The behavior of the nominal exchange rate between the Brazilian Real and the dollar in 2024

By Nathalie Marins, Ricardo Summa & Daniel Consul (Guest bloggers)

Currency devaluations can disrupt developing economies by raising import costs and food prices, which in turn reduces real wages. This impact is particularly detrimental to lower-income households, which typically allocate a substantial portion of their income to essential goods. Consequently, when the local currency weakens, governments encounter increased political pressure due to rising prices that erode purchasing power. Throughout 2024, the Brazilian real faced a continuous process of depreciation that intensified in December, prompting headlines accusing recent fiscal policy decisions of triggering a full-blown currency crisis. However, a closer look at the data suggests that external financial factors, monetary and exchange rate policy choices, and a short-term “flight to quality” played a far more significant role in driving this depreciation. In the following pages, we will examine the behavior of Brazil's currency in 2024 and explore the factors behind this trend.

Read rest here.

Exchange Rate Arrangements: Fix, Float, or Manage?

Updated version of a textbook chapter on exchange rate arrangements. It is for undergraduate use. From the abstract:

The paper tries to provide a concise summary of the main debates on exchange rate arrangements. It a simple taxonomy of exchange rate arrangements, fixed, flexible and managed, and a brief analysis of the main debates about their advantages and disadvantages. It emphasizes the different policy objectives of mainstream and heterodox schools of thought, suggesting that they tend to be more relevant than the specific defense of one particular exchange rate arrangement. In that sense, there are divergences on their preferences within schools of thought. The paper also discusses the causes of currency crises and the role of the dollar in the international monetary system.

Full paper can be downloaded here.

Exchange rates and income distribution in a surplus approach perspective

Old paper, presented two years ago in México, and to be published soon by the university press there. In Spanish. For those interested. The model is the same (with minor changes) one used to discuss inflation, in an old paper, eventually published here in a book on Post Keynesian economics edited by Forstater and Wray. Link here.

More on currency crises and the euro crisis

I wrote a while ago about currency crises (see here). There I suggested that classical-Keynesian or post-Keynesian views on currency crises invert the causality between fiscal and balance of payments problems in a currency crisis. Currency crises are not caused by excessive fiscal spending financed by monetary emissions, which would lead to inflation, and eventually after a run on the currency and depletion of reserves to a devaluation, but on current account problems.

There two key problems with the conventional view. On the one hand, the very monetarist notion that increases in money supply have direct impact on prices, and no effect on quantities. That would be an extreme natural rate hypothesis. But also that these models presume that fiscal deficits and debt denominated in domestic currency are the problem in currency crises, when the relevant debt is the foreign one, related to the current account deficit, and denominated in foreign currency. In other words, whereas default in the former is not possible, in the latter it clearly is. The mismatch between government receipts in domestic currency and foreign debt obligations in foreign currency is the key problem in currency crises.

Fiscal deficits might play a role in a currency crisis, but it is ultimately an indirect one. If the fiscal deficit, by leading to an increase in the level of activity (not prices) leads to a current account deficit, then it does exacerbate the external constraint of the economy, and might contribute to the eventual depreciation. Note that this suggests that the variations of the level of income are more relevant for the adjustment of the balance of payments, than changes in the exchange rate, something noted for the case of peripheral economies, in particular Argentina during the Gold Standard, by A. G. Ford (for a discussion of that go here).

In a classical-Keynesian view the fiscal crisis might be a result of the currency crisis, and not vice versa (as I discussed for Brazil here). If the crisis leads to a recession, then fiscal revenues collapse, and spending increases, particularly unemployment insurance expenditures, welfare spending, and transfers, exacerbating the fiscal problems. Further, the central bank might hike the domestic interest rate, to preclude capital flight and further devaluation and that would have an additional effect on interest payments on domestic debt, also worsening the fiscal stance.

This currency crisis story might have some relation to the current debate between Marc Lavoie and Sergio Cesaratto on whether the European crisis should be seen as a a monetary sovereignty problem (Marc) or balance of payments crisis (Sergio). Both would agree that the crisis is not the result of fiscal problems, as described above. Even in Greece, that had higher fiscal deficits than others, the relevance of those deficits, and the enforcing of brutal austerity afterwards, has been associated to the current account. Note that in common currency areas, like the United States, federal fiscal transfers (and not just inter-state transfers) would allow for imbalances to continue without leading to contraction of output to reduce the regional balance of payments constraints, as noted by Nate Cline and David Fields here.

