Archive for the Category International economics


Applying Occam’s Razor to the forward value of the yen

After my previous post, Brian McCarthy left the following remarks:

I believe there is a fair bit of empirical evidence that current spot rates are a better predictor of future spot rates than are current forward rates. So a naive “long carry” strategy does generate positive returns over time. The reason this “free money” isn’t arbitraged away, I would imagine, is that the strategy doesn’t have a good sharpe ratio. ie low returns relative to the volatility. In market slang it’s “picking up pennies in front of the steam roller,” involving a significant risk of ruin if done “in size.”

So the market really does “expect” the yen to be at 106 in 30 years, which is where it is today.

This is a good argument, but in the end I favor the alternative view.

Over the past 40 years, the US price level has risen from 1 to 3.975, while the Japanese price level has risen from 1 to 1.556. That means the US price level has risen by 2.555 relative to the Japanese price level.  Over the same period, the yen has appreciated from 241.37 to 106 to the dollar, a ratio of 2.227.  So the appreciation of the yen in the very long run is pretty close to the change predicted by PPP (although over shorter periods there are quite wide discrepancies.)

So here’s how I look at things.  The simplest explanation for the forward yen trading at 50 is that the public expects Japan to continuing having lower inflation than the US, just as has been the case for the past 40 years.  They expect the yen to continue appreciating, just as it has over the past 40 years.

The alternative explanation is possible, but involves more “epicycles”:

1.  Yes, the Japanese yen has been appreciating in the very long run.

2.  Yes, the Japanese inflation rate is consistently lower than in the US.

3.  Yes, the 30-year forward yen is trading at a strong premium, just as you’d expect if these trends were going to continue.

4.  But these facts are actually unrelated.  Starting right now, the Japanese inflation will suddenly rise to US levels, even though the markets don’t seem to expect that.  And starting right now the yen will stop appreciating.  And instead some other “real factor” explains why the forward yen is trading at a strong premium, some real factor that would cause 30-year Japanese real interest rates to be hundreds of basis points lower than American real interest rates.

That’s all theoretically possible, but isn’t the simplest explanation that the forward yen is at a strong premium because investors expect the spot yen to appreciate, and they expect the spot yen to appreciate for the same reason that it’s strongly appreciated over the past 40 years?

PS.  After I wrote this post (a few days ago), I discovered a similar post written earlier by Julius Probst, who has a very nice monetary economics blog.  He anticipates my basic point.  But read his post anyway, as it ends with some interesting remarks on Japanese monetary policy.


Taxes, trade and GDP

Noah Smith has a good post on a topic that’s getting a lot of attention in the blogosphere.  It seems that the recently enacted tax reform is likely to dramatically boost reported exports, without (necessarily) impacting actual exports at all:

Here’s an example adapted from Guvenen et al.’s paper. Suppose that NoahCorp produces the NoahPhone, using research, design and branding done in the U.S., then sells it to people in Japan. Normally, the revenue from that sale would be counted in U.S. exports. But in order to avoid paying corporate tax on the profits from the sale, NoahCorp sells its patents and brands to NoahCorp Ireland for a pittance. It then declares that the profit from the Japanese phone sale actually goes to the Ireland subsidiary, not the U.S. parent company. The parent then doesn’t have to pay U.S. corporate tax. And the phone sale doesn’t get counted in U.S. exports. . . .

The result of all this profit-shifting is that the U.S. trade deficit seems wider than it really is, while U.S. income on foreign investments gets overstated. It looks like the U.S. is really bad at selling things overseas, but very good at choosing its foreign investments. For many years, pundits believed that wise U.S. investing was partially making up for uncompetitive manufacturing — now, it turns out that both of those stories might be different aspects of the same illusion.

With the new and lower corporate tax rate, companies will now be willing to declare this revenue as income from US exports.  And that could have political implications for an administration that is all about smoke and mirrors and marketing:

Nothing real will be changing, of course. The same phones will still be sold, and the same intellectual property will be created. But it will look like a huge win for the Donald Trump administration, which pledged to cut trade deficits.

I’m a bit skeptical that this will work.  Unless I’m mistaken, any gain in the trade account will be offset by deterioration in the services account as investment income declines, leaving the current account unaffected.  (Someone tell me if I’ve made a mistake here.)  And it’s the current account that pundits focus on, not the trade account.

