March 23, 2010

A Misalignment Primer

As the release of the next Treasury Report to Congress on International Economic and Exchange Rate Policies looms, it might be useful to recount the various ways in which different observers define currency "misalignment".

Currency misalignment can be determined on the basis of the following criteria or models:

• Relative purchasing power parity (PPP)
• The "Penn Effect"
• The behavioral equilibrium exchange rate (BEER) approach
• The macroeconomic balance effect
• The basic flows approach
• An equilibrium approach

I have discussed several of these approaches in the past [0] [1], but a review of the approaches bear repeating, if only because there so much confusion regarding what constitutes currency misalignment.

Relative PPP

Relative PPP can be expressed as:

s = μ + p - p*

where lowercase letters denote log values, s is the price of foreign currency, p is the price index, and * denotes a foreign variable, and μ is a constant arising from the fact that p and p* are indices.

Using this criteria, a currency is misaligned if s deviates from the μ + p - p*. One difficulty is that μ has to be estimated. Typically, estimates of μ can vary drastically with sample period. Oftentimes, there is a time trend in q ( which equals s - μ - p + p*), which means that relative PPP cannot literally hold. Then, one might have to allow for a (ad hoc) time trend, which itself has to be estimated. In Chinn (Emerging Markets Review, 2000), I apply this approach to the East Asian currencies, pre-crisis.

In the case of China, presented below is the (log) trade weighted real effective exchange rate of China, (q), using the latest data spliced to an older series incorporating the swap rates pre-1994 per discussion in Chinn, Dooley, Shrestha (1999). Upwards denotes depreciation.

Figure 1: Log trade weighted real effective exchange rate, CPI deflated (blue); and linear trend estimated 1980-2009. Source: IMF, International Financial Statistics, various issues; and author's calculations.

Using a simple linear trend, one obtains the counter-intuitive result that the RMB is overvalued. This suggests caution.

For more on effective exchange rates, see this survey paper.

Absolute PPP

Given the drawback of relative PPP, it seems like one could get around the problem of estimating μ by using actual prices of identical bundles of goods across countries, rather than price indices.

s = p - p* or equivalently p = s + p*

where lowercase letters denote log values, s is the price of foreign currency, p is the price level, and * denotes a foreign variable.

The problem is that prices of identical bundles of goods are not collected. One thing that comes close is the Big Mac -- hence the MacParity measure. But the problem is that prices of Big Macs (when expressed in a common currency) are systematically lower in lower income countries, and systematically higher in higher income countries. This is true when using Big Mac prices [2] [latest estimate] Parsley and Wei (2005) and when using the "price levels" in the Penn World Tables. This is so much a stylized fact that it is sometimes called "The Penn Effect".

The Penn Effect

Instead of viewing the "Penn Effect" as a problem, one can exploit this stylized fact. Define r ≡ p - s - p*. Then one can exploit the relationship:

r = α 0 + α 1 (y-n)

Where y-n is log per capita income. In Cheung et al. (2008), we exploited this relationship (following Frankel (2005), in a panel regression setting. In that study, we found an approximate 40% RMB misalignment (in log terms). Using updated data, namely the 2008 vintage of the World Development Indicators, we found something closer to 10% misalignment. The scatterplot of data, the regression line, and the RMB's path are depicted in Figure 2, originally discussed in this post (paper here).

Figure 2: Price level-per capita income in PPP terms relationship (blue line), +/- 1 std error band (long dashed lines), +/- 2 std error band (short dashed lines); OLS estimates for 1980-2006 period. Source: authors' calculations.

The Behavioral Equilibrium Exchange Rate (and related) Approach

Yet another approach is to use some theoretically and empirically motivated equations to estimate an exchange rate relationship. The variables can include productivity variables, or relative price of nontradables, or fiscal variables like the deficit, or interest differentials. Typically the variables can be motivated by some model of the exchange rate; which ones are included are motivated by goodness of fit. Goldman Sachs and JP Morgan had models of this sort. Zhang (China Economic Review, 2001) and Wang (2004) in Prasad (IMF, 2004) are some models in the public domain (see this 2007 Teasury working paper). Chinn (2000) implements a specific type of BEER (or productivity based) model for East Asian exchange rates.

