Economist's View

Why All Exchange Rates Are Bad

Tim Taylor:

Why All Exchange Rates Are Bad: The economics of exchange rates can be tough sledding. Every now and then, I post on the bulletin board beside my office a quotation from Kenneth Kasa back in 1995: "If you asked a random sample of economists to name the three most difficult questions confronting mankind, the answers would probably be: (1) What is the meaning of life? (2) What is the relationship between quantum mechanics and general relativity? and (3) What's going on in the foreign exchange market. (Not necessarily in that order)."

But even after duly acknowledging that exchange rates can be a tough subject, the political discussion of how exchange rates are manipulated and unfair to the US economy is a dog's breakfast of confusions about facts, institutions, and economics. For one of many possible examples, see the op-ed published in the Wall Street Journal last week by Judy Shelton, an economist identified as an adviser to the Trump transition team, titled "Currency Manipulation is a Real Problem." The obvious conclusion to draw from that essay, and from a number of other writing on manipulated exchange rates, is that all exchange rates are bad.

Sometimes other countries have policies that the value of their currency is lower relative to that of the US dollar. This is bad, because it benefits exporters from those countries and helps them to sell against US companies in world markets.

But other times, countries are manipulating the value of the exchange rate so that the value of their currency is higher relative to the US dollar, like China. This is also bad, as Shelton write in the WSJ: "Whether China is propping up exchange rates or holding them down, manipulation is manipulation and should not be overlooked. ... A country that props up the value of its currency against the dollar may have strategic goals for investing in U.S. assets."

Exchanges rates that move are bad, too. Shelton writes that "free trade should be based on stable exchange rates so that goods and capital flow in accordance with free-market principles."
But stable exchange rates are also bad.  After all, China is apparently stabilizing its exchange rate at the "wrong" level, and the argument that exchange rate manipulation is a problem clearly implies that many major exchange rates around the world should be reshuffled to different levels.

The bottom line is clear as mud. Exchange rates are bad if they are higher, or lower, or moving, or stable. The goal is that exchange rates should be manipulated to arrive at some perfect level, and then should just stick at that level without any further manipulation, which would be forbidden. This perspective on exchange rates is so confused as to be incoherent. With the perils of explaining exchange rates in mind, let me lay out some alternative facts and perspectives.

Currencies are traded in international markets; indeed, about $5 trillion per day is traded on foreign exchange markets. This amount is vastly more than what is needed for international trade of goods and services (about $24 trillion per year) or for foreign direct investment (which is about $1.0-1.5 trillion per year). Thus, exchange rate markets are driven by investors trying to figure out where higher rates of return will be available in the future, while simultanously trying to reduce and diversify the risks they face if exchange rates shift in a way they didn't expect. Because of these dynamics, exchange rate markets are notoriously volatile. For example, they often react quickly and sharply when new information arises about the possibilities of changes in national-level interest rates, inflation rates, and growth rates.

In this context, deciding whether exchange rates have bubbled too high or too low is a tricky business. But William R. Cline regularly puts out a set of estimates. For example, he writes in "Estimates of Fundamental Equilibrium Exchange Rates, November 2016" (Peterson Institute for International Economics, Policy Brief 16-22):

"As of mid-November, the US dollar has become overvalued by about 11 percent. The prospect of fiscal stimulus and associated interest rate increases under the new US administration risks still further increases in the dollar.  The new estimates, all based on October exchange rates, again find a modest undervaluation of the yen (by 3 percent) but no misalignment of the euro and Chinese renminbi. The Korean won is undervalued by 6 percent. Cases of significant overvaluation besides that of the United States include Argentina (by about 7 percent), Turkey (by about 9 percent), Australia (by about 6 percent), and New Zealand (by about 4 percent). A familiar list of smaller economies with significantly undervalued currencies once again shows undervaluation in Singapore and Taiwan (by 26 to 27 percent), and Sweden and Switzerland (by 5 to 7 percent)."

Several points are worth emphasizing here. The exchange rates of the euro, China's renminbi, and Japan's yen don't appear much overvalued. The US dollar does seem overvalued, but the underlying economic reasons aren't mainly about manipulation by other countries. Instead, it's because investor in the turbulent foreign exchange markets are looking ahead at promises from the Trump administration that would lead to large fiscal stimulus and predictions from the Federal Reserve of higher exchange rates, and demanding more US dollars as a result.

Countries around the world have sought different ways to grapple with risks of exchange rate fluctuations. Small- and medium-sized economies around the world are vulnerable to a nasty cycle in which they first become a popular destination for investors around the world, who hasten to buy their currency (thus driving up its value), as well as investing in their national stock and real estate markets (driving up their prices), and also lending money. But when the news shifts and some other destination becomes the flavor-of-the-month as an investment destination, then as investors sell off the currency and their investments in the country, the exchange rate, stock market, and real estate can all crash. This situation can become even worse if the country has done a lot of borrowing in US dollars, because when the exchange rate falls, it becomes impossible to repay those US-dollar loans. The combination of falling stock market and real estate prices, together with a wave of bad loans, can lead to severe distress in the country's financial sector and steep recession. For details, check with Argentina, Mexico, Thailand, Indonesia, Russia, and a number of others.

The International Monetary Fund puts out regular reports describing exchange rate arrangements, like the Annual Report on Exchange Arrangements and Exchange Restrictions 2014. That report points out that about one-third of the countries in the world have floating exchange rates--that is, rates that are mostly or entirely determined by those $5 trillion per day exchange rate markets. About one-eighth of the countries in the world have "hard peg" exchange rate, in which the country either doesn't have its own separate currency (like the countries sharing the euro) or else the countries technically have a separate currency but manage it so that the exchange rate is always identical (a "currency board" arrangement).

The rest of the economies in the world have some form of "soft peg" or "managed" exchange rate policy. These countries don't dare to leave themselves open to the full force and fluctuations of the international exchange rate markets. But on the other hand, they also don't dare lock in a stable exchange rate in a way that can't change, no matter the cross-national patterns of interest rates, inflation rates, and growth rates. Many of these countries are quite aware that the ultra-stable exchange rate known as the euro has not, to put it mildly, been an unmixed blessing for the countries of Europe.

The fundamental issue is that an exchange rate is a price, the price of one currency in terms of another currency. A weaker currency tends to favor exporters, because their production costs in the domestic currency are lower compared to the revenue they gain when selling in a foreign currency.
A stronger currency tends to favor importers, because they can afford to buy more goods in the supermarket that is the world economy.

Of course, the reality is that the US economy has all kinds of different players, some of whom would benefit from a stronger exchange rate and some of whom would benefit from a weaker exchange rate. Think about the difference between a firm that imports inputs, uses them in production, and re-exports much of the output, as opposed to a form that imports goods that are sold directly to US consumers. Think about the difference between a worker in a firm that does almost no exporting, but benefits as a consumer from stronger exchange rates, and a worker in a firm that does most of its production in the US and then exports heavily, where the employer would benefit from a weaker exchange rate. Think about a firm which has invested heavily in foreign assets: a weaker US dollar makes those foreign assets worth relatively more in US dollar terms, thus rewarding the firm for its foresight in investing abroad.

Here's one useful way to cut through the confusions about what a higher or lower exchange rate means, which is from work done by economists Gita Gopinath,  Emmanuel Farhi, Oleg Itskhoki, who point out that the economic effects of changes in exchange rates are fundamentally the same as a  policy that combines changes in value-added and payroll taxes. Specifically, a weaker currency has the same effect as a policy of a policy of raising value-added taxes and cutting payroll taxes by an equivalent amount. This should make some intuitive sense, because a weaker currency makes it harder for buyers (like a higher value-added tax) but reduces the relative costs of domestic production (like a lower payroll tax).

In short, every time the US exchange rate moves, for whatever reason, there will be a mixed bag of those who benefit and those who are harmed. A weaker currency is the economic equivalent of combining a higher tax that hinders consumption, like the higher value-added (or sales) tax, with an offsetting cut in a tax that lowers costs of domestic production, like the lower payroll tax. If the policy goal is to help US exporters, but not to impose costs on US importers and consumers, then seeking a lower US dollar exchange rate is the wrong policy tool. It is a mirage (and a fundamental confusion) to argue that some change in the dollar exchange rate will be all benefits and no costs for the US economy.

Just to be clear, I'm certainly not arguing that exchange rates are never "too high" or "too low"; it's clear that exchange rates are volatile and can have bubbles and valleys.

Nor am I arguing that countries never try to manipulate their exchange rates; indeed, I would argue that every country manipulates its exchange rates in one way or another.   If countries allow their exchange rates to float, then when the central bank adjusts interest rates or allows a chance in inflation or stimulates an economy, the exchange rate is going to shift, which is clearly a way in which exchange rates are manipulated by policy.  If countries don't let their exchange rates move, that's clearly a form of manipulation. And if countries allow their exchange rates to move, but act to limit big swings in those movements, that is also manipulation.

What I am arguing is that given even a basic notion how exchange rate markets work and the economic forces that affect exchange rates, it is opaque how "non-manipulation" would work. Are exchange rates going to be held stable across countries, even in the face of cross-national economic changes in interest rates, inflation, and  growth? A wide variety of experience, including the breakdown of the Bretton Woods agreement in the early 1970s and the current problems with euro, suggest that holding exchange rates stable is impractical over time and can have some very bad consequences. But if exchange rates are going to be allowed to move, then the question arises of who decides when and how much. Most national governments, especially after having watched the euro in action, will want to keep some power over exchange rates. There are serious people who discuss what kind of international agreements and cooperation it would take to have greater exchange rate stability, but it's a hard task, and squawking about how all exchange rates are bad--stronger, weaker, moving, stable--is not a serious answer.

Ditching TPP Won’t Solve the Trade Deficit

Jared Bernstein:

Ditching TPP Won’t Solve the Trade Deficit: President Trump wasted no time tackling his campaign promise to reverse America’s trade deficit: On Monday he signed a memorandum withdrawing from the Trans-Pacific Partnership, a move he promised would be a “great thing for the American worker.” The withdrawal dovetails with promises to impose tariffs on imports and crack down on American companies that manufacture overseas.

These steps make for great optics. But in economic terms, they’re unlikely to move the needle. For the country to improve its trade balance, the president’s going to have to do a lot more.

Ripping up trade deals won’t achieve much. ...

And it’s hard to imagine much good emanating from Twitter-shaming China, or writing a check to the occasional factory to prevent it from outsourcing some of its jobs. Such measures are far too ad hoc to make a systemic difference.

So what would work?...

After explaining five possible ways to improve the trade balance (duties on imports from countries that manipulate their currency, countervailing currency intervention to neutralize attempts to manipulate a currency, capital controls, import certificates equal to the value of a countries exports, and enforceable rules on things like currency manipulation and rules of origin), he concludes with:

... In the 1970s and ’80s, as trade deficits became persistent, politicians did not hesitate to respond through these sorts of interventions. Our obsession with unfettered markets has since precluded such efforts, even though our trading partners have not been nearly so constrained. President Trump’s ascendancy may change that equation. The question is whether his administration will get it right.

China, Currency Manipulation, and Trump's Day One

Brad Setser:

China, Manipulation, Day One, the 1988 Trade Act and the Bennet Amendment: President-elect Trump has said that he plans to declare China a currency manipulator on day one.

I am among those who think this is a bad idea. This isn’t the right time to signal that China’s long-standing exchange rate management has crossed over the line and become manipulation. If China responded by ending all exchange rate management—no daily fix, no band, no intervention, a true float—the renminbi would certainly fall, and potentially fall by a lot.