Alternatively, in the absence of fiscal transfers from a federal European government, if the European Central Bank (ECB) had the ability to buy euro denominated bonds of peripheral countries and keep their borrowing costs low, fiscal policy could be used by member countries, without risk of default. That's what Marc Lavoie has argued, that at the heart of the problem there is a monetary sovereignty problem. Basically the ECB could transform what is effectively a foreign currency problem, since peripheral countries have a constraint in euros, into an essentially domestic problem with no risk of default. On the other hand, it is also true that the manifestation of the euro crisis is in the form of a regular balance of payments problem, as noted by Sergio Cesaratto. In a sense, both are correct. The imbalances in the current account, which Sergio puts at the center, become relevant because in the absence of fiscal transfers, and of a monetary authority providing a zero risk asset for governments to borrow in times of crisis, as emphasized by Marc, the adjustment is done by variations of the level of income.

The difference might lie not so much in the diagnostic, which is basically the same (they also agree on Keynesian fashion that the current account adjustment is done by variations in quantities not prices), but on the policy alternatives. Sergio's emphasis seems to suggest that exit is the best alternative. Marc's views would indicate that reforming the institutions would be better (mind you, they might think differently, I'm suggesting what the different emphasis might imply). It is unclear to me that depreciation and exit from the euro would solve the problems of peripheral countries (on the role of depreciation on solving the external problem in Greece, that is, Greexit, go here). On the other hand, the reform of the European institutional framework has proceeded at pace that seems too slow for the magnitude of the problems faced in the peripheral countries. There is no good alternative.

PS: The Troika's solution is austerity, since the the crisis is seen as a fiscal problem, as in conventional currency crises models. And the ECB should in that framework remain concerned only with inflation.

Smithin on Endogenous Money, Fiscal Policy, Interest and Exchange Rates

New Working Paper by John Smithin. From the Introduction:

One of the main collective contributions of the various heterodox schools of monetary thought, such as circuit theory, Post Keynesian theory, in both its horizontalist and structuralist versions, modern money theory (now known simply by its acronym MMT), and others, has been to stress the importance of the endogeneity of money via bank credit creation. This issue was hardly discussed at all in the economics mainstream after Keynes’s death, not until the very end of twentieth century and the beginning of the twenty-first.

Read rest here.

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.

Financialization and the Resource Curse in Brazil

"Financialization and the Resource Curse: The Challenge of Exchange Rate Management in Brazil"

By Kevin P. Gallagher and Daniela Magalhães Prates

Indeed, Brazil has been blessed and cursed with high commodity prices (from 2003 to mid-2008 and 2009-2011) and low interest rates in the core economies after the 2008 global financial crisis. Such an environment, coupled with the high domestic policy rate and the sophistication of the Brazilian financial system, has made Brazil a much sought after destination for carry trade operations through short-term financial flows that are largely transmitted through the foreign exchange derivatives market. Speculative operations into this market have accentuated the upward pressure on the exchange rate, which has come with higher commodities prices, leading to what we refer to here as a financialization of the resource curse (pp. 2).

Read rest here.

Bill Lucarelli on The Euro: A currency in search of a state

 

New paper concerning Euro by Bill Lucarelli

From the abstract:

To understand the structural dynamics of the current eurozone crisis, it is necessary to examine the longstanding internal contradictions that the system has inherited from its inception under the Maastricht Treaty and the neoliberal strategy which has governed its evolution from the first experiments in economic and monetary union in the 1970s. A brief narrative of the evolution of the European Monetary Union yields some insights into its peculiar institutional design. More specifically, the article examines the dangerously self-reinforcing logic between speculative bond markets and cascading, deflationary policies of austerity imposed on those countries encountering severe debt crises. This examination reveals the fragile foundations upon which the eurozone was constructed [...] The stark contrast between US monetary and exchange rate policies and the straightjacket imposed in the eurozone by the ECB during the financial crisis that began in 2008 could not be more revealing. As David Fields and Matias Vernengo (2012) [see here] contend,

By buying great quantities of Treasuries, the Fed not only keeps stable bond prices and low interest rates, but also provides assurances that Treasury bonds remain a secure asset. That allows the US Treasury to maintain high fiscal deficits on a sustainable basis. That is the exact opposite of what the ECB has done for the countries in the periphery of Europe. Countries in the currency union lose control of monetary policy and cannot depreciate the exchange rate. But a common currency setting also brings to an end the possibility for a single nation to run fiscal deficits since the sources of funding are either removed or subjected to supra-national control.

Read rest here (subscription required).

On the Argentine crisis again

This week the Supreme Court heard the case of the Vulture Funds against Argentina. I wrote a while ago about that here. The paper on the more recent crisis and devaluation is available here.

