Archive for the Category Exchange Rates


Borat in Hawaii

One of the most interesting things about the long Japanese deflation was the relative stability of the Japanese yen, against the dollar.  It’s depreciated about 1% since the end of 1993:

Screen Shot 2016-03-08 at 4.29.39 PM

You’d have expected the Japanese yen to have appreciated strongly in recent decades, as the US price level (GDP deflator) has risen from 73 to 100 since early 1994, while the Japanese price level has fallen from 117 to 100.  Thus the ratio of US to Japanese prices has risen from 0.91 to 1.62. And that’s not because I cherry-picked the data, as of a month ago the yen was down about 10% against the dollar, since the end of 1993.  Thus the deviation from PPP would have been even bigger.

I frequently argue that inflation doesn’t matter, what matters is NGDP growth per capita.  Here is the NGDP of Japan since the beginning of 1994:

Screen Shot 2016-03-07 at 10.13.01 AM

It’s up about 1%.  But Japan’s population is up about 1% or 2%, depending on the source, meaning that NGDP/person is either flat or down 1%.

How about in the US?  The following graph shows NGDP/person:

Screen Shot 2016-03-07 at 10.18.40 AM

So in the US NGDP/person is up about 106.7%, versus at most zero in Japan. You might say that’s comparing apples and oranges, as one is in dollars and the other is in yen.  But as we saw the exchange rate is pretty stable since the end of 1993.  On the other hand, if PPP does not hold, what difference does that make?  RGDP in Japan has been rising, so Japanese living standards are on the way up.

Here’s how I would interpret this data.  This is telling us that compared with early 1994, Japanese tourists have become much poorer in a relative sense, every time they visit Hawaii.  Relative to American tourists, they have a hard time affording positional goods, like the best hotel rooms.

Just think about the size of this relative impoverishment of Japanese tourists.  In PPP terms, Japan’s per capita GDP (World Bank) is $36,426, a normal developed country.  What does it mean to lose half your purchasing power?  Here are some countries about half as rich as Japan:

Screen Shot 2016-03-07 at 10.10.16 AMPlease don’t misunderstand me; I’m not saying that Japan is that poor, the $36,412 figure shows their current PPP income.  I’m just trying to give you a sense of how big a drop it is.  In fact, at the end of 1993 the yen was quite strong in real terms, so the Japanese seemed rich when they visited Hawaii.  But since then, the drop has been precipitous, with Japanese tourists losing over half their purchasing power, relative to Americans.

One silver lining is that Japan remains 50% richer than Borat’s home country (Kazakhstan) which has a GDP/person of only $24,228, so I don’t expect to see any Japanese tourists confusing the elevator with their hotel room.

Finally, I get to the point.  The PPP theory is pretty elastic, but not infinitely so.  The fall in the real value of the yen is probably close to the maximum possible.  If Japan were to simply to push the yen back to 125/dollar, and then peg it for several decades, they would likely experience at least as high an inflation rate as the US, probably higher.  Because the US is now out of the zero rate trap, I predict our inflation rate will average at least 1.5% over the next few decades.  If Japan doesn’t end up with significant inflation, it won’t be because they are unable to do it with monetary policy alone.  Rather it would be because they stupidly allowed the yen to appreciate over time.  It’s up to them.  The US may grouse, but as we showed with the Chinese dollar peg, we are (Thank God!) a paper tiger.

And if I’m wrong, and the real yen exchange rate keeps plunging, then Japanese workers will have Kazakhstani wage by 2040.  If those highly productive Japanese workers can’t take market share at Kazakhstani wage levels, then Japan should just fold up shop.

Is it 1985-86 again?

See if this sounds familiar. Halfway through a long expansion, industrial production levels off, after years of rapid growth. This is blamed on two factors, declining oil prices and a strong dollar.  I could be describing the past year, or I could be describing 1985-86:

Notice how industrial production leveled off for a couple years, before resuming its rise:

Screen Shot 2016-02-02 at 1.01.16 PMAnd here is the oil price, which fell gradually in the 1982-85 period and then plunged in 1985-86:

Screen Shot 2016-02-02 at 1.00.55 PM

And here is the trade-weighted dollar, which soared in value, and then plunged:Screen Shot 2016-02-02 at 1.00.42 PM

My hunch is that the dollar was more important than oil.  Tight money led to a slowdown in NGDP growth and a strong dollar.  NGDP growth (year over year) slowed from 12.4% in 1984 Q1, to only 4.9% 1986 Q4. Eventually the Fed eased policy, and NGDP accelerated.  The 1980s boom resumed.  It actually eased a bit too much in the late 1980s, which set up the 1990-91 recession.

Does this mean that history will repeat? No. But it’s an interesting comparison.

PS.  While writing this I forget that Caroline Baum made a similar observation in her book “Just What I Said“, where she pointed out:

This isn’t the first time that a change in oil prices has been regarded as a tax increase or tax cut and anointed with the ability to help or hinder economic growth. Time-trip back to early 1986, when oil prices plunged to $10 a barrel in April from $30 at the end of 1985. This was hailed as good news – a tax cut! – for consumers, which was guaranteed to boost US economic growth.

It didn’t turn out that way.  Following the plunge in oil prices, gross domestic product growth slipped to an anemic 1.7% in the second quarter of 1986 . . .

Ah, recall the days when 1.7% RGDP growth was anemic, not above trend.


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.