Category Archives: Economics

Basic Exchange Rate Theories

The Monetary Approach to Exchange Rates

The Monetary Approach to the Exchange Rate remedies the fixed exchange rate limitation of MABOP. Instead of monetary disequilibrium being adjusted by international money flows, as in a world with fixed exchange rates like exist under a gold standard, the MAER has flexible exchange rates leading to monetary equilibrium, as money demand and money supply, controlled by central banks, is equilibrated through exchange rate changes. A country with a managed float requires for its analysis both MABOP and MAER.

Unlike the MABOP approach, where exchange rate changes equal zero, the MAER assumes currency reserve flows are zero (with no central bank intervention) and exchange rates move instead. The relationship can be written

E’ = D’ – P'(foreign) – Y’,

which means that the change in the exchange rate equals the change in domestic credit minus the change in the foreign price level minus the change in domestic income. An increase in domestic credit by the central bank, with constant demand for money, will lead to a higher exchange rate with domestic currency in terms of foreign currency. In other words, the domestic currency is losing value relative to the foreign currency. An increase in domestic income will lead to a stronger domestic currency and a lower exchange rate, which is why Y’ and E’ are of opposite sign. An increase in the foreign price level leads to fewer imports and a stronger currency.

The Portfolio Balance Approach to Exchange Rates

The MAER assumes that domestic and foreign bonds are perfect substitutes, meaning that investors are indifferent to the currency that a bond is denominated in and care only about the return. In other words, uncovered interest rate parity holds between bonds in different currencies.

The Portfolio Balance Approach allows for imperfect substitutability, where investors do perceive currency risk and balance their portfolios accordingly. PB models contain a risk premium in forward exchange rates, and uncovered interest rate parity does not hold. As a country’s supply of bonds on the market increases, the currency’s risk premium increases, and the domestic currency depreciates. The equation describing the MAER above is modified to be

E’ = D’ + (B’ – B'(foreign)) – P'(foreign) – Y’

The additional term added to the MAER equation above, (B’ – B'(foreign)), shows that an increase in domestic bond supplies greater than a corresponding increase in foreign bond supplies will lead to a weaker domestic currency and a higher exchange rate.

Sterilization

The central bank, in a fixed exchange rate system, can attempt to maintain a money supply greater or less than money demand, which would lead to money flows out of or into the country, through increasing or decreasing the supply of domestic credit. If the central bank wants to increase the supply of money, but demand for money also increases, causing an inflow of reserves, then the central bank can sterilize the reserve inflow by increasing the supply of domestic credit by the amount of the inflow.

Under flexible exchange rates, a central bank can buy foreign bonds and sell domestic bonds, which would lead to higher exchange rates, or a depreciated domestic currency.

Source: Husted and Melvin, International Economics

Balance of Payments Theories

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National Income Accounting

A country’s current account measures the value of its trade in goods, services, investment income (not buy/sell of financial assets), and unilateral transfers. The current account indicates whether a country is a net borrower or lender to the rest of the world. The current account must be matched by a financial account, which measures foreign investment in domestic financial assets, of opposite sign. The national income accounting identity is

Y = C + I + G + X

where Y is GDP, C is consumption spending, I is investment, G is government spending, and X is the current account. This identity can be rearranged to show many things, including the fact that when savings is greater than investment there is a current account surplus, where savings includes both the private and government sectors. In other words, X = S – I. A negative X means that a country must borrow from the world to finance its imports. The current account deficit will fall when domestic spending, private or government, falls relative to domestic income.

In the absence of decreased government spending, the exchange rate and interest rate markets will cause a reduction in the current account. As the current account is financed by selling domestic securities to the world, the domestic currency is pressured downward, causing interest rates to rise, making domestic securities even more attractive. But the higher interest rates, and hence greater borrowing costs, cause a decrease in domestic spending. Domestic income increases due to the weaker currency leading to greater exports. The reduced domestic spending and higher income cause a reduction in the current account deficit.

The Elasticities Approach to the Balance of Trade

The change in the quantity demanded of foreign goods due to a change in the exchange rate of the two currencies is measured by the elasticity of demand, or the percent change in demand due to percent change in price. Elastic means the absolute value of the ratio is greater than one. Similarly, the change in amount supplied due to changes in price is measured by the elasticity of supply.

