There are many things that we teach our undergrads, which then get forgotten (or rejected, if I must be polite) by professional economists.  The minimum wage costs jobs, low interest rates don’t mean easy money, trade with China benefits the US, monetary policy remains highly effective at zero rates, etc., etc.  I taught all these ideas right out of the textbooks I used, because I believe them.  And here’s one more: current account deficits are not a problem; they merely represent an imbalance between saving and investment in a particular region.  If we abolished CA deficits for all regions, down to the individual level, we’d have to abolish banks.  You want a house?  Save up some money.

A recent report by the Peterson Institute at least avoids the worst sort of mistake:

In the latest chapter of the saga over countries that seek unfair trade advantages from currency manipulation, the US Treasury has released a new report aimed at curbing the practice. Treasury is correct not to indict any countries for “currency manipulation” at this time but also to create a “monitoring list” of five major countries—China, Germany, Japan, Korea, and Taiwan—that could become “manipulators” in the future and thus require close surveillance. The objective is to deter countries from returning to past practices of manipulation, and the new Treasury report should be quite helpful in that regard. . . .

However, Congress should not have focused on countries that have a bilateral trade surplus with the United States. All that matters for the impact of currency manipulation on the United States is the multilateral current account balance of the manipulators. In today’s world of distributed production, country X may buy materials from the United States, process and sell them to country Y, which then assembles the final goods for shipment to the United States. Country X would have a bilateral deficit with the United States and country Y a bilateral surplus, yet either or both might be guilty of currency manipulation that distorts the overall US current account balance and economy.

That’s half right, the bilateral surplus doesn’t matter, but neither does the multilateral surplus.  There is no plausible harm that could come to the US from other countries running CA surpluses.  There are some vulgar old Keynesian models that claim that high saving policies, which can as a side effect lead to CA surpluses, could hurt the US by reducing global AD. Paradox of thrift. I hope no reader of this blog takes those theories seriously.  And as for the theory that current manipulation is a “beggar-thy-neighbor” policy, it is refuted every time an expansionary monetary policy move in Japan or Europe leads to a rise in global stock prices “despite” the accompanying currency depreciation.

We would underline the importance of Treasury’s decision to limit “allowable” current account surpluses to 3 percent of a country’s GDP. We at the Peterson Institute for International Economics have analyzed “fundamental equilibrium exchange rates” for years and have concluded that any imbalance above 3 percent of GDP, on either the surplus or deficit sides, is excessive and probably unsustainable; Treasury itself has often cited our estimates in its semiannual reports as authoritative. The staff of the International Monetary Fund has developed norms for current account positions that are even tougher, suggesting that both China and Japan should run no surpluses at all. There has been some discussion of defining a “material” (global) current account surplus at a higher level, perhaps 4 percent of GDP, and Treasury itself sought international agreement on such a norm at the G-20 meetings in Korea in 2010. Hence they are to be commended for concluding that “allowable” surpluses should not exceed 3 percent.

I find these proposals to be frightening, as they are based on a misunderstanding of basic international economics.  CA surpluses should be welcomed, as they suggest the surplus country probably has sound fiscal policy, and is not engaged in the sort of ruinous debt run-up that led Greece and Italy and Portugal into their current mess.  Most tax regimes strongly distort the saving/investment process, and hence even switching to a neutral treatment of saving and investment would often lead to a big CA surplus.  The rest of the world should try to copy Germany and Singapore.  We obviously won’t all end up with CA surpluses, but we’ll have more saving and investment, and hence faster economic growth.  If the zero rate bound is a problem, then raise the inflation target high enough so that it doesn’t bind.

To see what’s wrong with the 3% proposal, let’s look at the eurozone, which currently runs a 2.8% CA surplus.  That’s slightly under the proposed Peterson Institute limit, and hence not a problem.  But what about individual eurozone members, should we look at their CA balances?  Well, are they engaged in currency manipulation?  At first glance it would appear the answer is no, they don’t even have their own currency to manipulate. It would be as crazy to complain about the CA surpluses of an individual eurozone member as it would be to complain about the CA surplus of Massachusetts, (which is not actually measured (AFAIK) but would probably be at German proportions if it were.)

And yet, the report does name Germany as a country to watch, probably because its CA surplus is 7.7% of GDP.  But then why not pick on the Netherlands, at 9.7% of GDP? And why focus on individual eurozone countries, but not individual US states?  Believe it or not, it’s no longer enough to stop all “currency manipulation”, the CA surplus opponents now want to stop the sensible countries from being sensible, they want them to start running up large budget deficits.  After, all the recent Chinese case proves that this is not about currency manipulation.  China is working hard to prevent the yuan from falling, despite their large CA surplus.  Germany doesn’t even control their currency, and at the ECB they always push for a stronger euro.

