In my research on the Great Depression, I kept running across researchers who focused on gold flows between central banks. This made no sense to me, as gold flows are a zero sum game; one country’s gain is another country’s loss. But the Great Depression involved worldwide deflation. How could this be caused by flows from one country to another? The answer is that it cannot, rather what matters is gold reserve ratios–is country A attracting gold because it is raising its gold reserve ratio, or is country B losing gold because it is lowering its gold reserve ratio? So why not calculate global gold reserve ratios? No one had done that before, so I did.
The same problem applies to changes in exchange rates, which are also a zero sum game. If the euro depreciates against the dollar, then the dollar appreciates against the euro. It’s not clear why this should have any impact on world commodity prices.
As I said in my earlier post on S&D, never reason from a price change; always look at the underlying factor that caused prices to change. In several posts I argued that a stronger yuan would be deflationary, if brought about by tighter monetary policy in China (which is what was implicitly being recommended by China’s critics.) So how can a weaker euro also be deflationary? The answer has to do with the causes of the weaker euro–loss of confidence in European financial assets.
It is interesting to compare the recent crisis to July - November 2008, when the dollar also appreciated strongly against the euro. In 2008 the problem was financial turmoil in the US, just the opposite of the current situation. So why did the dollar strengthen both then and now?
Instead of looking at differences, let’s focus on some underlying similarities. In both late 2008 and the past few weeks, there has been an increase in demand for the ultimate form of liquidity in the world economy; US dollars. And in both cases the Fed responded passively, allowing NGDP growth expectations to fall (sharply in 2008, modestly this time.) As Friedman and Schwartz showed, if the Fed is passive during a period of increased demand for liquidity, then they have effectively tightened monetary policy. Indeed they showed that this is true even if interest rates fall to low levels and the monetary base soars. Both the crisis of 2008, and the much smaller recent crisis (combined with Fed passivity), have made monetary policy in the US effectively tighter.
Exchange rates by themselves tell us nothing about whether global monetary policy is becoming easier or tighter. A stronger yuan caused by tight money in China would have been deflationary. And a weaker euro that led to increased demand for US dollars is also deflationary.
But these effects would not occur if the Fed was targeting NGDP. Under a NGDP target, the euro might still weaken during a sovereign debt crisis in Greece, but this would not have a deflationary impact on the US. The deflationary effects that we observe occur because (and only because) the Bernanke Fed, like the Fed of the 1930s, has been passive in the face of increases in the demand for dollars. They have continued targeting interest rates at a steady level, even as the Wicksellian natural interest rate has fallen.
Exchange rates measure changes in the value of one money against another. Stock, commodity, and real estate prices measure changes in the value of money against non-monetary assets. Which are the more reliable indicators of global macro conditions?
I also noticed that China is now taking a hit from the weak euro. The yuan is appreciating in trade-weighted terms. Maybe those demanding a stronger yuan will get their way. The Chinese government is currently cracking down on real estate, and this is also scaring markets. Tens of millions of Chinese are moving from shacks to apartments. Is the Chinese government drawing the wrong lesson from the US housing bubble? I don’t have the answer, as their market is very complex and highly distorted. But it is certainly an issue worth watching.
PS. Speaking of the Great Depression, I recently did a talk on that subject at Oxford. Nick Cowen of the The Oxford Libertarian Society was the one who invited me to Oxford, and I’d like to thank Nick for making it available at their website. I had a very nice visit to England (apart from having the world’s smallest hotel room in London), and greatly enjoyed my conversations at Oxford, and also with fellow blogger Leigh Caldwell in London. I also gave a talk at the IEA in London. On the way back I stopped in Iceland (and got stuck there) I’ll file a report on Iceland later, in case anyone is interested.