Canadian Finance Minister Jim Flaherty is concerned that Switzerland's actions to depreciate the Swiss Franc against the Euro could lead to a currency war. But currency wars don't have to be bad; they could be good. It depends on how they are fought. If fought the right way, an invisible hand may lead to a good outcome that was unintended by any of those fighting the war.
Just to illustrate what I mean, let's first start with a simple example of the Gold Standard. This would help us understand currency wars of the 1930's.
Under the Gold Standard, every country pegs the value of its currency against gold. And suppose we start out in equilibrium, where every country believes it has sufficient gold reserves to enable it to cover foreseeable circumstances where it might need to sell gold in exchange for its currency at that price of gold.
Then something bad happens that causes every country to want to double its gold reserves. What happens next?
1. There might be a bad currency war. Each country raises interest rates and cuts its spending to increase capital account inflows and net exports to attract gold from abroad. In terms of gold, it's a zero sum game. One country's gain of gold is another country's loss of gold. From a wider context, it's a negative sum game, because the world will suffer recession and deflation.
2. Or, there might be a good currency war. Each country raises the price of gold to devalue its currency to increase net exports to attract gold from abroad.
Why is that second war a good currency war? It's still a zero sum game, isn't it? One country's net exports are another country's net imports? One country's gain of gold is another country's loss of gold?
In terms of gold, it truly is a zero sum game. But from a wider context, it's a positive sum game. Step back and think how the problem could be cured, at a global level. If each country wants to hold double the amount of gold reserves, it can't be done. There's only so much gold in the world. You can't double the tonnes of gold in existence. But you can double the value of those tonnes of gold in terms of money. If every country doubled the price of gold (halved the value of its currency against gold), that would get the world back to equilibrium. One tonne of gold reserves would now be able to do the same job that two tonnes of gold reserves would have been able to do at the old exchange rates.
And the good currency war, where each country tries to gain gold reserves by raising its own price of gold (devaluing its own currency), leads us exactly to that global cure. All it needs is for every country to wage war enthusiastically and keep on retaliating until each has its own desired doubled value of gold reserves.
A simple story of the 1930's is that it started out as a bad currency war. Each country tightened its monetary policy, and that lead to the Depression. And then it eventually turned into a good currency war. The Depression slowly ended as countries devalued against gold and thereby loosened their monetary policies.
That was the gold standard. It's different today. The problem isn't an international shortage of gold reserves; its an international shortage of monetary demand for goods. And we can't print gold, but we can print paper money. And each country wants to expand the monetary demand for its own goods, in part by devaluing its exchange rate to increase net exports. And net exports are a zero sum game. But just as under the gold standard example, there are two different ways to fight the war: a bad way and a good way.
1. The bad way to fight a currency war is to devalue your own currency by making other countries' currency more scarce. Your country might gain, since your net exports might increase; but the world as a whole loses monetary demand for goods.
2. The good way to fight a currency war is to devalue your own currency by making your own currency more plentiful. Your country will gain, since your net exports will increase; but the world as a whole gains monetary demand for goods.
If countries fight a currency war by loosening their own monetary policy, rather than by tightening other countries' monetary policy, it doesn't really matter if each individual country sees most of its gains as coming from increased net exports. That just gives them the extra incentive to be doing something they all ought to be doing anyway.
Here are a couple of hypothetical examples, for a world of two identical countries:
1. Country A devalues by buying B's currency in exchange for A's bonds. Country B retaliates by buying A's currency for B's bonds. The net result is exactly as if each country did an open market sale of bonds. There is less currency in circulation and more bonds. That's a bad currency war. It's a tightening of global monetary policy. It's a negative sum game.
2. Country A devalues by buying B' bonds in exchange for A's currency. Country B retaliates by buying A's bonds in exchange for B's currency. The net result is as if each country did an open market purchase of bonds. There is more currency in circulation and less bonds. That's a good currency war. It's a loosening of global monetary policy. It's a positive sum game. It's global quantitive easing.