A currency devaluation should normally cause an increase in the balance of trade, but this is not always so if there are low short run elasticities. This causes what is called the J Curve in the balance of trade, where the balance actually decreases after currency devaluation before beginning to improve. This could be due to the currency contract period, when contracts enacted before the devaluation must be fulfilled. Inelastic demand for imports would also cause a J Curve. The change in domestic and foreign prices is measured by the pass through effect. The difference in profit margins between countries, and the greater pricing flexibility among higher profit margin countries, lessens the effect of a devaluation.

The Absorption Approach to the Balance of Trade

Here, the balance of trade is defined as an economy’s production less its “absorption”, or total domestic spending. Absorption has to decrease in an economy with full resource utilization for the current account balance to increase, which would allow domestic prices to fall and exports to rise. A devaluation here will produce domestic inflation as foreigners bid up the price of domestic goods. A currency devaluation could improve output and GDP, and increase the current account, while absorption remained unchanged in an economy not employing all its resources.

The Monetary Approach to the Balance of Payments

The Elasticities and Absorption Approaches have the limitation that they do not consider the financial account and instead focus on the trade in goods and services, which worked well in a world of limited capital mobility. MABOP emphasizes monetary disequilibrium in explaining balance of payments disequilibria, where monetary disequilibrium is the difference between the fiat currency supplied and the currency demanded. Excess money demand will lead to increased exports. This analysis assumes fixed exchange rates and high capital mobility.

The exports are paid for with foreign currency, which the commercial bank will exchange for dollars with the Federal Reserve. These dollars are created by the Fed and lead to an increase in the supply of base money and hence domestic credit. The demand for money can be written as

L = kPY

with L the demand for money, k a constant, P the domestic price level, and Y is real income. The demand to hold money increases with P or Y. MABOP assumes a stable demand for money. MABOP states that the percentage change in the balance of payments minus the percentage change in the exchange rate equals the inflation rate of the foreign currency plus the percentage growth of real income (Y) minus the percentage change in domestic credit (due to the increase or decrease in base money). This can be written as

R’ – E’ = P'(foreign) + Y’ – D’

The Monetary Approach assumes fixed exchange rates, so E’ = 0. With a fixed exchange rate, like a gold standard system, an increase of domestic credit by the central bank, assuming prices, income, and money demand are constant, will cause a decrease in foreign reserves. An increase in domestic credit leads to a weaker BOP as spending goes up to decrease excess cash reserves, and vice versa.

BOP problems are monetary phenomena in this world, and countries could not run perpetual deficits since they could not inflate a gold backed currency. Instead, the deficit running country would eventually run out of reserves. Domestic prices would become cheap and foreigners would buy domestic goods, and the exports would bring in currency until the system reached equilibrium again.

A domestic credit adjustment by the central bank would be used to equilibrate the BOP. Barring this, an increase in domestic income, which would strengthen the currency, would improve the BOP with domestic credit unchanged.

Regardless of the forces acting on the BOP, Gresham’s Law is always at work under fixed exchange rates and a currency managed by a central bank. People will always seek to unload overvalued currency and buy undervalued currency.

According to the MABOP analysis of currency crises, budget deficits contribute to inflation since it is known they will eventually be monetized. Devaluations of a currency do not keep pace with inflation, leading to overvalued exchange rates. Exports fall while imports rise, leading to a trade deficit and capital flight. Governments must borrow to finance the balance of payments deficit, which leads to high interest payments. Each step of the cycle makes the next step worse and the cycle is perpetuated until the government capitulates.

It can be seen that in an international commodity money system, such as the gold standard, governments would not have to worry about the supply of money, or conversely they would not be able to manipulate the supply of money. In this case each individual’s money holdings is based on his marginal utility of money and flows between countries are no more important than flows between cities or individuals. Under fiat systems too the analysis must begin with the individual’s demand for money (methodological individualism versus aggregate analysis) to avoid the problems associated with the abstraction of the country.

Mexican Fiscal and Monetary History

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Mexico maintained a fixed exchange rate of 12.50 pesos to the dollar until 1976. To accomplish this, the Banco de Mexico actively intervened in the currency market to keep the peso at the desired exchange rate. The central bank would use its foreign currency reserves, usually dollars, to buy pesos. This decreases the supply of pesos on the market and increases the supply of dollars, making pesos more valuable relative to the dollar. A main reason for this is to maintain the purchasing power of the peso in order to keep imports affordable.

On the other hand, if the peso is perceived to be overvalued, the bank will sell pesos in exchange for dollars, driving the value of the peso down. Mexican exports will be more attractive with a weaker peso.

