Archive for the Category Exchange Rates


Some thoughts on “overvalued” and “undervalued” exchange rates

Benn Steil and Emma Smith have a new post on the Big Mac Index:

The Economist magazine’s famous Big Mac Index uses the price of McDonald’s Big Macs around the world, expressed in a common currency (U.S. dollars), to estimate the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose.

But burgers travel badly.  So in 2013 we created our own index—one that better meets the condition that the product can flow quickly and cheaply across borders.

The Geo-Graphics Little Mac Index compares the price of iPad minis across countries. iPad minis are a global product that, unlike Big Macs, do in fact travel the earth with their owners.

.  .  .

Overall, the Little Mac Index suggests that the dollar has become slightly more overvalued (up from 5 percent) since the beginning of 2015.  The euro is undervalued by 11 percent, and the yen by 10 percent.  Having been fairly valued at the beginning of last year, the renminbi – following on the heels of China’s large devaluation in August – is now 5 percent undervalued.  This compares with an implausible 46 percent undervaluation on the Big Mac Index.  Maybe Congress is Lovin’ It, but we think the Economist needs to hold the mustard.

Given recent events, only a complete moron, or Donald Trump, would claim the yuan is undervalued.  So that’s a point in favor of the Little Mac Index.  But let’s step back and think about what terms like ‘overvalued’ and ‘undervalued’ actually mean.  Do they mean the exchange rate is artificially set at a different level from the black market rate?  Perhaps in cases like Venezuela, but in most cases these are actual market exchange rates, where you can freely buy and sell the currency in question.  So clearly that’s not what the creators of the Big Mac and Little Mac indices have in mind.

But then what does it mean to say an asset price is under or overvalued?  Does it mean the market is in some sense wrong, as when there is a bubble?  Perhaps, but then why would you expect these “Mac” excises to find the right exchange rate? Yes, PPP predicts a certain relationship between prices, but we have very good economic theories, such as Balassa/Samuelson theory, which explain why we should not expect PPP to hold for all goods.  So a deviation from the prediction of PPP actually tells us nothing about under and overvaluation.

Nor is it clear why Steil and Smith think it’s better to use a traded good than a non-traded good.  Let’s take that to the logical extreme, and use a good that is so easily traded that the law of one price holds, say gold.  AFAIK, the price of gold in New York, London, Hong Kong, Tokyo, Zurich, etc., is virtually identical, when measured in a common currency.  So Steil and Smith have picked a good that is more easily traded that Big Macs, but less easily traded than gold.  But why is that optimal? Using gold, PPP would always seem to hold true.  Even worse, a sudden adjustment in the exchange rate (such as Switzerland’s 15% appreciation a year ago), would leave the price of gold in Zurich exactly the same as before, when measured in dollar terms.  In other words, if they had chosen a very easily traded good like gold, instead of Little Macs, Steil and Smith would have found the Swiss franc to be correctly valued right before, and right after, a sudden 15% adjustment.  Does that make sense?

It seems to me that if you really want to look for exchange rates that are out of line with PPP, you’d use non-traded goods like Big Macs, not traded goods like gold. Little Macs fall in between, and offer no obvious advantage over either extreme.

In my view all of these exercises miss the point.  Exchange rates should not be set to make PPP come true. Nor should exchange rates be set to generate a current account balance of zero.  Trying to set rates to make these equalities hold would create a macroeconomic disaster.  Exchange rates should be set at a level that provides macroeconomic equilibrium, something like low and steady growth in NGDP.  The only meaningful sense that an exchange rate can be said to be overvalued is if it leads to below target NGDP growth (or inflation, if you prefer.) For instance, despite falling from 80 to the dollar, to 120 to the dollar, the yen is still overvalued, as most experts forecast about 1% inflation going forward, which is below their 2% target.

This sense in which an exchange rate can be overvalued is exactly the same as saying the short term interest rate is too high, or the TIPS spread is too low, or the nominal price of zinc is too low.  A counterfactual monetary policy that produced on target NGDP growth, would (by assumption) lead to a lower short-term nominal interest rate, a higher TIPS spread, and a higher nominal price of zinc.  And a lower domestic currency value in the forex markets.  That doesn’t mean the market is “wrong” in a “violation of the EMH” sense, rather it means monetary policy is too tight to achieve macroeconomic equilibrium.