The Macroeconomic Balance approach

The Macroeconomic Balance approach takes the perspective from saving and investment rates (see Peter Isard's survey). Recall:

CA ≡ (T-G) + (S-I)

In other words, the current account is, by an accounting identity, equal to the budget balance and the private saving-investment gap. This is a tautology, unless one imposes some structure and causality. One can do this by taking the budget balance as exogenous (or use the cyclically adjusted budget balance), and then include the determinants of investment and saving. Then one obtains "norms" for the current account. Chinn and Prasad (2003) is one example of this approach.

Then, using trade elasticities, one can back out the real exchange rate that would yield that current account. If that exchange rate is stronger than the actually observed exchange, then that currency would be considered "undervalued".

The closely-related Fundamental Equilibrium Exchange Rate (FEER) determines the current account norm on a more judgmental basis (in other words, the current account norm is not estimated econometrically, just imposed per the analysts priors).

[update 3/24, 8am Pacific] I should have mentioned Paul Krugman's take on this issue. My interpretation is that it fits into the Macroeconomic Balance approach, except he sidesteps the step of comparing the counterfactual exchange rate that hits the CA norm against the actual, and just compares the CA against the CA norm. In Chinn and Ito (2008) (Figure 4), we found -- at least in the 2001-04 period -- that China's CA was verging on being statistically significantly different from the norm. My guess is that the CA would be significantly different from the CA norm in the 2004-08 period.

The Basic Balance approach

One could take a more ad hoc approach, asking what is the "normal" level of stable inflows -- for instance looking at the sum of the current account and foreign direct investment, and see whether that value "made sense". Or one could look at the sum of the current account and private capital inflows. If either of the flows are "too large", then the currency would be considered undervalued (since a stronger currency would imply a smaller current account balance).

It is interesting to make two observations. First, note the need for many non-model based judgments. To see this point, recall the balance of payments accounting definition:

CA + KA + ORT ≡ 0

Where CA is current account, KA is private capital inflows, and ORT is official reserves transactions (+ is a reduction in forex reserves).

Saying CA + KA is too big is the same, then, as saying ORT is too small, i.e., reserves are rising "too fast". Morris Goldstein and Nick Lardy are among the most prominent exponents of this approach (see e.g., this this small volume).

Alternatively, running surpluses that are "too large" for "too long" will lead to foreign exchange reserves that are "too large". Obviously, a lot of judgment is necessary here.

Second, one aspect of this judgment is that it is conditional on the constellation of all other macro policies, including monetary, fiscal and regulatory, in place. If the CA+KA is adjudged to be "too large", one could say the exchange rate is "too weak", but one could say with equal validity that the fiscal policy is "insufficiently expansionary".

The final approach would be to step back and think in terms of "equilibrium" exchange rates. One might argue that the exchange rate is undervalued if, in the absence of central bank intervention, the exchange rate would be stronger. Of course, this means that whenever any central bank pegs an exchange rate, then the exchange rate is definitionally misaligned. I suspect when people use this particular definition, it is usually conjoined with some sort of threshold. One problem in my mind with operationalizing this definition is figuring out what that the "threshold" is.

A more fundamental conception of what an "equilibrium" exchange rate is is laid out by my colleague Charles Engel. As noted in this post, the equilibrium exchange rate is the one that minimizes the distortion from sticky prices and other rigidities. That is not necessarily the exchange rate delivered by a free float, even in the absence of capital controls. Indeed, it might be best delivered by some type of monetary policy (see the paper).

This approach departs from the "equilibrium" approach embodied in the real models of the late Alan Stockman, as summarized here, in that those models assumed away nominal rigidities. With complete markets, the free floating exchange rate is almost irrelevant since the real rate will always adjust to the right levels.

Review and Summing Up

Two last observations. First, each of these approaches has advantages and disadvantages. PPP and variants are easy to implement, but are more akin to parity conditions, so it's not clear over what horizon they apply to. The macroeconomic balance and FEER approaches are most appropriate to the medium term, and hence perhaps more relevant to policy questions. But they require more judgment on the parameters of the models. Moving to the basic balance approach, the time horizon is the shortest, and of perhaps most interest to policy analysts, and yet requires the greatest subjective judgment, since one needs to take a strong stand on what constitutes the appropriate values for critical variables. (There are also data considerations as well -- the PPP criteria is most popular in part because of the limited data requirements.)

