Monetary Chicken

[kirisutogomen]

treptoplax asked me if we're playing Chicken, and if anyone's actually behind the wheel.

Today's topic is the price of money. Eh? The price of money? That doesn't sound right. OK, I'm referring to exchange rates -- effectively, the price of money. Money is a fairly abstract concept, and the idea of there being a price of money in terms of other money admittedly sounds abstruse. Is it relevant to us, or is it just an interesting topic for discussion?

Even if you don't take trips abroad, or work for a major exporter, there are secondary effects from exchange rates on your life. We all buy imported products (e.g., gasoline), and the prices of competing domestic goods are strongly affected by the prices of imports. Interest rates affect what we earn on savings or pay for lending. The status of the dollar as the global reserve currency allows the government to borrow very cheaply, and that affects the taxes we pay. This stuff matters to us, and I think we ought to be informed, especially as so many of our elected leaders seem to have no clue.

I'm going to hit some points of exchange rate theory, and then move on to the specifics of our current monetary situation. treptoplax specifically asked about the monetary policy of the US vs. China, so I'll mention some about that. I'm not going to make much effort to include up-to-date currency conversion rates, but you can consult a forex converter if you're hungry for realtime quotes.

There are two main schools of thought regarding the determination of exchange rates in the short run. Fortunately, one of them is a traditional, mostly obsolete approach, and economists only disagree on some details of the modern approach. Exchange rates in the long run are a slightly woolier area, but there are certainly some concrete things we can talk about. Defining the distinction between the short run and the long run is an especially vague area.

The traditional approach to short-run exchange rate movements is based on a balance of payments approach. We import goods and export goods. When we import goods, we've got dollars, but we're buying from people who want money denominated in a foreign currency (I'm going to call it yuan for convenience). When we export goods, the buyers have yuan but we want dollars. In both cases, there's going to have to be some currency conversion. Summing the effects, let's say the US is a net importer from China. There's a bunch of dollars that need converting into yuan. However this is done, whether through American banks or Chinese banks, you've got extra supply of dollars and extra demand for yuan. This naturally drives the value of the dollar down vs. the yuan.

The modern approach, or asset approach, focuses on the relative rates of return on money deposits, and depends on a concept called interest rate parity. The basic idea is that you shouldn't be able to make free money. If I hold an interest-bearing demand depoist account in Japan (I'll get to China later), I should make the same amount of money as I would if I held balances in the US.

Currently, short-term rates in the US are around 2.37%, and in Japan you can get a whopping 0.02%. So why would anyone keep any yen? Just borrow your yen at nearly zero,
exchange it for dollars, and deposit into a US money market account. Assuming you're a big commercial bank or other high-credit rating outfit, you ought to be able to do this for arbitrarily enormous quantities and make free money.

The strategy as outlined is risky, however. You've got no guarantee that you'll be able to convert those dollars back into yen at the same rate you bought them at. If the dollar collapses while you're doing this, you could be toast. Fortunately, there's a solution. You can perfectly hedge your currency risk. Capital markets include currency forward contracts, which are simply a promise to buy currency X using currency Y at a specific future date and at a fixed price.

The trick is that this fixed price isn't the same as the current exchange rate. In fact, it's going to be at a value that precisely cancels the difference in returns on your short-term deposits. I.E., if a dollar is 104 yen now, and dollar deposits pay 2.35% more than yen depoists, you can only exchange December '05 dollars at 104/1.0235 yen per dollar. Now your returns on dollar deposits will be identical to returns on yen deposits.

The logic of interest rate parity works in both directions -- a change in relative interest rates can drive a change in currency values, and vice versa.

So, what about China? Well, the Chinese have chosen to fix their currency against the dollar. The Bank of China promises that you can buy yuan from them or sell yuan to them at 8.28 to the dollar. Now what happens?

If the US is a massive net importer from China, the traditional theory would imply that the dollar would drop against the yuan. China, however, prevents this, by issuing yuan to buy up alll the extra dollars. They've been forced to do this to where the Bank of China now holds half a trillion US dollars.

The modern theory implies that if the exchange rate is fixed, short-term rates are going to be identical. In fact Chinese rates are slightly higher than US rates (about 3%), as China does not have an absolutely perfect credit rating (a distinction belonging solely to the US government). It's close enough, though.

