Category Archives: Exchange Rates

To fix or not to fix: Jeffry Frieden’s “Currency Politics”

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The decision by the Swiss National Bank to abandon its peg to the euro serves as an example of the relatively limited life spans of fixed exchange rate regimes. While the fragility of exchange rate commitments has been known since the publication of a 1995 paper by Obstfeld and Rogoff, the question of why some central banks fix the value of their currencies and others do not is less well understood. Jeffry Frieden’s Currency Politics provides a thoughtful guide to the political economy of exchange rate policy.

Frieden, the Stanfield Professor of International Peace at Harvard’s Department of Government, analyzes the decisions on the choice of exchange rate regime and also the level of the exchange rate. There is rarely a consensus within a country on these issues, and the position of the domestic parties depends on how they are affected by fluctuations in the exchange rate. The principal supporters of a fixed rate will be those who are exposed to substantial foreign exchange rate risk in their global activities, such as financial institutions and multinational corporations. Those who have borrowed in a foreign currency will also have a stake in keeping the domestic value of their debt fixed. Producers of tradable goods tied largely to world prices, such as commodities and standardized manufactured goods, will favor a depreciated exchange rate, as will those who use nontradable goods as inputs. While decisions over the choice of regime and the level of a currency’s value are conceptually separate, Frieden writes that the politics usually lead to a split between those who favor a fixed rate versus those who seek a depreciation.

Frieden tests these hypotheses with data from a range of historical experiences: the U.S. from the Civil War through the end of the 20th century, Europe during the period from the end of the Bretton Woods regime to the introduction of the euro, and Latin America from 1970 to 2010. He uses both qualitative and quantitative analysis in these sections of the book, and his use of data from the earlier periods is particularly skillful. The results show that a consideration of exchange rate-related issues sheds light on the divisions that exist over policies, and can lead to revised views of accepted versions of history.

In the case of the U.S., for example, Frieden breaks the post-Civil War era into the 1862-79 period, when the U.S. returned to the gold standard, and the period of 1880-96, when the gold standard came under attack from the Populist movement. In the first era, those business and financial interests who were most exposed to currency volatility sought to resume the linkage to gold that had been broken in order to finance the Civil War. They were opposed by tradable good producers, including many (but not all) manufacturers, farmers and miners. After 1873, the political divisions centered on whether the U.S. would go on a bimetallic standard of gold and silver, or base the dollar solely on gold. Frieden uses Congressional voting patterns to test whether economic divisions were reflected in Congressional voting on measures related to currency policy. The results generally confirm the influence of the interests he suggests were governing factors. For example, Congressional districts from New England and Pennsylvania, which included manufacturers who competed with foreign producers, were more likely to oppose measures that would return the U.S. to the gold standard. Similarly, representatives of farm products that were exported also opposed a return to gold, while other farming districts tended to support it.

The return of the U.S. to the gold standard in 1879 did not end the dispute. Falling agricultural prices prompted farmers to agitate for a bimetallic regime that would lead to a devaluation of the dollar. Miners concentrated in the Rocky Mountains also supported the use of silver. Manufacturers, on the other hand, abandoned the anti-gold movement as they were protected by high tariffs.  Frieden’s empirical analysis of votes on monetary measures between 1892-95 shows that debt, which has often been viewed as the source of farmers’ concerns, did not sway representatives to vote against gold; indeed, the districts with the largest debt levels were pro-gold. But representatives of export-oriented farm districts were more likely to vote against the gold standard. The People’s Party (the “Populists”) united the farmers, miners and other groups in supporting a bimetallic standard, and in 1896 joined the Democratic Party in supporting William Jennings Bryant for President. Bryant’s loss, followed by a second loss in 1900, signaled the end of organized opposition to the gold standard.

Frieden undertakes similar analyses of depreciation and variation in European exchange rates between 1973-94 and reports evidence supporting the argument that producers exposed to currency risk favored stability, while tradable producers preferred flexibility. Similarly, an analysis of the determinants of Latin American choices of exchange rate regime between 1960 and 2010 finds that the more open economies favor fixed exchange rates. However, manufacturers in the more open economies preferred flexibility.

Frieden convincingly demonstrates, therefore, that exchange rate policy is governed by distributional concerns. Different interests take opposing sides over whether a fixed or flexible regime will be chosen, and whether it will be used as a policy tool to favor domestic producers. The relative influence of the competing interest groups can change over time.  An increase in trade or financial openness, for example, can lead to a new alignment of parties.

Can these considerations be applied to the Swiss case? The dropping of the currency peg discomforted both those who favored a fixed rate and those who will be adversely affected by the subsequent appreciation. But the Swiss central bank must be concerned about the impact of the European Central Bank’s policy of quantitative easing, which would require further intervention and the accumulation of more foreign exchange. The Swiss move may be more of a tactical maneuver during a volatile period than a strategic change in policy. However, those Swiss firms who will see their profits from foreign sales plummet will not be quiescent about the new regime.

Here and There: Nov. 5, 2013

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  1. Jérémie Cohen-Sutton has a review at the Bruegel blog of the recent discussion regarding the impact of the choice of exchange rate regimes on economic performance. He provides links to the relevant posts.
  2. The IMF holds its Fourteenth Jacques Polak Annual Research Conference at its headquarters in Washington, DC on November 7-8, 2013. The program is here and there is a preview here.
  3. There is an informative summary at Twenty-Cent Paradigms of the discussion over Germany’s current account surplus.

