whereas the world is blessed by a rules-based trading system that staves off protectionism, there is no similar architecture governing exchange rates

TO BE NOTED: From the WaPo:

"Repeating A 1930s Mistake?

By Sebastian Mallaby
Sunday, May 17, 2009

Those who are ignorant of history will be condemned to repeat it, as a teacher no doubt told you long ago. But the urgent question today is actually the opposite one: Can a team that is positively steeped in history -- particularly the history of the 1930s -- avoid the mistakes of that era and engineer a quick recovery from a Depression-size shock? Christina Romer, the chair of the White House Council of Economic Advisers and an authority on the 1930s, recently gave a hopeful answer to this question at the Council on Foreign Relations. But there was one gap in her argument, and therein lies a threat to the "green shoots" of recovery.

Romer has a right to optimism. Managed adroitly, crashes need not take a catastrophic toll. A year or two after the 1929 panic on Wall Street, there was no inevitability about calamity, as Philip Zelikow of the University of Virginia recalled recently. There were signs of an economic rebound; Germany's democratic government was holding together; Japan remained a responsible player in the international system. It took the policy errors of the early 1930s to change all that. Those errors need not be repeated now.

What errors? In 1930, the United States imposed the notorious Smoot-Hawley tariff, setting up a pattern of retaliation that exacerbated the downturn and splintered the world. This time, by contrast, there has been surprisingly little backlash against open trade. In 1931, the U.S. Federal Reserve hiked interest rates aggressively. This time the Fed, led by another scholarly expert on the 1930s, is forcing down interest rates by printing money. In 1932, the U.S. government tightened fiscal policy. Again, the lesson of that error has been absorbed aggressively -- witness the enormous fiscal stimulus.

But there is one less comforting part of the 1930s comparison. The international tensions of the 1930s were not just about trade; they were also about exchange rates. To get a leg up on each other, countries devalued their currencies, and each devaluation triggered the next one. In 1930, New Zealand secured a cost advantage for its butter exports by devaluing its money. The next year Denmark, its main butter rival, responded with its own devaluation. The two nations proceeded to chase each other downward.

Today, nothing quite so damaging seems likely. But whereas the world is blessed by a rules-based trading system that staves off protectionism, there is no similar architecture governing exchange rates. Countries can keep their money cheap to boost exports, even if they risk exporting trouble at the same time. Indeed, this is a fair description of China's behavior over much of this decade. Whereas Romer can confidently say that economic policy is better now than in the 1930s with respect to trade, interest rates and stimulus, it is hard to be so confident with respect to exchange rates.

This chink in Romer's comparison with the Depression clouds her sunny outlook for U.S. economic growth. In her Council on Foreign Relations speech, Romer acknowledged that the traditional engine of the economy -- U.S. consumers -- will be sputtering for the near future: U.S. households lost about a quarter of their wealth during the 2007-08 chaos and must now save. She also acknowledged that the new engine of growth -- spending by the U.S. government -- will have to slow down, too: The federal deficit will have to shrink once this stimulus is done. So Romer pinned her hopes for sustained recovery on export growth plus higher rates of business investment, with the investment presumably dependent on expanding markets abroad.

Will that export growth prove possible? The trouble is that other major economies harbor the same hope. Angela Merkel, the German chancellor, has stated categorically that Germany likes its export-led growth model and has no plans to change. Japan, to its credit, has passed a hefty stimulus, allowing government spending to replace exports, but it cannot sustain this policy because its national debt is astronomical. That leaves one other big economy -- China. Some Chinese leaders want to shift toward domestic consumption rather than exports, which is why the government's stimulus package includes money for health care. But the Chinese also want to boost growth urgently, and the surest way to do that is to spend money on the things that they are used to spending money on -- ports, roads and other infrastructure that winds up stoking China's export engine.

If the United States, Germany, Japan and China all aim to boost exports, we are in for trouble. It is impossible for all the big economies to improve their trade positions simultaneously; a jockeying for advantage, through the manipulation of exchange rates or through other measures, is certainly conceivable. Just as in the Depression, we have no rules for governing the disputes that may arise out of such conflict. It is too early to congratulate the scholar-statesmen for banishing all whiff of 1930s-style tensions."

this perspective contrasts with Charles Wyplosz's view, who argues that QE is basically a beggar thy neighbor policy

TO BE NOTED: From Econbrowser:

"The Demise of the Dollar? Should We Worry about Quantitative Easing and Deficit Spending?