OK, now on to long-term exchange rates. The foundation of long-run expectations is the concept of purchasing power parity, or the Law of One Price. If we assume a good which can be costlessly teleported from the US to China (or vice versa), the price in yuan should be exactly equivalent to the price in dollars. Obviously, we're not teleporting anything, which is why this is a long-term phenomenon. All those extra costs will slow down the trend towards equalizing prices. The adjustment takes place via both changes in the prices of goods and exchage rate movements.

My favorite measure of PPP is the Big Mac Index (invented by The Economist, and discussed in an little flyer from the St. Louis Fed, including more academic references). Currently a Big Mac is $3.00 in the US and $1.26 in China. The implication would be that the yuan is 58% undervalued relative to the dollar. This correlates well with the balance of payments situation; the Chinese central bank is frantically snapping up dollars to prevent the yuan from rising against the dollar, implying that the yuan is underalued. (In contrast, however, the prices of Starbucks tall lattes are identical in China and the US.) More rigorously, the OECD maintains a PPP department with a lot more numbers.

I promise, there's only a little more theory.

Some secondary factors adjust our expectations, whether based on balance of payments, interest rate parity, or purchasing power parity.

Relative inflationary expectations are important. The currency with the higher expected inflation will have the weaker currency. Price inflation in the US is running at around 3%, while in China it's running at about 4.5%. (Right here I should emphasize that Chinese economic statistics should usually be taken with a lot of NaCl. They're not very good at collecting the numbers, and also tend to mildly distort them.) The relevant variable is a change in relative expectations. If China's state-owned banks are lending money with abandon (which they are), that will fuel inflation. If the Federal Reserve is raising the fed funds rate, inflationary expectations here are more moderate.

Trade barriers are sometimes a strong driver of exchange rates. They're generally only significant if one country is raising or lowering barriers while the other is not. A "trade war" isn't a powerful influence on forex rates, but if the US drops barriers to import of Chinese textiles, that will drive the dollar lower vs. the yuan.

Changes in personal preferences are occasionally of interest. If all of a sudden Chinese green zinfandel is all the rage, and everyone in the US drinks a bottle every day, the dollar will naturally devalue vs. the yuan.

National productivity is key. Poor countries like China tend to have much higher productivity growth than rich countries (the "catch-up effect"). That usually results in currency appreciation in the poor country vs. the rich world.

The money supply is carefully watched by exchange rate junkies. I can't get into the concepts here, but essentially, if the government is printing a pile of money, the exchange rate depreciates. The Chinese central bank is printing yuan like crazy in order to buy all the dollars I mentioned before.

OK, so what does all this actually mean for our current situation?

Very few countries actually just let their currency float, i.e., be determined entirely by market forces. Most rich nations use what's called a dirty float, and their central banks regularly intervene in the foreign exchange market to manage their currency. The New York Federal Reserve Bank is the entity that we use for this purpose. As I mentioned, intervention can expand or contract the money supply quite a bit, which could create undesirable inflation or deflation. Often central banks will engage in what's called sterilization, in which they counteract the money supply effects of their intervention. As it turns out, though, while sterilized interventions happen a lot, it turns out that the evidence is that sterilizing an intervention essentially negates its effect on your currency as well as domestic inflation.

The Chinese have pegged their currency to the dollar. What happens then? Well, one effect is that China has decided to surrender a lot of control of their monetary policy to the United States. As long as Chinese short-term rates are required to move more or less synchronously with dollar rates, the Bank of China has to change the money supply to maintain those interest rates. Developing countries have often chosen to peg their currencies, especially if their central bank has no credibility in fighting inflation. In an extreme example, Ecuador has actually abolished their currency and converted their entire economy to US dollars. If the yuan were to float, and the markets did not have confidence in the Bank of China's inflation-fighting credentials, that could create unnecessarily high costs of funds for Chinese borrowing. As long as Chinese money supply growth is determined
by Alan Greenspan, there's a simplicity and predictability that wouldn't exist with discretionary monetary policy.

Developing countries have often chosen to deliberately peg their currencies at less than what the fair market value would actually be. This gives an artificial stimulus to major export industries, which is often believed to be important in rapid industrialization during the period while the domestic market has limited demand for higher-end products.