Second, in some ways, it's not necessarily correct to think of these approaches as all inconsistent (in some instances they might be). Better to think that some approaches are more appropriate at one horizon versus another horizon. (This echoes Richard Cooper's description of how elasticities, absorption and monetarist interpretations were all consistent over time, in thinking about the effects of devaluations.) That is why a finding that the RMB is only 10% in value below that predicted by the Penn Effect is not definitive when talking about misalignment in the short run (and it's why, despite findings of a fairly small misalignment in Cheung et al. (2009), I think a revaluation of the RMB combined with expansionary fiscal policy, and altered regulatory policy, is called for in the context of an IS-LM-BP model. [3])

(Interesting aside: Fan Gang and Yiping Huang have cited Cheung et al. in favor of the no-undervaluation thesis. I thank them for their citation (who doesn't like publicity?!), but I still think that a finding of small misalignment along one dimension is not conclusive. Other criteria do suggest undervaluation, although I do not think a RMB revaluation is in and of itself sufficient to remedy the imbalance (see Prasad (2010)). See the estimates of trade elasticities cited here.)

I summarize the typology of studies in this table (which is adapted from Cheung et al. (2006).

Table 1 (modified): from Cheung, Chinn and Fujii (2006)).

For a volume on the topic of currency misalignment in developing countries, see Hinkle and Montiel (1999).

Posted by Menzie Chinn at March 23, 2010 12:20 PM

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Menzie,

You left one out. What about the Politically Motivated CYA Approach, see Schumer, 2004; also see Soros and Frank, 2010

Posted by: RicardoZ at March 23, 2010 01:19 PM

Menzie,
I'm writing a literature review of papers on eurozone expansion and I'm trying to conclude with suggestions for future research.

I'm pouring through recent data and the one thing that hits me is how widespread current account reversals are in Europe right now. Despite being somewhat familiar with the literature I'm still a little flumoxed with the chain of causality.

For example take Latvia. It's my impression that the decline in global aggregate demand led to a huge capital outflow in Latvia who was greatly dependent on foreign capital. Latvia was defending a euro peg so it was forced to maintain high central bank interest rates despite the decreased nominal GDP. Thus Latvia not only has declining investment but it has surging savings the latter of which is not typical of most recessions. (Could this also perhaps be partly the result of a reverse wealth effect from a rapidly deflating real estate bubble?) Furthermore, rising public debt levels are forcing it into a procyclical fiscal policy.

Meanwhile the price level and unit labor costs (reer) were inflated by the foreign capital inflow and now that it is gone Latvia is left with an uncompetitive price level leaving it rotting on the beach like a stranded fish (GDP down 40% below trend).

I'm also looking at foreign reserve data and net international asset positions (influenced by Eichengreen) but that data is somewhat wanting and seems not to yield much.

Am I reading the data correctly? In your opinion is this the narrative that is typical in such events? Any imput you may offer is welcome. Until I write the conclusion I'll probably be embarrasing myself with too frequent commenting as a distraction.

Posted by: Mark A. Sadowski at March 23, 2010 02:08 PM

Mark A. Sadowski: I'm afraid I know too little about the Eastern European experiences in the current crisis to say much. But it seems to me that with rising risk aversion, we should've expected a reversal of capital flows to Latvia. Rising (private) household savings rate are also not uncommon in recessions, and with a deflating asset boom, I'd even expect HH savings rates to rise. One thing I'd do is consult the Milesi-Ferretti and Razin literature on current account reversals, and see how the Latvian experience matches -- or doesn't -- with that experience. Hope that is helpful.

Posted by: Menzie Chinn at March 23, 2010 02:55 PM

Menzie,
Thanks very much. Based on what you've said it sounds like I'm not too much in left field.

I've read some of the Milesi-Ferretti and Razin literature but I'll take yet another look. It could be I'm just suffering from a tremendous lack of self confidence.

It seems as though few people have their eye on Eastern Europe right now (I'm a little lonely). It's my research focus and it seems exceedingly interesting at this moment in time.

Posted by: Mark A. Sadowski at March 23, 2010 03:10 PM

I hope none of this is meant to apply to the debate over whether China is guilty of currency manipulation. If your throw out the view that the market price is the correct one, you better have a good replacement, and you better have a good excuse. One could go through similar exercises to determine the proper price of carrots in the grocery store, but I think there, as here, you would be wasting your time and never be able to come up with a better alternative to the market price.
As Krugman points out, the official capital flows are the issue. It is a waste of effort to look at the level of the exchange rate and try to figure the "proper" level. The effect on trade flows is much easier to estimate from the balance-of-payments identity and the official flows.
Reserve accumulations of the size observed in Asian economies are inexcusable on any grounds other than that during the present deficient global AD, we, being richer, are better able to withstand unemployment than they.