Those two examples, being hypothetical, are much simpler than real world cases. But the underlying point remains: if countries are devaluing by loosening their own monetary policy, rather than by tightening others' monetary policy, it's a war we want to break out.
(For more on the Swiss devaluation, see Scott Sumner, David Beckworth, Josh Hendrickson, David Glasner, and Marcus Nunes. What the Swiss experience reinforces, as those bloggers note, is that there is a lot more to monetary policy than just setting an interest rate.)
Worthwhile Canadian Initiative 
Nick,
“Country A devalues by buying B’ bonds in exchange for A’s currency. Country B retaliates by buying A’s bonds in exchange for B’s currency. The net result is as if each country did an open market purchase of bonds. There is more currency in circulation and less bonds.”
In both cases, there will be neither more nor less currency in circulation as a result of the operation.
Currency in circulation is the paper cash and coins withdrawn by the non-financial sector from their deposit accounts, less the currency deposited by this sector into their deposit accounts.
So how does either CB OMOs, or CB forex purchases force households or firms to turn around and withdraw more or less currency from their deposit accounts? It doesn’t.
These withdrawals and deposits are the intentional decisions of deposit holders, as they respond to changes in the price level, changes in payments technologies, or other preferences for transacting with cash rather than by writing checks or using electronic payments.
An increase in the availability and convenience of auto-bill pay systems has a far bigger impact on currency in circulation than a CB forex intervention.
The forex intervention may force the financial intermediaries to quote a different exchange rate, and thus affect trade, and therefore prices, and therefore demand for currency, eventually tricking into more currency withdrawals. But the act of purchasing foreign currency does not cause currency in circulation to increase.
But if all CBs do this, so exchange rates are unchanged, then there will be zero impact on currency in circulation, which is economically irrelevant anyway. I fail to see the transmission mechanism if all CBs do this.
And can we please get out of the commodity money model? That was always a fantasy, but now that we are not even nominally on the gold standard, it’s a misleading view of monetary operations — coming hot on the heels of the “we didn’t understand money operations well enough to warn against the euro” post.
Is the problem here that the US can’t buy Chinese bonds? Or does it not matter what assets the US buys?
Can we be reasonably confident about avoiding stagflation once inflation gets rolling and central banks start to tighten once more?
rsj: “And can we please get out of the commodity money model? That was always a fantasy, but now that we are not even nominally on the gold standard, it’s a misleading view of monetary operations…”
Actually, Canada has had a commodity money for the last 20 years. So have most modern central banks. The commodity is no longer gold. It’s the CPI basket of goods. And convertibility is not direct, it’s indirect. And it’s a crawling peg, at 2% per year, not a fixed peg. We call it “inflation targeting”. But it’s a commodity money.
You really need to stop thinking of monetary policy as setting interest rates. If nothing else, the Swiss devaluation should teach you that. Did the Swiss cut interest rates to loosen monetary policy and devalue the Swiss Franc? Nope. They just announced a target, and Bingo! That mythical magical confidence fairy did the rest. God only knows how. It doesn’t make any sense at all, if the only thing central banks can do is set an overnight rate of interest, and everyone knows monetary policy is tapped out when they hit the ZLB. So there is no way the Swiss could have devalued. Unless they used magic.
Nick, whatever model you use — it has to be consistent with a basic awareness of the institution.
Central banks cannot buy baskets of goods and services.
Government purchase of output is fiscal policy.
CBs try to achieve an inflation target by setting borrowing rates and/or purchasing assets, hoping that the change in borrowing rates and asset prices creates the right amount of inflation.
But it need not, and that is certainly not the same as maintaining a peg.
Btw, I’m waiting for the rush of inflation to take hold in switzerland. I’m sure it will happen any day now…
Andrew: “Is the problem here that the US can’t buy Chinese bonds? Or does it not matter what assets the US buys?”
I think the fact that the US can’t buy Chinese bonds means it’s a rather lopsided war in that case. If China buys US bonds and/or currency in a sterilised forex intervention (so the supply of yuan does not increase), that’s a problem.
“Can we be reasonably confident about avoiding stagflation once inflation gets rolling and central banks start to tighten once more?”