Over the weekend, I was working on my long delayed manuscript on exchange rate modeling [0], and pondering how useful the conventional econometric techniques were for making predictions about the future value of the dollar.

Figure 1: Log value of trade weighted dollar, against a basket of major currencies (blue), and against a broad basket of currencies (red); and Deutsche Bank forecasts, calculated using implied changes of DB TWI (dark blue boxes). NBER defined recession shaded gray; only peak indicated for current recession. Source: Federal Reserve via FRED II, Deutsche Bank Exchange Rate Perspectives (27 March 2009), NBER, and author's calculations.

Why wonder? Well, in the final chapter of the text, I outlined the use of Taylor rule fundamentals to explain exchange rates (see this paper and these posts [1], [2], [3]). However, the fact that several central banks have hit the zero interest rate bound, and instituted quantitative easing (QE), makes the plausibility of such models limited in the near future.

Figure 2: Assets of the Federal Reserve, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright. Source: Hamilton, "The Fed's new balance sheet".

At the same time, we are witnessing a substantial increase in government debt, as documented in this post. Working off a portfolio balance model, as discussed in this post, one would expect a depreciation of the dollar or an increase in the exchange risk premium. However, all developed countries are expanding debt to GDP ratios.

Table 1.5 from OECD, Economic Outlook (March 2009) [pdf].

(Notice that gross debt differs from net debt, so these figures are not comparable to those in this post.)

Deutsche Bank, in its most recent Exchange Rate Perspectives (March 27, 2009) [not online], concludes:

Fiscal expansion combined with QE

What is the implication of fiscal expansion combined with QE? We have argued that history suggests the implications of higher fiscal deficits for the dollar will depend on whether or not the higher deficits are accompanied by higher relative US longer-term rates (Fiscal Deficits and the Dollar, ERP, September 2008). So if relatively more activist fiscal policy in the US raises relative US yields, history suggests this should be positive for the dollar. But there is widespread concern that if the higher deficits are accompanied by expectations of or actual QE, this will be negative for the dollar. This is essentially a "risk premium" argument that even with higher relative US yields, because of or under QE, this will be negative for the dollar. Looking at historical experience for episodes of risk premia against the dollar by examining the correlation between daily returns in EURUSD versus the longer-term rate differential indicates six episodes of negative correlations between the differential and the dollar. Four of these are episodes of risk premium in favor of the dollar, with declines in the dollar rate differential associated with a higher dollar. There have only been two episodes—in the late summer and early fall of 1998 and in the summer of 2003 -- when a move in rate differentials in favor of the dollar was associated with a weaker dollar. There have thus historically been very few episodes of such a risk premium. Presently this correlation between changes in the yield differential and the dollar is running around zero to very modestly negative. This is consistent with the view that most of the recent sharp depreciation in the dollar has been in line with the decline in US rate differentials and there is little or no evidence that higher expected fiscal deficits in the US combined with QE have created a risk premium against the dollar ...

Interestingly, this perspective contrasts with Charles Wyplosz's view, who argues that QE is basically a beggar thy neighbor policy. Perhaps it is, but when many countries are undertaking QE [4] [5] the effects cancel out.

What about China? As Brad Setser points out, China has slowed accumulation of Treasurys. How this will play out depends on how much the currency composition of assets changes as a consequence. And indeed whether the slowdown in accumulation persists.

Returning to the question that inspired this post, DB asserts that the long term yield differential will drive the dollar. That seems to be a hypothesis that one will be able to test as the data roll in. So I remain hopeful that the empirical methods of the past will prove yet again useful in the future, despite the changed nature of the world.

[Addition, 8:15pm Pacific It turns out that Barry Eichengreen has already observed this nullification effect -- but adds that it would be better to coordinate QE across countries. See this article from last month.]

By the way, if you're looking for estimates of increased debt-to-GDP stocks on interest rates, see Table 3.5 of the OECD, Economic Outlook (March 2009) [pdf]....you'll see a reference to this paper.

Technorati Tags: zero interest rate policy, quanitative easing, exchange rates, Taylor rule, and portfolio balance.

Posted by Menzie Chinn at April 13, 2009 07:40 PM"