Uncomfortable as it is to say, right now it is in the United States’ economic interest for China to continue to manage its exchange rate. ...

I guess you could argue that that China’s reserves sale have been persistent and one-sided, and thus fit the letter of law. But China has sold foreign exchange in the market to keep the yuan from depreciating. The monthly data suggest has China not bought foreign exchange in the market to keep the yuan from appreciating in the past 6 quarters or so... Its intervention in the market has worked to prevent exchange rate moves that would have the effect of widening China’s current account surplus over time. Every indicator of intervention that I track is telling the same story.

I can see how a case could be made that China’s broader exchange rate management—notably its use of the fix to guide the CNY—could meet the 1988 law’s definition of manipulation. ... I have consistently argued that China’s currency is still tightly managed. ...

But that doesn’t mean naming China is a good thing to do right now. ...

The goal of the United States right now, in my view, should be to encourage China to manage its currency in a way that doesn’t give rise to strong expectations of further depreciation that could fuel potentially unmanageable outflows—while encouraging China to put in place the bank recapitalization and social safety net needed to more permanently wean China off external demand. ...

There's much more in the full post.

When The Trade Data Does Not Add Up

Anyone have the answer? This is from Brad Setser:

When The Trade Data Does Not Add Up: This is ... about a rather puzzling thing that I only noticed as a result of the Brexit debate. ...

A big part of the non-EU surplus in services comes from the United States. In 2015, the UK reported a 27 billion GBP (just over $40 billion) surplus in services trade with the U.S. and an overall surplus in goods and services with the United States.

The funny thing? The U.S. also thinks it runs a surplus in services trade with the UK. A $14 billion surplus in 2015...

It is pretty hard to square those two data points. UK data is from the Office of National Statistics’ Pink Book, U.S. data is from the Bureau of Economic Analysis (BEA), table 1.3 of the “International Transactions” data set.

It turns out that the U.S. thinks it sells more services to the UK than the UK thinks it buys...

And the UK thinks it sells more services to the U.S. than the U.S. thinks it buys. ...

My guess is that such discrepancies are actually common in the services trade numbers. Goods trade is calculated by customs bureaus. Lots of the numbers on services trade come from surveys, estimates, and the like.

IMF Cannot Quit Fiscal Consolidation (in Asian Surplus Countries)

Brad Setser:

IMF Cannot Quit Fiscal Consolidation (in Asian Surplus Countries): In theory, the IMF now wants current account surplus countries to rely more heavily on fiscal stimulus and less on monetary stimulus.

This shift makes sense in a world marked by low interest rates, the risk that surplus countries will export liquidity traps to deficit economies, and concerns about contagious secular stagnation. Fiscal expansion tends to lower the surplus of surplus countries and regions, while monetary expansion tends to increase surpluses.

And large external surpluses should be a concern in a world where imbalances in goods trade are once again quite large—though the goods surpluses now being chalked up in many Asian countries are partially offset by hard-to-track deficits in “intangibles” (to use an old term), notably China’s ongoing deficit in investment income and its ever-rising and ever-harder-to-track deficit in tourism.

In practice, though, the Fund seems to be having trouble actually advocating fiscal expansion in any major economy with a current account surplus.

Best I can tell, the Fund is encouraging fiscal consolidation in China, Japan, and the eurozone. These economies have a combined GDP of close to $30 trillion. The Fund, by contrast, is, perhaps, willing to encourage a tiny bit of fiscal expansion in Sweden (though that isn’t obvious from the 2015 staff report) and in Korea—countries with a combined GDP of $2 trillion.*

I previously have noted that the Fund is advocating a 2017 fiscal consolidation for the eurozone, as the consolidation the Fund advocates in France, Italy, and Spain would overwhelm the modest fiscal expansion the Fund proposed in the Netherlands (Germany would remain on the fiscal sidelines per the IMF’s recommendation).

The same seems to be true in East Asia’s main surplus economies. ...

Bottom line: if the Fund wants fiscal expansion in surplus countries to drive external rebalancing and reduce current account surpluses, it actually has to be willing to encourage major countries with large external surpluses to do fiscal expansion. Finding limited fiscal space in Sweden and perhaps Korea won’t do the trick. 20 or 30 basis points of fiscal expansion in small economies won’t move the global needle. Not if China, Japan, and the eurozone all lack fiscal space and all need to consolidate over time.

Hard truths for the IMF

Simon Wren-Lewis:

Hard truths for the IMF: It is to the IMF’s credit that they have an Independent Evaluation Office, and their recent report on the Eurozone crisis is highly critical of the IMF’s actions. The IMF’s own staff told them in 2010 that Greek debt could well not be sustainable, but the IMF gave in to European pressure not to restructure Greek debt. Instead the Troika went down the disastrous route of excessive austerity, and the IMF underestimated (unwittingly or because they had to) the impact that austerity would have. In the last few years we keep hearing about an ultimatum the IMF has given European leaders to agree to restructure this debt, and on each occasion the IMF appears to fold under pressure.

These repeated errors suggest a structural problem. Back in 2015, Poul Thomsen, who runs the IMF’s European department, said “we need to ensure that we treat our member states equally, that we apply our rules uniformly.” But that is exactly what the IMF has failed to do with the Eurozone and Greece.

As Barry Eichengreen writes..., it is not as if the IMF have had problems demanding commitments from regional bodies such as African or Caribbean monetary unions and central banks in the past. The problem is much more straightforward. He notes that European governments are large shareholders in the Fund, and that “the IMF is a predominantly European institution, with a European managing director, a heavily European staff, and a European culture.”

In other words we have something akin to regulatory capture. The IMF’s job is to be an impartial arbitrator between creditor and debtor, ensuring that the creditor takes appropriate losses for imprudent lending but also that the debtor adjusts its policies so they become sustainable. In the case of the Eurozone it has in effect sided with the creditors, and ruinous austerity has been the result of that.

The Return of Elasticity Pessimism

Paul Krugman:

The Return of Elasticity Pessimism (Wonkish): I talked at the Council for European Studies conference in Philly last night, and was surprised by one aspect of the discussion. As you might expect if you’re into these things, my take on the euro was strongly informed by the theory of Optimum Currency Areas; I expected pushback. But I didn’t realize how many people now seem to believe that real exchange rates don’t matter for adjustment — that is, that even internal devaluation (downward adjustment of prices and wages relative to trading partners) isn’t necessary in the aftermath of unsustainable capital inflows.

It turns out ... that we’re seeing a significant revival of the “elasticity pessimism” widely prevalent during the post World War II “dollar shortage”. This was the belief that trade flows barely respond to price signals, and hence that devaluations don’t help alleviate imbalances. Now as then, the argument rests in large part on specific cases...

The difference is that in the late 1940s this kind of argument was deployed in support of more government intervention — keep those exchange controls in place, because devaluation won’t work — whereas now it’s being deployed as an argument against activism — never mind the euro, it’s all rigidities that must be cured with structural reform. ...

I guess I’m showing a strong preconception here — that done right, analysis will show that trade elasticities remain fairly large. Certainly willing to be proved wrong — but we need to do this carefully, because it’s really important for future policy.

'China’s Trilemma—and a Possible Solution'

Just say no to monetary policy:

China’s trilemma—and a possible solution, by Ben Bernanke, Brookings Institution: China’s central banker, Zhou Xiaochuan of the People’s Bank of China (PBOC), and other top Chinese officials recently launched a communications offensive to persuade markets and foreign policymakers that no significant devaluation of the Chinese currency is planned.[1] Is the no-devaluation strategy a good one for China? If it is, what does China need to do to make its exchange-rate commitments credible? ...

China faces the classic policy trilemma of international economics, that a country cannot simultaneously have more than two of the following three: (1) a fixed exchange rate; (2) independent monetary policy; and (3) free international capital flows. Accordingly, China’s ability to manage its exchange rate may depend, among other factors, on its willingness and ability to adjust on other policy margins.

...[discussion of the costs and benefits of various options] ...

So what to do? An alternative worth exploring is targeted fiscal policy, by which I mean government spending and tax measures aimed specifically at aiding the transition in China’s growth model. (Spending on traditional infrastructure like roads and bridges is not what I have in mind; in the Chinese context, that’s part of the old growth model.) For example, as China observers have noted, the lack of a strong social safety net—the fact that Chinese citizens are mostly on their own when it comes to covering costs of health care, education, and retirement—is an important motivation for China’s extraordinarily high household saving rate. Fiscal policies aimed at increasing income security, such as strengthening the pension system, would help to promote consumer confidence and consumer spending. Likewise, tax cuts or credits could be used to enhance households’ disposable income, and government-financed training and relocation programs could help workers transition from slowing to expanding sectors. Whether subsidies to services industries are appropriate would need to be studied; but certainly, unwinding existing subsidies to heavy industry and state-owned enterprises, together with efforts to promote entrepreneurship and a more-level playing field, would be constructive.

There are recent indications China might be moving this direction. ...

Targeted fiscal action has a lot to recommend it, given China’s trilemma. Unlike monetary easing, which works by lowering domestic interest rates, fiscal policy can support aggregate demand and near-term growth without creating an incentive for capital to flow out of the country. At the same time, killing two birds with one stone, a targeted fiscal approach would also serve the goals of reform and rebalancing the economy in the longer term. Thus, in this way China could effectively pursue both its short-term and longer-term objectives without placing downward pressure on the currency and without new restrictions on capital flows. It’s an approach that China should consider.

Paul Krugman: When Fallacies Collide

Does protectionism cause recessions?:

When Fallacies Collide, by Paul Krugman, Commentary, NY Times: The formal debates among the Republicans who would be president have exceeded all expectations. Even the most hardened cynics couldn’t have imagined that the candidates would sink so low, and stay so focused on personal insults. Yet last week, offstage, there was in effect a real debate about economic policy between Donald Trump and Mitt Romney, who is trying to block his nomination.

Unfortunately, both men are talking nonsense. Are you surprised?

The starting point for this debate is Mr. Trump’s deviation from free-market orthodoxy on international trade. Attacks on immigrants are still the central theme of the Republican front-runner’s campaign, but he has opened a second front on trade deficits, which he asserts are being caused by the currency manipulation of other countries, especially China. This manipulation, he says, is “robbing Americans of billions of dollars of capital and millions of jobs.”

His solution is “countervailing duties” — basically tariffs — similar to those we routinely impose when foreign countries are found to be subsidizing exports in violation of trade agreements.

Mr. Romney claims to be aghast. In his stop-Trump speech last week he warned that if The Donald became president America would “sink into prolonged recession.” Why? The only specific reason he gave was that those duties would “instigate a trade war and that would raise prices for consumers, kill our export jobs and lead entrepreneurs and businesses of all stripes to flee America.”

This is pretty funny if you remember anything about the 2012 campaign. ... Mr. Romney was saying almost exactly the same things Mr. Trump is saying now. ...

More important than Mr. Romney’s awkward history here, however, is the fact that his economic analysis is all wrong. Protectionism can do real harm, making economies less efficient and reducing long-run growth. But it doesn’t cause recessions.

Why not? ... In fact, a worldwide trade war would, by definition, reduce imports by exactly the same amount that it reduces exports. There’s no reason to assume that the net effect on employment would be strongly negative.

But didn’t protectionism cause the Great Depression? No, it didn’t — protectionism was a result of the Depression, not its cause. ...

So there you have it. The good news is that there was a real policy debate going on within the G.O.P. last week. The bad news is that it was junk economics on both sides.

'What Did You Do in the Currency War, Daddy?'