Despite continued economic growth in Mexico in the 1970s, budget deficits and inflation were rising, and deficits were financed through foreign debt. A precursor of problems to come, the peso was devalued by 56% in 1976 and taken off its fixed exchange rate in favor of a managed floating rate. In the managed floating rate system, the peso would be allowed to move within a band which would be enforced with central bank intervention.

The Mexican government, expecting increasing oil revenues from high world prices, increased borrowing in dollars. However, oil prices plummeted in the early 1980s, greatly reducing revenues and dollar inflows. Declining international economic conditions decreased demand for Mexico’s primary exports. Foreign capital, made nervous by the growing debt, began to leave Mexico, putting downward pressure on the now overvalued peso. These dollars had been used to service the growing Mexican debt, and in their absence the government announced in 1982 that it could not service its debt on billions of dollars of loans.

Neoclassical economists developed the Monetary Approach to the Balance of Payments (MABOP) theory to explain the cycle indebted Latin American countries found themselves in during the 1970s and 1980s. According to MABOP, budget deficits contribute to inflation since it is known they will eventually be monetized. Devaluations of a currency do not keep pace with inflation, leading to overvalued exchange rates. Exports fall while imports rise, leading to a trade deficit and capital flight. Governments must borrow to finance the balance of payments deficit, which leads to high interest payments. Each step of the cycle makes the next step worse and the cycle is perpetuated until the government must capitulate and devalue the currency.

Miguel de la Madrid came into office in 1982, inheriting an economy in crisis and in serious need of reform after years of government intervention. The first order of business was to tackle the near 100% inflation rate. The government was able to slow inflation to around 65% by 1985 through spending cuts and tighter monetary policy, but at the cost of a 13% decrease in GDP over the same period. Another top priority was government debt reduction, which resulted in net transfers through debt payments to foreign creditors of 6% of GDP between 1982 and 1985.

Despite publicly claiming to control inflation, the government was incentivized to inflate the money supply through the existence of an “inflation tax”, which is the wealth transfer from holders of cash to the spender of newly created money, in this case the government. Money creation was such that this course of action equated to up to 8% of GDP between 1983 and 1985. By 1986, inflation had returned to its 1982 level of near 100%.

The Mexican government was still heavily involved in the economy, controlling the banking sector and limiting foreigners’ ability to invest in Mexican businesses. Government debt and controls had smothered the economy, causing a drop in per capita income in the 1980s almost as large as that seen in the Depression. Clearly, a freeing of the economy through free market policies was in order.

In 1987 and 1988, the Mexican government signed two agreements with the business, labor, and agriculture sectors popularly called the Pacto, which through its various incarnations has attempted to curb expansionary monetary and fiscal policies, control prices and wages, renegotiate debt, deregulate markets, and privatize state-owned businesses.

The Mexican public sector owned 1,155 businesses in 1982, and by 1994 940 of those were divested. The tax system was simplified, rates were decreased, tax collection and tax revenue increased, and government spending and fiscal deficits fell. The government also implemented financial and trade liberalization. The elimination of bank reserve requirements and mandatory financing of public sector businesses removed a heavy burden from private finance and allowed capital to flow to more productive areas in the economy. Banks were privatized, capital controls were lifted, and foreign capital was allowed greater access to Mexican investment. Trade liberalization came in the form of reduced import licensing and tariffs, and was codified with the passage of the North American Free Trade Agreement (NAFTA) in 1993 (Gould, 1995).

Mexico’s economic liberalization programs and successful foreign debt renegotiation in 1990 attracted capital inflows, which were made more attractive by the low interest rates seen at the time in the U.S. The financial sector’s unburdening resulted in rapid credit expansion, made possible by a large reduction in public debt and a rise in the Mexican stock market and real estate prices. Expectations of economic growth and an abundance of foreign and domestic capital led to decreased lending standards which, when faced with an economic slowdown in 1993, resulted in a rapidly increasing number of non-performing loans on the books of Mexican banks.

Local Mexican commercial banks increased credit to the private sector by an average of 25% per year from 1988 to 1994. During this same period, credit card debt rose 31% per year and mortgage loans rose 47% per year (Gil-Diaz, 1998). This local credit expansion combined with large foreign capital inflows led to rising aggregate demand within Mexico and a strengthening peso which could only lead to a current account deficit. Unfortunately, the Pacto contained within it a commitment to keep the exchange rate within a narrow band that was not in harmony with the current heated economic conditions.

With foreign money spurning low U.S. interest rates in favor of higher Mexican rates, largely in the form of short term capital, money flowed into Mexican markets. The Banco de Mexico acquired an increasing supply of dollar reserves and was able to provide the needed pesos to the market.