McKinnon and Wolf on global imbalances and Chinese liberalization

This is a bit old. It was published earlier this month in the Financial Times, as a response to Wolf's column. McKinnon is a well-known exchange rate specialist, and one of the few that has, correctly in my judgment, not been overly concerned with the international role of the dollar for the last three decades. His concern with Chinese liberalization of financial markets is that it would lead to inflows, since interest rates in the developed world are too low, and instead of balancing the trade surpluses, it would lead to more accumulation of reserves. The implicit notion is that if rates of interest were higher abroad, and Chinese funds flowed abroad it would be okay to liberalize, one supposes.

Note that this is also what Martin Wolf suggested in the original column (subscription required). In his words: "In the long run China’s capital account will presumably become largely open and in time, no doubt, China’s savers will own large parts of the world." In other words, the idea is that Chinese funds would finance the over spending in the rest of the world, and help in dealing with global imbalances, and Chinese savers would invest in real assets abroad. In contrast, if inflows were added to the trade surpluses, the Chinese would add to the 'problem' of the global imbalances.

Note that this view goes hand in hand with the notion that the accumulation of reserves is intrinsically bad. Wolf says:

"The principal form of capital outflow has been the accumulation of foreign currency reserves by the government. At $3.8tn last December (almost $3,000 for each Chinese person), these are gigantic and extremely unrewarding. It would be far better if some of this were converted into real assets."

Don't get me wrong, China holds more reserves than it needs for avoiding a currency crisis, or any sort of balance of payments problem that might arise (in a very distant future). Yet, the notion that China could open the capital account and not get into the kinds of problems that all the countries that liberalized financial markets did seems excessively optimistic.

There is essentially no problem if China maintains a trade surplus and attracts capital flows, increasing their reserves. And that has no relation to the financing of their investment, or the transition to a more consumer oriented economy. As I said a while ago global rebalancing is one of the myths of the current crisis. If the US grows faster, say as the result of an improbable fiscal expansion, the imbalances would grow larger, and that would be good.

I hope that China doesn't open the capital account, but that has nothing to do with the global imbalances, and all to do with the problems of financial liberalization.

In the long run China’s capital account will presumably become largely open and in time, no doubt, China’s savers will own large parts of the world. - See more at: http://magazine.thenews.com.pk/mag/moneymatter_detail.asp?id=7688&catId=194#sthash.fw6I8fiF.dpuf

Is Venezuala's SICAD II Resolving Exchange Rate Problems?

 By Mark Weisbrot

All economies have major structural and policy problems, but some problems are more important and urgent than others at particular times. In Venezuela, the most important economic problem is in the exchange rate system. A fixed exchange rate system with periodic devaluations tends to be more crisis-prone than other exchange rate regimes, especially in a country like Venezuela where inflation has historically been higher than that of its trading partners. This is particularly important right now because opposition leaders who have called for the overthrow of the government have pointed to 57 percent inflation and widespread shortages of consumer goods as justification for (often violent) street protests over the past two months. Although the protests have failed to attract the working and poorer people who are most hurt by the shortages, they are still a major complaint – as is inflation – for most Venezuelans.

Read rest here

Mark Weisbrot: Will Venezuela's New Floating Exchange Rate Curb Inflation?

Since Venezuela exports petroleum and petroleum byproducts and imports most of what it needs, the exchange rate is crucial for economic stability. Food scarcity and inflation has been cited among the reasons why there is ongoing protests in Venezuela. Hoping to quell some of this protest, last week the Bank of Venezuela introduced another exchange system, Sicad II, hoping to take control of inflation and scarcity of essential goods.To discuss all this and more is our guest, Mark Weisbrot, who recently returned from Venezuela. Mark Weisbrot is an economist and codirector of the Center for Economic and Policy Research in Washington, D.C.

Coordinate Currencies or Stagnate

By Thomas I. Palley

The global economy needs exchange rate coordination now. Absent that, the world is likely to be increasingly afflicted by exchange rate fluctuations and policy acrimony. These are bound to undermine the economic recovery and increase the likelihood of stagnation.

Read the rest here.

China's overvalued currency?

The Economist finally gets what we said long ago using their data. And the appreciation is bigger than what they think.

The dollar has NOT depreciated since the 1970s?

Mike Norman had an intriguing graph a while ago (see here) showing that if one uses the broad, rather than the major currencies, index for the US trade weighted exchange rate, then the dollar did not depreciate (which I prefer to go down, since if you define the exchange rate as the domestic price of foreign currency, as most countries do, up is actually a depreciation). I decided to explore the issue. I reproduce the graph below, putting both indexes together.

Note that these are nominal exchange rates. The broad index, as noted by Mike, actually only depreciates in the 2000s, and overall has not depreciated.

