Thursday, 25 September 2014

Competitive exchange rates

This is a non-concept apparently, and I'd really like to know why.

Economics is my day job and I'll tackle just about anything but definitely not macroeconomic theory, because I know almost nothing about it for reasons we don't need to explore.

From this position of utter ignorance, I'd really love to know why we shouldn't care about the exchange rate. Because my very crude argument suggests there is at least an arguable case for the RBNZ to lean against the exchange rate. It goes like this.

  1. Suppressing the exchange rate is feasible. We would go bust very quickly if we tried to pump up the $NZ, but we could keep it low for an extended period if we wanted.
  2. It would expand the scope of the non-traded sector. At the margin, there would be more kiwis doing productive work here, because they'd be more competitive with foreign producers.
  3. The tradable sector would benefit, for obvious reasons. 

The price of imports would rise of course. That is a negative. But its not a-priori obvious why it exceeds the benefits.


  1. John.

    On 1. It's not so clear. The RBNZ has an unlimited supply of NZD with which it can buy foreign currency in order to drive down the value of the NZD. But that doesn't stop foreign currency markets taking the offsetting position if they think the ER is correctly valued (in terms of uncovered interest rate parity). It is true by definition that the net capital inflow equals I-S + G-T. If the gross outflow from the RBNZ is not exactly offset by an increase in the gross inflow, then the intervention will need to have reduced I or G or increased S or T. It is not clear why that would happen.

    2. If successful in reducing I (the most likely reason for being able to stem the capital inflow), yes resources would likely switch from producing for I to producing for exports and local consumption, but why that means there would be more kiwis doing productive work rather than there would be a switch in the productive work they are doing is unclear to me.

    3 and the comment after 3. Absent an identified market failure, one might expect that prices are allocating resources to their most productive use. Any policy that redirects resources will imply benefits where the resources go to and costs where the resources come from. If the onus is not on a policy proposer to identify what the failure is that causes the resources to be poorly allocated in the first place, any argument can be made. "Yes there would be a cost to other sectors if we heavily subsidised the NZ banana-growing-in-greenhouse industry but it is not a priori obvious why the costs outweigh the benefits."

    Finally, note that a massive creation of NZD to buy foreign currency will by the definition of a trade result in an equal and opposite position taken by others even if it is not offsetting in the effect on the exchange rate. This sudden increase in holdings of NZ currency would surely imply a massive expansion of aggregate demand in NZ. Maybe that would have good effects, but if so it would be because monetary policy is too tight and expansion would be a good thing. Why even bother with a round-about expansion via the foreign exchange markets when the RBNZ could conduct expansionary policy by lowering the OCR in the normal fashion.

    Bottom line: the exchange rate is an endogenously determined price, that perfectly matches willing buyers to willing sellers. If there is something wrong with that price, it must mean that there is something wrong with the underlying supply or demand. One needs to identify what that problem is and address it directly to avoid treating the symptom rather than the disease.

  2. Thanks Seamus.

    Picking up your last point first, you've left open the possibility that the exchange rate is over-valued, so lets assume the RBNZ is correct and it is indeed over-valued.

    You say they should not attempt to correct this problem directly because its not the real problem, just a symptom of something realer. I think you're saying that they should instead cut the OCR interest rate.

    The effects of these two tools (selling $nz and cutting the OCR) are not the same, so isn't there actually an open question as to which tool would be more effective/desirable overall?

    The exchange rate affects the prices of all traded goods/services, whether or not there is a borrow/lend aspect to the trade that would be affected by the OCR. Cutting the OCR just seems an odd and roundabout way of fixing an over-valued exchange rate.

    Incidentally, please don't get the idea that I'm arguing for the RBNZ to take any particular action regarding the $nz. I'm a big fan of cost-benefit analysis for decisions of this kind and I haven't seen one.

    I am just trying to understand your twitter comment from yesterday, which I took to mean that RBNZ shouldn't even be thinking about the competitiveness effect of the exchange rate. To be frank, this sounds like thought policing. As if you really really hope they never take the idea seriously enough to investigate.

    Yet your comment above recognises there are costs and benefits and doesn't come anywhere near proving that its always and everywhere a bad idea to consider intervening in the forex market.

    So I'm still puzzled as to why leaning against the exchange rate is so obviously such a bad idea that we should never even consider it.

  3. John. Starting from the top. I wasn't thinking so much that the high E.R. might be a symptom of too-tight monetary policy. I was thinking that the most likely problem that some might address is that our savings rate is too low. That seemed to be the gist of Labour's ideas on monetary policy, for example, although it became incoherent when their policy to address the *level* of the ER was to allow the RBNZ to change the *variance* of the kiwisaver contribution rate. In any event, if low savings is a problem, ie if by some criterion the choices individual NZers are making about the tradeoff between consumption now and consumption in the future are inappropriate, the way to deal with that is by addressing savings directly, not intervening in the currency markets.