On the other hand, this would tend to boost reported GDP, without boosting actual GDP.  It will be interesting to see how large the effect will be, and how durable.  My hunch is that any boost to growth would be modest (below 1%) and temporary.

I don’t worry at all about the President taking credit for things that are not real, as the public sees through the phony data.  When Trump took office he claimed the the unemployment rate almost immediately fell from the 30% to 40% range, down to about 4.1%.  But nobody took this seriously.  (Ditto for his recent claim to have repealed Obamacare).  Trump has made so many absurd claims that even his supporters don’t take anything he says seriously.  All that matters in 2020 is how the American people feel they are doing, not what the data show.

HT:  David Levey

At least the Treasury doesn’t focus on “intentions”

Here is the Treasury’s list of the three criteria it uses to identify “currency manipulators”:

Pursuant to Section 701 of the Trade Facilitation and Trade Enforcement Act of 2015, this section seeks to identify any major trading partner of the United States that has: (1) a significant bilateral trade surplus with the United States, (2) a material current account surplus, and (3) engaged in persistent one-sided intervention in the foreign exchange market. Section 701 requires data on each major trading partner’s bilateral trade balance with the United States, its current account balance as a percentage of GDP, the three-year change in the current account balance as a percentage of GDP, foreign exchange reserves as a percentage of short-term debt, and foreign exchange reserves as a percentage of GDP. Data for the most recent four-quarter period (January to December 2016, unless otherwise noted) are provided in Table 1 (on p. 13) and Table 2 (below).

This is obviously beyond stupid.  (Since when do bilateral trade deficits mean anything?)  But at least the Treasury doesn’t try to read minds, and interpret the intentions of other countries.

Matthew McOsker sent me an article from the Economist, which nicely illustrates the confusion surrounding the concept of currency manipulation:

Awkwardly for America, two of its friends in Asia have recently scored more highly than China: South Korea and, most clearly, Taiwan. But the highest score of all goes to Switzerland, by dint of its whopping current-account surplus and its hefty foreign-currency purchases. This illustrates one of the method’s flaws: in terms of the goods and services that it can actually buy, the Swiss franc is in fact among the world’s most overvalued currencies.

This is why it’s so important to have a clear definition of currency manipulation.  The Economist clearly thinks the concept is related to undervalued currencies, and most people probably agree.  But whether a currency is “undervalued” is completely unrelated to whether some of the other criteria are met, such as large purchases of foreign exchange and/or a current account surplus.  If you really believe that large purchases of foreign exchange and a big current account surplus constitute currency manipulation, then you should have the courage of your convictions and label Switzerland as one of the world’s worst villains.  After all, it is among the world’s leaders in both categories.

And this leads to another irony.  I frequently point out that the more conservative the central bank, the bigger the balance sheet as a share of GDP. Thus in the future we may end up seeing more and more countries like Switzerland, with huge purchases of foreign assets in a futile attempt to prevent their currency from appreciating.

To avoid being labeled a currency manipulator, they may instead choose to buy domestic assets (as in Japan).  This will also boost domestic saving, depreciate the currency and increase the current account.  But since they won’t be buying “foreign exchange”, they just might fool the US Treasury.  (It’s not hard, when the Treasury is hamstrung by the silly mandate given to it by Congress.)

Here’s another irony.  Some people seem to think that fixed exchange rate regimes are evidence of currency manipulation.  But in the 1990s the EU had a fixed exchange rate system with the express purpose of preventing currency manipulation.  In fact, fixed exchange rate regimes determine the path of the nominal exchange rate.  But if currency manipulation happens at all (I doubt it), then it surely relates to real exchange rates. Thus if currency manipulation happens, it is equally likely to occur with a fixed or floating exchange rate regime.  Indeed you don’t even need your own currency to “manipulate” your real exchange rate.  Germany depreciated its real exchange rate in the 2000s.  If Wisconsin wanted to depreciate its real exchange rate it could do so.

But why would they want to?

What does it mean to “manage” a currency?

Commenter Matthew McOsker made this attempt:

I think the definition is simple where one country consciously manages the value of their domestic country against a foreign country.