That’s the big question. If you think that the problem is structural unemployment, not a shortage of aggregate demand, then loosening monetary policy will only cause inflation. My view is that it’s a problem of AD. If AD increases too quickly, there might be more inflation than reduced unemployment, because it takes time for firms to hire extra workers and ramp up production to meet the increased demand. But that’s the least of our worries right now, globally.
rsj: “Central banks cannot buy baskets of goods and services.”
Under the gold standard, they didn’t do a lot of buying and selling gold either. It’s called “indirect convertibility”. For example, the central bank could peg the price of haircuts without ever buying or selling haircuts — by adjusting the price of gold. Whenever the price of haircuts starts to rise above target, the central bank lowers the price of gold (sells gold). Whenever the price of haircuts starts to fall below target, the central bank raises the price of gold (buys gold). Or it could use silver. Or copper. Or wheat futures. Or the TSX300. Or bonds, or forex.
Stop thinking about what the central bank is buying or selling. Remember that what matters is that it is buying or selling its own money.
Stop thinking about what the central bank is buying or selling today. Remember what matters is the central bank’s commitment to its future strategy.
“Btw, I’m waiting for the rush of inflation to take hold in switzerland. I’m sure it will happen any day now…”
It already has happened. Asset prices jumped instantly on the news. It will take longer for sticky goods prices to respond. And they will respond by not falling. because if the Swiss hadn’t done what they did, they would have faced deflation.
Like the other “quasi-monetarists”, after the Swiss experience I have lost all patience with that closed-minded “horizontalist” perspective, whether it come from MMTers or Neo-Wicksellian mainstreamers. People who can only see the individual trees of the mind-numbing institutional and accounting detail of what they falsely think is how “modern” central banks operate. It’s total BS. Read those other posts I linked to. And Scott Sumner’s latest.
A good and timely post, I was thinking about the parallels between Canada and Switzerland; there are some interesting ones, especially for exporters in the eastern part of the country who are finding it difficult to compete with a high CAD, as well as the threat capital inflows attempting to find a “safe haven” in a country with better debt ratios.
There are countries who run their currencies as fixed pegs or close to, most notably in Asia after economies got creamed by currency flows. Now they are much more wary of floating exchanges for economies with disparate terms of trade.
Canada, though, is in an interesting spot; could it reasonably peg its currency to the USD? I think, actually, there is some ability to do this as long as its inflation vis a vis the US doesn’t diverge. On that front I think that’s where the peg would never work for Canada unless the US starts having more of a fiscal policy than its current dysfunctional gridlock. Canada seems more mature here and this could lead to higher inflation if the government’s job-producing initiatives start working (whatever they are).
I think Nick what you point out about currency wars and monetary policy is that the implications for inflation depend. When we talk about “currency wars” we also need to talk about “trade wars” because capital flows are an integral part of what this is all about.
jesse: thanks. We could peg the Loonie to the USD (we did in the past), but I think it would be a big mistake. Especially at present. We need to keep an independent monetary policy. The Fed can’t even get monetary policy right for the US, let alone get it right for Canada. The Bank of Canada hasn’t been perfect, but it could have been a lot worse.
Nick,
Very much agreed. Currency wars is just another name for global QE. But what about capital controls with a currency peg, a la China? Their defense of that peg leads to them pursuing contractionary monetary policy to combat the inflation maintaining the peg and sterilizing inflows would produce. The Fed could, of course, effectively make China abandon the peg if it was determined to do so, but barring that, the dimunition of Chinese demand makes this into the bad kind of currency war, no?
http://obsoletedogma.blogspot.com/2011/09/snb-currency-wars-china-peg.html
“I think it would be a big mistake”
The distinction for the CHF compared to Canada’s current situation is that a lot of the flows were financial, not “real”, and that was affecting the “real” economy. The Swiss decided their non-bank economy was beggar thy neighbour and was in danger of entering a severe recession if nothing was done. Canada is not in that position, yet, but if people looking for “safety” decide the Swiss aren’t worth the hassle, they might start turning to Canada in greater numbers. That is a risk the Bank of Canada and the federal government should be planning for, and I’m reading between the lines on the MoF’s recent public statements. So it’s a great question, in my view, to ask what Canada could do to shoo off a swarm of locusts.
