Interest Rate as Policy Choice, Exchange Rate as Degree of Freedom

In the previous post, I discussed a short paper by Paul Krugman on the “invisible bond vigilantes” and noted convergence, on the issue, to the position of modern monetary theorists. Briefly, the bond vigilantes, in the view of both Krugman and modern monetary theorists, are not so much an “invisible” as a nonexistent threat to nations that satisfy four conditions:

1. The government is a currency issuer;
2. The exchange rate floats;
3. The monetary authorities set the interest rate;
4. The government avoids borrowing in foreign currency.

Under these conditions, as Krugman points out, there is little reason to expect a loss of confidence in the currency, but if there were, the impact would be more favorable than in the case of nations operating under fixed-exchange-rate or common-currency arrangements. For non-economists among us, this point seems worthy of elaboration.

In his paper, Krugman writes:

Think about it this way: with the Fed setting interest rates, any loss of confidence in US bonds would cause not a rise in rates but a fall in the dollar – and a fall in the dollar would be a good thing, helping make US industry more competitive.

We can unpack this statement a little by briefly comparing the implications of the different currency arrangements.

 
Fixed Exchange Rate or Common Currency

Under a fixed exchange rate, assuming there is a commitment to that exchange rate, a loss of confidence in the currency will force the central bank to intervene to maintain its (external) value. As demand for the currency drops, the monetary authorities will need to bring about a rise in interest rates to attract capital inflow.

In this framework, the interest rate plays the role of what Edward Harrison calls the relief valve, which has implications for the costs of servicing public debt.

Of course, in the case of an individual nation, there could be a revaluation of the currency, rather than a defense of it. In a common-currency arrangement, such as the EMU, the constraint on individual nations is more binding. The essential point, though, is simply that if the central bank intends to defend a particular exchange rate, it is the interest rate that provides a degree of freedom, bearing the brunt of any market pressures.

The implication is that a loss of confidence requires a macroeconomic policy response from government that will only further destabilize the economy. For one thing, the necessary increase in interest rates, brought about through a tightening of monetary policy, will be contractionary, in the mainstream view. For another, and more importantly from the perspective of modern monetary theory, the higher interest rates, by raising the cost of debt servicing, will limit the ability of governments to maintain aggregate demand through deficit expenditure.

In short, the impacts of a loss of confidence on both monetary and fiscal policy will be contractionary in a fixed-exchange-rate or common-currency arrangement.

 
Floating Exchange Rate

Under a floating exchange rate, assuming the monetary authorities are committed to their interest-rate target, a loss of confidence will result in depreciation of the currency. In this case, the exchange rate provides the relief valve. As long as the government has not borrowed significantly in foreign currency, its ability to service debt will not be inhibited.

The central bank could, if it wished, alter its interest-rate target in an attempt to limit exchange-rate movements, and this in the mainstream view would be contractionary, but this would be a deliberate policy choice not dictated by market pressures.

If, instead, the central bank commits to the interest-rate target, it will be the exchange rate that bears the brunt of any loss in confidence. Such currency depreciation, as Krugman points out, tends to be expansionary, because it lifts the competitiveness of export and import-competing industries.

So, under a floating exchange rate, a loss of confidence neither undermines the government’s capacity to pursue appropriate deficit expenditure nor compels an alteration in monetary policy, provided the government has not borrowed significantly in foreign currency.

 
If, Not When

In closing, it is worth reiterating that all this discussion has been predicated on there being a loss of confidence in the currency. In reality, there is little reason to expect a loss of confidence in the case of the US, UK, Canada, Japan, Sweden, or other nations with modern monetary systems, provided deficit expenditure is for the purposes of narrowing the output gap and the four conditions emphasized both by Krugman and modern monetary theorists all apply.

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70 thoughts on “Interest Rate as Policy Choice, Exchange Rate as Degree of Freedom

  1. “a loss of confidence will result in depreciation of the currency. ”

    Not necessarily. That depends on the reaction of other central banks across the globe. If you have central banks across the globe supporting a regime with an export led policy you can expect that they will move to prevent a loss of confidence from impacting their economy.

    The Swiss being a case in point when the Euro started to slip.

    A loss of confidence in one currency requires a relative shift in confidence into another. These are non-convertible currencies so there still has to be someone coming in the opposite direction.

  2. Thanks for elaborating Peter, makes perfect sense. But I STILL don’t know what IS-LM has to do with any of it. But that’s my problem. I will figure this out, documenting my journey along the way:

    IS-LM: One Woman’s Story

    I fully expect it to be categorized under the suspense genre. Perhaps horror.

  3. “So, under a floating exchange rate, a loss of confidence neither undermines the government’s capacity to pursue appropriate deficit expenditure nor compels an alteration in monetary policy, provided the government has not borrowed significantly in foreign currency.”

    A lot of wishful thinking here.

    A loss of confidence leads to central bank intervention – not just to put a floor on the fall of the exchange rate but to reverse the direction of expectations. Other factors include keeping the exchange markets functional. Since foreign exchange is limited, it also leads to liability dollarizarion. Also to keep the balance of payments from getting out of control, fiscal policy has to give in.

