The new Andrew K. Rose paper on fixed and floating exchange rates

by on October 22, 2013 at 7:38 am in Economics, Uncategorized | Permalink

The pdf is here, and the core result is that during the recent global financial crisis, fixed exchange rate regimes fared as well as floating rates with inflation targeting.  (Krugman comments here, Antonio Fatas comments here.)  That finding should not come as a surprise, for a few reasons:

1. Floating rates can be tough on countries which import a lot of oil, or which import critical inputs for their production or exports.

2. A lot of countries in 2008-2009 did not experience a traditional AD-only shock, rather they experienced trade shocks, which for the purposes of macro are like real shocks.  Floating rates offer less protection against real shocks than against nominal shocks.

3. One of the benefits of floating rates is that a country can crank up the rate of price inflation when it needs to, to offset negative demand shocks.  If you are targeting an inflation rate, you are not doing this and that means you lose out on a potential benefit of floating rates.

4. Fixed rates (or rather a single currency) have been a definite disaster for the eurozone.  Because of the nature of the EU, the absence of capital controls (except for Cyprus), and proximity, it is easy to switch your funds out of the failing countries, thereby whacking their banking systems.  I would rather have a euro in a German bank than a Greek bank, and so on.  This problem with “fixed rates” is especially strong in common currency areas with insolvent banks, and excess sovereign-bank connections, and it is less difficult in other fixed rate settings.

1 mofo. October 22, 2013 at 8:46 am

“Floating rates can be tough on countries which import a lot of oil, or which import critical inputs for their production or exports.”

Shouldnt that act as a price signal to come up with a way to mitigate those shocks? Im thinking a robust futures market should be able to communicate that information out combined with change in consumer behavior.

Im just a dumbshit non-PhD non-economist, but arent exchange rates just another price signal? Wouldnt maintaining a fixed exchange rate simply transfer the cost of currency exchange elsewhere? I mean, price controls dont work on anything else, why should they on currency?

2 Ray Lopez October 22, 2013 at 9:47 am

Google “Impossible Trilemma” dumbshit Mofo (self-described!), or, since you’re too challenged to do it yourself, here it is: Reed and lern something.

3 mofo. October 22, 2013 at 1:11 pm

I dont think your link really answers the meat of my questions. If the price of a thing tends to fluctuate, and there is an robust, open market for that thing (like commodities for instance), then price signals + speculation should smooth the shock and let all the market players know how they should value that thing. Oversimplifying, I know, but you get the point. What difference does it make to a market why prices fluctuate? A shock from a currency value shift should be the same as a shock from a supply or demand change. Either way, markets can handle that. Why should a country base its currency policy on preventing this one particular type of market pricing?

And little in that article speaks to the notion that exchange rates are price signals. Ok so you cant have price controls on currency and free capitol controls at the same time, so what?

What was i supposed to lern from reedin that article?

4 Michail Trepas October 22, 2013 at 3:29 pm

A bit confused, your comment is.
Maybe I could illuminate a point or two:
(1) Exchange rates are prices, of course
(2) When the exchange rate of an oil importing country gets whacked, the oil becomes too expensive and may lead the country to recession. Another aspect is that the politicians, ministers etc tend to “depreciate” along with the currency
(3) A stable exchange rate is an important element of a healthy investment environment. A fixed exchange rate looks like paradise, at least in theory.

5 mofo. October 22, 2013 at 3:55 pm

Thats a fair answer, i think. Given 1 (exchange rates are prices), then wouldnt the best course of action from an economic perspective be to let the market dictate those prices, rather than a central authority (like a central bank)? Given 2, how is that different than any other supply shock? Why should the government of a country take special steps to mitigate this particular shock (other than the practical ones you mention)? As for #3, why? Why cant exchange rate stability be handled via futures and markets rather than via central planning? Shouldnt market pricing of monetary exchanges be superior to one planned by a central authority?

6 Ray Lopez October 22, 2013 at 8:17 pm

You f’ing stupid dumbshit Mofo, o you u just trollin’? The man just answered your question, then you come up with this howler: “Why should the government of a country take special steps to mitigate this particular shock (other than the practical ones you mention)?” Besides the practical ones he mentioned, here’s another answer: because they can. If you have a fixed exchange rate, you’ll not ever, ever, ever have the ‘supply shock’ you mention (except in special circumstances, like Argentina, but I digress). The point being: if you can prevent a ‘supply shock’ with fixed exchange rates, why not do it? There are drawbacks to a fixed exchange rate, such as in the Impossible Trilemma article. Gess u never lerned the 3 Rs in skool: reeding, riting and rithmitic?