I called it “multiculturalism”. There are those like Plosser who only see MP working through interest rates – so that MP is easy and potentially inflationary, and those like Evans who have a “more opnen mind”:
Stagflation has nothing to do with the current situation. This is not the 1970’s again, this is the 1930’s. Nobody cares and nobody should care about stagflation.
Nick: Do you think the Fed is too wishy-washy in its communications? The SNB comes across as practically daring someone to test them – “Go ahead punk, make my day!”. Also, could/should the Fed say something like “We will buy in unlimited quantities until such time as inflation is X%, and continue until NGDP level returns to trend”?
The SNB experience would seem to suggest it would work.
Obsolete dogma: Good post. And you made almost all my points yesterday! I think you are right about China.
jesse: it’s different for Canada because: the US is our biggest trading partner; but when there’s a crisis, everybody wants US dollars, not Loonies. Canada is not (yet?) seen as a safe haven, unlike Switzerland.
marcus: “Multiculteralism”? Maybe. Being able to look at monetary policy from more than one point of view. Allowing different conceptual schemes. Framing. Duck/rabbit. Wouldn’t that be more like “post-modernism”?
Determinant: I basically agree. But if AD literally jumped 10% overnight, I would be a little worried. Even with loads of idle resources, it takes time to crank up output. Give it a few months.
Patrick: “Nick: Do you think the Fed is too wishy-washy in its communications?”
Understatement of the year. It doesn’t even know what it wants to communicate. Yes, yes, and yes!
“Canada is not (yet?) seen as a safe haven, unlike Switzerland.”
My point is that the risk of this should be on the radar of the Ministry of Finance and the Bank of Canada, especially now. I’m trying to work through what could be done given Canada’s economic situation of being tied to the US economy but also being a petrodollar. The Swiss trade mostly with the Eurozone so from that POV they are similar to Canada in terms of trade partner diversity. Canada of course has a much larger GDP and population but so does Japan.
By the way, how does the bank of Canada set the overnight rate of interest? Answer: 99% communications channel. And people at the Bank have told me exactly that. It says it wants the overnight rate at x%, and it goes to x%. It doesn’t actually really need to do anything, 99% of the time. It’s that damned post-modern confidence fairy that does the work.
“It’s that damned post-modern confidence fairy that does the work.”
This is the so-called central bank bazooka. It isn’t a confidence fairy threat, it’s a confidence fairy promise. 🙂
Remember in 2008 when LIBOR and the TED spread went off the charts, the central banks stepped in and cleaned up like a boss.
Nick:” 99% communications channel.”
Of course, that’s cause they have the OMO sledgehammer to back it up.
I was more taken today by his musings about lowering tariffs to counter the problem of cross border price differentials. Now there’s a start on a tariff war I could appreciate.
Nick,
Your topic for this post was the argument that forex purchases by SNB cause currency in circulation to increase, which drives up the price level.
This is a simple, testable, and wrong theory. Let’s wait and see what happens to SNB currency circulation. What do you think will happen?
It will have be the same result as what happened to currency (and deposits) after the U.S. did QE, or after Japan did Q.E.
Namely, no change.
We’ve seen this pattern before — you have a pet paleo-monetarist theory that cannot stand up to observational facts, and instead retreat to faith-based arguments — “I don’t know how it works, but it just does, because I assume that it does.”
By the way, I also believe that the SNB intervention was a good move, and may even be inflationary, but that is because of the current account changes. A low forex rates stimulates exports and hinders imports.
But not if all CBs do it.
And the point of your post was there is an effect _even if all CBs do it, whereas I claim that there is no effect if all CBs do it — assuming each CB also maintains the same nominal interest rate.