    It is pure fantasy to think floating exchange rates removes the balance-of-payments constraint.

  4. “It is pure fantasy to think floating exchange rates removes the balance-of-payments constraint.”

    It isn’t – because there are other central banks in the world pursuing their own agenda.

    A ‘loss of confidence’ (whatever that is) may lead to central bank intervention – but it won’t be your central bank. It will be that of the exporters to your currency area that stand to lose a lot of business.

    There is no accepted theory of exchange rates that fits with the empirical data. So to suggest there is a constraint at all or what the nature of it is is simply is not supported by the data. An ‘imbalance’ isn’t necessarily out of balance. To suggest otherwise is just wrong.

  5. There is a lot of support. Instead of going into elasticities and all that, simply look at export levels and gdp to start seeing the trend.

    Instead you simply deny.

    About exchange rate theory, look at it this way: it doesnt adjust to bring the imbalance into balance. Rarely. This precisely is the issue: it makes the issue/constraint harder to deal with.

  6. Neil: A ‘loss of confidence’ (whatever that is) may lead to central bank intervention – but it won’t be your central bank. It will be that of the exporters to your currency area that stand to lose a lot of business.

    At least two implicit assumptions are made here:
    1. Potential loss of import goods is neutral to the functioning of the broad economy.
    2. Your currency area is big enough to cause headaches to other central banks.

    I would say that both assumptions are rather strong ones and cannot be easily extended to the majority of countries in the world.

  7. “I would say that both assumptions are rather strong ones and cannot be easily extended to the majority of countries in the world.”

    There are always two sides to a balance sheet:

    – It can similarly be said that the assumption you make is that a potential loss of export goods is neutral to lots and lots of foreign economies. Why would that be given that they are all *pushing* ‘export led growth’ (as instructed by the IMF) and are liquidity enabling that to occur? Exporters don’t want my currency, they want their own.

    – Why was there foreign savings in the currency to start with that allows a ‘crisis’ to happen? Net saving by the foreign sector in the domestic currency doesn’t spring up by accident. You are only entitled to import what you export unless the foreign sector allows more. Foreign Central bank liquidity action is what likely allows ‘more’.

    The MMT position is that the government sector withdraws from the foreign exchange management process and leaves it to the private sector – using other policy control tools instead if it has to to maintain stability. So it pays no interest on government financial assets and does not take foreign currency loans. The government spending previously injected via financial assets is injected by government spending/tax cuts in the domestic economy some of which may then ‘leak’ abroad.

    Beyond that it is counter-cyclical reinjection of an amount equivalent to the excess savings desires of the non-government sector – preferably via the automatic stabilisers.

    I find it difficult to see how such a pragmatic approach can cause an insurmountable problem. It is simply a focus on the domestic economy and free capital flows – with the exchange floating.

  8. “About exchange rate theory, look at it this way: it doesnt adjust to bring the imbalance into balance. ”

    That’s because it isn’t an ‘imbalance’. It is balanced unit-for-unit by the capital account – which somebody somewhere considers a good deal *otherwise it wouldn’t happen*.

  9. Neil, you are not fair considering all sides.

    Loss of export markets might not be that painful as loss of import markets. Firstly, in the former case government can still keep the economy going because even in the neoliberal sense it should have accumulated some fiscal capacity for stimulus. Secondly, in the latter case the loss of imports might disrupt domestic production chains also triggering losses of export markets and therefore downward spiral.

    It is not about which currency is involved and which currency is not involved. Prudent macromanagement requires you to consider risks. It can be that nothing is wrong with you and your trade partners, but there is big bang on the other end of the world (in the USA or eurozone) and USD appreciation is causing your currency depreciation with all potential consequences mentioned above. It has nothing to do with MMT, savings desires of foreigners or locals. You are just an observer of how exogenous events ruin your production economy, triggering political problems and all related economic problems about uncertainty, confidence and so on. But you do not have a plan because in your mind there is no problem.

    You (and MMT in general) tends to oversimplify the world too much. Understanding of monetary operations does not tell you much about real life in the interconnected real world. The world, of which politics is part of. And the world where changes to economic habits are politically very painful.

  10. “Loss of export markets might not be that painful as loss of import markets”

    I would say they are likely to be just as painful if not more so. And given that the exporter has the capacity to fix the situation why wouldn’t they do that? Particularly as they have built up the import deficit by providing liquidity to that market. They wouldn’t have done that unless the market was important.

    “It can be that nothing is wrong with you and your trade partners,”

    It must be, because a foreign central bank can always bring down the relative value of its own currency wrt to another simply by buying the foreign scrip. Which is exactly what the Swiss did wrt. Euro when there was a ‘loss of confidence’ in the Euro.

    “and USD appreciation is causing your currency depreciation ”

    USD appreciation can only happen if the Federal Reserve allows it. It can be reversed by providing liquidity to the markets (flooding the world with dollars) – again something that they have already done with the Euro.

    Currencies are relative values. Arbitrage firms ensure that is the case.