What does it mean to “manage” the value of a currency. If you mean “enact government policies that impact the exchange rate”, then all countries are guilty.  If you mean enact government policies with the intention of affecting the exchange rate, then does it matter if that’s the sole purpose, or just one of many channels?  Didn’t Bernanke mention exchange rates as one channel by which QE could affect the US economy?  Some people argue that Japan’s recent adoption of negative IOR was (among other things) aimed at depreciating the yen.  But they had no specific exchange rate peg, and the yen continues to move up and down each day.  It probably wasn’t aimed at boosting the current account balance, but rather boosting prices and GDP. Is that currency manipulation?

People are going to need to be much more specific if they intend to convince me that there is a coherent definition out there.

I’m still waiting for a definition of “currency manipulation”

Due to my recent move, I’m still catching up on the last few months in the blogosphere.  (Today I spent $750 (and many hours) registering my car in California.)  Thus I finally got around to reading an earlier post by David Glasner, which responds to my complaint that “currency manipulation” is an incoherent concept.  More specifically, I made this charge:

But I would go much further; there is no intellectually respectable definition of currency manipulation.

And David responded:

Well, my only response is that I consider Max Corden to be just about the most theoretically-respectable economist alive. So let me quote at length from Corden’s essay “Macroeconomic and Industrial Policies” reprinted in his volume Protection, Growth and Trade (pp. 288-301)

There is clearly a relationship between macroeconomic policy and industrial policy on the foreign trade side. . . . The nominal exchange rate is an instrument of macroeconomic policy, while tariffs, import quotas, export subsidies and taxes and voluntary export restraints can all be regarded as instruments of industrial policy. Yet an exchange-rate change can have “industrial” effects. It therefore seems useful to clarify the relationship between exchange-rate policy and the various micro or industrial-policy instruments.

The first step is to distinguish a nominal from a real exchange-rate change and to introduce the concept of “exchange-rate protection. . . . If the exchange rate depreciates to the same extent as all costs and prices are rising (relative to costs and prices in other countries) there may be no real change at all. The nominal exchange rate is a monetary phenomenon, and it is possible that it is no more than that. A monetary authority may engineer a nominal devaluation designed to raise the domestic currency prices of exports and import-competing goods, and hence to benefit these industries. But if nominal wages quickly rise to compensate for the higher tradable-goods prices, no real effects – no rises in the absolute and relative profitability of tradable-goods industries – will remain. Monetary policy can influence the nominal-exchange rate, and possibly can even maintain it at a fixed value, but it cannot necessarily affect the real exchange rate. The real exchange rate refers to the relative price of tradable and non-tradable goods. While its absolute value is difficult to measure because of the ambiguity of the distinction between tradable and non-tradable goods, changes in it are usually – and reasonably – measured or indicated by relating changes in the nominal exchange rate to changes in some index of domestic prices or costs, or possibly to the average nominal wage level. This is sometimes called an index of competitiveness.

A nominal devaluation will devalue the real exchange rate if there is some rigidity or sluggishness either in the prices of non-tradables or in nominal wages. The nominal devaluation will then raise the prices of tradables relative to wage costs and to labour-intensive non-tradables. Thus it protects tradables. This is “exchange-rate protection”. It protects the whole group of tradables relative to non-tradables. It will tend to shift resources into tradables out of non-tradables and domestic demand in the opposite direction. If at the same time macroeconomic policy ensures a demand-supply balance for non-tradables – hence decreasing aggregate demand (absorption) in real terms appropriately – a balance of payments surplus (or at least a lesser deficit than before) will result. This refers to the balance of payments on current account since the concurrent fiscal and monetary policies can have varying effects on private capital inflow.

If the motive for the real devaluation was to protect tradables, then the current account surplus will be only a by-product, leading to more accumulation of foreign exchange reserves than the country’s monetary authority really wanted. Alternatively, if the motive for the real devaluation was to build up the foreign-exchange reserves – or to stop their decline – then the protection of tradables will be the by-product.

The main point to make is that a real exchange-rate change has effects on the relative and absolute profitability of different industries, a real devaluation favouring tradables relative to non-tradables, and a real appreciation the opposite. A nominal exchange-rate change can thus serve an industrial-policy purpose, provided it can be turned into a real exchange-rate change and that the incidental effects on the balance of payments are accepted.