It’s a myth that CA surpluses are some sort of “imbalance” that markets would correct if only governments would stop manipulating the currency.  Is Massachusetts manipulating the US dollar?  Indeed, without recent Chinese “manipulation”, the yuan would fall and their CA surplus would expand even further.  To their credit, the smarter Keynesians understand that the CA surpluses actually reflect saving/investment differentials, and can only be attacked with government policies aimed at reducing that imbalance, i.e. with tax cuts and/or higher government spending.

But in that case, Massachusetts is just as guilty as the Germans or the Dutch.  Maybe someone should put sanctions on Massachusetts’s products until my home state starts running a Puerto Rican-style fiscal policy.

In Australia they use Australian workers to build $400,000 condos on the beach, and then trade the condos to the Chinese in exchange for 400 HDTVs made by Chinese workers.  If both sides agree to this transaction, what possible harm could it do?  Can someone explain that to me?  But in the world in international economics, there is something sinister about this voluntary exchange, as it leads to a $400,000 CA “deficit” for Australia, and a “surplus” for China. What does that even mean? In America we might trade the mortgages on homes built with American labor, for Chinese goods. Again, there is supposedly something sinister about this normal business transaction. I don’t get it.

Of course it could be worse, in the world of American politics the transaction would be described as China “raping” the US.

PS.  Commenter HL suggested that Japan’s recent problems with an appreciating yen flow from the passage of this new law:

The latest step by Treasury was required by the Trade Enforcement and Trade Facilitation Act (the “customs bill”), which became law in February 2016.

I’m not sure if that’s true, but it’s interesting that Japan’s recent problems began in February.  In fact, the BOJ needs to drive the yen far lower, and thus they should say “to hell with the US”.  Unfortunately, they probably need to wait until mid-November to make that move.  And even then, the Japanese are too polite.  The others can ignore us, however.  We can’t touch the Germans as they are in the EU.  And China now has the world’s biggest economy; it’s too late to kick them around.  If Trump’s elected he’ll find himself kissing Xi’s ring.

PPS.  Over at Econlog I have a new post discussing the recent moves in the yen.

Last week, I pointed to a Financial Times headline that suggested the yen was falling on rumors of a cut in the interest rate on reserves (which is already negative):

In the long run, you want to rely on a worldview that allows you to make sense out of the myriad news events that are reported each day.  I believe that framework is market monetarism.  Let’s take an example, a headline from today’s FT:

Yen dives on talk of negative rates on loans

If you relied on the mainstream media, that headline would make no sense.  “Wait, weren’t we told on Twitter that Sumner was foolishly attached to the notion that negative IOR was expansionary, despite all indications to the contrary?  If so, how are we to understand this headline?”  On the other hand if you relied on market monetarism, there would be no cognitive dissonance to deal with.  It would all make perfect sense.

Tuesday, Tyler pointed to another FT story, this time claiming the exact opposite:

Ten weeks after BoJ governor Haruhiko Kuroda startled both financial markets and parliamentarians with Nirp, the yen has appreciated by some 8 per cent against the dollar. The stock market has rebounded sharply this month, however the Topix bank index remains 11 per cent lower since the advent of Nirp.

Under such a policy, risk assets were supposed to rise, but instead demand for Japanese government bonds rallied, rewarding the risk averse. Meanwhile, even finance ministry officials concede that the deflationary mindset is more entrenched than ever. There is agreement that Nirp has backfired and such an unsustainable monetary policy cannot support growth, let alone help financial asset prices.

Who to believe, the FT, or the FT?  Answer, the FT.  Today’s Financial Times provides the results of about as dramatic an event study as you could ever want:

Yen surges and stocks hit as BoJ stands pat

So much for the theory that negative IOR is contractionary.  And the concurrent fall in global stock markets puts another nail in the theory of “currency wars” and “beggar-thy-neighbor”.  The failure of the BOJ to devalue the yen is going to hurt the US and European economies.

Why so much confusion?  Because people forget that while a lower policy rate is expansionary on any given day, low rates are also an indication that money has been too tight.  This paradox is resolved if we make the (quite plausible) assumption that when the Wicksellian natural rate is falling, the policy rate usually tends to fall more slowly, making policy effectively tighter (as in 2008).  And when the Wicksellian rate is rising, the policy rate usually tends to rise more slowly, making policy effectively looser (as in the 1970s.)

It doesn’t take a genius to understand that you evaluate a policy’s effect by looking at the immediate market reaction, not market moves in the following weeks, which could be caused by 101 factors.  Oh wait, I guess it does take a genius.

Here’s a graph showing the fall in the yen last week on rumors of a rate cut, and the more than 3% gain today on the market disappointment at the BOJ’s inaction:

A few weeks ago, I did a post suggesting that the BOJ appears to be giving up on its 2% inflation target.  I suggested that this meeting would give us an answer:

What should Japan do?  I suppose they should do whatever they want to do.  It doesn’t make much sense to target inflation at 2% if you don’t want to target inflation at 2%.