    “You (and MMT in general) tends to oversimplify the world too much. ”

    Slightly better to abstract than catastrophise. Catastrophising is a recognised stage of depression and paranoia. And the recommended solution is to balance your thinking by actually looking at the risk and impact of the things you are irrationally terrified about. Things that are very unlikely to happen should receive the attention their probability deserve.

    Currency is an *exchange*, which means you move out of one and into another *and somebody else must come in the opposite direction*.

    So if one goes down, then something else must go up. For every short position there is a long position.

    And with a floating rate non-convertible system, the currency issuer can *always* push down the value of their currency wrt any other in the world unless the other currency issuer doesn’t want their currency to go up.

  11. Neil: USD appreciation can only happen if the Federal Reserve allows it

    Neil, with all respect, it is quite pointless to argue with you. BoJ has been fighting yen appreciation for ages. Yes, SNB decided to fix the rate and be done with it. But any interference of this types sends wrong price signals. If prices are disturbed for just a short while, noone might notice. But if it goes on for years, what kind of imbalances might be built in the system? You seem to completely discount these and similar macroeconomic risks on a pure MMT basis that government deficit can fix them all. Probably it can. Especially in theory and if given some time. But this is where we completely depart. I do not think of government as some supernatural body with perfect foresight and perfect altruism. And of people who vote for such government as people with similar traits. I rather tend to take a pragmatic position where history and reality is a good guide. Governments generally suck. And suck from big S. It does not mean there can be no exceptions. But as we say an exception only proves the rule. Even if governments do not suck international matters are effectively barter based and therefore involve intergenerational transfers. By giving “ok” to any exchange rate imbalances aka foreign savings desires etc, you implicitly give ok to intergenerational transfers. I have a very strong opinion in this regard. Please do not tell me how wrong I am and how right you are. You express a political view which I reject. Insisting on your political position in light of this obvious contradiction is very counterproductive to any debate.

  12. “Neil, with all respect, it is quite pointless to argue with you. ”

    Try debating instead then.

    “Yes, SNB decided to fix the rate and be done with it. But any interference of this types sends wrong price signals.”

    Doesn’t that rather assume that manipulating the rate isn’t the normal position? The economies in the world are in tension and ‘floating rate’ doesn’t mean that there is any kind of ‘free market’ in currencies. The rates are essentially fixed between competing central banks and currency areas. Yen appreciation can only be dealt with if the counterparty agrees that the appreciation is unwarranted and doesn’t respond to an intervention.

    The MMT proposal of offsetting the savings desires of the non-government sector gives an import deficit country another lever to counteract the manipulation of its domestic currency circulation flow by the foreign economies it is openly trading with.

  13. “The economies in the world are in tension and ‘floating rate’ doesn’t mean that there is any kind of ‘free market’ in currencies”

    Very good. So there is no international cooperation and everybody tries to abuse the economic mistakes of some other country.

    Why do you say that budget deficits fix those mistakes and therefore eliminate the source of tension? Are you even sure that (insufficient) budget deficits address THE problem?

  14. The dynamics of international trade is to tend drain domestic circulation from import deficit countries and transfer it to ‘foreign savings’ largely at foreign central banks. That does not resolve itself via ‘market forces’ due to the nature of endogenous money. There is no market for ‘loanable funds’.

    So it has to be offset or the domestic circulation continues to drain – limiting domestic response and creating greater demand for imports. You either offset by confiscating the ‘savings’ and recirculating, converting them into bonds (which is just creating new liabilities of a different type), or by issuing new liabilities into circulation.

  15. There is a reason for domestic drain. None of the options MMT offers (which is pretty much just one) anyhow addresses the reason of drain.

    You can consider confiscating savings but then your government will not last for long. Confiscation is hardly associated with confidence, i.e. something that does not have a definition in your mind as per your statement above.

  16. “You can consider confiscating savings but then your government will not last for long”

    Taxation is confiscation, and government survive just nicely with that in place.

    So again the evidence doesn’t support your position.

  17. Neil, it is one thing to tax income and another thing to confiscate savings. At least most people would clearly make a distinction between the two. In the case of exchange rates and foreign sector we are clearly talking about savings and not income.

  18. “Neil, it is one thing to tax income and another thing to confiscate savings”

    Not really. It’s all confiscation of one form or another. You could target it at unused reserve balances owned by foreign domiciled banks or you could set a cap for them so that it is only cancelled if they have too much – forcing them to recycle the money into the domestic sector.

    Or you could envisage ‘central bank fees’ that apply if the reserve balance is ever transferred out of a foreign domiciled bank – pretty much ensuring saving is a one way gate.

    None of them are as clean as simply offsetting the savings with new liabilities and declining to pay interest on reserves/bonds – particularly foreign held reserves/bonds

  19. Neil, are you going to control the whole financial system including its private part!? I am afraid you set your targets too high. If that was that simple, I am sure our world would have been different. So while I appreciate your mental exercises on what on *can* envision and can *not*, I very much welcome you back into our world. In our world central bank settlement balances are just a tiny-tiny-tiny-tiny blip on the screen noone gives a fook about.