Assigned Readings: October 9, 2013

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This paper investigates the potential impacts of the degree of divergence in open macroeconomic policies in the context of the trilemma hypothesis. Using an index that measures the relative policy divergence among the three trilemma policy choices, namely monetary independence, exchange rate stability, and financial openness, we find that emerging market countries have adopted trilemma policy combinations with the least degree of relative policy divergence in the last fifteen years. We also find that a developing or emerging market country with a higher degree of relative policy divergence is more likely to experience a currency or debt crisis. However, a developing or emerging market country with a higher degree of relative policy divergence tends to experience smaller output losses when it experiences a currency or banking crisis. Latin American crisis countries tended to reduce their financial integration in the aftermath of a crisis, while this is not the case for the Asian crisis countries. The Asian crisis countries tended to reduce the degree of relative policy divergence in the aftermath of the crisis, probably aiming at macroeconomic policies that are less prone to crises. The degree of relative policy divergence is affected by past crisis experiences – countries that experienced currency crisis or a currency-banking twin crisis tend to adopt a policy combination with a smaller degree of policy divergence.

 

A central result in international macroeconomics is that a government cannot simultaneously opt for open financial markets, fixed exchange rates, and monetary autonomy; rather, it is constrained to choosing no more than two of these three. In the wake of the Great Recession, however, there has been an effort to address macroeconomic challenges through intermediate measures, such as narrowly targeted capital controls or limited exchange rate flexibility. This paper addresses the question of whether these intermediate policies, which round the corners of the triangle representing the policy trilemma, afford a full measure of monetary policy autonomy. Our results confirm that extensive capital controls or floating exchange rates enable a country to have monetary autonomy, as suggested by the trilemma. Partial capital controls, however, do not generally enable a country to have greater monetary control than is the case with open capital accounts unless they are quite extensive. In contrast, a moderate amount of exchange rate flexibility does allow for some degree of monetary autonomy, especially in emerging and developing economies.

 

The more severe a financial crisis, the greater has been the likelihood of its management under an IMF-supported programme and the shorter the time from crisis onset to programme initiation. Political links to the United States have increased programme likelihood but have prompted faster response mainly for ‘major’crises. Over time, the IMF’s response has not been robustly faster, but the time sensitivity to the more severe crises and those related to fixed exchange rate regimes did increase from the mid-1980s. Similarly, democracies had tended to stall programme initiation but have become more supportive of financial markets’ demands for quicker action.

Reality and Illusion

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U.S. Senators and Representatives have urged President Obama to place the issue of currency manipulation on the agenda for the negotiations for the Trans-Pacific Partnership, a trade pact (see here). The lawmakers claim that China and Japan manipulate their exchange rates in order to boost exports at the expense of U.S. firms. In the current political environment, this may be the only issue on which there is bipartisan agreement.

The charge that China manipulates its exchange rate is less relevant today than it was several years ago. The Chinese currency has appreciated against the dollar since 2005, although the pace of this rise has moderated. Moreover, the Chinese have made clear that they will not accept linking exchange rates to trade talks. Blaming the Japanese for currency manipulation revives memories of the 1970s and 1980s when concerns about Japan’s economic might were common. The subsequent decline in Japan’s relative fortunes might give pause to those who fear Chinese predominance.

The fall in the value of the yen is due to “Abenomics,” the economic policies introduced by Japan’s Prime Minister Shinzo Abe after his election in December 2012 to stimulate the Japanese economy. These include aggressive monetary expansion by the Bank of Japan, which raised its inflation target to 2% and promised to double the size of the monetary base over a two-year period. Not surprisingly, this has led to a 25% depreciation of the yen against the dollar.

The U.S. lawmakers are responding to those developments. But they should be careful in their finger-pointing. The Federal Reserve’s Quantitative Easing 1, 2 and 3, which were implemented to stimulate the U.S. economy, led to charges of “currency wars” by foreign finance ministers. Barry Eichengreen, however, has pointed out that these policies were not implemented to depreciate the dollar but to stimulate the U.S. economy, and will have positive externalities for other nations. This differs from intervention in the foreign currency market undertaken to keep an exchange rate undervalued to boost exports. Bergsten and Gagnon claim that more than 20 countries manipulate their economies in this manner.

There is another interesting aspect of the U.S criticism. The prices of Japanese goods in the U.S. are determined by the real exchange rate, i.e., the nominal rate adjusted by the U.S. and Japanese price levels. Japanese prices have fallen in recent years, which by itself would result in a depreciation of the yen’s real exchange rate. The five-year averages of the annual rates of change in the Japanese and U.S. GDP deflators show this trend very clearly:

% GDP Deflator Japan U.S.
1998-2002 -1.06 1.78
2003-2007 -1.27 2.87
2008-2012 -1.34 1.78

The causes of Japanese deflation have been the subject of much research (and dispute): see, for example, here and here. Ito and Mishkin hold the Bank of Japan’s monetary policy largely responsible for the fall in prices during this period. The increase in the Bank of Japan’s targeted inflation rate is intended to break that trend.

But why didn’t U.S. officials criticize this aspect of Japanese monetary policy? Perhaps because the yen was appreciating in nominal terms, which partly offset the cumulative impact of the decline in Japanese prices on U.S.-Japanese trade (and was hardly evidence of a currency manipulator). But this may also be an example of the “money illusion” that exists with respect to exchange rates. Observers often overlook the distinction of real and nominal rates. The impact of Chinese inflation on the real exchange value of its currency, for example, is usually ignored or not understood (but see here). U.S. policymakers who confuse the two should not be surprised when their indignation is not met with a respectful response.

Here and There: October 3, 2013

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1. Jérémie Cohen-Sutton has a review at the Bruegel blog of the recent literature on the trilemma. He provides links to the relevant papers.

2. Michael Hutchison of the University of California-Santa Cruz and Helen Popper of the University of Santa Clara have organized this year’s West Coast Workshop on International Finance and Open Economy Macroeconomics on October 11. The program is here.