I recently gave a talk in Honolulu hosted by the Korean Institute of Economic Policy, and this was a heated topic of discussion. Koreas was criticized in the Treasury's semi-annual report on currency manipulation (though not formally identified a a manipulator), and I had the impression their criticism of US monetary policy was an attempt to say "see, you do it too." My defense of the US was not popular:

Ben Bernanke:

What did you do in the currency war, Daddy?: The financial crisis and its immediate aftermath saw close cooperation among the world’s policymakers, especially central bankers. For example, in October 2008, the Federal Reserve coordinated simultaneous interest-rate cuts with five other major central banks. It also established currency swap arrangements—in which the Fed provided dollars in exchange for foreign currencies—with fourteen foreign central banks, including four from emerging markets. However, once the crisis had passed and recovery begun, national economic interests began to diverge. In particular, some foreign policymakers argued that the Fed’s aggressive monetary policies, undertaken to support the U.S. economic recovery, were damaging their own economies.

Two criticisms were prominent, and a third perennial issue also reared its head. First, several foreign policymakers accused the Fed of engaging in “currency wars”—deliberately weakening the dollar to gain an advantage in trade. (The phrase is most closely associated with Brazilian finance minister Guido Mantega, who leveled the charge when the Fed began a second round of quantitative easing in November 2010.) A second complaint, raised prominently by Reserve Bank of India governor Raghuram Rajan, among others, was that shifts in Fed policy (toward either greater tightness or greater ease) were creating spillovers—sharp swings in capital flows and increased market volatility—that destabilized financial markets in emerging-market countries. This concern has surfaced again recently, as the Fed has initiated what may prove to be a series of interest-rate increases. ...

Skipping to the bottom line (after a long, detailed discussion):

Overall, I find little support for the claims that the Fed has engaged in currency wars. Although the Fed’s monetary policies of recent years likely put downward pressure on the dollar, the effect of the weaker dollar on US net exports was largely offset by the effects of higher US incomes on Americans’ demand for imported goods and services. Indeed, recent years have seen neither an increase in US net exports nor any sustained depreciation of the dollar.

'Competitiveness: Some Basic Macroeconomics of Monetary Unions'

Simon Wren-Lewis:

Competitiveness: some basic macroeconomics of monetary unions: From comments on an earlier post, it is clear how many people do not understand how a monetary union works..., I thought a brief primer might be useful.

We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. ... So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.

So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. ...Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world. ...

The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. ...

One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. ...

What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it.... But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.

'Chinese Spillovers'

Paul Krugman:

Chinese Spillovers: China is clearly in economic trouble. But how worried should we be about spillovers from China’s woes to the rest of the world economy? I have in general been telling people “not very”, although it’s a bigger issue for Japan and Korea. But Citi’s Willem Buiter suggests that it could be a quite big deal, leading to a global recession. ... So could he be right?

Let me start with the case for not worrying too much, which comes down to the fact that China’s economy, while big, is still a small fraction of the global economy...

One possibility is ... that a Chinese slump could, via its impact on commodity prices, do a lot more harm to some other emerging markets than the above analysis suggests. I’m still working on this, although so far I don’t seem to be finding much there.

Another possibility is an international version of the financial accelerator. As Buiter points out, many emerging markets seem to be vulnerable thanks to private-sector foreign currency debt (which was so deadly in 1997-98). ...

Maybe, also, we could see some version of the financial contagion so obvious in the 1990s. Troubles in Brazil might make investors leery of other emerging markets, driving up interest spreads and forcing fiscal austerity that worsens the downturn. Or for matter, to the extent that the same hedge funds have been buying assets in a number of emerging nations, losses in one place could force them to liquidate assets elsewhere, causing a sort of global debt deflation. That was a popular story in the 1990s...

Overall, I’m not convinced of the Buiter thesis; China still seems to me not big enough to bring down the rest of the world. But I’m not rock-solid in that conviction, largely because we’ve seen so much contagion in the past. Stay tuned.

Paul Krugman: Other People’s Dollars, and Their Place in Global Economics

"We can learn a lot by following the dollars":

Other People’s Dollars, and Their Place in Global Economics, by Paul Krugman, Commentary, NY Times: Soon after arriving here, I stopped at an A.T.M.; I needed some dollars, and all I had were dollars.

O.K., weak joke. What I needed were Australian dollars... There are actually four English-speaking countries with dollars of their own; the others are the Canadian loonie and the New Zealand kiwi. And you can learn a lot about the global economy, busting some popular monetary myths, by comparing those currencies and how they serve their economies.

All four dollar nations are, if you take the long view, highly successful economies..., we’re all wealthy nations that have weathered economic storms better than most of the rest of the world. ...

So what can we learn from these dollar success stories? What myths can we bust?

First, we learn that even relatively small countries closely linked to big neighbors can maintain monetary independence..., that should have been made obvious by the example of Canada...

Second, we learn that what right-wingers call currency “debasement” ... can be a very good thing. Canada was able to combine spending cuts with strong growth in the 1990s because exports were raised by the depreciation of the loonie. Australia rode through the Asian financial crisis of 1997-98 with little damage thanks largely to a falling Aussie. In both cases times would have been much tougher if the countries had been using U.S. dollars, or worse yet been on the gold standard.

Third, we learn that people pay far too much attention to the role national currencies play in the international monetary system..., a glance at Australia shows that both positive and negative claims about the international role of the dollar are wildly exaggerated. The Aussie dollar plays no special role in the world monetary system, yet Australia has consistently attracted bigger inflows of capital relative to the size of its economy — and run proportionately bigger trade deficits — than the United States.

What’s important for both capital and trade, it turns out, is whether your economy offers good investment opportunities under an umbrella of legal and political stability. Whether you control an international currency is a trivial concern by comparison.

So we can learn a lot by following the dollars... And what we learn in particular is that monetary economics should be approached pragmatically, not in terms of mystical notions of value.

Take it from those who share our language, but not our currency: There are many ways to make money work.

'International Money Mania'

Paul Krugman:

International Money Mania: China is claiming that it’s not devaluing the renminbi to gain competitive advantage, it’s adding flexibility to prepare for the yuan as an international reserve currency, becoming part of the basket in the IMF’s SDRs and all that. That’s highly implausible as a story about what’s happening right now; but it may be true that China’s urge to loosen capital controls is driven in part by its global-currency ambitions. ...

So what are the advantages of owning a reserve currency? ...

What you’re left with, basically, is seigniorage: the fact that some people outside your country hold your currency, which means that in effect America gets a zero-interest loan corresponding to the stash of dollar bills — or, mainly $100 bills — held in the hoards of tax evaders, drug dealers, and other friends around the world. In normal times this privilege is worth something like $20-30 billion a year; that’s not a tiny number, but it’s only a small fraction of one percent of GDP.

The point is that while reserve-currency status may have political symbolism attached, it’s essentially irrelevant as an economic goal — and definitely not worth distorting policy to achieve. Someone needs to tell the Chinese, you shall not crucify this country on a cross of SDRs.

'Do Asset Purchase Programs Push Capital Abroad?'

Thomas Klitgaard and David Lucca at the NY Fed's Liberty Street Economics"

Do Asset Purchase Programs Push Capital Abroad?: Euro area sovereign bond yields fell to record lows and the euro weakened after the European Central Bank (ECB) dramatically expanded its asset purchase program in early 2015. Some analysts predicted massive financial outflows spilling out of the euro area and affecting global markets as investors sought higher yields abroad. These arguments ignore balance of payments accounting, which requires any financial outflow from the euro area to be matched by a similar-sized inflow, absent a quick and substantial current account improvement. The focus on cross-border financial flows also is misguided since, according to asset pricing principles, the euro and global asset prices can move without any change in financial outflows. ...

The recent experience with quantitative easing in Japan helps illustrate our point. In late 2012, the yen started to depreciate with the increased likelihood that the country would expand its asset purchase program. In April 2013, when the policy was actually implemented, commentary similar to that on the ECB program anticipated a “wall of money” flowing out of Japan in search of higher yields and affecting global asset prices. Indeed, analysts worried that emerging countries would have trouble absorbing these flows, leading to asset price bubbles. While asset prices and exchange rates adjusted in Japan and abroad, a surge in outflows never occurred. ... The wall of money never materialized.

Nor does euro area data suggest substantial financial outflows. ...

The euro’s fall has been a key channel through which the ECB’s asset purchase policy has affected financial markets in the rest the world. However, the idea that foreign asset prices would be pushed up by a surge in money flowing out of the region, as some observers predicted, runs contrary to balance of payments accounting and asset pricing principles and should be discounted.

'Annoying Euro Apologetics'

My response to this argument that economists don't get the politics of the euro was simply "I think we get the underlying political motivations. But whether the euro was politically motivated for the most part, or not, economics matters for the sustainability of a political union." Paul Krugman has more to say:

Annoying Euro Apologetics, by Paul Krugman: Are there good arguments against the proposition that the creation of the euro was an epic mistake? Maybe. But the arguments I’ve been hearing lately are really bad. And they’re also deeply annoying.

One argument I keep seeing is that economist critics like myself don’t understand that the euro was a political and strategic project, not merely a matter of economic costs and benefits. Yes, I’m a dumb uncouth economist, completely unaware of the role of politics and international strategy in policy decisions, who never heard of the European project and its origins in the effort to put Europe’s legacy of war behind it, not to mention strengthen democracy in the Cold War.

Well, actually I do know all about that. The point, however, is that while the European project has at every stage combined economic objectives with broader political goals – it’s about peace and democracy through integration and prosperity – the project can’t be expected to work unless the economic measures are a good idea in and of themselves, or at least a non-catastrophic idea. What happened in the march to the euro was that European elites, in love with the symbolism of a single currency, closed their minds to warnings that currency union – unlike the removal of trade barriers – was at best ambiguous in its economic logic, and arguably, even ex ante, a very bad idea indeed.

An alternative argument, which we’re hearing from depressed European economies like Finland, is that the short-term costs of inflexibility are outweighed by the supposedly huge gains from greater integration. But where’s the evidence for these huge gains? ...

As I said, maybe there are good arguments against the proposition that the euro was a mistake. But pointing out that politics matters, and economies grow, doesn’t cut it; these aren’t the factoids you’re looking for.

'This is What Economists Don’t Understand About the Euro Crisis – or the U.S. Dollar'

One of those "economists don't understand" thingies:

This is what economists don’t understand about the euro crisis – or the U.S. dollar, by Kathleen McNamara, Monkey Cage: Prominent American economists are weighing in on the Greek debt crisis, with more than a hint of schadenfreude. The title of a New York Times op-ed by Gregory Mankiw says it all in one smarmy sentence. “They told you so: Economists were Right To Doubt the Euro.” Economists are condescendingly scolding the Europeans for venturing into a single currency without the proper underlying economic conditions. Paul Krugman has relentlessly excoriated the leaders of Europe for being what he calls “self-indulgent politicians” who have “spent a quarter-century trying to run Europe on the basis of fantasy economics.” The conventional wisdom seems to be that the problems of the euro zone are, as economist Martin Feldstein once put it, “the inevitable consequence of imposing a single currency on a very heterogeneous group of countries.”

What this commentary gets wrong, however, is that single currencies are never the product of debates about optimal economic solutions. Instead, currencies like the U.S. dollar itself are the result of political battles, where motivated actors try to centralize power. This has most often occurred “through iron and blood,” as Otto van Bismarck, the unifier of Germany put it, as a result of catastrophic wars. Smaller geographic units were brought together to build the modern nation state, with a unified fiscal system, a common national language that was often imposed by force, a unified legal system, and, a single currency. Put differently (with apologies to sociologist Charles Tilly), war makes the state, and the state makes the currency. ...