    But please notice how your own logic leans towards balanced budgets. Don’t you find this contradiction interesting?

  20. “But please notice how your own logic leans towards balanced budgets. Don’t you find this contradiction interesting?”

    Not at all. The problem is the excess saving of the non-government sector – caused because the loanable funds model of neo-classical economics is invalid in a credit economy.

    You either solve that by eliminating the savings or offsetting them. The ‘natural’ process is to eliminate the savings via bankruptcy and capital destruction in a business cycle depression.

    MMT suggests its more sensible to offset them by reinjecting at the bottom end via automatic stabilisers. Saves a lot of gnashing of teeth and suffering.

    The simple goal is to maintain the circulation of tokens at the optimum value so that you have full employment and price stability.

  21. “MMT suggests its more sensible to offset them by reinjecting at the bottom end via automatic stabilisers”

    *re*injecting? I hear, I hear. But it is not so much about where you inject them, but where they end up. 1 dollar is 1 vote.

  22. “*re*injecting? I hear, I hear. But it is not so much about where you inject them, but where they end up. 1 dollar is 1 vote.”

    You can’t have it all I’m afraid. Domestic policy independence, fixed exchange rates and free capital flows don’t all go together. You can only have two out of the three.

  23. This is actually a good discussion. Appreciate both sides.

    I lean to Neil’s position, which at least I understand. I also understand Sergei’s point that just delivering more dollars to hoarders is problematic. Isn’t the best approach to deficit spend in some way that minimizes leakage to the undeserving sectors? Obviously this is easier said than done, but you have to try to do the right thing. What is the alternative?

    Sergei– What do you think the U.S. should do to combat Chinese mercantilism?

    With regard to Japan, it seems that China has been playing them by buying Japanese bonds. Any thoughts?

  24. Dan, yes, the problem is leakages, not the inadequate fiscal position. Every case of a leakage will probably be special and require a unique solution. The proclaimed goal to satisfy saving desires is ridiculous. Saving desires are unlimited. Wealth is a part of our social game and therefore can not be too much. Buffett might slow down but for each Buffett there will be millions happy to take his position and carry on. Forever-ever.

    China? Isn’t it ironic that China very much outplayed USA on its own pitch? What is Apple without China? Or Walmart? It is not me who is pretending to have answers to all questions. But in a world of nations competing on numerous dimensions I find it hard to believe that the winner can be the one with the highest fiscal deficit. However if the only tool you have is a hammer then all problems look like a nail.

    It does not take a brain cell to print a higher deficit. But it takes a bit of work to put any deficit to good use. What MMT theoretically proposes is good but far from enough or satisfactory. And what MMT theoretically proposes can practically be very easily abused. In fact it happens all the time since republicans tend to run higher deficits than democrats. Do you think it is a coincidence?

  25. Sergei, I’ve read the discussion, but I’m still not quite sure what you propose instead of governmetn satisfying non-government sector’s saving desires. Would you agree with the re-injection point if we assumed (really, just theoretically) that government does put deficits into a good use and that money doesn’t end up in rich guys pockets?

    You also said that it’s good, but not enough or satisfactory – what did you mean exactly?

  26. @ Sergei,

    “It does not take a brain cell to print a higher deficit. But it takes a bit of work to put any deficit to good use.”

    Agree and think the MMT Job Guarantee Program fulfilled locally and federally funded addresses this nicely, don’t you think?

  27. “You also said that it’s good, but not enough or satisfactory – what did you mean exactly”

    MMT might be good for a closed economy. But with regards to the foreign sector MMT has a ridiculous position. It is enough to say here that Mosler has just said that he does not know of any real life case when a country was physically forced to run trade surpluses. http://www.imf.org would be a good start. As well as google “troika greece”. It is really not worth starting it all over again and use the space of this blog.

  28. But I agree with RVMarkov that the MMT folks do have a good, if untested, proposal.

    I still haven’t heard from Sergei what he would do, although we seem to agree that money spent wisely by the government to plug chronic leakages would be good. It may not be easy, but what is the alternative?

  29. Yes, the proposal is good. I was really taken by it for a while. However having observed a pretty clear hostility of MMTers towards critics of its foreign sector analysis I do not buy this proposal any more. For one thing MMT attitude towards foreign sector (aka imports are benefits etc) is an inter-generational transfer and my political views do not allow me to accept it as an unconditional benefit. Something MMT does wholeheartedly.

  30. “nd my political views do not allow me to accept it as an unconditional benefit. ”

    And that’s the crux of the matter. Fundamentally you don’t want to believe what the economics says.

    That’s fair enough. But don’t then suggest that the economic analysis is ‘flawed’ when really it is ‘flawed relative to my religious beliefs’.

    I mean bringing up Greece as evidence against MMT really is a bit desperate. You know damn well why Greece is in the position it is in – it doesn’t have a floating rate exchange system to act as a buffer. Floating rate and non-convertibility completely alter the dynamics.