Predictably in an environment inundated with foreign capital and easy credit, leveraged investment began to flow to less productive projects chasing returns, increasing the fragility of the economy and leaving it vulnerable to changing international investment conditions, which occurred when U.S. interest rates rose, decreasing the demand for peso denominated investments and exposing the multitude of bad loans on the books of Mexican banks (Kaplan, 1998). As investors began to demand dollars in exchange for pesos at the managed exchange rate, Mexico’s foreign reserves began to shrink to the point that peso devaluation became necessary. The peso/dollar exchange rate went first from 3 to 3.5 pesos to the dollar, with the managed currency band still in effect. This move did not end speculative pressure on the peso, and the government increased the peso’s band. With pressure mounting, the government was forced to capitulate totally on December 22, 1994 by removing the peso’s managed float and allowing the currency to move freely against the dollar. This effectively devalued the peso from four pesos to the dollar to 7.2 pesos to the dollar in one week’s time. The U.S. government began buying pesos in an attempt to stop a collapse, and then put forth $50 billion in loan guarantees to Mexico, which were accepted and repaid ahead of schedule by 1997.

The Fed and Stock Prices

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This study shows that as much as half of stock market gains since 1994 are the result of Fed actions or expected Fed actions. Despite the danger in being long the stock market when the Fed’s ability to manipulate stock prices runs out, what other manifestations of this misallocation will arise?

U.S Manufacturing Productivity and Employment

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Pat Buchanan makes an interesting point in this article about how bailouts of banks who have foolishly lent to foreign governments has affected U.S. manufacturing. He says that the countries which have borrowed money and could not repay were encouraged to lower their exchange rates in order to make their exports more attractive, which has made American made products less attractive.

This seems plausible, but does not seem powerful enough to warrant all the hand wringing we so often hear in the media. Usually, the loss of American manufacturing jobs is blamed on greedy corporations who move their factories overseas in search of cheap labor. The question of why overseas labor is so much cheaper is rarely addressed other than the fact that there exist teeming masses of exploitable human fodder.

This article shows that U.S. manufacturing has in fact not gone down, but has stayed at around 21% of world output. What has decreased is U.S. manufacturing employment. This is indeed due to higher labor costs, but those higher labor costs come from government regulation. This causes manufacturers to invest in labor saving technology to increase productivity per worker, which is simply the efficient use of available factors. In countries with cheaper labor relative to technology, more workers are used. So what should be decried is not a nonexistent decline in manufacturing, but the government/labor union-engineered decline in manufacturing employment.

Inflation and Capital Consumption

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Inflation has many negative, often unnoticed, consequences for an economy. This is one example from Rothbard’s Chapter 12, which deals with credit expansion and business cycles, of Man, Economy, and State. Businesses can unknowingly consume their capital in an inflationary environment. Capital goods purchases are recorded at cost. When finished goods are sold later, they are recorded with an inflationary gain. The seemingly profitable business might consume the profits they believe have been earned above what they need for capital replacement. However, when it comes time to replace the capital, it will also be inflated and the business will realize that its profits were illusory, and it had unwittingly been consuming its capital.

The recent housing boom provides a good example of capital consumption. Home prices soared, causing American homeowners to feel wealthier. They used this wealth to finance purchases of consumption goods, much of them imported. When housing prices fell, people realized they had been fooled by the effects of monetary inflation on the housing markets and had been consuming capital all along.

This illustrates the importance of capital theory in any understanding of the way manipulations of the supply of money and credit can cause relative distortions in the capital structure. In a world free of government and bank credit manipulation, the capital structure would be arrayed in conformity to society’s time preferences, where any investment would have to be financed through saving, which means putting off consumption now for more consumption in the future. The ratio of the price of current goods and future goods provides the natural rate of interest and is a direct result of the collective time preferences of consumers, savers, and investors.

When interest rates and the supply of money are manipulated, people are fooled into thinking that they are richer and can afford to spend more when their assets rise in value, when in reality they are increasing their time preference by consuming their capital. This is the economic boom period. The bust follows when assets must be liquidated in order to finance the increased consumption brought on by the illusion of prosperity.