European leaders weren’t stupid or self indulgent when they decided to move ahead with the euro, without fiscal union or strong Europe-level democracy. They just cared more about politics and international security than economics. They wanted to build a Europe that had transcended the divisions of the Cold War, and bind together Germany, which was reunited and much more powerful, with the rest of Europe. When they did think about economics, they hoped that a strong euro, anchored in an independent European Central Bank located in Frankfurt and built on a commitment to protecting the stability of the currency, would help resolve the problems of currency depreciation, spiraling inflation and economic instability that came with the weak currencies of the “Club Med” countries to the south of Europe.

European leaders, the IMF and the European Commission have done a terrible job at handling the Greek debt crisis. However, criticizing the euro because it doesn’t meet the ideal economic conditions for a single currency is missing the point. ...

I think we get the underlying political motivations. But whether the euro was politically motivated for the most part, or not, economics matters for the sustainability of a political union.

'AIIB: The First International Financial Institution of the 21st Century'

Cecchetti & Schoenholtz:

AIIB: The first international financial institution of the 21st century: ...What happens when official international financial institutions (IFIs) fail to respond to a changing environment? The same thing that happens to firms that stop innovating. New, more competitive institutions (firms) arise that compel them to change or – like dinosaurs – become extinct.

We may be witnessing this process of creative destruction right now. Last month, a group of 57 founding nations led by China signed the articles of agreement to establish the Asian Infrastructure Investment Bank (AIIB) with an initial subscribed capital of $100 billion. While most of the G20 nations, including the big European states, Australia, and South Korea, are among the founding members, the United States, Japan, and Canada are noticeably not.

No one disputes the need for more official infrastructure funding... What we find the most interesting is that the AIIB founders didn’t ask member countries to approve an expansion of either the World Bank or the ADB. Instead, they opted for a new organization altogether.

Why? The problem is institutional legitimacy arising from issues of power and governance. ...

The most glaring problem with the 20th century IFI’s – the BIS, IMF, World Bank and the regional development banks – is representation. ... Perhaps most important are the veto rights. ...

Is the AIIB likely to do better? There are reasons to be hopeful. ...

Of course, the proof will be in the pudding. When the AIIB begins operations, observers will be watching closely whether these ideals are realized. ...

As economists, we like competition. If the AIIB meets the high standards its leaders espouse, it will heighten the pressure on the existing IFIs’ political masters to change with the times. In addition, in light of numerous potential areas of conflict between China and the United States (think cyberspace and the South China Sea for starters), wouldn’t we all benefit from having these two leading economies and governments instead focus their competitive energies on improving global infrastructure finance?

From this perspective, we see a powerful argument for the United States to do two things.  First, the U.S. Congress should belatedly approve the IMF’s 2010 Quota and Governance Reforms to signal its support for continued global economic and financial cooperation in coming decades. And second, after failing to stop the AIIB, and refusing to participate as a founding member, the United States should join the institution as soon as it can, participating actively in holding it to the highest 21st century standards.

Paul Krugman: Europe’s Impossible Dream

Why did Europe ignore the "euroskeptics"?:

Europe’s Impossible Dream, by Paul Krugman, Commentary, NY Times: ... To someone who didn’t know much economics, or chose to ignore awkward questions, establishing a unified European currency sounded like a great idea. It would make doing business across national borders easier, while serving as a powerful symbol of unity. Who could have foreseen the huge problems the euro would eventually cause?

Actually, lots of people. ... The only big mistake of the euroskeptics was underestimating just how much damage the single currency would do.

The point is that it wasn’t at all hard to see, right from the beginning, that currency union without political union was a very dubious project. So why did Europe go ahead with it?

Mainly, I’d say, because the idea of the euro sounded ... forward-looking, European-minded, exactly the kind of thing that appeals to the kind of people who give speeches at Davos. Such people didn’t want nerdy economists telling them that their glamorous vision was a bad idea...

And the euro came. For a decade after its introduction a huge financial bubble masked its underlying problems. But now ... all of the skeptics’ fears have been vindicated.

Furthermore, the story doesn’t end there. When the predicted and predictable strains on the euro began, Europe’s policy response was to impose draconian austerity on debtor nations — and to deny the simple logic and historical evidence indicating that such policies would inflict terrible economic damage while failing to achieve the promised debt reduction.

It’s astonishing even now how blithely top European officials dismissed warnings that slashing government spending and raising taxes would cause deep recessions...

What should Europe do now? There are no good answers — but the reason there are no good answers is because the euro has turned into a Roach Motel, a trap that’s hard to escape. If Greece still had its own currency, the case for devaluing that currency, improving Greek competitiveness and ending deflation, would be overwhelming.

The fact that Greece no longer has a currency, that it would have to create one from scratch, vastly raises the stakes. My guess is that euro exit will still prove necessary. And in any case it will be essential to write down much of Greece’s debt.

But we’re not having a clear discussion of these options, because European discourse is still dominated by ideas the continent’s elite would like to be true, but aren’t. And Europe is paying a terrible price for this monstrous self-indulgence.

'Show Some Mercy'

Greg Mankiw:

... In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets. Easy monetary policy would have offset some of the pain from tight fiscal policy. Mr. Friedman and Mr. Feldstein were right: The euro has turned into an economic liability that has exacerbated political tensions. For this, the European elites who pushed for the currency union bear some responsibility.

As creditor nations and international institutions sort through the wreckage, it is worth bearing in mind the lessons from Mr. Keynes. A nation can only withstand so much economic pain before the political fallout becomes ugly. And that fallout can extend beyond the border of the problem nation.

Yes, the Greeks have every reason to be contrite. But it might also be wise for the rest of the world to show some mercy.

'The Effect of the Strong Dollar on U.S. Growth'

Mary Amiti and Tyler Bodine-Smith in the NY Fed's Liberty Street Economics blog:

The Effect of the Strong Dollar on U.S. Growth: The recent strengthening of the U.S. dollar has raised concerns about its impact on U.S. GDP growth. The U.S. dollar has appreciated around 12 percent since mid-2014, rising against almost all of our trading partners, with the largest gains against Japan, Mexico, Canada, and the euro area. There was far less movement against newly industrial Asian economies and hardly any change against China. In this blog, we ask how the strength of the dollar affects U.S. GDP growth. Although the dollar can impact the U.S. growth through a number of different channels, we focus on the direct impact through the U.S. trade balance. Our analysis shows that a 10 percent appreciation in one quarter shaves 0.5 percentage point off GDP growth over one year and an additional 0.2 percentage point in the following year if the strength of the dollar persists.  ...

'An Unsustainable Position'

Paul Krugman:

An Unsustainable Position: Everyone is talking about the IMF’s new update to its debt sustainability analysis, which says that Greece’s attempt to surrender is doomed to failure without massive debt relief. That’s surely the right conclusion.

However, it’s hard to accept the document’s claim that this is a new development...

The point, surely, is that the plan for Greece was never feasible. No matter how willing a nation is to suffer, no matter how willing to run primary surpluses on a scale that is very rare in history, trying to pay off high debt through austerity without any kind of monetary offset is basically a recipe for debt deflation and failure. This is, in fact, what the IMF’s own research has said. ...

So it’s good to see the IMF being realistic here, but the institution remains unwilling to face up fully to past errors — which matters, because these past errors are prologue to the doom that faces any attempt to stay the course.

'Negotiating with Germany is a Waste of Time'

Kevin O'Rourke:

...I don’t suppose that any other left wing party that may come to power in the future seeking to challenge the current European economic policy mix will be as feckless as Syriza. The lesson that they will draw from this debacle is: negotiating with Germany is a waste of time; be willing to act unilaterally, be willing to default unilaterally, have a plan for achieving primary surplus if you haven’t already achieved it, have a hard default and euro exit (now possible, thanks to the Germans) option in your back pocket, and be willing to use it at the first sign of hassle from the ECB. A deal could have been done today that would have strengthened the Eurozone, but instead it has just become a lot more fragile.

'Are we Sure that Tsipras Caved In?'

Gloomy European Economist Francesco Saraceno:

Are we Sure that Tsipras Caved In?: Germany did not speak yet, and until then nothing is certain. But it looks like the new Tsipras proposal may turn into an agreement between Greece and its creditors. ..

At first sight, this does not look good for Tsipras..., in fact the new package is even more “austerian” than the Juncker plan, as it contains deficit reduction for 12 billions instead of 8.

This said, if Tsipras manages to link the package to the obtention of a new loan (plus unblocking of structural funds) for a duration of three years, he will have obtained what he has been asking so far in vain, and what had been refused to Papandreou in 2011: Time and money. ...

In this light the referendum was very important. By asking the Greek people the mandate to negotiate while remaining in the euro, he succeeded in throwing the ball in the creditors camp. Those speaking of betrayal of the people’s will probably did not pay attention to the Greek debate in the week of July 5th. This is why Syriza keeps climbing in the polls, by the way.

Tsipras had to pay the price of a stricter austerity than he would have wished for. But he gains breathing space, which is orders of magnitude more valuable. No surprise that Germany is hesitant. If a deal is not reached, as of now, it will be clear to all who will have kicked Greece out.

Paul Krugman: Ending Greece’s Bleeding

What should Greece do now?:

Ending Greece’s Bleeding, by Paul Krugman, Commentary, NY Times: Europe dodged a bullet on Sunday. Confounding many predictions, Greek voters strongly supported their government’s rejection of creditor demands. ...

A “yes” vote in Greece would have condemned the country to years more of suffering under policies that haven’t worked and in fact, given the arithmetic, can’t work: austerity probably shrinks the economy faster than it reduces debt, so that all the suffering serves no purpose. The landslide victory of the “no” side offers at least a chance for an escape from this trap.

But how can such an escape be managed? Is there any way for Greece to remain in the euro? And is this desirable...?

The most immediate question involves Greek banks. In advance of the referendum, the European Central Bank cut off their access to additional funds... The central bank now faces an awkward choice: if it resumes normal financing it will as much as admit that the previous freeze was political, but if it doesn’t it will effectively force Greece into introducing a new currency.

Specifically, if the money doesn’t start flowing..., Greece will have no choice but to start paying wages and pensions with i.o.u.s, which will de facto be a parallel currency — and which might soon turn into the new drachma.

Suppose, on the other hand, that the central bank does resume normal lending, and the banking crisis eases. That still leaves the question of how to restore economic growth. ...

Imagine, for a moment, that Greece had never adopted the euro... What would basic economic analysis say it should do now? The answer, overwhelmingly, would be that it should devalue ... to encourage exports and to break out of the cycle of deflation. ...

Would Greek exit from the euro work...? Maybe not — but consider the alternatives. Unless Greece receives really major debt relief, and possibly even then, leaving the euro offers the only plausible escape route from its endless economic nightmare.

And let’s be clear: if Greece ends up leaving the euro, it won’t mean that the Greeks are bad Europeans. Greece’s debt problem reflected irresponsible lending as well as irresponsible borrowing, and in any case the Greeks have paid for their government’s sins many times over. If they can’t make a go of Europe’s common currency, it’s because that common currency offers no respite for countries in trouble. The important thing now is to do whatever it takes to end the bleeding.