  31. Peter, sorry to bother you. But since I’m no longer speaking to Neil Wilson because he won’t talk about the US on his UK blog, can you please tell him that he’s looking at me funny?

    Thanks.

    Also, did you know half the people in this world have BOOBIES? I tell it the way it is, you just can’t handle the TRUTH.

    #MMT

    ps. I’m gonna flunk this class, aren’t I?

  32. Neil, you misinterpret the situation. The problem is not about my religious beliefs. I resist the hidden political agenda of MMT. It is clear from all responses because the questions raised are never addressed head on. Rather the questions are dumbed on those who dared to ask and they sooner or later get banned from commenting. Who is religious here? Why don’t you just for a difference answer the question in a simple yes/no format? Is there a transfer or not? Simples. And then we can all see how you are able to defend your *economic* *theory*. Please notice that both qualifiers are asteriked because both are challenged here.

  33. “It is clear from all responses because the questions raised are never addressed head on.”

    They are and have been. Randy wrote two chapters in his book on the subject.

    It’s like the guy banging his head against the wall and demand that you stop it hurting.

    To which you respond there is no need to bang your head against the wall. And then you get the angry response “NO. I want you to stop it hurting”.

    If you believe in banging your head against a wall, it’s going to hurt. Can’t help you with that one.

  34. and as always no answer. qed. you wrote 10 sentences when I asked for just one word which you forgot to mention

  35. @ Sergei,

    “For one thing MMT attitude towards foreign sector (aka imports are benefits etc) is an inter-generational transfer and my political views do not allow me to accept it as an unconditional benefit.”

    I don’t see it as inter-generational transfer.

    The very impose of taxation creates the unemployment. It doesn’t make any sense what so ever to create unemployment first and then not to provide enough national currency (spending) to all in search of it (the unemployed).

    I see it this way, and I believe that’s Warren Mosler’s view: Set the right size government first and Fed funds rate preferably permanently at zero, but it is political choice (through political elections), then maintain full employment through taxation and let the exchange rate float. The goal isn’t to achieve current account surpluses or deficits. The goal is to put in optimal use the available real resources and technology of the country maintaining full employment, and if the country lacks any of the necessary resources or technology, then the foreign trade should solve such problems.

  36. Without indicating a strong opinion one way or the other on the specific issue of the external sector (I appreciate the discussion on both sides), I will just make a general comment about an aspect of MMT alluded to by Sergei:

    The proclaimed goal to satisfy saving desires is ridiculous. Saving desires are unlimited.

    I think of it this way. MMT indicates that if the government deficit is smaller than the non-government (i.e. private-domestic plus external) net-saving desire corresponding to full employment, there will be unemployment. But, of course, this net-saving desire corresponding to full employment depends on distribution, institutions, regulations and other factors.

    The MMT observation suggests two types of policy response to unemployment: 1 accommodate that net-saving desire or 2 attempt to reduce that net-saving desire. To choose 1 over 2, 2 over 1, or some combination of 1 and 2 (or neither — which would mean leaving unemployment unaddressed) would all be equally political actions. But both 1 and 2 also have economic — not just political — implications.

    I agree with Sergei that to choose 1 to the exclusion of 2 will often be a bad approach. For example, at the moment, I think there should be redistribution of income through increased taxes on the wealthy (likely to reduce the net-saving desire) in conjunction with overall deficit expenditure. That is partly a political position and partly an economic one. Greater income equality appears to be correlated with stronger and more sustainable growth. This observation has both economic and political content.

    Further, having chosen some combination of 1 and 2, how 1 and 2 are carried out will also be both political and economic.

    In this connection, RVMarkov appropriately mentions the job guarantee. This mechanism would ensure full employment with the least accommodation of net-saving desire in the given institutional and distributional context.

    I don’t see fiscal policy as a single hammer (an analogy of Sergei’s). It provides many hammers from which to choose, since every array of expenditure and tax measures puts in place a different set of real economic actions. However, neither does this mean that fiscal policy is the only valid means of attempting to influence the net-saving desire. Regulations, institutions, distribution and more all matter.

    These general remarks are intended to apply equally to private-domestic net-saving behavior and foreign net-saving behavior. What ends are being served by the net-saving behavior? They may not be ends that are to the overall benefit of the general community. There are political choices to be made on all such questions, either consciously or by omission, and there are also economic effects to be taken into account.

    Having said all that, it is not clear to me that the disagreement between MMTers and others on the external sector is due to anything other than the way these factors are organized analytically in the different perspectives. That is, unless I am mistaken, I think these considerations are understood by both sides.

  37. Trixie, how can there be a pop quiz when:

    1. You persist in disrupting the class;
    2. The “students” know more than the “teacher”?

  38. “The proclaimed goal to satisfy saving desires is ridiculous. Saving desires are unlimited.”

    Net savings desires have practical limits. The domestic private sector isn’t going to want to not-spend 100% of its income. Nor is the foreign sector going to desire to send 100% of it’s real output to the US.

    The thing that’s unlimited is the desire for more income from which to save and from first principles MMT offers inflation and real resources as the constraints against opening the fiscal spigot to provide unlimited income. Accommodation doesn’t run off into infinity.