The more interesting question is what should they want to do?  I’d say NGDPLT. But they seem to have other ideas.

Either way, we should have an answer by the end of the month.

Today we got the answer.  The FT also reports the following:

The BoJ also changed its guess of when inflation will reach 2 per cent from the “first half of fiscal 2017” to “fiscal 2017”. Any further delay would mean admitting Mr Kuroda will not reach the target during his term in office.

The whole point is to not adjust the forecast, but rather to adjust the policy instruments.  A very disappointing performance by Mr. Kuroda.  That’s not to say it couldn’t be worse, he has gotten Japan out of its nearly two-decade bout of deflation. But he’ll need to be far more aggressive at the July meeting if he doesn’t want to lose all credibility.  As it is, the BOJ lost a significant amount of credibility today.  Here’s Bloomberg:

A majority of economists surveyed by Bloomberg had predicted some action to counter a strengthening yen that had cast a shadow over the outlook for wage gains and investment spending. The explosion of volatility shows how investors have singled out central banks as the key driver for global financial markets.  .   .   .

“It’s the central banks that still set the course,” said Jan Von Gerich, chief strategist at Nordea Bank AB in Helsinki. “Even slight deviations from what people are expecting are enough to trigger market moves.” .   .   .

“The BOJ had an opportunity to at least temporarily short-circuit the yen trend but failed to act,” said Lee Hardman, a foreign-exchange strategist at Bank of Tokyo-Mitsubishi UFJ Ltd. “It has provided the green light for further yen strength in the near-term.”

A few weeks back I pointed out that the Japanese yen plunged in value in response to news of negative IOR.  Much of the media and blogosphere seemed to have the opposite reaction.  A few days after the announcement, the yen appreciated strongly on news that the BOJ was backing off from further rate cuts.  The media interpreted this as evidence that negative IOR led to currency appreciation.  Who was right?  And how would we know?

In the long run, you want to rely on a worldview that allows you to make sense out of the myriad news events that are reported each day.  I believe that framework is market monetarism.  Let’s take an example, a headline from today’s FT:

Yen dives on talk of negative rates on loans

If you relied on the mainstream media, that headline would make no sense.  “Wait, weren’t we told on Twitter that Sumner was foolishly attached to the notion that negative IOR was expansionary, despite all indications to the contrary?  If so, how are we to understand this headline?”  On the other hand if you relied on market monetarism, there would be no cognitive dissonance to deal with.  It would all make perfect sense.

Do yourself a favor and start relying on MM for your worldview, it makes life much less painful.

PS.  Nick Rowe has a very good new post on some odd claims made by the Bank of Canada.  They suggested that fiscal stimulus by the new Trudeau government would have an expansionary impact.  The BOC governor suggests it will work because inflation in Canada is “low”.  But it’s not clear why that matters, as interest rates in Canada are not at the zero bound.  Just one more example of the creeping advance of old Keynesianism—something I expected to happen, but hoped would not.

HT:  Benn Steil

Here’s Paul Krugman:

Brad DeLong asks why monetarism — broadly defined as the view that monetary policy can and should be used to stabilize economies — has more or less disappeared from the scene, both intellectually and politically.

That’s not just a description of monetarism; it also describes New Keynesianism, as DeLong pointed out in 1999.  Is New Keynesian economics actually dead?  Here’s an example of New Keynesianism, from the same year that DeLong wrote the article:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

Yes, I’d say that NK view from 1999 (expressed by Paul Krugman, BTW) is essentially dead.  I’m not sure what we have now: new, new Keynesianism, old Keynesianism, or as many Keynesianism as there are Keynesians.  (I vote for the latter.) Just as old monetarism is mostly dead, having been replaced by market monetarism.

Krugman also suggests that monetarism is dead because real world governments don’t implement our policies, exactly as we sketch them out.  (He forgets that market monetarists invented negative IOR).  Which of course means that Krugman’s Keynesianism is also dead, as governments are certainly not doing the sort of fiscal stimulus that he recommends.  Indeed the Japanese recently combined fiscal austerity with monetary stimulus, and he seemed to think the Japanese were doing a pretty good job when he met with them recently:

We are all very much wishing, I am a great admirer of the policy moves that have been made by Japan, but they are not good enough, partly because all of the rest of us are in trouble as well.

Yes, he would have preferred they not raise taxes, but the tax increase did not cause a setback to the labor market:

And monetary stimulus did get them out of deflation:

However the BOJ needs to do much more if they don’t want to slip back into deflation.

PS.  Ramesh Ponnuru also has a reply to Paul Krugman.

