rate is negative. It is a political problem that involves class conflict. It is because agents that cannot consume out of wages (which have stagnated) cannot borrow themselves out of the crisis, and the federal government, the only one that can, will not do it for political reasons (to keep workers demands in line). That's why heterodox economists are not just for expansionary fiscal policy (and don't think that if the Fed signals more inflation investment confidence will pick up), but argue for higher wages, stronger unions, and debt relief.

* Let alone the funny thing that both sides in this dispute are basically arguing that the economy gravitates around a trend that is exogenous and attracts the actual economy (in a stronger or weaker way), and the way they actually measure the gravitational center (the natural trend) is by averaging the actual rates.

PS: And no, it's not a joke, they do actually sell that T-shirt!