Now as all CBs are not going to do it, we expect it to have a positive effect. That is not evidence in favor your model — evidence in favor or against your model must be a change in the quantity of currency in circulation, which in your own words, is the cause of the change in prices — Unless you are going to issue some form of retraction, and then propose an alternate mechanism that would cause prices to increase even if the quantity of currency does not.
But after many interventions we know that the CB has extremely limited capacity to cause the number of non-financial sector deposits or currency to increase as a result of quantitative easing — even in an environment of positive interest rates. And we also know why — because the financial sector will for the most part undo whatever changes are made by the CB, as the CB is neither the marginal purchaser nor seller of “money” to the non-financial sector. The only thing left are rates — forex rates, interest rates — rates, not quantities.
Btw,
If you want to re-write this post, striking the phrase
“The good way to fight a currency war is to devalue your own currency by making your own currency more plentiful.” and related phrases, acknowledging that the amount of currency that households withdraw or deposit is controlled by them in toto, and not by the central bank — then you can propose some alternate channel by which, if all central banks “promise” to cut the forex rate of their own currency in half, then this will result in some form of income boom.
The problem with appealing to the confidence fairy in that case is that households know that the CBs cannot deliver on such a promise — not if each CB is equally determined.
As an aside, arguing that “CB communications strategies” is what is needed to address mass unemployment has to be the logical end-game of our modern day rabbit hole economics. Keynes would be weeping, and with good reason.
rsj: “…then propose an alternate mechanism…”
One billiard ball moves, and hits another, which moves, and hits another…Is that what you mean by “mechanism”? Economics isn’t like that. People are not like billiard balls. Causality doesn’t work the same way. People have expectations. If they expect everyone else (including the central bank) to act in accordance with a new equilibrium, each individual will move to that new equilibrium.
In about one month from now I will put my watch back one hour, and get up about one hour earlier by the sun. So will most Canadians. What is the “mechanism” that causes us to do that? Does the government come round and check we have all put our watches back, and fine us if we don’t? Or send a cop to wake us up? Nope. I will set my watch back because I expect that everyone else will do the same. And as long as the government acts like everyone else, and doesn’t falsify our expectations, the move to the new equilibrium is a self-fulfilling belief.
Given the upward-sloping IS curve, and the restoration of confidence, a successful loosening of monetary policy would, in current circumstances, probably result in a reduced demand for currency, and the central bank would accommodate that reduced demand by reducing the supply.
It’s only the lack of credibility that requires a disequilibrium move by the central bank, because then it actually has to carry out its threat. Read the Swiss Bank announcement. It was all about threatened action. There was no action needed. Because the threat was credible. Someone looking for billiard balls will see nothing. And totally miss what happened.
OK, but when does economics allow you to invent channels that aren’t operative?
You said that that forex purchases increase the quantity of currency which increases the price level.
But that cannot be true.
So if you still believe that CB forex purchases lead to an increased price level, you have to explain why — what is your channel?
I proposed a channel that only works if one CB does it — e.g. lowering forex rates stimulates exports which increases incomes (demand).
That is an orthodox channel.
You are proposing that if all CBs simultaneously de-value, then this will have the same effect. Obviously it must happen through some other channel. If the channel is not an increased quantity of currency — then what is the channel?
At this point, you just said “well, it does work”, and appealed to “confidence”, without explaining confidence in what or how, or why people would have this confidence to begin with.
You still need to identify the behavioral mechanism that causes the change, instead of just asserting that the change occurs via some unknown and ineffable mechanism.
http://www.six-swiss-exchange.com/indices/security_info_en.html?id=CH0009980894CHF9
Monetary policy in action. Suddenly, corporate finance in Switzerland just got a whole lot easier.
rsj: “I proposed a channel that only works if one CB does it — e.g. lowering forex rates stimulates exports which increases incomes (demand).”
First off, “channel” is still billiard ball way of thinking.
Second, you are thinking Y=C+I+G+X-M, with causality going from right to left. “Where will the demand come from?” you are asking. Because that increased demand, to move the system, seems to have to come from outside the system. It doesn’t. It comes from itself.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/02/but-where-will-the-demand-come-from-in-praise-of-older-keynesians.html
It is the threat of creating an excess supply of the medium of exchange, the hot potato, that enforces the new equilibrium. And that ain’t an unknown and ineffable force. (Not “mechanism”, which is billiard ball terminology again).