This does not mean that it is an optimal form of industrial policy. . . . [P]rotection policy could be directed more precisely to the industries to be protected, avoiding the by-product effect of an undesired balance-of-payments surplus; and in any case it can be argued that defensive protection policy is unlikely to be optimal, positive adjustment policy being preferable. Nevertheless, it is not difficult to find examples of countries that have practiced exchange-rate protection, if implicitly. They have intervened in the foreign-exchange market to prevent an appreciation of the exchange rate that might otherwise have taken place – or at least, they have “leaned against the wind.” – not because they really wanted to build up foreign-exchange reserves, but because they wanted to protect their tradable-goods industries – usually mainly their export industries.

Notice that the first part of this quotation repeatedly makes the point that what matters is not the nominal exchange rate, but rather the real exchange rate.  The nominal rate matters only to the extent that it impacts the real rate.  That’s progress, as David had previously cited data on China’s nominal exchange rate (specifically the peg to the dollar) as evidence of currency manipulation. I pointed out that the real value of the Chinese yuan had been appreciating during this period.   In his reply David notes (correctly) that the real appreciation does not prove that China was not manipulating the currency.  I’m happy to accept that response, and leave China as an open question.  Perhaps China did manipulate its currency, but we’d need to go beyond the nominal exchange rate peg.

But I’m still trying to discover a definition of currency manipulation in the Corden quote above.  Is it here?

A nominal devaluation will devalue the real exchange rate if there is some rigidity or sluggishness either in the prices of non-tradables or in nominal wages. The nominal devaluation will then raise the prices of tradables relative to wage costs and to labour-intensive non-tradables. Thus it protects tradables.

I can’t figure out what that means.  Taken literally it seems to imply that a nominal appreciation depreciation that is associated with a real appreciation depreciation is a form of protectionism.  But that’s obviously nonsense.  So what is he claiming?  We know the nominal exchange rate doesn’t matter; only the real rate matters.  But currency manipulation can’t be just a depreciation in the real exchange rate, as real exchange rates move around for all sorts of reasons. If a revolution broke out in Indonesia tomorrow, I don’t doubt that the real value the their currency would plummet.  But no one would accuse Indonesia of currency manipulation.

So we need to look deeper than the nominal exchange rate, and we need to look deeper than the real exchange rate.  How about a decline in the real exchange rate caused by government policy?  Maybe, but I don’t recall anyone accusing the Norwegians of currency manipulation when they set up a sovereign wealth fund for their oil riches.  That’s a government policy that encourages national saving and hence boosts the current account.  Nor was Australia accused of currency manipulation when they did tax reform in the late 1990s.

The term ‘motive’ seems to play a role in the passage above:

If the motive for the real devaluation was to protect tradables, then the current account surplus will be only a by-product, leading to more accumulation of foreign exchange reserves than the country’s monetary authority really wanted. Alternatively, if the motive for the real devaluation was to build up the foreign-exchange reserves – or to stop their decline – then the protection of tradables will be the by-product.

As an economist, references to “motives” make me very uncomfortable.  Let’s take the example of China.  Did China’s government try to reduce the real value of the yuan because they saw what happened during the 1997 SE Asia crisis, and wanted a big war chest in case they faced a balance of payments crisis?  Or did they do the weak yuan policy to shift resources from domestic industries to tradable goods industries?  I have absolutely no idea, nor do I see why it matters.  Surely if a concept of currency manipulation has any coherent meaning, it cannot depend on the motive of the policymakers in a particular country?  We aren’t mind readers.  This is especially true if we are to believe that currency manipulation hurts other countries, as its proponent seem to suggest.  How will it be identified?

In the spirit of Bastiat, consider the following analogy.  Suppose that for years we had been buying bananas from Colombia for 10 cents a pound.  American consumers got to eat lots of cheap tasty fruit, which don’t grow well in non-tropical countries.  Then in 2018, Trump sends a team of investigators down to Colombia, and finds out that we’ve been scammed.  It’s actually not a warm country, indeed quite cool due to its high elevation.  The Colombian government had spent millions building giant greenhouses to grow bananas.  We’ve been tricked into buying all these cheap bananas from Colombia, which artificially created a “competitive advantage” in the banana industry through subsidies.