Paul Krugman: Europe’s Many Economic Disasters

Was the creation of the euro a mistake? Should it be eliminated?:

Europe’s Many Economic Disasters, by Paul Krugman, Commentary, NY Times:  ... Why are there so many economic disasters in Europe? Actually, what’s striking at this point is how much the origin stories of European crises differ. Yes, the Greek government borrowed too much. But the Spanish government didn’t — Spain’s story is all about private lending and a housing bubble. And Finland’s story doesn’t involve debt at all. It is, instead, about weak demand for forest products, still a major national export, and the stumbles of Finnish manufacturing, in particular of its erstwhile national champion Nokia.

What all of these economies have in common, however, is that by joining the eurozone they put themselves into an economic straitjacket. ...

Does this mean that creating the euro was a mistake? Well, yes. But that’s not the same as saying that it should be eliminated now that it exists. The urgent thing now is to loosen that straitjacket. This would involve action on multiple fronts...

But there are many European officials and politicians who are opposed to anything and everything that might make the euro workable, who still believe that all would be well if everyone exhibited sufficient discipline. And that’s why there is even more at stake in Sunday’s Greek referendum than most observers realize.

One of the great risks if the Greek public votes yes — that is, votes to accept the demands of the creditors, and hence repudiates the Greek government’s position and probably brings the government down — is that it will empower and encourage the architects of European failure. The creditors will have demonstrated their strength, their ability to humiliate anyone who challenges demands for austerity without end. And they will continue to claim that imposing mass unemployment is the only responsible course of action.

What if Greece votes no? This will lead to scary, unknown terrain. Greece might well leave the euro, which would be hugely disruptive in the short run. But it will also offer Greece itself a chance for real recovery. And it will serve as a salutary shock to the complacency of Europe’s elites.

Or to put it a bit differently, it’s reasonable to fear the consequences of a “no” vote, because nobody knows what would come next. But you should be even more afraid of the consequences of a “yes,” because in that case we do know what comes next — more austerity, more disasters and eventually a crisis much worse than anything we’ve seen so far.

'Path to Grexit Tragedy Paved by Political Incompetence'

Barry Eichengreen:

Path to Grexit tragedy paved by political incompetence: Since our last episode, the crisis in Greece has escalated further. Negotiations between the government and its creditors collapsed over the weekend, and restrictions on bank withdrawals will now follow.

The next step is for the government to issue the equivalent of IOUs to pay salaries and pensions. The country is seemingly on the slippery slope to exiting the euro.

Many of us doubted that it would come to this. In particular, I doubted that it would come to this.

Nearly a decade ago, I analyzed scenarios for a country leaving the eurozone. I concluded that this was exceedingly unlikely to happen. The probability of a Grexit, or any Otherexit, I confidently asserted, was vanishingly small.

My friend and UC Berkeley colleague Brad DeLong regularly reminds us of the need to “mark our views to market.” So where did this prediction go wrong?

Why a euro exit didn’t make sense

My analysis was based on a comparison of economic costs and benefits of a country exiting the euro. The costs, I concluded, would be severe and heavily front-loaded.

Raising the possibility, however remote, of exit from the euro would ignite a bank run in said country. The authorities would be forced to shutter the financial system. Economic activity would grind to a halt. Losing access to not just their savings but also imported petrol, medicines and foodstuffs, angry citizens would take to the streets.

Not only would any subsequent benefits, by comparison, be delayed, but they would be disappointingly small.

With the government printing money to finance its spending, inflation would accelerate, and any improvement in export competitiveness due to depreciation of the newly reintroduced national currency would prove ephemeral.

In Greece’s case, moreover, there is the problem that the country’s leading export, refined petroleum, is priced in dollars and relies on imported oil, which is also priced in dollars. So much for the advantages of a depreciated currency.

Agricultural exports for their part will take several harvests to ramp up. And attracting more tourists won’t be easy against a drumbeat of political unrest.

What went wrong?

How did Greece end up in this pickle? Some say that the specter of a bank run was no longer a deterrent to exit once that bank run started anyway due to the deep depression into which the Greek economy had sunk.

But what is remarkable is how the so-called bank run remained a jog – it was still perfectly manageable until the Greek government called its referendum on the terms of the bail out deal offered by international creditors, negotiations broke down and exit became a real possibility.

Nonperforming loans — ones that are in default or close to it — were already rising, to be sure, but the banks still had all the liquidity they needed. The European Central Bank supported the Greek banking system with emergency liquidity assistance (ELA) right up to the very end of June. Only when Greece stopped negotiating did the Central Bank stop increasing ELA. And only then did a full-fledged bank run break out.

So I stand by the economic argument. Where I need to mark my views to market, however, is for underestimating the role of politics. In particular, I underestimated the extent of political incompetence – not just of the Greek government but even more so of its creditors.

In January Syriza had run on a platform of no more spending cuts or tax increases but also of keeping the euro. It should have anticipated that some compromise would be needed to square this circle. In the event, that realization was strangely late in coming.

And Prime Minister Alexis Tsipras and his government should have had the courage of its convictions. If it was unwilling to accept the creditors’ final offer, then it should have stated its refusal, pure and simple. If it preferred to continue negotiating, then it should have continued negotiating. The decision to call a referendum in midstream only heightened uncertainty. It was a transparent effort to evade responsibility. It was the action of leaders more interested in retaining office than in minimizing the cost to the country of the crisis.

A hard lesson learned

Still, this incompetence pales in comparison with that of the European Commission, the ECB and the IMF.

The three institutions opposed debt restructuring in 2010 when the crisis still could have been resolved at low cost. They continued to resist it in 2015, when a debt write-down was the obvious concession to Mr Tsipras & Company. The cost would have been small. Pretending instead that Greece’s debts could be repaid hardly enhanced their credibility.

Instead, the creditors first calculated the size of the primary budget surpluses that Greece would have to run in order to hypothetically repay its debt. They then required the government to raise taxes and cut spending sufficiently to produce those surpluses.

They ignored the fact that, in so doing, they consigned the country to an even deeper depression. By privileging their own balance sheets, they got the Greek government and the outcome they deserved.

The implication is clear. Never underestimate the ability of politicians to do the wrong thing. I will try to remember next time.

Fed Watch: Events Continue to Conspire Against the Fed

Tim Duy:

Events Continue to Conspire Against the Fed, by Tim Duy: Federal Reserve policymakers just can't catch a break lately. Riding on the back of strong data in the second half of last year, they were positioning themselves to declare victory and begin the process of policy normalization, AKA "raising interest rates." Then the bottom fell out. Data in the first half of the year turned sloppy. Although policymakers on average - and Federal Reserve Chair Janet Yellen in particular - could reasonably believe the underlying momentum of the economy had not changed, that the data reflected largely temporary factors, the case for a rate hike by mid-year evaporated all the same. The risk of being wrong was simply more than they were willing to bear in the absence of clear inflation pressures.

The story was clearly shifting by the end of June. Key data on jobs and the consumer firmed as expected, raising the possibility that September was in play. Salvation from ZIRP, finally. Federal Reserve Governor Jerome Powell called it a coin toss. Via Bloomberg:

Speaking at a Wall Street Journal event in Washington Tuesday, Powell said he forecast stronger growth than in the first half of 2015, growth in the labor market and a “greater basis for confidence” in inflation returning to 2 percent.

“If those things are realized, I feel that it is time, it will be time, potentially as soon as September,” he said. “I don’t think the odds are 100 percent. I think they’re probably in the 50-50 range that we will realize those conditions, but that’s my forecast.”

Earlier, San Francisco Federal Reserve President John Williams said he expected two rate hikes this year. Via Reuters:

"Definitely my own forecast would be having us raise rates two times this year, but that would depend on the data," San Francisco Fed President John Williams told reporters at the bank's headquarters.

Rate increases of a quarter percentage point each would be reasonable, he said, with little point in making rate increases any smaller.

Given that we have basically written off the possibility of a rate hike in October (Fed not positioning for a rate hike every meeting and no one expects October for a first hike in the absence of the press conference), that leaves September and December for hikes.

Over the weekend, New York Federal Reserve President William Dudley also raised the possibility of September in an interview with the Financial Times:

A Federal Reserve interest-rate hike will be “very much in play” at the central bank’s September meeting if the recent strengthening of the US economy continues, according to one of America’s top central bankers.

William Dudley, the president of the Federal Reserve Bank of New York, said recent evidence of accelerating wage gains, improving incomes, and growing household spending had alleviated some of his concerns about the sustainability of momentum in America’s jobs market.

Former Federal Reserve Governor Laurence Meyer expects Yellen to also be comfortable with two rate hikes in 2015 by the time September rolls around. Via Bloomberg:

"We expect the incoming data between now and the September meeting to help ease concerns about the growth outlook, prompting Chair Yellen and a majority of the FOMC to see two hikes this year as appropriate," Meyer said in a note to clients.

No, September was not a sure bet, but you could see how the data evolved to get you there. But then came Greece. Greece - will it never end? Financial markets were roiled as Greek Prime Minister Alexis Tsipras abandoned the latest round of bailout negotiations with the EU, IMF, and ECB and instead pursued a national referendum on the last version of the bailout proposal. Most of you know the story from that point on - run on Greek banks, the ECB ends further ELA extensions, a bank holiday is declared, likely missing a payment to the IMF etc., etc.

At this juncture, everything in Greece is now in flux. Greece will be holding a referendum on a deal that apparently no longer exists, so it is not clear what negotiations would happen even if it passes. Moreover, it seems likely that the economic damage that will occur in the next week or longer will almost certainly require an even bigger give on the part of Greece's creditors. Is that going to happen? There is no exit plan to force Greece out of the Euro. What if Greece refuses to leave? How does Europe respond to a growing humanitarian crisis Greece as the economy collapsed? This could drag on and on and on.

As would be reasonably expected, the jump in risk sank equities across the globe, in the process stripping away US stock gains for 2015. Not that there was much to give - it only took a little over 2% on the SP500. Yields on Treasuries sank in a safe-haven bid, and market participants pushed Federal Reserve rate hike expectations out beyond 2015.

At this moment, there is obviously little to confirm that 2015 is off the table. To be sure, we know the Fed is watching the situation closely. Back to the FT and Dudley:

That said, Mr Dudley warned that the financial market implications of a Greek exit from the euro could be graver than many investors seemed to believe, because it would set a “huge precedent” indicating that euro membership was reversible.

People “underestimate all the different channels in terms of how contagion works”, the central banker said. “We saw that in the financial crisis. People did not anticipate that the Lehman failure was going to affect the economy and financial markets to the degree that it did.”

At the risk of being guilty of underestimating contagion, I am optimistic that the ring fencing around Greece will hold. This will be a political disaster for Europe, and a humanitarian disaster for Greece, but I expect will ultimately prove to have limited impact beyond those borders.

Famous last words.

Of course, even if that is correct, we don't know it to be correct, and thus the Fed will again proceed cautiously, just like they did in the face of the weak first quarter. Hence, all else equal, pushing out the timing of the first hike is reasonable. September, though, is a long ways off, and plenty can happen between now and then. So what will the Fed be watching?

First is the data, as they have emphasized again and again. We have three labor reports between now and September, beginning this week. Strong monthly gains coupled with falling unemployment rates and further evidence of wage growth would go a long way to supporting a rate hike. All would give the Fed the faith that inflation will soon be heading toward target. This is especially the case if recent consumer spending and housing numbers hold and if business investment picks up. And it would be further helpful if the global economy did not sink under the weight of Greece. Essentially, the Fed wants to be confident that the first quarter was a fluke and thus the economy is in fact fairly resilient.

