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Macroeconomic policy and exchange rate regimes under global financial integration

by Biagio Bossone (Biagio BOSSONE is an Italian national,  currently advises international financial organizations on financial sector development issues and technical assistance programs in several countries in Africa, Asia and the Pacific, Latin America, and Northern Africa and the Middle East. He is a consultant to private-sector organizations. He has taught at various universities in Italy.)

(Warning…wonkish)

 

Macroeconomic policy and exchange rate regimes  under global  financial integration

I want to come back to the bossone">post I wrote recently on Angry Bear, regarding the power of exchange rates to insulate economies from shocks and to grant independence to economic policy action, with the purpose to derive some clear (and testable) propositions.

For the benefit of readers, let me explain that my previous post originated from Antonio Fatas’ challenge to conventional wisdom whereby sudden stops – or the abrupt reductions in net capital inflows caused by crisis confidence – are relevant only for countries with fixed exchange rates, whereas they are not much of a concern for countries that have their own currencies. An interesting yet non-conclusive controversy followed, with positions ranging from that expressed by Paul Krugman, who holds that the adjustment mechanism to a confidence crisis varies with the underlying exchange rate regime (i.e., it is contractionary under fixed rates and expansionary under floating) to Andrew Rose’s observation that the economic performance of ‘fixers’ versus ‘floaters’ has not been dissimilar since 2007, going through Brad DeLong’s claim that under extraordinary dysfunction (not just a change in market views of the long-term fundamental value of the currency), exchange-rate depreciation no longer yields expansionary effects.

In my post, I argued that the dysfunction need not be as extreme as DeLong claims, and that the effectiveness of floating rates depends ultimately on how financial markets evaluate the sustainability of an economy’s public liabilities (both money and debt) against its macro policy framework. As my arguments go, even with floating, a largely indebted and financially integrated country suffering from poor credibility in the eyes of the markets would find its policy space severely constrained by the need to protect its liabilities from the risk of future (internal and external) value losses, as determined by the market response to its policy stance. If the country was in recession or secular stagnation and intended to recover output and employment gaps through active demand management, markets might undermine the country’s good intentions and bring it back on its policy decisions, under the threat of sudden stops and capital flights. The exchange rate is, therefore, a ‘veil’: markets see the economy’s risks through it, and are indifferent to the underlying exchange rate regime.

The key variables determining the latitude of the policy space available to an economy wanting to exploit the ‘insulating’ and ‘independence’ power of floating exchange rates are: i) the economy’s stock of (debt and money) liabilities, ii) its level of credibility in the markets’ judgment (whether the judgment is right or wrong is another matter), and iii) its degree of integration in the global financial markets. Thus,

Proposition I

The policy space available to a country that is fully financially integrated into the global markets, and operates under a floating exchange rate regime, grows narrower with the economy’s stock of liabilities and is limited by the country’s market reputation as a debtor.

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The Exchange Rate as a ‘Veil’

(Dan here…Biagio Bossone will be joining contributors to Angry Bear.  Here is his first post for AB concerning the impact of exchange rates)

by Biagio Bossone      (Biagio BOSSONE is an Italian national,  currently advises the World Bank Group/IMF on financial sector development issues and technical assistance programs in several countries in Africa, Asia and the Pacific, Latin America, and Northern Africa and the Middle East. He is a consultant to private-sector organizations He has taught at various universities in Italy.)

The Exchange Rate as a ‘Veil’

A few years back, Antonio Fatas challenged the conventional wisdom whereby sudden stops – or the abrupt reductions in net capital inflows caused by crisis confidence – are relevant only for countries with fixed exchange rates, arguing that where countries run large persistent current account deficits, sudden stops of capital could be contractionary even under floating rates. The issue was at the center of a lively controversy, yet is has remained unresolved. Coming to a closure on it requires considering that the effectiveness of exchange rates as an adjustment mechanism must be seen in relation to the role that financial markets play in the context of a given country. This is what this post sets out to do, after reviewing the terms of the controversy.

The controversy

Various views were expressed on the issue. Andrew Rose noted that the magnitude of the business cycle had not varied significantly between inflation targeters and hard fixers over the period since 2007, and concluded that the ‘insulation’ power of different exchange rate regimes is in fact similar. Paul Krugman countered that a decline in the capital account caused by a sudden stop must be matched by a rise in the current account, and noted that the mechanism to produce such adjustment varies with the underlying exchange rate regime: it works though import compression under fixed rates, while it works through depreciation and export growth under floating rates. As a consequence, a shock that is contractionary under fixed rates (or a monetary union) is expansionary under floating rates.

Kenneth Rogoff remarked that outcomes are sensitive to long-term debt sustainability and future inflation. A country with its own currency has indeed the ability to escape a debt crisis through seigniorage and inflation, but this works only to the extent that inflation is not priced in. In fact, as Giancarlo Corsetti and Luca Dedola pointed out, the historical record indicates that outright default on public debt denominated in domestic currency is far from rare, including in countries where the authorities control the ‘printing press’: the moment investors anticipate inflationary financing, interest rates rise and reduce the gains from debt monetization up to the point of undermining its effectiveness altogether.

Interestingly, Brad DeLong claimed that in a sudden stop the central bank can credibly commit to persistently keeping the short-term safe nominal interest rate at zero (swapping out cash and pulling in bonds ad libitum), yet such policy would have no effects on the economy’s real equilibrium if, on the relevant margin, government-printed cash were to become as unsatisfactory an asset as government bonds: under similar circumstances, people would not want to dump government bonds for cash and foreign securities; they would dump both government bonds and cash for foreign securities. Economic chaos would be such that foreigners would be unwilling to trade their own currencies for domestic goods and services or assets (e.g., domestically-located property). However, as DeLong also noted, for this scenario to hold there should be an extraordinary degree of dysfunction, not just a reduction in market views of the long-term fundamental value of the currency.

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Global Stability, National Responsibilities

by Joseph Joyce

Global Stability, National Responsibilities

The global financial crisis demonstrated clearly how the flow of money across borders could deepen and widen a financial crisis. A decline in U.S. housing prices led to a re-examination of the safety of financial securities based on them and an implosion in credit markets as financial institutions sought to re-establish their soundness by shedding the securities that were now seen as toxic. These institutions included European banks that had purchased mortgage-backed securities and other collateralized debt obligations. Eventually the emerging markets were brought into the vortex by capital outflows that disrupted their own financial markets. But are we ready to change the rules governing global finance if they impinge on national sovereignty?

Andrew Haldane, chief economist of the Bank of England, spoke last October about the need to manage global finance as a system. He identified four areas that require strengthening: global surveillance, improvements to national debt structures, the establishment of macro-prudential and capital flow management policies, and improved international liquidity assistance. Advances have been made in all these areas since the crisis.

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