Currency Wars, Seen and Unseen Consequences, and the Difficulty in Predicting Them

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James Rickards in his book “Currency Wars” describes the ongoing struggle between governments to weaken their currencies, and focuses on what he calls the three “supercurrencies”, the dollar, yuan, and euro. Rickards identifies three theaters of this war, the Asian, the Eurasian and the Atlantic theaters. The participants in this war go beyond the respective central banks to include the IMF, the World Bank, the BIS, the UN, and banks, hedge funds, politicians, and MNCs. The current currency war is called Currency War 3, and is following the two previous wars of 1921-1936 and 1967 -1987.

The Asian theater is being fought between the U.S. and China and is considered to be the main front in the various currency wars today. The yuan was seen to be overvalued against the dollar up until 1983, when it stood at 2.8 yuan to the dollar. This allowed the growing Chinese economy, which did not yet have a large export component, to import capital goods for the creation of a modern infrastructure. As the time came for exports to form a larger part of the Chinese economy the yuan was gradually devalued against the dollar so that, by 1993, the exchange rate was 5.3 to the dollar (compare this deft move to the disastrous Import Substitution Industrialization policies in Latin America). On January 1, 1994, China devalued the yuan to 8.7 to the dollar, causing the U.S. Treasury to label China a currency manipulator. China, for its part, seems to be more concerned with the millions of workers it has which are dependent on export based jobs and the political instability which would result if unemployment sets in.

China, eager for cover to control its own Muslim population, supported the U.S. “War on Terror”, which thawed relations between the two countries and allowed an expansion of what Rickards calls investment codependence. This time also saw the initiation of the Fed’s policy of low interest rates, which began in 2000 after the Tech Bubble collapse, where the fed funds rate fell 4.75 percent from July 2000 to July 2002. The fed funds rate stayed below 1.8 percent until October 2004.

Greenspan feared deflation, which he saw as being caused by, among other things, China’s exportation of low prices allowed by their cheap labor. These low rates also made otherwise marginal investments appear attractive and caused investors to look for yield in riskier places, including the sub-prime real estate loan market and the commercial real estate market, setting off the real estate bubble of 2002-2007.

Ben Bernanke, who advocated the Treasury issuing debt financed by Fed money printing for the purpose of buying the stock of private companies and a broad tax cut financed by money creation as a way to stimulate the economy, was appointed to the Fed Board of Governors in 2002. Bernanke feared deflation as much as Greenspan did and proved a strong ally.

The U.S.-China trade deficit, which was at $50 billion in 1997, had grown to $234 billion by 2003, when concern about the effects of the weakness of the yuan began to intensify in the U.S. As mentioned above, low Chinese labor costs are exported to the U.S. and cause fears of deflation. Newly printed dollars, hoped to create inflationary pressure by the Fed, are instead held by the People’s Bank of China as reserves, which acts as a way of China absorbing U.S. inflation. The dollars are bought with newly created yuan. This move allows the Chinese to keep the dollar strong and the yuan weak and thwarts the Fed’s attempts at inflation. Since the PBOC prints yuan to buy newly printed dollars, it has in effect decided to follow the Fed’s monetary policy. The PBOC, looking to earn a yield on its dollar reserves, buy U.S. Treasuries, and owns close to one trillion dollars of these securities. These purchases also help keep U.S. interest rates low and allow borrowing to continue, which is in China’s favor.

As the American economy began to decline and the Greenspan/Bernanke easy money policies were no longer able to hide the problems in the U.S. economy, American politicians began to blame China for stealing U.S. manufacturing jobs. Responding to pressure from the U.S., China allowed the yuan to strengthen from 8.28 per dollar in 2005 to 6.29 per dollar today. With employment concerns in both the U.S. and China, the currently quiet currency war could come back to the surface at any time.

What could the unseen consequences of all this manipulation, from both sides, be? China’s economy has obviously been skewed towards mass production for the foreign, largely American, market. This has not taken place due solely to comparative advantage but to a weak yuan/strong dollar policy by the Chinese. China would be in a precarious position if U.S. demand for Chinese goods dropped, whether due to changing consumer preferences or to U.S. protectionist policies. In contrast, the American manufacturing sector has been sent offshore, where cheaper labor and less stringent regulations are to be found and from whence cheap goods can be imported with a relatively strong dollar. So the U.S. is also in a dangerous place. Both the U.S. and China have made their economies less robust, the Americans with a less diverse economy and the Chinese with an export/weak currency dependent economy (the Chinese economy is not less diverse because it was starting from such a low point).

How to take advantage? Some say to buy yuan, since it is “obviously” undervalued and has to go up at some point. Unfortunately “obviously” undervalued assets are not always obvious to others; just ask me and my fellow TBT investors.