Second is the financial fallout from Greece. Mostly, they will be carefully watching to see if the Greece crisis impacts domestic credit markets and banking. Do interest rate spreads widen? Do lenders tighten underwriting conditions? Does interbank lending proceed without impediments? If they see conditions emerge like this, I would expect them to match market expectations and just stay out of the rate hike business until the fallout from Greece is clear. This likely holds even in the face of solid US data. There will (or at least should) recognize that periods of substantial unrest in credit markets are not the time to be raising rates.

Bottom Line: The Fed was already approaching the first rate hike cautiously, wary of even dipping their toes in the water. The crisis in Greece will make them even more cautious. Like their response to the first quarter data, until they see a clear path, they will be on the sidelines. That said, given the plethora of warnings not to underestimate the global impact of the crisis in Greece, one should be watching the opposite side of the story. Solid data and limited Greece impact would leave December at a minimum, and even September, in play.

Stiglitz: Troika has 'Kind of Criminal Responsibility'

From Time:

Joseph Stiglitz to Greece’s Creditors: Abandon Austerity Or Face Global Fallout: ... “They have criminal responsibility,” he says of the so-called troika of financial institutions that bailed out the Greek economy in 2010, namely the International Monetary Fund, the European Commission and the European Central Bank. “It’s a kind of criminal responsibility for causing a major recession,” Stiglitz tells TIME in a phone interview.

Along with a growing number of the world’s most influential economists, Stiglitz has begun to urge the troika to forgive Greece’s debt – estimated to be worth close to $300 billion in bailouts – and to offer the stimulus money that two successive Greek governments have been requesting.

Failure to do so, Stiglitz argues, would not only worsen the recession in Greece – already deeper and more prolonged than the Great Depression in the U.S. – it would also wreck the credibility of Europe’s common currency, the euro, and put the global economy at risk of contagion. ...

Paul Krugman: Greece Over the Brink

Just say no:

Greece Over the Brink, by Paul Krugman, Commentary, NY Times: It has been obvious for some time that the creation of the euro was a terrible mistake. Europe never had the preconditions for a successful single currency....

Leaving a currency union is, however, a much harder and more frightening decision than never entering in the first place...

But the situation in Greece has now reached what looks like a point of no return. Banks are temporarily closed and the government has imposed capital controls... It seems highly likely that the government will soon have to start paying pensions and wages in scrip, in effect creating a parallel currency. And next week the country will hold a referendum on whether to accept the demands of the “troika” ... for yet more austerity.

Greece should vote “no,” and the Greek government should be ready, if necessary, to leave the euro.

To understand why I say this, you need to realize that most ... of what you’ve heard about Greek profligacy and irresponsibility is false. Yes, the Greek government was spending beyond its means in the late 2000s. But ... all the austerity measures ... been more than enough to eliminate the original deficit and turn it into a large surplus.

So why didn’t this happen? Because the Greek economy collapsed, largely as a result of those very austerity measures, dragging revenues down with it.

And this collapse, in turn, had a lot to do with the euro, which trapped Greece in an economic straitjacket. Cases of successful austerity ... typically involve large currency devaluations... But Greece, without its own currency, didn’t have that option. ...

It’s easy to get lost in the details, but the essential point now is that Greece has been presented with a take-it-or-leave-it offer that is effectively indistinguishable from the policies of the past five years. ...

Don’t be taken in by claims that troika officials are just technocrats explaining to the ignorant Greeks what must be done. These supposed technocrats are in fact fantasists who have disregarded everything we know about macroeconomics, and have been wrong every step of the way. This isn’t about analysis, it’s about power — the power of the creditors to pull the plug on the Greek economy, which persists as long as euro exit is considered unthinkable.

So it’s time to put an end to this unthinkability. Otherwise Greece will face endless austerity, and a depression with no hint of an end.

'Former Finance Minister of Cyprus on the Greek Crisis'

Branko Milanovic:

Former Finance Minister of Cyprus on the Greek crisis: While on vacations in Greece, I had a chance today (Sunday 28 June) to have a long discussion with Michael Sarris who was Cypriot Minister of Finance between 2005 and 2008 when the Euro was introduced in Cyprus and then again Minister of Finance during the March 2013 crisis when Cyprus faced negotiations with “the institutions” very similar to those faced today by Greece.  Very few people in the world have as informed and first-hand knowledge of the situation as Michael Sarris does. Here are my questions and his answers. ...

Greece: It’s the Politics, Stupid!

Gloomy European Economist Francesco Saraceno:

It’s the Politics, Stupid!: I have been silent on Greece, because scores of excellent economists from all sides commented at length...

But last week has transformed in certainty what had been a fear since the beginning. The troika, backed by the quasi totality of EU governments, were not interested in finding a solution that would allow Greece to recover while embarking in a fiscally sustainable path. No, they were interested in a complete and public defeat of the “radical” Greek government. ...

What happened...? Well, contrary to what is heard in European circles, most of the concessions came from the Greek government. On retirement age, on the size of budget surplus (yes, the Greek government gave up its intention to stop austerity, and just obtained to soften it), on VAT, on privatizations, we are today much closer to the Troika initial positions than to the initial Greek position. Much closer.

The point that the Greek government made repeatedly is that some reforms, like improving the tax collection capacity, actually demanded an increase of resources, and hence of public spending. Reforms need to be disconnected from austerity, to maximize their chance to work.  Syriza, precisely like the Papandreou government in 2010 asked for time and possibly money. It got neither.

Tsipras had only two red lines it would and it could not cross: Trying to increase taxes on the rich (most notably large coroporations), and not agreeing to further cuts to low pensions. if he crossed those lines, he would become virtually indistinguishable from Samaras and from the policies that led Greece to be a broken State.

What the past week made clear is that this, and only this was the objective of the creditors. This has been since the beginning about politics. Creditors cannot afford that an alternative to policies followed since 2010 in Greece and in the rest of the Eurozone materializes.

Austerity and structural reforms need to be the only way to go. Otherwise people could start asking questions; a risk you don’t want to run a few months before Spanish elections. Syriza needed to be made an example. You cannot  survive in Europe, if you don’t embrace the Brussels-Berlin Consensus. Tsipras, like Papandreou, was left with the only option too ask for the Greek people’s opinion, because there has been no negotiation, just a huge smoke screen. Those of us who were discussing pros and cons of the different options on the table, well, we were wasting our time.

And if Greece needs to go down to prove it, so be it. If we transform the euro in a club in which countries come and go, so be it.

The darkest moment for the EU.

'Breaking Greece'

Paul Krugman:

Breaking Greece: I’ve been staying fairly quiet on Greece... But given reports from the negotiations in Brussels, something must be said...

This ought to be a negotiation about targets for the primary surplus, and then about debt relief that heads off endless future crises. And the Greek government has agreed to what are actually fairly high surplus targets, especially given the fact that the budget would be in huge primary surplus if the economy weren’t so depressed. But the creditors keep rejecting Greek proposals on the grounds that they rely too much on taxes and not enough on spending cuts. So we’re still in the business of dictating domestic policy.

The supposed reason for the rejection of a tax-based response is that it will hurt growth. The obvious response is, are you kidding us? The people who utterly failed to see the damage austerity would do — see the chart, which compares the projections in the 2010 standby agreement with reality — are now lecturing others on growth? Furthermore, the growth concerns are all supply-side, in an economy surely operating at least 20 percent below capacity. ...

At this point it’s time to stop talking about “Graccident”; if Grexit happens it will be because the creditors, or at least the IMF, wanted it to happen.

'Thinking About the All Too Thinkable'

Paul Krugman:

Thinking About the All Too Thinkable: The path toward non-Grexit — toward Greece and its creditors reaching a deal that keeps it in the euro — is getting narrower, although it’s not yet completely closed. ...

At this point quite a few people on the creditor/Troika side of the negotiations seem almost to welcome the prospect. But this is bizarre in terms of their underlying interests. Yes, the lives of the officials would become easier, for a while, because they wouldn’t have to deal with Syriza. But from the point of view of the creditors, Grexit would be a pure negative. They would almost surely receive less in payments than they would under any deal that keeps Greece in, and the proof that the euro is in fact reversible would grease the rails for future crises, even if the ECB is able to contain this one.

And as Martin Wolf points out, Greece will still be there, and will still need dealing with.

The Greeks, on the other hand, should feel conflicted. There would probably be a lot of financial chaos in the immediate aftermath of euro exit. And maybe the apocalyptic warning from the Bank of Greece that devaluation would push the nation back into the Third World is right, although I’d like to know about the model and historical examples that would justify this claim. But absent that kind of implosion, a devalued currency should eventually produce an export-led recovery — I understand the cynicism one hears, but demand curves do slope downwards even in Greece.

The point is that nobody should be casual or confident here. But the creditors should actually be even more worried than the Greeks about a potential exit that has no upside for the rest of Europe.

'Why Currency Manipulation Matters'

Joseph E. Gagnon:

Why Currency Manipulation Matters: Currency manipulation (CM) by foreign countries has become a major part of the debate over Trade Promotion Authority (TPA) in Congress. Lawmakers opposed to TPA have charged that China’s efforts to keep the value of its currency down in order to expand exports contributed to US job losses since the turn of the century. Previously, Fred Bergsten and I raised the possibility of including currency chapters in trade agreements as one of several possible strategies for countering CM. This post, however, focuses exclusively on the costs of CM to the US economy.

Some observers describe the cost of CM entirely in terms of jobs lost for US workers; others dispute the notion that CM has any effect on US employment. But the truth is more complicated than these simple nostrums.

Economic circumstances determine whether CM has any effect on total employment. In the recent past [when the economy was in a deep recession], CM held down US employment to a major extent. In the near future [when the economy has fully recovered], CM probably will have a negligible effect on employment.

However, CM imposes costs on the US economy even when we are at full employment. These costs are roughly comparable in magnitude to all of the gains that are projected from trade agreements with Asia-Pacific countries. ...

IMF profile of Hélène Rey

From a much longer IMF profile of Hélène Rey, professor of economics at the London Business School:

... Among her most influential work is the research she did with Gourinchas when she was at Princeton on the role of the United States in a globalized financial system. Blanchard says it “changed the discussion on the current account deficit in the United States.”

Before the recent global financial crisis, when economists and politicians were concerned about the ballooning U.S. current account deficit, Gourinchas and Rey showed that the U.S. position was not as bad as it looked because of the country’s role as the center of the international financial system.

“Although the U.S. was running a big trade deficit, economists were not taking into account the large amounts the U.S. was earning on the financial side from capital gains and changes in the value of the dollar,” Gourinchas told F&D.

“For example, almost all U.S. foreign liabilities are in dollars, whereas approximately 70 percent of U.S. foreign assets are in other currencies. So a 10 percent depreciation of the dollar increases the value of foreign assets and represents a transfer of about 5.9 percent of U.S. GDP from the rest of the world to the United States. For comparison, the trade deficit on goods and services in 2004 was 5.3 percent of GDP. So these capital gains can be very large.”

As Gourinchas and Rey (2005) pointed out, a depreciation of the U.S. dollar has two beneficial effects on the external position of the United States. It helps boost net exports and increases the dollar value of U.S. assets.

Gourinchas and Rey said that the U.S. position at the center of the system gave it what they called an “exorbitant privilege”... The exorbitant privilege, Rey and Gourinchas explained, came about because the United States could borrow at a discount on world financial markets and get high yields on its external assets. They tracked how the United States had gradually taken on riskier overseas investments.

“Then we pushed these ideas further, by pointing out that the key role of the United States makes it also look very much like an insurer for the rest of the world,” Rey explains. ...