There are some major problems, however, with the Chinese currency peg. One is that they've now tied the fortunes of their economy to ours. If our economy is weak, and we cut interest rates down to very low levels, China is forced to do the same, even if their economy is booming. That can create all sorts of economic problems; for example, the artificially low rates encourage overborrowing, and investment in projects with expected returns that should be considered inadequate in a rapidly developing nation.

Another problem with currency pegs in general is that if world forex markets consider your currency to be overvalued, they'll attack your currency. If you're in the opposite position from where China is right now, and instead of issuing yuan to buy dollars, you're selling dollars to buy yuan, you're limited by how many dollars you've got. Once the central bank runs out of foreign currency reserves, the peg collapses. If the markets think that this is a reasonable possibility, they will accelerate the process, by madly selling your currency back to you until you run out of reserves, and your peg falls apart, and the traders make giant piles of money. This happens fairly often, and while it's not a problem at the moment for China, it could be if they decide to revalue the yuan and repeg it at a higher rate.

OK, so what? Well, the US is in a unique position, as our currency is the global reserve asset of choice. I'm not going to get into the Bretton Woods agreement, but I'll just mention that gold used to be the global reserve asset of choice, and central banks still hold a lot of gold, but after Nixon ditched the gold standard, and we passed through a few years of wild and crazy adjustment, everyone noticed that gold doesn't pay interest, and government debt does.

In a pure float, your central bank theoretically wouldn't need any foreign currency reserves, but hardly anyone is willing to give up at least some tools for exchange rate management. A bank (such as the Bank of Japan) using a dirty float needs dollar reserves to intervene in the forex markets, and a country employing a peg needs lot of reserves to defend their currency if necessary. This is especially true if you're using a currency board, and obviously indispensable if you've given up and just switched to dollars (a la Ecuador).

As it is, the US is the dominant economy on the planet (although less so than a few decades ago) and as such our dollar is the one true reserve currency. This is a big advantage for us, as it means that we can fund very big budget deficits and trade deficits; central banks around the world will buy hundreds of billions of dollars of our debt, which simultaneously soaks up lots of extra dollars generated by our massive net imports. With this comes much lower interest rates than we would otherwise face, which cuts government spending on making those interest payments, and stimulates the economy by making it more attractive to borrow.

The problem with this is that we're exploiting these advantages to the fullest, and more. Consumer borrowing is sky high, as is government borrowing. There's no sign of us cutting back on imports. Sooner or later this causes the currency to start depreciating, and it's sooner. Actually, it's already happening. The dollar has been falling vs. both the euro and the yen for a few years now. It would have fallen farther against the yen, except that Japan has been buying zillions of dollars to stimulate exports. Eventually central banks are going to get sick of having their main reserve currency fall like a rock. Now that the euro exists, it's a plausible alternative. While Asia's economies are the fastest growing in the world, the yen is also a suitable replacement. If monetary authorities start to dump dollars, the recent decline could turn into a sickening plunge.

So, are we playing Chicken? Well, we're claiming that the dollar is still the only reasonable choice as a global reserve currency. Heck, we're still the 800 pound gorilla, and we've been growing much faster than either Europe or Japan (as I mentioned above, fast productivity growth supports your currency). We're increasing short-term rates, which ought to make the dollar more attractive as an investment. The Federal Reserve has the strongest inflation-fighting credentials in the world. Outside of the new members of the EU, nobody expects any major countries to peg their currencies against the euro or yen. Sure, we've got a big, big current-account deficit, but that's due to pathetic economic growth in Japan and Europe, and the export-promoting monetary policies of Japan and China. If China would just let the yuan be valued at a reasonable level, it would slash our trade deficit, and if Europe and Japan would stop dorking around and start getting richer at a civilized rate, they'd be able to afford to buy more of our stuff.

As long as we seem to believe that, it's credible that we'll just keep motoring along with what's implicitly a weak dollar policy, letting the rest of the world fund our spending. As long as China appears to believe that their severely undervalued peg won't cause a crisis due to inappropriately low interest rates, it's credible that they'll keep motoring along on their present course as well.