So far I’ve talked about nominal exchange rates.  But what about real exchange rates, can they also be overvalued or undervalued?  Elsewhere I’ve argued that real and nominal exchange rates are so different that they should not even be discussed in the same course.  And yet many people foolishly talk about them synonymously. What would it mean to say the China’s real exchange rate is undervalued?  In that case you’d be arguing that China’s government policies encourage too much saving, too little investment, or both.  In other words, the policies encourage too big a S-I gap, which of course is the current account surplus.  I’m not saying that’s true (I doubt it) but that would be the argument.  In that case it would be stupid to adjust the exchange rate (doing so would produce a depression) you’d want to change the saving/investment policies.

Off topic, I love the ambition in this post by C. Harwick, where he derives NGDP targeting from first principles.  I don’t know anything about this blogger, but based on this post he seems much younger and much smarter than I am.  However I disagree with the final two bullet points in item #13.

PS.  I have a new post on IS shocks, over at Econlog.

Thinking out loud

Always dangerous to speculate when the market is changing minute by minute, but a few observations:

1.  Over at Econlog I did a post earlier this morning, suggesting that the China slowdown is reducing the Wicksellian equilibrium global interest rate.  Since central banks foolishly target interest rates rather than NGDP, this makes monetary policy more contractionary.

2.  Why does this seem to affect foreign markets more than the US market?  One possibility that that economies like Germany and Japan are more exposed to a global slowdown, as manufacturing exports are a bigger part of their economies. But that suggests the yen and euro should be falling against the dollar, whereas they are actually appreciating strongly.  Indeed the appreciation is so strong that one could easily attribute much of the recent stock market decline in Europe and Japan to their strengthening currencies.  Now of course I always say “never reason from a price change,” so let me emphasize that I am implicitly assuming the stronger yen and euro reflect tighter money, not surging growth expectations in Europe and Japan.  I don’t think anyone in their right mind believes global growth prospects have been rapidly improving in the last week, especially when you look at commodity and stock prices.

3.  The falling TIPS spreads and real interest rates suggest that AD expectations are falling in the US, but not anywhere near to recession levels.  After all, did anyone expect a recession last time the S&P was at this level?  Obviously not.  The tighter money in Europe and Japan suggests those economies will be hit harder than the US.

4.  If Europe and Japan are facing tighter money than the US, why would that be? Probably because markets think it would be easier for the Fed to at least partially offset this shock, via a delay in the interest rate increase.  Areas already at the zero bound would have to be more creative, and history has shown that central banks tend to be slower to react at the zero bound, especially when there are sudden and unanticipated shocks like this.  (It’s easier to offset anticipated shocks, like 2013’s fiscal austerity.)

This is all very speculative, and I don’t have a lot of confidence on my analysis. And as always, I don’t forecast asset prices, I merely try to ascertain what the market is forecasting.  Unfortunately the Hypermind market is still not very efficient.  It opened this morning at 3.6%, which was actually up slightly in the past few days.  I don’t think that reflects actual NGDP expectations.  Last I looked it was down to 3.4%, but of course efficient markets respond immediately to shocks.  This tells me that while the market is a nice demonstration project, there is no substitute for a very deep and liquid NGDP prediction market subsidized by Uncle Sam.  If it’s not the biggest $100 bill on the sidewalk, it’s right up there.

One other point.  I’m much more concerned by falling TIPS spreads and falling 30-year bond yields, than I am by falling equity prices.  Stocks often show large price breaks, without there being any change in the business cycle.

PS.  I agree with Lars Christensen’s analysis (except the part about China not becoming the biggest economy.  We face this problem because they already are the biggest.)  I think Lars is right about the two key mistakes being the Chinese yuan/dollar peg and Yellen’s tight money policy.

Cochrane needs to review Hume, Fisher, and Friedman

John Cochrane has lots of sensible things to say about the euro-crisis, but his analysis is marred by a serious error:

A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a liter bottle, that wouldn’t threaten the

metric system.

Bailouts are the real threat to the euro. The European Central Bank has been buying Greek, Italian, Portuguese and Spanish debt. It has been lending money to banks that, in turn, buy the debt. There is strong pressure for the ECB to buy or guarantee more. When the debt finally defaults, either the rest of Europe will have to raise trillions of euros in fresh taxes to replenish the central bank, or the euro will inflate away.

Leaving the euro would also be a disaster for Greece, Italy and the others. Reverting to national currencies in a debt crisis means expropriating savings, commerce-destroying capital controls, spiraling inflation and growth-killing isolation. And getting out won’t help these countries avoid default, because their debt promises euros, not drachmas or lira.

Perils of Devaluation

Defenders think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth.

Hume, Fisher, and Friedman would have approved of the measuring stick analogy.  But they also understood that money is non-neutral in the short run.