Gourinchas said Washington has become more like the world’s venture capitalist since the 1990s. “During the whole period, U.S. assets have shifted more and more out of long-term bank loans toward foreign direct investment (FDI) and, since the 1990s, toward FDI and equity. At the same time, its liabilities have remained dominated by bank loans, trade credit, and debt—that is, low-yield safe assets.

“Hence, the U.S. balance sheet resembled increasingly one of a venture capitalist with high-return risky investments on the asset side. Furthermore, its leverage ratio has increased sizably over time.”

Rey says they expanded on this research during the global financial crisis, finding that the United States had reversed its role by channeling resources to the rest of the world through its external portfolio—on a large scale. “Our estimate is 13 to 14 percent of U.S. GDP in 2008 alone. So that was very significant.”

The United States was providing “some sort of global insurance to the world economy and the rest of the world—earning the equivalent of an insurance premium in good times and paying out in bad times. And that’s exactly what we see in the data.”

“While the United States enjoys an exorbitant privilege on one side,” says Rey, “it also, as global insurer, has an exorbitant duty in time of crisis on the other.”

'US External Debt: A Curious Case'

Should we be worried about the U.S. net international investment position (the difference between US assets abroad and foreign claims on the US)? Paul Krugman says it's "actually a symptom of US relative strength":

As Tim Taylor notes, the U.S. net international investment position ... has moved substantially deeper into the red in recent years...

But why? You might be tempted to say that it’s obvious: we’ve been running big budget deficits, borrowing the money from foreigners, so of course our debt to those foreigners is surging. But that story implicitly requires a surge in the trade deficit (or more precisely the current account deficit, which includes investment income), which hasn’t happened. ...

So it’s not about borrowing vast sums abroad... But what is it? ... The big move is a sharp rise in the value of foreign holdings of US equity, not matched by any comparable rise in US holdings of foreign equity. What’s that about?

The answer, I believe, is that we’re looking at the differential performance of stock markets. ... So the value of foreign holdings of US equities ... has surged along with the Obama stock market, while US holdings abroad have seen no comparable boost.

And this means that the plunge in the U.S. international investment position, far from showing weakness, is actually a symptom of US relative strength, reflected in strong stock prices.

I think I’m right about this, although happy to hear alternative stories.

'Time US Leadership Woke Up To the New Economic Era'

Larry Summers:

Time US leadership woke up to new economic era: This past month may be remembered as the moment the United States lost its role as the underwriter of the global economic system. ... This failure of strategy and tactics was a long time coming, and it should lead to a comprehensive review of the US approach to global economics. ...

Largely because of resistance from the right, the US stands alone in the world in failing to approve the International Monetary Fund governance reforms that Washington itself pushed for in 2009. ...

Meanwhile, pressures from the left have led to pervasive restrictions on infrastructure projects financed through existing development banks, which consequently have receded as funders, even as many developing countries now see infrastructure finance as their principle external funding need.

With US commitments unhonoured and US-backed policies blocking the kinds of finance other countries want to provide or receive through the existing institutions, the way was clear for China to establish the Asian Infrastructure Investment Bank. There is room for argument about the tactical approach that should have been taken once the initiative was put forward. But the larger question now is one of strategy. ...

What is crucial is that the events of the past month will be seen by future historians not as the end of an era, but as a salutary wake up call.

'Germany's Trade Surplus is a Problem'

Ben Bernanke:

Germany's trade surplus is a problem: ...in recent years China has been working to reduce its dependence on exports and its trade surplus has declined accordingly. The distinction of having the largest trade surplus, both in absolute terms and relative to GDP, is shifting to Germany. ...

In a slow-growing world that is short aggregate demand, Germany’s trade surplus is a problem. Several other members of the euro zone are in deep recession,... and ... their fiscal situations don’t allow them to raise spending or cut taxes... Despite signs of recovery in the United States, growth is also generally slow outside the euro zone. The fact that Germany is selling so much more than it is buying redirects demand from its neighbors (as well as from other countries around the world), reducing output and employment outside Germany at a time at which monetary policy in many countries is reaching its limits.

Persistent imbalances within the euro zone are also unhealthy, as they lead to financial imbalances as well as to unbalanced growth. ...

Systems of fixed exchange rates, like the euro union or the gold standard, have historically suffered from the fact that countries with balance of payments deficits come under severe pressure to adjust, while countries with surpluses face no corresponding pressure. ...

Germany has little control over the value of the common currency, but it has several policy tools at its disposal to reduce its surplus—tools that, rather than involving sacrifice, would make most Germans better off. Here are three examples.

1. Investment in public infrastructure. ...
2. Raising the wages of German workers. ...
3. Germany could increase domestic spending through targeted reforms, including for example increased tax incentives for private domestic investment; the removal of barriers to new housing construction; reforms in the retail and services sectors; and a review of financial regulations that may bias German banks to invest abroad rather than at home.

Seeking a better balance of trade should not prevent Germany from supporting the European Central Bank’s efforts to hit its inflation target...

...global imbalances are not only a Chinese and American issue.

Paul Krugman: Strength Is Weakness

Is the rising value of the dollar good news?:

Strength Is Weakness, by Paul Krugman, Commentary, NY Times: We’ve been warned over and over that the Federal Reserve, in its effort to improve the economy, is “debasing” the dollar..., the Fed’s critics keep insisting that easy-money policies will lead to a plunging dollar. Reality, however, keeps declining to oblige. Far from heading downstairs to debasement, the dollar has soared through the roof. ... Hooray for the strong dollar!

Or not. ... Currency markets ... always grade countries on a curve. The United States isn’t exactly booming, but it looks great compared with Europe... Markets have responded to those poor prospects by pushing interest rates incredibly low. In fact, many European bonds are now offering negative interest rates.

This remarkable situation makes even those low, low U.S. returns look attractive by comparison. So capital is heading our way, driving the euro down and the dollar up.

Who wins from this market move? Europe: a weaker euro makes European industry more competitive against rivals, boosting both exports and firms that compete with imports, and the effect is to mitigate the euroslump. Who loses? We do, as our industry loses competitiveness, not just in European markets, but in countries where our exports compete with theirs. ...

In effect, then, Europe is managing to export some of its stagnation to the rest of us. ... And the effects may be quite large. ...

One thing that worries me is that I’m not at all sure that policy makers have fully taken the implications of a rising dollar into account. The Fed, still eager to raise interest rates despite low inflation and stagnant wages, seems to me to be too sanguine about the economic drag. ...

Oh, and one more thing: a lot of businesses around the world have borrowed heavily in dollars, which means that a rising dollar may create a whole new set of debt crises. Just what the global economy needed.

Is there a policy moral to all this? One thing is that it’s really important for all of us that Mario Draghi at the European Central Bank and associates succeed in steering Europe away from a deflationary trap; the euro is their currency, but it turns out to be our problem. Mainly, though, this is another reason for the Fed to fight the urge to pretend that the crisis is over. Don’t raise rates until you see the whites of inflation’s eyes!

Fed Watch: Will the Dollar Impact US Growth?

Tim Duy:

Will the Dollar Impact US Growth?, by Tim Duy: A quick one while I wait for my flight at National. Scott Sumner argues that the strong dollar will not impact US growth. In response to a Washington Post story, he writes:

This is wrong, one should never reason from a price change. There are 4 primary reasons why the dollar might get stronger:

1. Tighter money in the US (falling NGDP growth expectations.)
2. Stronger economic growth in the US.
3. Weaker growth overseas.
4. Easier money overseas.

In my view the major factor at work today is easier money overseas. For instance, the ECB has recently raised its growth forecasts for 2015 and 2016, partly in response to the easier money policy adopted by the ECB (and perhaps partly due to lower oil prices—but again, that’s only bullish if the falling oil prices are due to more supply, not less demand–see below.) That sort of policy shift in Europe is probably expansionary for the US.

The initial point is correct - arguing from a price change is a risky proposition. Go to the underlying factors. But I think the next paragraph is a bit questionable. I think that the policy shift in Europe does reduce tail risk for the global economy, and is therefore a positive for the US economy (I suspect the Fed thinks so as well). But it reduces tail risk because ECB policy is supporting not one but two positive economic shocks - both falling oil and a rising falling Euro. And, all else equal, a rising falling euro means a stronger dollar, which means a negative for the US economy. Tail risk for Europe is reduced at a cost for the US economy (a cost that the Federal Reserve and US Treasury both seem willing to endure).

That said, all this means is that Sumner is right, you can't reason from a price change, but reasoning in a general equilibrium framework is very, very hard. Sumner gets closer here, but still I think falls short:

However NGDP growth forecasts in the Hypermind market have trended slightly lower in the past couple of months. Unfortunately, this market is still much too small and illiquid to draw any strong conclusions. Things will improve when the iPredict futures market is also up and running, and even more when the Fed creates and subsidizes a NGDP prediction market. But that’s still a few years away. Nonetheless, let’s assume Hypermind is correct. Then perhaps money in the US has gotten slightly tighter, and perhaps this will cause growth to slow a bit. But in that case the cause of the slower growth would be tighter money, not a stronger dollar.

So let's try to close the circle - not only can't you reason from a price change, but also you need to pay attention to the entire constellation of prices. If ECB policy - and, by extension, the falling euro - was a net positive for the US economy, shouldn't we expect higher long US interest rates? But long US rates continue to hover around 2%, which seems crazy given the Fed's stated intention to start raising rates. Consider, however, that the stronger dollar does in fact represent tighter monetary conditions, but long interest rates are falling, which acts as a counterbalance by loosening financial conditions. Essentially, markets are anticipating that the stronger dollar saps US growth, but the Fed will respond with a slower pace of policy normalization, which acts in the opposite direction. So the stronger dollar does negatively impact growth, but market participants expect a monetary offset.

Hence - and I think Sumner would agree with this - the ball is in the Federal Reserve's court. The stronger dollar is a negative for the US economy, while the expected impact on monetary policy is a positive. The net impact is neutral. You should anticipate a stronger domestic economy offset by a larger trade deficit.

That is, of course, assuming the Federal Reserve takes sufficient note of the rising dollar, and its impact on inflation, by lowering the expected path of short term interest rates. And perhaps this is exactly what is revealed in next week's Summary of Economic Projections. Look for the possibility next week that the Fed is both hawkish - by opening the door for a June hike - and dovish - by lowering the median rate projections in the dot plot.

Update: I see Paul Krugman is lamenting the possibility that some FOMC members interpret falling interest rates as reason to tighten policy more aggressively - a view primarily outlined by New York Federal Reserve President William Dudley. My read of the bond market implies that market participants expect the opposite - the Fed needs to accept additional financial accommodation. That said, Dudley's stance clearly opens the door to the possibility of the Fed running an excessively tight policy stance, which wouldn't happen if they took their inflation target seriously.

'No Guarantees, No Trade!'

Friederike Niepmann and Tim Schmidt-Eisenlohr of the NY Fed's Liberty Street Economics blog:

 No Guarantees, No Trade!: World trade fell 20 percent relative to world GDP in 2008 and 2009. Since then, there has been much debate about the role of trade finance in the Great Trade Collapse. Distress in the financial sector can have a strong impact on international trade because exporters require additional working capital and rely on specific financial products, in particular letters of credit, to cope with risks when selling abroad. In this post, which is based on a recent Staff Report, we shed new light on the link between finance and trade, showing that changes in banks’ supply of letters of credit have economically significant effects on firms’ export behavior. Our research suggests that trade finance helps explain the drop in exports in 2008–2009, especially to smaller and poorer markets. ...

Paul Krugman: What Greece Won

How well did Greece do?:

What Greece Won, by Paul Krugman, Commentary, NY Times: Last week, after much drama, the new Greek government reached a deal with its creditors. ... So how did it go?