  39. Peterc– Thank you! Your comments provide an excellent resolution (for me) of the apparent confusion. In this light, the job guarantee does seem like a really good idea…

  40. “For example, at the moment, I think there should be redistribution of income through increased taxes on the wealthy (likely to reduce the net-saving desire) ”

    Not sure about that Peter. Just as likely to cause more hoarding and extraction.

    I’d rather it was somewhat more difficult to get the income in the first place – particularly rents. In computer game terms, they beat Level 1 easily. Level 2 should be considerably more difficult.

  41. Peterc,

    About “net saving desires”, there is a confusion around here about accounting identities and behaviour.

    A trade deficit is not the result of “net saving desires of foreigners in the issuer’s currency” (as it typically worded). An import is due to a resident purchasing a foreign product over a domestically produced one and says something about the relative competitiveness of domestic and foreign producers. It also depends on the domestic income in addition to the competitiveness. Exports on the other hand depends on domestic producers compete by other producers (both foreign and domestic (with respect to the foreign nation)). In addition imports/exports depend on incomes.

    For example:

    For a constant propensity to import, an economy contracting has less imports even if foreigners suddenly increase their portfolio preference of assets denominated in the currency of the nation. So for example, the United States trade balance improved during the crisis/recession even though foreigners wanted more USD denominated assets (in the “flight to quality” environment).

    Plus there are many confusions such as imports being invoiced in the domestic currency and so on which makes the Chartalist story of trade determination chimerical.

    The weakness due to trade imbalances also manifests on the monetary side and a sudden portfolio shifts leads to liability dollarization of the official sector, troubles in the foreign exchange markets etc. More importantly, it acts by downward adjustment to income. Trade deficits lead to hemorrhage in the flow of funds.

    Nations who are competitive in the international markets are more successful than those who do not and something needs to be done to solve this. It is strange how some theory ignores this basic empirical fact and thinks that balance of payments does not matter and worse thinks others don’t get it!

  42. Ramanan, do you follow “External economy considerations” parts of the future MMT text book on billi blog?
    You may be helpful there. It is still continuing next Friday.

  43. “Plus there are many confusions such as imports being invoiced in the domestic currency”

    That’s no confusion at all.

    For there to be an import, not only does there have to be a real sale, but there also has to be a monetary sale in the opposite direction.

    Everybody has to get what they want.

    So the domestic importer will largely want to pay with domestic currency and the foreign exporter will largely want to receive their own currency.

    The foreign exchange system then has to settle those desires to the risk satisfaction of all *or the import just doesn’t happen*.

    That’s the thing about international trade – the money has to be right as well as the goods. There are two sales there.

    So it is utterly irrelevant what currency the import is invoiced in. That just determines which notional currency area borders the monetary exchange has to happen in.

  44. Total nonsense as usual.

    First you claim there is no imbalance. As per your logic, it does not matter if the trade imbalance rises every year by say 0.5-1%. Let us say first it is 3%, then 3.5% and then 4% and so on till like 9% … no imbalance at all – wow how illuminating!

    “So it is utterly irrelevant what currency the import is invoiced in. That just determines which notional currency area borders the monetary exchange has to happen in.”

    The border is not really so relevant as you present. If someone oil firm in Malaysia is importing oil from Saudi Arabia, it is exchanging it for US dollars. Not sure why you think border is relevant for this part.

    Plus if I carry out your logic, and let the government pay for imports in a foreign currency, it does not matter at all. Plus you forgot to add qualifications – wait … nations with purely floating currency with no official sector debt in foreign currency.

    But wait, trade imbalances lead to the nation’s increase in net indebtedness in domestic as well as foreign currencies. Neither of this matters to you. It simply does not matter at all.

    “money has to be right ”

    Can money be left or wrong?

  45. Peter, you have homework!

    In this connection, RVMarkov appropriately mentions the job guarantee. This mechanism would ensure full employment with the least accommodation of net-saving desire in the given institutional and distributional context.

    How so?

    I’d expand on my thoughts on why I don’t see that connection, but I don’t need anyone to remind me that I have BOOBIES. And that’s why I can’t understand it.

  46. Trixie, I just mean that full employment can be achieved with a smaller budget deficit in the case of a job guarantee than with generalized deficit expenditure. And a smaller budget deficit corresponds to less net saving.

  47. “s per your logic, it does not matter if the trade imbalance rises every year by say 0.5-1%. Let us say first it is 3%, then 3.5% and then 4% and so on till like 9% … no imbalance at all – wow how illuminating!”

    But there isn’t. Somebody has to be saving to allow that to happen as a matter of *accounting*. The capital account balances the current account.

    That is not an arguable point. It is a matter of fact. It’s the nature of free capital flows.

    That’s why the trade balance remains away from zero. Because there is no force to push them back. Everybody is happy with the trade.

    ” If someone oil firm in Malaysia is importing oil from Saudi Arabia, it is exchanging it for US dollars. Not sure why you think border is relevant for this part.”