The difference between the two rates are the countries that are included in the respective indexes. In the broad index there are 26 countries (one is not a country really, the Euro-area), while the major currencies index includes only 7 currencies, which are traded widely outside of their home country, namely: the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. The broad index includes developing countries like Argentina, Brazil, Chile, China, India, Mexico, Russia, South Korea and Venezuela. An explanation of how the indexes are built can be found here. The weights used now for calculating the indexes are here.

Note that rates of inflation in developing countries, particularly in the 1970s and 1980s, when the two exchange rates diverge widely, were considerably higher than the rates of inflation (which were at historical high levels, but much lower) in developed countries and the US. So what happens when we look at the real indexes, broad and major currencies?

As it can be seen, the real indexes are quite similar, and by all measures the dollar has depreciated in real terms from the early 1970s, with two big swings associated to the Reagan and Clinton (asset bubble driven) booms. The point is that in countries with higher inflation than the US depreciated their currencies in nominal terms significantly (in part that explains their higher inflation rates), and in nominal terms the US currency appreciated, but once inflation is taken into consideration the index looks very much like the major currencies one, with an overall depreciation of about 20% or so in real terms.

Note that this does NOT threaten the international position of the dollar, and the US does not need to depreciate its currency to solve a current account problem. And in fact if you look at the last crisis, which started in the US, you still had an appreciation associated to a run to the dollar. For more on that see this paper.

Labor Theory of Beer

The graph above shows the number of minutes that workers have to work to buy 500ml of beer (h/t to Renata Lins of chopinhofemenino, great blog if you read Portuguese). By the way, a pint in the US is slightly less than that (around 473ml). Note that the amount of time a worker needs to work depends on the price in dollars. So, for example, China is at the bottom of the list, with workers getting to bliss (yep a General Equilibrium concept bitches) in less than ten minutes, because beer is cheap in dollars, not as a result of high wages. Japanese workers, on the other hand, with higher wages, need to work more like 15 minutes because beer is really expensive.

What's the deal with PPP?

In a previous post I suggested that there might some problems with using Purchasing Power Parity (PPP) measures of income per capita, the traditional measure of well-being used by the World Bank, for example. And although some might think that the main problems are basically empirical, my fundamental preoccupation is theoretical (see this paper, which in fact comes from my thesis).

PPP was developed by Gustav Cassel as an extension of the Quantity Theory of Money (QTM) to international matters. The quantity of money determined domestically the internal price level, and the exchange rate was determined as the ratio of domestic and foreign prices (or vice versa depending on how you define the exchange ratio), or in dynamic versions, the change in the exchange rate was defined as the difference of the inflation rates.

Wicksell was very critical of Cassel's theory, as I note in my paper [there were significant personal differences between the two main authors of the Swedish school, beyond their divergences on economic theory]. He basically suggested that the rate of interest, the natural rate determined by the productivity of capital and the savings decisions of economic agents, was the key variable, not the money supply. Hence, the bank rate, if it was lower than the natural rate, would not only generate his famous cumulative process of inflation, but it would also lead to flows of capital, provided that it was not in line with the bank rate of interest in other countries, and would basically determined the foreign exchange rate [note that Wicksell, and not the Keynes of the Tract, as is often argued, is the first, in 1919, to defend what we would today refer to as the uncovered interest parity condition].

From our perspective what matters here is that, even within the marginalist approach, the notion that the Quantity of Money, and prices, determine the equilibrium exchange rate is ultimately incorrect, once money is endogenous, as Wicksell assumed [note that the modern consensus in macroeconomics, both the New Keynesians and the so-called New Neoclassical Synthesis, assume an exogenous rate of interest, using some sort of rule, typically a variation of Taylor's rule]. Further, if we assume free capital movement, which implies a uniform rate of profit, marginalism would require that capital would flow to places in which it is scarce, and eventually (in the long run) the rate of profit or the natural rate of interest would be equalized.* Hence, the exchange rate that would be establish after the process is complete, would correspond to the uniform natural rate, which governs the bank rate, which as we saw is what Wicksell suggested determines exchange rate. So there must exist a natural exchange rate that corresponds to the natural rate of interest (and the natural rate of unemployment and its correspondent real wage, Friedman would argue).

It is obvious that there are 'imperfections' and the natural rate of interest is not equalized in the real world, so the exchange rate also deviates from the natural rate. But that isn't the main problem with the mainstream view. As we saw, the capital debates undermine the theoretical basis for a natural rate of interest, and hence for a natural exchange rate (or a natural rate of unemployment for that matter). Hence, it is the Keynesian (and Sraffian) institutional rate of interest, as determined by monetary authorities that rules the roost. The conventional rate of interest is then connected to a conventional exchange rate [then institutional factors become relevant, like the existence or not of capital controls, etc.].