Well, if you were to believe many of the news reports and opinion pieces of the past few days, you’d think that it was a disaster... Some factions within Syriza apparently think so, too. But it wasn’t. ... Greece came out of the negotiations pretty well, although the big fights are still to come. ...

To make sense of what happened, you need to understand that the main issue of contention involves just one number: the size of the Greek primary surplus, the difference between government revenues and government expenditures not counting interest on the debt. The primary surplus measures the resources that Greece is actually transferring to its creditors. ...

Syriza has always been clear that it intends to keep running a modest primary surplus. If you are angry that the negotiations didn’t make room for a full reversal of austerity, a turn toward Keynesian fiscal stimulus, you weren’t paying attention.

The question instead was whether Greece would be forced to impose still more austerity. The previous Greek government had agreed to a program under which the primary surplus would triple over the next few years, at immense cost to the nation...

Why would any government agree to such a thing? Fear ... that the creditors would cut off their cash flow or, worse yet, implode their banking system if they balked at ever-harsher budget cuts.

So did the current Greek government back down and agree to aim for those economy-busting surpluses? No, it didn’t. In fact, Greece won new flexibility for this year, and the language about future surpluses was obscure. ... And the creditors ... made financing available to carry Greece through the next few months. ...

Why, then, all the negative reporting..., nothing that just happened justifies the pervasive rhetoric of failure. Actually, my sense is that we’re seeing an unholy alliance here between left-leaning writers with unrealistic expectations and the business press, which likes the story of Greek debacle because that’s what is supposed to happen to uppity debtors. But there was no debacle. Provisionally, at least, Greece seems to have ended the cycle of ever-more-savage austerity..., the first real debtor revolt against austerity is off to a decent start, even if nobody believes it. What’s the Greek for “Keep calm and carry on”?

'If China Stops Manipulation, Its Currency Will Depreciate'

Jeff Frankel:

If China Stops Manipulation, Its Currency Will Depreciate: A rare issue on which the two parties in the US Congress agree is the problem of “currency manipulation,” especially on the part of China. Perhaps spurred by the 2014 appreciation of the dollar and the first signs of a resulting loss of American net exports, Congress is once again considering legislation to attack currencies that are seen as unfairly undervalued. The proposed measures include the threat of countervailing duties against imports from offending countries, although that would be inconsistent with international trading rules.

Even if one accepts the possibility of identifying a currency that is manipulated, however, China no longer qualifies. Under recent conditions, if China allowed its currency to float freely, without intervention, the renminbi would more likely depreciate against the dollar than appreciate. US producers would then find it harder to compete on international markets, not easier. ...

Dean Baker tweets:

this assumes that only flows affect currency values and not stocks. The fact China holds close to $4tr in reserves likely matters

'Greece Did OK'

How did Greece do? Paul Krugman says:

Greece Did OK: Now that the dust has settled a bit, we can look calmly at the deal — if it really is a deal that survives through tomorrow, which some people doubt. And it’s increasingly clear that Greece came out in significantly better shape, at least for now.

The main action, always, involves the Greek primary surplus — how much more will they need to raise in revenue than they can spend on things other than interest? The question these past few days would be whether the Greeks would be forced into agreeing to aim for very high primary surpluses under the threat of being pushed into immediate crisis. And they weren’t. ...

Right now, Greece has avoided a credit cutoff, and worse yet an ECB move to pull the plug on its banks, and it has done so while getting the 2015 primary surplus target effectively waived.

The next step will come four months from now, when Greece makes its serious pitch for lower surpluses in future years. We don’t know how that will go. But nothing that just happened weakens the Greek position in that future round. ...

So Greece has won relaxed conditions for this year, and breathing room in the run-up to the bigger fight ahead. Could be worse.

Paul Krugman: Weimar on the Aegean

The lesson of Weimar Germany is different than many people think:

Weimar on the Aegean, by Paul Krugman, Commentary, NY Times: Try to talk about the policies we need in a depressed world economy, and someone is sure to counter with the specter of Weimar Germany, supposedly an object lesson in the dangers of budget deficits and monetary expansion. But the history of Germany after World War I is almost always cited in a curiously selective way. We hear endlessly about the hyperinflation of 1923, when people carted around wheelbarrows full of cash, but we never hear about the much more relevant deflation of the early 1930s, as the government of Chancellor Brüning — having learned the wrong lessons — tried to defend Germany’s peg to gold with tight money and harsh austerity.

And what about what happened before the hyperinflation, when the victorious Allies tried to force Germany to pay huge reparations? ... In the end, and inevitably, the actual sums collected from Germany fell far short of Allied demands. But the attempt to levy tribute... — incredibly, France actually invaded and occupied the Ruhr, Germany’s industrial heartland, in an effort to extract payment — crippled German democracy and poisoned relations with its neighbors.

Which brings us to the confrontation between Greece and its creditors. ... Greece cannot pay its debts in full. Austerity has devastated its economy as thoroughly as military defeat devastated Germany...

Despite this catastrophe, Greece is making payments to its creditors ... of around 1.5 percent of G.D.P. And the new Greek government is willing to keep running that surplus. What it is not willing to do is meet creditor demands that it triple the surplus..., cuts have already driven Greece into a deep depression...

What would happen if Greece were simply to refuse to pay? Well, 21st-century European nations don’t use their armies as bill collectors. But there are other forms of coercion. We now know that in 2010 the European Central Bank threatened, in effect, to collapse the Irish banking system unless Dublin agreed to an International Monetary Fund program.

The threat of something similar hangs implicitly over Greece, although my hope is that the central bank ... wouldn’t go along.

In any case, European creditors should realize that flexibility — giving Greece a chance to recover — is in their own interests. They may not like the new leftist government, but it’s a duly elected government whose leaders are ... sincerely committed to democratic ideals. Europe could do a lot worse — and if the creditors are vengeful, it will.

Paul Krugman: A Game of Chicken

Europe is playing a dangerous game:

A Game of Chicken, by Paul Krugman, Commentary, NY Times: On Wednesday, the European Central Bank announced that it would no longer accept Greek government debt as collateral for loans. This move, it turns out, was more symbolic than substantive. Still, the moment of truth is clearly approaching.

And it’s a moment of truth not just for Greece, but for the whole of Europe — and, in particular, for the central bank, which may soon have to decide whom it really works for.

Basically, the current situation may be summarized with the following... Germany is demanding that Greece keep trying to pay its debts in full by imposing incredibly harsh austerity. The implied threat if Greece refuses is that the central bank will cut off the support it gives to Greek banks, which is what Wednesday’s move sounded like but wasn’t. And that would wreak havoc with Greece’s already terrible economy.

Yet pulling the plug on Greece would pose enormous risks, not just to Europe’s economy, but to the whole European project... What we’re looking at here is, in short, a very dangerous confrontation. ..., how much more can Greece take? Clearly, it can’t pay the debt in full; that’s obvious to anyone who has done the math.

Unfortunately, German politicians have never explained the math to their constituents. Instead, they’ve taken the lazy path: moralizing about the irresponsibility of borrowers, declaring that debts must and will be paid in full, playing into stereotypes about shiftless southern Europeans. And now that the Greek electorate has finally declared that it can take no more, German officials just keep repeating the same old lines. ...

Furthermore, there’s still reason to hope that the European Central Bank will refuse to play along.

On Wednesday, the central bank made an announcement that sounded like severe punishment for Greece, but wasn’t, because it left the really important channel of support for Greek banks (Emergency Liquidity Assistance — don’t ask) in place. So it was more of a wake-up call than anything else, and arguably it was as much a wake-up call for Germany as it was for Greece.

And what if the Germans don’t wake up? In that case we can hope that the central bank takes a stand and declares that its proper role is to do all it can to safeguard Europe’s economy and democratic institutions — not to act as Germany’s debt collector. As I said, we’re rapidly approaching a moment of truth.

US/Euro Foreign Exchange Rate

“A strong dollar has always been a good thing for the United States,” Treasury Secretary Jacob J. Lew declared not long ago, a position that he has restated frequently.

In 2011, Timothy F. Geithner, then the Treasury secretary, said, “A strong dollar will always be in the interest of the United States.”

But is it really a good thing — for the United States and the global economy?

A Tale of Two Pegs

Paul Krugman on the independence of central banks from the concerns of "hard-money types":

A Tale of Two Pegs: I’m still in Hong Kong, and ... by the numbers Switzerland’s monetary situation pre-collapse and Hong Kong’s now look remarkably similar. ... So is the Hong Kong dollar at risk of a franc-like event?

No, it isn’t. There’s not a hint of pressure to drop the currency board. Why is Hong Kong different?

The answer, I’d argue, is that the institutional setup and history of Hong Kong plays very differently with hard-money ideologues than the Swiss peg did... Swiss currency intervention looked to the usual suspects like activist monetary policy, runaway expansion of the central bank’s balance sheet, “printing money” to debase the currency even if the goal was to keep it from getting stronger. Meanwhile, Hong Kong has a currency board, which is the next best thing to the gold standard, so maintaining the peg — through the very same mechanisms Switzerland was using! — became a demonstration of stern Victorian monetary virtue. Hence no chorus demanding that the peg be abandoned.

Remember, there was no forcing event in Switzerland; as far as the finances go, the SNB could have maintained the peg forever. It was the nagging from hard-money types that led to the debacle. Meanwhile, Hong Kong has managed to wrap the very same policy in libertarian clothes, and there’s no problem.

Paul Krugman: Francs, Fear and Folly

 A lesson to be learned:

Francs, Fear and Folly, by Paul Krugman, Commentary, NY Times: ...On Thursday the Swiss National Bank, the equivalent of the Federal Reserve, shocked the financial world with a double whammy, simultaneously abandoning its policy of pegging the Swiss franc to the euro and cutting the interest rate it pays on bank reserves to minus, that’s right, minus 0.75 percent. Market turmoil ensued.

And you should feel a shiver of fear, even if you don’t have any direct financial stake in the value of the franc. For Switzerland’s monetary travails illustrate in miniature just how hard it is to fight the deflationary vortex now dragging down much of the world economy. ...

If you ask me, the Swiss just made a big mistake. But frankly — francly? — the fate of Switzerland isn’t the important issue. What’s important, instead, is the demonstration of just how hard it is to fight the deflationary forces that are now afflicting much of the world — not just Europe and Japan, but quite possibly China too. And while America has had a pretty good run the past few quarters, it would be foolish to assume that we’re immune.

What this says is that you really, really shouldn’t let yourself get too close to deflation — you might fall in, and then it’s extremely hard to get out. This is one reason that slashing government spending in a depressed economy is such a bad idea: It’s not just the immediate cost in lost jobs, but the increased risk of getting caught in a deflationary trap.

It’s also a reason to be very cautious about raising interest rates when you have low inflation, even if you don’t think deflation is imminent. Right now serious people — the same serious people who decided, wrongly, that 2010 was the year we should pivot from jobs to deficits — seem to be arriving at a consensus that the Fed should start hiking very soon. But why? There’s no sign of accelerating inflation in the actual data, and market indicators of expected inflation are plunging, suggesting that investors see deflationary risk even if the Fed doesn’t.

And I share that market concern. If the U.S. recovery weakens, either through contagion from troubles abroad or because our own fundamentals aren’t as strong as we think, tightening monetary policy could all too easily prove to be an act of utter folly.

So let’s learn from the Swiss. They’ve been careful; they’ve maintained sound money for generations. And now they’re paying the price.

More here.