    Ignoring the fact that you can always get oil in your own currency, let’s follow that on to its logical conclusion.

    If a firm situated in the national borders of Malaysia is importing oil from Saudi Arabia and paying in US dollars, then it has to get those dollars from somewhere first. And it has to have those dollars and demonstrably have those dollars before the Oil will be shipped. If the two sides of the trade aren’t in place to the satisfaction of all then the oil stays in the refinery.

    So where does it get the US dollars from? The local currency is the Ringgit, and the local licensed banks can only create Ringgit. So those dollars have to be bought in the same way as the Oil, and they have to be bought with Ringgit from somebody who currently wants Ringgit more than dollars *and* has some dollars.

    To the Malaysians US dollars are exactly the same as oil. They have to be imported.

    So what’s the process for importing the dollars starting with the creation of Ringgit?

  48. Neil: The foreign exchange system then has to settle those desires to the risk satisfaction of all *or the import just doesn’t happen*.

    Completely ignoring the financial sector? Both seller and buyer get their local currency deposits and the financial sector takes the credit risk of fx movements. And when shit hits the fan banks have to be bailed out.

  49. Trixie, I just mean that full employment can be achieved with a smaller budget deficit in the case of a job guarantee than with generalized deficit expenditure. And a smaller budget deficit corresponds to less net saving.

    Ugh. You suck. I shall return…

  50. “Both seller and buyer get their local currency deposits and the financial sector takes the credit risk of fx movements. ”

    That’s how the savings arise sorted then.

    “And when shit hits the fan banks have to be bailed out.”

    No they don’t. That is a policy error – as MMT economists constantly point out. The banks should go into resolution and the private funders of the credit system then take a bath – including foreign depositors. That then eliminates excess savings via the bankruptcy process – which is the pressure release valve in stress situations.

  51. Neil: No they don’t. That is a policy error – as MMT economists constantly point out.

    a) This is an illusion. You can point it out but it does not make it real. 1 dollar is 1 vote.
    b) Banks are public-private partnerships.

  52. “This is an illusion.”

    It isn’t – as Iceland nicely demonstrated for all of us.

    The economic prescription is that banks have to be able to go bust – in the same way as any other private sector entity.

    If you can’t organise your politics to make that a reality then you lose policy freedom. Just as you do if you fix the exchange rate or worry incessantly about public debt.

    “Banks are public-private partnerships.”

    Doesn’t matter what they are. If they go bust the investors and depositors who aren’t insured take a loss – and need to take a loss.

  53. Neil, you have a funny choice of examples. I am afraid Iceland demonstrate exactly what you do not want to see. That is when banks fail governments step in and bail them out. Which is precisely what British and Dutch governments did. And did for political reasons. Governments have a skin in the game. Which is the reason why banks are public-private partnerships. And the reason why writing down creditors is such a difficult task. You can put your proposals as much as you want but this is all pretty much ivory tower stuff.

  54. “The capital account balances the current account.”

    Tautologies.

    The difference between my expenditure and income (assuming the first is greater than the second) also balances with my “capital account”. Doesn’t mean my deficit is irrelevant.

    About points on banks and external crisis, you completely forget that if the government lets banks fail due to external crisis, the nation will be shut from the rest of the world. Even if not, new banks will come and will fail. The external sector issue is fundamental and has to do with real factors, not just monetary.

    Your point about oil being invoiced in any currency is fantastical honestly. Sorry your other arguments lead nowhere.

  55. “…the nation will be shut from the rest of the world. Even if not, new banks will come and will fail.”

    when has this happened?

  56. “when has this happened?”

    It never has. Unfortunately it is impossible to engage in understanding the issues – because anything that shows the fears are unfounded is dismissed out of hand.

    It becomes a normative argument and is essentially a political position.

    The external sector argument is not fundamental.

    “Your point about oil being invoiced in any currency is fantastical honestly.”

    I said nothing about invoiced. I said *paid*.

    Warren points out that you can buy oil in pretty much any currency, and there is no reason he would say that for a laugh.

  57. “Which is precisely what British and Dutch governments did.”

    But *not* the Icelandic one. What foreign governments do to clear up their own mess is their problem – even more so if you clearly state the insolvency conditions before hands.

    It demonstrates *precisely* what I want to show.

  58. “when has this happened?”

    I thought Paul Krugman reminded MMTers the fall of the Franc in the early 20th century.

    It happens whenever nations borrow from the IMF. At the time there is a general low acceptance of the currency.

    Surely you don’t think there is no banking crisis due to the external sector?

    “Warren points out that you can buy oil in pretty much any currency, and there is no reason he would say that for a laugh.”

    Ha ha ha!

    Learn some International Monetary economics. So in India, there is an arrangement between oil firms and the central bank where the central bank exchanges foreign reserves for the domestic currency of the oil firms. This is because if the oil firms directly try to exchange in the fx markets in large quantities, it will disrupt the markets.

    You are assuming that the fx market is like kind of an infinite thing which easily exchanges anything without any trouble.