Leave aside the theoretical problems of purchasing power parity measures, since they are NOT attractors of the actual exchange rates [the reasons why Argentina had a 1 to 1 exchange rate with the dollar for a decade, or Greece has a 'fixed' parity too are political and institutional], and even if for some purposes you may want to use PPP rates as a measure of material welfare, one may also be interested in actual market exchange rates for other purposes. Indeed, for most of the relevant matters that concern economic well being, particularly in peripheral countries, like the capacity to repay foreign debt and avoid default and import capital goods to promote growth, it is the market exchange rate that is central to convert incomes in different countries into a common numeraire.**

* The fact that capital does NOT flow to developing countries is something that still puzzles very much mainstream economists like Robert Lucas (see here).

** Which means that China is considerably less developed than Argentina and Brazil, even if it is growing fast, it has a regional hegemonic project, and is, by sheer size, one of the most important economies in the world.

A Keynesian Theory of Hegemonic Currencies

By Thomas I. Palley

Several years ago (June 2006) I wrote an article advancing a new theory of why the dollar is the world’s dominant currency and why it is likely to remain so. The article was published in the midst of the last boom and sank like a stone. But now debate about the cause of the dollar’s hegemony has been revived in an interesting paper by Fields and Vernengo titled “Hegemonic currencies during the crisis: The dollar versus the euro in a Cartelist perspective” (also here). Their paper provides an opportunity to revive discussion, so I am posting the article again. Here it is (subject to a couple of word edits):

The U.S. dollar is much in the news these days and there is a sense that the world economy may have become excessively reliant on the dollar. This reliance smacks of dysfunctional co-dependence whereby the U.S. and the rest of the world both rely on the dollar’s strength, but neither is well served by it.

Read the rest here.

Kevin Gallagher on capital controls

Another interesting talk at the Central Bank of Argentina, this one by Kevin Gallagher from the University of Boston based to a great extent on his recent work with José Antonio Ocampo and Stephany Griffith-Jones on the regulation of capital flows (see here).

He has three main points to make. First, there is increasing and overwhelming evidence that there is no connection between capital account liberalization and economic growth. He cited the recent work by Arvind Subramanian, Olivier Jeanne and John Williamson (the latter of Washington Consensus fame) at the Peterson Institute, called "Who Needs to Open the Capital Account?," who argue (2012, p. 5) that "the international community should not seek to promote totally free trade in assets -- even over the long run-- because ... free capital mobility seems to have little benefit in terms of long run growth."

Second, it seems that the International Monetary Fund (IMF) has come to partially recognize the appropriateness of capital account regulations and has gone so far as to recommend (and officially endorse) a set of guidelines regarding the appropriate use of Capital Account Regulations (CARs), the new term for capital controls within the IMF. He warned, correctly I think, that changes within the IMF can be seen as a reform that tries to restrict the use of capital account regulations to emergencies, and situations approved by the IMF within article 4 consultations, when article 6 guarantees that countries can use them freely.

Finally, and more importantly, Kevin warned that Bilateral Investment Treaties (BITs) and Free Trade Agreements (FTAs) have regularly included very restrictive language on capital account regulations, and have a tendency to restrict the policy space in developing countries, exactly when a consensus that this restrictions do not provide any benefit in terms of growth.

The spurious victory of MMT

Sergio Cesaratto (Guest Blogger)

In a widely read blog aggregator Randy Wray has declared victory of MMT and that we are all MMTs by now. Victory on who? And I personally do not feel MMT, or better I feel MMT, Sraffian, Kaleckian, Marxist and many other things, each taken with a degree of salt. Fanaticism and over-excitement is not part of heterodox Economics, let alone of academic work, and the fact that Wray got so nervous after a initial critical comment by a reader is telling that we might be far away from a cold and equilibrate economic dialogue. MMT has provided a lot of important insights, as other approaches, about the European crisis. Also intellectual adversaries like Werner Sinn have contributed to our understanding of the crisis, in this case over the role of Target 2 (that for the first time or so Wray mentions). MMT has, indeed, missed the main feature of the EZ crisis: its nature of a balance of payment crisis. Anyway, I do not see the MMT explanation as alternative, but as complementary to the BoP crisis view. In this regard, more modesty would help everybody in our common scientific and political enterprise. While my own view of the EZ crisis as a BoP crisis is here (this WP is a longer version of an article in a book that will be published likely by Routledge, a blog version is here), below you can find some critical remarks on the MMT view of the EZ crisis part of a longer paper that will be published in Spanish. These remarks develop a bit further the post on MMT already published here which is also a section of the WP. Having said so, I am ready to acknowledge that along Godley 1992, De Grauwe 1998, Kelton and Wray (and few others like Barba and Pivetti) have provided prescient predictions of the forthcoming crisis, each emphasises one aspect of it.

