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.

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

  1. “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?

  2. 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.

  3. 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…

  4. “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.

  5. 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.

  6. “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.

  7. 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.

  8. “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.

  9. “…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?

  10. “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.

  11. “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.

  12. “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.

  13. “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

  14. “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.

  15. 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.

  16. 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.

  17. 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.

  18. 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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