This past May I pointed out that the euro debt crisis was increasing the demand for dollars and depressing AD in the US. One sign was the dollar appreciating as investors fled to safety. As I expected, this slowed the US economy in the second and third quarters, necessitating the Fed’s QE2 program. QE2 did “work,” at least to a limited extent. It raised the prices of assets such as stocks and foreign exchange. Rumors of QE2 may have roughly offset the effects of the euro crisis, putting the dollar and expected NGDP growth back where they were in April.
Unfortunately, the euro crisis seems to be flaring up again. Look at how the euro has recently slipped from 1.40 to 1.35. As the dollar rises again, stocks start declining. Let’s hope this is just a temporary blip; if the euro crisis became severe it could have a deflationary impact on the US economy–requiring still more QE (or better yet something more effective like level targeting or much lower IOR.) Ironically all this occurs against a backdrop of relentless criticism of the Fed’s “inflationary” policies.
Readers of this blog might recall I often say “never reason from a price change.” So why am I making such a big deal about changes in exchange rates? In fact, it is very dangerous to draw conclusions from exchange rates alone. You need to look at the news events that cause the changes, and look for confirmation in other asset markets such as stocks, commodities, commercial real estate and TIPS spreads.
The ECB doesn’t seem to realize that its policy is far too tight for most eurozone members; not just the PIIGS, but also major economies like France. This is making the eurozone debt crisis even worse, although in my view they also face serious long term fiscal imbalances that go beyond the current recession.
The tight money policy in Europe causes the debt crisis to flare up and the euro itself depreciates as there is a flight to safety. And guess which major exporter of machinery benefits from the weaker euro? My Canadian readers might like this analogy: Suppose commodity prices plunge. This might weaken the Canadian dollar, as Canada is a major commodity exporter. But it might also help the manufacturing exporters in the Ontario region.
Currencies are not a zero sum game. The tight money policy of the ECB makes eurozone NGDP growth decline, even if the euro depreciates during a debt crisis. An exchange rate of 1.35 could represent easy money in both the US and Europe, or tight money in both regions. With all the focus on exchange rates let’s not lose sight of the underlying monetary policies, which show up in expected NGDP growth rates in each region. Get those right, and it makes little or no difference what happens to exchange rates.
PS: A few posts back I linked to an amusing anti-QE video. A commenter named “wkw ” animated it for me, and Greg Ransom was nice enough to colorize the animation. (He doesn’t know that I prefer watching classic film is the original B&W version.) If I knew people were going to be speaking my lines, I wouldn’t have used ungainly phrases like NGDP.