Nick Rowe,
To play devil’s advocate for a second, the initial effect of an exogenous increase in base money through OMOs is just to increase the cash reserves of banks. That doesn’t leave the financial system unless banks withdraw it. So where’s the hot potato?
W. Peden: What is that chart showing?
W Peden: were banks in equilibrium before? If so, they are not in equilibrium now.
I don’t deny the explanandum, even for the sake of playing devil’s advocate. I’m just looking to see if I’ve got the explanans right. [/pretentious philosophy of science jargon.]
As I see it, there is an important explanatory step between an increase in the monetary base and an increase in financial assets like stock markets. Banks, pension funds, insurance companies, hedge funds and other holders of securities purchased by the central bank all have a cash preference, just like any other economic agent. So they try to get back to their preferred cash-to-assets ratio by purchasing securities.
However, as a closed system, they are in a circuit. Yet, of course, there is an element here that is not simply part of the closed system: the price securities adjusts to the new supply situation and goes up as the institutions try to get towards equilibrium. So we get the effect that I observed in my first comment.
The most important and ubiquitous “leak”, as I see it, is not the cash (which, as has been said, only leaves the system on the customer’s demand) but on financial assets.
Tim Congdon is good on this stuff, although Sayers’ book on banking from the early 1960s is still very useful. As you say, so much of awry monetary thinking is due to a fixation on interest rates, which are just a price residual from the dynamics of supply and demand (which, looked at from another angle, are the residual of price & stock!).
The reason why I think this is important is that it helps us to understand why monetary policy actions which affect the demand for base money, like IOER, are so important. Another example of monetary policy actions having important effects on demand for a kind of money would be the effects of a long term credible plan involving the reduction of broad money on the demand for broad money (which we can arguably see in the distress borrowing in Britain after the Medium-Term Financial Strategy was announced).
Nick: “It’s only the lack of credibility that requires a disequilibrium move by the central bank, because then it actually has to carry out its threat.”
It’s only the lack of a “billiard ball mechanism” that causes the lack of credibility in the first place. QE cannot cause inflation via the quantity of money channel because there is no mechanism for reserves to become deposits. It can only work through the portfolio rebalancing channel (and then as far as I can tell, only if there is a risk of perpetual QE). Japan has done a full years GDP worth of QE and is still stuck at the ZIRB. I suspect the market has serious doubts about QE, and global competitive devaluation is clearly equivalent. I’m not certain because I still haven’t decided how to evaluate the states of perpetual liquidity trap (it seems we have to consider the asymptotic equilibrium). But I’m with rsj on the need for billiard balls.
K,
“and then as far as I can tell, only if there is a risk of perpetual QE”
Permanent, not perpetual. Even this has to be softened, because bank’s do not base their balance sheet composition decisions on their expectations of the monetary base 20 years’ hence. If a bank acquires a bunch of non-interest bearing assets, it needs to restructure its balance sheet NOW unless it has a very good reason to anticipate a future change in monetary policy (e.g. a credible inflation targeting ceiling). Which also explains Japan.
The claim that there is no mechanism for reserves to become deposits is also inaccurate, but in an astonishingly uninteresting way.
K: did Japan ever announce a target? Did it back off as soon as the policy started to work? What sort of expectations does that create. A perceived temporary QE is near useless, in current circumstances. It’s not what the central bank does today. It’s what it threatens to do tomorrow, and the day after,…if its target is not met.
(And even then it is more technically correct to say that the base money CREATES deposits.)
Nick, two can play at the confidence fairy game. I say that households know that the CB is ineffectual at forcing down forex rates as the other CBs will respond. Therefore there is no confidence and you don’t get a coin under your pillow.
Look, whether it is fairies, Angels, or God himself, when you need to appeal to a Deus-ex-Machina to make your case, then you have left the realm of science and have both feet planted firmly in faith.
Now you may be right, but you still need argue that you are right.