Posted by: don at March 23, 2010 04:06 PM

Don: By your criteria, every country regime categorized by Levy-Yeyati and Sturzenegger, or by Reinhart and Rogoff, as fixed, managed floating, crawling peg, is manipulating its currency. Is that what you believe?

Posted by: Menzie Chinn at March 23, 2010 04:30 PM

Very good. But the diagnosis continues to be difficult. The euro difficulties show that the exchange rate equilibrium is, in the best case, a "moving target". At the end, I coincide with the opinion that the political decision is always the worst.
A float exchange rate instead of euro would have translated in a higher risk premium and higher cost of financing house bubble. Now, the only escape to Greece and Spain would be a costly devaluation.
Cooperation between governments would be good, but impossible. The objectives are very opposed.

Posted by: Luis H Arroyo at March 23, 2010 05:34 PM

"By your criteria, every country regime categorized by Levy-Yeyati and Sturzenegger, or by Reinhart and Rogoff, as fixed, managed floating, crawling peg, is manipulating its currency. Is that what you believe?"
Exactly. Would it make any difference if I referred to all intervention as being "currency management?" I'm not trying to say anything about whether the currency manipulation is "bad" or "good," that has to rest on other criteria. But again, the metric I would for such a determination is the volume of capital flows, not the level of the exchange rate.
In some cases a cogent argument can be made to justify currency intervention. Some examples: insulation against dramatic swings in relative prices (e.g. a substantial oil exporter with a substantial manufacturing sector or a country like Switzerland subject to currency swings based on investment conditions sentiments); a country in clear need of international reserves. Some have noted that the oil exporters built up substantial reserves build up during the last oil price spike. Currency manipulation? Definitely, but I'm not sure it deserves the same response as deliberate currency depreciation to foster export-led growth.

Posted by: don at March 23, 2010 06:27 PM

I'm kind of siding with Krugman's hardball approach,

You have make policy in the domicile were you can.

Posted by: Cedric Regula at March 23, 2010 07:50 PM

Cedric Regula: Just to clarify, the analytics in my post and Paul Krugman's post are not inconsistent. On policy measures, also not sure we disagree. We both think China needs to allow faster appreciation; I'm just not sure that in and of itself, it'll be sufficient to effect rebalancing.

Posted by: Menzie Chinn at March 23, 2010 08:25 PM

I would add Krugman's PPE method (proof pudding eating); cuts through the gibberish quicker. I encourage readers (who have the patience for this stuff) to read Yiping Huang, then Fan Gang. Prof. Chinn fails to mention that complete paragraphs of the latter come straight from the former.

Posted by: Qingdao at March 24, 2010 05:29 AM

Menzi,

Ok. Your analysis is more scholarly than Krugman's. I guess Krugman for some time has been stating that mercantilism "works", and the trade deficit is the proof.

I have plenty of doubts that a currency pair can fix all problems, but it certainly can create a bunch.

But Krugman has concluded that if the Chinese won't change their peg, the only practical solution the US has (assuming getting the entire US "competitive" with China is not practical) is a 25% import duty.

We have all heard of the downside risks here, but again, it's about making choices that are "sustainable" vs. the unsustainable track we have been on.

Posted by: Cedric Regula at March 24, 2010 07:26 AM

Menzie;

You've done a masterful job of highlighting the model uncertainty surrounding exchange rate misalignments. If memory serves, however, you've also done some nice work on the statistical uncertainty that remains even after one assumes that a particular conceptual approach is the "correct" one. What's the latest on that?

Simon

Posted by: Simon van Norden at March 24, 2010 08:11 AM

Menzie,

Why a single trend line in the relative PPP analysis? How about a discontinuity about 1990? This would show a sharply uptrend line up to 1990 and a modest downtrend line from 1990 to now. Perhaps such could be confirmed by looking at accumulated dollar reserves, either by change of rate of accumulation, or a determination of historically large such amount accumulated.

Such a look, if verified, would lead to the more comfortable conclusion of the RMB appreciating for 20 years and becoming undervalued.

Ed

Posted by: Ed Hanson at March 24, 2010 10:53 AM

Ed Hanson: Because single trends impose discipline. Believe me, with judicious choice of trend breaks, I can get just about anything. See Figure 3 in Cheung, Chinn and Fujii (2006, published in 2009).

