External economy considerations – Part 6

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to publish the text sometime in 2013. Our (very incomplete) textbook homepage – Modern Monetary Theory and Practice – has draft chapters and contents etc in varying states of completion. Comments are always welcome. Note also that the text I post here is not intended to be a blog-style narrative but constitutes the drafting work I am doing – that is, the material posted will not represent the complete text. Further it will change as the drafting process evolves.

Chapter 21 Policy in an Open Economy: Exchange Rates, Balance of Payments, and Competitiveness

This material updates the work already done on Chapter 21 that appeared in the following blogs:

A day full of meetings and commitments today – so not as much progress as normal for a Friday. But I am just continuing filling in the gaps in the Chapter.

21.7 Currency crises

Many developing countries have currency sovereignty which means they can enforce tax liabilities in the currency that the government issues. It doesn’t matter if other currencies are also in use in those countries, which is common. For example, the USD will often be in use in a less developed country alongside the local currency and be preferred by residents in their trading activities.

But, typically, the residents still have to get local currency to pay their taxes. That means the government of issue has the capacity to spend in that currency.

The general principle thus remains – as long as there are real resources available for use in a less developed country, the government can purchase them using its currency power.

In particular, this concept of real fiscal space extends to the millions of people who are unemployed in less developed countries. Given there is no market demand for their services, the government in each country can easily purchase these services with the local currency without placing pressure on labour costs in the country.

The investment in these programs is measured by the real resources that they consume relative to not undertaking the initiative. These resources extend to imports and many less developed countries have to import food for basic subsistence.

Will this investment undermine the current account and introduce inflation as the current depreciates due to a widening trade deficit? All open economies are susceptible to balance of payments fluctuations.

As we have learned in earlier chapters, these fluctuations were problematic for nations running external deficits under the fixed exchange rate, convertible currency regimes (for example, the Bretton Woods scheme) because the government was forced to keep the domestic economy in a depressed state to keep the imports down wo the central bank could maintain the parity without losing its foreign currency reserves.

For a flexible exchange rate economy, the exchange rate does the adjustment. There is no consistent evidence that budget deficits create catastrophic exchange rate depreciations in flexible exchange rate countries?

Any increase in domestic spending will push up import demand. In particular, growth in private capital formation is likely to be more important intensive because most less-developed countries import capital.

Well targetted government spending can create domestic import-competing activity. For example, Job Guarantee workers could produce goods and services that nation might normally import including processed food products.

Moreover, a fully employed economy with strong labour force skill development structures are likely to attract foreign direct investment if the political system is stable.

So while the current account might move into deficit as the economy grows, which means the nation is sacrificing less real resources away in return for real imports from abroad, the capital account would move into surplus. The overall net effect is not clear.

Finally, a depreciated currency stimulates local employment because imported goods become more expensive and exports become cheaper with the distributional impacts of these changes likely to be felt more by the middle and higher income groups than the poorer groups as luxury imported goods become more expensive.

These exchange rate movements are likely once off adjustments as the economy adjusts to the higher growth path and thus need not be a source of on-going inflationary pressure.

It is true that a currency depreciation for a nation that is wholly dependent on imported food can be damaging. We would argue that there is a genuine role for the multilateral agencies, such as the International Monetary Fund, to play in such circumstances.

The agencies should buy the local currency to ensure flexibility in the exchange rate does not price the population, in particular, low income households, out of food. This is a simple solution which is preferable to to forcing these nations to run austerity campaigns just to keep their exchange rate higher.

What about currency crises?

In the 1990s, there were three major currency crises in the world economy. In 1992, as the German government moved to unify the country after the breakdown of the Berlin Wall, the fiscal expansion required to improve the public infrastructure in the former East Germany, was accompanied by rising interest rates as the Bundesbank, (the German central bank) feared inflation.

The German mark appreciated significantly as a result of capital inflow attracted by the higher interest rates and net exports fell.

The problem was that the German mark was the benchmark currency in the European Exchange Rate Mechanism (ERM), which other Western European nations fixed the currencies. This arrangement had been in place since March 1979.

Under any pegged currency arrangement, the nations pegging their currencies have to increase their own interest rates in line with increases in rates in the benchmark nation.