Tell me why households, banks, and firms, responding to a joint announcement by all the world’s central banks that they will each de-value vis-a-vis the other will respond with anything other than laughter.
There may well be a reason, but inventing a false reason (e.g. an increase in currency) wont work, and appealing to fairies wont convince.
Just skimmed the abstract of this paper, that came in today. It says Inflation targeting central banks have fared better during the recession.
http://www.bepress.com/bejm/vol11/iss1/art22/?sending=11512
Nick Rowe,
It would be interesting to see if the paper includes banks that have basically given up on inflation targeting (like the Bank of England) in the survey. Actually, excluding the UK is likely to improve the case for inflation targeting, but not primarily because of bad monetary policy!
Nick: “did Japan ever announce a target? Did it back off as soon as the policy started to work? What sort of expectations does that create.”
All of the above. So they totally failed on the communication strategy, which might, I agree, otherwise have worked if everyone believed in the mechanism of QE. But the short rate doesn’t depend on expectations. Expectations work In setting the short rate because bank can control it no matter what people might be expecting. They are in fact omnipotent (and people know it). Quantity of reserves, on the other hand, can be exploded by a factor of ten and still we could enter deflation. There’s no mechanical link, and Japan is evidence. So their lousy promises were backed by some random empty actions. This is why Bernanke threatens us with secret weapons: he knows the danger to his own credibility if he keeps threatening us with his QE pea shooter.
This one is interesting.
In this NK model, price flexibility is a negative during liquidity trap, when central banks lack commitment.
Click to access zero_bound_2011.pdf
Nick:
I think rsj has made a valid point: please tell us why households, banks, and firms, responding to a joint announcement by all the world’s central banks that they will each de-value vis-a-vis the other will respond with anything other than laughter?
There may well be a reason, but inventing a false reason (e.g. an increase in currency) wont work, and appealing to fairies wont convince.
If today the Canadian CB announces a new overnight rate then the market will react, because it has the past experience that the CB has the right tools to achieve its interest rate target and there’s an advantage in being a first mover.
If the Canadian CB announces that the Moon is made of cheese then the result will be, after a moment of shock, widespread laughter – no matter how confidently the CB announces that the Moon is made of cheese.
There’s a difference between being able to threaten with action (especially if that action has already been demonstrated in the past) and between threatening with impossible to perform action.
So you need to prove that a simultaneous policy by all CBs is physically possible, before invoking the “CB threat of action causes a Pavlovian reflex in market participants” logic.
Suppose (falsely) everyone has expectations exactly like rsj. That there will be $0 increase in future AD, P and/or Y. I am Ben Bernanke. I commit to printing trillions and buying up every single financial asset — government bonds, commercial bonds, stocks, and new stocks and bonds as issued, and will keep on doing this forever and ever until my NGDP target is met. At this point even rsj says, “OK, that would maybe increase future AD by $1, and increase future NGDP by $1”. So now everyone starts spending more, even if it’s just a small amount. But that’s not an equilibrium expectation either, because we are still not at my NGDP target, so I repeat my commitment, and rsj raises his expectation another $1 when he sees that everyone else has raised their expectation too, and raised their desired spending. And so on.
Roosevelt did it. The Swiss did it. Central banks have been loosening monetary policy and creating inflation throughout history. Did history come to a full stop in 2009?
Half the US seems to be afraid of inflation. All Bernanke has to say is “Yep, I’m going to do whatever it takes to make sure your fears are justified!”
rsj,
“It will have be the same result as what happened to currency (and deposits) after the U.S. did QE”
They’ll expand in volume? I see. I’m not sure what that does for your argument. Maybe you mean like when the UK did QE-
– oh, that doesn’t work for you either. Ooops!
Don’t worry, I’m sure Japan will save the case-
Click to access page6.pdf
– … oh deary me! Even during an asset price recession, QE1 in Japan STILL boosted broad money growth.
Nick wrote:
“I am Ben Bernanke. I commit to printing trillions and buying up every single financial asset”
But that is not what the Swiss have done. They have set the forex rate which is a sterilized operation.