Posted by: Menzie Chinn at March 24, 2010 01:57 PM

Simon van Norden: Thanks for the compliment. I'm afraid we've made no advances since our 2008 paper (Figure 2 above is drawn from that paper, and contains the plus/minus 1 and 2 standard error bands). It would be nice to apply our methodology to another approach (e.g., BEER), but remains to be done.

Posted by: Menzie Chinn at March 24, 2010 05:15 PM

"one obtains the counter-intuitive result that the RMB is overvalued. This suggests caution"

Why is that? Bias?
Things in China that are comparable to the US are more expensive than in the US. Of course lots of things are not comparable, for one China has a lot of migrant labor willing to work for much less. But that does not imply that RMB is undervalued.
RMB's volatility (against USD) is, of course, undervalued.

Posted by: HZ at March 24, 2010 09:27 PM

I can certainly accept the rule and discipline of a single trend line, as long as judicial check to see if a reasonable break would not provide better result. Adequate disclosure of data and method certainly makes such decisions open and reviewable.

But, I do believe that such graphs can have a tendency to hide what is going on monetarily by showing the distortions within the economy. The very fact that China has accumulated unheard amount of foreign currency reserves indicate that their fix has undervalued their currency. A similar situation in the USA occurred after FDR changed the fix of the dollar to gold in the thirties. Gold flow into the US showed that the dollar was controlled at value greater than its gold price, and gold flowed in. More difficult to analyze, but I postulate that the RMB is undervalued compared to the dollar (as well as other major currencies because of the discipline of floating exchange rates) and is shown by the historically very unusual build up of foreign currency in China.

Such analytical graphs as presented by you, Menzie, do show the economic distortion manifest in China due to command economy. The dominoes that follow such a dictatorial command, are a continued corrupt and weak banking system, as well as productive people not getting full value of the creative work. Just a note to remember, China has access to top tier world bankers of Hong Kong, whose expertise could have solved China's banking system problems years ago, but that mechanism is impossible if the power structure is unwilling to surrender that power.

Posted by: Ed Hanson at March 25, 2010 05:55 AM

Mark,

M. Hudson has written an article on Latvia, sorry but I do not have a link.

Posted by: ray l love at March 25, 2010 06:29 AM

ray l love,

I've never heard of Michael Hudson or of RTFL but I can see that he has written a number of articles on the Latvian situation that may be worth reading. Is there a particular one you have in mind?

Mark Weisbrot and Rebecca Ray have a very good CEPR paper dealing specifically with the Latvian situation:

I used Latvia as an example because it is the most extreme case. The other Baltic States and Ireland have been impacted similarly.

I've preformed a simple ANOVA analysis and it shows that exchange rate regime has a highly statistically significant relationship with economic performance and current account reversal in the EU since 2007. All of the EU countries with pegs (except Denmark) have been seriously impacted. This is consistent with most of the literature on current account reversals and exchange rate regimes.

There is some chauvinism on my part involved. I'm half Scottish via my mother (who was herself half highlander and so not terribly different ethnicly from the Irish) and part Lithuanian via my father (which is the only other nation in the Baltic language family save Latvian). I was excited by the economic performance of the Baltic Tigers and the Celtic Tiger a few years ago just as I'm shocked with how things are going there now.

Neoliberalism was great on the way up but I think that it may have contrubuted to a downside risk.

Posted by: Mark A. Sadowski at March 25, 2010 10:51 AM

People was saying the same thing about the Japanese Yen: persistent current account surplus, large forex reserve (much larger than China on a per capita basis) and therefore Yen must be undervalued. The experience of past twenty years proved that is simply wrong. How could an economy with a persistently undervalued currency suffer persistent deflation? Japan has a much higher propensity for private savings relative to the rest of the world. So does China.
How could a government be able to enforce undervalued currency over decades? Other things (price, wage etc) would have adjusted to eliminate undervaluation.

Posted by: HZ at March 25, 2010 05:13 PM

HZ,

Ahem, when they were saying the yen was undervalued, it was 250 to the buck(early '80s).

And they were kicking our butts.

Posted by: Cedric Regula at March 25, 2010 08:24 PM

Yes, but they claimed the same when the Yen was at 100 as well, since the trade surplus didn't go away even after the Yen tripled in value.
If a nation wants to save, unless other nations have an equal desire to save, the saver will run a surplus. In Japan's case that is even with a huge fiscal deficit. Forcing the Yen to appreciate caused Japan to suffer deflation, which in turn caused people to save even more -- since 1) people expect lower future income and 2) savers are rewarded in deflation.
The exact opposite is needed in the current context: US could do well to use a little deflation, which would encourage domestic savings (just witness how much the savings rate went up last year); China should run a higher inflation, which will encourage current consumption and favor income growth.