Let us consider an economy in which a deficit of the public sector is accompanied by a current account deficit. Given full monetary sovereignty, the MMT scholars apply the same argument envisaged for a closed economy to an open economy: a public deficit corresponds to net private wealth desired either by the domestic private sector or by the foreign sector, so there are no limits to the foreign holdings of Government bonds “so long as the rest of the world wants to accumulate its IOUs”:

“a country can run a current account deficit so long as the rest of the world wants to accumulate its IOUs. The country’s capital account surplus “balances” its current account deficit…. We can even view the current account deficit as resulting from a rest of world desire to accumulate net savings in the form of claims on the country.” (Wray 2011 MMP26).

It is hard to believe that the proviso “long as the rest of the world wants to accumulate its IOUs” applies to the majority of the countries.

To sustain his view, Wray extends the Chartalist tax-theory of money – the currency issued by the State to finance its spending is accepted since the State itself accepts tax payments only in that currency – to the foreign sector, although this is not required to pay taxes in the deficit country:

“Any sovereign State obtains “something for nothing” by imposing a tax liability and then issuing the currency used by those with tax liabilities to meet the obligation. The only difference here is that the U.S. government has obtained output produced outside the U.S., by those who are not subject to its sovereign power—in other words, by those not subject to U.S. taxes. However, even within any nation there can be individuals who avoid and evade taxes imposed by the sovereign power, but who are still willing to offer their output to obtain the sovereign’s currency. Why? Because those who are not able to avoid and evade taxes need the currency, hence, are willing to offer their own output to obtain the currency. The U.S. dollar has value outside the U.S. because U.S. taxpayers need the currency.” (Wray 2006a: 22)

It does not seem that, however, the Chinese wish dollars to buy goods from the U.S. taxpayers (or to buy goods from those who would like to buy U.S. goods). Chinese do not export to the U.S. in order to import from them, but accept nonetheless U.S. dollars from complex reasons that make that currency unique that we do not consider here. A part the particular status of the US dollar as the favourite international currency, it may be argued that only the strong currencies of countries with persistent CA surpluses – that it is useful to denominate here mercantilist countries, say Switzerland or Germany – may have the status of international currencies. Liabilities denominated in the currencies of the non-mercantilist countries (with the exception of the US) do not have the unlimited acceptance that Wray pretends they would anyway have just on the basis of full monetary sovereignty that include the disregard of the foreign exchange rate (disregard that might discourage foreigners to accept IOUs denominated in that currency, as Wray (2011 MMP 11) pretends in passages like this:

“What is important for our analysis, however, is that on a floating exchange rate, a government does not need to fear that it will run out of foreign currency reserves (or gold reserves) for the simple reason that it does not convert its domestic currency to foreign currency at a fixed exchange rate. Indeed, the government does not have to promise to make any conversions at all.”

However, precisely the lack of this promise, or its long run unsustainability (as in many examples of currency board), and the expectation of a depreciation of the currency that implies that the government of a non-mercantilist country might have to pay on its liabilities interest rates that would make the domestic and, symmetrically, foreign deficit and debts unsustainable. So, it is not so much the full monetary sovereignty of a currency that matters, but the underlying secular CA situation of a country that makes the difference in terms of sustainability of those debts (Frenkel and Rapetti 2009: 689). Floating exchange rates helps, of course, but not so much because they assure the acceptance of any amount of national liabilities at sustainable interest rates – how could they? - but because they may contribute to long-run balanced foreign accounts and (symmetrically) to the stabilisation of domestic stock and flow accounts. Unfortunately Wray (2011 MMP 25) seems to invite the countries “where the foreign demand for domestic currency assets is limited” to pursue the catastrophic road of foreign borrowing (for them “there still is the possibility of non government borrowing in foreign currency to promote economic development that will increase the ability to export”) which, by the way, presupposes a renunciation to monetary sovereignty.