7 mofo. October 23, 2013 at 9:25 am

Geez, you are nastly little ‘man’, arent you? If ‘because they can’ is really an acceptable answer for why a government should undertake an economic action then you should just stop pretending to be practicing science and just call yourself a propagandist. Why not do it? Because there are likely other, unseen consequences to doing it, like there are for every other government price fixing scheme. Nothing ethier of you has said has gone beyond “its super great and has little downside” You can offer the same arguments in favor of any price fixing scheme: It gets politicians re-elected, it prevents recession, its an important element of a healthy investment environment. It prevents price shocks. The only downside is that they dont really work, they come with lots of unintended consequences and ill bet fixed exchange rates do too.

8 mofo. October 22, 2013 at 3:59 pm

Also, if we simply let oil prices rise or fall based on exchange rate, wont the market eventually find its own solutions? The OPEC oil shocks of the ’70s eventually led to more efficient cars and more non-OPEC oil production, for example. Wouldnt it be more desirable for a country to endure the short term pain a floating currency might cause in hopes that the market will find a better long term one?

9 Michael Trepas October 23, 2013 at 1:48 am

Ray has a point about the protection against shocks via a fixed exchange rate (and its drawbacks – read about the Trilemma).

Actually, when a country fixes its exchange rate, it says to investors: “Come here and invest, and I promise that you will not be paid (dividents, rents, whatever) in depreciated (inflated) currency”.

This statement can be credible, though breaking it is not unknown (European crisis of 1992, Asian crisis of 1998 come to mind).

Futures, forwards and markets in general can offer a hedging tool. They incorporate current prices (interest rates etc), projecting where the value of an asset “should” be in time X. However, they have no prediction value when it comes to shocks – interest rates may spike, capital flows may change direction, all hell may break loose etc.

About choosing to accept short-term pain in order to get long-term gain, I personally tend to disagree, but that’s just a “feeling” and no more.

10 mofo. October 23, 2013 at 9:28 am

So then its a form of investor subsidy? Come here and invest and our country will assume the risks associated with currency exchange?

11 Michael Trepas October 23, 2013 at 3:50 pm

Subsidy? An interesting word, but I think “insurance policy against currency downside” is more appropriate!

As a government price-fixing scheme, I think it is more “noble” than other schemes:

(1) The monetary authority promises that it will keep the fixed rate, “tying its hands” in terms of domestic monetary policy: It tells investors (foreign and native) that it will not loosen policy in order to technically boost the domestic economy (and get the politicians re-elected), inflating the currency along the way.

(2) On a bigger scale, many economies with floating exchange rates will try to devalue in order to boost their exports in expense of the others(“beggar-thy-neighbor”). Situations like this tend to provoke tension between the countries, which can result to threats, counter-measures, sanctions etc.

12 Ray Lopez October 22, 2013 at 9:45 am

In the tone of the great journalist and somber radio voice Alistair Cooke, who introduced Masterpiece Theatre on TV, you could say: “Fixed exchange rates by Robert A. Mundell vs floating exchange rates by Milton Friedman…one of the great themes in economics literature”.

13 prior_approval October 22, 2013 at 9:50 am

‘Floating rates can be tough on countries which import a lot of oil’

Which is probably the singlest best explanation why the U.S. is willing to sacrifice all the longer term advantages of a weaker dollar (another decade old point Dean Baker loves to hammer on). Americans refuse to accept a higher dollar price for gasoline, and this refusal plays out politically, and has my whole life. Partiicularly with the notable crash and burn of former Republican/independent presidential candidate John Anderson – ‘He did not fare much better as an announced candidate in the summer and fall, but the last six weeks of 1979 saw a modest reversal of his fortunes. He introduced (as congressional legislation) his signature campaign proposal, advocating that a 50-cent a gallon gas tax be enacted with a corresponding 50% reduction in social security taxes. This idea, while not broadly supported, was hailed as interesting and innovative.[15] Experts agreed that it would reduce consumption dramatically and cost average families nothing if they drove less than about 18,000 miles a year, depending upon the fuel efficiency of their vehicles.’

‘Fixed rates (or rather a single currency) have been a definite disaster for the eurozone’

I knew that with enough space, a renamed eurogeddon would make an appearance. Though let’s be honest – now, it is just a disaster, compared to a catastrophe, or better yet, compared to a collapse, unlike the pronouncements of just a couple of falls ago.

‘I would rather have a euro in a German bank than a Greek bank, and so on’

Maybe – but I bet Hypo Real’s final shareholders would have preferred their shares to be in a Greek bank. ‘With the German state (via SoFFin) already owning 90% of HRE, an extraordinary general meeting on 5 October 2009 approved a €1.30 per share squeeze out of the remaining private shareholders,[12] including J.C. Flowers (which a year earlier had taken a 25% stake at €22.50 per share).’

