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Recent peso policy developments bring up theoretical controversies

The latest issue in exchange rates is still what will happen as the Fed carries out the process of raising short-term interest rates on government paper from levels that were effectively zero before last December. Usually such moves increase the value of the home currency, as investors and traders exchange their money for dollar-denominated assets that are now paying more interest. With peso decline in prospect, the FT reports on ideas within the administration about acting to stabilize the dollar-peso exchange rate.  Broadly, the idea would be to arrange a facility that could lend dollars to banks in return for collateral in pesos, much as solvent US banks can borrow from the money markets by putting up certain acceptable kinds of collateral.  In the case with two different currencies, such loans are called currency swaps. Concern exists as the US  tightens monetary policy that fears might develop, leading to a sharp fall in the value of the peso. Both countries have reason to  fear such a development: Mexico with debt denominated in dollars and the U.S. with its hopes of improving its trade balance. The quoted official is Commerce Secretary Wilbur Ross.

Quoting from the Financial Times article, “Recalling the Mexican ‘Tequila crisis’ of 1994, Mr Ross told CNBC the then US Treasury had ‘put in place lines of credit between the central banks’ to help stem currency outflows. ‘We need to think of a mechanism to make the dollar-peso exchange rate more stable,’ said Mr Ross, a billionaire investor, who insisted such matters were outside his immediate remit as commerce secretary and a subject for the US Treasury.”

Another example would be a $20 billion hedging program recently set up by the Mexican central bank (link is to another FT article), which according to Mexican central bankers is geared toward short-run stability within its current floating-rate regime.

This leads back to an interesting question in open-economy macroeconomics: can a country control its interest rate at the same time it stabilizes the value of its currency without making use of capital controls or some other contrivance to keep asset-holders from selling the currency when the interest rate is lowered. Traditionally, chartalism and MMT have been associated with the “trilemma” view that policymakers cannot simultaneously: 1) freely conduct domestically oriented monetary policy; 2) set an exchange rate; and 3) maintain open capital markets. They argue that flexibility is what allows a country such as the US to run a government deficit without running into problems like those experienced by Greece, which is a participant in a currency union–or Mexico with its large amounts of debt in dollars. A swap facility might be looked at as a way of getting around the trilemma, at least barring huge peso-dollar misalignments. So is the swap line recently set up by the Bank of Mexico. Some good recent papers in stock-flow-consistent (SFC) macro argue against the trilemma and in favor of the so-called compensation view, according to which, nothing special has to happen for the exchange rate to stay constant, though a government that is unable to avoid running  out of reserves certainly cannot effectively peg its currency. There is  sympathy for the SFC approach among many or most MMTers, including Randy Wray of the SFC-friendly Levy Institute.

Some very interesting and not-too-old papers by economists bear on this issue.

  1. Angrick’s paper in SFC economics arguing for the compensation view and against the trilemma view.
  2. Claudio Sardoni and Wray in 2007. MMTers appear to be charged with open-economy idiocy. Here is a paper by Wray with Keynesian Claudio Sardoni on the fixed-versus-flexible exchange rate issue. You be the judge: are they waffling on the issue after taking a hard line in favor of floating rates, as charged recently by some critics.
  3. Jan Priewe on recent exchange-rate trends and euro-area policy issues as they relate to theories of exchange-rate determination. Is there a good theory of what causes exchange rates to move in one direction or another? Priewe argues that theories based on purchasing power across countries and other “fundamentals” do not predict well. What else is  there? Theories based on quirkiness of typical market behavior, and perhaps, in my view, nonlinear phenomena. As a bonus, Priewe’s article includes some interesting figures.

(I apologize for bad links in the initial version of the post; they should work now.)

The articles are all clearly written and relatively nontechnical, though Priewe currency-policy jargon one often finds in financial newspapers and blogs.



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