Wray insists, however, on only one aspect of full monetary sovereignty, that we can define as ‘internal’, that is the possibility of the government to finance any amount of spending at the desired nominal interest rate, while conceding at most a benign neglect to the exchange rate role in securing the external balance, what we may define as the ‘external’ side of monetary sovereignty. If, for instance:

“it is believed that a budget deficit can raise demand and increase a trade deficit or cause inflation—either of which might negatively impact the foreign exchange value of the currency—the central bank might react by raising the target interest rate to increase rest of world (…) demand for the currency. Fiscal policy is also constrained by perceived pressures on exchange rates. To be sure, even nations on floating exchange rates formulate monetary and fiscal policy with some consideration given to possible impacts on exchange rates. However, with fixed exchange rate systems, there is very little room to maneuver ... What we might call sovereign power is severely reduced. It is no coincidence that countries operating with fixed exchange rates today strive for policy austerity—and that they are quickly punished when they adopt overly expansionary policy. The principles discussed above do not really apply to government finance in a nation on a fixed exchange rate. Effectively, government liabilities are “backed by” foreign currency and gold reserves as there is a promise to convert domestic currency at a fixed exchange rate. Adoption of flexible exchange rates increases independence of domestic policy. (Wray 2006b: 9)

But, once again, the difficulty does not seem that there is “a promise to convert domestic currency at a fixed exchange rate”: as long as a country has abundant foreign reserves this is not a problem at all. The true question is again the structural foreign account situation of a country. Fixed exchange systems or currency unions perfectly fit mercantilist countries, as the experience of Germany in the Bretton Woods, EMU and EMS regimes shows (Cesaratto and Stirati 2011). Of course, it does not fit non-mercantilist countries. With fixed exchange rates it not so much the limit to the possibility of debt monetization that cause high interest rates (as long as a country retains a sovereign central bank monetization is in principle always possible), but the fact that the exchange rate might be inconsistent with the foreign imbalances. This may lead at the same time to restrictive domestic policies, that negatively affect the GDP growth, and to higher interest rates in order to assure the external financing of the foreign/domestic debts. The higher interest rates worsen net foreign incomes balance of the CA (and symmetrically the interest costs of domestic debts). This, combined with the GDP stagnation, places the country on an unsustainable domestic debt/GDP path.[1] Non-mercantilist countries need floating regimes not to be able to issue any amount of foreign liabilities - as long as they are “backed by the national currency – as Wray pretends, but because the exchange rate flexibility is the necessary instrument, within many limits, to render consistent the support to domestic demand with balanced foreign accounts. (Controls of capital outflows might be also necessary to let the country to finance fiscal deficits at sustainable interest rates). [2] For a third kind of country, the foreign exchange regime is irrelevant: as the US Treasury Secretary Paul Polson once famously said: “The dollar is our money, but is your problem”. This is the “exorbitant privilege” famously denounced by the then De Gaulle’s finance minister Giscard D’Estaing.

Wray, however, if he does not neglect that the prerogative to let the foreign debt levitate is due to ‘dollar hegemony’, that is an American prerogative, it al least to downplay it as an ancillary problem. Indeed, where he explicitly discusses the point, he reluctantly (but openly) admits that the irrelevance proposition that any State “can run budget deficits that help to fuel current account deficits without worry about government or national insolvency” applies indeed only to the US: “precisely because the rest of the world wants Dollars. But surely that cannot be true of any other nation. Today, the US Dollar is the international reserve currency—making the US special”, and “the two main reasons why the US can run persistent current account deficits are: a) virtually all its foreign-held debt is in Dollars; and b) external demand for Dollar-denominated assets is high—for a variety of reasons. “ (Wray 2011 MMP 25).

So Wray is correct when he says that full money sovereignty is helpful to pursue national full employment policies, but not for the right reasons. It is not true that, a part the US, ‘normal countries’ can finance any amount of government (and even private) spending by issuing an internationally accepted currency (so without care for the foreign accounts). In particular, non-mercantilist countries typically experience the foreign constraint to their full employment policies. In their case full monetary sovereignty matters not so much in the ‘internal’ sense of being freely able to issue any amount of money – what is plainly impossible – but from the ‘external’ point of view of floating exchange rates that take care of the external equilibrium while the country pursue the desired policies. It is this external role of the sovereign monetary regime that frees (as well known) monetary policy to finance government spending at a sustainable interest rate (this may require also capital controls). A proof of why Wray is wrong is in the EZ periphery’s experience: in spite of the lack of national monetary sovereignty, during the EMU years private and government spending benefited of low nominal interest rates (and negative real interest rates): a sovereign central bank could not have done better from that point of view. The problems came form the external aspect of the lack of full monetary sovereignty: the impossibility of adjusting the growing foreign imbalances (due to strong imports and lose of price competitiveness). These imbalances are at the basis of the consequent growing sovereign spreads, not the ECB policy. Of course, a strong action by the ECB to abate the spreads (what it could do) would be enormously helpful once the spreads rose. But it would not solve the external imbalances that were at the origin of the crisis and that, indeed, matured when the sovereign spreads were at historically low level.