    Am off. Commenters seem to be mixing how they want the world to work versus how it actually works.

  59. “I thought Paul Krugman reminded MMTers the fall of the Franc in the early 20th century.

    It happens whenever nations borrow from the IMF. At the time there is a general low acceptance of the currency.”

    No, you stated that international financial markets will shun countries after letting their banks default. These aren’t examples of that.

    How long would these shunnings last?

    “Commenters seem to be mixing how they want the world to work versus how it actually works.”

    Hardly. The events and relationships you describe are surely questions of policies specific to individual countries in short time periods, not questions of fundamentally how these markets “work.” I think Neil’s Iceland example stands and is as relevant as any examples you provide

  60. “So in India, there is an arrangement between oil firms and the central bank where the central bank exchanges foreign reserves for the domestic currency of the oil firms. This is because if the oil firms directly try to exchange in the fx markets in large quantities, it will disrupt the markets.”

    That’s precisely my point again. Central banks take foreign earnings off domestic companies and swap it for domestic currency.

    Which they will do when the currency gets too strong for their export policy. It’s the job of the central bank to suppress spikes and ensure liquidity and that tends to drain circulation from import deficit countries and transfer it to ‘foreign savings’ in export surplus countries.

    And that’s down to the consequence of endogenous money.

  61. Neil: But *not* the Icelandic one. What foreign governments do to clear up their own mess is their problem – even more so if you clearly state the insolvency conditions before hands

    Well, Icelandic government did not have a problem to start with. Private Icelandic banks dumped their foreign branches and subsidiaries. The case is closed and perfectly legal from any standpoint of private law which recognizes limited liability. The Icelandic government was then bullied to cover up for the foreign losses. It told everybody to have a long walk. Why do you use Icelandic government as a proof for your point? There was no problem for them to solve.

    Regarding telling everybody about insolvency conditions upfront, could you please describe, from a systemic point of view, how you see such system working and how systemic effects will trickle down to individual bank strategies and strategies of their clients? EU, with it current regulatory bonanza, is trying to implement something like this, i.e. crisis management directive, and we will be able to see how this will work out. I am really curious about your views on this because this is the point I spent a pretty decent amount of my work time trying to foresee and understand. I promise that if you tell me a consistent story I will fly in and buy enough beers or whatever you drink to get completely wasted in our discussions about MMT. I might even invite Ramanan so that we have more fun. What would you say? We will surely take that any discussion that can follow off this blog.

  62. The model I’m seeing at the moment is to split the currency pairs into two. So, for example, you have Rupees -> US dollars and US dollars -> Rupees. Those are two separate markets. I have Rupees to sell and I want US dollars for them and I have US dollars to sell and I want Rupees for them. You have equivalent directed pairs for every actual currency pair in the FX market.

    ISTM then that the market selling US dollars and wanting Rupees is ultimately the liquidity responsibility of the Indian Central Bank (via the private banks it authorises),and the market selling Rupees and wanting US dollars is ultimately the liquidity responsibility of the Federal Reserve (via the private banks it authorises).

    Layered on top of that you then have market participants that take liquidity out of one channel and squirt it into another channel (possibly via several other currency pairs) – either due to underlying real transactions or purely nominal speculation. That normal keeps things liquid, but the thinner the trade on a directed currency pair the more likely it will dry up.

    The key then is understanding the non-linear feedback that generates at an aggregate level which seems to cause a nominal drain to savings in the ‘wrong place’ due to the nature of endogenous money.

    Personally I think it will need a proper multiple actor led simulation creating to get a grip on it. The problem is very similar to the issue with designing computer network protocols and I wonder if one of the simulators can be adapted.

    I don’t trust the flat mathematical models. We don’t use those in computer network simulation because they never correctly relate to the real world. I want millions of nodes interacting and the ability to watch just one of them so I can see it is behaving as the real world entity does.

  63. Great post, thanks for the link Peter. I especially like Neil Wilson’s comment (but don’t tell him). I don’t understand what this obsession is with everyone wanting to become an export nation. Can’t happen. Something has to “give”. Harrison’s “relief valve” is the best I’ve seen so far in getting that point across. Hopefully Krugman continues to run with it.

    Also, BOOBIES.

  64. I have a suspicion that FX side bets mimic some of the characteristics of a fixed exchange rate. Large multi-nationals supposedly make side bets to mitigate damaging effects of currency movements. It’s alleged that counterparties to these bets are in the financial sector because it’s often hard to find counterparties with symmetric interests that would have the natural incentives to place opposing bets. It’s also alleged that these bets aren’t supported by capital (unlike retail banking or insurance). This suggests that there are vested interests in manipulating currency markets to maintain stability so that the financial sector wins the bets that are made against multi national conglomerates. Given that we’ve seen Libor manipulation and more recently energy market manipulation, it doesn’t seem far fetched to suspect that FX markets are substantially manipulated in favour of the financial sector (i.e. exchange rate stability). If all this is true, then the resulting system looks quite similar to a fixed exchange rate. It also suggests that there are substantial vested interests in lobbying government against policies that might cause currency movements.

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