Nick Rowe has a nice new post that is loosely related to the “never reason from a price change” theme. Nick suggests that it doesn’t make sense to talk about the effect of changes in exchange rates. Instead one should either talk about the effects of factor “X” that caused the exchange rate to change, or if you are interested in public policy issues you might want to talk about the effect of a central bank policy aimed at preventing the exchange rate from changing.
According to conventional wisdom, currencies that come under speculative attack can be defended with high interest rates. By raising interest rates high enough, the monetary authority can make it prohibitively costly for speculators to take short positions in the currency under attack. High interest rates may also convey a positive signal regarding the commitment of the monetary authority to maintaining a fixed exchange rate. According to the contrarian view, neither of these mechanisms is persuasive. Interest rates have to be increased to very high annualized rates in order to entice investors to hold local currency-denominated assets in the face of a small expected devaluation over a short horizon, and such extremely high interest rates are rarely observed in practice. The signaling value of high interest rates is also unclear. Although signals must be costly in order to be credible, often they impose costs that are too high for the monetary authority to take in stride. Moreover, as the costs of high interest rates mount, the monetary authority’s signal can become less credible over time, raising devaluation expectations. A vicious spiral can result, as expectations of a devaluation force higher interest rates, which in turn impose greater costs on the economy. In the end, high interest rates can have the perverse effect of increasing the probability that a speculative attack ends in the devaluation of the currency.
I think that’s basically right. But it’s also an odd way of stating the thesis. Notice that changes in interest rates are implicitly viewed as a sort of monetary policy stance. That’s especially dangerous during a speculative crisis, when rapid changes in the expected future exchange rate cause enormous and rapid changes in the Wicksellian equilibrium nominal interest rate. The real question is not whether high interest rates help; it’s whether or not tight money helps.
Again, I’m not quibbling with the Kraay’s paper, which is sophisticated and seems accurate. But using the term ‘monetary policy’ rather than ‘interest rates’ would help clarify the analysis:
1. High interest rates might reflect expectations of devaluation, and hence policy failure. In that case they will not reflect tight money and will be associated with policy failure, on average.
2. High interest rates might reflect the liquidity effect from a tight money policy, which makes devaluation less likely.
3. Even if high interest rates reflect tight money, the policy may fail in the long run of the tight money leads to politically unacceptable output losses, which forces an eventual change in policy. (see Argentina 1998-2002, the USA 1931-33 and Britain 1992.)
The basic underlying fact of the situation is that the economy is growing very slowly because Congressional Republicans have done everything in their power to apply the fiscal brakes to the recovery. Among macroeconomic forecasters, this is not a remotely controversial assertion but rather an obvious fact that they wearily plug into their models.
File that away in your “obvious facts” folder along with Prescott’s claim that it is a proven scientific fact that monetary shocks have virtually no effect on the business cycle.
HT: Ramesh Ponnuru