Posted by: HZ at March 25, 2010 10:30 PM

Euro zone countries and individual states in the US have no choice but to do what I suggested. Of course US and China are not in a political union, only a currency union with one willing and one unwilling partners. But to suggest that is manipulation on an econ board is just ignoring the basics of economics, as if prices and wages will never adjust in response.
The true driver of imbalance is structural. Difference in savings pattern is one. Secondly one just needs to look at the productivity differential between a Chinese industrial worker and a farmer (who is literate, able and willing to work and with very little land to plot) to see how it is net positive for global productivity to shift Chinese farmers into manufacturing. Trying to stop that process through currency is the true manipulation. And US won't benefit either, since the same can be said for a lot more Asians outside of China and that is where manufacturing jobs will go to (and are going to now with Chinese wage growth, even without the help of currency appreciation).

Posted by: HZ at March 25, 2010 10:56 PM

HZ,
You wrote:
"The exact opposite is needed in the current context: US could do well to use a little deflation, which would encourage domestic savings (just witness how much the savings rate went up last year);..."

If you're recomending deflation as a strategy to narrow the current account deficit in the US over the long term count myself deeply sceptical. Certainly the global economic downturn led to decreased international capital flows (surplus nations reduced savings relative to investment and deficit nations did the opposite) but I think that's a short term "benefit" that is not the result of a change in the long run rate of inflation.

Inflation in the US is already low enough not to have any major distortionary effects on the rate of savings. As long as I'm making public policy pronouncements that will be ignored, may I recommend a more "structural" approach such as shifting from taxing income to taxing consumption? Almost all our trading partners have VATs for example.

Posted by: Mark A. Sadowski at March 26, 2010 08:12 AM

HZ,

I don't think we should let central banks try and cast inflation or deflation magic spells on the citizenry.

I makes for too much confusion, and making people believe their money is no good, or too good, seems like a basic violation of human rights to me and there should be something in the Constitution about it.

If you want to "encourage savings", first we would need to stop encouraging consumption so much.

Paying real, after tax, interest on low risk savings is a fine way that we have abandoned.

Using tax law to support consumption, like the mortgage deduction, etc... could be scaled back.

We could add a VAT, but we have substantial sales taxes already. Not that I don't think real policy makers will try stimulating consumption and savings at the same time thru more tax policy. Then throw a carbon tax on top for good measure. We seem to be moving towards an age where both republicans and democrats will embrace regressive taxes.

But as you point out, when policy makers rely on magic spells, oftentimes the result is something unintended, as is the case with many magic spells.

As recent poll of the little people in Japan inquired why they save so much. They said it was because they think the government is going broke and they won't get their pension. (translates to social security) So maybe people aren't as dumb as policy makers think.

Posted by: Cedric Regula at March 26, 2010 09:27 AM

Cedric,
Interesting observation about Japan. Of course a nation can not have net financial savings within itself. Private savings must equal to investment and government deficit plus external savings (c/a surplus). If one looks at Japan's demographic structure it is striking that Japan has an effective "one-child" policy without China's repression. It is entirely rational for such a country to accumulate external savings for retirement. The alternative is to raise the birth rate in one of the most densely populated nations on earth. In the case China, people should think what they fear more: a rapidly aging China that runs C/A surplus and depends on the world for retirement, or a China that grows its population in face of severe domestic resource constraints and is yet highly technologically capable.

Posted by: HZ at March 27, 2010 10:30 AM

Mark,
Your prescription for consumption tax is also deflationary. I am agnostic whether fiscal or monetary policy should be used -- indeed I am highly suspicious of the vaunted efficacy of monetary policy.
Ireland is going through deflation. They have no choice having the same currency as Germany. Yet I suspect that they are doing the right thing and they have a brighter future than those who resist change.