However, the other nations did not have a commensurate fiscal expansion to offset the damaging effects of the rising interest rates on their local economy. It became apparent that the commitment to the fixed exchange rate system (ERM) would mean rising unemployment in these nations and the associated political difficulties.

Players in the foreign exchange markets predicted that eventually the pegging nations would abandon the ERM and let their currencies depreciate against the German mark.

This led to the currencies of these nations being sold off in the foreign exchange markets, which immediately forced the nations to consider the fixed arrangements.

The impetus to the breakdown of the system, was the “short selling” attack on the British pound by speculator George Soros. In foreign exchange markets, a speculator can contract to sell a currency at some future date for a predetermined price.

The contract, of-course, means that when the contract comes due, the speculator also has buy the other currency in the contract.

If the contracts are large enough they can thus have a significant impact on the value of the currency and lead other speculators following suit. George Soros short sold the British pound against the German mark.

Britain left the program in September 1992 after the Bank of England had spent over £6 billion purchasing foreign currencies in an attempt to maintain the currency within the agreed ERM limits as the speculative activity drove its price down. The British government was not prepared to increase its interest rates in line with Germany, which they considered would cause a major recession.

In this case, the speculators won but only because these governments were intent on pegging their currencies but were not prepared to accept the monetary policy interdependence that came with the decision to peg.


27.8 Capital controls

The history of financial crises indicates that large-scale financial speculation can undermine a nation’s real economy relatively quickly if the government attempts to peg their currency to another or the economy has significant foreign-currency denominated debt exposure (private or public).

while the international community could agree that certain forms of speculative activity would be considered illegal, in lieu of that, the nation under attack has to defend its own prosperity.

One such suggestion is to introduce capital controls which limit the size and flexibility of international financial flows.

In September 1998, during the Asian debt crisis, the Malaysian government introduced capital controls after the currency had appreciated significantly and the central bank had pushed interest rates up towards 18 per cent and undermined the viability of many local businesses.

Capital controls are policies that restrict the free movement of capital, either in terms of inflows or outflows.

There are broadly two types of capital controls used:

  • Aministrative or direct controls, which impose limits or bans on capital flows.
  • Market-based controls, which impose extra costs on capital flows which reduce the incentives to shift funds across national borders.

A government might, for example, place limits on foreign exchange transactions, international bank transactions, or bank withdrawals. Restrictions on movements of precious metals such as gold might also be considered.

The aim is to limit the scope of speculative flows (in or out) to manipulate the exchange rate and strain the central bank’s foreign exchange reserves.

Capital controls allow the central bank to run an autonomous monetary policy and the treasury to use fiscal policy to manage domestic demand in the interests of the nation.




Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.

This Post Has One Comment

  1. Bill

    “We would argue that there is a genuine role for the multilateral agencies, such as the International Monetary Fund, to play in such circumstances.

    The agencies should buy the local currency to ensure flexibility in the exchange rate does not price the population, in particular, low income households, out of food.”

    I’ve been giving this a bit of thought recently.

    ISTM that what happens is that ‘export led’ nations drain domestic circulation from ‘import led’ countries in a mercantilist manner. That, assuming no fiscal response from the ‘import led’ nation, then leads to a feedback condition where the domestic economy is continually weakened and becomes dependent on imports.

    The government response should be to fund a Job Guarantee and get the domestic circulation back up. That may lead. short term, to a currency depreciation. However a currency depreciation in one direction is a currency appreciation in the other direction – which of course impacts upon the business and economy of the ‘export led’ nations.

    Therefore when the pips are squeezed the export led nation will judge whether a target nation is sufficiently valuable as an export market to require artificial action. At which point the monetary system in that export nation will start to undertake ‘liquidity actions’ to make more of its currency available in the target nation (i.e. buy up the target currency using their own). And that halts, and may reverse, any decline of the exchange rate. (the interventions of the Swiss and the Japanese – plus the continued intervention of China are the evidence for this view).

    The IMF therefore is required to step in when a nation cannot obtain sufficient required real goods and services in exchange for its own real exports – because it is not yet of sufficient size and importance to have an export-led nation depend on it for the export-led economy’s health.

    Advanced nations can run deficits for as long as there are nations with export-led policies that depend on those deficits. Those export led nations are forced by their policies to act like the IMF – running up financial savings denominated in foreign currencies with no guarantee that they’ll ever get any real goods and services for them.

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