In comparison, this is what has happened to Greek bank shareholders – ‘The National Bank of Greece (NBG) has approved has approved a recapitalization plan worth 9.76 billion euros ($12.8 billion), insisting it will raise enough money privately to avoid nationalization after Eurobank failed to do so. Greece’s banks were brought into financial turmoil after the government imposed 74 percent losses on investors in a frantic bid to write down debt during a crushing economic crisis.’

Though Eurobank will be nationalized, the fact that the other three systemic banks were able to attract enough private capital this spring is an interesting commentary of what people think about placing their money into a Greek bank.

14 Merijn Knibbe October 22, 2013 at 10:24 am

As far as I’m concerned there do seem to be substantial differences when you compare, wel, comparable countries. The floating countries do better when it comes to a combination of growth, unemployment or the depth of the crisis, at least in Europe:

Bear in mind that a statistical significant difference is a weird thing. When ‘A’ is not significantly larger than ‘B’ and ‘B’ is not significantly larger than ‘C’, ‘A’ can still be significantly larger than ‘C’. The post linked to might in a sense compare ‘A’ with ‘C’.

15 Mark A. Sadowski October 23, 2013 at 1:12 am

Prior to the recession large current account imbalances were common in the EU. All members with the exception of the Czech Republic, Denmark, France Italy and the United Kingdom had either surpluses or deficits exceeding 3% of GDP in 2007. In the majority of these cases these were deficits although large surpluses existed in the Low Countries, Austria, Finland, Germany and Sweden.

Between 2007 and 2010 a dramatic adjustment in these balances occurred with nearly all of these imbalances moving towards balance. Only Luxembourg and Portugal had large imbalances grow larger over the period and the number of large imbalances (over 3% of GDP) declined from 22 to 11. A strong and statistically significant correlation exists between the positive change in the current account balance and the gap between actual GDP and trend GDP growth (10 year) that developed between 2007 and 2010.

A single factor ANOVA test supports the conclusion that countries with currencies pegged to the euro suffered larger declines in growth relative to trend. Two sample t-tests assuming unequal variances suggest that countries with pegged currencies did significantly worse between 2007 and 2010 relative to trend than either countries in the euro zone or those outside the euro zone with flexible currencies. An ANOVA test and two sample t-tests show that current account reversals between 2007 and 2010 were significantly larger in countries pegged to the euro than in countries in the euro zone or those countries outside the euro zone with flexible currencies.

16 Gougdkutd October 22, 2013 at 10:59 am

“…trade shocks, which for the purposes of macro are like real shocks.”

Are Some kinds of shocks real for purposes of reality but not real for purposes of macro? Or vice versa?

17 REN October 22, 2013 at 11:50 pm

Greece or one of the PIIGs gives a bond to a German Bank. Said German bank issues Euro Credit money, which then vectors to Greece. The debt instrument i.e. bond, which is a claim on the Credit Money just issued, now resides outside of Greek legal authority.

Greece then spends the Euro Credit money on unemployment, or whatever. Those Credit Dollars enter the Greek economy, and then soon vector out in pursuit of, say German goods, such as a BMW, etc. Those Euro credit monies find their way to German savings accounts. Because Germany is mercantilist, hence exporting more than they import -the former Greek Euro’s end up as savings in a German bank. Those former Greek Euros, now cannot find their way to satisfy the debt instrument. The two paths, like forlorn lovers, cannot meet. The former credit money issued off of the double entry ledger, cannot return to that ledger.

Greek government officials then issue another Bond, rolling over the interest in the first bond. This makes the usury in the bond go exponential due to compounding.
At this point, Greece has not used their credit money to create new “wealth” but instead used it on consumption. Climbing up the exponential means that Greece would have to become mercantilist themselves in order to pull the German savings toward Greece, in order to satisfy the debt instrument.

So, to my mind several economic rules have been broken. 1) A Sovereign has allowed debt money creation outside of its law, and hence the debt cannot be jubileed. 2) The nature of credit money means that it should not be used on consumption, but only on future productivity – that way the usury/interest can be paid. 2.5) The interest was allowed to go exponential and hence becomes onerous 3) Germany does’t understand the dynamic, and is unwilling to forgive debts – especially those debts that are onerous due to compounding. 4) Financial predators want to harvest real Greek assets in order to satisfy the debt claims. In this case, they want to permanently toll the commons and other formerly free parts of the Greek economy, in order to take perpetual rents on society. This then leads to Oligarchy.

All of this could have been avoided if Greece had their own money, and an exchange rate. As soon as debts climb, the exchange rate adjusts with fast feedback. That cannot happen in the Euro Private Credit Bank money system.

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