Friday, October 15, 2010

QE2 and Begger Your Neighbor

I favor quantitative easing combined with a target for the growth path of money expenditures, in particular, final sales of domestic product. The Fed has seemed poised to undertake some quantitative easing along with an at least temporarily higher target for inflation. While I oppose having any target for inflation, it seems likely to me that a prompt return to any reasonable growth path for money expenditures would be associated with a temporary increase in inflation.

It is also likely that quantitative easing and these expectations of inflation (or greater real growth) will cause a depreciation of the dollar on foreign exchange markets. That the dollar did depreciate in response to Federal Reserve discussions of quantitative easing and inflation targets is no surprise.

Ceteris paribus, one of the pathways by which quantitative easing can result in an increase in money expenditures on domestic product is through a decrease in the exchange rate. Imports become more expensive, which tends to raise domestic demand for import-competing goods and services. Exports become cheaper to foreigners, raising their demand for domestically -produced goods and services. The "cost of living" is likely to increase, since that includes the prices of imported goods, but the rate of inflation on domestically produced goods will only rise due to anticipated excess demands for those products. That, of course, is the possible unfortunate side effect of returning money expenditures to a target growth path.

Again, ceteris paribus, this pathway for expanding money expenditures on domestic product has an adverse impact on money expenditures on foreign goods and services. As foreign products become more expensive in dollar terms, fewer of them are purchased. The foreigners export less. Similarly, as exports expand due to lower prices in terms of foreign currencies, at least some of those sales come at the expense of foreign producers.

Suppose the foreigners "retaliate" by their own quantitative easing. The exchange rates don't change after all, and so the "ceteris paribus" condition doesn't hold. Changes in the prices of imports and exports, and decreased imports and expanded exports are not a means by which money expenditures rise in any country. Instead, excess money balances are spent on all goods and services (domestic and foreign) and so every country would tend to both import more as its residents spend on foreign goods as well as domestically produced goods, and export more as foreigners spend more too.

Now, if there are some countries that already have sufficient money expenditures, then they should not undertake quantitative easing to keep their exchange rate from rising. No, they should only do what is needed to keep their money expenditures on target. An increase in their exchange rate, resulting in reduced exports and greater imports would help prevent the development of excess money expenditures in their economy. It would help relieve inflationary pressures.

So, why the worries about "beggar your neighbor?" Suppose it is 100 years ago, and the typical country is on the gold standard and small relative to the world economy. The key goal of monetary policy is to keep the domestic paper money redeemable for gold. If gold is flowing into a country, there is no problem in maintaining currency at par. The only "problem" that might develop (keeping in mind that inflation, unemployment and everything else is irrelevant to the one golden goal of monetary policy,) is that gold may flow out of the country, gold reserves may disappear, and then redeeming paper money with gold may become impossible.

If this sad state of affairs should develop, then the obvious and practical response is raise interest rates. These higher interest rates should attract foreign short term investment (a net capital inflow) which will slow, stop, or reverse the outflow of gold. The goal of monetary policy can be maintained.

Of course, using monetary policy to raise interest rates tends to slow the economy and perhaps results in a recession--money expenditures grow more slowly or shirk, sales fall, and production and employment fall. This unfortunate side effect of the policy to maintain redeemability can help, because by slowing real growth, the demand for foreign goods will tend to fall and so reduce the gold outflow.

The long run solution to the problem however, is for money incomes, particularly wages, to grow more slowly, or perhaps even shrink. This will improve the competitiveness of domestic industry. The result is an export led recovery, because unit costs for export industries are lower compared to the rest of the world, and further, as economic recovery leads to growing demand, less of that demand will be for imported goods because, again, the lower unit costs provides domestic producers with an improved competitive edge.

Now, rather than go through this painful approach described above, suppose a country decides to give its domestic industries the desired competitive edge by devaluation--raising the price of gold in terms of the domestic currency. Of course, this sacrifices the core goal of monetary policy--keeping the currency tied to gold at par. But will it provide the improved competitiveness?

By devaluing the currency, imports become more expensive and, from the point of view of foreigners, exported goods become cheaper. Domestic industries are given a competitive edge without slowing the growth of wages or reducing them. There is no need to raise interest rates and attract foreign investment. There is no need for the economy to slow.

Obviously, there are complications. With less gold being received for exports and more gold being paid for imports, it is possible that the gold outflow would accelerate. There is the J curve. And, of course, expectations of a devaluation will result in a gold outflow. But leave these issues aside for a moment.

What if other countries retaliate? Suppose they devalue their currencies as well? Then this competitive edge created by devaluation does not materialize. And so, devaluation does not result in the gold outflow being slowed, stopped, or reversed. The exchange rates between countries don't change, and so nothing much happens.

Ah.. but the "goal" of monetary policy, keeping the paper money on par has been violated, with no good purpose. Right? The world has fallen into a "beggar your neighbor" policy seeking to develop a favorable balance of trade (and nongold capital flows,) to build gold reserves at the rest of the world's expense, and it doesn't work. And each currency is devalued more and more. The horror!

But suppose there is no gold standard. And there is no goal of maintaining the gold redeemablity of paper money. If an exchange rate depreciates, there is no goal of obtaining gold or other foreign exchange to maintain redeemability. No, the goal is to maintain money expenditures on domestic product. In that world--the real world of today--there is no reason to worry that other countries might retaliate to quantitative easing by doing some themselves. Their quantitive easing helps by increasing their domestic purchases, at least some of which are your exported goods.

P.S. Later I will discuss the possibility that trading partners keep their currencies from appreciating by increasing their rate of accumulation of short term debt. (In other words, China responds to U.S. quantitative easing by accelerating their rate of purchase of U.S. Treasury bills.)


  1. I have been thinking something like this for the last week, but I couldn't state it so clearly and logically as this. The worries about what China will do if the Fed aggressively pursues quantitative easing are overblown.

  2. I like Dinar.and its revaluation of currency.

  3. You write that, for a small country on the gold standard: “The only ‘problem’ that might develop . . . is that gold may flow out of the country, gold reserves may disappear, and then redeeming paper money with gold may become impossible.” I wonder about the timing. Even if the central bank has plenty of gold in its vaults, when someone presents paper money for redemption in gold it will take them a few minutes to retrieve the gold from their vaults; the redemption will not be *instantaneous*. Now, suppose they have no gold in their vaults, but they do have other assets: bars of silver, pound sterling notes, or whatever. To get the gold to redeem notes of their national currency they have to engage in a transaction, buying gold in exchange for the asset they are holding. This may take longer than a few minutes. But perhaps it will not take *much* longer, and how long is *too* long? Suppose it took two weeks to get and deliver the gold; would it not suffice, to maintain the value of their paper currency, that they promised to redeem it for gold *within two weeks of its presentation*? If so, they would not have to hold any gold reserves. In short, I do not understand the fixation on gold reserves.

  4. "In that world--the real world of today--there is no reason to worry that other countries might retaliate to quantitative easing by doing some themselves."

    Sure there is. If you engage in QE and get your exchange rate down, your exports will have the advantage. If others engage in QE, their x-rate falls and your exports lose their advantage, their imports now gaining the advantage.

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