    I raised the possibility of expansionary monetary policy. I don't see any evidence that monetary policy has been too tight in NZ recently, but I was simply saying that direct intervention to drive the NZD down is expansionary monetary policy, which *if* that was thought to be optimal could be achieved through conventional policy without the need to second guess the markets.

    Now *if* (and I will grant that this if is, or should be, the crux of the debate), the markets are getting the ER right (in terms of setting it at a level where the risk-adjusted expected rate of return is the same across countries), then the ER will be at the right level to allocate resources given the excessively low savings rate, excessively high investment rate, excessively tight monetary policy, or whatever is considered the underlying problem of which the high ER is the problem. And addressing that problem directly will have an impact on the ER exactly to the extend needed to redirect resources to the new environment. If the corrective policy is to indulge in expansionary monetary policy, better to use the conventional small-adjustment at a time short-term interest rate tool that the RBNZ has, and leave the interplay of S&D to determine how best to allocate that expansion of demand across different sectors including tradeables.

  4. And continuing, as the previous comment was going to exceed the character limit:

    Now back to the "if". I stated that if the ER is set correctly in terms of equalising risk-adjusted rates of return, that will be the socially optimal level, conditional on whatever structural problems (like low savings, etc.) are present but not addressed. This is because I can't see any particular externality in exchange markets that would suggest that the private optimum is not the social optimum. But the "if" does leave open the possibility that the markets have the ER wrong, and that the market makers are going to lose money. I can see a coherent argument for the RNBZ intervening direclty in the markets if
    a) they think this is the case
    b) they think that their intervention will make the markets come to their collective senses and not just offset their efforts,
    c) they think that bursting this bubble now will be better for the NZ economy than letting it burst later.
    A lot of the RBNZ piece you linked to originally was about justifying a). Eric and Matt suggested that they may have underestimated the ongoing effect of the ChCh rebuild. I don't have an opinion, but I have never been one to want to put my own money on the line based on confidence that I have read the tea leaves better than everyone else. I really don't have a view on b) at all; I just don't know enough about the actual workings of finance markets. On c), I can see a story in which the I-S gap in NZ is funded mainly by short-term portfolio investment from overseas, with the possibility of an I crunch at some point in the future if there is a sudden ER crash when the short-term lending suddenly dries up. That was the point of my tweet that I would feel happier if we saw more FDI rather than portfolio investment, which is why I am happy to see foreign purchases of NZ farms. But I didn't see a justification along these lines in the RBNZ document, and a) and b) are not sufficient to justify intervention in my mind, given what I think is the well-documented failure of central banks to achieve anything with direct currency-market interventions in the past.

    Which brings me to "competitiveness". Yes, I can see it sounds like "thought policing". The ratio of flippancy to nuance rises (at least in my case) along the continuum from academic paper to blog post to tweet. One can talk about the lack of competitiveness of a particular sector of the economy if underlying fundamentals are operating through prices to direct resources away from that sector to others. But it is meaningless to talk about the competitiveness of the economy. I don't think the RBNZ were doing the latter, but the general public tend to use the word when guilty of the mercantalist fallacy, and so I wish economists would abandon the word from their lexicon altogether, lest they fuel the fallacy still further.

  5. Thanks Seamus - that's very interesting.

    Good luck in expunging 'competitiveness' from the lexicon because its probably the most fundamental concept in everyday firm/market settings. Along with its corollary, the market power we all seek.

    Our everyday business experience also makes it quite natural to think of NZ as a single entity that can and should be seeking an edge in world markets. And based on what happened to the $nz yesterday (which was just a threat, not action) many would question your view that central banks have failed to achieve anything in forex markets. They might also point to China's apparently successful strategy in recent years.

    It is obvious I think that deliberately suppressing the currency is equivalent to a particular form of trade protection. Maybe this is the real reason we're not supposed to consider it. But again the micro-analogy is troublesome: firms get to choose their own boundaries - what is traded and what is done internally - but countries should not apparently.

    Anyway, thanks for engaging on this - I've learned a lot.

  6. John. Absolutely, "competitveness" is fundamental in firm/market settings. And therein lies the problem. I have often thought that if I were teaching a course in trade, the first lecture would start with the statement that a firm is a poor metaphor for a country. A household is a much better one.

  7. Jeez, it's such a big topic, where do you begin. And FWIW this used to be MY day job in the dim and distant.
    Two quick thoughts. I do have some sympathy for using 'competitive', if it means in this context (and it usually does) an exchange rate where exporters can earn at least a normal profit. And the XR won't always allow that, since it's the outcome of more than trade flows, and what suits the traders might or might not suit the investors/speculators.
    Re #1 I'm not convinced that a policy of systematic debasing of the XR does exporters any good in the long run, partly on theoretical grounds (because there are so many ways the 'benefit' gets clawed back, inc via higher input costs), and partly on experience. The managed (downwards) float of the NZ$ in Muldoon's day for example did sweet FA for the trade balance or exporters' fundamental competitiveness. Conversely the steady rise of the yen in the 80s forced Japanese companies to become more efficient, to their lasting benefit