HT:  James Elizondo

“Currency wars” are one of those topics about which almost everything you read is wrong.

1.  The media often confuses changes in nominal exchanges rates (determined by monetary policy) with changes in real exchange rates (determined by national saving/investment policies).

2.  The media often draws meaningless distinctions between policies explicitly aimed at reducing exchange rates, with other policies (such as QE and negative IOR) that have the effect of reducing exchange rates.  For instance, the US dollar price of euros rose from $1.31 to 1.37 on the day QE1 was announced in March 2009.  Is that currency manipulation?

3.  The media tends to assume a zero sum game, but currency depreciation by one country will often boost stock markets all over the world, by boosting global AD.

4.  The media has a “pro-international agreement” bias.  International agreements made by highly educated public servants seem like responsible policymaking.  If the media knows little about the issue, they’ll defer to the experts.  And “war” sounds like a bad thing.  But recall that these are the same experts who pressured the Japanese NOT to devalue in the 1990s, as they were sliding into deflation.  How’d that advice work out?

In my view, things get even worse if central banks are perceived to have run out of ammo.  (Put aside the question of whether they have actually run out of ammo, which seems impossible.)  Suppose the Fed has room to raise and lower interest rates, but the BOJ and ECB have no room. Of course, they can still devalue if they wish.  Now assume an international agreement to avoid “currency wars”.  So they can’t devalue either.  In that case, you’ve resurrected Bretton Woods, at the worst possible time.  The US becomes central banker to the world.  (David Beckworth has shown that the Fed is already a “monetary superpower”, and a currency agreement under these circumstances would make them even more of a superpower—controlling the fate of not just China, but also Japan and the eurozone.

I hope you can see the obvious problem here.  The Fed insists that its mandate is to control American inflation, not Japanese and eurozone inflation.  But if we have an agreement to ban currency wars, then the Fed has a moral obligation to stabilize the average inflation rate in the US, Japan, and Europe.  I think it goes without saying that current policy is too tight, under that mandate.

And this blog post suggests that there already may be an implicit currency stabilization agreement:

More so, what if central banks think they’re at the limits of monetary policy anyway? If you combine that thought with pressure from the G20 you get to de facto agreement anyway, right? Or at least the behaviour of central banks can be explained, and predicted to an extent, by assuming the existence of a de facto agreement.

Here’s Citi’s Steven Englander saying just that:

It is probably better to think of G20 as similar to Friedman and Savages’s billiards player (link, page 12,13), G20 may not have made a deal but they are behaving as if they did, so we may as well analyze the consequences from that perspective. One question to ask is why they would agree to setting aside currency as a macroeconomic weapon the likely answer is that the winners of the currency war battles may have decided that they were not benefitting enough to offset the negative impact of the ancillary asset market volatility that emerged. Basically they were acknowledging policy ineffectiveness or at least monetary policy ineffectiveness, and the Statement pretty much admitted that.

So we now find ourselves in a situation where G3 has trouble cutting rates. The ECB and BoJ are reluctant because of the strains it is putting on their financial institutions and political unpopularity. The Fed is reluctant for similar reasons and because it seems unlikely that one cut would do great things for the US economy and it would certainly raise a suspicion that negative rates were beckoning. An already unpopular institution would become politically toxic. Bottom line, easing is hard to do. An ECB or BoJ hike is unlikely, needless to say. The Fed has already indicated its reluctance to hike and is very unlikely to hike to defend the currency if anything they seem to be cheering any weakness the USD encounters.

Put this all together and you have an extremely high bar for any G3 central bank cutting rates and an extremely high bar to them raising (and an even higher bar to any of them raising rates in response to currency weakness).

The point being that the FX market is now discounting the chances of aggressive central bank reaction in opposition to short term directional moves. Like, you know, they would if a deal had actually been agreed.

The new reality is one in which FX is being dictated by market forces rather than central banks. Or more so, we suppose, one in which some market participants can push exchange rates around without coming up against a central bank pushing back.

Of course, this could all go out the window when Japan pulls the trigger at its next monetary policy meeting on April 27th. Or they could opt for intervention (since mon pol might be exhausted, goes the theory while another theory says any intervention would have to be short and sharp considering the G20 once again) and surprise our inboxes. Inboxes that have already been surprised by this move in JPY, of course.

I would add that it is not “market forces” pushing the yen much higher; it’s a dramatically tighter monetary policy out of Japan.  You might wonder, “How did that happen?”  Expectations fairies—people have stopped believing that Kuroda will ease as needed to hit the BOJ’s inflation target.  Even though the BOJ did nothing “concrete” in the past few weeks, the future expected path of BOJ policy has become much tighter.

Pay attention to the April 27 BOJ meeting, and then a few days later to the Q1 GDP for the US, which might be negative.