Of course, at the European aggregate level and with the backing of the ECB the financial imbalances would be perfectly sustainable, and indeed the EZ would a perfect MMT country that issue an international currency (and even with a balanced CA with the rest of the world). The institutional change required for the EZ to resemble the US would, however, be too challenging for a club of independent nations as real Europe is. This would require a transfer of many government budget functions to a federal government along the existing public debts, while local States would work as the American local States. Federal transfers from dynamic to troubled areas should dramatically increase while minimum standard welfare rights should be universally recognised to all European citizens. Labour mobility and infra-EZ direct investment should be incentivised. Beautiful but out of reach. Of course much less would be required to re-balance the EZ, but even that sounds utopia given that it entails a profound change in the mercantilist attitude of the dominant economy.

Returning to the criticism to Wray and his MMT fellows, full monetary sovereign, that is the power of a country to issue a non-convertible currency that is fully accepted for domestic and foreign payments, is not, with the possible exception of the US, a full prerogative of all countries and, therefore, the panacea MMT exponents envisage. The evident neglect of the foreign exchange troubles that a ‘normal‘ country would incur if a larger government deficit/debt are associated to an increasing foreign deficit/net debt, implies a neglect by the MMT of the foreign constraint that ‘normal’ countries meet in sustaining full employment demand even with flexible exchange rates. MMT exponents reflect too much the US unique position as issuer of the main international mean of payment.[3] The neglect of the foreign constraint – which can be expressed as the necessity for ‘normal’ countries to keep the CA in balance over the long run, i.e. a balance between revenues and leakages of international currencies – leads the MMT exponents to a one-sided interpretation of the European troubles. These do not straightforwardly depend on the abandonment of national monetary sovereignty as the power to monetise public (and domestic) debts, in particular the high sovereign spreads do not depend on this. It is rather the abandonment of the currencies flexibilities in a non optimal currency area in the context of financial liberalisation that has led first to the capital flows from the core to the periphery that typically develops in a fixed exchange setting. Later, the ensuing external/domestic imbalances were ultimately made unsustainable by the capital flow reversal (also typical) and consequent dramatic rise in the sovereign (and non sovereign) spreads. So the story in not precisely that told by the MMT scholars. The story must pass through the foreign imbalances that, however, are neglected by them, probably reflecting some American insularity.

References:
Frenkel R. and Rapetti M. (2009) A developing country view of the current global crisis: what should not be forgotten and what should be done, Camb. J. Econ. (2009) 33 (4): 685-702.

C. Sardoni & L. Randall Wray, 2007. "Fixed and Flexible Exchange Rates and Currency Sovereignty," Economics Working Paper Archive wp_489, Levy Economics Institute,

Wray L.R. (2006a) Understanding Policy in a Floating Rate Regime, Working Paper No. 51, Center for Full Employment and Price Stability, University of Missouri-Kansas City

Wray L.R. (2006b) Extending Minsky's Classifications of Fragility to Government and the Open Economy by. Working Paper No. 450 The Levy Economics Institute.
Wray L.R. (2011 MMP 11) Modern Money Theory and Alternative Exchange Rate Regimes http://www.neweconomicperspectives.org/2011/08/mmp-blog-11-modern-money-theory-and.html

Wray L.R. (2011 MMP 25), Currency Solvency and the Special Case of the US Dollar http://neweconomicperspectives.org/2011/11/mmp-blog-25-currency-solvency-and.html
Wray L.R. (2011 MMP 26) Sovereign Currency and Government Policy in the Open Economy, http://neweconomicperspectives.org/2011/11/mmp-blog-26-sovereign-currency-and.html

Notes:
[1] That pegging is not a problem for mercantilist countries is partially recognised by Nersisyan and Wray (2010: 13): ‘Adoption of a peg forces a government to surrender at least some fiscal and monetary policy space—of course, constraints are less restrictive if the nation can run current account surpluses to accumulate foreign currency (or precious metal) reserves’.

[2] Sardoni and Wray (2007: 15-6) regards the flexibility of the exchange rate as a pre-requisite for full employment fiscal policy in so far as the state can finance spending not taking the external parities into account. Their only preoccupation is about the possible consequences on domestic inflation, while the positive effects of the trade balance are even regarded suspiciously (since a trade deficit is seen as sustainable and positive from a domestic welfare point of view). These arguments seem to reflect the unique U.S. position and do not look general.

[3] The EZ is in the same position, but it unfortunately does not take advantage of this opportunity.