In Zimbabwe the government destroyed the supply-side of the economy and then printed money to paper over the problem.  Of course their RGDP fell.  I could offer the following examples in reply:

1.  The big Argentine devaluation of 2002 turned a depression into 8% a year RGDP growth.

2.  The big US devaluation of 1933 turned a depression into 8% a year RGDP growth.

Cochrane could argue that there must have been “real” factors at work, but unfortunately in both Argentina and America all the real factors were government policies he (rightly) loathes.  Both countries grew rapidly in response to currency devaluation despite counterproductive statist policies.  And those two examples are at least as relevant (or irrelevant) as Zimbabwe.  Greece has both real and nominal problems, and thus is totally unlike Zimbabwe.

We know that when countries are severely depressed due to a fall in NGDP, a sharp currency devaluation most certainly will boost competitiveness.  That doesn’t mean that Greece doesn’t have all sorts of other problems, but Greek wages would not immediately double if they exchanged two drachmas for each euro.

I’m increasingly frustrated with the tendency of modern Chicago economists to treat Friedman as a hero, and then gloss over the fact that his greatest achievement was showing that recessions and depressions are caused by nominal shocks.

On all the microeconomic issues Cochrane is right, but on the euro he couldn’t be more wrong:

The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.

Fisher said the dollar was like a measuring stick with a length that was always changing.  He opposed fixed exchange rates (i.e. the gold standard) because he wanted the central bank to keep the “length” stable.  Greece can’t do that if it’s tied to Germany.  Friedman understood this problem as well, which is why he predicted the euro would end badly.  He was right.

Cochrane should have called for the ECB to make sure nominal growth doesn’t plunge next year.  If they want to make the euro work (and it seems they do) then the least the ECB can do is provide enough NGDP growth so that the structural problems in countries like Greece are not compounded by disequilibrium in the labor market.  [The original version omitted “not” before compounded.]

And I sure wish Chicago would go back to teaching its students the lessons of Hume, Fisher, and Friedman.

HT:  Tyler Cowen

Update: Ramesh Ponnuru has an excellent critique of a piece in The American Conservative that is critical of NGDP targeting.

Bondage and Discipline

When inflation rates in most countries soared during the 1970s, economists reacted by developing ad hoc theories about why this was inevitable with discretionary monetary regimes and governments that had a short term focus.  The ink was hardly dry on all these acclaimed “time-inconsistency” theories when they were decisively refuted by events.  Inflation fell sharply all over the world, in good countries and also in countries lacking “discipline.”

But economists hold on to clever theories even after they’ve been refuted; after all, the world should work that way.  Thus the theories are still taught in textbooks.

And I believe this way of thinking may have helped to create the current euromess.  Consider the following two systems:

1.  The current eurosystem.

2.  A fixed exchange rate regime where all countries have their own national euros, which trade at exchange rates of one.  For instance, imagine the US, Canada, and Australia all fixed their dollars to each other at an exchange rate of 1.0.  (We’re actually pretty close right now.)

If I’m not mistaken, the Europeans do have something similar in the coinage area, where each country has its own distinctive coins.  Why not do that for bills as well?  In that case the adoption of the euro would have still involved the same sort of “currency reform” (say 1500 lira for one Italian euro) but Italy would have preserved its own national currency.

Now lets think about the advantages and disadvantages of my alternative.

1.  Advantage:  Italy could devalue in a crisis.  It could avoid a macroeconomic disaster.

2.  Disadvantage:  Italy could devalue in a crisis, delaying needed fiscal reforms.

I don’t see the disadvantage as being all that important.  Even with your own currency, markets will still impose “discipline” in the form of higher interest rates.  There is no free lunch for deficit countries in a world of rational expectations.  Thinking you can continually fool markets with inflationary policies is not a strategy, it’s a delusion.  In addition, the peripheral countries were arguably better behaved in the pre-1999 EMS (when they’d better behave or they’d face higher rates) then in the post-1999 eurozone, when they could borrow at German interest rates and throw a wild party.  Indeed the system I am proposing (similar to the old EMS) was one where the peripheral countries were behaving in an increasingly responsible fashion, sharply reducing their inflation rates.  And before anyone jumps in and says “they were only doing that because they needed to in order to join the eurozone,” consider that the vast majority of non-European countries were also reducing their inflation rates during the 1990s.  Even countries with much worse fiscal traditions than Italy and Greece.

So why wasn’t my proposal adopted, if it was as clearly superior as I claim?  If you are a non-economist you are going to find the following hard to comprehend, but trust me, it’s true.  Even though the time-inconsistency theory was totally discredited by events, it still holds a powerful sway over the minds of the world’s macroeconomists.  Discipline is the key.  If you allow just a bit of inflation, it’s like giving a drunk a sip of whiskey.  All hell will break lose.