Posted by: HZ at March 27, 2010 10:35 AM

I can't resist but to point out that currency warriors like Shumer or Krugman or Peter Navarro are rather naive. Their assumption that China has few good choice may be true. Their assumption that China is powerless as a creditor is naive to the extreme. Nobody says China has to buy US obligations or US products (even if that may be true in the very long term). If China loses confidence in USD it could go buy (or at least try to buy) half a trillion dollar of crude oil. What would happen to oil price then? How much more debt US has to incur to buy the oil it needs -- and how does that affect economic activity or trade or simply confidence when US trade deficit worsens instead of improving with a falling USD? If USD falls precipitously with a sky high oil price, what would happen to our vaunted global military power? When faced with a precipitously falling USD, would a capitalist say "wow, let me invest in the US to take advantage of the lower production cost" (which even if he does would take years to accomplish) or would he rather say "gee, are we going to have a revolution here? should I get out fast?".
And you know what, the funny thing is that none of these great advocates for American manufacturing would ever want to work or see their own children work on an assembly line. Somehow that is a great future for other Americans. Assembly line is probably the most mind numbing place you can think of -- by definition if you have to think to work on a line you are not maximizing productivity. It may be an improvement for people doing back breaking farm labor with primitive tools. It is certainly not what people aspire to if they have other choices.

Posted by: HZ at March 27, 2010 10:57 AM

HZ,
I think a deflationary monetary policy is deflationary. Give me a country that has a consumption tax and hand me their printing press. I'll give them inflation by the end of the day.

Posted by: Mark A. Sadowski at March 27, 2010 12:03 PM

If you tax consumption and reduce fiscal deficit it is deflationary.
It doesn't take a genius to create hyperinflation if you debauch the currency. Otherwise just having a printing press is not going to work -- you need to convince credit worthy people to incur or increase their debt. Just ask Japan.

Posted by: HZ at March 27, 2010 02:21 PM

HZ,
If you replace income taxes with a consumption tax in a revenue neutral fashion it need not change the deficit at all. And even if it does reduce the deficit, it would likely have little effect on inflation if monetary policy offsets it.

Japan (and I now fear the US) is a near ideal model of how not to practice monetary policy in a liquidity trap. Purchases of longer term securities will raise GDP through reduction of longer term interest rates according to the FRB's own model.

I refer you to Mishkin's textbook, Woodford's papers, Gagnon's policy proposals, Sumner's blog, some of Krugman's columns and blog entries, ocassionally DeLong's blog, and Bernanke (until he fell under the spell of Plosser).

And I should mention that Gagnon has been a guest contributor of this blog:

http://www.econbrowser.com/archives/2009/11/guest_contribut_5.html

Posted by: Mark A. Sadowski at March 27, 2010 03:09 PM

Mark,
I said the tax was deflationary, meaning it is one factor/input that has a deflationary impact. I take it that you mean you are not advocating deflation even if the tax is deflationary, since there are ways to counter the deflationary effect. OK.

Central banks don't live in a vacuum. Unconventional policy making in a crisis may be okay. Otherwise so long as we live in a democracy you need to face people like Ron Paul and the Tea Party. If you want to conduct fiscal policy through monetary policy don't complain when the central bank gets crushed by politics.

Interestingly all these great manipulations of expectations by a central bank is A-Ok. But a transparent currency peg is not.

In the end nothing the CBs do will correct structural mismatches across the globe.

Posted by: HZ at March 27, 2010 04:43 PM

HZ,
You wrote:
"Interestingly all these great manipulations of expectations by a central bank is A-Ok. But a transparent currency peg is not."

The pegs by the Baltic States and Bulgaria worked great until they didn't. I'm an empiricist.

Posted by: Mark A. Sadowski at March 27, 2010 06:01 PM

Cedric,

"I don't think we should let central banks try and cast inflation or deflation magic spells on the citizenry."

I don't advocate that central banks do either. These are just natural tendencies that the respective economies are exhibiting (China/inflation, US/deflation) and for very good and rational reasons. The central banks, on the other hand, are fighting it hard based what their theory/model says. I am saying it is not a bad thing if they don't succeed completely in their fights.

Posted by: HZ at March 27, 2010 06:09 PM

"The pegs by the Baltic States and Bulgaria worked great until they didn't."

And I bet the peg wasn't the only reason why they failed.

Posted by: HZ at March 27, 2010 08:44 PM

HZ,
The peg is highly significant statistically and this is consistent with most of the literature on current account reversals and exchange rate regimes.

Posted by: Mark A. Sadowski at March 27, 2010 09:21 PM

HZ,

It would be terrible if we used a stimulative monetary policy, and if that fails, fiscal stimulus(tax breaks), to pay for a consumption tax and keep AD growing, so that we can have GDP growth.