Here’s my question:  Why does it matter why the Colombian bananas were cheap?  If we benefited from buying the bananas at 10 cents a pound, why would we care if the price reflected true competitive advantage or government subsidy?  Does the US benefit from buying 10-cent bananas, or not?

But that’s not all.  Even if you convinced me that we should worry about interventionist policies in our trading partners, I’d still want a definition of currency manipulation.  There are a billion ways that a foreign government could influence a real exchange rate.  Which ones are “manipulation”? It’s meaningless to talk about China depreciating its currency, without explaining HOW.  A currency is just a price, and reasoning from a currency change (real or nominal) is simply reasoning from a price change.  Which specific actions constitute currency manipulation?  I don’t want motives, I need verifiable actions.  And does this concept have to involve a current account surplus?  Australia’s been running CA deficits for as long as I can remember.  Suppose the Aussie government did enough “currency manipulation” to reduce their trend CA deficit from 4% of GDP to 2% of GDP.  But it was still a deficit.  Would that be “manipulation”.  Why or why not?

Should we care why a country has a big CA surplus? Suppose Switzerland has a big CA surplus due to high private saving rates, Singapore has a big CA surplus due to high public saving in common stocks, and China has a CA surplus due to high public saving in foreign exchange.  What difference does it make?  (And I haven’t even addressed Ricardian equivalence, which further clouds these distinctions.)

We know that the only way that governments can affect the real exchange rate is by enacting policies that impact national saving or national investment.  But almost all policies impact either national saving or national investment.  So which of those count as manipulation?  Is it merely policies that lead to the accumulation of foreign exchange?  If so, then won’t you simply encourage countries to use some other technique for boosting national saving? An alternative policy that avoids having them be labeled currency manipulators?

And why is this called “creating a competitive advantage”.  It doesn’t give an overall economy a competitive advantage, just one sector—exports. Other sectors are put in an equal and opposite disadvantage.  So why not call these currency manipulation policies “competitive disadvantage”.  Or conversely, why not label agricultural subsidies a form of “competitive advantage”.  After all, just as high saving policies boost the export sector, agricultural subsidies boost the agricultural sector.  Or consider America’s low saving fiscal policy, which boosts our service sector.  Do those policies also give America a competitive advantage?  After all, services are far bigger than exports.

When you read people use the term “competitive advantage” it’s hard to avoid the inference that they are claiming that these policies will somehow boost aggregate demand.  Paul Krugman rightly mocked those arguments back in the 1990s, pointing out that monetary policy determines AD.  So then is “currency manipulation” just a special theory that only applies at the zero bound?  It’s hard to tell, the descriptions of this concept are all so vague.

I’d still like a very short and highly precise definition of currency manipulation.  Just a couple sentences.  What data points do I look at to determine if a currency is being manipulated?  If it’s the nominal exchange rate then I disagree with the definition.  If it’s the real exchange rate then I disagree with the definition.  If it’s the current account balance then I disagree with the definition.  If it’s the accumulation of foreign exchange then I disagree with the definition.  A definition involving any of those criteria would be so flawed as to be meaningless.  So what is the definition?

PS.  David also asks the following question:

Scott often cites sticky prices as an important assumption of macroeconomics, so I don’t understand why he thinks that the nominal exchange rate has no effect on trade. If prices do not all instantaneously adjust to a change in the nominal exchange rate, changes in nominal exchange rates are also changes in real exchange rates until prices adjust fully to the new exchange rate.

Talking about the effect of a price on quantities is reasoning from a price change, and hence wrong.  If the currency depreciation is caused by monetary stimulus, then I agree that output is likely to rise in the short run, due to sticky wages.  But that’s equally true in a closed economy.  As far as the trade balance, it depends on the relative size of the income and substitution effects.  The massive dollar devaluation of 1933 had almost no effect on the trade balance, as the income and substitution effects were roughly equal size, but pushed in opposite directions.  So was that currency manipulation?  Did FDR’s motives matter?  I still don’t understand why any of this matters.

PPS.  David’s post also refers to “undervalued currencies”, but this term is just as vague as currency manipulation or competitive advantage.  What makes a currency undervalued?