The Aussies showed that 6% to 7% trend NGDP growth keeps nominal interest rates above zero, allowing them to avoid liquidity traps.  Also allowing Australia to avoid recessions, and without inflation shooting up to double digits.   Yet the theory says this policy can’t work.  So we’ll just close our eyes to reality and pretend Australia doesn’t exist.  We’ll set up a regime that you can check into, but you can’t check out of.  Because we don’t trust democracy.  People might at some future date come to the realization that the system is not optimal, indeed it is a disaster.  And we can’t allow them to change their minds in that case.  It’s all about the time inconsistency problem.  Discipline and more discipline.

By the way, bondage disasters know no cultural boundaries.  In the early 1930s the discipline imposed by the gold standard destroyed the German economy–ushering the Nazis into power.  During 1998-2001 discipline wrecked the Argentine economy.  Now it’s damaging other economies.  There’s no telling where it will hit next.

Countries really do need self-control.  All the success stories exhibit that cultural trait.  But you don’t get there by putting your monetary system into a straight-jacket and throwing away the key.  Only by changing your culture.

PS.  I still have lots of grading to do.  I’ll get to old comments this weekend.

PPS.  What if bloggers ran the world?  These two posts suggests that not much would change:

Here’s Tyler Cowen:

At this point you have to be asking whether it is better to simply end the eurozone now, no matter how painful that may be.  Unless of course you are an optimist about Italy reaching two percent growth, or Germany becoming fully cosmopolitan.  As a politician I probably could not bring myself to pull the plug, but as a blogger I wonder if that might not, at this point, be the wiser thing to do.

And here’s Matt Yglesias:

If I were an elected official, I’d be extremely reluctant to pull the plug on this endeavor even though it was misguided from the start and isn’t functioning in practice. But I’d be leaping at the opportunity to be the second prime minister to bail on the whole thing if someone else went first.

Well!  If I was a politician . . . I’d . . . I’d . . . yeah, I’d probably wimp out too.

The doomsday device

Here’s a scene from Dr.Strangelove:

The Ambassador reveals that his side has installed a doomsday device that will automatically destroy life on Earth if there is a nuclear attack against the Soviet Union. The American President expresses amazement that anyone would build such a device. But Dr. Strangelove (Sellers), a former Nazi and weapons expert, admits that it would be “an effective deterrent… credible and convincing.” However, a recent study by an American think tank had dismissed it as being too dangerous to be practical.

It turns out that the biggest problem is that the machine cannot be deactivated if something goes wrong.  And something did go wrong; a single rogue bomber attacked the Soviet Union at the instructions of General Jack D. Ripper:

From his wheelchair, Strangelove explains the technology behind the Doomsday Machine and why it is essential that not only should it destroy the world in the event of a nuclear attack but also be fully automated and incapable of being deactivated.

Recently I’ve been wondering about the EU’s backup plan if the euro didn’t work out.  One option would be to go back to the previous national currencies.  But that’s easier said than done.  Presumably it would be costly and time consuming, but even that isn’t the main problem.  After all, the countries previously converted to the euro without much problem. It’s not the end of the world.

But there’s a much bigger problem with deactivating the doomsday device euro.  Unlike when it was first set up, some of the new currencies would be introduced at different (lower) exchange rates.  And the expectation of devaluation is extremely destabilizing for financial markets.  That’s how George Soros got rich—he knew that the UK pound was under stress in 1992, and that the only two likely possibilities were a steep devaluation or no change.  He bet on devaluation, and won a billion dollars.  So devaluations are quite destabilizing.  Even so, they’ve been done before; it’s not the end of the world.

Unfortunately, there is no currency to devalue in this case.  So it’s not as easy to do as when a country has its own currency, and decides to suddenly change the par value.  There would probably have to be a decision to call a bank holiday, and impose all sorts of capital controls, to prevent everyone from smuggling euros out of the country into Swiss banks right before the official changeover.  That’s not easy.  But it’s not impossible.  The US did a bank holiday in the 1930s, and other countries have imposed capital controls.  So it’s not the end of the world.

Unfortunately, we are not just dealing with one country.  If it was just Greece, the government could meet in secret and work out an emergency transition plan.  Then suddenly spring it on the public.  But things have gone way beyond just Greece.  We are looking at the possibility of a complete breakup of the eurozone.  So the 17 countries would have to independently reach the conclusion that the euro was done, and then get together and meet in secret, without the meeting leaking out to the press.  And recall that right now these countries are getting along about as well as the US and Soviet Union during the cold war.  Still, it’s not . . .

On second thought, time to cue up Vera Lynn’s “We’ll Meet Again.”