Tho since the dollar is not pegged to anything, we could probably go for a considerable, and extended, period of time before the buck hits zero and we need a new currency. Call it the "Real" maybe?

But that's just my opinion. However, I think I could explain it to 80 million baby boomers nearing retirement, even tho I only made it thru econ 102 and have forgotten how the textbook derivation would go anyway. But, just what we need, a consumption tax on our bed pans.

I won't let the CBs off that easily, however, because in the 2001-2002 recession they did do their usual thing of fighting a downturn with monetary policy. Now some people are trying say the resulting housing bubble was a failure in bank intermediation (regulatory "lapse").

Contrary to popular belief, the Fed does not have a fleet of Black Helicopters that they use to drop money on the citizenry, and bank intermediation is the conduit they rely on.

So, in my opinion, if you are the plumber, you should know the state of the plumbing before turning the water main on.

They are saying they didn't know.

So they inflated a housing bubble, then it popped, which is why we now have deflation.

With regard to Chinese inflation, there is always more than one cause for things economic, but the peg is an inflationary force because they do print RMB to match the trade surplus inflow of dollars(which they send back to us). In the past they were able to keep things under control with issuing RMB sterilization bonds domestically, but for some reason, lately that stopped working. Tho I hear it's mainly commodity (food) and real estate inflation that they have. Like over-capacity in residential housing and CRE in the US, they can't re-flate over-capacity in the manufacturing sector in China. Tho they did do "Cash for Refrigerators", and temporary programs like that as part of last years stimulus spending.

But like you say, "I am saying it is not a bad thing if they don't succeed completely in their fights.", agreed. Oftentimes the economy wants to do something that's right for the vast majority of the participants, rather than what the Global Overlords deem is right.

Posted by: Cedric Regula at March 28, 2010 06:19 AM

Mark,
I will offer Hongkong (with a significantly larger economy I amy add) as an example of success. Yes Hongkong does have to learn to deal with inflation/deflation of exogenous nature.

Cedric,
If the peg stays, it is unlikely both CBs will succeed in their pursuits since their goals are at odds with each other.

Posted by: HZ at March 28, 2010 10:45 AM

HZ,
Are you aware that Hong Kong is running a sizable current account surplus (14.2% of GDP as recently as 2008)? Thus the term "current account reversal" would not apply to them, as the most negative consequences only apply to those countries running deficits.

Posted by: Mark A. Sadowski at March 28, 2010 12:03 PM

HK is dealing with exogenous inflation. It will do alright. It had experienced exogenous deflation in the past as well.
Ireland is probably experiencing what you called "current account reversal" and needs to adjust and deflate. But I suspect that they will do fine (actually do great, much better than those that resist adjustment) in the long run.

Posted by: HZ at March 28, 2010 12:59 PM

HZ,
Consumer Prices fell 1.0% in Hong Kong last year. Real GDP is forecast to be 9% below trend in 2010.

On the other hand, yes, Ireland is experiencing a current account reversal. And real GDP there is forecast to be 28% below trend in 2010. Most economists expect a long painful adjustment ahead for them.

Based on a number of factors my opinion is that countries that are already on the euro (like Ireland) should stay on it. Countries that are pegged to the euro like Latvia probably should have floated at the beginning of the crisis. Now it's too late as a great deal of public debt has already been taken on.

Posted by: Mark A. Sadowski at March 28, 2010 02:17 PM

I just noticed this post at vox:

http://www.voxeu.org/index.php?q=node/4806

Among other things it states the following about emerging Europe (using a very different method than me):

"For the most part, countries with pegged exchange rates experienced larger downward growth revisions (on average, in excess of two percentage points) compared to countries with more flexible exchange rates. None of the least-affected countries in the sample had a pegged exchange rate."

Posted by: Mark A. Sadowski at March 28, 2010 03:11 PM

Mark,
The troubled countries you are talking about would never have been able to run persistent c/a deficits and borrow in their own currencies anyway. US (and maybe UK, Australia, NZ) are the few that are able to run c/a deficits and borrow in their own currencies -- although someone for sure has to take the Forex risk, in US's case we kind of know who are bearing the risk while in the other cases it is not clear.

Take Latin America for example, it doesn't matter whether they have pegs or not, they all had various crises. The problems lie elsewhere (and much deeper than simple exchange rate).

Posted by: HZ at March 28, 2010 07:28 PM

HZ,
Prove it.

Posted by: Mark A. Sadowski at March 28, 2010 09:21 PM