So the point rsj has made is that your “The good way to fight a currency war is to devalue your own currency by making your own currency more plentiful.” SNB approach cannot work and thus cannot be credible, without you outlining a rational channel that makes it credible.
Consider this simple model: assume that Switzerland and Germany are the only two countries on the planet and they trade with each other. The Swiss would set the exchange rate to 1.2000 to make the Franc more plentiful and would commit to purchase Marks every time the Franc strengthens below the magic 1.2000 boundary. This forces the exchange rate to 1.2000.
What could the Germans do to devalue their currency and make it more plentiful than under the 1.2000 exchange rate? They cannot simultaneously announce a rate target different from the SNB one 🙂
Some other ‘global CB action’ might be credible. Do you retract your current, forex based approach (the SNB approach applied to the global economy) and will you outline the one that you think would work?
Devaluation increases demand by changing the balance of trade. In the case where devaluation is not an option, e.g. the U.S. can’t devalue against the Chinese yuan, the same effect can be obtained by trade restrictions.
But the Swiss intervention I think is more “defensive” than “aggressive”. They are reacting to a sudden large currency move.
“Roosevelt did it.”
Roosevelt removed a binding constraint on the path of future monetary policy. As a result of that constraint, real interest rates were 12%, real wages were spiking, corporate profits negative in aggregate, and the real value of debt was also climbing. In short, everything was going in the “wrong” direction. The result of eliminating the constraint had a large impact on the confidence fairy.
Today, there is no constraint on policy. Markets are well aware that the Fed may engage in multiple future rounds of monetary easing. That is why real interest rates are not positive 12%, but negative 2%. Real wages and the real value of debt have been falling, and corporate profits are at peak and have been rising. In short, everything is moving in the “right” direction.
I can understand why Determinant says this is like the 30’s: we appear to have a large output gap. Beyond that though, the situation seems very different. As Bernanke pointed out, there were pernicious effects associated with severe deflation in the 30’s; these same effects are not apparent with modest inflation in 2011.
I agree with others above that Nick is proposing global coordinated QE. Like any QE program, the jury is out on whether it works or just piles up ER’s. Svensson argues real depreciation of a currency is a guaranteed solution, but this cannot be done through QE, only by stand-alone competitive devaluation.
BTW, if you want to make a comparison with the 30’s, I think 1937 is much more appropriate.
@David Pearson What do you mean by the ‘right’ direction, in particular with respect to real wages and corporate profits?
Nick, your ideas are interesting, but I don’t think that even a “good” currency war will help the current situation, for the same reason that “quantitative easing” can’t do much.
The basic problem for many countries and for the world as a whole is lack of demand. The situation can only be fixed if some sector somewhere can be made to demand more. In a normal recession, central banks get housing sectors to demand more by reducing the interest rate. The basic problem we are facing is that this can’t work when interest rates are up against the lower bound.
I don’t think that even your “good” currency war would change that. If currencies fluctuate in value relative to each other, it will move demand around from country to country, but it will be zero-sum. Sure, money will be created, but that money will just suffer the same fate as all the money created by “quantitative easing” – it will sit in the banks, which will not lend it out to companies that are facing a lack of demand. Like quantitative easing, it might not be completely useless if it reduces interest rates on higher risk and longer term loans, but it is unlikely to do much.
We need to think about how to get some part of the world economy to demand more. To me, the only reasonable solution is government stimulus. Central banks can’t do more than they are already doing.
White Rabbit said: “Consider this simple model: assume that Switzerland and Germany are the only two countries on the planet and they trade with each other. The Swiss would set the exchange rate to 1.2000 to make the Franc more plentiful and would commit to purchase Marks every time the Franc strengthens below the magic 1.2000 boundary. This forces the exchange rate to 1.2000.
What could the Germans do to devalue their currency and make it more plentiful than under the 1.2000 exchange rate? They cannot simultaneously announce a rate target different from the SNB one 🙂
Will other things (like commodities) start rising in value but not labor? Will that lead to price inflation with very little if any real GDP growth?