The twist is that we're not playing a classic two-player game of Chicken, because Japan is playing, too (using a similar argument as China), and Europe is sitting in a Volvo in the middle of the road. Who's going to swerve depends on how credible it is that we really believe what we say, and talk is cheap. It depends to a large extent on which of us is driving what kind of car, and whether we know what we're driving. My take is that we're driving a jacked-up Ford Excursion (it rolls over if you sneeze too hard), Japan is driving a sputtering big car with clouds of black smoke coming out the tailpipe, and China somehow got their hands on a Maserati. I think China believes that they're driving a turbocharged police cruiser, Europe trusts that Volvos are safe, and in a typically American fashion we figure that SUVs must be invincible because they're so big, so we're talking on our cell phone. (Japan knows what they're driving, and figures we're all going to swerve, and Europe will get out of the way.)

OK, I've probably carried the Chicken metaphor way too far. I've also been especially long-winded, even for me, so I'm just going to stop here.

Comments

[treptoplax.livejournal.com]

Ok, that mostly meshes with my half-baked economic understanding and intuition. You cleverly mostly avoided answering the question I meant to but didn't quite ask:

What's the failure mode?

Total collapse of the Chinese banking system, or world-wide economic depression, or both, seem plausible worst-case scenarios to me. Investors don't seem to believe that, which I mostly blame on the fact that people are stupid and round unlikely risks (like Tsunamis or LTCM failure) to zero probability before multiplying out the consequences, but...?

Small Poultry

[kirisutogomen.livejournal.com]

Total collapse of the Chinese banking system is not an entirely outlandish possibility. Their financial sector is still run with a socialist mentality; there's no concept of risk management or return on investment. Directing funds towards recipients currently in favor with the Party is still the culture.

Until that banking culture undergoes the standard-issue messy capitlaist overhaul, there's always the real possibility of a crisis. I expect the government would prevent a collapse by injecting hundreds of billions of dollars of fresh capital, which would prevent a complete self-immolation. It would also fuel inflation, and present serious moral hazard -- why change your lending practices if the government will bail you out?

Back in the late 1980s China mismanaged their money supply, and had to shoot their economy in the foot to prevent it from running off a cliff. Then a million pissed-off people went to protest at the Gate of Heavenly Peace, and we all know how well that turned out for everybody involved. If China ends up having to stomp on an inflationary spiral again, it's not going to spark war with Taiwan or anything, but they could have serious domestic strife, and would probably stop helping with North Korea (as if that situation could get any worse).

It's strange how people estimate very low probabilities. We're very bad at it. How much more likely are you to die in a plane crash compared with dying in an escalator accident? How do those probabilities compare with that of winning one of those multimillion dollar lotteries? I think we overestimate more than we underestimate, but I bet it depends on whether you're talking a 1-in-100 chance or a 1-in-1,000,000 chance. (We probably end up treating them both as 1-in-10,000 or something.)

World-wide economic depression is a lot less likely, obviously. We've only really had the one global depression, though, so it's hard to say. Arguably it was caused by monetary supply mismanagement, trade policy, and/or an asset price bubble. I might argue that our currency imbalances could be causing all three.

We're assuming that our excess liquidity will continue to get soaked up by central banks loading up on dollars, and China is printing as much money as it takes to maintain their dollar peg. If either or both backfire, we'll have a nasty bout of inflation. But inflation, while usually bad for economies, is very unlikely to cause a depression, unless it gets to hyperinflation status, which is not going to happen. We're dumb, but we're not that dumb.

If China insists on maintaining the currency peg and an abnormally high trade surplus vis-a-vis the US, there's a small but non-negligible chance that we'll have a protectionist spasm in response. Europe is instinctively protectionist as it is, and the rapid rise of the euro is making their exports much less competitive, which could also prompt a flurry of trade barriers. If we end up with a trade war between the three largest economic units, that could wreak absolute havoc.

As far as asset price bubbles go, the only real danger is from property prices. China is currently in the most danger here, although a disturbing number of rich countries are also riding the ragged edge, and Japan has demonstrated quite convincingly that if mismanaged, the aftereffects of a property mania can last for a long time (15 years and counting).

Other possibilities are less dramatic, but also potentially quite troublesome. If the dollar loses status as the reserve currency, it's fairly likely that there won't be a single replacement currency. It would be vaguely parallel to the collapse of the Bretton Woods framework; for most of the 1970s, there was economic instability of both inflationary and recessionary flavors all over the world. Of course, at the time there was also the problem of sudden spikes in the price of oil, which is not a problem we have this time ar...OK, forget I mentioned that.